Chapter 3:
Commercial Banking
Contents
3.1. An Economic Analysis of Financial
Structure
3.2. Banking Management
3.3. Banking Industry Development Trend
3.1. An Economic Analysis of
Financial Structure
8-4
Eight Basic Facts
1. Stocks are not the most important sources of
external financing for businesses
2. Issuing marketable debt and equity securities is
not the primary way in which businesses
finance their operations
3. Indirect finance is many times more important
than direct finance
4. Financial intermediaries are the most important
source of external funds
8-5
Eight Basic Facts (cont’d)
5. The financial system is among the most
heavily regulated sectors of the economy
6. Only large, well-established corporations
have easy access to securities markets to
finance their activities
7. Collateral is a prevalent feature of
debt contracts
8. Debt contracts are extremely complicated
legal documents that place substantial
restrictive covenants on borrowers
8-6
Transaction Costs
Financial intermediaries have evolved to
reduce transaction costs
Economies of scale
Expertise
8-7
Asymmetric Information
Adverse selection occurs before
the transaction
Moral hazard arises after the transaction
Agency theory analyses how
asymmetric information problems affect
economic behavior
8-8
Adverse Selection:
The Lemons Problem
If quality cannot be assessed, the buyer is
willing to pay at most a price that reflects the
average quality
Sellers of good quality items will not want to sell
at the price for average quality
The buyer will decide not to buy at all because
all that is left in the market is poor quality items
This problem explains fact 2 and partially
explains fact 1
8-9
Adverse Selection: Solutions
Private production and sale of information
Free-rider problem
Government regulation to increase information
Fact 5
Financial intermediation
Facts 3, 4, & 6
Collateral and net worth
Fact 7
8-10
Moral Hazard in Equity Contracts
Called the Principal-Agent Problem
Separation of ownership and control
of the firm
Managers pursue personal benefits and power
rather than the profitability of the firm
8-11
Principal-Agent Problem: Solutions
Monitoring (Costly State Verification)
Free-rider problem
Fact 1
Government regulation to increase information
Fact 5
Financial Intermediation
Fact 3
Debt Contracts
Fact 1
8-12
Moral Hazard in Debt Markets
Borrowers have incentives to take on
projects that are riskier than the lenders
would like
8-13
Moral Hazard: Solutions
Net worth and collateral
Incentive compatible
Monitoring and Enforcement of Restrictive
Covenants
Discourage undesirable behavior
Encourage desirable behavior
Keep collateral valuable
Provide information
Financial Intermediation
Facts 3 & 4
8-14
8-15
Conflicts of Interest
Type of moral hazard problem caused by economies of
scope
Arise when an institution has multiple objectives and, as
a result, has conflicts between those objectives
A reduction in the quality of information in financial
markets increases asymmetric information problems
Financial markets do not channel funds into productive
investment opportunities
The economy is not as efficient as it could be
8-16
Why Do Conflicts of Interest Arise?
Underwriting and Research in
Investment Banking
Information produced by researching companies is
used to underwrite the securities. The bank is
attempting to simultaneously serve two client groups
whose information needs differ.
