chapter 12 depository financial institutions. 12-2 fundamentals of bank management banks are like...

Chapter 12

Depository Financial Institutions

12-2

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

12-3

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

12-4

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

12-5

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

12-6


Assets or Uses of Funds Federal government securities

Remained fairly constant over the years.

highly marketable and liquidCounter-cyclical—increase during recessions and decrease during expansions

Banks treat federal securities as a residual use of funds

12-7


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

12-8


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

12-9


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

12-10


Liabilities of Sources of Funds Miscellaneous Liabilities have experienced a

significant increase during past 30 years Discount Borrowing: Borrowing from

Federal Reserve 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

12-11


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

12-12


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

12-13


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

12-14


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

12-15


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

12-16


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

12-17

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


12-18


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

12-19

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

12-20


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

12-21


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 If interest rates rise while a bank has negative GAP, the

bank can expect to pay more from its liabilities than it can expect to generate from higher interest rates on its assets

12-22


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

12-23


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

12-24

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

12-25

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

12-26

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

12-27

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

12-28

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

12-29

Consolidation

McFadden 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 McFadden Act

12-30

Consolidation

Riegle-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 asset was 17% all banking assets in 1980 Total asset declined to less that 3%

12-31

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

12-32

Consolidation

Economics of Consolidations Two theoretical arguments are often

provided Economies of scale Economies of scope

Economies of Scale: Average cost of lending services falls as the size of banking operation rises

Economies of Scope: Average cost of offering different lines of business falls as the number of lines of business rises

12-33

Consolidation

Empirical Evidence of Theoretical Arguments Research do not find evidence significant

economies of over 5 billion asset size Also little evidence exits supporting the

existence of economies of scale What then explains such massive levels of

consolidations through mergers and acquisitions

12-34

Consolidation

Major reason was the cost savings from consolidations Stream lining of operation Increased efficiency: many efficient banks

acquired small previously protected inefficient banks and made them efficient

Installation of new management Reduce excess capacities

12-35

Nontraditional Banking

Traditionally commercial bank accepted demand deposits and made business loans

However, Federal Reserve granted BHC some more regulatory freedom allowing them to own subsidiaries that could perform other activities

However, these activities were limited to activities closely related to banking: Credit card services Credit insurance Investment advice

12-36


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

12-37


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

12-38

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% 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)

12-39

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

12-40

Globalization

American Banks Abroad Rapid expansion of US banks into foreign

countries Growth of international trade American multinational corporation with

operations abroad 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

12-41

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

12-42

Globalization

Foreign Banks in the United States Organizational Forms:

Branch of a Foreign Bank Subsidiary of a Foreign Bank Agency of a Foreign Bank

12-43

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

12-44

Globalization

Eurodollars Eurodollar deposits made in foreign banks were

denominated in US dollars, which eliminated the foreign exchange risk for Americans

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

“Shell” branches are created in tax haven countries (Bahamas and Caymans) who have almost zero taxation and no regulation

12-45

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

12-46

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

12-47

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 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

chapter 12 depository financial institutions. 12-2 fundamentals of bank management banks are like...

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