chapter eleven

McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter ElevenCommercial Banks


Definition of a Commercial Bank

• Represent the largest group of depository institutions measured by asset size.

• Perform functions similar to those of savings institutions and credit unions - they accept deposits (liabilities) and make loans (assets)

• Liabilities include nondeposit sources of funds such as subordinated notes and debentures

• Loans are broader in range, including consumer, commercial, international, and real estate

• Regulated separately from savings institutions and credit unions

• Represent the largest group of depository institutions measured by asset size.

• Perform functions similar to those of savings institutions and credit unions - they accept deposits (liabilities) and make loans (assets)

• Liabilities include nondeposit sources of funds such as subordinated notes and debentures

• Loans are broader in range, including consumer, commercial, international, and real estate

• Regulated separately from savings institutions and credit unions


Differences in Balance Sheets

Depository Institutions Nonfinancial Firms Assets Liabilities Assets LiabilitiesLoans Deposits Deposits Loans

Other Other financial financial assets assets

Other Other Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity

Depository Institutions Nonfinancial Firms Assets Liabilities Assets LiabilitiesLoans Deposits Deposits Loans

Other Other financial financial assets assets

Other Other Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity


Commercial Bank Balance Sheet*

AssetsTotal cash assets………………. $ 253.8 4.8% U.S. gov securities…………… $ 801.4 Other…………………………. 391.6 Investment securities………….. 1,193.0 22.6% Interbank loans………………. 223.0 Loans exc. Interbank………… 3,314.3 Comm. and Indust…………..$ 948.5 Real estate…………………… 1,343.0 Individual……………………. 496.4 All other……………………… 526.4 Less: Reserve for losses……… 58.7 Total loans……………………… $3,478.6 66.0%Other assets…………………….. 347.6 6.6%Total assets…………………….. $5,273.0

AssetsTotal cash assets………………. $ 253.8 4.8% U.S. gov securities…………… $ 801.4 Other…………………………. 391.6 Investment securities………….. 1,193.0 22.6% Interbank loans………………. 223.0 Loans exc. Interbank………… 3,314.3 Comm. and Indust…………..$ 948.5 Real estate…………………… 1,343.0 Individual……………………. 496.4 All other……………………… 526.4 Less: Reserve for losses……… 58.7 Total loans……………………… $3,478.6 66.0%Other assets…………………….. 347.6 6.6%Total assets…………………….. $5,273.0


Commercial Bank Balance Statement*

Liabilities and Equity Transaction accounts…………… $ 667.4 12.8%Nontransaction accounts………... 2,688.5 54.4%Total deposits…………………… $3,355.9Borrowings……………………… 1,006.0 21.3%Other liabilities………………….. 462.3 2.8%Total liabilities………………….. $4,824.2Equity…………………………… 448.8 8.7%

*Aggregate balance sheet and percentage distributions for all U.S.commercial banks as of May 26, 1999 in billions of dollars

Liabilities and Equity Transaction accounts…………… $ 667.4 12.8%Nontransaction accounts………... 2,688.5 54.4%Total deposits…………………… $3,355.9Borrowings……………………… 1,006.0 21.3%Other liabilities………………….. 462.3 2.8%Total liabilities………………….. $4,824.2Equity…………………………… 448.8 8.7%

*Aggregate balance sheet and percentage distributions for all U.S.commercial banks as of May 26, 1999 in billions of dollars


Balance Sheet

• Assets– loans and investment securities

• Liabilities– transaction accounts - the sum of noninterest-bearing demand

deposits and interest-bearing checking accounts

– NOW account - an interest-bearing checking account

– negotiable CDs - fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market

• Equity– common and preferred stock, surplus or additional paid-in

capital, and retained earnings (continued)

• Assets– loans and investment securities

• Liabilities– transaction accounts - the sum of noninterest-bearing demand

deposits and interest-bearing checking accounts

– NOW account - an interest-bearing checking account

– negotiable CDs - fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market

• Equity– common and preferred stock, surplus or additional paid-in

capital, and retained earnings (continued)


Balance Sheet

• Off-Balance-Sheet activities– off-balance-sheet asset - when an event occurs, this item

moves onto the asset side of the balance sheet or income is realized on the income statement

– off-balance-sheet liability - when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement

• Trust services– generates fees by holding and managing individuals or

corporations assets

• Correspondent banking– generates fees by provision of banking services to other banks

