Commercial banks

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FINANCE UNIVERSITY UNDER THE GOVERNMENT

OF THE RUSSIAN FEDERATION

INTERNATIONAL FINANCE FACULTY

Department of Macroeconomics

Abstract

ON THE COURSE of

“Macroeconomics”

«Commercial banks»

Written by:

Zhirkova S.N.

Student of 2-3 group IFF

Approved by:

Orusova O.V.

Associate professor, PhD

Moscow 2013

Contents

Introduction

Chapter 1. The banking system

Part 1.1 Economic concepts in banking

Part 1.2 How banks make money

Chapter 2. Commercial banks

Part 2.1 Banking multiplier

Part 2.2 Equilibrium in money market

Part 2.3 Interest rate and it's role in economy

Conclusion

Introduction

Banking system - one of the most important and integral structures of the market economy. Development banks, commodity production and circulation was parallel and closely intertwined. The banks, conducting cash transactions, crediting the economy, acting as intermediaries in the redistribution of capital, significantly increase the overall efficiency, promote the growth of labor productivity.

The modern banking system - is the most important sector of the national economy of any developed country. Its practical role in the fact that it operates in the state system of payments and settlements; most of its business transactions are conducted through deposits, investments and credit transactions; along with other financial intermediaries direct public savings banks to businesses and industrial structures. Commercial banks in accordance with the monetary policy of the State to regulate cash flow, affecting the rate of turnover, emissions, total weight, including the amount of cash in circulation. Stabilisation of money supply growth - a key to reducing inflation, ensuring consistency in the price level at which the market economy affect the economy of the economy most effectively. The modern banking system - is an area of diverse services to its customers - from traditional deposit-loan and Cash transactions are determined based banking, to new forms of monetary and financial instruments used by banking institutions (leasing, factoring, trust, etc.).

Today, with the development of commodity and financial markets, the structure of the banking system becomes much more complicated. New types of financial institutions, the new credit facilities, tools, and methods of serving customers.

Chapter 1. The banking system

In order for any bank to survive without relying on liquidity measures like state intervention to salvage it, it must make profit from several sources. Commercial banks make their money from diverse schemes like investment, credit interest rates and the use of their own banking fees and for cards that they charge their customers.

By making a pool of the large capital base made up of cash deposits, a bank can be able to invest the money in the meantime in profitable schemes that have a financial implication in the bank and through advertising. Another most common standard of doing business by commercial banks is by charging interests on loans that can bring a large amount of profit ranging from a tenth of the amount lent to double the amount or more in certain long-term transactions. In special cases like loans that have a high risk value, especially those extended on an economically insecure basis, banks charge a high interest rate that will buffer the credit consequences in case of loss. In this manner a bank can make a high profit when external factors remain the same and the customer makes good his repayment.

Financial fees like those involved in opening of an account are some of the other means of making money for a bank. This is possible in a case where the commercial bank enjoys a large following which when other long term security measures are excluded has little effect on the custodial expenses that come with the deposit. Other charges include those contained in transfer fees and ATM fees for the city residents who have no access to the physical bank or are constrained by time to visit the real bank. Banks can also offer services of money transfer through cell phones by including service charges higher than normal rates in the telecommunication industry.

Part 1.1 Economic concepts in banking

Banks both create and issue money. While commercial banks no longer issue their own banknotes, they are effectively the distribution system for the notes printed, and the coins minted, by the U.S. Treasury. The Federal Reserve buys coins and paper money from the Treasury and distributes them through the banking system, as needed. Banks effectively buy currency from the Fed, or sell it back when they have excess amounts on hand. (To lean more, see How The Federal Reserve Was Formed.)

Every day there are millions of financial transactions in the United States, some conducted with paper currency, but many more done with checks, wire transfers and various types of electronic payments. Banks play an invaluable role in the settling of these payments, making sure that the proper accounts are credited or debited, in the proper amounts and with relatively little delay.

Banks play a major role as financial intermediaries. Banks collect money from depositors, essentially borrowing the money, and then simultaneously lend it out to other borrowers, forging a chain of debts. This is especially significant when asset values decline. As asset values decline, those assets are less able to service debt, which in turn makes it more difficult for borrowers to borrow, and reduces lending capacity. What follows, is a decrease in the flow of credit from savers to spenders and a decline in economic activity. At the same time, banks often find that they must raise capital, and their capital needs compete with those available savings.

Maturity transformation is part and parcel of what banks do on a daily basis. Many investors are willing to invest on a very short term basis, but many projects require long-term financial commitments. What banks do, then, is borrow short-term, in the form of demand deposits and short-term certificates of deposit, but lend long-term; mortgages, for instance, are frequently repaid over 30 years. By doing this, banks transform debts with very short maturities (deposits) into credits with very long maturities (loans), and collect the difference in the rates as profit. However, they are also exposed to the risk that short-term funding costs may rise much faster than they can recoup through lending.

