Chapter 3 Banks and Other Financial Institutions © 2003 John Wiley and Sons

2 Chapter Outcomes n Describe the major financial institutions and their roles in the financial system 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

3 Chapter Outcomes (Continued) n Discuss general regulation of the banking system and how depositors’ funds are protected 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 Chapter Outcomes (Continued) n Discuss bank management in terms of bank liquidity and bank solvency n Describe liquidity management in terms of asset management and liabilities management n Briefly explain why and how bank capital is managed n Describe the characteristics of several foreign banking systems

5 Major Financial Institutions Involved in Directing Savings to Business Firms n Commercial Banks Make loans to and purchase debt securities issued by business firms Institutions that purchase both debt and equity securities issued by businesses: n Mutual Funds n Insurance Companies n Pension Funds n Investment Banks & Brokerages

6 Role of Individual Savers & Investors n Make deposits in commercial banks n Purchase shares in mutual funds n Purchase securities from/through investment banks and brokerages n Pay premiums to insurance companies n Make contributions to pension funds

7 Financial Institution Definitions n Insurance Companies Provide financial protection to individuals and businesses for life, property, liability, and health uncertainties n Pension Funds Receive contributions from employees and/or their employers and invest the proceeds on behalf of the employees for use during their retirement years

8 Financial Institution Definitions n Investment Companies Sell shares in their firms to individuals and others and invest the pooled proceeds in corporate and government securities n Mutual Fund Open-end investment company that can issue an unlimited number of its shares to its investors and use the pooled proceeds to purchase corporate and government securities

9 Financial Institution Definitions n Investment Banking firms Sell or market new securities issued by businesses to individual and institutional investors n Brokerage Firms Assist individuals to purchase new or existing securities issues or to sell previously purchased securities

10 Financial Institution Definitions n Finance Companies Provide loans directly to consumers and businesses or aid individuals in obtaining financing of durable goods and homes n Mortgage Banking Firms Originate mortgage loans on homes and other real property by bringing together borrowers and institutional investors

11 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 n UNIVERSAL BANK: Bank that engages in both commercial banking and investment banking activities

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

13 Overview of the Banking System (Continued) n Glass-Steagall Act of 1933: n Glass-Steagall Act of 1933: Provided for separation of commercial banking and investment banking activities in the U.S. n Gramm-Leach-Bliley Act of 1999: n Gramm-Leach-Bliley Act of 1999: Repealed the separation of commercial banking and investment banking activities provided for in the Glass-Steagall Act

14 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

15 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

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

17 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

18 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

19 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

20 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

21 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

22 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

23 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)

24 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

25 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)

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

27 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

28 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

29 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

30 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%

31 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

32 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 will lead to a form of universal banking