Banking
In this section, you will learn:
 the types of banks
 about securitization of bank loans
 the kinds of risks banks face and how they
manage these risks
 what causes bank runs and bank panics
 how deposit insurance reduces bank runs but
increases moral hazard
 about the regulation of banks
Types of banks
 Commercial banks
 largest category, about 7000 in U.S.
 Savings institutions, aka savings and loan
associations (S&Ls)
 Originally, mutual banks (owned by depositors),
focused on savings deposits & mortgage loans
 Over time, became corporations, branched into
other types of deposit accounts and loans
Types of banks
 Credit unions
 nonprofit, owned by their depositors (“members”)
 each restricts membership to a specific group,
e.g. teachers, veterans
 Finance companies
 raise funds by issuing bonds and borrowing from
banks
 do not accept deposits, therefore less regulated
 many specialize in a specific type of loan,
e.g. car loans, subprime mortgages
Loans and Deposits by Type of Bank, 12/31/2009
9,000
8,000
Billions of dollars
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
Commercial
banks
Deposits
Loans
Savings
institutions
Credit unions
Finance
companies (do
not accept
deposits)
Large vs. small banks
 Community bank
 small, < $1 billion in assets
 operates in a small geographic area
 they account for 90% of all commercial banks
by number, but account for a small portion of
total bank assets
 have a niche in small business lending
 Large banks
 capable of making huge loans to corporations
 enjoy economies of scale
Subprime lenders
 Subprime lenders specialize in high-risk loans,
charge (sometimes astronomically) high rates
 Subprime finance companies
 introduction of credit scoring fueled rapid
growth, esp. subprime mortgages
 Payday lenders
 make small short-term loans
 charge high fees, commonly equivalent to
400-500% APR
 controversial
Subprime lenders
 Pawnshops
 Small, short-term loans using borrowers’
property as collateral
 Loan sharks
 illegal, organized crime
 violate usury laws
 encourage repayment using threats of violence
 in decline due to competition from payday
lenders and pawnshops
Securitization
 Securitization: the process of creating
securities backed by pools of loans with similar
characteristics
 Mortgage-backed securities (MBS)
 the most prevalent type of securitized asset
 more liquid than the underlying loans
 MBS backed by subprime mortgages played
important role in the recent economic crisis
The securitization process
 Borrowers take out loans from commercial banks
or finance companies.
 The lenders sell their loans to the securitizer, a
large financial institution.
 The securitizer gathers a large pool of similar
loans, e.g. $100 million of subprime mortgages.
 The securitizer issues new securities that entitle
their owners to a share of the payments the
original borrowers make on the underlying loans.
 The securities are bought by financial institutions
and traded in secondary markets.
Fannie and Freddie
 Federal National Mortgage Association (FNMA,
or Fannie Mae), created in 1938
 Federal Home Loan Corporation (Freddie Mac),
created in 1970
 both created to increase supply of mortgage
loans, help more people achieve “the American
dream”
 Fannie and Freddie are the largest securitizers
of mortgages
Fannie and Freddie
 Fannie and Freddie are government sponsored
enterprises (GSEs), private corporations linked
to the government.
 Perceived to have implicit govt backing,
therefore can borrow funds at lower cost than
other financial institutions can.
 Suffered huge losses on subprime mortgages in
2007-2008.
 To prevent bankruptcy, federal government put
Fannie and Freddie under conservatorship.
NOW YOU TRY:
Benefits of securitization
 List all the parties involved in the securitization
of prime mortgages (e.g. by Fannie or Freddie).
 For each, name at least one benefit they
receive.
