CAPITAL MARKET. < CHAPTER 3 >. DEPOSITORY INSTITUTIONS. CONTENTS OF OUR PRESENTATION. WHAT A DEPOSITORY INSTITUTION IS ? ASSEST/LIABILITY PROBLEM OF DEPOSITORY INSTITUTIONS Funding risk Liquidity concerns COMMERCIAL BANKS Bank services Bank funding Regulation
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< CHAPTER 3 >
Depository institutions include commercial banks, saving and loan associations, savings banks, and credit unions. These financial intermediaries accept deposits. Deposits represent the liabilities of the deposit accepting institutions. With the funds raised through deposits and other funding sources, depository institutions make direct loans to various entities and also invest in securities. Their income is derived from two sources ; the income generated from the loans they make and the securities they purchase, and fee income.
S&L, saving banks, and credit unions are commonly called “thrifts”, which are specialized types of depository institutions.
Depository institutions are highly regulated because of the important role they play in the financial system. Demand deposit accounts provide the principal means that individuals and business entities use for making payments. Also, goverment implements monetary policy through the banking system. Because of their important role, depository institutions are afforded special privileges such as access to federal deposit insurance and access to a goverment entity that provides funds for liquidity or emergency needs.
The asset/liability problem that depository institutions face is quite simple to explain, althuogh not necessarily easy to solve. A depository institutions seeks to earn a positive spread between the asset in which it invest and the cost of its funds. The spread is referred to as spread income or margin. The spread income allows the institutions to meet operating expenses and earn a fair profit on its capital.
In generating spread income a depository institutions faces several risks, including credit risk, regulatory risk, and funding risk. Credit risk , also called default risk refers to the risk that a borrower will default on a loan obligation to the depository institution or that the issuer of a security that the depository institutions holds will default on it obligation. Regulatoryrisk is the risk that regulators will change the rules and affect the earning of the institution unfavorably.
The second concerns the privilege allowed to banks to borrow at the discount window of the Federal Reserve Banks.
The third alternative, selling securities that it owns, requires that the depository institution invest a portion of its funds in securities that are both liquid and have little price risk.
The fourth alternative primarily includes using marketable securities owned as collateral for raising in the repurchase agreement market.
Federal deposit insurance
As of March 2001, 8,237 commercial banks were operating in the U.S. All rational banks must be members of the Federal Reserve System and must be insured by the Bank Insurance Fund ( BIF), which is administered by the Federal Deposit Insurance Corporation (FDIC). Federal depository insurance began in the 1930s, and the insurance program is administered by the FDIC.BIF was created by the Financial Institutions Reform , Recovery,and Enforcement Act of 1989 (FIRREA)
# of Banks
% of Banks
% of Assets
Less than $25 million 1,016 12,33 16,903 0,27
$25 to 50 million 1,636 19,86 61,068 0,97
$50 to 100 million 2,107 25,58 151,517 2,40
$100 to 300 million 2,307 28,01 388,908 6,16
$300 to 500 milllion 459 5,57 174,586 2,77
$500 to 1 billion 322 3,91 217,623 3,45
$1 to 3 billion 219 2,66 366,722 5,81
$3 to 10 billion 92 1,12 517,332 8,20
$10 billion or more 79 0,96 4,416,155 69,98
Total institutions 8,237 100,00 6,310,814 100,00
Individual banking encompasses consumer lending, residential mortgage lending, consumer installment loans, credit card financing,automobile and boat financing, brokerage services,student loans, and individual-oriented financial investment services such as personal trust and invesment services. Mortgage lending and credit card financing generate interest and fee income. Mortgage lending is often referred to as “ mortgage banking”. Brokerage services and financial invesment services also generate fee income.
Loans to nonfinancial corporations, financial corporations and goverment entities fall into the category of institutional banking. Also included in this category are commercial real estate financing,leasing activities, and factoring. In the case of leasing, a bank may be involved in leasing equipment either as lessors, as lenders to lessors , or as purchasers of leases.
Global banking covers a broad range of activities involving corporate financing and capital market and foreign exchange products and services.
The financial products developed by banks to manage risk also yield income. These product include interest rate swaps, interest rate agreement,currency swaps, forward contracts and interest rate options.
Demand deposit pay no interest and can be withdrawn upon demand. Time deposits,also called certificates of deposit, set a fixed maturity date and pay either a fixed or floating interest rate. A money market demand account is one that pays interest based on short term interest rates. The market for short term debt obligations is called the money market, which is how these deposits get their name.
