CHAPTER 13

COMMERCIAL BANK OPERATIONS

CHAPTER OVERVIEW AND LEARNING OBJECTIVES
This chapter surveys the structure and importance of the U.S. commercial banking industry.
The chapter describes the basic operation of commercial banks in terms of their sources and uses
of funds as reflected in their major balance sheet accounts.
The chapter explains how banks make decisions about risk-taking, funding, and pricing.
The chapter discusses the development and structure of bank and financial holding companies.

CAREER PLANNING NOTE: THE ENTRY LEVEL IN COMMERCIAL BANKING

Large banks have a well-defined entry level for college graduates. New recruits complete one to two years
of training. The first phase immerses them in accounting, finance, regulation, and the banks policies and
procedures. The second phase involves rotations among the banks key lines of business. Then trainees
undergo a placement process to find their first permanent assignment. Those ranking nearer the top of their
training class will have more nearly their first choice. Today, banking involves a wide range of career
options, both functionally and geographically. The nations largest banks now operate in practically all 50
states, and deliver many services either not permitted or not invented 20 years ago.

READING THE WALL STREET JOURNAL: HITTING THE HIGHLIGHTS

The Journals layout is designed to get a busy reader up to speed in a matter of minutes. In a hurry first
thing in the morning? Scan the Whats News columns on the front page, then page through Section C
(Money & Investing). These items make up the financial worlds daily brief.

TOPIC OUTLINE AND KEY TERMS

I.

An Overview of the Banking Industry

A.

Fewer banks, more branches.

1.
Less than 8,000 banks: The number of banks has declined significantly as the
industry has consolidated.
2.
More than 80,000 banking offices: The number of branches has increased
significantly as geographical restrictions on banking have relaxed.

B.

Many small banks, a few very large banks.

1.
94% of U.S. banks hold only 18% of banking industry deposits.
2.
The largest 89 banks (about 1% of U.S. banks) hold 67% of total deposits.

C.

II.

Holding companies predominate.

1.
A bank holding company is a company owning an interest in at least 1 bank.
2.
As of 2005, some 5,154 holding companies controlled 6,160 banks with about
96% of U.S. commercial bank assets.
Bank Balance Sheet: Uses of Funds (Assets) = Sources of Funds (Liabilities + Capital).
A.

Sources of Funds: Liabilities + Capital

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1.

Deposit Liabilities: Transaction Deposits; Savings Deposits; Time Deposits.

a.

Transaction Deposits: Demand Deposits; NOW Accounts:

(1)
Demand Deposits, also known as checking accounts.
(2)
NOW (Negotiable Order of Withdrawal) Accounts
i.
pay interest;
ii.
just for individuals, governments, and nonprofits

b.

Savings Deposits: Savings Accounts; MMDAs.

(1)
Savings Accounts comprise about 13% of all deposits
(2)

c.

2.

3.

B.

MMDAs (Money Market Deposit Accounts)

i.
comprise about 40% of all deposits
ii.
interest plus limited transactional features

Time Deposits: Certificates of Deposit; Negotiable Certificates of Deposit

(1)
Non-transferable Certificates of Deposit
i.
usually under $100,000
ii.
terms of 30 days to 5 years
(2)
Negotiable (or Jumbo) CDstransferable in secondary market
i.
$100,000 or more
ii.
terms rarely exceed 90 days

Non-deposit Liabilities: Fed Funds Purchased; Repurchase Agreements; Other

a.

Fed Funds Purchased: Most important non-deposit source of funds.

(1)
Recall purpose of Fed Funds Market from Chapters 2 and 3
(2)
Banks buy and sell Fed Funds overnight to adjust liquidity.

b.

Repurchase Agreements: Another liquidity adjustment mechanism.

(1)
Bank sells securities but agrees to repurchase them
i.
essentially a self-securing loan
ii.
usually overnight but can last longer
(2)
T-Bills are a common form of collateral.

c.

