BASICS OF COMMERCIAL BANKING

INTRODUCTION
Commercial banking is a business. Banks fill a market need by providing a service, and
they earn a profit by charging customers for that service. They key commercial banking activities
are taking in deposits from savers and making loans to households and firms. To earn a profit, a
bank needs to pay less for the funds it receives from depositors than it earns on the loans it
makes. We begin our discussion of the business of banking by looking at a bank’s sources of
funds- primarily deposits- and – uses of funds - primary loans.
What is a Commercial Bank?
A commercial bank is a financial institution that grants loans, accepts deposits, and offers
basic financial products such as savings accounts and certificates of deposit to individuals and
businesses. It makes money primarily by providing different types of loans to customers and
charging interest.

FUNCTIONS OF COMMERCIAL BANKING

1. Accepting Deposits
Accepting deposits is one of the oldest functions of a commercial bank. When banks
started, they charged a commission for keeping money on behalf of the public.
a. Savings Deposit - interest bearing deposit accounts held at a bank or other financial
institution.
b. Checking Account- most liquid bank account, meaning you have easy access to your money.
c. Money market account - an interest-bearing account at a bank or credit union, sometimes
referred to as money market deposit accounts (MMDA).
d. Certificate of deposit - When a depositor purchases a certificate of deposit, they agree to
leave a certain amount of money on deposit at the bank for a certain period of time, such as 1
year. In exchange, the bank agrees to pay them a pre-determined interest rate, and guarantees the
repayment of their principal at the end of the term.

2. Advancing Credit Facilities

Advancing loans is an essential function of banks since it accounts for the highest
percentage of revenue earned annually.
3. Credit Creation
While granting loans to customers, banks do not provide the loan in cash to the borrower.
Instead, the bank creates a deposit account from which the borrower can draw funds.

4. Agency Functions
Commercial banks serve as agents of their customers by helping them in collecting and
paying cheques, dividends, interest warrants, and bills of exchange.

THE BANK BALANCE SHEET

A bank’s sources and uses of funds are summarized on its balance sheet, which is a
statement that lists an individual’s or a firm’s assets and liabilities to indicate the individual’s or
firm’s financial position on a particular day.
a. Assets - something of value that an individual or firms own.
b. Liability - something that an individual or firms owes.
c. Bank capital – it is also called shareholder’s equity which is the difference between the value
of the bank’s assets and the value of its liabilities.

BANK ASSETS
Bank acquire its assets through the funds they receive from their depositors, the funds
they borrow, the funds they acquire for their shareholders who purchase the bank's new stock
issues and the profits they retain from their operation.

Most Important Bank Assets

A. Reserves and other cash assets - Reserves is the most liquid assets that the bank holds. It
consists of vault cash, cash on hand and in bank or in other deposits with other banks.
Excess reserves - when the bank holds above or over to the required reserves.

B. Securities - Marketable securities are assets that can be liquidated to cash quickly.
Examples: Stocks, bonds, preferred shares
C. Loans Receivable - are the funds that a company has lent that have not yet been repaid. This
does not include money paid, it is only the amounts that are expected to be paid.
1. Loans to business - is borrowed capital that companies apply toward expenses that they are
unable to pay for themselves.
2. Consumer loans - made to households primarily to buy their daily needs and even wants.
3. Real estate loans - is financing used to purchase a property, and there are several types
available to aspiring homeowners and real estate investors alike. Each loan type will come with
different approval requirements, interest rates, and terms.
● Residential mortgages - mortgages loans made to purchase a house.
● Commercial mortgages - mortgages made to purchase establishments like stores,
office, factories and other commercial buildings.

D. Other Assets - this includes the physical assets that the bank has including computer
equipment and buildings
● Collateral - refers to any asset or property that a consumer promises to a lender
as backup in exchange for a loan.

Examples:
● Personal loans - are used by consumers to consolidate existing debt, build credit
or finance everyday expenses.
● Small business loans - are a popular way to support a growing business, and can
be used to finance hiring, office space, or equipment.
● Mortgages and auto loans - are the most common types of secured loans used by
consumers.

