Commercial Bank Management

Commercial banks have undergone great changes during the 20th and early 21st centuries, paralleling the ongoing evolution of the new ways in which business and commerce are conducted. This paper will provide an in-depth analysis of how such institutions are managed as well as the role commercial banks play in the 21st century economy. By understanding the many types of services such institutions offer, the reader will glean a better understanding of the vital contributions commercial banks provide for today's entrepreneurial environments.

Keywords: Commercial Banks; Federal Deposit Insurance Corporation (FDIC); Federal Reserve; Glass-Steagall Act; Great Depression; Intermediate-term Loan; Long-term Financing; Risk

Overview

Background

On April 18, 1906, the city of San Francisco experienced one of the most significant natural events in its storied history as a magnitude 7.8 earthquake violently razed much of the city. Amadeo Peter Giannini, who only two years earlier had founded the Bank of Italy in that city, immediately put on his clothes and rushed a horse-drawn produce cart to his bank. Picking through the rubble of his fledgling banking institution, he removed and secreted away about $2 million in gold, coins and securities. He brought the cart to the North Beach docks, where he set up two wooden barrels with a plank across them as a makeshift desk. Using the money from his leveled bank, he began to offer businesses credit based on informal agreements, helping to bring about the redevelopment of San Francisco.

Giannini's acts after the great earthquake were extraordinary measures taken during extraordinary times. However banks have long played a role, albeit somewhat understated during "normal" times, in the development and redevelopment of businesses and economies. Business is, after all, essential to the strength of an economic system — it provides jobs, produces goods and services, and generates tax revenues. For these reasons, banks — and in particular, commercial banks — have become the artery by which businesses receive their lifeblood at their earliest stages.

Commercial banks are also critical for the individual. Simple savings accounts, into which people have long deposited their personal funds, have expanded explosively into a tremendous range of options for individuals to see financial security and investment returns. Still, security is perhaps the most invaluable requirement in an individual's asset management endeavors, and the protections offered by commercial banks are not just anticipated but expected, as such institutions have long provided the most secure of financial management protocols.

Commercial banks have undergone great changes during the 20th and early 21st centuries, paralleling the ongoing evolution of the new ways in which business and commerce are conducted. This paper will provide an in-depth analysis of how such institutions are managed as well as the role commercial banks play in the 21st century economy. By understanding the many types of services such institutions offer, the reader will glean a better understanding of the vital contributions commercial banks provide for today's entrepreneurial environments.

A Brief History of Commercial Banks

In the earliest civilizations, those with wealth entrusted the storage of their gold and priceless items to an institution few dared to pillage, for it was one of the most fortified buildings in the city, was constantly crowded and was by reputation protected by the most powerful entities known: the gods. In fact, the first monetary depository was not a bank, government building or fortress, but a temple, a place whose sacredness was often enough of a deterrent for any would-be thief.

Of course, during these ancient times, temples did little with people's wealth except store it, where it would neither appreciate nor depreciate in value nor serve as the basis for any financial transaction. It was not until the 18th century BC, when the Code of Hammurabi was written, when priests in the temple also served as financial managers, administering loans and other financial arrangements with the people of the community.

Banks have evolved and diversified significantly since Hammurabi's era. People continued to put their pay and other personal financial wealth into savings banks, but others have used land banks to purchase their own real estate and investment banks to pursue growth via the markets. At the earliest stages of the formation of the United States, such diversity led a large percentage of the population to seek "one-stop" banking, creating a strong evolution of the commercial bank. Those seeking liquidity in their assets simply deposited their funds into a savings account, but a growing number of businesses and entrepreneurs sought loans and mortgages in order to strengthen their business position, yet they also sought liquidity. While they had the fortune of having access to a number of banking institutions, the majority of the early American banking customers used commercial banks, which were increasingly offering a wide range of services (Wright, 2001).

By definition, a commercial bank is an institution that provides banking services for businesses. Commercial banks provide savings and checking accounts for customers, but they also provide loans, lines of credit, foreign exchange and payment and transactions (Pritchard, 2009). While commercial banks' primary focus is on the business customer, a large percentage of the customers they attract are private individuals as well.

The growing use of commercial banks among business and individual customers alike has created issues for this form of banking. In the early 20th century, commercial banking had begun to expand into investing as well. Some leaders at the time of the Great Depression saw this trend as one of the contributions to the collapse of the stock market, as commercial banks were providing margin loans, underwriting stock purchases and even trading on stocks. When the market collapsed in 1929, commercial banks' attachment to the markets meant that the banks would suffer, exacerbating the situation. When President Franklin Roosevelt sought to reinvigorate the economy, he and his colleagues in Congress introduced the Glass-Steagall Act. Under this law, commercial banks and investment banks were given a definitive divorce, saying that the two should mesh no longer, in light of what Roosevelt saw as dangerous practices by a type of institution that should have been focused on financial security, not gains — a condition that is largely believed to have contributed to the epic collapse of Wall Street.

