Chapter 12

1. Chapter 12 Depository Financial Institutions

2. Fundamentals of Bank Management • Banks are like any other business firms that • Buy • Sell • Make a profit • However there is a difference • What they buy and sell is money • When they buy money, we say they are borrowing • When they sell money, we say they are lending

3. Fundamentals of Bank Management • For banks, the raw material is money • They are the Repackagers of money • They make a profit when • When they buy (borrow) money at a lower rate then sell (lend) it for • When they manage risk successfully

4. Fundamentals of Bank Management • Similar to any other business, their accounting principles follow the simple rule Asset = Liability + Owner’s Equity • Which can be reorganized as Asset - Liability = Owner’s Equity • Lets go over these components carefully

5. Fundamentals of Bank Management Assets or Uses of Funds • Loans are major component of their assets • Trends of loans • In 1980 loans were 54% of all assets • in 2007 they grew to 59% • Most of this increase coming from mortgages • Cash and investments in state and local government securities is another category of asset • Over the years this asset has declined • Holding assets in the form of cash has opportunity cost

6. Fundamentals of Bank Management Assets or Uses of Funds • Federal government securities • Remained fairly constant over the years. • highly marketable and liquid • Counter cyclical • Increase during recessions • Decrease during expansions • Banks treat federal securities as a residual use of funds

7. Fundamentals of Bank Management Assets or Uses of Funds • Banks are barred by law from owning stocks—why? • It is a consumer protection law • Stock returns are too volatile and risky • Banks are not allowed to engage in risky speculation with depositors’ money • However, banks do buy stocks for trusts they manage—not shown among bank’s own assets

8. Fundamentals of Bank Management Liabilities of Sources of Funds • Transaction Deposits: • 23% of all liabilities in 1970 • 6% of all liabilities in 2007 • Used to be major source of funds • Generally banks pay low interest (if any) on demand deposits. • Increase in interest paid on other types of assets has caused this decline

9. Fundamentals of Bank Management Liabilities of Sources of Funds • Non-transaction deposits • Represented 46% of banks’ funds in 2007 • Passbook savings deposits—traditional form of savings • Time deposits—certificates of deposit with scheduled maturity date with penalty for early withdrawal • Money Market Deposit Accounts (MMDA)—pay money market rates and offer limited checking functions • Negotiable CDs—can be sold prior to maturity

10. Fundamentals of Bank Management • Liabilities of Sources of Funds • Miscellaneous Liabilities have experienced a significant increase during past 30 years • Discount Borrowing: Borrowing from Federal Reserve Bank • Federal Funds Market: • Borrowing from another bank • Unsecured loans between banks, often on an overnight basis • Foreign Banks: • Borrowing from their foreign branches, • Parent corporation, and • Subsidiaries and affiliates

11. Fundamentals of Bank Management Liabilities of Sources of Funds • Miscellaneous Liabilities • Repurchase Agreements • Sell government securities to another banks or corporate depositors • With agreement to re-purchase at later date at a higher price • Higher price represents the interest • Securities serves as a collateral • Securitization • Pooling loans into securities • Selling them to investors to raise new funds

12. Fundamentals of Bank Management Liabilities of Sources of Funds • Miscellaneous Liabilities • Securitization • Transform non traded financial instruments into traded securities • Pooling non traded loans into securities • Selling them to investors to raise new funds • Underlying assets serve as a collateral

13. Fundamentals of Bank Management • Bank Capital or Equity • Individuals purchase stock in bank • Bank pays dividends to stockholders • Serves as a buffer against risk • Equity capital has remained stable at 6%-8% • However, riskiness of banks’ assets has increased • Bank regulators force banks to increase their capital position to compensate for the increased risk of assets (loans) • Equity is most expensive source of funds so bankers prefer to minimize the use of equity

14. Fundamentals of Bank Management • Bank Profitability • Bank management must balance between liquidity and profitability tradeoff. • Net Interest Income • Difference between total interest income (interest on loans and interest on securities and investments) and interest expense (amount paid to lenders) NII = Interest income – Interest expense

15. Fundamentals of Bank Management • Bank Profitability • Net Interest Margin (NIM) • Net interest income as a percentage of total bank assets NIM = (NII/Asset)*100 • Also known as interest rate spread

16. Fundamentals of Bank Management • Bank Profitability • Factors that determine Net Interest Margin • Better service • Implies higher rates on loans and lower interest on deposits • Monopoly power • Allows bank to pay lower deposit rate • Charge higher interest rate • However, it is becoming more unlikely due to enormous competition from other banks and nonbank competitors • Bank’s risk • Interest rate and credit risk

