Chapter Eleven

Commercial Banks:
Industry Overview
Commercial Banks

 Commercial banks are the largest group of financial

institutions in terms of total assets
 Major assets are loans
 Major liabilities are federally insured deposits—thus, they are
considered depository institutions
 Perform services essential to U.S. financial markets
 Play a key role in the transmission of monetary policy
 Provide payment services
 Provide maturity intermediation services
 Banks are regulated to protect against disruptions to the
services they perform and to protect government insured
deposits

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Commercial Bank Assets

 Loans generate the most revenue for banks

 Loans and investment securities continue to be the primary
assets of the banking industry
 Though business loans were the major asset on bank balance
sheets between 1965 and 1987, they have dropped in
importance since 1987
 Investment securities generate revenue and provide
banks with liquidity
 Cash assets are held to meet reserve requirements and to
provide liquidity
 Other assets include premises and equipment, other real
estate owned, etc.

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Commercial Bank Assets,
Liabilities, and Equity, 2016

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Commercial Bank Assets
Continued
 Commercial banks face unique risks because of
their asset structure
 Credit (default) risk is the risk that loans are not repaid
 Liquidity risk is the risk that depositors will demand more
cash than banks can immediately provide
 Interest rate risk is the risk that interest rate changes
erode profitability or net worth
 Credit, liquidity, and interest rate risk all contribute to a
commercial bank’s level of insolvency risk

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Commercial Bank Liabilities

 Transaction accounts are the sum of noninterest-bearing

demand deposits and interest-bearing checking accounts
 Transaction accounts are about 15.5% of total deposits
 Interest-bearing checking accounts are called negotiable order
of withdrawal (NOW) accounts
 Household (retail) savings and time deposits have been
declining in recent years because of competition from money
market mutual funds (MMMFs)
 Passbook savings accounts with no set
 Retail time deposits maturity and no check-
 Large time deposits writing privileges
 Negotiable CDs are fixed-maturity interest-bearing deposits
with face values of $100,000 or more that can be resold in the
secondary market

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Commercial Bank Liabilities and
Equity
 Nondeposit liabilities
 Fed funds purchased
 Repurchase agreements
 Notes and bonds

 Minimum levels of equity capital are required by

regulators to act as a buffer against losses
 Common and preferred stock
 Surplus or additional paid-in capital
 Retained earnings

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Off-Balance-Sheet Activities

 Commercial banks engage in many fee-related activities

that are conducted off the balance sheet
 Guarantees such as letters of credit
 Future commitments to lend
 Derivative transactions
 E.g., futures, forwards, options, and swaps

 Off-balance-sheet (OBS) assets

 When an event occurs, this item moves onto the asset side of
the balance sheet or income is realized on the income statement
 Off-balance-sheet (OBS) liabilities
 When an event occurs, this item moves onto the liability side of
the balance sheet or an expense is realized on the income
statement

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SIZE, STRUCTURE, AND
COMPOSITION OF THE INDUSTRY
 Number of banks have been decreasing over time
 U.S. had 14,483 banks in 1984
 U.S. had 5,289 banks in 2016
 The Reigle-Neal Act of 1994
 Made it easier for banks to open branches across state lines
 Financial Services Modernization Act of 1999
 Gave commercial banks the full authority to enter the investment
banking (and insurance) business

 Industrial loan corporations (ILCs) are considered

“non-bank” banks
 E.g., Walmart and Target both attempted to utilize ILCs, and
Target’s application was approved
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SIZE, STRUCTURE, AND
COMPOSITION OF THE INDUSTRY -
Shadow Banking
 Shadow banking
 Activities of nonfinancial service firms that perform banking
services

 How does it work?

 Savers place their funds with Money Market Mutual Funds
(MMMFs) and similar funds, which invest those funds in the
liabilities of shadow banks. Borrowers get loans and leases from
shadow banks rather than from traditional banks.

