Commercial Bank Behavior Is Banking Becoming More Competitive?

Commercial Bank BehaviorCommercial Bank Behavior

Is Banking Becoming More Is Banking Becoming More Competitive?Competitive?

Recent Bank Mergers1990: ABN and AMRO ($218 billion): ABN and AMRO ($218 billion)1996: Chemical Bank and Chase Manhattan ($297 billion): Chemical Bank and Chase Manhattan ($297 billion)1996: Mitsubishi Bank and Bank of Tokyo ($752 billion): Mitsubishi Bank and Bank of Tokyo ($752 billion)1997: Union Bank of Switzerland and Swiss Bank ($595 billion) : Union Bank of Switzerland and Swiss Bank ($595 billion) 1997: NationsBank and Barnett ($310 billion): NationsBank and Barnett ($310 billion)1998: Royal Bank and Bank of Montreal ($330 billion) : Royal Bank and Bank of Montreal ($330 billion) 1998: Toronto Dominion and CIBC ($320 billion) : Toronto Dominion and CIBC ($320 billion) 1998: NationsBank and BankAmerica ($570 billion): NationsBank and BankAmerica ($570 billion)1998: Banc One and First Chicago NBD ($240 billion): Banc One and First Chicago NBD ($240 billion)1998: Citicorp and Traveler’s ($700 billion): Citicorp and Traveler’s ($700 billion)2003: Bank of America and Fleet ($851billion): Bank of America and Fleet ($851billion)2003: JP Morgan and Bank One ($1trillion): JP Morgan and Bank One ($1trillion)

The last 20 years has seen considerable consolidation in the banking industry…

Assets Number of Banks

Share of Banks (%)

Share of Assets (%)

>$25M 1211 14 .4

$25-50M 1851 21.5 1.2

$50-$100M 2179 25.3 2.8

$100-$500M 2693 31.2 9.8

$500M-$1B 296 3.4 3.7

$1-$10B 314 3.6 15.9

<$10B 77 .9 66.1

Total 8621 100 100

Consolidation has created a market where a small group of large banks controls a majority of total assets

Bank Assets (Billions)

Citigroup 1,497

JP Morgan + Bank One 1,097

Bank of America + Fleet 851

Wells Fargo 349

Wachovia 341

Met Life 277

Washington Mutual 268

US Bancorp 180

ABN Amro N America 140

Bank Boston 75

Total 5,075

The 10 largest banks in the US control around 40% of all banking assets

Concentration RatiosConcentration Ratios

0

5

10

15

20

25

30

35

40

45

Banking

C(4)

C(8)

C(20)

The concentration ratio is the percentage of market share owned by the largest m firms in the industry (usually 4, 8, 20, 50)

Concentration RatiosConcentration Ratios

0

10

20

30

40

50

60

70

80

90

100

Banking Apparel Petroluem Finance Automobiles

C(4)

C(8)

C(20)

Bank Assets (Billions)

Citigroup (US) 1,497

JP Morgan + Bank One (US) 1,097

Mizuho Financial Group (Japan) 1,080

Bank of America + First Union (US) 851

UBS (Switzerland) 851

Sumitomo Mitsui (Japan) 844

DeutscheBank (Germany) 795

Mitsubishi Tokyo (Japan) 781

HSBC (UK) 759

BNP Paribas (France) 744

However while the US is the world’s largest economy, only three of the ten largest banks in the world are American.

The banker’s optimization problem has three dimensions…

As a competitive firm, the bank must choose prices (interest rates) to maximize profits)

As a portfolio manager, a bank must choose a portfolio composition to minimize risk

As a financial intermediary, a bank must solve the informational problems that exist between borrowers and lenders (moral hazard and adverse selection)

As a financial intermediary, a bank must solve the informational problems that exist between borrowers and lenders (moral hazard and adverse selection)

Most of the informational problems that exist between the bank and potential depositors have been solved through regulation and insurance (FDIC), but the bank must still deal with the moral hazard and adverse selection problems associated with its loan customers

Diversification

Loan Covenants

Credit Rationing (Credit Limits)

