Size Distribution of Insured Commercial Banks, September 30, 2008 and update 3,046 4,039 486 86 7,640 39.9 52.9 6.1 1.1 1.3 9.7 10.0 79.0.

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