Commercial Banks: Industry Overview

8-1McGraw-Hill/IrwinChapter ElevenCommercial Banks: Industry Overview11-2McGraw-Hill/IrwinCommercial BanksCommercial banks are the largest group of financial institutions in terms of total assetsMajor assets are loansMajor liabilities are deposits—thus, they are considered depository institutionsPerform services essential to U.S. financial marketsplay a key role in the transmission of monetary policyprovide payment servicesprovide maturity intermediationBanks are regulated to protect against disruptions to the services they perform11-3McGraw-Hill/IrwinCommercial Bank AssetsLoans generate revenue for bankscommercial and industrial loans are declining because of nonbank substitutes such as commercial papermortgages are increasing in importanceInvestment securities generate revenue and provide banks with liquidityCash assets are held to meet reserve requirements and to provide liquidityOther assets include premises and equipment, other real estate owned, etc.11-4McGraw-Hill/IrwinCommercial Bank AssetsCommercial banks face unique risks because of their asset structurecredit (default) risk is the risk that loans are not repaidliquidity risk is the risk that depositors will demand more cash than banks can immediately provideinterest rate risk is the risk that interest rate changes erode net worthcredit, liquidity, and interest rate risk all contribute to a commercial bank’s level of insolvency risk11-5McGraw-Hill/IrwinCommercial Bank LiabilitiesTransaction accounts are the sum of noninterest-bearing demand deposits and interest-bearing checking accountsinterest bearing deposit accounts are called negotiable order of withdrawal (NOW) accountsHousehold (retail) savings and time deposits have been declining in recent years because of MMMFspassbook savings accountsretail time depositsLarge time depositsnegotiable CDs are fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market11-6McGraw-Hill/IrwinCommercial Bank Liabilities & EquityNon-deposit liabilitiesfed funds purchasedreposnotes and bondsMinimum levels of equity capital are required by regulators to act as a buffer against lossescommon and preferred stocksurplus or additional paid-in capitalretained earnings11-7McGraw-Hill/IrwinOff-Balance-Sheet ActivitiesCommercial banks engage in many fee-related activities that are conducted off the balance sheetguarantees such as letters of creditfuture commitments to lendderivative transactions (e.g., futures, forwards, options, and swaps)Off-balance-sheet assetwhen an event occurs, this item moves onto the asset side of the balance sheet or income is realized on the income statementOff-balance-sheet liabilitywhen an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement11-8McGraw-Hill/IrwinCommercial BanksThe Reigle-Neal Act of 1994 allowed nationwide branch networks to evolve14,483 banks with some 60,000 branches in 19847,350 banks with some 83,000 branches in 2007The Financial Services Modernization Act of 1999gave commercial banks the full authority to enter the investment banking and insurance businessIndustrial loan corporations (ILCs) are considered “non-bank” banks11-9McGraw-Hill/IrwinCommercial BanksA megamerger is a merger of commercial banks with assets of $1 billion or moreEconomies of scale refer to the degree to which a firm’s average unit costs of producing financial services fall as its output of services increasediseconomies of scale occur when the costs of joint production of FI services are higher than they would be if they were produced independentlyEconomies of scope refer to the degree to which a firm can generate cost synergies by producing multiple financial service productsX efficiencies refer to cost savings due to greater managerial efficiency11-10McGraw-Hill/IrwinCommercial BanksRetail banking is consumer-orientedresidential and consumer loans are funded by accepting small depositscommunity banks specialize in retail bankingWholesale banking is commerce-orientedcommercial and industrial loans are often funded with purchased fundsregional or superregional banks engage in a complete array of wholesale banking activitiesmoney center banks rely heavily on nondeposit or borrowed sources of funds often borrowed in the federal funds market11-11McGraw-Hill/IrwinCommercial BanksBecause larger banks generally lend to larger corporations, their interest rate spreads and net interest margins are usually narrower than those of smaller banksinterest rate spread is the difference between lending and deposit ratesnet interest margin is interest income minus interest expense divided by earning assetsLarge banks tend to pay higher salaries and invest more in buildings and premises than small banksLarge banks tend to diversify their operations more and generate more noninterest income than small banks11-12McGraw-Hill/IrwinIndustry PerformanceU.S. commercial banks flourished during the economic expansion of the 1990sThe economic downturn of the early 2000s caused performance to deteriorate only slightlyBy 2003 ROA and ROE had reached all-time highsIn the fourth quarter of 2006 mortgage delinquencies (particularly subprime mortgages) surgedLosses from falling values of subprime mortgages caused fourth quarter 2007 net income to hit a 16-year low11-13McGraw-Hill/IrwinWholesale Banking ServicesControlled disbursement accountsAccount reconciliationLockbox servicesElectronic lockboxFunds concentrationElectronic funds transferCheck deposit servicesElectronic initiation of letters of creditTreasury management softwareElectronic data interchangeFacilitating business-to-business e-commerceElectronic billingVerifying identitiesAssisting small business entries in e-commerce11-14McGraw-Hill/IrwinRetail Banking ServicesAutomated teller machines (ATMs)Point-of-sale (POS) debit cardsPreauthorized debits and creditsPaying bills via telephoneOnline bankingSmart cards (stored-value) cardsInternet bankingcomplements existing business for already existing bankssome new internet-only banks have no “brick and mortar”11-15McGraw-Hill/IrwinRegulatorsThe Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banksThe U.S. has a dual banking system—banks can be either nationally or state charteredthe Office of the Comptroller of the Currency (OCC) charters and regulates national banksstate agencies charter and regulate state banksThe Federal Reserve System (FRS) has regulatory power over nationally chartered banks and their holding companies and state banks that opt in to the Federal Reserve Systema holding company is a parent company that owns a controlling interest in a subsidiary bank or other FI11-16McGraw-Hill/IrwinInternational Commercial BankingCommercial banking has truly become an international and global marketThe four largest banks in the world, as of 2007, are from four different countriesUBS Group is a Swiss bank with $1.96 trillion in assetsBarclays Bank is a U.K. bank with $1.96 trillion in assetsBNP Paribas is a French bank with $1.90 trillion in assetsCitigroup is a U.S. bank with $1.88 trillion in assets11-17McGraw-Hill/IrwinInternational Commercial BankingAdvantages of international expansionrisk diversificationeconomies of scaledistribute new product innovations internationallyopportunity to find the cheapest and most available sources of fundsservice the needs of domestic multinational corporationsregulatory avoidance11-18McGraw-Hill/IrwinInternational Commercial BankingDisadvantages of international expansioninformation and monitoring costs are generally higher in foreign marketsforeign assets may be subject to nationalization or expropriation by host country governmentsthe fixed costs of establishing foreign organizations may be extremely high11-19McGraw-Hill/IrwinGlobal Banking PerformanceBanks in most regions of the world posted strong performance in the early and mid-2000smortgage lending boosted revenue in France and Spainas personal bankruptcies rose worldwide, U.K. banks’ profitability was maintained because of diversificationin 2001 the Japanese government backed the purchase of $90 billion of shares of Japanese banks in an attempt to avert a banking collapsethe Chinese state-run banking system deteriorated in the early 2000s, which caused China to ease restrictions on foreign bank operations