Chapter 12 Depository Financial Institutions Fundamentals of Bank

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Major Trends in Bank Management § For most of the 20 th 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

Consolidation Mc. Fadden 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

Consolidation Mc. Fadden 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

Consolidation Mc. Fadden 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

Consolidation Mc. Fadden Act of 1927 § Bank Holding Company: An entity that can own one of more banks and non bank institutions as subsidiary § Under the Mc. Fadden 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

Consolidation Mc. Fadden 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 Mc. Fadden Act

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

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

Nontraditional Banking The Glass-Steagall Act of 1933 § 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)

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

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%

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)

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

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

Globalization § Edge Act (1919) § Permitted US banks to establish special subsidiaries to facilitate international financing § Exempt from the Mc. Fadden 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

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

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

Globalization § Foreign Banks in the United States § Prior to 1978 foreign banks operating in the US were largely unregulated § No reserve requirement § Exempt from Mc. Fadden 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

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

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

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

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