• Off-Balance-Sheet activities– off-balance-sheet asset - when an event occurs, this item

moves onto the asset side of the balance sheet or income is realized on the income statement

– off-balance-sheet liability - when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement

• Trust services– generates fees by holding and managing individuals or

corporations assets

• Correspondent banking– generates fees by provision of banking services to other banks


Economies of Scale and Scope

• Economies of scale - the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase

• Economies of scope - the degree to which a firm can generate cost synergies by producing multiple financial service products

• Megamerger - the merger of banks with assets of $1 billion or more

• X efficiencies - cost savings due to the greater managerial efficiency of the acquiring firm

• Economies of scale - the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase

• Economies of scope - the degree to which a firm can generate cost synergies by producing multiple financial service products

• Megamerger - the merger of banks with assets of $1 billion or more

• X efficiencies - cost savings due to the greater managerial efficiency of the acquiring firm


Measuring Economies of Scale

ACi = TC i

Si

Where: ACi = Average costs of the ith bank TCi = Total costs of the ith bank Si = Size of the bank measured by assets, deposits or loans

ACi = TC i

Si

Where: ACi = Average costs of the ith bank TCi = Total costs of the ith bank Si = Size of the bank measured by assets, deposits or loans


Economies of Scale and the Effect of Technology Improvement

Average Cost Old Technology

AC1

New Technology

AC2

Size 0

Average Cost Old Technology

AC1

New Technology

AC2

Size 0


Economies of Scope

• By offering more services to a given customer;– revenue can be enhanced– costs can be reduced

• Cost economies of scope– investments in one financial service (such as lending)

may reduce costs to produce financial services in other areas (such as securities underwriting or brokerage)

• Revenue economies of scope

• By offering more services to a given customer;– revenue can be enhanced– costs can be reduced

• Cost economies of scope– investments in one financial service (such as lending)

may reduce costs to produce financial services in other areas (such as securities underwriting or brokerage)

• Revenue economies of scope


Bank Size and Concentration

• Community bank - a bank that specializes in retail or consumer banking

• Regional or superregional bank - a bank that engages in a complete array of wholesale commercial banking activities

• Federal funds market - an interbank market for short-term borrowing and lending of bank reserves

• Money center bank - a bank that relies heavily on nondeposit or borrowed sources of funds

• Community bank - a bank that specializes in retail or consumer banking

• Regional or superregional bank - a bank that engages in a complete array of wholesale commercial banking activities

• Federal funds market - an interbank market for short-term borrowing and lending of bank reserves

• Money center bank - a bank that relies heavily on nondeposit or borrowed sources of funds


Bank Size and Activities

• Large banks have easier access to capital markets and can operate with lower amounts of equity capital

• Large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits

• Large banks lend to larger corporations which means that their interest rate spread is narrower– the difference between lending and deposit rates

• Large banks are more diversified and generate more noninterest income

• Large banks have easier access to capital markets and can operate with lower amounts of equity capital

• Large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits

• Large banks lend to larger corporations which means that their interest rate spread is narrower– the difference between lending and deposit rates

• Large banks are more diversified and generate more noninterest income


Industry Performance

• Provision for loan losses - bank management’s recognition of expected bad loans for the period

• Net charge-offs - actual losses on loans and leases

• Net operating income - income before taxes and extraordinary items

• Provision for loan losses - bank management’s recognition of expected bad loans for the period

• Net charge-offs - actual losses on loans and leases

• Net operating income - income before taxes and extraordinary items


Regulators

• Federal Deposit Insurance Corporation (FDIC)– insures the deposits of commercial banks

• Office of the Comptroller of the Currency (OCC)– function is to charter national banks as well as close them

– has the power to approve/disapprove of mergers

• Federal Reserve System– requires all banks to meet the same noninterest-bearing

reserve requirements

• State Authorities– performs for state chartered banks similar functions as the

OCC does for national banks

• Federal Deposit Insurance Corporation (FDIC)– insures the deposits of commercial banks

• Office of the Comptroller of the Currency (OCC)– function is to charter national banks as well as close them

– has the power to approve/disapprove of mergers

• Federal Reserve System– requires all banks to meet the same noninterest-bearing

reserve requirements

• State Authorities– performs for state chartered banks similar functions as the

OCC does for national banks

chapter eleven

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