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Chapter 17 Commercial Bank Operations Outline Background on Commercial Banks Bank Market Structures Bank Sources of Funds Transaction Deposits Savings Deposits Time Deposits Money Market Deposit Accounts Federal Funds Purchased Borrowing from the Federal Reserve Banks Repurchase Agreements Eurodollar Borrowings Bonds Issued by the Bank Bank Capital Summary of Bank Sources of Funds Uses of Funds by Banks Cash Bank Loans Investment in Securities Federal Funds Sold Repurchase Agreements Eurodollar Loans Fixed Assets Proprietary Trading Summary of Bank Uses of Funds Off-Balance Sheet Activities Loan Commitments Standby Letters of Credit Forward Contracts on Currencies Interest Rate Swap Contracts International Banking International Expansion Impact of the Euro on Global Competition International Exposure Key Concepts Before discussing the chapter, emphasize the shift from a market orientation to a focus on particular financial institutions. Explain how each type of financial institution may now be part of a financial conglomerate. Identify the main sources of bank funds, and elaborate where necessary. Identify the main uses of bank funds, and elaborate where necessary. POINT/COUNTER-POINT: Should Banks Engage in Other Financial Services Besides Banking? POINT: No. Banks should focus on what they do best. COUNTER-POINT: Yes. Banks should increase their value by engaging in other services. They can appeal to customers who want to have all their financial services provided by one financial institution. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Many banks have expanded their services by acquiring other types of financial institutions that can provide the services. However, they sometimes pay too much for the institutions that can offer these services. In general, offering additional services can be beneficial if the bank does not incur excessive costs from offering these services. Questions 1. Bank Balance Sheet. Create a balance sheet for a typical bank, showing its main liabilities (sources of funds) and assets (uses of funds). ANSWER: Liabilities 1. Transaction deposits 2. Savings deposits 3. Time deposits 4. Money market deposit accounts 5. Federal funds purchased 6. Repurchase agreements 7. Eurodollar borrowings Assets 1. Cash 2. Loans 3. Investment securities 4. Federal funds sold 5. Repurchase agreements 6. Eurodollar loans 7. Fixed assets 2. Bank Sources of Funds. What are four major sources of funds for banks? What alternatives does a bank have if it needs temporary funds? What is the most common reason that banks issue bonds? ANSWER: 1. Transaction deposits 2. Savings deposits 3. Time deposits 4. Money market deposit accounts Sources of temporary funds include: 1. Federal funds market 2. Discount window 3. Repos 4. Eurodollar borrowings Banks may issue bonds to purchase fixed assets. 3. CDs. Compare and contrast the retail CD and the negotiable CD. ANSWER: Retail CDs and negotiable CDs (NCDs) both specify a minimum deposit, a stated maturity, and a stated interest rate. Yet, NCDs differ from retail CDs because their minimum investment is much higher. In addition, they can be sold in a secondary market, whereas there is no secondary market for retail CDs. 4. Money Market Deposit Accounts. How does the money market deposit account differ from other bank sources of funds? ANSWER: MMDAs differ from conventional time deposits in that they do not specify a particular maturity. In addition, a limited number of checks can be written against these accounts. 5. Federal Funds. Define federal funds, federal funds market, and federal funds rate. Who sets the federal funds rate? Why is the federal funds market more active on Wednesday? ANSWER: Federal funds are loaned in the federal funds market from one bank (or other depository institution) to another at an interest rate known as the federal funds rate. The federal funds rate is not directly set by anyone, but is determined by the market. The rate changes frequently in response to changing supply and demand conditions. The Fed influences the federal funds rate by adjusting the money supply. The federal funds market is active on Wednesday because depository institutions use the market to adjust their required reserve position on that day (it is the final day of the settlement period for required reserves). 6. Federal Funds Market. Explain the use of the federal funds market in facilitating bank operations. ANSWER: The federal funds market is used by depository institutions that experience a temporary shortage of funds and desire to borrow from other depository institutions. It is also used by institutions that have excess funds and desire to lend those funds out. The federal funds market plays a crucial role in facilitating bank operations by providing a mechanism for banks to manage their short-term liquidity needs and meet reserve requirements imposed by central banks, such as the Federal Reserve in the United States. Here's how the federal funds market works and its significance for banks: 1. Interbank Lending : The federal funds market enables banks to lend and borrow funds from one another on an overnight basis. Banks with excess reserves can lend funds to banks that are temporarily short of reserves, allowing the borrowing banks to meet their reserve requirements and maintain liquidity. 2. Federal Funds Rate : The interest rate at which banks lend and borrow funds in the federal funds market is known as the federal funds rate. The Federal Reserve sets a target range for the federal funds rate as part of its monetary policy objectives. Banks adjust their lending and borrowing activities in response to changes in the federal funds rate, which influences overall liquidity conditions in the banking system. 