copyright © 2000 by harcourt, inc. all rights reserved. 4-1 chapter 4 background: consolidation...

Copyright © 2000 by Harcourt, Inc. All rights Reserved.

4-1

Chapter 4Background: Consolidation Trends, Moral

Hazard and Agency Issues, Types of Ownership and Organizations


4-2

Types of Equity Ownership

Privately Owned Firms Stock-Owned Firms Mutual Firms Not-for-Profits


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.


4-4

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.


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.


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.


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.


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.


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.


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


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.


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.


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


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.


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.


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.


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


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.


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.


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.


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.


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.


4-23

Expanded insurance-type activities to include:

• joint ventures with insurance companies to

sell insurance to bank customers; and

• the sale of annuities.


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.


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.


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.


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.


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.


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.


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.


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.


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.


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.


4-34

The Future

Virtual Financial Institutions Smart Cards E-cash


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.


4-36

Illustration of Economies of Scale

No. ofLoans

Bank ACommercialLoans, $

AverageCost, $

No. ofLoans

Bank BConsumerLoans, $

AverageCost, $

0 12,000 0 12,000

100 60,000 600 100 52,000 520

200 100,000 500 200 100,000 500

300 132,000 440 300 156,000 520

400 156,000 390 400 220,000 550


4-37Illustration of Economies of Scope

No. of LoansCommercial

No. of LoansConsumer

Total Cost ifMade Jointly

Total Cost ifMade Separately

100 100 $102,000 $112,000200 152,000 160,000300 210,000 216,000400 216,000 280,000

200 100 144,000 152,000200 196,000 200,000300 256,000 256,000400 324,000 320,000

300 100 178,000 184,000200 232,000 232,000300 294,000 288,000400 364,000 352,000

400 100 204,000 208,000200 260,000 256,000300 324,000 312,000400 396,000 376,000

copyright © 2000 by harcourt, inc. all rights reserved. 4-1 chapter 4 background: consolidation...

Documents

equity assets

equity ratio

measurement of equity

equity financing

equity capital ratio

net worthvalue of equity

equity roefinancing

equity roedupont relation