Credit Scoring

Credit scoring is an attempt to estimate loan default rates based on observable characteristics. The most common credit score was developed by Fair/Isaac Co. and is known as your FICO number (300 – 850)

These are NOT in a FICO Score

How you pay your bills (35%)

Amount of Debt/Amount of Available Credit (30%)

Length of Credit History (15%)

Mix of Credit (Types of Loans) (10%)

Applications for new credit (10%)

Key Components of FICO Score

Age

Race

Employment

Income

Education

Marital Status

To estimate your FICO score, click here

Credit Score % of Population

Interest Rate*

499 and below 1 ------

500 - 549 5 9.29%

550 - 599 7 8.53%

600 - 649 11 7.71%

650 - 699 16 6.56%

700 - 749 20 6.02%

750 - 799 29 5.90%

800 - 850 11 5.90%

* Interest Rate on a $150,000 , 30 Year Fixed Rate Mortgage

As a competitive firm, the bank must choose prices (interest rates) to maximize profits)

A bank makes its profits from the spread between the interest rate it charges on loans and the interest rate it pays on deposits

(Interest rate on loans) (Quantity of loans)

– (Quantity of Deposits) (Interest paid on deposits)

Profits

Note: This is ignoring income from fees!

Assets Liabilities

$50,000 (T-Bills) - 4%

$100,000 (Savings) - 2%

Assets – Liabilities = $100,000 (Equity)

Acme National Bank

$100,000(5 yr. Loans) – 5%

$5,000 (Cash) - 0%

$10,000 (Reserves) - 0%

$300,000 (30 yr Mort.) – 7%

$100,000 (Checking) - 0%

$100,000 (1 yr. CD) - 3%

$65,000 (5 yr. CD) – 4%

Profit = .04 ($50,000) + .05 ($100,000) + .07($300,000) = $28,000- .02($100,000) + .03($100,000) + .04 ($65,000) = $ 7,600

$20,400

Profits equal revenues minus costs

However, profits don’t take into account the scale of operations (How large is the bank?)

Assets Liabilities

$50,000 (T-Bills) - 4%

$100,000 (Savings) - 2%


Acme National Bank

$100,000(5 yr. Loans) – 5%

$5,000 (Cash) - 0%

$10,000 (Reserves) - 0%

$300,000 (30 yr Mort.) – 7%

$100,000 (Checking) - 0%

$100,000 (1 yr. CD) - 3%

$65,000 (5 yr. CD) – 4%

Profit = $20,400

Total Assets = $465,000

Return on Assets (ROA) =After Tax ProfitsTotal Assets

=$20,400

$465,000= .044 (4.4%)

Return on Equity (ROE) =After Tax Profits Equity

=$20,400

$100,000= .20 (20%)

ROE vs. ROAROE vs. ROA

Company ACompany A

Assets = 100Assets = 100

Profits = 10Profits = 10

Debt = 20Debt = 20

Equity = 80_________Equity = 80_________

ROA = 10%

ROE = 12.5%

Company BCompany B

Assets = 100Assets = 100

Profits = 10Profits = 10

Debt = 80Debt = 80

Equity = 20_________Equity = 20_________

ROA = 10%

ROE = 50%

The more leveraged a firm is, the higher the return to equity for a given ROA. However, a highly leveraged firm carries more risk!

Equity Capital to Assets in BankingEquity Capital to Assets in Banking

7.5

8

8.5

9

9.5

10

1998 1999 2000 2001 2002

State

National

Return on AssetsReturn on Assets

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1998 1999 2000 2001 2002

State

National

Return on EquityReturn on Equity

0

5

10

15

20

1998 1999 2000 2001 2002

State

National

Assets Liabilities

$50,000 (T-Bills)

$100,000 (Savings)


Acme National Bank

$100,000(5 yr. Loans)

$5,000 (Cash)

$10,000 (Reserves)

$300,000 (30 yr Mort.)

