Chapter One

Commercial Banks
Chapter Eleven

Teaching Notes
V. Web Links

Part III

Commercial Banks

Commercial Banks

Chapter Eleven

Chapter Eleven

Commercial Banks: Industry Overview

Teaching Notes

Teaching Notes

1. Commercial Banks as a Sector of the Financial Institutions Industry: Chapter Overview
Loans are the major asset of all banks and deposits are the primary funds source.

In other words, their chief assets and liabilities are pieces of paper. This means that banks and other FIs will typically have a difficult time differentiating their product from one another, and intense competition and low margins can be expected unless there are significant competitive barriers such as regulations, time and distance between banks, etc.

2. Definition of a Commercial Bank
Banks are a subset of the three main types of DIs: banks, savings institutions, and credit unions. All three offer similar services. Banks will normally be larger, have a more diversified loan portfolio that includes more business lending and will have more sources of funds beyond deposits. Banks also play a unique role in our economy. The banking system is the conduit for monetary policy and banks are involved in much of the payments system and in credit allocation. Banks provide risk, maturity, denomination, and liquidity intermediation services to savers, helping to maximize the amount of funds available to potential borrowers.

3. Balance Sheet and Recent Trends
a. Assets
Major categories (2004 data) (Total Assets = $8,244.4 billion, September 2004)
� Liquid assets - Total cash assets (primarily vault cash, currency in the process of collection, correspondent balances and reserves at the Fed) comprised 5% of assets.
� U.S. government securities comprised 56% of the investment portfolio and about 13% of total assets. This investment portfolio is very safe and liquid.
� Loans - Loans are the highest earning asset on the bank balance sheet. They are also the largest category. As of 2004 loans comprised 57.5% of total assets. The major loan types include:

*Bank loans by type*	*% of Loans*	*% of Assets*
Interbank loans	4.1%	2.3%
Commercial and industrial loans	18.8%	10.8%
Real estate loans	53.7%	30.9%
Consumer loans	17%	9.8%
Other loans	8.1%	4.6%
Reserve for loan losses	(1.6%)	(0.1%)

Numbers rounded slightly

The primary risk a bank faces is credit risk, and a bank is unlikely to be able to remain profitable if there are significant problems in the loan portfolio.
Mortgage lending is increasing at most banks and C&I loans are declining. The former has occurred because of the demise of S&Ls and growth in the mortgage markets, particularly securitization. The latter is occurring because businesses have been able to procure alternative financing through the commercial paper market at rates below bank loans and because the public debt markets have grown rapidly.
� Other assets, primarily non-earning assets accounted for about 13.3% of total assets.
(Numbers are rounded slightly, includes reserve for loan losses as per the text)

In the 1950s cash and securities comprised some 70% of total assets and loans were about 26%. What does this imply about how the industry has changed? Obviously, liquidity risk and credit risk are much higher than in the past. However, banks now have more funds sources and the loan portfolio is better analyzed and better diversified than in the past.

b. Liabilities
Major categories (2004 data)
� Deposits: Deposits are the largest source of funds. As of 2004 deposits comprised almost 65% of total funding. Transaction accounts are checking accounts (such as NOWs that pay interest or demand deposits that do not pay interest).
� Transaction deposits comprised 13% of total deposits and slightly less than 9% of total funding. Transactions deposits are declining as a source of funding at banks.
� Nontransaction deposits include savings account, MMDAs and CDs. Nontransaction accounts made up 87% of total deposits and 56% of total funding.
� Passbook savings and retail CDs comprised 59% of total deposits, negotiable CDs ($100,000 or greater) were about 12.8% of total deposits.

In the 1950s interest bearing sources of funds were under 25% of total funding; today most funds sources are interest bearing. What does this imply about the sensitivity of bank profits to interest rates today as compared to the past? This also illustrates why banks have sought to increase fee based sources of income.

� Borrowings and Other Liabilities include notes and bonds outstanding, fed funds borrowed, and repurchase liabilities and were 25% of total funding.