Other Borrowings
(1)
Trading Liabilities
(2)
Eurodollars (See Chapter 12).
(3)
Bankers Acceptances (see Chapters 7 and 12).
(4)
Federal Home Loan Bank Advances
(5)
Discount Window Loans (see Chapters 2 and 3).
(6)
Capital Notes or Bonds
i.
usually subordinate to depositors claims
ii.
may count as capital for some regulatory purposes

Capital Accounts: Capital stock; Undivided Profits; Special Reserve Accounts.

a.
Capital Stock: Direct investments of common or preferred equity.
b.
Undivided Profits: Accumulated earnings not paid out in dividends.
c.
Special Reserve Accounts: Against losses on loans or securities.

Uses of Funds: Assets

1.

Cash Assets: About 4% of industry assets.

a.
Vault cash--Physical currency and coin counts for reserve requirements.
b.
Reserves at the Fed (see Chapters 2 and 3).

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(1)
(2)

c.
d.
e.
2.

Investments: About 17% of industry assets; risk discouraged in favor of liquidity.

a.
U.S. Treasury securities (see Chapters 7 and 8).
b.
Agency securities (see Chapters 7, 8, and 9).
c.
Municipal securities (see Chapter 8).
(1)
Probably the riskiest securities banks are allowed to own.
(2)
Interest is exempt from federal income tax.

3.

Loans and Leases: Main earning assets of any bank; about 59% of industry assets.

4.

III.

Required reserves per Reg D

Excess reserves
i.
for settling transactions with Fed
ii.
for check-clearing
iii.
for Fed Funds transactions
Balances at other banks.
Fed Funds Sold (see Chapters 2 and 3).
Reverse Repurchase Agreements.

a.

Major categories of bank loans:

(1)
Commercial and Industrial. Loans (about 11% of assets)
i.
Working capital
ii.
Equipment
(2)
Loans to Depository Institutions
(3)
Real Estate Loans (about 34% of assets; see Chapter 9)
i.
Commercial (construction; permanent)
ii.
Residential (construction; permanent)
iii.
Development
(4)
Agricultural Loans
(5)
Consumer Loans
i.
Credit cards
ii.
Student loans
iii.
Vehicles and other consumer purchases

b.

Lease financing: Bank purchases asset and leases to customer.

(1)
Fast-growing line of business for large banks.
(2)
Common financing technique for
i.
fleet assets (aircraft, ships, etc.)
ii.
rolling stock (trucks, rail cars, etc)
iii.
other capital equipment (cranes, generators, etc.)

Other Assets.
a.
Trading account assetssecurities held for resale.
b.
Fixed assetsland, buildings, equipment, etc,.
c.
Intangiblesgoodwill, prepaids, etc.

Loan Pricing: One of the most important management decisions in banking.

A.

Three key considerations in loan pricing.

1.
2.
3.

Earn a high enough interest rate to cover the costs of funding the loan.
Recover the administrative costs of originating and monitoring the loan.
Provide adequate compensation for risk
a.
Credit (or default) risk.

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b.
c.
B.

C.

Liquidity risk.
Interest rate risk.

The Prime Rate

1.

Historically a benchmark, or base rate, on short-term business and agricultural loans.

a.
The lowest loan rate posted by commercial banks.
b.
The rate banks charged their most creditworthy customers.
c.
All other borrowers were typically quoted rates as some spread above
prime, depending on their risk.

2.

Recently, the role of the prime rate has changed.

a.
Over the last 25 years, fewer loans have been priced using prime.
b.
Now, lenders choose among several other benchmark rates:
(1)
LIBORLondon Interbank Offered Rate
(price of short-term Eurodollar deposits)
(2)
Treasury rates
(3)
Fed Funds rate
c.
Popular media still use the Prime Rate as a barometer.

Base rate pricing: marking up from a minimum offered the least risky borrowers.
1.
2.

3.

Possible base rates: Prime, LIBOR, Treasury, Fed Funds.

Markups include three adjustments:
a.

For increased default risk above the risk associated with the base
rate. The banks credit department assesses default risk.

b.

