Determinants of Interest Rates

1
Commercial Banks
2
Depository Institutions
3
Non Financial Firms
4
Commercial Banks vs. Savings Institutions and
Credit Unions

• Composition of assets and liabilities including
  non deposit sources of liabilities (subordinated
  notes and debentures)
• Breadth of loans (consumer, commercial,
  international and real estate)
• Separate regulations

5
Commercial Banks-Financial Statements

• Report of Condition- balance sheet of a
  commercial bank reporting information at a single
  point in time.
• Report of Income - income statement of a
  commercial bank reporting revenues, expenses, net
  profit or loss and cash dividends over a period
  of time.

6
Banks Report of Condition
7
Commercial Banks-Major Assets

• Loans and Leases- the majority of assets
• Reserve for loan and lease losses- a contra-asset
  account representing an estimate by the banks
  management of the of gross loans (and leases)
  that will have to be charged off due to future
  defaults. Additions to the reserve for loan and
  lease losses accounts (and in turn the the
  expense account provision for losses on loans
  and leases) to meet expected defaults reduce
  retained earnings and thus equity. Unexpected
  defaults (e.g. due to a sudden major recession)
  are meant to be written off against the remainder
  of the banks equity.
• Securities - interest bearing deposits with other
  FIs, Fed Funds sold, Repos, Treasuries and
  agencies, munis, mortgage backed securities, and
  other debt and equity securities.
• Cash and balance due from other depository
  institutions- vault cash, Fed deposits, cash in
  collection, deposits at other Fis (Cash at other
  banks is generally used to purchase services from
  Correspondent banks- banks that provide services
  to other banks.
• Other Assets- premises, fixed assets, other real
  estate, intangibles

8
Source FDIC
9
Commercial Banks-Major Liabilities

• Two major sources of funds
• 1. Deposits
• Transaction Accounts
• Demand Deposits- checkable deposits that bear no
  interest.
• NOW (Negotiable Order of Withdrawal) accounts-
  interest bearing checking accounts.
• Non-Transaction Accounts- savings, retail or
  small time deposits (usuallylt100k) and large
  time deposits (gt100k, primarily negotiable CDs).
• 2. Borrowed (purchased) funds and other
  liabilities -borrowings including purchases of
  Fed Funds, repos, notes and bonds, etc.

10
Commercial Banks-Equity

• Common and Preferred Stock
• Additional paid-in-capital
• Retained earnings
• Regulators require banks to hold a minimum level
  of equity capital to act as a buffer against
  losses. Banks tend to hold equity a min levels
  because of low cost of deposit funding.

11
Commercial Banks-Major Risks

• Credit or default risk
• Insolvency risk- because commercial banks are
  highly leveraged and therefore hold little
  equity, compared to total assets, even a
  relatively small amount of loan defaults can wipe
  out bank equity, leaving it insolvent.

12
Commercial Banks-Major Risks

• Duration mismatch - liabilities tend to be of
  shorter maturity than assets.
• Liquidity risk- liquid instruments are used to
  fund less liquid assets such as loans.
• Interest rate risk
• Maturity mismatch - borrowings coming due at
  times different from the cash flows from assets.

13
Commercial Banks- Off Balance Sheet Activities

• Activities are allowed to be taken off balance
  sheet when a contingent event triggers the
  asset/income or liability/expense.
• 5 Major Categories of Off Bal. Sheet Activities
• 1. Loan commitments- a contractual commitment by
  a FI to loan to a customer an amount at a given
  interest rate. Usually comes with an up-front
  fee (facility fee) and may have a back-end fee
  (or committed fee) on any unused commitment.
• 2. Commercial Letters of Credit and Standby
  Letters of Credit- the bank guarantee on payment
  for goods shipped or sold (commercial letters of
  credit) coverage of other non-traded related
  contingencies (standby letters of credit).

14
Commercial Banks- Off Balance Sheet Activities

• 5 Major Categories of Off Bal. Sheet Activities
  (cont.)
• 3. Forward purchases and sales of when issued
  securities - Fis (especially I banks) enter into
  forward or future commitments to buy or sell
  securities before issue.
• 4. Loans sold- loans sold to other investors that
  if sold with recourse can be returned to the
  originating institution if the credit quality
  deteriorates.
• 5. Derivative Contracts - futures, forwards,
  swaps and option positions taken by a bank for
  hedging and other purposes.

