CHAPTER 13 & 16

1. CHAPTER 13 & 16 COMMERCIAL BANK OPERATIONS & REGULATION

2. An Overview of the Banking Industry Today • The commercial banking industry is comprised of less than 9,000 banks down from a peak of 15,000 in 1980. • Commercial banks' geographic expansion was once limited but these limits have been almost eliminated. • Consequently, while the number of banks has declined, the total number of bank branches has grown to over 70,000.

3. Number of Banks and Branches, 1920-2001, Exhibit 13.1

4. An Overview of the Banking Industry Today (concluded) • The decline in the number of banks can be attributed to the rapid pace of consolidation in the industry. • Large banks dominate asset and deposit holdings in the industry.

5. Bank Holding Companies • The bank holding company is the major form of organization for banks in the United States and was used: • To achieve geographic expansion. • To offer traditional nonbanking financial services. • To reduce their tax burden. • The 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act allowed banks to acquire banks in other states.

6. Bank Holding Companies (concluded) • Bank Holding Companies were first regulated under the Bank Holding Company Act of 1956, with major amendments made in 1970 to include one-bank holding companies under the definition of a bank holding company. • There was a concern about concentrated economic power and concern that troubled bank holding companies could undermine the confidence in commercial banks. • The Federal Reserve regulates bank holding companies.

7. Financial Holding Companies • Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley) • Extended list of allowable financial activities for Fed certified financial holding companies • Insurance underwriting and investment banking

8. The Largest BHC’s and FHC’s 25 Largest Bank Holding Companies Year End 2002

9. Bank Failures in the United States • Occur when a bank’s assets are worth less than its liabilities. • Deposit insurance was developed to reassure depositors that their deposits were safe even if their bank failed.

10. Deposit Insurance • Deposit insurance was first enacted in 1933 for up to $2,500 per account. • Over time the limit increased to $100,000 per account. • Currently, deposits are insured up to $100,000 per depositor.

11. Bank Regulators • Bank Insurance Fund (FDIC-1933) and (SAIF-1989) • Insures deposits to $100,000. • Examines state chartered, non-Fed member banks and S & L's. • Autonomous funding from deposit premiums. • Influences all banks by providing deposit insurance.

12. Bank Regulators (continued) • Federal Reserve System (1913) • Examines state chartered, member banks. • Autonomous funding--independent. • Monetary control authority. • Regulates bank and financial holding companies. • Comptroller of the Currency (OCC) 1863 • Charters national banks; closes failed national banks. • Examines national banks. • Autonomous funding--independent.

13. Bank Regulators (concluded) • State Banking Agencies • Charter state banks. • Examine state chartered banks. • Protect public.

14. Bank Examinations • Are an important part of bank regulation • Bank examinations are intended to promote and maintain safe and sound bank operating practices. • The examination procedure includes: • bank financial information collected quarterly (call reports). • on-site bank examinations. • discussion of examination findings with bank management.

15. Bank Examinations, cont. • Areas of the Bank Analyzed in the Examination Process • Capital adequacy. • Asset quality. • Management competency. • Risk Management. • Earnings of the bank. • Liquidity of the bank.

16. Bank Sources of Funds -- Liabilities and Capital • Demand deposits accounts • Savings Accounts • Certificates of Deposit • Borrowed Funds from Other Institutions • Capital Notes and Bonds • Bank Capital Accounts – Equity or Ownership

17. Uses of Funds -- Bank Assets • Cash assets • Federal Funds sold represent excess reserves. • Bank investments • U.S. Treasury securities offer safety, liquidity, collateral, and income. • U.S. government agency securities provide safety and income. • Municipal securities provide income and a tax shield.

18. Bank loans • Loans are generally more risky than the investment portfolio. • Banks make fixed rate or floating rate loans. • Many loans are secured by collateral; others are unsecured.

19. Commercial and Industrial Loans • Represent the major loan category of banks. • Bridge loans -- a business financing agreement with repayment coming from the completion of the agreement. • Seasonal loans -- financing of varying working capital needs over a year with repayment coming from the reduction in working capital. • Long-term asset loans -- financing equipment over several years with repayment coming from future profits and cash flows of the borrower.

20. Other Loans • Loans to depository institutions -- loans to respondent banks, S&Ls, and foreign banks. • Real estate loans -- fixed or variable rate long-term loans • residential mortgage loans • commercial and industrial real estate loans

21. Other Loans (concluded) • Consumer loans to individuals • most are paid back in installments • includes credit card and purchase credit • Bank Credit Cards -- credit extended to consumer at the time of purchase and/or cash advance: • once local, credit card networks are now worldwide • bank earns fees from annual fee, merchant discount and interest on revolving credit balances

22. The Prime Rate • The commercial loan index rate posted by banks. • Traditionally, most loans were tied to the prime rate, but today other market rates such as LIBOR, Treasury or CD rates are used as loan pricing reference rates. • The prime rate remains a popular media indicator of changing credit conditions. • The prime rate lags or follows market rates.

23. Base Rate Loan Pricing • Most banks use a base rate of interest as a markup base for loan rates. • The base rate may be the prime rate, the Federal Funds rate, LIBOR, or the Treasury rate and is expected to cover the following: • the cost of funds of the bank. • the bank's administrative costs • a fair return to the bank shareholders

24. Base Rate Loan Pricing Factors • An upward adjustment from prime for default risk. • An adjustment for term to maturity. • An adjustment for competitive factors.

25. Match-funding Loan Pricing • The loan rate is determined by adding a spread to the deposit cost to cover administrative costs, default risk, and a competitive return to bank shareholders. • By matching the maturities of sources and uses, changing market interest rates are less likely to affect bank earnings.

26. Analysis of Loan Credit Risk: The 5 C’s of Credit • character -- willingness to pay. • capacity -- cash flow. • capital -- wealth. • collateral -- pledged assets. • conditions -- current economic conditions.

27. Fee-Based Services • Fee-based services have become important sources of bank revenue. • Correspondent banking involves the sale of bank services to other banks and institutions. • Bank leasing is an important type of credit service. • Trust operations involve the bank acting in a fiduciary capacity for customers.

28. Fee-Based Services (continued) • Investment products such as brokerage services and mutual funds are relatively new, but increasingly important sources of fee income. • Financial Holding Companies—May own insurance underwriting and investment banking companies.

29. Off-balance Sheet Banking • Off-balance-sheet activities are fee-based activities that give rise to contingent assets and liabilities.

30. Off-balance Sheet Banking (continued) • Loan commitments – plan ahead • Letters of credit • Loan brokerage • Derivative securities

31. Securitization • Mortgage, auto or credit card loans are pooled together in a trust arrangement. • Securities are sold to individual and institutional investors. • The cash flow collections from the loans are forwarded to the trust and investors.

32. Securitization (concluded) • The bank earns loan origination fees, perhaps underwriting fees, and loan servicing fees, and the funds raised by the securitization are used to originate more loans. • Securitizing loans enables the bank to generate fees without added bank equity capital, required reserves (no funding needed), and deposit insurance premiums.