Lesson 3: Commercial Banking: An Introduction 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 services related to trade and international exchange.
Commercial banks also tend to offer retail services to individual clients, known as retail banking. Universal Banks 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 2017, there were 4,918 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. U.S. Bank Balance Sheets 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. The Early Church and Banking Beginning in the Middle Ages, the only European institution with significant liquid wealth (money, precious metals and jewels) was the Church,
from which lending occurred to finance wars, building, famine relief and crusades. The importance of the Church as an institutional lender declined with the rise of merchant lending beginning in the 13th century, and more so with the advent of the Reformation. The Church and Usury The early Christian Church banned usury, as did many Moslem traditions, though interest-bearing loans could generally be issued by followers of Judaism. However, non-military affiliates of the Knights Templar issued letters of credit to participants in the Crusades. Usury restrictions and enforcement diminished as religious
authorities gradually made exceptions for government borrowing, opportunity costs, credit risk, credit sales, late payments, repurchase agreements, etc., then eventually, redefining usury as the imposition of exploitative interest rates in the 12th Century. Relaxation of such restrictions enabled families in Christian communities to enter the lending business. The Advent of Merchant Banking The growth of mutual confidence among merchants led to the Italian merchant banking industry, which originated with merchants lending their own capital,. Early merchant banks created a variety of instruments (e.g., bills of exchange) evidencing acceptance from and lending of capital to others. For example, 12th and 13th century merchant bankers from Piacenza, Siena, and Lucca actively
engaged in borrowing and lending activities, and bills were widely issued and accepted by merchants in the major trading arenas. 14th century Florentine families (e.g., the Bardi, Peruzzi and de Medici families), and later elsewhere on the Italian peninsula, Pisa, Volterra, and Tivoli families accepted from and loaned deposits to other merchants. After the Church and other non-merchant institutions ceased acting as major participants in these money markets, by the 16th century, European banks were providing deposit and lending services to the general populations of Europe. Early Merchant Banks Nevertheless, merchants were primary providers of funding to merchant banks, and through the 19th century, governments were among the primary recipients of funding,
largely for war financing. Merchant banks, generally organized as limited partnerships, proliferated in 17th century European trading centers such as Amsterdam and a bit later in London (e.g., Barings Bank in the mid-18th century and the Rothchilds somewhat later). 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. English Banking in the 17th through Early 20th Centuries Early English usury activities was largely left to Jews The Edict of Expulsion issued by King Edward I in 1290 forced Jews from the country The Lombards, the term used by the English to refer collectively to financiers from Northern Italy,
including Genoa, Lucca, Venice and Florence filled the financing gap left by the departed Jews The Royal Mint warehoused stocks of gold on behalf of merchants, goldsmiths and the wealthy of England until its 1642 seizure by Parliament during the English Civil War. The Mint was no longer considered to be secure for holding gold, and private goldsmiths who maintained secure vaults as a necessary part of their business began to hold gold on behalf of clients. Goldsmiths issued receipts (acceptances, which evolved into banknotes and checks) for gold deposited with them, took on value as money stock by depositors. Goldsmiths loaned both gold and receipts evidencing ownership of gold to borrowing clientele as long as the goldsmiths were able to predict when withdrawals would be made and to ensure that they maintained gold stocks on hand adequate to satisfy withdrawal demands. Such forecasting of withdrawals relative to deposits and maintenance of reserves was an important forerunner to fractional reserve banking.
Early History of American Banking The oldest bank in the U.S. is the Bank of New York (now, Bank of New York Mellon), which dates from 1784. B. Variations of Depository Institutions 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.
Variations of the Commercial Bank, continued 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. Variations of the Commercial Bank, continued 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. 2. 3. 4. 5. 6. 7.
8. Financing of imports and exports Participation in Eurocurrency and Eurobond markets on behalf of clients Trading foreign exchange and derivative instruments on behalf of clients Providing advice, consulting and information to clients in the global setting Participation in international loan syndications Providing international cash management services for clients Providing loans and accepting deposits 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.
Thrift Institutions Savings and Loans institutions Savings Banks Credit Unions 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 Committees 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). Basel I Amendments 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, continued Basel II sought to adopt more flexible and risksensitive measures and regulatory frameworks. Basel II focused on banks internal risk measurement systems rather than a single one size fits all system. Basel II provided new supervisory guidelines. Very importantly, Basel II 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. Alternative systems are used by banks, including the CreditMetrics system at J.P. Morgan/Chase.
