Chapter 12
Depository Financial
Institutions
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
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
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
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
Fundamentals of Bank Management
Assets or Uses of Funds
 Federal government securities
 Remained fairly constant over the
years.
 highly marketable and liquid
 Counter cyclical
 Increase during recessions
 Decrease during expansions
 Banks treat federal securities as a
residual use of funds
Fundamentals of Bank Management
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
Fundamentals of Bank Management
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
Fundamentals of Bank Management
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
Fundamentals of Bank Management
 Liabilities of Sources of Funds
 Miscellaneous Liabilities have experienced a
significant increase during past 30 years
 Discount Borrowing: Borrowing from Federal
Reserve Bank
 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
Fundamentals of Bank Management
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
Fundamentals of Bank Management
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
Fundamentals of Bank Management
 Bank Capital
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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
Fundamentals of Bank Management
 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
Fundamentals of Bank Management
 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
Fundamentals of Bank Management
 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
Fundamentals of Bank Management
 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
Fundamentals of Bank Management
 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
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
Fundamentals of Bank Management
 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
Fundamentals of Bank Management
 Interest Rate Risk
 Mismatch in maturity of a bank’s assets and
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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
Fundamentals of Bank Management
 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
Fundamentals of Bank Management
 Liquidity Risk
 Possibility that transactions deposits and
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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
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
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
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
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
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
Consolidation
McFadden Act of 1927
 Reciprocity Rights
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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
Consolidation
Riegle-Neal Interstate Banking and Branching
Efficiency Act
 Passed in 1994
 Allowed BHC to acquire banks in any state
 By 1997 all banks were permitted to open
branches across states
 Number of unit banks shrunk dramatically
 14,400 in the early 1980
 7,282 in 2007
 For banks with $100 million assets
 Total assets was 17% all banking assets in 1980
 It declined to less that 3% in 2007
Consolidation
Riegle-Neal Interstate Banking and Branching
Efficiency Act
 Consolidation however did not affect the
availability of banking services for
consumers
 Although the number of unit banks
declined, the number of bank offices
(branch and head office) actually went up
 In addition ATM, telephone and internet
banking were introduced
 These provided better access to banking
services for consumers
Nontraditional Banking
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 (stocks)
Nontraditional Banking
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
Nontraditional Banking
The 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%
Nontraditional Banking
The Glass-Steagall Act
 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)
Nontraditional Banking
The 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
Globalization
 American Banks Abroad
 Two major factors explain rapid expansion
of US banks in foreign countries:
 Growth of international trade
 American multinational corporation with
operations abroad
Globalization
 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
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
Globalization
 Foreign Banks in the United States
 Organizational Forms:
 Branch of a Foreign Bank
 Subsidiary of a Foreign Bank
 Agency of a Foreign Bank
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
Globalization
 Eurodollars
 Eurodollar deposits made in foreign banks were
denominated in US dollars, which eliminated the
foreign exchange risk
 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
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
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
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 to 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