BUFN722-ch02.ppt

BUFN722- Financial Institutions ch2 - 1

BUFN 722

ch-02

Depository Institutions


Overview of Depository Institutions

• In this segment, we explore the depository FIs:Size, structure and compositionBalance sheets and recent trendsRegulation of depository institutionsDepository institutions performance


Products of U.S. FIs

• Comparing the products of FIs in 1950, to products of FIs in 2000:Much greater distinction between types of FIs

in terms of products in 1950 than in 2000Blurring of product lines and services over timeWider array of services offered by all FI typesRefer to Tables 2-1A and 2-1B in the text


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


Largest Depository Institutions, 2000 by total assets (billions)

Citigroup $804.3

J.P. Morgan Chase 707.5

BankAmerica 671.7

Banc One 283.4

First Union 246.6

Wells Fargo 241.1

Washington Mutual 190.8

Fleet Boston 179.1

SunTrust Banks 100.6

HSBC 87.1


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


Functions and Structural Differences

• Functions of depository institutionsRegulatory 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


Definition of a Commercial Bank

• Represent the largest group of depository institutions measured by asset size.

• Perform functions similar to those of savings institutions and credit unions - they accept deposits (liabilities) and make loans (assets)

• Liabilities include nondeposit sources of funds such as subordinated notes and debentures

• Loans are broader in range, including consumer, commercial, international, and real estate

• Regulated separately from savings institutions and credit unions

• Represent the largest group of depository institutions measured by asset size.

• Perform functions similar to those of savings institutions and credit unions - they accept deposits (liabilities) and make loans (assets)

• Liabilities include nondeposit sources of funds such as subordinated notes and debentures

• Loans are broader in range, including consumer, commercial, international, and real estate

• Regulated separately from savings institutions and credit unions


Differences in Balance Sheets

Depository Institutions Nonfinancial Firms Assets Liabilities Assets LiabilitiesLoans Deposits Deposits Loans

Other Other financial financial assets assets

Other Other Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity

Depository Institutions Nonfinancial Firms Assets Liabilities Assets LiabilitiesLoans Deposits Deposits Loans

Other Other financial financial assets assets

Other Other Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity


All US Commercial Banks Balance Sheet* ($ Bil.) Federal Reserve Bulletin, May 26, 1999

AssetsTotal cash assets………………. $ 253.8 4.8% U.S. gov securities…………… $ 801.4 Other…………………………. 391.6 Investment securities………….. 1,193.0 22.6% Interbank loans………………. 223.0 Loans exc. Interbank………… 3,314.3 Comm. and Indust…………..$ 948.5 Real estate…………………… 1,343.0 Individual……………………. 496.4 All other……………………… 526.4 Less: Reserve for losses……… 58.7 Total loans……………………… $3,478.6 66.0%Other assets…………………….. 347.6 6.6%Total assets…………………….. $5,273.0

AssetsTotal cash assets………………. $ 253.8 4.8% U.S. gov securities…………… $ 801.4 Other…………………………. 391.6 Investment securities………….. 1,193.0 22.6% Interbank loans………………. 223.0 Loans exc. Interbank………… 3,314.3 Comm. and Indust…………..$ 948.5 Real estate…………………… 1,343.0 Individual……………………. 496.4 All other……………………… 526.4 Less: Reserve for losses……… 58.7 Total loans……………………… $3,478.6 66.0%Other assets…………………….. 347.6 6.6%Total assets…………………….. $5,273.0


Commercial Bank Balance Statement*

Liabilities and Equity Transaction accounts…………… $ 667.4 12.8%Nontransaction accounts………... 2,688.5 54.4%Total deposits…………………… $3,355.9Borrowings……………………… 1,006.0 21.3%Other liabilities………………….. 462.3 2.8%Total liabilities………………….. $4,824.2Equity…………………………… 448.8 8.7%

*Aggregate balance sheet and percentage distributions for all U.S.commercial banks as of May 26, 1999 in billions of dollars

Liabilities and Equity Transaction accounts…………… $ 667.4 12.8%Nontransaction accounts………... 2,688.5 54.4%Total deposits…………………… $3,355.9Borrowings……………………… 1,006.0 21.3%Other liabilities………………….. 462.3 2.8%Total liabilities………………….. $4,824.2Equity…………………………… 448.8 8.7%

*Aggregate balance sheet and percentage distributions for all U.S.commercial banks as of May 26, 1999 in billions of dollars


Balance Sheet

• Assetsloans and investment securities

• Liabilitiestransaction accounts - the sum of noninterest-bearing demand

deposits and interest-bearing checking accounts• NOW account - an interest-bearing checking account

negotiable CDs - fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market

• Equitycommon and preferred stock, surplus (additional paid-in

capital; paid in capital in excess of par), and retained earnings (continued)

