Chapter 5: Commercial Banking

Introduction

The roots of modern banking date back to the sixth century B.C. The first banking operations existed in Mesopotamia, Ancient Greece and the Mediterranean region, where goldsmith bankers originated to facilitate trade by providing loans to merchants. Later, merchants started to become bankers and merchant banking flourished. Merchant bankers gained dominance during the Roman Empire times. In fact, the origin of the term “bank” is the merchant’s bank, or banco on which money was exchanged in the market.

Commercial banks or deposit banks collect savings from lenders, deposit them and use these savings to make loans to borrowers. Commercial banks make profits by matching savers and borrowers. Commercial banks also play important roles in the economy by bringing small amounts of money together from many savers and re-packaging these funds into larger packages of loans for businesses and individual clients. Moreover, they transform the maturity of funds by borrowing deposits usually with a short term and lending those funds in the form of loans with a long term. They also help diminish asymmetric information problems. They reduce adverse selection problems by collecting information about the creditworthiness of loan applicants. They also reduce moral hazard problems by carefully watching the borrowers.

Functions of Commercial Banking

The financial system brings economic actors together through financial markets and financial institutions and channels those funds between surplus and deficit units. Thus, there is a continuous flow of funds from surplus units to deficit units either directly through financial markets or indirectly through financial intermediaries. Financial intermediaries act like a bridge between lenders and borrowers.

We can classify financial intermediaries or financial institutions as depository institutions and non-depository institutions. Depository institutions include commercial banks, savings banks and savings and loans associations as well as credit unions. Non-depository institutions include insurance companies, pension funds, mutual funds, finance companies and investment banks.

Commercial banks are financial firms, which collect deposits from savers and channel those deposits to borrowers in the form of loans. Commercial banks offer borrowers short-term loans such as lines of credit or overdraft facilities. On the other hand, they offer depositors the ability to withdraw or pay money on demand or on a specific date at a fixed return. Hence, commercial banks provide guarantee of money at short notice. Commercial banks hold financial assets for others and invest those financial assets to create more wealth in the economy.

The regulation of the banking sector is the key to maintaining the public’s trust. Governments naturally have laws in place to prevent banks from engaging in dangerous activities.

In the case of direct finance, a saver lends money to parties seeking funds without a financial intermediary such as a bank. In the case of indirect finance, a financial intermediary issues its own financial instruments called securities using funds of savers.

The existence of asymmetric information in financial markets is the main reason for indirect finance. Asymmetric information exists if one party in a financial transaction has information not possessed by the other party. Asymmetric information may lead to adverse selection problems or moral hazard problems. Those businesses, which seek funds for low quality investment projects are likely to be the ones which desire to borrow most. As savers cannot distinguish between these high quality and low quality potential borrowers due to asymmetric information, they may be less willing to lend their funds. This problem arising from asymmetric information is called adverse selection. Even if savers lend their funds, there is a likelihood that the borrower may act immorally and engage in a behavior such as lax management of the loan that increases risk after the loan is made. This kind of problem, which stems from asymmetric information is called moral hazard. Financial intermediaries can reduce those asymmetric information problems and save lenders from incurring these costs by specializing in assessing potential borrowers and monitoring loans.

Commercial banks are able to provide lending to companies at a relatively low rate of return because of the economies of scale they can enjoy compared with the primary investor. These economies of scale include:

• Efficiencies in gathering information on the riskiness of lending to a particular firm and subsequent monitoring
• Risk spreading across a large number of borrowers
• Low transaction costs due to standardized securities
• A regular flow of liquidity through deposits or borrowings.

Commercial banks are financial institutions, which can create credit and money.

Banks create deposits when they lend money through loans. Instead of giving loans in cash, banks issue checks against the name of the borrowers. Banks must keep a certain proportion of deposits with the central bank, which is called the legal minimum cash reserve. The remaining portion can be used to make loans and create money. Commercial banks create money or credit against deposits through the money multiplier.

We can define money as anything that economic actors use as a payment mechanism in economic transactions or debt settlement. We need money since economic actors exchange goods and services in return for money. By eliminating the costs and inefficiencies of the barter system, money enables people to specialize their production and consequently enhances higher productivity in the economy.

Besides providing a medium of Exchange, money provides a way of measuring value as well. We call this function of money as “the unit of account”. Money also allows people to accumulate wealth in a widely accepted “store of value”, which can be used for consumption or investment purposes today or in the future.

Business lines in the commercial banking industry can be classified as Retail Banking and Corporate Banking. Retail banking mainly covers individuals and includes financial services such as credit cards and consumer loans as well as mortgages. It also covers very small enterprises, such as those of physicians or home services. Corporate banking transactions cover large businesses and include financial services like overnight loans, short-term loans, revolving facilities, term loans, committed lines of credit or large commercial and industrial loans.