ANSWERS:
Benefits of securitization
 Homebuyers/borrowers
 Easier to get loans, lower interest rates
because securitization increases the pool of
funds available for making home loans
 Banks
 profit from selling loans for more than they
lent, can use proceeds to make more loans
 achieve geographic diversification: sell loans
made in their community, buy MBS backed by
loans throughout the country, thus protected
from local shocks
ANSWERS:
Benefits of securitization
 Securitizers
 Earn income from securitizing mortgages and
selling MBS
 Buyers of MBS
 get assets that are (usually) safe and very
liquid
The subprime mortgage fiasco
 The housing bubble. House prices…
 rose 71% during 2002-2006
 fell 33% during 2006-2009
 Risky lending
 Subprime lenders lowered standards regarding
borrowers income, credit
 Zero down payment loans, adjustable rate
mortgages with low initial “teaser rates”
 Lenders resold loans, so less concerned with
default risk
The subprime mortgage fiasco
 The crash
 Falling house prices put many homeowners
“underwater” – market value of house less than
amount owed on mortgage
 Homeowners couldn’t afford payments, couldn’t
borrow more
 Rising delinquencies and foreclosures
Change in U.S. house price index
and rate of new foreclosures, 1999-2009
14%
1.4
10%
1.2
8%
1.0
6%
0.8
4%
2%
0.6
0%
0.4
-2%
0.2
-4%
-6%
1999
0.0
2001
2003
2005
2007
2009
New foreclosure starts
(% of total mortgages)
Percent change in house prices
(from 4 quarters earlier)
12%
US house price index
New foreclosures
The subprime mortgage fiasco
 Consequences: huge losses for
 Subprime lenders
 investment banks and other institutions holding
MBS
 Contributed to the worst recession in decades
The business of banking
 A bank’s balance sheet summarizes its
financial condition at a point in time. It lists
 assets: what the bank owns,
including securities, loans, and reserves
 reserves: the portion of deposits not lent out
 liabilities: what the bank owes others,
including deposits and borrowings (from other
banks or the Federal Reserve)
 Net worth = assets – liabilities
 Net worth is also called equity or capital
Balance sheet for “Duckworth Bank”
Assets
(uses of funds)
Liabilities and Net Worth
(sources of funds)
Reserves
$ 10
Deposits
$ 70
Securities
$ 10
Borrowings
$ 20
Loans
$ 80
Net Worth
$ 10
TOTAL
$100
TOTAL
$100
Measuring bank profits
 Return on assets (ROA) = profits/assets
 Return on equity (ROE) = profits/capital
 Example:
 Suppose Duckworth Bank’s profits = $2
 Recall from Duckworth’s balance sheet:
assets = $100, net worth = capital = $10
 So, ROA = $2/$100 = 2%
and ROE = $2/$10 = 10%
 ROE is what the stockholders care about
Managing liabilities and assets
 Banks get most of their funds from deposits,
which generally cost less than borrowings
 On the asset side:
 loans generate income but are not liquid
 reserves are liquid but generate no income
 Liquidity management: how banks handle the
tradeoff between liquidity and income
 Federal Funds: short-term interbank loans
banks take out when they need extra liquidity
Managing credit risk
 Credit risk (default risk): the risk that borrowers
will not repay their loans
 Banks reduce credit risk by requiring collateral,
an asset of the borrower that banks can seize if
borrower defaults. Requiring collateral reduces…
 adverse selection: risky borrowers less likely to
take out loans
 moral hazard: after taking out a loan, borrower
has incentive to use the funds responsibly
 Banks can also reduce credit risk by selling some
of their loans
Managing interest rate risk
 Interest rate risk: the uncertainty in bank
profits arising from changes in interest rates
 maturity mismatch between liabilities and
assets – depositors can withdraw funds at any
time, but many loans don’t mature for years
 liabilities more rate-sensitive than assets:
e.g., an increase in rates increases cost of
borrowings more than income from loans
Managing interest rate risk
 To manage interest rate risk, banks can:
 sell loans to reduce their exposure to rate
changes
 make loans with floating interest rates
(also called adjustable rates), so an increase in
interest rates increases income as well as costs
 trade derivatives to hedge against interest rate
changes
Equity and insolvency risk
 Insolvency: when assets < liabilities
 A wave of defaults can cause insolvency.
 Banks can protect themselves by holding more
capital.
 Equity ratio (ER) = capital/assets
 ER is related to return on equity:
ROE = profit/capital
= (profit/assets)/(assets/capital)
= ROA/ER
NOW YOU TRY:
Balance Sheet Analysis
a. Fill in the blank spaces on each balance sheet.
b. Compute ROA, ROE, and ER for each bank,
assuming each
bank has
$1200 profit.
c. Which bank
would you
rather own,
and why?
Balance sheet for Apple Bank
Assets
Reserves
Liabilities
$2,000 Deposits
$10,000
Securities $10,000 Borrowings
$6,000
Loans
???
$8,000 Net Worth
Balance sheet for Orange Bank
Assets
Reserves
Liabilities
$2,000 Deposits
$8,000
Securities $10,000 Borrowings
???
Loans
$6,000
$8,000 Net Worth
ANSWERS:
Balance Sheet Analysis
Apple & Orange have same ROA = 1200/20000 = 6%
Apple ROE = 1200/4000 = 30%
Orange ROE =
1200/6000 = 20%
Apple ER =
4000/20000 = 20%
Orange ER =
6000/20000 = 30%
Balance
sheet for
Apple Bank
Reason
to choose
Apple:
Assets
Liabilities for
• higher
ROE, so more profitable
owners $2,000 Deposits
Reserves
$10,000
Securities $10,000 Borrowings
$6,000
Reason
Loans to choose
$8,000 Orange:
Net Worth
$4,000
• higher ER, so less risk of
Balance sheet
Orange
Banklose
insolvency
in thefor
event
assets
Assets
Liabilities
value
Reserves
$2,000 Deposits
$8,000
Securities $10,000 Borrowings
$6,000
Loans
$6,000
$8,000 Net Worth
CASE STUDY
The banking crisis of the 1980s
Number of failures
350
300
250
S&L failures
200
bank failures
150
100
50
0
1980
1985
1990
1995
CASE STUDY
The banking crisis of the 1980s
 Huge surge in bank, S&L failures during 1980s
 One cause: rising interest rates
 Most S&Ls had huge maturity mismatch
between rate-sensitive liabilities and long-term
loans
 Most loans made when interest rates were low
 Interest rates rose sharply during 1970s, 1980s.
