Download 11:00 Commercial Banking

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 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 2016, there were 5,113 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.
Early History of European and
American Banking
• 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 pawnbroker 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.
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. 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).
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
institution’s or unit’s 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 [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.
What Makes Banks Special?
Empirical Evidence
• 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.
What Makes Banks Special?
Empirical Evidence, continued
• 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.
What Makes Banks Special?
Empirical Evidence, continued
• 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, supporting
Bernanke’s 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.
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.
Adverse Selection and Rationing,
continued
• 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 lowrisk 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.
Adverse Selection and Rationing,
continued
• 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) + (.20).
Adverse Selection and Rationing,
continued
• The bank 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 risktaking 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
Capital
Debt
1.0088
Debt
Equity
0.0712
Equity
Totals 1.0800
1.0800
.980
.980
0 _
.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:
Assets
Capital
Assets
Debt
1.0088
Equity
0.7912
Totals 1.8000
1.8000
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
Outcome 2:
Capital
Debt
0
Equity
0
0