1 Credit Crisis of 2007 2009 Lenders Made SubPrime Mortgages Borrowers had insufficient income to make monthly payments Many mortgages had teaser rates Low payments resulting in negative amortization ID: 639404
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Chapter 1Banking and the Financial Services Industry
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Credit Crisis of 2007 - 2009
Lenders Made “Sub-Prime” Mortgages
Borrowers
had insufficient income to make monthly paymentsMany mortgages had “teaser” ratesLow payments resulting in negative amortization Multiple Mortgage Banks FailAs the mortgages write-downs were recognized, the mortgage banks’ capital was depleted
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Credit Crisis of 2007 - 2009Collapse and/or Failure of:
Bear Stearns
Lehman Brothers
CountrywideWashington MutualWachovia3Slide4
Credit Crisis of 2007 - 2009Government Response
Fannie Mae and Freddie Mac placed into conservatorship
Loaned AIG over $150 billion
Insured money market mutual fundsCreated Commercial Paper Funding Facility Increased FDIC coverage to $250,000Temporarily through 2009
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Credit Crisis of 2007 - 2009Government Response
Established Troubled Asset Relief Program – TARP
Established Term Asset-Backed Securities Loan Facility – TALF
Invested $125 billion in nine large U.S. banksPromoted mortgage loan modifications5Slide6
Credit Crisis of 2007 - 2009Impact on Banks and the Banking Environment
Biggest impact of declining real estate values concentrated in the areas that experienced the largest run-up in real estate values
Many large banks experienced large losses while many small banks did not
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Credit Crisis of 2007 - 2009Slide8
Credit Crisis of 2007 - 2009Impact on Banks and the Banking Environment
Largest Investment Banks
Goldman Sachs and Morgan Stanley
Converted to Financial Holding CompaniesBear Stearns and Merrill LynchAbsorbed by other financial institutionsLehman BrothersFailed
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How Do Banks Differ?Global Banks
Offer a wide array of products and services globally
Super-Regional Banks
Similar to global banks but smaller in size and market penetrationCommunity BanksSmaller trade area with total assets under $1 billion9Slide10
How Do Banks Differ?
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How Do Banks Differ?
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How Do Banks Differ?Bank Holding Companies
Owns controlling interest in one or more commercial banks
Parent Organization versus Subsidiaries
One-Bank Holding CompaniesMultibank Holding Companies12Slide13
How Do Banks Differ?
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How Do Banks Differ?
Financial Holding Companies
The primary advantage to forming an FHC is that the entity can engage in a wide range of financial activities not permitted in the bank or in a BHC
Authorized to engage in:Underwriting and selling insurance and securitiesCommercial bankingMerchant bankingInsurance company portfolio investment activities
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How Do Banks Differ?Financial Holding Companies
Fed may not permit forming an FHC (or converting a BHC to an FHC) if any of its insured depository institution subsidiaries are:
not well capitalized,
not well managed,did not receive at least a “Satisfactory” rating in its most recent CRA exam15Slide16
How Do Banks Differ?Financial Holding Companies
An FHC can own a bank or BHC or a thrift or thrift holding company
Each of these companies owns subsidiaries, while the parent financial holding company also owns other subsidiaries directly
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How Do Banks Differ?
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How Do Banks Differ?Holding Company Financial Statements
The consolidated financial statements of a holding company and its subsidiaries reflect aggregate or consolidate performance
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How Do Banks Differ?
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How Do Banks Differ?
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How Do Banks Differ?
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How Do Banks Differ?
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How Do Banks Differ?Holding Company Financial Statements
While the consolidated financial statements of a holding company and its subsidiaries reflect aggregate performance, it is useful to examine the parent company’s statements alone
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How Do Banks Differ?