Treasury Bill rate peaked at 14% in 1981
 Result: huge increase in costs without
corresponding increase in income
CASE STUDY
The banking crisis of the 1980s
 Another cause: the commercial real estate bust
 Early 1980s real estate boom:
 surge in demand for comm. real estate loans
 banks relaxed lending standards to cash in on boom
 Congress allowed S&Ls to make commercial loans,
S&Ls made huge loans to real estate developers
 Recession in early 1980s led to defaults
 Falling oil prices hurt Texas and Oklahoma
 Oversupply of commercial real estate led to
plummeting property prices, increasing defaults
Bank runs
 Bank run: when depositors lose confidence in a
bank and make sudden, large withdrawals
 Even if the loss in confidence is not justified, the
sudden withdrawals overwhelm the bank,
deplete its liquid assets
 To pay withdrawals, the bank must sell assets
quickly, often at “fire sale” prices
 Soon, bank capital is driven below zero
Bank panics
 Bank panic: simultaneous bank runs occurring at
many banks
 18 bank panics in U.S. during 1873-1933
 Early 1930s: bank panics caused 30% of banks to
fail, contributing to the Great Depression
 FDR’s “bank holiday” (March 6, 1933):
all banks closed until govt declared them solvent,
helped end the bank panic
 No bank panics in U.S. since 1933
Deposit insurance
 Deposit insurance: a government program that
compensates depositors when a bank fails
 Federal Deposit Insurance Corporation
(FDIC):
 created in 1933
 provides insurance on deposits up to $250,000
(increased from $100,000 in 2008)
DISCUSSION QUESTION:
Deposit Insurance
 How can deposit insurance reduce bank runs
and bank panics?
 How does deposit insurance affect the
incentives of
 depositors?
 banks?
 Is deposit insurance a good idea?
Effects of deposit insurance
 Reduces bank runs/panics: depositors less likely
to withdraw funds since deposits are insured
 Eliminates depositors’ incentive to monitor banks
to insure banks are not taking excessive risks
 Reduces banks’ incentives to avoid making risky
high-interest loans
Deposit insurance exacerbates
moral hazard in banking,
increases chance of future bank failures
Bank regulation
 Charter: a license to operate a bank
 Each bank applies for a charter from a state
agency or from the Office of the Comptroller of
the Currency (OCC)
 Every bank is regulated by one or more of these:
 Federal Reserve
 OCC
 FDIC
 state agencies
Restrictions on balance sheets
 Assets
 banks can hold government bonds and safe
corporate bonds, not stock or risky corp. bonds
 no single loan can be “too large” (15% of bank
capital for nationally chartered banks)
 Capital
 U.S. requires minimum equity ratio = 5%
 1988 Basel Accord requires capital equal 8% of
“risk adjusted assets,” a weighted average of
assets (higher weights for riskier assets)
Bank supervision
 Banks required to report info about finances and
activities
 Bank examinations: regulators visit banks at
least annually to examine banks’ records,
interview managers, etc.
Closing insolvent banks
 When a bank becomes insolvent, its depositors
may not know or care, due to deposit insurance
 Moral hazard becomes severe for insolvent
banks: managers figure they have nothing to
lose by making very risky gambles
 Result: net worth may become more negative
before bank closes
 Thus, regulators try to close insolvent banks
quickly to prevent further losses
Closing insolvent banks
 Regulators allowed to close banks when
capital = 2% of assets or less
 They may do so, or may allow bank to operate
 Forbearance: a regulator’s decision not to
close an insolvent bank
 occurs to avoid the pain and costs of closing
the bank
 a gamble that the bank’s finances will improve
 exacerbated the S&L crisis because failing
banks were allowed to incur further losses
SECTION SUMMARY
 Banks are institutions that accept deposits
and make loans. Types include commercial
banks, savings institutions, and credit unions.
Finance companies make loans but do not accept
deposits. Subprime lenders make loans to people
with low incomes or bad credit.
 Many bank loans, especially mortgages, are
securitized. Securitization increases the funds
available for loans and allows banks to reduce
default risk and interest rate risk by selling loans.
SECTION SUMMARY
 A bank’s assets include its loans, reserves,
and securities. A bank’s liabilities include
its deposits and borrowings. Net worth or bank
capital is the difference between assets and
liabilities. The balance sheet shows assets on the
left and liabilities and net worth on the right.
 Banks try to reduce credit (default) risk by
screening and monitoring borrowers, and by
requiring collateral. Banks reduce interest rate
risk by selling loans, making adjustable rate loans,
and hedging with derivatives.
SECTION SUMMARY
 A bank run occurs when depositors lose
confidence and make sudden withdrawals.
They can cause otherwise healthy banks to fail.
 Deposit insurance prevents bank runs by
promising to pay off depositors if their bank fails.
Deposit insurance increases the moral hazard that
banks may take on excessive risks.
 U.S. banks are regulated by a variety of agencies.
Regulators restrict the riskiness of bank assets
and require minimum levels of capital.