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Chap 2, Class 2

Purpose: Introduce different types of Depository Institutions and provide an overview of their functions and history

Outline: Different types of depository institutions Commercial banks Savings institutions

Savings & Loans Savings Banks

Credit unions

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Different Types of Depository Institutions

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Commercial Banks: Generally large banks that offer a wide range of services Usually service larger clients

Savings Institutions Generally smaller banks that offer fewer services Usually service smaller clients

Credit Unions Generally smaller institutions that specialize in personal banking

for a select group of clients (depositors) who also own the bank

Savings & Loan: Traditionally focus on mortgage lending

Savings Banks: Operate as a more diversified savings institution

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Owned by depositors Accept deposits in the form of shares

Lend to members Mainly smaller consumer loans

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COMMERCIAL BANKS

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Equity Capital = 104.8Equity Capital = 137.06

Equity Capital = 1,500.7

Commercial Banks are by far the largest Depository Institutions

Services: Checking and deposit accounts – attract deposits Consumer and residential lending Commercial and industrial lending (C&I loans)

In General: Commercial banks provide a wider array of

services to customers than other DIs

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Why?

Source: FDIC Quarterly Banking

13Source: FDIC Quarterly Banking

1. Struggling financial sector Started in the 1980s – the banking sector was hit by high inflation (

prime rate > 20%)

Deregulation Acts ▪ 1980 Depository Deregulation and Monetary Control Act (DIDMCA) –

(allowed banks to merge)▪ 1982 Garn-St. Germain Depository Institution Act (DIA)▪ Competitive Equality in Banking Act

2. Regulatory Changes 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act –

Allowed bank holding companies to acquire banks in other states

Big bank mergers Bank of America and FleetBoston ($47 billion in 2003) J.P. Morgan Chase & Bank One ($60 billion in 2004)

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Meant to allow DIs to better compete with non-DI financial institutions

How did the merger wave change the industry?

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1984 2012

Smallest banks % of total 83.2% 33%

Small bank % of total 14.9% 58.5%

Large Banks % of total 1.9% 8.5%

Number of banks

1984 2012

Smallest banks % of total 16.1% 0.9%

Small bank % of total 20.5% 8.1%

Large Banks % of total 63.4% 91%

Share of Financial Assets

% small banks % large banks

Under 100 mill

Over 1 bill

85 banks controlled 79.9% of financial sector assets

Average size of banks has been increasing due to mergers.

Large banks often rely on quantitative information (factual financial info.) on their borrowers lend to larger borrowers.

Small banks focus on relationship lending (qualitative information) lend to smaller borrowers

The effect of large bank mergers on credit availability to small businesses? Large firms have access to capital markets (through commercial paper

and corporate bonds). Small business financing became more difficult to obtain

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Commercial BankA

Business Loans (C&I Loans)

Securities

Real Estate Loans

Consumer Loans

Transaction Deposits

Non-transaction Deposits

Subordinated Debt (issued only by large banks)

Equity Capital (Net worth)

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C&I Loans (10.72%): Loans to businesses, not secured by real estate. These loans are

generally illiquid due to the information collection and monitoring services of banks.

Securities (29.91%): Mainly: U.S. Treasuries Municipal bonds Investment grade corporate bonds

Real Estate Loans (27.31%): Commercial loans to businesses that are secured by real estate Residential loans (e.g. home mortgages). They are becoming increasingly liquid due to securitization!

Consumer Loans (13.97%): Credit cards; auto loans; student loans; etc.

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Transaction Deposits: They are deposits that you can write a check against; the most liquid kind

of deposits (on average 8% of total liabilities in 2009).

Demand Deposits(): ▪ The bank must give you your funds on demand and cannot pay interest

on them (regulation).

▪ They are insured by the regulator (FDIC).

▪ Banks hold a certain % of them on reserve at the FED.

NOW (Negotiable Order of Withdrawal) Accounts:▪ They pay interest but revert to the status of a demand deposit if the

funds fall below a minimum balance.21

Non-transaction Deposits (on average 56% in 2009):

Passbook Savings and Money Market Deposit Accounts: ▪ Pay interest and are liquid since the holder can withdraw funds anytime. ▪ MMDAs have limitations on the number of transactions and generally

have a minimum balance requirements.

Time Deposits: ▪ Pay higher interest but are less liquid than MMDAs and passbook

accounts (with maturities of at least 14 days).

Negotiable CDs: ▪ Time deposits with a value greater than $100,000 (this is the cut-off to be

fully insured by FDIC)▪ They are traded in the secondary market just like bonds.

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Subordinated Debt: Large banks may issue longer-maturity publicly-traded bonds. They are subordinate (junior) to the bank’s other liabilities (for

regulatory reasons). Issued only by large banks.

Capital (Net worth): Difference between bank assets and liabilities. It is important as a buffer to prevent bankruptcy. Banks must hold minimum 8% of their risk weighted assets as

capital.

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Activities that are not reported on the balance sheet but are moved back on when a contingent event occurs.Examples: letter of credit, derivative contracts, loan commitments.

Can be used to avoid regulatory costs and taxes.

Can be used to hedge interest rate, credit and FX risks.

Can significantly increase risk exposure!!!!

