size distribution of insured commercial banks, september 30, 2008 and update 3,046 4,039 486 86...
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Size Distribution of Insured Commercial Banks, September 30, 2008 and update
3,0464,039 486 867,640
39.952.9 6.1 1.1
1.3 9.710.079.0
Bank Failures in the United States, 1934–2010
Source: www.fdic.gov/bank/historical/bank/index.html.
Subsidiary of Toronto-DominionSubsidiary of BofA
Ten Largest Foreign Banks, December 30, 2008Ten Largest Foreign Banks, 2008
Decline of Traditional BankingDecline in cost advantages in acquiring funds (liabilities)
Rising inflation rise in interest rates and disintermediationLow-cost source of funds, checkable deposits, declined in importance
Decline in income advantages on uses of funds (assets)Information technology less need for banks to finance short-term credit and issue loans IT lower transaction costs for other financial institutions
Bank Responses: •Riskier Lending … Commercial real estate, leveraged buyouts, takeovers•Off balance sheet activities
Bank Consolidation
• Benefits of bank consolidationIncreased competition close inefficient banksEfficiencies from economies of scale and scopeLower chance of failure -- diversified portfolios
• CostsFewer community banks less lending to small
businessBanks in new areas increased risks/failures
Skirting branch restrictions•ATMs, Bank Holding Cos.
Interstate Banking and BranchingEfficiency Act, 1994
Pre-Crisis Findings:•Net interest margin up•ROA, ROE up for big banks•Intrastate deregulation more positive for all but big banks•Interstate deregulation helps big banks most•Non-performing loans down for biggest banks but up for smaller banks•State of economy has stronger impact on bank performance than branching deregulation
Geographic deregulation
Skirting branch restrictions•ATMs, Bank Holding Cos.
December, 2008)
8%
10%
12%
13%31%
7%3%
7%
9%
6%
37%
31%10%
16%
http://www2.fdic.gov/sdi/main.asp
General Principles of Bank Management
• Liquidity Management• Asset Management• Liability Management• Capital Adequacy Management• Credit Risk• Interest-rate Risk
Liquidity Management: Ample Excess Reserves
• Suppose required reserves are 10% of deposits• Excess reserves are insurance against the costs associated with deposit outflows
• Cost incurred is the interest rate paid on the borrowed funds
Assets Liabilities Assets Liabilities
Reserves $20M Deposits $100M Reserves $10M Deposits $90M
Loans $80M Bank Capital
$10M Loans $80M Bank Capital
$10M
Securities $10M Securities $10M
Assets Liabilities Assets Liabilities
Reserves $10M Deposits $100M Reserves $0 Deposits $90M
Loans $90M Bank Capital
$10M Loans $90M Bank Capital
$10M
Securities $10M Securities $10M
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrowing $9M
Securities $10M Bank Capital $10M
Liquidity Management: Other Alternatives and Their Costs
• The cost of selling securities is the brokerage and other transaction costs and forgone interest
• Borrowing from the Fed also incurs interest payments based on the discount rate
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Bank Capital $10M
Securities $1M
Assets Liabilities
Reserves $9M Deposits $90M
Loans $90M Borrow from Fed $9M
Securities $10M Bank Capital $10M
Liquidity ManagementA Last Alternative: Reduce Loans
• Reduction of loans is the most costly way of acquiring reserves
• Calling in loans antagonizes customers
• Other banks may only agree to purchase loans at a substantial discount
Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M
Asset Management: Goals and ToolsGoals
1. Seek the highest possible returns on loans and securities
2. Reduce risk
3. Have adequate liquidity
Tools
1. Find borrowers who will pay high interest rates and have low possibility of defaulting
2. Purchase securities with high returns and low risk
3. Lower risk by diversifying
4. Balance need for liquidity against increased returns from less liquid assets
Liability Management• Recent phenomenon due to innovation by money center banks
• Expansion of overnight loan markets and new financial instruments
– Negotiable CDs, Federal Funds
– Checkable deposits are now a less important source of funds
Capital Adequacy Management• Bank capital helps prevent bank failure
• The amount of capital affects return for the owners (equity holders) of the bank Low return on assets can be high return on equity
• Regulatory requirement Skin-in-the-game– Benefits bank owners: a cushion that makes their investment safe– Costly to owners: low debt:equity ratio low return on equity
• Choice depends on the state of the economy and levels of confidence
Capital Adequacy Management: Returns to Equity Holders
Return on Assets: net profit after taxes per dollar of assets
ROA = net profit after taxes
assetsReturn on Equity: net profit after taxes per dollar of equity capital
ROE = net profit after taxes
equity capital
Relationship between ROA and ROE is expressed by the
Equity Multiplier: the amount of assets per dollar of equity capital
EM =Assets
Equity Capital
net profit after taxes
equity capitalnet profit after taxes
assets assets
equity capital
ROE = ROA EM
Application: How a Capital Crunch Caused a Credit Crunch During the Global Financial Crisis
• Huge losses on holdings of Mortgage Backed Securities Losses reduced bank capital
• Banks could not raise much capital in weak economy• Tightened lending standards and reduced lending.
