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CHAPTER 2. DRIVERS OF CHANGE, INNOVATION, AND CONSOLIDATION IN THE FINANCIAL-SERVICES INDUSTRY. Learning Objectives. To understand … 1. The drivers of change in the FSI as the components of TRICK 2. Innovation as a diffusion process and the technological and contractual aspects of innovation

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Chapter 2

CHAPTER 2

DRIVERS OF CHANGE, INNOVATION, AND CONSOLIDATION IN THE FINANCIAL-SERVICES INDUSTRY

Chapter 2


Learning objectives
Learning Objectives

  • To understand …

    • 1. The drivers of change in the FSI as the components of TRICK

    • 2. Innovation as a diffusion process and the technological and contractual aspects of innovation

    • 3. Consolidation and corporate restructuring in the FSI, especially bank mergers

Chapter 2


Chapter theme
Chapter Theme

  • Heraclitus, the Greek philosopher, said: “All is flux, nothing stays still. Nothing endures but change.”

  • This chapter focuses on change in banking and the FSI and what drives it

  • Innovation and consolidation, among other things, reflect the effects of the changes driving banking and the FSI

Chapter 2


Components of a dynamic model of change trick
COMPONENTS OF A DYNAMIC MODEL OF CHANGE: TRICK

  • Transparency

  • Risk exposure

  • Information technology

  • Competition for customers

  • Kapital adequacy

  • Model:TRICK + Rational Self-Interest => Financial Innovation

Chapter 2


T ransparency
TRANSPARENCY

Readily understood, clear, or easily detected with regard to financial statement information, disclosure, monitoring and discipline by holders of debt and equity contracts, market valuations, and accountability of managers, directors, and safety-net managers

Chapter 2


R isk exposure leads to
RISK EXPOSURE (leads to)

Risk-Management Techniques

  • Asset-Liability Management (ALM)

  • Credit Analysis

  • Derivatives: Futures, Forwards, Options, and Swaps

  • Securitization

Chapter 2


Exposure to what
Exposure to What?

  • The risks of banking

    • 1. Credit risk

    • 2. Interest-rate risk

    • 3. Liquidity risk

    • 4. Foreign-exchange risk

    • 5. Operational risk

    • 6. Solvency (capital-adequacy) risk depends on the risks above

Chapter 2


I nformation technology
INFORMATION TECHNOLOGY

“The information standard has replaced the gold standard as the basis for world finance”

- Walter Wriston

Chapter 2


C ompetiton for customers
COMPETITONFOR CUSTOMERS

Basic Ingredients to Attract Customers

  • Price

  • Convenience

  • Confidence (federal safety net/guarantee)

Chapter 2


K apital adequacy
KAPITAL ADEQUACY

  • Market Discipline

    • Costs of financial distress and cost of funds

  • Regulatory Discipline

    • Risk-based capital requirements

  • Graham-Leach-Bliley Act of 1999

  • Community Reinvestment Act (modernization tied to fairness)

Chapter 2


Innovation as a diffusion process
INNOVATION AS A DIFFUSION PROCESS

  • Innovation -- the introduction of something new

    Ex: 1961 introduction of the first negotiable certificate of deposit

  • Preliminary Distinctions

    • .Invention vs. innovation

    • .Autonomous innovation vs. induced innovation

    • .Market-induced innovation vs. regulation-induced innovation

Chapter 2


New technology and product diffusion
NEW TECHNOLOGY AND PRODUCT DIFFUSION

  • August 2000 Internet Penetration for U.S. Households = 41%

  • Top Ten Cities for Penetration:

    San Francisco (66%)

    Seattle (64%)

    San Diego (62%)

    Portland (62%)

    Washington D.C. And Boston (59%)

    Denver and Kansas City (57%)

    Orlando (56%)

    Baltimore (55%)

Chapter 2


Diffusion of e banking
DIFFUSION OF E-BANKING

  • Except for ATMs, diffusion rate has been slow

  • “Paper currency and checks are still used for the overwhelming majority of consumer payments, while electronic transfer, such as those made over the ACH, account for a very small fraction. In contrast, for the major money and securities markets in this country, electronic payments are the rule rather than the exception”

    -- Edward W. Kelley, Jr.

Chapter 2


Innovation and the design of financial contracts
INNOVATION AND THE DESIGN OF FINANCIAL CONTRACTS

Two Basic Contracts of Banking

1. Deposit Account

  • Checking Accounts

  • Savings Accounts

  • Certificate of Deposits

  • Individual Retirement Accounts

    2. Loan Agreement

  • Fixed or Adjustable Rate Mortgages

  • C&I Term Loans

  • Automobile Loans

  • Credit-Card Loans

Chapter 2


Credit extention building blocks

The Blocks

Zero Coupon

Fixed Rate

Variable Rate

Amortized

Can Be Viewed In Terms Of:

Present Value

Future Value

Payment

Interest Rate

Number of Periods

CREDIT EXTENTION BUILDING BLOCKS

Chapter 2


Background tvm formulas
Background: TVM Formulas

  • Panel B of Table 2-2 presents the time-value-of-money (TVM) formulas on a pair-wise basis

