Commercial Bank Behavior Is Banking Becoming More Competitive?

Recent Bank Mergers : ABN and AMRO ($218 billion) 1990: ABN and AMRO ($218 billion) : Chemical Bank and Chase Manhattan ($297 billion) 1996: Chemical Bank and Chase Manhattan ($297 billion) : Mitsubishi Bank and Bank of Tokyo ($752 billion) 1996: Mitsubishi Bank and Bank of Tokyo ($752 billion) : Union Bank of Switzerland and Swiss Bank ($595 billion) 1997: Union Bank of Switzerland and Swiss Bank ($595 billion) : NationsBank and Barnett ($310 billion) 1997: NationsBank and Barnett ($310 billion) : Royal Bank and Bank of Montreal ($330 billion) 1998: Royal Bank and Bank of Montreal ($330 billion) : Toronto Dominion and CIBC ($320 billion) 1998: Toronto Dominion and CIBC ($320 billion) : NationsBank and BankAmerica ($570 billion) 1998: NationsBank and BankAmerica ($570 billion) : Banc One and First Chicago NBD ($240 billion) 1998: Banc One and First Chicago NBD ($240 billion) : Citicorp and Traveler’s ($700 billion) 1998: Citicorp and Traveler’s ($700 billion) : Bank of America and Fleet ($851billion) 2003: Bank of America and Fleet ($851billion) : JP Morgan and Bank One ($1trillion) 2003: JP Morgan and Bank One ($1trillion) The last 20 years has seen considerable consolidation in the banking industry…

AssetsNumber of Banks Share of Banks (%) Share of Assets (%) >$25M $25-50M $50-$100M $100-$500M $500M-$1B $1-$10B <$10B Total Consolidation has created a market where a small group of large banks controls a majority of total assets

BankAssets (Billions) Citigroup1,497 JP Morgan + Bank One1,097 Bank of America + Fleet851 Wells Fargo349 Wachovia341 Met Life277 Washington Mutual268 US Bancorp180 ABN Amro N America140 Bank Boston75 Total5,075 The 10 largest banks in the US control around 40% of all banking assets

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

Concentration Ratios

BankAssets (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)

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 hereclick here

Credit Score% of Population Interest Rate* 499 and below % % % % % % % * 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!

AssetsLiabilities $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, ($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?)

AssetsLiabilities $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 =$20,400 Total Assets = $465,000 Return on Assets (ROA)= After Tax Profits Total Assets = $20,400 $465,000 =.044 (4.4%) Return on Equity (ROE)= After Tax Profits Equity = $20,400 $100,000 =.20 (20%)

ROE vs. ROA Company A Assets = 100 Profits = 10 Debt = 20 Equity = 80_________ ROA = 10% ROE = 12.5% Company B Assets = 100 Profits = 10 Debt = 80 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 Banking

Return on Assets

Return on Equity

AssetsLiabilities $50,000 (T-Bills) $100,000 (Savings) Assets – Liabilities = $100,000 (Equity) 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 CostInterest 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, Q+ $100, Q

Let Q = Total Number of Loans $20,000Total Monthly Costs + $100, Q Cost # of Loans $20,000 Slope = $ $21,000 3 Fixed Costs Variable Costs =

You have estimated the demand for mortgages to be as follows: Q = ( 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 = (.06) – 90.4 (.05) = 113 Your total annual revenues would be $100,000 (113)(.06) = $678,000

Q = ( r ) – 90.4 ( UR ) # of Loans Interest Rate UR = 5% 113 6% r = Q UR -- (Demand) OR r = (113) (.05) -- (Inverse Demand) =.06

Elasticity of Demand refers to the responsiveness of demand to price changes (here, the price is the interest rate) Q = ( r ) – 90.4 ( UR ) # of Loans Interest Rate UR = 5% 113 6%

Revenue Maximization…. Total Revenues = Q($100,000)r = Q = ( r ) – 90.4 ( UR ) $100, r- 642 r (UR) r Maximizing Total Revenues involves taking the derivative with respect to the interest rate and setting it equal to zero… (624) r (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% % =.1205 = (.1205 ) – 90.4 (.05 ) Revenues = $100,000 (75)(.1205) = $903,750 Total Revenues

Profit Maximization… Total Revenues = Q ($100,000) r = Q UR -- Total Monthly Revenues Q UR -- $100,000 Q 2 Q= Total Monthly Revenues = $24,840 - $14,487 UR QQ r 12 $100, $100, (Monthly)

Total Monthly Revenues = $2,070 - $1,207 URQQ Profit Maximization… Quantity $ $100,000*Demand MR Marginal Revenue is the derivative of Total Revenue with respect to Q Marginal Revenues = Q $2,070 - $1,207 UR

$20,000Total Monthly Costs + $100, Q= Profit Maximization… Marginal Cost is the derivative of Total Cost with respect to Q $ Quantity Marginal Costs $333.33= Total Costs

Profit Maximization… Profits = Total Revenues – Total Costs UR =.05 Q=63 Maximization Condition Marginal Revenues = Marginal Costs $333.33= r = Q UR -- =.1412 (14. 12%) Solving for Q Q $2,070 - $1,207 UR

Quantity $ $100,000*Demand MC MR % Profits = Total Revenues – Total Costs $20,000Total Monthly Costs + $100, = - = $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…..

Elasticity of Demand refers to the responsiveness of demand to price changes – as number of banks increases, demand becomes more elastic Q = ( r ) – 90.4 ( UR ) Q Interest Rate This number gets bigger! More elastic Less elastic

Q = ( 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 Spreads

As a portfolio manager, a bank must choose a portfolio composition to minimize risk AssetsLiabilities $50,000 (T-Bills) $100,000 (Savings) Assets – Liabilities = $100,000 (Equity) 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:

AssetsLiabilities $50,000 (T-Bills) (1) $100,000 (Savings) (0) Assets – Liabilities = $100,000 (Equity) 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, $100,000 $465, $300,000 $465, = 10.4 $100,000 $365, $65,000 $365,000 5 = 1.16

AssetsLiabilities $50,000 (T-Bills) (1) $100,000 (Savings) (0) Assets – Liabilities = $100,000 (Equity) 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

AssetsLiabilities $50,000 (T-Bills) (1) $100,000 (Savings) (0) Assets – Liabilities = $100,000 (Equity) 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?