copyright© 2002 thomson publishing. all rights reserved. fina 441, part i, financial markets...

Copyright© 2002 Thomson Publishing. All rights reserved.

• FINA 441, Part I, Financial Markets (done!)

• FINA 441, Part II, Financial Institutions or Intermediaries• DEPOSITORY (Commercial Banks, S&Ls, Savings

Banks, Credit Unions)

• CONTRACTUAL (Life Insurance Co, Fire/Casualty Insurance Co, Pension Funds)

• INVESTMENT (Finance Co., Investment Co./Mutual Funds, Money Market Funds)

• OTHER (Investment Bankers, Mortgage Bankers, Security Dealers/Brokers)

Where are we going in this course?


DIRECT- involves only one contract between lender & borrower- called dis-intermediation- E.g. you loan money to your neighbor

SEMI-DIRECT- Involves essentially one contract but . . .- A middle party is needed to execute it- E.g. you buy Intel stock through Charles Schwab from your neighbor

INDIRECT- Involves two contracts - Financial intermediary is in the middle- E.g. you deposit money in the bank which loans it to your neighbor

FINANCIAL INTERMEDIARIES


FUNCTIONS OF FIN. INTERMEDIARIES

Maturity & Liquidity IntermediationE.g. You deposit $ in savings account, which is loaned out in a 30-yr fixed-rate mortgage to your neighbor; even though the loan won’t be paid off for many years, yet you can get your money at any time. Financial intermediaries absorb liquidity risk!

Interest-rate and Inflation Risk IntermediationE.g. Bank absorbs risk from borrower locking into fixed rate for 30 years.

Repackaging SizeE.g. Bank can re-package the size of a security to the level desired. Most of us don’t have $100,000 sitting around to lend to our neighbor, so many of us poor investors can pool our $.

Diversification & Default RiskE.g. You deposit $ in savings account, pooled together with other investors, so that no one investor is lending to only one borrower. Depository institutions also offer government deposit insurance. In short, financial intermediaries absorb default risk.

Efficiencies & SpecializationE.g. Bank is better able to invest in mortgages (legal issues, credit approval, etc.). Since the bank has specialized in this, it has economies of scale (full-time lawyers, appraisers, credit specialists, etc.)

Clearing House for PaymentsE.g. financial intermediaries make possible EFT, credit/debit cards, checks, etc. which wouldn’t exist otherwise


Types of Financial Intermediaries

Assets of Financial Institutions (in $ billions)40 year 20 year 10 year

Type $ % $ % $ % $ % Growth% Growth% Growth%Depository

Commercial Banks 517 39% 1481 37% 3334 30% 14133 33% 2733 953 423S&Ls & Savings Banks 250 19% 792 20% 1365 12% 1254 3% 501 157 91Credit Unions 18 1% 67 2% 215 2% 883 2% 4905 1317 410

ContractualLife Insurance Co. 201 15% 464 11% 1367 12% 4826 11% 2400 1039 352Fire & Casualty Insurance Co. 50 4% 182 5% 533 5% 1369 3% 2737 751 256Pensions (private) 112 8% 504 12% 1629 15% 5471 13% 4884 1085 335Pensions (gov't) 60 5% 197 5% 737 7% 2686 6% 4476 1362 363

InvestmentFinance Companies 64 5% 205 5% 610 6% 1663 4% 2597 810 272Mutual Funds (Invest. Co.) 47 4% 70 2% 654 6% 6962 16% 14812 9945 1064Money Mkt Mutual Funds 0 0% 76 2% 498 5% 3259 8% n/a 4287 653

Total 1319 100% 4038 100% 10942 100% 42506 100% 3222 1052 387GDP 2788 14256GDP as % of total assets 69% 34%

1970 1980 1990 2010


Role of Financial Institutions

Types of Depository Financial Institutions

CommercialBanks

Total Assets$15.2T(2014)

Savings InstitutionsTotal Assets

$1.1 T(2014)

Credit UnionsTotal Assets

$1.05 T(2014)

https://www2.fdic.gov/hsob/HSOBRpt.asp

CHAPTER

17Commercial

Bank

Operations


Commercial Bank Consolidations

Today there are half as many banks as there were in 1985. Today, the largest 5 banks control half of bank assets vs. 30% in 2001.


