Text book Problems

17 Commercial Bank Operations

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the market structure of commercial banks,

· ▪ describe the most common sources of funds for commercial banks,

· ▪ explain the most common uses of funds for commercial banks, and

· ▪ describe typical off-balance sheet activities for commercial banks.

Measured by total assets, commercial banks are the most important type of financial intermediary. Like other financial intermediaries, they perform the critical function of facilitating the flow of funds from surplus units to deficit units.

17-1 BACKGROUND ON COMMERCIAL BANKS

Up to this point, the text has focused on the role and functions of financial markets. From this point forward, the emphasis is on the role and functions of financial institutions. Recall from  Chapter 1  that financial institutions commonly facilitate the flow of funds between surplus units and deficit units. Commercial banks represent a key financial intermediary because they serve all types of surplus and deficit units. They offer deposit accounts with the size and maturity characteristics desired by surplus units. They repackage the funds received from deposits to provide loans of the size and maturity desired by deficit units. They have the ability to assess the creditworthiness of deficit units that apply for loans, so they can limit their exposure to credit (default) risk on the loans they provide.

17-1a Bank Market Structure

In 1985, more than 14,000 banks were located in the United States. Since then, the market structure has changed dramatically. Banks have been consolidating for several reasons. One reason is that interstate banking regulations were changed in 1994 to allow banks more freedom to acquire other banks across state lines. Consequently, banks in a particular region are now subject to competition not only from other local banks but also from any bank that may penetrate that market. This has prompted banks to become more efficient in order to survive. They have pursued growth also as a means of capitalizing on economies of scale (lower average costs for larger scales of operations) and enhanced efficiency. Acquisitions have been a convenient way to grow quickly.

   As a result of this trend, there are less than half as many banks today as there were in 1985, and consolidation is still occurring.  Exhibit 17.1  shows how the number of banks has declined over time, thereby increasing concentration in the banking industry. The largest 100 banks now account for about 75 percent of all bank assets versus about 50 percent in 1985. The largest five banks now account for more than 50 percent of bank assets, versus 30 percent in 2001. JPMorgan Chase & Company is the largest bank in the United States with about $2.3 trillion in assets, while Bank of America Corporation has about $2.2 trillion in assets and Citigroup Inc. has about $1.9 trillion in assets.

   Large banks have expanded over time by acquiring other banks. They also acquired many other types of financial service firms in recent years.

Exhibit 17.1 Consolidation among Commercial Banks over Time

   Many banks are owned by bank holding companies, which are companies that own at least 10 percent of a bank. The holding company structure allows more flexibility to borrow funds, issue stock, repurchase the company's own stock, and acquire other firms. Bank holding companies may also avoid some state banking regulations.

   The operations, management, and regulation of a commercial bank vary with the types of services offered. Therefore, the different types of financial services (such as banking, securities, and insurance) are discussed in separate chapters. This chapter on commercial bank operations applies to independent commercial banks as well as to commercial bank units that are part of a financial conglomerate formed by combining a bank and other financial services firms.

   The traditional role of a bank was to serve depositors who want to deposit funds and borrowers who want to borrow funds. Banks charge a higher interest rate on funds loaned out than the interest rate they pay on deposits. The difference in interest between loans and deposits must be sufficient to cover other expenses (such as salaries) and generate a reasonable profit for the bank's owners. Although banks have become much more sophisticated over time, the traditional role still applies.

   The primary operations of commercial banks can be most easily identified by reviewing their main sources of funds, their main uses of funds, and the off-balance sheet activities that they provide, as explained in this chapter.

17-2 BANK SOURCES OF FUNDS

WEB

www.fdic.gov

Statistics on bank sources and uses of funds.

To understand how any financial institution (or subsidiary of that institution) obtains funds and uses funds, its balance sheet can be reviewed. The institution's reported liabilities and equity indicate its sources of funds, and its reported assets indicate its uses of funds. The major sources of commercial bank funds are summarized as follows.

Deposit Accounts

· 1. Transaction deposits

· 2. Savings deposits

· 3. Time deposits

· 4. Money market deposit accounts

Borrowed Funds

· 1. Federal funds purchased (borrowed)

· 2. Borrowing from the Federal Reserve banks

· 3. Repurchase agreements

· 4. Eurodollar borrowings

Long-Term Sources of Funds

· 1. Bonds issued by the bank

· 2. Bank capital

Each source of funds is briefly described in the following subsections.

17-2a Transaction Deposits

A  demand deposit account , or checking account, is offered to customers who desire to write checks against their account. A conventional demand deposit account requires a small minimum balance and pays no interest. From the bank's perspective, demand deposit accounts are classified as transaction accounts that provide a source of funds that can be used until withdrawn by customers (as checks are written).

   Another type of transaction deposit is the  negotiable order of withdrawal (NOW) account , which pays interest as well as providing checking services. Because NOW accounts at most financial institutions require a larger minimum balance than some consumers are willing to maintain in a transaction account, traditional demand deposit accounts are still popular.

Electronic Transactions  Some transactions originating from transaction accounts have become much more efficient as a result of electronic banking. Most employees in the United States have direct deposit accounts, which allow their paychecks to be directly deposited to their transaction account (or other accounts). Social Security recipients have their checks deposited directly to their bank accounts. Computer banking enables bank customers to view their bank accounts online, pay bills, make credit card payments, order more checks, and transfer funds between accounts.

   Bank customers use automated teller machines (ATMs) to make withdrawals from their transaction accounts, add deposits, check account balances, and transfer funds. Debit cards allow bank customers to use a card when making purchases and have their bank account debited to reflect the amount spent. Banks also allow preauthorized debits, in which specific periodic payments are automatically transferred from a customer's bank account to a particular recipient. Preauthorized debits are commonly used to cover recurring monthly expenses such as utility bills, car loan payments, and mortgage payments.

17-2b Savings Deposits

The traditional savings account is the passbook savings account, which does not permit check writing. Passbook savings accounts continue to attract savers with a small amount of funds, as such accounts often have no required minimum balance.

