The Basics of Commercial Banking The Bank Balance

The Basics of Commercial Banking: The Bank Balance Sheet The key commercial banking activities are taking deposits from savers & making loans. Bank’s primary sources/use of funds are deposits/loans, summarized in balance sheet (shows financial position on a particular day). The typical layout is based on: Assets (something owned) = Liabilities (something owed) + Equity (bank capital)

Bank Liabilities Checkable (transaction) deposits against which depositors write checks represent liabilities to banks and assets to households and firms. • Demand deposits pay NO interest. • Negotiable Order of Withdrawal (NOW) pay interest. Non-transaction deposits against which depositors cannot write checks • Savings accounts, money market deposit accounts (MMDA) & time deposits (CD) CD < $100 K are small-denomination time deposits. CD ≥ $100 K are large-denomination time deposits & negotiable, have 2 ndary market. • Checkable deposits & small-denomination CDs covered by FDIC (≤ $250 K). Borrowings to cover loans in excess of funds from depositors. • Short-term interbank loans borrowed at the federal funds rate • Loans from foreign branches or other subsidiaries or affiliates • Repos (banks sell clients securities, e. g. T-bills & repurchase them next day) During the financial crisis, bankruptcies of large firms left the counterparties to their repos with significant losses or a delay in accessing their funds, or both. • Discount loans from the Federal Reserve System. Bank Capital (Equity or Bank Net Worth) Sale of stock to shareholders + retained profits (≈13% of US banks assets in 2012).

Bank Assets Funds they: receive from depositors borrow from other institutions acquire initially from shareholders retain as profits from operations Reserves (the most liquid) = vault $ ($ on hand, including ATMs & with other banks) + bank deposits with the FED. Required (Fed regulated % of demand deposit and NOW accounts). Excess (above Fed required, important source of liquidity, soared in crisis). Cash in collection (claims on other banks for uncollected funds). Securities (banks cannot invest checkable deposits in corp bonds or common stock) Marketable liquid assets that banks trade in financial markets. From Treasury (called 2 ndary reserves due to liquidity), gov’t agencies & corp bonds. Loans (the largest category of bank assets) illiquid relative to marketable securities, with greater default risk and higher information costs. Business: commercial & industrial (40 to 20%↓ to commercial paper market in 80 s) Consumer: made to households for automobiles & other durable goods (stable %) Real estate: residential and commercial mortgages (30% in 1973, 60% in 2012).

The Rise and Fall and (Partial) Rise of the Checking Account Households hold less in checking accounts relative to other fin assets than before, partly due to the wealth effect. As wealth increased over time, households were better able to afford to hold assets, such as CDs, where their money was tied up for a while but on which they earned a higher rate of interest. During the 2007 -2009 financial crisis, checking account deposits increased. They provide a safe haven for households and small businesses because their funds are safe up to the $250, 000 federal deposit insurance ceiling.

Constructing a Bank Balance Sheet Bank capital as a percentage of assets = 231 / 2, 223 = 10. 04%

The Basic Operations of a Commercial Bank You open a checking account with $100 at Wells Fargo. With 10% reserve requirement, bank has $90 excess reserves. Bank uses its excess reserves to buy $30 T-bills and make $60 loan. Spread = average interest % on bank assets - average interest % on bank liabilities

Bank Capital and Bank Profits Net interest margin = spread / total value of its earning assets. Bank’s profits often expressed as return on assets ROA = (after-tax profit) / assets. Return on equity (managements performance) ROE = ROA (assets / capital) ROE = (after-tax profit) / capital. Bank Leverage = assets / capital Leverage Ratio = capital / assets Leverage magnifies relatively small ROAs into large ROEs. If bank’s loss or ROA = -3% , wit 8. 5 leverage, ROE = -0. 03*8. 5 = -25. 5%. If leverage = 35, ROE = -0. 03*8. 5 = -105% (small loss wipes out all capital). Moral hazard contributes to high bank leverage (if managers compensated for ROE, they may take on more risk than shareholders would prefer). FDIC increases moral hazard by reducing incentive for depositors to monitor banks. To deal with this risk, capital requirements regulations place limits on value of assets commercial banks can acquire relative to their capital.

