CAPITAL MARKET
DEPOSITORY INSTITUTIONS
CONTENTS OF OUR PRESENTATION
•WHAT A DEPOSITORY INSTITUTION IS ?
•ASSEST/LIABILITY PROBLEM OF DEPOSITORY INSTITUTIONS
Funding risk
Liquidity concerns
•COMMERCIAL BANKS
Bank services
Bank funding
Regulation
Federal deposit insurance
•SAVING AND LOAN ASSOCIATIONS
Assets
Funding
Regulation
The S&L Crisis
•SAVINGS BANKS
•CREDIT UNION
Depository institutions include commercial banks, saving and loan
associations, savings banks, and credit unions. These financial
intermediaries accept deposits. Deposits represent the liabilities of
the deposit accepting institutions. With the funds raised through
deposits and other funding sources, depository institutions make
direct loans to various entities and also invest in securities. Their
income is derived from two sources ; the income generated from the
loans they make and the securities they purchase, and fee income.
S&L, saving banks, and credit unions are commonly called “thrifts”,
which are specialized types of depository institutions.
Depository institutions are highly regulated because of the
important role they play in the financial system. Demand deposit
accounts provide the principal means that individuals and
business entities use for making payments. Also, goverment
implements monetary policy through the banking system.
Because of their important role, depository institutions are
afforded special privileges such as access to federal deposit
insurance and access to a goverment entity that provides funds
for liquidity or emergency needs.
ASSET/LIABILITY PROBLEM OF DEPOSITORY INSTITUTIONS
Funding risk
Liquidity concerns
ASSET/ LIABILITY PROBLEM OF DEPOSITORY INSTITUTION
The asset/liability problem that depository institutions face is quite simple to
explain, althuogh not necessarily easy to solve. A depository institutions
seeks to earn a positive spread between the asset in which it invest and the
cost of its funds. The spread is referred to as spread income or margin. The
spread income allows the institutions to meet operating expenses and earn a
fair profit on its capital.
In generating spread income a depository institutions faces several
risks, including credit risk, regulatory risk, and funding risk. Credit risk ,
also called default risk refers to the risk that a borrower will default on a
loan obligation to the depository institution or that the issuer of a security
that the depository institutions holds will default on it obligation.
Regulatory risk is the risk that regulators will change the rules and affect
the earning of the institution unfavorably.
LIQUDITY CONCERNS
In several ways ;
1. Attract additional deposits,
2. Use existing securities as collateral for borrowing from a federal
agency or other financial institution,
3. Sell securities that it owns,
4. Raised short term funds in the money market.
The first alternative self-explanatory.
The second concerns the privilege allowed to banks to borrow at
the discount window of the Federal Reserve Banks.
little
The third alternative, selling securities that it owns,
requires that the depository institution invest a portion of
its funds in securities that are both liquid and have
price risk.
The fourth alternative primarily includes using
marketable securities owned as collateral for
raising in the repurchase agreement market.
COMMERCIAL BANKS
Bank services
Bank funding
Regulation
Federal deposit insurance
Commercial Banks;
As of March 2001, 8,237 commercial
banks were operating in the U.S. All
rational banks must be members of the
Federal Reserve System and must be
insured by the Bank Insurance Fund (
BIF), which is administered by the Federal
Deposit Insurance Corporation (FDIC).
Federal depository insurance began in the
1930s, and the insurance program is
administered by the FDIC.BIF was created
by the Financial Institutions Reform ,
Recovery,and Enforcement Act of 1989
(FIRREA)
TABLE 3-1 Distribution of FDIC-Insured Commercial Banks by Size
Asset Size
# of Banks
% of Banks
Assets
% of Assets
Less than $25 million
1,016
12,33
16,903
0,27
$25 to 50 million
1,636
19,86
61,068
0,97
$50 to 100 million
2,107
25,58
151,517
2,40
$100 to 300 million
2,307
28,01
388,908
6,16
$300 to 500 milllion
459
5,57
174,586
2,77
$500 to 1 billion
322
3,91
217,623
3,45
$1 to 3 billion
219
2,66
366,722
5,81
$3 to 10 billion
92
1,12
517,332
8,20
$10 billion or more
79
0,96
4,416,155
69,98
8,237
100,00
6,310,814
100,00
Total institutions
BANK SERVICES
Individual banking
Institutional banking
Global banking
Individual banking encompasses consumer lending, residential
mortgage lending, consumer installment loans, credit card
financing,automobile and boat financing, brokerage services,student loans,
and individual-oriented financial investment services such as personal trust
and invesment services. Mortgage lending and credit card financing
generate interest and fee income. Mortgage lending is often referred to as “
mortgage banking”. Brokerage services and financial invesment services
also generate fee income.