The liabilities of banks tend to have less default risk than the assets and typically have a shorter maturity than the assets. That is, banks normally provide maturity and credit risk intermediation services to savers by providing savers with safer, shorter maturity accounts while purchasing or creating longer term riskier claims. The banks in turn earn the interest rate spread between the rates charged on the assets and the rates paid on the liabilities.

c. Equity
Capital requirements specify the minimum amount of capital a bank must maintain (see Chapter 13 for specific requirements) under the Basle Accord. Information on the Basle Accord and recent changes can be found at the website of the Bank of International Settlements (BIS). In 2004 equity comprised 9.9% of total funding. Equity consists of common stock (par and surplus), preferred stock and retained earnings. Regulators define other accounts that may serve as equity for the purposes of calculating minimum capital requirements.

One is surprised to learn that banks typically employ about 90% debt in their capital structure. Few nonfinancial firms allow their debt ratios to get over 50% (other than in Highly Levered Transactions). Nonfinancial firms in volatile industries often use little or no debt. DIs must employ a high amount of leverage to offer stockholders a satisfactory rate of return since their ROA is generally very low (in the 0.5%-2% range). Their ROA is low because they primarily have paper assets and liabilities. Recall from microeconomics that in industries with non-differentiable products, competition will force economic rents (NPVs) to zero. The ability of banks to use such high debt ratios arises from a) banks’ ability to closely manage and hedge risk and b) deposit insurance. Banks that do not learn to manage risk appropriately quickly fail when environmental factors change. Moreover, most bank creditors do not demand a risk premium in the form of higher deposit rates at risky banks because the government guarantees their deposits. This is an example of a market failure and the problem of moral hazard engendered by deposit insurance.

d. Off Balance Sheet Activities
Off balance sheet (OBS) assets and liabilities are activities that may lead to changes in on balance sheet assets and liabilities respectively, contingent upon some event occurring.
Example of OBS activities include (ranked by size in 2004): ¹
� Swap agreements
� Written or purchased options contracts
� Forward & futures contracts other than for foreign exchange
� Loan commitments
� Commitments to buy or sell foreign exchange (spot or forward)
� Credit derivatives
� Securities borrowed or lent
� Standby letters of credit

e. Other Fee Generating Activities
Much of this material is not in the text.
� Correspondent banking - larger banks serve as agents for smaller banks, assisting in
* check clearing
* purchasing securities
* foreign exchange
* loan participations (both ways)
* obtaining and placing fed funds
* trust services
* obtaining brokered deposits (Jumbo C.D.s, Euro$)
� Leasing - Banks may be able to use tax breaks from purchasing equipment that small/medium size businesses cannot.
� Trust operations – Trust functions are offered only by larger banks, but trust services are made available at most banks through correspondent relationships. Trust operations are providing fiduciary services for a third party.
� Swap brokers - Many larger banks act as swap brokers/swap partners helping financial institutions better match the interest sensitivity of their assets and liabilities. They take a fee for this service.
� Brokerage services
� Underwriting- Underwriting income via bank subsidiaries.
� Banks can advise and manage mutual funds but cannot sponsor the fund.

4. Size, Structure, and Composition of the Industry
As of December 2004 there were 7,660 commercial banks. This number has declined 39.9% since 1989.

The decline is somewhat misleading however since from over a roughly similar time period from 1989 to 1997 the total number of banks including branches grew over 15% from 59,536 to 68,814 (Source FDIC). Bank total assets also grew over 60% from 1988 to 1997. Industry consolidation has been occurring rapidly, largely via unassisted mergers, but total bank assets and the total number of banking facilities have grown at significant rates. Banking remains a growth industry.

a. Economies of Scale and Scope
The last few years have seen many megamergers (mergers of banks with over $1 billion in total assets). Text Table 11-4 contains a list. Primary reasons include cost and revenue economies and regulatory changes.

