1. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-1 Chapter 4 Background: Consolidation Trends, Moral Hazard and Agency Issues, Types of Ownership and Organizations

2. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-2 Types of Equity Ownership Privately Owned Firms Stock-Owned Firms Mutual Firms Not-for-Profits

3. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-3 Privately Owned Firms Is the typical form of organization for small community banks. They are typically Subchapter S corporations. Provides limited liability to owners. Earnings taxed at the personal tax rate.

4. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-4 Stock Owned Firms Financial institutions are frequently incorporated, providing limited liability protection to shareholders. Limited liability protection helps institutions raise funds in the equity, bond and commercial paper market. The primary disadvantage is the double taxation of earnings.

5. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-5 Mutual Firms Depositors of a mutual S&L and policyholders of mutual insurance companies are the “owners” of the mutual financial institutions. Initial deposits or premiums provide the funds necessary to begin operations. Profits earned from investing funds received are paid out in the form of interest on deposits or refunds on premiums.

6. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-6 Owner-members of a mutual don’t have the opportunity to sell shares to realize capital gains. Profits not distributed to owner-members are retained for institutional use only. Tax treatment Net income retained by the mutual is subject to corporate taxes. Profits distributed to policyholders or depositors is subject to personal income tax.

7. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-7 Not-for-Profit Organizations Not-for-profit organizations, such as credit unions, provide goods and services at below market rates or at no cost to their members. Income earned in excess of expenses is distributed in the form of: reduced loan rates; increased deposit rates; and/or refunds for previous payments.

8. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-8 Income retained is used to provide a cushion against potential losses. Not-for profits do not pay taxes even if they retain excess income.

9. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-9 Measurement of Equity or Net Worth Value of equity = Value of assets - Value of liabilities Value of assets must be greater than the value of liabilities to be a going concern. Increases in equity financing reduce the likelihood of bankruptcy.

10. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-10 Functions of Equity Capital Provides long-term funds for investments and asset growth Builds confidence in creditors, such as bank depositors Provides protection against losses to the federal deposit insurance fund

11. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-11 Financial Leverage and Return on Equity (ROE) Financing operations with the use of borrowed funds instead of equity is called using financial leverage. Financial leverage affects the level and variability in ROE to stockholders.

12. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-12 Measurement of Return on Equity (ROE) Dupont Relation ROE = Return on Assets ÷ Equity Multiplier where: Return on Assets (ROA) = Net Income ÷ Assets Equity Multiplier (EM) = Assets ÷ Equity ROE = Net Income ÷ Equity An increase in EM reflects increasing financial leverage and can result in an increase in ROE.

13. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-13 Assume a financial institution has a ROA of 1.5%. Calculate ROE if 1) the equity ratio is 10% and 2) if the equity ratio is 8% Equity capital ratio = (equity ÷ assets) = 10% EM = 1 ÷ 0.10 = 10 ROE = 1.5% x 10 = 15% Equity capital ratio = 8% EM = 1 ÷ 0.08 = 12.5 ROE = 1.5% x 12.5 = 18.75

14. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-14 Bank Holding Companies (BHC) A BHC is a firm that owns controlling interest in one or more bank subsidiaries. A BHC is permitted to own nonbank subsidiaries. BHCs are popular because they create loopholes to circumvent: geographical restrictions; product restrictions; and capital requirements.

15. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-15 BHC as a Loophole for Equity Capital Regulations Capital regulation requires banks to finance a portion of their growth using equity sources. Through double leverage, a parent organization of a holding company can borrow money and then downstream the borrowed funds as new equity to a subsidiary bank. Double leverage reduces the amount of equity capital required for a holding company to control a large volume of assets.

16. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-16 Multibank Holding Companies (MBHCs) and Geographical Diversification A MBHC is a holding company with a number of different banks as subsidiaries, each with separate officers and directors. MBHCs were initially created to circumvent state branching and interstate branching restrictions. The 1956 Douglas Amendment prohibited MBHCs from acquiring banks in other states unless state laws allowed it.

17. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-17 In the 1980’s regional pacts allowed the establishment of interstate bank affiliates, creating superegionals. IBBEA of 1994 permitted MBHCs with interstate operations to convert costly subsidiaries into interstate branches. Geographical restrictions also were circumvented by the use of: consumer banks; and loan production offices

18. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-18 Community Protection Against Undue Concentration of Power in Nationwide Banks Under IBBEA an interstate acquisition can’t be approved if the BHC would control more than: 10% of the insured deposits in the U.S.; or 30% of the deposits in the state of the acquired bank. Under the CRA of 1997 a BHC must meet the credit needs of all its local communities.

19. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-19 One Bank Holding Companies (OBHC) as a Loophole to Escape Product Restrictions A OBHC is a holding company which owns a single bank subsidiary along with other subsidiaries engaged in nonbanking activities. The Bank Holding Company Act of 1956 and its amendments gave the Federal Reserve the authority to determine the permissible nonbanking activities.

20. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-20 Regulation of BHCs BHC Act of 1956 and its later amendments gave the Fed the authority to approve BHC: formation; permissible nonbanking activities; the acquisition of bank and nonbank subsidiaries; and geographical expansion.

21. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-21 Corporate Separateness Is the idea that bank and nonbank subsidiaries from the same BHC can be operated without affecting one another. Separateness is promoted by requiring securities activities to be operated in separate units, known as Section 20 subsidiaries, of a parent company. Subsidiary revenues from these activities is limited to a Fed-determined maximum, currently 25% of overall subsidiary revenues.

22. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-22 Relaxation of Product Restrictions in the 1980’s and 1990’s Expanded securities activities to include corporate debt and equity securities underwriting. Expanded brokerage and mutual fund activities to include: discount brokerage; investment advisory services; and sale of nonproprietary, private-label, and proprietary mutual funds.

23. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-23 Expanded insurance-type activities to include: joint ventures with insurance companies to sell insurance to bank customers; and the sale of annuities.

24. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-24 The OCC’s Op-Sub or Part 5 Rule Op-Sub (operating subsidiary) rule allows national banks to apply and conduct new business through operating subsidiaries of the bank rather than forming holding companies under Fed supervision. OCC through Op-Subs has permitted: municipal revenue bond underwriting; and limited real estate development and real estate leasing activities.

25. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-25 Source of Strength Doctrine Requires the holding company to be a source of financial and managerial support to its subsidiary banks. The doctrine implies a close relationship between the parent and the subsidiaries, opposing firewalls and separateness. The doctrine is practiced by the Fed.

26. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-26 One Savings and Loan Holding Companies (OSLHC) SLHC Act of 1968 allowed: OSLHCs to engage in almost any type of activity as long as they held primarily home- mortgage related assets; and nonfinancial firms to own thrifts.

27. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-27 Some diversified SLHCs engage in activities that are impermissible to BHCs such as: insurance underwriting; real estate development; and general manufacturing. FIRREA gave regulators the ability to deny permission to engage in activities that are perceived to endanger: the stability of the institution; and the safety of the deposit insurance system.

28. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-28 Chain Banking and Franchise Banking In franchise banking an independent financial institution leases the right to use the name and marketing programs of a large umbrella organization. Chain banking occurs when: one investor owns 5% of the voting stock in one or more banks and holds a managerial post in each bank; or when an individual or group owns at least 10% of the voting shares of two or more banks.

29. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-29 Stockholder-owned versus Mutual Firms Ownership rights in mutual firms are nonnegotiable: diminishing the degree of control over management; and eliminating the opportunity to earn capital gains. When an owner cancels a policy or closes a deposit account he/she also cancels a claim on a pro rata share of the institution’s retained earnings.

30. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-30 Empirical evidence indicates that compared to mutual associations, stock associations are: riskier and more aggressive because they grow at a faster pace; and not necessarily more profitable or efficient.

31. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-31 Conversions from Mutual to Stock Associations Reasons for thrifts include the need to: raise capital to meet capital requirements; and participate in merger activity either as a buyer or seller in order to grow. Reasons for insurance companies include the need to: get access to the capital markets; and increase flexibility for purchasing other businesses and for pursuing growth opportunities worldwide.

32. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-32 Mutual Holding Companies Give insurance companies and thrifts access to capital markets by being affiliated with stockholder owned companies. How the organizational structure works The original mutual association becomes the parent company. The original owners of the mutual association retain majority ownership in the affiliates. Stock in the affiliates can be sold to the public.

33. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-33 Characteristics of Credit Unions They are not-for-profit organizations. They are subject to a common bond requirement. They pay no taxes on profits retained to increase net worth. They are similar to mutual associations in that: credit union members are the owners of the organization with the ownership shares being nonnegotiable; and they have no other source of equity-like capital other than retained earnings.

34. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-34 The Future Virtual Financial Institutions Smart Cards E-cash

35. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-35 Economies of Scale and Scope Economies of scale occur when the average cost of producing a good or service declines as the amount produced increases. Economies of scope occur when the cost of producing two or more items jointly is less than the cost of separately producing the items. Economies of scale and scope are not mutually exclusive.

36. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-36 Illustration of Economies of Scale

37. Copyright © 2000 by Harcourt, Inc. All rights Reserved. 4-37 Illustration of Economies of Scope