CHAPTER 13
BASICS OF
COMMERCIAL
BANKING
Presentation by
Basics of Commercial
Banking
TABLE OF CONTENT
Introduction
The bank balance sheet
Bank assets
Bank Liabilities
Bank Capital
Basic operations
Basics of Commercial Banking
TABLE OF CONTENT
Management of Bank Assets
Management of Bank Liabilities
Management of Bank Capital
Bank Capital and Bank profit
Managing Bank Risk
1
INTRODUCTION
Commercial banking is a business.
sources of funds - primarily deposits
use of funds - primarily loans
2
THE BANK BALANCE SHEET
Balance Sheet
- summarized bank's sources and uses of funds.
-is a statement that lists an individual's or a firm's
assets and liabilities to indicate the individual's or
firm's financial position on a particular day.
3
THE BANK BALANCE SHEET
ASSETS LIABILITIES BANK CAPITAL
is something of value that an is something that an equity is the difference
individual or firm owns. individual or a firms owes. between the value of the
bank's assets and the value of
its liabilities.
4
BANK ASSETS
Banks acquire bank assets with the funds they receive
from depositors, the funds they borrow, the funds they
acquire from their shareholders purchasing the bank's
new stock issues, and the profits they retain from their
operations.
MOST IMPORTANT BANK ASSETS
Reserves and
Other Assets
The most liquid asset that banks hold is
reserves.
Excess Reserves - Reserves that banks hold over
and above those that are required
As authorized by Congress, the BSP mandates
that banks hold a percentage of their demand
deposits and NOW accounts (but not Money
Market Deposit Accounts (MMDAs)) as
required reserves.
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MOST IMPORTANT BANK ASSETS
SECURITIES
Marketable securities are liquid assets that
banks trade in financial markets.
Because of their liquidity, bank holding of
Government Treasury securities are sometimes
called secondary reserves.
. Commercial banks cannot invest checkable
deposits in corporate bonds or common stock
in nonfinancial corporations.
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MOST IMPORTAT BANK ASSETS
LOANS
RECEIVABLE
Loans are illiquid relative to marketable
securities and entail greater default risk and
higher information costs. As a result, the interest
rates banks receive on loans are higher than
those they receive on marketable securities.
NEXT
01
Loans to business
called commercial and industrial, or C&I, loans
02
Consumer loans
made to households primarily to buy automobiles,
LOANS furniture and other goods
RECEIVABL
03
Real estate Loans
E
include mortgage loans and any other loans backed
with real estate as collateral.
RESIDENTIAL MORTGAGES - Mortgage loans
made to purchase homes
COMMERCIAL MORTGAGES - while mortgages
made to purchase stores, offices, factories, and other
commercial buildings
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MOSTV IMPORTANT BANK ASSETS
OTHER
ASSETS
Other assets include banks’ physical assets, such
as computer equipment and buildings. This
category also includes collateral received from
borrowers who have defaulted on loans.
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10
BANK LIABILITIES
The most important bank liabilities are the funds a
bank acquires from savers.
Bank deposits offer households and firms certain
advantages over other ways in which they might hold
their funds.
Banks offer a variety of deposit accounts because
savers have different needs.
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DEMAND OR CURRENT ACCOUNT
DEPOSITS
Bank offer savers demand or current account deposits, which
are accounts against which depositors can write checks.
Demand deposits - current account deposits on which banks do
not pay interest.
Negotiable Order of Withdrawal / NOW account - hecking
accounts that pay interest.
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NONDEMAND DEPOSITS
Banks offer nondemand deposits for savers who are willing to sacrifice
immediate access to their funds in exchange for higher interest
payments.
Most important types of of nontransaction deposits:
Money Market Deposit Accounts
Savings Account (MMDAs)
Certificate of
Time Deposits
Deposit (CDs)
Page 13
BORROWINGS
A bank can earn a profit from this borrowing if the interest rate
it pays to borrow funds is lower than the interest it earns by
lending the funds to households and firms.
