Depository Financial

Institutions
Chapter 12

The Fundamentals of Bank

Management

Banks are business firms that buy

(borrow) and sell (lend) money to
make a profit
Money is the raw material for banks
Repackagers of money
Financial claims on both sides of
balance sheet

LiabilitiesSources of funds
AssetsUses of funds

Bank Assets

Total loans increased from 53% of total

assets in 1970 to 62% in 1990most
increase coming from mortgages
Decline in cash and investments in state and
local government securities
Holdings of federal government securities is
fairly constanthighly marketable and liquid

Counter-cyclicalincrease during recessions and

decrease during expansions
Banks treat federal securities as a residual use of
funds

Commercial Bank Assets

Loans
Securities
Cash Assets

Loans (60.1%)

Commercial and Industrial Loans

(14.8%)
Consumer Loans (8.5%)
Real Estate Loans (28%)
Interbank Loans (Federal Funds)
(4.6%)

Securities (24.1%)

U. S. Government Securities
State and Municipal Bonds

Cash Assets (4.5%)

Vault cash.
Reserve deposits at the Federal
Reserve banks.
Correspondent balances.
Cash items in the process of
collection.

Bank Assets
Banks are barred by law from
owning stockstoo risky
However, banks do buy
stocks for trusts they manage
not shown among banks
own assets

Bank Liabilities

Percentage of funds from

transactions deposits has reduced
from 43% in 1970 to 10% in 2002

Used to be major source of funds

Generally low interest (if any) paid on
demand deposits and increase in
interest paid on other types of assets
has caused this decline

Commercial Bank
Liabilities and Equity
Capital

Transactions deposits. (9.5%)

Savings deposits and smalldenomination time deposits. (41.3%)
Deferred availability cash items.
Large-denomination time deposits.
(15.6%)
Purchased funds.
Other borrowings.

Bank Liabilities

Non-transaction deposits represented

47% of banks funds in 2002

Passbook savings depositstraditional form

of savings
Time depositscertificates of deposit with
scheduled maturity date with penalty for
early withdrawal
Money market deposit accountspay money
market rates and offer limited checking
functions
Negotiable CDscan be sold prior to maturity

Bank Liabilities

Miscellaneous Liabilities have experienced a

significant increase during past 25 years

Borrowing from Federal Reservediscount borrowing

Borrowing in the federal funds marketunsecured
loans between banks, often on an overnight basis
Borrowing by banks from their foreign branches, parent
corporation, and their subsidiaries and affiliates
Repurchase Agreementssell government securities
with agreement to re-purchase at later date

SecuritizationPooling loans into securities and

selling to raise new funds

Bank Capital (Equity)

Individuals purchase stock in bank

Bank pays dividends to stockholders
Serves as a buffer against risk
Equity capital has remained stable at 7%-8%,
but riskiness of bank assets has increased
Bank regulators force banks to increase their
capital position to compensate for the
increased risk of assets (loans)
Equity is most expensive source of funds so
bankers prefer to minimize the use of equity

Bank Profitability

Bank management must balance

between liquidity and profitability
Net Interest Income

Difference between total interest

income (interest on loans and interest on
securities and investments) and interest
expense (amount paid to lenders)
Closely analogous to a manufacturing
companys gross profit

Bank Profitability

Net interest marginnet interest income

as a percentage of total bank assets
Factors that determine banks interest
margin

Better service means higher rates on loans and

lower interest on deposits
Might have some monopoly power, but this is
becoming more unlikely due to enormous
competition from other banks and nonbank
competitors
Also affected by a banks riskinterest rate and
credit

Bank Profitability

Service charges and fees and other

operating income

Additional source of revenue

Become more important as banks have
shifted from traditional interest income to
more nontraditional sources on income

Salaries and wages

Banks are very labor-intensive

Pressure to reduce personnel and improve
productivity

Bank Profitability

Security gains/losses

Results from the fact that securities held for

investment are shown at historical cost
This may result in a gain or loss when the security is
sold

Net Income after Taxes

Net Income less taxes

Return on Assets (ROA)Net Income after taxes
expressed as a percentage of total assets
Return on Equity (ROE)Net Income after taxes
divided by equity capital

Bank Risk

Leverage Risk

LeverageCombine debt with equity to purchase

assets
Leveraging with debt increases risk because debt
requires fixed payments in the future
The more leveraged a bank is, the less its ability to
absorb a loss in asset value
Leverage RatioRatio of banks equity capital to
total assets [9% in 2002]
Regulators in US and other countries impose riskbased requirementsriskier the asset, higher
the capital requirement

Bank Risk

Credit Risk

Possibility that borrower may default

Important for bank to get as much
information as possible about borrower
asymmetric information
Charge higher interest or require higher
collateral for riskier borrower
Loan charge-offs is a way to measure past
risk associated with a banks loans
Ratio of non-performing loans (delinquent
30 days or more) to total loans is a
forward-looking measure

Bank Risk

Interest Rate Risk

Mismatch in maturity of a banks assets and liabilities

Traditionally banks have borrowed short and lent
long
Profitable if short-term rates are lower than longterm rates
Due to discounting, increasing interest rates will
reduce the present value of banks assets
Use of floating interest rate to reduce risk
The one-year re-pricing GAP is the simplest and
most commonly used measure of interest rate risk

