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Chapter 1 Banking and the Financial Services Industry

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  1. Chapter 1Banking and the Financial Services Industry

  2. 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

  3. Credit Crisis of 2007 - 2009 • Collapse and/or Failure of: • Bear Stearns • Lehman Brothers • Countrywide • Washington Mutual • Wachovia

  4. 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

  5. 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

  6. 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

  7. Credit Crisis of 2007 - 2009

  8. 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

  9. 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

  10. How Do Banks Differ?

  11. How Do Banks Differ?

  12. 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

  13. How Do Banks Differ?

  14. 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

  15. 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

  16. 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

  17. How Do Banks Differ?

  18. How Do Banks Differ? • Holding Company Financial Statements • The consolidated financial statements of a holding company and its subsidiaries reflect aggregate or consolidate performance

  19. How Do Banks Differ?

  20. How Do Banks Differ?

  21. How Do Banks Differ?

  22. How Do Banks Differ?

  23. 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

  24. 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

  25. 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

  26. Organizational Structure and Financial Services Business Model S-Corporation Banks

  27. 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

  28. 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

  29. 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

  30. 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

  31. 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

  32. 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

  33. 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

  34. 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

  35. 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

  36. 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

  37. 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

  38. Different Channels for Delivering Banking Services Branch Banking Automated Teller Machines Internet (Online) Banking Call Centers Mobile Banking

  39. Chapter 2Government Policies and Regulation

  40. Historical Bank Regulation • Glass-Steagall Act (1933-1999) • Created three distinct industries • Commercial Banking • Investment Banking • Insurance

  41. 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

  42. Historical Bank Regulation • Changes in: • Products and Services • MMMFs • LPOs • Commercial Paper • Junk Bonds • Payment Methods

  43. 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

  44. Ensure Safety & Soundness and Provide an Efficient & Competitive System • Supervision and Examination • FDIC • OCC

  45. 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

  46. 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

  47. 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