For term-to-maturity.
(1)
Most business loans are variable rate--as the base rate
increases or decreases, the loan rate adjusts accordingly.
(2)
For fixed-rate loans the bank will adjust the short-term base rate
by an amount consistent with the current yield curve.

c.

For competitive factorsa customers access to alternatives.

Expressed mathematically: rL = BR + DR + TM + CF
where: rL =
BR =
DR =
TM =
CF =

D.

individual customer loan rate

the base rate
adjustment for default risk above base-rate customers
adjustment for term-to-maturity
competitive factor

Nonprice adjustments to alter the effective return under a given nominal rate.
1.

2.

Compensating balances.
a.
Bank requires borrower to carry minimum balance in non-interest-bearing
deposit account.
b.
Effective return increases because net loan amount is lower.
Other nonprice adjustments
a.
Risk reclassification.
b.
Additional collateral or specified collateral.
c.
Shorter maturities (or rest periods for lines of credit).

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E.
IV.

V.

Analyzing, managing, and pricing credit risk.

A.

Five Cs of Credit:
1.
Character (willingness to pay)
2.
Capacity (cash flow)
3.
Capital (wealth or net worth)
4.
Collateral (security)
5.
Conditions (economic conditions)

B.

Credit scoring based on the information in the borrowers credit report:

1.
Payment history
2.
Amount owed
3.
Length of credit history
4.
Extent of new debt
5.
Type of credit in use

C.

Default risk premiums for identified risk categories determined from analysis of
credit losses over several business cycles.

Pricing bank deposits, the banks main source of loanable funds.

A.
B.
C.

VI.

Matched-funding loan pricing: Fixed-rate loans are funded with deposits or borrowed
funds of the same maturity.

Must offer depositors high enough rates to attract and retain a stable deposit base.
Must not pay so much on deposits that profitability is compromised.
Competition puts pressure on the spread from both sides
1.
bank may have to charge lower rates on loans
2.
bank may have to pay higher rates on deposits

Fee-based services.
A.

B.

C.

Correspondent banking: sale of bank services to other financial institutions.

1.
Common correspondent services
a.
check clearing and collection
b.
securities
c.
foreign exchange
d.
participation in large loans
e.
data processing
2.
Not a recent development, but unique to the U.S.
a.
Many small banks need large bank services
b.
Large banks provide these services
Trust services: management of client wealth.
1.
As fiduciary, bank holds and manages assets for beneficiary.
2.
Trust function is strictly segregated from other bank functions.
3.
Common trust services
a.
administration of estates
b.
management of pension assets
c.
registration and transfer of securities
d.
administration of bond indentures
Nonbanking financial services: Investments and insurance.
1.
Deregulation allows these services, provided clients clearly understand they are
not covered by deposit insurance.
2.
Banks can compete directly with mutual funds and securities firms.

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3.
VII.

VIII.

Insurance powers of banks are more limited.

Off-balance-sheet banking
A.

Loan commitments: unfunded promises to make loans in the future.

1.
Lines of credit (allow total advances up to a limit).
2.
Term loans (certain dollar amount longer than 1 year).
3.
Revolving credit (lines of credit allowing payment and reborrowing within limit).

B.

Letters of credit: Written promises to pay a third party on clients behalf.

1.
Commercial letters of credit
a.
client buys goods and services
b.
bank promises to pay seller on behalf of client
c.
seller presents bank with draft to invade letter of credit
2.
Standby letters of credit
a.
bank guarantees clients financial performance of some contract
b.
clients counterparty relies on banks creditworthiness, not borrowers
c.
beneficiary invades SLC by presenting draft to bank
d.
common uses of SLCs
(1)
securities offerings
(2)
credit enhancement of other debts
(2)
completion of projects

C.

Derivatives: Interest rate/currency forwards, futures, options, swaps (see Ch. 11)
1.
Hedging (encouraged by regulators)
2.
Speculating (discouraged by regulators)

D.

Loan brokerage: Sale of loans after origination.

1.
Restores liquidity and earns fees.
2.
Avoids regulatory burden of loans on books.

E.

