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Commercial Banks. Depository Institutions. Non Financial Firms. Commercial Banks vs. Savings Institutions and Credit Unions. Composition of assets and liabilities including non deposit sources of liabilities (subordinated notes and debentures)
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Commercial Banks vs. Savings Institutions and Credit Unions • Composition of assets and liabilities including non deposit sources of liabilities (subordinated notes and debentures) • Breadth of loans (consumer, commercial, international and real estate) • Separate regulations
Commercial Banks-Financial Statements • Report of Condition- balance sheet of a commercial bank reporting information at a single point in time. • Report of Income - income statement of a commercial bank reporting revenues, expenses, net profit or loss and cash dividends over a period of time.
Commercial Banks-Major Assets • Loans and Leases- the majority of assets • Reserve for loan and lease losses- a contra-asset account representing an estimate by the banks’ management of the % of gross loans (and leases) that will have to be “charged off” due to future defaults. Additions to the reserve for loan and lease losses accounts (and in turn the the expense account “ provision for losses on loans and leases”) to meet expected defaults reduce retained earnings and thus equity. Unexpected defaults (e.g. due to a sudden major recession) are meant to be written off against the remainder of the bank’s equity. • Securities - interest bearing deposits with other FIs, Fed Funds sold, Repos, Treasuries and agencies, munis, mortgage backed securities, and other debt and equity securities. • Cash and balance due from other depository institutions- vault cash, Fed deposits, cash in collection, deposits at other Fis (Cash at other banks is generally used to purchase services from Correspondent banks- banks that provide services to other banks. • Other Assets- premises, fixed assets, other real estate, intangibles
Commercial Banks-Major Liabilities • Two major sources of funds • 1. Deposits • Transaction Accounts • Demand Deposits- checkable deposits that bear no interest. • NOW (Negotiable Order of Withdrawal) accounts- interest bearing checking accounts. • Non-Transaction Accounts- savings, retail or small time deposits (usually<$100k) and large time deposits (>$100k, primarily negotiable CDs). • 2. Borrowed (purchased) funds and other liabilities -borrowings including purchases of Fed Funds, repos, notes and bonds, etc.
Commercial Banks-Equity • Common and Preferred Stock • Additional paid-in-capital • Retained earnings • Regulators require banks to hold a minimum level of equity capital to act as a buffer against losses. Banks tend to hold equity a min levels because of low cost of deposit funding.
Commercial Banks-Major Risks • Credit or default risk • Insolvency risk- because commercial banks are highly leveraged and therefore hold little equity, compared to total assets, even a relatively small amount of loan defaults can wipe out bank equity, leaving it insolvent.
Commercial Banks-Major Risks • Duration mismatch - liabilities tend to be of shorter maturity than assets. • Liquidity risk- liquid instruments are used to fund less liquid assets such as loans. • Interest rate risk • Maturity mismatch - borrowings coming due at times different from the cash flows from assets.
Commercial Banks- Off Balance Sheet Activities • Activities are allowed to be taken “off balance sheet” when a contingent event triggers the asset/income or liability/expense. • 5 Major Categories of Off Bal. Sheet Activities • 1. Loan commitments- a contractual commitment by a FI to loan to a customer an amount at a given interest rate. Usually comes with an up-front fee (facility fee) and may have a back-end fee (or committed fee) on any unused commitment. • 2. Commercial Letters of Credit and Standby Letters of Credit- the bank guarantee on payment for goods shipped or sold (commercial letters of credit) coverage of other non-traded related contingencies (standby letters of credit).
Commercial Banks- Off Balance Sheet Activities • 5 Major Categories of Off Bal. Sheet Activities (cont.) • 3. Forward purchases and sales of when issued securities - Fis (especially I banks) enter into forward or future commitments to buy or sell securities before issue. • 4. Loans sold- loans sold to other investors that if sold with recourse can be returned to the originating institution if the credit quality deteriorates. • 5. Derivative Contracts - futures, forwards, swaps and option positions taken by a bank for hedging and other purposes.
Reasons for Off Balance Sheet Activities • Desire to earn additional fee income to complement declining margins or spreads on traditional lending. • Avoidance of regulatory costs or “taxes” since reserve requirements and deposit insurance premiums are not levied on off balance sheet activities. • Risk reduction or possibly risk increasing.
Other Fee Generating Activities • Trust Services- the trust departments of a commercial bank holds and manages assets for individuals or corporations. • Correspondent banking- the provision of banking services to other banks that do not have the staff resources to perform the service themselves. Services might include: check clearing, check collection, f/x trading, hedging services, participation in large loans etc. Payment on services is generally in the form of non-interest bearing deposits.
Bank Consolidation • Easing regulatory restrictions- in the 80s and 90s, regulators allowed banks to merge with other banks across state lines and brand banking across state lines has also eased. • Economies of scale - the degree to which a firm’s average unit cost of producing fin. services fall as its output of services increases. • Economies of scope - the degree to which firm can generate cost synergies by producing multiple fin. Services products. • X Efficiencies- cost savings due to the greater managerial efficiency of the acquiring firm.
Income Statement - Report of Income • Direct relationship between the balance sheet and report of income. The composition of an FIs assets and liabilities combined with the interest earned or paid, directly determines the interest income and expenses on the income statement (rather than reflecting sales and COGS).
Income Statement - Report of Income • Interest income - first on the income statement. Recorded on an accrued basis. Interest past due can still be recorded as generating income until 90 days after the due date. Interest from investment securities is also included. • Interest expenses - 2nd major category. Determined directly by liabilities. • Net interest income = total interest income - total interest expense.
Income Statement - Report of Income • Provision for loan losses - a non-cash tax deductible expense. The current periods allocation to the allowance for loan losses listed on the balance sheet.first on the income statement. • Non-interest income - all other income from activities both on & off bal. sheet. • Total operating income (total revenue) - the sum of interest income and non-interest income.
Income Statement - Report of Income • Non-interest expense -consists mainly of personnel expenses (generally large relative to non-interest income). • Income before taxes and extraordinary items (operating profit) = net interest income - provision for loan losses + (non-interest income - non interest expense) • Income Taxes • Extraordinary income - events that are unusual or infrequent. • Net income
Bank Types • Community Banks - <$1B in asset size. Tend to specialize in retail or consumer banking (i.e. real estate or residential mortgage, consumer loans). • Regional or Superregional Banks- a bank that engages in a complete array of wholesale banking activities. Including consumer and residential lending and C&I loans. Usually have access to purchased funds such as Fed Funds. • Money Center Banks - a bank that relies heavily on non-deposit or borrowed sources of funds. These are the very biggest banks and usually operate with no or few branches. Asset or lending size does not necessarily make a money center bank. Rather physical location and geographic area (foot print) distinguish money center banks.
Bank Regulators • Federal Deposit Insurance Corporation (FDIC) - insures the deposits of commercial banks. Levies insurance premiums on banks, manages the deposit insurance fund and conducts bank examinations. • The Office of the Comptroller of the Currency (OCC) - the oldest bank regulator (est. 1863). A sub agency of the US Treasury. Primary function is to charter national banks as well as to close them. Also approves (or disapproves) merger applications. • Federal Reserve - regulates and examines bank holding Cos. as well as banks themselves. • State Authorities - perform similar functions to the OCC but for state chartered commercial banks.