Sources of Funds and Uses of Funds in Commercial Banking

The liabilities and the capital of a commercial bank constitute its sources of funds, while the assets of a commercial bank constitute its uses of funds.

The primary source of funds for commercial banks are deposits, whereas the primary use of funds is loans. Besides deposits, other liabilities or sources of funds for commercial banks include borrowings from other financial institutions. Besides loans, other assets or uses of funds for commercial banks include required reserves against deposits and excess reserves held in the Central Bank, currency in ATMs, deposits with other banks and assets invested in marketable securities such as government bonds, corporate bonds and asset backed securities. Excess reserves are reserves held by commercial banks above the reserves held to meet reserve requirements of the Central Bank. An asset-backed security (ABS) is a financial security such as a bond or note, which is collateralized by a pool of assets such as loans, leases, credit card debt, royalties, or receivables.

Liabilities and Equity Capital of Commercial Banks

Liabilities are claims on the assets of businesses at a certain point of time. Liabilities of a commercial bank can be categorized as controllable and uncontrollable liabilities. Noncontrollable liabilities are the liabilities over which clients have discretion rather than the bank and mainly consists of deposits in the form of demand deposits, checkable deposits, savings deposits and small denomination time deposits. Liabilities, the amount of which can be controlled by the bank are referred to as controllable liabilities. Controllable liabilities include large denomination time deposits and short-term borrowings in the interbank money market.

The deposit account held in a bank is an asset for the deposit holder, who is household or firm whereas it is a liability for the commercial bank.

The interbank money market is a market, in which banks extend loans to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate.

The most important source of funds and liability item for commercial banks is deposits. Bank deposits may offer savers interest revenue as well as liquidity and safety against theft. Savers may make deposits for daily transactions and hold those funds in the form of demand deposits, which allow them to access those funds immediately on demand. Checkable accounts do not pay any interest to the deposit holders. On the other hand, time deposits offer interest payment to the savers, as the deposit holders must keep their deposits in the bank for a certain period. Time deposit holders can access those funds only at maturity.

Assets of Commercial Banks

Assets are items of value owned by businesses at a certain point of time. Those assets include notes and coins, balances with the Central Bank, inter-bank loans, advances, investments, premises and computers. The most important assets of a commercial bank can be categorized as follows:

• Loans
• Securities
• Cash Assets
• Fixed Assets

The main category of assets commercial banks hold is loans. Loans include commercial loans, consumer loans and short-term loans extended in the interbank market or loans extended through repurchase agreements. Loans extended to businesses are called corporate or commercial loans. Banks may sometimes require businesses to pledge some assets as a collateral to secure the loan, so that they can be seized in the event of repayment failure. However, some loans granted to businesses with high creditworthiness are uncollateralized.

Revolving credits are widely used by businesses to finance their short-term working capital needs. These credits are self-liquidating working capital loans, which can be withdrawn and repaid at different points of time within a certain limit. Another common type of loan made by commercial banks are spot credits or term loans , which are offered for a specific amount for a specific time charging a fixed interest. Term loans are generally used for a specific purpose like purchase of machinery.

Banks also make loans to individuals in the form of consumer loans. Consumer loans are granted to finance purchase of autos, houses, home improvements, household appliances or durable consumer goods. Banks also offer loans in the interbank market. The funds lent are returned with interest at the maturity of the loan. Repurchase agreements (repos) are another way of providing short term loans.

Another category of assets includes investments in securities such as government bonds and Treasury bills. Banks hold some vault cash at their offices to meet withdrawal demands. They also maintain some reserve deposits with the Central Bank as well as deposits with other commercial banks which are called correspondent balances . Last but not the least, banks maintain some fixed assets like land and buildings to carry out their operations.

Commercial banks grant loans to households and businesses. Loans granted to businesses are called commercial loans or industrial loans, while loans granted to households to finance automobile, furniture or consumer goods are called consumer loans. Commercial banks also grant real estate loans which are backed with real estate as collateral. Real estate loans granted to purchase homes are classified as residential mortgages. Real estate loans granted to purchase stores, offices, factories etc. are classified as commercial mortgages.

The difference between the average interest rate banks receive on their assets and the average interest rate they pay on their liabilities is called the bank’s spread. Commercial banks attempt to diminish their risks by diversifying their loans and other investments to avoid an unexpected loan default from sinking the entire bank.

Revenues and Expenses of Commercial Banks

A commercial bank can earn profit if its revenues exceed its expenses. The main sources of revenue in the form of interest revenue, commissions and fees for a commercial bank are as follows:

• Granting loans
• Investing in marketable securities
• Providing credit cards and debit cards
• Servicing deposit accounts
• Providing financial advice
• Providing wealth management services
• Carrying out foreign exchange

The expenses of a commercial bank in the form of interest expense and costs arise mainly from the following:

• Collecting deposits
• Borrowings
• Providing financial services

Commercial banks earn interest income on the loans they grant and the securities they invest in. In general, Interest income has the largest share as a source of revenues for commercial banks. Some revenues that commercial banks generate stem from the charges for services provided by the bank, such as commissions, service fees or trading profits. These revenues constitute noninterest income.