Borrowings include short-term loans in the BSP funds market,
loans from a bank's foreign branches or other subsidiaries or
affiliates, repurchase agreements, and discount loans from the
BSP. The federal funds market is the market in which banks
make short-term loans - often just overnight - to other banks.
14
BANK CAPITAL
Bank capital, also called shareholder's equity, or
bank net worth, is the difference between the
value of a bank's assets and the value of its
liabilities.
Illustrative case:
the following entries are from the actual balance
sheet of a Domestic bank,S
Services 01
It is mostly presented before an
audience.
Solution:
Services 01
It is mostly presented before an
audience.
Solution:
PAGE 212
GAME TIME!
The category gives a vague hint to what sort of answer you are looking for (person,
phrase, thing etc.). First to guess will get a point!
Game name: REBUS PUZZLE
WEIGHT!
BLOCK
DOLLAR
19
BASIC OPERATIONS OF A
COMMERCIAL BANK
Banks make profits through the process of asset
transformation: They borrow short (accept deposits)
and lend long (make loans). When a bank takes in
additional deposits, it gains an equal amount of
reserves; when it pays out deposits, it loses an equal
amount of reserves
20
BASIC OPERATIONS OF A
COMMERCIAL BANK
Banks manage their assets to maximize profits by seeking the
highest returns possible on loans and securities while at the
same time trying to lower risk and making adequate provisions
for liquidity. Although liability management was once a staid
affair, large (money center) banks now actively seek out
sources of funds by issuing liabilities such as negotiable CDs
or by actively borrowing from other banks and corporations.
02
22
MANAGEMENT OF BANK
ASSETS
To maximize its profits, a bank must simultaneously scek the
highest returns possible on loans and securities, reduce risk
and make adequate provisions for liquidity by holding liquid
assets. Although more liquid assets tend to earn lower
returns, banks still desire to hold them. Specifically, banks
hold excess and secondary reserves because they provide
insurance against the costs of a deposit outflow.
23
BANKS' OBJECTIVE:
1 2 3
Banks try to find borrower Banks try to purchase Banks manage the liquidity of the
who will pay high interest securities with high returns assets so that its reserve
requirements can be met without
rates and will most likely and low risk. By diversifying
incurring huge costs. This implies
settle their loans on time. By and purchasing many different that liquid securities must be held
adopting consecutive loan types of assets (short-term and even if they earn a somewhat lower
policies banks avoid high long-term, treasury bills) return than other assets. The bank
default rate but may miss out banks can lower risk must balance its desire for liquidity
associated with investments. against the increased earnings that
on attractive lending
can be obtained from less liquid
opportunities that earn high assets such as loans.
interest rates.
24
MANAGEMENT OF BANK
LIABILITIES
Banks no longer depended on demand deposits as the
primary source of bank funds. Instead they
aggressively set target goals for their asset growth and
tried to acquire funds (by issuing liabilities) as they
were needed.
25
MANAGEMENT OF BANK
CAPITAL
Banks manage the amount of capital they hold to
prevent bank failure and to meet bank capital
requirements set by the regulatory authorities.
However, they do not want to hold too much capital
because by so doing, they will lower the returns to
equity holders.
THYNK UNLIMITED
GAME
TIME!
pictures linked by one word - the player's aim is to
work out what the word is.
BEEF
YELLOW
26
BANK CAPITAL AND BANK
PROFIT
If we subtract the bank's cost of providing its services
from the fees it receives, divide the result by the bank's
total assets, and then add the bank's net interest margin,
we have an expression for the bank's total profit earned
per peso of assets, which is called its return on assets
(ROA). ROA is usually measured in terms of after-tax
profit, or the profit that remains after the bank has paid
its taxes:
27
BANK CAPITAL AND BANK
PROFIT
A bank's shareholders own the bank's capital, which represents the value of their
investment-or-equity in the firm. Naturally, shareholders are more interested in the
profit the bank's managers are able to earn on the shareholders' investment than in the
retum on the bank's total assets. So, shareholders often judge bank managers not on
the basis of ROA but on the basis of return on equity (ROE). which is after-tax profit
per peso of equity, or bank capital:
28
MANAGING BANK RISK
Managing liquidity risk
Liquidity risk is the possibility that
a bank may not be able to meet its
cash needs by selling assets or
raising funds at a reasonable cost.