Glass-Steagall was functionally repealed in 1998 (the law's formal repeal occurred one year later), when investment giant Travelers (who owned Salomon Smith Barney) purchased commercial banking icon Citicorp. In fact, the failure of three of the five largest investment banks during the recession that began in 2007 has ignited interest in revisiting the pre-Glass-Steagall era (Gross, 2008), when commercial banks were heavily involved in investments.

Commercial banks, which were initially created for the purpose of business development and support, have become very diverse in terms of the services they provide. At the same time, they are increasingly seen as more trustworthy institutions for financial security than more limited-service banks or larger investment banks. It is important to understand how commercial banks manage this broad scope of services.

Applications

Loans

One of the most important services a commercial bank offers is the loan. Lending funds to any customer will indubitably help that party in pursuing an immediate and critical goal. Commercial banks have proven to be important resources for such pursuits.

Commercial lending may be seen in two general forms:

• Intermediate-term Loans
• Long-term Financing

Intermediate term loans are an arrangement that has a life of between one and three years. Consumers use such shorter-term loans in order to finance working capital needs, purchase equipment such as computers and small machinery, using the hardware that is purchased as the basis for the repayment of the loan. In long-term financing, monies are issued primarily for larger companies (rather than small businesses), who use the loan to purchase real estate or a facility. In the case of long-term loans, up to 80 percent of the target asset's value is typically paid, with the remainder of that property's value serving as the collateral (Peavler, 2009).

Loans are one of the most important services a bank may offer its customers, particularly when they seek funds to support their pursuits of vital assets, such as new home, office space, or new inventory and equipment. Bank loans, therefore, may be considered the lifeblood of new and small (as well as large) businesses. One of the key individuals at a commercial institution, therefore, is the loan officer, whose job is to seek out and secure clients for loans. Loan officers are also charged with reviewing the client's credit history and assets in order to ensure that the client will be able to repay the loan. Furthermore, loan officers are expected to pursue delinquent loan recipients, assisting them in repayment plans if the original terms of the arrangement are not met (US Bureau of Labor Statistics, 2009).

The issue that arises when business customers demonstrate an inability to repay their loans to a commercial bank underscores an important point about the risks of the business of commercial lending. Even in times of relative economic stability, the notion of lending to new or expanding businesses represents a significant risk. If the economy turns sour and business falls, the commercial bank also stands to lose on repayment of loans. In the recession that began in 2007, the number of US commercial bank loans dropped more than 1 percent in 2009, a significant drop from the previous year. Large banks saw the biggest drop, 1.5 percent, at that time (Wagner, 2009). This trend exemplifies the risks involved in commercial lending — if the consumer experiences the challenges of a faltering economy (or marketplace), the commercial bank may be saddled with the debt, rendering it not just unable to collect on the single loan but unlikely to issue loans to others as freely as in previous cases.

Commercial banks have taken the lead on issuing loans for all sizes of business as they have increasingly among individuals. However, lending is not the only commercial banking activity seeing increased attention in the 21st century economy. Another strengthening area falling under the purview of commercial banks is investment practices.

Investments

It may be said that one of the major contributing factors to the depth and longevity of the Great Depression was assumption (Whipps, 2008). There were many investment banks in 1929, but most individuals also had their own personal accounts in commercial banks, which offered them a wide range of services. It was assumed that the stock market, which had shown great growth previously, would continue to grow and deliver returns for investors.

Commercial banks were all too willing to take part in the expanding markets. Investment banks, after all, were considered too expensive for anyone without strong corporate backing or were otherwise not wealthy. Commercial banks offered similar services, and at far more affordable rates. However, such banks failed to monitor the risks involved, and placed depositors' money into what were falsely believed to be safe investments. When the markets crashed, investors rushed to their banks in the hope of retrieving any and all of their monies, but the money simply was not there. Thus, the collapse of the country's economy was worsened exponentially by the fact that consumers did not have any protection from the investment practices of the commercial banks.

Lessons of the Great Depression

Glass-Steagall went a long way to separate investment banking from the traditional services of commercial banks. The law identified the risks involved with investments, particularly when such investments are made on the basis of a bank's securities. In 1933, one of Roosevelt's other actions to restore order to the finance industry, however, went far to create a backing system for banks, known as the Federal Deposit Insurance Corporation (FDIC). The FDIC would help prop up the existing banking system, which was still lying in ruins, as well as provide future banks with protection from similar collapses. Still, the establishment of the FDIC would not contradict the actions of Glass-Steagall, since the act operated under the impression that any "safety nets" offered by the federal government would not be expanded more than necessary ("Understanding how," 1998). In other words, although the FDIC and other government-initiated protections would be in place to insure the bank from failed accounts, such insurance did not open the door for future investments by commercial banks.