One of the most vital roles of banks is in money creation. Importantly, money creation at the individual bank level is not the same thing as "printing money;" currency is just one type of money. Instead, banks create money through fractional reserve banking. Fractional reserve banking is a key concept to understanding modern banking and money creation.

Fractional reserve banking refers to the fact that banks keep only a small portion of their deposits on hand. When a customer comes into the bank and deposits $100, perhaps $10 of that will be kept on hand in the form of cash or easily-liquidated securities. The remaining $90 will be lent out to customers as loans, or used to acquire the stock or bonds of other companies. This phenomenon is known as the money multiplier and can be expressed as the formula: m = 1 / reserve requirement. If the reserve requirement is 10% (or 0.1), every dollar deposited with a bank, can become $10 of new money.

This is a key concept, because this is how banks increase the money supply and effectively create money. If banks simply acted as storehouses or vaults for money, there would be far less money available to lend.

Part 1.2 How banks make money

As mentioned before, banks basically make money by lending money at rates higher than the cost of the money they lend. More specifically, banks collect interest on loans and interest payments from the debt securities they own, and pay interest on deposits, CDs, and short-term borrowings. The difference is known as the "spread," or the net interest income, and when that net interest income is divided by the bank's earning assets, it is known as the net interest margin.

The largest source by far of funds for banks is deposits; money that account holders entrust to the bank for safekeeping and use in future transactions, as well as modest amounts of interest. Generally referred to as "core deposits," these are typically the checking and savings accounts that so many people currently have.

In most cases, these deposits have very short terms. While people will typically maintain accounts for years at a time with a particular bank, the customer reserves the right to withdraw the full amount at any time. Customers have the option to withdraw money upon demand and the balances are fully insured, up to $250,000, therefore, banks do not have to pay much for this money. Many banks pay no interest at all on checking account balances, or at least pay very little, and pay interest rates for savings accounts that are well below U.S. Treasury bond rates.

If a bank cannot attract a sufficient level of core deposits, that bank can turn to wholesale sources of funds. In many respects these wholesale funds are much like interbank CDs. There is nothing necessarily wrong with wholesale funds, but investors should consider what it says about a bank when it relies on this funding source. While some banks de-emphasize the branch-based deposit-gathering model, in favor of wholesale funding, heavy reliance on this source of capital can be a warning that a bank is not as competitive as its peers.

Investors should also note that the higher cost of wholesale funding means that a bank either has to settle for a narrower interest spread, and lower profits, or pursue higher yields from its lending and investing, which usually means taking on greater risk.

While deposits are the pimary source of loanable funds for almost every bank, shareholder equity is an important part of a bank's capital. Several important regulatory ratios are based upon the amount of shareholder capital a bank has and shareholder capital is, in many cases, the only capital that a bank knows will not disappear.

Common equity is straight forward. This is capital that the bank has raised by selling shares to outside investors. While banks, especially larger banks, do often pay dividends on their common shares, there is no requirement for them to do so.

Banks often issue preferred shares to raise capital. As this capital is expensive, and generally issued only in times of trouble, or to facilitate an acquisition, banks will often make these shares callable.This gives the bank the right to buy back the shares at a time when the capital position is stronger, and the bank no longer needs such expensive capital.

Equity capital is expensive, therefore, banks generally only issue shares when they need to raise funds for an acquisition, or when they need to repair their capital position, typically after a period of elevated bad loans. Apart from the initial capital raised to fund a new bank, banks do not typically issue equity in order to fund loans.

Banks will also raise capital through debt issuance. Banks most often use debt to smooth out the ups and downs in their funding needs, and will call upon sources like repurchase agreements or the Federal Home Loan Bank system, to access debt funding on a short term basis.

There is frankly nothing particularly unusual about bank-issued debt, and like regular corporations, bank bonds may be callable and/or convertible. Although debt is relatively common on bank balance sheets, it is not a critical source of capital for most banks. Although debt/equity ratios are typically over 100% in the banking sector, this is largely a function of the relatively low level of equity at most banks. Seen differently, debt is usually a much smaller percentage of total deposits or loans at most banks and is, accordingly, not a vital source of loanable funds.

For most banks, loans are the primary use of their funds and the principal way in which they earn income. Loans are typically made for fixed terms, at fixed rates and are typically secured with real property; often the property that the loan is going to be used to purchase. While banks will make loans with variable or adjustable interest rates and borrowers can often repay loans early, with little or no penalty, banks generally shy away from these kinds of loans, as it can be difficult to match them with appropriate funding sources.