Rebus
Puzzle
ITEM #1
+ PSALM 28:6-7 + + ion
ITEM #1
Adverse
Selection
ITEM #2
+ LAT + (mineral - min)
ITEM #2
Collateral
29
WHAT IS CREDIT RISK?
Credit risk is the risk that borrowers might default on
their loans. One source of credit risk is asymmetric
information, which often results in the problems of
adverse selection and moral hazard
30
DEFINITION OF TERMS
ASYMMETRIC ADVERSE MORAL HAZARD
INFORMATION SELECTION
describes the situation in it is a market situation where it is the risk that a party has
which one party has better buyers and sellers have not entered into a contract in
information than does the different information. This is good faith. This is the
other party. There are two the problem investors problem investors experience
problems arising from experience in distinguishing in verifying that borrowers
asymmetric information: low-risk borrowers from are using their funds as
adverse selection and moral high-risk borrowers before intended.
hazard. making an investment.
Since borrowers know more about their financial health and their rule plans for using borrowed money than
do banks, banks may find themselves inadvertently lending to poor credit risks.
METHODS BANKS CAN USE TO Page 31
MANAGE CREDIT RISK
whether individuals or financial firms – can reduce their exposure to risk by
diversifying their holdings. If banks lend too much to ONE borrower, to
borrower in ONE region, or to borrowers in ONE region, or to borrowers in
Diversification ONE industry, they are exposed to greater risks from these loans.
investors
bank loan officers screen loan applicants to eliminate potentially bad risks and
obtain a pool of credit worthy borrowers. Individual borrowers usually must
give loan officers information about their employment, income, and net worth.
Credit-risk analysis If the borrower is inclined in business, they must supply information about
their current and projected profits and net worth. Banks often use credit scoring
techniques.
METHODS BANKS CAN USE TO Page 32
MANAGE CREDIT RISK
to reduce problems of adverse selection, banks generally require that a borrower
Collateral put up collateral, or assets pledged to the bank in the event that the borrower
defaults.
in some circumstances, bank minimize the costs of adverse selection and moral
Credit hazards through credit rationing. A bank either grants a borrower’s loan
rationing application but limits the size of the loan or simply declines to lend any amount
to the borrower at the current interest rate.
METHODS BANKS CAN USE TO Page 33
MANAGE CREDIT RISK
to reduce the costs of moral hazard, banks monitor borrowers to make sure they
Monitoring and don’t use the funds borrowed to pursue unauthorized, risky activities.
restrictive covenant
Long-term business the ability of banks to access credit risks on the basis of private information on
relationships borrowers is called relationship banking.
34
MANAGING INTEREST-RATE RISK
Banks experience interest-rate risk if changes in market
interest rates cause a bank’s profit or its capital to
fluctuate. The effect of a change in market interest
rates on the value of a bank’s assets and liabilities is
similar to the effect of a change in interest rates on
bond prices.
35
REDUCING INTEREST-RATE RISK
• Bank managers can use a variety of strategies to reduce their exposure to interest-rate risk.
Banks with negative gaps can make more adjustable or floating-rate loans. Unfortunately for
banks, many loan customers are reluctant to take out adjustable-rate loans because while the
loans reduce the interest-rate risk banks face, they increase the interest-rate risk borrowers
face.
• Banks can also use interest-rate swap in which they agree to exchange, or swap, the payments
from a fixed-rate loan for the payments on an adjustable-rate loan owned by a corporation or
another financial firm. Banks can also use futures contracts and options contracts to help
hedge interest-rate risk.
36
REDUCING INTEREST-RATE RISK
ITEM #3
+
ITEM #2
Bond
Price/s
CHAPTER 13
THANK
YOU