17. Fundamentals of Bank Management • Bank Profitability • Service charges and fees and other operating income • Additional source of revenue • Become more important as banks have shifted from traditional interest income to more nontraditional sources on income

18. Fundamentals of Bank Management • Bank Profitability • Net Income after Taxes • Net Income less taxes • Return on Assets (ROA) • Net Income after taxes expressed as a percentage of total assets • Return on Equity (ROE) • Net Income after taxes expressed as a percentage of total equity capital

19. Bank Risks • Leverage Risk • Leverage—Combine debt with equity to purchase assets • Leveraging with debt increases risk because debt requires fixed payments in the future • The more leveraged a bank is, the less its ability to absorb a loss in asset value • Leverage Ratio—Ratio of bank’s equity capital to total assets [10% in 2007] • Regulators in US and other countries impose risk-based capital requirements—riskier the asset, higher the capital requirement

20. Fundamentals of Bank Management • Credit Risk • Possibility that borrower may default • Important for bank to get as much information as possible about borrower—asymmetric information • Charge higher interest or require higher collateral for riskier borrower • Loan charge-offs is a way to measure past risk associated with a bank’s loans • Ratio of non-performing loans (delinquent 30 days or more) to total loans is a forward-looking measure

21. Fundamentals of Bank Management • Interest Rate Risk • Mismatch in maturity of a bank’s assets and liabilities • Traditionally banks have borrowed short and lent long • Profitable if short-term rates are lower than long-term rates • Due to discounting, increasing interest rates will reduce the present value of bank’s assets • Use of floating interest rate to reduce risk • The one-year re-pricing GAP is the simplest and most commonly used measure of interest rate risk

22. Fundamentals of Bank Management • Trading Risk • Banks act as dealers in financial instruments such as bonds, foreign currency, and derivatives • At risk of a drop in price of the financial instrument if they need to sell before maturity • Difficult to develop a good measure of trading risk since is it hard to estimate the statistical likelihood of adverse price changes

23. Fundamentals of Bank Management • Liquidity Risk • Possibility that transactions deposits and savings account can be withdrawn at any time • Banks may need additional cash if withdrawals significantly exceed new deposits • Traditionally banks provided liquidity through the holding of liquid assets (cash and government securities) • Historically these holdings were a measure of a bank’s liquidity, but have declined as a percentage of total assets during the past 30 years (41%-1970; 24%-2002) • During past 30 years banks have used miscellaneous liabilities to increase their liquidity

24. Major Trends in Bank Management • For most of the 20th century banks were insulated from competition from other financial institutions • However, that has changed over time • Trends that produced this transition can be summarized by the following: • Consolidation within the banking industry • Rise of non traditional banking • Globalization

25. Consolidation McFadden Act of 1927 • Prohibited banks from branching across state lines • Intension was to prevent the formation of a few large, nationwide banks, who might monopolize the industry • For that purpose, many states also had restrictions that limited or prohibited branching within their state boundaries • Result—many, many small banks protected from competition from larger national banks

26. Consolidation McFadden Act of 1927 • Unintended Consequences: • Created banking a localized monopoly • Inefficient local banks • There were over 14,000 small • 40% of these banks had less 25 million assets

27. Consolidation McFadden Act of 1927 • Large efficient banks wanted to enter into these untapped market • Over the years a number of loopholes were exploited to bypass this act • Loan production offices • Acquisition of failed thrift institutions under S&L bail out • Most effective was the use of Bank Holding Company (BHC) • Reciprocity rights

28. Consolidation McFadden Act of 1927 • Bank Holding Company: An entity that can own one of more banks and non bank institutions as subsidiary • Under the McFadden act BHC could own banks in different states if permitted by state laws • Therefore, a BHC to own banks across state lines • This would serve the same purpose as to having branches across different states

29. Consolidation McFadden Act of 1927 • Reciprocity Rights 1975 Maine allowed BHC from other states to enter, if Maine BHC received the same rights • 1982 New York passed the same law • Massachusetts formed regional reciprocity pact • By mid 1990 about 30% of domestic banking assets were owned by out of state BHCs • All these severely compromised the effectiveness of the McFadden Act

