Chapter 12 Depository Financial Institutions. Fundamentals of Bank Management Banks are like any other business firms that Buy Sell Make a profit

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


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


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


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


Assets or Uses of Funds Federal government securities

Remained fairly constant over the years.

highly marketable and liquidCounter cyclical

Increase during recessions Decrease during expansions

Banks treat federal securities as a residual use of funds


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


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


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


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


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


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


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


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


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


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

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



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


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


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


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


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 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

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

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

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

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

Consolidation

McFadden Act of 1927 Reciprocity Rights1975 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

ConsolidationRiegle-Neal Interstate Banking and Branching Efficiency ActPassed in 1994Allowed BHC to acquire banks in any stateBy 1997 all banks were permitted to open branches across statesNumber 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 ActConsolidation however did not affect the availability of banking services for consumersAlthough the number of unit banks declined, the number of bank offices (branch and head office) actually went upIn addition ATM, telephone and internet banking were introducedThese provided better access to banking services for consumers

Nontraditional Banking

The Glass-Steagall Act of1933 Prohibited commercial banking from

engaging in investment banking Some investment banking operations were

allowed: Underwriting general obligation municipal bonds

Act as agent for private placements Not for public, not registered with SEC, Raising funds small business

They were still prohibited from underwriting corporate bonds and equity (stocks)

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 BankingThe 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 BankingThe 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 BankingThe 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 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

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 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

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

Documents

Chapter 12 Depository Financial Institutions. Fundamentals of Bank Management Banks are like any other business firms that Buy Sell Make a profit