Chapter 14
The Commercial Banking Industry:
Structure, Products, and Management
Learning Objectives
You will understand how important commercial banks are to the functioning of a
modern economy and financial system.
You will explore the structure of the United States’ banking industry—one of the
most important in the world.
You will examine the content of bank financial statements and learn how to read
them.
You will see how banks create and destroy money and credit and why this activity
is vital to the operation of both the economy and the financial system.
Chapter Outline
14.1. Introduction to Banking
14.2. The Structure of U.S. Commercial Banking
14.2.1. A Trend toward Consolidation
14.2.1.1. Falling Industry Numbers as Small Banks Are Taken Over by
Larger Ones
14.2.1.2. A Counter Trend: Bath Small and Large May Survives
14.2.1.3. Economies of Scale Support a Consolidating Industry
14.2.2. Branch Banking
14.2.3. Bank Holding Companies (BHCs)
14.2.4. Financial Holding Companies (FHCs)
14.2.5. International Banking
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Answer: Banks are important to the money and capital markets for a number of reasons.
Banks hold a significant portion of the total assets held by all financial institutions. Bank
checking accounts (demand deposits) are the principal means of making payments in our
economy. Commercial banks have the ability to create money using excess reserves
generated from the public’s deposits, nondeposit borrowings, and sales of assets. Banks
also serve as the principal channel for government monetary policy and serve as
guarantor and record keeper for many security offerings.
2. Four dominant movements in the structure of U.S. banking in recent years have
been:
a. The spread of branch banking.
b. The growth of holding companies.
c. The rise of interstate banking.
d. The convergence of bank and nonbank firms.
Explain what has happened in these four areas and why.
Answer: Banks are moving toward consolidation into larger units for cost savings and
branch offices have grown rapidly. The rapid growth of branches has been aided by more
liberal state and federal branching laws and the movement of consumers to the suburbs.
Bank holding companies have increased dramatically in number and size,
acquiring banks and many banking-related businesses. This represents banking’s attempt
to diversify geographically and by product line.
Interstate banking has expanded with new enabling legislation with bank holding
companies allowed to make acquisitions across state lines in order to open up new
sources of revenue and rescue failing banks.
In 1999 with passage of the Gramm-Leach-Bliley Act, leading banks in the
United States began to move toward universal banking more aggressively, establishing
financial holding companies (FHCs), combining banking, securities, insurance, and other
affiliates under one corporate umbrella. Many large and small U.S. banks have created
FHCs because their traditional deposits and loans are declining and they feel the need to
find new services and new revenue sources.
These four movements represent attempts by banks to remain competitive in
rapidly changing financial markets. By diversifying geographically and by product line,
banks can continue to compete against a growing array of other financial institutions
including mutual funds and very large foreign banks. By convergence, banking
organizations are looking more and more like other financial-service providers, offering
many of the same services as security firms, insurance companies, and other service
suppliers.
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
4. How numerous are bank failures and what seem to be their most important
causes? Why are bank failures different from the failures of other businesses and
how are they resolved today?
Answer: The rapid expansion of services has not protected some banks from getting into
serious trouble, however, due to declining economies and falling real estate and stock
prices coupled with excessive government control over who does and does not receive
loans. For example, recently banks in Japan, Korea, and Russia were forced to grapple
with financial crises, with many banks collapsing or being swept up into mergers to add
vitally needed capital and experienced management.
The reasons behind most bank failures are numerous. Some bankers are willing to
accept greater risk in their operations, in part because of intensified competition and
government insurance of deposits. Deregulation has given banks greater opportunities to
market new services and expand geographically without such strict government controls,
but it has also increased their opportunities for failure. The volatility of economic and
financial conditions make bank earnings and stock prices more unstable and force
bankers to devote more time to control and management risk.
Bank failures are often more difficult to resolve than the failures of other
businesses and typically require some form of regulation over the failure process in order
to avoid misallocation of resources. Deposit insurance, designed mainly to head off
depositor runs against healthy banks, reduces the incentive of most depositors to demand
that a troubled bank pay off its creditors and pay higher interest rates on its deposits. A
troubled bank can continue to raise funds by selling government-insured deposits, no
matter how bad its financial situation might be, thus increasing its reliance on the
government’s deposit guarantees and increasing the amount the government must pay
insured depositors when the bank’s doors are finally closed.