Spinning occurs when an investment bank allocates
hot, but underpriced, IPOs to executives of other
companies in return for their companies’ future
business
8-17
Why Do Conflicts
of Interest Arise? (cont’d)
Auditing and Consulting in Accounting Firms
Auditors may be willing to skew their judgments and
opinions to win consulting business
Auditors may be auditing information systems or tax
and financial plans put in place by their nonaudit
counterparts
Auditors may provide an overly favorable audit to
solicit or retain audit business
8-18
Conflicts of Interest: Remedies
Sarbanes-Oxley Act of 2002 (Public
Accounting Return and Investor
Protection Act)
Increases supervisory oversight to monitor and
prevent conflicts of interest
Establishes a Public Company Accounting
Oversight Board
Increases the SEC’s budget
Makes it illegal for a registered public accounting
firm to provide any nonaudit service to a client
contemporaneously with an impermissible audit
8-19
Conflicts of Interest:
Remedies (cont’d)
Sarbanes-Oxley Act of 2002 (cont’d)
Beefs up criminal charges for white-collar crime
and obstruction of official investigations
Requires the CEO and CFO to certify
that financial statements and disclosures are
accurate
Requires members of the audit committee to be
independent
8-20
Conflicts of Interest:
Remedies (cont’d)
Global Legal Settlement of 2002
Requires investment banks to sever the link
between research and securities underwriting
Bans spinning
Imposes $1.4 billion in fines on accused
investment banks
Requires investment banks to make their analysts’
recommendations public
Over a 5-year period, investment banks are
required to contract with at least 3 independent
research firms that would provide research to their
brokerage customers
8-21
Financial Crises
and Aggregate Economic Activity
Crises can be caused by:
Increases in interest rates
Increases in uncertainty
Asset market effects on balance sheets
Problems in the banking sector
Government fiscal imbalances
8-22
8-23
8-24
3.2. Banking Management
Basic Banking—Cash Deposit
First National Bank First National Bank
Assets Liabilities Assets Liabilities
Vault +$100 Checkable +$100 Reserves +$100 Checkable +$100
Cash deposits deposits
Opening of a checking account leads to an
increase in the bank’s reserves equal to the
increase in checkable deposits
9-27
Basic Banking—Check Deposit
First National Bank When a bank receives
Assets Liabilities
additional deposits, it
gains an equal amount of reserves;
Cash items in +$100 Checkable +$100
process of deposits when it loses deposits,
collection
it loses an equal amount of reserves
First National Bank Second National Bank
Assets Liabilities Assets Liabilities
Reserves +$100 Checkable +$100 Reserves -$100 Checkable -$100
deposits deposits
Basic Banking—Making a Profit
First National Bank Second National Bank
Assets Liabilities Assets Liabilities
Required +$100 Checkable +$100 Required +$100 Checkable +$100
reserves deposits reserves deposits
Excess +$90 Loans +$90
reserves
Asset transformation-selling liabilities with one set of
characteristics and using the proceeds to buy assets with
a different set of characteristics
The bank borrows short and lends long
Bank Management
Liquidity Management
Asset Management
Liability Management
Capital Adequacy Management
Credit Risk
Interest-rate Risk
Liquidity Management:
Ample Excess Reserves
Assets Liabilities Assets Liabilities
Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank $10M Loans $80M Bank $10M
Capital Capital
Securities $10M Securities $10M
If a bank has ample excess reserves, a deposit
outflow does not necessitate changes in other
parts of its balance sheet
Liquidity Management:
Shortfall in Reserves
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank $10M Loans $90M Bank $10M
Capital Capital
Securities $10M Securities $10M
Reserves are a legal requirement and the
shortfall must be eliminated
Excess reserves are insurance against the costs
associated with deposit outflows
Liquidity Management: Borrowing
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M
Cost incurred is the interest rate paid on the
borrowed funds
Liquidity Management:
Securities Sale
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M
The cost of selling securities is the brokerage
and other transaction costs
Liquidity Management:
Federal Reserve
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrow from Fed $9M
Securities $10M Bank Capital $10M
Borrowing from the Fed also incurs interest
payments based on the discount rate
Liquidity Management: Reduce
Loans
Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M
Reduction of loans is the most costly way of
acquiring reserves
Calling in loans antagonizes customers
Other banks may only agree to purchase loans at a
substantial discount
Asset Management: Three Goals
Seek the highest possible returns on
loans and securities
Reduce risk
Have adequate liquidity
Asset Management: Four Tools
Find borrowers who will pay high
interest rates and have low possibility
of defaulting
Purchase securities with high returns and
low risk
Lower risk by diversifying
Balance need for liquidity against
increased returns from less liquid assets
Liability Management
Recent phenomenon due to rise of money
center banks
Expansion of overnight loan markets and
new financial instruments (such as