• Assetsloans and investment securities

• Liabilitiestransaction accounts - the sum of noninterest-bearing demand

deposits and interest-bearing checking accounts• NOW account - an interest-bearing checking account

negotiable CDs - fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market

• Equitycommon and preferred stock, surplus (additional paid-in

capital; paid in capital in excess of par), and retained earnings (continued)


Balance Sheet

• Off-Balance-Sheet activitiesoff-balance-sheet asset - when an event occurs, this item

moves onto the asset side of the balance sheet or income is realized on the income statement

off-balance-sheet liability - when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement

• Trust servicesgenerates fees by holding and managing assets of individuals

or corporations

• Correspondent bankinggenerates fees by provision of banking services to other banks

• Off-Balance-Sheet activitiesoff-balance-sheet asset - when an event occurs, this item

moves onto the asset side of the balance sheet or income is realized on the income statement

off-balance-sheet liability - when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement

• Trust servicesgenerates fees by holding and managing assets of individuals

or corporations

• Correspondent bankinggenerates fees by provision of banking services to other banks


Commercial Banks

• Primary assets:Real Estate Loans: $1,670.3 billion C&I loans: $1,048.2 billionLoans to individuals: $609.7 billionOther loans: $367.5 billionInvestment security portfolio: $1,662.0 billion

• Of which, Treasury bonds: $710.0 billion

• Inference: Importance of Credit Risk


Commercial Banks

• Primary liabilities:Deposits: $4,176.6 billionBorrowings: $1,532.5 billionOther liabilities: $401.0 billion

• Inference:Highly leveraged


Small Banks, Nation

C&I17.96%

Credit Card1.55%

Consumer10.98%

Other6.74%

Real Estate62.77%


C&I29.38%

Credit Card7.55%

Consumer9.12%Other

14.10%

Real Estate39.85%

Large Banks, Nation


Structure and Composition

• Shrinking number of banks:14,416 commercial banks in 198512,744 in 19898,315 in 2000

• Mostly the result of Mergers and AcquisitionsM&A prevented prior to 1980s, 1990sConsolidation has reduced asset share of small

banks


Structure and Composition of Commercial Banks

• Financial Services Modernization Act 1999Allowed full authority to enter investment

banking (and insurance)

• Limited powers to underwrite corporate securities have existed only since 1987


Composition of Commercial Banking Sector

• Community banks

• Regional and Super-regionalAccess to federal funds market to finance their

lending activities

• Money Center banksBank of New York, Bank One, Bankers Trust,

Citigroup, J.P. Morgan/Chase, HSBC Bank USA

• declining in number


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


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.


Off-balance sheet activities

• Heightened importance of off-balance sheet itemsLarge increase in derivatives positions is a

major issueStandby letters of creditLoan commitmentsWhen-issued securitiesLoans sold


Other Fee-generating Activities

• Trust services

• Correspondent bankingCheck clearingForeign exchange tradingHedgingParticipation in large loan and security

issuances• Payment usually in terms of noninterest bearing

deposits


Key Regulatory AgenciesFDIC (BIF and SAIF)- insures depositsOCC: Primary function is to charter national banks.

– Power to disapprove mergers

FRS: monetary policy, lender of last resort. • requires all banks to meet the same noninterest-bearing reserve

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

State bank regulators– performs for state chartered banks similar functions as the OCC

does for national banks

Dual Banking System: Coexistence of nationally and state-chartered banks.


Other Regulatory Issues

• Importance of Bank Holding Companies is increasing.

• BHCs regulated by FRS.


Reserve Requirements of Depository Institutions

Type of Deposit % of EffectiveNet Transaction Accounts Deposits Date

$0 million - $52 million 3.0% 12/19/1995>$52 million 10.0% 12/19/1995Nonpersonal time deposits 0.0% 12/27/1990Eurocurrency liabilities 0.0% 12/27/1990


Key Regulatory Legislation• 1927 McFadden Act: Controls branching of national

banks.• 1933 Glass-Steagall: separates securities and banking

activities.• 1956 Bank Holding Company Act and subsequent

amendments specifies permissible activities and regulation by FRS of BHCs.

• 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


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.



• 1989 FIRREAImposed restrictions on investment activitiesReplaced FSLIC with FDIC-SAIFReplaced FHLB with Office of Thrift

SupervisionCreated Resolution Trust Corporation



• 1991 FDIC Improvement ActIntroduced Prompt Corrective ActionRisk-based deposit insurance premiums Limited “too big to fail”



• 1994 Riegle-Neal Interstate Banking and Branching Efficiency ActPermits 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.