17-2c Time Deposits

Time deposits are deposits that cannot be withdrawn until a specified maturity date. The two most common types of time deposits are certificates of deposit (CDs) and negotiable certificates of deposit.

Certificates of Deposit  A common type of time deposit is a retail certificate of deposit (or retail CD), which requires a specified minimum amount of funds to be deposited for a specified period of time. Banks offer a wide variety of CDs to satisfy depositors' needs. Annualized interest rates offered on CDs vary among banks and even among maturity types at a single bank. There is no secondary market for retail CDs. Depositors must leave their funds in the bank until the specified maturity or forgo a portion of their interest as a penalty.

   The rates offered by CDs are easily accessible on numerous websites. For example, Bank-Rate ( www.bankrate.com ) and Bank CD-Rate Scanner ( www.bankcd.com ) identify banks that are currently paying the highest rates on CDs. Because of easy access to CD rate information online, many depositors invest in CDs at banks far away to earn a higher rate than that offered by local banks. Some banks allow depositors to invest in CDs online by providing a credit card number.

   In recent years, some financial institutions have begun to offer CDs with a callable feature (referred to as callable CDs). That is, they can be called by the financial institution, forcing an earlier maturity. For example, a bank could issue a callable CD with a five-year maturity, callable after two years. In two years, the financial institution will likely call the CD if it can obtain funds at a lower rate over the following three years than the rate paid on that CD. Depositors who invest in callable CDs earn a slightly higher interest rate, which compensates them for the risk that the CD may be called.

Negotiable Certificates of Deposit  Another type of time deposit is the  negotiable CD (NCD) , which is offered by some large banks to corporations. Negotiable CDs are similar to retail CDs in that they have a specified maturity date and require a minimum deposit. Their maturities are typically short term, and their minimum deposit requirement is $100,000. A secondary market for NCDs does exist.

   The level of large time deposits is much more volatile than that of small time deposits, because investors with large sums of money frequently shift their funds to wherever they can earn higher rates. Small investors do not have as many options as large investors and are less likely to shift in and out of small time deposits.

17-2d Money Market Deposit Accounts

    Money market deposit accounts (MMDAs)  differ from conventional time deposits in that they do not specify a maturity. From the depositor's point of view, MMDAs are more liquid than retail CDs but offer a lower interest rate. They differ from NOW accounts in that they provide limited check-writing ability (a limited number of transactions is allowed per month), require a larger minimum balance, and offer a higher yield.

   The remaining sources of funds to be described are of a nondepository nature. Such sources are necessary when a bank temporarily needs more funds than are being deposited. Some banks use nondepository funds as a permanent source of funds.

17-2e Federal Funds Purchased

The federal funds market allows depository institutions to accommodate the short-term liquidity needs of other financial institutions. Federal funds purchased (or borrowed) represent a liability to the borrowing bank and an asset to the lending bank that sells them. Loans in the federal funds market are typically for one to seven days. Such loans can be rolled over so that a series of one-day loans can be made. The intent of federal funds transactions is to correct short-term fund imbalances experienced by banks. A bank may act as a lender of federal funds on one day and as a borrower shortly thereafter, since its fund balance changes on a daily basis.

   The interest rate charged in the federal funds market is called the  federal funds rate . Like other market interest rates, it moves in reaction to changes in demand or supply or both. If many banks have excess funds and few banks are short of funds, the federal funds rate will be low. Conversely, a high demand by many banks to borrow in the federal funds market combined with a small supply of excess funds available at other banks will result in a higher federal funds rate. The federal funds rate is typically the same for all banks borrowing in the federal funds market, although a financially troubled bank may have to pay a higher rate. The federal funds rate is quoted on an annualized basis (using a 360-day year) even though the loans are usually for terms of less than one week. This rate is typically close to the yield on a Treasury security with a similar term remaining until maturity. The federal funds market is typically most active on Wednesday, because that is the final day of each particular settlement period for which each bank must maintain a specified volume of reserves required by the Fed. Banks that were short of required reserves on average over the period must compensate with additional required reserves before the settlement period ends. Large banks frequently need temporary funds and therefore are common borrowers in the federal funds market.

17-2f Borrowing from the Federal Reserve Banks

WEB

www.neworkfed.org/markets/markets/omo/dmm/fedfundsdata.cfm

Information about bank borrowing in the federal funds market.

Another temporary source of funds for banks is the Federal Reserve System, which serves as the U.S. central bank. Along with other bank regulators, the Federal Reserve district banks regulate certain activities of banks. They also provide short-term loans to banks (as well as to some other depository institutions). This form of borrowing by banks is often referred to as borrowing at the discount window. The interest rate charged on these loans is known as the  primary credit lending rate .

   As of January 2003, the primary credit lending rate was to be set at a level that always exceeded the federal funds rate. This was intended to ensure that banks rely on the federal funds market for normal short-term financing and borrow from the Fed only as a last resort.

   Loans from the Federal Reserve are short term, commonly from one day to a few weeks. To ensure there is a justifiable need for the funds, banks that wish to borrow at the Federal Reserve must first obtain the Fed's approval. Like the federal funds market, loans from the Fed are mainly used to resolve a temporary shortage of funds. If a bank needs more permanent sources of funds, it will develop a strategy to increase its level of deposits.

   The Federal Reserve is intended to be a source of funds for banks that experience unanticipated shortages of reserves. Frequent borrowing to offset reserve shortages implies that the bank has a permanent rather than a temporary need for funds and should therefore satisfy this need with a more permanent source of funds. The Fed may veto continuous borrowing by a bank unless there are extenuating circumstances that prevent the bank from obtaining temporary financing from other financial institutions.

17-2g Repurchase Agreements

A  repurchase agreement (repo)  represents the sale of securities by one party to another with an agreement to repurchase the securities at a specified date and price. Banks often use a repo as a source of funds when they expect to need funds for just a few days. The bank simply sells some of its government securities (such as Treasury bills) to a corporation with a temporary excess of funds and buys those securities back shortly thereafter. The government securities involved in the repo transaction serve as collateral for the corporation providing funds to the bank.

