Chapter 11 text Summary - book \"Financial Markets and Institutions\" PDF

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Chapter 11: Commercial Banks Commercial Bank: is a depository institution whose major assets are loans ad whose major liabilities are deposits o Largest FI group o Provide loans to and accept deposits from nonfinancial firms and people o Commercial banks loans are broader in range, including consum...

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Chapter 11: Commercial Banks  Commercial Bank: is a depository institution whose major assets are loans ad whose major liabilities are deposits o Largest FI group o Provide loans to and accept deposits from nonfinancial firms and people o Commercial banks loans are broader in range, including consumer, commercial, and real estate loans, than are those of other depository institutions. o Commercial banks’ liabilities include more nondeposit sources of funds, such as subordinate notes and debentures, than do those of other depository institutions. o Play a key role in the transmission of monetary policy for the central bank and the economy o Efficentcy with which they provde patment services direftly beneifts the econoiy o Offer maturity intermediation series to the economy o Regulated separately from savings and institutions o Fig. 11-1 Shows the differences pg. 347 Balance Sheets and Recent Trends  Assets (Table 11-1) o total loans 51.4% of total assents o investment securities 29.2% o Cash 10.6% o Other 8.7% o Loans fall into 4 categories  1. Real estate, about 58% includes both commercial and residential  2. Individual loans, about 20% such as loans for auto purchases, credit cards, etc.  3. Business, about 17% also called commercial and industrial  4. Other, about 5% loans to emerging-market countries o investment securities provide banks with liquidity- exposed to high liquidity risk o liquidity risk: risk that aries when a financial instuation’s liabiltitty holders such as depostors demand cash for the finaocial claims they hold with the financial insitation

 What can we learn from the assets of the balance sheet about the risks faced by banks?

o Major risk faced by banks are credit/default risk, liquidity risk, interest rate risk, and ultimately, insolvency risk  Credit / Default Risk Example A firm wants to borrow $10,000 from a bank. The funds will be returned in one year, with interest, if the project is successful. The probability of success is “p”. If the project is not successful, the bank gets nothing. Assume that the bank’s goal is to breakeven. That is, the bank needs to earn $10,000 in expectation from issuing the loan. Then, the bank’s problem is to charge the correct amount of interest, $X, to breakeven. Calculate the dollars of interest and the interest rate the bank should charge the firm under the following scenarios: (back of exam) p = 99% p = 95% p = 90%

 How to Banks manage credit risk? o They can screen applicants

o Monitor o Law of large numbers o Diversify; across industries and geographically o Collateral- if you don’t pay loan, bank can take machinery, land, car, etc o Off balance sheet activities  Liabilities o Commercial banks have two major sources of funds:  Deposits  Borrowed or other liability funds o Major difference between banks and other firms is their high leverage or debt to assets ratio o Transactions Accounts: the sum on non-interest bearing demand deposits and interest bearing checking accounts (NOW accounts)  Only held by individuals, sole proprpoetship, nonprofit organizations, governmental units and pension funds o Second major deposits is retail or household savings and time deposits of less than $100,000 o Third major segment of deposits funds are the large time deports of $100,000 or more  Negotiable certificates of deposits: fixed maturity interest bearing deposits with face values of $100,000 or more that can be resold in the secondary market o Liability structure tend to reflect short matury stucuter than that of their asset portfolio o Liquidity risk: risk that arises when a financial institution’s liability holders such as depositors demand cash for the financial claims they hold with the financial institution. o Interest rate risk: risk incurred by a financial institution when the maturity of its assets and liabilities are mismatched and interest rates are volatile  Equity o Common and preferred stock, suprolus or additional paid in captual and retained earnings o Regulators require a minimum level of equity is as a buffer against losses from Off balance sheet activities o However, due to the low cost of deposit funding, banks choose to hold equity close to the minimum levels set by regulators  Off Balance Sheet Activities o When an event occus, this item moves onto the asset side of the bslance sheet or income is reailzie on the income statement o OBS include issuing various types of guarantees (letters of credit), which often have a strong insuarce underwriting elemtn and making future commitments to lend

