Transcript Chapter 12

Chapter 12
Depository Financial Institutions
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
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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
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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
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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
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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 and decrease during
expansions
 Banks treat federal securities as a
residual use of funds
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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
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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
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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
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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
 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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
 If interest rates rise while a bank has negative GAP, the
bank can expect to pay more from its liabilities than it
can expect to generate from higher interest rates on
its assets
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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
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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
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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
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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
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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
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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
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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
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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
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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 asset was 17% all banking assets in 1980
 Total asset declined to less that 3%
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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
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Consolidation
 Economics of Consolidations
 Two theoretical arguments are often provided
 Economies of scale
 Economies of scope
 Economies of Scale: Average cost of lending
services falls as the size of banking operation
rises
 Economies of Scope: Average cost of offering
different lines of business falls as the number of
lines of business rises
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Consolidation
 Empirical Evidence of Theoretical Arguments
 Research do not find evidence significant
economies of over 5 billion asset size
 Also little evidence exits supporting the
existence of economies of scale
 What then explains such massive levels of
consolidations through mergers and
acquisitions
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Consolidation
 Major reason was the cost savings from
consolidations
 Stream lining of operation
 Increased efficiency: many efficient banks
acquired small previously protected inefficient
banks and made them efficient
 Installation of new management
 Reduce excess capacities
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Nontraditional Banking
 Traditionally commercial bank accepted
demand deposits and made business loans
 However, Federal Reserve granted BHC some
more regulatory freedom allowing them to own
subsidiaries that could perform other activities
 However, these activities were limited to
activities closely related to banking:
 Credit card services
 Credit insurance
 Investment advice
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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
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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
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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%
 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)
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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
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Globalization
 American Banks Abroad
 Rapid expansion of US banks into foreign
countries
 Growth of international trade
 American multinational corporation with operations
abroad
 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
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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
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Globalization
 Foreign Banks in the United States
 Organizational Forms:
 Branch of a Foreign Bank
 Subsidiary of a Foreign Bank
 Agency of a Foreign Bank
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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
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Globalization
 Eurodollars
 Eurodollar deposits made in foreign banks were
denominated in US dollars, which eliminated the foreign
exchange risk for Americans
 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
 “Shell” branches are created in tax haven countries
(Bahamas and Caymans) who have almost zero
taxation and no regulation
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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
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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
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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
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
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