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 Depository Financial Institutions Chapter 9 Unit III Financial Institutions

2. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–2 Fundamental Issues 1.What are the historical origins of modern banking institutions? 2.How did today’s segmented groupings of depository institutions arise? 3.What are the key assets of commercial banks? 4.What are the key liabilities of commercial banks? 5.How do savings institutions differ from commercial banks? 6.How do credit unions raise and allocate their funds?

3. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–3 Origins of Money: review from ch. 1: Goldsmith Bankers The difficulties of the barter system led to the use of commodities (especially metals) as money. Bullion:  Uncoined gold or silver used as money.  Divided into standardized units as coins for portability and making change. Fractional-reserve banking:  A system in which banks hold reserves equal to less than the amount of total deposits.

4. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–4 The Roots of Modern Banking Merchant bankers:  Merchants who, after receiving payment from the purchasers of their goods, would then repay those who had provided loan financing. The Italian merchant bankers:  The term bank derives from the merchants’ bench, or banco, on which money changed hands in the marketplaces of medieval Italy.  The term bankruptcy refers to the “breaking of the bench” that occurred when a merchant banker became overextended and failed.

5. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–5 The Advent of Modern Banking Three key features of the banking business:  Banks take deposits from customers and maintain accounts on customers’ behalf.  Banks manage payments on behalf of customers by collecting and paying checks, notes, and other “banking currency.”  Banks provided advances to customers in the form of loans. The interest on these loans and the fees that banks charge for accounting and deposit services are the banks’ sources of revenues and, ultimately, profits.

6. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–6 Early American Banking Bank of North America:  Founded by Robert Morris, a Philadelphia financier.  Chartered in 1871 by the Continental Congress. Dual banking system:  A regulatory structure in which either states or the federal government can grant bank charters. The Free-Banking Period (1837 until 1863):  Two types of banks  Banks operated by state governments.  Private banks incorporated under state free-banking laws.

7. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–7 The Two-Tiered Banking System National Banking Act of 1863  Granted federal charters to a number of banks (all within the Union states).  Imposed a federal tax on all notes issued by state banks (mostly based in Confederate states).  Imposed reserve requirements on the deposits of banks and prohibited branch banking by state- chartered banks.  Required national banks to back their notes by posting government bonds.

8. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–8 The Rise of Thrift Institutions Less than 200 years ago, few options for people who wanted to buy a house or get a loan Commercial banks mainly lent to business customers, not the average family: this helped lead to the rise of thrifts. Mutual ownership:  A depository institution organizational structure in which depositors own the institution. Types of mutual ownership  Savings banks (thrift institutions)  Savings and loan institutions  Credit unions

9. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–9 Segmented Banking in the Twentieth Century Bank run:  An unexpected series of cash withdrawals at a depository institution that can induce its failure.

10. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–10 Regulations Extensive federal regulation:  Home Owners Loan Act of 1933: required a federal charter for savings institutions.  National Housing Act of 1934: created deposit insurance for savings institutions.  Federal Credit Union Act: authorized federal charters for credit unions.  Thus in the 1930, the Federal government became very involved in the business of depository institutions, and the “segmenting” of these institutions into banks, savings banks, and credit unions came into place.

11. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–11 Commercial Banks Commercial bank:  A depository institution that faces few legal restrictions on its powers to lend to businesses and can legally issue checking deposits from which holders may write unlimited numbers of checks. Asset:  Anything owned by a person or business that has a market value.  Major assets of banks are various types of loans and government securities.

12. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–12 Commercial Bank Assets: Loans Commercial and industrial (C&I) loans:  Loans that commercial banks and other depository institutions make to businesses. Often these loans are secured with collateral. Collateral:  Assets that a borrower pledges as security in case it should fail to repay a loan. Consumer Loans  Credit extended to individuals.

13. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–13 Consumer Loans Installment credit:  Loans to individual consumers that entail periodic repayments of principal and interest. Revolving credit:  Loans to individuals that permit them to borrow automatically up to specified limits and to repay the balance of the loan at any time. (credit cards are a major form of revolving credit.)  Real estate loans: used to finance purchase of real property, such as homes, buildings, etc. Most bank real estate loans are to businesses.

14. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–14 Commercial Bank Assets ($ Billions), May 31,2005 Table 9–1 SOURCE: Board of Governors of the Federal Reserve System, H.8 (510) Statistical Release. Commercial & industrial loans 985.4 11.8% Consumer loans 704.7 8.4% Real estate loans 2,684.3 32.0% Interbank loans 285.6 3.4% Other loans 422.0 5.0% Total loans 5,082.0 60.6% U.S. government securities 1,202.2 14.4% Other securities 862.8 10.3% Total securities 2,065.0 24.7% Cash assets 340.2 4.1% Other assets 891.3 10.6% Total assets 8,378.5 100.0%

15. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–15 Commercial Bank Assets (cont’d) Term federal funds:  Interbank loans with maturities exceeding one day.  Smaller banks are predominantly federal funds lenders. Securities  U.S. government securities (Treasury bills, notes, and bonds) are a key type of security held by commercial banks.  State and municipal bonds are also held as bank assets.

16. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–16 Commercial Bank Assets (cont’d) Cash assets:  Depository institution assets that function as media of exchange.  Vault cash that a depository institution holds on location to honor cash withdrawals by depositors.  Reserve deposit accounts that depository institutions maintain at Federal Reserve banks.  Correspondent balances are deposit accounts that banks hold with other banks.  Cash items in process of collection are checks deposited for immediate credit but not yet cleared.

17. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–17 Commercial Bank Asset Allocations Figure 9–1 SOURCES: Federal Reserve Bulletin and H.8(510) Statistical Release, Board of Governors of the Federal Reserve System, various issues.

18. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–18 Commercial Bank Liabilities and Equity Capital Liability:  A legally enforceable claim on the assets of a business or individual. Net worth:  The excess of assets over liabilities, or equity capital. Equity capital:  The excess of assets over liabilities, or net worth.

19. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–19 Commercial Bank Liabilities Noncontrollable liabilities:  Liabilities whose dollar amounts bank customers largely determine once banks have issued the liabilities to them.  Transactions deposits  Savings deposits  Small-denomination time deposits.  Deferred availability cash items.

20. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–20 Commercial Bank Liabilities and Equity Capital ($ Billions), July 31, 2005 Table 9–2 *Authors’ estimate. SOURCE: Board of Governors of the Federal Reserve System, H.8 (510) Statistical Release. Transactions deposits 678.8 8.1% Small time and savings deposits 1,293.6 15.4% Large time deposits 2,853.0 34.1% Total deposits 4,825.4 57.6% Borrowings from banks $ 362.6 4.3% Other borrowings 1,245.4 14.9% Total borrowings 1,608.0 19.2% Other liabilities 1,286.4 15.1% Equity capital* 678.7 8.1%* Total liabilities & equity 8,378.5 100.0%

21. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–21 Controllable Liabilities And Equity Capital Controllable liabilities:  Liabilities whose dollar amounts banks can directly manage.  Large-denomination time deposits  Purchased funds (very short-term bank borrowings in the money market)  Other borrowings  Sales of repurchase agreements, borrowings from the Federal Reserve, and Eurodollar liabilities.  Subordinated notes and debentures

22. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–22 The Top Ten Banks Based on Deposits in the United States Table 9–3 SOURCES: American Banker, October 19, 2004; Federal Reserve Bulletin. Bank Deposits ($ Billions) Bank of America 575.5 Citigroup 524.4 J.P. Morgan Chase 346.5 Wells Fargo 268.1 Wachovia 245.6 Washington Mutual 126.6 U.S. Bankcorp 119.9 SunTrust 85.5 HSBC Holdings 75.4 National City 73.0

23. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–23 Commercial Bank Liabilities and Equity Capital Figure 9–2 SOURCES: Federal Reserve Bulletin and H.8(510) Statistical Release, Board of Governors of the Federal Reserve System, various issues..

24. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–24 Savings Institutions Similar to banks in that they issue transactions deposits and savings deposits. Major difference is on the asset side. Major asset of savings institutions (over 60%) is mortgage loans. Traditional long term 15-30 year mortgages leads to interest rate risk for such institutions. Another asset is mortgage backed securities: agencies like GNMA and FNMA issue these.

25. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–25 Deposits at Federally Insured Savings Institutions Figure 9–3 SOURCES: Federal Reserve Bulletin, Board of Governors of the Federal Reserve System; and Quarterly Financial Results and Conditions of the Thrift Industry, Office of Thrift Supervision, various issues.

26. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–26 Assets and Liabilities of Savings Institutions ($ Billions) Table 9–4 SOURCE: Quarterly Financial Results and Conditions of the Thrift Industry, Office of Thrift Supervision, May 2005. Cash and securities 74.0 5.5% Mortgage loans 838.362.5% Mortgage-backed securities 159.2 11.9% Commercial loans 40.6 3.0% Consumer loans 77.6 11.3% Other assets 151.1 5.8% Total assets $1,340.8 100.0% Total deposits 784.6 58.5% Government borrowings 241.6 18.0% Other borrowings 166.1 12.4% Other liabilities 25.4 1.9% Equity capital 123.1 9.2% Total equity & liabilities $1,340.8 100.0%

27. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–27 Assets and Liabilities and Equity at Federally Insured Credit Unions ($ Billions) Table 9–5 SOURCE: Statistics for Federally Insured Credit Unions, National Credit Union Administration, May 2005. Loans 419.063.3% Securities 163.724.7% Cash assets 53.68.1% Other assets 26.13.9% Total assets $ 662.4100.0% Share deposits 570.286.1% Other liabilities & equity 92.213.9% Total liabilities & equity $ 662.2100.0%

28. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–28 Credit Union Advantages Credit unions are:  relatively uncomplicated institutions.  are nonprofit institutions.  take deposits from and lend only to members.  charge less from loans and pay higher interest rates. Benefits of limited membership  Clientele generally have steady jobs and are savers.  Clientele are more creditworthy.  Credit unions are exempt from taxation.

29. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–29 Defining the Limits of Credit Union Membership The Federal Credit Union Act of 1934 limited membership to “groups having a common bond of occupation or association, or to groups within a well- defined neighborhood, community, or rural district.” In July 1998, Congress changed the definition of a credit union to “a viable alternative retail bank.” It directed the National Credit Union Administration (NCUA), the chief federal regulator, to define a “local, well-defined community” for credit union membership.

30. © 2006 Thomson Business and Professional Publishing. All rights reserved.9–30 Credit Unions: Controversy  Credit unions are exempt from corporate taxes and also from the Community Reinvestment Act of 1977, which requires banks and savings associations to meet the needs of their local community  Banks feel this gives credit unions an unfair advantage over them: credit unions may be able to pay higher interest rates or have lower fees  Credit unions argue banks just trying to take over more of the financial services industry  Also credit unions argue they already serve the local community since that is who their members are made up of.