o Also involves engaging in derivative transitions (futures, forwards, options, swaps) o Off Balance Sheet Liability: when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realize on the income statement  Mortgage-backed securities o Benefits  Earing fee income  Don’t need to hold reserves  Manage interest rate risk o Costs  Can increase insolvency risk for the bank  Reduced incentives to screen loan applicants  How to create a MBS? o Step 1: banks loan money to individuals to buy a home  Agree to pay bank $1,200/month for mortgage o Step 2: loans are pooled together and sold  Sold to Fannie Mae or an investment bank o Step 3: bonds are issued  Implication o Key factor in financial crisis o Banks sell mortgage, have reduced incentive to screen  Ex: my mortgage was sold in 3 months Challenges to Banks and Competition  Competition from commercial paper market for high-quality business loans o Commercial paper is short-term debt issued by corporations either directly or via an underwriter to institutional investors (including money market funds). Rates are often less than those obtained from a bank. o Impact on banks: high quality borrowers leave market increases default/credit risk  Competition from money market mutual funds for deposits o Impact on commercial banks: fewer deposits for banks higher cost of borrowing  Competition from non-banks in the bank space- Wal-Mart has sought to become a bank, but has so far resorted to partnering with existing banks o Impact on commercial banks: fewer deposits for banks, higher cost of borrowing, possibly fewer loans Size, Structure and Composition of the Industry  Number of banks is decreasing

 Result of mergers and acquisitions  Strict regulations on commercial banks over the last centrally limited geographically diversification opportunities  Shadow banking: activities of non financial service firms that perform banking services  Bank Size Concentration o Recent consolidation in banking appears to have reduced the asset shares of the smallest banks from 36.6% to 88.% o Community bank: a bank that specializes in retail or consumer bankingproviding mortgages and consumer loans o Wholesale banking: commercial oriented banking, such a rpvid commercial and industrial loans funded with purchased funds o Regional or super regional bank: finance their lending and investment activities  Small Banks o Retail concentrated o Generally hold fewer OBS assets and liabilities  Larger o Retail and wholesale o Easy access to purchased funds and capital markets compared to small banks’ access is a reason for many of these differences o Tend to use more purchased funds and have fewer cost deposits o Lend to larger corporations  Interest rate spread and net interest margin are narrower  Consolidation is controversial o Small businesses tend to borrow from local banks and build long-term relationships o Effects of Consolidation  Moves decision making authority to a central location (negative)  More complex organization may not focus on small business loans (negative)  More diversification- can take on riskier loans (positive)  Empirical Findings o In dollars, large banks lend more to small businesses than small banks do  52.3% of loans to small businesses come form large banks o Small banks rely more on business from businesses (9.2% of loans) than large banks do (3.4% of loans) o Consolidation among small banks increased lending to small businesses  Diversification benefits its outweighed negative effects Regulators  Federal Deposit Insurance Corporation: insures the deposits of its commercial banks o Levies premiums on banks, manages the deport insurance fund, acts as the receiver and liquidator

o Managers the insurance for both commercial banks and savings associations o Virtually all banks  Office of the Comptroller of the Currency: o Oldest US bank regulator, sub agency of U.S. Treasury o Charters national banks as well as closes them o Examines national banks and has the power to approve and disprove mergers o Bank can choose to be a state chartered bank, less regulated and restrictions o The choice of being a nationally or state charted bank lies at the foundation of dual banking system: the coexistence of both national and state banks  Federal Reserve System o Has regulatory over some banks and where their holding company parents o All nationally charted banks are automatically members of the FRS o 850 state chose to be members of FRS o since 1980, all banks regardless of membership have to meet the same noninterest bearing reserve requirements o primary advantage of membership is direct access tot eh federal funds wire transfer network for nation interbank and borrowing and lending of reserves o holding companies: a parents company that owns a controlling interest in a subsidiary bank or other FI (citigroup is PH or Citibank, national bank) o holding companies are regulated by the FRS  State Authorities o Regulate state chartered banks o Perform similar functions to those of the OCC performs for national banks...