Reserve Requirements and Borrowing in the Federal Funds Markets:
A bank can not invest $1for every $1 it obtains in deposits. Specified percentages are called reserve ratios, and dolar amounts based on them that are required to be kept on deposit at a Federal Reserve Banks are called required reserves. The reserve ratios are establish by the Federal Reserve Board(the Fed).
Reserve requirements in each period are to be satisfied by actual reserves.
If actual reserves exceed required reserves , the difference is referred to as excess reserves.
Bank temporarily short of their required reserves can borrow reserves from banks with excess reserves. The market where banks borrow or lend reserves is called the federal funds market. The interest rate charge to borrow funds in this market is called the federal funds rate.
Other Nondeposit Borrowing : Most deposits have short maturities. Bank borrowing in the federal funds market and at the discount window of the Fed is short term. Other nondeposit borrowing can be short term in the form of issuing obligation in the money market , or intermediate long term in the form of issuing securities in the bond market.
Banks that raise most of their funds from the domestic and international money markets, relying less on depositors for fund , are called money center banks. A regional bank , by contrast, is one that relies primarily on deposit for funding and makes less use of the money markets to obtain funds.
Regulation of Interest Rates: Even though regulation of the interest rates that banks can pay was eliminated for accounts other than demand deposit. Federal regulation prohibit the payment of interest on demand accounts.
Until the 1960s, market interest rates stayed below the ceiling. As market interest rates rose abow the ceiling and ceilings were extended to all depository institutions after 1966, these institutions found it difficult to compete with other financial institution to attract funds.
To circumvent the ceilings on time deposits and recapture the lost funds,banks developed the negotiable certificate of deposit , which in effect had higher ceiling , and eventually no ceiling at all. As all depository instutions fund it difficult to compete in the 1970s, federal legislation in the form of the Depository Instutions Regulation and Monetary Control Act of 1980 gave banks relief.
Geographical Restrictions: The McFadden Act of 1927 allowed each state the right to set its own rules on instrastate branch banking. In 1994 Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act permitting adequately capitalized and managed bank holding companies to acquire banks in any state subject to certain limitations and approval by the Federal Reserve. Starting in June 1997, this legislation allowed interstate mergers between adequately capitalized and managed banks, subject to concentration limits and state laws.
Permissible Activities for Commercial Banks : The key legislation is the Gramm-Leach-Bliley Act of 1999.
The activities of banks and bank holding companies are regulated by Federal Reserve Board, which was charged with the responsibility of regulating the activities of bank holding companies by the Bank Holding Company Act of 1956.
Early legislation governing bank activities developed against the following background :
Congress passed the Banking Act 1933. Four sections of the 1933 act barred commercial banks from certain invesment banking activities-Sections 16, 20,21 and 32. These four sections are popularly referred to as the Glass-Steagall Act.
Bank could neither underwrite securities and stock, nor act as dealers in the secondary market for securities and stock , although Section 16 does provide two exceptions. Section 16 also restricted the activities of banks in connection with corporate securities such as corporate bonds and commercial paper.
Under Section 20 of the Glass-Steagall Act, commercial bank that were members of the Federal Reserve System were prohibited from maintaining a securities firm.
Section 21 prohibited any “ person, firm,corperation,association,business trust, or other similar organization” that receives deposits from engaging in the securities business as defined in Section 16. Section 32 further prevented banks from circumventing the restrictions on securities activities.
The Glass-Steagall Act also imposed restrictions on bank activities in insurance area. Specifically , it imposed restrictions on the underwritting and selling of insurance.
Capital Requirements for Commercial Banks: The capital structure of banks, like that of all corporations , consist of equity and debt…
The capital structure of banks,like that of all corporations,consist of equity and debt. Commercial banks, like some other depository institutions and like investment banks,which it discuss in chapter 5,are highly leveraged institutions. that is, the ratio of equity capital to total assets is low,typically less than 8% in the case of banks. This level gives rise to regulatory concern about potential insolvency resulting from the low level of capital provided by the owners. An additional concern is that the amount of equity capital is even less adequate because of potential liabilities that do not appear on the bank’s balance sheet. These so-called “off-balance sheet” obligations include commitments such as letters of credit and obligations on customized interest rate agreements ( such as swaps,caps and floors).
Prior to 1989, capital requirements for a bank were based solely on it’s total assets. No consideration was given to the types of assets. In January 1989, the Federal Reserve adopted guidelines for capital adequacy based on the credit risk of assets held by the bank.