Managing Credit Risk: The Usual Suspects
• Screening
• Specialization in lending
• Monitoring and enforcement of restrictive covenants
• Long-term customer relationships
• Loan commitments
• Collateral and compensating balances
• Credit rationing– deny loan counter adverse selection
– limit loan amount counter moral hazard
Managing Interest-Rate Risk
• If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits
Basic gap analysis:(rate sensitive assets - rate sensitive liabilities) x interest rates
= bank profit
First National Bank
Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
Variable-rate and short-term loans Variable-rate CDs
Short-term securities Money market deposit accounts
Fixed-rate assets $80M Fixed-rate liabilities $50M
Reserves Checkable deposits
Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital
Off Balance Sheet Assets/Activities•Structured investment vehicles (SIVs)•Loan sales (secondary loan participation)•Fees for
•Foreign exchange trades for customers•Servicing mortgage backed security•Backup lines of credit/overdraft privileges•Standby lines of credit guaranteeing securities/commercial paper
Trading activities Principal-agent problem—trade against own client? •Bond markets•Foreign exchange markets •Financial derivatives
Internal controls: reduce principal-agent problem from trading
• Separation of trading activities and bookkeeping
• Limits on exposure
• Value-at-risk maximum daily loss with 1% chance
• Stress testing doomsday scenario impacts
Innovations: Response to Interest Rate Volatility• Adjustable-rate mortgages• Financial DerivativesInnovations: Response to Information Technology• Bank credit cards and debit cards• Electronic banking
– ATM/Home banking/ABM/Virtual banking• Junk bonds• Commercial paper market … backed by banks• SecuritizationInnovations: Avoiding Regulation/Loophole Mining• Sweep accounts … reserve requirements• Money Market Mutual Funds … Regulation Q
Shadow Banking System• Financial intermediaries that conduct maturity, credit, and liquidity transformation
without access to central bank liquidity or public sector credit guarantees.– Finance companies– Asset backed commercial paper (ABCP) conduits – Limited purpose finance companies– Structured investment vehicles (SIVs)– Credit hedge funds– Money market mutual funds (MMMFs)– Securities lenders– Government sponsored enterprises (GSEs)
• Interconnections with each other and traditional banking system– ABCP– Asset backed securities– Collateralized debt obligations (CDOs)– Repurchase agreements
• Liabilities of shadow banking system = $16 trillion vs. $13 trillion for banks.
