Lesson 2: Commercial Banks

A. Commercial Banks

• The traditional commercial bank functions: – financial intermediation (transform deposits into loans), and – facilitate payments (through bank drafts or checks).

• Corporate banking services, typically offered by commercial banks, refers to financial services offered to corporations, including extension of loans, treasury and cash management services and services related to trade and international exchange.

• Commercial banks also tend to offer retail services to individual clients, known as retail banking.

• Universal banks engage in many kinds of financial activities:– commercial banking– investment banking– often provide other financial services such as insurance.

Commercial Banks in the U.S.

• As of 2013, there were 5,844 commercial banks in the United States. • The largest 4% held over 70% of the total assets in the commercial banking system.• Many years of restrictions inhibited the growth of the largest U.S. commercial banks,

but this regulation has been steadily eroded since the early 1980s. • Capital:

– The typical U.S. commercial bank obtains approximately 70% of its funding from client deposits.

– Approximately twenty percent of bank funding is obtained through borrowing, though this figure is much higher for certain money center wholesale banks (such as JPMorgan Chase).

– U.S. banks normally maintain equity capitalization of approximately 5% to 10% of total assets.

• Assets:– Approximately 60-65% of typical commercial bank assets are loans, with commercial,

industrial and real estate loans representing the bulk of these loans.– Investment securities, in particular, those issued by the U.S. government, comprise

approximately twenty percent of bank assets. – Fed reserves, cash and demand deposits constitute most of the remaining bank assets.

Early History of Banking• Egypt and Mesopotamia: gold was deposited in temples for safe-keeping.• 18th century BCE Babylon, records of loans made by temple priests have survived. • Greeks and Romans from the 4th century BCE, with private entrepreneurs joining

temples and public bodies in the practice of financial transactions such as accepting deposits, making loans and changing money. Temples remained common venues for banking activities.

• Commercial banking, more as we know it today, originated in 12th century Europe (in particular, Genoa):– Genoese bancherius (money changers) accepted demand and time deposits and made

loans. – Facilitated payment services by transferring deposits.

• The oldest bank in the U.S. is the Bank of New York (now, Bank of New York Mellon), which dates from 1784.

• The oldest continuously-operating bank in the world is Banca Monte dei Paschi di Siena, founded as a pawn-broker for charitable purposes in 1472.

B. Variations of the Commercial Bank

• Commercial banks engage in traditional banking activities such as accepting deposits, making loans and operating payments systems.

• The traditional function of investment banks is to assist clients in the placement of securities such as shares of stock and bonds to the general public. Investment banks underwrite (guarantee sales of) securities as part of this role.

• Merchant banks by tradition engage in trade finance. They also tend to take equity positions in ongoing firms, frequently emphasizing equity positions rather than debt positions.

• Islamic banks provide financial services adhering to Islamic law. Islamic banks do not borrow or lend with interest but often share in the profits of the firms in which they invest.

• Universal banks have broader arrays of activities, including commercial banking, investment banking, insurance and securities brokerage. – Common in Europe and Japan, U.S. banking regulation prohibited universal banking activity during much of the 20th century.– Deregulation during the late 1990s and first decade of the 21st century made universal banking more common in the U.S.

• Private banks manage the assets of high net worth individuals. Many commercial banks have private bank units.• Offshore banks are branches or subsidiaries of a parent bank.

– Often free from host country regulations affecting reserve requirements, disclosure, taxes, etc. – The IMF recognizes the Bahamas, Bahrain, the Cayman Islands, the Netherlands Antilles, Panama, Hong Kong and Singapore

as major offshore banking centers. – Many offshore banks are essentially private banks or exist to remain out of reach of regulators where clients reside.

• Thrift Institutions

International Banks

• The primary functions of international banks are to serve firms conducting business on an international scale.

• Services provided by such banks are likely to include the following: 1. Financing of imports and exports

2. Participation in Eurocurrency and Eurobond markets on behalf of clients

3. Trading foreign exchange and derivative instruments on behalf of clients

4. Providing advice, consulting and information to clients in the global setting

5. Participation in international loan syndications

6. Providing international cash management services for clients

7. Providing loans and accepting deposits

8. Providing factor services

Illustration: The International Bank as the Guarantor

• Fred's Blue Jeans, U.S. clothing manufacturer agrees (in principle) to sell to a Bulgarian distributor $100,000 in clothing.

