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					                                            CHAPTER 13

                          COMMERCIAL BANK OPERATIONS

      This chapter surveys the structure and importance of the U.S. commercial banking industry.

      The chapter describes the basic operation of commercial banks in terms of their sources and uses
       of funds as reflected in their major balance sheet accounts.

      The chapter explains how banks make decisions about risk-taking, funding, and pricing.

      The chapter discusses the development and structure of bank and financial holding companies.

Large banks have a well-defined entry level for college graduates. New recruits complete one to two years
of training. The first phase immerses them in accounting, finance, regulation, and the bank’s policies and
procedures. The second phase involves rotations among the bank’s key lines of business. Then trainees
undergo a placement process to find their first permanent assignment. Those ranking nearer the top of their
training class will have more nearly their first choice. Today, banking involves a wide range of career
options, both functionally and geographically. The nation’s largest banks now operate in practically all 50
states, and deliver many services either not permitted or not invented 20 years ago.

The Journal’s layout is designed to get a busy reader up to speed in a matter of minutes. In a hurry first
thing in the morning? Scan the “What’s News” columns on the front page, then page through Section C
(Money & Investing). These items make up the financial world’s “daily brief”.


I.       An Overview of the Banking Industry

         A.      Fewer banks, more branches.
                 1.     Less than 8,000 banks: The number of banks has declined significantly as the
                        industry has consolidated.
                 2.     More than 80,000 banking offices: The number of branches has increased
                        significantly as geographical restrictions on banking have relaxed.

         B.      Many small banks, a few very large banks.
                 1.    94% of U.S. banks hold only 18% of banking industry deposits.
                 2.    The largest 89 banks (about 1% of U.S. banks) hold 67% of total deposits.

         C.      Holding companies predominate.
                 1.     A “bank holding company” is a company owning an interest in at least 1 bank.
                 2.     As of 2005, some 5,154 holding companies controlled 6,160 banks with about
                        96% of U.S. commercial bank assets.

II.   Bank Balance Sheet: Uses of Funds (Assets) = Sources of Funds (Liabilities + Capital).

      A.     Sources of Funds: Liabilities + Capital

             1.      Deposit Liabilities: Transaction Deposits; Savings Deposits; Time Deposits.

                     a.      Transaction Deposits: Demand Deposits; NOW Accounts:
                             (1)     Demand Deposits, also known as checking accounts.
                             (2)     NOW (Negotiable Order of Withdrawal) Accounts—
                                     i.     pay interest;
                                     ii.    just for individuals, governments, and nonprofits

                     b.      Savings Deposits: Savings Accounts; MMDAs.
                             (1)     Savings Accounts comprise about 13% of all deposits
                             (2)     MMDAs (Money Market Deposit Accounts)
                                     i.      comprise about 40% of all deposits
                                     ii.     interest plus limited transactional features

                     c.      Time Deposits: Certificates of Deposit; Negotiable Certificates of Deposit
                             (1)    Non-transferable Certificates of Deposit
                                    i.      usually under $100,000
                                    ii.     terms of 30 days to 5 years
                             (2)    Negotiable (or “Jumbo”) CDs—transferable in secondary market
                                    i.      $100,000 or more
                                    ii.     terms rarely exceed 90 days

             2.      Non-deposit Liabilities: Fed Funds Purchased; Repurchase Agreements; Other

                     a.      Fed Funds Purchased: Most important non-deposit source of funds.
                             (1)    Recall purpose of Fed Funds Market from Chapters 2 and 3
                             (2)    Banks buy and sell Fed Funds “overnight” to adjust liquidity.

                     b.      Repurchase Agreements: Another liquidity adjustment mechanism.
                             (1)    Bank sells securities but agrees to repurchase them
                                    i.       essentially a self-securing loan
                                    ii.      usually “overnight” but can last longer
                             (2)    T-Bills are a common form of collateral.

                     c.      Other Borrowings—
                             (1)    Trading Liabilities
                             (2)    Eurodollars (See Chapter 12).
                             (3)    Bankers’ Acceptances (see Chapters 7 and 12).
                             (4)    Federal Home Loan Bank Advances
                             (5)    Discount Window Loans (see Chapters 2 and 3).
                             (6)    Capital Notes or Bonds
                                    i.      usually subordinate to depositors’ claims
                                    ii.     may count as “capital” for some regulatory purposes

             3.      Capital Accounts: Capital stock; Undivided Profits; Special Reserve Accounts.
                     a.      Capital Stock: Direct investments of common or preferred equity.
                     b.      Undivided Profits: Accumulated earnings not paid out in dividends.
                     c.      Special Reserve Accounts: Against losses on loans or securities.