   Repurchase agreement transactions occur through a telecommunications network connecting large banks, other corporations, government securities dealers, and federal funds brokers. The federal funds brokers match up firms or dealers that need funds (wish to sell and later repurchase their securities) with those that have excess funds (are willing to purchase securities now and sell them back on a specified date). Transactions are typically in blocks of $1 million. Like the federal funds rate, the yield on repurchase agreements is quoted on an annualized basis (using a 360-day year) even though the loans are for short-term periods. The yield on repurchase agreements is slightly less than the federal funds rate at any given time because the funds loaned out are backed by collateral and are therefore less risky.

17-2h Eurodollar Borrowings

If a U.S. bank is in need of short-term funds, it may borrow dollars from those banks outside the United States (typically in Europe) that accept dollar-denominated deposits, or  Eurodollars . Some foreign banks (or foreign branches of U.S. banks) accept large short-term deposits and make short-term loans in dollars. Because U.S. dollars are widely used as an international medium of exchange, the Eurodollar market is very active.

17-2i Bonds Issued by the Bank

Like other corporations, banks own some fixed assets such as land, buildings, and equipment. These assets often have an expected life of 20 years or more and are usually financed with such long-term sources as the issuance of bonds. Common purchasers of these bonds are households and various financial institutions, including life insurance companies and pension funds. Banks finance less with bonds than do most other corporations because they have fewer fixed assets than corporations that use industrial equipment and machinery for production. Therefore, banks have less need for long-term funds.

17-2j Bank Capital

Bank capital generally represents funds acquired by the issuance of stock or the retention of earnings. In either case, the bank has no obligation to pay out funds in the future. This distinguishes bank capital from all the other sources of funds, which represent a future obligation by the bank to pay out funds. Bank capital as defined here represents the equity or net worth of the bank. Capital can be classified as primary or secondary. Primary capital results from issuing common or preferred stock or retaining earnings, whereas secondary capital results from issuing subordinated notes and bonds.

   A bank's capital must be sufficient to absorb operating losses in the event that expenses or losses exceed revenues, regardless of the reason for the losses. Although long-term bonds are sometimes considered to be secondary capital, they are a liability to the bank and therefore do not appropriately cushion against operating losses.

   Although the issuance of new stock increases a bank's capital, it dilutes the bank's ownership because the proportion of the bank owned by existing shareholders decreases. A bank's reported earnings per share are also reduced when additional shares of stock are issued unless earnings increase by a greater proportion than the increase in outstanding shares. For these reasons, banks generally avoid issuing new stock unless absolutely necessary.

   Bank regulators are concerned that banks might maintain a lower level of capital than they should and have therefore imposed capital requirements on them. Because capital can absorb losses, a higher level of capital is thought to enhance a bank's safety and may increase the public's confidence in the banking system.

   The required level of capital for each bank depends on its risk. Assets with low risk are assigned relatively low weights while assets with high risk are assigned high weights. The capital level is set as a percentage of the risk-weighted assets.

   Therefore, riskier banks are subject to higher capital requirements. The same risk-based capital guidelines have been imposed in several other industrialized countries. Additional details are provided in the next chapter.

17-2k Distribution of Bank Sources of Funds

Exhibit 17.2  shows the distribution of bank sources of funds. Transaction and savings deposits make up 38 percent of all bank liabilities. The distribution of bank sources of funds is influenced by bank size. Smaller banks rely more heavily on savings deposits than do larger banks because small banks concentrate on household savings and therefore on small deposits. Much of this differential is made up in large time deposits (such as NCDs) for very large banks. In addition, the larger banks rely more on short-term borrowings than do small banks. The impact of the differences in the composition of fund sources on bank performance is discussed in  Chapter 20 .

   The main sources of funds have been identified, so now the bank uses of funds can be discussed. The more common uses of funds by banks include the following:

· ▪ Cash

· ▪ Bank loans

· ▪ Investment in securities

· ▪ Federal funds sold (loaned out)

· ▪ Repurchase agreements

· ▪ Eurodollar loans

· ▪ Fixed assets

· ▪ Proprietary trading

Exhibit 17.2 Bank Sources of Funds (as a Proportion of Total Liabilities)

17-2l Cash

Banks must hold some cash as reserves to meet the reserve requirements enforced by the Federal Reserve. Banks also hold cash to maintain some liquidity and to accommodate any withdrawal requests by depositors. Because banks do not earn income from cash, they hold only as much cash as is necessary to maintain a sufficient degree of liquidity. They can tap various sources for temporary funds and therefore are not overly concerned with maintaining excess reserves.

   Banks hold cash in their vaults and at their Federal Reserve district bank. Vault cash is useful for accommodating withdrawal requests by customers or for qualifying as required reserves, while cash held at the Federal Reserve district banks represents the major portion of required reserves. The Fed mandates that banks maintain required reserves because they provide a means by which the Fed can control the money supply. The required reserves of each bank depend on the composition of its deposits.

17-2m Bank Loans

The main use of bank funds is for loans. The loan amount and maturity can be tailored to the borrower's needs.

Types of Business Loans  A common type of business loan is the  working capital loan  (sometimes called a self-liquidating loan), which is designed to support ongoing business operations. There is a lag between the time when a firm needs cash to purchase raw materials used in production and the time when it receives cash inflows from the sales of finished products. A working capital loan can support the business until sufficient cash inflows are generated. These loans are typically short term, but they may be needed by businesses on a frequent basis.

   Banks also offer  term loans , which are used primarily to finance the purchase of fixed assets such as machinery. With a term loan, a specified amount of funds is loaned out for a specified period of time and a specified purpose. The assets purchased with the borrowed funds may serve as partial or full collateral on the loan. Maturities on term loans commonly range from 2 to 5 years and are sometimes as long as 10 years. Banks that offer term loans typically impose protective covenants, which specify specific conditions for the borrower that may protect the bank from loan default. For example, a bank may specify a maximum level of dividends that the borrower can pay to its shareholders each year. This protective covenant is intended to ensure that the borrower has sufficient cash to repay its loan on time.