Loans to nonfinancial corporations, financial corporations and
goverment entities fall into the category of institutional banking. Also
included in this category are commercial real estate financing,leasing
activities, and factoring. In the case of leasing, a bank may be involved
in leasing equipment either as lessors, as lenders to lessors , or as
purchasers of leases.
Global banking covers a broad range of activities involving corporate
financing and capital market and foreign exchange products and
services.
Corporate financing involves two components;
1. The procuring of funds for a bank’s customers
2. Advice on such matters as strategies for obtaining funds, corporate
restructuring , divestitures, and acquisitions
Banks generate income in three ways ;
1. The bid-ask spread,
2. Capital gains on the securities or foreign currencies use in
transactions,
3. In the case of securities, the spread between interest income
earned by holding the security and the cost of funding the
purchase of that security.
The financial products developed by
banks to manage risk also yield
income. These product include
interest rate swaps, interest rate
agreement,currency swaps, forward
contracts and interest rate options.
BANK FUNDING
The three sources of funds for banks ;
1. Deposits
2. Nondeposit borrowing
3. Common stock and retained earning
Banks are highly leveraged financial institutional , which means that
most of their funds come from borrowing.
Deposit : Several types of deposit accounts are available.
Demand deposit pay no interest and can be withdrawn upon demand.
Time deposits,also called certificates of deposit, set a fixed maturity
date and pay either a fixed or floating interest rate. A money market
demand account is one that pays interest based on short term interest
rates. The market for short term debt obligations is called the money
market, which is how these deposits get their name.
Reserve Requirements and Borrowing in the Federal Funds Markets:
A bank can not invest $1for every $1 it obtains in deposits. Specified
percentages are called reserve ratios, and dolar amounts based on them
that are required to be kept on deposit at a Federal Reserve Banks are called
required reserves. The reserve ratios are establish by the Federal Reserve
Board(the Fed).
Two types of deposits:
•
Transaction deposit
•
Nontransaction deposit
Demand deposits and what the Fed calls “ other checkable deposits” are
classified as transaction deposits. Saving and time deposits are
nontransactions deposits.
To compute required reserves, the Federal Reserve uses an established
two-week period called the deposit computation period.
Reserve requirements in each period are to be satisfied by actual reserves.
If actual reserves exceed required reserves , the difference is referred to as
excess reserves.
Bank temporarily short of their required reserves can borrow reserves from
banks with excess reserves. The market where banks borrow or lend reserves
is called the federal funds market. The interest rate charge to borrow funds in
this market is called the federal funds rate.
Borrowing at the Fed Discount Window:
The Federal Reserve Bank is the banker’s bank.
The Fed establishes the types of eligible collateral.
Currently it includes :
1. Treasury securities, federal agency securities, and municipal securities, all
with maturity of less than 6 months,
2. Commercial and industrial loans with 90 days or less to maturity.
The interest rate that the Fed charges to borrow funds at the discount window is
called the discount rate.
Other Nondeposit Borrowing : Most deposits have short maturities.
Bank borrowing in the federal funds market and at the discount window
of the Fed is short term. Other nondeposit borrowing can be short term
in the form of issuing obligation in the money market , or intermediate
long term in the form of issuing securities in the bond market.
Banks that raise most of their funds from the domestic and
international money markets, relying less on depositors for fund , are
called money center banks. A regional bank , by contrast, is one that
relies primarily on deposit for funding and makes less use of the money
markets to obtain funds.
