Chapter 12 Depository Financial Institutions. 12-2 Fundamentals of Bank Management Banks are like...
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Transcript of Chapter 12 Depository Financial Institutions. 12-2 Fundamentals of Bank Management Banks are like...
Chapter 12
Depository Financial Institutions
12-2
Fundamentals of Bank Management Banks are like any other business firms that
buy sell make a profit
However there is a difference What they buy and sell is money When they buy money, we say they are
borrowing When they sell money, we say they are lending
12-3
Fundamentals of Bank Management
For banks, the raw material is money They are the Repackagers of money They make a profit when
When they buy (borrow) money at a lower rate then sell (lend) it for
When they manage risk successfully
12-4
Fundamentals of Bank Management Similar to any other business, their
accounting principles follow the simple rule
Asset = Liability + Owner’s Equity Which can be reorganized as
Asset - Liability = Owner’s Equity
Lets go over these components carefully
12-5
Fundamentals of Bank Management Assets or Uses of Funds
Loans are major component of their assets Trends of loans
In 1980 loans were 54% of all assets in 2007 they grew to 59% Most of this increase coming from mortgages
Cash and investments in state and local government securities is another category of asset Over the years this asset has declined Holding assets in the form of cash has
opportunity cost
12-6
Fundamentals of Bank Management
Assets or Uses of Funds Federal government securities
Remained fairly constant over the years.
highly marketable and liquidCounter-cyclical—increase during recessions and decrease during expansions
Banks treat federal securities as a residual use of funds
12-7
Fundamentals of Bank Management
Assets or Uses of Funds Banks are barred by law from owning
stocks—why? It is a consumer protection law Stock returns are too volatile and risky Banks are not allowed to engage in risky
speculation with depositors’ money However, banks do buy stocks for trusts
they manage—not shown among bank’s own assets
12-8
Fundamentals of Bank Management
Liabilities of Sources of Funds Transaction Deposits:
23% of all liabilities in 1970 6% of all liabilities in 2007 Used to be major source of funds Generally banks pay low interest (if any) on
demand deposits. Increase in interest paid on other types of
assets has caused this decline
12-9
Fundamentals of Bank Management
Liabilities of Sources of Funds Non-transaction deposits
Represented 46% of banks’ funds in 2007 Passbook savings deposits—traditional form of
savings Time deposits—certificates of deposit with
scheduled maturity date with penalty for early withdrawal
Money Market Deposit Accounts (MMDA)—pay money market rates and offer limited checking functions
Negotiable CDs—can be sold prior to maturity
12-10
Fundamentals of Bank Management
Liabilities of Sources of Funds Miscellaneous Liabilities have experienced a
significant increase during past 30 years Discount Borrowing: Borrowing from
Federal Reserve Federal Funds Market:
Borrowing from another bank unsecured loans between banks, often on
an overnight basis Foreign Banks:
Borrowing from their foreign branches, parent corporation, and Subsidiaries and affiliates
12-11
Fundamentals of Bank Management
Liabilities of Sources of Funds Miscellaneous Liabilities
Repurchase Agreements Sell government securities to another banks or
corporate depositors With agreement to re-purchase at later date at
a higher price Higher price represents the interest Securities serves as a collateral
Securitization Pooling loans into securities Selling them to investors to raise new funds
12-12
Fundamentals of Bank Management
Liabilities of Sources of Funds Miscellaneous Liabilities
Securitization Transform non traded financial instruments
into traded securities Pooling non traded loans into securities Selling them to investors to raise new funds Underlying assets serve as a collateral
12-13
Fundamentals of Bank Management
Bank Capital or Equity Individuals purchase stock in bank Bank pays dividends to stockholders Serves as a buffer against risk Equity capital has remained stable at 6%-8% However, riskiness of banks’ 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
12-14
Fundamentals of Bank Management
Bank Profitability Bank management must balance between
liquidity and profitability tradeoff. Net Interest Income
Difference between total interest income (interest on loans and interest on securities and investments) and interest expense (amount paid to lenders)
NII = Interest income – Interest expense
12-15
Fundamentals of Bank Management
Bank Profitability Net Interest Margin (NIM) Net interest income as a percentage of
total bank assets
NIM = (NII/Asset)*100
Also known as interest rate spread
12-16
Fundamentals of Bank Management
