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Chapter 2

Depository Institutions

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Overview of Depository Institutions

In this segment, we explore the depository FIs: Size, structure and composition Balance sheets and recent trends Regulation of depository institutions Depository institutions performance

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Products of U.S. FIs

Comparing the products of FIs in 1950, to products of FIs in 2003: Much greater distinction between types of FIs in

terms of products in 1950 than in 2003 Blurring of product lines and services over time Wider array of services offered by all FI types (Refer to Tables 2-1A and 2-1B in the text)

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Specialness of Depository FIs

Products on both sides of the balance sheet Loans

Business and Commercial Deposits

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Other outputs of depository FIs

Other products and services 1950: Payment services, Savings products, Fiduciary

services By 2003, products and services further

expanded to include: Underwriting of debt and equity, Insurance and

risk management products

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Size of Depository FIs

Consolidation has created some very large FIs

Combined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs

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Largest Depository Institutions

Citigroup $1,208.9J.P. Morgan Chase* 770.9Bank of America** 736.4Wells Fargo 393.9Wachovia 388.0 Bank One* 326.6Washington Mutual 275.2Fleet Boston** 200.2U.S. Bancorp 188.8SunTrust Banks 181.0

Total Assets ($Billions)

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Depository Institutions

Commercial Banks Largest depository institutions are commercial banks. Differences in operating characteristics and

profitability across size classes.• Notable differences in ROE and ROA as well as the spread

Thrifts S&Ls Savings Banks Credit Unions

Mix of very large banks with very small banks

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Functions & Structural Differences

Functions of depository institutions Regulatory sources of differences across types

of depository institutions. Structural changes generally resulted from

changes in regulatory policy. Example: changes permitting interstate

branching Reigle-Neal Act

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Commercial Banks

Primary assets: Real Estate Loans: $2,272.3 billion C&I loans: $870.6 billion Loans to individuals: $770.5 billion Investment security portfolio: $1,789.3 billion

Of which, Treasury bonds: $1,005.8 billion

Inference: Importance of Credit Risk

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Commercial Banks

Primary liabilities: Deposits: $5,028.9 billion Borrowings: $1,643.3 billion Other liabilities: $238.2 billion

Inference: Highly leveraged

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Small Banks, Nation

Credit Card1%

Consumer8%

Other14%Real Estate

63%

C&I14%

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Large Banks, Nation

Credit Card7%

Consumer10%

Other21%

Real Estate44%

C&I18%

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Structure and Composition

Shrinking number of banks: 14,416 commercial banks in 1985 12,744 in 1989 7,769 in 2004

Mostly the result of Mergers and Acquisitions M&A prevented prior to 1980s, 1990s Consolidation has reduced asset share of small

banks

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Structure & Composition of Commercial Banks

Financial Services Modernization Act 1999 Allowed full authority to enter investment

banking (and insurance) Limited powers to underwrite corporate

securities have existed only since 1987

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Composition of Commercial Banking Sector

Community banks Regional and Super-regional

Access to federal funds market to finance their lending activities

Money Center banks Bank of New York, Deutsche Bank (Bankers

Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USA

declining in number

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Balance Sheet and Trends

Business loans have declined in importance Offsetting increase in securities and

mortgages Increased importance of funding via

commercial paper market Securitization of mortgage loans

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Some Terminology

Transaction accounts Negotiable Order of Withdrawal (NOW)

accounts Money Market Mutual Fund Negotiable CDs: Fixed-maturity interest

bearing deposits with face values over $100,000 that can be resold in the secondary market.

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Off-balance Sheet Activities

Heightened importance of off-balance sheet items Large increase in derivatives positions is a

major issue Standby letters of credit Loan commitments When-issued securities Loans sold

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Trading and Other Risks

Allied Irish / Allfirst Bank $750 million loss

National Australian Bank $450 million loss

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Other Fee-generating Activities

Trust services Correspondent banking

Check clearing Foreign exchange trading Hedging Participation in large loan and security

issuances Payment usually in terms of noninterest bearing

deposits

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Key Regulatory Agencies

FDIC (BIF and SAIF) OCC: Primary function is to charter national banks. FRS: monetary policy, lender of last resort.

National banks are automatically members of the FRS. State-chartered banks can elect to become members.

State bank regulators Dual Banking System: Coexistence of nationally and state-

chartered banks.

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Web Resources

For more detailed information on the regulators, visit:

http://www.fdic.gov

http://www.occ.treas.gov

http://federalreserve.gov

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Other Regulatory Issues

Importance of Bank Holding Companies is increasing.

