CHAPTER 2 Financial Services: Depository Institutions Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

2-2 Overview of Financial Institutions

2-3 Overview of Financial Institutions

2-4 Overview of Depository Institutions  This chapter discusses depository FIs: –Size, structure, and composition –Balance sheets and recent trends –Regulation of depository institutions –Depository institutions performance

2-5 Products of U.S. FIs  Comparing the products of FIs in 1950, to products of FIs in 2007: –Much greater distinction between types of FIs in terms of products in 1950 than in 2010 –Blurring of product lines and services over time and wider array of services –(Refer to Tables 2-1A and 2-1B in the text)

2-6 Specialness of Depository FIs  Products on both sides of the balance sheet –Loans  Business and Commercial –Deposits

2-7 Other outputs of depository FIs  Other products and services 1950: –Payment services, savings products, fiduciary services  By 2007, products and services further expanded to include: –Underwriting of debt and equity, Insurance and risk management products

2-8 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

2-9 Largest US Depository Institutions 1. J.P.Morgan Chase2, Bank of America 2, Citigroup1, Wells Fargo1, U.S. Bancorp HSBC North America Bank of NY Mellon Suntrust State Street Corp BB&T Holding Co. Assets ($Billions)

2-10 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 –Mix of very large banks with very small banks

2-11 Structure and Composition  Shrinking number of banks: –14,416 commercial banks in 1985 –12,744 in 1989 –6,911 in 2009  Mostly the result of Mergers and Acquisitions –M&A prevented prior to 1980s, 1990s –Consolidation has reduced asset share of small banks

2-12 Regulation, Functions & Structure  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

2-13 Breakdown of Loan Portfolios

2-14 Commercial Banks: Asset Concentration Size 2009 Assets Percent of Total 1984 Assets Percent of Total All FDIC Insured 11, , $100M or Less $100M - $1B1, $1B - $10B1, $10B or more9,

2-15 Structure & Composition of Commercial 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

2-16 Composition of Commercial Banking Sector  Community banks  Regional and Super-regional –Access to federal funds market to finance their lending and investment activities  Money Center banks –Bank of New York Mellon, Deutsche Bank (Bankers Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USA  Declining in number

2-17 Balance Sheet and Trends  Business loans have declined in importance  Offsetting increase in securities and mortgages  Increased importance of funding via commercial paper market  Securitization of mortgage loans  Temporary effects: credit crunch during recessions of and

2-18 Commercial Banks, September 2009  Primary assets: –Real Estate Loans: $3,799.3 B –C&I loans: $1,210.7 B –Loans to individuals: $959.1 B –Investment security portfolio: $3,335.2 B –Of which, Treasury securities: $1,225.5 B  Inference: Importance of Credit Risk

2-19 Commercial Banks  Primary liabilities: –Deposits: $8,178.2 billion –Borrowings: $2,065.6 billion –Other liabilities: $307.4 billion  Inference: –Highly leveraged

2-20 Some Terminology  Transaction accounts  Negotiable Order of Withdrawal (NOW) accounts  Money Market Mutual Fund  Negotiable CDs: Fixed-maturity interest bearing deposits with face values over $100,000 that can be resold in the secondary market

2-21 Equity  Commercial Banks equity capital –11.08 percent of total liabilities and equity (2009) –TARP program intended to encourage increase in capital  Citigroup $25 B  BOA $20 B –Through 2009: $300 B in capital injections through TARP

2-22 Off-Balance-Sheet Activities  Heightened importance of off- balance-sheet items –OBS assets, OBS liabilities –Regulatory incentives –Risk control and risk producing  Role of mortgage backed securities  “Toxic” assets  Expansion of oversight

2-23 Major OBS Activities –Loan commitments –Standby letters of credit and letters of credit –Futures, forwards, and swaps –When-issued securities

2-24 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

2-25 Bank Regulators Go to the pdf slide about OJK

2-26 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

2-27 Savings Institutions: Recent Trends  Industry is smaller overall  Intense competition from other FIs –Mortgages, for example

2-28 Primary Regulators  Office of Thrift Supervision (OTS) –Charters and examines all federal S&Ls  FDIC-DIF Fund –FDIC Oversaw and managed Savings Association Insurance Fund (SAIF) –SAIF and BIF merged in January 2007 to form DIF –Same regulatory structure applied to commercial banks

