Finance 208
Seminar in Financial Institutions
Professor A. Sinan Cebenoyan
Frank G. Zarb School of Business
Hofstra University
Overview
Set one
Copyright 2002-A.S. Cebenoyan
1
US Depository Institutions
• Incentives, always incentives!
• Commercial Banks
• Thrifts
S&L’s and Savings Banks
Credit Unions
Copyright 2002-A.S. Cebenoyan
2
Commercial Banks
•
•
•
•
1985----->>> 14,416
1998----->>> around 9,000
Why? Failures and M&A
Community, Regional, Super Regional, and
Money Center Banks
Copyright 2002-A.S. Cebenoyan
3
Commercial Banks continued
• Assets: Business Loans (C and I)
Securities
Mortgages
Consumer Loans
Other (LDC)
Copyright 2002-A.S. Cebenoyan
4
Commercial Banks continued
• Liabilities: Deposits
transactions
NOW
Savings and Time
Negotiable CD’s
Borrowings and Other
Copyright 2002-A.S. Cebenoyan
5
Commercial Banks continued
• Off-Balance Sheet Activities
Fee-related activities
Letters of Credit
Derivatives
Swaps
Copyright 2002-A.S. Cebenoyan
6
Regulation
• FDIC
• COC
• The Fed
Copyright 2002-A.S. Cebenoyan
7
Thrifts
• Savings and Loans
Long-term mortgages backed by short-term
savings deposits (helped by the yield curve)
Disintermediation
Regulation Q
DIDMCA
Regulatory Forbearance
Copyright 2002-A.S. Cebenoyan
8
Thrifts continued
• FSLIC in trouble.>>>>FIRREA (1989)
SAIF under FDIC
RTC
strengthen capital requirements
QTL test
Number of S&Ls down sharply
Copyright 2002-A.S. Cebenoyan
9
Thrifts continued
• Savings Banks
New England
mutual to stock
more diversified than S&Ls (assets)
more reliant on deposits >>less borrow
State regulators
Copyright 2002-A.S. Cebenoyan
10
Thrifts continued
• Credit Unions
65% of assets in small Consumer loans
hold large amount of Government Sec.’s
Residential mortgages very small
lending funded by savings deposits
NCUA and NCUIF
Copyright 2002-A.S. Cebenoyan
11
Insurance Companies
• Life Insurance Companies
death, illnesses, and retirement
• Property-Casualty Insurance
personal injury and liability
accidents, theft, fire...
Copyright 2002-A.S. Cebenoyan
12
Life Insurance Companies
• Life Insurance
Ordinary Life (Term, Whole, Endowment
Variable, Universal, Variable
Universal) ---- 58%
Group Life --- 40%
Industrial Life ---- 0.2%
Credit Life ------ 2%
Copyright 2002-A.S. Cebenoyan
13
• Other Life Insurer Activities
Annuities
Private Pension Funds
Accident and Health Insurance
• Balance Sheet
Assets>>15.9% Gov.Sec., 65% corp.
Bonds and stock, 8% mortgs., balance
policy and other loans
Liabilities>>53% net policy reserves
• Regulation >> McCarran-Ferguson Act ‘45
Copyright 2002-A.S. Cebenoyan
14
Property-Casualty Insurance
• PC Insurance
Fire Insurance
Homeowners
Commercial
Marine
Auto liability+ PD, Liability other
Copyright 2002-A.S. Cebenoyan
15
• Balance Sheet and Underwriting Risk
Loss Risk >>>Predictability:
Property(more) vs. liability(less predict.)
Severity vs. Frequency
Long tail(claims later) versus short tail
Loss ratio (Losses/Premiums)
Copyright 2002-A.S. Cebenoyan
16
Securities Firms and Investment
Banks
• Size, Structure, + Composition of
Industry
Very Large number of firms
Sizes >>>Merrill Lynch to regionals
Activities:Investing, Investment Banking (IPO,
PP) Market Making, Trading (Pure Arbitrage, Risk
Arbitrage, Program Trading), Back-Office and
Other
Copyright 2002-A.S. Cebenoyan
17
• Balance Sheet and Recent Trends
Commissions down after crashes, but up mostly in
the 90’s. Underwriting and Holdings of Fixed
income securities >>> Risk implications
Assets: Long Positions in Securities and
Commodities (26%) and Reverse repurchase
agreements (35%).