• The U.S. and Bulgarian firms have not previously done business – counterparty risk

• The Bulgarian distributor arranges for a letter of credit from its bank. • This letter of credit, issued by the Bulgarian bank for a fee is essentially a promise

that the bank will pay $100,000 on behalf of its client, the Bulgarian distributor. • The U.S. manufacturer (actually, usually the U.S. bank which the manufacturer

used to help arrange for the letter of credit) ships the blue jeans to Bulgaria, where a bill of lading is issued to the Bulgarian bank.

• This bill of lading transfers ownership of the blue jeans to the Bulgarian bank and a sight draft requesting payment is issued by the exporter.

• Payment is made to the exporter and the bank transfers title to the blue jeans to the importer and receives payment, both for the blue jeans and for issuing the letter of credit.

C. Bank Safety

• Widespread failure in the banking system is often considered more devastating than failure in other industries.

• The primary regulators for banking systems within individual countries are the central banks of those countries.

• As world banking markets have become more integrated, cooperation among individual governments and central banks have lagged.

• The Bank for International Settlements is the oldest international organization existing to promote international monetary and financial cooperation among central banks.

• The primary functions of the BIS are to act as a center:– to perform and promote international economic, monetary and bank research, – to provide a forum for discussion and cooperation among central banks and– to act as a counterparty (intermediary) for central bank financial transactions.

The Basel Committee

• The Basel Committee, founded in 1974 by central bank governors of Group of Ten countries, meets regularly at the BIS to make recommendations on bank supervision activities and standards for best practices in banking.

• Two objectives of the Committee:– to ensure that bank supervision activities are effective and – no international banks evade appropriate supervision.

• The Committee’s policy initiatives are not sanctioned by any legal authority.

• The Committee reports to the central banks of its member countries.

Basel I

• One major concern of the Basel Committee has been capital adequacy standards. • The Basle Accord of 1988 (Basel I) was intended:

– to provide for capital and credit risk measurement systems and – to set minimum capital standards for banks operating in the international arena.

• Basle I provided that banks engaging in cross-border transactions were required to maintain a minimum capital standard of 8%.

• In addition, such banks are expected to maintain a core capital ratio of 4% (shareholder equity and reserves divided by a risk-based weighted total of assets where riskier assets receive a higher weight) that may be accompanied by a supplemental capital ratio of 4% (subordinated debt divided by a risk-based weighted total of assets).

• The focus of Basel I was credit risk.• However, many international banks were maintaining substantial exposure in

currencies, equities, derivative securities, traded debt instruments and commodities. • The Accord was amended in 1996 to require banks to implement internal portfolio

models appropriate to the wider array of banking activities to compute capital requirements (e.g., VAR).

Basel II

• In 1999, the Committee began a series of meetings leading to the implementation of a new set of capital adequacy standards.

• The new directives are centered around “Three Pillars” of an effective capital framework:– Minimum capital requirements, expanding on the standards set forth in 1988,– Effective supervision, and– Market discipline to improve disclosure and encourage sound bank practices

• Basel II, first published in 2004 acknowledged the significant changes in banking practices, financial markets and supervisory practices.

• Basel II sought to adopt more flexible and risk-sensitive measures and regulatory frameworks.

• Basel II focused on banks’ internal risk measurement systems rather than a single “one size fits all” system.

• It provided new supervisory guidelines.• Very importantly, it allowed for financial markets to play an enhanced role in bank

discipline through the pricing of bank securities.

Basel III

• Basel III, agreed to in 2011 and to be phased in from 2013 to 2019, seeks to:– Improve the banking sector's ability to absorb shocks arising

from financial and economic stress, whatever the source,– improve risk management and governance, and– strengthen banks' transparency and disclosures.

• Furthermore, the Accord intends to reform target: – bank-level regulation, helping to raise the resilience of

individual banks to periods of stress. – system wide risks that can build up across the banking sector as

well as the procyclical amplification of these risks over time.

CAMELS

The Fed developed the CAMELS to gauge the risk of a bank.

1. Capital adequacy, 2. Asset quality, 3. Management, 4. Earnings, 5. Liquidity and 6. Sensitivity to market risk.

Value At Risk (VaR)• As discussed above, the 1996 amendment to Basel I permits banks to use their own portfolio models to

compute capital requirements. • The Value-at-Risk (VaR) model measures the loss size or threshold over a given period of time consistent

with a specified probability:– VaR = Asset Value × Daily return standard deviation × Confidence interval factor × the Square Root of time – VaR = Asset Value × × z × t

• Asset value is the total value of the bank or relevant component, the daily return standard deviation applies to this asset value, the confidence interval factor represents the maximum acceptable probability that this loss will be exceeded (typically a z-value such as 1% from a normal distribution) and time is measured in days.