BANK LIABILITIES
Bank liabilities are the debts incurred by a bank. The most important bank liability
category is deposits, the financial wealth that others have placed with the bank for safekeeping.
The funds are being used by the bank to make investments, for instance, by buying bonds, or to
make loans to households and firms which earn its income. By using liabilities, the owners of the
bank can leverage their bank capital to earn much more than would otherwise be possible using
only the bank's capital.

Main Types of Deposit Accounts

 Deposits against which checks can be written offer a convenient way to make payments.
Banks offer a variety of deposit accounts because savers have different needs.

A. Demand or Current Account Deposits

A current account, also called a demand deposit account, is a basic checking account.
Current account deposits come in different varieties, which are determined partly by the desire of
bank managers to tailor the checking accounts they offer to meet the needs of households and
firms. Consumers deposit money and the deposited money can be withdrawn as the account
holder desires on demand. These accounts often allow the account holder to withdraw funds
using bank cards, checks, or over-the-counter withdrawal slips.

B. Nondemand Deposits
Nondemand deposits are deposits that cannot be withdrawn or transferred to third parties
using some means of instruction (such as checks, telephone transfers, etc). Savers use only some
of their deposits for day-to-day transactions. Banks offer non demand deposits for savers who are
willing to sacrifice immediate access to their funds in exchange for higher interest payments. The
most important types of nontransaction deposits are saving accounts, money market deposit
accounts (MMDAs) and time deposits or certificates of deposit (CDs).

C. Borrowings
Banks often have more opportunities to make loans than they can finance with funds they
attract from depositors. To take advantage of these opportunities, banks raise funds by
borrowing. A bank can earn a profit from this borrowing if the interest rate it pays to borrow
funds is lower than interest it earns by lending the funds to households and firms.
Borrowings include short-term loans, BSP funds market, loans from a bank’s foreign
branches or other subsidiaries or affiliates, repurchase agreements, and discount loans from the
BSP.

BANK CAPITAL
Bank capital is the difference between a bank's assets and its liabilities, and it represents
the net worth of the bank or its equity value to investors. The asset portion of a bank's capital
includes cash, government securities, and interest-earning loans (e.g., mortgages, letters of credit,
and inter-bank loans). Bank capital is one of the most basic financial figures used to gauge a
bank's financial strength and is often used in the calculation of more complex figures.
Bank capital can be considered a rough estimate of the value that the bank's owners
and/or investors can hope to recuperate if the bank liquidates its assets and use that money to pay
off its liabilities - the higher the bank capital, the more the owners and/or investors can
recuperate. Banks can earn profits through either lending or investing the cash deposited in them
by their clients. As such, banks possess a strong incentive not to hold onto deposits but, at the
same time, need to hold onto a sufficient percentage of deposits in order to keep enough cash on
hand to satisfy any withdraws made by their clients. Regulators also set capital requirements
designed to ensure that banks can keep operating despite market losses and thus prevent a run on
those same banks. Although bank capital is not used as a capital requirement itself, it is often
used to calculate such figures including what is called Tier 1 capital, a figure that represents a
bank's core financial strength.

BASIC OPERATIONS OF A COMMERCIAL BANK

Banks make profits through the process of asset transformation. They borrow short
(accept deposits) and lend long (make loans). When a bank takes in additional deposits, it gains
an equal amount of reserves; when it pays out deposits, it loses an equal amount of reserves.
Banks manage their assets to maximize profits by seeking the highest returns possible on loans
and securities while at the same time, trying to lower risk and making adequate provisions for
liquidity. Although liability management was once a staid affair, large banks now actively seek
out sources of funds by issuing liabilities such as negotiable CDs or by actively borrowing from
other banks and corporations.
When a depositor puts money in a checking account and the bank uses the money to
finance a loan, the bank has transformed a financial asset for a saver into a liability for a
borrower. Like other businesses, a bank takes inputs, adds value to them and delivers outputs.