B.   Uses of Funds: Assets

     1.     Cash Assets: About 4% of industry assets.
            a.     Vault cash--Physical currency and coin counts for reserve requirements.
            b.     Reserves at the Fed (see Chapters 2 and 3).
                   (1)     Required reserves per Reg D
                   (2)     Excess reserves—
                           i.       for settling transactions with Fed
                           ii.      for check-clearing
                           iii.     for Fed Funds transactions
            c.     Balances at other banks.
            d.     Fed Funds Sold (see Chapters 2 and 3).
            e.     Reverse Repurchase Agreements.

     2.     Investments: About 17% of industry assets; risk discouraged in favor of liquidity.
            a.     U.S. Treasury securities (see Chapters 7 and 8).
            b.     Agency securities (see Chapters 7, 8, and 9).
            c.     Municipal securities (see Chapter 8).
                   (1)     Probably the riskiest securities banks are allowed to own.
                   (2)     Interest is exempt from federal income tax.

     3.     Loans and Leases: Main earning assets of any bank; about 59% of industry assets.

            a.      Major categories of bank loans:
                    (1)    Commercial and Industrial. Loans (about 11% of assets)
                           i.       Working capital
                           ii.      Equipment
                    (2)    Loans to Depository Institutions
                    (3)    Real Estate Loans (about 34% of assets; see Chapter 9)
                           i.       Commercial (construction; permanent)
                           ii.      Residential (construction; permanent)
                           iii.     Development
                    (4)    Agricultural Loans
                    (5)    Consumer Loans
                           i.       Credit cards
                           ii.      Student loans
                           iii.     Vehicles and other consumer purchases

            b.      Lease financing: Bank purchases asset and leases to customer.
                    (1)     Fast-growing line of business for large banks.
                    (2)     Common financing technique for—
                            i.      “fleet assets” (aircraft, ships, etc.)
                            ii.     “rolling stock” (trucks, rail cars, etc)
                            iii.    other capital equipment (cranes, generators, etc.)

     4.     Other Assets.
            a.     Trading account assets—securities held for resale.
            b.     Fixed assets—land, buildings, equipment, etc,.
            c.     Intangibles—goodwill, prepaids, etc.

III.   Loan Pricing: One of the most important management decisions in banking.

       A.     Three key considerations in loan pricing.

              1.     Earn a high enough interest rate to cover the costs of funding the loan.
              2.     Recover the administrative costs of originating and monitoring the loan.
              3.     Provide adequate compensation for risk—
                     a.      Credit (or default) risk.
                     b.      Liquidity risk.
                     c.      Interest rate risk.

       B.     The “Prime Rate”

              1.     Historically a benchmark, or base rate, on short-term business and agricultural loans.
                     a.      The lowest loan rate posted by commercial banks.
                     b.      The rate banks charged their most creditworthy customers.
                     c.      All other borrowers were typically quoted rates as some spread above
                             prime, depending on their risk.

              2.     Recently, the role of the prime rate has changed.
                     a.      Over the last 25 years, fewer loans have been priced using “prime”.
                     b.      Now, lenders choose among several other benchmark rates:
                             (1)      LIBOR—“London Interbank Offered Rate”
                                      (price of short-term Eurodollar deposits)
                             (2)      Treasury rates
                             (3)      Fed Funds rate
                     c.      Popular media still use the Prime Rate as a barometer.