   Term loans can be amortized so that the borrower makes fixed periodic payments over the life of the loan. Alternatively, the bank can periodically request interest payments, with the loan principal to be paid off in one lump sum (called a  balloon payment ) at a specified date in the future. This is known as a  bullet loan . Several combinations of these payment methods are also possible. For example, a portion of the loan may be amortized over the life of the loan while the remaining portion is covered with a balloon payment.

   As an alternative to providing a term loan, the bank may purchase the assets and lease them to the firm in need. This method, known as a  direct lease loan , may be especially appropriate when the firm wishes to avoid adding more debt to its balance sheet. Because the bank is the owner of the assets, it can depreciate them over time for tax purposes.

   A more flexible financing arrangement is the informal line of credit, which allows the business to borrow up to a specified amount within a specified period of time. This is useful for firms that may experience a sudden need for funds but do not know precisely when. The interest rate charged on any borrowed funds is typically adjustable in accordance with prevailing market rates. Banks are not legally obligated to provide funds to the business, but they usually honor the arrangement to avoid harming their reputation.

   An alternative to the informal line of credit is the  revolving credit loan , which obligates the bank to offer up to some specified maximum amount of funds over a specified period of time (typically less than five years). Because the bank is committed to provide funds when requested, it normally charges businesses a commitment fee (of about one-half of 1 percent) on any unused funds.

   The interest rate charged by banks on loans to their most creditworthy customers is known as the  prime rate . Banks periodically revise the prime rate in response to changes in market interest rates, which reflect changes in the bank's cost of funds. Thus the prime rate moves in tandem with the Treasury bill rate and other market interest rates. The prime rate in recent years is shown in Exhibit 17.3. It increased during the 2004- 2006 period when economic conditions were strong. Conversely, it decreased during recessions, such as during the financial crisis in 2008. The prime rate tends to adjust in response to changes in other interest rates that influence the bank's cost of funds. When economic conditions are weak, however, the spread between the prime rate and the bank's cost of funds tends to widen because banks require a higher premium to compensate for credit risk.

Exhibit 17.3 Prime Rate over Time

Loan Participations  Some large corporations wish to borrow a larger amount of funds than any individual bank is willing to provide. To accommodate a corporation, several banks may be willing to pool their available funds in what is referred to as a  loan participation . One of the banks serves as the lead bank by arranging for the documentation, disbursement, and payment structure of the loan. The main role of the other banks is to supply funds that are channeled to the borrower by the lead bank. The borrower may not even realize that other banks have provided much of the funds. As interest payments are received, the lead bank passes the payments on to the other participants in proportion to the original loan amounts they provided. The lead bank receives fees for servicing the loan in addition to its share of interest payments.

   The lead bank is expected to ensure that the borrower repays the loan. Normally, however, the lead bank is not required to guarantee the interest payments. Thus all participating banks are exposed to credit (default) risk.

Loans Supporting Leveraged Buyouts  Some commercial banks finance leveraged buyouts (LBOs), in which a management group or a business relies mostly on debt to purchase the equity of another business. Firms request LBO financing because they perceive that the market value of certain publicly held shares is too low. Yet because the borrowers are highly leveraged, they may experience cash flow pressure during periods when sales are lower than normal. It is desirable that these firms have access to equity funds because it can serve as a cushion during periods of poor economic conditions. Although such firms prefer not to go public again during such periods, they are at least capable of doing so. Banks financing these firms can, as a condition of any loan, require that the firms reissue stock if they experience cash flow problems.

   Some banks originate the loans designed for LBOs and then sell them to other financial institutions, such as insurance companies, pension funds, and foreign banks. In this way, they can generate fee income by servicing the loans while avoiding the credit risk associated with them.

   Bank regulators monitor the amount of bank financing provided to corporate borrowers that have a relatively high degree of financial leverage. These loans, known as  highly leveraged transactions (HLTs) , are defined by the Federal Reserve as credit that results in a debt-to-asset ratio of at least 75 percent. In other words, the level of debt is at least three times the level of equity. About 60 percent of HLT funds are used to finance LBOs, and some of the remaining funds are used to repurchase a portion of the outstanding stock. HLTs are usually originated by a large commercial bank that provides 10 to 20 percent of the financing itself. Other financial institutions participate by providing the remaining 80 to 90 percent of the funds needed.

Collateral Requirements on Business Loans  Commercial banks are increasingly accepting intangible assets (such as patents, brand names, and licenses to franchises and distributorships) as collateral for commercial loans. This change is especially important to service-oriented companies that do not have tangible assets.

Lender Liability on Business Loans  In recent years, businesses that previously obtained loans from banks have filed lawsuits claiming that the banks terminated further financing without sufficient notice. These so-called lender liability suits have been prevalent in the farming, grocery, clothing, and oil industries.

Volume of Business  Loans The volume of business loans provided by commercial banks changes over time in response to economic conditions. When the economy is strong, businesses are more willing to finance expansion. When economic conditions are weak, businesses defer expansion plans and therefore do not need as much financing. Economic growth increased during the 2004-2006 period, resulting in a major increase in business loans provided by banks. During the credit crisis of 2008-2009, however, the volume of business loans decreased.

WEB

www.fdic.com

Information about bank loan and deposit volume.

Types of Consumer Loans  Commercial banks provide individuals with  installment loans  to finance purchases of cars and household products. These loans require the borrowers to make periodic payments over time.

   Banks also provide credit cards to consumers who qualify, enabling them to purchase various goods without having to reapply for credit on each purchase. Credit card holders are assigned a maximum limit based on their income and employment record, and a fixed annual fee may be charged. This service often involves an agreement with VISA or MasterCard. If consumers pay off the balance each month, they normally are not charged interest. Bank rates on credit card balances are sometimes about double the rate charged on business loans. State regulators can impose  usury laws  that restrict the maximum rate of interest charged by banks, and these laws may be applied to credit card loans as well. A federal law requires that banks abide by the usury laws of the state where they are located rather than the state where the consumer lives.

