Chapter Fourteen Investment Banking, Insurance, and Other Sources of Fee Income Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Topics The Ongoing Search for Fee Income Investment Banking Services Mutual Funds and Other Investment Products Trust Services and Insurance Products Benefits of Product-Line Diversification Economies of Scope and Scale Information Flows and Customer Privacy 14-2

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Fees? To Supplement Traditional Sources of Funds That May be Inadequate To Lower Production Costs Due to Economies of Scale To Offset Higher Production Costs To Reduce Overall Risk by Finding New Sources of Revenue – Diversification To Promote Cross-Selling of Traditional and New Services Due – Economies of Scope 14-3

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Traditional Sources of Fee Income Service Charges on Deposit Accounts, ATMs, Fees for Insufficient Funds Credit Card Service Fees Commitment Fees for Making Credit Available Over a Designated Time Period Fees for Use of Safe Deposit Boxes Rental of Bank Property to Individuals and Businesses 14-4

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Newer Sources of Fee Income Commissions and Fees From Investment Banking Services (GLBA) Brokerage Commissions for Aiding in the Purchase of Securities Fiduciary Income – Trust Services Commissions for the Sake of Insurance Servicing Fees from Securitization and Sales of Loans 14-5

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Investment Banking Services Under The Authority Of The Gramm-Leach- Bliley-Act Many Banking Firms Have Either Acquired Or Formed Their Own Investment Banking Affiliates. The Primary Role Of Investment Bankers Is to Serve As Financial Advisers To Corporations, Governments, And Other Large Institutions. 14-6

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Investment Banking Revenue 14-7

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. CB-IB Combinations Advantages Product-line (service) diversification to possibly lower risk Economies of scale and scope -> efficiencies in management, facilities, and other business resources Disadvantages Ethical breakdowns Possible tying contracts Increased risk exposure (higher risks, more volatile returns, more cyclical) The benefits may not be able to offset the costs 14-8

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Crisis of M&A among IB and CB Bear Stearns into J.P. Morgan Chase Morgan Stanley and Goldman Sachs converted to an FHC status More regulation in the future The role of the Fed as a systemic regulator 14-9

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Mutual Funds Companies that Offer Shares in a Pool of Securities and Flow Through Any Earnings Generated to Shareholding Customers NAV Calculations Registration With SEC Has Prospectus, Each Fund Has Investment Objective Professional Money Manager Diversification 14-10

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. T wo Different Ways for FHCs to Be Involved with Mutual Funds (post-GLBA) Proprietary Funds Offered Through One of Their Affiliated Companies ▫ Offer Investment Advice ▫ Serve as Transfer Agents ▫ Execute the Transactions of the Fund Nonproprietary Funds – The Offering Institution Acts as a Broker for an Unaffiliated Mutual Fund 14-11

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Two Popular Mutual Funds Exchange Traded Funds (ETFs) – Behave Like Index-Tracking Mutual Funds but Trade All Day on Stock Exchanges Hedge Funds – Private Partnerships Whose Shares are Offered Primarily to Wealthy Clients that Often Make High-Stakes Bets on the Direction of the Market 14-12

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Annuities A Savings Instrument in Which the Customer Makes Cash Payments to an Investment Manager Who Places Them Into Earning Assets and Where Later the Purchaser Receives a Stream of Income From Those Assets 14-13

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Annuities Fixed Annuities ▫ Promise a Customer Who Contributes a Lump Sum a Fixed Rate of Return Over the Life of the Contract Variable Rate Annuities ▫ A Lump Sum of Money is Invested Into a Basket of Stocks, Mutual Funds or Other Investments Return for a Customer But is Not Promised a Fixed Equity ▫ Index Annuity – Combines Features of Both Fixed and Variable Annuities 14-14

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Risks and Regulations Regarding Investment Products Risks ▫ Fluctuations in Market Value ▫ Banks May Run Into Compliance Problems if Fail to Properly Register with SEC Customers Must be Informed that Investment Products are: ▫ Not Insured by the FDIC ▫ Not a Deposit or Other Obligation of a Depository Institution ▫ Subject to Investment Risks 14-15

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Quick Quiz What law prohibited U.S. commercial banks to offer investment banking services and why? How did this affect the ability of U.S. banks to compete for underwriting business? What advantages do commercial banks with investment banking affiliates appear to have over competitors that do not offer investment banking services? Possible disadvantages? What risks do investment products pose for the institutions that sell them and how these risks can be mitigated? 14-16

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Trust Services One of the Oldest Bank Activities These Services are Centered on the Management of Property Owned By a Bank’s Customers, Such as Securities, Land, Buildings and Other Investments Often Generate Large Deposits Deposits Must be Fully Secured; FDIC Insurance Applies But Only to the Legal Limit 14-17

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Trusts Living Trusts – Allows Trust Officers to Act on Behalf of a Living Customer without a Court Order Testamentary Trusts – Arise Under a Probated Will and Used to Save on Estate Taxes Irrevocable Trusts – Allows Wealth to be Passed Free of Gift and Estate Taxes Charitable Trusts – Used to Support Worthwhile Causes Indenture Trusts – Used Collect, Hold and Manage Assets to Back an Issue of Securities by a Corporation Dynasty Trusts – Set Up to Avoid Paying Federal Estate Taxes and Generation-Skipping Taxes 14-18

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Offerings of Insurance Related Products Life Insurance Policies Life Insurance Underwriters Property-Casualty Insurance Policies Property-Casualty Insurance Underwriting 14-19

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Insurance Products Disclosure Rules An Insurance Product is not a Deposit or Other Obligation of a Depository Institution An Insurance Product is not Insured by the FDIC Insurance Products May Involve Investment Risk and Possible Loss of Value Depository Institutions Cannot Base Granting Loans Based on the Purchase of Insurance 14-20

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Benefits of Diversification: Product- Line Diversification Effect Offering More Than One Product or Service Through the Same Company in Order to Reduce the Overall Risk of the Revenues Flows Through the Individual Firm 14-21

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Bank Return With Traditional and Nontraditional Services 14-22

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Bank Risks with Traditional and Nontraditional Services 14-23

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Potential Economies of Scale and Scope Economies of Scale (Size) Economies of Scope (Lower Joint Costs) 14-24

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Customer Privacy from GLBA Protecting the Personal Information That Customers Supply to Their Financial-Service Providers So That Customers are Not Damaged By the Release of Their Private Data to Outside Parties 14-25

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Quick Quiz What is convergence? Product-line diversification? Economies of scale and scope? Why might they be of considerable importance for banks and other financial service providers? A commercial bank decides to expand its services to include the underwriting of new security offerings as well as offering the traditional deposit services. The expected return from traditional services is 3% with the standard deviation of 2%. The expected return for the security underwriting services is 15% with the standard deviation of 7%. The correlation of returns between two services is 0.15 and the proportion of traditional services is 70%. Calculate the effects of the new service on the FHC’s overall return and risk