Introduction to Finance - Lecture 8: Commercial Banks PDF

# Introduction to Finance ## Chapter 8: Banking (Core) Services ### Balázs Fazekas, PHD **Assistant Lecturer** DE-GTK, Institute of Finance and Accounting ## Commercial Banks - In two-tier banking systems commercial banks represent the second tier - These banks keep direct contact with the bus...

# Introduction to Finance ## Chapter 8: Banking (Core) Services ### Balázs Fazekas, PHD **Assistant Lecturer** DE-GTK, Institute of Finance and Accounting ## Commercial Banks - In two-tier banking systems commercial banks represent the second tier - These banks keep direct contact with the business entities; they manage companies' and households'- - accounts - deposits - credits/loans - and provide other financial services for them. ## Balance Sheet of Banks ### Assets - Cash and Cash Equivalents - US Treasuries - Municipal Bonds - Asset-Backed Securities - Loans - business loans, usually called commercial and industrial (C&I) loans - real estate loans - residential mortgages - home equity loans - commercial mortgages - consumer loans - credit cards - auto loans - interbank loans ### Liabilities and Equity - Checkable Deposits - Non-Transaction Deposits - Borrowings from Other Banks - Bank Capital ## Balance Sheet - Assets and L&E ### Assets - Represents the resources owned by the firm - Are bought or created to increase a firm's value or benefit the firm's operations - Use of Capital ### Liabilities and Equity (L&E) - Total liabilities represent the total amount of money the firm owes its creditors - Equity represents the capital provided by the owners and by the profitable operation of firm (reinvested profits) - Source of Capital ## Services of Commercial Banks ### Core Bank Services - Payment Service - Gathering Deposits - Giving Loans ### Additional Non-Bank Services - Leasing - Factoring - Intermediation of financial services (insurance, security trade) - Trade with foreign exchange - Financial Services connected to the core services (credit cards) - Asset management (investment funds) - Etc. ## 3.1 Loans ## Loan vs Credit ### Credit - The creditor is liable to - provide a line of credit for a given fee - (provides an opportunity for the borrower to withdraw money up to a limit) - The borrower is able to - withdraw money up to a limit and within maturity automatically. - No actual money disbursement, just the opportunity for it. ### Loan - The lender is liable to - provide the money agreed upon in the contract. - The borrower is liable to - pay back the money lend and - pay the interest for the capital. - The money is actually disbursed in case of a loan. ## Loan vs Credit (Examples) ### Credit - Overdraft - The bank grants a limit and up to that limit the customer is able to withdraw money at will. - For offering the limit (no matter whether the money is withdrawn or not) the bank charges a fee. ### Loan - Mortgage - For a given purpose the bank gives the capital agreed upon in the contract and it disburses the money automatically. - The borrower must pay back the money with interests. ## Why We Need Credit/Loan ### Cause for Loan (Long Term) - To make such activities, - that we are not able to fund with our own capital, or - that we do not want to fund with our own capital. - Exp.: We take a loan in order to fund our long-term investment. ### Cause for Loan (Short Term) - Securing liquidity and the money required by the regular operation. - Bridging the gap of short-term cash in- and outflows. - Exp.: We have an overdraft. If the current cash inflows do not cover the cash outflows than we can withdraw money from our current account up to the limit of the overdraft. ## Categorization of Loans - Unsecured and secured loan - Maturity (short, medium, long-term) - The way money is provided (loan, credit, guarantee) - Technical form of loan/credit - Interest payment (fix or floating) ## Unsecured and Secured Loan ### Unsecured Loan - There is no collateral, only the regular income of the borrower. - There is a higher risk for the lender, as losses are not compensated in default loans. - Higher interests are charged on the loans. ### Secured Loan - The borrower pledges some asset (e.g. a car or property) as collateral for the loan. - If the borrower defaults than the lender takes the possession of the asset. - Decreases the risk for the lender. - Lower interest is charged on the loan. ## Interest Payment ### Fixed - Interest rate is fixed and known for the full period of the loan at the time when the contract is made. ### Floating - Interest rate is changing within the lifespan of the loan. - Changes happen based on the pre-fixed benchmark (e.g.: inflation, interbank interest rate). ## Technical Form ### Open-End Loan - Revolving credit is a loan with a predetermined spending limit that automatically renews as the debt is paid off. - Use and repayment is flexible up to the limit. - E.g.: Credit card, overdraft ### Closed-End Loan - Used