CHAPTER 13
COMMERCIAL BANK OPERATIONS
Loans
 Loans are very profitable to banks, they take time to
arrange,are subject to greater default risk and have less
liquidity than most bank investments.
 Most bank loans consist of promissory notes.A promissory
note is unconditional promise made in writing by the
borrower to pay the lender a specific amount of money at
specified future date.Repayment could be in periodic
installmenst,in single amount or on demand.
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 Bank loans may be secured or unsecured, however most are
secured that is are backed by a collateral.
 Banks make either fixed or floating rate loans. The interest on
floating loans is periodically adjusted to changes in a selected
short term rate usually a Treasury rate or LIBOR. If interest
rates are unstable banks prefer to make floating rate loans.
However, most bank loans carry fixed rates.
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Copyright© 2006 John Wiley & Sons, Inc.
Major categories of bank loans:
 Bridge loan: supplies cash for specific transaction with
repayment coming from an identifiable cash flows.
 Seasonal Loan: financing for temporary discrepancies
between business revenues and expenses because of
manufacturing or sales cycle of business.
 Long- term assets: loans to finance purchase of assets.
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 Loans to Depository Institutions: have variety of maturities
and can be for variety of purposes.
 Real Estate Loans : finance purchase, construction of both
residential housing and commercial facilities.
 Agricultural Loans: both short and long term loans for farmers.
 Consumer Loans: to individuals and their maturities and
conditions vary.
• Bank Credit Cards.
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Lease Financing
 Banks purchase the property on customer’s request and the
lease it (rent) to the customer. Fast-growing line of business
for large banks.
 Main economic justification is taxation.
 Common financing technique for—



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“fleet assets” (aircraft, ships, etc.)
“rolling stock” (trucks, rail cars, etc)
other capital equipment (cranes, generators, etc.)
Copyright© 2006 John Wiley & Sons, Inc.
Key considerations in loan pricing
 Earn a high enough interest rate to cover the cost of
loanable funds
 Recover administrative costs of originating and monitoring
the loan
 Provide adequate compensation for risk—
 Credit (or default) risk
 Liquidity risk
 Interest rate risk
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Loan Pricing: One of the most important management
decisions in banking
Some key considerations
 The “Prime Rate”
 Base rate pricing
 Non-price adjustments
 Matched-funding loan pricing
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The “Prime Rate”
 Historically a benchmark rate
 The lowest loan rate posted by commercial banks
 The rate banks charged their most creditworthy customers
 Other borrowers were typically charged some spread above
prime
 Recently, the role of the prime rate has changed
 Over the last 20 years, fewer loans have been priced using
“prime”
 Now, lenders choose among several other benchmark rates:
 LIBOR—“London Interbank Offered Rate”
 Treasury rates
 Fed Funds rate
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Base rate pricing: marking up from a minimum offered the
least risky borrowers
 Possible base rates: Prime, LIBOR, Treasury, Fed Funds
 Markups include three adjustments:
For increased default risk
For term-to-maturity
For competitive factors—a customer’s access to alternatives
 rL = BR + DR + TM + CF
where:
rL =
BR =
individual customer loan rate
the base rate
DR =
adjustment for default risk above base-rate
customers
TM =
CF =
10
adjustment for term-to-maturity
competitive factor
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Example
 Bank base rate is 7%,two customers a small firm and a large firm
want loans. The large firm is well known nationally, has sold
commercial paper on occasion, and wants a floating rate loan. The
smaller firm wants a 1 year fixed rate loan.1 year T. securities sell
for 0.75% above 3 month T-bill.
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Pricing Factor
Small Firm
Base rate
7%
Default risk
adjustment
3%
2%
Term to maturity
adjustment
0.75%
0.00
Competitive factor
adjustment
1%
0.00
Loan rate
11.75%
9.00%
Copyright© 2006 John Wiley & Sons, Inc.
Large Firm
 Compensating balances- Bank requires borrower to carry minimum balance in noninterest-bearing deposit account; e.g. loan is $100,000 then you
have to maintain 10,% as deposit in the bank that is $10,000.
 Matched Funding:
A way to control interest rate risk of fixed rate loans by
financing them with deposits of the same maturity. e.g.
Bank gives1 year fixed rate loan, can be financed with 1 year
CD.
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Analyzing, managing, and pricing credit risk
 Five “C”s of Credit:
1. Character (willingness to pay, credit history)
2. Capacity (projected cash flow)
3. Capital (wealth or net worth)
4. Collateral (security for the loan)
5. Conditions (economic conditions)
 Credit scoring involves assigning a potential borrower
score based on the information in the borrower’s credit
report:
1. Payment history
2. Amount owed
3. Length of credit history
4. Extent of new debt
5. Type of credit in use
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Advantages of credit scoring are it is efficient, inexpensive,
gives fast decisions and minimizes discriminatory lending
practices.
While disadvantages, impersonal, does not allow for
special circumstances and difficult for potential borrower to
improve their score.
 Once the five C’s are analyzed a customer
is assigned to a credit rating category and
default risk premiums is determined for
each risk categories.
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Pricing deposits, the bank’s main source of loanable funds
 Must offer depositors high enough rates to attract and retain a stable
deposit base
 Must not pay so much on deposits that profitability is compromised
 Competition puts pressure on the “spread” from both sides
bank may have to charge lower rates on loans
bank may have to pay higher rates on deposits
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