1. Commercial Bank Operations
Chapter 17
Commercial Bank Operations
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2. Chapter Outline Commercial banks as financial intermediaries
Bank market structure
Bank sources of funds
Uses of funds by banks
Off-balance sheet activities
International banking

3. Commercial Banks as Financial Intermediaries
Commercial banks serve all types of surplus and deficit units
Offer deposit accounts with the size and maturity characteristics desired by surplus units
Repackage funds received from deposits to provide loans of the size and maturity desired by deficit units

4. Bank Market Structure (cont’d)
Benefits of diversified services to individuals and firms
Individuals and firms have various financial needs that they can now satisfy with one conglomerate
Some financial conglomerates specialize in the services desired by individuals or large firms
Benefits of diversified services to financial institutions
Financial institutions can reduce their reliance on the demand for any single service they offer
Diversification may result in less risk for the institution
The units of a financial conglomerate may generate some new business just because they offer convenience to clients who already rely on its other services

5. Bank Sources of Funds
A financial institution’s liabilities represent its sources of funds
Transaction deposits
A demand deposit account (checking account) is offered to customers who desire to write checks
A conventional account requires a small minimum balance and pays no interest
A negotiable order of withdrawal (NOW) account provides checking services as well as interest but requires a larger minimum balance
Electronic transactions
About two-thirds of all employees in the U.S. have direct deposit accounts
More than 60 percent of bank customers use ATMs
Debit cards and preauthorized debits can be used for recurring monthly payments

6. Bank Sources of Funds (cont’d)
Savings deposits
Until 1986, Regulation Q restricted the interest rate banks could offer on passbook savings
Ceilings prevented commercial banks from competing for funds during periods of higher interest rates
An automatic transfer service (ATS) account allows customers to maintain an interest-bearing savings account that automatically transfers funds to their checking account when checks are written

7. Bank Sources of Funds (cont’d)
Time deposits
Time deposits are deposits that cannot be withdrawn until a specified maturity date
Retail certificates of deposit (CDs) require a specified minimum amount of funds to be deposited for a specified period of time
Annualized interest rates vary among banks and maturity types
There is no organized secondary market
Depositors will normally forgo a portion of their interest as a penalty for early withdrawal

8. Bank Sources of Funds (cont’d)
Time deposits (cont’d)
Certificates of deposit (cont’d)
Bull-market CDs reward depositors if the market performs well
Bear-market CDs reward depositors if the market performs poorly
Callable CDs can be called by the financial institution early
Pay a slightly higher interest rates, which compensates depositors for risk
Negotiable certificates of deposit (NCDs):
Are offered by some large banks to corporations
Typically have short-term maturities
Typically require a minimum deposit of $100,000
Do not have a secondary market

9. Bank Sources of Funds (cont’d)
Money market deposit accounts (MMDAs):
Were created with the Garn-St Germain Act of 1982
Differ from conventional time deposits in that they do not specify a maturity
Are more liquid than retail CDs
Normally pay a lower rate than retail CDs
Differ from NOW accounts in that they provide limited check-writing ability

10. Bank Sources of Funds (cont’d)
Federal funds purchased
Federal funds purchased represent a liability to the borrowing banks and an asset to the lending bank that sells them
Loans in the federal funds market are typically for one to seven days
The intent of federal funds transactions is to correct short-term fund imbalances experienced by banks
The interest rate charged in the federal funds market is the federal funds rate
Typically between 0.25 percent and 1.00 percent above the T-bill rate
Banks that are short of required reserves on the average over a settlement period must compensate with additional reserves

11. Bank Sources of Funds (cont’d)
Borrowing from the Federal Reserve banks
The interest rate charged on loans from the Fed is the discount rate
Loans from the discount window are commonly from one day to a few weeks
The discount window is mainly used to resolve a temporary shortage of funds
Banks commonly borrow in the federal funds market instead of the discount window because the Fed may disapprove of continuous borrowing by a bank

12. Bank Sources of Funds (cont’d)
Repurchase agreements
A repurchase agreement (repo) represents the sale of securities by one party to another with an agreement to repurchase the securities at a specified date and price
Banks use repos as a source of funds when they need funds just for a few days
The bank sells some government securities to a corporation and buys those securities back later
Repos occur through a telecommunications network connecting large banks, corporations, government securities dealers, and federal funds brokers
Repo transactions are typically in blocks of $1 million
The repo yield is slightly less than the federal funds rate

13. Bank Sources of Funds (cont’d)
Eurodollar borrowing
Eurodollars are dollar-denominated deposits in banks outside the U.S.
Eurobanks are foreign banks or foreign branches of U.S. banks that accept large short-term deposits and make short-term loans in dollars
Bonds issued by the bank
Banks issue bonds to finance fixed assets
Common purchasers of bank bonds are households and various financial institutions
Banks finance less with bonds than other corporations

14. Bank Sources of Funds (cont’d)
Bank capital
Bank capital represents funds attained through the issuance of stock or through retained earnings
Represents the equity or net worth of the bank
Primary capital results from issuing common or preferred stock or retained earnings
Secondary capital results from issuing subordinated notes and bonds
Banks generally avoid issuing new stock because:
It dilutes the ownership of the bank
The bank’s reported EPS are reduced

15. Bank Sources of Funds (cont’d)

16. Uses of Funds by Banks Cash
Banks are required to hold some cash as reserves by reserve requirements imposed by the Fed
Banks hold cash to maintain some liquidity and accommodate withdrawal requests
Banks only hold as much cash as necessary because cash does not pay interest
Banks hold cash in vaults and in their Fed district bank