       C.     Base rate pricing: marking up from a minimum offered the least risky borrowers.

              1.     Possible base rates: Prime, LIBOR, Treasury, Fed Funds.
              2.     Markups include three adjustments:

                     a.      For increased default risk above the risk associated with the base
                             rate. The bank’s credit department assesses default risk.

                     b.      For term-to-maturity.
                             (1)     Most business loans are variable rate--as the base rate
                                     increases or decreases, the loan rate adjusts accordingly.
                             (2)     For fixed-rate loans the bank will adjust the short-term base rate
                                     by an amount consistent with the current yield curve.

                     c.      For competitive factors—a customer’s access to alternatives.

              3.     Expressed mathematically: rL = BR + DR + TM + CF

                             where: rL =      individual customer loan rate
                                    BR =      the base rate
                                    DR =      adjustment for default risk above base-rate customers
                                    TM =      adjustment for term-to-maturity
                                    CF =      competitive factor

      D.     Nonprice adjustments to alter the effective return under a given nominal rate.

             1.      Compensating balances.
                     a.      Bank requires borrower to carry minimum balance in non-interest-bearing
                             deposit account.
                     b.      Effective return increases because net loan amount is lower.
             2.      Other nonprice adjustments—
                     a.      Risk reclassification.
                     b.      Additional collateral or specified collateral.
                     c.      Shorter maturities (or “rest periods” for lines of credit).

      E.     Matched-funding loan pricing: Fixed-rate loans are funded with deposits or borrowed
             funds of the same maturity.

IV.   Analyzing, managing, and pricing credit risk.

      A.     Five “C”s of Credit:
             1.     Character (willingness to pay)
             2.     Capacity (cash flow)
             3.     Capital (wealth or net worth)
             4.     Collateral (security)
             5.     Conditions (economic conditions)

      B.     Credit scoring based on the information in the borrower’s credit report:
             1.      Payment history
             2.      Amount owed
             3.      Length of credit history
             4.      Extent of new debt
             5.      Type of credit in use

      C.     Default risk premiums for identified risk categories determined from analysis of
             credit losses over several business cycles.

V.    Pricing bank deposits, the bank’s main source of loanable funds.

      A.     Must offer depositors high enough rates to attract and retain a stable deposit base.
      B.     Must not pay so much on deposits that profitability is compromised.
      C.     Competition puts pressure on the “spread” from both sides—
             1.     bank may have to charge lower rates on loans
             2.     bank may have to pay higher rates on deposits

VI.   Fee-based services.

      A.     Correspondent banking: sale of bank services to other financial institutions.
             1.     Common correspondent services—
                    a.      check clearing and collection
                    b.      securities
                    c.      foreign exchange
                    d.      participation in large loans
                    e.      data processing
             2.     Not a recent development, but unique to the U.S.
                    a.      Many small banks need “large bank” services
                    b.      Large banks provide these services

       B.     Trust services: management of client wealth.
              1.      As fiduciary, bank holds and manages assets for beneficiary.
              2.      Trust function is strictly segregated from other bank functions.
              3.      Common trust services—
                      a.      administration of estates
                      b.      management of pension assets
                      c.      registration and transfer of securities
                      d.      administration of bond indentures

       C.     Nonbanking financial services: Investments and insurance.
              1.    Deregulation allows these services, provided clients clearly understand they are
                    not covered by deposit insurance.
              2.    Banks can compete directly with mutual funds and securities firms.
              3.    Insurance powers of banks are more limited.

VII.   Off-balance-sheet banking

       A.     Loan commitments: unfunded promises to make loans in the future.
              1.     Lines of credit (allow total advances up to a limit).
              2.     Term loans (certain dollar amount longer than 1 year).
              3.     Revolving credit (lines of credit allowing payment and reborrowing within limit).

       B.     Letters of credit: Written promises to pay a third party on client’s behalf.
              1.      Commercial letters of credit—
                      a.      client buys goods and services
                      b.      bank promises to pay seller on behalf of client
                      c.      seller presents bank with draft to “invade” letter of credit
              2.      Standby letters of credit—
                      a.      bank guarantees client’s financial performance of some contract
                      b.      client’s counterparty relies on bank’s creditworthiness, not borrower’s
                      c.      beneficiary “invades” SLC by presenting draft to bank
                      d.      common uses of SLCs—
                              (1)      securities offerings
                              (2)      credit enhancement of other debts
                              (2)      completion of projects

       C.     Derivatives: Interest rate/currency forwards, futures, options, swaps (see Ch. 11)
              1.     Hedging (encouraged by regulators)
              2.     Speculating (discouraged by regulators)

       D.     Loan brokerage: Sale of loans after origination.
              1.     Restores liquidity and earns fees.
              2.     Avoids regulatory burden of loans on books.