VaR Illustration 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.
Stress Testing A stress test is an analysis, which might include a simulation designed to determine how the financial institution (unit thereof, portfolio or even individual instrument) might withstand a negative event, series of events or an economic crisis. The stress test typically focuses on the institutions or units equity capitalization. Stress Testing: Illustration Initial $240.9Bill. 10-yr. mortgage value: $180Bill. Initial $166.86Bill. 1-yr. Deposit value: $162Bill.
Interest rates increase from 3% to 10% Pro-Forma Balance Sheets: Before and After Interest Rate Stress $billions Balance Sheet at Low Interest Rate: Balance Sheet High Interest Rate: Assets Capital Assets Capital Deposits 162 Deposits 147.27 Equity 18 Equity
-55.01 Totals 180 180 93.26 93.26 Table 3: Simplified Bank Stress Test 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  and Fama  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. What Makes Banks Special? Empirical Evidence Banks, in their roles as delegated monitors, have access to special information. Mikkelson and Partch  found that announcements of bank credit lines produced positive abnormal returns for prospective borrowers James  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. What Makes Banks Special? Empirical Evidence, continued Bernanke  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 Depressionera 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 informationprovision services, lending is diminished and the economy suffers. What Makes Banks Special? Empirical Evidence, continued
Slovin, Sushka and Polonchek  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, supporting Bernankes assertions. 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 a precursor to real output declines. 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; Part 1: Safe Investment
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: Depositors would receive $94 1.05 = $98.70 Shareholders 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 investment. Illustration 1: The Asset Substitution
Problem; Part 2: Risky Investment Alternatively, the bank can invest $100 into a risky commercial real estate loan whose return is 15% with probability equal to 80%, while the probability of default equals 20%, in which case the bank receives nothing. 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 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: $16.30-$6=$10.30 with probability .8 and -$6 with probability .2. The expected profit to shareholders is $8.24-$1.2=$7.04, much 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 Capital Debt 1.0088 Debt .980 Equity0.0712 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
Bank Licensing: Sets standards for new banks and continued bank operations. Capital Requirements Exposure, activity and affiliation restrictions, including lending and diversification restrictions, occasional prohibitions on non-bank financial activities such as proprietary investing, affiliating with stock brokerage firms Reserve requirement: requirements to maintain holdings of central bank notes or deposits with the central bank, gold, foreign currency, etc. Governance requirements such as organizational structure and domicile, director requirements Reporting and disclosure requirements Deposit insurance: Perhaps the most effective mechanism against a bank run. Basel III Capital Requirements
Mitigating Moral Hazard Moral hazard and too-big-to-fail make people angry. Journalists, politicians and advocates for more responsible financial institutions have noted that that failing banks and their managers seem to receive more favorable treatment than taxpayers, consumers and bank clients, even, in some cases, calling for jail terms for managers of failed banks. What more can regulators do to mitigate the moral hazard problem inherent in banking? Extended Liability
Force managers to face more substantial consequences for risk-taking. For example, since 2015, bank managers in the U.K. have been potentially subject to bonus claw-backs in event of misconduct. Presidents of New England banks between 1867 and 1880 were substantial shareholders of shares subject to double liability. In the event of bank insolvency, the Comptroller of the Currency could seize additional assets from individual manager-shareholders up to the value of the initially paid-in capital to satisfy creditor obligations. Such seizures were essentially a form of double liability.
Control Shareholder Risk-Taking Incentives Between 1863 and 1933, shareholders of nationally chartered banks and certain state-chartered banks could be held liable beyond their equity shares. In insolvency, a receiver could assess the value of the bank's assets and revalue outstanding shares. Shareholders could be assessed additional amounts based on this assessed share value (technically, par value or paid-in capital), from which payments would be made to creditors. Shareholder insolvency can limit the success of a double liability system due to actual amounts recovered by bank receiverships. For example, when Banco Kentucky failed in 1931, the receiver assessed shareholders, $350,000 but insolvency of many of shareholders resulted in a collection of less than $113,000.
Grossman (2001) found that banks were less likely to fail in states requiring double liability. When the City of Glasgow Bank failed in 1879, calls were levied on shareholders at 2750 for each 100 share. Brazil still maintains double liability for certain banks.
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