BHCs regulated by FRS.

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Key Regulatory Legislation

1927 McFadden Act: Controls branching of national banks.

1933 Glass-Steagall: separates securities and banking activities, established FDIC, prohibited interest on demand deposits.

1956 Bank Holding Company Act and subsequent amendments specifies permissible activities and regulation by FRS of BHCs.

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Legislation (continued)...

1970 Amendments to the Bank Holding Company Act: Extension to one-bank holding companies

1970 International Banking Act: Regulated foreign bank branches and agencies in USA

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Legislation (continued)

1980 DIDMCA and 1982 DIA (Garn-St. Germain Depository Institutions Act) Mainly deregulation acts. Phased out Regulation Q.

1987 Competitive Equality in Banking Act (CEBA) Redefined bank to limit growth of nonbank

banks.

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Legislation (continued)

1989 FIRREA Imposed restrictions on investment

activities Replaced FSLIC with FDIC-SAIF Replaced FHLB with Office of Thrift

Supervision Created Resolution Trust Corporation

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Legislation (continued)

1991 FDIC Improvement Act Introduced Prompt Corrective Action Risk-based deposit insurance premiums Limited “too big to fail”

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Legislation (continued)

1994 Riegle-Neal Interstate Banking and Branching Efficiency Act Permits BHCs to acquire banks in other states. Invalidates some restrictive state laws. Permits BHCs to convert out-of-state subsidiary

banks to branches of single interstate bank. Newly chartered branches permitted interstate if

allowed by state law.

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1999 Financial Services Modernization Act

Financial Services Modernization Act Allowed banks, insurance companies, and

securities firms to enter each others’ business areas

Provided for state regulation of insurance Streamlined regulation of BHCs Prohibited FDIC assistance to affiliates and

subsidiaries of banks and savings institutions Provided for national treatment of foreign banks

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Recent Legislative Changes

USA Patriot Act of 2001 Sarbanes-Oxley Act of 2002

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Industry Performance

Economic expansion and falling interest rates through 1990s

Brief downturn in early 2000 followed by strong performance improvements Record earnings $106.3 billion 2003

Only 3 failures in 2003 versus 206 in 1989 Serious concerns regarding expected interest

rate increases

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Banking and Ethics

Bank of America and Fleet Boston Financial 2004

J.P. Morgan Chase and Citigroup 2003 role in Enron

Riggs National Bank and money laundering concerns 2003

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Savings Institutions

Comprised of: Savings and Loans Associations Savings Banks

Effects of changes in Federal Reserve’s policy of interest rate targeting combined with Regulation Q and disintermediation.

Effects of moral hazard and regulator forbearance.

Qualified Thrift Lender (QTL) test.

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Savings Institutions: Recent Trends

Industry is smaller overall Intense competition from other FIs

mortgages for example Concern for future viability

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Primary Regulators

Office of Thrift Supervision (OTS). Charters and examines all federal S&Ls.

FDIC-SAIF Fund. Oversees and manages Savings Association

Insurance Fund (SAIF).

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Web Resources

For more information on the regulation of savings institutions, visit:

Treasury www.ots.treas.gov

FDIC www.fdic.gov

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Savings Banks

Mutual organizations Primarily East Coast Not exposed to the oil-based shocks of 1980s Real estate price exposure Demutualization

May be regulated at both state and federal level

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Credit Unions

Nonprofit depository institutions owned by member-depositors with a common bond.

Exempt from taxes and Community Reinvestment Act (CRA).

Expansion of services offered in order to compete with other FIs.

Approximately 56% federally chartered and subject to NCUA regulation.

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Web Resources

For information on credit unions visit:

American Bankers Association www.aba.com

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Global Issues

Near crisis in Japanese Banking Eight biggest banks reported positive six-

month profits China

Deterioration, NPLs at 50% levels Opening to foreign banks (WTO entry)

German bank problems in early 2000s Implications for future competitiveness

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Pertinent Websites

Federal Reserve www.federalreserve.gov

Credit Union National Association www.cuna.org

FDIC www.fdic.gov

National Credit Union Administration www.ncua.gov

Office of Comptroller of the Currency www.occ.treas.gov

Office of Thrift Supervision www.ots.treas.gov

Wall Street Journal www.wsj.com

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*Financial Statement Analysis

Time series analysis of key ratios ROE framework

ROE = ROA × EM ROA = PM × AU