Securitization: assignment of cash flows from assets (usually loans) via securities to
investors.
1.
Similar rationale to loan brokerage.
2.
Bank transfers assets to trust; sells ownership units in trust.
3.
Banks can underwrite securitizations themselves after deregulation.

Bank and Financial Holding Companies: The most common way of organizing U.S. banks.
A.

De facto branching.
1.
Multibank holding companies circumvent branching restrictions.
2.
Recent deregulation makes branching easier.

B.

Diversification into nonbank services.

1.
Fed allows certain nonbank subsidiaries within a holding company.
2.
BHCs with acceptable CRA ratings (see Chapter 16) can qualify
as financial holding companies and have subsidiaries in almost any financial
service.

C.

Tax avoidance.
1.
Interest paid on debt is tax-deductible.
2.
Most dividends received from subsidiaries are tax-exempt.
3.
Nonbank subsidiaries can be structured to avoid local taxes.

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COMPLETION QUESTIONS
1.

In commercial banks ________ deposits are the most important source of funds; ________ loans
represent the major investment category.

2.

________ deposits represent about two thirds of M1.

3.

Though interest payments have been prohibited on demand deposits in the past, banks have paid
________ interest by offering "free" checking accounts, convenience, and other perks.

4.

Several money market securities are listed below. Indicate whether each security represents a bank
asset, a bank liability, or neither.
a.
Banker's Acceptance
________________
b.
Negotiable Certificate of Deposit
_______________
c.
Treasury Bill
________________
d.
Federal Funds Purchased
________________

5.

The bank investment portfolio provides both ________ and ________ to the bank.

6.

A ________ loan provides funds for a specific transaction.

7.

A ________ is an informal agreement to lend in the near future; a ________ credit agreement is a
formal contract, supported by fees, to lend on demand for a period of several years.

8.

While traditionally the "best" loan rate offered to bank customers, today the ________ rate plays a
smaller role as a posted reference or index bank rate.

9.

________ deposit balances are a form of nonprice adjustments to loan yields.

10.

The Five Cs of Credit are _____________________ , _____________________ ,

_____________________ , _____________________ , and _____________________ .

TRUE-FALSE QUESTIONS
T

1.

F
2.
to lend.

F
3.
With credit cards, the bank generates revenues from both
borrowers and retailers.

F
funds.

F
5.
A bank would prefer to make a fixed-rate mortgage loan if it
predicts higher interest rates in coming years.

F
6.
Demand deposits represent the largest source of funds for
commercial banks.

F
7.
revenue.

4.

The prime rate today represents the lowest bank lending rate.
A revolving credit agreement is a longer-term informal agreement

The level of a banks prime rate is directly related to its cost of

Fee-based services have become an increasing share of bank

176

F
8.
for banks.

Fed Funds sold represent an important source of borrowed funds

Regulators prohibit derivatives as a hedging technique.

F
10.
the banks.

9.

In a letter of credit, a borrower substitutes its creditworthiness for

MULTIPLE-CHOICE QUESTIONS
1.

Which of the following is not a bank demand deposit account?

a.
treasury tax and loan account
b.
large corporate account
c.
Federal Reserve deposit account
d.
correspondent deposit account

2.

The interest rate paid by banks on deposit accounts today is

a.
a market rate determined by the bank.
b.
a rate set by the Federal Reserve Board.
c.
restricted by Regulation Q.
d.
a rate agreed upon by all the banks in town.

3.

Bank borrowed funds (bank liability) have what characteristic?

a.
not insured by FDIC.
b.
short-term.
c.
large denomination.
d.
all of the preceding.

4.

To a bank, all of the following are advantages of holding U.S. Treasury securities except:
a.
they are highly marketable
b.
they may be used as collateral
c.
they offer relatively high interest rates
d.
they pose little or no default risk

5.