   Assessing the applicant's creditworthiness is much easier for consumer loans than for corporate loans. An individual's cash flow is typically simpler and more predictable than a firm's cash flow. In addition, the average loan amount to an individual is relatively small, warranting a less detailed credit analysis.

   Since the interest rate on credit card loans and personal loans is typically much higher than the cost of funds, many commercial banks have pursued these types of loans as a means of increasing their earnings. The most common method of increasing such loans is to use more lenient guidelines when assessing the creditworthiness of potential customers. However, there is an obvious trade-off between the potential return and exposure to credit risk. When commercial banks experience an increase in defaults on credit card loans and other personal loans, they respond by increasing their standards for extending such loans. This results in a reduced allocation of funds to credit card loans, which also reduces the potential returns of the bank. When the economy weakened during the credit crisis in 2008 and 2009, for example, many banks raised their standards for credit card loans and reduced the amount of credit that they would allow consumers to have. As economic conditions improve, commercial banks tend to increase their allocation of funds toward credit card loans.

Real Estate Loans  Banks also provide real estate loans. For residential real estate loans, the maturity on a mortgage is typically 15 to 30 years, although shorter-term mortgages with a balloon payment are also common. The loan is backed by the residence purchased. During the economic expansion in the 2004-2006 period, many banks offered loans to home buyers of questionable credit standards. These subprime mortgages were given to home buyers who had relatively lower income, high existing debt, or only a small down payment for purchasing a home. Many commercial banks expected to benefit from subprime mortgage loans because they could charge up-front fees (such as appraisal fees) and higher interest rates on the mortgages to compensate for the risk of default. Furthermore, they presumed that real estate values would continue to rise and so the residence backing the loan would serve as adequate collateral.

   In 2008, however, there were many defaults on subprime mortgages. As of January 2009, about 10 percent of all homeowners with mortgages were either late on their payments or subject to foreclosure. Banks and other financial institutions were forced to take over the ownership of many homes, which led to an excess supply of homes in the housing market. Consequently, the prices of homes declined substantially, which further reduced the collateral value of the homes taken back by the banks. Thus banks that originated mortgages and held them as assets were adversely affected by the credit crisis.

   Commercial banks also provide commercial real estate loans, such as loans to build shopping malls. In general, during the early 2000s banks required more stringent standards for borrowers to qualify for commercial real estate loans. For this reason, the default rate on commercial real estate loans provided by commercial banks was low compared to the default rate on residential loans during the credit crisis. In addition, commercial banks commonly retain the commercial real estate loans that they originate as assets. Banks and other financial institutions are likely to use greater diligence in assessing real estate loan applicants when they retain the mortgages that they originate.

17-2n Investment in Securities

Banks purchase various types of securities. One advantage of investing funds in securities rather than loans is that the securities tend to be more liquid. In addition, banks can easily invest in securities whereas more resources are required to assess loan applicants and service loans. However, they normally expect to generate higher rates of return on funds used to provide loans.

Treasury and Agency Securities  Banks purchase Treasury securities as well as securities issued by agencies of the federal government. Government agency securities can be sold in the secondary market, but the market is not as active as it is for Treasury securities. Federal agency securities are commonly issued by federal agencies, such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Funds received by the agencies issuing these securities are used to purchase mortgages from various financial institutions. Such securities have maturities that can range from one month to 25 years.

   The values of the mortgages held by Fannie Mae and Freddie Mac declined in 2008 as a result of the large amount of late payments and mortgage defaults during the credit crisis. Consequently, there were concerns that Fannie Mae and Freddie Mac might not be able to cover their debt security payments. In September 2008, the U.S. government took control of Fannie Mae and Freddie Mac, thereby ensuring the safety of the debt securities issued by these agencies.

Corporate and Municipal Bonds  Banks also purchase corporate and municipal bonds. Although corporate bonds are subject to credit risk, they offer a higher return than Treasury or government agency securities. Municipal bonds exhibit some degree of risk but can also provide an attractive return to banks, especially when their after-tax return is considered. The interest income earned from municipal securities is exempt from federal taxation. Banks purchase only  investment-grade securities , which are those rated as “medium quality” or higher by rating agencies.

Mortgage-Backed Securities  Banks also commonly purchase mortgage-backed securities (MBS), which represent packages of mortgages. Banks tend to purchase mortgages within a particular “tranche” that is categorized as having relatively low risk. During the credit crisis in 2008 and 2009, however, there were many defaults on mortgages within tranches that had been assigned high ratings by rating agencies. Consequently, banks that had invested in MBS experienced losses during the credit crisis. The market value of MBS at any bank is difficult to measure because the MBS are not standardized and the secondary market transactions between parties are not conducted through an organized exchange. Thus two banks could have an equal proportion of their assets classified as MBS, but one bank's MBS may be much riskier than the other bank's MBS.

17-2o Federal Funds Sold

Some banks often lend funds to other banks in the federal funds market. The funds sold, or lent out, will be returned (with interest) at the time specified in the loan agreement. The loan period is typically very short, such as a day or a few days. Small banks are common providers of funds in the federal funds market. If the transaction is executed by a broker, the borrower's cost on a federal funds loan is slightly higher than the lender's return because the broker matching up the two parties charges a transaction fee.

17-2p Repurchase Agreements

Recall that, from the borrower's perspective, a repurchase agreement transaction involves repurchasing the securities it had previously sold. From a lender's perspective, the repo represents a sale of securities that it had previously purchased. Banks can act as the lender (on a repo) by purchasing a corporation's holdings of Treasury securities and then selling them back at a later date. This provides short-term funds to the corporation, and the bank's loan is backed by these securities.

17-2q Eurodollar Loans

Branches of U.S. banks located outside the United States, as well as some foreign-owned banks, provide dollar-denominated loans to corporations and governments. These so-called Eurodollar loans are common because the dollar is frequently used for international transactions. Eurodollar loans are short term and denominated in large amounts, such as $1 million or more.

