LEARNING OBJECTIVES

2. LEARNING OBJECTIVES After studying this chapter, you should be able to: Understand bank balance sheets. 10.1 Describe the basic operations of a commercial bank. 10.2 Explain how banks manage risk. 10.3 Explain the trends in the U.S. commercial banking industry. 10.4

3. To Buy a House, You Need a Loan • In 2012, despite record low mortgage interest rates, people had difficulty in obtaining mortgage loans or refinancing old loans. • Banks granted mortgages only to applicants with nearly perfect histories and the willingness to make large down payments. • Problems in the mortgage market reduced the effectiveness of the Fed’s monetary policy, which aimed at increasing spending on goods and services through lowering interesting rates.

4. Key Issue and Question Issue: During and immediately following the 2007–2009 financial crisis, there was a sharp increase in the number of bank failures. Question: Is banking a particularly risky business? If so, what types of risks do banks face?

5. 10.1 Learning Objective Understand bank balance sheets.

6. The Basics of Commercial Banking: The Bank Balance Sheet The Basics of Commercial Banking: The Bank Balance Sheet • The key commercial banking activities are taking in deposits from savers and making loans to households and firms. • A bank’s primary sourcesof funds are deposits, and primary usesof funds are loans, which are summarized in the bank’s balance sheet. A balance sheet is a statement that shows an individual’s or a firm’s financial position on a particular day. • The typical layout of a balance sheet is based on the following accounting equation: Assets = Liabilities + Shareholders’ equity.

7. The Basics of Commercial Banking: The Bank Balance Sheet

8. Asset is something of value that an individual or a firm owns; in particular, a financial claim. Liability is something that an individual or a firm owes, particularly a financial claim on an individual or a firm. Bank capital is the difference between the value of a bank’s assets and the value of its liabilities; also called shareholders’ equity. The Basics of Commercial Banking: The Bank Balance Sheet

9. Bank Liabilities Checkable Deposits Checkable deposits (ortransaction deposits)are accounts against which depositors can write checks. • Demand deposits are checkable deposits on which banks do not pay interest. • NOW (negotiable order of withdrawal) accounts are checking accounts that pay interest. • Checkable deposits are liabilities to banks and assets to households and firms. The Basics of Commercial Banking: The Bank Balance Sheet

10. Nontransaction Deposits • The most important types of nontransaction deposits are savings accounts, money market deposit accounts (MMDAs), and time deposits, or certificates of deposit (CDs). • Checkable deposits and small-denomination time deposits are covered by federal deposit insurance. • CDs of less than $100,000 are called small-denomination time deposits. CDs of $100,000 or more are called large-denomination time deposits.CDs worth $100,000 or more are negotiable, which means that investors can buy and sell them in secondary markets prior to maturity. Federal deposit insurance is a government guarantee of deposit account balances up to $250,000. The Basics of Commercial Banking: The Bank Balance Sheet

11. Borrowings • Banks often make more loans than they can finance with funds they attract from depositors. • Bank borrowings include short-term loans in the federal funds market, loans from a bank’s foreign branches or other subsidiaries or affiliates, repurchase agreements, and discount loans from the Federal Reserve System. • The federal funds market involves interbank loans borrowed at the federal funds rate. • With repurchase agreements (“repos”), banks sell securities, such as Treasury bills, and agree to repurchase them, typically the next day. The Basics of Commercial Banking: The Bank Balance Sheet

12. Making the Connection The Rise and Fall and (Partial) Rise of the Checking Account Households hold less in checking accounts relative to other financial assets than they once did, partly due to the wealth effect. As wealth increased over time, households were better able to afford to hold assets, such as CDs, where their money was tied up for a while but on which they earned a higher rate of interest. The Basics of Commercial Banking: The Bank Balance Sheet

13. Bank Assets • Bank assets are acquired by banks with the funds they: • receive from depositors • borrow from other institutions • acquire initially from shareholders • retain as profits from operations Reserves and Other Cash Assets Reserves are bank assets consisting of vault cash plus bank deposits with the Federal Reserve. Vault cash is cash on hand in a bank (including currency in ATMs and deposits with other banks). The Basics of Commercial Banking: The Bank Balance Sheet

14. Required reserves are reserves the Fed requires banks to hold against demand deposit and NOW account balances. Excess reserves are reserves banks hold above those necessary to meet reserve requirements. • Excess reserves can provide an important source of liquidity to banks, and during the financial crisis, bank holdings of excess reserves soared. • Another important cash asset is cash items in the process of collection—claims banks have on other banks for uncollected funds. The Basics of Commercial Banking: The Bank Balance Sheet

