1. © 2006 Thomson Business and Professional Publishing. All rights reserved. T H I R D E D I T I O N PowerPoint Presentation by Charlie Cook The University of West Alabama The Business of Banking— Depository Institution Management and Performance Chapter 10 Unit III Financial Institutions

2. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–2 Fundamental Issues 1.What are the key sources of depository institution revenues and costs? 2.What are common measures of depository institution profitability? 3.How has the philosophy of depository institution management evolved? 4.What are key elements of the modern asset- liability approach to managing risks at depository institutions? 5.What is the main determinant of depository institutions’ performance?

3. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–3 Bank Management Profits, of course, are revenues minus costs. Thus begin by looking at the typical revenue and cost elements of banks.

4. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–4 Sources of Depository Institution Revenues Interest income:  Interest revenues that depository institutions derive from their holdings of loans and securities. Noninterest income:  Revenues that depository institutions earn from sources other than interest income, such as trading profits, loan management fees, or fees that they charge for services that they provide their customers.

5. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–5 Sources of Commercial Bank Revenues Figure 10–1 SOURCE: Federal Deposit Insurance Corporation. Noninterest income has become a more important source of bank revenues in recent years, although the majority of bank revenues continues to flow from their interest earnings.

6. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–6 Sources of Depository Institution Revenues Fee income has risen quite a bit in recent years for banks and other depository institutions: why? http://www.boston.com/business/articles/2007/0 3/01/bank_of_america_again_raises_fees_on_ overdrafts/http://www.boston.com/business/articles/2007/0 3/01/bank_of_america_again_raises_fees_on_ overdrafts/

7. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–7 Depository Institution Operations Costs Interest expenses:  The portion of depository institution costs incurred through payments of interest to holders of the institutions’ liabilities. (interest on savings deposits, cd’s, etc.) Loan loss reserves:  An amount of cash assets that depository institutions hold as liquidity that they expect to be depleted as a result of loan defaults.

8. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–8 Depository Institution Operations Costs Loan loss provisions:  An expense that depository institutions incur when they add funds to loan loss reserves. Real Resource Expenses:  Banks, like other firms, have to use factors of production: they hire workers, use land and capital equipment, etc. Over half of bank costs fall into this category.

9. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–9 Commercial Bank Expenses Figure 10–2 Over half of the expenses of commercial banks are noninterest expenses on real resources such as labor and capital goods. Interest expenses on deposit funds and purchased funds account for nearly all remaining expenses, although expenses on loan loss provisions typically account for a small portion of total bank costs. SOURCE: Federal Deposit Insurance Corporation. Loan loss provisions 12%

10. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–10 Banking and employment growth After many years of stagnant employment growth, banks in recent years have increased their share of total employment in the U.S. Perhaps this is due to the increase in U.S. exports of financial services.

11. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–11 Employment at Depository Institutions as a Share of Total U.S. Employment. Figure 10–3 SOURCE: Federal Deposit Insurance Corporation.

12. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–12 Depository Institution Profitability Return on assets: (ROA)  A depository institution’s profit as a percentage of its total assets. Typical banks ROA is around 1-2%.

13. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–13 Depository Institution Profitability Return on equity: (ROE) A depository institution’s profit as a percentage of its equity capital. Typical banks ROE is around 10-15%.

14. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–14 Depository Institution Profitability In the previous equation, equity capital is just assets minus liabilities, or net worth. These are said to be retrospective measures of profits, looking backwards at the past.

15. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–15 Commercial Banks’ Average Returns on Assets (a) and Equity (b) Figure 10–4 Panel (a) shows that the average return on assets of commercial banks rose in the early 1990s and then leveled off, and panel (b) shows that this was also true of the average return on equity. Both measures of bank profitability were much more volatile in the early 1990s than they have been since. SOURCE: Federal Deposit Insurance Corporation.

16. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–16 Depository Institution Profitability Net interest margin:  The difference between a depository institution’s interest income and interest expenses as a percentage of total assets.  This can be a more prospective or forward looking measure of profits.

17. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–17 Depository Institution Profitability Numerator is sometimes called net interest income. Generally, well-run banks have a high net interest income and margin. It can measure both current and prospective profitability: a bank with a rising net interest margin generally will see improved profits in the future.

18. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–18 Theories of Bank Management Real bills doctrine:  A bank management philosophy that calls for lending primarily to borrowers who will use the funds to finance production or shipping of physical goods, thereby ensuring speedy repayment of the loans. Self-liquidating loans  Loans to finance the transportation or production of goods. They were fairly safe and short term loans, thus keeping the bank very liquid.

19. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–19 Theories of Bank Management  Two problems with this management philosophy: 1. Short term, low risk loans are also lower return loans to banks, thus possibly lower profits. 2. In a recession, when demand for goods is down, banks might refuse to lend to firms, but this worsens the economic decline. One way to offset this last problem is to create a Central Bank (like our Federal Reserve) to act as a lender of last resort during economic declines. This is often considered to be one of the roles of the Fed. (but not the only role)

20. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–20 Theories of Bank Management (cont’d) Shiftability theory:  A management approach in which depository institutions still make self liquidating loans, but also begin making some longer term less liquid loans as well. To offset the greater risk from the longer term loans, also hold some low risk securities as well to act as secondary reserves.  In other words, hold a mix of illiquid loans and more liquid securities that act as a secondary reserve held as a contingency against potential liquidity problems.  Secondary reserves  Securities that depository institutions can easily convert to cash in the event that such a need arises.  Primary reserves  Cash assets.

21. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–21 Shiftability theory Thus banks “shifted” the allocation of their assets in this management theory. Many US banks used this philosophy prior to the Great Depression. In the depression however, even securities prices fell, thus not acting as a very good secondary reserve against riskier long term loans.

22. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–22 Theories of Bank Management (cont’d) Anticipated-income approach:  A depository institution management philosophy that calls for depository institutions to make loans more liquid by issuing them as installment loans that generate income in the form of periodic payments of interest and principal.  Helps increase liquidity of banks: makes loans more similar to the “self-liquidating” loans of the real bills doctrine.

23. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–23 Theories of Bank Management (cont’d) Conversion-of-funds approach:  A depository institution management philosophy under which managers try to fund assets of specific maturities by issuing liabilities with like maturities.  For example, if a bank plans on giving a lot of short term loans, then issue short term deposits (like short term cd’s) to match these loans.  This tends to keep the net interest margin fairly constant.

24. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–24 Theories of Bank Management (cont’d) Asset-liability management approach:  A depository institution management philosophy that emphasizes the simultaneous determination of both the asset and the liability sides of the institution’s balance sheet. Gap management:  A technique of depository institution asset-liability management that focuses on the difference (“gap”) between the quantity of assets subject to significant interest rate risk and the amount of liabilities subject to such risk.

25. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–25 Theories of Bank Management (cont’d) Gap management: A positive gap means that rate sensitive assets exceed rate sensitive liabilities: if interest rates rise, this will likely raise the banks net interest margin since their interest income will go up more than their interest expense. Thus managers prefer a positive gap if they expect a rise in interest rates, and a negative gap if they expect a fall in rates.

26. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–26 Duration Gap Analysis Duration  A measure of the average time during which the bank receives all payments of principal and interest on a financial instrument within a bank’s portfolio of assets. Generally assets with longer duration are considered riskier. Duration gap:  The average duration of a depository institution’s assets minus the average duration of its liabilities.

27. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–27 Duration Gap Analysis Duration gap:  If this gap is positive and the bank expects interest rates to rise, they are likely to rearrange their asset and liability mix in order to move this gap towards the negative side.

28. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–28 Other Methods of Managing Risk What if individual borrowers are too big for one bank?  Syndicated loan: A loan arranged by one or two banks but funded by these and other banks.  Major projects often involve more than one bank.

29. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–29 Bank Syndicated Lending in Total and As a Share of Total Corporate Financing Figure 10–5 SOURCE: Bank for International Settlements, Quarterly Banking Profile, various issues. (b)(c)

30. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–30 The Model-based Approach To Credit-risk Management Value-at-risk model:  A statistical framework for evaluating how changes in interest rates and financial instrument prices affect the overall value of a portfolio of financial assets.  Some banks now purchase such models from various firms as a way of managing their risks.

31. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–31 Other Methods of Managing Risk Another way of dealing with risk is to use Credit derivatives:  Derivatives are financial instruments whose returns depend on the returns of other financial instruments.  Thus a credit derivative has a return based on loan credit risks. Default swap:  A credit derivative that requires the seller to assume the face value of a debt in the event of default..

32. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–32 Notional Value of Credit Derivatives Held by U.S. Banks Figure 10–6 SOURCE: Office of the Comptroller of the Currency, Bank Derivatives Report, various issues.

33. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–33 Global Distribution of the Notional Value of Credit Derivatives among Contract Counterparties Figure 10–7 SOURCES: Office of the Comptroller of the Currency, Bank Derivatives Report, various issues; authors’ estimates.

34. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–34 An Evolving Depository Institution Market Structure An Evolving Depository Institution Market Structure Market structure:  The organization of the loan and deposit markets in which depository institutions interact.  Recall the idea of market structure from your microeconomics class: 4 basic structures, perfect competition, monopoly, monopolistic competition, and oligopoly. Market concentration:  The degree to which the few largest depository institutions dominate loan and deposit markets.

35. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–35 Perfect Competition Perfect competition:  A market structure in which no single depository institution can influence loan or deposit interest rates.  Rivalry among institutions yields market loan and deposit interest rates that just cover the costs that the institutions incur in making loans and issuing and servicing deposits Normal profit:  A profit level just sufficient to compensate depository institution owners for holding equity shares in the depository institution instead of purchasing ownership shares of other enterprises.

36. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–36 Imperfect Competition and Market Power Pure monopoly:  The dominance of a loan or deposit market by a single depository institution or by a small group of institutions that work together to maximize their profits. Market power:  The ability of one or a few depository institutions to dominate loan and deposit markets sufficiently to set higher loan rates and lower deposit rates as compared with purely competitive market interest rates.

37. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–37 Imperfect Competition and Market Power (cont’d) Supranormal profits:  Levels of profit above those required to induce depository institution owners to hold shares of ownership in those institutions instead of shares of other businesses.  Market power allows banks to “gouge” consumers of the services of these institutions because the institutions are able to charge higher prices for fewer services.

38. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–38 Does Market Concentration Matter? Some economists argue that unrestricted rivalry among depository institutions ultimately can lead to too much market concentration. Structure-conduct-performance (SCP) model:  A theory of depository institution market structure in which the structure of loan and deposit markets influences the behavior (conduct) of depository institutions in those markets, thereby affecting their performance.

39. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–39 The Structure-Conduct-Performance Model Figure 10–8

40. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–40 The Structure-Conduct-Performance Model By the SCP model, the more concentrated the banking industry gets, becoming more like an oligopoly or monopoly, which affects the banks conduct, such as charging higher loan rates or paying lower interest to depositors, thus affecting the banks performance, namely becoming more profitable than in a perfectly competitive world.

41. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–41 The Structure-Conduct-Performance Model Book mentions an old study by Stephen Rhoades: he estimated that total bank lending was 14 percent lower than it would be if the banking industry were perfectly competitive. He also estimated that bank profits were 13% more than if the industry were perfectly competitive.

42. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–42 An alternative view: Efficient structure theory. Efficient structure theory:  A theory of depository institution market structure in which greater market concentration and higher depository institution profits arise from the fact that a few depository institutions can operate more efficiently in loan and deposit markets as compared with a large number of institutions.  Economies of scale  Higher profits  So both models predict higher bank profits due to greater concentration, but for different reasons.

43. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–43 Is there a winner? Still controversial. Berger’s research on SCP and Efficient structure theory:  Neither SCP nor the efficiency structure theories emphasis on economies of scale seemed to fit most of the real world, what counts is the efficiency of the management of a commercial bank. Well run banks earn higher profits, and often capture larger market shares.

44. © 2006 Thomson Business and Professional Publishing. All rights reserved.10–44 The Efficient Structure Theory Figure 10–9