Chapter 13: ANSWERS TO "DO YOU KNOW" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. Approximately how many banks operate in the United States? Discuss trends in the number of banks versus the number of banking offices. What do these trends tell us about the future structure of the banking industry?
Solution: Thereareapproximately8,000banksintheU.S.Thenumberofbankshasbeendecliningfor the lastcenturywhilethenumberofofficeshasbeenincreasing.Theincreaseinthenumberofofficesisattributedtoanincreasednumberofbranchesperbank.Asregulatorygeographicrestrictionsarefurtherrelaxed,wewillseefurtherconsolidationintheindustry,whichmeansfewerbanks,butnotnecessarilyfewerbranches.
2. The interest rate on borrowed funds is usually higher than the interest rate on small time deposits. Given that, why do large banks continue to rely more heavily on borrowed funds as a source of funds?
Solution: The demand for loans at the largest institutions has outpaced the institutions’ ability to fund those loans with deposits. In addition, borrowed funds are a more flexible source of funds in that the funds can be raised quickly and retired quickly.
3. What are the major sources of bank funds? How do these differ between large and small banks?
Solution: The most important source of funds is deposits, which account for 67 percent of bank liabilities and capital. Deposits are much more important for small banks than large banks. Large banks get more of their funds directly from the money markets (borrowed funds) in the form of Fed Funds purchased and repurchase agreements.
4. How does the proportion of capital for a typical bank compare with that of a typical industrial firm? Do you believe banks have adequate capital? Why or why not?
Solution: Small banks use a higher proportion of capital than large banks, but in general banks are thinly capitalized compared to industrial firms. A typical bank is financed with only 9 percent capital and less for large banks. Most industrial firms are financed with 40 to 60 percent capital. Because most banks are prudently managed, invested in relatively safe, marketable assets, and highly regulated the amount of capital is probably adequate. Some bankers, however, would argue that the amount of capital required by regulation is excessive.
5. Why do you think that small banks are financed by a higher proportion of capital than large banks?
Solution: Large banks have direct access to the money markets, so equity is less important to them as a source of funds. Also, small banks tend to be managed more conservatively.
DO YOU UNDERSTAND?
1. Why do you think small banks have a higher proportion of assets in investments than do large banks?
Solution: Small banks rely more on secondary reserves for liquidity. Large banks are able to purchase liquidity directly in the money markets. Small banks, therefore, tend to have more assets invested in Treasury securities, which are safe and highly liquid and therefore provide a source of liquidity on the asset side of the balance sheet.
2. Describe a typical Fed Funds transaction. Why do you think small banks sell more Fed Funds as a proportion of total assets than large banks?
Solution: A Fed Funds transaction is basically an unsecured loan of excess reserves from one bank to another, usually for a period of one day. In general, small banks carry more excess reserves. Large banks carry fewer excess reserves because they have direct access to the money markets.
3. How does loan portfolio composition differ between large and small banks? Can you provide an explanation?
Solution: Large banks have a much higher proportion of commercial loans, which they compete for in a national market. Smaller banks tend to operate in more local markets and have more of a retail emphasis. Smaller banks tend to have a higher proportion of agriculture and real estate loans than large banks, which have more of a wholesale emphasis.
4. What factors go into setting the loan interest rate? Explain how each factor affects the rate.
Solution: The prime rate, the Federal Funds rate, a Treasury rate, or LIBOR will often serve as a banks base rate. It is expected to account for the bank’s administrative expenses and a fair return to the bank’s shareholders. Banks add or subtract from the base rate based on the borrower’s default risk and on whether the borrower has attractive borrowing alternatives. Next, an adjustment for the term of the loan is added. If the term structure of interest rates slopes upward, for example, banks would add a positive term adjustment to the base rate.
5. What customer characteristics do banks typically consider in evaluating consumer loan applications? How does each of these factors influence the decision of the bank to grant credit?
Solution: BankstypicallyusethefiveC’sofcredit:character(willingnesstopay),capacity(cashflow),capital(wealth),collateral(security),andconditions(economicconditions).Character,capacity,capital,andcollateralallhaveapositiveinfluenceonthebank’sdecision.Acustomer’ssensitivitytopooreconomicconditionsisanegativeinfluenceonthedecision.
DO YOU UNDERSTAND?
1. What are the main factors a bank must consider when setting the interest rate to offer on deposits?
Solution: There are two major factors. First, the bank must offer a high enough interest rate to attract and retain deposits. If deposit rates are too high, however, they squeeze the spread between the average return on assets and the average cost of liabilities. Second, to meet competition, banks not only have to lower rates charged on loans, but also have to increase rates on deposits. Bank managers should recognize that market forces ultimately determine deposit rates.
2. List and describe the major fee-based services offered by commercial banks.
Solution: Themajorfee-basedservicesarecorrespondentbanking,trustservices,investmentproducts,andinsuranceproducts.Correspondentbankingisthesaleofbankingservicestootherbanksornonbankfinancialinstitutions.Trustoperationsinvolvethebank’sactinginafiduciarycapacityforanindividualoralegalentity.Trusttypicallyinvolvesholdingandmanagingassetsforthebenefitofathirdparty.Theinvestmentandinsuranceproductssoldbybanksinvolvethesaleofbrokerageservices,mutualfunds,orannuitiesthroughaffiliatednonbankcompanies.
3. Discuss the uses of standby letters of credit (SLCs). What benefits do SLCs offer to a bank’s commercial customers?
Solution: In an SLC transaction, the bank acts as a third party in a commercial transaction between the bank’s customer and the beneficiary substituting the bank’s creditworthiness for that of its customer. Thus, if the bank’s customer fails to meet the terms and conditions of the commercial contract, the bank guarantees the performance of the contract as stipulated by the terms of the SLC.
4. What are the major reasons that banks sell loans?
Solution: First, to earn fee income for originating and servicing sold loans. Second, a bank may have a competitive advantage in booking certain types of loans and, therefore, can use the funds from loan sales to fund additionalsimilarloans.Third,loansalespermitbankstoinvestinanddiversify across a different set of loans than they originate and service. Finally, banks may sell loans to avoid burdensome regulatory taxes such as federal deposit premiums, foregone interest from holding required reserves, and mandatory capital requirements.
5. What are the major benefits to banks of securitization?
Solution: First, by selling rather than holding loans, banks reduce the amount of assets and liabilities, thereby reducing reserve requirements, capital requirements, and deposit insurance premiums. Second, securitization provides a source of funding loans that is less expensive than other sources. Finally, banks generate origination and loan servicing fees in the securitization process.