Bank Profitability Factors that determine Net Interest
Margin Better service Implies higher rates on loans and lower interest
on deposits Monopoly power Allows bank to pay lower deposit rate Charge higher interest rate However, it is becoming more unlikely due to
enormous competition from other banks and nonbank competitors
Bank’s risk Interest rate and credit risk
12-17
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
Fundamentals of Bank Management
12-18
Fundamentals of Bank Management
Bank Profitability 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 expressed as a percentage of total equity capital
12-19
Bank Risks
Leverage Risk Leverage—Combine 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 Ratio—Ratio of bank’s equity
capital to total assets [10% in 2007] Regulators in US and other countries impose
risk-based capital requirements—riskier the asset, higher the capital requirement
12-20
Fundamentals of Bank Management
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 bank’s loans Ratio of non-performing loans (delinquent 30
days or more) to total loans is a forward-looking measure
12-21
Fundamentals of Bank Management
Interest Rate Risk Mismatch in maturity of a bank’s assets and liabilities Traditionally banks have borrowed short and lent long Profitable if short-term rates are lower than long-term
rates Due to discounting, increasing interest rates will reduce
the present value of bank’s 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 If interest rates rise while a bank has negative GAP, the
bank can expect to pay more from its liabilities than it can expect to generate from higher interest rates on its assets
12-22
Fundamentals of Bank Management
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
12-23
Fundamentals of Bank Management
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 bank’s 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
12-24
Major Trends in Bank Management
For most of the 20th century banks were insulated from competition from other financial institutions
However, that has changed over time Trends that produced this transition can be
summarized by the following: Consolidation within the banking industry Rise of non traditional banking Globalization
12-25
Consolidation
McFadden Act of 1927 Prohibited banks from branching across
state lines Intension was to prevent the formation of
a few large, nationwide banks, who might monopolize the industry
For that purpose, many states also had restrictions that limited or prohibited branching within their state boundaries
Result—many, many small banks protected from competition from larger national banks
12-26
Consolidation
McFadden Act of 1927 Unintended Consequences: Created banking a localized
monopoly Inefficient local banks There were over 14,000 small 40% of these banks had less 25
million assets
12-27
Consolidation
McFadden Act of 1927 Large efficient banks wanted to enter into
these untapped market Over the years a number of loopholes
were exploited to bypass this act Loan production offices Acquisition of failed thrift institutions under
S&L bail out Most effective was the use of Bank Holding
Company (BHC) Reciprocity rights
12-28
Consolidation
McFadden Act of 1927 Bank Holding Company:
An entity that can own one of more banks and non bank institutions as subsidiary
Under the McFadden act BHC could own banks in different states if permitted by state laws
Therefore, a BHC to own banks across state lines
This would serve the same purpose as to having branches across different states
12-29
Consolidation
McFadden Act of 1927 Reciprocity Rights
1975 Maine allowed BHC from other states to enter, if Maine BHC received the same rights
1982 New York passed the same law Massachusetts formed regional reciprocity
pact By mid 1990 about 30% of domestic
banking assets were owned by out of state BHCs
All these severely compromised the effectiveness of the McFadden Act
12-30
Consolidation
Riegle-Neal Interstate Banking and Branching Efficiency ActPassed in 1994Allowed BHC to acquire banks in any stateBy 1997 all banks were permitted to open branches across statesNumber of unit banks shrunk dramatically
14,400 in the early 1980 7,282 in 2007 For banks with $100 million assets
Total asset was 17% all banking assets in 1980 Total asset declined to less that 3%
12-31
Consolidation
Riegle-Neal Interstate Banking and Branching Efficiency ActConsolidation however did not affect the availability of banking services for consumersAlthough the number of unit banks declined, the number of bank offices (branch and head office) actually went upIn addition ATM, telephone and internet banking were introducedThese provided better access to banking services for consumers
12-32
Consolidation
Economics of Consolidations Two theoretical arguments are often
provided Economies of scale Economies of scope