2-29 Credit Unions  Nonprofit DIs 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  Claim of unfair advantage of CUs over small commercial banks

2-30 Composition of Credit Union Deposits, 2009

2-31 Global Issues  Spread of US financial crisis to other countries  Many European banks saved from bankruptcy through support of governments and central banks  Interest rates at or below 1 percent  Links to the macroeconomy

CHAPTER 2 Financial Services: Depository Institutions Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

3-33 Overview  This chapter discusses insurance companies –Two major groups:  Life  Property & Casualty –Financial crisis and insurance companies –Size, structure, and composition –Balance sheets and recent trends –Regulation of insurance companies –Global competition and trends

3-34 Insurance and Financial Crisis  Insurance companies as investors in securities –Subprime mortgage pools fell in value –Credit default swaps (CDS) fell –AIG was a major writer of CDS securities  Potential impact on other companies used to justify AIG bailout  Increased risk exposure

3-35 Insurance Companies  Differences in services provided by: –Life insurance companies –Property and casualty insurance

3-36 Size, Structure & Composition  Size, structure, and composition of the industry: –In 1988: 2,300 life insurance companies with aggregate assets of $1.12 trillion –Mid 2000s: 1,300 companies –In early 2006: $4.5 trillion in assets  3 largest wrote 25% of new premium business in 2008

3-37 Size, Structure & Composition continued: –In 2009: $0.7 trillion in assets –Increasing involvement of commercial banks  In 2008: Commercial banks sold 30.5 percent of fixed annuity insurance contracts and 12.) percent of variable rate insurance contracts

3-38 Life Insurance Companies  Significant consolidation in life insurance industry although not to the same extent witnessed in banking  Competition from within industry and from other FIs  Conversion to stockholder controlled companies

3-39 Mutual vs. Stock Insurance Companies

3-40 Life Insurance: Issues  Demutualization  Adverse selection –Insured have higher risk than general population –Alleviated by grouping of policyholders into risk pools

3-41 Life Insurance Companies  Life insurance products: –Ordinary life  Term life, whole life, endowment life  Variable life, universal life, variable universal life –Group life –Industrial life –Credit life

3-42 Distribution of Premiums

3-43 Other Life Insurer Activities –Annuities  Reverse of life insurance activities  Topped $347.4 billion in 2008  Ethics: Conseco, 2004 –Private pension funds  Compete with other financial service cos.  In 2009, managing over $2.2 trillion (43% of all private pension plans) –Accident and health insurance  Morbidity insurance  Over billion in premiums in 2008

3-44 Balance Sheet –Long-term assets  Need to generate competitive returns on savings components of life insurance policies  Bonds, equities, government securities  Policy loans –Long-term liabilities  Net policy reserves to meet policyholders’ claims  Separate account business 3 represented 0.1% of total liabilities and capital in 2009

3-45 Recent Trends  Impact of financial crisis –Drop in value of securities  Capital losses from bonds and stocks exceeded $35 billion –Historically low short term interest rates  Adverse impact on ability to lower rates on new policies  Incentive to surrender existing policies –Dwindling reserves led to Treasury Department extending bailout funds –Late 2009 showed improvement

3-46 Property and Casualty Insurance  Size and Structure –Currently about 2,000 companies –Highly concentrated; Top 10 firms have over 50% of market in terms of premiums written  Top 100 firms: over 95%  M&A activity is increasing concentration

3-47 P&C Products  Fire insurance and allied lines  Homeowners multiple peril insurance  Commercial multiple peril insurance  Automobile liability and physical damage insurance  Liability insurance (other than automobile)

3-48 Property & Casualty  Changing composition of net premiums written, 2008 versus 1960: –Decline in fire insurance and allied lines: 2.4% in 2008 vs. 16.6% in 1960 –Homeowners MP: 13.3% vs. 5.2% in 1960 –Commercial MP: 7.1% vs. 0.4% in 1960 –Auto L&PD: 39.1% vs. 43% in 1960 –Other liability: 12.8% vs. 6.6% in 1960

3-49 P&C Balance Sheet  Similar to life insurance companies (smaller asset base) –Requirement for liquid assets  Major liabilities –Loss reserves –Loss adjustment expense –Unearned premiums

3-50 Loss Risk  Underwriting risk may result from: –Unexpected increases in loss rates –Unexpected increases in expenses –Unexpected decreases in investment yields or returns  Property versus liability –Losses from liability insurance less predictable –Example: Claims due to asbestos damage to workers’ health