Since the repeal of Glass-Steagall, however, the idea of commercial banks acting in part as investment banks has captured the attention of observers, particularly in the wake of the virtual collapse of many of the largest investment banks in the world at the start of the 2007 recession. At the end of the Great Depression, the fear remained that commercial banks would return to the reckless practice of using customer assets to play the often volatile market. The Federal Reserve, which is responsible for regulation of the financial industry, has imposed a myriad of regulations on the investment banking industry. With the security created by the FDIC and the sizable volume of commercial banks' deposit and capital bases, some argue that commercial banks may (with the application of the same Federal Reserve regulations imposed on investment banks) be able to expand once again into Wall Street with less risk of collapse than their investment counterparts (Berman, 2008).

Then again, the collapse of the investment banking industry did not leave the commercial banking industry unscathed. Bank of America's purchase of investment giant Merrill Lynch led to headaches as the commercial bank inherited a public relations nightmare regarding executive bonuses. Executive incentives were later blamed for much of the high-risk activity of financial institutions that resulted in the global financial crisis in 2008 (DeYoung, Peng & Yan, 2013). Investment bank Wells Fargo purchased (and later absorbed) troubled commercial bank Wachovia during the crisis, but came under fire because of its mortgage lending practices (Flitter, 2009). Wachovia had inherited a "timebomb" of subprime mortgages as a result of its own acquistion of Golden West bank, but it was not alone in sinking under the burden of bad loans (Cole & White, 2012). Large banks had adopted the risky but profitable practice of securitizing real estate loans rather than holding them, which resulted in cavalier lending to home buyers who were uncreditworthy or unlikely to be able to continue making mortgage payments that would "balloon" sometime in the life of the mortgage. Small banks departed from their historic model and took on large commercial real estate loans. Easy lending drove up real estate values and created an unsustainable "bubble" that would burst, resulting in mass (and massive) defaults (Kyle, 2012). Mortgage Backed Securities (MBS) were sold to investors, including investment banks. As long as the real estate market was rising, investing in MBS and MBS derivatives was profitable, but when it crashed these instruments lost their value. In 2009, 117 commercial banks failed (Armbrister, 2013). Amid the ongoing interest in allowing commercial banks to invest once again is a vocal counter-argument that suggests a return to separation between the two types of institutions.

The continuing debate over the expansion of commercial bank services, which already include a myriad of offerings such as loans, savings and checking and money management, to include investment opportunities is reflective of an important point. The shortcomings of a great number of investment firms that contributed to the ongoing recession highlighted the apparent strength of commercial banks. This strength is based upon the popularity of commercial banks among businesses and individuals alike, as the large volume of deposits bolsters the banks' assets. Commercial banks, which long offered more services than savings and investment banks, may continue to enjoy the faith of consumers and businesses in stable and troubled economies alike.

Conclusions

In 1964, a Chicago Tribune article proclaimed, "David Rockefeller, President of Chase Manhattan Bank, briefed President [Lyndon] Johnson today on his recent meeting with Premier Nikita Khruschev of Russia" (www.Liberty-Tree.ca). The event illustrates the high regard people have for the institutions they charge with the management of their money: Johnson, the leader of the free world, would not be the one to meet with the leader of the Soviet Union. Instead, the head of the one of the largest banks in the world had the honor to represent the United States before the country's greatest adversary at the time.

In addition to the basic services commercial banks provide, such as deposit, checking and savings programs, they enable businesses and individuals to gain access to funds that may be used to either create, expand or maintain their corporate operations. During recessions, this aspect of commercial bank management can be both a challenge, due to the scarcity of lending funds, and a great benefit, because the generation of business means jobs, tax revenues and other business.

Commercial banks were the target of increased attention throughout the 20th century and are even more so in the 21st century. They have proven invaluable for businesses and individuals alike, providing a myriad of services that foster business and maintain the economy. The people's faith in commercial banks has led to a call for these institutions to expand their services to include investing, particularly in light of the stability they have due to government regulations and a broad base of securities.

How the management of commercial banks continues to evolve to meet the needs of an ever-changing global economy will demonstrate the relevance of commercial banking in the US and elsewhere. With the benefit of precedent, however, the trend of commercial bank expansions into investment arenas offers a strong indication that such practices, proposed and current, will continue.

Terms & Concepts

Commercial Banks: Financial institutions that provide services to small and large businesses as well as individual clients.

Federal Reserve: The Federal agency charged with regulatory oversight and monetary policy for banks and other financial institutions.