negotiable CDs)
Checkable deposits have decreased in
importance as source of bank funds
Capital Adequacy Management
Bank capital helps prevent bank failure
The amount of capital affects return for
the owners (equity holders) of the bank
Regulatory requirement
Capital Adequacy Management:
Preventing Bank Failure When
Assets Decline
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M
High Bank Capital Low Bank Capital
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $90M Reserves $10M Deposits $96M
Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M
Capital Adequacy Management:
Returns to Equity Holders
Return on Assets: net profit after taxes per dollar of assets
net profit after taxes
ROA =
assets
Return on Equity: net profit after taxes per dollar of equity capital
net profit after taxes
ROE =
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
Assets
EM =
Equity Capital
net profit after taxes net profit after taxes assets
equity capital assets equity capital
ROE = ROA EM
Capital Adequacy
Management: Safety
Benefits the owners of a bank by making
their investment safe
Costly to owners of a bank because the
higher the bank capital, the lower the
return on equity
Choice depends on the state of the
economy and levels of confidence
Credit Risk: Overcoming Adverse
Selection and Moral Hazard
Screening and information collection
Specialization in lending
Monitoring and enforcement of
restrictive covenants
Long-term customer relationships
Loan commitments
Collateral and compensating balances
Credit rationing
Interest-Rate Risk
First National Bank
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
Variable-rate and short-term loans Variable-rate CDs
Short-term securities Money market deposit accounts
Fixed-rate assets $80M Fixed-rate liabilities $50M
Reserves Checkable deposits
Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital
If a bank has more rate-sensitive liabilities than assets, a
rise in interest rates will reduce bank profits and a decline
in interest rates will raise bank profits
Interest Rate Risk: Gap Analysis
Basic Gap Analysis:
(rate-sensitive assets rate sensitive liabilities)
interest rates = in bank profits
Maturity Bucket Approach
measures the gap for several maturity subintervals
Standardized Gap Analysis
accounts for differing degrees of rate sensitivity
Interest Rate Risk: Duration Analysis
Duration Analysis:
% market value of security
percentage point interest rate duration in years
Uses the weighted average duration of
a financial institution's assets and of its liabilities
to see how net worth responds to a change in
interest rates
9-47
Off-Balance-Sheet Activities
Loan sales (secondary loan participation)
Generation of fee income
Trading activities and risk management
techniques
Futures, options, interest-rate swaps, foreign
exchange
Speculation
Off-Balance-Sheet Activities (cont’d)
Trading activities and risk management
techniques (cont’d)
Principal-agent problem
Internal Controls
Separation of trading activities and bookkeeping
Limits on exposure
Value-at-risk
Stress testing
3.3. Banking Industry Development
Trend
Figure 1 Time Line of the Early History of Commercial
Banking in the United States
Primary Supervisory Responsibility of
Bank Regulatory Agencies
Federal Reserve and state banking
authorities: state banks that are members
of the Federal Reserve System.
Fed also regulates bank holding
companies.
FDIC: insured state banks that are not
Fed members.
State banking authorities: state banks
without FDIC insurance.
Financial Innovation and the Growth
of the “Shadow Banking System”
Financial innovation is driven by the
desire
to earn profits
A change in the financial environment will
stimulate a search by financial institutions
for innovations that are likely to be
profitable
Responses to Changes in Demand
Conditions: Interest-Rate Volatility
Adjustable-rate mortgages
Flexible interest rates keep profits high when
rates rise
Lower initial interest rates make them attractive
to home buyers
Financial derivatives
Ability to hedge interest rate risk
Payoffs are linked to previously issued (i.e.
derived from) securities.
Responses to Changes in Supply
Conditions: Information Technology
Bank credit and debit cards
Improved computer technology lowers
transaction costs
Electronic banking
ATM, home banking, ABM and virtual banking
Digital banking
Junk bonds
Commercial paper market
Securitization and the Shadow
Banking System
Securitization
To transform otherwise illiquid financial assets
into marketable capital market securities.
Securitization played an especially prominent
role in the development of the subprime
mortgage market in the mid 2000s.
Avoidance of Existing Regulations
Loophole Mining:
Reserve requirements act as a tax on deposits
Restrictions on interest paid on deposits led to
disintermediation
Money market mutual funds
Sweep accounts
Financial Innovation and the Decline
of Traditional Banking
As a source of funds for borrowers,
market share has fallen.
Commercial banks’ share of total financial
intermediary assets has fallen
No decline in overall profitability
Increase in income from off-balance-sheet
activities
Figure 2 Bank Share of Total
Nonfinancial Borrowing, 1960–2014
Source: Federal Reserve Bank of St. Louis, FRED data base:
http://research.stlouisfed.org/fred2/; https://www2.fdic.gov/hsob/index.asp.