       E.     Securitization: assignment of cash flows from assets (usually loans) via securities to
              1.      Similar rationale to loan brokerage.
              2.      Bank transfers assets to trust; sells ownership units in trust.
              3.      Banks can underwrite securitizations themselves after deregulation.

VIII.   Bank and Financial Holding Companies: The most common way of organizing U.S. banks.

        A.      De facto branching.
                1.      Multibank holding companies circumvent branching restrictions.
                2.      Recent deregulation makes branching easier.

        B.      Diversification into nonbank services.
                1.      Fed allows certain nonbank subsidiaries within a holding company.
                2.      BHCs with acceptable CRA ratings (see Chapter 16) can qualify as “financial
                        holding companies” and have subsidiaries in almost any financial service.

        C.      Tax avoidance.
                1.     Interest paid on debt is tax-deductible.
                2.     Most dividends received from subsidiaries are tax-exempt.
                3.     Nonbank subsidiaries can be structured to avoid local taxes.


1.      In commercial banks ________ deposits are the most important source of funds; ________ loans
        represent the major investment category.

2.      ________ deposits represent about two thirds of M1.

3.      Though interest payments have been prohibited on demand deposits in the past, banks have paid
        ________ interest by offering "free" checking accounts, convenience, and other “perks”.

4.      Several money market securities are listed below. Indicate whether each security represents a bank
        asset, a bank liability, or neither.
        a.       Banker's Acceptance                     ________________
        b.       Negotiable Certificate of Deposit       _______________
        c.       Treasury Bill                           ________________
        d.       Federal Funds Purchased                 ________________

5.      The bank investment portfolio provides both ________ and ________ to the bank.

6.      A ________ loan provides funds for a specific transaction.

7.      A ________ is an informal agreement to lend in the near future; a ________ credit agreement is a
        formal contract, supported by fees, to lend on demand for a period of several years.

8.      While traditionally the "best" loan rate offered to bank customers, today the ________ rate plays a
        smaller role as a posted reference or index bank rate.

9.      ________ deposit balances are a form of nonprice adjustments to loan yields.

10.     The “Five Cs of Credit” are _____________________ , _____________________ ,
        _____________________ , _____________________ , and _____________________ .


T       F       1.      The prime rate today represents the lowest bank lending rate.

T    F       2.      A revolving credit agreement is a longer-term informal agreement to lend.

T    F       3.      With credit cards, the bank generates revenues from both borrowers and retailers.

T    F       4.      The level of a bank’s prime rate is directly related to its cost of funds.

T    F       5.      A bank would prefer to make a fixed-rate mortgage loan if it predicts higher
                     interest rates in coming years.

T    F       6.      Demand deposits represent the largest source of funds for commercial banks.

T    F       7.      Fee-based services have become an increasing share of bank revenue.

T    F       8.      Fed Funds sold represent an important source of borrowed funds for banks.

T    F       9.      Regulators prohibit derivatives as a hedging technique.

T    F       10.     In a letter of credit, a borrower substitutes its creditworthiness for the bank’s.

1.   Which of the following is not a bank demand deposit account?
     a.     treasury tax and loan account
     b.     large corporate account
     c.     Federal Reserve deposit account
     d.     correspondent deposit account

2.   The interest rate paid by banks on deposit accounts today is
     a.      a market rate determined by the bank.
     b.      a rate set by the Federal Reserve Board.
     c.      restricted by Regulation Q.
     d.      a rate agreed upon by all the banks in town.

3.   Bank borrowed funds (bank liability) have what characteristic?
     a.     not insured by FDIC.
     b.     short-term.
     c.     large denomination.
     d.     all of the preceding.

