Commercial Bank Operations: How Banks Make Money
Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2
Chapter 17 shifts the book from financial markets to financial institutions. And it starts with the biggest ones: commercial banks. By total assets, they are the most important type of financial intermediary in the economy. Their core job is simple. Take money from people who have it (surplus units) and move it to people who need it (deficit units). But the way they do it is worth understanding.
The Banking Landscape
The U.S. banking industry has changed dramatically. In 1985, there were over 14,000 banks. Today, that number has been cut by more than half. The consolidation started when interstate banking regulations were loosened in 1994, letting banks acquire competitors across state lines. The result is a more concentrated industry. The largest 100 banks control about 75% of all bank assets. JPMorgan Chase alone has about $2.3 trillion in assets.
Many banks are owned by bank holding companies. This structure gives them more flexibility to borrow funds, issue stock, and acquire other firms. It also helps them avoid some state banking regulations.
The traditional bank model is straightforward. Pay depositors interest on their money. Charge borrowers a higher rate on loans. The difference between what the bank earns on loans and what it pays on deposits needs to cover salaries, rent, and other overhead while still leaving a profit for shareholders.
Where Banks Get Their Money
Banks have four main categories of funding.
Deposit accounts are the bread and butter. Transaction deposits (checking accounts and NOW accounts) give customers check-writing ability. Savings accounts are the classic passbook variety. Time deposits include CDs, which lock up money for a fixed period in exchange for a higher rate. Money market deposit accounts (MMDAs) offer better rates than savings accounts but with limited check-writing.
Savings and transaction deposits make up about 38% of all bank liabilities. Smaller banks lean more heavily on household savings. Larger banks rely more on negotiable CDs (NCDs), which require a minimum $100,000 deposit and can be traded in a secondary market.
Borrowed funds cover short-term gaps. Banks borrow from each other through the federal funds market, typically for one to seven days. The interest rate on these loans is the federal funds rate, which you hear about in the news all the time. Banks can also borrow from the Federal Reserve at the discount window, but that rate is always set above the fed funds rate to make sure banks treat it as a last resort.
Repurchase agreements (repos) are another option. A bank sells Treasury securities to a corporation and agrees to buy them back shortly. The securities serve as collateral. Eurodollar borrowings let U.S. banks borrow dollar-denominated deposits from banks outside the country.
Long-term sources include bonds and bank capital (equity). Banks issue fewer bonds than industrial companies because they have fewer fixed assets. Bank capital comes from issuing stock or retaining earnings. Regulators care a lot about capital levels because capital acts as a cushion against losses. The required capital level depends on the bank’s risk profile. Riskier banks need more capital.
How Banks Use Their Money
The asset side of the balance sheet shows where the money goes.
Loans are the primary use of funds, making up about 59% of bank assets. Business loans include working capital loans, term loans, lines of credit, and revolving credit facilities. Consumer loans include installment loans and credit cards. Credit card rates are often double the rate on business loans. Real estate loans cover both residential mortgages and commercial property.
The chapter spends some time on the subprime mortgage disaster. During the 2004-2006 boom, many banks gave mortgages to people with low incomes, high debt, or tiny down payments. They charged higher rates and up-front fees to compensate for the risk. They assumed home prices would keep rising. That assumption turned out to be catastrophically wrong. By January 2009, about 10% of all homeowners with mortgages were either late on payments or in foreclosure.
Banks also participate in loan participations, where several banks pool funds for a single large loan. One bank leads the deal, handles the paperwork, and distributes interest payments. The other banks provide funds and share the risk.
Securities account for about 27% of bank assets. Banks buy Treasury securities, agency securities (like those issued by Fannie Mae and Freddie Mac), corporate bonds, municipal bonds, and mortgage-backed securities. Municipal bond interest is exempt from federal taxes, which makes them attractive. Investment-grade ratings are required.
Other uses include federal funds sold (lending to other banks), repos from the lending side, Eurodollar loans, fixed assets, and proprietary trading. That last one is worth highlighting. Before the credit crisis, proprietary trading was a major income source for large banks. Trading desks would take speculative positions in stocks, bonds, and derivatives using the bank’s own money. It was profitable in good times but produced massive losses during the crisis. The Dodd-Frank Act introduced the Volcker Rule to limit this activity.
Off-Balance-Sheet Activities
These are services that generate fees without showing up as assets or liabilities. But they create real obligations.
Loan commitments promise a borrower that funds will be available when needed. The bank charges a fee for this promise. Standby letters of credit back a customer’s obligation to a third party. If the customer fails to pay, the bank steps in.
Forward contracts on currencies let banks serve as intermediaries for companies that want to lock in exchange rates. Interest rate swaps let two parties exchange fixed and floating rate payments, with the bank collecting a fee for arranging the deal.
Credit default swaps became infamous during the 2008 crisis. Banks sell these contracts to provide insurance against bond or mortgage defaults. The seller collects regular payments. If defaults happen, the seller owes the buyer big money. During the credit crisis, sellers of credit default swaps on mortgage-backed securities got hammered. The market for these swaps exceeded $30 trillion by 2008.
International Banking
Many U.S. banks expanded internationally to find growth when interstate banking was restricted at home. They establish foreign branches and subsidiaries. Citigroup is a prime example, offering services worldwide from forex trading to acquisition finance to cash management.
The euro simplified things for banks operating across Europe. One currency instead of sixteen means fewer exchange rate headaches and better economies of scale. But international exposure also creates risk. Banks with large loans to struggling European governments like Greece, Portugal, and Spain found this out the hard way.
My Take
This chapter is a solid overview of how banks actually work. The balance sheet approach makes it easy to see both sides of the equation. What surprised me is how thin the margins are. Banks earn maybe 3-4 percentage points between what they charge on loans and what they pay on deposits. That does not leave much room for error, which is why loan losses during the credit crisis wiped out entire institutions.
The shift toward off-balance-sheet activities is also worth noting. Banks are not just taking deposits and making loans anymore. They are running complex derivatives operations and investment portfolios. That diversification can help, but it also means more ways to get into trouble.