Glass-Steagall Act: Post-Depression law (repealed in 1999) that separated commercial bank activities from those of investment banks.

Intermediate-term Loan: A 1-3-year commercial bank loan businesses use for capital, equipment purchases and other short-term needs.

Bibliography

Armbrister, M. (2013). Rules targeting risky loans spark worry. Northern Colorado Business Report, 18, 3-8. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89334819&site=ehost-live

Bank of Italy. (2009). Retrieved August 15, 2009 from Anecdotage.com. http://www.anecdotage.com/index.php?aid=13764.

Berman, D. K. (2008, June 24). Maybe it's time to put the banks and Wall Street dealers back together. Wall Street Journal — Eastern Edition, 251.

Chicago Tribune. (1964, September). Banking quotes. Retrieved August 22, 2009 from Liberty-Tree.ca. http://quotes.liberty-tree.ca/quote/chicago%5ftribune%5fquote%5f5043.

Cole, R., & White, L. (2012). Déjà vu all over again: the causes of U.S. commercial bank failures this time around. Journal of Financial Services Research, 42(1/2), 5-29. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=77837086&site=ehost-live

DeYoung, R., Peng, E. Y., & Yan, M. (2013). Executive compensation and business policy choices at u.s. commercial banks. Journal of Financial & Quantitative Analysis, 48, 165-196. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87775044&site=ehost-live

Flitter, E. (2009, August 11). It's Glass-Steagall, with a twist. BankThink. Retrieved August 20, 2009 from American Banker.com http://www.americanbanker.com/bankthink/image%5fwar-1000884-1.html.

Gross, D. (2008, September 15). Shattering the Glass-Steagall: The rise of the commercial banks. Moneybox. Retrieved August 17, 2009 from Slate.com http://www.slate.com/id/2200148/.

Kyle, A. (2012). A commentary on 'déjà vu all over again: The causes of U.S. commercial bank failures this time around'. Journal of Financial Services Research, 42(1/2), 31-34. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=77837081&site=ehost-live

Peavler, R. (2009). Commercial bank term loans. Retrieved August 17, 2009 from http://bizfinance.about.com/od/generalinformation/a/termloans.htm.

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Suggested Reading

Are bank deposits safe? (2008, March 19). BusinessWeek Online. Retrieved August 23, 2009 from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=31410654&site=ehost-live.

Bank credit at all commercial banks. (1993, October). Economic Indicators. 28.

Frame, W. S., Hancock, D. & Passmore, W. (2007). Federal home loan bank advances and commercial bank portfolio composition. Working Paper Series — Federal Reserve Bank of Atlanta, 17, 1-32. Retrieved August 23, 2009 from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=26073231&site=ehost-live.

Klee, E. & Natalucci, F. (2005). Profits and balance sheets at US commercial banks in 2004. Federal Reserve Bulletin, 91, 143-174. Retrieved August 23, 2009 from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=17659929&site=ehost-live.

McNulty, J., Murdock, M., & Richie, N. (2013). Are commercial bank lending propensities useful in understanding small firm finance?. Journal of Economics & Finance, 37, 511-527. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90053001&site=ehost-live

Yunfeng, Z., Junwen, F. & Xiaoyang, L. (2008). Summarization and analysis on commercial bank risk management. Canadian Social Science, 4, 30-36. Retrieved August 23, 2009 from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=32753473&site=ehost-live. First, large commercial banks had transitioned their retail businesses away from traditional “originate-and-hold” lending models that relied on interest income generated from repeat borrower-lender relationships, and toward “originate-and-securitize” lending models that relied heavily on volatile fee income generated by nonrepeat, arm’s-length financial transactions. Second, banks became increasingly reliant on home mortgages to fuel the expan- sion of their originate-and-securitize business, in the process selling trillions of dollars of mortgage-backed securities (MBS) and/or derivatives of MBS to insti- tutional investors (banks, insurance companies, and pension funds) in the United States and abroad. Third, commercial and investment banks committed a pair of fundamental risk management mistakes: Portfolios were overweighted in MBS as institutional investors underestimated the covariances of housing prices across regions, and these portfolios were financed with large amounts of (often short- maturity) leverage. This approach generated record industry earnings during the relatively benign conditions of the 1990s and 2000s; however, the absence of dis- ciplining macroeconomic stress during this period allowed risk to build up on the balance sheets of both banks and borrowers, and these risks were eventually exposed when the housing bubble collapsed The article discusses Basel III, new banking regulations passed down by the Federal Reserve Bank on July 2, 2013, whose phase-in takes effect on January 1, 2015. The new banking rules require all banks to increase their capital reserves from four percent to six percent and keep more cash on hand for offsetting the risk associated with high-risk commercial real estate loans. Community bankers are concerned about its applicability to community banks with less than 50 billion dollars in assets.