Chapter 11: Commercial Banks: Industry Overview

Why are commercial banks considered depository institutions?

- Major liabilities are federally insured deposits - Major assets are loans

Why are banks regulated?

- To protect against disruptions to the services they perform - To protect government insured deposits

What are the major sources of equity?

1. Common and preferred stock 2. Surplus or additional paid-in capital 3. Retained earnings - Minimum levels of equity capital are required by regulators to act as a buffer against losses

Noncurrent Loans

Loans past due 90 days or more and loans that are not accruing interest because of problems of the borrower.

The Federal Reserve System (FRS)

Serves as the central bank of the U.S. and has regulatory power over nationally chartered banks, their holding companies and state banks that opt into the Federal Reserve System. - The primary advantage of this membership is direct access to the federal funds wire transfer network for nationwide interbank borrowing and lending of reserves.

Dual Banking System

The coexistence of both nationally and state-chartered banks, as in the United States.

Commercial Banks

The largest group of financial institutions in terms of total assets. - They perform functions similar to those of savings institutions and credit unions—they accept deposits (liabilities) and make loans (assets). - While deposits are the major source of funding, their liabilities usually include several types of non-deposit sources of funds (such as subordinated notes and debentures). - Their loans are broader in range, including consumer, commercial, international, and real estate loans.

Transaction Accounts

The sum of non interest-bearing demand deposits and interest-bearing checking accounts

Commercial banks face unique risks because of their asset structure. What are these major risks that contribute to a commercial bank's level of insolvency risk?

1. Credit (default) risk is the risk that loans are not repaid 2. Liquidity risk is the risk that depositors will demand more cash than banks can immediately provide 3. Interest rate risk is the risk that interest rate changes erode profitability or net worth

What are included in non-deposit liabilities

1. Fed funds Purchased 2. Repurchase Agreements 3. Notes and Bonds

Who are the key commercial bank regulators?

1. Federal Deposit Insurance Corporation (FDIC) 2. Office of the Comptroller of the Currency (OCC) 3. Federal Reserve System (FRS) 4. State bank regulators

What are the major disadvantages of international expansion?

1. Information/Monitoring Costs - are generally higher in foreign markets 2. Nationalization/Expropriation - it faces the political risk that a change in government may lead to the nationalization of those fixed assets. 3. Fixed Costs - of establishing foreign organizations may be extremely high

What are included in commercial bank assets?

1. Loans - generate the most revenue for banks - Loans and investment securities continue to be the primary assets of the banking industry - Though business loans were the major asset on bank balance sheets between 1965 and 1987, they have dropped in importance since 1987. The major reason for this has been the rise in nonbank loan substitutes, especially commercial paper 2. Investment securities - generate revenue and provide banks with liquidity 3. Cash assets - are held to meet reserve requirements and to provide liquidity 4. Other assets that include premises and equipment, other real estate owned, etc.

What services do commercial banks perform that are essential to U.S. financial markets?

1. Play a key role in the transmission of monetary policy 2. The efficiency with which they provide payment services directly benefits the economy 3. Provide maturity intermediation services

What are the major advantages of international expansion

1. Risk diversification 2. Economies of scale - potentially lower its average operating costs by expanding its activities beyond domestic boundaries 3. Innovations - distribute new product innovations internationally 4. Funds source - opportunity to find the cheapest and most available sources of funds 5. Customer relationships - maintain contact with and service the needs of domestic multinational corporations 6. Regulatory avoidance - seeking low-regulatory, low-tax countries can allow an FI to lower its net regulatory burden and increase its potential net profitability.

What are some of the major recent events concerning global banking performance?

1. The financial crisis of 2008-2009 spread worldwide and banks saw losses that were magnified by illiquid markets ~ The largest banks in the Netherlands, Switzerland, and the U.K. had net losses in 2008 ~ Banks in Ireland, Spain, and the U.S. were especially hard hit because they had large investments in mortgages and mortgage-backed securities 2. Many European banks averted outright bankruptcy thanks to direct support from their central banks and national governments 3. Greece suffered a severe debt crisis in the spring of 2010 ~ Problems from the Greek banking system then spread to other European nations, such as Portugal, Spain and Italy ~ The situation stabilized after 2012, but a major debt payment was due from Greece to creditors on June 30, 2015 * Deal was reached that required Greece to surrender to all of its creditors' demands: tax increases, pension reform, and the creation of a fund (under European supervision) with state- owned assets earmarked to be privatized or liquidated 4. European banking system was rocked again in June 2016 with "Brexit"

What are included in a commercial bank's liabilities?

