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Chapter 1 Banking and the Financial Services Industry. Credit Crisis of 2007 - 2009. Lenders Made “Sub-Prime” Mortgages Borrowers had insufficient income to make monthly payments Many mortgages had “teaser” rates Low payments resulting in negative amortization Multiple Mortgage Banks Fail

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credit crisis of 2007 2009
Credit Crisis of 2007 - 2009
  • Lenders Made “Sub-Prime” Mortgages
    • Borrowershad insufficient income to make monthly payments
    • Many mortgages had “teaser” rates
    • Low payments resulting in negative amortization
  • Multiple Mortgage Banks Fail
    • As the mortgages write-downs were recognized, the mortgage banks’ capital was depleted
credit crisis of 2007 20093
Credit Crisis of 2007 - 2009
  • Collapse and/or Failure of:
    • Bear Stearns
    • Lehman Brothers
    • Countrywide
    • Washington Mutual
    • Wachovia
credit crisis of 2007 20094
Credit Crisis of 2007 - 2009
  • Government Response
    • Fannie Mae and Freddie Mac placed into conservatorship
    • Loaned AIG over $150 billion
    • Insured money market mutual funds
    • Created Commercial Paper Funding Facility
    • Increased FDIC coverage to $250,000
      • Temporarily through 2009
credit crisis of 2007 20095
Credit Crisis of 2007 - 2009
  • Government Response
    • Established Troubled Asset Relief Program – TARP
    • Established Term Asset-Backed Securities Loan Facility – TALF
    • Invested $125 billion in nine large U.S. banks
    • Promoted mortgage loan modifications
credit crisis of 2007 20096
Credit Crisis of 2007 - 2009
  • Impact on Banks and the Banking Environment
    • Biggest impact of declining real estate values concentrated in the areas that experienced the largest run-up in real estate values
      • Many large banks experienced large losses while many small banks did not
credit crisis of 2007 20098
Credit Crisis of 2007 - 2009
  • Impact on Banks and the Banking Environment
    • Largest Investment Banks
      • Goldman Sachs and Morgan Stanley
        • Converted to Financial Holding Companies
      • Bear Stearns and Merrill Lynch
        • Absorbed by other financial institutions
      • Lehman Brothers
        • Failed
how do banks differ
How Do Banks Differ?
  • Global Banks
    • Offer a wide array of products and services globally
  • Super-Regional Banks
    • Similar to global banks but smaller in size and market penetration
  • Community Banks
    • Smaller trade area with total assets under $1 billion
how do banks differ12
How Do Banks Differ?
  • Bank Holding Companies
    • Owns controlling interest in one or more commercial banks
    • Parent Organization versus Subsidiaries
      • One-Bank Holding Companies
      • Multibank Holding Companies
how do banks differ14
How Do Banks Differ?
  • Financial Holding Companies
    • The primary advantage to forming an FHC is that the entity can engage in a wide range of financial activities not permitted in the bank or in a BHC
    • Authorized to engage in:
      • Underwriting and selling insurance and securities
      • Commercial banking
      • Merchant banking
      • Insurance company portfolio investment activities
how do banks differ15
How Do Banks Differ?
  • Financial Holding Companies
    • Fed may not permit forming an FHC (or converting a BHC to an FHC) if any of its insured depository institution subsidiaries are:
      • not well capitalized,
      • not well managed,
      • did not receive at least a “Satisfactory” rating in its most recent CRA exam
how do banks differ16
How Do Banks Differ?
  • Financial Holding Companies
    • An FHC can own a bank or BHC or a thrift or thrift holding company
      • Each of these companies owns subsidiaries, while the parent financial holding company also owns other subsidiaries directly
how do banks differ18
How Do Banks Differ?
  • Holding Company Financial Statements
    • The consolidated financial statements of a holding company and its subsidiaries reflect aggregate or consolidate performance
how do banks differ24
How Do Banks Differ?
  • Holding Company Financial Statements
    • While the consolidated financial statements of a holding company and its subsidiaries reflect aggregate performance, it is useful to examine the parent company’s statements alone
how do banks differ26
How Do Banks Differ?
  • Holding Company Financial Statements
    • The parent typically pays very little in income tax because 80 percent of the dividends from subsidiaries is exempt
      • Taxable income from the remaining 20 percent and interest income is small relative to deductible expenses
        • Under IRS provisions, each subsidiary actually pays taxes quarterly on its taxable income
        • With a consolidated tax return, however, the parent company can use taxable income from its subsidiaries to offset its loss
organizational structure and financial services business model
Organizational Structure and Financial Services Business Model
  • S-Corporation Banks
    • Have favorable tax treatment because a qualifying firm does not pay corporate income tax
      • The firm allocates income to shareholders on a pro rata basis and each individual pays tax at personal tax rates on the income allocated to them
        • Given the opportunity to avoid double taxation at the firm and individual level, many closely held banks have chosen S-corporation status
      • The primary limitation to qualifying for S-corporation status is a requirement that the bank must have no more than 100 shareholders
organizational structure and financial services business model29
Organizational Structure and Financial Services Business Model
  • Financial Services Business Models
    • The principal advantage of being a depository institution is access to FDIC deposit insurance
