Depository Depository InstitutionsInstitutions

Chapter 2

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K. R. Stanton

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Products of U.S. FIs

Comparing the products of FIs in 1950, to products of FIs in 2003: Much greater distinction between types of FIs in

terms of products in 1950 than in 2003 Blurring of product lines and services over time Wider array of services offered by all FI types (Refer to Tables 2-1A and 2-1B in the text)

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Size of Depository FIs

Consolidation has created some very large FIs

Combined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs

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Depository Institutions

Commercial Banks Largest depository institutions are commercial banks. Differences in operating characteristics and

profitability across size classes.• Notable differences in ROE and ROA as well as the spread

Thrifts S&Ls Savings Banks Credit Unions

Mix of very large banks with very small banks

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Functions & Structural Differences

Functions of depository institutions Regulatory sources of differences across types

of depository institutions. Structural changes generally resulted from

changes in regulatory policy. Example: changes permitting interstate

branching Reigle-Neal Act

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Differences in Balance Sheets

Depository Institutions Nonfinancial Firms Assets Liabilities Assets LiabilitiesLoans Deposits Deposits Loans

Other Other financial financial assets assets

Other Other Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity

Depository Institutions Nonfinancial Firms Assets Liabilities Assets LiabilitiesLoans Deposits Deposits Loans

Other Other financial financial assets assets

Other Other Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity

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Structure and Composition

Shrinking number of banks: 14,416 commercial banks in 1985 12,744 in 1989 7,769 in 2004

Mostly the result of Mergers and Acquisitions M&A prevented prior to 1980s, 1990s Consolidation has reduced asset share of small banks

Financial Services Modernization Act 1999 Allowed full authority to enter investment banking (and

insurance) Limited powers to underwrite corporate securities

have existed only since 1987

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Composition of Commercial Banking Sector

Community banks Regional and Super-regional

Access to federal funds market to finance their lending activities

Money Center banks Bank of New York, Deutsche Bank (Bankers

Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USA

declining in number

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Off-balance Sheet Activities

Heightened importance of off-balance sheet items Large increase in derivatives positions is a

major issue Standby letters of credit Loan commitments When-issued securities Loans sold

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Trading and Other Risks

Allied Irish / Allfirst Bank $750 million loss

National Australian Bank $450 million loss

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Other Fee-generating Activities

Trust services Correspondent banking

Check clearing Foreign exchange trading Hedging Participation in large loan and security

issuances Payment usually in terms of noninterest bearing

deposits

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Key Regulatory Agencies

FDIC (BIF and SAIF) OCC: Primary function is to charter national banks. FRS: monetary policy, lender of last resort.

National banks are automatically members of the FRS. State-chartered banks can elect to become members.

State bank regulators Dual Banking System: Coexistence of nationally and state-

chartered banks.

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Other Regulatory Issues

Importance of Bank Holding Companies is increasing.

BHCs regulated by FRS.

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Legislation

1927 McFadden Act 1933 Glass-Steagall 1956 Bank Holding Company Act 1970 acts 1980 DIDMICA and 1982 DIA 1987 Competitive Equality in Banking Act 1989 FIRREA 1991 FDICIA 1994 Riegle Neal Interstate Branching Act Financial Services Modernization Act

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CAMELS Rating

C – Capital adequacy A – Asset quality M – Management E – Earnings L – Liquidity S – Sensitivity to Market Risk ratings are 1 to 5 with 1 being sound in all

categories

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Balance Sheet Regulations

Liquidity Fed gives minimum reserve requirements

reserve computation period 2 weeks beginning on Tuesday and ending on Monday

14 days later Capital Adequacy – minimum capital requirements

to constrain leverage capital-to-assets ratio risk-based capital ratio

Tier I Tier II

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Balance Sheet Regulations

Basel Accord – implement risk-based capital ratios for banks (1993)

redid to incorporate market risk 2001 Basel II

Pillar 1 Pillar 2 Pillar 3

Risk-adjusted assets total risk-based capital ratio core capital ratio

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Industry Performance

Economic expansion and falling interest rates through 1990s

Brief downturn in early 2000 followed by strong performance improvements Record earnings $106.3 billion 2003

Only 3 failures in 2003 versus 206 in 1989 Serious concerns regarding expected interest

rate increases

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Banking and Ethics

Bank of America and Fleet Boston Financial 2004

J.P. Morgan Chase and Citigroup 2003 role in Enron

Riggs National Bank and money laundering concerns 2003

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Savings Institutions

Comprised of: Savings and Loans Associations Savings Banks

Effects of changes in Federal Reserve’s policy of interest rate targeting combined with Regulation Q and disintermediation.

Effects of moral hazard and regulator forbearance.

Qualified Thrift Lender (QTL) test.

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S&Ls

deposit insurance without there was asymmetric information problem also potential for bank panics created FDIC to deal with this moral hazard adverse selection

regulatory forbearance political interference (Keating 5) revolving door

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Savings Institutions: Recent Trends

Industry is smaller overall Intense competition from other FIs

mortgages for example Concern for future viability

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Primary Regulators

Office of Thrift Supervision (OTS). Charters and examines all federal S&Ls.

FDIC-SAIF Fund. Oversees and manages Savings Association

Insurance Fund (SAIF).

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Savings Banks

Mutual organizations Primarily East Coast Not exposed to the oil-based shocks of 1980s Real estate price exposure Demutualization

May be regulated at both state and federal level

89% state chartered concentrated in New England area

rely less on deposits

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Credit Unions

Nonprofit depository institutions owned by member-depositors with a common bond.

Exempt from taxes and Community Reinvestment Act (CRA).

Expansion of services offered in order to compete with other FIs.

Approximately 56% federally chartered and subject to NCUA regulation.

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Global Issues

Near crisis in Japanese Banking Eight biggest banks reported positive six-

month profits China

Deterioration, NPLs at 50% levels Opening to foreign banks (WTO entry)

German bank problems in early 2000s Implications for future competitiveness

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*Financial Statement Analysis

Time series analysis of key ratios ROE framework

ROE = ROA × EM ROA = PM × AU