To be successful, a bank must make prudent loans and investments so that it earns a high
enough interest rate to cover its costs and to make a profit. This plan may sound simple, but it
hasn’t been easy for banks to earn a profit in the past decade.

MANAGEMENT OF BANK ASSETS

To maximize its profits, a bank must simultaneously seek the highest returns possible on
loans and securities, reduce risk, and make adequate provision for liquidity by holding liquid
assets.
Banks try to accomplish these objectives by using the following strategy:
✔ Banks try to find borrower who will pay high interest rates and will most likely settle
their loans on time.
✔ Banks try to purchase securities with high returns and low risk.
✔ Banks manage the liquidity of the assets so that its reserve requirements can be met
without incurring huge costs.
MANAGEMENT OF BANK LIABILITIES
Before the 1960’s bank liability management involved
a. Heavy dependence on demand deposits as sources of bank funds, and
b. Non-reliance on overnight loans and borrowing from other banks to meet their reserve
needs
In the 60’s – large banks key financial centers such as New York, Chicago and San Francisco in
the United States, began to explore ways in which the liabilities on their balance sheets could
provide them with reserves on liquidity. Overnight loans market such as the federal funds market
in the United States expanded and new financial instruments enables banks to acquire funds
quickly.
Banks no longer depended on demand deposits as the primary source of bank funds. Instead they
aggressively set target goals for their asset growth and tried to acquire funds (by issuing
liabilities) as they were needed.
Hence, negotiable CDs and bank borrowings greatly increased in importance as a source of bank
funds in recent years. Demand deposits have decreased in importance as source of funds.

MANAGEMENT OF BANK CAPITAL

Banks manage the amount of capital they hold to prevent bank failure and to meet bank
capital requirements set by the regulatory authorities.
However, they do not want to hold too much capital because by doing so, they will lower
the returns to equity holders.
In determining the amounts of bank capital, managers must decide how much of the
increased safety that covers with higher capital (the benefit) they are willing to trade off against
the lower return on equity that comes with lower capital (the cost).
Because of the high costs of holding capital to satisfy the requirement by regulatory
authorities, bank managers often want to hold less capital required.

BANK CAPITAL AND BANK PROFIT

 As with other business, a bank’s profit is the difference between its revenue and its costs.
A bank’s revenue is earned primarily from interest on its securities and loans and from fees it
charges for credit and debit cards, servicing deposit accounts, providing financial advice and
wealth management services, originating and collecting payments on securitized loans, and
carrying out foreign exchange transactions. A bank’s costs are the interest it pays to its
depositors, the interest it pays on loan or other debt, and its costs of providing its services. A
bank’s net interest margin is the difference between the interest it receives on its securities and
loans and the interest it pays on deposits and debt, divided by the total value of its earning assets.
If we subtract the bank’s cost of providing its services from the fees it receives, divide by
the result by the bank’s total assets, and then add the bank’s net interest margin, we have an
expression for the bank’s total profit earned per peso of assets, which is called its return on
assets (ROA).
After −tax profit
ROA=
Bank assets

A bank’s shareholders own bank’s capital, which represents the value of their
investments – or – equity in the firm. Naturally, shareholders are more interested in the profit the
bank’s managers are able to earn on the shareholders’ investment than in the return on banks’
total assets. So, shareholders often judge bank managers not on the basis of ROA but on the basis
of return on equity (ROE).
After−tax profit
ROE=
Bank capital

ROA and ROE are related by the ratio of a bank’s assets to its capital:
After−tax profit
ROE=
Bank capital

Basis Return on Equity (ROE) Return on Assets(ROA)

Introduction Measures how much a business earns A measure to gauge how much
with respect to the amount of equity profit is generated by the business
put in the business. with the number of total assets
invested in the business.
Difference in A ratio that is calculated with net This ratio is measured with net
denominator income as the numerator and total income as a numerator and total
 equity as the denominator. assets as a denominator.
DU Point ROE is also calculated using du Pont No such measures applicable for
Analysis analysis, which helps to identify the calculation of ROA.
whether ROE has increased due net
profit margin or leverage or is it due
to an increase in asset turnover