17-2r Fixed Assets

Banks must maintain some amount of fixed assets, such as office buildings and land, so that they can conduct their business operations. However, this is not a concern to the bank managers who decide how day-to-day incoming funds will be used. They direct these funds into the other types of assets already identified.

17-2s Proprietary Trading

Banks also engage in proprietary (or “prop") trading, in which they use their own funds to make investments for their own account. For example, banks may have an equity trading desk that takes positions in equity securities as well as a fixed-income desk that takes speculative positions in bonds and other debt securities; they may also have a derivatives trading desk that takes speculative positions in derivative securities. Proprietary trading was a major contributor to the total income generated by commercial banks prior to the credit crisis, when economic conditions were very favorable. The trading desks tend to engage in much more risk than traditional bank lending operations, and some commercial banks experienced large losses on their proprietary trading during the financial crisis.

   Banks also manage investment portfolios in which they pool funds provided by clients and make investments with the funds on behalf of the bank's clients. They charge an annual management fee to clients for managing these funds. The hedge fund may generate periodic fees from clients for managing the funds. Banks may own private equity funds, which pool funds provided by wealthy individual and institutional investors, and then invest the funds in businesses. They may charge their investor clients fees for their service and take a portion of the profit from managing the funds before distributing profits to their investor clients.

   The Wall Street Reform and Consumer Protection Act (also called the Dodd-Frank Act) of 2010 imposes a limit on the amount of proprietary trading by banks. This provision is referred to as the Volcker rule, because it was recommended by Paul Volcker, a previous member of the Board of Governors of the Fed. However, its implementation was delayed due to many arguments about its interpretation. The arguments were intense because some banks wanted to retain their flexibility to engage in a large amount on proprietary trading.

17-2t Summary of Bank Uses of Funds

The distribution of bank uses of funds is illustrated in  Exhibit 17.4 . Loans of all types make up about 59 percent of bank assets while securities account for about 27 percent. The distribution of assets for an individual bank varies with the type of bank. For example, smaller banks tend to have a relatively large amount of household loans and government securities; larger banks have a higher level of business loans (including loans to foreign firms).

   The distribution of bank uses of funds indicates how commercial banks operate. In recent years, however, banks have begun to provide numerous services that are not indicated on their balance sheet. These services differ markedly from banks' traditional operations, which focused mostly on channeling deposited funds into various types of loans and investments.

Commercial Bank Balance Sheet  A commercial bank's sources of funds represent its liabilities or equity, and its uses of funds represent its assets. Each commercial bank determines its own composition of liabilities and assets, which determines its specific operations.

Exhibit 17.4 Bank Uses of Funds (as a Proportion of Total Assets)

EXAMPLE

Exhibit 17.5  shows the balance sheet of Hornet Bank. The bank's assets are shown on the left side of the balance sheet. The second column indicates the dollar amount of each asset, and the third column shows the size of each asset in proportion to total assets in order to illustrate how Hornet Bank distributes its funds. Hornet's main assets are commercial and consumer loans in addition to securities. The balance sheet shows the bank's holdings at a particular moment in time, but the bank frequently revises the composition of its assets in response to economic conditions. When the economy improves and creditworthy businesses want to expand, Hornet Bank will sell some of its holdings of Treasury securities and use the funds to provide more corporate loans.

   Hornet Bank's liabilities and stockholders' equity are shown on the right side of the balance sheet. Hornet obtains funds from various types of deposits, and incurs some expenses from all types of deposits. In particular, it must hire employees to serve depositors. The composition of Hornet's liabilities determines its interest expenses: it does not pay interest on demand deposits, but it does pay a relatively high interest rate on large COs.

   Hornet also incurs expenses from managing its assets. Its main expense is the cost of hiring employees to assess the creditworthiness of businesses and households that request loans. In general, Hornet wants to generate enough income from its assets so that it can cover its expenses and provide a reasonable return to its shareholders. Its primary source of income is the interest received on the business loans that it provides. Its capital is shown on the balance sheet as common stock issued and retained earnings.

Exhibit 17.5 Balance Sheet of Hornet Bank as of June 30, 2013

ASSETS	DOLLAR AMOUNT (IN MILLIONS)	PROPORTION OF TOTAL ASSETS	LIABILITIES AND STOCKHOLDERS' EQUITY	DOLLAR AMOUNT (IN MILLIONS)	PROPORTION OF TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
Cash (includes required reserves)	$ 50	5%	Demand deposits	$ 250	25%
Commercial loans	400	40%	NOW accounts	60	6%
Consumer loans	250	25%	Money market deposit accounts	200	20%
Treasury securities	80	8%	Short-term CDs	250	25%
Corporate securities	120	12%	CDs with maturities beyond one year	120	12%
Federal funds sold (lent out)	10	1%	Federal funds purchased (borrowed)	0	0%
Repurchase agreements	20	2%	Long-term debt	30	3%
Eurodollar loans	0	0%
Fixed assets	70	7%	Common stock issued	50	5%
		Retained earnings	40	4%
TOTAL ASSETS	$1,000	100%	TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY	$1,000	100%

Exhibit 17.6 How Commercial Banks Finance Economic Growth

    Exhibit 17.6  shows how commercial banks use the key balance sheet items to finance economic growth. They channel funds from their depositors to households and thereby finance household spending. They channel funds from depositors to corporations and thereby finance corporate expansion. They also use some deposits to purchase Treasury and municipal securities and thereby finance spending by the Treasury and municipalities.

17-3 OFF-BALANCE SHEET ACTIVITIES

Banks commonly engage in off-balance sheet activities, which generate fee income without requiring an investment of funds. However, these activities do create a contingent obligation for banks. The following are some of the more popular off-balance sheet activities:

· • Loan commitments

· • Standby letters of credit

· • Forward contracts on currencies

· • Interest rate swap contracts

· • Credit default swap contracts

17-3a Loan Commitments

A loan commitment is an obligation by a bank to provide a specified loan amount to a particular firm upon the firm's request. The interest rate and purpose of the loan may also be specified. The bank charges a fee for offering the commitment.