ABC Bank is considering a taxable security yielding 10% and a nontaxable municipal bond
yielding 6%. If ABC's marginal tax rate is 46%, which of the following is the best choice, assuming
each instrument represents essentially the same risk?
a.
Always take the tax-free bond.
b.
Always select the taxable security because its yield is higher.
c.
Compare the securities on an after-tax basis and buy the municipal.
d.
Compare the securities on an after-tax basis and buy the taxable bond.

6.

While time deposits are banks' major source of funds, their major use is:
a.
investments.
b.
consumer loans.
c.
demand deposits.
d.
commercial loans.
e.
real estate loans

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7.

As a bank depositor shifts funds from demand deposits to savings to time deposits, the depositor's
a.
liquidity declines and interest income decreases.
b.
liquidity declines and interest income increases.
c.
liquidity increases but default risk increases.
d.
implicit interest increases and explicit interest declines.

8.

All of the following have encouraged bank loan securitization except:

a.
the bank is able to increase the amount of bank capital needed.
b.
securitizing loans is an important source of funds.
c.
fees from origination, servicing and underwriting are important sources of revenue.
d.
required reserves and deposit insurance premiums are reduced because deposit sources
have been replaced by loan securitization sources.

9.

All of the following are a source of common equity capital for banks except:
a.
common equity.
b.
retained earnings.
c.
capital notes.
d.
reserve accounts.

10.

Two important functions of bank investments (as distinguished from loans) are
a.
capital and income
b.
income and safety
c.
liquidity and income
d.
funding and liquidity.

SOLUTIONS TO COMPLETION QUESTIONS

1.

time; real estate

2.

demand

3.

implicit or effective or nonmonetary

4.

a. liability b.

5.

liquidity; income

6.

bridge

7.

line of credit; revolving

8.

prime

9.

compensating

10.

character, capacity, capital, collateral, and conditions

liability c. asset d. liability

SOLUTIONS TO TRUE-FALSE QUESTIONS

1.

F
High-quality businesses are borrowing at rates below prime today. Traditionally,
the "prime" represented the "best" rate for quality credit customers.

2.

F
bank.

Revolving credit is usually a formal commitment to lend in return for a fee to the

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3.

T
Retailers pay a percentage of their credit card receipts; credit card holders may
pay an annual fee to the bank and finance charges (interest) if they carry a balance.

4.

5.

F
If rates are expected to increase, the bank would want a variable rate loan; the
customer would want a fixed rate (see Chapter 6).

6.

Time deposits are the major source of funds for banks.

7.

Fee-based services are less related to interest rate, liquidity, and credit risk.

8.

F
Federal Funds sold are an asset; Federal Funds purchased (liability) are a source
of funds.

9.

F
Regulators generally permit derivatives and accept their use for hedging, but
discourage their use for speculation.

10.

If the cost of funds (CDs) increase, the bank may increase its prime rate.

The bank's credit worthiness replaces that of the borrower customer.

SOLUTIONS TO MULTIPLE-CHOICE QUESTIONS

1.

Federal Reserve deposits are assets of the bank.

2.

Most deposits provide a rate determined by local market conditions.

3.

d
large.

Most borrowed funds are money market transactions -- short-term, uninsured, and

4.

Treasuries yield less than other, riskier assets.

5.

c
Analyze in either of two ways. (1) Find the after-tax yield on the taxable security;
compare with the no-tax yield on the muni: 10% (1-.46) = 5.4%, a lower after- tax yield
than the 6% muni. (2) Adjust the tax-free security to a pretax equivalent basis and
compare with the taxable yield. 6%/(1-.46) = 11.11%, which exceeds the 10% taxable.

6.

7.

b
The depositor is shifting toward deposits where withdrawal is increasingly costly.
To compensate for the illiquidity, the yield increases.

8.

a
Securitization holds the level of assets relatively constant, thus holding the amount
of required equity capital relatively constant.

9.

c
Capital notes, while usually subordinate to deposits, are contractual debt funds,
which require that interest and principal be paid at definite times.

10.

c
Bank investments provide liquidity to honor commitments while earning steady
income.

Real estate loans are the major asset or use of funds of banks.

179