1. ©2009, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Eleven Commercial Banks: Industry Overview

2. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-2 McGraw-Hill/Irwin Commercial Banks Commercial banks are the largest group of financial institutions in terms of total assets Major assets are loans Major liabilities are deposits—thus, they are considered depository institutions Perform services essential to financial markets –play a key role in the transmission of monetary policy –provide payment services –provide maturity intermediation Banks are regulated to protect against disruptions to the services they perform Commercial banks are the largest group of financial institutions in terms of total assets Major assets are loans Major liabilities are deposits—thus, they are considered depository institutions Perform services essential to financial markets –play a key role in the transmission of monetary policy –provide payment services –provide maturity intermediation Banks are regulated to protect against disruptions to the services they perform

3. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-3 McGraw-Hill/Irwin Commercial Banks Differences in Balance Sheets of Com. Banks and Non Financial Firms

4. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-4 McGraw-Hill/Irwin Commercial Bank Assets Loans in 4 broad classes: business or commercial and industrial loans; commercial and residential real estate loans; individual loans (for auto purchases and credit card loans) all other loans (like the loans to emerging market countries) Loans generate revenue for banks –commercial and industrial loans are declining because of nonbank substitutes such as commercial paper –mortgages are increasing in importance Investment securities generate revenue and provide banks with liquidity (interest bearing deposits purchased from other Fıs, Fed Funds sold to other banks, RePOs, Treasury securities, municipal securities, mortgage backed securities and other debts and securities) Cash assets are held to meet reserve requirements and to provide liquidity Other assets include premises and equipment, other real estate owned, etc. Loans in 4 broad classes: business or commercial and industrial loans; commercial and residential real estate loans; individual loans (for auto purchases and credit card loans) all other loans (like the loans to emerging market countries) Loans generate revenue for banks –commercial and industrial loans are declining because of nonbank substitutes such as commercial paper –mortgages are increasing in importance Investment securities generate revenue and provide banks with liquidity (interest bearing deposits purchased from other Fıs, Fed Funds sold to other banks, RePOs, Treasury securities, municipal securities, mortgage backed securities and other debts and securities) Cash assets are held to meet reserve requirements and to provide liquidity Other assets include premises and equipment, other real estate owned, etc.

5. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-5 McGraw-Hill/Irwin Commercial Bank Assets

6. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-6 McGraw-Hill/Irwin Commercial Bank Assets Commercial banks face unique risks because of their asset structure –credit (default) risk is the risk that loans are not repaid –liquidity risk is the risk that depositors will demand more cash than banks can immediately provide –interest rate risk is the risk that interest rate changes erode net worth –credit, liquidity, and interest rate risk all contribute to a commercial bank’s level of insolvency risk Commercial banks face unique risks because of their asset structure –credit (default) risk is the risk that loans are not repaid –liquidity risk is the risk that depositors will demand more cash than banks can immediately provide –interest rate risk is the risk that interest rate changes erode net worth –credit, liquidity, and interest rate risk all contribute to a commercial bank’s level of insolvency risk

7. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-7 McGraw-Hill/Irwin Commercial Bank Assets Trend of the Assets in the US Banking Sector

8. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-8 McGraw-Hill/Irwin Commercial Bank Liabilities deposits + borrowed or other liability funds+owner equity Transaction accounts are the sum of noninterest-bearing demand deposits and interest-bearing checking accounts –interest bearing deposit accounts are called negotiable order of withdrawal (NOW) accounts Household (retail) savings and time deposits –passbook savings accounts –retail time deposits Large time deposits –negotiable CDs are fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market Transaction accounts are the sum of noninterest-bearing demand deposits and interest-bearing checking accounts –interest bearing deposit accounts are called negotiable order of withdrawal (NOW) accounts Household (retail) savings and time deposits –passbook savings accounts –retail time deposits Large time deposits –negotiable CDs are fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market

9. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-9 McGraw-Hill/Irwin Commercial Bank Liabilities & Equity Non-deposit liabilities –fed funds purchased –repos –notes and bonds Minimum levels of equity capital are required by regulators to act as a buffer against losses –common and preferred stock –surplus or additional paid-in capital –retained earnings Non-deposit liabilities –fed funds purchased –repos –notes and bonds Minimum levels of equity capital are required by regulators to act as a buffer against losses –common and preferred stock –surplus or additional paid-in capital –retained earnings

10. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-10 McGraw-Hill/Irwin Off-Balance-Sheet Activities The balance sheet itself does not reflect the total scope of bank activities. Under current accounting standards, such activities are not shown on the current balance sheet. Off balance sheet asset or liability will we a part of asset or liability after an activity or event occurs. Banks’ intention is to earn fee income and avoid regulatory “tax avoidance” as these activities do have tax avoidance incentives. P. 326, Table 11-2 is the summary of consolidated off balance sheet commitments of the US banks. The balance sheet itself does not reflect the total scope of bank activities. Under current accounting standards, such activities are not shown on the current balance sheet. Off balance sheet asset or liability will we a part of asset or liability after an activity or event occurs. Banks’ intention is to earn fee income and avoid regulatory “tax avoidance” as these activities do have tax avoidance incentives. P. 326, Table 11-2 is the summary of consolidated off balance sheet commitments of the US banks.

11. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-11 McGraw-Hill/Irwin Off-Balance-Sheet Activities Commercial banks engage in many fee-related activities that are conducted off the balance sheet –guarantees such as letters of credit –future commitments to lend –derivative transactions (e.g., futures, forwards, options, and swaps) Off-balance-sheet asset –when an event occurs, this item moves onto the asset side of the balance sheet or income is realized on the income statement Off-balance-sheet liability –when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement Commercial banks engage in many fee-related activities that are conducted off the balance sheet –guarantees such as letters of credit –future commitments to lend –derivative transactions (e.g., futures, forwards, options, and swaps) Off-balance-sheet asset –when an event occurs, this item moves onto the asset side of the balance sheet or income is realized on the income statement Off-balance-sheet liability –when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement

12. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-12 McGraw-Hill/Irwin Size, Structure and Composition of the Industry: Commercial Banks The Reigle-Neal Act of 1994 allowed nationwide branch networks to evolve –14,483 banks with some 60,000 branches in 1984 –7,350 banks with some 83,000 branches in 2007 The Financial Services Modernization Act of 1999 –gave commercial banks the full authority to enter the investment banking and insurance business Industrial loan corporations (ILCs) are considered “non-bank” banks A megamerger is a merger of commercial banks with assets of $1 billion or more The Reigle-Neal Act of 1994 allowed nationwide branch networks to evolve –14,483 banks with some 60,000 branches in 1984 –7,350 banks with some 83,000 branches in 2007 The Financial Services Modernization Act of 1999 –gave commercial banks the full authority to enter the investment banking and insurance business Industrial loan corporations (ILCs) are considered “non-bank” banks A megamerger is a merger of commercial banks with assets of $1 billion or more

13. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-13 McGraw-Hill/Irwin Commercial Banks Economies of Scale Economies of scale refer to the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase –diseconomies of scale occur when the costs of joint production of FI services are higher than they would be if they were produced independently Wells Fargo and First Interstate Bancorp is an example of potential diseconomies of scale due to the inability to integrate IT, cost was 180 million $. Economies of scale refer to the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase –diseconomies of scale occur when the costs of joint production of FI services are higher than they would be if they were produced independently Wells Fargo and First Interstate Bancorp is an example of potential diseconomies of scale due to the inability to integrate IT, cost was 180 million $.

14. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-14 McGraw-Hill/Irwin Commercial Banks Economies of scope refer to the degree to which a firm can generate cost synergies by producing multiple financial service products. Investment in one financial service area may have synergistic benefits in lowering the costs to produce financial services in other areas. X efficiencies refer to cost savings due to greater managerial efficiency Economies of scope refer to the degree to which a firm can generate cost synergies by producing multiple financial service products. Investment in one financial service area may have synergistic benefits in lowering the costs to produce financial services in other areas. X efficiencies refer to cost savings due to greater managerial efficiency

15. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-15 McGraw-Hill/Irwin Commercial Banks Retail banking is consumer-oriented –residential and consumer loans are funded by accepting small deposits –community banks specialize in retail banking Wholesale banking is commerce-oriented –commercial and industrial loans are often funded with purchased funds –regional or superregional banks engage in a complete array of wholesale banking activities –money center banks rely heavily on no deposit or borrowed sources of funds often borrowed in the federal funds market Retail banking is consumer-oriented –residential and consumer loans are funded by accepting small deposits –community banks specialize in retail banking Wholesale banking is commerce-oriented –commercial and industrial loans are often funded with purchased funds –regional or superregional banks engage in a complete array of wholesale banking activities –money center banks rely heavily on no deposit or borrowed sources of funds often borrowed in the federal funds market

16. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-16 McGraw-Hill/Irwin Commercial Banks Because larger banks generally lend to larger corporations, their interest rate spreads and net interest margins are usually narrower than those of smaller banks –interest rate spread is the difference between lending and deposit rates –net interest margin is interest income minus interest expense divided by earning assets Large banks tend to pay higher salaries and invest more in buildings and premises than small banks Large banks tend to diversify their operations more and generate more noninterest income than small banks Because larger banks generally lend to larger corporations, their interest rate spreads and net interest margins are usually narrower than those of smaller banks –interest rate spread is the difference between lending and deposit rates –net interest margin is interest income minus interest expense divided by earning assets Large banks tend to pay higher salaries and invest more in buildings and premises than small banks Large banks tend to diversify their operations more and generate more noninterest income than small banks

17. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-17 McGraw-Hill/Irwin Industry Performance U.S. commercial banks flourished during the economic expansion of the 1990s The economic downturn of the early 2000s caused performance to deteriorate only slightly By 2003 ROA and ROE had reached all-time highs In the fourth quarter of 2006 mortgage delinquencies (particularly subprime mortgages) surged Losses from falling values of subprime mortgages caused fourth quarter 2007 net income to hit a 16- year low U.S. commercial banks flourished during the economic expansion of the 1990s The economic downturn of the early 2000s caused performance to deteriorate only slightly By 2003 ROA and ROE had reached all-time highs In the fourth quarter of 2006 mortgage delinquencies (particularly subprime mortgages) surged Losses from falling values of subprime mortgages caused fourth quarter 2007 net income to hit a 16- year low

18. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-18 McGraw-Hill/Irwin Wholesale Banking Services Controlled disbursement accounts Account reconciliation Lockbox services Electronic lockbox Funds concentration Electronic funds transfer Check deposit services Electronic initiation of letters of credit Controlled disbursement accounts Account reconciliation Lockbox services Electronic lockbox Funds concentration Electronic funds transfer Check deposit services Electronic initiation of letters of credit Treasury management software Electronic data interchange Facilitating business-to- business e-commerce Electronic billing Verifying identities Assisting small business entries in e-commerce Treasury management software Electronic data interchange Facilitating business-to- business e-commerce Electronic billing Verifying identities Assisting small business entries in e-commerce

19. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-19 McGraw-Hill/Irwin Retail Banking Services Automated teller machines (ATMs) Point-of-sale (POS) debit cards Preauthorized debits and credits Paying bills via telephone Online banking Smart cards (stored-value) cards Internet banking –complements existing business for already existing banks –some new internet-only banks have no “brick and mortar” Automated teller machines (ATMs) Point-of-sale (POS) debit cards Preauthorized debits and credits Paying bills via telephone Online banking Smart cards (stored-value) cards Internet banking –complements existing business for already existing banks –some new internet-only banks have no “brick and mortar”

20. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-20 McGraw-Hill/Irwin Regulators The Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks The U.S. has a dual banking system—banks can be either nationally or state chartered –the Office of the Comptroller of the Currency (OCC) charters and regulates national banks –state agencies charter and regulate state banks The Federal Reserve System (FRS) has regulatory power over nationally chartered banks and their holding companies and state banks that opt in to the Federal Reserve System –a holding company is a parent company that owns a controlling interest in a subsidiary bank or other FI The Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks The U.S. has a dual banking system—banks can be either nationally or state chartered –the Office of the Comptroller of the Currency (OCC) charters and regulates national banks –state agencies charter and regulate state banks The Federal Reserve System (FRS) has regulatory power over nationally chartered banks and their holding companies and state banks that opt in to the Federal Reserve System –a holding company is a parent company that owns a controlling interest in a subsidiary bank or other FI

21. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-21 McGraw-Hill/Irwin International Commercial Banking Commercial banking has truly become an international and global market The four largest banks in the world, as of 2007, are from four different countries –UBS Group is a Swiss bank with $1.96 trillion in assets –Barclays Bank is a U.K. bank with $1.96 trillion in assets –BNP Paribas is a French bank with $1.90 trillion in assets –Citigroup is a U.S. bank with $1.88 trillion in assets Commercial banking has truly become an international and global market The four largest banks in the world, as of 2007, are from four different countries –UBS Group is a Swiss bank with $1.96 trillion in assets –Barclays Bank is a U.K. bank with $1.96 trillion in assets –BNP Paribas is a French bank with $1.90 trillion in assets –Citigroup is a U.S. bank with $1.88 trillion in assets

22. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-22 McGraw-Hill/Irwin International Commercial Banking Advantages of international expansion –risk diversification –economies of scale –distribute new product innovations internationally –opportunity to find the cheapest and most available sources of funds –service the needs of domestic multinational corporations –regulatory avoidance Advantages of international expansion –risk diversification –economies of scale –distribute new product innovations internationally –opportunity to find the cheapest and most available sources of funds –service the needs of domestic multinational corporations –regulatory avoidance

23. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-23 McGraw-Hill/Irwin International Commercial Banking Disadvantages of international expansion –information and monitoring costs are generally higher in foreign markets –foreign assets may be subject to nationalization or expropriation by host country governments –the fixed costs of establishing foreign organizations may be extremely high Disadvantages of international expansion –information and monitoring costs are generally higher in foreign markets –foreign assets may be subject to nationalization or expropriation by host country governments –the fixed costs of establishing foreign organizations may be extremely high

24. ©2009, The McGraw-Hill Companies, All Rights Reserved 11-24 McGraw-Hill/Irwin Global Banking Performance Banks in most regions of the world posted strong performance in the early and mid-2000s –mortgage lending boosted revenue in France and Spain –as personal bankruptcies rose worldwide, U.K. banks’ profitability was maintained because of diversification –in 2001 the Japanese government backed the purchase of $90 billion of shares of Japanese banks in an attempt to avert a banking collapse –the Chinese state-run banking system deteriorated in the early 2000s, which caused China to ease restrictions on foreign bank operations Banks in most regions of the world posted strong performance in the early and mid-2000s –mortgage lending boosted revenue in France and Spain –as personal bankruptcies rose worldwide, U.K. banks’ profitability was maintained because of diversification –in 2001 the Japanese government backed the purchase of $90 billion of shares of Japanese banks in an attempt to avert a banking collapse –the Chinese state-run banking system deteriorated in the early 2000s, which caused China to ease restrictions on foreign bank operations