Investors Only equity investors are considered ROA measures how much profit

for the calculation of ROE. is generated by the business with
the funds invested by the equity
shareholders preferred
shareholders, and also total debt
investment as the funds required
for the total assets is provided by
all these set of investors.
Adjustment For the calculation of ROE, it is not As the total asset is funded by
required to adjust the numerator of the both equity and debt holders, it is
ratio as the denominator is only required to add back interest
equity, not the combination of both expenses in the net income, which
debt and equity. As debt is not seats in the numerator of the ratio.
involved, interest need not be added
back in the numerator.
Table 1. Comparative Table https://www.wallstreetmojo.com/roe-vs-roa/

The ratio of assets to capital is one measure of bank leverage the inverse of which (the
ratio of capital to assets) is called a bank’s leverage ratio. Leverage is a measure of how much
debt an investor assumes in making an investment. The ration of assets to capital is a measure of
bank leverage because banks take on debt by, for instance, accepting deposits to gain funds to
accumulate assets.
Moral hazard can contribute to high bank leverage in two ways. First, bank managers are
typically compensated at least partly on the basis of their ability to provide shareholders with a
high ROE. So, to increase ROE, bank managers may make riskier investments. Deposits with
accounts below the deposits insurance limit do not suffer losses if their bank fails as a result of
the bank’s managers having taken on excessive risk. So, bank managers do not have to fear that
becoming more highly leverage will cause many depositors to withdraw their funds.
To deal with the risk of banks becoming too highly leveraged, government regulations
called capital requirements have place limits on the value of the assets commercial banks can
acquire relative to their capital. Expanded capital requirements, domestically and globally, were
an important regulatory response by governments to a financial crisis.

MANAGING BANK RISK

In addition to risks that banks may face from inadequate capital relative to their assets,
banks face several other types of risk. In this section, we examine how banks deal with the
following three types of risks: liquidity risk, credit risk, and interest-rate risk.

Managing Liquidity Risk

Liquidity Risk is the possibility that a bank may not be able to meet its cash needs by
selling assets or raising funds at a reasonable cost. For example, large deposit withdrawals might
force a bank to sell relatively illiquid securities and possibly suffer losses on the sales. The
challenge to the banks in managing liquidity risk to reduce their exposure to risk without
sacrificing too much profitability. For example, a bank can minimize liquidity risk by holding
fewer loans and securities and more reserves. Such as strategy reduces the bank’s profitability,
however, because the bank earns no interest on vault cash and only a low interest rate on its
reserve deposits with the Fed. So, although the low interest rate environment during the years
following the financial crisis caused many banks to hold amounts of excess reserves, more
typically banks reduce liquidity risk through strategies of asset management and liquidity
management.
It can also be managed through ensuring balance sheet earns a desired net interest
margin, without exposing the institution to undue risks from the interest rate volatility. Assess its
ability to meet its cash flow and collateral needs (under both normal and stressed conditions)
without having a negative impact on day-to-day operations or its overall financial position.
Lastly, mitigate that risk by developing strategies and taking appropriate actions designed to
ensure that necessary funds and collateral are available when needed.

Managing Credit Risk

Credit risk is the risk that the borrowers might default on their loans. One source of
credit risk is asymmetric information which often results in the problems of adverse selection
and moral hazard.
 ● Adverse Selection - this is the problem experienced in distinguishing low-risk
borrowers from high-risk borrowers before making an investment.
● Moral Hazard- this is the problem experienced in verifying that borrowers are using
their funds as intended.

Different Methods Banks Can Use to Manage Credit Risk:

A. Diversification Investors- whether individuals or financial firms- can reduce their exposure
to risk by diversifying their holdings. If banks lend too much to one borrower to one borrower, to
borrower in one region, or to borrowers in one industry, they are exposed to greater risks from
those loans. For example, a bank who granted most of its loans to oil exploration and drilling
firms in Texas would have likely suffered serious losses on those loans following the decline in
oil prices that began in June 2014 and lasted through January 2016. By diversifying across
borrowers, regions, and industries, banks can reduce their credit risk.

