Depository Financial Institutions Chapter 12 The Fundamentals of Bank Management

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Depository Financial Institutions

  • Chapter 12

The Fundamentals of Bank Management

  • Banks are business firms that buy (borrow) and sell (lend) money to make a profit

  • Money is the raw material for banks—Repackagers of money

  • Financial claims on both sides of balance sheet

    • Liabilities—Sources of funds
    • Assets—Uses of funds

Bank Assets

  • Total loans increased from 53% of total assets in 1970 to 62% in 1990—most increase coming from mortgages

  • Decline in cash and investments in state and local government securities

  • Holdings of federal government securities is fairly constant—highly marketable and liquid

    • Counter-cyclical—increase during recessions and decrease during expansions
    • Banks treat federal securities as a residual use of funds

Commercial Bank Assets

  • Loans

  • Securities

  • Cash Assets

Loans (60.1%)

  • Commercial and Industrial Loans (14.8%)

  • Consumer Loans (8.5%)

  • Real Estate Loans (28%)

  • Interbank Loans (Federal Funds) (4.6%)

Securities (24.1%)

  • U. S. Government Securities

  • State and Municipal Bonds

Cash Assets (4.5%)

  • Vault cash.

  • Reserve deposits at the Federal Reserve banks.

  • Correspondent balances.

  • Cash items in the process of collection.

Bank Assets

  • Banks are barred by law from owning stocks—too risky

  • However, banks do buy stocks for trusts they manage—not shown among bank’s own assets

Bank Liabilities

  • Percentage of funds from transactions deposits has reduced from 43% in 1970 to 10% in 2002

    • Used to be major source of funds
    • Generally low interest (if any) paid on demand deposits and increase in interest paid on other types of assets has caused this decline

Commercial Bank Liabilities and Equity Capital

  • Transactions deposits. (9.5%)

  • Savings deposits and small-denomination time deposits. (41.3%)

  • Deferred availability cash items.

  • Large-denomination time deposits. (15.6%)

  • Purchased funds.

  • Other borrowings.

Bank Liabilities

  • Non-transaction deposits represented 47% of banks’ funds in 2002

    • Passbook savings deposits—traditional form of savings
    • Time deposits—certificates of deposit with scheduled maturity date with penalty for early withdrawal
    • Money market deposit accounts—pay money market rates and offer limited checking functions
    • Negotiable CDs—can be sold prior to maturity

Bank Liabilities

  • Miscellaneous Liabilities have experienced a significant increase during past 25 years

    • Borrowing from Federal Reserve—discount borrowing
    • Borrowing in the federal funds market—unsecured loans between banks, often on an overnight basis
    • Borrowing by banks from their foreign branches, parent corporation, and their subsidiaries and affiliates
    • Repurchase Agreements—sell government securities with agreement to re-purchase at later date
  • Securitization—Pooling loans into securities and selling to raise new funds

Bank Capital (Equity)

  • Individuals purchase stock in bank

  • Bank pays dividends to stockholders

  • Serves as a buffer against risk

  • Equity capital has remained stable at 7%-8%, but riskiness of bank assets has increased

  • Bank regulators force banks to increase their capital position to compensate for the increased risk of assets (loans)

  • Equity is most expensive source of funds so bankers prefer to minimize the use of equity

Bank Profitability

  • Bank management must balance between liquidity and profitability

  • Net Interest Income

    • Difference between total interest income (interest on loans and interest on securities and investments) and interest expense (amount paid to lenders)
    • Closely analogous to a manufacturing company’s gross profit

Bank Profitability

  • Net interest margin—net interest income as a percentage of total bank assets

  • Factors that determine bank’s interest margin

    • Better service means higher rates on loans and lower interest on deposits
    • Might have some monopoly power, but this is becoming more unlikely due to enormous competition from other banks and nonbank competitors
    • Also affected by a bank’s risk—interest rate and credit

Bank Profitability

  • Service charges and fees and other operating income

    • Additional source of revenue
    • Become more important as banks have shifted from traditional interest income to more nontraditional sources on income
  • Salaries and wages

    • Banks are very labor-intensive
    • Pressure to reduce personnel and improve productivity

Bank Profitability

  • Security gains/losses

    • Results from the fact that securities held for investment are shown at historical cost
    • This may result in a gain or loss when the security is sold
  • Net Income after Taxes

    • Net Income less taxes
    • Return on Assets (ROA)—Net Income after taxes expressed as a percentage of total assets
    • Return on Equity (ROE)—Net Income after taxes divided by equity capital

Bank Risk

  • Leverage Risk

    • Leverage—Combine debt with equity to purchase assets
    • Leveraging with debt increases risk because debt requires fixed payments in the future
    • The more leveraged a bank is, the less its ability to absorb a loss in asset value
    • Leverage Ratio—Ratio of bank’s equity capital to total assets [9% in 2002]
    • Regulators in US and other countries impose risk-based requirements—riskier the asset, higher the capital requirement

Bank Risk

  • Credit Risk

    • Possibility that borrower may default
    • Important for bank to get as much information as possible about borrower—asymmetric information
    • Charge higher interest or require higher collateral for riskier borrower
    • Loan charge-offs is a way to measure past risk associated with a bank’s loans
    • Ratio of non-performing loans (delinquent 30 days or more) to total loans is a forward-looking measure

Bank Risk

  • Interest Rate Risk

    • Mismatch in maturity of a bank’s assets and liabilities
    • Traditionally banks have borrowed short and lent long
    • Profitable if short-term rates are lower than long-term rates
    • Due to discounting, increasing interest rates will reduce the present value of bank’s assets
    • Use of floating interest rate to reduce risk
    • The one-year re-pricing GAP is the simplest and most commonly used measure of interest rate risk