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OCCPrimary Supervisor

State AgencyPrimary Supervisor

Federal Charter State Charter

Federal Reserve FDIC

Chose to not to be part of the Federal Reserve System

Chose to be part of the Federal Reserve System

Charter determines a banks power, capital requirements and lending limits

Savings Institutions

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Savings & Loans (Thrifts): Traditionally focus on mortgage lending• Main functions:

• Accept Deposits • Lend funds in several forms but mainly residential mortgages

Savings Banks: Operate as a more diversified saving institution• Main functions:

• Accept Deposits • Lend funds in many forms:

• Residential mortgages• Commercial and Industrial Loans (C&L)• Corporate Bonds• Stocks

Functions

Established primarily to serve personal savers – collect short-term deposits and use them to make residential mortgage loans

Today they perform services similar to commercial banks (but must hold at least 65 % of their assets as mortgages or mortgage-backed securities) – only Savings and Loans (thrifts)

Many thrifts began as mutual organizations that were legally owned by their depositors.

Recently, they have converted to stock-issuing institutions and therefore they raise equity from public investors.

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Both Saving Banks and Savings & Loans are chartered by: Federally – The Office of the Comptroller of Currency (OCC) State

Originally: Deposits:

▪ Savings Banks – Federal Deposit Insurance Corp. (FDIC)

▪ Savings & Loans – Federal Savings & Loans Insurance Corp (FSLIC)

Savings banks were limited by law to only offer savings accounts and to make their income from mortgages and student loans.

Management at Savings & Loans is determined by depositors ▪ The weight of each depositor’s vote depends on the percent of bank funds deposited by

the individual

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Currently: Changes in bank regulation have made the operations of these two

banks almost indistinguishable The main difference between the two is that management in an

S&L is determined by depositors

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S&L Crisis 1980’s Increasing interest rates due to monetary and foreign policy exposed

S&Ls to severe interest rate risk S&Ls were locked into long-term mortgages that paid fixed interest

rates The rates on short-term deposits adjusted upward so S&Ls faced a

negative margin

Margin = r(mortgage) – r(deposits)

Excessive risk taking in lending (gambling for resurrection) Federal Savings and Loan Insurance Corporation (FSLIC) – the

insurance provider for S&L deposits suffered severe capital shortages ▪ 1987 Competitive Equality in Banking Act

▪ 1989 Financial Institutions Reform Recovery and Enforcement Act FIRREA31

Recapitalized FSLIC

Replaced FSLIC with FDIC

Real estate fall out Real estate in Texas and the Southwest collapsed S&Ls were exposed to a large number of defaults

Their numbers decreased by 35% during the 1980’s There were about 1,300 S&Ls as of 2006 year-end.

Deposit insurance cost of these failures exceeded $160B. Now they are under the regulation of FDIC and pay risk-based deposit

insurance premiums.

Savings Banks Mainly located on the East Coast Location insulated banks against large losses in real estate values in the

southwest

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1990-1991 real estate fallout in New England Real estate market crash severely affected Savings Banks

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Financial Institution Reform and Recovery Act 1989 Abolished Federal Savings and Loan Insurance Corporation (FSLIC) Created Savings Association Insurance Fund (SAIF) – (FDIC managed) Created Resolution Trust Corp. to close the most insolvent SIs Restricted SIs non-mortgage related asset holdings

Federal Deposit Insurance Corporation Improvement Act 1991 Introduced risk-based depository insurance premiums Introduced regulatory intervention whenever bank capital falls below a

certain point Limited the use of too-big-to fail bailouts Extended federal regulation to branches of foreign banks

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Cash and due forms 9.58% US Treasuries 0.56% Mortgage loans 44.88% MBS 20.75% Bonds and notes 5.12% Commercial loans 4.66% Consumer loans 7.65%

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Total Deposits 76.48% Other Borrowing 7.23% Fed Repurchase Agreements 2.68% Other Liabilities 1.72% Net worth (capital) 11.89%

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OCC State AgencyPrimary Supervisor

Federal Charter State Charter

Federal Reserve FDIC

Saving BankSaving & Loan

Charter determines a banks power, capital requirements and lending limits

Formerly regulated by the Office of Thrift Supervision 2011 OTS was consolidated with OCC

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Credit Unions

Non-profit depository institutions, owned by their members.

Investors paid an entrance fee and invested funds to buy at least one share

CUs lend the deposited funds to other members

Limited customer base (only members – common attribute) Profession Residential location Affiliation (University)

Generally charge lower rates to members and pay higher rates to depositors – from non-profit status

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Cash equivalents 4.3% US Gov. securities 19.9% MBS 4.9% Corporate Bonds 2.0% Other investment securities 3.5% Home Mortgages 28.1% Consumer Credit 23.8% Business Loans 4.0% Other loans 4.7%

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Share drafts 10.8%

Small time and savings shares 67.9%

Large time deposits 7.2%

Misc. liabilities 3.8% Net worth (capital) 10.3%

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Question: how do Credit Unions make their profits?

Answer: They don’t !!!!!▪ Credit Unions are non-profit organizations, so they take the

money they earn on loans and distribute it to their owners – the depositors

▪ They only take what they need to cover costs. This allows them to pay higher rates on deposits and charge lower rates on loans

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National Credit Union Administration

State AgencyPrimary Supervisor

Federal Charter State Charter

Deposits insured by the National Credit Union Insurance Fund

Deposits may be insured by the National Credit Union Insurance Fund

Depositor Institution Comparison

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In 2009: All three types of DIs have the largest fraction of their assets in

mortgages Commercial banks have a large fraction of their business in C&I loans Commercial banks use investment securities more than other DIs Commercial banks are more diversified Credit unions are more customer oriented (more consumer loans) Savings banks focus on residential mortgages The main source of funding for all three banks is deposits

Different types of Depository Institutions Commercial Banks Savings Institutions Credit Unions

Functions Assets Liabilities

History (trends) Merger wave S&L Crisis

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