3-51 Loss Rates  Severity versus frequency –Loss rates more predictable on low-severity, high- frequency lines (such as fire, auto, homeowners peril) than on high-severity, low-frequency lines (such as earthquake, hurricane, financial guaranty) –Claims in high-severity, low-frequency lines may not be independent –Higher uncertainty forces PC firms to invest in more short-term assets and hold larger capital and reserves than life insurance firms

3-52 Insurance Risks Post 9/11  Crisis generated by terrorist attacks forced creation of federal terrorism insurance program in 2002  Federal government provides backstop coverage under Terrorism Risk Insurance Act of 2002 (TRIA) –Caps losses for insurance companies

3-53 Long Tail Versus Short Tail  Long-tail risk exposure –Arises where peril occurs during coverage period but claim is made many years later –Examples: Asbestos cases and Dalkon shield case –Efforts to contain long-tail risks within subsidiaries  Example: Halliburton

3-54 Insurance Costs: Social Inflation  Product inflation versus social inflation –Unexpected inflation may be systematic or line-specific –Social inflation: Unexpected changes in awards by juries  Reinsurance –Approximately 75 percent of reinsurance by US firms is written by non-US firms such as Munich Re

3-55 Underwriting Ratios  Loss ratios have generally increased  Expense ratios have generally decreased  Trend toward selling directly through their own brokers rather than independent brokers  Combined ratio: −Includes both loss and expense experience −If greater than 100, premiums are insufficient to cover losses and expenses

3-56 Investment Yield / Return Risk  Operating ratio = combined ratio after dividends minus investment yield  Importance of investment income: –Causes PC managers to place importance on measuring and managing credit risk and interest rate risk

3-57 P&C: Recent Trends  Several catastrophes over –Hurricane Hugo 1989, San Francisco Earthquake 1991, Oakland fires 1991, Hurricane Andrew 1991 –2004, Hurricanes Charley, Frances, Ivan, Jeanne in rapid succession generated claims comparable to Andrew. –Hurricane Katrina, 2005  Trough of underwriting cycle –September 11, 2001 terrorist attacks created an insurance crisis (and heightened demand).  Potential for crowding out market solutions via government actions

3-58 Global Issues  Insurance industry increasingly global  Worldwide, 2008 was a bad year –130 natural catastrophes, 174 manmade –2008 earthquake in China: Almost half of worldwide insurance losses –Global financial crisis  Improvement in 2009 as financial markets and economies recover –Higher premiums and better investment results

Insurance in Indonesia 2-59

Insurance in Indonesia 2-60

Insurance in Indonesia 2-61

Insurance in Indonesia 2-62

Insurance in Indonesia 2-63

Insurance in Indonesia,

Insurance in Indonesia 2-65  Penetration and Density

CHAPTER 2 Financial Services: Depository Institutions Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

4-67 Overview  This chapter discusses securities brokerage firms and investment banks –Activities of securities firms and investment banks –Size, structure, and composition –Balance sheets and recent trends –Regulation of securities firms and investment banks –Global issues

4-68 Securities Firms & Investment Banks  Nature of business –Underwrite securities –Market making –Advising (example: M&A, restructurings)

4-69 Securities Firms & Investment Banks  Growth in domestic M&A: –Less than $200 billion in 1990 –$1.83 trillion in 2000 –In US: bottomed out at $458 billion in 2002 ($1.2 trillion worldwide) –Topped $1.7 trillion 2007 ($4.5 trillion worldwide) –Effects of financial crisis: fell to $808 billion in 2009 ($1.7 trillion worldwide)  Worst financial crisis since 1930s, but M&A activity still greater than early 2000s

4-70 Mergers and Acquisitions,

4-71 Structural Changes in Recent Years  Acquisition of Bear Stearns by J.P. Morgan Chase  Bankruptcy of Lehman Brothers  Acquisition of Merrill Lynch by Bank of America  Only two remaining major firms: –Goldman Sachs and Morgan Stanley  Converted to commercial bank holding companies in 2008

4-72 Largest M&A Transactions

4-73 Size, Structure & Composition  Dramatic increase in number of firms from 1980 to 1987; Decline of 37% following the 1987 crash, to year 2006  1987: Salomon Brothers held $3.21 billion in capital  2006: Merrill Lynch held capital of $35.5 billion