� Economies of scale and scope are generated by declines in unit costs required to produce bank activities as the bank gets larger or adds more services respectively.
� Cost economies of scale result from fixed costs spread over larger output as the bank grows.
� Institutions such as J.P. Morgan and Chase Manhattan estimated that their merger would result in cost savings of $1.5 billion.
� Cost economies of scope result from cost sharing when multiple products are offered. That is, as more products are added, costs do not rise proportionally with revenues.
� The Financial Services Modernization Act of 1999 (FSMA) allows banks to merge with insurance firms and investment banks for the first time since 1934. The 1998 merger of Citicorp and Travelers (a bank and an insurance firm) prompted the change.
� The merger of UBS and Paine Webber is another example of a merger that may exploit cost economies of scope.
� Both of these economies derive from fixed costs arising from technology. As more customers and/or more services are added the cost per unit to provide the service (such as brokerage, financial planning, underwriting insurance, etc,) drops, improving profitability.
� Revenue economies of scale and scope also provide motives for mergers. Additional revenues can be generated via mergers by adding additional customers, moving into less competitive markets and stabilizing revenue by serving customers in different regions. The 2004 J.P. Morgan Chase acquisition of Bank One, added Bank One’s large credit card operations and retail network in an attempt to broaden Chase’s revenue sources.
� X efficiencies are cost savings that occur which are not attributable to economies of scale and scope. They may include managerial learning processes or other unspecified cost savings.
� Diseconomies of scale may also arise from mergers. It is notoriously difficult to manage large institutions that have different organizational cultures. Managerial hubris cannot be overlooked in discussing mergers. Managers tend to over estimate their ability to generate revenue and cost economies and tend to underestimate the complexities involved, including loss of employee morale when jobs are cut, technological problems in integrating different computer systems, problems in corporate culture, etc.

It remains to be seen whether these cost economies will turn out to be illusory or real. This author is skeptical. Academic studies identify large economies of scale up to the $10-$25 billion range in asset size. It is likely that overcapacity, integration problems and difficulties in merging corporate cultures will result in lower synergies than anticipated. Recall the conglomerate boom of the 1960s that led to the divestiture boom of the 1970s and 1980s. Citigroup recently decided to divest Traveler’s, reversing their prior merger. Only time will tell.

Academics have been forecasting a sharp decline in the number of banks in the U.S. for years. Indeed, most developed countries operate with far fewer banks than we have. U.S. regulations have long been designed to protect the small community bank (banks with assets under $1 billion). These banks may eventually go the way of the five and dime store.

b. Bank Size and Concentration
The largest banks increasingly dominate the industry (see text or below) and the largest banks control the vast majority of industry assets. This is now true in all aspects of the financial services industries. Banks are often classified as
� money center banks that are the largest banks, typically located in New York city. These banks generally rely on nondeposit sources of funds and are heavily engaged in wholesale banking (with or without a retail banking presence). Wholesale banking refers to providing loans services to corporations and other institutions as well as acquiring nondeposit sources of funds. Retail banking is providing consumer oriented banking services such as loans and deposits. Money center banks include Bank of New York, Citigroup, J.P. Morgan Chase, HSBC Bank USA and Bankers Trust (owned by Deutsche Bank).
� superregional or regional banks that operate primarily in one or more regions of the country
� community banks that operate in local markets

Summary of Text Table 11-5

Size & Type 2004	% of total # banks	% of total banks assets
Community banks	94.2%	13.6%
$1-10 billion	4.7%	11.8%
≥ $10 billion	1.1%	74.6%
	100.0%	100.0%

Notice the heavy concentration of assets among the largest banks. Nevertheless, thousands of small banks remain throughout the country, although more and more of these small institutions are being absorbed by mergers. Absorptions are running higher than new charters so the trend toward increasing concentration will continue.

c. Bank Size and Activities
Large banks generally are less liquid, are more heavily concentrated in loans and use more purchased sources of funds. They have greater access to brokered deposits and non-deposit liabilities and they tend to hold less equity.

Large banks lend to more sophisticated corporate customers which means that their profit margins are often lower than for smaller banks that operate in more isolated, less competitive circumstances. A key ratio for bank management includes the net interest margin which is equal to the interest rate spread divided by earning assets. The interest rate spread is the interest earned on assets minus the interest paid on liabilities.

Large banks typically pay higher salaries than smaller banks and have greater investments in facilities and in the provision of services. On the other hand large banks generate substantially more fee income than small banks.

At times small banks have been more profitable than large banks, but this has not always been the case. The higher profitability at smaller banks is often due to a lack of local competition. As large banks gain the ability to enter local markets it is questionable whether the smaller banks’ profitability can be maintained.

