Chapter Eleven Commercial Banks Industry Overview Learning Goals

Chapter Eleven Commercial Banks: Industry Overview Learning Goals LG 11 -1 Define what a commercial bank is. LG 11 -2 Identify the main assets held by commercial banks. LG 11 -3 Identify the main liabilities held by commercial banks. LG 11 -4 Understand the types of off-balance sheet activities that commercial banks undertake. LG 11 -5 Discuss which factors have motivated the signifiant decrease in the number of commercial banks. LG 11 -6 Evaluate the performance of the commercial banking industry in recent years LG 11 -7 Know the main regulators of commercial banks. LG 11 -8 Lis the world’s biggest banks. Mc. Graw-Hill/Irwin 8 -1 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Commercial Banks / Depository Institutions • 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 Mc. Graw-Hill/Irwin 11 -2 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Balance Sheet Structures of Commercial Banks vs. Nonfinancial Firms Mc. Graw-Hill/Irwin 11 -3 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Commercial Bank Assets • 1. 2. 3. 4. • • 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, Re. POs, 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. Mc. Graw-Hill/Irwin 11 -4 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Commercial Bank Assets and Risks • 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 Mc. Graw-Hill/Irwin 11 -5 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

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 A savings account is an interest-bearing deposit account held at a bank or another financial institution that provides a modest interest rate. Banks or financial institutions may limit the number of withdrawals you can make from your savings account each month Large time deposits – Mainly negotiable CDs which are fixed-maturity interest-bearing deposits with face values of $100, 000 or more that can be resold in the secondary market. Mc. Graw-Hill/Irwin 11 -6 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Commercial Bank Liabilities & Equity • Non-deposit liabilities 1. Fed funds purchased 2. Repos (seller) 3. Notes and bonds (seller) • 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 Mc. Graw-Hill/Irwin 11 -7 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

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. Mc. Graw-Hill/Irwin 11 -8 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Off-Balance-Sheet Activities • 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 Mc. Graw-Hill/Irwin 11 -9 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Size, Structure and Composition of the Industry: Commercial Banks • The number of banks in the USA is decreasing: 6, 676 banks in 2010. – 14, 483 banks with some 60, 000 branches in 1984 – 7, 350 banks with some 83, 000 branches in 2007 • Strict regulations imposed on commercial banks limited geographical diversification opportunities. Mc. Graw-Hill/Irwin 11 -10 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Commercial Banks Bank Size and Concentration • • • Retail banking /community banks (small or community banks with less than 1 billion in asset size) and specializes in retail or consumer banking. – They provide residential and consumer loans and accepting smaller deposits. Large banks in terms of their assets size are called: Wholesale banking is commerce-oriented – commercial and industrial loans are often funded with purchased funds – Some of the very biggest banks are classified as being: – money center banks that rely heavily on no deposit or borrowed sources of funds often borrowed in the federal funds market – Federal fund market: an interbank market for short term borrowing and lending of bank reserves. – Money center banks are also major participants in foreign currency markets and are therefore subject to foreign exchange risk Mc. Graw-Hill/Irwin 11 -11 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Commercial Banks Bank Size and Concentration – It is important to note that asset or lending size does not necessarily make a bank a money center bank. – Classification as a money center bank is based in part on: * location of the bank. Specifically, a money center bank is a bank located in a major financial center (e. g. , New York) *the bank’s heavy reliance on non-deposit or borrowed sources of funds that heavily relies on both national and international money markets for its source of funds Mc. Graw-Hill/Irwin 11 -12 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Commercial Banks Bank Size and Concentration Main differences between small banks and large banks: – small banks generally hold fewer off-balance-sheet assets and liabilities than large banks. – large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits than small banks – large banks lend to larger corporations which means that interest rate spreads and net interest margins are usually narrower than those of smaller banks because the risk is lower in large corporation than small businesses. – interest rate spread is the difference between lending and deposit rates Mc. Graw-Hill/Irwin 11 -13 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Commercial Banks Bank Size and Activities • 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 than small banks. Mc. Graw-Hill/Irwin 11 -14 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

Regulators FDIC+OCC+FRS+State Authorities • The Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks • The U. S. has a dual banking system: national banks / state banks • 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 who are members of the Federal Reserve System Mc. Graw-Hill/Irwin 11 -15 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

International Commercial Banking Advantages 1. risk diversification diversify the risk of its earnings flows. 2. economies of scale lower its average operating costs by expanding its activities beyond domestic boundaries. 3. distribute new product innovations internationally 4. opportunity to find the cheapest and most available sources of funds 5. regulatory avoidance such as activity restrictions and reserve requirements or taxes impose constraints, with globalization they can operate in low-regulatory, low-tax countries. Mc. Graw-Hill/Irwin 11 -16 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved

International Commercial Banking Disadvantages – information and monitoring costs are generally higher in foreign markets Mc. Graw-Hill/Irwin 11 -17 © 2009, The Mc. Graw-Hill Companies, All Rights Reserved