CHAPTER 13 & 16 COMMERCIAL BANK OPERATIONS & REGULATION.

CHAPTER 13 & 16

COMMERCIAL BANK OPERATIONS & REGULATION

Copyright© 2003 John Wiley and Sons, Inc.

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.


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


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.


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.


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.


Financial Holding Companies

Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley)Extended list of allowable financial activities for Fed certified financial holding companiesInsurance underwriting and investment banking


The Largest BHC’s and FHC’s

25 Largest Bank Holding Companies Year End 2002


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.


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.


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.


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) 1863Charters national banks; closes failed national banks.Examines national banks.Autonomous funding--independent.


Bank Regulators (concluded)

State Banking AgenciesCharter state banks.Examine state chartered banks.Protect public.


Bank ExaminationsAre an important part of bank regulationBank 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.


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.


Bank Sources of Funds -- Liabilities and Capital

Demand deposits accountsSavings Accounts Certificates of DepositBorrowed Funds from Other InstitutionsCapital Notes and BondsBank Capital Accounts – Equity or Ownership


Uses of Funds -- Bank Assets

Cash assetsFederal 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.


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.


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.


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 loanscommercial and industrial real estate loans


Other Loans (concluded)

Consumer loans to individualsmost are paid back in installmentsincludes 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 worldwidebank earns fees from annual fee, merchant discount and interest on revolving credit balances


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.


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


Base Rate Loan Pricing Factors

An upward adjustment from prime for default risk.An adjustment for term to maturity.An adjustment for competitive factors.


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.


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.


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.


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.


Off-balance Sheet Banking

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


Off-balance Sheet Banking (continued)

Loan commitments – plan aheadLetters of creditLoan brokerageDerivative securities


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.


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.

CHAPTER 13 & 16 COMMERCIAL BANK OPERATIONS & REGULATION.

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