Chapter 17 Commercial Bank Operations Questions 1. Bank Balance Sheet. Create a balance sheet for a typical bank, showing its main liabilities (sources of funds) and assets (uses of funds). ANSWER: Liabilities 1. Transaction deposits 2. Savings deposits 3. Time deposits 4. Money market deposit accounts 5. Federal funds purchased 6. Repurchase agreements 7. Eurodollar borrowings Assets 1. Cash 2. Loans 3. Investment securities 4. Federal funds sold 5. Repurchase agreements 6. Eurodollar loans 7. Fixed assets 2. Bank Sources of Funds. What are four major sources of funds for banks? What alternatives does a bank have if it needs temporary funds? What is the most common reason that banks issue bonds? ANSWER: 1. Transaction deposits 2. Savings deposits 3. Time deposits 4. Money market deposit accounts Sources of temporary funds include: 1. Federal funds market 2. Discount window 3. Repos 4. Eurodollar borrowings Banks may issue bonds to purchase fixed assets. 3. CDs. Compare and contrast the retail CD and the negotiable CD. 185 186 Chapter 17/Commercial Bank Operations ANSWER: Retail CDs and negotiable CDs (NCDs) both specify a minimum deposit, a stated maturity, and a stated interest rate. Yet, NCDs differ from retail CDs because their minimum investment is much higher. In addition, they can be sold in a secondary market, whereas there is no secondary market for retail CDs. 4. Money Market Deposit Accounts. How does the money market deposit account differ from other bank sources of funds? ANSWER: MMDAs differ from conventional time deposits in that they do not specify a particular maturity. In addition, a limited number of checks can be written against these accounts. 5. Federal Funds. Define federal funds, federal funds market, and federal funds rate. Who sets the federal funds rate? Why is the federal funds market more active on Wednesday? ANSWER: Federal funds are loaned in the federal funds market from one bank (or other depository institution) to another at an interest rate known as the federal funds rate. The federal funds rate is not directly set by anyone, but is determined by the market. The rate changes frequently in response to changing supply and demand conditions. The Fed influences the federal funds rate by adjusting the money supply. Chapter 17/Commercial Bank Operations 187 The federal funds market is active on Wednesday because depository institutions use the market to adjust their required reserve position on that day (it is the final day of the settlement period for required reserves). 6. Federal Funds Market. Explain the use of the federal funds market in facilitating bank operations. ANSWER: The federal funds market is used by depository institutions that experience a temporary shortage of funds and desire to borrow from other depository institutions. It is also used by institutions that have excess funds and desire to lend those funds out. 7. Borrowing at the Discount Window. Describe the process of “borrowing at the discount window.” What rate is charged, and who sets it? Why do banks commonly borrow in the federal funds market rather than through the discount window? ANSWER: "”Borrowing at the discount window” represents the borrowing by depository institutions from the Federal Reserve. The interest rate charged on these loans is known as the discount rate and is set by the Fed. Banks tend to prefer the federal funds market over the discount window because the Fed may monitor the bank’s reasons for borrowing. The Fed’s discount window is intended to accommodate banks that experience “unanticipated” shortages of funds. 8. Repurchase Agreements. How does the yield on a repurchase agreement differ from a loan in the federal funds market? Why? ANSWER: Repo rates are usually slightly lower than federal fund rates because a repo is backed by securities. 9. Bullet Loan. Explain the advantage of a bullet loan. ANSWER: A bullet loan represents a loan whose principal is paid off in one lump sum. That is, a bullet loan specifies a balloon payment at a future point in time. This type of loan is useful for a borrower will have limited funds in the near future. 10. Bank Use of Funds. Why do banks invest in securities, even though loans typically generate a higher return? How does a bank decide the appropriate percentage of funds that should be allocated to each type of asset? Explain. ANSWER: Securities provide a bank with liquidity, because they can often be sold easily in the secondary market. In addition, many securities purchased by banks have low risk. Therefore, the securities can be used to minimize liquidity risk and default risk. The optimal allocation of funds is dependent on a bank’s degree of risk aversion and anticipated economic conditions. There is no formula to determine the optimal allocation. Banks must weigh the higher potential return from some uses of funds against the lower return and lower risk of other uses of funds. 11. Bank Capital. Explain the dilemma faced by banks when determining the optimal amount of capital to hold. A bank’s capital is less than 10 percent of its assets. How do you think this percentage would compare to that of manufacturing corporations? How would you explain this difference? 188 Chapter 17/Commercial Bank Operations ANSWER: Banks may prefer a low level of capital because they can possibly achieve a higher return to shareholders (higher earnings per share). However, regulators enforce minimum capital requirements so that a bank’s capital is sufficient to absorb operating losses that could occur. Banks are more highly leveraged (less capital and more liabilities) than manufacturing companies because their future cash inflows are much more predictable. They can handle the future payments due to liabilities, because they know the future level of cash inflows. 12. HLTs. Would you expect a bank to charge a higher rate on a term loan or a highly leveraged transaction (HLT) loan? Why? ANSWER: It would charge a higher rate for a highly leverage transaction (HLT) loan since this type of loan has a higher level of risk. 13. International Banking. Explain the operations of foreign branches of U.S. banks. ANSWER: Branches are full-service banking offices that can compete directly with other banks located in that area. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Lower interest rates may reduce the size of banks.” Lower interest rates are beneficial because they can increase the spread between the interest banks earn on their assets versus the interest they pay on their liabilities. However, during the 1992–1996 period when interest rates were so low, many households withdrew bank deposits and invested their money in stock mutual funds. This can reduce the efficiency of banks because it limits the total profits (in dollars), while there are some fixed expenses (salaries, etc.) that must be paid. For this reason, some banks may attempt to merge to consolidate their fixed expenses. b. “Banks are at a regulatory disadvantage when competing with other financial institutions for funds.” Banks are subject to excessive documentation rules on capital requirements on their assets, and are subject to reserve requirements on transaction accounts. They also must pay an insurance premium on deposits. Other financial institutions are not subject to these rules. c. “If the demand for loans rises substantially, interest rates will adjust to ensure that commercial banks can accommodate the demand.” If loan demand rises, interest rates on deposits and loans will increase. Thus, the high deposit rate will attract more funds, while the high loan rate will discourage some potential borrowers from obtaining loans. The interest rate adjusts to the point at which the supply of deposits is adequate to accommodate loan demand.