14. commercial banks 14.1 what is the role of commercial banks and why do they exist?

1©Anthony Santomero (1998) and S. Christoffersen (1999)

14. Commercial Banks

14.1 What is the role of commercial banks and why do they exist?

• Banks act as middlemen between borrowers and lenders.

• Theory suggests that banks continue to exist because of informational asymmetries between borrowers or lenders. Banks have information on a group of borrowers and lenders from their existing loans and deposit base.

• Banks are able to profit from this information because they are better able to locate good investments.

• Society benefits from the information provided by banks if banks can better distinguish good and bad loans. Good projects are distinguished from bad ones and are more easily able to raise capital in the markets.


14.2 What makes commercial banks special?

• Commercial banks are the main conduit for money dispersion and a payments system in Canada.

• Economic stability depends on a well-functioning system of institutions.

• The value of commercial banks is reflected by the special Charter given to Commercial banks from the Bank of Canada that limited direct participation in payments system.

• The guarantees provided by the FDIC and the CDIC (Federal and Canadian deposit insurance companies) also distinguish commercial banks from investment banks, mutual funds, and insurance companies.

• Because of the importance of banks, regulation is very burdensome. Banks are restricted from investing in risky assets such as corporate equity, and real estate (aside from their own). Commercial banks are also required to keep a regulated amount of capital allocated to the risky aspects of its portfolio.

• Until 1934, Canadian banks issued their own currency.


14.3 Liabilities

• Liabilities are very short term and highly liquid, especially compared to the assets carried by the bank. This results in potential duration mismatching and leaves the bank susceptible to bank runs.

• Transaction accounts are checking, NOW (Negotiable Orders of Withdrawal), demand deposits for businesses, and debit cards

• Non-Transaction accounts are savings and time accounts, money market accounts and CDs.

• All deposits are guaranteed up to US$100,000 by the FDIC and CDN$60,000 by the CDIC.

• Borrowings include fed funds, REPOs, Floating Rate Notes, and discount loans from the Fed.

• Equity capital is regulated and under the Banking of International Settlements Basle Accord, a bank must have at least 8% of risk-weighted assets in equity capital. Equity capital includes common and preferred stock, retained earnings, and loan loss provisions.


14.4 Assets• The amount of cash held by the commercial banks is also regulated and

referred to as required reserves. Required reserves must be in one of two forms: (1) Vault Cash or (2) Clearing account at the Fed.

• The amount of reserves is determined by the structure of the liabilities. 3% must be set aside for the first $52 million in liabilities. 10% must be set aside for liabilities above $52 million. In Canada, the reserve requirement is approximately 10%.

• Required reserves are a tax for banks because no income is earned on them.

• Banks often invest in securities backed by the Fed, agencies, states, and Bank of Canada. All of these issuers tend to have better ratings than the banks. If this is the case, the returns on the assets are less than the cost of the liabilities, does this make sense?

• Loans account for almost 65% of a bank’s assets. These are very illiquid. Include mortgage lending, personal loans, and credit card loans.

• Other assets include the physical property of the bank.


14.5 Banking Balance Sheet

Assets Liabilities

Deposits 63%

Transaction (18%)

Non-Transaction (45%)

Borrowings 16.2%

Foreign Offices 6.2%

Other 5.3%

Total Equity 8.8%

Cash 5.3%

Securities

US government 17%

Other 6.6%

Loans

Interbank 4.8%

Commercial 17.1%

Real Estate 25.8%

Individual11.8%

Other 5.6%

Other (Physical Building) 5.5%


14.6 Why regulate?

• Financial stability of institutions is necessary for economic stability so regulation is meant to ensure this.

• Financial institutions have an enormous amount of personal information which could be misused if not regulated

• Want to ensure competitive pricing for consumers

• Control the risks taken by banks

• Deposit taking institutions are susceptible to banking panics because of the short-term nature of their liabilities and the long-term nature of their assets.


