Chapter 17Commercial Bank OperationsFinancial Markets and Institutions, 7e, Jeff MaduraCopyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter OutlineCommercial banks as financial intermediariesBank market structureBank sources of fundsUses of funds by banksOff-balance sheet activitiesInternational banking

Commercial Banks as Financial IntermediariesCommercial banks serve all types of surplus and deficit unitsOffer deposit accounts with the size and maturity characteristics desired by surplus unitsRepackage funds received from deposits to provide loans of the size and maturity desired by deficit units

Bank Market Structure (contd)Benefits of diversified services to individuals and firmsIndividuals and firms have various financial needs that they can now satisfy with one conglomerateSome financial conglomerates specialize in the services desired by individuals or large firmsBenefits of diversified services to financial institutionsFinancial institutions can reduce their reliance on the demand for any single service they offerDiversification may result in less risk for the institutionThe units of a financial conglomerate may generate some new business just because they offer convenience to clients who already rely on its other services

Bank Sources of FundsA financial institutions liabilities represent its sources of fundsTransaction depositsA demand deposit account (checking account) is offered to customers who desire to write checksA conventional account requires a small minimum balance and pays no interestA negotiable order of withdrawal (NOW) account provides checking services as well as interest but requires a larger minimum balanceElectronic transactionsAbout two-thirds of all employees in the U.S. have direct deposit accountsMore than 60 percent of bank customers use ATMsDebit cards and preauthorized debits can be used for recurring monthly payments

Bank Sources of Funds (contd)Savings depositsUntil 1986, Regulation Q restricted the interest rate banks could offer on passbook savingsCeilings prevented commercial banks from competing for funds during periods of higher interest ratesAn automatic transfer service (ATS) account allows customers to maintain an interest-bearing savings account that automatically transfers funds to their checking account when checks are written

Bank Sources of Funds (contd)Time depositsTime deposits are deposits that cannot be withdrawn until a specified maturity dateRetail certificates of deposit (CDs) require a specified minimum amount of funds to be deposited for a specified period of timeAnnualized interest rates vary among banks and maturity typesThere is no organized secondary marketDepositors will normally forgo a portion of their interest as a penalty for early withdrawal

Bank Sources of Funds (contd)Time deposits (contd)Certificates of deposit (contd)Bull-market CDs reward depositors if the market performs wellBear-market CDs reward depositors if the market performs poorlyCallable CDs can be called by the financial institution earlyPay a slightly higher interest rates, which compensates depositors for riskNegotiable certificates of deposit (NCDs):Are offered by some large banks to corporationsTypically have short-term maturitiesTypically require a minimum deposit of $100,000Do not have a secondary market

Bank Sources of Funds (contd)Money market deposit accounts (MMDAs):Were created with the Garn-St Germain Act of 1982Differ from conventional time deposits in that they do not specify a maturityAre more liquid than retail CDsNormally pay a lower rate than retail CDsDiffer from NOW accounts in that they provide limited check-writing ability

Bank Sources of Funds (contd)Federal funds purchasedFederal funds purchased represent a liability to the borrowing banks and an asset to the lending bank that sells themLoans in the federal funds market are typically for one to seven daysThe intent of federal funds transactions is to correct short-term fund imbalances experienced by banksThe interest rate charged in the federal funds market is the federal funds rateTypically between 0.25 percent and 1.00 percent above the T-bill rateBanks that are short of required reserves on the average over a settlement period must compensate with additional reserves

Bank Sources of Funds (contd)Borrowing from the Federal Reserve banksThe interest rate charged on loans from the Fed is the discount rateLoans from the discount window are commonly from one day to a few weeksThe discount window is mainly used to resolve a temporary shortage of fundsBanks commonly borrow in the federal funds market instead of the discount window because the Fed may disapprove of continuous borrowing by a bank

Bank Sources of Funds (contd)Repurchase agreementsA 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 priceBanks use repos as a source of funds when they need funds just for a few daysThe bank sells some government securities to a corporation and buys those securities back laterRepos occur through a telecommunications network connecting large banks, corporations, government securities dealers, and federal funds brokersRepo transactions are typically in blocks of $1 millionThe repo yield is slightly less than the federal funds rate

Bank Sources of Funds (contd)Eurodollar borrowingEurodollars are dollar-denominated deposits in banks outside the U.S.Eurobanks are foreign banks or foreign branches of U.S. banks that accept large short-term deposits and make short-term loans in dollarsBonds issued by the bankBanks issue bonds to finance fixed assetsCommon purchasers of bank bonds are households and various financial institutionsBanks finance less with bonds than other corporations

Bank Sources of Funds (contd)Bank capitalBank capital represents funds attained through the issuance of stock or through retained earningsRepresents the equity or net worth of the bankPrimary capital results from issuing common or preferred stock or retained earningsSecondary capital results from issuing subordinated notes and bondsBanks generally avoid issuing new stock because:It dilutes the ownership of the bankThe banks reported EPS are reduced

Bank Sources of Funds (contd)

Uses of Funds by BanksCashBanks are required to hold some cash as reserves by reserve requirements imposed by the FedBanks hold cash to maintain some liquidity and accommodate withdrawal requestsBanks only hold as much cash as necessary because cash does not pay interestBanks hold cash in vaults and in their Fed district bank

