Commercial Bank Operations

1. 17 Commercial Bank Operations

2. Chapter Objectives • Describe the most common sources of funds for commercial banks • Describe the most common uses of funds for commercial banks • Describe typical off-balance sheet activities for commercial banks

3. Bank Participation in Financial Conglomerates • Impact of the Financial Services Modernization Act (1999) • Banks and other financial service firms were given more freedom to merge and offer a range of financial services • Insurance • Securities services • Banks now a subsidiary of financial conglomerates

4. Bank Participation in Financial Conglomerates • Benefits of diversified services to individuals and firms • Individuals can obtain all their financial services at a single financial conglomerate • Deposits • Loans • Investing (brokerage) • Insurance • Businesses can obtain loans, issue stocks and bonds, and have their pension fund managed by the same institution

5. Bank Participation in Financial Conglomerates • Benefits of diversified services to the financial institution • Reduce reliance on demand for single service • Economies of scale and scope • Diversification (service and geographical) may result in less risk • Generate new business

6. Bank Sources of Funds • Transaction deposits • Demand deposit account (checking) • Savings Deposits • Passbook savings

7. Bank Sources of Funds • Time Deposits • Certificate of deposit (CD) • No secondary market • Negotiable CD • Short-term, minimum $100,000 • Can trade among investors via dealer • Money Market Deposit Accounts (MMDAs) • More liquid than CDs : no specified maturity • Limited check writing • Created in 1982

8. Bank Sources of Funds • Federal Funds Purchased • Short-term loans between banks • Allows banks to meet reserve requirement or funding needs • Interest rate charged is the federal funds rate • Borrowing from the Federal Reserve Banks • Borrowing at the discount window • Discount rate • Intended for meeting temporary short-term reserve requirement needs • Must get Fed approval

9. Bank Sources of Funds • Repurchase agreements • Sale of securities by one party to another with an agreement to repurchase the securities at a specified date and price • Banks may sell T-bills to a corporation with temporary excess cash (bank demand deposit) and then buy them back later • Source of funds for a few days • Collateralized by the treasury bills

10. Bank Sources of Funds • Eurodollar borrowings • Banks outside the United States make dollar-denominated loans • Eurodollar market is very large • Bonds issued by the bank • Like other businesses, banks issue bonds to finance long-term fixed assets • Usually subordinated to deposits • Part of secondary regulatory capital

11. Bank Sources of Funds • Bank capital • Obtained from issuing stock or retaining earnings • No obligation to pay out funds in the future • Must be sufficient to absorb operating losses

12. Uses of Funds by Banks • Loans make up about 64 percent of bank assets, while all securities make up about 22 percent of assets. Cash represents 6 percent of bank assets. • Cash and “due from” balances at institutions • Currency/coin provided via banks • Reserve requirements imposed by Fed • Tool for controlling the money supply • Due from Fed and vault cash count as reserves • Also hold cash and due from balances to maintain liquidity and accommodate withdrawal requests by depositors

13. Uses of Funds by Banks • Bank Loans • Types of business loans • Working capital loans • Term loans • Purchasing fixed assets • Protective covenants • Informal line of credit • Revolving credit loan

14. Uses of Funds by Banks • Bank Loans • Loan participations • Sometimes large firms seek to borrow more money than an individual bank can provide • Lead bank • Loans supporting leveraged buyouts • Banks charge a high loan rate • Monitored by bank regulators

15. Uses of Funds by Banks • Bank Loans • Collateral requirements on business loans • Increasingly accepting intangible assets • Important to service-oriented firms • Increased lending risk with service businesses--telecomm • Types of consumer loans • Installment loans • Credit cards • Real estate loans

16. Uses of Funds by Banks • Investment securities (bank income and liquidity) • Treasury securities • Government agency securities • Freddie Mac • Fannie Mae • Corporate and municipal securities • Investment grade only • Federal funds sold • Lending funds in the federal funds market

17. Uses of Funds by Banks • Repurchase agreements • Eurodollar loans • Branches of U.S. banks located outside of the U.S. • Foreign-owned banks • Fixed assets • Office buildings • Land

18. Off-Balance Sheet Activities • Loan commitments • Obligation of bank to provide a specified loan amount to a particular business upon request • Note issuance facility (NIF) • Banks earn fee income for risk assumed • Standby letters of credit (SLC) • Backs a customer’s obligation to a third party • Banks earn fee income

19. Off-Balance Sheet Activities • Forward contracts • Agreement between a customer and bank to exchange one currency for another on a particular future date at a specified exchange rate • Allows customers to hedge their exchange-rate risk

20. Off-Balance Sheet Activities • Swap contracts • Two parties agree to periodically exchange interest payments on a specified notional amount of principal • Banks serve as intermediaries or dealer and/or guarantor for a fee