$100,000 (Checking)

$100,000 (1 yr. CD)

$65,000 (5 yr. CD)

Total Assets = $465,000

A Bank also faces two constraints:

Cash + Reserves = (Reserve Requirement) (Checkable Deposits)

= (.05)($100,000) = $5,000

Equity = (.04)(Assets) = (.04)($465,000) = $18,600

Federal Reserve

Basel Accord

Lets assume that you have the only bank in town. You offer one type of loan – a 30 year $100,000 fixed APR mortgage. You offer savings accounts that pay 3% interest per year.

You have monthly fixed costs equal to $20,000. Further, you have annual administrative costs equal to 1% of your total funds raised.

Let Q = Total Number of Loans

$20,000

Fixed Cost Interest Cost Administrative Costs

For example, if you want to create 3 mortgages, you will need to raise $300,000 in deposits that will earn $9,000 per year (3% of $300,000) and incur $3,000 (1% of $300,000) in administrative expenses.

Total Monthly Cost = $20,000 + $750 + $250 = $21,000

Total Monthly Costs

+ $100,000.0312

Q + $100,000.0112

Q

Let Q = Total Number of Loans

$20,000Total Monthly Costs

+ $100,000.0412

Q

Cost

# of Loans

$20,000

Slope = $333.33

$21,000

3

Fixed CostsVariable Costs

=

You have estimated the demand for mortgages to be as follows:

Q = 155.0 - 624 ( r ) – 90.4 ( UR )

Interest Rate Charged

Unemployment Rate

For example, if you set your mortgage rate at 6% (.06) and the local unemployment rate is 5% (.05), you will be able to sell 113 mortgages

Q = 155.0 - 624 (.06) – 90.4 (.05) = 113

Your total annual revenues would be $100,000 (113)(.06) = $678,000

Q = 115.0 - 624 ( r ) – 90.4 ( UR )

# of Loans

Interest Rate

UR = 5%

113

6%

r =

115624

1624

Q90.4624

UR- -

(Demand)

OR

r =

155624

1624

(113)90.4624

(.05)- -

(Inverse Demand)

= .06

33.113

06.624

d

dd Q

P

P

QElasticity of Demand refers to the responsiveness of demand to price changes (here, the price is the interest rate)

Q = 155.0 - 624 ( r ) – 90.4 ( UR )

# of Loans

Interest Rate

UR = 5%

113

6%d

dd

d

dd Q

P

P

Q

PPQ

Q

P

Q

%

%

Revenue Maximization….

Total Revenues = Q($100,000)r =

Q = 155 - 624 ( r ) – 90.4 ( UR )

$100,000 155 r - 642 r2

- 90.4 (UR) r

Maximizing Total Revenues involves taking the derivative with respect to the interest rate and setting it equal to zero…

155 - 2 (624) r - 90.4 (UR) = 0

Solving for r …

r = 155 – 90.4(UR)

2 (624)

r = 155 – 90.4(.05)

2 (624)

If the unemployment rate is equal to 5%, the revenue maximizing loan rate is 12.05%

# of Loans

UR = 5%

75

12.05%

= .1205

= 155 - 624 ( .1205 ) – 90.4 (.05 )

175

1205.624

d

dd Q

P

P

Q

Revenues = $100,000 (75)(.1205) = $903,750

Total Revenues

Profit Maximization…

Total Revenues = Q ($100,000)

r =

155624

1624

Q90.4624

UR- -

Total Monthly Revenues

155624

1624

Q90.4624

UR- - $100,000Q

2

Q=


=

$24,840 - $14,487 URQ Q- 160 2

r12

12$100,000

12$100,000

12

12 12

(Monthly)


=

$2,070 - $1,207 UR Q Q- 13.32


Quantity

$

$100,000*DemandMR

Marginal Revenue is the derivative of Total Revenue with respect to Q

Marginal Revenues =

Q- 26.6$2,070 - $1,207 UR


+ $100,000.0412

Q=


Marginal Cost is the derivative of Total Cost with respect to Q

$

Quantity

Marginal Costs $333.33=

Total Costs


Profits = Total Revenues – Total Costs

UR = .05

Q = 63

Maximization Condition Marginal Revenues = Marginal Costs

$333.33=

r =

155624

1624

Q90.4624

UR- - = .1412 (14. 12%)