5. Industry Performance
Banks enjoyed excellent profitability during most of the 1990s, weaker performance in the early 2000s, but record high performance in 2003 and on into 2004. ² In 2004 banks had an average ROA of 1.31% and a ROE of 14.01%, both figures are good. Bank ROA’s vary from 0.5% to 2% typically. Bank profitability has been high because of higher noninterest income and lower loan loss provisions. Consumer loan demand and demand for mortgage credit has remained high as well. Banks have also benefited from a long period of low interest rates which has encouraged borrowing. Credit card rates in particular have not fallen as quickly as bank costs, improving bank margins. Better information technology has helped reduce costs and the growth of credit derivatives and mortgage securitization has helped banks to shift risks to other entities. The yield on earning assets in 2004 was 5.18% and the cost of funding earning assets was 1.56%, giving a net interest margin of 3.62%which is quite good. ³

The provision for loan losses is a charge to earnings based on management’s expectation of how many loans will go bad in the current quarter. Net charge offs are actual write offs. Noncurrent loans to assets and net charges offs to assets have fallen in 2003 and 2004 from their prior levels. (0.59% and 0.61% are the September 2004 ratio levels respectively.)

Over the longer term, the industry is now much stronger today than it was in the late 1980s and early 1990s. For instance, two hundred and six banks failed in 1989; three had failed in 2004 as of September. The stronger economy, improvements in technology, low interest rates and the additional oversight brought about by the FDIC Improvement Act of 1990 helped turn the banking industry around in the last decade, and banks continue to have high net operating income levels and a higher margin of safety.

6. Technology in Commercial Banking
Technology is profoundly changing the banking industry, and the major changes are still ahead. Technology investments can generate operating efficiencies and economies of scale and scope. Internet and wireless communications constitute new methods of offering both existing and new financial services to current and potential customers at much lower costs than currently available.

a. Products Available in Wholesale Banking
Cash management services: Technology is allowing banks to offer corporate customers real time information of cash balances related to the following services:
� Controlled disbursement accounts – Accounts that allow the customer to know exactly which checks or payments will be withdrawn that day from the account.
� Real time account reconciliation
� Electronic lockboxes allow corporate customers to reduce the float time, in this context float is the time between when the customer pays the check and the corporation collects.
� Funds concentration allows sweeping of funds from various accounts into one centrally managed account.
� Electronic funds transfer via CHIPS or Fedwire, automated payments via ACHs and automated message transfers via SWIFT
� Automated check deposit services
� Electronically generated letters of credit
� Access to treasury management software
� Electronic invoicing interchange between businesses
� Electronic B2B commerce
� Electronic billing
� Verification of identities in transactions

b. Products Available in Retail Banking
� ATMs and ATM networks
� Point of sale cards
� Home banking
� Preapproved debits or credits
� Paying bills by phone
� E-mail billing
� Online banking
� Smart cards
Online banking services are beginning to grow at a much more rapid pace. Availability, security and cost of high speed Internet remain issues, but the younger generation in particular seems increasingly willing to use online bank services. This area will probably still suffer from overcapacity and customer resistance for some time however. Internet only banks have not thrived. Customers still desire to interact with people for many transactions and appear to prefer to deal with established banks, even if they plan to use electronic banking functions.

7. Regulators
a. Federal Deposit Insurance Corporation
The FDIC, created in 1933, manages the deposit insurance funds for the thrift and banking industries. The FDIC examines banks and disposes of failed bank and savings association assets.

b. Office of the Comptroller of the Currency
The OCC has been around since the Civil War. The OCC grants national charters, although banks may be state chartered instead. The OCC examines national banks and approves or disapproves their merger applications.

Prior to 1863 the U.S. had only state chartered banks. In an attempt to help finance the Civil War, the National Banking Acts of 1863 and 1864 created nationally chartered banks that the federal government could more tightly regulate. The laws required nationally chartered banks to hold U.S. government bonds to collateralize their bank notes. This allowed the government to finance the rest of the war. The acts did not however outlaw state banking. As a result, we have a dual banking system today.

About twenty–six percent of federally insured banks are nationally chartered banks; the remainder is state chartered. Nationally chartered banks must be members of the Fed and must be FDIC insured. State chartered banks have a choice on both. State chartered banks may have less regulations imposed upon them and state chartered banks cannot use the word ‘national’ in their name.

c. The Federal Reserve System
About 38% of federally insured banks are members of the Federal Reserve and 62% are not. Fed membership allows banks direct access to the FedWire system. The Fed regulates bank holding company activities.
d. State Authorities
State chartered banks are regulated by state banking authorities. Federally insured state chartered banks pass into receivership of the FDIC if they fail.