      • The FDIC charges banks a premium for the insurance, which ensures qualifying deposit holders that the FDIC will guarantee the principal amount of each deposit up to the maximum allowed
      • The existence of deposit insurance allows depository institutions to pay low rates on insured deposits and ensures that such deposits are relatively stable in times of crisis
organizational structure and financial services business model30
Organizational Structure and Financial Services Business Model
  • Financial Services Business Models
    • The primary disadvantage of operating as a bank (or BHC) is that the firm is subject to regulation as a bank
    • Prior to 2008, investment banks avoided regulation as banks, which allowed them to operate with substantially lower equity capital per dollar of risk assets and enter lines of business not generally available to commercial banks
      • The combined effect was greater financial leverage and business operations in many high-risk areas such as proprietary trading
organizational structure and financial services business model31
Organizational Structure and Financial Services Business Model
  • Transactions Banking Versus Relationship Banking
    • Transactions Banking
      • Involves the provision of transactions services such as checking accounts, credit card loans, and mortgage loans that occur with high frequency and exhibit standardized features
      • Because the products are highly standardized, they require little human input to manage
organizational structure and financial services business model32
Organizational Structure and Financial Services Business Model
  • Transactions Banking Versus Relationship Banking
    • Relationship Banking
      • Emphasizes the personal relationship between the banker and customer
        • For example, the key feature of a loan that is relationship driven is that the lender adds real value to the borrower during the credit granting process
        • In addition to the provision of funds, the lender may provide expertise in accounting, business, and tax planning
organizational structure and financial services business model33
Organizational Structure and Financial Services Business Model
  • Transactions Banking Versus Relationship Banking
    • Relationship Banking
      • Lending institutions generally charge higher rates and often hold the loans in portfolio
      • Aggressively market noncredit products and services to such customers in order to lock in the relationship
organizational structure and financial services business model34
Organizational Structure and Financial Services Business Model
  • Transactions Banking Versus Relationship Banking
    • Securitization
      • The process of pooling a group of assets with similar features—for example, credit card loans or mortgages—and issuing securities that are collateralized by the assets
        • The securities are sold to investors who receive the cash flows from the loans net of servicing, guarantee, and trust fees
        • The entire process adds liquidity to the market because the loan originators regularly repeat the process knowing that investors will demand the securities
organizational structure and financial services business model35
Organizational Structure and Financial Services Business Model
  • Transactions Banking Versus Relationship Banking
    • Originate-to-Distribute (OTD)
      • When loan origination is separated from ownership
        • The flaw is that lenders who originated the loans knew they would not own the loans long term
        • They were, therefore, less concerned about the quality of the assets originated
organizational structure and financial services business model36
Organizational Structure and Financial Services Business Model
  • Transactions Banking Versus Relationship Banking
    • Originate-to-Distribute (OTD)
        • In order to grow their business and continue originating loans, they increasingly made loans to less qualified borrowers
        • When the underlying assets defaulted at higher-than-expected rates, investors in the securities did not receive the promised payments
        • The net result is that liquidity largely dried up for most securitizations
organizational structure and financial services business model37
Organizational Structure and Financial Services Business Model
  • Universal Banking
    • Refers to a structure for a financial services company in which the company offers a broad range of financial products and services
      • Combined traditional commercial banking that focused on loans and deposit gathering with investment banking
      • Underwrote securities, advised on mergers and acquisitions, managed investment assets for customers, took equity positions in companies, bought and sold assets for a speculative profit, offered brokerage services, and made loans and accepted deposits
organizational structure and financial services business model38
Organizational Structure and Financial Services Business Model
  • Universal Banking
    • The presumed advantage of universal banking is the ability to cross-sell services among customers
    • Participation in diverse products and services would presumably increase the information advantage and allow the bank to serve customers more efficiently and at better prices
organizational structure and financial services business model39
Organizational Structure and Financial Services Business Model
  • Universal Banking
    • There is no consensus on whether universal banking is successful
    • U.S. firms that tried to achieve this goal of a “one-stop financial supermarket” have not outperformed more traditional competitors
different channels for delivering banking services
Different Channels for Delivering Banking Services