Largest U.S. Banks


Bank Participation in Financial Conglomerates

Impact of the Financial Services Modernization Act (1999) Prompted by the Citicorp-Traveler’s merger Gave more freedom to merge and offer a range of

financial services Insurance Securities services

Many banks are now subsidiaries of a financial conglomerate



Benefits of diversified services To Individuals: they can obtain all their

financial services at a single place (one stop shop)

Deposits Loans Investing (brokerage) Insurance

To Businesses: they can obtain loans, issue stocks and bonds, and have their pension fund managed by the same institution



Benefits of diversified services to the financial institution Reduce reliance on demand for single

service Economies of scale and scope Diversification (service and geographical)

may result in less risk Generate new business

Risks of conglomerates: too big to failNOTE: there are bills currently before Congress

now that would split big banks and their diversified services. This is an attempt to prevent the “too-big-to-fail” syndrome.


Sources of Funds (right hand of Balance Sheet)

Source: Federal Reserve


Bank Sources of Funds

Transaction deposits Demand deposit account

Checking account that does not pay interest Negotiable order of withdrawal (NOW) account

Interest-bearing checking account Requires larger minimum balance

Savings Deposits Passbook savings Regulation Q until 1986 – max. interest rate

Auto Transfer Service (ATS) created in 1978 allows ZBA accounts and overdraft protection.



Time Deposits (have specific maturity) Retail certificate of deposit (CD)

No secondary market Early withdrawal penalty New: Bull-market, bear-market and callable CDs

Negotiable CD Short-term, minimum $100,000, usually $1m, no

FDIC insurance Marketable -- can trade among investors via dealer

Money Market Deposit Accts (MMDAs) More liquid than CDs with no maturity Limited check writing (e.g. 5 per month) Created in 1982 with Garn St. Germain Act



Federal Funds Purchased Short-term loans between banks (usually 1-7 days), often to meet reserve

requirements (most report weekly on Wed.) Allows banks to borrow S/T (seasonal, etc.) or may provide a S/T

investment Interest rate is the Federal Funds Rate, typically above the T-bill rate since

small amounts of liquidity and default risk may exist. Borrowing from the Federal Reserve Banks

Borrowing at the discount window, which is discouraged Discount Rate (usually 1% higher than Fed Fds Rate) Intended for meeting temporary short-term reserve requirement needs Must get Fed approval, Fed may frown at you



Repurchase agreements Sale of T-bills (usually) by bank to a business with

excess cash and an agreement to repurchase the securities at a later date and higher price

Source of funds for a few days for the bank Collateralized by the Treasury bills Form of paying interest on large customer

checking balances (Rogers Elementary!)



Eurodollar borrowings Banks outside the United States make dollar-

denominated loans (maybe even to US banks) Eurodollar market is very large (Saddam Hussein

was caught with a briefcase full of what?) Bonds issued by the bank

Like other businesses, banks issue bonds to finance long-term fixed assets

Usually subordinated to deposits



Bank capital Represents amount of equity stockholders have Obtained from issuing stock and retaining earnings The more capital, the more “safe” the bank is because

capital is a buffer to absorb future losses Banks often resist building up too much capital because it

lowers the return on equity (ROE). Stated another way, the more leverage the bank, the more ROE is magnified.

Capital is usually approx. 6-12% of assets but it really depends on risk-based capital requirement and size of bank

Primary capital (stock & RE) is of higher quality than secondary capital (subordinated notes & bonds)


A major reason banks failed during the financial crisis because of inadequate capital.Basel III (or the Third Basel Accord) is a global regulatory standard on bank capital adequacy, stress testing, and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11, and scheduled to be introduced from 2013 until 2018. (Basel is a town in Switzerland where they meet.) Basel III strengthens bank capital and introduces new regs on liquidity and leverage.