Thus, the marketplace frequently does not set in motion the timely closure of
problem banks and lets many uninsured depositors escape before failure occurs. This was
one of the reasons the U.S. government enacted the Federal Deposit Insurance
Corporation Improvement Act of 1991. Under the terms of this law, the FDIC was given
broad new powers to resolve problem-bank situations, taking control even before a bank
becomes insolvent. The Improvement Act restricts the ability of regulatory agencies to
prop up a troubled bank with government loans when it really should be closed. Current
rules require that problem banks either raise more capital from their stockholders or be
turned over to a receiver (usually the FDIC) to sell off their assets.
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
6. What are the principal uses of commercial bank funds? Major sources of funds?
Answer: Principal uses of bank funds include cash for customer withdrawals, marketable
securities (especially government obligations), and real estate, commercial, and
individual loans. Major sources of funds are demand deposits, time and savings deposits,
deposits from foreign offices, money-market borrowings, and owner’s (equity) capital.
7. What new sources and uses of funds have been developed in banking recently?
Answer: Important new sources of funds include loan sales and the securitization of
loans into pools so that securities can be sold against the pooled loans and fluctuating rate
CDs and notes obtained in international markets. Among the most important funds uses
today are home-equity loans, collateralized by the borrower’s home; and money-market-
based loans to large corporations as well as consumer installment loans.
9. What benefits do standby credit letters provide for banks and their customers?
Answer: Standby credit letters are issued by banks to customers who are borrowing from
another lender or selling securities in the open market. They provide banks with fee
income without adding assets which would require additional capital. They benefit the
customers who would have to pay a higher interest rate without the standby credit letter.
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The largest expense item is interest on deposits followed by salaries and wages of
employees. Interest on nondeposit funds, such as federal funds and long-term borrowing,
is becoming increasingly important as an expense item (especially among the largest
banks).
11. What is the net interest margin? The noninterest margin? Why are they
important?
Answer: Net interest margin is the difference between interest income and interest
expenses. It tells the banker whether the borrowing and lending of funds is being
managed efficiently. Net interest margin is the key determinant of bank profitability for
most banks.
Noninterest margin is the difference between total noninterest income and
noninterest expenses. Noninterest margin is becoming increasingly important as banks
shift to more nontraditional services that generate fee income. Noninterest margin
reflects the profitability of these new activities as well as the ability of management to
control operating expenses.
12. How do banks control risk in their loans and in their investment portfolios?
Answer: One of the greatest challenges bank managers face is making new loans and
properly monitoring those loans already on the books. This challenge is a stiff one
because loans are usually a bank’s number-one asset and number-one revenue generator.
Moreover, most of a bank’s risk exposure is usually concentrated in its loan portfolio.
Top-performing banks today routinely prepare written loan policies, designed to guide
loan decisions and shape the whole loan portfolio the way management and the
stockholders prefer. Written loan policies help to train new loan officers and assist
management in determining how well its policies are being followed.
In addition to making loans, banks also extend credit to their customers by
purchasing a customer’s securities (principally stocks and bonds), which bankers place in
their investment portfolio. Bank investment portfolios provide a source of income that
supplements loan income and stabilizes overall revenue and earnings. Because risk is
normally heaviest in the loan portfolio, bank investments are generally positioned in safer
assets to help offset loan risk. Moreover, investments in marketable securities can be
drawn upon for cash when the bank faces significant liquidity pressures. An investments
officer must consider several different factors when deciding which securities to add to a
bank’s investment portfolio, including their expected after-tax rate of return, how that
expected return correlates with returns from other assets the bank holds, the credit rating
of the securities under review, and the projected liquidity (cash) needs of the institution.
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13. Why are banks so sensitive to liquidity risk? How do they raise cash to meet
liquidity needs?
Answer: Perhaps more than any other business, banks are challenged by continuing
liquidity (cash) requirements. They must raise cash at a reasonable cost at precisely those
times cash is needed, often in huge volume. Banks are “liquidity sensitive” because many
of their deposits are payable immediately upon customer demand. A bank’s liquidity
manager must invest surplus cash right away to avoid loss of income and cover cash
deficits as soon as they arise.
14. What are the most popular measures of bank performance? What do they
measure?
Answer: Today, banks are closely watched by their customers, by regulators, and by
investors in the money and capital markets. Their performance is evaluated not only
relative to each institution’s own goals but also relative to the performance of the bank’s
competitors. Four dimensions of bank performance tend to be most closely followed in
the industry:
1. The market value or stock price of a banking institution.
2. The rate of return or profitability ratios of a bank.
3. The bank’s risk exposure along several different dimensions.
4. The operating efficiency of the institution.
The principles of financial management teach that a bank’s stock price is usually
the single best indicator of how well the firm is performing because its shareholders must
be satisfied they are earning a competitive return on their capital. However, many banks
around the world either do not have stockholders or have stock so infrequently traded that
a realistic value cannot be determined. This is why many banks pay close attention to
measures of profitability, such as the return on assets (ROA) and the return on equity
capital (ROE)––the ratios of net after-tax income divided by total assets or equity capital.