Branch Banking

Automated Teller Machines

Internet (Online) Banking

Call Centers

Mobile Banking

historical bank regulation
Historical Bank Regulation
  • Glass-Steagall Act (1933-1999)
    • Created three distinct industries
      • Commercial Banking
      • Investment Banking
      • Insurance
historical bank regulation45
Historical Bank Regulation
  • Definition of a Commercial Bank
  • Limitations on:
    • Geographic Scope
    • Products and Services
  • Results:
    • Large number of small banks
    • Limited products and services banks could offer
    • Limited geographic area to operate
historical bank regulation46
Historical Bank Regulation
  • Changes in:
    • Products and Services
      • MMMFs
      • LPOs
      • Commercial Paper
      • Junk Bonds
      • Payment Methods
goals and functions of bank regulation
Goals and Functions of Bank Regulation

Ensure the Safety and Soundness of Banks

Provide an Efficient and Competitive Financial System

Provide Monetary Stability

Maintain the Integrity of the Payments System

Protect Consumers from Abuses

ensure safety soundness and provide an efficient competitive system
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Supervision and Examination
    • FDIC
    • OCC
ensure safety soundness and provide an efficient competitive system49
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Supervision and Examination
    • CAMELS
      • Capital
      • Asset Quality
      • Management Quality
      • Earnings Quality
      • Liquidity
      • Sensitivity to Market Risk
ensure safety soundness and provide an efficient competitive system50
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Supervision and Examination
    • Memorandum of Understanding
      • Formal regulatory document
    • Cease and Desist Order
      • Legal document
      • Has legal standing
ensure safety soundness and provide an efficient competitive system51
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • New Charters
    • Dual Banking System
    • Office of the Comptroller of the Currency
      • Charters national banks
    • Office of Thrift Supervision
      • Charters federal savings banks and savings associations
    • National Credit Union Administration
      • Charters federal credit unions
ensure safety soundness and provide an efficient competitive system52
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • New Charters
    • State Banking Authorities
      • Charter state banks
    • State Savings Authorities
      • Charter state savings banks
    • State Credit Union Authorities
      • Charter state credit unions
ensure safety soundness and provide an efficient competitive system53
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • National versus State Charter
    • All banks obtain FDIC deposit insurance as part of the chartering process
    • National banks must join the Fed
      • Primary regulator is the OCC
ensure safety soundness and provide an efficient competitive system54
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • National versus State Charter
    • State banks may join the Fed
      • State banks are regulated by their state banking authority
      • State banks also have a primary federal regulator
        • Federal Reserve for member banks
        • FDIC for non-member banks
ensure safety soundness and provide an efficient competitive system57
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Commercial Banks, Savings Institutions, and Credit Unions
    • Commercial Banks
      • Specialize in short-term business credit
    • Savings Institutions
      • Specialize in real estate loans
      • Stockholder versus Mutual Ownership
      • “Qualified Thrift Lender”
      • Unitary Thrift Holding Company
ensure safety soundness and provide an efficient competitive system58
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Commercial Banks, Savings Institutions, and Credit Unions
    • Credit Unions
      • “Common Bond” requirement
      • Exempt from Federal Taxation
ensure safety soundness and provide an efficient competitive system60
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Farm Credit System
    • Farm Credit Administration
    • 4 Farm Credit Banks
    • 81 Agricultural Credit Associations
    • 9 Federal land Credit Associations
    • 1 Agricultural Credit Bank
ensure safety soundness and provide an efficient competitive system61
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Farm Credit System
    • Provides credit and other services to:
      • Agricultural producers and farmer-owned agricultural and aquatic cooperatives
      • Agricultural processing and marketing activities
      • Rural housing
      • Farm-related businesses
      • Rural utilities
      • Foreign and domestic companies involved in international agricultural trade
ensure safety soundness and provide an efficient competitive system62
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Farm Credit System
    • Not considered depository institutions because they do not accept transactions deposits
    • Federal Farm Credit Banks Funding Corporation
      • Issues debt on behalf of the Farm Credit Banks
ensure safety soundness and provide an efficient competitive system63
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Federal Deposit Insurance
    • Currently full coverage for demand deposit accounts until 12/31/2013
    • Currently coverage of at least $250,000 per depositor on interest-bearing accounts
