Environment of
Economics, Finance and Monetary
CHAPTER 3.
Commercial Bank
1
Chapter Introduction
3.1 An Overview of Commercial Bank
3.2 Services Offered by Bank
3.3 Types of Banks
3.4 Changes in Banking Industry
3.5 Banking Management: Managing Risks and Profit
3.1 An Overview of Commercial Bank
3.1.1 Definition of Commercial Bank
• Definition of bank: A bank is a
commercial or state institution that
provides financial services , including
issuing money in various forms, receiving
deposits of money, lending money and
processing transactions and the creating
of credit.
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Definition of commercial bank
• (1)
A commercial bank accepts deposits
from customers and in turn makes loans,
even in excess of the deposits; a
process known as fractional-reserve
banking. Some banks (called Banks of
issue) issue banknotes as legal tender.
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Fractional Reserve Banking
• Fractional reserve banking is a banking system in
which only a fraction of bank deposits are backed by
actual cash on hand and are available for withdrawal.
• Many U.S. banks were forced to shut down during
the great depression because too many people
attempted to withdraw assets at the same time.
Example
• Banks are required to keep a certain amount of the
cash depositors give them on hand available for
withdrawal.
• If someone deposits $100, the bank can't lend out
the entire amount. That said, it isn't required to keep
the entire amount either. Most banks are required to
keep 10% of the deposit, referred to as reserves.
This reserve requirement is set by the State bank
and is one of the tools to implement monetary
policy.
Definition of commercial bank
• (2)
A commercial bank is a type of financial
institution that accepts deposits, offers
checking account services, makes business,
personal and mortgage loans, and offers basic
financial products like certificates of deposit
(CDs) and savings accounts to individuals and
small businesses.
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Some main points
• Accepts deposits
• Makes loans
• Offers other financial services
• A commercial bank is usually
defined as an institution that both
accepts deposits and makes
loans; there are also financial
institutions that provide selected
banking services without meeting
the legal definition of a bank.
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• Many banks offer ancillary
financial services to make
additional profit; for example,
most banks also rent safe deposit
boxes in their branches.
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• Currently in most jurisdictions
commercial banks are regulated &
require permission to operate.
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3.1.2 Purpose of a Commercial Bank
3.1.2.1 Provide loans
• Banks have influenced economies &
politics for centuries. Historically, the
primary purpose of a bank was to provide
loans to trading companies. Banks provided
funds to allow businesses to purchase
inventory, and collected those funds back
with interest when the goods were sold.
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• For centuries, the banking industry only
deal with businesses, not consumers.
Commercial lending today is a very
intense activity, with banks carefully
analyzing the financial condition of their
business clients to determine the level
of risk in each loan transaction.
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3.1.2.2 Provide banking services
• Banking services have
expanded to include services
directed at individuals, and risk in
these much smaller transactions
are pooled.
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3.1.3 A Bank’s Profit
• A bank generates a profit from
the difference between the level of
interest it pays for deposits and
other sources of funds, and the
level of interest it charges in its
lending activities.
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• This difference is referred to as
the spread between the cost of
funds and the loan interest rate.
Historically, profitability from
lending activities has been cyclic
and dependent on the needs and
strengths of loan customers.
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A Bank’s Profit (cont')
• In recent history, investors have demanded a more
stable revenue stream and banks have therefore
placed more emphasis on transaction fees, primarily
loan fees but also including service charges on array
of deposit activities and ancillary services
(international banking, foreign exchange, insurance,
investments, wire transfers, etc.). However, lending
activities still provide the bulk of a commercial bank's
income.
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3.1.4 History of Banking
• The name bank derives from the
Italian word banco "desk/bench",
used during the Renaissance by
Florentines bankers, who used to
make their transactions above a
desk covered by a green
tablecloth.
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History of Banking (cont')
• However, there are traces of
banking activity even in the
Babylonian times, and indeed a
book about the history of banking
is named : Banking, from Babylon
to Wall Street.
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3.2 Services Offered by Banks
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3.2.1 Banking Services
• Although the basic type of
services offered by a bank
depends upon the type of bank
and the country, services provided
usually include:
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Banking Services (cont')
1. Taking deposits from their customers
and issuing current or checking
accounts and savings accounts to
individuals and businesses.
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Current account
• A current account is a personal
bank account which you can take
money out of at any time using your
cheque book or cash card.
Savings account
• A savings account is a bank
account with a limited number of
transactions per month and which
pays a higher interest rate than a
checking account.
• Why does a savings account have
higher interest rate than a checking
account?
Banking Services (cont')
2. Extending loans to individuals and
businesses.
3. Cashing check (cheque)
4. Facilitating money transactions such
as wire transfers and cashier's checks
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What is a cheque?
• A cheque or check is a document that orders
a bank to pay a specific amount of money
from a person's account to the person in
whose name the cheque has been issued.
cashier's checks and personal cheque
• A cashier's check or cheque is a cheque
guaranteed by a bank, drawn on the bank's
own funds and signed by a cashier
• An individual can use a cashier's check
instead of a personal check to guarantee
funds are available for payment. A cashier's
check is secured because the individual
must first deposit the amount of the check
into the issuing institution's own account.
Banking Services (cont')
5. Issuing credit cards, ATM cards,
and debit cards
6. Storing valuables, particularly in a
safe deposit box
7. Consumer & commercial financial
advisory services
8. Pension & retirement planning
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3.2.2 Financial transactions channels
1. A branch, banking center or
financial center is a retail location
where a bank or financial institution
offers a wide array of face to face
service to its customers.