Uses of Funds by Banks (contd)Bank loansLoans are the main use of bank fundsTypes of business loansA working capital loan is designed to support ongoing business operationsTerm loans are used to finance the purchase of fixed assetsConditions by which the borrower must abide are protective covenantsTerm loans are often amortized so that the borrower makes fixed paymentsIf the loan principal is paid off in one balloon payment, it is a bullet loan

Uses of Funds by Banks (contd)Bank loans (contd)Types of business loans (contd)A direct lease loan involves purchasing the assets and leasing them to the firmAn informal line of credit allows the business to borrow up to a specified amount within a specified period of timeA revolving credit loan obligates the bank to offer up to some specified maximum amount of funds over a specified period of timeThe interest rate charged by banks on loans to their most creditworthy customers is known as the prime rate

Uses of Funds by Banks (contd)Bank loans (contd)Loan participationsSeveral banks pool their available funds in a loan participationOne of the banks serves as the lead bank and other banks supply funds that are channeled to the borrowerThe lead bank receives fees for servicing the loan in addition to its share of interest paymentsAll participating banks are exposed to credit risk

Uses of Funds by Banks (contd)Bank loans (contd)Collateral requirements on business loansCommercial banks are increasingly accepting intangible assets as collateralLender liability on business loansBusiness that previously obtained loans are filing lawsuits claiming that the banks terminated further financing without sufficient noticePrevalent in the farming industryVolume of business loansVolume increased consistently throughout the 1990s and then declined in the 20012003 period

Uses of Funds by Banks (contd)Bank loans (contd)Types of consumer loansInstallment loans are used to finance purchases of cars and household productsBanks provide credit cards to customersState regulators can impose usury laws to restrict the maximum rate of interest charged by banksThe interest rate charged on credit card loans and personal loans is typically much higher than the cost of fundsMany banks have used more lenient guidelines when assessing the creditworthiness of potential customers

Uses of Funds by Banks (contd)Bank loans (contd)Real estate loansFor residential real estate, the maturity on a mortgage is typically 15 to 30 yearsLoans are backed by the residence purchasedBanks provide some commercial real estate loans to finance commercial development

Uses of Funds by Banks (contd)Investments in securitiesBanks purchase Treasury securities and government agency securitiesGovernment agency securities:Can be sold in the secondary marketHave a less active market than Treasury securitiesAre not a direct obligation of the federal governmentAre commonly issued by federal agencies such as Freddie Mac or Fannie MaeGenerate interest income that is subject to state and local income taxesBanks purchase investment-grade corporate and municipal securities

Uses of Funds by Banks (contd)Investments in securities (contd)Bank investment in securities over timeGenerally, banks hold securities that:Offer a lower expected return than the loans they provideOffer more liquidity and are subject to lower default risk than loans they provideDuring weak economic conditions:Firms are unwilling to expandBanks extend fewer loans and increase their purchases of securitiesIn the 1990s, banks used a relatively high proportion of their funds for loansIn 2002, banks reduced their loans while increasing their investment in securities

Uses of Funds by Banks (contd)Federal funds soldFunds lent out will be returned at a specified time with interestSmall banks are common providers of funds in the federal funds marketRepurchase agreementsBanks can act as the lender on a repo by purchasing a corporations holdings of Treasury securitiesEurodollar loansEurodollar loans are provided by branches of U.S. banks located outside the U.S. and some foreign-owned banksFixed assetsBanks must maintain some amount of fixed assets so that they can conduct their business operations

Uses of Funds by Banks (contd)

Off-Balance Sheet ActivitiesOff-balance sheet activities:Generate fee income without requiring an investment of fundsCreate a contingent obligation for banksAre required to be recognized as assets or liabilities and reported at fair market valueA loan commitment is an obligation by a bank to provide a specified loan amount to a particular firm upon the firms requeste.g., a note issuance facility (NIF) requires banks to purchase the commercial paper of a firm if the firm cannot place its paper in the market at an acceptable interest rate

Off-Balance Sheet Activities (contd)A standby letter of credit (SLC) backs a customers obligation to a third partyA forward contract is an agreement between a customer and a bank to exchange one currency for another on a particular future date at a specified exchange rateWith a swap contract, two parties agree to periodically exchange interest payments on a specified notional amount of principal

International Banking (contd)Global competition in foreign countriesU.S. banks have recently established foreign subsidiaries wherever they expect more foreign expansion by U.S. firmse.g., Southeast Asia, Eastern Europe, and Latin AmericaAs a result of NAFTA, U.S. banks have expanded their business into Mexico to:Help finance the establishment of subsidiaries by U.S.-based corporationsBenefit from the increased international trade by offering bankers acceptances and foreign exchange servicesOffer credit card services and other households services in Mexico

International Banking (contd)Impact of the euro on global competitionThe euro has increased bank expansion throughout Europe because the euro:Simplifies transactionsReduces exposure to exchange rate riskEncourages firms to engage in a bond or stock offering to support their European businessMakes it easier to achieve economies of scale and enables banks internal reporting systems to be more efficientU.S. banks and European banks are expanding throughout Europe by acquiring existing banks