      • Coverage will revert to $100,000 ($250,000 for retirement accounts) per depositor on 1/1/2014
      • Original limit in 1933 was $5,000
ensure safety soundness and provide an efficient competitive system64
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Federal Deposit Insurance
    • Goal is for fund to be 1.25% of deposits
      • Banks pay risk-based deposit insurance premium to the Deposit Insurance Fund
ensure safety soundness and provide an efficient competitive system65
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Federal Deposit Insurance
    • Federal Deposit Insurance Corporation
      • Receiver of failed institutions
        • Liquidate
        • Sell
      • Too Big to Fail Policy
ensure safety soundness and provide an efficient competitive system66
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Product Restrictions: Depository Institutions versus Non-Depository Institutions
    • Banks are restricted on what products and services they can offer
    • http://www.occ.treas.gov/corpapps/BankAct.pdf
ensure safety soundness and provide an efficient competitive system68
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Activities Permissible for a National Bank
    • General Banking Activities
      • Branching
      • Consulting and financial advice
      • Corporate governance
      • Correspondent service
      • Finder activities
      • Leasing
      • Lending
      • Payment services
ensure safety soundness and provide an efficient competitive system69
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Activities Permissible for a National Bank
    • Fiduciary, Insurance and Annuities Activities
      • General trust activities, employee benefit accounts, and real estate brokerage
      • Insurance and annuities activities
      • Securities activities
ensure safety soundness and provide an efficient competitive system70
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Activities Permissible for a National Bank
    • Technology and Electronic Activities
      • Digital certification
      • Electronic bill payments
      • Electronic correspondent services
      • Electronic storage and safekeeping
      • Internet access service
      • Internet and PC banking
      • Software development and production
ensure safety soundness and provide an efficient competitive system71
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Activities Permissible for a National Bank
    • Investments
      • Asset-backed securities
      • Bank stock
      • Bankers acceptances
      • Corporate bonds
      • Collateralized mortgage-related investments
      • Commercial paper
      • Money market preferred stock,
      • Trust preferred securities
      • State and local bonds
ensure safety soundness and provide an efficient competitive system72
Ensure Safety & Soundness and Provide an Efficient & Competitive System
  • Shortcomings of Restrictive Bank Regulation
    • Does not prevent bank failure
    • Cannot eliminate economic risk
      • Assumed markets for bank products could be protected
      • Discriminated against U.S. based firms
    • Does not guarantee that bank management will make good decisions
maintaining monetary stability and the integrity of the payments system
Maintaining Monetary Stability and the Integrity of the Payments System
  • The Role of the Central Bank in the Economy: The Federal Reserve System
    • Fundamental Functions
      • Conduct monetary policy
      • Provide and maintain the payments system
      • Supervise and regulate banking operations
maintaining monetary stability and the integrity of the payments system74
Maintaining Monetary Stability and the Integrity of the Payments System
  • The Role of the Central Bank in the Economy: The Federal Reserve System
    • Organization
      • Board of Governors
      • 12 Federal Reserve District Banks
maintaining monetary stability and the integrity of the payments system75
Maintaining Monetary Stability and the Integrity of the Payments System
  • The Role of the Central Bank in the Economy: The Federal Reserve System
    • Monetary Policy
      • Open Market Operations
        • Open market purchases (sales) increase (decrease) reserves & the money supply
maintaining monetary stability and the integrity of the payments system76
Maintaining Monetary Stability and the Integrity of the Payments System
  • The Role of the Central Bank in the Economy: The Federal Reserve System
    • Monetary Policy
      • Discount Rate
        • Decreasing (Increasing) the discount rate makes bank borrowing less (more) expensive, which leads to an increase (decrease) in the money supply
maintaining monetary stability and the integrity of the payments system77
Maintaining Monetary Stability and the Integrity of the Payments System
  • The Role of the Central Bank in the Economy: The Federal Reserve System
    • Monetary Policy
      • Reserve Requirements
        • Decreasing (Increasing) reserve requirements increases (decreases) the money supply
          • Last changed April 1992
maintaining monetary stability and the integrity of the payments system78
Maintaining Monetary Stability and the Integrity of the Payments System
  • The Federal Reserve’s Crisis Management Tools
    • Term Auction Facility
    • Term Securities Lending Facility
    • Primary Dealer Credit Facility
maintaining monetary stability and the integrity of the payments system79
Maintaining Monetary Stability and the Integrity of the Payments System