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2. ATM is a computerized
telecommunications device that
provides a financial institution's
customers a method of financial
transactions in a public space
without the need for a human clerk
or bank teller
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3. Mail is part of the postal system
which itself is a system wherein
written documents typically enclosed
in envelopes, and also small
packages containing other matter,
are delivered to destinations around
the world
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4. Telephone banking is a service
provided by a financial institution
which allows its customers to
perform transactions over the
telephone
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5. Online banking is a term used for
performing transactions, payments
etc. over the Internet through a
bank, credit union or building
society's secure website
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3.3 Types of Banks
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The first classification
criteria
• Banks' activities can be divided into retail
banking, dealing directly with individuals and
small businesses; business banking, providing
services to mid-market business; corporate
banking, directed at large business entities;
and investment banking, relating to activities
on the financial markets.
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• Most banks are profit-making,
private enterprises. However,
some are owned by government,
or are non-profits.
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• Central banks are non-commercial bodies or
government agencies often charged with
controlling interest rates and money supply
across the whole economy. They generally
provide liquidity to the banking system and act
as Lender of last resort in event of a crisis.
• - central bank is a non-commercial agency
• - central bank is an administrative agency
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• Commercial bank: the term used for a normal bank
to distinguish it from an investment bank. After the
Great Depression, the U.S. Congress required that
banks only engage in banking activities, whereas
investment banks were limited to capital market
activities. Since the two no longer have to be under
separate ownership, some use the term "commercial
bank" to refer to a bank or a division of a bank that
mostly deals with deposits and loans from
corporations or large businesses.
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• Community Banks: locally operated financial
institutions that empower employees to make
local decisions to serve their customers and the
partners
– Community banks tend to focus on the needs of the
business and families where the bank holds branches
and offices
– Lending decisions are made by people who
understand the local need of customers
– Employee often reside within the communities they
serve
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• Community development
banks: regulated banks that
provide financial services and
credit to underserved markets or
populations.
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• Postal savings banks: savings
banks associated with national postal
systems.
• Private banks: manage the assets of
high net worth individuals.
– high net worth individuals are customers that
have investible assets exceed a given amount
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• Offshore banks: banks located in
jurisdictions with low taxation and
regulation. Many offshore banks
are essentially private banks.
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• Savings bank: in Europe, savings banks take their
roots in the 19th or sometimes even 18th century. Their
original objective was to provide easily accessible
savings products to all strata of the population. In some
countries, savings banks were created on public
initiative, while in others socially committed individuals
created foundations to put in place the necessary
infrastructure. Nowadays, European savings banks
have kept their focus on retail banking: payments,
savings products, credits and insurances for individuals
or small and medium-sized enterprises.
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• Apart from this retail focus, they also differ
from commercial banks by their broadly
decentralized distribution network, providing
local and regional outreach and by their
socially responsible approach to business
and society.
– Focus on retail banking
– broadly decentralized distribution network
– socially responsible approach to business and
society.
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• Building societies: conduct retail
banking.
• Ethical banks: banks that prioritize the
transparency of all operations and make
only what they consider to be socially-
responsible investments.
Types of Banks in Vietnam?
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Banks are facing increasing
competition from other financial
institutions and nonfinancial
corporations in a global
environment.
• Nonbanks
– Other intermediaries and nonfinancial
companies that have taken increasing
share of intermediation
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3.4 Changes in Banking
Industry
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3.4.1 Ongoing Changes in Structure of Banking Industry
• Increased competition in financial services
industry
• Considerable erosion in domain and
effectiveness of many long-standing financial
regulations
• Significant increase in share of total bank
assets controlled by largest banks
• Pace and dollar volume of mergers increased
significantly
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3.4.2 Evolution of International Banking
• Increase in international borrowing and lending
by domestic banks
• Many foreign banks made significant inroads into
U.S. markets by the 1980s.
• Agency of a Foreign Bank
– U.S. Banking office of foreign bank
– Can borrow funds only in wholesale and
money markets
– Not allowed to accept retail deposits
In Vietnam?
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3.5 Bank Management:
Managing Risk and Profits
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• Primary function of a bank loan officer is
to evaluate or assess the default risk
associated with lending to particular
borrowers
• Firms
• Individuals
• Domestic and foreign governments
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• Asymmetric Information
– Potential borrower knows more about the risks
and returns of an investment project than
bank loan officer
• Adverse Selection Problem
– When least desirable borrowers pursue a loan
most diligently
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Adverse selection
• Adverse selection is the problem created by
asymmetric information before the transaction
occurs. Adverse selection occurs when the potential
borrowers who are the most likely to produce an
undesirable (adverse) outcome-the bad credit risks-
are the ones who most actively seek out a loan and
are thus most likely to be selected.
• Because adverse selection makes it more likely that
loans might be made to bad credit risks, lenders
may decide not to make any loans even though
there are good credit risks in the market place.
Example
• Friend A: a conservative person
• Friend B: an inveterate gambler
• Who will you choose?
• Moral Hazard Problem
– When borrower has incentive to use proceeds
of loan for more risky venture after loan is
funded
– Bank manager must manage interest rate risk
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Moral Hazard Problem
• Moral hazard is the problem created by asymmetric
information after the transaction occurs.
• The borrower might engage in activities that are
undesirable (immoral) from the lender’s point of
view, because they make it less likely that the loan
will be paid back => lenders may decide that they
would rather not make a loan
Example
• You made a loan to a friend who need the money
to invest in opening a shop. Once you have made
the loan, however, the friend use your money to
gamble at cards
• The risk of moral hazard might therefore discourage
you from making the loan to the friend
• Adjustable-(Variable-) Rate Loan
– When interest rate on loan is adjusted up or
down as cost of funds rises or falls
– Banks can use financial futures contracts,
options and swaps to manage interest rate
risk
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• Advantages and disadvantages
of internet banking?
• How can you reduce security
risk when you use internet
banking services?
END OF CHAPTER 4
