CHAPTER 3
DEPOSITORY INSTITUTIONS
CONTENTS
•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 individualoriented 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 socalled
“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 G-10 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 DEPOSIT 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 fixedrate 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 depositorsthey 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 headto-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 statechartered 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
END…