3. Monetary Policy Transmission : The federal funds market serves as a key channel through which monetary policy decisions made by the Federal Reserve are transmitted to the broader economy. By adjusting the target federal funds rate, the Federal Reserve can influence borrowing costs, credit availability, and economic activity. 4. Reserve Management : Banks use the federal funds market to manage their reserve positions and ensure compliance with regulatory reserve requirements. Banks with excess reserves can earn interest income by lending funds in the federal funds market, while banks facing a shortfall can borrow funds to meet their reserve needs. 5. Stabilizing Overnight Interest Rate : The federal funds market helps stabilize overnight interest rates and maintain liquidity in the banking system. The Federal Reserve conducts open market operations, such as buying and selling government securities, to adjust the supply of reserves in the banking system and keep the federal funds rate within its target range. Overall, the federal funds market plays a vital role in the functioning of the banking system by providing a mechanism for banks to manage their short-term liquidity needs, meet reserve requirements, and implement monetary policy objectives. It facilitates efficient allocation of funds among banks, helps stabilize overnight interest rates, and supports the transmission of monetary policy decisions to the broader economy. 7. Borrowing at the Federal Reserve. Describe the process of borrowing from the Federal Reserve. What rate is charged, and who sets it? Why do banks commonly borrow in the federal funds market rather than through the Federal Reserve? ANSWER: “Borrowing at the discount window” represents the borrowing by depository institutions from the Federal Reserve. The interest rate charged on these loans is known as the discount rate and is set by the Fed. Banks tend to prefer the federal funds market over the discount window because the Fed may monitor the bank’s reasons for borrowing. The Fed’s discount window is intended to accommodate banks that experience “unanticipated” shortages of funds. 8. Repurchase Agreements. How does the yield on a repurchase agreement differ from a loan in the federal funds market? Why? ANSWER: Repo rates are usually slightly lower than federal fund rates because a repo is backed by securities. 9. Bullet Loan. Explain the advantage of a bullet loan. ANSWER: A bullet loan represents a loan whose principal is paid off in one lump sum. That is, a bullet loan specifies a balloon payment at a future point in time. This type of loan is useful for a borrower will have limited funds in the near future. 10. Bank Use of Funds. Why do banks invest in securities, even though loans typically generate a higher return? How does a bank decide the appropriate percentage of funds that should be allocated to each type of asset? Explain. ANSWER: Securities provide a bank with liquidity, because they can often be sold easily in the secondary market. In addition, many securities purchased by banks have low risk. Therefore, the securities can be used to minimize liquidity risk and default risk. The optimal allocation of funds is dependent on a bank’s degree of risk aversion and anticipated economic conditions. There is no formula to determine the optimal allocation. Banks must weigh the higher potential return from some uses of funds against the lower return and lower risk of other uses of funds. 11. Bank Capital. Explain the dilemma faced by banks when determining the optimal amount of capital to hold. A bank’s capital is less than 10 percent of its assets. How do you think this percentage would compare to that of manufacturing corporations? How would you explain this difference? ANSWER: Banks may prefer a low level of capital because they can possibly achieve a higher return to shareholders (higher earnings per share). However, regulators enforce minimum capital requirements so that a bank’s capital is sufficient to absorb operating losses that could occur. Banks are more highly leveraged (less capital and more liabilities) than manufacturing companies because their future cash inflows are much more predictable. They can handle the future payments due to liabilities, because they know the future level of cash inflows. 12. HLTs. Would you expect a bank to charge a higher rate on a term loan or a highly leveraged transaction (HLT) loan? Why? ANSWER: It would charge a higher rate for a highly leverage transaction (HLT) loan since this type of loan has a higher level of risk. 13. Credit Crisis. Explain how some mortgage operations by some commercial banks (along with other financial institutions) played a major role in instigating the credit crisis. ANSWER: There were many defaults on subprime mortgages. Banks and other financial institutions were required to take ownership of the homes, which led to an excess supply of homes in the housing market. Consequently, the prices of homes declined substantially, which further reduced the collateral value of the homes taken back by banks. Thus, banks that originated mortgages and held them as assets were adversely affected by the credit crisis. 