Module 5.1

Question 1

Background on Commercial Banks

Answer 1

Bank Market Structure

I nterstate banking regulations were changed in
1994 to allow banks more freedom to acquire
other banks across state lines.

The number of banks has declined over time,
thereby increasing concentration in the banking
industry. (Exhibit 17.1)

Many banks are owned by bank holding
companies, allowing more flexibility to borrow
funds, issue stock, repurchase the company’s
own stock, and acquire other firms.

Question 2

Consolidation among Commercial
Banks over Time

Answer 2

Question 3

Bank Sources of Funds

Answer 3

Deposit Accounts

Transaction deposits

Savings deposits

Time deposits

Money market deposit accounts
Borrowed Funds

Federal funds purchased (borrowed)

Borrowing from the Federal Reserve banks

Repurchase agreements

Eurodollar borrowings
Long
Term Sources of Funds

Bonds issued by the bank

Bank capital

Question 4

Transaction Deposits

Answer 4

A demand deposit account , or checking account, is offered
to customers who desire to write checks.

A conventional demand deposit account requires a small minimum
balance and pays no interest.

A negotiable order of withdrawal (NOW) account pays interest and
provides checking services.

Electronic Transactions Some transactions originating
from transaction accounts have become much more efficient
as a result of electronic banking (direct deposit accounts,
computer banking, preauthorized debits).

Question 5

Savings Deposits and Time Deposits

Answer 5

The traditional savings account is the passbook savings
account, which does not permit check writing.
Time Deposits

D eposits that cannot be withdrawn until a specified maturity.

Certificates of Deposit ( or retail CDs) require a specified
minimum amount of funds to be deposited for a specified
period of time. Recently callable CDs have been issued.

Negotiable Certificates of Deposit Have a specified
maturity and require a minimum deposit. Maturities are
typically short term, and the minimum deposit is $100,000. A
secondary market for NCDs does exist.

Question 6

Money Market Deposit Accounts

and

Federal Funds Purchased

Answer 6

D iffer from conventional time deposits in that they do not
specify a maturity.

P rovide limited check writing ability, require a larger
minimum balance, and offer a higher yield.
Federal Funds Purchased

R epresent a liability to the borrowing bank and an asset to
the lending bank. (typically for one to seven days)

I ntent is to correct short term fund imbalances by banks.

The interest rate charged in the federal funds market is
called the federal funds rate

Question 7

Borrowing from the Federal Reserve Banks

and

Repurchase Agreements

Answer 7

T he Federal Reserve district banks regulate certain activities
of banks and provide short term loans to banks.

Often referred to as borrowing at the discount window.

The interest rate charged is the primary credit lending rate

Mainly used to resolve a temporary shortage of funds.
Repurchase Agreements

R epresents the sale of securities with an agreement to
repurchase the securities at a specified date and price.

O ccur through a telecommunications network connecting
large banks.

Question 8

Eurodollar Borrowings

and

Bonds Issued by the Bank

Answer 8

M ay borrow dollars from those banks outside the United
States (typically in Europe) that accept dollar denominated
deposits, or Eurodollars.
Bonds Issued by the Bank

Banks own fixed assets such as land, buildings, and
equipment which are usually financed with long term
sources such as the issuance of bonds.

Common purchasers of these bonds are households and
various financial institutions.

Question 9

Bank Capital

Answer 9

Represents funds acquired by the issuance of stock or the
retention of earnings.

A bank’s capital must be sufficient to absorb operating losses
in the event that expenses or losses exceed revenues,
regardless of the reason for the losses.

In 1988, regulators imposed new, risk based capital
requirements that were completely phased in by 1992. Under
this system, the required level of capital for each bank
depends on its risk.

Question 10

Bank Sources of Funds (as a
Proportion of Total Liabilities)

Answer 10

Question 11

Distribution of Bank Sources of Funds

Answer 11

Smaller banks rely on savings deposits while larger banks
rely more on short term borrowings. (Exhibit 17.2

Common Uses of Funds by Banks

Cash

Bank loans

Investment in securities

Federal funds sold (loaned out)

Repurchase agreements

Eurodollar loans

Fixed assets

Proprietary trading

Question 12

Bank
Uses of Funds

Answer 12

Cash

Banks must hold some cash as reserves to meet
the reserve requirements enforced by the
Federal Reserve.

Because banks do not earn income from cash,
they hold only as much cash as is necessary to
maintain a sufficient degree of liquidity.

Banks hold cash in their vaults and at their
Federal Reserve district bank.

Question 13

Bank Loans

Answer 13

Types of Business Loan

Working capital loan (sometimes called a self liquidating
loan) D esigned to support ongoing business operations.

T erm loans Primarily to finance the purchase of fixed
assets such as machinery.

I nformal line of credit Allows the business to borrow
up to a specified amount within a specified period of time.

R evolving credit loan Obligates the bank to offer up to
some specified maximum amount of funds over a specified
period of time.

P rime rate Interest rate charged by banks on loans to
their most creditworthy customers. (See Exhibit 17.3)

Question 14

Prime Rate over Time

Answer 14

Question 15

Bank Loans
(

Loan Participations

and
Loans Supporting Leveraged Buyouts

Answer 15

One bank serves as the lead bank by arranging for the
documentation, disbursement, and payment structure of the
loan.

