Comprehensive Study Notes on Commercial Banking Basics

Basics of Bank Balance Sheets and Liabilities

  • Definition of Balance Sheet: A summary of a bank's sources and uses of funds that illustrates the relationship between assets and liabilities.

  • Bank Liabilities: These represent the funds that banks acquire from savers, which are subsequently used to make investments or loans to borrowers.

  • Types of Checkable Deposits:     - Demand Deposits: Traditional checking accounts against which depositors can write checks. These do not earn any interest.     - NOW Accounts: Stands for Negotiable Order of Withdrawals. These are essentially interest-bearing checking accounts on which unlimited checks can be written, provided the depositor has sufficient funds.

  • Non-transaction Deposits: Also known as time deposits. These consist of:     - Savings accounts.     - Money market deposits.     - Certificates of Deposit (CDs).

  • Primary Liability: Checking accounts are considered the main liability for commercial banks.

Bank Assets and Acquisition Strategies

  • Asset Portfolio Composition: A bank's assets reflect the demand for loans by customers tempered by the bank's need to balance returns against various risks, such as liquidity risk and interest rate risk.

  • Methods for Acquiring Assets:     - Funds received from depositors.     - Borrowed funds.     - Funds acquired from shareholders purchasing new bank stock (equity).     - Profits retained from operations.

  • Reserves and Vault Cash: The most liquid assets a bank holds. This includes:     - Literal cash in the vault.     - Cash held in ATMs.     - Deposits held in other banks.

  • Reserve Classifications:     - Required Reserves: The portion of cash a bank must keep on hand as mandated by the Federal Reserve.     - Excess Reserves: Any funds held beyond the required reserves. These are used to create loans for borrowers, serving as the bank's primary profit generator.

The Fractional Banking System and Money Creation

  • Fractional Banking System: A system where banks keep only a fraction of their deposits in the vault as cash and lend out the remainder. This process increases the money supply through the expansion of checking accounts.

  • Money Creation Example:     - If a bank has $10,000\$10,000 in demand deposits and the Federal Reserve mandates a 10%10\% required reserve, the bank keeps $1,000\$1,000 in the vault.     - The remaining $9,000\$9,000 are excess reserves used to create loans.     - These loans become liabilities in other accounts, leading to further lending (e.g., 10%10\% of $9,000\$9,000 is kept, $8,100\$8,100 is lent; then 10%10\% of $8,100\$8,100 is kept, $7,290\$7,290 is lent).

  • The Money Multiplier: Used to calculate the total expansion of the money supply resulting from an initial infusion of cash.     - Formula: Money Multiplier=1Reserve Requirement\text{Money Multiplier} = \frac{1}{\text{Reserve Requirement}}     - Example: With a 10%10\% reserve requirement: 10.1=10\frac{1}{0.1} = 10     - Potential new loans from $9,000\$9,000 in excess reserves: \9,000 \times 10 = \90,00090,000

Loan Categories and Characteristics

  • Loans as Assets: Loans are the largest asset for banks. They are illiquid compared to other securities and entail higher default risk and higher information costs (the difficulty in knowing if a borrower can pay back).

  • Interest Rates: Because of high default risk and information costs, interest rates on loans are higher than those on other types of securities.

  • Major Loan Categories:     - Commercial and Industrial Loans: Loans made to businesses to finance long-term investments (machinery/equipment) or short-term needs (inventory). Historically roughly 30%30\% of loan distribution.     - Consumer Loans: Loans to individuals for durable goods like furniture and cars. Historically roughly 20%20\% of loan distribution.     - Mortgages: Real estate or home loans. Historically roughly 50%50\% of loan distribution.

  • Trend in Commercial Loans: Since the 1970s, the share of commercial and industrial loans has declined (from previous levels of 45−50%45-50\%) because companies now procure funds via other methods, such as issuing bonds.

Bank Capital and Solvent Sustainability

  • Bank Capital: Also referred to as shareholders' equity or net worth.

  • The Accounting Equation: Assets=Liabilities+Bank Capital\text{Assets} = \text{Liabilities} + \text{Bank Capital}

  • Equity Calculation: Bank Capital=Value of Assets−Value of Liabilities\text{Bank Capital} = \text{Value of Assets} - \text{Value of Liabilities}

  • Components: Includes funds from stock purchases plus accumulated profits.