Liabilities: Repurchase agreements (47%)
securities and comm. sold short +loans+equity
• Regulation: SEC, NYSE, NASD, SIPC
Copyright 2002-A.S. Cebenoyan
18
Finance Companies
• 2 Major Types:
1) Installment (auto) loans to consumers
2) Consumer+corporate loans, Factoring
• Commercial Paper used in Financing
• No Deposits -->>> Not much regulation
Copyright 2002-A.S. Cebenoyan
19
Mutual Funds
• Diversification
• Lower Transaction Costs
• First in Boston, 1924,
360 in 1970
about 8,000 today ($5 trillion managed
once) after last 2 years maybe $2-3 trillion!
Copyright 2002-A.S. Cebenoyan
20
Mutual Funds continued
• Short-term funds
Taxable or tax-exempt
Money market mutual funds
• Long Term Funds
Bond, income, and equity funds
Returns: income and dividends,
capital gains when sold, capital
appreciation
Marked-to-Market daily
NAV
open versus closed-end
• Load Funds, REITs
• Balance Sheets:
• MMMF 75% in short
term securities (foreign
and domestic deposits,
RP’s, CP, US gov.secs)
• Long term Funds 63%
in stocks, US Treasuries
and muni. bonds 23%.
• Regulated by the SEC,
and States.
Copyright 2002-A.S. Cebenoyan
21
Overview of the Federal Reserve
System
• Today, Fed’s duties are:
• Conducting the nation’s monetary policy…in
pursuit of full employment and stable prices
• Supervising and regulating Financial Inst.s…safety
and soundness…credit rights of consumers
• Maintaining the stability of the fin’l system
...containing systemic risk
• Providing certain fin’l services…major role in
operating the nation’s payment system
Copyright 2002-A.S. Cebenoyan
22
Background
• History of failures.
• December 23, 1913 Wilson signs into law the Federal
Reserve Act
• To provide for the establishment of Federal Reserve Banks, to
furnish an elastic currency,…,effective supervision…
• Other Acts followed to fill in other needs
Structure of the System
•Board of Governors, Washington, D.C.
•12 Regional Federal Reserve Banks
•Federal Open Market Committee (FOMC)
•Board + President of NY Fed+ 4 rotating other presidents
Copyright 2002-A.S. Cebenoyan
23
Three Major Tools Fed uses to conduct Monetary
policy:
•Open Market Operations - FOMC
•Reserve Requirements - Board has sole authority
•The Discount Rate - Board approves any change by a Fed bank
Banking Supervision
•shared with OCC + FDIC
•All member banks + BHCs + Foreign activities of
member banks, US activities of foreign banks, Edge Act
corporations
Copyright 2002-A.S. Cebenoyan
24
Federal Reserve Banks
•12 regional feds with 25 branches: Operate the nationwide
payments system, distribute the nation’s currency and coin,
supervise, regulate member banks and BHCs, and serve as Banker
to the US Treasury.
Copyright 2002-A.S. Cebenoyan
25
Monetary Policy
• Goals of Monetary Policy
– maximum employment
– stable prices
– moderate long-term interest rates
• Reserves Market
– Demand for Reserves
» Required reserves and excess reserves
– Supply of Reserves
» (Borrowed Reserves) Discount Window and
(Nonborrowed Reserves) Open Market Operations
– Federal Funds Rate
Copyright 2002-A.S. Cebenoyan
26
Open Market Operations
• Buying and selling of Securities by the Fed
– Purchase adds to nonborrowed reserves, a sale reduces
them
– When fed buys securities, it pays by issuing a check on
itself, when the seller deposits the check in her bank,
the bank presents the check to the Fed for payment, and
the Fed increases the reserve account of the seller’s
bank at the federal reserve bank. The reserves of the
seller’s bank rise with no offsetting decline elsewhere;
consequently, the total volume of reserves increases.
– This dollar for dollar change in the reserves makes
Open M. Ops. The most powerful, flexible, and precise
tool of monetary policy.
Copyright 2002-A.S. Cebenoyan
27
• Other factors Influencing Nonborrowed Reserves
(Technical factors):
– Amount of currency in circulation
– Size of Treasury Balances at the Fed
– Volume of Federal reserve Float
• Techniques of Open Market Operations
– Outright Purchases and Sales
• through auctions with dealers
– Repurchase agreements
• for temporary adjustments, buy from dealers who
will repurchase by a fixed date at a fixed price.
– Matched Sale-Purchase transactions
Copyright 2002-A.S. Cebenoyan
28
• The Discount Window
• Complements Op. Mkt. Ops…and implementation
of longer-term monetary policy goals
• Facilitates B/S adjustments of individual banks that
face temporary changes in asset-liability structure
• Uniform Discount rate across all Reserve Banks
• If holding deposits subject to reserve requirements
then eligible for discount window access.