Solving for Q

Q- 26.6$2,070 - $1,207 UR

Quantity

$

$100,000*Demand

MC

MR

63

14.1%

Profits = Total Revenues – Total Costs


+ $100,000.0412

63=- = $41,000

Total Monthly Revenues = $100,000(63)(.1412)/12 = $74,130

$33,130Profits =

Annual Profit = $397,560

Over time, more banks move into the area…..

dd

d

Q P

P Q

Elasticity of Demand refers to the responsiveness of demand to price changes – as number of banks increases, demand becomes more elastic

Q = 155 - 624 ( r ) – 90.4 ( UR )

Q

Interest Rate

This number gets bigger!

More elastic

Less elastic

dd

d

Q P

P Q

Q = 155 - 624 ( r ) – 90.4 ( UR )

Q

Interest Rate

This number gets bigger!

Demand

MC

MR

As Demand Becomes more elastic…

The Spread between price (interest rate) and costs decreases

Quantity increases

Profits decrease

Q

r

As long as there are profits to be made, more banks enter the area. Eventually, price = marginal costs and profits drop to zero.

Banking SpreadsBanking Spreads

0

2

4

6

8

10

12

14

Jan

-85

Jan

-86

Jan

-87

Jan

-88

Jan

-89

Jan

-90

Jan

-91

Jan

-92

Jan

-93

Jan

-94

Jan

-95

Jan

-96

Jan

-97

Jan

-98

Jan

-99

Jan

-00

Jan

-01

Jan

-02

Jan

-03

Jan

-04

Prime

Fed Funds

Spread

Banking SpreadsBanking Spreads

As a portfolio manager, a bank must choose a portfolio composition to minimize risk

Assets Liabilities

$50,000 (T-Bills)

$100,000 (Savings)


Acme National Bank

$100,000(5 yr. Loans)

$5,000 (Cash)

$10,000 (Reserves)

$300,000 (30 yr Mort.)

$100,000 (Checking)

$100,000 (1 yr. CD)

$65,000 (5 yr. CD)

= 21.5% of Assets

Suppose that the yield curve shifts up by 100 basis points:

Assets Liabilities

$50,000 (T-Bills) (1)

$100,000 (Savings) (0)


Acme National Bank

$100,000(5 yr. Loans) (3)

$5,000 (Cash) (0)

$10,000 (Reserves) (0)

$300,000 (30 yr Mort.) (15)

$100,000 (Checking) (0)

$100,000 (1 yr. CD) (1)

$65,000 (5 yr. CD) (5)

= 21.5% of Assets

Durations are indicated in parentheses

Duration (Assets) =

Duration (Liabilities) =

$50,000$465,000 1 +

$100,000$465,000 3 +

$300,000$465,000 15 = 10.4

$100,000$365,000 1 +

$65,000$365,000 5 = 1.16

Assets Liabilities

$50,000 (T-Bills) (1)

$100,000 (Savings) (0)


Acme National Bank

$100,000(5 yr. Loans) (3)

$5,000 (Cash) (0)

$10,000 (Reserves) (0)

$300,000 (30 yr Mort.) (15)

$100,000 (Checking) (0)

$100,000 (1 yr. CD) (1)

$65,000 (5 yr. CD) (5)

= 21.5% of Assets

Duration Gap = Duration (Assets) – Duration (Liabilities)Liabilities

Assets

= 10.4 – 1.16 $365,000

$465,000= 9.5

Assets Liabilities

$50,000 (T-Bills) (1)

$100,000 (Savings) (0)


Acme National Bank

$100,000(5 yr. Loans) (3)

$5,000 (Cash) (0)

$10,000 (Reserves) (0)

$300,000 (30 yr Mort.) (15)

$100,000 (Checking) (0)

$100,000 (1 yr. CD) (1)

$65,000 (5 yr. CD) (5)

= 21.5% of Assets

Duration Gap = 9.5

For every 100 basis point increase in the yield curve, this bank’s equity (as a percentage of assets) drops by 9.5%

How much of an interest rate change can this bank withstand before it inadequately capitalized?

Commercial Bank Behavior Is Banking Becoming More Competitive?

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