Other important performance indicators include the net interest margin, which
reflects the “spread” between interest revenue from loans and investments and interest
expense associated with deposits and other borrowings divided by bank size. Another key
indicator is the ratio of equity capital (or net worth) to total assets. If the risky assets a
bank holds decline in value by more than the volume of its owners’ equity (net worth),
the institution may become insolvent. Similarly, the banker must monitor the proportion
of all loans outstanding that are judged to be noncurrent and, therefore, not paying out as
promised and determine how adequately are covered by loan-loss reserves set aside by
management. If these loan-loss measures deteriorate, management must respond quickly
to strengthen the bank’s equity capital and improve its loan quality.
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
16. Is the ability of banks to create money of significance for the economy and the
creation of jobs?
Answer: Yes, by making loans with excess reserves, the banking system creates total
deposits and loans greater than the original volume of funds received. Money creation by
banks is a major source of credit flows in the economy.
The money banks create is immediately available for spending so the economy
can grow faster but must be regulated in quantity and growth rate to prevent rising
inflation if money growth outstrips the growth of output in the economy.
19. Why is money creation and destruction of importance in the pursuit of public
policy?
Answer: The capacity of banks to create and destroy money has a number of important
implications for the financial system and the economy. Creation of money by banks is
one of the most important sources of credit funds in the global economy – an important
supplement to the supply of savings in providing funds for investment so that the
economy can grow faster. Money created by banks is instantly available for spending
and, therefore, unless carefully controlled by government action, can fuel inflation. That
is why Federal Reserve System and other central banks around the globe regulate interest
rates and the growth of credit principally by influencing the growth of bank reserves and
deposits.
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
2. Construct the report of condition (balance sheet) for First National Bank for
December 31 of the year just ended from following information.
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
3. See if you can fill in correctly the missing items from the balance sheet (report of
condition) and the statement of earnings and expenses (report of income) of the
bank whose financial accounts are listed below:
Balance Sheet Statement of Earnings and Expenses
Cash and interbank deposits $11 Revenue sources: $?
Investment securities ? Domestic loan interest and fees 6
Federal funds sold 8 Foreign loan interest and fees 4
Loans, gross 81 Income from security investments 1
Allowance for loan losses (6) Miscellaneous revenues ?
Unearned discount on loans (1) Total revenues
Net Loans ?
Premises and fixed assets 2 Expenses:
Miscellaneous assets 5 Interest on Deposits ?
Total assets $110 Interest on nondeposit borrowings 1
Demand deposits ? Salaries and wages 2
Saving deposits 20 Occupany costs 1
Time deposits 65 Provision for loan losses 1
Nondeposit borrowings 12 Miscellaneous expenses 2
Total liabilities ? Total expenses 15
Stockholder's equity capital 4 Net perating income 3
Income taxes ?
Net income (or loss) after taxes 1
ANSWER:
Balance Sheet Statement of Earnings and Expenses
Cash and interbank deposits $11 Revenue sources: $7
Investment securities 3 Domestic loan interest and fees 6
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
The above figures are derived by recognizing that total liabilities equals total assets less
equity capital and net loans are equal to gross loans less allowance for loan losses and
the unearned discount on loans. Moreover, net operating income equals revenues less
total expenses and net income after taxes equals net operating income less income taxes.
4. Suppose you have been given the financial information below for a commercial
bank:
Income taxes owed $13 Interest paid to depositors $64
Noninterest revenues from service fees 70 Interest on nondeposit borrowings 8
Interest revenues from loans 129 Salaries and wages of bank employees
27
Interest and dividends from 26 Overhead costs 3
investments in securities Loan-loss provision 2
Dividends paid to stockholders 4 Securities gains (or losses) 0
a. Calculate this bank's net interest income, net noninterest income, pretax net
operating income, net income after taxes, undivided profits (or retained
earnings), total revenues, and total expenses.
ANSWER: The bank’s net interest income is $129 + 26 - 64 - 8 = $83. Its net
noninterest income must be $70 - 27- 3 - 2 = $38. Then pretax net operating income is
$83 + $38 = $121. With taxes owed of $13 net after-tax income must be $108. With
dividends of $4, undivided profits would be $104. Total revenues must be $129 + 26 +
70 or $225, while expenses would total $64 + 8 + 27 + 3 + 2 or $104.
b. Suppose the above bank's return on assets – the ratio of its net income after
taxes to total assets – is 0.85 percent. What is the total of the bank's assets in
dollars?