REGULATION
Because of special role that commercial banks play in the
financial system , banks are regulated and supervised by several
federal and state government entities.
The regulations historically cover four areas:
1. Ceilings imposed on the interest rate that can be paid on deposit
accounts.
2. Geographical restrictions on branch banks.
3. Permissiple activities for commercial banks.
4. Capital requirements for commercial banks.
Regulation of Interest Rates: Even though regulation of the interest rates that
banks can pay was eliminated for accounts other than demand deposit. Federal
regulation prohibit the payment of interest on demand accounts.
Until the 1960s, market interest rates stayed below the ceiling. As market interest
rates rose abow the ceiling and ceilings were extended to all depository
institutions after 1966, these institutions found it difficult to compete with other
financial institution to attract funds.
To circumvent the ceilings on time deposits and recapture the lost funds,banks
developed the negotiable certificate of deposit , which in effect had higher ceiling
, and eventually no ceiling at all. As all depository instutions fund it difficult to
compete in the 1970s, federal legislation in the form of the Depository Instutions
Regulation and Monetary Control Act of 1980 gave banks relief.
Geographical Restrictions: The McFadden Act of 1927 allowed each state
the right to set its own rules on instrastate branch banking. In 1994 Congress
passed the Riegle-Neal Interstate Banking and Branching Efficiency Act
permitting adequately capitalized and managed bank holding companies to
acquire banks in any state subject to certain limitations and approval by the
Federal Reserve. Starting in June 1997, this legislation allowed interstate
mergers between adequately capitalized and managed banks, subject to
concentration limits and state laws.
Permissible Activities for Commercial Banks : The key legislation is
the Gramm-Leach-Bliley Act of 1999.
The activities of banks and bank holding companies are regulated by
Federal Reserve Board, which was charged with the responsibility of
regulating the activities of bank holding companies by the Bank Holding
Company Act of 1956.
Early legislation governing bank activities developed against the following
background :
1. Certain commercial bank lending was believed to have reinforced the
stock market crash of 1929.
2. The stock market crash itself led to the breakdown of the banking
system.
3. Transactions between commercial banks and their securities affiliates
led to abuses.
Congress passed the Banking Act 1933. Four sections of the 1933 act
barred commercial banks from certain invesment banking activities-Sections
16, 20,21 and 32. These four sections are popularly referred to as the
Glass-Steagall Act.
Bank could neither underwrite securities and stock, nor act as dealers in the
secondary market for securities and stock , although Section 16 does
provide two exceptions. Section 16 also restricted the activities of banks in
connection with corporate securities such as corporate bonds and
commercial paper.
Under Section 20 of the Glass-Steagall Act, commercial bank that were
members of the Federal Reserve System were prohibited from maintaining a
securities firm.
Section 21 prohibited any “ person, firm,corperation,association,business
trust, or other similar organization” that receives deposits from engaging in
the securities business as defined in Section 16. Section 32 further
prevented banks from circumventing the restrictions on securities activities.
The Glass-Steagall Act also imposed restrictions on bank activities in
insurance area. Specifically , it imposed restrictions on the underwritting and
selling of insurance.
Capital Requirements for Commercial Banks: The capital structure of
banks, like that of all corporations , consist of equity and debt…
Capital Requirements For Commercial Banks
The capital structure of banks,like that of all corporations,consist of
equity and debt. Commercial banks, like some other depository
institutions and like investment banks,which it discuss in chapter
5,are highly leveraged institutions. that is, the ratio of equity capital
to total assets is low,typically less than 8% in the case of banks. This
level gives rise to regulatory concern about potential insolvency
resulting from the low level of capital provided by the owners. An
additional concern is that the amount of equity capital is even less
adequate because of potential liabilities that do not appear on the
bank’s balance sheet. These so-called “off-balance sheet”
obligations include commitments such as letters of credit and
obligations on customized interest rate agreements ( such as
swaps,caps and floors).