• Suppose a bank with $1 billion in its derivative asset portfolio seeks to compute its VaR. The portfolio experiences a .5% daily standard deviation in its daily returns. The bank wishes to determine the size of a loss that has a 1% probability of being incurred over a 5-day week:

VAR = $1,000,000,000 × .005 × 2.326 × 5 = $26,005,471 • Thus, assuming that daily asset returns are normally distributed (often a questionable assumption),

uncorrelated over time and with a standard deviation of .005, there is a 1% probability that the bank will experience a loss exceeding $26,005,471 during any given 5-day week.

• The one-tailed z-value corresponding with the 1% confidence interval is 2.326. Thus, 99% of the time, losses realized by the institution will be less than the computed VaR figure.

• Alternative systems are used by banks, including the CreditMetrics system at J.P. Morgan/Chase.

D. What Makes Banks Special?• Banks have special status in the economy. What makes banks so special to be singled out for special regulatory treatment?• James [1987] and Fama [1985] discuss the unique role of the bank in providing capital in under uncertainties, costly

information retrieval and with a costly reserve requirement. This reserve requirement is, in some respects, like a tax. These authors observe that yields on bank CDs are not much different from those on bank commercial paper and bank acceptances. Changes in reserve requirements do not seem to affect bank yields. What makes banks special in that they can absorb this "tax" on deposits and pass it on to their customers through wider spreads?

• Banks, in their roles as delegated monitors, have access to special information. Mikkelson and Partch [1986] found that announcements of bank credit lines produced positive abnormal returns for prospective borrowers

• James [1987] documents higher than normal stock returns for firms announcing acceptance of a loan from a bank. • These announcement effects seem to differ markedly from those associated with non-bank securities issued in capital

markets.• This positive bank loan result suggests that financial markets perceive banks to be capable of obtaining useful non-public

information about firms in the loan application process, information that does not seem to be obtained in the public securities issuance process.

• Bernanke [1983] argues that the failure of banks to engage in normal intermediation services were key contributors in the 1930-33 real output crunch. Bernanke argued that the role of the banking system in reducing Depression-era output cannot be fully explained by declines in money supply. Bank failures to provide credit amplified other factors contracting real output. Bernanke claimed the two major contributors to the financial collapse were:– the loss of confidence in financial institutions, particularly commercial banks, and – the pervasive insolvency of debtors.

• Bernanke argued that when banks fail to provide these information-provision services, lending is diminished and the economy suffers.

• Slovin, Sushka and Polonchek [1993] examined borrower share price responses to the 1984 failure of Continental Illinois Bank, the largest in the U.S. to that date. Their study found significantly negative abnormal returns (-4.2%) to borrower shares.

• Bernanke found that a financial crisis, such as suspended bank deposits, failing business liabilities, differentials between BAA corporate bond yields and yields on U.S. government monetary variables, that a financial crisis was related to real output.

E. Adverse Selection and Rationing• Stiglitz and Weiss [1981] describe adverse selection where interest rates affect the pool of borrowers & why banks ration credit

when rates rise.• Suppose a bank that can make $100 loans, all at 5%, to high- and low-risk borrowers, between which the bank cannot distinguish.

The bank’s “safe” customers invest loan proceeds in projects paying $106 with certainty. If the bank extends a very safe 5% loan, the future value of the loan is $105.

• Now, suppose the bank extends a loan of $100 to a “risky” company at the same interest rate of 5%. – Probability of the risky loan being repaid is 80%, where the loan customer receives a project payoff of $120. – Probability of default equals 20%, in which case the loan pays 0 because the project payoff is zero. – The expected profit to the loan customer is (.8×$15) + (.2×0) = $12.00. The expected profit to the bank is (.8×$5) + (.2×-100) = -$16.

• Suppose that the bank’s market contains some proportion of low-risk borrowers along with high-risk. If the proportion of performing (low-risk) loans were to be sufficiently high, the bank would continue to make loans at an interest rate of 5%. Thus, in the low (5%) interest rate environment, the bank will continue to make loans as long as the pool of borrowers contains enough low risk borrowers.

