Chapter 17
Commercial Bank Operations
Outline
Background on Commercial Banks
Bank Market Structure
Bank Sources of Funds
Transaction Deposits
Savings Deposits
Time Deposits
Uses of Funds by Banks
Cash
Bank Loans
Investment in Securities
Off-Balance Sheet Activities
Loan Commitments
International Banking
International Expansion
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.
POINT/COUNTER-POINT:
Should Banks Engage in Other Financial Services Besides Banking?
POINT: No. Banks should focus on what they do best.
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
ANSWER: Many banks have expanded their services by acquiring other types of financial institutions
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
1. Transaction deposits
2. Savings deposits
7. Eurodollar borrowings
Assets
1. Cash
2. Loans
3. Investment securities
Chapter 17: Commercial Bank Operations ❖ 3
2. Bank Sources of Funds. What are four major sources of funds for banks? Which alternatives does a
bank have if it needs temporary funds? What is the most common reason that banks issue bonds?
ANSWER:
1. Transaction deposits
Sources of temporary funds include:
1. Federal funds market
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 for banks?
5. Federal Funds. Define federal funds, the federal funds market, and the federal funds rate. Who sets
the federal funds rate? Why is the federal funds market more active on Wednesday?
ANSWER: Federal funds are loaned in the federal funds market from one bank (or other depository
institution) to another at an interest rate known as the federal funds rate.
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6. Federal Funds Market. Explain the use of the federal funds market in facilitating bank operations.
ANSWER: The federal funds market is used by depository institutions that experience a temporary
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?
ANSWER: “Borrowing at the discount window” represents the borrowing by depository institutions
8. Repurchase Agreements. How does the yield on a repurchase agreement differ from a loan in the
federal funds market? Why?
ANSWER: Repo rates are usually slightly lower than federal fund rates because a repo is backed by
securities.
9. Bullet Loan. Explain the advantage of a bullet loan.
ANSWER: A bullet loan represents a loan whose principal is paid off in one lump sum. That is, a
10. Banks’ 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.
ANSWER: Securities provide a bank with liquidity, because they can often be sold easily in the
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?
ANSWER: Banks may prefer a low level of capital because they can possibly achieve a higher return
Chapter 17: Commercial Bank Operations ❖ 5
12. HLTs. Would you expect a bank to charge a higher rate on a term loan or a highly leveraged
transaction (HLT) loan? Why?
13. Credit Crisis. Explain how some mortgage operations by some commercial banks (along with other
financial institutions) played a major role in instigating the credit crisis that began in 2008.
ANSWER: There were many defaults on subprime mortgages. Banks and other financial institutions
14. Bank Use of Credit Default Swaps. Explain how banks use credit default swaps.
ANSWER: Some commercial banks and other financial institutions buy credit default swaps in order
CRITICAL THINKING QUESTION
Bank Operations During the Credit Crisis. During the credit crisis in the 2008-2009 period, banks
were criticized for restricting their credit. Write a short essay to explain why you think banks should or
should not be allowed to restrict their credit during the credit crisis.
ANSWER
Before the crisis, many banks extended their credit too far, which is why they were heavily exposed to
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.”
Lower interest rates are beneficial because they can increase the spread between the interest
b. “Banks are no longer as limited when competing with other financial institutions for funds
targeted for the stock market.”
A bank’s traditional services do not include investing funds for individuals in the stock market.
c. “If the demand for loans rises substantially, interest rates will adjust to ensure that commercial
banks can accommodate the demand.”
If loan demand rises, interest rates on deposits and loans will increase. Thus, the high deposit
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
a. Should the bank continue to focus on attracting funds by offering CDs, or should it push its other
types of deposits?
It should push its checking accounts and its MMDAs. While the bank does not know the precise
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?
The bank should not focus on real estate loans, because the loan portfolio will be affected by a
decline in the real estate market. Many loan defaults could occur at once. The real estate loans
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 how a bank and its financial service subsidiaries can help Carson Company obtain
funding so as to expand its business.
Carson may rely on a bank for loans, and it can rely on its securities subsidiaries to help it issue
b. Explain how a bank and its financial service subsidiaries can help Carson Company hedge its
exposure to risk.
The bank and its subsidiaries can execute transactions in financial futures that may hedge