Chapter11.ppt

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Chapter ElevenCommercial Banks:

Industry Overview

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Commercial Banks

Commercial banks are the largest group of financialinstitutions in terms of total assets

Major assets are loans

Major liabilities are depositsthus, they are considereddepository 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 theservices they perform

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Commercial Bank Assets

Loansgenerate 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 providebanks 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.

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Commercial Bank Assets

Commercial banks face unique risks because oftheir asset structure credit (default) risk is the risk that loans are not

repaid

liquidity risk is the risk that depositors will demandmore 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 banks level of insolvency risk

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Commercial Bank Liabilities

Transaction accounts are the sum of noninterest-bearingdemand 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 beendeclining in recent years because of MMMFspassbook 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 inthe secondary market

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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

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Off-Balance-Sheet Activities

Commercial banks engage in many fee-related activitiesthat are conducted off the balance sheet guarantees such as letters of credit

future commitments to lend

derivative transactions (e.g., futures, forwards, options, andswaps)

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 incomestatement

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Commercial Banks

The Reigle-Neal Act of 1994 allowed nationwidebranch 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 of1999

gave commercial banks the full authority to enter theinvestment banking and insurance business

Industrial loan corporations (ILCs) areconsidered non-bank banks

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Commercial Banks

A megamerger is a merger of commercial banks with assetsof $1 billion or more

Economies of scale refer to the degree to which a firmsaverage unit costs of producing financial services fall as itsoutput 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 producedindependently

Economies of scope refer to the degree to which a firm can

generate cost synergies by producing multiple financialservice products

X efficienciesrefer to cost savings due to greater managerialefficiency

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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 withpurchased funds

regional or superregional banks engage in a complete

array of wholesale banking activities money center banks rely heavily on nondeposit orborrowed sources of funds often borrowed in the federalfunds market

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Commercial Banks

Because larger banks generally lend to larger corporations,their interest rate spreads and net interest margins areusually narrower than those of smaller banks

interest rate spread is the difference between lending and depositrates

net interest margin is interest income minus interest expensedivided 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

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Industry Performance

U.S. commercial banks flourished during theeconomic expansion of the 1990s

The economic downturn of the early 2000s causedperformance 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 mortgagescaused fourth quarter 2007 net income to hit a 16-year low

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Wholesale Banking Services

Controlled disbursementaccounts

Account reconciliation

Lockbox services

Electronic lockbox

Funds concentration

Electronic funds transfer

Check deposit services

Electronic initiation ofletters of credit

Treasury managementsoftware

Electronic data

interchange Facilitating business-to-

business e-commerce

Electronic billing

Verifying identities Assisting small business

entries in e-commerce

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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

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Regulators

The Federal Deposit Insurance Corporation (FDIC)insures the deposits of commercial banks

The U.S. has a dual banking systembanks can be

either nationally or state chartered the Office of the Comptroller of the Currency (OCC)chartersand regulates national banks

state agencies charter and regulate state banks

The Federal Reserve System (FRS) has regulatorypower over nationally chartered banks and their holdingcompanies and state banks that opt in to the FederalReserve System a holding company is a parent company that owns a controlling

interest in a subsidiary bank or other FI

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International Commercial Banking

Commercial banking has truly become an

international and global market

The four largest banks in the world, as of 2007, arefrom 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

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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 multinationalcorporations

regulatory avoidance

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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

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Global Banking Performance

Banks in most regions of the world posted strongperformance in the early and mid-2000s mortgage lending boosted revenue in France and Spain

as personal bankruptcies rose worldwide, U.K. banksprofitability was maintained because of diversification

in 2001 the Japanese government backed the purchase of$90 billion of shares of Japanese banks in an attempt toavert a banking collapse

the Chinese state-run banking system deteriorated in theearly 2000s, which caused China to ease restrictions onforeign bank operations