Chapter 03: Commercial Banking

Background of Commercial Banks

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Historically this is the most important institution around
the globe.
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In lesser developed financial systems, the other important
source of financing for business is equity.
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Commercial banks are major providers of liquidity to the
economy and the rest of the financial system.
 What is a Commercial Bank?

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A commercial bank is an institution that grants loans, accepts,
deposits, and offers basic financial products such as savings
accounts and certificate of deposit to business, as opposed to a
retail bank that provides similar financial products for individuals.
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A commercial bank makes money primarily by providing different
types of loans to customers and charging interest.
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The bank funds come from money deposited by the bank
customers in saving accounts, checking accounts, money market
accounts, and certificate of deposits.
 A. Functions of Commercial Banks

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Accepting Deposits
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Advancing Credit Facilities (short-term medium loans)
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Credit Creation (using cheques instead of cash)
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Agency Functions (collecting cheques and payments and
even trading shares, securities and debentures, and advisory
services for clients on buying and selling investments)
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Other Functions (buying and selling currency, custodian of
other valuables).
 B. Types of Loans Offered by Commercial Banks

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Bank Loan (loans with defined interest rate for a fixed
period)
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Cash Credit (the use of credit cards)
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Bank Overdraft
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Discounted bills of exchange
 C. Regulation by Central Banks

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Commercial banks are regulated by the central banks in
their respective countries. Central banks act as a
supervisor of commercial banks, and they impose certain
regulations to ensure bank operates with stipulated rules.
Commercial Banks Balance Sheet
 Commercial Banks and Payment Systems

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Commercial banks are the largest provider of payment
services.
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Traditionally payment instructions have taken the form of
paper check, with written instruction by the payer to the
bank to take funds and transfer it to the payee’s account.
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Payers using the Point of Sale system to submit payment
instructions.
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Internet and Mobile Banking
 The Payment System Infrastructure

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When both the payer and the payee have accounts with
the same bank, the transfer will be in-house accounting
operation.
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If both have different banks, there is a clearing house
system to transfer funds from different banks.
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As payment system has evolved, there is now an
automated clearing house especially on bulk payments.
 Credit and Stored Value Cards

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Credit card transaction involves an extension of credit to
pay for the goods or service that is bought.
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Stored value cards are cards with a certain maximum
amount that the holder can spend and should be only
used in specific stores.
 Payments Media in the Money Stock

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Clearly, balances in transaction accounts are related to overall transaction
activity in the economy, which in turn is related to the overall level of
economic activity and employment. For this reason, economists have long
regarded such accounts – and currency, also used for transactions – to be of
special interest. Indeed, one measure of the nation’s money stock – M1 – is
defined to include currency and transaction deposits.
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Some economists have argued that not only are transaction deposits related
to spending and the economy but certain other accounts too. This is
because funds can easily be moved from these other accounts to
transaction accounts to cover purchases. Accordingly, they advocate a
broader measure of the money stock – M2 – that includes other retail
deposits at commercial banks and other depository institutions.
Payments Media in Money Stock
 Velocity (Turn Over of Money)

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The figure above illustrates the relationship between M1 and M2 and
GDP. Shown are the velocities of M1 and M2 – the ratios of GDP to the
M1 and M2 measures of the money stock (top and bottom lines,
respectively). It represents the number of times the money stock turns
over each year for purchases of all final goods and services (GDP). If
the velocity of the money is stable – the public wishes to hold money in
proportion to its spending and income – then a change in the money
stock will translate into a proportionate change in GDP. If the country
wants a 3% increase in the GDP, this can be achieved through a 3%
increase in money stock. If velocity varies a good bit and cannot be
predicted easily, trying to stabilize the economy by controlling the money
stock would prove counterproductive.
 Cont. Velocity

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The deterioration of the relationship between the money
and stock and economic activity owes importantly to the
evolution of the financial system. Over recent decades,
financial institutions have provided the public with a wide
array of financial instruments having features similar to
those of components of the money stock. In response,
the public has substituted other financial instruments for
standard money balances, disrupting relationships
between measures of money and GDP.
 Liquidity Provision