1. Transaction accounts (majority segment of deposits) ~ Transaction accounts are about 15.5% of total deposits ~ Interest-bearing checking accounts are called negotiable order of withdrawal (NOW) accounts 2. Household (retail) savings and time deposits - have been declining in recent years because of competition from money market mutual funds (MMMFs) ~ Small nontransaction accounts, which include passbook savings accounts and retail time deposits 3. Large time deposits 4. Nondeposit liabilities and other liabilities - includes purchases of federal funds (bank reserves) on the interbank market and repurchase agreements (temporary swaps of securities for federal funds) at the short end of the maturity spectrum, to the issuance of notes and bonds at the longer end

What are fee-generating activities do commercial banks engage in that cannot be easily identified from analyzing their on- and off-balance-sheet accounts?

1. Trust services - holds and manages assets for individuals or corporations. - Estate assets and assets delegated to bank trust departments by less financially sophisticated investors. - Pension fund assets 2. Correspondent banking - is the provision of banking services to other banks that do not have the staff resources to perform the services themselves. - These services include check clearing and collection, foreign exchange trading, hedging services, and participation in large loan and security issuances.

What are some major events recently with U.S. commercial banks industry performance?

1. U.S. commercial banks flourished during the economic expansion (and falling interest rates) of the 1990s ~ Commercial bank earnings were a record $71.6 billion in 1999 2. The economic downturn of the early 2000s caused performance to deteriorate only slightly ~ Average ROA was 1.19% in 2000, down from 1.31% in 1999 3. By 2003, ROA and ROE had reached all-time highs 4. In the fourth quarter of 2006, mortgage delinquencies (particularly subprime mortgages) surged 5. Losses from falling values of subprime mortgages caused fourth quarter 2007 net income to hit a 16-year low. 6. Performance deteriorated in the late 2000s during the strongest recession in the U.S. since the Great Depression ~ Less than half of all institutions reported increased earnings in 2007, the first time in 23 years that a majority of institutions had not posted full-year earnings increases 7. ROA and ROE over time ~ In 2008, annual ROA was a poor 0.13%, and it fell again in 2009 to 0.09% before rising to 0.65% in 2010 ~ Similarly, ROE was 1.33% in 2008, 0.85% in 2009, and 9.26% in 2015 8. Number of insured institutions on the FDIC's "Problem List" declined from 203 to 183 during 2015, and there were only 8 bank failures 9. Performance has deteriorated slightly in 2016 as ROA and ROE fell to 0.95% and 8.43%, respectively ~ Higher expenses for loan losses and lower noninterest income from trading and asset servicing

Region or Superregional Banks

A bank that engages in a complete array of wholesale commercial banking activities. - The majority of banks in these two largest size classes - Range in size from several billion dollars to several hundred billion dollars in assets - Normally are headquartered in larger regional cities (Dallas, New Orleans, etc) and often have offices and branches in locations throughout large portions of the United States - In addition to mortgage and business loans, these banks perform a lot of services for the community banks and have access to the federal funds market (where banks lend to each other overnight).

Money Center Banks

A bank that relies heavily on non-deposit or borrowed sources of funds. - Some of the biggest banks are often classified as these. - Include the Bank of New York Mellon, Deutsche Bank (through its U.S. acquisition of Bankers Trust), Citigroup, J.P. Morgan Chase, and HSBC North America (formerly Republic NY Corporation). - These banks are more likely to buy loans from smaller banks and then securitize them as opposed to just making loans themselves. - These larger banks tend to have smaller interest rate spreads due to greater competition in the big markets. - Located in a major financial center (e.g., New York) that heavily relies on both national and international money markets for its source of funds. - Major participants in foreign currency markets and are therefore subject to foreign exchange risk

Community Banks

A bank that specializes in retail or consumer banking. - Banks with less than $1 billion in asset size. - Tend to provide mortgage and business loans to local communities. - Decreasing both in number and importance

Commercial Paper

A short-term debt instrument issued by corporations either directly or via an underwriter to institutional investors in the financial markets, such as money market mutual funds

Shadow Banking

Activities of nonfinancial service firms that perform banking services. - Savers place their funds with MMMFs and similar funds, which invest those funds in the liabilities of these banks. Borrowers get loans and leases from them rather than from traditional banks. - Face significantly less regulation than traditional banks. - E.g., Companies that make loans based on a firms inventory or accounts payable.