14.7 What is a Banking Panic?

• A bank panic results from a massive withdraw of deposits because of depositors are uncertain there is enough asset value to pay everyone. As a depositor you don’t want to be the one at the end of the line because you risk not being paid.

• Even if depositors cannot completely verify whether assets have decreased in value below the outstanding deposits, the fear of not getting your money is enough to cause a panic.

• Do you think transparency would help prevent or promote banking panics?

• Could a panic happen to a mutual fund?

• What measures could the bank impose to prevent a banking panic?

• What characteristics about a bank result in a banking panic?

• Does a bank have to be insolvent for there to be a banking panic?


14.8 Getting around Regulation

• The trend in banking has been to find ways around the regulation to improve profitability. Competition from other institutions has reduced the profitability of banks especially when they face strong There are two main problems commercial banks are trying to avoid:

(1) Limitations on the businesses that banks can participate in

(2) Assets that need capital backing

• The solutions that banks have taken in these cases is

(1) In the US, Bank Holding Companies were established with many subsidiaries that provided access to various businesses. In Canada, Schedule 1 banks are prohibited from forming Bank Holding Companies but Canadian banks can partake in underwriting.

(2) Move fee-based income off the balance sheet


14.9 Organization of Banks in the US

• In 1933, the Glass-Steagall Act legally separated commercial and investment banks in the US. This strictly prevented commercial banks from underwriting.

QUESTION: Why would the regulators want to make it illegal for commercial banks to underwrite new companies?

• The Glass-Steagall Act has slowly been eroded by loopholes. The biggest loophole is the ability for banks to form Bank Holding Companies with subsidiaries. One subsidiary, a Section 20 subsidiary, can partake in underwriting practices. The Section 20 Subsidiary can underwrite CP, MBS, and municipal revenue.

• Firewalls separate the Section 20 Sub and the lending activities of the institution. A firewall is a legal barrier separating the activities of a bank from those of its subsidiaries.


14.10 Organization of Banks in Canada

• In Canada, there is no law like the Glass-Steagall Act. However, Canada’s regulatory environment is characterized by four pillars-- banks, trusts, insurance companies, and securities dealers. Each pillar is regulated differently and traditionally the four pillars didn’t mix.

• Canadian banks cannot distribute insurance products through their branches and they cannot provide leases on vehicles. The MacKay report discusses the allowance of banks into these areas.

• Schedule I banks cannot form Bank Holding Companies as in the US. Why have Canadian regulators been reluctant to allow Bank Holding Companies?

• Although Canadian banks can underwrite securities, the institutions enforce Chinese Walls between the underwriting and lending practices of the bank. Chinese Walls are internally imposed barrier within an organization that limits the flow of confidential client information among departments or areas.


14.11 Off-Balance Sheet Activities

• OBS activities are a method to earn fees without having to claim them on the balance sheet as an asset where the bank is required to hold 8% of the asset in capital.

• OBS activities include:

Forward Rate Agreements

Stand-by letters of Credit

Revolving Credit (type of loan commitment)

Underwriting

Advisory Services

Investment Management Services

Brokerage Services

NIFs

• OBS was often risky and not regulated like the regular business of the bank. Recent regulatory measures have tried to improve the regulation of OBS activities.

• Traditional measures of the well-being of bank, such as Return on Assets, is not a good measure of profitability because of OBS.


14.12 Regulation in the US

• State and National banks

• State banks are controlled by the Superintendent of Banks

• National banks are controlled by the Comptroller of the Currency.

• All national banks are part of the Federal Reserve System. State banks can choose to be part of the Federal Reserve System.

• Most banks in the US are traditionally state banks since they have been prohibited from crossing state lines. These barriers are eroding as US banks nationalize.

• FDIC (Federal Deposit Insurance Company) introduced in 1933. Each bank pays premiums to FDIC for the insurance it offers on deposits.


14.13.1 Regulation in Canada: OSFI and CDIC (Source: MacKay Report)

• Provincial and federal banks.

• Provinces have no explicit regulatory power over federal banks. Each province has exclusive jurisdiction over local credit unions and caisses populaires.* Each province has a superintendent of deposit-taking institutions and a superintendent of insurance and securities commission.