8. Global Issues
Of the top 20 global banks in the world ranked by asset size, only 3 are U.S. banks (Citigroup, J.P. Morgan Chase and Bank America).

This result is an artifact of U.S. bank regulations however that have promoted small community banks. If one looked at lists of the most profitable and sophisticated banks, one would find more U.S. banks on that list.

The advantages of globalizing operations include:
� Additional risk diversification by including operations in other economies
� Economies of scale and scope
� Innovations - U.S. banks have been global industry leaders in generating new products such as OTC derivatives not developed by overseas banks.
� Expanded funds sources
� Maintenance of customer relationships as many corporate customers have gone global and have needed banking services for their overseas operations
� Avoidance of domestic regulations - The U.S. tends to be the most tightly regulated market and engaging in overseas operations allows U.S. banks to operate with less scrutiny
Disadvantages of globalization of banking services include:
� Greater information production and monitoring costs involved in evaluating overseas loans and investments. The U.S. generally has higher disclosure requirements than most other countries.
� Overseas operations may face expropriation or repatriation problems.
� The fixed costs to enter foreign markets may be quite high and may not be easily recovered once an investment is made.

Global Banking Performance
Japan
The Japanese banking industry has been bailed out three times since 1998. Japanese banks have had difficulty since Basel I revealed inadequate levels of equity at many Japanese banks. Japan’s problems have extended well beyond the banking industry however. Traditionally, Japanese banks have been the center piece of a corporate structure termed the keiretsu. The keiretsu featured a tight nexus of ownership among the corporate members and the bank. The bank provided major funding to the corporations. When these corporations became less competitive in the 1990s, the banks continued to make loans to these firms rather than forcing the changes that were required to restore the companies to competitiveness. In the latest bailout, private firms such as Goldman Sachs, Merrill Lynch and Deutsche Bank have become involved. This is a very positive sign for growth in Japan as it indicates a greater openness to competition in both the corporate and financial sectors.
China
According to official figures, at China’s four state run banks about 1/5 of loans are nonperforming. Some economists put the rate as high as 50%. At a U.S. bank, when about 5% of loans go bad the institution is usually on the verge of bankruptcy. Similar to Japan, China is now allowing more foreign interests in its banking industry in order to improve performance. ⁴

Germany
Germany’s large banks are having profit problems because of continued weak economic performance (unemployment is around 10%), largely due to weak internal demand and poor corporate profits. Regulations also provide funding advantages for small banks, allowing them to offer lower loan rates than large banks. This limits funds sources for the big banks, which must then engage in higher risk funding activities such as trading and fee income.

Russia
Russia is still struggling to build a Western style banking system with sufficient regulation to deter corruption. This is occurring against a backdrop of Putin’s increasingly authoritarian rule. Russia is planning on instituting deposit insurance and not allowing banks that refuse to conform to the rules or those that remain too risky to obtain insurance. This has created the potential for bank runs however during the transition. Risk in the Russian financial system remains quite high.

V. Web Links

V. Web Links

http://www.federalreserve.gov/ Website of the Board of Governors of the Federal Reserve

http://www.mybank.com/ This comprehensive listing will help you locate banks on the World Wide Web.

http://www.occ.treas.gov/ Office of the Comptroller of the Currency

http://www.americanbanker.com The publication of the banker’s trade association

http://www.fdic.gov/ The Federal Deposit Insurance Corporation’s website: new regulations and current and historical banking statistics are available on this site.

VI. Student Learning Activities

VI. Student Learning Activities

1. Go to http://www.ffiec.gov/ and link to the NIC data and find the current list of top bank holding companies in the U.S.

2. Go to Value Line Investment Surveys, Standard and Poors or some other investment service and obtain a current industry analysis for the bank industry. Is performance projected to improve over the data given in the text or is performance slipping? Identify the major causes of any differences.

3. Why did the proposed merger in 1999 between Deutsche Bank and Dresdner Bank fail? What were the potential pros and cons of such a merger? Both the Wall Street Journal and the Economist are good starting points for your research.