Depository Institutions: Commercial Banks

• Depository institutions (DIs) are institutions where a significant portion of their funds comes from customer deposits.
• There are three types of DIs: Commercial Banks, Savings Institutions, and Credit Unions.
• Historically, Commercial Banks focused on business loans and securities investments, Savings Institutions on mortgage loans, and Credit Unions on consumer loans.
• Due to competition and changes in regulations, these differences have started to fade away.

Commercial Banks

• Commercial banks are the largest depository institutions.
• They have stock ownership, are owned by stockholders, and are run by an appointed board.
• They accept deposits (liabilities) and make loans (assets).
• Commercial banks offer residential, business, and consumer loans, with a recent heavy concentration in residential loans.
• Their non-deposit liabilities include bonds, Fed funds borrowed, and Repos.
• Commercial banks have separate regulations from thrifts.
• Their assets include mortgage, business, and consumer loans.
• Their liabilities include deposits and non-deposit sources of funds like Equity, Debts (Bonds, Fed funds borrowing, Repos).

Quick History of Commercial Banks

• The number of commercial banks decreased from the 1980s onward mainly through mergers & acquisitions (M&A).
• J. P. Morgan acquired Chase Manhattan for $33.6 billion in Sept. 2000.
• Norwest acquired Wells Fargo for $34.3 billion in June 1998.
• Bank of America acquired FleetBoston Financial for $49.3 billion in Oct. 2003.
• J. P. Morgan Chase acquired Bank One for $60.0 billion in Jan. 2004.

Community Banks

• Community banks are small banks with under $1 billion in assets.
• They specialize retail or consumer banking (residential mortgages and consumer loans) and focus on the local deposit base.
• The number of community banks has decreased due to consolidation.

Regional or Superregional Banks

• These are large banks with over $1 billion in assets.
• They engage in a complete array of wholesale commercial banking activities including consumer, residential, commercial and industrial C&I lending, regionally and nationally.
• Large banks can access the Fed Fund market for financing, and their money center banks rely more on borrowed funds.
• Large banks rely more on off-balance sheet activities to generate more income.

Key Terms

• Federal funds market: An interbank market for short-term borrowing and lending of bank reserves.
• Spreads: The difference between a bank's lending rates and deposit rates.
• Money center banks: Banks that have a heavy reliance on non-deposit or borrowed sources of funds.
• Off-Balance sheet (OBS) activities: Financial arrangements that do not directly impact the balance sheet but affect the financial condition and performance.

Breakdown of Loans Portfolio

• Small banks are defined as banks with less than $1 billion in assets.
• Large banks are defined as banks with assets of $1 billion or more.

Simple Balance Sheet

• Assets include Loans and Other assets.
• Liabilities and Equity include Deposits and Other liabilities and equity.
• DIs offer products to their customers on both sides of their balance sheet (loans on the asset side and deposits on the liability side).

Balance Sheet

• Assets for a typical bank include Loans, Trading assets, and Property.
• Liabilities include Deposits and Debt.
• Equity includes Property and Equity.

Unique Balance Sheet Items for Banks

• Assets: Property, Trading assets, Loans to customers, and Deposits to the central bank
• Liabilities: Loans from the central bank and interbank market, Deposits from customers, and Trading liabilities
• Equity: Common and preferred shares
• Balance Sheet Equation: ASSETS = LIABILITIES + EQUITY

Loans and Deposits from Customers

• Loan and deposit operations are the source of revenue for banks.
• Banks receive a small interest for depositing money, then lending it out at a much higher rate to make profit.
• Loans to customers are classified as assets since the bank expects to receive interest and principal repayments.
• Deposits are classified as liabilities since the bank expects these deposits to be withdrawn.

Loans and Deposits to Central Bank

• Deposits from a bank in a central bank are considered assets, since the bank can withdraw them easily plus receive a small interest payment.
• Loans from the central bank are considered liabilities.

Trading Assets and Liabilities

• Assets: Banks may hold marketable securities or certain currencies for trading purposes.
• Liabilities: May include long term liabilities (bonds) and short positions (CDs).

Typical Income Statement

• Non-interest Revenue. Broker fees, fees from products services, and gains on sale of trading assets.
• Interest Revenue. Interest expense is the direct interest expense paid to the deposits used to fund the loans, and does not include interest expense from general debt.
• Credit Loss Provisions. Credit are written off as a provision for credit loss.

Uses of Funds (Assets)

• Residential mortgages: Primary assets, with the highest percentage, followed by Mortgage Backed securities MBS.
• Business (Commercial and Industrial C&I): Consumer loans: car loans, student and personal loan. Business & industrial loan: equipment financing, expansion, and acquisition financing.
• Securities investments: Marketable securities (short-run): T-bills, CDs, other money market instruments as well as investment securities (long-run): Notes & bonds (corporate or government or foreign).

Sources of Funds (Liabilities)

• Commercial banks have two major sources of funds other than the equity provided by owners.
• From deposits: Transaction accounts, Savings accounts.
• From non-deposits: Borrowed funds, Short and long-term: Repos, Fed Funds, Fed discount loans, bonds.
• They also hold Equity. Equity is mostly called Net worth*. Commercial banks are highly leveraged. Equity could be as low as 10%

Depository Sources

• Transaction Accounts.
  • Demand deposit: A non-interest bearing checking account, now able to offer interest since 2011.
  • Negotiable Order of Withdrawal (NOW) : Checking account that pays interest.
• Savings deposits (Non Transaction Accounts):
  • Passbook savings: Interest bearing savings account.
  • Automatic Transfer Service (ATS): Links demand and savings deposits to automatically transfer funds from the savings to the demand account.
  • Time Deposits

Time Deposits

• Retail CDs: Small fixed-maturity interest- bearing CDs, under USD 100,000.
• Negotiable CDs: Large fixed-maturity interest-bearing CDs over USD 100,000.
• Money Market Deposit Account (MMDA): Offers higher interest than savings and NOW accounts investing in money market funds and has no specific maturity.

Non-Depository Sources

• Bank Reserves: Purchase/borrowing of funds from banks at the Fed Fund Rate.
• Fed Loans: Discount window with commercial banks borrowing short-term loans from CB at discount rate.
• Repos: Short-term lending where securities are used.
• Long-term borrowing (Bonds): Issuance of notes and bonds.
• Equity: Minimum total asset requirement is 10% + retained earnings + preferred stock, that protects against bank runs and bank losses .

Key Terms

• Discount window: Facility controlled by the Fed that allows member banks to borrow money on liquidity.
• Fed fund rate: Rate at which banks lend back and worth is the interbank reserve.
• Discount rate: Rate that banks borrow from the Fed.
• Paid in capital: Shares issued.
• Retained earnings: Bank income retained reinvestment.
• Preferred stock: It has higher claim and pays mandatory dividend while having no voter rights.