CHAPTER 2
Financial Services: Depository Institutions
Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin
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Overview of Depository Institutions
This chapter discusses 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 2007:– Much greater distinction between types
of FIs in terms of products in 1950 than in 2010
– Blurring of product lines and services over time and wider array of services
– (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 2007, 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 US Depository Institutions
1. J.P.Morgan Chase 2,041.02. Bank of America 2,252.83. Citigroup 1,888.64. Wells Fargo 1,228.65. U.S. Bancorp 265.16. HSBC North America 390.77. Bank of NY Mellon 212.58. Suntrust 178.39. State Street Corp. 162.710. BB&T 165.3
Holding Co. Assets ($Billions)
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Commercial Banks– Largest depository institutions are
commercial banks– Differences in operating characteristics
and profitability across size classesNotable differences in ROE and ROA, as well
as the spread
– Mix of very large banks with very small banks
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Structure and Composition
Shrinking number of banks:– 14,416 commercial banks in 1985– 12,744 in 1989– 6,911 in 2009
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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Regulation, Functions & Structure
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
branchingReigle-Neal Act
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Commercial Banks: Asset Concentration
Size2009
AssetsPercent of Total
1984Assets
Percent of Total
All FDIC Insured
11,866.4 100.0 2,508.9 100.0
$100M or Less 142.9 1.2 404.2 16.1$100M - $1B 1,104.2 9.3 513.9 20.5$1B - $10B 1,158.9 9.8 725.9 28.9$10B or more 9,460.4 79.7 864.8 34.5
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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 and investment activities
Money Center banks– Bank of New York Mellon, Deutsche Bank
(Bankers Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USADeclining 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 Temporary effects: credit crunch during
recessions of 1989-92 and 2001-02
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Commercial Banks, September 2009
Primary assets:– Real Estate Loans: $3,799.3 B– C&I loans: $1,210.7
B– Loans to individuals: $959.1 B– Investment security portfolio: $3,335.2
B– Of which, Treasury securities: $1,225.5 B
Inference: Importance of Credit Risk
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Commercial Banks
Primary liabilities:– Deposits: $8,178.2 billion– Borrowings: $2,065.6 billion– Other liabilities: $307.4 billion
Inference:– Highly leveraged
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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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Equity
Commercial Banks equity capital– 11.08 percent of total liabilities and
equity (2009)– TARP program 2008-2009 intended to
encourage increase in capitalCitigroup $25 BBOA $20 B
– Through 2009: $300 B in capital injections through TARP
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Off-Balance-Sheet Activities
Heightened importance of off-balance-sheet items– OBS assets, OBS liabilities– Regulatory incentives– Risk control and risk producing
Role of mortgage backed securities“Toxic” assetsExpansion of oversight
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Major OBS Activities
– Loan commitments– Standby letters of credit and letters
of credit– Futures, forwards, and swaps– When-issued securities
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Other Fee-Generating Activities
Trust services Correspondent banking
– Check clearing– Foreign exchange trading– Hedging– Participation in large loan and security
issuancesPayment usually in terms of noninterest
bearing deposits
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Key Regulatory Agencies– FDIC
DIF Role in preventing contagious runs or panics
– 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 national and
state-chartered banks
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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
1978 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– Authorized NOW accounts nationwide– Increased deposit insurance from $40,000
to $100,000– Reaffirmed limitations on bank powers to
underwrite and distribute insurance products
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Legislation (continued)… 1987 Competitive Equality in Banking
Act (CEBA)– Redefined bank to limit growth of nonbank
banks 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”– Extended federal regulation over foreign
bank branches and agencies
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Legislation (concluded)
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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Proposed 2010
Financial Services Regulatory Overhaul Bill– Financial Services Oversight Council– Power to break up FIs that pose a risk to
the system– Consumer Financial Protection Agency– GAO audit of Federal Reserve Activities– Nonbinding proxy on executive pay– Clearinghouses for some derivatives
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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
Performance remained strong through mid 2000s as interest rates rose
Late 2000s: Strongest recession since 1930s
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Savings Institutions
Comprised of:Savings and Loans AssociationsSavings 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
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Primary Regulators
Office of Thrift Supervision (OTS)– Charters and examines all federal S&Ls
FDIC-DIF Fund– FDIC Oversaw and managed Savings
Association Insurance Fund (SAIF)– SAIF and BIF merged in January 2007 to
form DIF – Same regulatory structure applied to
commercial banks
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Credit Unions Nonprofit DIs 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 Claim of unfair advantage of CUs over
small commercial banks