30. Consolidation Riegle-Neal Interstate Banking and Branching Efficiency Act • Passed in 1994 • Allowed BHC to acquire banks in any state • By 1997 all banks were permitted to open branches across states • Number of unit banks shrunk dramatically • 14,400 in the early 1980 • 7,282 in 2007 • For banks with $100 million assets • Total assets was 17% all banking assets in 1980 • It declined to less that 3% in 2007

31. Consolidation Riegle-Neal Interstate Banking and Branching Efficiency Act • Consolidation however did not affect the availability of banking services for consumers • Although the number of unit banks declined, the number of bank offices (branch and head office) actually went up • In addition ATM, telephone and internet banking were introduced • These provided better access to banking services for consumers

32. Nontraditional Banking The Glass-Steagall Act of1933 • Prohibited commercial banking from engaging in investment banking • Some investment banking operations were allowed: • Underwriting general obligation municipal bonds • Act as agent for private placements • Not for public, not registered with SEC, Raising funds small business • They were still prohibited from underwriting corporate bonds and equity (stocks)

33. Nontraditional Banking The Glass-Steagall Act • Commercial banks gradually weakened the effectiveness of the act • They resorted to court system to argue that they should be allowed to perform activities like: • Underwriting municipal revenue bonds • Underwriting commercial paper • Managing mutual funds • Finally Fed agreed to let BHC to own investment banking subsidiary known as section 20 affiliates on a limited basis

34. Nontraditional Banking The Glass-Steagall Act • Essentially Fed broaden the definition of activities “closely related to banking” • Operations of section 20 affiliates could not exceed 5% of total investment banking revenue • Limit was increased gradually to 10% and 25%

35. Nontraditional Banking The Glass-Steagall Act • This led to emergence of mega universal banks through acquisition of several investment banks: • Bank of America and Montgomery Securities (now Merrill Lynch) • Citibank and Travelers Group (Salomon Smith Barney)

36. Nontraditional Banking The Glass-Steagall Act • Finally, the Gramm-Leach-Bliley Act (1999) repealed the Glass-Steagall Act Off-balance Sheet Activities • Another area of growth in recent years • These activities increase risk exposure for banks with no effect on bank’s balance sheet • Future market • Option market • Guarantee and commitment business

37. Globalization • American Banks Abroad • Two major factors explain rapid expansion of US banks in foreign countries: • Growth of international trade • American multinational corporation with operations abroad

38. Globalization • Edge Act (1919) • Permitted US banks to establish special subsidiaries to facilitate international financing • Exempt from the McFadden Act’s prohibition against interstate banking. Subsidiary in • California to manage trade and financing with South Korea • Florida to manage trade and financing with Latin America

39. Globalization • Foreign Banks in the United States • About one third of all business loans are made by foreign banks. • Some of the well known foreign banks include: • French Bank BNP Paribas • Bank of Tokyo-Mitsubishi • HSBC • Bank of Montreal

40. Globalization • Foreign Banks in the United States • Organizational Forms: • Branch of a Foreign Bank • Subsidiary of a Foreign Bank • Agency of a Foreign Bank

41. Globalization • Foreign Banks in the United States • Prior to 1978 foreign banks operating in the US were largely unregulated • No reserve requirement • Exempt from McFadden act • International Banking Act of 1978 • Foreign banks subject to same federal regulations as domestic banks • However, certain established banks were grandfathered and were not subject to the law

42. Globalization • Eurodollars • Eurodollar deposits made in foreign banks were denominated in US dollars, which eliminated the foreign exchange risk • These foreign banks were exempt from Regulation Q and could offer higher interest than US banks • American banks opened foreign branches: • Gain access to Eurodollars • Borrow abroad during periods of tight money by the FED

43. Globalization • Eurobonds • Corporate and foreign government bonds sold: • Outside borrowing corporation’s home country • Principal and interest are denominated in borrowing country’s currency • Number of tax advantages • Little government regulation

44. Globalization • Domestically Based International Banking Facilities (IBF) • Offers both US and foreign banks comparable conditions as foreign countries to lure offshore banking back to US • IBF is a domestic branch that is regulated by Fed as if it were located overseas. • No reserve or deposit insurance requirements • Essentially bookkeeping operations with no separate office

45. Globalization • Domestically Based International Banking Facilities (IBF) • Many states exempt income from IBFs from state and local taxes • IBFs are not available to domestic residents, only to business that is international in nature with respect to sources and uses of funds • Foreign subsidiaries of US multinationals can use IBFs provided funds to not come from domestic sources and not used for domestic purposes