Holding Company Financial Statements
The parent typically pays very little in income tax because 80 percent of the dividends from subsidiaries is exempt
Taxable income from the remaining 20 percent and interest income is small relative to deductible expenses Under IRS provisions, each subsidiary actually pays taxes quarterly on its taxable incomeWith a consolidated tax return, however, the parent company can use taxable income from its subsidiaries to offset its loss
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Organizational Structure and Financial Services Business Model
S-Corporation Banks
Have favorable tax treatment because a qualifying firm does not pay corporate income tax
The firm allocates income to shareholders on a pro rata basis and each individual pays tax at personal tax rates on the income allocated to them Given the opportunity to avoid double taxation at the firm and individual level, many closely held banks have chosen S-corporation statusThe primary limitation to qualifying for S-corporation status is a requirement that the bank must have no more than 100 shareholders
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Organizational Structure and Financial Services Business Model
S-Corporation Banks
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Organizational Structure and Financial Services Business Model
Financial Services Business Models
The principal advantage of being a depository institution is access to FDIC deposit insurance
The FDIC charges banks a premium for the insurance, which ensures qualifying deposit holders that the FDIC will guarantee the principal amount of each deposit up to the maximum allowedThe existence of deposit insurance allows depository institutions to pay low rates on insured deposits and ensures that such deposits are relatively stable in times of crisis
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Organizational Structure and Financial Services Business Model
Financial Services Business Models
The primary disadvantage of operating as a bank (or BHC) is that the firm is subject to regulation as a bank
Prior to 2008, investment banks avoided regulation as banks, which allowed them to operate with substantially lower equity capital per dollar of risk assets and enter lines of business not generally available to commercial banks The combined effect was greater financial leverage and business operations in many high-risk areas such as proprietary trading
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Organizational Structure and Financial Services Business Model
Transactions Banking Versus Relationship Banking
Transactions Banking
Involves the provision of transactions services such as checking accounts, credit card loans, and mortgage loans that occur with high frequency and exhibit standardized featuresBecause the products are highly standardized, they require little human input to manage
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Organizational Structure and Financial Services Business Model
Transactions Banking Versus Relationship Banking
Relationship Banking
Emphasizes the personal relationship between the banker and customer For example, the key feature of a loan that is relationship driven is that the lender adds real value to the borrower during the credit granting processIn addition to the provision of funds, the lender may provide expertise in accounting, business, and tax planning
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Organizational Structure and Financial Services Business Model
Transactions Banking Versus Relationship Banking
Relationship Banking
Lending institutions generally charge higher rates and often hold the loans in portfolio Aggressively market noncredit products and services to such customers in order to lock in the relationship33Slide34
Organizational Structure and Financial Services Business Model
Transactions Banking Versus Relationship Banking
Securitization
The process of pooling a group of assets with similar features—for example, credit card loans or mortgages—and issuing securities that are collateralized by the assetsThe securities are sold to investors who receive the cash flows from the loans net of servicing, guarantee, and trust feesThe entire process adds liquidity to the market because the loan originators regularly repeat the process knowing that investors will demand the securities
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Organizational Structure and Financial Services Business Model
Transactions Banking Versus Relationship Banking
Originate-to-Distribute (OTD)
When loan origination is separated from ownership The flaw is that lenders who originated the loans knew they would not own the loans long termThey were, therefore, less concerned about the quality of the assets originated
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Organizational Structure and Financial Services Business Model
Transactions Banking Versus Relationship Banking
Originate-to-Distribute (OTD)