  • Insolvency Risk: If liabilities exceed assets, the bank becomes insolvent and cannot honor deposits. This was the core issue for Silicon Valley Bank (SVB), where rising interest rates caused the price of their government bonds (assets) to fall, leading to insolvency.

Measuring Bank Profitability

  • Basic Profit Formula: π=Revenue−Costs\pi = \text{Revenue} - \text{Costs}

  • Revenue Sources: Interest received on securities and loans, plus fees from credit and debit cards.

  • Cost Sources: Interest paid to depositors (savings accounts), interest paid on other loans/debts, and operating costs (salaries, services).

  • Net Interest Margin: A measure of investment efficiency.     - Formula: Net Interest Margin=Interest Received−Interest PaidValue of Earning Assets\text{Net Interest Margin} = \frac{\text{Interest Received} - \text{Interest Paid}}{\text{Value of Earning Assets}}     - A positive margin indicates efficient investment; a negative margin indicates capital is utilized inefficiently.     - Example: $4,000,000\$4,000,000 interest received, $8,000,000\$8,000,000 interest paid, $20,000,000\$20,000,000 in assets: 4,000,000−8,000,00020,000,000×100=−20%\frac{4,000,000 - 8,000,000}{20,000,000} \times 100 = -20\%

  • Return on Assets (ROA): ROA=After-Tax ProfitValue of Assets\text{ROA} = \frac{\text{After-Tax Profit}}{\text{Value of Assets}}

  • Return on Equity (ROE): ROE=After-Tax ProfitBank Capital\text{ROE} = \frac{\text{After-Tax Profit}}{\text{Bank Capital}}

  • Bank Leverage: How much debt an investor assumes. It is the ratio of assets to capital.     - Relationship Formula: ROE=ROA×Bank AssetsBank Capital\text{ROE} = \text{ROA} \times \frac{\text{Bank Assets}}{\text{Bank Capital}}

Managing Risks: Liquidity and Credit

  • Liquidity Risk: The possibility that a bank may not meet its cash needs by selling assets or raising funds at reasonable costs.     - Asset Management (To Earn Returns): Lending in the Federal Funds Market (overnight lending) or engaging in Reverse Repurchase Agreements (Repo) involving buying Treasuries to sell back within 24 hours.     - Liquidity Management (To Gain Cash): Borrowing from the Federal Funds Market, engaging in Repurchase Agreements, or borrowing from the Federal Reserve’s "Discount Window."

  • Credit Risk: The risk that borrowers will default on loans, driven by asymmetric information.     - Adverse Selection: People with bad credit are more likely to seek loans because they know more about their financial instability than the bank does.     - Moral Hazard: If the government provides bailouts, banks may engage in riskier behavior knowing they won't bear the full loss.

  • Hedge Against Credit Risk: Diversification. Banks must spread loans across different industries, regions, and individuals to avoid concentrated exposure.

Historical Trends and The Regulatory Framework

  • Dual Banking System: A system in the U.S. where banks are chartered either by the state or the federal government.

  • National Banking Act of 1863 and 1864: Prevented banks from using deposits to buy ownership in non-financial firms to stop bank runs.

  • Federal Reserve Act of 1913: Created the Federal Reserve System as the "Lender of Last Resort" to help banks with temporary liquidity problems through discount loans.

  • FDIC (Federal Deposit Insurance Corporation): Established after the Great Depression to insure deposits. It manages bank failures by either closing the bank and paying depositors (up to $250,000\$250,000) or facilitating takeovers.

  • Deregulation (1970s-1990s): Historical prohibitions on interstate banking and branching were removed, blurring the lines between commercial and non-commercial banking and allowing banks to grow significantly (economies of scale).

The 2007-2009 Financial Crisis and TARP

  • Market Collapse: The market for Mortgage-Backed Securities (MBS) froze, making it impossible to value bank assets accurately.

  • Credit Crunch: Banks tightened credit for consumer and commercial loans as their balance sheets deteriorated, leading to the recession in December 2007.

  • Troubled Asset Relief Program (TARP): Passed in October 2008, providing $700,000,000,000\$700,000,000,000 as a capital injection to unfreeze credit lines.

  • TARP Controversy:     - Critics: Argued it rewarded "Too Big to Fail" institutions, creating moral hazard by privatizing profits and subsidizing losses.     - Supporters: Argued it prevented a second Great Depression or an "economics apocalypse."

  • Outcome: By 2017, TARP had earned a $30,000,000,000\$30,000,000,000 profit for the government.