Other banks supply funds that are channeled to the borrower
by the lead bank.

Loans Supporting Leveraged Buyouts

A management group or a business relies mostly on debt to
purchase the equity of another business.

Firms request LBO financing because they perceive that the
market value of certain publicly held shares is too low.
16

Question 16

Bank Loans
(

Collateral Requirements on Business Loans

and

Lender Liability on Business Loans

and

Volume of Business Loans

Answer 16

Commercial banks are increasingly accepting intangible
assets (such as patents, brand names, and licenses to
franchises and distributorships) as collateral.

Lender Liability on Business Loans

In recent years, businesses that previously obtained loans
from banks have filed lawsuits claiming that the banks
terminated further financing without sufficient notice.

Volume of Business Loans

When the economy is strong, businesses are more willing to
finance expansion.

Question 17

Types of Consumer Loans

Answer 17

Installment loans Loans to finance purchases of cars
and household products.

Banks also provide credit cards to consumers who qualify,
enabling them to purchase various goods without having to
reapply for credit on each purchase.

Since the interest rate on credit card loans and personal
loans is typically much higher than the cost of funds, many
commercial banks have pursued these types of loans as a
means of increasing their earnings.

Question 18

Real Estate Loans

Answer 18

For residential real estate loans, the maturity on a mortgage
is typically 15 to 30 years, although shorter term mortgages
with a balloon payment are also common.

The loan is backed by the residence purchased.

Commercial banks also provide commercial real estate
loans, such as loans to build shopping malls.

Question 19

Investment in Securities

Answer 19

Treasury and Agency Securities

Banks purchase Treasury securities as well as securities
issued by agencies of the federal government.

Corporate and Municipal Bonds

Although corporate bonds are subject to credit risk, they
offer higher return than Treasury or agency securities.

Municipal bonds exhibit some degree of risk but can also
provide an attractive after tax return to banks.

Mortgage Backed Securities

R epresent packages of mortgages.

Question 20

Federal Funds Sold

and

Repurchase Agreements

Answer 20

Some banks lend funds to other banks in the federal funds
market.

The funds sold, or lent out, will be returned (with interest) at
the time specified in the loan agreement.
Repurchase Agreements

Involves repurchasing the securities it had previously sold.

Banks can act as the lender (on a repo) by purchasing a
corporation’s holdings of Treasury securities and then
selling them back at a later date.

Question 21

Eurodollar Loans

and

Fixed Assets

and

Proprietary Trading

Answer 21

Eurodollar loans are short term and denominated in large
amounts, such as $1 million or more.
Fixed Assets

Banks must maintain some amount of fixed assets, such as
office buildings and land, so that they can conduct their
business operations.
Proprietary Trading

Use of bank funds to make investments for their own
account.

Question 22

Summary of Bank Uses of Funds

and

Commercial Bank Balance Sheet

Answer 22

Loans make up about 59% of bank assets

Securities account for 27% of bank assets

Commercial Bank Balance Sheet

Each commercial bank determines its own composition of
liabilities and assets, which determines its specific
operations. (Exhibits 17.5 & 17.6)

Question 23

Bank Uses of Funds (as a Proportion
of Total Assets)

Answer 23

Question 24

Balance Sheet of Hornet Bank as of
June 30, 2013

Answer 24

Question 25

How Commercial Banks Finance
Economic Growth

Answer 25

Question 26

Off
Balance Sheet Activities

Answer 26

Loan commitments

Standby letters of credit

Forward contracts on currencies

Interest rate swap contracts

Credit default swap contracts

Question 27

Loan Commitments

and

Standby Letters of Credit

Answer 27

A n obligation by a bank to provide a specified loan amount
to a particular firm upon the firm’s request.

N ote issuance facility (NIF) Type of loan commitment,
in which the bank agrees to purchase the commercial paper
of a firm if the firm cannot place its paper in the market at
an acceptable interest rate.
Standby Letters of Credit

B acks a customer’s obligation to a third party.

Question 28

Forward Contracts on Currencies

and

Interest Rate Swap Contracts

and

Credit Default Swap Contracts

Answer 28

A n agreement between a customer and a bank to exchange
one currency for another on a particular future date at a
specified exchange rate.
Interest Rate Swap Contracts

T wo parties agree to periodically exchange interest
payments on a specified notional amount of principal.

T he bank receives a transaction fee for its services.
Credit Default Swap Contracts

P rivately negotiated contracts that protect investors against
the risk of default on particular debt securities.

Question 29

International
Banking

Answer 29

The most common way for U.S. commercial banks to
expand internationally is by establishing branches, full
service banking offices that can compete directly with other
banks located in a particular area.

U.S. banks have recently established foreign subsidiaries
wherever they expect more foreign expansion by U.S. firms.
Impact of the Euro on Global Competition

Simplifies transactions and reduces exposure to exchange
risk

May also encourage firms to engage in stock and bond
offerings to support European businesses

Question 30

International Exposure

Answer 30

With European countries such as Greece, Spain, and
Portugal experiencing weak economies and large budget
deficits, banks with large loans to these countries are
exposed to the possibility of loan defaults.