In order to grow their business and continue originating loans, they increasingly made loans to less qualified borrowersWhen the underlying assets defaulted at higher-than-expected rates, investors in the securities did not receive the promised paymentsThe net result is that liquidity largely dried up for most securitizations
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Organizational Structure and Financial Services Business Model
Universal Banking
Refers to a structure for a financial services company in which the company offers a broad range of financial products and services
Combined traditional commercial banking that focused on loans and deposit gathering with investment bankingUnderwrote securities, advised on mergers and acquisitions, managed investment assets for customers, took equity positions in companies, bought and sold assets for a speculative profit, offered brokerage services, and made loans and accepted deposits
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Organizational Structure and Financial Services Business Model
Universal Banking
The presumed advantage of universal banking is the ability to cross-sell services among customers
Participation in diverse products and services would presumably increase the information advantage and allow the bank to serve customers more efficiently and at better prices38Slide39
Organizational Structure and Financial Services Business Model
Universal Banking
There is no consensus on whether universal banking is successful
U.S. firms that tried to achieve this goal of a “one-stop financial supermarket” have not outperformed more traditional competitors39Slide40
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Different Channels for Delivering Banking Services
Branch Banking
Automated Teller Machines
Internet (Online) BankingCall CentersMobile Banking41Slide42
Chapter 2Banking and the Financial Services Industry
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Government Policies and Regulation
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Historical Bank Regulation
Glass-
Steagall
Act (1933-1999)Created three distinct industriesCommercial BankingInvestment BankingInsurance44Slide45
Historical Bank Regulation
Definition of a Commercial Bank
Limitations on:
Geographic ScopeProducts and ServicesResults:Large number of small banksLimited products and services banks could offerLimited geographic area to operate
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Historical Bank Regulation
Changes in:
Products and Services
MMMFsLPOsCommercial PaperJunk BondsPayment Methods
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Goals and Functions of Bank Regulation
Ensure the Safety and Soundness of Banks
Provide an Efficient and Competitive Financial System
Provide Monetary StabilityMaintain the Integrity of the Payments SystemProtect Consumers from Abuses47Slide48
Ensure Safety & Soundness and Provide an Efficient & Competitive System
Supervision and Examination
FDIC
OCC48Slide49
Ensure Safety & Soundness and Provide an Efficient & Competitive System
Supervision and Examination
CAMELS
CapitalAsset QualityManagement QualityEarnings QualityLiquiditySensitivity to Market Risk
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Supervision and Examination
Memorandum of Understanding
Formal regulatory documentCease and Desist OrderLegal documentHas legal standing
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
New Charters
Dual Banking System
Office of the Comptroller of the CurrencyCharters national banksOffice of Thrift SupervisionCharters federal savings banks and savings associationsNational Credit Union AdministrationCharters federal credit unions
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
New Charters
State Banking Authorities
Charter state banksState Savings AuthoritiesCharter state savings banksState Credit Union AuthoritiesCharter state credit unions
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
National versus State Charter
All banks obtain FDIC deposit insurance as part of the chartering process
National banks must join the FedPrimary regulator is the OCC53Slide54
Ensure Safety & Soundness and Provide an Efficient & Competitive System
National versus State Charter
State banks may join the Fed
State banks are regulated by their state banking authorityState banks also have a primary federal regulatorFederal Reserve for member banksFDIC for non-member banks
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Commercial Banks, Savings Institutions, and Credit Unions
Commercial Banks
Specialize in short-term business creditSavings InstitutionsSpecialize in real estate loansStockholder versus Mutual Ownership“Qualified Thrift Lender”Unitary Thrift Holding Company
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Commercial Banks, Savings Institutions, and Credit Unions
Credit Unions
“Common Bond” requirementExempt from Federal Taxation58Slide59
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Farm Credit System
Farm Credit Administration
4 Farm Credit Banks81 Agricultural Credit Associations9 Federal land Credit Associations1 Agricultural Credit Bank
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Farm Credit System