  • The Role of Depository Institutions and the Economy
    • Banks are the primary conduit for monetary policy
    • Banks are the primary source of credit for most small businesses and many individuals
efficient and competitive financial system
Efficient and Competitive Financial System
  • Product restrictions, barriers to entry, and restrictions on mergers and the degree of branching can clearly enhance safety and soundness, but they also hinder competition
  • Effective financial regulation requires a delicate balance between the system’s competitiveness and general safety and soundness concerns
efficient and competitive financial system83
Efficient and Competitive Financial System
  • Organizational Form of the Banking Industry
    • Bank Holding Companies
      • Parent
      • Subsidiaries
    • One-Bank Holding Companies
    • Mutli-Bank Holding Companies
efficient and competitive financial system84
Efficient and Competitive Financial System
  • Consumer Protection
    • Reg. B
      • Equal Credit Opportunity
        • Cannot discriminate on the basis of sex, race, marital status, religion, age, or national origin
    • Reg. Z
      • Truth-in-Lending
        • Requires disclosure of:
          • Effective interest rates, total interest paid, total of all payments
          • Why credit was denied
efficient and competitive financial system85
Efficient and Competitive Financial System
  • Key Federal Legislation
    • Depository Institutions Deregulation and Monetary Control Act of 1980
      • DIDMCA
    • Depository Institutions Act of 1982
      • Garn-St. Germain
    • Competitive Equality Banking Act of 1987
efficient and competitive financial system86
Efficient and Competitive Financial System
  • Key Federal Legislation
    • Financial Institutions Reform, Recovery, and Enforcement Act of 1989
      • FIRREA
    • Federal Deposit Insurance Corporation Improvement Act of 1991
    • FASB 115
      • Held-to-maturity
      • Trading account securities
      • Available-for-sale
efficient and competitive financial system87
Efficient and Competitive Financial System
  • Key Federal Legislation
    • Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
    • Gramm-Leach-Bliley Act of 1999
    • USA Patriot Act (2001)
    • Sarbanes-Oxley Act (2002)
    • Check Clearing for the 21st Century Act aka Check 21 (2004)
efficient and competitive financial system88
Efficient and Competitive Financial System
  • Key Federal Legislation
    • Fair and Accurate Credit Transactions Act (FACT) of 2003
    • Servicemembers Civil Relief Act (SCRA) of 2003
    • Deposit Insurance Reform Act of 2005
    • Troubled Asset Relief Act (2008)
    • TARP Capital Purchase Program (2008)
    • Amended Reg. Z (Truth in Lending Act of 1968)
efficient and competitive financial system89
Efficient and Competitive Financial System
  • Key Federal Legislation
    • Housing and Economic Recovery Act (HERA) of 2008
      • Federal Housing Finance Regulatory Reform Act of 2008
      • Federal Housing Finance Agency (FHFA)
      • HOPE for Homeowners Act of 2008
      • Treasury Emergency Authority Provisions
      • Secure and Fair Enforcement of Mortgage Licensing Act (SAFE) of 2008
      • Foreclosure Prevention Act of 2008
      • FHA Modernization Act of 2008
efficient and competitive financial system90
Efficient and Competitive Financial System
  • Current Unresolved Regulatory Issues
    • Capital Adequacy
      • From a regulator’s perspective, increased capital requirements make banks safer
      • Increasing capital requirements also has disadvantages
        • Equity is more expensive than debt
        • Most banks do not have ready access to the equity markets
      • This can lead to more consolidation
efficient and competitive financial system91
Efficient and Competitive Financial System
  • Current Unresolved Regulatory Issues
    • Regulatory Reform
      • Regulation of depository institutions is highly fragmented
        • Federal Reserve
        • OCC
        • OTS
        • FDIC
        • NCUA
efficient and competitive financial system92
Efficient and Competitive Financial System
  • Current Unresolved Regulatory Issues
    • Regulatory Reform
      • Non-depository institutions are not subject to the same regulatory burdens as depository institutions
        • Large investment banks
        • Insurance companies
        • Finance companies
        • Hedge funds
        • Credit card companies
efficient and competitive financial system93
Efficient and Competitive Financial System
  • Current Unresolved Regulatory Issues
    • Regulatory Reform
      • Since the Fed is willing and able to assist financial players they do not directly supervise, the system appears to be at greater risk than it was before the most recent financial innovations
analyzing bank performance
Analyzing Bank Performance
  • In 2008, depository institutions reported:
    • Worsening asset quality leading to higher charge-offs
    • Shrinking net interest income
    • Declining non-interest income
      • These factors led to lower profits, ROE, ROA, and bank failures
analyzing bank performance97
Analyzing Bank Performance
  • Depository Institution Failures
    • Over 1,500 bank failures between 1985 and 1993
    • 0 in 2005 or 2006
    • 3 in 2007
    • Sharp increase in 2008 and 2009
      • 26 in 2008
      • 72 through mid-August 2009
commercial bank financial statements
Commercial Bank Financial Statements

