1. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall.1 CHAPTER 3 Depository Institutions

2. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2 Learning Objectives What is a depository institution What is the asset/liability problem faced by depository institutions How does a depository institution generate income What are the differences between commercial banks, savings and loan associations, savings banks, and credit unions

3. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. 3 Learning Objectives (continued) The asset/liability problem all depository institutions face The risks faced by depository institutions The funding sources available to commercial banks and thrifts Risk-based capital requirements

4. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Asset/Liability Problem of Depository Institutions Spread Income or Margin –Difference in the cost between investments (loans and securities) and the cost of funds (deposits and other sources) Credit Risk –Possibility of loan default or untimely payments 4

5. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Asset/Liability Problem of Depository Institutions (continued) Regulatory Risk –Changes that could affect operations Funding Risk –Changes in interest rates Liquidity Concerns –Withdrawal and loan demands 5

6. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Concerns of Regulators Credit Risk –Obligations of a financial instrument that fail to be met Settlement Risk –The expected transfer of a trade or obligation that fails to occur 6

7. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Concerns of Regulators (continued) Market Risk –Adverse price move or a large increase in the price volatility of assets (debt obligations, equities, commodities, currencies) Liquidity Risk –Market liquidity –Funding liquidity 7

8. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Concerns of Regulators (continued) Operational Risk –Inadequate or failed internal processes Orange County, California Barings Bank, U.K. Enron, U.S. –GARP Operational Risk Classification of Loss EmployeeBusiness Process RelationshipsTechnology External 8

9. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Concerns of Regulators (continued) Legal Risk –Failure to comply with laws –Failure to apply ethical standards –Failure to fulfill contractual obligations 9

10. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Commercial Banks Bank Services –Individual banking –Institutional banking –Global banking 10

11. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Commercial Banks (continued) Bank Funding –Deposits –Nondeposit borrowing –Common stock and retained earnings 11

12. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Commercial Banks (continued) Deposits –Demand deposits (checking accounts) –Time deposits (certificates of deposit) –Money market demand account (MMDA) 12

13. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Commercial Banks (continued) Nondeposit borrowing –Federal Reserve Bank Discount window –Reserve Requirements All 12 Federal Reserve Banks Penalty for failure to satisfy reserve requirements 13

14. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Capital Requirements for Banks Basel Committee on Banking Supervision –Basel I Framework July 1988 Minimum capital standards –Basel II Framework June 2004 Addressed risks faced by banks in formulating risk-based capital requirements 14

15. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Capital Requirements for Banks (continued) Credit Risk and Risk-Based Capital Requirements –Tier 1 Core capital –Tier 2 Supplementary capital 15

16. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Capital Requirements for Banks (continued) 16

17. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Capital Requirements for Banks (continued) Federal Deposit Insurance –Intent is to protect small depositors (currently accounts up to $100,000) –Safety net for Banks Creates the potential for a ‘moral hazard’ among banking institutions 17

18. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Capital Requirements for Banks (continued) Federal Deposit Insurance –Reform proposals Connecting deposit premiums to riskiness of assets Decreased insurance coverage Insurance premiums based on expected loss 18

19. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Savings and Loans Associations Assets –Garn-St. Germain Act 1982 Consumer loans Nonconsumer loans Municipal securities 19

20. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Savings and Loans Associations (continued) Funding –Negotiable order of withdrawal (NOW) accounts –Money market deposit accounts (MMDA) 20

21. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Savings and Loans Associations (continued) Regulation –Federally chartered S&L’s by the Home Owners Loan Act of 1933 Supervised by the Office of Thrift Supervision (OTS) –State chartered S&L 21

22. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Savings and Loans Associations (continued) Regulation –Depository Institution Deregulation and Monetary Control Act 1980 (DIDMCA) Phased out maximum permitted interest rates 22

23. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Savings and Loans Associations (continued) Regulations –Federal Home Loan Bank Board 1975 (FHLBB) Allows ability to raise funds in the money market Permission to form finance subsidiaries 23

24. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Savings and Loans Associations (continued) The S&L Crisis –Regulation helped in creating funding risk –High interest rate volatility in 1970’s –S&L’s faced difficulties of borrowing short and lending long –Regulators were slow to respond and to understand the deteriorating situation 24

25. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Savings Banks Similar to S&L’s Greater portfolio diversification –Corporate bonds –Treasury and government securities –Municipal securities –Common stock –Consumer loans 25

26. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Savings Banks Were able to handle funding risk better than S&L’s Principal source of funds –deposits 26

27. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Credit Unions Smallest and youngest of the depository institutions “Common bond” requirement for membership Member owned –Member deposits are called shares 27

28. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Credit Unions (continued) State chartered Federally chartered –Insured by the National Credit Union Share Insurance Fund (NCUSIF) Funds primarily from member deposits 28

29. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Credit Unions (continued) Lender of Last Resort –Central Liquidity Facility (CLF) –Administered by the NCUA 29

30. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Summary Depository institutions raise funds, make loans and invest in securities They seek to earnings through positive spread between assets and cost of funds Basil Committee on Banking Supervision establishes risk and management guidelines for banks 30

31. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Summary (continued) Commercial banks may be classified as individual, institutional and global The Federal Reserve Banks establish reserve requirements for banks 31