4-74 Size, Structure & Composition  Many recent inter-industry mergers (i.e., insurance companies and investment banks) –Role of Financial Services Modernization Act, 1999  Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley gone by end of 2008

4-75 Types & Relative Sizes of Firms  National full-line firms are largest –BOA (via acquisition of Merrill Lynch) Morgan Stanley  National full-line firms specializing in corporate finance are second in size –Goldman Sachs, Salomon Brothers/Smith Barney (Citigroup)

4-76  Remainder of industry: –Large investment banks (Lazard Ltd. And Greenhill & Co.) –Regional securities firms (subdivided into large, medium and small) –Specialized discount brokers, electronic trading firms, venture capital firms, and other firms Types & Relative Sizes of Firms

4-77 Top Bank Holding Companies 2009 (by brokerage fee income)

4-78 Key Activities  Investing  Investment banking –Activities related to underwriting and distributing new (IPOs) and secondary (seasoned) issues of debt and equity  Public offerings & private placements  Market making –Increasing importance of online trading  Technology risk –Decimalization

4-79 Activities (continued)  Trading –Position trading, pure arbitrage, risk arbitrage, program trading  Cash management  Assisting with M&A  Back-office and service functions

4-80 Recent Trends  Decline in trading volume and brokerage commissions –Particularly since crash of 1987, although some recovery since 1992; Record volumes  Declines in market values--and commission income  Resurgence in market values and commissions during mid-2000s  New lows in 2008

4-81 Trends (continued)  Pretax net income over $9 billion per year  Pretax profits soared to $21.0 billion in 2000 –Curtailed by economic slowdown and September 11 attacks 2001  Worries over securities law violations and investor confidence  Financial crisis, 2008  Profits recovered, 2009

4-82 Securities Industry Pretax Profits,

4-83 Balance Sheet  Key assets: –Long positions in securities and commodities –Reverse repurchase agreements –Implications: Market, interest rate & F/X risks  Key liabilities: –Repurchase agreements major source of funds –Securities and commodities sold short –Broker call loans from banks  Capital levels much lower than in banks

4-84 Regulation  Primary regulator: SEC –Reiterated by National Securities Markets Improvement Act (NSMIA) of 1996 –Prior to NSMIA, regulated by SEC and states

4-85 Regulation  Early 2000s erosion of SEC dominance –Increased vigilance by State Attorneys General  Criminal cases brought mainly by states against securities law violators ∙ New York State vs. Merrill Lynch  Spring 2003, $1.4 billion in penalties over investor abuses  New rules brought by SEC for greater disclosure by analysts of potential conflicts of interest

4-86 Regulation (continued)  Sarbanes-Oxley Act of 2002 –Independent auditing oversight board under SEC –Instigated by Enron, Global Crossings, Tyco, WorldCom

4-87 Regulation (continued)  SEC sets regulatory standards –Day-to-day regulation: Financial Industry Regulatory Authority (FINRA)  Example: Floor trader at Fleet specialist fined $25,000 for mishandling customer orders (10,000 shares of GM sold from Fleet’s account on rumors of problems at GM)

4-88 Extension of Oversight  Additional oversight from US Congress –Hearings focused on role of investment banks in the financial crisis  Goldman Sachs bundling of toxic assets

4-89 Extension of Oversight  2010 Financial Services Regulatory Overhaul Bill –Financial Services Oversight Council –New authority for Federal Reserve to oversee payment, clearing, and settlement systems  Executive compensation in the financial crisis culminated in “pay czar” (Feinberg)

4-90 Investor Protection & Other Monitoring  Securities Investors Protection Corporation (SIPC) –Protection level of $500,000  October 2003 implementation of provisions of Patriot Act to combat money laundering –Scrutiny of individual identities and affiliations with terrorists

4-91 Web Resources  For details of regulation of securities firms and investment banks, visit: SEC NYSE NASD SIPC

4-92 Global Issues  Global nature of securities firms –Competition between US and European firms –Foreign investors’ transactions in US securities and US investors’ transactions in foreign securities exchanges increased –Global concern about capital, liquidity and leverage following the financial crisis  Implications for global competitiveness ∙ Strategic alliances ∙ Exits from foreign markets

4-93 Pertinent Websites Federal Reserve NASD NYSE SEC Securities Industry Association SIPC