15. Securities • Marketable securities are liquid assets that banks trade in financial markets. • Banks are allowed to hold securities issued by the U.S. Treasury and other government agencies and corporate bonds. • Bank holdings of U.S. Treasury securities are also called secondary reserves due to their liquidity, • In the United States, commercial banks cannot invest checkable deposits in corporate bonds or common stock. The Basics of Commercial Banking: The Bank Balance Sheet

16. Loans • The largest category of bank assets. • Loans are illiquid relative to marketable securities and have greater default risk and higher information costs. • There are three categories of loans: • loans to businesses: commercial and industrial loans • consumer loans: made to households primarily to buy automobiles and other goods • real estate loans: residential and commercial mortgages • The commercial paper market in the 1980s caused banks to lose many of the businesses that had been using short-term commercial and industrial loans. The Basics of Commercial Banking: The Bank Balance Sheet

17. Loans Figure 10.1 The Changing Mix of Bank Loans, 1973–2012 The types of loans granted by banks have changed significantly since the early 1970s. The Basics of Commercial Banking: The Bank Balance Sheet

18. Other Assets • This category includes: • banks’ physical assets (e.g., computer equipment and buildings). • collateral received from borrowers who have defaulted on loans. The Basics of Commercial Banking: The Bank Balance Sheet

19. Bank Capital • Also called shareholders’ equity, or bank net worth. • Bank capital is the difference between the value of a bank’s assets and the value of its liabilities. • A bank’s capital represents the funds contributed by the bank’s shareholders through their purchases of stock the bank has issued plus accumulated retained profits. • In 2012, bank capital was about 13% of bank assets for the U.S. banking system as a whole. • As the value of a bank’s assets or liabilities changes, so does the value of the bank’s capital. The Basics of Commercial Banking: The Bank Balance Sheet

20. Solved Problem 10.1 Constructing a Bank Balance Sheet a. Use the entries to construct a balance sheet similar to the one in Table 10.1, with assets on the left side of the balance sheet and liabilities and bank capital on the right side. b. The bank’s capital is what percentage of its assets? The Basics of Commercial Banking: The Bank Balance Sheet

21. 10.1 Solved Problem 10.1 Constructing a Bank Balance Sheet Solving the Problem Step 1Review the chapter material. Step 2Answer part (a) by using the entries to construct the bank’s balance sheet. The Basics of Commercial Banking: The Bank Balance Sheet [To Jim: remove extra 10.1 from top of problem line]

22. Solved Problem 10.1 Constructing a Bank Balance Sheet Step 3Answer part (b) by calculating the bank’s capital as a percentage of its assets. Total assets = $2,223 billion Bank capital = $231 billion Bank capital as a percentage of assets The Basics of Commercial Banking: The Bank Balance Sheet

23. 10.2 Learning Objective Describe the basic operations of a commercial bank.

24. The Basic Operations of a Commercial Bank The Basic Operations of a Commercial Bank T-account is an accounting tool used to show changes in balance sheet items. Example: You open a checking account with $100 at Wells Fargo. Wells Fargo uses its excess reserves to buy Treasury bills worth $30 and make a loan worth $60.

25. Making the Connection In Your Interest Your Bank’s Message to You: “Please Go Away!” • Your bank may well lose money on your checking account, which typically costs about $300 a year to maintain. • In addition to loaning out depositors’ money, banks traditionally earn income from depositors by: (1) collecting fees from stores when debit cards are used, (2) charging overdraft fees, and (3) collecting fees when depositors purchase financial products. • Dodd-Frank Act of 2012 placed limits on fees for debit cards and overdrafts. • Banks have responded to the new regulations by closing branches in lower-income neighborhoods, increasing their marketing of financial services to higher-income customers, and raising minimum balance requirements. The Basic Operations of a Commercial Bank

26. Bank Capital and Bank Profits Net interest margin is the difference between the interest a bank receives on its securities and loans and the interest it pays on deposits and debt, divided by the total value of its earning assets. • A bank’s profits are commonly expressed in terms of its return on assets. Return on assets (ROA) is the ratio of the value of a bank’s after-tax profit to the value of its assets. The Basic Operations of a Commercial Bank

27. To judge how much a bank’s managers are able to earn on the shareholder’s investment, we use the return on equity. Return on equity (ROE) is the ratio of the value of a bank’s after-tax profit to the value of its capital. • ROA and ROE are related by the ratio of a bank’s assets to its capital: The Basic Operations of a Commercial Bank

