Commercial Bank Operations

Chapter Objectives

Describe the most common sources of funds for commercial banks Describe the most common uses of funds for commercial banks Describe typical off-balance sheet activities for commercial banks

Bank Participation in Financial Conglomerates

Impact of the Financial Services Modernization Act (1999)

Banks and other financial service firms were given more freedom to merge and offer a range of financial services

Insurance Securities services

Banks now a subsidiary of financial conglomerates

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Bank Participation in Financial Conglomerates

Benefits of diversified services to individuals and firms

Individuals can obtain all their financial services at a single financial conglomerate
Deposits Loans Investing Insurance

(brokerage)

Businesses can obtain loans, issue stocks and bonds, and have their pension fund managed by the same institution
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Bank Participation in Financial Conglomerates

Benefits of diversified services to the financial institution

Reduce reliance on demand for single service Economies of scale and scope Diversification (service and geographical) may result in less risk Generate new business

Bank Sources of Funds

Transaction deposits

Demand deposit account (checking)

Savings Deposits

Passbook savings

Bank Sources of Funds

Time Deposits

Certificate of deposit (CD)

No

secondary market

Negotiable CD
Short-term,

minimum $100,000 Can trade among investors via dealer

Money Market Deposit Accounts (MMDAs)

More liquid than CDs : no specified maturity Limited check writing Created in 1982

Bank Sources of Funds

Federal Funds Purchased

Short-term loans between banks Allows banks to meet reserve requirement or funding needs Interest rate charged is the federal funds rate Borrowing at the discount window Discount rate Intended for meeting temporary short-term reserve requirement needs Must get Fed approval
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Borrowing from the Federal Reserve Banks

Bank Sources of Funds

Repurchase agreements

Sale of securities by one party to another with an agreement to repurchase the securities at a specified date and price Banks may sell T-bills to a corporation with temporary excess cash (bank demand deposit) and then buy them back later Source of funds for a few days Collateralized by the treasury bills
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Bank Sources of Funds

Eurodollar borrowings

Banks outside the United States make dollardenominated loans Eurodollar market is very large Like other businesses, banks issue bonds to finance long-term fixed assets Usually subordinated to deposits Part of secondary regulatory capital

Bonds issued by the bank

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Bank Sources of Funds

Bank capital

Obtained from issuing stock or retaining earnings No obligation to pay out funds in the future Must be sufficient to absorb operating losses

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Uses of Funds by Banks

Loans make up about 64 percent of bank assets, while all securities make up about 22 percent of assets. Cash represents 6 percent of bank assets. Cash and due from balances at institutions

Currency/coin provided via banks Reserve requirements imposed by Fed

Tool

for controlling the money supply Due from Fed and vault cash count as reserves

Also hold cash and due from balances to maintain liquidity and accommodate withdrawal requests by depositors
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Uses of Funds by Banks

Bank Loans

Types of business loans

Working capital loans Term loans

Purchasing fixed assets Protective covenants

Informal line of credit Revolving credit loan

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Uses of Funds by Banks

Bank Loans

Loan participations
Sometimes

large firms seek to borrow more money than an individual bank can provide Lead bank

Loans supporting leveraged buyouts

Banks

charge a high loan rate Monitored by bank regulators

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Uses of Funds by Banks

Bank Loans

Collateral requirements on business loans

Increasingly

accepting intangible assets Important to service-oriented firms Increased lending risk with service businesses--telecomm

Types of consumer loans

Installment

loans Credit cards

Real estate loans

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Uses of Funds by Banks

Investment securities (bank income and liquidity)

Treasury securities Government agency securities

Freddie Mac Fannie Mae Investment grade only

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Corporate and municipal securities

Federal funds sold

Lending funds in the federal funds market

Uses of Funds by Banks

Repurchase agreements Eurodollar loans

Branches of U.S. banks located outside of the U.S. Foreign-owned banks

Fixed assets

Office buildings Land

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Off-Balance Sheet Activities

Loan commitments

Obligation of bank to provide a specified loan amount to a particular business upon request Note issuance facility (NIF) Banks earn fee income for risk assumed

Standby letters of credit (SLC)

Backs a customers obligation to a third party Banks earn fee income

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Off-Balance Sheet Activities

Forward contracts

Agreement between a customer and bank to exchange one currency for another on a particular future date at a specified exchange rate Allows customers to hedge their exchange-rate risk

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Off-Balance Sheet Activities

Swap contracts

Two parties agree to periodically exchange interest payments on a specified notional amount of principal Banks serve as intermediaries or dealer and/or guarantor for a fee

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