• Federal banks are controlled by the federal Office of the Superintendent of Financial Institutions (OSFI). This office was established in 1987 as a result of the Estey Report. It replaced a tripartite system of the Inspector General of Banks, external auditors, and the Minister of Finance.

• All banks (8 Schedule 1 and 50 Schedule 2) are incorporated federally and are regulated by OSFI. There are 59 trust and loan institutions that are federally incorporated and 25 provincially incorporated trust and loan institutions.

• CDIC established in 1967. Each member institution pays premiums. Why do you think CDIC was so late in being established compared to the US?


14.14 Regulation in Canada: The Bank of Canada (Source: MacKay Report)

• Bank of Canada was established in 1934 as a private institution and owned by federal government since 1938.

• The Bank of Canada is run independently of the federal government. Why?

• Mandate of the Bank of Canada:

Regulates the supply of credit and currency

Control and protect the Canadian Dollar

Minimizes fluctuations in production, trade, prices, and employment

Promote economic and financial well-being of Canada

• The Bank of Canada can insist OSFI inspect any financial institution. The Bank can also ask for any information it needs.

• The Minister of Finance also has regulatory powers.


14.15 International Regulation

• Bank for International Settlements (BIS) is a worldwide regulator of banking activity occurring over borders.

• Within BIS, the Basle Committee on Banking Supervision provides broad-based framework for banking regulation. Its principals are adopted across many countries in consolidated efforts to improve global financial stability.

• Basle Committee on Banking Supervision was established by the Central Banks of the G-10 countries in 1975. It consists of senior representatives from the central banks in each of these countries.

• 25 core principles that govern banking regulation around the world

Preconditions for effective supervision (Principle 1), Licensing and structure (Principle 2-5), Prudential regulations and requirements (Principle 6-15), Methods of ongoing banking supervision (Principle 16-20), Information Requirements of Banking Organization (Principle 21), Formal powers of supervision (Principle 22), Cross-border banking (Principle 23-25)


14.16.1 Risk-Based Capital Standards to Control Risk

• Prevention of banking panics is one of the reasons regulators are concerned about the risk-taking of institutions

• All bank’s must hold 8 percent of their risk-based assets in capital. At least 4 percent of their risk-based capital is Tier 1 capital while the remaining 4 percent can be Tier 2 capital.

• Tier 1 capital includes common stock, noncumulative preferred stock, and minor interests in consolidated subsidiaries.

• Tier 2 capital includes cumulative preferred stock, subordinated debt, convertible debt, and loan loss provisions up to 1.25% of assets.

• Deduct capital allocated to subsidiaries so they do not double count

• Previously all assets, even cash, was considered risky and 8% of total asset value had to have capital. Off-balance sheet activities received zero weightings. What was flawed with this method of controlling risk?


14.16.2 Risk-Based Capital Standards to Control Risk:

Balance Sheet Items

• Now the FDIC and the CDIC places a higher risk weighting on riskier assets. The weights can be either 0, 20, 50, or 100%. Off-balance sheet activities are also risk weighted.

• Zero percent weight: Gold, cash from OECD central banks, claims guaranteed by OECD central governments, direct local currency of non-OECD countries if the the bank holds liabilities in that currency

• Twenty percent weight: Cash in collection, claims on depository institutions within the OECD, collateralized loans guaranteed by OECD government, general obligations backed by US government, securities of US Govt agencies, loans collateralized by cash within the bank, mutual funds invested in assets qualifying for the zero or 20% rating

• Fifty percent weight: loans secured by 1-4 family residential mortgages, mortgage-backed securities where the pool of mortgages meet the 1-4 family residential requirement, revenue bonds of OECD central governments, credit-equivalent amounts of interest-rate swaps and FX rate contracts


14.16.3 Risk-Based Capital Standards to Control Risk:

Off-Balance Sheet Items

• Regulators recognized off-balance sheet items were risky and should be accounted for in the risk assessment of the bank.