Financial Innovation and the Decline
of Traditional Banking
Decline in cost advantages in acquiring funds
(liabilities)
Rising inflation led to rise in interest rates and
disintermediation
Low-cost source of funds, checkable deposits, declined in
importance
Decline in income advantages on uses of funds
(assets)
Information technology has decreased need for banks to
finance short-term credit needs or to issue loans
Information technology has lowered transaction costs for
other financial institutions, increasing competition
Financial Innovation and the Decline
of Traditional Banking
Banks’ Responses
Expand into new and riskier areas of lending
Commercial real estate loans
Corporate takeovers and leveraged buyouts
Pursue off-balance-sheet activities
Non-interest income
Concerns about risk
Structure of the U.S. Commercial
Banking Industry
Restrictions on branching
McFadden Act and state branching regulations
Response to branching restrictions
Bank holding companies
Automated teller machines
Table 1 Size Distribution of Insured
Commercial Banks, June 30, 2014
Table 2 Ten Largest U.S. Banks,
June 30, 2014
Bank Consolidation and Nationwide
Banking
The number of banks has declined
dramatically over the last 30 years.
Bank failures and consolidation
Deregulation: Riegle-Neal Interstate Banking
and Branching Efficiency Act of 1994
Economies of scale and scope from information
technology
Results may be not only a smaller number
of banks but a shift in assets to much
larger banks.
Figure 3 Number of Insured Commercial Banks in the
United States, 1934–2014 (Third Quarter)
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.
What will the Structure of the U.S. Banking Industry
Look Like in the Future?
Although the U.S. retains a unique
banking structure in possessing a large
number of banks, its structure is
converging with systems in Europe and
Japan.
How far the convergence between
banking systems will extend is the subject
of ongoing academic debate
Are Bank Consolidation and
Nationwide Banking Good Things?
Benefits
Increased competition, driving inefficient banks
out of business
Also, increased efficiency from economies of
scale and scope
Lower probability of bank failure from more
diversified portfolios
Are Bank Consolidation and
Nationwide Banking Good Things?
Costs
Elimination of community banks may lead to
less lending to small business
Banks expanding into new areas may take
increased risks and fail
Separation of the Banking and Other
Financial Service Industries
Erosion of Glass-Steagall
Prohibited commercial banks from underwriting
corporate securities or engaging in brokerage
activities
Section 20 loophole was allowed by the Federal
Reserve enabling affiliates of approved
commercial banks to underwrite securities as
long as the revenue did not exceed a specified
amount
U.S. Supreme Court validated the Fed’s action
in 1988
Separation of the Banking and Other
Financial Service Industries
Gramm-Leach-Bliley Financial Services
Modernization Act of 1999
Abolishes Glass-Steagall
States regulate insurance activities
SEC keeps oversight of securities activities
Office of the Comptroller of the Currency
regulates bank subsidiaries engaged in
securities underwriting
Federal Reserve oversees bank holding
companies
Separation of the Banking and Other
Financial Service Industries
Universal banking
No separation between banking and securities
industries
British-style universal banking
May engage in security underwriting
Separate legal subsidiaries are common
Bank equity holdings of commercial firms are less
common
Few combinations of banking and insurance firms
Separation of the Banking and Other
Financial Service Industries
Some legal separation
Allowed to hold substantial equity stakes in
commercial firms but holding companies are
illegal
International Banking
Rapid growth
Growth in international trade and multinational
corporations
Global investment banking is very profitable
Ability to tap into the Eurodollar market
Eurodollar Market
Dollar-denominated deposits held in
banks outside of the U.S.
Most widely used currency in international
trade
Offshore deposits not subject to
regulations
Important source of funds for U.S. banks
Foreign Banks in the United States
Agency office of the foreign bank
Can lend and transfer fund in the U.S.
Cannot accept deposits from domestic
residents
Not subject to regulations
Subsidiary U.S. bank
Subject to U.S. regulations
Owned by a foreign bank
Foreign Banks in the United States
Branch of a foreign bank
May open branches only in state designated as
home state or in state that allow entry of out-of-
state banks
Limited-service may be allowed in any other
state
Subject to the International Banking Act of
1978
Table 3 Ten Largest Banks in the
World, 2014