• Now suppose that the bank’s cost of funds increases to 10% on its loans. The bank’s “safe” customers will not want to borrow at 10% because their investments will never cover the 10% required interest payment.

• Suppose that the bank can extend a loan of $100 at 10% to the risky company. • Potential profits to the loan customer equals $120.00 - $110.00 = $10.00 with .8 probability and $0 with .2 probability. The

expected profit to the loan customer equals $8. The expected profit to the bank is (.8×10) + (.2×-100) = -$12. Banks will not to lend when interest rates rise.

• Suppose the bank increases its rate? For example, if the bank increases its lending rate to 35%, increasing expected profits to 0 = .8(135 - 110) + (.2-100). This rate enables the bank to break even, the expected profit to the borrower is negative: .8(120-135) + (.20).

• The cannot lend at a rate that borrowers will pay. Raising rates to cover costs of capital to the bank does not result in profitable loans; higher rates force away safer borrowers. Only high-risk customers will borrow, but only if there are low risk customers.

• How does the bank respond to adverse selection in this higher interest rate environment? Rather than raise interest rates, the bank will refuse to make loans (ration credit). Thus, when rates rise, banks will ration credit rather than make low-risk loans.

F. Moral Hazard and the Asset Substitution Problem

• Corporate law provides for limited liability for shareholders. • Limited shareholder liability is valuable to shareholders and is

costly to creditors. • Limited liability provides opportunity for increased risk-taking by

managers on behalf of shareholders. • Increased risk-taking by managers increases shareholder wealth

by enabling shareholders to benefit from highly successful ventures. While creditors do not share proportionately in the gains of the successful venture, they do stand to lose if the risky ventures are unsuccessful.

• Shareholders have a call option on the firm's assets. • Creditors have riskless debt and a short position in a put.

Illustration 1: The Asset Substitution Problem

• Consider an example involving a bank that has $100 in assets, financed by $94 in deposits at an interest rate of 5% and $6 in equity. If the bank were to invest $100 by extending a loan on a very safe residential real estate mortgage, surely to earn a 6% return in one year, the depositors would receive $94 1.05 = $98.70 and shareholders would receive the remaining ∙($100 1.06 - $98.70 = $7.30. Thus, assuming that the residential real estate is quite safe and ∙ignoring administrative costs, shareholders earn an expected profit of $1.30 on their $6.

• Alternatively, the bank can invest $100 into a much riskier commercial real estate loan whose return is 15% with probability equal to 80%, while the probability of default equals 20%, in which case nothing is paid.

• Depositors receive $98.70 with a probability of 80% and zero (there are no assets with which to pay creditors) with a probability of 20%. In the case of bank failure, shareholders facing limited liability would simply abandon their claims on the bank and default on depositor obligations. On the other hand, in the more successful scenario, shareholders receive $115-$98.70 = $16.30 with a probability of 80%, while facing a 20% percent probability of receiving zero. The potential profits to shareholders based on their initial $6 investment are $10.30 with probability of .80 and -$6 with probability equal to .20. The expected profit to shareholders equals $7.04, higher than the expected profit for the safe residential real estate strategy.

Illustration 2: The Asset Substitution Problem

• Suppose that the First Bank has the opportunity to invest all of its $1 billion in assets in a relatively safe portfolio of residential mortgages. The portfolio of mortgages has a 95% chance of paying off $1.08 billion in one year and a 5% chance of only paying off $980 million.

• The expected value of this portfolio is $1.075 billion.• Alternatively, the institution can invest in a portfolio of

commercial real estate equity positions, which will pay off $1.8 billion with probability equal to 50% and nothing otherwise. The expected value of this portfolio is $900 million.

• Depositors financed 97% of the institution's assets ($970 million) at 4%; limited liability shareholders financed 3%.

The Asset Substitution Problem (Cont.)

Pro-Forma Balance Sheets: Investment in Safe Mortgage Portfolio ($billions)Outcome 1: Outcome 2:

Assets Capital Assets CapitalDebt 1.0088 Debt .980 Equity 0.0712 Equity 0 _

Totals 1.0800 1.0800 .980 .980

E[AA] = (.95 1.0800) + (.05 .980) = 1.07500

E[DA] = (.95 1.0088) + (.05 0) = 1.00736

E[EA] = (.95 0.0712) + (.05 .980) = 0.06764

Pro-Forma Balance Sheets: Investment in Risky Equity Portfolio ($billions)

Outcome 1: Outcome 2:Assets Capital Assets Capital

Debt 1.0088 Debt 0 Equity 0.7912 Equity 0

Totals 1.8000 1.8000 0 0

E[AB] = (.5 1.8000) + (.5 0) = .9000

E[DB] = (.5 1.0088) + (.5 0) = .5044

E[EB] = (.5 0.7912) + (.5 0) = .3956

G. Bank Issues of Securities• Federal Funds markets allow banks and other depository institutions to

borrow from one another to meet Federal Reserve requirements. Excess reserves of one bank may be loaned to other banks for satisfaction of reserve requirements. The rate at which these loans are extended is referred to as the Federal Funds Rate.