to finance a specific purpose for a specific period of time. - They are also called installment loans because consumers are required to follow a regular payment schedule. - E.g.: Mortgage ## Bank Guarantees and Letter of Credit - Not actual loans, do not necessarily mean the transfer of money. - Promises from a financial institution that they will make payment for a third party if the client of the bank is not able to make the payment. - The purpose of such deals is to strengthen the trust between the market participants. - A typical area of such deals is the international trade, where the legislative and economic environment is different. ## How Letter of Credit Works? - The bank gives the guarantee (the bank requires securities as collateral and collects a fee) - The transaction is made. - The seller proves the delivery for the bank with the appropriate document. - The bank makes the payment instead of the buyer. - The buyer pays for the bank. ## Process of Lending - Loan Application - **Analysis of Creditworthiness** - Credit Proposal - Contract - Disbursement - Monitoring - Repayment - Collecting, handling the problems of repayment ## Analysis of Creditworthiness - 5C - **Character:** The characteristics and history of the firms, persons, management. - **Capacity:** The borrower's ability to repay a loan, debt-to-income. - **Capital:** The own capital of the borrower committed. - **Collateral:** Asset that compensates the bank if the loan defaults. - **Conditions:** How a borrower intends to use the money. ## 5. Leasing ## Definition of Leasing - A contract, where: - The lessor (financial institution) purchases an asset chosen by the lessee (borrower) - The lessor has the ownership right of the asset, while - The lessee has the right of possession and use of the asset for specific periodic lease payments, and - At the end the ownership is granted for the lessee or it has the right to buy the asset by paying residual value. - Meaning: - The financial institution funds the asset and has the ownership but the lessee will actually use the asset. ## Process of Leasing - The lessee chooses the asset. - Financial institution buys the equipment and gets it's ownership. - The lessor grants the right of possession and use and in return collects the lease payments from the lessee. ## Types of Lease - Capital lease - Operating lease - Leaseback ## Capital vs Operating Lease ### Capital Lease - Long term funding. - At the end, the ownership is granted for the lessee, or it has the right to buy the asset by paying residual value. - Purpose: Investments, purchase of long-term assets. ### Operating Lease - Short term rent. - The lessee does not want to obtain the ownership of the asset on the long run, temporarily need for the asset. - The financial institution leases the asset multiple times for more clients. ## Capital vs Operating Lease (Table) | Feature | Capital Lease | Operating Lease | |---|---|---| | Ownership of the Asset | Financial institution | Lessee | | Ownership After Lease | Yes | No | | Registration of Asset | Lessee | Financial institution | | Amortization Accounted | Lessee | Financial institution | | Maturity | Medium and long term | Short and medium term | | Collaterals | Usual loan collaterals | The subject of lease | | Termination of the Contract | No | Yes | ## Leaseback - Possibility for firms with liquidity problems. - The firm sells it's own asset to the financial institution but leases it back immediately. - The firm is able to keep it's asset and at the same time get money on the short run. - On the long run, at the end of the maturity the firm gets back the ownership right. ## Lease vs Loan - In case of a lease, the financial institutions have the ownership while in loans the borrower is the owner. - In case of default, the financial institution is able to have the asset without legal procedures. - Lease grants a higher protection for the financial institutions. - The risk of the loan is less dependent upon the financial situation of the borrower, therefore funding with lease might be available for economic actors that are not trustworthy. ## 6. Deposits ## Checkable Deposits - Checkable deposits are deposits where depositors can withdraw the money at will. - These include all checking accounts. - Some checkable deposits pay interest, but most checking accounts pay very little or no interest. - Instead, depositors use checking accounts for payment services, which, nowadays, also includes electronic banking services. ## Non-Transaction Deposits ### Savings Accounts - Not used as a payment system. - They pay more interest. - Nowadays, statement savings are recorded electronically. ### Certificate of Deposit (CD) - Time deposit where the depositor agrees to keep the money in the account until the CD expires. - Higher interest rate. - Although the depositor can withdraw the money before the CD expires, banks charge a significant fee for this. ## Thank You for Your Attention!