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Chapter Outline
Commercial banks as financial intermediaries Bank market structure Bank sources of funds Uses of funds by banks Off-balance sheet activities International banking
deposit accounts with the size and maturity characteristics desired by surplus units Repackage funds received from deposits to provide loans of the size and maturity desired by deficit units
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regulations were changed in 1994 to allow banks more freedom to acquire banks across state lines
Competition among banks increased Banks needed to become more efficient as a means of survival Acquisitions were a convenient method to grow quickly
The
number of banks today is about one-half that existed in 1985 The largest 100 banks now represent about 75 percent of all bank assets
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Some commercial banks have acquired other types of financial service firms Conglomerates are composed to various units offering specialized services The Act gave banks and other financial service firms more freedom to merge, without having to divest some of the financial services that they acquired The Act allowed financial institutions to offer a diversified set of financial services
Individuals and firms have various financial needs that they can now satisfy with one conglomerate Some financial conglomerates specialize in the services desired by individuals or large firms Financial institutions can reduce their reliance on the demand for any single service they offer Diversification may result in less risk for the institution The units of a financial conglomerate may generate some new business just because they offer convenience to clients who already rely on its other services
A demand deposit account (checking account) is offered to customers who desire to write checks
A negotiable order of withdrawal (NOW) account provides checking services as well as interest but requires a larger minimum balance Electronic transactions
About two-thirds of all employees in the U.S. have direct deposit accounts More than 60 percent of bank customers use ATMs Debit cards and preauthorized debits can be used for recurring monthly payments
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Savings deposits
Until
1986, Regulation Q restricted the interest rate banks could offer on passbook savings
Ceilings prevented commercial banks from competing for funds during periods of higher interest rates
An
automatic transfer service (ATS) account allows customers to maintain an interest-bearing savings account that automatically transfers funds to their checking account when checks are written
Time deposits
Time
deposits are deposits that cannot be withdrawn until a specified maturity date Retail certificates of deposit (CDs) require a specified minimum amount of funds to be deposited for a specified period of time
Annualized interest rates vary among banks and maturity types There is no organized secondary market Depositors will normally forgo a portion of their interest as a penalty for early withdrawal
Bull-market CDs reward depositors if the market performs well Bear-market CDs reward depositors if the market performs poorly Callable CDs can be called by the financial institution early
Pay a slightly higher interest rates, which compensates depositors for risk
Are offered by some large banks to corporations Typically have short-term maturities Typically require a minimum deposit of $100,000 Do not have a secondary market
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created with the Garn-St Germain Act of 1982 Differ from conventional time deposits in that they do not specify a maturity Are more liquid than retail CDs Normally pay a lower rate than retail CDs Differ from NOW accounts in that they provide limited check-writing ability
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Federal funds purchased represent a liability to the borrowing banks and an asset to the lending bank that sells them Loans in the federal funds market are typically for one to seven days The intent of federal funds transactions is to correct short-term fund imbalances experienced by banks The interest rate charged in the federal funds market is the federal funds rate
Typically between 0.25 percent and 1.00 percent above the T-bill rate
Banks that are short of required reserves on the average over a settlement period must compensate with additional reserves
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interest rate charged on loans from the Fed is the discount rate Loans from the discount window are commonly from one day to a few weeks The discount window is mainly used to resolve a temporary shortage of funds Banks commonly borrow in the federal funds market instead of the discount window because the Fed may disapprove of continuous borrowing by a bank
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Repurchase agreements
A repurchase agreement (repo) represents the sale of securities by one party to another with an agreement to repurchase the securities at a specified date and price Banks use repos as a source of funds when they need funds just for a few days
The bank sells some government securities to a corporation and buys those securities back later
Repos occur through a telecommunications network connecting large banks, corporations, government securities dealers, and federal funds brokers Repo transactions are typically in blocks of $1 million The repo yield is slightly less than the federal funds rate
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Eurodollar borrowing
Eurodollars are dollar-denominated deposits in banks outside the U.S. Eurobanks are foreign banks or foreign branches of U.S. banks that accept large short-term deposits and make short-term loans in dollars Banks issue bonds to finance fixed assets Common purchasers of bank bonds are households and various financial institutions Banks finance less with bonds than other corporations
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Bank capital
Bank
capital represents funds attained through the issuance of stock or through retained earnings
Represents the equity or net worth of the bank
Primary
capital results from issuing common or preferred stock or retained earnings Secondary capital results from issuing subordinated notes and bonds Banks generally avoid issuing new stock because:
It dilutes the ownership of the bank The banks reported EPS are reduced
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higher level of capital is thought to enhance a banks safety because capital can absorb losses In 1981, regulators imposed a minimum primary capital requirement of 5.5 percent of total assets and a minimum total capital requirement of 6 percent of total assets In 1988, regulators imposed risk-based capital requirements that were completely phased in by 1992
The required level of capital is dependent on its risk Assets with low risk are assigned low weights, and assets with high risk are assigned high weights
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8%
Transaction deposits
12%
30%
Borrowed funds Other sources
16% 10%
24%
Cash
Banks
