Commercial Bank Operations

Commercial Bank Operations: Learning Goals

• Key components of commercial bank operations include understanding their definition, balance sheet composition, liabilities, assets, and common risks.

Definition of Commercial Banks

• Commercial banks take deposits from surplus units and give loans to deficit units.
• Banks profit from the difference between interest charged on loans and interest paid on deposits.

Bank Sources of Funds - Deposit Accounts

• Transaction deposits, savings deposits, time deposits, and money market deposit accounts are considered deposit accounts.
• Current deposit accounts allow depositing and withdrawing money anytime using checks or online access.
• Conventional demand deposit accounts require a small minimum balance
• Savings deposit accounts allow limited transactions, especially for withdrawals, although unlimited withdrawals are possible today.
• Special notice accounts require advance notice for withdrawals, in return attractive interest is paid.
• Fixed deposit/term deposits have a specified minimum amount required for deposit during a specified period with penalty for early withdrawal.
• Fixed deposit accounts earn a higher interest rate in return for keeping the money deposited for a fixed time period with early encashment possible.
• Money market deposit accounts differ from conventional time deposits, and do not have specified maturities.
• Money market deposit accounts provide limited check-writing ability, and require a larger minimum balance, offering a higher yield.

Bank Sources of Funds - Borrowed Funds

• Commercial banks transact with other banks and financial institutions, borrowing short and long term if needed.
• Borrowings from other banks/FIs are call money loans and the short term loan must get paid immediately in full whenever the lender asks for it.
• Call money does not have a fixed payment date term loans, the lender needs to give prior notice ranging from 1 to 14 days when they need the money back with interest.
• Federal funds purchased represent a liability to the borrowing bank and an asset to the lending bank for one to seven days, correcting short-term fund imbalances.
• The interest rate in the federal funds market is the federal funds rate.
• Federal Reserve banks regulate certain bank activities and provide short-term loans to banks, referred to as borrowing at the discount window.
• The interest rate charged by the Federal Reserve Banks is the primary credit lending rate with these used to resolve a temporary shortage of funds.
• Repurchase agreements involve the sale of securities with an agreement to repurchase them at a specified date and price, handled through a telecommunications network connecting large banks.

Bank Sources of Funds - Long Term Sources

• Long-term funding can go towards fixed assests and equipment
• Banks issue bonds to finance assets like land, buildings, and equipment, purchased by households and financial institutions.
• Bank capital/stockholders' equity: Funds can get acquire these funds by issuing stock or keeping profits, offering banks no obligation to pay them out in the future.

Bank Uses of Funds

• Banks must keep reserve funds in Bangladesh Bank accounts, also keeping cash to entertain requests made by depositors.
• Banks should not keep excess cash despite its liquidity, because unlike investments it does not yield any income.
• Sometimes commercial banks keep deposits with other banks/financial institutions if they have idle money without better investment options.
• Banks can lend the money to other banks at a call money rate, where they can ask for repayment of the loan with interest any day without any prior notice.
• Banks invest in government bonds, treasury bills, treasury bonds, and corporate bonds, which are issued by other companies.

Cash Reserve Ratio (CRR) & Statutory Liquidity Ratio (SLR)

• CRR and SLR requirements specify certain amounts that banks must keep, relative to their total demand and term deposits.
• Suppose a commercial bank has total 100 crore in demand and term deposit. According to Bangladesh Bank's regulation it must keep 4 crore in CRR and 13 crore in SLR.
• The Cash Reserve Ratio is the cash balance held with Bangladesh Bank or their agent bank, which is 4% of total demand and term deposit.
• The Statutory Liquidity Ratio includes cash held inside the bank, gold, government securities, and excess reserve, and is 13% of total demand and term deposit.

Bank Uses of Funds: Loans and Advances

• Business/Term loans finance the purchase of fixed assets like land, buildings, and machinery, with a range from 2 to 10 years.
• The asset purchased with loan amount can act as collateral of a loan.
• A working capital loan supports ongoing business operations, while restrictive covenants impose specific conditions to protect the bank from loan default.
• Repayment happens with equal installments which contain both interest and principal payments (More Popular).
• Or repayment happens by a balloon Payment, this is when loan as bullet loans loans where the principal is paid only at the end of maturity.
• Direct lease loans involves the business renting the asset from the bank with the bank remaining the owner of the asset, charging depreciation.
• The informal line of credit allows borrowing up to specified amount for a specified time, which is useful for businesses with unpredictable cashflow needs.
• Under an informal line of credit banks have no legal obligation to supply funds if needed.
• The revolving credit loan provides a legal obligation/commitment to supply a maximum amount when needed and chargers commitment fees on the unused limit.
• Consumer installment loans finance the purchase of personal car or other assets, fulfilled with a monthly equal installments throughout the loan terms with loans that may be secured or unsecured.
• Real estate/home loans purchase new flats, construction, or renovation of an existing home with a term ranging from 1 year to 25 years.
• Real estate loans are backed by the asset and the maximum amount can go up to 20 Million.
• Credit cards are a type of loan from the bank.
• Card holders get credit to make payments for goods and services with banks sending them statements of usage and time to repay full balance without interest.
• Credit cards have very high interest charge rates when the balance is not paid and banks also charge fixed annual fees against credit cards.
• The credit limit is based on income and employment profile.

Common Risks Faced by Commercial Banks

• Credit/Default Risk: The likelihood that the borrower will not pay the promised interest and principal which would cause the bank to charge a higher the interest rate.
• Interest Rate Risk: The potential loss due to movements in interest rates.
• When interest rates rise, longer-term assets lose value more than shorter-term liabilities, hurting bank equity, also forcing banks to pay higher interest rates on deposits and waiting to earn the higher interest rates.
• Foreign Exchange Risk: The risk that the value of the bank's assets or liabilities changes due to currency exchange rate fluctuations.
• Liquidity Risk: When a bank has to struggle to meet its obligations to repay deposits,
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• The best way to eliminate liquidity by always having efficient cash to pay out but not optimal to profit or expand.
• This risk is severe when a balance sheet is focused on illiquid assets and commercial banks should plan cashflows appropriately.
• Operational Risk: The risk of loss resulting from inadequate or failed internal processes, people, and systems or external events.
• Cybersecurity Risk: When there are weaknesses in firms' IT infrastructure, there could be loss of clients money.
• Banks should consider Internal and External Fraud, Forgery, bribes, theft, theft, check fraud, hashing, system breaches, money laundering, data theft etc as serious concerns.
• Business Disruptions and Systems Failures can happen due to hardware or software system failures, and power failures that result in serious obstacles in business and eventually leading to financial loss.