Chapter 9

Commercial Banks

Contents

Commercial Bank Balance Sheet

Commercial Bank Liabilities

Commercial Bank Assets

Commercial Bank Capital Accounts

Commercial Bank Management

Liquidity Management

Liability Management

Capital Management

The Importance of Commercial Banks

Savers Borrower

Funds

Primary claims

Funds Funds

Primary claimsSecondary claims

FinancialIntermediaries

The Importance of Commercial Banks

• Depository institutions play a key role in

channeling funds from savers (surplus unit)

to borrowers (deficit units)

• Commercial banks dominate among

depository institutions.

• Banks take in funds by accepting _____

• Banks use the funds mainly to ______

deposit

grant loans

The Importance of Commercial Banks

• Commercial banks are the oldest and most diversified of all financial intermediaries.

• Banks are important in the money supply process.

• Banks create money by lending or buying the securities

The Commercial Bank Balance Sheet

• Banks earn a profit on the “spread” (3%-4%)

by obtaining funds at relatively low interest

rates and lending at higher interest rates.

• In recent years, fees have played an

increasingly important role in bank profits.

The Commercial Bank Balance Sheet

• A bank balance sheet is a statement of its

assets, liabilities, and net worth at a given point in

time.

•Assets are what it owns.

Loan, securities (Investment) earning assets

•Liabilities are what it owes.

Demand deposit, saving deposit, time deposit

The Commercial Bank Balance Sheet

– Net worth (capital accounts, capital) is

the difference between its assets and

liabilities.

Common stocks, retained earning

•Assets = Liabilities + Net Worth

•Assets - Liabilities = Net Worth

Figure 9-1

Table 9-1

Commercial Bank Liabilities

Transactions Deposits

(checkable deposits)

Non-transaction Deposits

Non-deposit borrowing

Other liabilities

Commercial Bank Liabilities

Transactions Deposits (checkable deposits)

Demand Deposits: non-interest bearing checking accounts

Negotiable Order Of Withdrawal (NOW) Accounts: interest-bearing checking accounts

Automatic Transfer Service (ATS) Accounts:Paired accounts with checks on non-interest baring accounts & automatic transfers to it from interest-bearing accounts

Commercial Bank Liabilities

Non-Transactions Deposits

Passbook Savings Accounts Any amount of funds can be added or withdrawn at any timeSmall Certificates of Deposit (CDs up to $100,000)There are penalties if withdrawing before maturity (3 months to 5 years) similar to time deposit in ThailandMoney Market Deposit Accounts (MMDAs) Special type of saving account with limited check writing feature (no more than 6 times per month) Negotiable CDs. Large CDs over $100,000

Commercial Bank Liabilities

Non-deposit Borrowing

Borrowing from the Fed

discount loans, discount window

pay interest at the discount rate

Borrowing from other banks’ excess reserve

overnights loans between bank

federal funds

pay interest at federal fund rate

Commercial Bank Assets

Cash Assets

Loans

Securities

Other Assets

Commercial Bank Assets

Most of banks’ assets are in form of income-earning assets or earning assets (85%) Loan

Securities

However, banks are subjected to maintains portion of their source of funds (liabilities) in form of non-interest-earning legal reserves Coin and currency in banks

Bank’s deposit balance at the central bank

Commercial Bank Assets

Cash Assets

Vault cash - Currency and coins at bank

o to meet public’s demand

o to meet reserve required

Deposits with Federal Reserve Bank (central bank)o to meet reserve required

o to facilitate check clearing process

Deposits with other bankso Correspondent banking – smaller banks maintain deposits in

larger banks in return of services e.g. check collection, investment counsel, and transaction in securities and foreign currency

Commercial Bank Assets

Loans

Real Estate Loans: collateralized by property (real estate), Ex. Mortgage

Securitization – banks bundle many real estate loans into the package and issue the securities based on this package to investors

Business Loans: Regular installment loans

Lines of credit (subject to compensating balance)

Commercial Bank Assets

Consumer Loans: Auto loans

Credit cards banks get the fee from business accepting the card and also get the interest rate if the cardholders design to pay the minimum balance.

Overdraft arrangement

Other Loans: Federal funds sold

Securities

Other assets Building, Land, Equipment

Commercial Bank Capital Accounts

• Bank capital derives from the issue of bank stock

shares and from retained earnings

• Bank capital provides a cushion that protects a bank's

owners from potential bank insolvency

– Total assets are less than total liabilities

– Negative net worth

Writing Off Bad Loans

Bank needs to write off $600,000 for bad loans

Writing Off Bad Loans

• Immediate write off bad loans can make the bank to

face the situation of insolvency.

– Close the banks

– Find new owners to take over the bank

(through Merger & Acquisition)

• Bank usually (also subject to the regulation) sets aside

contingent funds against loan loss in advance

loan loss reserve (Allowance for bad debts)

Commercial Bank Management

• Commercial banks strive to: – earn solid profits;

– maintain extremely low exposure to the possibility of becoming insolvent, and

– maintain high liquidity (the ability to immediately meet currency withdrawals) by managing liquidity and capital.

T-Accounts

• T-accounts are statements of the change in the balance sheet resulting from a given event. – ie. if a customer withdraws $200 in cash from a savings

account at the Bank of Medicine Bow.

ie. Clearing a check for $12,000 written by a bank customer

The Importance of Liquidity

• Banks must have emergency plans to meet large reserve withdrawals, so banks need to hold liquid assets like Treasury bills.