Part and parcel of a bank's lending practices is its evaluation of the credit worthiness of a potential borrower and the ability to charge different rates of interest, based upon that evaluation. When considering a loan, banks will often evaluate the income, assets and debt of the prospective borrower, as well as the credit history of the borrower. The purpose of the loan is also a factor in the loan underwriting decision; loans taken out to purchase real property, such as homes, cars, inventory, etc., are generally considered less risky, as there is an underlying asset of some value that the bank can reclaim in the event of nonpayment.

As such, banks play an under-appreciated role in the economy. To some extent, bank loan officers decide which projects, and/or businesses, are worth pursuing and are deserving of capital.

Consumer lending makes up the bulk of North American bank lending, and of this, residential mortgages make up by far the largest share. Mortgages are used to buy residences and the homes themselves are often the security that collateralizes the loan. Mortgages are typically written for 30 year repayment periods and interest rates may be fixed, adjustable, or variable. Although a variety of more exotic mortgage products were offered during the U.S. housing bubble of the 2000s, many of the riskier products, including "pick-a-payment" mortgages and negative amortization loans, are much less common now.

Automobile lending is another significant category of secured lending for many banks. Compared to mortgage lending, auto loans are typically for shorter terms and higher rates. Banks face extensive competition in auto lending from other financial institutions, like captive auto financing operations run by automobile manufacturers and dealers.

Prior to the collapse of the housing bubble, home equity lending was a fast-growing segment of consumer lending for many banks. Home equity lending basically involves lending money to consumers, for whatever purposes they wish, with the equity in their home, that is, the difference between the appraised value of the home and any outstanding mortgage, as the collateral.

As the cost of post-secondary education continues to rise, more and more students find that they have to take out loans to pay for their education. Accordingly, student lending has been a growth market for many banks. Student lending is typically unsecured and there are three primary types of student loans in the United States: federally sponsored subsidized loans, where the federal government pays the interest while the student is in school, federally sponsored unsubsidized loans and private loans.

Credit cards are another significant lending type and an interesting case. Credit cards are, in essence, personal lines of credit that can be drawn down at any time. While Visa and MasterCardare well-known names in credit cards, they do not actually underwrite any of the lending. Visa and MasterCard simply run the proprietary networks through which money (debits and credits) is moved around between the shopper's bank and the merchant's bank, after a transaction.

Not all banks engage in credit card lending and the rates of default are traditionally much higher than in mortgage lending or other types of secured lending. That said, credit card lending delivers lucrative fees for banks: Interchange fees charged to merchants for accepting the card and entering into the transaction, late-payment fees, currency exchange, over-the-limit and other fees for the card user, as well as elevated rates on the balances that credit card users carry, from one month to the next.

In the Money Market, to make a profit is simply buying and selling of money and short term securities which is also called borrowing and investing. So, to make a profit, banks will borrow funds (accept deposits, buy money) at a lower interest rate than it will lend funds (sell money). The difference in the interest rates is the profit made by banks.

Chapter 2. Commercial banks

Part 2.1 Banking multiplier

Deposit multipliers are a strategy that is applied when it is necessary to identify the amount of money that is created in the money supply of a bank. The resulting figure helps to ensure that the bank is maintaining at least the minimum amount of funds on hand to comply with any government regulations regarding the operation of the institution. Calculating the deposit multiplier also helps the bank to know what surplus or excess funds are on hand to make loans to individuals and businesses.

To arrive at the deposit multiplier, it is important to know the current status of bank reserves as well as the deposits on hand. By determining the ratio between the reserves and the deposits, it is possible to arrive at the current reserve ratio that will apply in the current economic situation. The deposit multiplier is normally considered to be roughly one-fourth of the calculated reserve ratio, although the exact ratio will fluctuate as economic conditions change.

In the United States, regulations regarding the function of financial institutions make it necessary for the banks in the Federal Reserve System to operate with the function of a deposit multiplier. Other banking institutions in the country also function within these same guidelines. The benefit to this arrangement is that the banks maintain enough resources on hand to provide services to their customers and be able to write new loans and mortgages as a means of generating more revenue.

Part 2.2 Equilibrium in money market

In deciding how much money to hold, people make a choice about how to hold their wealth. How much wealth shall be held as money and how much as other assets? For a given amount of wealth, the answer to this question will depend on the relative costs and benefits of holding money versus other assets. The demand for money is the relationship between the quantity of money people want to hold and the factors that determine that quantity.