17. Uses of Funds by Banks (cont’d)
Bank loans
Loans are the main use of bank funds
Types of business loans
A working capital loan is designed to support ongoing business operations
Term loans are used to finance the purchase of fixed assets
Conditions by which the borrower must abide are protective covenants
Term loans are often amortized so that the borrower makes fixed payments
If the loan principal is paid off in one balloon payment, it is a bullet loan

18. Uses of Funds by Banks (cont’d)
Bank loans (cont’d)
Types of business loans (cont’d)
A direct lease loan involves purchasing the assets and leasing them to the firm
An informal line of credit allows the business to borrow up to a specified amount within a specified period of time
A revolving credit loan obligates the bank to offer up to some specified maximum amount of funds over a specified period of time
The interest rate charged by banks on loans to their most creditworthy customers is known as the prime rate

19. Uses of Funds by Banks (cont’d)
Bank loans (cont’d)
Loan participations
Several banks pool their available funds in a loan participation
One of the banks serves as the lead bank and other banks supply funds that are channeled to the borrower
The lead bank receives fees for servicing the loan in addition to its share of interest payments
All participating banks are exposed to credit risk

20. Uses of Funds by Banks (cont’d)
Bank loans (cont’d)
Collateral requirements on business loans
Commercial banks are increasingly accepting intangible assets as collateral
Lender liability on business loans
Business that previously obtained loans are filing lawsuits claiming that the banks terminated further financing without sufficient notice
Prevalent in the farming industry
Volume of business loans
Volume increased consistently throughout the 1990s and then declined in the 2001–2003 period

21. Uses of Funds by Banks (cont’d)
Bank loans (cont’d)
Types of consumer loans
Installment loans are used to finance purchases of cars and household products
Banks provide credit cards to customers
State regulators can impose usury laws to restrict the maximum rate of interest charged by banks
The interest rate charged on credit card loans and personal loans is typically much higher than the cost of funds
Many banks have used more lenient guidelines when assessing the creditworthiness of potential customers

22. Uses of Funds by Banks (cont’d)
Bank loans (cont’d)
Real estate loans
For residential real estate, the maturity on a mortgage is typically 15 to 30 years
Loans are backed by the residence purchased
Banks provide some commercial real estate loans to finance commercial development

23. Uses of Funds by Banks (cont’d)
Investments in securities
Banks purchase Treasury securities and government agency securities
Government agency securities:
Can be sold in the secondary market
Have a less active market than Treasury securities
Are not a direct obligation of the federal government
Are commonly issued by federal agencies such as Freddie Mac or Fannie Mae
Generate interest income that is subject to state and local income taxes
Banks purchase investment-grade corporate and municipal securities

24. Uses of Funds by Banks (cont’d)
Investments in securities (cont’d)
Bank investment in securities over time
Generally, banks hold securities that:
Offer a lower expected return than the loans they provide
Offer more liquidity and are subject to lower default risk than loans they provide
During weak economic conditions:
Firms are unwilling to expand
Banks extend fewer loans and increase their purchases of securities
In the 1990s, banks used a relatively high proportion of their funds for loans
In 2002, banks reduced their loans while increasing their investment in securities

25. Uses of Funds by Banks (cont’d)
Federal funds sold
Funds lent out will be returned at a specified time with interest
Small banks are common providers of funds in the federal funds market
Repurchase agreements
Banks can act as the lender on a repo by purchasing a corporation’s holdings of Treasury securities
Eurodollar loans
Eurodollar loans are provided by branches of U.S. banks located outside the U.S. and some foreign-owned banks
Fixed assets
Banks must maintain some amount of fixed assets so that they can conduct their business operations

26. Uses of Funds by Banks (cont’d)

27. Off-Balance Sheet Activities
Generate fee income without requiring an investment of funds
Create a contingent obligation for banks
Are required to be recognized as assets or liabilities and reported at fair market value
A loan commitment is an obligation by a bank to provide a specified loan amount to a particular firm upon the firm’s request
e.g., a note issuance facility (NIF) requires banks to purchase the commercial paper of a firm if the firm cannot place its paper in the market at an acceptable interest rate

28. Off-Balance Sheet Activities (cont’d)
A standby letter of credit (SLC) backs a customer’s obligation to a third party
A forward contract is an agreement between a customer and a bank to exchange one currency for another on a particular future date at a specified exchange rate
With a swap contract, two parties agree to periodically exchange interest payments on a specified notional amount of principal

29. International Banking (cont’d)
Global competition in foreign countries
U.S. banks have recently established foreign subsidiaries wherever they expect more foreign expansion by U.S. firms
e.g., Southeast Asia, Eastern Europe, and Latin America
As a result of NAFTA, U.S. banks have expanded their business into Mexico to:
Help finance the establishment of subsidiaries by U.S.-based corporations
Benefit from the increased international trade by offering banker’s acceptances and foreign exchange services
Offer credit card services and other households services in Mexico

30. International Banking (cont’d)
Impact of the euro on global competition
The euro has increased bank expansion throughout Europe because the euro:
Simplifies transactions
Reduces exposure to exchange rate risk
Encourages firms to engage in a bond or stock offering to support their European business
Makes it easier to achieve economies of scale and enables banks’ internal reporting systems to be more efficient
U.S. banks and European banks are expanding throughout Europe by acquiring existing banks