Chapter 3 Banks and Other Depository Institutions © 2000 John Wiley & Sons, Inc.

2 Chapter Outcomes n Describe the differences between commercial banking and investment banking n Identify the functions of banks and of the banking system n Describe the early history of U.S. depository institutions n Discuss general regulation of the banking system and how depositors’ funds are protected

3 Chapter Outcomes (Continued) n Describe the structure of banks in terms of bank charters, branch banking, and bank holding companies n Briefly describe the bank balance sheet and the major account categories that it contains

4 Overview of the Banking System n COMMERCIAL BANK: n COMMERCIAL BANK: Accepts deposits, makes loans, and issues check-writing accounts n INVESTMENT BANK: n INVESTMENT BANK: Helps businesses sell their securities to raise financial capital

5 Commercial and Investment Banking Intermediation Activities Savers Commercial Bank Investment Bank Business Firms Money Bank’s CDs Firm’s Note Firm’s Bond

6 Overview of the Banking System (Continued) n GLASS-STEAGALL ACT (1933): n GLASS-STEAGALL ACT (1933): Traditionally separated commercial banking and investment banking activities n UNIVERSAL BANK: n UNIVERSAL BANK: Can engage in both commercial banking and investment banking activities

7 Commercial Banking Intermediation Activities 1. SAVERS deposit money in a COMMERCIAL BANK and receive, in return, Certificates of Deposit (or have savings accounts set up for them) 2. The COMMERCIAL BANK lends money to a BUSINESS FIRM and receives, in return, the firm’s note which is a promise to repay the loan

8 Investment Banking Intermediation Activities INVESTMENT BANK 1. SAVERS provide money to an INVESTMENT BANK and receive, in return, the securities (e.g., bonds) issued by a BUSINESS FIRM INVESTMENT BANK 2. The INVESTMENT BANK either first purchases the BUSINESS FIRM’S securities (e.g., bonds) and resells them to SAVERS, or just “markets” the securities to SAVERS

9 Financial Institutions in the U.S. Banking System n Commercial Banks n Savings and Loan Institutions n Savings Banks n Credit Unions

10 Processing or Clearing Checks Through the Banking System A CHECK can be: n Presented Directly to the Bank on Which it was Written n Presented Through a Bank Clearinghouse and then to the Bank on Which it was Written n Cleared Through a Federal Reserve Bank and then Presented to the Bank on Which it was Written

11 Historical Development of the U.S. Banking System n Early Chartered Banks n First Bank of the United States n Second Bank of the United States n State Banks from 1836 to the Civil War n Entry of Thrift Institutions

12 General Banking Legislation n National Banking Act of 1864 n Federal Reserve Act of 1913 n Depository Institutions Deregulation and Monetary Control Act of 1980 n Garn-St. Germain Depository Institutions Act of 1982

13 Structure of Banks: Bank Charters n DUAL BANKING SYSTEM: Commercial banks can obtain charters either from the federal government or a state government n FEDERALLY CHARTERED BANKS: Must have “national” in their titles and be members of the Federal Reserve System and the Federal Deposit Insurance Corporation

14 Structure of Banks: Branch Banking n UNIT BANKING: Exists when a bank can have only one full-service office n LIMITED BRANCH BANKING: Allows additional banking offices within a defined distance of a bank’s main office n STATEWIDE BRANCH BANKING: Allows banks to operate offices throughout a state

15 Structure of Banks: Bank Holding Companies n HOLDING COMPANY: A firm that owns and controls other organizations or firms n ONE BANK HOLDING COMPANY: Permits a firm (OBHC) to own and control only one bank n MULTIBANK HOLDING COMPANY: Permits a firm (MBHC) to own and control two or more banks

16 The Bank Balance Sheet: Assets n Cash and Balances Due from Depository Institutions (about 7% of total assets) n Securities (about 18% of total assets) n Loans (about 59% of total assets) n Other Assets (about 16% of total assets)

17 Types of Bank Loans n Loans Secured by Real Estate n Loans to Depository Institutions n Commercial and Industrial Loans n Loans to Individuals n Other Loans

18 The Bank Balance Sheet: Liabilities and Owners’ Capital n Deposits (about 68% of total) n Other Liabilities (about 24% of total) n Owners Capital (about 8% of total)

19 Types of Bank Deposits n TRANSACTION ACCOUNTS: Demand Deposits NOW Accounts n NONTRANSACTIONAL ACCOUNTS: Time Deposits Savings Deposits n FOREIGN DEPOSITS

20 Bank Management: Basic Concepts n BANK LIQUIDITY: Reflects ability to meet depositor withdrawals and to pay off other liabilities when due n BANK SOLVENCY: Reflects ability to keep the value of a bank’s assets greater than its liabilities

21 Liquidity Management n ASSET MANAGEMENT: Maintaining “primary reserves” and “secondary reserves” to help meet depositor withdrawal demands and other liabilities when due n LIABILITY MANAGEMENT: Adjusting interest rates on rate sensitive liabilities like CDs to help maintain a desired level of liquidity

22 Capital Management: Three Capital Ratios n PRIMARY CAPITAL RATIO (PCR): Primary Capital/Total assets n TOTAL CAPITAL RATIO (TCR): (Primary Capital + Secondary Capital)/Total Assets n RISK-BASED CAPITAL RATIO (RCR): Total Capital/Risk-Adjusted Assets

23 Primary Capital and Total Capital Ratio Examples n Basic Information: n Basic Information: a bank has total assets = $100 million; owners’ capital = $4.5 million; loan loss reserve = $1.5 million; & subordinated notes = $2 million. n Primary Capital Ratio n Primary Capital Ratio = ($4.5 million + $1.5 million)/$100 million = 6% n Total Capital Ratio n Total Capital Ratio = ($6.0 million + $2.0 million)/$100 million = 8%

24 International Banking and Foreign Systems n INTERNATIONAL BANKING: Exists when banks operate in more than one country n INTERNATIONAL BANKING ACT OF 1978: Provided more consistent regulation of banks across countries

25 International Banking and Foreign Systems (Continued) n UNIVERSAL BANKING: Banks may engage in both commercial banking and investment banking activities n BANKING DEVELOPMENTS: --Germany is a universal banking country --U.S. banking deregulation may lead to a form of universal banking