1999 Financial Services Modernization Act

• Financial Services Modernization ActAllowed banks, insurance companies, and

securities firms to enter each others’ business areas

Provided for state regulation of insuranceStreamlined regulation of BHCsProhibited FDIC assistance to affiliates and

subsidiaries of banks and savings institutionsProvided for national treatment of foreign banks


Industry Performance

• Economic expansion and falling interest rates through 1990sCommercial banks record earnings of $71.6

billion

• Downturn in early 2000sReduction in performanceIncreased provision for loan losses

• Only 6 failures in 2000 versus 206 in 1989Technology risks remain

ch2 - 35

• The Commercial Banking Industry• I. Sources of Funds

A. Deposits at Commercial Banks1. Transaction Accounts

– Transaction accounts, widely known as checking accounts, facilitate monetary exchange.

– Some transaction accounts pay no interest and are often called demand deposits.

– Consumer accounts can pay interest.

– The most visible interest-bearing accounts are negotiable orders of withdrawal (NOW).

– In many cases, deposit accounts charge fees or maintenance charges.

– Recently, the use of debit cards at automated teller machines (ATMs) has given consumers greater flexibility.

– Debit cards are used to make purchases via point of sale terminals (POS).


2. Savings and Time Accounts– Called non-transaction deposits or time deposits, these

accounts are a major source of funds.

– Savings accounts allow deposits and withdrawals at any time without invoking a penalty.

– Money market accounts generally offer higher yields while requiring higher balances. They were created to compete with market instruments but yields are lower and slow to adjust.

– Certificates of deposit are more restrictive. They are designed to be held to maturity and carry a fixed rate of interest.

– All of these accounts are backed by federal guarantees that indemnify investors in the case of loss up to $100,000.


B. Non-deposit Liabilities

• Banks issue a variety of debt obligations. These are not covered by federal deposit insurance but provide large amounts of cash quickly and of the desired maturity.

• Banks may borrow from their holding companies in addition to the following methods of raising funds:

– Federal Funds– Security Repurchase Agreements

(REPOS)– Floating Rate Notes– Commercial Paper


C. Equity Capital• Equity capital can be raised through the issuance of

common or preferred stock.• A bank also has retained earnings.• Hybrid financial obligations have the characteristics

of both equity and debt:–Variable Rate Preferred Stock–Subordinated Debt–Perpetual Floaters

• II. Uses of FundsWhat distinguishes a bank is the manner in which it

raises funds anddeploys them.


A. Cash and Cash Equivalents

• Banks retain some of their resources in highly liquid form.

Vault cash is used for day-to-day contingencies.

Funds are maintained in a clearing account at the Fed.

Bank regulators determine minimum levels of the preceding resources, referred to as required reserves.

Unforeseen events lead to the maintenance of excess reserves.

Checks and drafts issued on other banks are cash in the process of collection.

Banks also hold CDs of other institutions.


B. Investment Securities

• Under current regulations, commercial banks were prohibited from holding non-financial corporate securities.

Bank portfolios consist largely of government issues. Why hold these when they pay generally lower rates?

– The bank may wish to “play the yield curve.”

– The government may be enticed into further business.

– Liquidity may be needed.

– State and local securities may offer higher yields due to creditworthiness or tax considerations.

– Government securities serve as temporary investments until more profitable ones arrive.

– Portfolio duration can be adjusted quickly through their use.


C. Loans

• Banks have superior information about their clients. This natural advantage can be used in making loans.

• Many loans are secured by real estate. Mortgages account for 25% of the total assets of the banking industry.

• Unsecured open-ended consumer debt is known as credit card receivables.

• Commercial and industrial loans are also a large component of commercial bank portfolios.

D. Tangible Property

• Commercial banks also own real property such as buildings, furniture, etc.


• III. Beyond the Bank Balance Sheet

• Competition has narrowed the spread between the cost of funds and return on investments. Banks have therefore branched out into various services that are “off balance sheet” activities.

A. Banking Services through Subsidiaries

• Activities include mortgage banking, consumer lending, leasing, real estate appraisal, and credit insurance.

B. Investment Management Services

• Through their trust and investment departments, banks manage billions of dollars of corporate securities. They also operate mutual funds, money market funds, and other investment companies.


C. Advisory Services

• Advisory services include: economic analysis, investment and financial advising, bankruptcy counseling, real estate appraisal, and bookkeeping and data processing services.

D. Brokerage Services

• Bank or holding company subsidiaries offer stock and bond brokerage services.

• Credit insurance on loans is often offered. Other types may be offered in the future as the new regulations are implemented.

E. Underwriting

• Historically, commercial banks had been restricted from the underwriting of debt and equity. This prohibition has changed with the Financial Modernization Act of 1999.


• IV. Profitability of Commercial Banking

• Performance of the commercial banking industry is frequently measured by the return on assets and return on equity.

• As the exhibits reveal, average return has been rather low over the last fifty years.

• Recently, however, commercial banks are doing well. This has been fueled by a good economy and the movement towards off-balance sheet services.