To simplify our analysis, we will assume there are only two ways to hold wealth: as money in a checking account, or as funds in a bond market mutual fund that purchases long-term bonds on behalf of its subscribers. A bond fund is not money. Some money deposits earn interest, but the return on these accounts is generally lower than what could be obtained in a bond fund. The advantage of checking accounts is that they are highly liquid and can thus be spent easily. We will think of the demand for money as a curve that represents the outcomes of choices between the greater liquidity of money deposits and the higher interest rates that can be earned by holding a bond fund. The difference between the interest rates paid on money deposits and the interest return available from bonds is the cost of holding money.

The supply curve of money shows the relationship between the quantity of money supplied and the market interest rate, all other determinants of supply unchanged. We have learned that the Fed, through its open-market operations, determines the total quantity of reserves in the banking system. We shall assume that banks increase the money supply in fixed proportion to their reserves. Because the quantity of reserves is determined by Federal Reserve policy, we draw the supply curve of money in Figure 10.9, “The Supply Curve of Money” as a vertical line, determined by the Fed's monetary policies. In drawing the supply curve of money as a vertical line, we are assuming the money supply does not depend on the interest rate. Changing the quantity of reserves and hence the money supply is an example of monetary policy.

The money market is the interaction among institutions through which money is supplied to individuals, firms, and other institutions that demand money. Money market equilibrium occurs at the interest rate at which the quantity of money demanded is equal to the quantity of money supplied. Figure 1, “Money Market Equilibrium” combines demand and supply curves for money to illustrate equilibrium in the market for money. With a stock of money (M), the equilibrium interest rate is r.

Figure 1. Money Market Equilibrium

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The market for money is in equilibrium if the quantity of money demanded is equal to the quantity of money supplied. Here, equilibrium occurs at interest rate r.

Part 2.3 Interest rate and it's role in economy

Interest rates are one of the major drivers of our economy, setting the pace for investment markets. Learning how interest rate changes can influence the marketplace can also help you understand how they impact your wallet.

The role of determining certain interest rates belongs to the Federal Reserve Board (also known as the “Fed”), an independent central banking organization created by Congress in 1913 to direct the nation's monetary policy. The Fed mainly consists of three parts: a Board of Governors, 12 Federal Reserve Banks and the Federal Open Market Committee (FOMC).The Fed has the power to set two important short-term interest rates:

· The Discount Rate. The rate the Fed charges to lend money to large, eligible banks.

· The Federal Funds Rate. The rate large banks charge to lend reserves to other banks that need short-term funds. This rate may change on a daily basis in response to market activity; however, the FOMC has the ability to target a specific rate.

As the Fed raises or lowers short-term interest rates, banks may raise or lower the interest rates they charge borrowers, including the prime rate. Changes in the prime rate may affect:

· You individually. Banks use the prime rate to set rates for credit cards and consumer loans. If you have an adjustable-rate mortgage or a credit card that has a rate tied to the prime rate, payments may rise or fall according to the prime rate.

· The whole economy. A change in the prime rate may affect the overall economy in several ways. For example, an increase may result in fewer consumers taking auto loans, which in turn may cause a slowdown in the automobile industry. On the other hand, when interest rates fall, businesses find it easier to finance expansion and other activities. Typically, increases in interest rates slow economic growth because consumers have less money to spend and less motivation to borrow. Conversely, if interest rates drop, the economy may benefit from increased spending.

It's also important to note that generally, as interest rates rise, the value of your investments (particularly bond investments) may decrease. This is known as interest rate risk. While all types of bonds are subject to interest rate risk, you may reduce the risk somewhat by choosing a fund that holds bonds of a shorter duration or average maturity.

Conclusion

Banking systems have been with us for as long as people have been using money. Banks and other financial institutions provide security for individuals, businesses and governments, alike. Let's recap what has been learned with this tutorial:

In general, what banks do is pretty easy to figure out. For the average person banks accept deposits, make loans, provide a safe place for money and valuables, and act as payment agents between merchants and banks.

Banks are quite important to the economy and are involved in such economic activities as issuing money, settling payments, credit intermediation, maturity transformation and money creation in the form of fractional reserve banking.

To make money, banks use deposits and whole sale deposits, share equity and fees and interest from debt, loans and consumer lending, such as credit cards and bank fees.

In addition to fees and loans, banks are also involved in various other types of lending and operations including, buy/hold securities, non-interest income, insurance and leasing and payment treasury services.

History has proven banks to be vulnerable to many risks, however, including credit, liquidity, market, operating, interesting rate and legal risks. Many global crises have been the result of such vulnerabilities and this has led to the strict regulation of state and national banks.

To sum up, we can definitely conclude that the commercial banks are now - the main part of the credit and financial system of any country. They occupy a dominant position in the market of loan capital. The scope of their activities in the developed economies are enormous. This gives an idea of the flow of funds statistics, passing through commercial banks.

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