Chapter Eleven

1. Chapter Eleven Commercial Banks

2. Definition of a Commercial Bank • Represent the largest group of depository institutions measured by asset size. • Perform functions similar to those of savings institutions and credit unions - they accept deposits (liabilities) and make loans (assets) • Liabilities include nondeposit sources of funds such as subordinated notes and debentures • Loans are broader in range, including consumer, commercial, international, and real estate • Regulated separately from savings institutions and credit unions

3. Differences in Balance Sheets Depository Institutions Nonfinancial Firms Assets LiabilitiesAssets Liabilities Loans Deposits Deposits Loans Other Other financial financial assets assets Other Other Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity

4. Commercial Bank Balance Sheet* Assets Total cash assets………………. $ 253.8 4.8% U.S. gov securities…………… $ 801.4 Other…………………………. 391.6 Investment securities………….. 1,193.0 22.6% Interbank loans………………. 223.0 Loans exc. Interbank………… 3,314.3 Comm. and Indust…………..$ 948.5 Real estate…………………… 1,343.0 Individual……………………. 496.4 All other……………………… 526.4 Less: Reserve for losses……… 58.7 Total loans……………………… $3,478.6 66.0% Other assets…………………….. 347.6 6.6% Total assets…………………….. $5,273.0

5. Commercial Bank Balance Statement* Liabilities and Equity Transaction accounts…………… $ 667.4 12.8% Nontransaction accounts………... 2,688.5 54.4% Total deposits…………………… $3,355.9 Borrowings……………………… 1,006.0 21.3% Other liabilities………………….. 462.3 2.8% Total liabilities………………….. $4,824.2 Equity…………………………… 448.8 8.7% *Aggregate balance sheet and percentage distributions for all U.S. commercial banks as of May 26, 1999 in billions of dollars

6. Balance Sheet • Assets • loans and investment securities • Liabilities • transaction accounts - the sum of noninterest-bearing demand deposits and interest-bearing checking accounts • NOW account - an interest-bearing checking account • negotiable CDs - fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market • Equity • common and preferred stock, surplus or additional paid-in capital, and retained earnings (continued)

7. Balance Sheet • Off-Balance-Sheet activities • off-balance-sheet asset - 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 liability - when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement • Trust services • generates fees by holding and managing individuals or corporations assets • Correspondent banking • generates fees by provision of banking services to other banks

8. Economies of Scale and Scope • Economies of scale - the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase • Economies of scope - the degree to which a firm can generate cost synergies by producing multiple financial service products • Megamerger - the merger of banks with assets of $1 billion or more • X efficiencies - cost savings due to the greater managerial efficiency of the acquiring firm

9. Measuring Economies of Scale ACi = TC i Si Where: ACi = Average costs of the ith bank TCi = Total costs of the ith bank Si = Size of the bank measured by assets, deposits or loans

10. Economies of Scale and the Effect of Technology Improvement Average Cost Old Technology AC1 New Technology AC2 Size 0

11. Economies of Scope • By offering more services to a given customer; • revenue can be enhanced • costs can be reduced • Cost economies of scope • investments in one financial service (such as lending) may reduce costs to produce financial services in other areas (such as securities underwriting or brokerage) • Revenue economies of scope

12. Bank Size and Concentration • Community bank - a bank that specializes in retail or consumer banking • Regional or superregional bank - a bank that engages in a complete array of wholesale commercial banking activities • Federal funds market - an interbank market for short-term borrowing and lending of bank reserves • Money center bank - a bank that relies heavily on nondeposit or borrowed sources of funds

13. Bank Size and Activities • Large banks have easier access to capital markets and can operate with lower amounts of equity capital • Large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits • Large banks lend to larger corporations which means that their interest rate spread is narrower • the difference between lending and deposit rates • Large banks are more diversified and generate more noninterest income

14. Industry Performance • Provision for loan losses - bank management’s recognition of expected bad loans for the period • Net charge-offs - actual losses on loans and leases • Net operating income - income before taxes and extraordinary items

15. Regulators • Federal Deposit Insurance Corporation (FDIC) • insures the deposits of commercial banks • Office of the Comptroller of the Currency (OCC) • function is to charter national banks as well as close them • has the power to approve/disapprove of mergers • Federal Reserve System • requires all banks to meet the same noninterest-bearing reserve requirements • State Authorities • performs for state chartered banks similar functions as the OCC does for national banks