Chapter 17

Commercial Bank
Operations

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline
 Commercial banks as financial
intermediaries
 Bank market structure
 Bank sources of funds
 Uses of funds by banks
 Off-balance sheet activities
 International banking

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Commercial Banks as Financial
Intermediaries
 Commercial banks serve all types of
surplus and deficit units
 Offer deposit accounts with the size and
maturity characteristics desired by surplus
units
 Repackage funds received from deposits to
provide loans of the size and maturity desired
by deficit units

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Bank Market Structure
 Banks are continuing to consolidate:
 Interstate
regulations were changed in 1994 to allow
banks more freedom to acquire banks across state
lines
 Competition among banks increased
 Banks needed to become more efficient as a means of
survival
 Acquisitions were a convenient method to grow quickly
 The number of banks today is about one-half that
existed in 1985
 The largest 100 banks now represent about 75
percent of all bank assets

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Bank Market Structure (cont’d)
 Bank participation in financial conglomerates
 Some commercial banks have acquired other types of financial
service firms
 Conglomerates are composed to various units offering
specialized services
 Impact of the Financial Services Modernization Act
 The Act gave banks and other financial service firms more
freedom to merge, without having to divest some of the financial
services that they acquired
 The Act allowed financial institutions to offer a diversified set of
financial services

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Bank Market Structure (cont’d)
 Benefits of diversified services to individuals and firms
 Individuals and firms have various financial needs that they can
now satisfy with one conglomerate
 Some financial conglomerates specialize in the services desired
by individuals or large firms
 Benefits of diversified services to financial institutions
 Financial institutions can reduce their reliance on the demand for
any single service they offer
 Diversification may result in less risk for the institution
 The units of a financial conglomerate may generate some new
business just because they offer convenience to clients who
already rely on its other services

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Bank Sources of Funds
 A financial institution’s liabilities represent its sources of
funds
 Transaction deposits
 A demand deposit account (checking account) is offered to
customers who desire to write checks
 A conventional account requires a small minimum balance and pays
no interest
 A negotiable order of withdrawal (NOW) account provides
checking services as well as interest but requires a larger
minimum balance
 Electronic transactions
 About two-thirds of all employees in the U.S. have direct deposit
accounts
 More than 60 percent of bank customers use ATMs
 Debit cards and preauthorized debits can be used for recurring
monthly payments

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Bank Sources of Funds (cont’d)
 Savings deposits
 Until
1986, Regulation Q restricted the interest rate
banks could offer on passbook savings
 Ceilings prevented commercial banks from competing for
funds during periods of higher interest rates
 An automatic transfer service (ATS) account
allows customers to maintain an interest-bearing
savings account that automatically transfers funds to
their checking account when checks are written

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Bank Sources of Funds (cont’d)
 Time deposits
 Time deposits are deposits that cannot be withdrawn
until a specified maturity date
 Retail certificates of deposit (CDs) require a
specified minimum amount of funds to be deposited
for a specified period of time
 Annualized interest rates vary among banks and maturity
types
 There is no organized secondary market
 Depositors will normally forgo a portion of their interest as a
penalty for early withdrawal

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Bank Sources of Funds (cont’d)
 Time deposits (cont’d)
 Certificates of deposit (cont’d)
 Bull-market CDs reward depositors if the market performs well
 Bear-market CDs reward depositors if the market performs poorly
 Callable CDs can be called by the financial institution early

 Negotiable certificates of deposit (NCDs):

 Are offered by some large banks to corporations
 Typically have short-term maturities
 Typically require a minimum deposit of $100,000
 Do not have a secondary market

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Bank Sources of Funds (cont’d)
 Money market deposit accounts (MMDAs):
 Were created with the Garn-St Germain Act of 1982
 Differ from conventional time deposits in that they do
not specify a maturity
 Are more liquid than retail CDs
 Normally pay a lower rate than retail CDs
 Differ from NOW accounts in that they provide limited
check-writing ability

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Bank Sources of Funds (cont’d)
 Federal funds purchased
 Federal funds purchased represent a liability to the borrowing
banks and an asset to the lending bank that sells them
 Loans in the federal funds market are typically for one to seven
days
 The intent of federal funds transactions is to correct short-term
fund imbalances experienced by banks
 The interest rate charged in the federal funds market is the
federal funds rate
 Typically between 0.25 percent and 1.00 percent above the T-bill
rate
 Banks that are short of required reserves on the average over a
settlement period must compensate with additional reserves

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Bank Sources of Funds (cont’d)
 Borrowing from the Federal Reserve banks
 The interest rate charged on loans from the Fed is the
discount rate
 Loans from the discount window are commonly from
one day to a few weeks
 The discount window is mainly used to resolve a
temporary shortage of funds
 Banks commonly borrow in the federal funds market
instead of the discount window because the Fed may
disapprove of continuous borrowing by a bank

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Bank Sources of Funds (cont’d)
 Repurchase agreements
 A repurchase agreement (repo) represents the sale of
securities by one party to another with an agreement to
repurchase the securities at a specified date and price
 Banks use repos as a source of funds when they need funds just
for a few days
 The bank sells some government securities to a corporation and
buys those securities back later
 Repos occur through a telecommunications network connecting
large banks, corporations, government securities dealers, and
federal funds brokers
 Repo transactions are typically in blocks of $1 million
 The repo yield is slightly less than the federal funds rate

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Bank Sources of Funds (cont’d)
 Eurodollar borrowing
 Eurodollars are dollar-denominated deposits in banks outside
the U.S.
 Eurobanks are foreign banks or foreign branches of U.S. banks
that accept large short-term deposits and make short-term loans
in dollars
 Bonds issued by the bank
 Banks issue bonds to finance fixed assets
 Common purchasers of bank bonds are households and various
financial institutions
 Banks finance less with bonds than other corporations

