Depository Institutions Chapter 2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. K. R. Stanton

McGraw-Hill/Irwin 2-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Products of U.S. FIs  Comparing the products of FIs in 1950, to products of FIs in 2003: Much greater distinction between types of FIs in terms of products in 1950 than in 2003 Blurring of product lines and services over time Wider array of services offered by all FI types (Refer to Tables 2-1A and 2-1B in the text)

McGraw-Hill/Irwin 2-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Size of Depository FIs  Consolidation has created some very large FIs  Combined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs

McGraw-Hill/Irwin 2-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Depository Institutions Commercial Banks  Largest depository institutions are commercial banks.  Differences in operating characteristics and profitability across size classes. Notable differences in ROE and ROA as well as the spread Thrifts  S&Ls  Savings Banks  Credit Unions Mix of very large banks with very small banks

McGraw-Hill/Irwin 2-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Functions & Structural Differences  Functions of depository institutions Regulatory sources of differences across types of depository institutions.  Structural changes generally resulted from changes in regulatory policy. Example: changes permitting interstate branching  Reigle-Neal Act

McGraw-Hill/Irwin 2-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Differences in Balance Sheets Depository Institutions Nonfinancial Firms Assets Liabilities Loans Deposits Deposits Loans Other financial financial assets assets Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity Depository Institutions Nonfinancial Firms Assets Liabilities Loans Deposits Deposits Loans Other financial financial assets assets Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity

McGraw-Hill/Irwin 2-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Structure and Composition  Shrinking number of banks: 14,416 commercial banks in ,744 in ,769 in 2004  Mostly the result of Mergers and Acquisitions M&A prevented prior to 1980s, 1990s Consolidation has reduced asset share of small banks  Financial Services Modernization Act 1999 Allowed full authority to enter investment banking (and insurance)  Limited powers to underwrite corporate securities have existed only since 1987

McGraw-Hill/Irwin 2-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Composition of Commercial Banking Sector  Community banks  Regional and Super-regional Access to federal funds market to finance their lending activities  Money Center banks Bank of New York, Deutsche Bank (Bankers Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USA  declining in number

McGraw-Hill/Irwin 2-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Off-balance Sheet Activities  Heightened importance of off-balance sheet items Large increase in derivatives positions is a major issue Standby letters of credit Loan commitments When-issued securities Loans sold

McGraw-Hill/Irwin 2-10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Trading and Other Risks  Allied Irish / Allfirst Bank $750 million loss  National Australian Bank $450 million loss

McGraw-Hill/Irwin 2-11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Fee-generating Activities  Trust services  Correspondent banking Check clearing Foreign exchange trading Hedging Participation in large loan and security issuances  Payment usually in terms of noninterest bearing deposits

McGraw-Hill/Irwin 2-12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Regulatory Agencies FDIC (BIF and SAIF) OCC: Primary function is to charter national banks. FRS: monetary policy, lender of last resort.  National banks are automatically members of the FRS. State-chartered banks can elect to become members. State bank regulators Dual Banking System: Coexistence of nationally and state-chartered banks.

McGraw-Hill/Irwin 2-13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Regulatory Issues  Importance of Bank Holding Companies is increasing.  BHCs regulated by FRS.

McGraw-Hill/Irwin 2-14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Legislation  1927 McFadden Act  1933 Glass-Steagall  1956 Bank Holding Company Act  1970 acts  1980 DIDMICA and 1982 DIA  1987 Competitive Equality in Banking Act  1989 FIRREA  1991 FDICIA  1994 Riegle Neal Interstate Branching Act  Financial Services Modernization Act

McGraw-Hill/Irwin 2-15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. CAMELS Rating  C – Capital adequacy  A – Asset quality  M – Management  E – Earnings  L – Liquidity  S – Sensitivity to Market Risk  ratings are 1 to 5 with 1 being sound in all categories

McGraw-Hill/Irwin 2-16 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Balance Sheet Regulations  Liquidity Fed gives minimum reserve requirements  reserve computation period 2 weeks beginning on Tuesday and ending on Monday 14 days later  Capital Adequacy – minimum capital requirements to constrain leverage capital-to-assets ratio risk-based capital ratio  Tier I  Tier II

McGraw-Hill/Irwin 2-17 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Balance Sheet Regulations  Basel Accord – implement risk-based capital ratios for banks (1993) redid to incorporate market risk  2001 Basel II Pillar 1 Pillar 2 Pillar 3  Risk-adjusted assets  total risk-based capital ratio  core capital ratio

McGraw-Hill/Irwin 2-18 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Industry Performance  Economic expansion and falling interest rates through 1990s  Brief downturn in early 2000 followed by strong performance improvements Record earnings $106.3 billion 2003  Only 3 failures in 2003 versus 206 in 1989 Serious concerns regarding expected interest rate increases

McGraw-Hill/Irwin 2-19 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Banking and Ethics  Bank of America and Fleet Boston Financial 2004  J.P. Morgan Chase and Citigroup 2003 role in Enron  Riggs National Bank and money laundering concerns 2003

McGraw-Hill/Irwin 2-20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Savings Institutions  Comprised of:  Savings and Loans Associations  Savings Banks Effects of changes in Federal Reserve’s policy of interest rate targeting combined with Regulation Q and disintermediation. Effects of moral hazard and regulator forbearance. Qualified Thrift Lender (QTL) test.

McGraw-Hill/Irwin 2-21 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. S&Ls  deposit insurance without there was asymmetric information problem also potential for bank panics created FDIC to deal with this moral hazard adverse selection  regulatory forbearance political interference (Keating 5) revolving door

McGraw-Hill/Irwin 2-22 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Savings Institutions: Recent Trends  Industry is smaller overall  Intense competition from other FIs mortgages for example  Concern for future viability

McGraw-Hill/Irwin 2-23 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary Regulators  Office of Thrift Supervision (OTS). Charters and examines all federal S&Ls.  FDIC-SAIF Fund. Oversees and manages Savings Association Insurance Fund (SAIF).

McGraw-Hill/Irwin 2-24 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Savings Banks  Mutual organizations Primarily East Coast Not exposed to the oil-based shocks of 1980s Real estate price exposure Demutualization  May be regulated at both state and federal level  89% state chartered concentrated in New England area  rely less on deposits

McGraw-Hill/Irwin 2-25 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Unions  Nonprofit depository institutions owned by member-depositors with a common bond.  Exempt from taxes and Community Reinvestment Act (CRA).  Expansion of services offered in order to compete with other FIs.  Approximately 56% federally chartered and subject to NCUA regulation.

McGraw-Hill/Irwin 2-26 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Global Issues  Near crisis in Japanese Banking  Eight biggest banks reported positive six- month profits  China Deterioration, NPLs at 50% levels Opening to foreign banks (WTO entry)  German bank problems in early 2000s  Implications for future competitiveness

McGraw-Hill/Irwin 2-27 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. *Financial Statement Analysis  Time series analysis of key ratios  ROE framework ROE = ROA × EM ROA = PM × AU