ANSWER: If the bank’s ratio of net income to assets is 0.85% and its net after-tax
income is $108, then $108/Total assets = 0.0085 or Total assets = $12,706.
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
c. Suppose this bank's return on stockholder's equity capital – the ratio of its
net income after taxes to total equity capital – is 12 percent. What is the
bank's total equity capital in dollars?
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
ANSWER: If the bank’s ratio of net income to total equity capital is 12%, then
108/Equity capital = 0.12 or Equity Capital = $900.
d. Suppose the above bank's total deposits equal 75 percent of its total
liabilities. How many deposits in total dollar volume does the bank hold?
ANSWER: If the bank’s total deposits stood at 75% of its total liabilities, its total
liabilities would be total assets less equity capital or $12,706 - $900 = $11,806. Since
deposits are 75% of this figure, the bank’s total deposits must be $8,855.
Web-Based Problems
1. As one of the chief regulators of the banking system, the Federal Reserve must
monitor the lending activities of commercial banks. The bank loan category
typically carrying the greatest default risk is Commercial and Industrial (C&I)
Loans. The Fed monitors these particular loans through a survey of Senior Loan
Officers. The following will help you get an idea about the types of information
this periodic survey provides.
a. Visit the Fed’s Web site at federalreserve.gov and click on “Surveys and
Reports.” Then click on “Senior Loan Officer Opinion Survey on Bank
Lending Practices” and find the most current survey. Download the
“Charts” (pdf) at the bottom of the report.
Answer: For January 2007 information:
Refer to http://federalreserve.gov/boarddocs/SnLoanSurvey/200701/default.htm
See also http://federalreserve.gov/boarddocs/SnLoanSurvey/200701/fullreport.pdf
For April 2007 information:
Refer to http://federalreserve.gov/boarddocs/SnLoanSurvey/200705/default.htm
See also http://federalreserve.gov/boarddocs/SnLoanSurvey/200705/fullreport.pdf
b. Have banks tightened lending standards on C&I loans since the previous
survey?
Answer: From the graph below, the banks tightened lending standards on C&I loans are
decreasing from January 2007 to April 2007.
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
c. Have banks raised interest rates on C&I loans since the previous survey?
Answer: From the net percentage of domestic responding spreads of loan rates over
banks’ costs of funds is decreasing from January 2007 to April 2007.
d. Referring to the graphs that you considered in parts (b) and (c), can you
identify any patterns that suggest what happens to business lending during
recessions?
Answer: During recessions, banks tighten lending standards on C&I loans and the spread
of loan rates over banks’ costs of funds decreases.
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
EXCEL 2. The profits of large, diversified banks do not always mirror those of other
industries. Therefore, the market value of their stocks will not necessarily move in
lockstep with the stock market as a whole. The purpose of this exercise is to see how
well the stocks of the largest of these banks have performed in recent years relative
to a broad measure of stock market value—the S&P 500 stock index.
a. Go online to a website such as that of the Wall Street Journal,
www.online.wsj.com/public/us and obtain the closing stock prices for the last
trading day of each month for the past five years for each of the top four
bank holding companies (measured by total assets) listed in the Financial
Developments box on page 426. Also, obtain the value of the S&P 500 on
those days. Enter these data into a spreadsheet.