Provides credit and other services to:
Agricultural producers and farmer-owned agricultural and aquatic cooperativesAgricultural processing and marketing activitiesRural housingFarm-related businessesRural utilities
Foreign and domestic companies involved in international agricultural trade
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Farm Credit System
Not considered depository institutions because they do not accept transactions deposits
Federal Farm Credit Banks Funding CorporationIssues debt on behalf of the Farm Credit Banks62Slide63
Ensure Safety & Soundness and Provide an Efficient & Competitive System
Federal Deposit Insurance
Currently full coverage for demand deposit accounts until 12/31/2013
Currently coverage of at least $250,000 per depositor on interest-bearing accountsCoverage will revert to $100,000 ($250,000 for retirement accounts) per depositor on 1/1/2014Original limit in 1933 was $5,000
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Federal Deposit Insurance
Goal is for fund to be 1.25% of deposits
Banks pay risk-based deposit insurance premium to the Deposit Insurance Fund64Slide65
Ensure Safety & Soundness and Provide an Efficient & Competitive System
Federal Deposit Insurance
Federal Deposit Insurance Corporation
Receiver of failed institutionsLiquidateSellToo Big to Fail Policy
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Product Restrictions: Depository Institutions versus Non-Depository Institutions
Banks are restricted on what products and services they can offer
http://www.occ.treas.gov/corpapps/BankAct.pdf
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Activities Permissible for a National Bank
General Banking Activities
BranchingConsulting and financial adviceCorporate governanceCorrespondent serviceFinder activitiesLeasing
Lending
Payment services
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Activities Permissible for a National Bank
Fiduciary, Insurance and Annuities Activities
General trust activities, employee benefit accounts, and real estate brokerageInsurance and annuities activitiesSecurities activities
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Activities Permissible for a National Bank
Technology and Electronic Activities
Digital certificationElectronic bill paymentsElectronic correspondent servicesElectronic storage and safekeepingInternet access serviceInternet and PC bankingSoftware development and production
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Activities Permissible for a National Bank
Investments
Asset-backed securitiesBank stockBankers acceptancesCorporate bonds Collateralized mortgage-related investmentsCommercial paper
Money market preferred stock,
Trust preferred securities
State and local bonds
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Shortcomings of Restrictive Bank Regulation
Does not prevent bank failure
Cannot eliminate economic riskAssumed markets for bank products could be protectedDiscriminated against U.S. based firmsDoes not guarantee that bank management will make good decisions
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Maintaining Monetary Stability and the Integrity of the Payments System
The Role of the Central Bank in the Economy: The Federal Reserve System
Fundamental Functions
Conduct monetary policyProvide and maintain the payments systemSupervise and regulate banking operations73Slide74
Maintaining Monetary Stability and the Integrity of the Payments System
The Role of the Central Bank in the Economy: The Federal Reserve System
Organization
Board of Governors12 Federal Reserve District Banks74Slide75
Maintaining Monetary Stability and the Integrity of the Payments System
The Role of the Central Bank in the Economy: The Federal Reserve System
Monetary Policy
Open Market OperationsOpen market purchases (sales) increase (decrease) reserves & the money supply75Slide76
Maintaining Monetary Stability and the Integrity of the Payments System
The Role of the Central Bank in the Economy: The Federal Reserve System
Monetary Policy
Discount RateDecreasing (Increasing) the discount rate makes bank borrowing less (more) expensive, which leads to an increase (decrease) in the money supply76Slide77
Maintaining Monetary Stability and the Integrity of the Payments System
The Role of the Central Bank in the Economy: The Federal Reserve System
Monetary Policy
Reserve RequirementsDecreasing (Increasing) reserve requirements increases (decreases) the money supplyLast changed April 1992
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Maintaining Monetary Stability and the Integrity of the Payments System
The Federal Reserve’s Crisis Management Tools
Term Auction Facility
Term Securities Lending FacilityPrimary Dealer Credit Facility78Slide79
Maintaining Monetary Stability and the Integrity of the Payments System
The Role of Depository Institutions and
the Economy
Banks are the primary conduit for monetary policyBanks are the primary source of credit for most small businesses and many individuals79Slide80
Maintaining Monetary Stability and the Integrity of the Payments System