are required to hold some cash as reserves by reserve requirements imposed by the Fed Banks hold cash to maintain some liquidity and accommodate withdrawal requests Banks only hold as much cash as necessary because cash does not pay interest Banks hold cash in vaults and in their Fed district bank
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Bank loans
Loans
A working capital loan is designed to support ongoing business operations Term loans are used to finance the purchase of fixed assets
Conditions by which the borrower must abide are protective covenants Term loans are often amortized so that the borrower makes fixed payments If the loan principal is paid off in one balloon payment, it is a bullet loan
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participations
Several banks pool their available funds in a loan participation One of the banks serves as the lead bank and other banks supply funds that are channeled to the borrower The lead bank receives fees for servicing the loan in addition to its share of interest payments All participating banks are exposed to credit risk
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The loan amount provided by a single bank to support an LBO is usually between $15 million and $40 million LBO financing is attractive to banks because of the high loan rate Firms request LBO financing because they perceive that the market value of certain publicly held shares is too low Some banks originate the loans designed for LBOs and then sell them to other financial institutions Bank financing to corporate borrowers with a high degree of financial leverage (highly leveraged transactions) results in a debtto-asset ratio of at least 75 percent
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Volume of business loans Volume increased consistently throughout the 1990s and then declined in the 20012003 period
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of consumer loans
Installment loans are used to finance purchases of cars and household products Banks provide credit cards to customers
State regulators can impose usury laws to restrict the maximum rate of interest charged by banks
The interest rate charged on credit card loans and personal loans is typically much higher than the cost of funds
Many banks have used more lenient guidelines when assessing the creditworthiness of potential customers
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estate loans
Banks provide some commercial real estate loans to finance commercial development
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Investments in securities
Banks purchase Treasury securities and government agency securities Government agency securities:
Can be sold in the secondary market Have a less active market than Treasury securities Are not a direct obligation of the federal government Are commonly issued by federal agencies such as Freddie Mac or Fannie Mae Generate interest income that is subject to state and local income taxes
time
Offer a lower expected return than the loans they provide Offer more liquidity and are subject to lower default risk than loans they provide Firms are unwilling to expand Banks extend fewer loans and increase their purchases of securities
In the 1990s, banks used a relatively high proportion of their funds for loans In 2002, banks reduced their loans while increasing their investment in securities
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Funds lent out will be returned at a specified time with interest Small banks are common providers of funds in the federal funds market Banks can act as the lender on a repo by purchasing a corporations holdings of Treasury securities Eurodollar loans are provided by branches of U.S. banks located outside the U.S. and some foreign-owned banks Banks must maintain some amount of fixed assets so that they can conduct their business operations
Repurchase agreements
Eurodollar loans
Fixed assets
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5% 14% 2% 5% 14%
Loans to foreign governments Cash and non-interest securities RA and fed funds Securities
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shifted funds to short-term money market securities such as bank CDs to avoid risk Commercial banks:
Experienced substantial inflows of funds Had only limited use for funds because businesses were unwilling to expand Were especially cautious because they were already experiencing an increase in problems loans
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Generate fee income without requiring an investment of funds Create a contingent obligation for banks Are required to be recognized as assets or liabilities and reported at fair market value
A loan commitment is an obligation by a bank to provide a specified loan amount to a particular firm upon the firms request
e.g., a note issuance facility (NIF) requires banks to purchase the commercial paper of a firm if the firm cannot place its paper in the market at an acceptable interest rate
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A standby letter of credit (SLC) backs a customers obligation to a third party A forward contract is an agreement between a customer and a bank to exchange one currency for another on a particular future date at a specified exchange rate With a swap contract, two parties agree to periodically exchange interest payments on a specified notional amount of principal
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International Banking
Because of interstate banking barriers, U.S. commercial banks were better able to grow by penetrating foreign markets The most common way for banks to expand internationally is through branches
Must
obtain Fed approval based on financial condition and experience in international business Agencies located in foreign countries are allowed to provide loans, but not to accept deposits or provide trust services
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banks have recently established foreign subsidiaries wherever they expect more foreign expansion by U.S. firms
e.g., Southeast Asia, Eastern Europe, and Latin America As a result of NAFTA, U.S. banks have expanded their business into Mexico to:
Help finance the establishment of subsidiaries by U.S.-based corporations Benefit from the increased international trade by offering bankers acceptances and foreign exchange services Offer credit card services and other households services in Mexico
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non-U.S. banks entered primarily to serve non-U.S. corporations that set up subsidiaries in the U.S. Since 1913, Edge Act corporations have been established in the U.S. to specialize in international banking and foreign financial transactions
Can accept deposits and provide loans specifically related to international transactions
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euro has increased bank expansion throughout Europe because the euro:
Simplifies transactions Reduces exposure to exchange rate risk Encourages firms to engage in a bond or stock offering to support their European business Makes it easier to achieve economies of scale and enables banks internal reporting systems to be more efficient
U.S.
banks and European banks are expanding throughout Europe by acquiring existing banks
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