🏦Financial Institutions and Markets Unit 3 – Commercial Banking and Bank Management

Key Concepts and Definitions

• Commercial banks financial institutions that accept deposits, make loans, and provide various financial services to individuals and businesses
• Balance sheet financial statement that lists a bank's assets, liabilities, and equity at a specific point in time
• Assets items of value owned by a bank, such as loans, securities, and cash
• Liabilities obligations or debts owed by a bank, including customer deposits and borrowed funds
• Equity represents the bank's net worth, calculated as total assets minus total liabilities
• Net interest margin (NIM) measures the difference between interest income earned on assets and interest expenses paid on liabilities, expressed as a percentage of average earning assets
• Return on assets (ROA) measures a bank's profitability relative to its total assets, calculated as net income divided by average total assets
• Return on equity (ROE) measures a bank's profitability relative to its shareholders' equity, calculated as net income divided by average shareholders' equity

Evolution of Commercial Banking

• Early banking systems emerged in ancient civilizations (Mesopotamia, Greece, Rome) to facilitate trade and commerce
• Medieval banking developed in Europe during the 12th and 13th centuries, with prominent banking families (Medici, Fugger) establishing international networks
• Fractional reserve banking allowed banks to lend out a portion of their deposits, leading to the creation of new money and credit in the economy
• Central banks were established in the 17th and 18th centuries to regulate the money supply, maintain financial stability, and serve as lenders of last resort (Bank of England, 1694)
• Modern commercial banking expanded rapidly in the 19th and 20th centuries, with the rise of joint-stock banks, branch banking, and international banking networks
  • Joint-stock banks are owned by shareholders and can raise capital through the issuance of stock
  • Branch banking involves a bank operating multiple locations to serve a wider customer base
• Technological advancements (ATMs, online banking, mobile banking) have transformed the delivery of banking services and increased accessibility for customers

Types of Commercial Banks

• Retail banks focus on serving individual customers and small businesses, offering products such as checking and savings accounts, personal loans, and mortgages
• Corporate banks cater to the financial needs of large corporations and institutions, providing services such as commercial lending, cash management, and investment banking
• Investment banks specialize in capital markets activities, including underwriting securities, facilitating mergers and acquisitions, and providing financial advisory services
• Private banks offer personalized financial services and wealth management solutions to high-net-worth individuals and families
• Digital banks operate primarily online, leveraging technology to provide banking services with lower overhead costs and increased convenience for customers
• Community banks are locally owned and operated, focusing on serving the financial needs of a specific geographic area or community
• Credit unions are member-owned financial cooperatives that provide banking services to their members, often with a focus on a particular group (employees, union members)

Bank Balance Sheet Structure

• Assets are listed on the left side of the balance sheet and represent the resources controlled by the bank
  • Cash and cash equivalents include physical currency, balances held at other banks, and short-term investments
  • Securities are financial instruments (government bonds, corporate bonds, mortgage-backed securities) held by the bank for investment purposes or to meet liquidity requirements
  • Loans are the primary earning assets for most banks, generating interest income
    • Loan types include commercial loans, consumer loans, and real estate loans
• Liabilities are listed on the right side of the balance sheet and represent the bank's obligations to depositors and creditors
  • Deposits are funds placed with the bank by customers, including checking accounts, savings accounts, and time deposits (certificates of deposit)
  • Borrowed funds include short-term and long-term debt obligations, such as interbank loans, repurchase agreements, and subordinated debt
• Equity represents the residual interest in the bank's assets after deducting liabilities
  • Common stock represents ownership shares in the bank
  • Retained earnings are the accumulated profits not distributed to shareholders as dividends

Bank Income Sources and Profitability

• Net interest income is the primary source of revenue for most banks, generated by the difference between interest earned on assets (loans, securities) and interest paid on liabilities (deposits, borrowed funds)
• Non-interest income includes fees and commissions earned from various services, such as account maintenance, transaction processing, and wealth management
• Operating expenses include salaries and benefits, occupancy costs, technology expenses, and other administrative costs
• Loan loss provisions are expenses set aside to cover expected losses on the bank's loan portfolio
• Net income is the bottom-line profit earned by the bank after deducting all expenses and taxes from total revenue
• Profitability ratios, such as return on assets (ROA) and return on equity (ROE), measure the bank's ability to generate profits relative to its size and capital base
• Efficiency ratio compares a bank's non-interest expenses to its total revenue, indicating how well the bank manages its operating costs

Risk Management in Banking

• Credit risk is the potential for loss due to borrowers defaulting on their loan obligations
  • Banks manage credit risk through careful underwriting, diversification, and ongoing monitoring of loan portfolios
• Liquidity risk arises when a bank is unable to meet its short-term financial obligations or fund loan growth
  • Banks manage liquidity risk by maintaining adequate cash reserves, holding liquid securities, and diversifying funding sources
• Market risk is the potential for loss due to changes in market prices (interest rates, foreign exchange rates, equity prices)
  • Banks use hedging techniques (derivatives, asset-liability management) to mitigate market risk exposure
• Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events
  • Banks manage operational risk through strong internal controls, employee training, and business continuity planning
• Reputational risk is the potential for damage to a bank's reputation, which can lead to loss of customer trust and business
  • Banks manage reputational risk through ethical conduct, transparency, and effective crisis management

Regulatory Framework and Compliance

• Central banks (Federal Reserve, European Central Bank) oversee the banking system, setting monetary policy and providing liquidity support
• Prudential regulation aims to ensure the safety and soundness of individual banks and the overall banking system
  • Capital adequacy requirements (Basel Accords) ensure that banks maintain sufficient capital to absorb potential losses
  • Liquidity requirements (Liquidity Coverage Ratio, Net Stable Funding Ratio) ensure that banks have adequate liquid assets to meet short-term obligations
• Consumer protection regulations (Truth in Lending Act, Fair Credit Reporting Act) safeguard the rights and interests of bank customers
• Anti-money laundering (AML) and know-your-customer (KYC) regulations require banks to implement measures to prevent financial crimes and terrorist financing
• Compliance risk is the risk of legal or regulatory sanctions, financial loss, or reputational damage resulting from a bank's failure to comply with laws, regulations, or internal policies
  • Banks manage compliance risk through robust compliance programs, employee training, and ongoing monitoring and reporting

Current Trends and Future Outlook

• Digitalization and fintech are transforming the banking landscape, with the rise of online and mobile banking, digital payments, and blockchain technology
• Open banking initiatives (PSD2 in Europe, Open Banking in the UK) are promoting greater competition and innovation by allowing third-party providers to access customer data and offer new services
• Sustainable finance and environmental, social, and governance (ESG) considerations are gaining importance as banks align their strategies with global sustainability goals
• Cybersecurity and data privacy are critical challenges for banks as they navigate the digital age and protect sensitive customer information
• Consolidation and mergers and acquisitions (M&A) activity are reshaping the banking industry as institutions seek economies of scale and competitive advantages
• Low interest rate environments and increased competition from non-bank financial institutions (shadow banks) are putting pressure on bank profitability and business models
• Regulatory reforms and increased scrutiny in the wake of the global financial crisis (2007-2009) have led to higher compliance costs and more conservative risk-taking by banks