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Efficient and Competitive Financial System
Product restrictions, barriers to entry, and restrictions on mergers and the degree of branching can clearly enhance safety and soundness, but they also hinder competition
Effective financial regulation requires a delicate balance between the system’s competitiveness and general safety and soundness concerns
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Efficient and Competitive Financial System
Organizational Form of the Banking Industry
Bank Holding Companies
ParentSubsidiariesOne-Bank Holding CompaniesMutli-Bank Holding Companies83Slide84
Efficient and Competitive Financial System
Consumer Protection
Reg. B
Equal Credit OpportunityCannot discriminate on the basis of sex, race, marital status, religion, age, or national originReg. ZTruth-in-LendingRequires disclosure of:Effective interest rates, total interest paid, total of all paymentsWhy credit was denied
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Efficient and Competitive Financial System
Key Federal Legislation
Depository Institutions Deregulation and Monetary Control Act of 1980
DIDMCADepository Institutions Act of 1982Garn-St. GermainCompetitive Equality Banking Act of 1987
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Efficient and Competitive Financial System
Key Federal Legislation
Financial Institutions Reform, Recovery, and Enforcement Act of 1989
FIRREAFederal Deposit Insurance Corporation Improvement Act of 1991FASB 115Held-to-maturityTrading account securitiesAvailable-for-sale
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Efficient and Competitive Financial System
Key Federal Legislation
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
Gramm-Leach-Bliley Act of 1999USA Patriot Act (2001)Sarbanes-Oxley Act (2002)Check Clearing for the 21st Century Act aka Check 21 (2004)
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Efficient and Competitive Financial System
Key Federal Legislation
Fair and Accurate Credit Transactions Act (FACT) of 2003
Servicemembers Civil Relief Act (SCRA) of 2003Deposit Insurance Reform Act of 2005Troubled Asset Relief Act (2008)TARP Capital Purchase Program (2008)Amended Reg. Z (Truth in Lending Act of 1968)
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Efficient and Competitive Financial System
Key Federal Legislation
Housing and Economic Recovery Act (HERA) of 2008
Federal Housing Finance Regulatory Reform Act of 2008Federal Housing Finance Agency (FHFA)HOPE for Homeowners Act of 2008Treasury Emergency Authority ProvisionsSecure and Fair Enforcement of Mortgage Licensing Act (SAFE) of 2008Foreclosure Prevention Act of 2008
FHA Modernization Act of 2008
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Efficient and Competitive Financial System
Current Unresolved Regulatory Issues
Capital Adequacy
From a regulator’s perspective, increased capital requirements make banks saferIncreasing capital requirements also has disadvantagesEquity is more expensive than debtMost banks do not have ready access to the equity marketsThis can lead to more consolidation
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Efficient and Competitive Financial System
Current Unresolved Regulatory Issues
Regulatory Reform
Regulation of depository institutions is highly fragmentedFederal ReserveOCCOTSFDIC NCUA
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Efficient and Competitive Financial System
Current Unresolved Regulatory Issues
Regulatory Reform
Non-depository institutions are not subject to the same regulatory burdens as depository institutionsLarge investment banksInsurance companiesFinance companiesHedge fundsCredit card companies
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Efficient and Competitive Financial System
Current Unresolved Regulatory Issues
Regulatory Reform
Since the Fed is willing and able to assist financial players they do not directly supervise, the system appears to be at greater risk than it was before the most recent financial innovations93Slide94
Chapter 3Analyzing Bank Performance
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Analyzing Bank PerformanceIn 2008, depository institutions reported:
Worsening asset quality leading to higher charge-offs
Shrinking net interest income
Declining non-interest incomeThese factors led to lower profits, ROE, ROA, and bank failures95Slide96
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Analyzing Bank PerformanceDepository Institution Failures
Over 1,500 bank failures between 1985 and 1993
0 in 2005 or 2006
3 in 2007Sharp increase in 2008 and 200926 in 200872 through mid-August 200997Slide98
Commercial Bank Financial Statements
Most depository financial institutions own few fixed assets and thus exhibit low operating leverage
Many bank liabilities carry short-term maturities. As a result, interest expense changes coincidentally with short-run changes in market interest rates
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Commercial Bank Financial Statements
