Commercial Banks

Commercial bank is a depository institution, whose major assets are loans (broader in range, including consumer, commercial and real estate loans) and whose major liabilities are deposits (liabilities can also come from nondeposit sources of funds, such as subordinate notes and debentures). Commercial banks are called depository institution because they get a significant proportion of their funds from customer deposits. Commercial bank is currently the largest type of financial institution based on dollar value of assets. With that being said, commercial banks act an important role in the US economy as it plays a key role in the transmission of monetary policy from the central bank (the Federal Reserve) to the rest of the economy.

Before 1999, it was fairly easy to distinguish between commercial banks and investment banks, thanks to the Glass-Steagall Act. Commercial banks involved with primarily with deposits and lending, while unlike commercial banks, investment banks were not authorized to issue notes or accept deposits. Instead, they served as brokers or intermediaries, bringing together investors with capital and the firms that needed that capital by underwriting, issuing, and distributing stocks, bonds, and other securities. Significant changes occurred in 1997 as the Federal Reserve and the Office of the Comptroller of the Currency (OCC) took action to expand bank holding companies’ permitted activities. In particular, the Federal Reserve allowed commercial banks to directly acquire existing investment banks rather than establish completely new investment bank subsidiaries.

The result was a number of mergers and acquisitions between commercial and investment banks in 1997 through 2000. From the late 1990s onward, however, the ability to enforce the Act eroded, and it was effectively repealed on November 12, 1999 by the Gramm-Leach-Bliley Act. The repeal of the Glass-Steagall Act of 1993 effectively removed the separation that previously existed between Wall Street Investment banks and depository banks. Now, you can see that the distinction between commercial banks and investment banks is meaningless. For example, JPMorgan Chase is among the largest commercial bank in the US, but at the same time is the lead underwriter in the Facebook IPO. I. Opening a commercial bank

In order to get a deeper understanding about commercial bank, it is worth for us to understand how commercial banks are established. Despite the huge numbers of commercial banks, starting and operating a commercial bank is a long process which involves a lot of regulatory and capital needs. Starting with an organizing group, the process is begun by securing several millions of dollar (the required capital is varied by state rule), which is used to bring together a management team with experiences in the banking industry as well as a board. After that, an application, which includes details about tentative location for the bank and a list of potential directors as well as comprehensive background of proposed directors, is submitted to regulators for them to review if the bank can be granted a charter.

The state filing fee is usually $15,000. If a charter is granted, you will have up to one year to open the bank. The bank cannot take deposit until FDIC insurance is paid. After all the process, the regulators would make a final field interview to examine bank’s readiness to accept customers. If so, the bank gets a charter and is opened for business. The new bank can raise capital either by private fund or by going public since the shares become liquid, which makes it easier to pay out investors. In addition, having an IPO in the original plan would make it easier to attract investors in the early-stage. II. Commercial Bank’s function

According to FDIC (Federal Deposit Insurance Corporation), there are 6,940 FDIC-insured commercial banks in the United States as of October 18th, 2013. The six largest banks by assets are JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley

Figure 1. Top US bank holding companies by assets (Fortune CNN) As mentioned above, commercial banks play a significant role in the economy: they satisfy the financial needs of individual, businesses and governments. Generally, the function of commercial bank is divided into 2 main categories: primary functions and secondary functions. The primary function of commercial bank includes:

Accepting various types of deposit from public, including current deposits, saving deposits and fixed deposits Making loans and advances to different clients, especially businessmen and entrepreneurs Creating (manufacturing) and supplying money to the financial market (this is an important role of the commercial bank – helping Fed in conducting monetary policy) Promoting different types of payment method, such as credit card, cheque, etc. Financing internal and foreign trade through discounting of exchange bills, which facilitates the movement of internal and external trade Providing facilities to remit funds from one place to another for their customers by issuing bank drafts, mail transfers or telegraphic transfers on nominal commission charges. The secondary function includes:

Agency services: collection and payment of credit instruments; purchase and sale of securities; collection of dividends on shares; acts as correspondent; income tax consultancy; execution of standing orders; acts as trustee and executor for customers General Utilities Services: to provide safety locker facility to customers; to provide money transfer facility; to issue cheque; to act as referee; to accept various bills for payment: phone bills, gas bills, water bills, etc; to provide merchant banking facility; to provide various cards: credit cards, debit cards, smart cards, etc.