Loan principal payments are not sources of revenue, while the interest payments on the principle are sources of revenue for commercial banks. In recent years, non-interest income has become a significant source of revenue, as interest rates have declined and competition has become tougher.

Besides interest expense, another significant cost item for commercial banks are the expenses for loss provisions. In case some proportion of loans are not repaid, commercial banks hold a certain proportion of their assets in liquid assets, which are referred to as loan loss reserves. Commercial banks also bear operating expenses for real resources such as labor, capital, land to provide banking services.

The profit of a commercial bank is the difference between the total income (the interest income and non-interest income) and the total costs (interest expense, loan loss provisions and operating expenses).

Risk Management in Commercial Banking

Commercial banks need to ensure that they establish and operate effective risk measurement and management systems in order to assess and mitigate the risks they are exposed to. For commercial banks, risk denotes negative consequences due to uncertainty of outcomes, which may influence the bank adversely. The uncertainty cannot be removed, but the exposure to uncertainty can be changed. Risk management in commercial banking necessitates that the risks are identified, assessed and controlled.

Risk management in commercial banks involve the following processes:

• Identification of risks
• Measurement of risks
• Pricing of risks
• Control of risks

An integrated risk management framework to mitigate individual and overall risks can help quantify and allocate the optimal capital and enhance the value creation strategy of the bank. Top managers should participate in the definition of objectives and procedures of the risk management system.

The most important types of risks, which commercial banks face, can be classified as follows:

• Interest rate risk, which arises from the different maturity structure of the banks’ assets and liabilities.
• Liquidity risk , which is the risk that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost.
• Credit risk, which is the risk of changes in the economic value of the bank’s assets due to unexpected changes in the creditworthiness of counterparties.
• Operational risk , which includes the risk of damages caused by human and technological factors

Interest Rate Risk

Usually, banks finance their assets such as loans or bonds by deposits or issuing other liabilities, the maturity of which is shorter than those assets. The imbalance between maturities of assets and liabilities leads to exposure to the interest rate risk. Interest rate risk stems from changes in market interest rates.

Interest rate risk is connected with the positions in the bank’s assets and liabilities portfolio. This risk can be measured by considering the following items:

• Interest-earning financial instruments
• Interest-bearing financial instruments
• Contracts on both sides of the balance sheet
• Derivatives whose value depends on market interest rates.

Commercial banks use the Gap analysis and Duration analysis to measure interest rate risk. Changes in market interest rates affect only interest rate-sensitive assets and liabilities. The Gap over a given time period (gapping period) is defined as the difference between the amount of interest rate sensitive assets and interest rate sensitive liabilities. A positive duration gap implies that the duration of the assets is greater than the duration of liabilities.

Changes in market interest rates may also influence the capital of commercial banks as well as the profits of the banks. Duration analysis measures the sensitivity of the bank’s capital to changes in market interest rates.

In order to diminish interest rate risk, commercial banks with negative gaps may attempt to make more floating rate loans rather than fixed rate loans. They may also use interest rate swaps to exchange payments from a fixed rate loan to a floating rate loan. Moreover, they may utilize derivatives such as futures and option contracts to hedge interest rate risk. A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including derivatives.

Liquidity Risk

Liquidity risk is the inability of the bank to meet its financial obligations when they become due. A commercial bank may be unable to meet short-term financial demands, if it experiences sudden unexpected cash outflows due to large deposit withdrawals, large credit disbursements, or unexpected market movements. Illiquidity of commercial banks may lead to reputation risk. Thus, bank managers must ensure that the bank maintains sufficient liquidity.

Credit Risk

Credit risk is the risk that borrowers may default on their loans. Credit risk arises because of asymmetric information problems mentioned before. The common process for controlling risks is based on risk limits and risk delegations. Limits impose upper bounds to the potential loss of transactions, or of portfolios of transactions. Delegations serve for decentralizing the risk decisions, within limits.

Relationship banking is a strategy used by banks to strengthen loyalty of customers and provide a single point of service for a range of products and services. Banks that do not differentiate risks of their customers would suffer from adverse selection. Overpricing good risks would discourage good customers. Underpricing bad risks would attract bad customers.

Operational Risk

Within the scope of operational risk, damages and losses may arise mainly due to the following reasons:

• Infidelity of human resources
• IT crashes
• Human errors
• Software breakdowns
• Fraud
• Electronic theft
• Adverse natural events
• Robberies
• Inadequacy of the procedures, control systems and organizational procedures.