Chapter 17
Commercial Bank Operations
Outline
Background on Commercial Banks
Bank Market Structure
Bank Sources of Funds
Transaction Deposits
Savings Deposits
Time Deposits
Money Market Deposit Accounts
Federal Funds Purchased
Borrowing from the Federal Reserve Banks
Repurchase Agreements
Eurodollar Borrowings
Bonds Issued by the Bank
Bank Capital
Distribution of Bank Sources of Funds
Uses of Funds by Banks
Cash
Bank Loans
Investment in Securities
Federal Funds Sold
Repurchase Agreements
Eurodollar Loans
Fixed Assets
Proprietary Trading
Summary of Bank Uses of Funds
Off-Balance Sheet Activities
Loan Commitments
Standby Letters of Credit
Forward Contracts on Currencies
Interest Rate Swap Contracts
Credit Default Swap Contracts
International Banking
International Expansion
Impact of the Euro on Global Competition
International Exposure
Chapter 17: Commercial Bank Operations ❖ 2
Key Concepts
1. Before discussing the chapter, emphasize the shift from a market orientation to a focus on particular
financial institutions.
2. Explain how each type of financial institution may now be part of a financial conglomerate.
3. Identify the main sources of bank funds, and elaborate where necessary.
4. Identify the main uses of bank funds, and elaborate where necessary.
POINT/COUNTER-POINT:
Should Banks Engage in Other Financial Services Besides Banking?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
Questions
1. Bank Balance Sheet. Create a balance sheet for a typical bank, showing its main liabilities (sources
of funds) and assets (uses of funds).
ANSWER:
Liabilities
7. Eurodollar borrowings
Assets
Chapter 17: Commercial Bank Operations ❖ 3
2. Bank Sources of Funds. What are four major sources of funds for banks? What alternatives does a
bank have if it needs temporary funds? What is the most common reason that banks issue bonds?
ANSWER:
4. Money market deposit accounts
Sources of temporary funds include:
Banks may issue bonds to purchase fixed assets.
3. CDs. Compare and contrast the retail CD and the negotiable CD.
4. Money Market Deposit Accounts. How does the money market deposit account differ from other
bank sources of funds?
5. Federal Funds. Define federal funds, federal funds market, and federal funds rate. Who sets the
federal funds rate? Why is the federal funds market more active on Wednesday?
6. Federal Funds Market. Explain the use of the federal funds market in facilitating bank operations.
7. Borrowing at the Federal Reserve. Describe the process of borrowing from the Federal Reserve.
What rate is charged, and who sets it? Why do banks commonly borrow in the federal funds market
rather than through the Federal Reserve?
8. Repurchase Agreements. How does the yield on a repurchase agreement differ from a loan in the
federal funds market? Why?
9. Bullet Loan. Explain the advantage of a bullet loan.
10. Bank Use of Funds. Why do banks invest in securities, even though loans typically generate a higher
return? How does a bank decide the appropriate percentage of funds that should be allocated to each
type of asset? Explain.
11. Bank Capital. Explain the dilemma faced by banks when determining the optimal amount of capital
to hold. A bank’s capital is less than 10 percent of its assets. How do you think this percentage would
compare to that of manufacturing corporations? How would you explain this difference?
Chapter 17: Commercial Bank Operations ❖ 6
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “Lower interest rates may reduce the size of banks.”
result of the withdrawals.
b. “Banks are no longer as limited when competing with other financial institutions for funds
targeted for the stock market.”
c. “If the demand for loans rises substantially, interest rates will adjust to ensure that commercial
banks can accommodate the demand.”
Managing in Financial Markets
As a consultant, you have been asked to assess a bank’s sources and uses of funds, and to offer
recommendations on how it can restructure its sources and uses of funds to improve its performance. This
bank has traditionally focused on attracting funds by offering certificates of deposit (CDs). It offers
checking accounts and money market deposit accounts (MMDAs), but it has not advertised these
accounts because it has obtained an adequate amount of funds from the CDs. It pays about 3 percentage
points more on its CDs than on its money market deposit accounts, but the bank prefers knowing the
precise length of time that it can use the deposited funds. (The CDs have a specified maturity whereas the
MMDAs do not.) Its cost of funds has historically been higher than that of most banks, but it has not been
concerned because its earnings have been relatively high. The bank’s use of funds has historically been
focused on local real estate loans to build shopping malls and apartment complexes. The real estate loans
have provided a very high return over the last several years. However, the demand for real estate in the
local area has slowed.
a. Should the bank continue to focus on attracting funds by offering CDs, or should it push its other
types of deposits?
Chapter 17: Commercial Bank Operations ❖ 7
b. Should the bank continue to focus on real estate loans? If the bank reduces its real estate loans,
where should the funds be allocated?
c. How will the potential return on the bank’s uses of funds be affected by your restructuring of the
asset portfolio? How will the cost of funds be affected by your restructuring of the bank
liabilities?
The potential return will likely be smaller because the interest rates on real estate loans are
Flow of Funds Exercise
Services Provided by Financial Conglomerates
Carson Company is attempting to compare the services offered by different banks, as it would like to have
all services provided by one bank.
a. Explain the different types of services provided by a financial conglomerate that may allow
Carson Company to obtain funds or to hedge its risk.
Carson may rely on financial conglomerates to issue bonds, issue stock, obtain loans, and trade
b. Review the services that you listed in the previous question. What services could provide
financing to Carson Company? What services could hedge Carson’s exposure to risk?
The underwriting and loan services provide financing. The derivative contracts can be used to