Many commercial bank deposits are insured by the FDIC. Insured deposits carry below-market interest rates
Banks operate with less equity capital than non-financial companies, which increases financial leverage and the volatility of earnings
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Commercial Bank Financial Statements
Bank Assets
Loans
Real EstateCommercialIndividualAgriculturalOther loans in domestic officesLoans and leases in foreign offices
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Commercial Bank Financial Statements
Bank Assets
Adjustment to Loans
Gross Loans and LeasesminusUnearned IncomeLoan and Lease Loss (Allowance for Loan Loss or ALL)equalsNet Loans and Leases
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Commercial Bank Financial Statements
Bank Assets
Investment Securities
Short-Term InvestmentsOne year or lessExamples:Interest-Bearing Deposits Due from Other BanksFed Funds SoldReverse ReposT-Bills
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Commercial Bank Financial Statements
Bank Assets
Investment Securities
Long-Term InvestmentsOver one yearExamples:T-Notes and T-BondsGovernment Agency IssuesForeign and Corporate BondsMortgage-Backed Securities
Municipal Securities: General Obligation
Municipal Securities: Revenue
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Commercial Bank Financial Statements
Bank Assets
Investment Securities
Held-to-MaturityTrading AccountAvailable-for-Sale104Slide105
Commercial Bank Financial Statements
Bank Assets
Investment Securities
Held-to-MaturityIntent and ability to hold until maturityRecorded at cost (Book Value)Changes in value (unrealized gains or losses) are NOT reflected on the balance sheet or income statementMay be a current or long-term asset, depending on maturity
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Commercial Bank Financial Statements
Bank Assets
Investment Securities
Trading AccountObjective is to generate trading profitsMarked-to-MarketChanges in value (unrealized gains and losses) ARE reflected on the Income StatementAlways a current asset, regardless of maturity of the underlying security
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Commercial Bank Financial Statements
Bank Assets
Investment Securities
Available-for-SaleFor those securities that do not fall into the HTM or Trading categoriesMarket-to-MarketChange in value (unrealized gains or losses) ARE reflected on the Balance Sheet (Change to Shareholder’s Equity)May be a current or long-term asset, depending on maturity
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Commercial Bank Financial Statements
Bank Assets
Non-Interest Cash and Due From Banks
Vault CashDeposits held at the Federal ReserveCash Items in Process of Collection (CIPC)Largest component of this category108Slide109
Commercial Bank Financial Statements
Bank Assets
Other Assets
Bank PremisesOREOOften foreclosed propertyBanker’s Acceptances109Slide110
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Commercial Bank Financial Statements
Bank Liabilities and Stockholder’s Equity
Transaction Accounts
Demand DepositsPays no interestAvailable to all customersNOW AccountsPays “market” interest rateNot available to for-profit corporationsATS Accounts
Pays “market” interest rate
Not available to for-profit corporations
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Commercial Bank Financial Statements
Bank Liabilities and Stockholder’s Equity
Transaction Accounts
MMDAsPays market interest rateLimited to six checks per monthAvailable to all customers113Slide114
Commercial Bank Financial Statements
Bank Liabilities and Stockholder’s Equity
Savings and Time Deposits
Savings DepositsNo MaturityTime Deposits (CDs)“Large” or Jumbo CDsNegotiable“Small” CDs
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Commercial Bank Financial Statements
Bank Liabilities and Stockholder’s Equity
Other Borrowings
Fed Funds Purchased Repurchase AgreementsBrokered DepositsDeposits Held in Foreign OfficesIssued by a bank subsidiary outside the U.S.Federal Home Loan Bank BorrowingsSubordinated Notes and Debentures
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Commercial Bank Financial Statements
Bank Liabilities and Stockholder’s Equity
Core Deposits
Deposits that are NOT very interest rate sensitiveRepresent permanent funding baseMade up of:Demand DepositsNOW and ATS accountsMMDAsSavings Accounts
“Small” Time Deposits
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Commercial Bank Financial Statements
Bank Liabilities and Stockholder’s Equity
Non-Core Deposits
Deposits that are very interest rate sensitiveAKAVolatile LiabilitiesHot MoneyPurchased LiabilitiesShort-Term Non-Core Funding
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Commercial Bank Financial Statements
Bank Liabilities and Stockholder’s Equity
Non-Core Deposits
Consist of:Federal Funds PurchasedRepos“Large” Time DepositsBrokered Time Deposits
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Commercial Bank Financial Statements
Bank Liabilities and Stockholder’s Equity
All Common and Preferred Equity
Preferred StockCommon Stock119Slide120