   One type of loan commitment is a  note issuance facility (NIF) , in which the bank agrees to purchase the commercial paper of a firm if the firm cannot place its paper in the market at an acceptable interest rate. Although banks earn fees for their commitments, they could experience illiquidity if numerous firms request their loans at the same time.

17-3b Standby Letters of Credit

A  standby letter of credit (SLC)  backs a customer's obligation to a third party. If the customer does not meet its obligation, the bank will. The third party may require that the customer obtain an SLC to complete a business transaction. For example, consider a municipality that wants to issue bonds. To ensure that the bonds are easily placed, a bank could provide an SLC that guarantees payment of interest and principal. In essence, the bank uses its credit rating to enhance the perceived safety of the bonds. In return for the guarantee, the bank charges a fee to the municipality. The bank should be willing to provide SLCs only if the fee received compensates for the possibility that the municipality will default on its obligation.

17-3c Forward Contracts on Currencies

A forward contract on currency is an agreement between a customer and a bank to exchange one currency for another on a particular future date at a specified exchange rate. Banks engage in forward contracts with customers that desire to hedge their exchange rate risk. For example, a U.S. bank may agree to purchase 5 million euros in one year from a firm for $1.10 per euro. The bank may simultaneously find another firm that wishes to exchange 5 million euros for dollars in one year. The bank can serve as an intermediary and accommodate both requests, earning a transaction fee for its services. However, it is exposed to the possibility that one of the parties will default on its obligation.

17-3d Interest Rate Swap Contracts

Banks also serve as intermediaries for interest rate swaps, whereby two parties agree to periodically exchange interest payments on a specified notional amount of principal. Once again, the bank receives a transaction fee for its services. If it guarantees payments to both parties, it is exposed to the possibility that one of the parties will default on its obligation. In that event, the bank must assume the role of that party and fulfill the obligation to the other party.

   Some banks facilitate currency swaps (for a fee) by finding parties with opposite future currency needs and executing a swap agreement. Currency swaps are similar to forward contracts, but they are usually for more distant future dates.

17-3e Credit Default Swap Contracts

Credit default swaps are privately negotiated contracts that protect investors against the risk of default on particular debt securities. Some commercial banks and other financial institutions buy them in order to protect their own investments in debt securities against default risk. Other banks and financial institutions sell them. The banks that sell credit default swaps receive periodic coupon payments for the term of the swap agreement. A typical term of a credit default swap is five years. If there are no defaults on the debt securities, the banks that sold the credit default swaps benefit because they have received periodic payments but are not required to make any payments. However, when there are defaults on the debt securities, the sellers of credit default swaps must make payments to the buyers to cover the damages. In essence, the sellers of credit default swaps are providing insurance against default.

   These contracts were heavily used to protect against the default risk from investing in mortgage-backed securities. During the credit crisis in 2008, commercial banks that sold credit default swap contracts incurred major expenses because of the high frequency of defaults on mortgage-backed securities. Conversely, commercial banks that purchased credit default swap contracts reduced the adverse impact of defaults on mortgagebacked securities (assuming that the counterparty that sold them the swaps did not default on its obligation).

17-4 INTERNATIONAL BANKING

Until historical barriers against interstate banking were largely removed in 1994, some U.S. commercial banks were better able to achieve growth by penetrating foreign markets than by expanding at home. Many U.S. banks have expanded internationally to improve their prospects for growth and to diversify so that their business will not be dependent on a single economy.

17-4a International Expansion

The most common way for U.S. commercial banks to expand internationally is by establishing branches, full-service banking offices that can compete directly with other banks located in a particular area. Before establishing foreign branches, a U.S. bank must obtain the approval of the Federal Reserve Board. Among the factors considered by the Fed are the bank's financial condition and experience in international business. Commercial banks may also consider establishing agencies, which can provide loans but cannot accept deposits or provide trust services.

   U.S. banks have recently established foreign subsidiaries wherever they expect more foreign expansion by U.S. firms, such as in Southeast Asia and Eastern Europe. Recently, expansion has also been focused on Latin America. The banks offer banker's acceptances, foreign exchange services, credit card services, and other household services.

   As an example of the diversity in international banking services, Citigroup offers a number of key services to firms around the world including foreign exchange transactions, forecasting, risk management, cross-border trade finance, acquisition finance, cash management services, and local currency funding. Citigroup serves not only large multinational corporations (e.g., Coca-Cola, Dow Chemical, IBM, Sony) but also small firms that need international banking services. By spreading itself across the world, Citigroup can typically handle the banking needs of all the subsidiaries of a multinational corporation.

17-4b Impact of the Euro on Global Competition

The use of a single currency in a number of European countries simplifies transactions because the majority of a bank's transactions between those countries are now denominated in euros. Use of the euro also reduces exposure to exchange rate risk, as banks can accept deposits in euros and use euros to lend funds or invest in securities. The use of a single currency throughout many European countries may also encourage firms to engage in bond or stock offerings to support their European business, as the euro can be used to support most of that business. Commercial banks can serve as intermediaries by underwriting and placing the debt or the equity issued by firms.

   The single currency makes it easier to achieve economies of scale and enables banks' internal reporting systems to be more efficient. As banks expand and capitalize on economies of scale, global competition has become more intense. Furthermore, the euro enables businesses in Europe to more easily compare the prices of services offered by banks based in different European countries. This also forces banks to be more competitive.

17-4c International Exposure

As banks attempt to penetrate international markets in order to capitalize on opportunities, they become exposed to conditions in those markets. In particular, European countries such as Greece, Portugal, and Spain have experienced weak economies and large budget deficits. The governments of these countries have borrowed substantially from banks in order to finance their budget deficits. They have struggled to meet their debt payments. Consequently, banks with large loans to these governments are exposed to the possibility of loan defaults. In addition, banks that penetrated these countries by offering loans to corporations in these countries are subject to possible loan defaults because the economies of these countries have been weak.

