CHAPTER
17
Commercial
Bank
Operations
Chapter Objectives
Describe the most common sources of funds
for commercial banks
Describe the most common uses of funds for
commercial banks
Describe typical off-balance sheet activities
for commercial banks
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Bank Participation in Financial
Conglomerates
Impact of the Financial Services
Modernization Act (1999)
Prompted by the Citicorp-Traveler’s merger
Banks and other financial service firms were given
more freedom to merge and offer a range of
financial services
Insurance
Securities services
Banks now a subsidiary of financial
conglomerates
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Bank Participation in Financial
Conglomerates
Benefits of diversified services to individuals and
firms
Individuals can obtain all their financial services at a
single financial conglomerate
Deposits
Loans
Investing (brokerage)
Insurance
Businesses can obtain loans, issue stocks and bonds,
and have their pension fund managed by the same
institution
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Bank Participation in Financial
Conglomerates
Benefits of diversified services to the financial
institution
Reduce reliance on demand for single service
Economies of scale and scope
Diversification (service and geographical) may
result in less risk
Generate new business
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Bank Sources of Funds
Transaction deposits
Demand deposit account (checking)
Negotiable order of withdrawal (NOW) account
1981
Requires larger minimum balance
Savings Deposits
Passbook savings
Regulation Q until 1986
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Bank Sources of Funds
Time Deposits
Certificate of deposit (CD)
No secondary market
Negotiable CD
Short-term, minimum $100,000
Can trade among investors via dealer
Money Market Deposit Accounts (MMDAs)
More liquid than CDs : no specified maturity
Limited check writing
Created in 1982
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Bank Sources of Funds
Federal Funds Purchased
Short-term loans between banks
Allows banks to meet reserve requirement or funding
needs
Interest rate charged is the federal funds rate
Borrowing from the Federal Reserve Banks
Borrowing at the discount window
Discount rate
Intended for meeting temporary short-term reserve
requirement needs
Must get Fed approval
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Bank Sources of Funds
Repurchase agreements
Sale of securities by one party to another with an
agreement to repurchase the securities at a
specified date and price
Banks may sell T-bills to a corporation with
temporary excess cash (bank demand deposit) and
then buy them back later
Source of funds for a few days
Collateralized by the treasury bills
Form of paying interest on large customer
checking balances
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Bank Sources of Funds
Eurodollar borrowings
Banks outside the United States make dollar-
denominated loans
Eurodollar market is very large
Bonds issued by the bank
Like other businesses, banks issue bonds to
finance long-term fixed assets
Usually subordinated to deposits
Part of secondary regulatory capital
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Bank Sources of Funds
Bank capital
Obtained from issuing stock or retaining earnings
No obligation to pay out funds in the future
Primary vs. secondary
Must be sufficient to absorb operating losses
As of 1992: risk-based capital requirement
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Uses of Funds by Banks
Loans make up about 64 percent of bank assets,
while all securities make up about 22 percent of
assets. Cash represents 6 percent of bank assets.
Cash and “due from” balances at institutions
Currency/coin provided via banks
Reserve requirements imposed by Fed
Tool for controlling the money supply
Due from Fed and vault cash count as reserves
Also hold cash and due from balances to maintain
liquidity and accommodate withdrawal requests by
depositors
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Uses of Funds by Banks
Bank Loans
Types of business loans
Working capital loans
Term loans
Purchasing fixed assets
Protective covenants
Informal line of credit
Revolving credit loan
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Uses of Funds by Banks
Bank Loans
Loan participations
Sometimes large firms seek to borrow more money
than an individual bank can provide
Lead bank
Loans supporting leveraged buyouts
Banks charge a high loan rate
Monitored by bank regulators
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Uses of Funds by Banks
Bank Loans
Collateral requirements on business loans
Increasingly accepting intangible assets
Important to service-oriented firms
Increased lending risk with service businesses--telecomm
Lender liability on business loans
Lender liability lawsuits—toxic dump under corner
business
Types of consumer loans
Installment loans
Credit cards
Real estate loans
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Uses of Funds by Banks
Investment securities (bank income and
liquidity)
Treasury securities
Government agency securities
Freddie Mac
Fannie Mae
Corporate and municipal securities
Investment grade only
Federal funds sold
Lending funds in the federal funds market
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Uses of Funds by Banks
Repurchase agreements
Eurodollar loans
Branches of U.S. banks located outside of the U.S.
Foreign-owned banks
Fixed assets
Office buildings
Land
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Off-Balance Sheet Activities
Loan commitments
Obligation of bank to provide a specified loan
amount to a particular business upon request
Note issuance facility (NIF)
Banks earn fee income for risk assumed
Standby letters of credit (SLC)
Backs a customer’s obligation to a third party
Banks earn fee income
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Off-Balance Sheet Activities
Forward contracts
Agreement between a customer and bank to
exchange one currency for another on a particular
future date at a specified exchange rate
Allows customers to hedge their exchange-rate
risk
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Off-Balance Sheet Activities
Swap contracts
Two parties agree to periodically exchange
interest payments on a specified notional amount
of principal
Banks serve as intermediaries or dealer and/or
guarantor for a fee
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