Bank Risk

  • Trading Risk

    • Banks act as dealers in financial instruments such as bonds, foreign currency, and derivatives
    • At risk of a drop in price of the financial instrument if they need to sell before maturity
    • Difficult to develop a good measure of trading risk since is it hard to estimate the statistical likelihood of adverse price changes

Bank Risk

  • Liquidity Risk

    • Possibility that transactions deposits and savings account can be withdrawn at any time
    • Banks may need additional cash if withdrawals significantly exceed new deposits
    • Traditionally banks provided liquidity through the holding of liquid assets (cash and government securities)
    • Historically these holdings were a measure of a bank’s liquidity, but have declined as a percentage of total assets during the past 30 years (41%-1970; 24%-2002)
    • During past 30 years banks have used miscellaneous liabilities to increase their liquidity

Major Trends in Bank Management

  • For most of the 20th century banks were insulated from competition from other financial institutions

  • US banking is in a period of transition due to recent changes in the regulations

  • The Consolidation Within the Banking Industry

    • McFadden Act of 1927

McFadden Act of 1927

  • Passed to prevent the formation of a few large, nationwide banking conglomerates

  • Prohibited banks branching across state lines

  • Many states also had restrictions that limited or prohibited branching within their state boundaries

  • Result—many, many small banks protected from competition from larger national banks

  • Over the years a number of loopholes were exploited to reduce effectiveness of law, primarily bank holding company—Parent corporation that can hold one or more subsidiary banks

  • Riegle-Neal Interstate Banking and Branching Efficiency Act [1994]—Overturned the McFadden Act

Economics of Consolidation

  • Is consolidation of banking industry good or bad?

  • How large should a bank be

    • Large enough to offer wide menu of products
    • Focus on a niche at which they are successful
  • Despite dramatic decrease in number of banks and banking organizations, number of banking offices (including savings institutions) has remained remarkable stable

Economics of Consolidation

  • Economies of Scale—Banks become more efficient as they get larger

  • Economies of Scope—Offering a multitude of products is more efficient [traditional and non-traditional products]

  • Little empirical evidence to support either types of economies

  • Possibly merger or expansion provided opportunity to become more efficient—something they should have done prior to the merger

Nontraditional Banking

  • Traditionally commercial bank accepted demand deposits and made business loans

  • Under the regulation of the Federal Reserve, bank holding companies provide banks with more regulatory freedom

  • However, activity is limited to activities closely related to banking

The Glass-Steagall Act (1933)

  • Separated commercial banks from investment banking—banks forced to choose

  • Before 1999, commercial banks could not underwrite corporate debt and equity

  • Commercial banks challenged restrictions--investment banks were starting to act like commercial banks

  • Circumventing Glass-Steagall—a number of rulings by Federal Reserve eroded the distinction between commercial and investment banks

  • The Gramm-Leach-Bliley Act (1999) repealed the Glass-Steagall Act


  • American Banks Abroad

    • Rapid expansion of US banks into foreign countries
      • Growth of foreign trade
      • American multinationals with operations abroad
    • Edge Act (1919)
      • Permitted US banks to establish special subsidiaries to facilitate involvement in international financing
      • Exempt from the McFadden Act’s prohibition against interstate banking


  • Foreign Banks in the United States

    • Many large and well-known banks in the US are foreign-owned
    • Organizational forms of foreign banks
      • Branch—integral part of foreign bank and carries bank’s name, full service
      • Subsidiary—legally separate with its own charter, full service
      • Agencies—make loans but cannot accept deposits
      • Representative Offices—make contact with potential customers of parent corporation

Foreign Banks in the United States

  • Prior to 1978 foreign banks operating in the US were largely unregulated

  • International Banking Act of 1978

    • Foreign banks subject to same federal regulations as domestic banks
    • Established banks were grandfathered and not subject to the law


  • Foreign banks were exempt from Regulation Q and could offer higher interest than US banks

  • Eurodollar deposits made in foreign banks were denominated in US dollars, which eliminated the foreign exchange risk for Americans

  • American banks opened foreign branches:

    • Gain access to Eurodollars
    • Borrow abroad during periods of tight money by the FED
  • “Shell” branches are created in tax haven countries (Bahamas and Caymans) who have almost zero taxation and no regulation


  • Corporate and foreign government bonds sold:

    • Outside borrowing corporation’s home country
    • Outside country in whose money principal and interest are denominated
  • Number of tax advantages and relatively little government regulation

Domestically Based International Banking Facilities (IBF)

  • Offers both US and foreign banks comparable conditions as foreign countries to lure offshore banking back to US

  • IBF is a domestic branch that is regulated by Fed as if it were located overseas.

  • No reserve or deposit insurance requirements

  • Essentially bookkeeping operations with no separate office

IBFs Cont.

  • Many states exempt income from IBFs from state and local taxes

  • IBFs are not available to domestic residents, only business that is international in nature with respect to sources and uses of funds

  • Foreign subsidiaries of US multinationals can use IBFs provided funds to not come from domestic sources and not used for domestic purposes

Nonbank Depository Institutions—The Thrifts

  • Comprised of savings and loan associations, mutual savings banks, and credit unions

  • Principal source of funds for all three thrifts is consumer deposits

  • Savings and Loans (S&L’s)

    • Invest principally in residential mortgages
    • This industry basically collapsed during the 1980s
    • Most S&L’s have converted their charters to commercial banks

The Thrifts

  • Mutual Savings Banks

    • Located mostly in the East
    • Operate like S&L’s, with more power to make consumer loans
    • This industry suffered same decline as S&L’s
  • Credit Unions

    • Basically unaffected by the problems in the 1980s since they did not have mortgages on their balance sheets
    • Organized around a common group and are generally quite small

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