These guidelines are referred to as risk-based capital requirements. The guidelines are based on a framework adopted in July 1988 by the Basle Committee on Banking Regulations and Supervisory Practises, which consists of the central banks and supervisory authorities of G-10 countries.
1.Regulators in the United States and abroad sought greater consistency in the evaluation of the capital adequacy of major banks throughout the world.
2. Regulators tried to establish capital adequacy standarts that take into consideration the risk profile of the bank.
The risk-based capital guidelines attempt to recognize credit risk by segmenting and weighting requirements.
U.S Treasury securities $ 100
Municipal general obligation bonds 100
Residential mortgages 500
Commercial loans 300
Total book value $1.000
Book value (in millions)
Product (in million)
U.S Treasury securities $ 100 0% $ 0
Municipal general obligation bonds 100 20 20
Residential mortgages 500 50 250
Commercial loans 300 100 300
Risk-weighted assets $570
Examples of Assets Including
Because of the important economic role played by banks, the U.S goverment sought a way to protect them against depositors who, because of what they thought were real or perceived problems with a bank, would withdraw funds in a disruptive manner. Bank panics occured frequently in the early 1930s, resulting in the failure of banks that might have survived economic difficulties except for massive withdrawals. As the mechanism devised in 1933 to prevent a " run on a bank” the U.S goverment created federal deposit insurance. The insurance was provided through a new agency, the Federal Deposit Insurance Corporation.
The Federal Deposit Insurance Corporation Improvement Act of 1991 ( FDICIA ) included a number of significiant reforms to improve the deposit insurance system. Despite the improvements, some major flaws remained, including two of particular concern:
A depository institution is assigned to one of nine categories based on a two-step process. The first is a capital group assignment based on capital ratios and the second is a supervisory subgroup assignment based on other relevant information.
TABLE3-3 FDIC’s Risk Ratings Assigned to Depository Institutions
Capital Group Descriptions
Group 1: Group 2: Group 3:
Total risk-based capital ratio equal to or grater than 10%
Tier 1 risk-based capital ratio equal or greater than 6%
Tier 1 leverage capital ratio equal to or greater than 5%
Not well capitalized
Total risk-basedcapital ratio equal to or greater than 8%
Tier 1 risk-based capital ratio equal to or greater than 4%
Tier 1 leverage capital ratio equal to or greater than 4%
Neither well capitalized nor adequately capitalized
Supervisory subgroup assignments for members of the BIF and the SAIF are made in accordance with section 327.4(a)(2)of the FDIC’s Rules and regulations.
See following Supervisory Subgroup descriptions.
In order to deal with the conflict noted earlier with respect to setting deposit insurance premiums, an “ expected loss “ pricing system would take into consideration:
The S&L Crisis
S&Ls represent a fairly old institution. The provision of funds for financing the purchase of a home motivated the creation of S&Ls. The collateral for the loan would be the home being financed.
S&Ls are either mutually owned or operate under corporate stock ownership. “ Mutually owned” means no stock is outstanding, so technically the depositors are the owners. To increase the ability of S&Ls to expand the sources of funding available to bolster their capital, legislation facilitated the conversion of mutually owned companies into a corporate stock ownership structure.
Like banks,S&Ls are now subject to reserve requirements on deposits established by the Fed. Prior to the passage of FIRREA, federal deposit insurance for S&Ls was provided by the Federal Savings and Loan Insurance Corporation(FSLIC). The Saving Association Insurance Fund (SAIF) replace FSLIC and is administered by the FDIC.
The only assets in which S&Ls were allowed to invest were mortgage, mortgage-backed securities,and goverment securities. Mortgage loans include fixed-rate mortgages and adjustable rate mortgages. Although most mortgage loans are for the purchase of homes, S&Ls do make construction loans.
Although S&Ls enjoyed a comparative advantage in originating mortgage loans,they lacked the expertise to make commercial and corporate loans. Rather than make an invesment in acquiring those skills,S&Ls took an alternative approach and invested in corporate bonds because these bonds were classified as corporate loans. More specifically, S&Ls became one of the major buyers of noninvesment-grade corporate bonds,more popularly referred to as”junk” bonds or “high yield” bonds. Under FIRREA, S&Ls are no longer permitted to invest new money in junk bonds.
S&Ls invest in short-term assets for operational and regulatory purposes. All S&Ls with federal deposit insurance must satisfy minimum liquidity requirements. These requirements are specified by the Office of Thrift Supervision.