    • 1. PV and FV of a lump sum

    • 2. FV of an annuity (payment) and annuity repaying a future amount

    • 3. PV of an ordinary annuity and annuity repaying a present value (loan-recovery factor, e.g., for a mortgage payment)

Chapter 2


The costs of innovative financial products and reputational capital
THE COSTS OF INNOVATIVE FINANCIAL PRODUCTS AND REPUTATIONAL CAPITAL

  • Legal, accounting, regulatory, and tax advisors

  • Computer systems for pricing and trading

  • Capital and personnel to support market-making, and

  • Educating issuers, investors, and traders

Chapter 2


Background to bank consolidation
BACKGROUND TO BANK CONSOLIDATION CAPITAL

  • Within an industry within a country

  • Across industries within a country

  • Across countries but in the same industry

  • Across countries and industries

Chapter 2


Motives for consolidation
MOTIVES FOR CONSOLIDATION CAPITAL

  • Cost Economies

    • Economies of Scale

    • Economies of Scope

  • Market Power

  • Managerial Agency Costs

  • Exploitation of the Federal Safety Net

Chapter 2


Alternative merger hypotheses
Alternative Merger Hypotheses CAPITAL

  • HypothesisSource of value creation

  • Information Undervaluation

  • Market power Horizontal mergers

  • Synergy Cost efficiencies

  • Taxes Tax (financial) synergy

  • Inefficient mgm Mismanagement

  • Earnings diversification Higher cash flows

Chapter 2


M a in banking and the fsi
M&A in Banking and the FSI CAPITAL

  • Citigroup merger (1998) predated GLB Act (1999) and helped force passage of the act

  • JPM and Chase (2000)

  • Bank of America and NationsBank (1998)

  • Wells Fargo and Norwest (1998)

  • Hostile takeovers (SunTrust failed in its bid for Wachovia – First Union won the battle but lost its name)

Chapter 2


View consolidation in terms of the roe model
View Consolidation in Terms of the ROE Model CAPITAL

  • ROE = ROA x EM

  • ROA = PM x AU

  • Profitability (accounting) measures are: PM, ROA, ROE

  • Sales, turnover, or utilization measure is: AU

  • Leverage factor is: EM

Chapter 2


Bank organizational forms in the us
BANK ORGANIZATIONAL FORMS IN THE US CAPITAL

  • Independent Banks

  • One-Bank Holding Companies

  • Multi-Bank Holding Companies

    Together, BHCs and independent banks are referred to as BANKING COMPANIES

Chapter 2


Phenomena driving decline in of banking companies
PHENOMENA DRIVING DECLINE IN # OF BANKING COMPANIES CAPITAL

  • Mergers among BHCs

  • BHCs acquiring viable independent banks

  • The failure of independent banks during the 1980s and 1990s

    “The whole banking structure is turning into an oligopoly in which four or five institutions dominate any particular geographic-based market”

    -- Furash

Chapter 2


A long view
A Long View CAPITAL

  • YearUnit banksBranch banksTotal

  • 1935 13,329 796 14,125

  • 2000 2,733 5,848 8,581

  • Change -10,596 5,052 -5,544

  • Counting ATMs, point-of-sale systems, automated clearing houses (for direct deposit), and opportunities for home banking via the Internet numerous e-based systems for delivering financial services also exist, besides the traditional brick-and-mortar banks and branches

Chapter 2


Consolidation
CONSOLIDATION CAPITAL

  • Mergers

  • Takeovers and Hostile Takeovers

  • Anti-Takeover Strategies

    • Shark Repellants

    • Poison Pills

    • Greenmail

    • Golden Parachutes

Chapter 2


Competition and access to financial services
Competition and Access to Financial Services CAPITAL

  • The Fed favors the industrial-organizational (IO) model, which has the following linkages, given the conditions of supply and demand:

  • Market structure => Conduct => Performance

Chapter 2


Merger and acquisition strategies
MERGER AND ACQUISITION STRATEGIES CAPITAL

  • “Hit ‘em where they ain’t”

    Ex: KeyCorp and Interstate Banking

  • Buck the Merger Trend

    Ex: SunTrust but then a failed hostile-takeover attempt

Chapter 2


Opportunties for community banks in the merger environment

Businesses are Worried About CAPITAL

Fewer Local Banks (16%)

Fewer Customized Services (18%)

Less Responsive to Community (26%)

Decline in Customer Service (28%)

Community Banks are

Worried About

Credit Unions (78%)

Brokerage/Securities Firms (63%)

Other Community Banks (60%)

Mutual-Fund Companies (52%)

Regional / Money-Center Banks (41%)

Farm-Credit Banks (40%)

OPPORTUNTIES FOR COMMUNITY BANKS IN THE MERGER ENVIRONMENT

Chapter 2


Regulatory concerns
Regulatory Concerns CAPITAL

  • Safety

  • Stability

  • Structure (competition)

Chapter 2


Chapter summary
Chapter Summary CAPITAL

  • TRICK + Rational self-interest => Financial Innovation

  • T = Transparency

  • R = Risk exposure (=> risk management)

  • I = Information technology

  • C = Competition for customers

  • K = Kapital adequacy

Chapter 2


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