Most depository financial institutions own few fixed assets and thus exhibit low operating leverage

Many bank liabilities carry short-term maturities. As a result, interest expense changes coincidentally with short-run changes in market interest rates

commercial bank financial statements99
Commercial Bank Financial Statements

Many commercial bank deposits are insured by the FDIC. Insured deposits carry below-market interest rates

Banks operate with less equity capital than non-financial companies, which increases financial leverage and the volatility of earnings

commercial bank financial statements100
Commercial Bank Financial Statements
  • Bank Assets
    • Loans
      • Real Estate
      • Commercial
      • Individual
      • Agricultural
      • Other loans in domestic offices
      • Loans and leases in foreign offices
commercial bank financial statements101
Commercial Bank Financial Statements
  • Bank Assets
    • Adjustment to Loans
      • Gross Loans and Leases
        • minus
      • Unearned Income
      • Loan and Lease Loss (Allowance for Loan Loss or ALL)
        • equals
      • Net Loans and Leases
commercial bank financial statements102
Commercial Bank Financial Statements
  • Bank Assets
    • Investment Securities
      • Short-Term Investments
        • One year or less
        • Examples:
          • Interest-Bearing Deposits Due from Other Banks
          • Fed Funds Sold
          • Reverse Repos
          • T-Bills
commercial bank financial statements103
Commercial Bank Financial Statements
  • Bank Assets
    • Investment Securities
      • Long-Term Investments
        • Over one year
        • Examples:
          • T-Notes and T-Bonds
          • Government Agency Issues
          • Foreign and Corporate Bonds
          • Mortgage-Backed Securities
          • Municipal Securities: General Obligation
          • Municipal Securities: Revenue
commercial bank financial statements104
Commercial Bank Financial Statements
  • Bank Assets
    • Investment Securities
      • Held-to-Maturity
      • Trading Account
      • Available-for-Sale
commercial bank financial statements105
Commercial Bank Financial Statements
  • Bank Assets
    • Investment Securities
      • Held-to-Maturity
        • Intent and ability to hold until maturity
        • Recorded at cost (Book Value)
        • Changes in value (unrealized gains or losses) are NOT reflected on the balance sheet or income statement
        • May be a current or long-term asset, depending on maturity
commercial bank financial statements106
Commercial Bank Financial Statements
  • Bank Assets
    • Investment Securities
      • Trading Account
        • Objective is to generate trading profits
        • Marked-to-Market
        • Changes in value (unrealized gains and losses) ARE reflected on the Income Statement
        • Always a current asset, regardless of maturity of the underlying security
commercial bank financial statements107
Commercial Bank Financial Statements
  • Bank Assets
    • Investment Securities
      • Available-for-Sale
        • For those securities that do not fall into the HTM or Trading categories
        • Market-to-Market
        • Change in value (unrealized gains or losses) ARE reflected on the Balance Sheet (Change to Shareholder’s Equity)
        • May be a current or long-term asset, depending on maturity
commercial bank financial statements108
Commercial Bank Financial Statements
  • Bank Assets
    • Non-Interest Cash and Due From Banks
      • Vault Cash
      • Deposits held at the Federal Reserve
      • Cash Items in Process of Collection (CIPC)
        • Largest component of this category
commercial bank financial statements109
Commercial Bank Financial Statements
  • Bank Assets
    • Other Assets
      • Bank Premises
      • OREO
        • Often foreclosed property
      • Banker’s Acceptances
commercial bank financial statements112
Commercial Bank Financial Statements
  • Bank Liabilities and Stockholder’s Equity
    • Transaction Accounts
      • Demand Deposits
        • Pays no interest
        • Available to all customers
      • NOW Accounts
        • Pays “market” interest rate
        • Not available to for-profit corporations
      • ATS Accounts
        • Pays “market” interest rate
        • Not available to for-profit corporations
commercial bank financial statements113
Commercial Bank Financial Statements
  • Bank Liabilities and Stockholder’s Equity
    • Transaction Accounts
      • MMDAs
        • Pays market interest rate
        • Limited to six checks per month
        • Available to all customers
commercial bank financial statements114
Commercial Bank Financial Statements
  • Bank Liabilities and Stockholder’s Equity
    • Savings and Time Deposits
      • Savings Deposits
        • No Maturity
      • Time Deposits (CDs)
        • “Large” or Jumbo CDs
          • Negotiable
        • “Small” CDs
commercial bank financial statements115
Commercial Bank Financial Statements
  • Bank Liabilities and Stockholder’s Equity
    • Other Borrowings
      • Fed Funds Purchased Repurchase Agreements
      • Brokered Deposits
      • Deposits Held in Foreign Offices
        • Issued by a bank subsidiary outside the U.S.
      • Federal Home Loan Bank Borrowings
      • Subordinated Notes and Debentures
commercial bank financial statements116
Commercial Bank Financial Statements
  • Bank Liabilities and Stockholder’s Equity