III. Risks faced by Commercial banks
Banking has never been a safety playground for people, and commercial banks are not exceptional. As a major financial institution of the economy, commercial banks are exposed to the risks that affect both the securities market and the economic condition that affect consumers. There are some major types of risk that commercial banks would usually face: 1. Credit Risk

Credit risk is said to be the most obvious risk to banks. It is the risk that banks’ borrower would default on making their promised payment of interest and principal to the bank. As long as the banks can correctly estimate the repayment rate, it is not a big problem. However, if bank fails to accurately estimate the rate of losses, or when economic conditions suddenly worsen, banks may face higher levels of bad which can shrink the bank’s capital reserves to an unacceptable level. Taken to the extreme, if a bank underestimates the amount of credit losses it will incur, the bank can fail altogether. 2. Liquidity Risk

Commercial banks lend out a vast majority of the deposits they receive, thus, they always face the risk of sudden rush of withdrawals that it cannot meet with the cash it has on hand. In order to meet the rushing withdrawal, banks can call upon lending facilities with other banks or the Federal Reserve. However, if many banks face the sudden withdrawals rush together, the short-term borrowing cost would increase. 3. Interest rate Risk

As banks’ profitability is based a lot on the interest rates that they charge and pay out, banks are exposed to and vulnerable to any changes in interest rate. Banks should always try hard to predict as accurate as possible the interest rate, or else the unexpected rate changes can significantly impair profitability. 4. Legal Risk

After the 2007 – 2008 bubble crisis, banks are more and more heavily regulated. Many more act and law rules are activated in order to control the activities of banks, which require them to always prepare and ready for those changes to make sure they will not be too vulnerable to that. IV. Current Trends

1. Bank’s performance is getting better
In late 2000s, Commercial banks’ performance deteriorated as the U.S. economy experienced its strongest recession since the Great Depression. For all of 2007, net income was $105.5 billion, a decline of $39.8 billion (27.4 percent) from 2006. Less than half of all institutions (49.2 percent) reported increased earnings in 2007, the first time in 23 years that a majority of institutions had not posted full year earnings increases. The average ROA for the year was 0.93 percent, which was the lowest yearly average since 1991, and the first time in 15 years that the industry’s annual ROA had been below 1 percent. Sharply higher loan loss provisions and a very rare decline in noninterest income were primarily responsible for the lower industry profits. Things got even worse in 2008. Net income for all of 2008 was $10.2 billion, a decline of $89.8 billion (89.8 percent) from 2007.

This was the lowest annual earnings total since 1989, when the industry earned $10.0 billion. The ROA for the year was 0.13 percent, the lowest since 1987. At the year-end 2008, there was an increase from 76 to 252 institutions on FDIC’s Problem List from the end of 2007. As the economy improved in the second half of 2009, so did commercial bank performance. Growth in operating revenues, combined with appreciation in securities values, helped the industry post a net profit. Commercial banks earned $2.8 billion in net income in the third quarter of 2009, more than three times the $879 million from 2008. The growth in net income comes from growth in net interest income, lower realized losses on securities and other assets, higher noninterest income, and lower noninterest expenses. Given that increase, however, 140 commercial banks failed in 2009.

This is the largest number of failures since 1992. The number of commercial banks on the FDIC’s “Problem List” rose from 416 to 552 during the third quarter of 2009, and total assets of “problem” institutions increased from $299.8 billion to $345.9 billion. Both the number and assets of “problem” institutions were at the highest level since the end of 1993. Improvements in bank performance continued into 2010 and afterward. Through the first six months of 2010, industry ROA and ROE increased to 0.60 percent and 5.44 percent, respectively, the highest in three years. Almost two out of three institutions reported higher year-over-year quarterly net income. T he amount of loans and leases that were noncurrent declined in the second quarter of 2010, the first quarterly decline since first quarter 2006.