• Borrowing either done as discounting paper, or as an
advance secured by collateral
• Adjustment Credit: for short-term liquidity needs
– Fed provides credit at its own discretion
– Borrowing must be for appropriate reason
– other sources must be sought first
Copyright 2002-A.S. Cebenoyan
29
• Seasonal Credit helps small institutions lacking access to national
money markets, e.g. agricultural banks
• Extended Credit: provided when exceptional circumstances or
practices adversely affect an institution.
• Emergency Credit: “unusual and exigent” circumstances, not used
since the 1930s
• Reserve Requirements:
– Since the MCA of 1980 all depository institutions, regardless of
membership in the Fed, are subject to reserve requirements
– 8-14 percent on transaction deposits, 0-9 percent on nonpersonal
time deposits
– The MCA broadened the reserve base and improved the
predictability of the link between reserves and M1
– In 1982 switch to Contemporaneous reserve requirement scheme
tightened the real-time link between M1 and reserves.
– 1984 focus shifts to M2, as M1 becomes highly sensitive to interest
rates
Copyright 2002-A.S. Cebenoyan
30
• Consumer Protection
– Federal reserve writes regulations to implement Consumer
protection laws enacted by Congress
– Federal reserve enforces state-chartered member banks
– staff examiners regularly evaluate banks
• The Fed and the Payments System
– The Fed is an active intermediary in clearing and settling interbank
payments, as they maintain reserve or clearing accounts for the
majority of depository institutions.
– Cash Services:Currency and Coin…ensure enough in circulation to
meet public’s demand. Notes issued by the Feds, coin by the
Treasury.
– Noncash-Transaction Services
• Check processing
• Electronic Funds transfer: Fedwire for large ACH for small-dollar
payments
Copyright 2002-A.S. Cebenoyan
31
• Fiscal Agency Functions
–
–
–
–
Maintaining the Treasury’s funds account
Clearing Treasury checks drawn on that account
Conducting nationwide auctions of Treasury securities
Issuing, servicing, and redeeming Treasury securities
• International Services
Copyright 2002-A.S. Cebenoyan
32
Why are Financial Intermediaries
Special?
• Flow of Funds in a world without FI’s
Households
net savers
Cash
Corporations
net borrowers
Equity and debt claims
•Monitoring costs (covenants)
•Liquidity
•Price Risk
Copyright 2002-A.S. Cebenoyan
33
• Flow of funds in a world with FI’s
Households
…
…
FI
Corporations
(brokers)
Cash
----------FI
Equity +
Debt
(asset-transformers)
Deposits and
insurance
policies
Cash
•Brokerage Function
reduce transaction costs, imperfections etc..
•Asset transformer:
purchase Primary Securities and sell deposits,
insurance policies,etc.(Secondary securities)
Copyright 2002-A.S. Cebenoyan
34
• Information Costs
FI does the monitoring to reduce agency costs
hence a delegated monitor
economies of scale
frequent monitoring in Bank Loans allows the FI to
gather information constantly (insider?)
Reduction of imperfections and information
asymmetries
• Liquidity and price risk
Through diversification, FI’s offer highly liquid and
low price -risk contracts on the liability side of their
B/S while investing in relatively illiquid and higher
price-risk securities of corporations on the asset side.
Copyright 2002-A.S. Cebenoyan
35
• Reduced Transaction Costs
Bulk asset purchases reduce costs (mutual funds and pension
funds)
Bid-ask spreads are lower in large quantity purchases
• Maturity Intermediation
Other Aspects
•
•
•
•
Transmission of Monetary Policy
Credit Allocation (residential mortgages, farming loans…)
Intergenerational Wealth Transfers (Time Intermediation)
Payment Services
check clearing and wire transfers
Copyright 2002-A.S. Cebenoyan
36
Specialness and Regulation
Negative externalities - Runs - Redlining
Net regulatory burden (Difference between the private benefits
to an FI from being regulated (guaranties) and the private costs of
regulations (examinations)).
• Safety and Soundness Regulation
Diversification (no more than 15% of own equity capital
can be lent to any one company or borrower
Capital requirements
Guaranty funds
Examinations
Copyright 2002-A.S. Cebenoyan
37
• Monetary Policy Regulation
Reserve Requirements
• Credit Allocation Regulation
QTL
• Consumer Protection Regulation
CRA
• Investor Protection Regulation
Securities Act of ‘33, Investment Co.
Act ‘40
• Entry Regulation
Copyright 2002-A.S. Cebenoyan
38