commercial banks, history, functions, roles

Presented By:A. NaumanMehwish Ali

COMMERCIAL BANK OPERATIONS

BackgroundBank

History: Form around 1600 (Only make profit) The bank of America 1782 Colonial land North banks End of 18th Century Formed Dozen of banks Pooled the wealth & lent to group of

Enterprises Since 1920 commercial banks equal about

50% aggregate output of U.S Economy Glass steagall act 1933 (Repealed 1999)

Pakistan

• Comprehensive restructuring in 1997• Promotion of Saving, investment, growth• Pressure points on commercial banks since 1997

1) Multipronged reforms introduce by SBP

2) Freezing of foreign currency

3) Fluctuation in economic activities and growth

4) Drive for accountability and loan recovery

Functions of Commercial Banks

Commercial Banks

General Functions

Primary

Functions

Agency

Functions

Bank Sources of Funds

Deposit Accounts • Transaction deposits • Savings deposits • Time deposits • Money market deposit accounts

Borrowed Funds • Federal funds purchased (borrowed)• Borrowing from the central bank• Repurchase agreements

Bank Sources of Funds

Transaction deposits• Demand deposit account

• Require a small minimum balance and pays no interest

• Negotiable order of withdrawal• Provide checking services as well as interest

services

Saving deposits

Bank Sources of Funds (cont)

Time deposits • Deposits that cannot be withdrawn until a

specified maturity date • Certificates of deposits (Retail CDs)

• Minimum amount of funds for a specified period of time

• Annual interest rates offered• No organized secondary market

Negotiable Certificates of Deposits • Some large banks offer to companies• Similar to retail CDs• Secondary market does exist

Bank Sources of Funds (cont)

Money Market Deposit Accounts • Different from time deposits in that they do not

specify a maturity • More liquid than retail CDs from the depositor’s point

of view

Federal funds purchased (Borrowed) This allows depository institutions to

accommodate the short term liquidity needs of other financial institutions federal funds purchased represent a liability to the borrowing bank and an asset to the lending bank sells them

Loans in the federal funds market are typically for 1-7 days.

Bank Sources of Funds (cont) Federal fund rate If many banks have excess funds and few banks are

short of funds, the federal funds rate will be low.

Borrowing from the central bank Central bank also provide short term loans to banks This is called borrowing at discount window. Interest rate charged on these loans is known as

discount rate. • Banks rely on the central bank’s fund market for normal

short term financing, and use of discount window as a last resort. Short term loans, from one day to a few weeks. First obtain the central bank’s approval. Temporary shortage of funds.

Bank Sources of Funds (cont)

Repurchase Agreements The bank simply sells some of its government

securities to a corporation with a temporary excess of funds and buys those securities back shortly thereafter.

Long term Sources of Funds

Bonds issued by the bank• Fixed assets (land, building, etc.) of banks are

usually financed by the issuance of bonds• Such bonds are purchased by the households and

various financial institutions.

Bank capital • Obtained from issuing stock or retaining earnings• No obligation to pay out funds in the future• Must be sufficient to absorb operating losses• As of 1992: risk-based capital requirement

Uses of Funds

Cash Bank must hold some cash as reserves to meet the

reserve requirement enforced by the central bank

Banks also hold cash to maintain some liquidity and accommodate any withdrawal requests by depositors.

Bank do not earn income from cash, they hold only as much cash as is necessary to maintain a sufficient degree of liquidity.

Uses of Funds

Bank loans Working Capital Loan ( self liquidating loan) Term loans

Used primarily to finance the purchase of fixed assets

Assets purchased with the borrowed funds may serve as collateral on the loan

Contains Protective agreements because of long term

Direct lease loan Bank can purchase the asset and leasing them to

the firm in need

Uses of Funds

Loan Participation • Some large corporation wish to borrow

a large amount of funds than any individual bank is willing to provide.

• To accommodate a corporation, several banks may be willing to pool their available funds in what is referred to as loan participation.

Off-Balance sheet activities

Loan commitment• A loan commitment is an obligation by a

bank to provide a specified loan amount to particular firm upon the firm’s request

• The interest rate and purpose of the loan may also be specified

• The bank charges a fee for offering the commitment

Standby Letters of Credit • Backs a customer’s obligation to a third party• Banks earn fee income

Forward Contract • Agreement between a customer and bank to

exchange one currency for another on a particular future date at a specified exchange rate

• Allows customers to hedge their exchange-rate risk

Swap Contract • Banks also serve as intermediaries for interest

rate swaps, where by two parties agree to periodically exchange interest payments on a specified estimated amount of principal

• Bank receives a transaction fee for its services

Off-Balance sheet activities (Con..)

International BankingInternational banks can be characterized by the

type of services they provide that distinguish them from domestic banks

Major Functions:

1. Trade financing

2. Cross-border transactions

3. Exchange rate risk

4. Trade foreign exchange products

5. Deal in Euro/Dollar currency market6. International loan syndicate – lending

to MNCs- project financing7. Underwriting of Eurobonds and foreign

bonds8. Consultancy and advice on (strategies,

interest rate and currency swap financing and international cash management)

International Banking (cont)

Factors affect interest rates

4 Factors are:

Production opportunitiesThe return (or yield) available within an economy from investments in productive (cash-generating) assets.

Time preferences for consumption

The preference of consumers for current consumption as opposed to saving for future consumption.

Interest??It is the cost of MoneyTransforms money-today into money-tomorrow

Factors affect interest rates

RiskThe chance that an investment will not provide the expected return.

Expected inflationThe tendency of prices to increase over time

Determinants of Interest RatesFormula:

r = r* + DRP + LP + MRP + IP

r• required return on a

debt security

r* • real risk-free rate of interest

IP • inflation premium

DRP • default risk premium

LP • liquidity premium

MRP • maturity risk premium

The Loanable Funds theory

We use the term “loanable funds market” to describe the arrangements and institutions by which saving of households

is made available to borrowers.

DemandSupply

Consu

mpt

ion1. According to the

Classical theory, the loanable funds market acts transfer of funds from households (suppliers) to firms and government (Demanders).

2. Saving (S) is the “source” of loanable funds.

Saving

Net taxes

Factor income

Why do households save?

1. To have a more secure future, to start a business, to finance a child’s education etc….

2. To earn interest. We view interest as

the “reward for saving

Saving = Supply of Funds

Dollars0

Inte

rest

rat

e

3%

5%

1.5 1.75

Supply of FundsInterest rate = Supply

Investment Demand

Dollars0

Inte

rest

rat

e

3%

5%

1.5

Demand for Funds by Business

1.0

A

B

Interest rate = Demand

Question Answer Session

Thank You