28. Managers of banks and other financial firms may have an incentive to hold a high ratio of assets to capital. • The ratio of assets to capital is one measure of bank leverage, the inverse of which (capital to assets) is called a bank’s leverage ratio. Leverage is a measure of how much debt an investor assumes in making an investment. Bank leverage is the ratio of the value of a bank’s assets to the value of its capital. • The inverse of bank leverage is the leverage ratio. • A high ratio of assets to capital (high leverage) is a two-edged sword: Leverage can magnify relatively small ROAs into large ROEs, but it can do the same for losses. The Basic Operations of a Commercial Bank

29. Moral hazard can contribute to high bank leverage. • If managers are compensated for a high ROE, they may take on more risk than shareholders would prefer. • Federal deposit insurance has increased moral hazard by reducing the incentive depositors have to monitor the behavior of bank managers. • To deal with this risk, government regulations called capital requirements have placed limits on the value of the assets commercial banks can acquire relative to their capital. The Basic Operations of a Commercial Bank

30. 10.3 Learning Objective Explain how banks manage risk.

31. Managing Bank Risk Managing Bank Risk Managing Liquidity Risk Liquidity risk is the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost. • Banks reduce liquidity risk through strategies of asset management and liquidity management. • Asset management involves lending funds in the federal funds market, usually for one day at a time. • Bank can also use reverse repurchase agreements: buying Treasury securities while at the same time agreeing to sell the securities back at a later date, often the next morning. • Liability management involves determining the best mix of borrowings using repurchase agreements or discount loans.

32. Managing Credit Risk Credit risk is the risk that borrowers might default on their loans. Diversification • By diversifying, banks can reduce the credit risk associated with lending too much to a single borrower. Managing Bank Risk

33. Credit-Risk Analysis Credit-risk analysis is the process that bank loan officers use to screen loan applicants. • Banks often use credit-scoring systems to predict whether a borrower is likely to default. • Historically, the high-quality borrowers paid the prime rate. • Today, most banks charge rates that reflect changing market interest rates instead of the prime rate. Prime rate was formerly the interest rate banks charged on six-month loans to high-quality borrowers (now an interest rate banks charge primarily to smaller borrowers). Managing Bank Risk

34. Collateral • Collateral is assets pledged to the bank in the event that the borrower defaults. • Used to reduce adverse selection. • A compensating balance is a required minimum amount that the business taking out the loan must maintain in a checking account with the lending bank. Credit Rationing Credit rationing is the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate. • Loan and credit limits reduce moral hazard by increasing the chance a borrower will repay. • If a bank cannot distinguish low- from high-risk borrowers, then it will run the risk of losing the low-risk borrowers when it raises the interest rate, leaving only the high-risk borrowers—a case of adverse selection. Managing Bank Risk

35. Monitoring and Restrictive Covenants • Banks keep track of whether borrowers are obeying restrictive covenants—explicit provisions in the loan agreement that prohibit the borrower from engaging in certain activities. Long-Term Business Relationships • The ability of banks to assess credit risks on the basis of private information on borrowers. • By observing the borrower, the bank can reduce problems of asymmetric information. • Good borrowers can obtain credit at a lower interest rate or with fewer restrictions. Managing Bank Risk

36. Managing Interest-Rate Risk Interest-rate risk is the effect of a change in market interest rates on a bank’s profit or capital. A rise (fall) in the market interest rate will lower (increase) the present value of a bank’s assets and liabilities. Managing Bank Risk

37. Measuring Interest-Rate Risk: Gap Analysis and Duration Analysis Gap analysis is an analysis of the gap between the dollar value of a bank’s variable-rate assets and the dollar value of its variable-rate liabilities. • Gap analysis is used to calculate the vulnerability of a bank’s profits to changes in market interest rates. • Most banks have negative gaps because their liabilities (deposits) are more likely to have variable rates than are their assets (loans and securities). Managing Bank Risk

38. Duration analysis is an analysis of how sensitive a bank’s capital is to changes in market interest rates. • If a bank has a positive duration gap, then: • the duration of the bank’s assets is greater than the duration of the bank’s liabilities. • an increase in market interest rates will reduce the value of the bank’s assets more than the value of the bank’s liabilities, which will decrease the bank’s capital. Managing Bank Risk

39. Reducing Interest-Rate Risk • Banks with negative gaps can make more adjustable-rate or floating-rate loans. So, if market interest rates rise, banks pay higher interest rates on deposits and also receive higher interest rates on their loans. • Banks can use interest-rate swaps—agree to exchange the payments from a fixed-rate loan for the payments on an adjustable-rate loan. • Banks can use futures contracts and options contracts that can help hedge interest-rate risk. Managing Bank Risk

40. 10.4 Learning Objective Explain the trends in the U.S. commercial banking industry.