Economies of Scale: Average cost of lending services falls as the size of banking operation rises
Economies of Scope: Average cost of offering different lines of business falls as the number of lines of business rises
12-33
Consolidation
Empirical Evidence of Theoretical Arguments Research do not find evidence significant
economies of over 5 billion asset size Also little evidence exits supporting the
existence of economies of scale What then explains such massive levels of
consolidations through mergers and acquisitions
12-34
Consolidation
Major reason was the cost savings from consolidations Stream lining of operation Increased efficiency: many efficient banks
acquired small previously protected inefficient banks and made them efficient
Installation of new management Reduce excess capacities
12-35
Nontraditional Banking
Traditionally commercial bank accepted demand deposits and made business loans
However, Federal Reserve granted BHC some more regulatory freedom allowing them to own subsidiaries that could perform other activities
However, these activities were limited to activities closely related to banking: Credit card services Credit insurance Investment advice
12-36
Nontraditional Banking
The Glass-Steagall Act of1933 Prohibited commercial banking from
engaging in investment banking Some investment banking operations were
allowed: Underwriting general obligation municipal
bonds Act as agent for private placements
Not for public, not registered with SEC, Raising funds small business
They were still prohibited from underwriting corporate bonds and equity
12-37
Nontraditional Banking
The Glass-Steagall Act Commercial banks gradually weakened the
effectiveness of the act They resorted to court system to argue that
they should be allowed to perform activities like:
Underwriting municipal revenue bonds Underwriting commercial paper Managing mutual funds
Finally Fed agreed to let BHC to own investment banking subsidiary known as section 20 affiliates on a limited basis
12-38
Nontraditional BankingThe Glass-Steagall Act Essentially Fed broaden the definition of activities
“closely related to banking” Operations of section 20 affiliates could not
exceed 5% of total investment banking revenue Limit was increased gradually to 10% and 25% This led to emergence of mega universal banks
through acquisition of several investment banks: Bank of America and Montgomery Securities (now
Merrill Lynch) Citibank and Travelers Group (Salomon Smith Barney)
12-39
Nontraditional BankingThe Glass-Steagall Act Finally, the Gramm-Leach-Bliley Act
(1999) repealed the Glass-Steagall Act
Off-balance Sheet Activities Another area of growth in recent years These activities increase risk exposure for
banks with no effect on bank’s balance sheet Future market Option market Guarantee and commitment business
12-40
Globalization
American Banks Abroad Rapid expansion of US banks into foreign
countries Growth of international trade American multinational corporation with
operations abroad Edge Act (1919)
Permitted US banks to establish special subsidiaries to facilitate international financing
Exempt from the McFadden Act’s prohibition against interstate banking. Subsidiary in
California to manage trade and financing with South Korea
Florida to manage trade and financing with Latin America
12-41
Globalization
Foreign Banks in the United States About one third of all business loans are
made by foreign banks. Some of the well known foreign banks
include: French Bank BNP Paribas Bank of Tokyo-Mitsubishi HSBC Bank of Montreal
12-42
Globalization
Foreign Banks in the United States Organizational Forms:
Branch of a Foreign Bank Subsidiary of a Foreign Bank Agency of a Foreign Bank
12-43
Globalization
Foreign Banks in the United States Prior to 1978 foreign banks operating in
the US were largely unregulated No reserve requirement Exempt from McFadden act International Banking Act of 1978
Foreign banks subject to same federal regulations as domestic banks
However, certain established banks were grandfathered and were not subject to the law
12-44
Globalization
Eurodollars Eurodollar deposits made in foreign banks were
denominated in US dollars, which eliminated the foreign exchange risk for Americans
These foreign banks were exempt from Regulation Q and could offer higher interest than US banks
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
12-45
Globalization
Eurobonds Corporate and foreign government bonds
sold: Outside borrowing corporation’s home country Principal and interest are denominated in
borrowing country’s currency
Number of tax advantages Little government regulation
12-46
Globalization
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
12-47
Globalization
Domestically Based International Banking Facilities (IBF) 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