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Bank Sources of Funds (cont’d)
 Bank capital
 Bank capital represents funds attained
through the issuance of stock or through
retained earnings
 Represents the equity or net worth of the bank
 Primary capital results from issuing common
or preferred stock or retained earnings
 Secondary capital results from issuing
subordinated notes and bonds

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Bank Sources of Funds (cont’d)
 Bank capital (cont’d)
A higher level of capital is thought to enhance a
bank’s safety because capital can absorb losses
 In 1981, regulators imposed a minimum primary
capital requirement of 5.5 percent of total assets and
a minimum total capital requirement of 6 percent of
total assets
 In 1988, regulators imposed risk-based capital
requirements that were completely phased in by 1992
 The required level of capital is dependent on its risk
 Assets with low risk are assigned low weights, and assets
with high risk are assigned high weights

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Bank Sources of Funds (cont’d)
Summary of Bank Sources of Funds

Savings deposits (incl.

MMDAs)
8%
Transaction deposits

12% 30%
Borrowed funds

Other sources
16%
Small-denomination time
deposits
10% 24%
Large-denomination time
deposits

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Uses of Funds by Banks
 Cash
 Banks are required to hold some cash as reserves by
reserve requirements imposed by the Fed
 Banks hold cash to maintain some liquidity and
accommodate withdrawal requests
 Banks only hold as much cash as necessary because
cash does not pay interest
 Banks hold cash in vaults and in their Fed district
bank

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Uses of Funds by Banks (cont’d)

 Bank loans
 Loans are the main use of bank funds
 Types of business loans
 A working capital loan is designed to support ongoing
business operations
 Term loans are used to finance the purchase of fixed assets
 Conditions by which the borrower must abide are protective
covenants
 Term loans are often amortized so that the borrower makes
fixed payments
 If the loan principal is paid off in one balloon payment, it is a
bullet loan

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Uses of Funds by Banks (cont’d)

 Bank loans (cont’d)

 Types of business loans (cont’d)
 A direct lease loan involves purchasing the
assets and leasing them to the firm
 An informal line of credit allows the business to
borrow up to a specified amount within a specified
period of time
 The interest rate charged by banks on loans
to their most creditworthy customers is known
as the prime rate
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Uses of Funds by Banks (cont’d)

 Bank loans (cont’d)

 Loan participations
 Several banks pool their available funds in a loan
participation
 One of the banks serves as the lead bank and
other banks supply funds that are channeled to the
borrower
 The lead bank receives fees for servicing the loan
in addition to its share of interest payments
 All participating banks are exposed to credit risk

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Uses of Funds by Banks (cont’d)

 Bank loans (cont’d)

 Types of consumer loans
 Installment loans are used to finance purchases
of cars and household products
 Banks provide credit cards to customers

 The interest rate charged on credit card loans and

personal loans is typically much higher than the

cost of funds

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Uses of Funds by Banks (cont’d)

 Bank loans (cont’d)

 Real estate loans
 For residential real estate, the maturity on a
mortgage is typically 15 to 30 years
 Loans are backed by the residence purchased
 Banks provide some commercial real estate loans
to finance commercial development

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Uses of Funds by Banks (cont’d)

 Investments in securities
 Banks purchase Treasury securities and government
agency securities
 Government agency securities:
 Can be sold in the secondary market
 Have a less active market than Treasury securities
 Are not a direct obligation of the federal government
 Banks purchase investment-grade corporate and
municipal securities

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Uses of Funds by Banks (cont’d)
 Investments in securities (cont’d)
 Bank investment in securities over time
 Generally, banks hold securities that:
 Offer a lower expected return than the loans they provide
 Offer more liquidity and are subject to lower default risk than
loans they provide
 During weak economic conditions:
 Firms are unwilling to expand
 Banks extend fewer loans and increase their purchases of
securities
 In the 1990s, banks used a relatively high proportion of their
funds for loans
 In 2002, banks reduced their loans while increasing their
investment in securities

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Uses of Funds by Banks (cont’d)
 Federal funds sold
 Funds lent out will be returned at a specified time with interest
 Small banks are common providers of funds in the federal funds
market
 Repurchase agreements
 Banks can act as the lender on a repo by purchasing a
corporation’s holdings of Treasury securities
 Eurodollar loans
 Eurodollar loans are provided by branches of U.S. banks located
outside the U.S. and some foreign-owned banks
 Fixed assets
 Banks must maintain some amount of fixed assets so that they
can conduct their business operations

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Uses of Funds by Banks (cont’d)
Summary of Bank Uses of Funds
Loans to households

10% Real estate loans

22% Business loans

Other loans

5% 28% Loans to foreign

governments
Cash and non-interest
14% securities
RA and fed funds
2%
5% 14% Securities

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Off-Balance Sheet Activities
 Off-balance sheet activities:
 Generate fee income without requiring an investment of funds
 Create a contingent obligation for banks
 Are required to be recognized as assets or liabilities and
reported at fair market value
 A loan commitment is an obligation by a bank to
provide a specified loan amount to a particular firm upon
the firm’s request
 e.g., a note issuance facility (NIF) requires banks to purchase
the commercial paper of a firm if the firm cannot place its paper
in the market at an acceptable interest rate

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Off-Balance Sheet Activities
(cont’d)
 A standby letter of credit (SLC) backs a
customer’s obligation to a third party
 A forward contract is an agreement between a
customer and a bank to exchange one currency
for another on a particular future date at a
specified exchange rate
 With a swap contract, two parties agree to
periodically exchange interest payments on a
specified notional amount of principal

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