Prior to 1989, capital requirements for a bank were based solely on it’s
total assets. No consideration was given to the types of assets. In
January 1989, the Federal Reserve adopted guidelines for capital
adequacy based on the credit risk of assets held by the bank.
These guidelines are referred to as risk-based capital requirements.
The guidelines are based on a framework adopted in July 1988 by the
Basle Committee on Banking Regulations and Supervisory Practises,
which consists of the central banks and supervisory authorities of G10 countries.
The two principle objectives of the guidelines are as follows:
1.Regulators in the United States and abroad sought greater
consistency in the evaluation of the capital adequacy of major banks
throughout the world.
2. Regulators tried to establish capital adequacy standarts that take
into consideration the risk profile of the bank.
The risk-based capital guidelines attempt to recognize credit
risk by segmenting and weighting requirements.
1. Capital consists of Tier 1 and Tier 2 capital, and minimum
requirements are establish for each tier. Tier 1 capital is
considered core capital (common stockholders’ equity, certain
types of preferred stock, and minority interest in consolidated
subsidiaries). Tier 2 capital called supplementary capital (
loan-loss reserves,perpetual debt, hybrid capital instruments
etc.).
2. The guidelines establish a credit risk weight for all assets. The
weight depends on the credit associated with each asset.The
four credit risk classifications for banksin the United States are
0%, 20%, 50%, and 100%, arrived at on no particular scientific
basis.
Asset
U.S Treasury securities
Book value(in millions)
$
100
Municipal general obligation bonds
100
Residential mortgages
500
Commercial loans
300
Total book value
$1.000
The risk- weighted assets are calculated as follows:
Book value
Asset
U.S Treasury securities
Municipal general obligation bonds
Residential mortgages
Commercial loans
Risk-weighted assets
(in millions)
$ 100
100
500
300
Risk
weight
0%
20
50
100
Product
(in million)
$0
20
250
300
$570
Risk
weight
0%
Examples of Assets Including
•U.S. Treasury securities
•Mortgage backed securities issued by the
Goverment National Mortgage Association
20%
•Muncipal general obligation bonds
•Mortgage-backed securities issued by the Federal
Home Loan Mortgage Corporation or the Federal
National Mortgage Assocation
50%
•Municipal revenue bonds
•Residental mortgages
100%
•Commercial loans and commercial mortgage
•LCD loans
•Corporate bonds
•Municipal IDA bonds
FEDERAL DEPOSıT INSURANCE
Because of the important economic role played by banks, the
U.S goverment sought a way to protect them against depositors who,
because of what they thought were real or perceived problems with a
bank, would withdraw funds in a disruptive manner. Bank panics occured
frequently in the early 1930s, resulting in the failure of banks that might
have survived economic difficulties except for massive withdrawals. As
the mechanism devised in 1933 to prevent a " run on a bank” the U.S
goverment created federal deposit insurance. The insurance was
provided through a new agency, the Federal Deposit Insurance
Corporation.
The Federal Deposit Insurance Corporation Improvement Act of
1991 ( FDICIA ) included a number of significiant reforms to improve the
deposit insurance system. Despite the improvements, some major flaws
remained, including two of particular concern:
•First is the increase in the amount of the deposit coverage to
$100,000.This coverage was set in 1980.The basic coverage increased five
times since 1934, from $5,000 to $100,000.With the exception of the
increase from $40,000 to $100,000 in 1980, historically, these increases
fundamentally reflected cost-of-living adjustment.
•Second flaw is the payment of insurance coverage – the premiums
charged by the FDIC for insurance coverage.
The conflict with respect to premiums is that on the one hand
FDICIA mandates that deposit insurance premiums should be priced
according to the risk posed by a depository institution; on the other hand,
FDICIA mandates that the FDIC maintain a target level of reserves
A depository institution is assigned to one of
nine categories based on a two-step
process. The first is a capital group
assignment based on capital ratios and the
second is a supervisory subgroup
assignment based on other relevant
information.