4.   To a bank, all of the following are advantages of holding U.S. Treasury securities except:
     a.      they are highly marketable
     b.      they may be used as collateral
     c.      they offer relatively high interest rates
     d.      they pose little or no default risk

5.   ABC Bank is considering a taxable security yielding 10% and a nontaxable municipal bond
     yielding 6%. If ABC's marginal tax rate is 46%, which of the following is the best choice,
     assuming each instrument represents essentially the same risk?
     a.      Always take the tax-free bond.
     b.      Always select the taxable security because its yield is higher.
     c.      Compare the securities on an after-tax basis and buy the municipal.
     d.      Compare the securities on an after-tax basis and buy the taxable bond.

6.    While time deposits are banks' major source of funds, their major use is:
      a.      investments.
      b.      consumer loans.
      c.      demand deposits.
      d.      commercial loans.
      e.      real estate loans

7.    As a bank depositor shifts funds from demand deposits to savings to time deposits, the depositor's
      a.      liquidity declines and interest income decreases.
      b.      liquidity declines and interest income increases.
      c.      liquidity increases but default risk increases.
      d.      implicit interest increases and explicit interest declines.

8.    All of the following have encouraged bank loan securitization except:
      a.       the bank is able to increase the amount of bank capital needed.
      b.       securitizing loans is an important source of funds.
      c.       fees from origination, servicing and underwriting are important sources of revenue.
      d.       required reserves and deposit insurance premiums are reduced because deposit sources
               have been replaced by loan securitization sources.

9.    All of the following are a source of common equity capital for banks except:
      a.       common equity.
      b.       retained earnings.
      c.       capital notes.
      d.       reserve accounts.

10.   Two important functions of bank investments (as distinguished from loans) are
      a.    capital and income
      b.    income and safety
      c.    liquidity and income
      d.    funding and liquidity.


1.    time; real estate

2.    demand

3.    implicit or effective or nonmonetary

4.    a. liability b.     liability c. asset d. liability

5.    liquidity; income

6.    bridge

7.    line of credit; revolving

8.    prime

9.    compensating

10.   character, capacity, capital, collateral, and conditions


1.    F   High-quality businesses are borrowing at rates below prime today. Traditionally, the
          "prime" represented the "best" rate for quality credit customers.

2.    F   Revolving credit is usually a formal commitment to lend in return for a fee to the bank.

3.    T   Retailers pay a percentage of their credit card receipts; credit card holders may pay an
          annual fee to the bank and finance charges (interest) if they carry a balance.

4.    T   If the cost of funds (CDs) increase, the bank may increase its prime rate.

5.    F   If rates are expected to increase, the bank would want a variable rate loan; the customer
          would want a fixed rate (see Chapter 6).

6.    F   Time deposits are the major source of funds for banks.

7.    T   Fee-based services are less related to interest rate, liquidity, and credit risk.

8.    F   Federal Funds sold are an asset; Federal Funds purchased (liability) are a source of funds.

9.    F   Regulators generally permit derivatives and accept their use for hedging, but discourage
          their use for speculation.

10.   F   The bank's credit worthiness replaces that of the borrower customer.


1.    c   Federal Reserve deposits are assets of the bank.

2.    a   Most deposits provide a rate determined by local market conditions.

3.    d   Most borrowed funds are money market transactions -- short-term, uninsured, and large.

4.    c   Treasuries yield less than other, riskier assets.

5.    c   Analyze in either of two ways. (1) Find the after-tax yield on the taxable security; compare
          with the no-tax yield on the muni: 10% (1-.46) = 5.4%, a lower after- tax yield than the
          6% muni. (2) Adjust the tax-free security to a pretax equivalent basis and compare with
          the taxable yield. 6%/(1-.46) = 11.11%, which exceeds the 10% taxable.

6.    e   Real estate loans are the major asset or use of funds of banks.

7.    b   The depositor is shifting toward deposits where withdrawal is increasingly costly. To
          compensate for the illiquidity, the yield increases.

8.    a   Securitization holds the level of assets relatively constant, thus holding the amount of
          required equity capital relatively constant.

9.    c   Capital notes, while usually subordinate to deposits, are contractual debt funds, which
          require that interest and principal be paid at definite times.

10.   c   Bank investments provide liquidity to honor commitments while earning steady income.