    • Core Deposits
      • Deposits that are NOT very interest rate sensitive
      • Represent permanent funding base
      • Made up of:
        • Demand Deposits
        • NOW and ATS accounts
        • MMDAs
        • Savings Accounts
        • “Small” Time Deposits
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Commercial Bank Financial Statements
  • Bank Liabilities and Stockholder’s Equity
    • Non-Core Deposits
      • Deposits that are very interest rate sensitive
      • AKA
        • Volatile Liabilities
        • Hot Money
        • Purchased Liabilities
        • Short-Term Non-Core Funding
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Commercial Bank Financial Statements
  • Bank Liabilities and Stockholder’s Equity
    • Non-Core Deposits
      • Consist of:
        • Federal Funds Purchased
        • Repos
        • “Large” Time Deposits
        • Brokered Time Deposits
commercial bank financial statements119
Commercial Bank Financial Statements
  • Bank Liabilities and Stockholder’s Equity
    • All Common and Preferred Equity
      • Preferred Stock
      • Common Stock
commercial bank financial statements123
Commercial Bank Financial Statements
  • Income Statement
    • Interest Income (II)
      • Includes interest and fees from:
        • Loans
        • Deposits at other institutions
        • Trading Account Securities
        • Municipal Securities
          • Estimated Tax Benefit =
          • Municipal Interest Rate/(1 – Marginal Tax Rate) = Tax-Equivalent Municipal Interest Income
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Commercial Bank Financial Statements
  • Income Statement
    • Interest Expense (IE)
      • Includes interest paid on all interest-bearing liabilities:
        • NOW Accounts
        • ATS Accounts
        • MMDAs
        • Savings Accounts
        • Time Deposits
        • Non-Core Liabilities
        • Long-Term Debt
commercial bank financial statements125
Commercial Bank Financial Statements
  • Income Statement
    • Interest Income (II)
      • minus
    • Interest Expense (IE)
      • equals
    • Net Interest Income (NII)
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Commercial Bank Financial Statements
  • Income Statement
    • Non-Interest Income (OI)
      • Includes:
        • Fiduciary (Trust) Income
        • Deposit Service Charges
        • Trading Revenues
        • Investment Banking Fees and Commissions
        • Insurance Commission Fees and Income
        • Net Servicing Fees
        • Net Gains (Losses) on Sales of Loans
        • Other Net Gains (Losses)
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Commercial Bank Financial Statements
  • Income Statement
    • Non-Interest Expense (OE)
      • Includes:
        • Personnel
        • Occupancy
        • Technology
        • Utilities
        • Deposit Insurance Premiums
        • Intangible Amortizations
        • Goodwill Imparement
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Commercial Bank Financial Statements
  • Income Statement
    • Non-Interest Expense (OE)
      • minus
    • Non-Interest Income (OI)
      • equals
    • Burden
      • Non-interest expense is typically larger than non-interest income
      • Reducing the Burden will increase bank profitability
commercial bank financial statements129
Commercial Bank Financial Statements
  • Income Statement
    • Provision for Loan and Lease Losses (PLL)
      • Estimate of potential losses on loans
      • Relationship between PLL and ALL
        • Beginning ALL (from Balance Sheet)
          • plus
        • This year’s PLL (from Income Statement)
          • minus
        • Charge-offs
          • plus
        • Recoveries
          • Equals
        • Ending ALL
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Commercial Bank Financial Statements
  • Income Statement
    • Provision for Loan and Lease Losses (PLL)
      • Relationship between PLL and ALL
        • Recall, ALL is a contra-asset account
          • When a loan is charged off, Gross Loans and the ALL account are decreased by the same amount
commercial bank financial statements131
Commercial Bank Financial Statements
  • Income Statement
    • Net Interest Income (NII)
      • minus
    • Burden
      • minus
    • PLL
      • plus
    • Realized Security Gains (Losses) (SG)
      • equals
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Commercial Bank Financial Statements
  • Income Statement
    • Pre-Tax Net Operating Income (te)
      • minus
    • Taxes (T)
      • minus
    • Extraordinary Items
      • equals
    • Net Income (NI)
commercial bank financial statements133
Commercial Bank Financial Statements
  • Income Statement
    • Total Revenue (TR) or Total Operating Income (TOI)
      • Includes:
        • Interest Income
        • Non-Interest Income
        • Realized Security Gains (Losses)
      • Analogous to Net Sales
commercial bank financial statements134
Commercial Bank Financial Statements
  • Income Statement
    • Total Operating Expense (EXP)
      • Includes
        • Interest Expense
        • Non-Interest Expense
        • PLL
      • Analogous to COGS + Operating Expenses
commercial bank financial statements135
Commercial Bank Financial Statements
  • Income Statement
    • NI = NII – Burden – PLL + SG – T
relationship between balance sheet income statement
Relationship Between Balance Sheet & Income Statement