B. Credit-Risk Analysis- in performing credit-risk analysis, bank loan officers screen loan
applicants to eliminate potentially bad risks and to obtain a pool of credit worthy borrowers.
Individual borrowers usually must give loan officers information about their employment,
income, and net worth. Business borrowers supply information about their current and projected
profits and net worth. Banks often use credit-scoring systems to predict statistically whether a
borrower is likely to default or not. An example is a Person who has not had jobs in the past 5
years is considered to have poor job history and is likely to default on a loan.

C. Collateral- in order to reduce problems of adverse selection, banks generally require that a
borrower put up a collateral, or assets pledged to the bank in the event that the borrower defaults.
An example is once an entrepreneur needs bank loan to start a business, the bank will likely to
ask you to pledge some of your assets, such as your house, as collateral. In addition, the bank
might require you to maintain a compensating balance, a required minimum amount that the
business taking out the loan must maintain in a checking account with the lending bank.

D. Credit Rationing- in some circumstances, banks minimize the cost of adverse selection and
moral hazard through credit-rationing. Here, the bank either grants a borrower's loan application
but limits the size of the loan or simply declines to lend any amount to the borrower at the
current interest rate. It occurs in response to possible moral hazard. Limiting the size of bank
loans reduces costs of moral hazard by increasing the chance that the borrower will repay the
loan to maintain a sound credit rating.
E. Monitoring and Restrictive Covenant- to reduce the costs of moral hazard, banks monitor
borrowers to make sure they don't use the funds borrowed to pursue unauthorized, risky
activities. A restrictive loan covenant is simply a statement in the loan agreement between the
lender and borrower stating that the small business can and cannot do certain things while it is
paying on the bank loan.

F. Long-Term Business Relationships- the ability of banks to access credit risks on the basis of
private information on borrowers is called "relationship banking." One of the best ways for bank
to gather information about a borrower's prospects or to monitor a borrower's activities is
through a long-term business relationship.

Managing Interest-Rate Risk

Banks experience interest-rate risk if changes in market interest rates that cause the
bank's profit or its capital to fluctuate. The effect of a change in market interest rates on the value
of a bank's assets and liabilities is similar to the effect of a change in interest rates on bond
prices. That is, a rise in the market interest rate will lower the present value of a bank’s assets
and liabilities, and a fall in the market interest rate will raise the present value of bank’s assets
and liabilities. The effect of a change in interest rates on a bank's profit depends in part on the
extent to which the bank's assets and liabilities are variable rate or fixed rate.
Reducing Interest-Rate Risk
Bank managers can use a variety of strategies to reduce their exposure to interest-rate
risk. Banks with negative gaps can make more adjustable-rate or floating-rate loans. That way, if
market interest rates rise and banks must pay higher interest rates on deposits, they will also
receive higher interest rates on their loans. Unfortunately for banks, many loan customers are
reluctant to take out adjustable-rate loans because while the loans reduce the interest-rate risk
banks face, they increase the interest-rate risk borrowers face.
Banks can also use interest-rate swaps in which they agree to exchange or swap, the
payments from a fixed-rate loan for the payments on an adjustable-rate loan owned by a
corporation or another financial firm. Swaps allow banks to satisfy the demands of their loan
customers for fixed-rate loans while reducing exposure to interest-rate risk. Banks can also use
futures contracts and options contracts to help hedge interest-rate risk.

Sources:
Cabrera, Ma. E. B. and Cabrera, G. A., (2020) Financial Markets and Institutions, 2020
edition, GIC Enterprises,2017 C. M. Recto Avenue, Manila Philippines
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https://thismatter.com/money/banking/bank-balance-sheet.htm
https://www.investment-and-finance.net/banking/n/nontransaction-deposit#:~:text=A%20deposit
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Submitted by: Group 6 - 2BSA2

Sumiran, Ric
Anonuevo, Marie Therese E.
Bulan, Aira Kristell
Deluna, Kimberly