Managing Bank Risk Liquidity risk = bank unable to get cash by selling assets or raising funds. Reduced with asset management (daily buying or revers Treasury repo), liquidity management (optimal borrowings mix using repos or discount loans). Credit risk = borrowers default on loans. Reduced by diversifying (instead of lending too much to a single borrower), credit-risk analysis (screening applicants, most banks now charge variable instead of prime rate (formerly 6 -month loans rate for high-quality borrowers), collateral (assets pledged to bank in default, reduce adverse selection), compensating balance (min checking account balance for business with loan), credit rationing (adverse selection – charging high rate when can’t distinguish high vs low risk borrowers, crowds out low, leaving only high risk loans), loan & credit limits (↓ moral hazard by ↑ of loan being repaid), monitoring restrictive covenants (prohibit certain activities by borrower), long-term relationships (use private info on borrowers to assess credit risk).

Interest-Rate Risk An ↑/↓ in market interest rate ↓/↑ present value of bank’s variable-% assets & liabilities. Gap analysis (v% assets - liabilities) = bank’s profit sensitivity to % change. Most banks’ gap < 0 (variable rates more likely for liabilities). With ↑ rates liability payments > v% asset earnings => lowering profit. Polktown National Bank gap = $150 M - $210 M = -$60 M. If rates ↑ 2%, v% assets earn. 02*$150 M = $3 M, liabilities pay. 02*$210 M = $4. 2 M, ↓ profits $1. 2 M, or using gap. 02(-$60 M) = -$1. 2 M. Duration analysis measures bank’s capital sensitivity to rate change. Most bank’s duration > 0 (assets have longer duration). Higher rates lower value of assets more, decreasing capital. Managing Interest-Rate Risk Banks issue more adjustable or floating-rate loans (to offset higher deposit rates) Banks use interest-rate swaps (exchange fixed-rate for adjustable-rate loan payments), futures and options.

History of U. S. Banking Dual banking system in US banks chartered by state or federal government (National Banking Act of 1863 allowed National banks). Bank panic (simultaneous bank runs) often prevented banks to return depositors’cash. After severe 1907 panic FED (lender of last resort to banks) is created with Federal Reserve Act in 1913. Following Great Depression panics FDIC is created in 1934. • In early 1900 s only instate banking allowed. In 1900, only 87 / 12, 427 commercial US banks had branches. No econ of scale for small, geographically limited banks. • Instate branching restrictions loosened after the mid-1970 s. • In 1994, the Riegle-Neal Interstate Banking & Branching Efficiency Act allowed phased interstate banking restrictions removal, consolidating banks. • In 2010, Congress discussed concerns about bank size (“too big to fail”) discussed, but no size limits were enacted.

Expanding the Boundaries of Banking Between 1960 and 2010, banks: 1. increased their funds and borrowings 2. relied less on C&I and consumer loans and more on real estate loans 3. expanded into nontraditional lending activities and generating fee’s revenues Off-balance-sheet activities do not affect assets or liabilities but generate fees: 1. Standby letter of credit is a promise by a bank to lend funds, if necessary, to a seller of commercial paper at the time that the commercial paper matures. 2. Loan commitment is an agreement by a bank to provide a borrower with a stated amount of funds during some specified period of time. 3. Loan sale is a financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party. 4. Trading activities earn fees from trading in multibillion-dollar derivatives markets. Bank losses from securities trading became a concern during 2007 -09 fin crisis.

Electronic Banking The first important development in electronic banking was the spread of ATMs. By mid-1990 s virtual banks (carry out all banking activities online) began to appear. By the mid-2000 s, most traditional banks had also begun providing online services. Check clearing is now done electronically. Checking account typically costs about $300 a year to maintain. In addition to loaning out depositors’ money, banks earn income from depositors by: 1) collecting fees from stores when debit cards are used, 2) charging overdraft fees, 3) collecting fees when depositors purchase financial products. Dodd-Frank Act of 2012 placed limits on fees for debit cards and overdrafts. Banks closed branches in lower-income neighborhoods, increased marketing to higher-income customers, raised min balance & charged for teller => ↑ use of ATMs Increased use of debit cards & smart phones to pay for goods => ↓ use of ATMs & $. In the face of the conflicting influences, the future of the ATM remains to be seen.

The Financial Crisis, TARP, and Partial Government Ownership of Banks As fin crisis unfolded, residential real estate mortgages began to decline in value. Mortgage-backed securities turned into “toxic assets”, difficult pricing in frozen market. Difficult to evaluate balance sheets and determine the true value of bank capital. Banks responded by tightening credit standards for consumer and commercial loans. Resulting credit crunch helped cause 2007 -09 recession, hard to fund spending. In Troubled Asset Relief Program Treasury purchased banks’ stock through Capital Purchase Program to inject capital into hundreds of troubled banks.