 Shadow banks face significantly less regulation than

traditional banks
SIZE, STRUCTURE, AND
COMPOSITION OF THE INDUSTRY
 Retail banking is consumer-oriented
 Residential and consumer loans are funded by accepting
small deposits
 Community banks specialize in retail banking

 Wholesale banking is commercial-oriented

 Commercial and industrial loans are often funded with
purchased funds
 Regional or superregional banks engage in a complete
array of wholesale banking activities
 Money center banks rely heavily on nondeposit or
borrowed sources of funds, often borrowed in the federal
funds market

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Top Ten U.S. Banks by Asset
Size, 2016

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Bank Size and Activities

 Size has traditionally affected the types of activities and

financial performance of commercial banks
 Small banks typically focus on the retail side
 Large banks usually engage in both retail and wholesale
banking, often focusing on the wholesale side of the business

 Interest rate spread is the difference between lending

and deposit rates
 Net interest margin is interest income minus interest
expense divided by earning assets
 Return on assets is net income divided by assets
 Return on equity is net income divided equity
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Bank Size and Activities
Continued
 Common differences between large and small banks
 Larger banks generally lend to larger corporations, meaning
their interest rate spreads and net interest margins have usually
been narrower than those of smaller regional banks
 Large banks tend to pay higher salaries and invest more in
buildings and premises than small banks
 Small banks usually hold fewer OBS assets and liabilities
 Large banks tend to diversify their operations more and
generate more noninterest income than small banks
 Large banks tend to use more purchased funds and have fewer
core deposits
 Large banks tend to hold less equity than do small banks
Industry Performance

 U.S. commercial banks flourished during the economic

expansion (and falling interest rates) of the 1990s
 Commercial bank earnings were a record $71.6 billion in 1999
 The economic downturn of the early 2000s caused
performance to deteriorate only slightly
 Average ROA was 1.19% in 2000, down from 1.31% in 1999
 By 2003, ROA and ROE had reached all-time highs
 In the fourth quarter of 2006, mortgage delinquencies
(particularly subprime mortgages) surged
 Losses from falling values of subprime mortgages
caused fourth quarter 2007 net income to hit a 16-year
low
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Industry Performance Continued

 Performance deteriorated in the late 2000s during

the strongest recession in the U.S. since the Great
Depression
 Less than half of all institutions reported increased
earnings in 2007, the first time in 23 years that a majority
of institutions had not posted full-year earnings increases

 ROA and ROE over time

 In 2008, annual ROA was a poor 0.13%, and it fell again in
2009 to 0.09% before rising to 0.65% in 2010
 Similarly, ROE was 1.33% in 2008, 0.85% in 2009, and
9.26% in 2015
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Industry Performance Concluded

 Number of insured institutions on the FDIC’s “Problem

List” declined from 203 to 183 during 2015, and there
were only 8 bank failures

 Performance has deteriorated slightly in 2016 as ROA

and ROE fell to 0.95% and 8.43%, respectively
 Higher expenses for loan losses and lower noninterest
income from trading and asset servicing

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Selected Indicators for U.S.
Commercial Banks, 1989 through
2016

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Regulators

 The Federal Deposit Insurance Corporation (FDIC)

insures the deposits of commercial banks
 The U.S. has a dual banking system—banks can be
either nationally or state-chartered
 The Office of the Comptroller of the Currency (OCC)
charters, closes, and examines national banks
 State authorities charter and regulate state-chartered banks

 The Federal Reserve System (FRS) serves as the

central bank of the U.S. and has regulatory power over
nationally chartered banks, their holding companies and
state banks that opt into the Federal Reserve System
 A holding company is a parent company that owns a
controlling interest in a subsidiary bank or other FI

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Bank Regulators

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20 Largest Banks in the World by
Total Assets

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 Global Issues

 Advantages of  Disadvantages of
international expansion international expansion
 Risk diversification  Information/monitoring costs
 Economies of scale  Nationalization/expropriation
 Innovations  Fixed costs
 Funds source
 Customer relationships
 Regulatory avoidance

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Global Banking Performance

 The financial crisis of 2008-2009 spread worldwide and

banks saw losses that were magnified by illiquid
markets
 The largest banks in the Netherlands, Switzerland, and the U.K.
had net losses in 2008
 Banks in Ireland, Spain, and the U.S. were especially hard hit
because they had large investments in mortgages and
mortgage-backed securities

 Many European banks averted outright bankruptcy

thanks to direct support from their central banks and
national governments
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Global Banking Performance
Continued
 Greece suffered a severe debt crisis in the spring of
2010
 Problems from the Greek banking system then spread to other
European nations, such as Portugal, Spain and Italy
 The situation stabilized after 2012, but a major debt payment
was due from Greece to creditors on June 30, 2015
 Deal was reached that required Greece to surrender to all of its
creditors’ demands: tax increases, pension reform, and the creation
of a fund (under European supervision) with state-owned assets
earmarked to be privatized or liquidated
 European banking system was rocked again in June
2016 with “Brexit”

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