15
Reasons for Off Balance Sheet Activities

• Desire to earn additional fee income to
  complement declining margins or spreads on
  traditional lending.
• Avoidance of regulatory costs or taxes since
  reserve requirements and deposit insurance
  premiums are not levied on off balance sheet
  activities.
• Risk reduction or possibly risk increasing.

16
Source FDIC
17
Other Fee Generating Activities

• Trust Services- the trust departments of a
  commercial bank holds and manages assets for
  individuals or corporations.
• Correspondent banking- the provision of banking
  services to other banks that do not have the
  staff resources to perform the service
  themselves. Services might include check
  clearing, check collection, f/x trading, hedging
  services, participation in large loans etc.
  Payment on services is generally in the form of
  non-interest bearing deposits.

18
Bank Consolidation

• Easing regulatory restrictions- in the 80s and
  90s, regulators allowed banks to merge with other
  banks across state lines and brand banking across
  state lines has also eased.
• Economies of scale - the degree to which a firms
  average unit cost of producing fin. services fall
  as its output of services increases.
• Economies of scope - the degree to which firm can
  generate cost synergies by producing multiple
  fin. Services products.
• X Efficiencies- cost savings due to the greater
  managerial efficiency of the acquiring firm.

19
Income Statement - Report of Income

• Direct relationship between the balance sheet
  and report of income. The composition of an FIs
  assets and liabilities combined with the interest
  earned or paid, directly determines the interest
  income and expenses on the income statement
  (rather than reflecting sales and COGS).

20
Income Statement - Report of Income

• Interest income - first on the income statement.
  Recorded on an accrued basis. Interest past due
  can still be recorded as generating income until
  90 days after the due date. Interest from
  investment securities is also included.
• Interest expenses - 2nd major category.
  Determined directly by liabilities.
• Net interest income total interest income -
  total interest expense.

21
Income Statement - Report of Income

• Provision for loan losses - a non-cash tax
  deductible expense. The current periods
  allocation to the allowance for loan losses
  listed on the balance sheet.first on the income
  statement.
• Non-interest income - all other income from
  activities both on off bal. sheet.
• Total operating income (total revenue) - the sum
  of interest income and non-interest income.

22
Income Statement - Report of Income

• Non-interest expense -consists mainly of
  personnel expenses (generally large relative to
  non-interest income).
• Income before taxes and extraordinary items
  (operating profit) net interest income -
  provision for loan losses (non-interest income
  - non interest expense)
• Income Taxes
• Extraordinary income - events that are unusual or
  infrequent.
• Net income

23
Banks Report of Income
24
Source FDIC
25
Bank Types

• Community Banks - lt1B in asset size. Tend to
  specialize in retail or consumer banking (i.e.
  real estate or residential mortgage, consumer
  loans).
• Regional or Superregional Banks- a bank that
  engages in a complete array of wholesale banking
  activities. Including consumer and residential
  lending and CI loans. Usually have access to
  purchased funds such as Fed Funds.
• Money Center Banks - a bank that relies heavily
  on non-deposit or borrowed sources of funds.
  These are the very biggest banks and usually
  operate with no or few branches. Asset or
  lending size does not necessarily make a money
  center bank. Rather physical location and
  geographic area (foot print) distinguish money
  center banks.

26
Source FDIC
27
Source FDIC
28
Bank Regulators

• Federal Deposit Insurance Corporation (FDIC) -
  insures the deposits of commercial banks. Levies
  insurance premiums on banks, manages the deposit
  insurance fund and conducts bank examinations.
• The Office of the Comptroller of the Currency
  (OCC) - the oldest bank regulator (est. 1863). A
  sub agency of the US Treasury. Primary function
  is to charter national banks as well as to close
  them. Also approves (or disapproves) merger
  applications.
• Federal Reserve - regulates and examines bank
  holding Cos. as well as banks themselves.
• State Authorities - perform similar functions to
  the OCC but for state chartered commercial banks.

29
Source FDIC