exam commercial bank

Why are commercial banks also called depository institutions?

Because a significant proportion of their funds come from customer deposits.

What are the major assets of commercial banks?

Loans (financial assets).

What are the major liabilities of commercial banks?

Deposits.

What services do commercial banks provide that are essential to U.S. financial markets?

Transmission of monetary policy, payment services, and maturity intermediation services.

Why are commercial banks regulated?

To protect against disruption in essential banking services and the costs this would impose on the economy and society.

What is the primary difference between the balance sheets of commercial banks and nonfinancial firms?

Commercial banks raise funds through deposits (liabilities) and invest in loans (assets), while nonfinancial firms raise funds through loans/liabilities and invest cash in deposits/assets.

What are the largest commercial bank asset categories?

Loans, investment securities, and cash.

What are the largest commercial bank liability categories?

Deposits and nondeposit liabilities.

What unique risks do commercial banks face because of their asset structure?

Credit risk, liquidity risk, interest rate risk, and insolvency risk.

What is credit risk?

The risk that promised cash flows from loans and securities held by FIs may not be paid in full.

What is liquidity risk?

The risk that a sudden and unexpected increase in liability withdrawals may require an FI to liquidate assets quickly at low prices.

What is interest rate risk?

The risk incurred when asset and liability maturities are mismatched and interest rates are volatile.

What is insolvency risk?

The risk that an FI may not have enough capital to offset a decline in asset value relative to liabilities.

What are transaction accounts?

Checkable deposits that are either demand deposits or NOW accounts.

What are demand deposits?

Transaction accounts that generally pay no explicit interest.

What are NOW accounts?

Negotiable order of withdrawal accounts that pay interest when a minimum balance is maintained.

What are money market deposit accounts?

Retail savings accounts with limited checking features.

What are retail CDs?

Time deposits with a face value below $100,000.

What are wholesale CDs?

Time deposits with a face value of $100,000 or more.

What are brokered deposits?

Wholesale CDs obtained through a brokerage or investment house instead of directly from a customer.

What are nondeposit liabilities?

Funding sources such as Fed funds, repos, commercial paper, medium-term notes, discount window loans, and bonds.

What are purchased funds?

Funds from markets such as interbank/federal funds markets used to finance lending and investment.

What is commercial bank equity capital?

Common stock, preferred stock, surplus/additional paid-in capital, and retained earnings.

What are off-balance-sheet activities?

Activities not immediately shown on the balance sheet that may affect future assets, liabilities, income, or expenses.

What are examples of OBS activities?

Loan commitments, letters of credit, guarantees, futures, forwards, swaps, and options.

What is a loan commitment?

A contractual commitment to lend up to a maximum amount at stated terms.

What is a commercial letter of credit?

A contingent guarantee sold by an FI to support trade/commercial performance.

What is a standby letter of credit?

A letter of credit covering more severe contingencies than commercial letters of credit.

Why do banks engage in OBS activities?

Earnings incentives and regulatory tax-avoidance incentives.

What are trust services?

Services where a bank holds and manages assets for individuals or corporations.

What is correspondent banking?

Providing banking services to other banks lacking the staff/resources to perform them.

What services can correspondent banking include?

Check clearing, collection, FX trading, hedging, and participation in large loan/security issuances.

What is shadow banking?

Banking activities performed by nonbank financial firms.

Why can shadow banks often operate more efficiently?

They face significantly reduced regulation.

Why has the number of U.S. commercial banks declined?

Mainly due to mergers and acquisitions.

What did the Riegle-Neal Act do?

Allowed/eased interstate branching and banking.

What did the Financial Services Modernization Act of 1999 do?

Allowed full entry into investment banking and insurance activities.

What is a community bank?

A bank with less than $1 billion in assets that specializes in retail banking.

What is retail banking?

Consumer-oriented banking such as residential/consumer lending and smaller deposits.

What is a regional or superregional bank?

A bank engaged in a broad array of wholesale/commercial banking activities.

What is a money center bank?

A bank heavily engaged in wholesale money market activity with retail banks and large firms as clients.

How do small banks typically differ from large banks?

Small banks focus more on retail banking, fewer OBS assets, fewer derivatives, and more localized markets.

How do large banks typically differ from small banks?

Large banks focus more on wholesale banking, purchased funds, OBS activity, and noninterest income diversification.

Why do larger banks tend to have narrower spreads and net interest margins?

Larger customers have bargaining power, large banks use more purchased funds, and rely less on core deposits.

Which yield curve tends to be best for bank profitability?

Steep yield curve.

Why is a steep yield curve best for banks?

Banks borrow short-term and lend long-term, widening spreads.

