Chapter Eleven

1. Chapter Eleven Commercial Banks

2. Chapter Outline • Depository Institutions Definition • Typical Characteristics of Commercial Banks • Trends in Commercial Banks • Bank Size and Activities • Regulation

3. 1. Depository Institutions • Financial Institutions that: • Accept deposits (Insured by government) • Make loans • Have access to payment system • Are heavily regulated • Three major groups • Commercial banks • Savings institutions • Credit Unions

4. 2. Commercial Banks • Largest group of depository institutions • Major liability includes deposits; nondeposit sources of funds include subordinated notes and debentures • Loans are broader in range than savings and credit unions: commercial, real estate, consumer, etc. • Deposits insured by FDIC • Regulated separately from savings institutions and credit unions: Federal Reserve, Office of the Comptroller of the Currency (OCC), FDIC

5. Differences in Balance Sheets Depository Institutions Nonfinancial Firms Assets LiabilitiesAssets Liabilities Loans Deposits Deposits Loans Other Other financial financial assets assets Other Other Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity

6. Commercial Bank Balance Sheet (b$, 2004) Assets Total cash assets………………. $ 416.9 U.S. gov securities…………… $ 1047.4 Fed Funds/Repurchase………. 384.6 Other…………………………. 447.3 Investment securities………….. 1,879.3 Interbank loans………………. 193.6 Loans exc. Interbank………… 4624.3 Comm. and Indust…………..$ 890.1 Real estate…………………… 2,544.9 Individual……………………. 806.3 All other……………………… 383.0 Less: Reserve for losses……… 78.1 Total loans……………………… $4,739.8 Other assets…………………….. 1,208.4 Total assets…………………….. $8,244.4

7. Commercial Bank Balance Sheet (b$, 2004) Liabilities and Equity Transaction accounts…………… $ 716.9 Nontransaction accounts………... 4,689.1 Total deposits…………………… $5,406.0 Borrowings……………………… 1,769.6 Other liabilities………………….. 247.4 Total liabilities………………….. $7,423.4 Equity…………………………… 821.4

8. Commercial Bank Balance Sheet (2004) Assets Total cash assets………………. 5.1% U.S. gov securities…………… 12.7% Fed Funds/Repurchase………. 4.7% Other…………………………. 5.4% Investment securities………….. 22.8% Interbank loans………………. 2.3% Loans exc. Interbank………… 56.1% Comm. and Indust………….. 10.8% Real estate…………………… 30.9% Individual……………………. 9.8% All other……………………… 4.6% Less: Reserve for losses……… 0.9% Total loans……………………… 57.5% Other assets…………………….. 14.6% Total assets…………………….. 100%

9. Commercial Bank Balance Sheet (2004) Liabilities and Equity Transaction accounts…………… 8.7% Nontransaction accounts………... 56.8% Total deposits…………………… 65.5% Borrowings……………………… 21.5% Other liabilities………………….. 3.0% Total liabilities………………….. 90.0% Equity…………………………… 10.0%

10. Industry Performance • A well run bank usually has an ROA of 0.5% to 3%. • To get an acceptable ROE, banks must resort to using a very high amount of leverage; the debt/asset ratio at a bank is usually over 90%. • The average ROA and ROE for commercial banks in 2003 is 1.40% and 15.31%, respectively, compared to 1989 when ROA and ROE averaged 0.49% and 7.71%.

11. 2.1 Trends in Commercial Banks • Portfolio Shift • As a percentage of the typical bank’s balance sheet, over the last 50 years, mortgages have risen and securities have fallen • Loss of Market Share • 20 years ago banks had 40% share • 10 years ago banks had 26% share • Today banks have 19% share

12. 2.2 Trends in Commercial Banks • Movement toward off-balance sheet activities • Movement away from net spread income (interest income minus interest expense) • Movement toward fee income

13. Balance Sheet Items • Assets • loans and investment securities • Liabilities • transaction accounts - the sum of noninterest-bearing demand deposits and interest-bearing checking accounts • NOW account - an interest-bearing checking account • negotiable CDs - fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market • Equity • common and preferred stock, surplus or additional paid-in capital, and retained earnings

14. Examples of Off-Balance Sheet Activities • Loan commitments • promises to make loans in return for fees • Trust services • generates fees by holding and managing individuals or corporations assets • Correspondent banking • generates fees by provision of banking services to other banks

15. 2.3 Trends in Commercial Banks • Consolidation • Number of Banks • 1989 12,709 • 1993 10,958 • 1999 8,579 • 2001 8,080 • 2004 7,660

16. Economies of Scale and Scope • Economies of scale • the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase • Economies of scope • the degree to which a firm can generate cost synergies by producing multiple financial service products • X efficiencies • cost savings due to the greater managerial efficiency of the acquiring firm

17. 4. Commercial Banks by Asset Size (2004)

18. Bank Size Classifications • Community bank - a small bank that frequently specializes in retail or consumer banking • Regional bank - a mid-sized bank that engages in a complete array of wholesale commercial banking activities • Super regional bank – a large regional bank – usually does business in more than one state • Money center bank - a bank that relies heavily on nondeposit or borrowed sources of funds • Financial conglomerate – a large bank that does a lot of other financial activities – investment banking, insurance etc.

19. Bank Size and Activities • Large banks have easier access to capital markets and can operate with lower amounts of equity capital • Large banks tend to have fewer core deposits • Large banks lend to larger corporations which means that their interest rate spread is narrower • Large banks are more diversified, have more off-balance-sheet activities and generate more noninterest income

20. Bank Size and Concentration • Wholesale banking • provide commercial and industrial loans funded with purchased funds • Retail banking • provide residential and consumer loans and accepting small deposits

21. Wholesale Banking Services • Controlled disbursement accounts • Account reconciliation • Lockbox services • Electronic lockbox • Funds concentration • Electronic funds transfer • Check deposit services

22. Wholesale Banking Services (cont..) • Electronic initiation of letters of credit • Treasury management software • Electronic data interchange • Facilitate business-to-business e-commerce • Electronic billing • Verifying identities • Assist small business entry in e-commerce

23. Retail Banking Services • Automated teller machines (ATMs) • Point-of-sale debit (POS) cards • Preauthorized debits/credits • Paying bills via telephone • On-line banking • Smart cards (stored-value cards)

24. 5. Regulators • Federal Deposit Insurance Corporation (FDIC) • insures the deposits of commercial banks • Office of the Comptroller of the Currency (OCC) • function is to charter national banks as well as close them • has the power to approve/disapprove of mergers • Federal Reserve System • requires all banks to meet the same noninterest-bearing reserve requirements • State Authorities • performs for state chartered banks similar functions as the OCC does for national banks