• Negotiable Certificates of Deposit (a type of Jumbo C.D.) are tradable depository institution CDs with denominations exceeding $100,000.

• Banker's Acceptances are originated when a bank accepts responsibility for paying a client's loan or assuming other financial responsibilities.

• Repurchase Agreements (Repos) are issued by financial institutions (usually securities firms) acknowledging the sale of assets and a subsequent agreement to re-purchase at a higher price.

• The counterparty transaction is a reverse repo.

H. Eurocurrency Issues• Eurodollars are freely convertible dollar-denominated time deposits outside the

United States. • Eurocredits (e.g., Eurodollar Credits) are bank loans denominated in currencies

other than that of the country where the loan is extended. Their rates are generally tied to LIBOR (the London Interbank Offered Rate) and U.S. rates.

• Eurobonds are generally underwritten, bearer bonds denominated in currencies other than that of the country where the loan is extended.

• Euro-Commercial paper is the term given to short-term (usually less than six months) notes issued by large, particularly "credit-worthy" institutions. Most commercial paper is not underwritten. The notes are generally very liquid (much more so than syndicated loans) and most are denominated in dollars. They are usually pure discount instruments.

• Euro-Medium Term Notes (EMTN's) are interest-bearing instruments usually issued in installments. Most are not underwritten. Eurobonds are generally underwritten, bearer bonds denominated in currencies other than that of the country where the loan is extended.

I. Banks as Monitors and Fiduciaries

• Banks could be ideal corporate monitors.– large financial resources necessary to take large positions– clients provide significant important and relevant information not be available to the

public• While effective in some respects, bank monitoring has not proven to be a

panacea.– Lending relationships skew incentives from maximizing shareholder wealth. – Banks may use their control to maximize creditor wealth rather than shareholder wealth. – Overlapping directorships and other business relationships that skew monitoring

incentives. – Banks may monitor less aggressively in order to support other business relationships

with their clients.• Banks are in ideal positions to obtain information from clients concerning

financial distress. – Japanese banks tend to actively support clients facing financial distress – German banks tend to provide much less support to their distressed clients.

Bank Trusts• Bank trusts act as fiduciaries for clients and as principals. • Banks might not be sufficiently motivated to actively monitor on behalf

of beneficiary-shareholders. • Usually, trusts are irrevocable such that trust beneficiaries have little

recourse if returns are low. • Trust beneficiaries cannot discipline banks to improve investment

performance. Compensation to bank and officer trustees is not normally related to investment performance.

• Banks vote the shares that they hold in trust. • Most banks derive most of their business from corporations, creating

conflicts of interest and reduced incentives to monitor. • Many banks and corporations have overlapping directorships and

other business relationships.

J. Structured Lending

• Structured finance activities involve the pooling of debts such as loans, bonds and mortgages and subsequent issuance of a prioritized and collateralized structure of claims known as tranches against these pools.

• Repackaging and pooling of these original instruments allows redistribution of risks.

• During the late 1990s and early part of this century, use of structured lending increased dramatically, bolstered by favorable ratings by credit agencies, leading to overvaluation and a subsequent bubble and crash.

Structured Lending Products

L. Asset-Liability Hedging

• Fixed income instruments provide for fixed interest payments at fixed intervals along with principal repayments.

• In the absence of default and liquidity risk, uncertainties in interest rate shifts are the primary source of pricing risk for many fixed income instruments.

Bond Yields and Sources of Risk

• A bond maturing in n periods with a face value of F pays interest annually at a rate of c with yield y.

• In general, bond risk might be categorized as follows:– Default or credit risk: the bond issuer may not fulfill all of its obligations– Liquidity risk: there may not exist an efficient market for investors to

resell their bonds– Interest rate risk: market interest rate fluctuations affect values of

existing bonds.

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