Ai = Dollar magnitude of the ith asset

Lj = Dollar magnitude of the jth liability

NW = Dollar magnitude of equity

yi = Average pre-tax yield on the ith asset

cj = Average pre-tax cost on the jth liability

relationship between balance sheet income statement138
Relationship Between Balance Sheet & Income Statement
  • Net Interest Income
    • Changes with changes in:
      • Composition
      • Volume
return on equity model
Return on Equity Model
  • Profitability Analysis
    • Return on Equity (ROE)
    • Return on Assets (ROA)
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Return on Equity Model
  • Profitability Analysis
    • Return on Equity
      • Net Income/Average Total Equity
      • ROA x EM
        • Net Income/Average Total Assets x

Average Total Assets/Average Total Equity

return on equity model141
Return on Equity Model
  • Expense Ratio and Asset Utilization
    • Asset Utilization (AU)
      • Total Revenue/Average Total Assets
        • TR/aTA
    • Expense Ratio (ER)
      • Total Operating Expenses/Average Total Assets
        • EXP/aTA
    • Tax Ratio (TAX)
      • Taxes/Average Total Assets
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Return on Equity Model
  • Expense Ratio and Asset Utilization
      • Net Income/Average Total Assets
      • ROA = AU – ER – TAX
return on equity model143
Return on Equity Model
  • Expense Ratio and Asset Utilization
    • Expense Ratio (ER)
      • Total Operating Expense/Average Total Assets
        • EXP/aTA
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Return on Equity Model
  • Expense Ratio and Asset Utilization
    • Expense Ratio (ER)
      • IE can change due to changes in:
        • Volume
          • Different levels of liabilities versus equity
        • Composition
          • Different mix of liabilities
        • Rates
return on equity model145
Return on Equity Model
  • Expense Ratio (ER)
      • Non-Interest Expense
      • OE can change due to changes in:
        • Personnel Expenses
        • Occupancy Expenses
        • Technology Expenses
        • Other Overhead Expenses
return on equity model146
Return on Equity Model
  • Income: Asset Utilization Components
    • Total Revenue
      • Includes:
        • Interest Income (II)
        • Non-Interest Income (OI)
        • Realized Security Gains or Losses (SG)
return on equity model147
Return on Equity Model
  • Income: Asset Utilization Components
    • II can change due to changes in:
      • Volume
        • Different levels of earning assets to total assets
        • Earnings Base (EB) = Average Earning Assets/aTA
      • Composition
        • Different mix of earning assets
      • Rates
return on equity model148
Return on Equity Model
  • Income: Asset Utilization Components
    • Non-Interest Income (OI)
      • OI can change due to changes in:
        • Fees
        • Trust Activities
        • Service Charges
        • Other Non-Interest Income
return on equity model149
Return on Equity Model
  • Aggregate Profitability Measures
    • Net Interest Margin (NIM)
      • Net Interest Income/Average Earning Assets
    • Spread
      • Interest Income/Average Earning Assets - Interest Expense/Average Interest-Bearing Liabilities
return on equity model150
Return on Equity Model
  • Aggregate Profitability Measures
    • Burden
      • (Non-Interest Expense – Non-Interest Income)/Average Earning Assets
        • Lower numbers are better
    • Efficiency Ratio
      • Non-Interest Expense/(Net Interest Income + Non-Interest Income)
        • Lower numbers are better
managing risks and returns
Managing Risks and Returns
  • Risk Management
    • Credit Risk
    • Liquidity Risk
    • Market Risk
    • Operational Risk
    • Reputation Risk
    • Legal Risk
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Managing Risks and Returns
  • Risk Management
    • Credit Risk
      • Historical Loss Rate
        • Gross Loan Losses (Charge-offs)
        • Recoveries
        • Net Losses
          • Charge-offs - Recoveries
managing risks and returns154
Managing Risks and Returns
  • Risk Management
    • Credit Risk
      • Expected Future Losses
        • Past-Due Loans
          • Interest and Principal has not been paid but it is still accruing interest
          • 30-89 days
          • 90 days and over
        • Non-Performing Loans
          • 90 days or more past-due
        • Non-Accrual Loans
          • Not accruing interest
managing risks and returns155
Managing Risks and Returns
  • Risk Management
    • Credit Risk
      • Expected Future Losses
        • Total Non-Current Loans
          • Non-Performing + Non-Accrual Loans
        • Restructured Loans
        • Classified Loans
          • Regulations force management to set aside reserves for loans that are clearly not going to be paid back
managing risks and returns156
Managing Risks and Returns
  • Risk Management
    • Credit Risk
      • Preparation for Losses
        • Provision for Loan Loss
          • IRS versus FASB and Regulators
        • Earnings Coverage of Net Losses
          • (Net Interest Income – Burden)/Net Loan and Lease Losses
          • Management can manipulate by delaying the recognition of bad loans
managing risks and returns157
Managing Risks and Returns
  • Risk Management
    • Credit Risk
      • Preparation for Losses
        • Lack of Diversification
        • High Loan Growth
        • Country Risk
managing risks and returns158
Managing Risks and Returns
  • Risk Management
    • Liquidity Risk
      • Funding Liquidity Risk
        • Inability to liquidate assts or raise required funding
      • Market Liquidity Risk
managing risks and returns159
Managing Risks and Returns
  • Risk Management
    • Liquidity Risk
      • Holding Liquid Assets
        • Pledging Requirements
        • Cash Assets
          • Not a good source of liquidity for a bank
      • Ability to Borrow for Liquidity
        • Volatile Liabilities
          • “Hot Money” versus Core Deposits
            • Large CDs
            • Fed Funds Purchased
            • Repos
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Managing Risks and Returns
  • Risk Management
    • Market Risk
      • Interest Rate Risk
        • Asset or Liability is considered “rate sensitive” if it can be re-priced during a particular time period
        • GAP/Earnings Sensitivity Analysis
          • Changes in spread/NIM due to changes in rates
        • Duration GAP
          • Market Value of Equity Sensitivity
managing risks and returns161
Managing Risks and Returns
  • Risk Management
    • Market Risk
      • Equity and Security Price Risk
      • Foreign Exchange Risk
        • Foreign Currency Translation Risk
          • Commitments and Guarantees denominated in a foreign currency
managing risks and returns162
Managing Risks and Returns
  • Risk Management
    • Operational Risk
      • Business Interruptions
      • Transaction Processing
      • Inadequate Information Systems
      • Breaches in Internal Controls
      • Client Liability
    • Legal Risk
      • Reputation Risk
managing risks and returns163
Managing Risks and Returns
  • Risk Management
    • Capital or Solvency Risk
      • Risk of becoming insolvent
        • Liabilities > Assets
    • Off-Balance Sheet Risk
      • Tier 1 Capital
        • Common Equity + Non-cumulative Preferred Stock
      • Risk-Weighted Assets
evaluating bank performance an application
Evaluating Bank Performance: An Application

Profitability Analysis for PNC in 2007

maximizing the market value of bank equity
Maximizing the Market Value of Bank Equity
  • Effective Management of:
    • Assets
    • Liabilities
    • Off-Balance Sheet Activities
    • Interest Rate Margin
    • Credit risk
    • Liquidity
    • Non-Interest Expense
    • Taxes
maximizing the market value of bank equity171
Maximizing the Market Value of Bank Equity
  • CAMELS Ratings
    • Capital Adequacy
    • Asset Quality
    • Management Quality
    • Earnings
    • Liquidity
    • Sensitivity to Market Risk
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Maximizing the Market Value of Bank Equity
  • CAMELS Ratings
    • Ratings from 1 (best) to 5 (worst)
      • 1 & 2
        • Sound banks
      • 3
        • Some underlying problems
      • 4 & 5
        • Problem banks
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Maximizing the Market Value of Bank Equity
  • Performance Characteristics of Banks by Size
    • Large Banks versus Small Banks
      • Higher ROE
      • Lower NIM
      • Higher Charge-offs
      • Lower Capital
financial statement manipulation
Financial Statement Manipulation
  • Off-Balance Sheet Activities
    • Window Dressing
    • Preferred Stock
    • Non-Performing Loans
    • Allowance for Loan Losses
    • Securities Gains and Losses
    • Non-Recurring Extraordinary Items