As a result, net operating income increased 437.01 percent in the first 6 months of the year. However, while the industry as a whole continued to improve, there were a growing number (829, up from 775 in March 2010) of problem institutions and 80 bank failures occurred in the first half of 2010. The period of 2011 to 2013 sees a stable increase in profit of commercial banks’ operation. Just in 2013, the banks’ ROE has increases slightly from 8.7% to 8.8% in the first half of the year. From the third quarter of 2012, the loan growth for the banks is positive at 1.5% and asset growth is calculated to be 2.6%. This signals a positive sign for future profitable performance of commercial banks.

Figure 2. US commercial banks’ ROA and ROE over years (Federal Reserve) 2. Banks merging together
US commercial banks are getting larger in size and get more concentrated on retail and wholesale banking and often concentrate on the wholesale side of the business. As of 2013, the United States had 6,940 commercial banks. Even though this may seem to be a large number, in fact the number of banks has been decreasing. For example, in 1984, the number of banks was 14,483. Consolidations in the form of mergers and acquisitions and departures due to bank failures explain the decline. Many of the acquired banks were banks that had failed or were failing, and most of them are community banks and retail banking.

The number of mergers and acquisitions increase a lot due to the opened law that allows commercial banks to merge with other banks (. It was not until the 1980s and 1990s that regulators (such as the Federal Reserve or state banking authorities) allowed banks to merge with other banks across state lines (interstate mergers), and it has only been since 1994 that Congress has passed legislation (the Reigle-Neal Act) easing branching by banks across state lines. Finally, it has only been since 1987 that banks have possessed (limited) powers to underwrite corporate securities. Full authority to enter the investment banking (and insurance) business was only received with the passage of the Financial Services Modernization Act in 1999.)

Figure 3. US sees steady decline of commercial banks
The biggest mergers include Bank of America’s purchase of NationsBank in 1998 for $66.6 billion, J.P. Morgan Chase’s purchase of Bank One in 2004 for 60.00 billion, and Bank of America’s purchase of Fleet Financial in 2004 for 43.0 billion. 3. Business loans decreased and mortgages have increased in importance in commercial bank’s asset A commercial bank usually has four asset types, which are securities, business loans, mortgages, and consumer loans. Over the longer term, there has been a drop in securities and an increase in mortgages. Through the mid-2000s, we saw a drop in business loans an increase in securities holdings, and a continued increase in mortgages.

Among the reasons for this changing are the growth in the commercial paper market, the securitization of mortgages, and the credit crunch of 1989-1992. Credit or default exposure is the primary risk from these assets. The financial crisis and the recession of 2008-2009 resulted in a reduction in all areas of lending and an increase in the banks’ holdings of less risky securities investments (e.g., Treasury securities, federal funds, and U.S. government agency securities). 4. Changing in type of deposit funding

Commercial banks’ transaction accounts include deposits that do not pay interest and NOW accounts that pay interest. Retail savings accounts include passbook savings accounts and small, nonnegotiable time deposits. Large time deposits include negotiable certificates of deposits that can be resold in the secondary market. The importance of transaction and retail accounts is shrinking due to the direct investment in money market mutual funds by individual investors that they do not go through commercial banks anymore. The shrink in the deposit markets coincide with the efforts to constrain the growth on the asset side of the balance sheet.

V. Conclusion
Most of us interact with commercial banks every day, whether it is a debit card purchase, an online payment or a loan application. Beyond providing these basic services, commercial banks are in the business of capital allocation for profit – also known as investing. In the commercial banking definition of investing, this means making loans and extending credit to people who can pay it back on the bank’s terms. In addition, commercial banks can invest in securities and even in issues that they help make public. However, these activities are regulated to have to be under the couch of a traditional investment bank. Even though commercial banks are involved with many different financial activities and act as an important player in the financial market, at the end of the day, however, commercial banks focus is still their customer and investors. They need to provide good service to customers and good returns to investors in order to retain success.

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