Commercial Banks

Commercial banks, which exist in every country, are the oldest and most important financial institutions in the world. They originated in the Middle Ages to collect savings from individuals and put them to use to finance commerce. The oldest operating bank in the world is the Monte dei Paschi di Siena in Italy, which dates back to 1472. The first commercial bank in the United States was the Bank of North America, established in Philadelphia in 1782. It operates today as the First Pennsylvania Bank. Commercial banks assets represent about one-third of the dollar assets of all U.S. financial institutions.

Commercial banks are financial intermediaries that channel funds from savers to borrowers in ways that are more attractive than those available to savers and borrowers who deal with each other directly. Banks thus increase the total amount of funds saved and invested. They encourage savings by providing deposit accounts that are available in almost any size and maturity, and with low credit and interest-rate risks. They encourage investment by making loans, similarly of almost any size and maturity, and accepting a variety of risk. To lessen the possibility of losses, banks charge more interest on loans than they pay out in deposit interest. This difference is often referred to as the interest rate spread.

The Bank Balance Sheet

Banks provide many deposit and lending services. Lending services appear on the asset side of a bank's Balance sheet, while deposit activities appear on the liability side.

Bank Management

Banking is a risky business. Banks assume credit risk in the form of possible default by borrowers, and interest rate risk in the form of unfavorable changes in interest rates that reduce revenues more than the cost of deposits. Banks also assume operating risk from inefficient management, liquidity risk from losses due to hurried sales of assets to meet deposit outflows, fraud risk from dishonest activities, and foreign currency risk from making loans or accepting deposits in other currencies. Because banks make much of their income by assuming a certain degree of risk, they do not want to aliminate it. Rather, they try to manage the risk by charging a sufficiently high interest rate to cover expected losses.

Frequently referred to as asset and liability management bank risk management may be divided into four major categories: credit risk management, liquidity risk management, interest-rate risk management, and capital mnagement.

Credit risk management involves screening applications for loans and purchases of bonds for creditworthiness, pricing the degree of risk assumed correctly, and diversifying the bank's total loan and investment portfolio to reduce its aggregate risk exposure.

Liquidity management applies to both a bank's assets and its liabilities. On the asset side, it involves determining the proper mix of cash, liquid investments, and loans (which are less liquid) needed to meet all demands for deposit outflows, on time and in full, thus avoiding the large, so-called fire losses that come from having to sell assets too hastily. On the liability side, liquidity management involves maintaining the ability to raise funds quickly by selling new large CDs and borrowing on the Fed funds market to meet deposit outflows. All banks practice asset liquidity management Only larger, solvent banks, however, can practice liability liquidity management because borrowing on the national money markets occurs only in large denominations.

Interest-rate risk management involves managing the maturity structure of the two sides of a bank s balance sheet (assets and liabilities) to control the effects of interest rate changes on income and capital.

Because a bank's capital assets act as a buffer to absorb losses before they must be charged against deposits, capital costs more than deposits as a source of funds. Capital management involves maintaining the minimum amount of capital needed to retain solvency, consistent with the degree of risk the bank wishes to assume. The greater the amount of credit liquidity, or interest-rate risk, the more capital is needed. Conversely, the more capital a bank has, the more risks it can assume.

Bank Structure

Banks vary according to size, number of branches, and organizational format. The United States has both more banks, as well as more banks per capita, than any other country. In 1990, U.S. banks operated more than 50,000 branch offices, and the total number of bank offices exceeded 60.000. The number of banks has declined after peaking at more than 30.000 in the 1920s. At the same time, the number of branches has increased.

Most banks are relatively small. Nearly 90% have assets smaller than those of the average bank$270 millionand 80% hold less than 15% of the banking system's total dollar assets. By contrast, the 150 largest banks, which make up less than 2% of all banks, have more than one-half the total assets. The largest U.S. banks are The Bank of America Corp. (Charlotte, N.C.) - $1,082,243 (consolidate assets), J. P. Morgan Chase & Company (Columbus, Ohio) - 1,013,985, and Citibank in New York with its consolidated assets about $706 billion. A small but increasing number of banks and banking offices in the United States are foreign-owned.

The ability of banks to established branch offices is restricted by law. States limit intrastate branching, and both state and federal law prohibit interstate branching. Until recently, one-third of the states, mostly in the Midwest, were "unit-banking" states: they prohibited any bank branches at all. Another third, mostly on the East Coast, were limited-branching states, allowing banks to form branches within ciry or country boundaries. The rest of the states, mostly on the West Coast, were statewide-branching slates. In recent years, most states have liberalized their branching laws, and in 1991 Colorado became the last state to abandon unit banking.

Banks may be owned independently or by holding company that owns one or more banks. Banks often prefer the holding company format for a number of reasons. First, they may wish to keep different banks or other affiliates as separate entities rather than branches for organizational purposes. Second, they may want to circumvent restrictions on branching within states and, more recently, across state boundaries. Beginning in the early 1980s most states began to permit acquisition of domestic banks by out-of-state holding companies.

A bank may also join a holding company in order to engage in certain financial activities not permitted to the bank itsell and to operate non-bank financial services offices across state lines. In 1990 there were some 6,500 bank holding companies, operating 8,700 banks. Holding companies own most large banks.

The Bank Holding Company Act of 1956 gave the Federal Reserve the right to regulate the powers of bank holding companies, and the Douglas Amendment to the act gave states the right to permit interstate banking acquisitions, which they began to do in the early 1980s. By the early 1990s almost all states permitted some form, of interstate acquisitions.

Bank Regulation

Banking has always been a relatively regulated industry, mostly to increase the safety of deposits and to reduce bank failures. Banks and bank holding companies are regulated in the types of products they may offer (primarily financial products); the number and locations of their offices; the minimum cash reserves they must maintain; the minimum capital they must maintain; the interest rate they may pay on deposits; the amount of lending to any single borrower; and the ability to merge with other banks. Bank regulation.

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