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Commercial Bank Financial Statements
Income Statement
Interest Income (II)
Includes interest and fees from:LoansDeposits at other institutionsTrading Account SecuritiesMunicipal SecuritiesEstimated Tax Benefit = Municipal Interest Rate/(1 – Marginal Tax Rate) = Tax-Equivalent Municipal Interest Income
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Commercial Bank Financial Statements
Income Statement
Interest Expense (IE)
Includes interest paid on all interest-bearing liabilities:NOW AccountsATS AccountsMMDAsSavings AccountsTime DepositsNon-Core LiabilitiesLong-Term Debt
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Commercial Bank Financial Statements
Income Statement
Interest Income (II)
minusInterest Expense (IE)equalsNet Interest Income (NII)125Slide126
Commercial Bank Financial Statements
Income Statement
Non-Interest Income (OI)
Includes:Fiduciary (Trust) IncomeDeposit Service ChargesTrading RevenuesInvestment Banking Fees and CommissionsInsurance Commission Fees and IncomeNet Servicing Fees
Net Gains (Losses) on Sales of Loans
Other Net Gains (Losses)
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Commercial Bank Financial Statements
Income Statement
Non-Interest Expense (OE)
Includes:PersonnelOccupancyTechnologyUtilitiesDeposit Insurance PremiumsIntangible AmortizationsGoodwill
Imparement
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Commercial Bank Financial Statements
Income Statement
Non-Interest Expense (OE)
minusNon-Interest Income (OI)equalsBurdenNon-interest expense is typically larger than non-interest incomeReducing the Burden will increase bank profitability
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Commercial Bank Financial Statements
Income Statement
Provision for Loan and Lease Losses (PLL)
Estimate of potential losses on loansRelationship between PLL and ALLBeginning ALL (from Balance Sheet)plusThis year’s PLL (from Income Statement)minusCharge-offs
plus
Recoveries
Equals
Ending ALL
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Commercial Bank Financial Statements
Income Statement
Provision for Loan and Lease Losses (PLL)
Relationship between PLL and ALLRecall, ALL is a contra-asset accountWhen a loan is charged off, Gross Loans and the ALL account are decreased by the same amount130Slide131
Commercial Bank Financial Statements
Income Statement
Net Interest Income (NII)
minusBurdenminusPLLplusRealized Security Gains (Losses) (SG)equals
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Commercial Bank Financial Statements
Income Statement
Pre-Tax Net Operating Income (te)
minusTaxes (T)minusExtraordinary ItemsequalsNet Income (NI)
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Commercial Bank Financial Statements
Income Statement
Total Revenue (TR) or Total Operating Income (TOI)
Includes:Interest IncomeNon-Interest IncomeRealized Security Gains (Losses)Analogous to Net Sales
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Commercial Bank Financial Statements
Income Statement
Total Operating Expense (EXP)
IncludesInterest ExpenseNon-Interest ExpensePLLAnalogous to COGS + Operating Expenses134Slide135
Commercial Bank Financial Statements
Income Statement
NI = NII – Burden – PLL + SG – T
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Relationship Between Balance Sheet & Income StatementA
i
= Dollar magnitude of the i
th assetLj = Dollar magnitude of the jth liabilityNW = Dollar magnitude of equityyi = Average pre-tax yield on the i
th
asset
c
j
= Average pre-tax cost on the j
th
liability
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Relationship Between Balance Sheet & Income StatementSlide138
Relationship Between Balance Sheet & Income StatementNet Interest Income
Changes with changes in:
Composition
Volume138Slide139
Return on Equity Model
Profitability Analysis
Return on Equity (ROE)
Return on Assets (ROA)139Slide140
Return on Equity Model
Profitability Analysis
Return on Equity
Net Income/Average Total EquityROA x EMNet Income/Average Total Assets x Average Total Assets/Average Total Equity
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Return on Equity Model
Expense Ratio and Asset Utilization
Asset Utilization (AU)
Total Revenue/Average Total AssetsTR/aTAExpense Ratio (ER)
Total Operating Expenses/Average Total Assets
EXP/
aTA
Tax Ratio (TAX)
Taxes/Average Total Assets
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Return on Equity Model
Expense Ratio and Asset Utilization
Net Income/Average Total Assets
ROA = AU – ER – TAX142Slide143
Return on Equity ModelExpense Ratio and Asset Utilization
Expense Ratio (ER)
Total Operating Expense/Average Total Assets
EXP/aTA143Slide144
Return on Equity ModelExpense Ratio and Asset Utilization
Expense Ratio (ER)
IE can change due to changes in:
VolumeDifferent levels of liabilities versus equityCompositionDifferent mix of liabilitiesRates
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Return on Equity ModelExpense Ratio (ER)
Non-Interest Expense
OE can change due to changes in:
