Chapter Eleven

1. Chapter Eleven Commercial Banks: Industry Overview McGraw-Hill/Irwin

2. 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 U.S. 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 McGraw-Hill/Irwin

3. Commercial Bank Assets • 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 • Cash assets are held to meet reserve requirements and to provide liquidity • Other assets include premises and equipment, other real estate owned, etc. McGraw-Hill/Irwin

4. 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 McGraw-Hill/Irwin

5. Commercial Bank Liabilities • 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 have been declining in recent years because of MMMFs • 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 McGraw-Hill/Irwin

6. 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 McGraw-Hill/Irwin

7. 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 McGraw-Hill/Irwin

8. 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 McGraw-Hill/Irwin

9. Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (IBBEA) • The interstate restrictions of the Bank Holding Company act were repealed. The IBBEA allowed interstate mergers between "adequately capitalized and managed banks, subject to concentration limits, state laws and Community Reinvestment Act (CRA) evaluations." • Financial holding companies continue to be prohibited from owning non-financial corporations in contrast to Japan and continental Europe. • Private equity firms started to provide many commercial banking services, by acquiring large ownership positions in non-financial corporations. McGraw-Hill/Irwin

10. Gramm–Leach–Bliley Act, Nov 1999 • Justification: individuals would be able to do both 'savings' and 'investment' at the same financial institution, which would be able to do well in both good and bad economic times. • Prior to the Act, most financial services companies were already offering both saving and investment opportunities to their customers. Norwest (later merged with Wells Fargo Bank) offered all types of financial services products in 1986. American Express attempted to enter all fields of financial business • Things culminated in 1998 when Citibank merged with Travelers Insurance creating CitiGroup. • The Gramm–Leach–Bliley Act repealing portions of the BHCA and the Glass–Steagall Act, allowing banks, brokerages, and insurance companies to merge, thus making the CitiCorp/Travelers Group merger legal. McGraw-Hill/Irwin

11. The Bank Holding Company Act • The Bank Holding Company Act of 1956 specified that the FED must approve the establishment of a BHC, and prohibited bank holding companies headquartered in one state from acquiring a bank in another state. • The law was to regulate and control banks that had formed bank holding companies in order to own both banking and non-banking businesses. The law generally prohibited a bank holding company from engaging in most non-banking activities or acquiring voting securities of certain companies that are not banks. McGraw-Hill/Irwin

12. Commercial Banks • A megamerger is a merger of commercial banks with assets of $1 billion or more • 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 • Economies of scope refer to the degree to which a firm can generate cost synergies by producing multiple financial service products • X efficiencies refer to cost savings due to greater managerial efficiency McGraw-Hill/Irwin

13. 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 nondeposit or borrowed sources of funds often borrowed in the federal funds market McGraw-Hill/Irwin

14. 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 McGraw-Hill/Irwin

15. 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 McGraw-Hill/Irwin

16. 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 Wholesale Banking Services McGraw-Hill/Irwin

17. 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” McGraw-Hill/Irwin

18. 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 McGraw-Hill/Irwin

19. 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 McGraw-Hill/Irwin

20. 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 McGraw-Hill/Irwin

21. 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 McGraw-Hill/Irwin

22. 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 McGraw-Hill/Irwin

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