Depository Financial Institutions Chapter 12 The Fundamentals of Bank Management

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

Globalization

• 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

Globalization

• 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

Eurodollars

• 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

Eurobonds

• 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