Prior to 1981, the bulk of the liabilities of S&Ls consisted of passbook savings accounts and time deposits. The interest rate that could be offered on these deposits was regulated. S&Ls were given favored treatment over banks with respect to the maximum interest rate they could pay depositors-they were permitted to pay an interest rate 0.5% higher, later reduced to 0.25%. With the deregulation of interest rates discussed earlier in this chapter, banks and S&Ls now compete head-to-head for deposits.
Since the early 1980s, however, S&Ls can offer accounts that look similar to demand deposits and that do pay interest call negotiable order of withdrawal(NOW) accounts. Unlike demand deposits, NOW accounts pay interest S&Ls were also allowed to offer money market deposits accounts(MMDA)
Since the 1980s, S&Ls more actively raised funds in the money market. They can borrow in the federal funds market and they have access to the Fed’s discount window. S&Ls can also borrow from the Federal Home Loan Banks. These borrowing called advances, can be short-term or long-term in maturity and the interest rate can be fixed or floating.
Federal S&Ls are chartered under the provision of the Home Owners Loan Act of 1933.
As in bank regulation. S&Ls historically were regulated with respect to the maximum interest rate on deposit accounts, geographical operations, permissible activities and capital adequacy requirements.
Two sets of capital adequacy standards apply to S&Ls, as they do for anks. S&Ls are also subject to two ratio tests based on “ core capital” and “tangible capital”. The risk based capital guidelines are similar to those imposed on banks. Instead of two tiers of capital , however,
S&Ls deal with three:
Tier 1 : tangible capital
Tier 2 : core capital
Tier 3 : supplementary capital
Until the early 1980s, S&Ls and all other lenders financed housing through traditional mortgages at interest rates fixed for the life of the loan. The period of the loan was typically long, frequently up to 30 years. Funding for these loan,by regulation, came from deposits having a maturity considerably shorter than the loans. As explained earlier, this sittuation creates the funding risk of lending long and borrowing short. It is extremely risky, although regulators took a long time to understand it.
No problem arises of course if interest rates are stable or declining, but if interest rates rise above the interest rate on the mortgage loans,a negative spread results,which must lead eventually into insolvency. Regulators at first endeavored to shield the S&L industry from the need to pay high interest rate without losing deposits by imposing a ceiling on the interst rate that would be paid by S&Ls and by their immediate competiors, the other depository institutions. However the approach did not and coukd not work.
With the high volatility of interest rates in the 1970s,followed by the historically high level of interest rates in the early 1980s, all depository institutions began to lose funds competitors exempt from ceiling, such as the newly formed money market funds; this development forced some increase in ceilings.
The ceilings in place since the middle of the 1960s did not protect the S&Ls; they began to suffer from diminished profits and increasingly from operating losses. A large fraction of S&Ls became technically insolvent as rising interest rates eroded the market value of their assets to the point where they fell short of the liabilities.
As institutions, saving banks are similar to, although much older than, S&Ls.They can be either mutually owned(in which case they are called mutual savings banks) or stockholders owned.
Although the total deposits at saving banks are less than those of S&Ls, savings banks are typically larger institutions.Asset structures of saving banks and S&Ls are similar.Residential mortgages provide the principal assets of saving banks.Because states permitted more portfolio diversification than federal regulatorsof S&Ls, savings bank portfolios weathered funding risk far better than S&Ls.Savings bank porfolios include corporate bonds, Treasury and goverment securities, municipal securities, common stock,and consumer loans.
The principal source of funds for savings banks is deposits.Typically, the ratio of deposits to total assets is greater for savings banks than for S&Ls.Savings banks offer the same types of deposit accounts as S&Ls, and deposits can be insured by either the BID or SAIF.
Credit unions are the smallest of the depository institutions.Credit unions can obtain either a state or federal charter.Their unique aspect is the ‘ common bond’ requirement for credit union membership.According to the statutes that regulate federal credit unions, membership in a federal credit union ‘shall be limited to groups having a common bond of occupation or association , or to groups within a well-defined neighborhood, community, or rural district.’
Credit union assets consist of small consumer loans, residential mortgages loans, and securities.Regulations 703 and 704 of NCUA set forth the types of investments in which a credit union may invest.They can make investments in corporate credit unions .
What is a corporate credit union?One might think that a corporate credit union is a credit union set up by employees of a corporation.It is not.Federal and state-chartered credit unions are referred to as ‘natural person’ credit unions because they provide financial services to qualifying members of the general public.In constrast, corporate credit unions provide a variety of investment services, as well as payment systems, only to natural person credit unions