Reigle-Neal Act of 1994

Allowed nationwide branch networks to evolve

Federal Funds Market

An interbank market for short-term borrowing and lending of bank reserves.

NOW Accounts (Negotiable Order of Withdrawal Accounts)

An interest-bearing checking account. - May be held only by individuals, sole proprietorships, nonprofit organizations, governmental units, and pension funds.

What activities do commercial banks engage in that are conducted off the balance sheet?

Commercial banks engage in many fee-related activities that are conducted off the balance sheet 1. Guarantees such as letters of credit ~ Future commitments to lend 2. Derivative transactions ~ Includes futures, forwards, options, and swaps

Wholesale Banking

Commercial-oriented banking, such as providing commercial and industrial loans funded with purchased funds.

Industrial loan corporations (ILCs)

Considered "non-bank" banks - Are allowed under Utah law, but can conduct business outside of Utah - E.g., Walmart and Target both attempted to utilize ILCs, and Target's application was approved

Retail Banking

Consumer-oriented banking, such as providing residential and consumer loans and accepting smaller deposits. - Community Banks specialize in this - Decreasing both in number and importance

Maturity Mismatch

Financial situation of a financial institution or company in which assets held to meet future liabilities are not aligned in terms of maturity time. - How a company organizes the maturity of its assets and liabilities can give details into the liquidity of its position. - If there is a material one, a liquidity squeeze could arise.

Negotiable Certificates of Deposit (CDs)

Fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market. - Deposit claims with promised interest rates and fixed maturities of at least 14 day that can be resold to outside investors in an organized secondary market

Financial Services Modernization Act of 1999

Gave commercial banks the full authority to enter the investment banking (and insurance) business.

Net Operating Income

Income before taxes and extraordinary items.

FDIC- Federal Deposit Insurance Corporation

Insures the deposits of commercial banks. - In so doing, it levies insurance premiums on banks, manages the deposit insurance fund (which is generated from those premiums and their reinvestment), and conducts bank examinations. - In addition, when an insured bank is closed, the FDIC acts as the receiver and liquidator.

Holding Company

Is a parent company that owns a controlling interest in a subsidiary bank or other FI

Net Interest Margin

Is interest income minus interest expense divided by earning assets.

Return on Assets

Is net income divided by assets.

Return on Equity

Is net income divided by equity.

Interest Rate Spread

Is the difference between lending and deposit rates.

Net Charge-Offs (NCOs)

Is the percent of loans written-off as uncollectible

Office of the Comptroller of the Currency (OCC)

It is the oldest U.S. bank regulatory agency. - Established in 1863, it is organized as a subagency of the U.S. Treasury. - Its primary function is to charter national banks as well as to close them. - In addition, the OCC examines national banks and has the power to approve or disapprove their merger applications.

What are some of the major common differences between large and small banks?

Large banks' relatively easy access to purchased funds and capital markets compared to small banks' access is a reason for many of these differences 1. Larger banks generally lend to larger corporations, meaning their interest rate spreads and net interest margins have usually been narrower than those of smaller regional banks 2. Large banks tend to pay higher salaries and invest more in buildings and premises than small banks 3. Small banks usually hold fewer OBS assets and liabilities 4. Large banks tend to diversify their operations more and generate more noninterest income than small banks 5. Large banks tend to use more purchased funds and have fewer core deposits 6. Large banks tend to hold less equity than do small banks

What are the risk-reducing and the risk-attributes of off-balance-sheet activities and instruments?

Risk-Reducing: - Banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business. - Aoid regulatory costs or "taxes" since reserve requirements and deposit insurance premiums are not levied on off-balance-sheet activities. Risk-Attributes: - Losses associated with off-balance-sheet mortgage-backed securities created and held by FIs.

What affects the types of activities and financial performance of small and large commercial banks and what do each focus on?

Size has traditionally affected the types of activities and financial performance of commercial banks - Small banks typically focus on the retail side - making loans and issuing deposits to consumers and small businesses. - Large banks usually engage in both retail and wholesale banking, often focusing on the wholesale side of the business

Who charters and regulates state-chartered banks?

State authorities

Off-Balance-Sheet (OBS) Assets

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 (OBS) Liabilities

When an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement.

Net Non-Interest Margin

is non-interest income minus non-interest expense divided by earning assets