SUMMARY

· ▪ Commercial banks have consolidated over time in an effort to achieve economies of scale and to become more efficient. Consequently, there are less than half as many banks today as there were in 1985, and consolidation is still occurring. Commercial banks have also acquired many other types of financial service firms in recent years.

· ▪ The most common sources of commercial bank funds are deposit accounts, borrowed funds, and long-term sources of funds. The common types of deposit accounts are transaction deposits, savings deposits, time deposits, and money market deposit accounts. These accounts vary in terms of liquidity (for the depositor) and the interest rates offered. Commercial banks can solve temporary deficiencies in funds by borrowing from other banks (federal funds market), from the Federal Reserve, or from other sources by issuing short-term securities such as repurchase agreements. When banks need longterm funds to support expansion, they may use retained earnings, issue new stock, or issue new bonds.

· ▪ The most common uses of funds by commercial banks are bank loans and investment in securities. Banks can use excess funds by providing loans to other banks or by purchasing short-term securities.

· ▪ Banks engage in off-balance sheet activities such as loan commitments, standby letters of credit, forward contracts, and swap contracts. These types of activities generate fees for commercial banks. However, they also reflect commitments by the banks, which can expose them to more risk.

POINT COUNTER-POINT

Should Banks Engage in Other Financial Services Besides Banking?

Point No.  Banks should focus on what they do best.

Counter-Point  Yes. Banks should increase their value by engaging in other services. They can appeal to customers who want to have all their financial services provided by one financial institution.

Who Is Correct?  Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Bank Balance Sheet Create a balance sheet for a typical bank, showing its main liabilities (sources of funds) and assets (uses of funds).

· 2. Bank Sources of Funds What are four major sources of funds for banks? What alternatives does a customers who want to have all their financial services provided by one financial institution. Who Is Correct? Use the Internet to learn more about this issue and then formulate your own opinion. bank have if it needs temporary funds? What is the most common reason that banks issue bonds?

· 3. CDs Compare and contrast a retail CD and a negotiable CD.

· 4. Money Market Deposit Accounts How does a money market deposit account differ from other bank sources of funds?

· 5. Federal Funds Define federal funds, federal funds market, and federal funds rate. Who sets the federal funds rate? Why is the federal funds market more active on Wednesday?

· 6. Federal Funds Market Explain how the federal funds market facilitates bank operations.

· 7. Borrowing from the Federal Reserve Describe the process of “borrowing at the Federal Reserve.” What rate is charged, and who sets it? Why do banks commonly borrow in the federal funds market rather than through the Federal Reserve?

· 8. Repurchase Agreements How does the yield on a repurchase agreement differ from a loan in the federal funds market? Why?

· 9. Bullet Loan Explain the advantage of a bullet loan.

· 10. Bank Use of Funds Why do banks invest in securities even though loans typically generate a higher return? Explain how a bank decides the appropriate percentage of funds that should be allocated to each type of asset.

· 11. Bank Capital Explain the dilemma faced by banks when determining the optimal amount of capital to hold. A bank's capital is less than 10 percent of its assets. How do you think this percentage would compare to that of manufacturing corporations? How would you explain this difference?

· 12. HLTs Would you expect a bank to charge a higher rate on a term loan or on a highly leveraged transaction (HLT) loan? Why?

· 13. Credit Crisis Explain how some mortgage operations by some commercial banks (along with other financial institutions) played a major role in instigating the credit crisis.

· 14. Bank Use of Credit Default Swaps Explain how banks have used credit default swaps.

Interpreting Financial News

Interpret the following comments made by Wall Street analysts and portfolio managers.

· a. “Lower interest rates may reduce the size of banks.”

· b. “Banks are no longer as limited when competing with other financial institutions for funds targeted for the stock market.”

· c. “If the demand for loans rises substantially, interest rates will adjust to ensure that commercial banks can accommodate the demand.”

Managing in Financial Markets

Managing Sources and Users of Funds As a consultant, you have been asked to assess a bank's sources and uses of funds and to offer recommendations on how it can restructure its sources and uses of funds to improve its performance. This bank has traditionally focused on attracting funds by offering certificates of deposit. It offers checking accounts and money market deposit accounts, but it has not advertised these accounts because it has obtained an adequate amount of funds from the CDs. It pays about 3 percentage points more on its CDs than on its MMDAs, but the bank prefers to know the precise length of time it can use the deposited funds. (The CDs have a specified maturity whereas the MMDAs do not.) Its cost of funds has historically been higher than that of most banks, but it has not been concerned because its earnings have been relatively high. The bank's use of funds has historically focused on local real estate loans to build shopping malls and apartment complexes. The real estate loans have provided a very high return over the last several years. However, the demand for real estate in the local area has slowed.

· a. Should the bank continue to focus on attracting funds by offering CDs, or should it push its other types of deposits?

· b. Should the bank continue to focus on real estate loans? If the bank reduces its real estate loans, where should the funds be allocated?

· c. How will the potential return on the bank's uses of funds be affected by your restructuring of the asset portfolio? How will the cost of funds be affected by your restructuring of the bank's liabilities?

FLOW OF FUNDS EXERCISE

Services Provided by Financial Conglomerates

Carson Company is attempting to compare the services offered by different banks, as it would like to have all services provided by one bank.

· a. Explain the different types of services provided by a financial institution that may allow Carson Company to obtain funds or to hedge its risk.

· b. Review the services that you listed in the previous question. What services could provide financing to Carson Company? What services could hedge Carson's exposure to risk?

INTERNET/EXCEL EXERCISE

Go to the website  www.chase.com  and list the various services offered by Chase that were mentioned in this chapter. For each service, state whether it reflects an asset (use of funds) or a liability (source of funds) for the bank. What interest rates does Chase offer on its CDs?

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. bank competition

· 2. [name of specific bank] AND loans

· 3. [name of specific bank] AND deposits

· 4. [name of specific bank] AND capital

· 5. [name of specific bank] AND balance sheet

· 6. [name of specific bank] AND assets

· 7. [name of specific bank] AND liabilities

· 8. bank AND capital

· 9. bank AND assets

· 10. bank AND loans