Personnel ExpensesOccupancy ExpensesTechnology ExpensesOther Overhead Expenses145Slide146
Return on Equity ModelIncome: Asset Utilization Components
Total Revenue
Includes:
Interest Income (II)Non-Interest Income (OI)Realized Security Gains or Losses (SG)146Slide147
Return on Equity Model
Income: Asset Utilization Components
II can change due to changes in:
VolumeDifferent levels of earning assets to total assetsEarnings Base (EB) = Average Earning Assets/aTACompositionDifferent mix of earning assets
Rates
147Slide148
Return on Equity ModelIncome: Asset Utilization Components
Non-Interest Income (OI)
OI can change due to changes in:
FeesTrust ActivitiesService ChargesOther Non-Interest Income
148Slide149
Return on Equity ModelAggregate Profitability Measures
Net Interest Margin (NIM)
Net Interest Income/Average Earning Assets
SpreadInterest Income/Average Earning Assets - Interest Expense/Average Interest-Bearing Liabilities149Slide150
Return on Equity ModelAggregate Profitability Measures
Burden
(Non-Interest Expense – Non-Interest Income)/Average Earning Assets
Lower numbers are betterEfficiency RatioNon-Interest Expense/(Net Interest Income + Non-Interest Income)Lower numbers are better
150Slide151
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Managing Risks and Returns
Risk Management
Credit Risk
Liquidity RiskMarket RiskOperational RiskReputation RiskLegal Risk152Slide153
Managing Risks and Returns
Risk Management
Credit Risk
Historical Loss RateGross Loan Losses (Charge-offs)RecoveriesNet LossesCharge-offs - Recoveries153Slide154
Managing Risks and Returns
Risk Management
Credit Risk
Expected Future LossesPast-Due LoansInterest and Principal has not been paid but it is still accruing interest30-89 days90 days and overNon-Performing Loans90 days or more past-due
Non-Accrual Loans
Not accruing interest
154Slide155
Managing Risks and Returns
Risk Management
Credit Risk
Expected Future LossesTotal Non-Current LoansNon-Performing + Non-Accrual LoansRestructured LoansClassified LoansRegulations force management to set aside reserves for loans that are clearly not going to be paid back
155Slide156
Managing Risks and Returns
Risk Management
Credit Risk
Preparation for LossesProvision for Loan LossIRS versus FASB and RegulatorsEarnings Coverage of Net Losses(Net Interest Income – Burden)/Net Loan and Lease LossesManagement can manipulate by delaying the recognition of bad loans
156Slide157
Managing Risks and Returns
Risk Management
Credit Risk
Preparation for LossesLack of DiversificationHigh Loan GrowthCountry Risk157Slide158
Managing Risks and Returns
Risk Management
Liquidity Risk
Funding Liquidity RiskInability to liquidate assts or raise required fundingMarket Liquidity Risk158Slide159
Managing Risks and Returns
Risk Management
Liquidity Risk
Holding Liquid AssetsPledging RequirementsCash AssetsNot a good source of liquidity for a bankAbility to Borrow for LiquidityVolatile Liabilities“Hot Money” versus Core Deposits
Large CDs
Fed Funds Purchased
Repos
159Slide160
Managing Risks and Returns
Risk Management
Market Risk
Interest Rate RiskAsset or Liability is considered “rate sensitive” if it can be re-priced during a particular time periodGAP/Earnings Sensitivity AnalysisChanges in spread/NIM due to changes in ratesDuration GAPMarket Value of Equity Sensitivity
160Slide161
Managing Risks and Returns
Risk Management
Market Risk
Equity and Security Price RiskForeign Exchange RiskForeign Currency Translation RiskCommitments and Guarantees denominated in a foreign currency161Slide162
Managing Risks and Returns
Risk Management
Operational Risk
Business InterruptionsTransaction ProcessingInadequate Information SystemsBreaches in Internal ControlsClient LiabilityLegal RiskReputation Risk
162Slide163
Managing Risks and Returns
Risk Management
Capital or Solvency Risk
Risk of becoming insolventLiabilities > AssetsOff-Balance Sheet RiskTier 1 CapitalCommon Equity + Non-cumulative Preferred StockRisk-Weighted Assets
163Slide164
Evaluating Bank Performance: An ApplicationProfitability Analysis for PNC in 2007
164Slide165
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Maximizing the Market Value of Bank Equity
Effective Management of:
Assets
LiabilitiesOff-Balance Sheet ActivitiesInterest Rate MarginCredit risk LiquidityNon-Interest ExpenseTaxes
170Slide171
Maximizing the Market Value of Bank Equity
CAMELS Ratings
Capital Adequacy
Asset QualityManagement QualityEarningsLiquiditySensitivity to Market Risk171Slide172
Maximizing the Market Value of Bank Equity
CAMELS Ratings
Ratings from 1 (best) to 5 (worst)
1 & 2 Sound banks3 Some underlying problems4 & 5 Problem banks
172Slide173
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Maximizing the Market Value of Bank EquityPerformance Characteristics of Banks by Size
Large Banks versus Small Banks
Higher ROE
Lower NIMHigher Charge-offsLower Capital174Slide175
175Slide176
Financial Statement ManipulationOff-Balance Sheet Activities
Window Dressing
Preferred Stock
Non-Performing LoansAllowance for Loan LossesSecurities Gains and LossesNon-Recurring Extraordinary Items176Slide177
Analyzing Bank Performance
177