41. Trends in the U.S. Commercial Banking Industry Trends in the U.S. Commercial Banking Industry The Early History of U.S. Banking The National Banking Act of 1863 made it possible for a bank to obtain a federal charter. National bank is a federally chartered bank. Dual banking system is the system in the United States in which banks are chartered by either a state government or the federal government.

42. Trends in the U.S. Commercial Banking Industry Bank Panics, the Federal Reserve, and the Federal Deposit Insurance Corporation • The Federal Reserve plays the role of a lender of last resort by making discount loans to banks. • Before the Fed existed, banks were subject to bank runs. • If many banks simultaneously experienced runs, a bank panic often resulted in banks being unable to return depositors’ money. • After the severe bank panic of 1907, Congress passed the Federal Reserve Act in 1913. • The Great Depression led to bank panics, and Congress responded with the creation of the Federal Deposit Insurance Corporation (FDIC) in 1934.

43. Figure 10.2 Commercial Bank Failures in the United States, 1980–2012 Bank failures in the United States were at low levels from 1960 until the savings and loan crisis of the mid-1980s. By the mid-1990s, bank failures had returned to low levels through the beginning of the financial crisis in 2007. Trends in the U.S. Commercial Banking Industry

44. The Rise of Nationwide Banking • In the early 1900s, banks were prohibited from crossing state lines. • In 1900, only 87 of the 12,427 commercial banks in the United States had any branches—unit banking. • The U.S. system of many small, geographically limited banks failed to take advantage of economies of scale in banking. • Restrictions on branching within the state loosened after the mid-1970s. • In 1994, the Riegle-Neal Interstate Banking and Branching Efficiency Act allowed for the phased removal of restrictions on interstate banking, further raising consolidation of banks. • In 2010, concerns about bank size and banks “too big to fail” were discussed in Congress, but no limits on size were finally enacted. Trends in the U.S. Commercial Banking Industry

45. Trends in the U.S. Commercial Banking Industry

46. Expanding the Boundaries of Banking • Between 1960 and 2010, banks: • increased their funds and borrowings • relied less on C&I and consumer loans and more on real estate loans • expanded into nontraditional lending activities and activities generating revenue from fees Off-Balance-Sheet Activities Off-balance-sheet activities are activities that do not affect a bank’s balance sheet because they do not increase either the bank’s assets or its liabilities. Trends in the U.S. Commercial Banking Industry

47. Off-Balance-Sheet Activities • Four important off-balance-sheet activities that banks have come to rely on to earn fee income: • 1. Standby letters of credit. • 2. Loan commitments. Standby letter of credit is a promise by a bank to lend funds, if necessary, to a seller of commercial paper at the time that the commercial paper matures. Loan commitment is an agreement by a bank to provide a borrower with a stated amount of funds during some specified period of time. Trends in the U.S. Commercial Banking Industry

48. Off-Balance-Sheet Activities • Four important off-balance-sheet activities that banks have come to rely on to earn fee income: • 3. Loan sales. • 4. Trading activities. Loan sale is a financial contract in which a bank agrees to sell the expected future returns from an underlying bank loan to a third party. • Banks earn fees from trading in the multibillion-dollar markets for futures, options, and interest-rate swaps. • Bank losses from trading in securities became a concern during the financial crisis of 2007-2009. Trends in the U.S. Commercial Banking Industry

49. Electronic Banking • The first important development in electronic banking was the spread of automatic teller machines (ATMs). • By the mid-1990s, virtual banks (banks that carry out all their banking activities online) began to appear. • By the mid-2000s, most traditional banks had also begun providing online services. • Check clearing is now done electronically. Trends in the U.S. Commercial Banking Industry

50. In Your Interest Making the Connection Is Your Neighborhood ATM About to Disappear? • ATMs are considered the first major product of modern information technology. • In response to recent regulations on charging certain fees, banks have closed some branches and charged customers fees for using a bank teller—leading to increased use of ATMs • Increased use of debit cards and smart phones to pay for goods have led to a reduction in the use of currency and ATMs. • In the face of the conflicting influences, the future of the ATM remains to be seen. Trends in the U.S. Commercial Banking Industry