Three Categories of Thrift Institutions: Overview

• Savings Associationsconcentrated primarily on residential mortgages

• Savings Bankslarge concentration of residential mortgagescommercial loanscorporate bondscorporate stock

• Credit Unionsconsumer loans funded with member deposits

• Savings Associationsconcentrated primarily on residential mortgages

• Savings Bankslarge concentration of residential mortgagescommercial loanscorporate bondscorporate stock

• Credit Unionsconsumer loans funded with member deposits


Savings Institutions

• Comprised of:• Savings Associations

– Formerly known as S&L (Savings & Loans)

• Savings BanksEffects of changes in Federal Reserve’s policy of

interest rate targeting combined with Regulation Q (eliminated in 1986) and disintermediation.

Effects of moral hazard and regulator forbearance.

Qualified Thrift Lender (QTL) test.


Savings Institutions: Recent Trends

• Industry is smaller overall

• Intense competition from other FIs mortgages for example

• Concern for future viability


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).


• Regulator forbearance - a policy of the FSLIC not to close economically insolvent FIs, allowing them to continue in operation

• Savings institutions - savings association and savings banks combined

• Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 - abolished the FSLIC and created a new savings association insurance fund (SAIF) under the management of the FDIC

• QTL test- qualified thrift lender test that sets a floor on the mortgage-related assets that thrifts can hold

• Mutual organization - an institution in which the liability holders are also the ownersOther S&Ls are stock held

• Regulator forbearance - a policy of the FSLIC not to close economically insolvent FIs, allowing them to continue in operation

• Savings institutions - savings association and savings banks combined

• Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 - abolished the FSLIC and created a new savings association insurance fund (SAIF) under the management of the FDIC

• QTL test- qualified thrift lender test that sets a floor on the mortgage-related assets that thrifts can hold

• Mutual organization - an institution in which the liability holders are also the ownersOther S&Ls are stock held


Savings Banks

• Mutual organizationsPrimarily East CoastNot exposed to the oil-based shocks of 1980sReal estate price exposureDemutualizationSince 1989, deposits insured by BIF

• May be regulated at both state and federal level


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.

Tend to hold higher level of equity than other depository institutions

Approximately 2/3 federally chartered and subject to NCUA regulation.


Assets of Savings Associations and Savings Banks

20%

2%

4%

5%

22%

47%

MortgageBackedSecuritiesConstruction andLandDevelopmentCommercial RealEstate Loans

MultifamilyResidential

Other assets

Mortgage loans

20%

2%

4%

5%

22%

47%

MortgageBackedSecuritiesConstruction andLandDevelopmentCommercial RealEstate Loans

MultifamilyResidential

Other assets

Mortgage loans


Composition of Credit Union Loan Portfolio, 1999

29%

16%

9%10%

13%

23%

First MortgageLoan

Other Real EstateLoans

Other Loans tomembers

Unsecured CreditCard Loans

All otherUnsecured Loans

Used VehicleLoans

29%

16%

9%10%

13%

23%

First MortgageLoan

Other Real EstateLoans

Other Loans tomembers

Unsecured CreditCard Loans

All otherUnsecured Loans

Used VehicleLoans


Composition of Credit Union Investment Portfolio, 1999

25%

8%

16%13%

38%

Corp Credit UnionInvestments

Other Investments

Bank and S&L CDs

U.S. GovObligations

Fed AgencySecurities

25%

8%

16%13%

38%

Corp Credit UnionInvestments

Other Investments

Bank and S&L CDs

U.S. GovObligations

Fed AgencySecurities


Composition of Credit Union Deposits, 1999

46%

27%

2%

13%

12% RegularShares

CDs

OtherDeposits

IRAs andKeoghAccountsMoney MarketShares

46%

27%

2%

13%

12% RegularShares

CDs

OtherDeposits

IRAs andKeoghAccountsMoney MarketShares


Global Issues

• Near crisis in Japanese Banking

• 19 of the biggest Japanese banks on credit watch list

• European banks continued to perform well

• Implications for future competitiveness


Other Trends

• Number of banks continues to decline.

• Increase in off-balance-sheet activities.

• Increase in income derived from fees-for-service rather than spread income.

• Increased competition between banks and across financial services sectors.

• Increased competition from foreign FIs.


Pertinent Websites

www.federalreserve.gov

www.cuna.org

www.fdic.gov

Banks www.occ.treas.gov

Savings institutions www.ots.treas.gov

www.us-banker.com

Credit unions www.aba.com

http://www.federalreserve.gov/

http://www.cuna.org/

http://www.fdic.org/

http://www.fdic.gov/

http://www.occ.treas.gov/




http://www.ots.treas.gov/




http://www.us-banker.com/

http://www.aba.com/

http://www.aba.com/

http://www.aba.com/


*Financial Statement Analysis

• Time series analysis of key ratios

• ROE frameworkROE = ROA × EMROA = PM × AU

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