14. Bank Use of Credit Default Swaps. Explain how banks used credit default swaps. ANSWER: Some commercial banks and other financial institutions buy credit default swaps in order to protect their own investments in debt securities against default risk. Other banks and financial institutions sell them. The banks that sell credit default swaps receive periodic coupon payments for the term of the swap agreement. If there are defaults on the debt securities, the sellers of credit default swaps must make payment to the buyers to cover the damages. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Lower interest rates may reduce the size of banks.” Lower interest rates are beneficial because they can increase the spread between the interest banks earn on their assets versus the interest they pay on their liabilities. However, when interest rates are very low, many households may withdraw bank deposits and invest their money in stock mutual funds or in other investments to earn a higher return. Bank assets could be reduced as a result of the withdrawals. b. “Banks are no longer as limited when competing with other financial institutions for funds targeted for the stock market.” A bank’s traditional services do not include investing funds for individuals in the stock market. However, banks are now commonly affiliated with brokerage firms or mutual funds and can offer services through them that serve individuals that invest in stocks. c. “If the demand for loans rises substantially, interest rates will adjust to ensure that commercial banks can accommodate the demand.” If loan demand rises, interest rates on deposits and loans will increase. Thus, the high deposit rate will attract more funds, while the high loan rate will discourage some potential borrowers from obtaining loans. The interest rate adjusts to the point at which the supply of deposits is adequate to accommodate loan demand. Managing in Financial Markets As a consultant, you have been asked to assess a bank’s sources and uses of funds, and to offer recommendations on how it can restructure its sources and uses of funds to improve its performance. This bank has traditionally focused on attracting funds by offering certificates of deposit (CDs). It offers checking accounts and money market deposit accounts (MMDAs), but it has not advertised these accounts because it has obtained an adequate amount of funds from the CDs. It pays about 3 percentage points more on its CDs than on its money market deposit accounts, but the bank prefers knowing the precise length of time that it can use the deposited funds. (The CDs have a specified maturity whereas the MMDAs do not.) Its cost of funds has historically been higher than that of most banks, but it has not been concerned because its earnings have been relatively high. The bank’s use of funds has historically been focused on local real estate loans to build shopping malls and apartment complexes. The real estate loans have provided a very high return over the last several years. However, the demand for real estate in the local area has slowed. a. Should the bank continue to focus on attracting funds by offering CDs, or should it push its other types of deposits? It should push its checking accounts and its MMDAs. While the bank does not know the precise length of time that it can use funds from these accounts, it should have easy access to other funds (if it experiences a shortage) in the federal funds market. Also, the bank should incur a lower cost of funds because the checking accounts do not pay interest and the MMDAs pay lower interest rates than the CDs. b. Should the bank continue to focus on real estate loans? If the bank reduces its real estate loans, where should the funds be allocated? The bank should not focus on real estate loans, because the loan portfolio will be affected by a decline in the real estate market. Many loan defaults could occur at once. The real estate loans had provided a high return because the real estate market performed well, but since the demand for real estate has declined, the performance of real estate loans may be poor. The bank may consider using its funds to invest in local business loans. It could also invest in Treasury securities but it must recognize that the return on Treasury securities and some other low-risk securities will have a low return. c. How will the potential return on the bank’s uses of funds be affected by your restructuring of the asset portfolio? How will the cost of funds be affected by your restructuring of the bank liabilities? The potential return will likely be smaller because the interest rates on real estate loans are relatively high. However, the risk (uncertainty) surrounding the return may be reduced once the loan portfolio is restructured to reduce the amount of real estate loans. The cost of funds should decline if there is less emphasis on the CDs and more emphasis on checking accounts or MMDAs. Flow of Funds Exercise Services Provided by Financial Conglomerates Carson Company is attempting to compare the services offered by different banks, as it would like to have all services provided by one bank. a. Explain the different types of services provided by a financial conglomerate that may allow Carson Company to obtain funds or to hedge its risk. Carson may rely on financial conglomerates to issue bonds, issue stock, obtain loans, and trade derivative securities (such as futures contacts, options contracts, interest rate swaps, and forward contracts). b. Review the services that you listed in the previous question. What services could provide financing to Carson Company? What services could hedge Carson’s exposure to risk? The underwriting and loan services provide financing. The derivative contracts can be used to hedge risk. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