TABLE3-3 FDIC’s Risk Ratings Assigned to Depository Institutions
Capital Group Descriptions
Group 1:
Group 2:
Group 3:
“well capitalized”
“Adequately capitalized”
“Undercapitalized”
Total risk-based capital
ratio equal to or grater
than 10%
Not well capitalized
Neither well capitalized nor
adequately capitalized
Tier 1 risk-based
capital ratio equal or
greater than 6%
Tier 1 leverage capital
ratio equal to or
greater than 5%
Total risk-basedcapital
ratio equal to or greater
than 8%
Tier 1 risk-based capital
ratio equal to or greater
than 4%
Tier 1 leverage capital
ratio equal to or greater
than 4%
Supervisory subgroup
assignments for members
of the BIF and the SAIF are
made in accordance with
section 327.4(a)(2)of the
FDIC’s Rules and
regulations.
See following Supervisory
Subgroup descriptions.
In order to deal with the conflict noted earlier with respect to setting
deposit insurance premiums, an “ expected loss “ pricing system would
take into consideration:
1. The differences in risk across depository institutions
2. The ability to generate revenue sufficient to pay fort he costs of
insuring deposits
The expcted loss price for a depository would depend on three factors:
1. The probability of default for that bank ,
2. Exposure,
3. Loss severity ( or loss given default)
Assets
Fundings
Regulations
The S&L Crisis
S&Ls represent a fairly old institution. The provision of funds for
financing the purchase of a home motivated the creation of S&Ls. The
collateral for the loan would be the home being financed.
S&Ls are either mutually owned or operate under corporate stock
ownership. “ Mutually owned” means no stock is outstanding, so
technically the depositors are the owners. To increase the ability of
S&Ls to expand the sources of funding available to bolster their
capital, legislation facilitated the conversion of mutually owned
companies into a corporate stock ownership structure.
Like banks,S&Ls are now subject to reserve requirements on deposits
established by the Fed. Prior to the passage of FIRREA, federal
deposit insurance for S&Ls was provided by the Federal Savings and
Loan Insurance Corporation(FSLIC). The Saving Association
Insurance Fund (SAIF) replace FSLIC and is administered by the
FDIC.
ASSETS
The only assets in which S&Ls were allowed to invest were mortgage,
mortgage-backed securities,and goverment securities. Mortgage loans
include fixed-rate mortgages and adjustable rate mortgages. Although
most mortgage loans are for the purchase of homes, S&Ls do make
construction loans.
Although S&Ls enjoyed a comparative advantage in originating mortgage
loans,they lacked the expertise to make commercial and corporate loans.
Rather than make an invesment in acquiring those skills,S&Ls took an
alternative approach and invested in corporate bonds because these
bonds were classified as corporate loans. More specifically, S&Ls became
one of the major buyers of noninvesment-grade corporate bonds,more
popularly referred to as”junk” bonds or “high yield” bonds. Under FIRREA,
S&Ls are no longer permitted to invest new money in junk bonds.
S&Ls invest in short-term assets for
operational and regulatory purposes.
All S&Ls with federal deposit
insurance must satisfy minimum
liquidity requirements. These
requirements are specified by the
Office of Thrift Supervision.
FUNDING
Prior to 1981, the bulk of the liabilities of S&Ls consisted of
passbook savings accounts and time deposits. The interest rate that
could be offered on these deposits was regulated. S&Ls were given
favored treatment over banks with respect to the maximum interest
rate they could pay depositors-they were permitted to pay an interest
rate 0.5% higher, later reduced to 0.25%. With the deregulation of
interest rates discussed earlier in this chapter, banks and S&Ls now
compete head-to-head for deposits.
Since the early 1980s, however, S&Ls can offer
accounts that look similar to demand deposits and
that do pay interest call negotiable order of
withdrawal(NOW) accounts. Unlike demand
deposits, NOW accounts pay interest S&Ls were
also allowed to offer money market deposits
accounts(MMDA)
Since the 1980s, S&Ls more actively raised funds in the
money market. They can borrow in the federal funds market
and they have access to the Fed’s discount window. S&Ls
can also borrow from the Federal Home Loan Banks. These
borrowing called advances, can be short-term or long-term in
maturity and the interest rate can be fixed or floating.