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Commercial banks perform another important role in being
a provider of liquidity to the rest of the financial system and
to business and households.
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By liquidity, we mean providing readily available funds for
making payment, often on little or no notice.
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Financial institutions, ordinary businesses, and
households occasionally find themselves in situation in
which they need funds quickly to cover some unexpected
outlay.
 Liquidity Provision

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Business of all sizes rely on commercial bank lines of credit to
cover a variety of contingencies.
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Commercial banks providing liquidity must manage their balance
sheets carefully if they are going to be able to honor all customer
demands for funds.
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The balance sheet presented shows that many loan balances
are determined by customer discretion and cannot be controlled
or predicted by the bank. To minimize the risk banks should have
state-of-the-art information management system to meet these
shocks and skilled managers.
 Dealing with Asymmetric Information

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Commercial banks and other lending institutions have invested
considerable resources to develop the expertise to make loans.
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The bank will monitor the borrower to better ensure that the
borrower is making decisions that will enhance prospect of
repayment of the loan. In this way the bank can impose
discipline to the borrower.
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Usually, commercial banks prefer the borrower also be a
depositor or a user of other services. This is known as
relationship banking.
 Maturity Transportation

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This occurs when the bank receives funds in the form of deposits
having one maturity and uses these funds to make loans or acquire
investments having another maturity.
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These practices are risky for banks. The maturity mismatch exposes
the bank to interest rate risk. If market interest rates rise, the bank will
immediately begin to experience its interest cost on deposit rising, but
it will take a very long time before it can replace its low-yielding loans
mature before they can be replaced with loans having higher interest
rates causes the value of those long-term loans to drop. Meanwhile, it
is experiencing an adverse cash flow as its interest cost rise much
faster than its interest receipts.
 Maturity Transformation

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Because of such risk, commercial banks engage in only a
limited amount of maturity transformation. They use their
short-term deposits to make short-term loans or acquire
marketable securities that do not have very long maturities.
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If a bank were to have a significant interest rate mismatch,
it could cover its resulting interest rate risk exposure with
financial features or options contracts that provide
compensation to the bank if long-term interest rates rise,
which can offset the impact of rising interest costs.
 The Safety Regulations Policy

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Commercial banks and other depository institutions are among the most
heavily regulated business in our economy. In part; this is because they
are fiduciary institutions that hold much of the public’s wealth, and there
has been a long-standing desire to use public policy to protect their
customers – especially retail customers – by ensuring that these
institutions do not engage in fraudulent or excessively risky practices. In
addition, it has long been recognized that difficulties faced by one bank
can disrupt the payment system and in other ways spill over to other
banks, and even disrupt the entire economy. Today, we call this systemic
risk. Banking crises over our history – including the recent financial crisis
and Great Recession – are testimony to the power of such spillovers.
 The Safety Regulations Policy

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To limit the scope for disruption, public policy over time has developed a
so-called safety net for commercial banks. This is called the deposit
insurance under Philippine Deposit Insurance Corporation, where
businesses are insured up to P 250,000 to P 500,000 per depositor. The
purpose behind deposit insurance has been not only to protect retail
depositors from losses, but just as importantly to discourage them from
running on their banks. If depositors came to fear that they might not be
able to get all of their funds back, they would rush to withdraw their
funds back, they would rush to withdraw their funds ahead of others and
place unsustainable strains on their bank’s liquidity. This likely would
lead to a broader panic among depositors that spreads to all banks and
spills over to the economy.
 The Safety Regulation Policy

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In addition, commercial banks have access to the
discount window of the central bank – a second
component of the safety net. This is intended to enable
financially sound institutions that may be facing
temporary liquidity shortages to be able to get funds
instantly in the form of a loan from the central bank to
avoid having to suspend payments to depositors and
thereby trigger a broader financial panic.