• If a bank is exposed to large deposit outflows and can obtain reserves only at substantial cost, it could find itself in serious trouble, even if it has a relatively large capital account.

The Liquidity-Risk Trade-off

• If bank decides to maintains high liquidity, bank will face less risk

• If bank decides to maintains low liquidity, bank will face higher risk

The Liquidity-Risk Trade-off

With a reserve requirement of 10%, the bank has no excess reserves.

Its assets are 90% in high return loans and 10% in low return securities.

What if depositors withdraw $20 million?

The Liquidity-Risk Trade-off

If depositors withdraw $20 million, Deposit decreases to $380 million Reserves also decreases to $20 million

However, required reserve ratio is 10%, bank need to maintain reserves at $38 million bank need to find more reserve for $18 million

Bank has marketable securities (liquid assets) only $10 million that is not enough bank need to find other funds

The Liquidity-Profitability Trade-off

• If bank decides to maintains low liquidity, bank will have a change to get higher return

• If bank decides to maintains high liquidity, bank will get lower return

• Higher liquidity means bank will hold more excess reserve (no return) and more marketable securities (low return) rather than lending the loan (higher return)

The Liquidity-Profitability Trade-off

• The bank has $10 million excess reserves.

• Its assets are split between high return loans & low return securities.

The Liquidity-Profitability Trade-off

• If depositors withdraw $20 m, then the balance sheet changes– Deposit decrease to $380 million

– Reserves decrease to $30 million

• With 10% required reserve ratio, bank has to maintain $38 million reserve bank need more $8 million

• Bank have lots of marketable securities to be liquidated and change to reserve no problem

• However, it is less profitable because it has fewer high-return loans.

The Liquidity-Profitability Trade-off

• If bank decides to maintains low liquidity,

bank will face higher risk but have more

opportunity to get higher return

• If bank decides to maintains high liquidity,

bank will face lower risk and get lower

return

Indicators of Bank Liquidity

• The ratio of bank loans to total assets– Higher ratio lower liquidity

• The ratio of securities to total assets– Higher ratio higher liquidity

• The ratio of demand deposit to total bank deposits – Higher ratio Bank need to maintain

more liquidity

Liability Management

• Banks look for good lending opportunities and then search for the funds to finance these loans.

• When a large bank finds a profitable lending opportunity, it can:

– “buy” federal funds;

– issue negotiable CDs at whatever interest rate is required to attract funds;

– issue repurchase agreements or borrow Eurodollars, or

– obtain funds through the commercial paper market.

Liability Management

• Aggressive liability management can be dangerous,

because a bank’s assets typically have longer

maturities than its liabilities.

• If interest rates rise sharply, banks can suffer severe

losses.

• Aggressive liability management allows banks to make

profitable loans that they would otherwise have to turn down.

Liability Management

3rd year 10th yearNow

Loans

Deposit

5%

1%

5%

4%

2nd year

7%

5%

Capital Management

• Bank capital provides a financial cushion so that transitory adverse developments will not cause insolvency.

• Bank capital also protects bank managers and owners from

their own mistakes and from various risks:

– default risk borrowers do not pay back their loans

– interest-rate risk when interest rate changes

– liquidity risk depositors will withdraw the fund

– Foreign exchange rate risk when exchange rate change

– political or country risk risk that fund or assets in other countries cannot be mobilized to home country

– management risk employees will engage in activities involving enormous risk (Barings Bank – Nicholas Leeson)

Capital Management

• Bank capital ratio =

• higher bank capital ratio – implies a lower risk of insolvency, – but also a lower rate of return.

Capital

Asset

The Capital Management Tradeoff

Earning Earning Total Assets

Capital Total Assets Capital= x

Return on Equity = ROA * Equity Multiplier

Note: A high capital ratio represents a low equity multiplier;

A low capital ratio represents a high equity multiplier

A trade-off arises between short-run profitability & the risk of insolvency

Capital Management

Earning/Capital = Earning/TA x TA/Capital

Suppose a bank has net income (earnings) 1m, TA 100m

Case 1: a bank has capital = 5mEarning / Capital = ???Case 2 : a bank has capital = 10mEarning / Capital = ???

Summary

Commercial bank raise the funds from accepting deposit

and use the funds in granting the loan

Bank earn interest rate spread between deposit rate and

loan rate and also earn the service fees

If bank faces daily shortage in reserve, bank can borrow

from Fed at discount rate or borrow from other banks at fed

fund rate

Loans are most-income-earning assets of the banks

Banks are subjected to maintains portion of their source of

funds in form of non-interest-earning legal reserves

(currency and deposit at Fed)

Summary

Smaller banks maintain deposits in larger banks in

return of services e.g. check collection, investment

counsel, and transaction in securities and foreign

currency Correspondent banking system

Bank may bundle many real estate loans into the

package and issue the securities based on this

package to investors securitization

Bank becomes insolvency if total asset is less than

total liability or negative net worth (equity)

Summary

If bank decides to maintains low liquidity, bank will face

higher risk but have more opportunity to get higher return

Aggressive liability management can be dangerous,

because a bank’s assets typically have longer maturities

than its liabilities. If interest rates rise sharply, banks can

suffer severe losses.

Bank capital provides a cushion that protects a bank's

owners from potential bank insolvency

higher bank capital ratio, implies a lower risk of insolvency,

but also a lower rate of return.