http://www.ny.frb.org/research/staff_reports/sr458.pdf
Possible Reforms
• Increase/tighten capital requirements• Trade derivatives only on public exchanges transparency• “Mark – to – funding” accounting
– Value assets relative to date their funding must be repaid
• Rapid “resolution” of TBTF institutions– Make bankruptcy credible– Put creditors at risk eliminate moral hazard of TBTF
•McFadden Act (1927) and Douglas Amendment (1956) limit interstate branching•Interstate Banking and Branching Efficiency Act (1994) deregulates branching•Gramm-Leach-Biley Financial Services Modernization Act (1999) repeals Glass-Steagall
Regulating Finance: Regulation and Its Discontents
• Lots of bases to coverCover a base by regulation or by deregulation
Unintended Consequences• Reactions to regulatory policies
frustrate regulator intentRegulate bank balance sheets off-balance sheet activitiesEmplace a safety net bankers become skydivers
• Regulation spreads to cover innovations complexity ineffectivenessWin by gaming the system
Asymmetric Information and Bank RegulationGovernment safety net• Deposit insurance and FDIC
– Short circuits bank failures and contagion effect• Payoff method• Purchase and assumption method
• Fed as lender of last resort: Too BIG to Fail• Financial consolidation Exacerbates Too Big to Fail• Safety net extended to non-bank financial institutions
Safety Net Moral Hazard Problems – Depositors don’t impose discipline of marketplace– Banks have an incentive to take on greater risk
Safety Net Adverse Selection Problems– Risk-lovers find banking attractive– Depositors have little reason to monitor bank
Attempted solutions: Constrain banks from taking too much risk• Promote diversification• Prohibit holdings of common stock• Set capital requirements … Capital as cushion
• Minimum leverage ratio• Basel Accord: risk-based capital requirements
… but there’s regulatory arbitragePrompt corrective action: Close ‘em down when capital inadequate
http://www.fdic.gov/regulations/resources/directors_college/sfcb/capital.pdf
Attempted solutions: Constrain banks from taking too much risk• Promote diversification• Prohibit holdings of common stock• Set capital requirements … Capital as cushion
• Minimum leverage ratio• Basel Accord: risk-based capital requirements
… but there’s regulatory arbitragePrompt corrective action: Close ‘em down when capital inadequate
• Monitor … CAMELS– Capital adequacy– Asset quality– Management– Earnings– Liquidity– Sensitivity to market risk
• Disclosure requirements … mark-to-market issue
• Restrictions on competition … make banking boring
Primary Supervisory Responsibility of Bank Regulatory Agencies
• Comptroller of the Currency—national banks chartered by Federal government since 1863
• Federal Reserve and state banking authorities—state banks that are members of the Federal Reserve System
• Fed also regulates bank holding companies (BHCs)– JPM, BoA, Citi,…
• FDIC—insured state banks that are not Fed members
• State banking authorities—state banks without FDIC insurance
29
The U.S. regulatory regime: In need of reform?
Sources: Financial Services Roundtable (2007), Milken Institute.
National banks State commercial and savings banks
Federal savings banks
Insurance companies
Securities brokers/dealers
Other financial companies, including mortgage
companies and brokers
• Fed• OTS
• OCC• FDIC
• State bank regulators• FDIC• Fed--state member commerical banks
• OTS• FDIC
• 50 State insurance regulators plus District of Columbia and Puerto Rico
• FINRA• SEC• CFTC• State securities regulators
• Fed• State licensing (if needed)• U.S. Treasury for some products
• OCC• Host county regulator
• Fed• Host county regulator
• OTS• Host county regulator
Federal branch
Foreign branch
Limited foreign branch
Fed is the umbrella or consolidated regulator
Primary/secondaryfunctionalregulator
Notes:Justice Department: Assesses effects of mergers and acquisitions on competitionFederal Courts: Ultimate decider of banking, securities, and insurance productsCFTC: Commodity Futures Trading CommissionFDIC: Federal Deposit Insurance CorporationFed: Federal ReserveFINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the CurrencyOTS: Office of Thrift SupervisionSEC: Securities and Exchange Commission
• Federal Housing Finance Agency
Fannie Mae, Freddie Mac, and Federal Home Loan Banks
Financial, bank and thrift holding companies
Justice Department• Assesses effects of mergers and acquisitions on competition
Federal courts• Ultimate decider of banking, securities, and insurance products