Answer:
Date Citigroup Inc. Bank of America JP Morgan Wachovia Corp S&P 500 Index
8/7/2007 48.59 48.67 21.47 47.56 1,476.71
7/7/2007 46.03 47.42 22 47.21 1,455.27
6/7/2007 50.7 48.89 22.58 51.25 1,503.35
5/7/2007 53.86 50.71 23.28 54.19 1,530.62
4/7/2007 52.47 50.34 23.76 54.98 1,482.37
3/7/2007 50.24 50.46 23.87 54.49 1,420.86
2/7/2007 49.29 50.27 23.54 54.81 1,406.82
1/7/2007 53.42 51.43 23.5 55.38 1,438.24
12/6/2006 53.98 52.22 23.26 55.82 1,418.30
11/6/2006 48.06 52.67 23.17 53.12 1,400.63
10/6/2006 48.13 52.15 22.68 53.84 1,377.94
9/6/2006 47.66 51.86 22.35 54.13 1,335.85
8/6/2006 47.36 49.83 22.08 52.99 1,303.82
7/6/2006 45.89 49.35 21.44 51.51 1,276.66
6/6/2006 45.83 46.07 20.3 51.94 1,270.20
5/6/2006 46.83 46.35 20.56 51.38 1,270.09
4/6/2006 47.45 47.32 20.49 56.93 1,310.61
3/6/2006 44.4 43.17 21.58 53.32 1,294.87
2/6/2006 43.6 42.99 21.96 53.33 1,280.66
1/6/2006 43.33 41.47 21.82 51.69 1,280.08
12/5/2005 45.14 43.27 21.06 49.84 1,248.29
11/5/2005 45.16 43.02 20.91 50.35 1,249.48
10/5/2005 42.17 40.57 20.89 47.19 1,207.01
9/5/2005 41.94 39.05 21.81 44.45 1,228.81
8/5/2005 40.32 39.91 21.89 46.35 1,220.33
7/5/2005 40.07 39.97 21.64 46.57 1,234.18
6/5/2005 42.17 41.81 21.66 45.85 1,191.33
5/5/2005 42.97 42.05 21.21 46.92 1,191.50
4/5/2005 42.83 40.89 20.99 46.89 1,156.85
3/5/2005 40.61 40.04 20.47 46.65 1,180.59
2/5/2005 43.12 41.95 21.15 48.57 1,203.60
1/5/2005 43.93 41.69 21.3 49.82 1,181.27
12/4/2004 43.15 42.25 20.99 47.78 1,211.92
11/4/2004 40.08 41.2 20.56 47.01 1,173.82
10/4/2004 39.74 39.88 20.7 44.31 1,130.20
9/4/2004 39.15 38.58 20.09 42.28 1,114.58
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
Date Citigroup Inc. Bank of America JP Morgan Wachovia Corp S&P 500 Index
10/3/2003 41.00 32.39 18.76 39.96 1,050.71
Number of
Stocks 609.76 771.84 1,332.62 625.63 95.17
c. Compute an annualized rate of return on the two investments you can follow
each month. Plot these rates of return. How well do they appear to track one
another?
Answer:
Date Values of Values of Bank of Values of JP Values of Values of S&P
Citigroup Inc. America Morgan Wachovia Corp 500 Index
8/7/2007 29628.04878 37565.60667 28611.40725 29754.75475 140544.0131
7/7/2007 28067.07317 36600.80272 29317.69723 29535.78579 138503.4881
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
d. One factor that could explain some of the differences you observe is the
dividend policy of banks versus that of the “typical” firm. Check on the
website to discover what the dividend payout (yield) is for banks versus the
“typical” firm. Which one is higher? How would this affect the appreciation
of banks’ stocks versus the market as a whole?
Answer:
Banks always pay the dividend to the stock holders, hence the appreciation of banks’
stock will be higher when the dividend payment is increasing.
3. As the text explains, the sources of bank revenue have been changing
significantly over the past several years and all banks are not making the same
choices. For example, some banks have focused more intently on developing
their credit card business, while others have moved into a variety of financial
service offerings, while still others have continued to rely upon traditional
business and consumer loans to generate revenues. This exercise asks you to
compare some of the financial ratios of several of the largest U.S. banks.
a. Please go to a website such as the Wall Street Journal’s
www.online.wsj.com/public/us and look up the financial information for each
of the banks listed in the Financial Developments box on page 426. Obtain
their profit margin, return on equity, and return on assets for the past 12
months.
Answer:
Citigroup Inc: refer to http://finance.yahoo.com/q/ks?s=C
Profit margin = 24.74%, return on equity = 17.82%, and return on assets = 1.13%
Bank of America Corp: refer to http://finance.yahoo.com/q/ks?s=BAC
Profit margin = 31.61%, return on equity = 16.46%, and return on assets = 1.46%
JP Morgan Chase & Co: refer to http://finance.yahoo.com/q/ks?s=JPM
Profit margin = 26.09%, return on equity = 14.06%, and return on assets = 1.16%
Wachovia Corp: http://finance.yahoo.com/q/ks?s=WB
Profit margin = 27.76%, return on equity = 14.86%, and return on assets = 1.38%
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Chapter 14 - The Commercial Banking Industry: Structure, Products, and Management
b. According to these measures how did the banks perform relative to each
other? Relative to the industry average?
Answer: These measures are close together for top banks holding companies. They
overall performance is relatively close to the industry average (Money Center Banks).
c. Can you identify any reasons for significant discrepancies between the
financial ratios across these large banks?
Answer: Bank performance depends heavily upon the type of bank. Banks devoted
primarily to commercial and mortgage lending posted much lower profitability ratios, but
they also enjoyed fewer loan losses and less risk exposure. Performance measurement
must always take into account differences in bank size, location, and especially the
product-line focus each bank adopts as its principal service mission.
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