Bank Risk

Trading Risk

Banks act as dealers in financial instruments

such as bonds, foreign currency, and
derivatives
At risk of a drop in price of the financial
instrument if they need to sell before maturity
Difficult to develop a good measure of trading
risk since is it hard to estimate the statistical
likelihood of adverse price changes

Bank Risk

Liquidity Risk

Possibility that transactions deposits and savings

account can be withdrawn at any time
Banks may need additional cash if withdrawals
significantly exceed new deposits
Traditionally banks provided liquidity through the
holding of liquid assets (cash and government
securities)
Historically these holdings were a measure of a banks
liquidity, but have declined as a percentage of total
assets during the past 30 years (41%-1970; 24%-2002)
During past 30 years banks have used miscellaneous
liabilities to increase their liquidity

Major Trends in Bank

Management

For most of the 20th century banks

were insulated from competition from
other financial institutions
US banking is in a period of transition
due to recent changes in the regulations
The Consolidation Within the
Banking Industry

McFadden Act of 1927

McFadden Act of 1927

Passed to prevent the formation of a few large,

nationwide banking conglomerates
Prohibited banks branching across state lines
Many states also had restrictions that limited or
prohibited branching within their state boundaries
Resultmany, many small banks protected from
competition from larger national banks
Over the years a number of loopholes were exploited to
reduce effectiveness of law, primarily bank holding
companyParent corporation that can hold one or
more subsidiary banks
Riegle-Neal Interstate Banking and Branching
Efficiency Act [1994]Overturned the McFadden Act

Economics of
Consolidation

Is consolidation of banking industry

good or bad?
How large should a bank be

Large enough to offer wide menu of products

Focus on a niche at which they are successful

Despite dramatic decrease in number of

banks and banking organizations, number
of banking offices (including savings
institutions) has remained remarkable
stable

Economics of
Consolidation

Economies of ScaleBanks become more

efficient as they get larger
Economies of ScopeOffering a multitude of
products is more efficient [traditional and nontraditional products]
Little empirical evidence to support either types
of economies
Possibly merger or expansion provided
opportunity to become more efficient
something they should have done prior to
the merger

Nontraditional Banking

Traditionally commercial bank

accepted demand deposits and made
business loans
Under the regulation of the Federal
Reserve, bank holding companies
provide banks with more regulatory
freedom
However, activity is limited to
activities closely related to banking

The Glass-Steagall Act

(1933)

Separated commercial banks from investment

bankingbanks forced to choose
Before 1999, commercial banks could not
underwrite corporate debt and equity
Commercial banks challenged restrictions-investment banks were starting to act like
commercial banks
Circumventing Glass-Steagalla number of
rulings by Federal Reserve eroded the distinction
between commercial and investment banks
The Gramm-Leach-Bliley Act (1999) repealed
the Glass-Steagall Act

Globalization

American Banks Abroad

Rapid expansion of US banks into foreign

countries

Growth of foreign trade

American multinationals with operations abroad

Edge Act (1919)

Permitted US banks to establish special

subsidiaries to facilitate involvement in
international financing
Exempt from the McFadden Acts prohibition
against interstate banking

Globalization

Foreign Banks in the United States

Many large and well-known banks in the US

are foreign-owned
Organizational forms of foreign banks

Branchintegral part of foreign bank and carries

banks name, full service
Subsidiarylegally separate with its own charter,
full service
Agenciesmake loans but cannot accept deposits
Representative Officesmake contact with
potential customers of parent corporation

Foreign Banks in the United

States

Prior to 1978 foreign banks operating

in the US were largely unregulated
International Banking Act of 1978

Foreign banks subject to same federal

regulations as domestic banks
Established banks were grandfathered and
not subject to the law

Eurodollars

Foreign banks were exempt from Regulation Q

and could offer higher interest than US banks
Eurodollar deposits made in foreign banks were
denominated in US dollars, which eliminated
the foreign exchange risk for Americans
American banks opened foreign branches:

Gain access to Eurodollars

Borrow abroad during periods of tight money by the FED

Shell branches are created in tax haven

countries (Bahamas and Caymans) who have
almost zero taxation and no regulation

Eurobonds

Corporate and foreign government

bonds sold:

Outside borrowing corporations home

country
Outside country in whose money
principal and interest are denominated

Number of tax advantages and

relatively little government regulation

Domestically Based International

Banking Facilities (IBF)

Offers both US and foreign banks

comparable conditions as foreign countries
to lure offshore banking back to US
IBF is a domestic branch that is regulated
by Fed as if it were located overseas.
No reserve or deposit insurance
requirements
Essentially bookkeeping operations with
no separate office

IBFs Cont.

Many states exempt income from IBFs

from state and local taxes
IBFs are not available to domestic
residents, only business that is
international in nature with respect
to sources and uses of funds
Foreign subsidiaries of US multinationals
can use IBFs provided funds to not come
from domestic sources and not used for
domestic purposes

Nonbank Depository
InstitutionsThe Thrifts

Comprised of savings and loan associations,

mutual savings banks, and credit unions
Principal source of funds for all three thrifts
is consumer deposits
Savings and Loans (S&Ls)

Invest principally in residential mortgages

This industry basically collapsed during the
1980s
Most S&Ls have converted their charters to
commercial banks

The Thrifts

Mutual Savings Banks

Located mostly in the East

Operate like S&Ls, with more power to make
consumer loans
This industry suffered same decline as S&Ls

Credit Unions

Basically unaffected by the problems in the

1980s since they did not have mortgages on
their balance sheets
Organized around a common group and are
generally quite small