REGULATION
Federal S&Ls are chartered under the
provision of the Home Owners Loan Act of
1933.
As in bank regulation. S&Ls historically were
regulated with respect to the maximum interest
rate on deposit accounts, geographical
operations, permissible activities and capital
adequacy requirements.
Two sets of capital adequacy standards apply to S&Ls, as they do
for anks. S&Ls are also subject to two ratio tests based on “ core
capital” and “tangible capital”. The risk based capital guidelines are
similar to those imposed on banks. Instead of two tiers of capital ,
however,
S&Ls deal with three:
Tier 1 : tangible capital
Tier 2 : core capital
Tier 3 : supplementary capital
THE S&L CRISIS
Until the early 1980s, S&Ls and all other lenders
financed housing through traditional mortgages
at interest rates fixed for the life of the loan. The
period of the loan was typically long, frequently
up to 30 years. Funding for these loan,by
regulation, came from deposits having a maturity
considerably shorter than the loans. As explained
earlier, this sittuation creates the funding risk of
lending long and borrowing short. It is extremely
risky, although regulators took a long time to
understand it.
No problem arises of course if interest rates are stable or declining, but if
interest rates rise above the interest rate on the mortgage loans,a negative
spread results,which must lead eventually into insolvency. Regulators at
first endeavored to shield the S&L industry from the need to pay high
interest rate without losing deposits by imposing a ceiling on the interst
rate that would be paid by S&Ls and by their immediate competiors, the
other depository institutions. However the approach did not and coukd not
work.
With the high volatility of interest
rates in the 1970s,followed by the
historically high level of interest
rates in the early 1980s, all
depository institutions began to
lose funds competitors exempt
from ceiling, such as the newly
formed money market funds; this
development forced some
increase in ceilings.
The ceilings in place since the middle
of the 1960s did not protect the S&Ls;
they began to suffer from diminished
profits and increasingly from
operating losses. A large fraction of
S&Ls became technically insolvent as
rising interest rates eroded the market
value of their assets to the point
where they fell short of the liabilities.
SAVING BANKS
As institutions, saving banks are similar to, although much older than,
S&Ls.They can be either mutually owned(in which case they are
called mutual savings banks) or stockholders owned.
Although the total deposits at saving banks are less
than those of S&Ls, savings banks are typically
larger institutions.Asset structures of saving banks
and S&Ls are similar.Residential mortgages
provide the principal assets of saving
banks.Because states permitted more portfolio
diversification than federal regulatorsof S&Ls,
savings bank portfolios weathered funding risk far
better than S&Ls.Savings bank porfolios include
corporate bonds, Treasury and goverment
securities, municipal securities, common stock,and
consumer loans.
The principal source of funds for savings banks
is deposits.Typically, the ratio of deposits to total
assets is greater for savings banks than for
S&Ls.Savings banks offer the same types of
deposit accounts as S&Ls, and deposits can be
insured by either the BID or SAIF.
CREDIT UNIONS
Credit unions are the smallest of the depository institutions.Credit unions
can obtain either a state or federal charter.Their unique aspect is the ‘
common bond’ requirement for credit union membership.According to the
statutes that regulate federal credit unions, membership in a federal
credit union ‘shall be limited to groups having a common bond of
occupation or association , or to groups within a well-defined
neighborhood, community, or rural district.’
Credit union assets consist of small consumer loans, residential mortgages
loans, and securities.Regulations 703 and 704 of NCUA set forth the types of
investments in which a credit union may invest.They can make investments in
corporate credit unions .
What is a corporate credit union?One might think that a corporate credit union
is a credit union set up by employees of a corporation.It is not.Federal and
state-chartered credit unions are referred to as ‘natural person’ credit unions
because they provide financial services to qualifying members of the general
public.In constrast, corporate credit unions provide a variety of investment
services, as well as payment systems, only to natural person credit unions
ŞENGÜL ÇİNE
SERAP ÇUBUK
NEZAHAT DEVECİ
EBRU FİLİK