• To account for the risks, OBS activities are converted to credit-equivalent amounts and then assigned risk-weights. The conversion to credit-equivalent amounts looks at the total amounts that could be lost from the OBS activities and weights these to get credit-equivalent amount that are risk-weighted.

• Credit conversion factors are 20%, 50%, and 100%.

• 100% conversion: direct backing financial claims, bankers’ acceptances, forward rate agreements, securities lent

• 50% conversion: unused commitments with a maturity greater than one year, transaction-related contingencies

• 20% short-term, self-liquidating, trade-related contingencies


14.16.4 An Example of Risk-Based Capital

A bank has the following asset base. What is the risk-based capital required? What is the capital required with no risk-weightings?

10 mil of revenue obligations backed by California state

5 mil of cash held at the Bank of Canada

15 mil of 1-4 family mortgages

5 mil of revolving credit (2 mil used and 3 mil unused) backing a loan to a Russian bank for 5 years

5 mil of revolving credit (2 mil used and 3 mil unused) backing a loan to a French bank for 5 years

2 mil in loans backed by the UK


14.17 MacKay Report

• Resulted from large Schedule 1 Canadian banks interest in merging.

January 23, 1998 Royal Bank and Bank of Montreal announced their merger.

April 17, 1998 CIBC and TD announced their merger decision

• Evaluated Canadian financial institutions along four themes:

Enhancing competition and competitiveness

Empowering consumers

Canadians’ Expectations and Corporate conduct

Improving the Regulatory Framework


14.17.1 Issues Facing MacKay Task Force

• 10% widely held rule• Bank Holding Companies • Dissatisfied Canadians• Taxation of capital• Accounting of goodwill• Automobile leasing• Demutualization of insurance companies• Insurance distribution through commercial banks• Competition and the need for scale• Unfair protection of banks which was not available to insurance

companies CDIC vs. CompCorp.


14.18.1 Recommendations of MacKay Report:

Enhancing competition

• Strengthen existing participants

• Encourage new domestic participants

• Make it easier for foreign financial institutions to serve Canadians

• Empower consumers


14.18.2 Enhance Competitiveness

• Remove the accounting disadvantages faced by Canadian vs. US banks

• Eliminate or modify capital taxes

• Mergers should be reviewed by Competition Bureau, public interest review process, and the Minister of Finance

• Increase the 10% limit on ownership to 20% where no more than 45% can be owned by holders over 10%.

• Allow regulated Bank Holding Companies to exist


14.18.3 Empowering consumers

• Disclose fees and commissions allowing consumers to compare across institutions

• Make marketing and sales documents more uniform and easier to understand

• Banks are required to legally keep minimum privacy standards of personal information

• Ban tied selling

• Provide an Ombudsman office for financial institutions and internal ombudsman within each institution to act as a first recourse for consumers


14.18.4 MacKay Report: Canadian expectations and Corporate Conduct

• Make lending more available and affordable to high-risk borrowers

• Government annually review business financing in Canada

• Decentralize decision-making to local branches

• Improve access to institutions and employees should relay information to customers about what identification is needed for accounts and what the terms and conditions are

14.18.5 Improving the Regulatory Framework

• Add Board of Directors to OSFI• Transfer responsibilities from CDIC to OSFI• Eliminate overlap between federal and provincial jurisdictions• Integrate CDIC and CompCorp (life insurance protection plan run by the

industry)


14.19 Summary

• Outlined the basic structure of a commercial and the need for banks in our economy.

• The importance placed on financial institutions has lead to intense regulation in all countries as a means of stabilizing economic activity. Banking panics is one example why regulation has been so burdensome for these institutions.

• Sometimes the regulation resulted in added risk-taking by institutions owing to competitive pressure and the desire to remain profitable.

• Regulation in the industry occurs domestically and internationally.

• Canada faces a cross-roads in the structure of its financial institutions. The MacKay Report outline makes recommendations for desired changes.

14. commercial banks 14.1 what is the role of commercial banks and why do they exist?

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