Why is an inverted yield curve harmful for banks?

Funding costs may exceed asset returns, compressing or reversing spreads.

What are advantages of international expansion for banks?

Risk diversification, economies of scale, innovation, funding access, customer relationships, and regulatory avoidance.

What are disadvantages of international expansion?

Monitoring costs, information costs, nationalization risk, expropriation risk, and fixed costs.

What does CAMELS stand for?

Capital adequacy, Asset quality, Management, Earnings, Liquidity, Sensitivity to market risk.

What is CAMELS used for?

Evaluating the safety and soundness of banks.

What does capital adequacy evaluate?

Risk assets, asset quality, growth, prospects, and management strength.

What does asset quality evaluate?

Classified assets, nonaccrual assets, allowance adequacy, and credit administration.

What does management evaluate?

Ability to operate safely within accepted banking practices.

What does earnings evaluate?

Loss coverage, capital protection, trends, peer comparisons, net income quality, and reliance on interest-sensitive funds.

What does liquidity evaluate?

Deposit volatility, borrowings, brokered deposits, liquidity assets, and access to funding sources.

What does sensitivity to market risk evaluate?

Impact of rate, FX, commodity, and equity changes on earnings/economic capital.

What does a CAMELS 1 rating mean?

Basically sound in every respect.

What does a CAMELS 2 rating mean?

Fundamentally sound with modest weaknesses.

What does a CAMELS 3 rating mean?

Moderate to unsatisfactory financial/operational/compliance weaknesses.

What does a CAMELS 4 rating mean?

Serious financial weaknesses or unsatisfactory conditions.

What does a CAMELS 5 rating mean?

Extremely high immediate or near-term probability of failure.

What is the report of condition?

The commercial bank balance sheet showing assets, liabilities, and equity capital.

What is the report of income?

The commercial bank income statement showing revenues, expenses, and net profit/loss over time.

What are cash and due from depository institutions?

Vault cash, Federal Reserve deposits, deposits at other financial institutions, and cash items in collection.

Do cash and due from depository institutions generate much income?

No.

What are investment securities?

Fed funds sold, repos, Treasury/agency securities, municipals, mortgage-backed securities, and other debt/equity securities.

Why are investment securities important?

They generate income, are highly liquid, have low default risk, and can usually be traded in secondary markets.

What are loans and leases?

Commercial and industrial loans, real estate loans, consumer loans, and other loans.

Why are loans and leases important?

They generate the largest revenue flow but are least liquid and a major source of credit/liquidity risk.

What are other assets?

Trading assets, premises/fixed assets, other real estate owned, intangible assets, and miscellaneous items.

What is interest income?

Income earned from loans, leases, and securities.

What is interest expense?

The cost of deposits and other interest-bearing liabilities.

What is net interest income?

Interest income minus interest expense.

What is provision for loan losses?

A noncash, tax-deductible expense allocated to expected loan losses.

What is noninterest income?

Income from fees and on/off-balance-sheet service activities.

What is total operating income?

Interest income plus noninterest income.

What is noninterest expense?

Operating expenses such as salaries, benefits, premises, and fixed assets.

What is income before taxes and extraordinary items?

Net interest income minus provision for loan losses plus noninterest income minus noninterest expense.

What is net income?

Final profit after taxes and extraordinary items.

What does ROA measure?

Net income earned per dollar of total assets.

What is the ROA formula?

Net income / Total assets.

What does ROE measure?

Net income earned per dollar of total equity capital.

What is the ROE formula?

Net income / Total equity capital.

What does net interest margin measure?

Net return earned on earning assets.

What is the net interest margin formula?

(Interest income − Interest expense) / Earning assets.

What does spread measure?

Difference between average asset yield and average liability cost.

What is the spread formula?

(Interest income / Earning assets) − (Interest expense / Interest-bearing liabilities).

What does profit margin measure?

A bank’s ability to control expenses.

What is the PM formula?

Net income / Total operating income.

What does asset utilization measure?

A bank’s ability to generate income from assets.

What is the AU formula?

Total operating income / Total assets.

What does equity multiplier measure?

Financial leverage.

What is the EM formula?

Total assets / Total equity capital.

What is the relationship between ROA, PM, and AU?

ROA = PM × AU.

What is the relationship between ROE, ROA, and EM?

ROE = ROA × EM.

What is the overhead efficiency ratio formula?

Noninterest income / Noninterest expense.

What actions can banks take to increase near-term net income?

Increase loan risk for higher rates or reduce noninterest expense.

What is the ultimate measure of commercial bank performance?

Value of common equity to shareholders.

Why are bank financial statements ideal for analysis?

Banks are heavily regulated and must publicly disclose financial information.