Bank Capital Regulation


Uses of Funds (left hand side of balance sheet)

Source: Federal Reserve


Uses of Funds by Banks

Cash and “due from” balances at institutions Currency/coin provided via banks Reserve requirements imposed by Fed

Due from Fed and vault cash count as reserves Hold cash and due from balances to maintain

liquidity and accommodate withdrawal requests by depositors



Bank Loans (59% of assets) Types of business loans

Working capital loans (business operating cycle) Term loans

Purchasing fixed assets Protective covenants & conditions

Informal line of credit (bank not obligated to lend) Revolving credit loan (bank obligated)


Uses of Funds by Banks: Volume of Small Business Loans



Bank Loans Loan participations (syndicates)

Sometimes large firms seek to borrow more money than an individual bank can provide

Lead bank will organize the syndicate Loans supporting leveraged buyouts

Banks charge a high loan rate Monitored by bank regulators Highly-leveraged transactions (HLTs) where debt ratio

> 75%.



Bank Loans Collateral requirements on business loans

Increasingly accepting intangible assets Important to service-oriented firms which have few hard assets Increased lending risk with service businesses--telecomm

Types of consumer loans Installment loans (cars, furniture, etc.) Credit cards Usury laws

Real estate loans


Bank Prime Rate Over Time

Theoretically, the prime rate is the rate charged to most creditworthy customers – moves in tandem with Fed funds rate, often 3% above.

http://research.stlouisfed.org/fred2/series/MPRIME?cid=117





Investment securities (bank income and liquidity) Treasury securities Government agency securities Corporate and municipal securities

Investment grade only

Federal funds sold



Repurchase agreements Eurodollar loans

Branches of U.S. banks located outside of the U.S. Foreign-owned banks

Fixed assets Office buildings Land


How Banks Finance Economic Growth


Off-Balance Sheet Activities

Loan commitments Obligation of bank to provide a specified loan

amount to a particular business upon request Banks earn fee income for risk assumed

Standby letters of credit (SLC) Backs a customer’s obligation to a third party Banks earn fee income



Forward contracts in foreign currency Agreement between a customer and bank to

exchange one currency for another on a particular future date at a specified exchange rate

Allows customers to hedge their exchange-rate risk



Interest rate swap contracts Two parties agree to periodically exchange interest

payments on a specified notional amount of principal

Banks serve as intermediaries or dealer and/or guarantor for a fee

Credit default swap contacts Privately negotiated contracts to protect investors

against the risk of default on debt securities


Baker Boyer Bank

In the 1800s, Walla Walla was the largest city in the Northwest and the financial and cultural center of the NW region (and it almost became the state capitol).

Baker Boyer Bank (BBB) was founded in 1869, twenty years before Washington became a state. The bank really started as a mercantile store where gold miners would keep their gold in the store’s safe. As much as $40,000 in gold would be left in the safe for more than a year, and though it wasn't common to give or ask for receipts, no losses were ever suffered.

At one point in 1911, the BBB building was the tallest building west of the Mississippi River.

During the banking crisis of the 1930s, most banks were forced to close, at least temporarily. But BBB was determined to remain open, even though it had been ordered closed. BBB allowed customers to use the back door of the bank until banks were allowed to reopen.

BBB is still partly owned by the families of the original founders, Dorsey Baker and John Boyer. Today the CEO is the great-great-granddaughter of Dorsey Baker.

BBB remains a community bank with 8 branches in WW, Tri-Cities, Milton-Freewater, and Yakima Megan Clubb,

CEO

1911, tallest building west of the Miss. River


Banner Bank

Banner Bank (BB) started in the 1890 (one year after Washington gained statehood and two years before the founding of WWU).

For most of its history, it was known as First Washington Bank and remained a small, community-based bank in Eastern Washington.

In 1995, the bank did an IPO and become a public company traded on the Nasdaq (ticker of BANR).

Since then, the bank has pursued a path of tremendous growth through mergers/acquisitions.

Today it has expanded to 93 branches in 31 counties throughout WA, OR and ID.

In 2000, the bank changed its name to Banner Bank.

WW Headquarters

Bank in Boise

copyright© 2002 thomson publishing. all rights reserved. fina 441, part i, financial markets...

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financial markets

savings banks

commercial bank operations

commercial bank consolidations

depository institutions

liquidity risk