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
Bank Failures in the United States, 1934–2010
Source: www.fdic.gov/bank/historical/bank/index.html.
Subsidiary of BofA
Subsidiary of Toronto-Dominion
TenLargest
LargestForeign
ForeignBanks,
Banks,December
2008
Ten
30, 2008
Decline of Traditional Banking
Decline in cost advantages in acquiring funds (liabilities)
Rising inflation  rise in interest rates and disintermediation
Low-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
Skirting branch restrictions
•ATMs, Bank Holding Cos.
Interstate Banking
and Branching
Efficiency Act, 1994
 Geographic deregulation
Skirting branch restrictions
•ATMs, Bank Holding Cos.
• Benefits of bank consolidation
Increased competition  close inefficient banks
Efficiencies from economies of scale and scope
Lower chance of failure -- diversified portfolios
• Costs
Fewer community banks  less lending to small
business
Banks in new areas  increased risks/failures
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
December, 2008)
8%
6%
10%
37%
12%
13%
31%
7%
3%
7%
9%
http://www2.fdic.gov/sdi/main.asp
16%
31%
10%
General Principles of Bank Management
•
•
•
•
•
•
Liquidity Management
Asset Management
Liability Management
Capital Adequacy Management
Credit Risk
Interest-rate Risk
Liquidity Management: Ample Excess Reserves
Assets
Liabilities
Reserves
$20M Deposits
Loans
$80M Bank
$10M Capital
Securities
Assets
$100M
$10M
Liabilities
Reserves
$10M Deposits
$90M
Loans
$80M Bank
$10M Capital
$10M
Securities
• Suppose required reserves are 10% of deposits
• Excess reserves are insurance against the costs associated with deposit outflows
Assets
Liabilities
Reserves
$10M Deposits
Loans
$90M Bank
$10M Capital
Securities
Assets
$100M
$10M
Reserves
Loans
Securities
Liabilities
$0 Deposits
$90M Bank
$10M Capital
$90M
$10M
• Cost incurred is the interest rate paid on the borrowed funds
Assets
Reserves
Liabilities
$9M Deposits
$90M
Loans
$90M Borrowing
$9M
Securities
$10M Bank Capital
$10M
Liquidity Management: Other Alternatives and Their Costs
Assets
Reserves
Liabilities
$9M Deposits
Loans
$90M
$90M Bank Capital
Securities
$10M
$1M
• The cost of selling securities is the brokerage and other transaction costs and
forgone interest
Assets
Reserves
Liabilities
$9M Deposits
Loans
$90M Borrow from Fed
Securities
$10M Bank Capital
$90M
$9M
$10M
• Borrowing from the Fed also incurs interest payments based on the discount rate
Liquidity Management
A Last Alternative: Reduce Loans
Assets
Reserves
Liabilities
$9M Deposits
Loans
$81M Bank Capital
Securities
$10M
• 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
$90M
$10M
Asset Management: Goals and Tools
Goals
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
net profit after taxes
assets
Return on Equity: net profit after taxes per dollar of equity capital
ROA =
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 net profit after taxes
assets


equity capital
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
First National Bank
Assets
Rate-sensitive assets
Liabilities
$20M Rate-sensitive liabilities
Variable-rate and short-term loans
Variable-rate CDs
Short-term securities
Money market deposit accounts
Fixed-rate assets
$80M Fixed-rate liabilities
Reserves
Checkable deposits
Long-term loans
Savings deposits
Long-term securities
Long-term CDs
$50M
$50M
Equity capital
• 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
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 Derivatives
Innovations: 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
• Securitization
Innovations: 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 cover
Cover a base by regulation or by deregulation
 Unintended Consequences
• Reactions to regulatory policies
 frustrate regulator intent
Regulate bank balance sheets  off-balance sheet activities
Emplace a safety net  bankers become skydivers
• Regulation spreads to cover innovations
 complexity  ineffectiveness
Win by gaming the system
Asymmetric Information and Bank Regulation
Government 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 arbitrage
Prompt 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 arbitrage
Prompt 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
The U.S. regulatory regime: In need of reform?
Justice Department
• Assesses effects of
mergers and acquisitions on
competition
Financial, bank and thrift
holding companies
• Fed
• OTS
Fannie Mae, Freddie Mac, and
Federal courts
Federal Home Loan Banks • Ultimate decider of
• Federal Housing Finance
Agency
banking, securities, and
insurance products
Fed is the umbrella or consolidated regulator
National banks
• OCC
Primary/
secondary • FDIC
functional
regulator
Federal
branch
• OCC
• Host county
regulator
State commercial Federal savings Insurance
and savings banks
banks
companies
Securities
brokers/dealers
Other financial companies,
including mortgage
companies and brokers
• OTS
• FDIC
• FINRA
• SEC
• CFTC
• State securities
regulators
• Fed
• State licensing
(if needed)
• U.S. Treasury
for some products
• State bank
regulators
• FDIC
• Fed--state member
commerical banks
Foreign
branch
• Fed
• Host county
regulator
• 50 State insurance
regulators plus
District of Columbia
and Puerto Rico
Limited foreign
branch
• OTS
• Host county
regulator
Sources: Financial Services Roundtable (2007), Milken Institute.
Notes:
Justice Department: Assesses effects of mergers and acquisitions on competition
Federal Courts: Ultimate decider of banking, securities, and insurance products
CFTC: Commodity Futures Trading Commission
FDIC: Federal Deposit Insurance Corporation
Fed: Federal Reserve
FINRA: Financial Industry Regulatory Authority
GSEs: Government Sponsored Enterprises
OCC: Comptroller of the Currency
OTS: Office of Thrift Supervision
SEC: Securities and Exchange Commission
29