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Chapter 1
Banking 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 payments Many mortgages had “teaser” rates Low payments resulting in negative
amortization Multiple Mortgage Banks Fail
As the mortgages write-downs were recognized, the mortgage banks’ capital was depleted
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Credit Crisis of 2007 - 2009
Collapse and/or Failure of: Bear Stearns Lehman Brothers Countrywide Washington Mutual Wachovia
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Credit Crisis of 2007 - 2009
Government Response Fannie Mae and Freddie Mac placed
into conservatorship Loaned AIG over $150 billion Insured money market mutual funds Created Commercial Paper Funding
Facility Increased FDIC coverage to $250,000
Temporarily through 2009
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Credit Crisis of 2007 - 2009
Government Response Established Troubled Asset Relief
Program – TARP Established Term Asset-Backed
Securities Loan Facility – TALF Invested $125 billion in nine large U.S.
banks Promoted mortgage loan modifications
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Credit Crisis of 2007 - 2009
Impact 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 - 2009
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Credit Crisis of 2007 - 2009
Impact on Banks and the Banking Environment Largest Investment Banks
Goldman Sachs and Morgan Stanley Converted to Financial Holding Companies
Bear Stearns and Merrill Lynch Absorbed by other financial institutions
Lehman Brothers Failed
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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 penetration
Community Banks Smaller trade area with total assets
under $1 billion
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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 Companies Multibank Holding Companies
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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
securities Commercial banking Merchant banking Insurance 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 exam
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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 income
With 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 status
The 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 allowed
The 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 features
Because 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 process
In 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 relationship
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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 assets
The securities are sold to investors who receive the cash flows from the loans net of servicing, guarantee, and trust fees
The 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 term
They 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 borrowers
When the underlying assets defaulted at higher-than-expected rates, investors in the securities did not receive the promised payments
The 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 banking
Underwrote 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 prices
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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 competitors
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Different Channels for Delivering Banking Services
Branch Banking Automated Teller Machines Internet (Online) Banking Call Centers Mobile Banking
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Chapter 2Government Policies and Regulation
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Historical Bank Regulation
Glass-Steagall Act (1933-1999) Created three distinct industries
Commercial Banking Investment Banking Insurance
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Historical Bank Regulation
Definition of a Commercial Bank Limitations on:
Geographic Scope Products and Services
Results: Large number of small banks Limited products and services banks
could offer Limited geographic area to operate
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Historical Bank Regulation
Changes in: Products and Services
MMMFs LPOs Commercial Paper Junk Bonds Payment 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 Stability Maintain the Integrity of the Payments
System Protect Consumers from Abuses
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Supervision and Examination FDIC OCC
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Supervision and Examination CAMELS
Capital Asset Quality Management Quality Earnings Quality Liquidity Sensitivity to Market Risk
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Supervision and Examination Memorandum of Understanding
Formal regulatory document Cease and Desist Order
Legal document Has 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
Currency Charters national banks
Office of Thrift Supervision Charters federal savings banks and
savings associations National Credit Union Administration
Charters federal credit unions
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
New Charters State Banking Authorities
Charter state banks State Savings Authorities
Charter state savings banks State Credit Union Authorities
Charter 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 Fed Primary regulator is the OCC
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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 authority
State banks also have a primary federal regulator
Federal Reserve for member banks FDIC 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 credit Savings Institutions
Specialize in real estate loans Stockholder 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” requirement Exempt from Federal Taxation
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Farm Credit System Farm Credit Administration 4 Farm Credit Banks 81 Agricultural Credit Associations 9 Federal land Credit Associations 1 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 cooperatives
Agricultural processing and marketing activities
Rural housing Farm-related businesses Rural 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 Corporation
Issues debt on behalf of the Farm Credit Banks
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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 accounts
Coverage will revert to $100,000 ($250,000 for retirement accounts) per depositor on 1/1/2014
Original 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 Fund
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Federal Deposit Insurance Federal Deposit Insurance Corporation
Receiver of failed institutions Liquidate Sell
Too 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.gov/publications/publications-by-type/other-publications-reports/bankact.pdf
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Ensure Safety & Soundness and Provide an Efficient & Competitive System
Activities Permissible for a National Bank General Banking Activities
Branching Consulting and financial advice Corporate governance Correspondent service Finder activities Leasing 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 brokerage
Insurance and annuities activities Securities 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 certification Electronic bill payments Electronic correspondent services Electronic storage and safekeeping Internet access service Internet and PC banking Software 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 securities Bank stock Bankers acceptances Corporate bonds Collateralized mortgage-related investments Commercial 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 risk
Assumed markets for bank products could be protected
Discriminated against U.S. based firms Does 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 policy Provide and maintain the payments
system Supervise and regulate banking
operations
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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 Organization
Board of Governors 12 Federal Reserve District Banks
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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 Monetary Policy
Open Market Operations Open market purchases (sales) increase
(decrease) reserves & the money supply
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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 Monetary Policy
Discount Rate Decreasing (Increasing) the discount rate
makes bank borrowing less (more) expensive, which leads to an increase (decrease) in the money supply
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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 Monetary Policy
Reserve Requirements Decreasing (Increasing) reserve
requirements increases (decreases) the money supply
Last 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 Facility Primary Dealer Credit Facility
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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 policy Banks are the primary source of credit
for most small businesses and many individuals
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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
Parent Subsidiaries
One-Bank Holding Companies Mutli-Bank Holding Companies
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Efficient and Competitive Financial System Consumer Protection
Reg. B Equal Credit Opportunity
Cannot discriminate on the basis of sex, race, marital status, religion, age, or national origin
Reg. Z Truth-in-Lending
Requires disclosure of: Effective interest rates, total interest paid,
total of all payments Why credit was denied
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Efficient and Competitive Financial System Key Federal Legislation
Depository Institutions Deregulation and Monetary Control Act of 1980
DIDMCA Depository Institutions Act of 1982
Garn-St. Germain Competitive 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
FIRREA Federal Deposit Insurance Corporation
Improvement Act of 1991 FASB 115
Held-to-maturity Trading account securities Available-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 1999 USA 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 2003
Deposit Insurance Reform Act of 2005 Troubled 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 2008
Federal Housing Finance Agency (FHFA) HOPE for Homeowners Act of 2008 Treasury Emergency Authority Provisions Secure and Fair Enforcement of Mortgage
Licensing Act (SAFE) of 2008 Foreclosure 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 safer
Increasing capital requirements also has disadvantages
Equity is more expensive than debt Most banks do not have ready access to
the equity markets This 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 fragmented Federal Reserve OCC OTS FDIC 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 institutions
Large investment banks Insurance companies Finance companies Hedge funds Credit 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 innovations
Chapter 3
Analyzing Bank Performance
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Analyzing Bank Performance
In 2008, depository institutions reported: Worsening asset quality leading to
higher charge-offs Shrinking net interest income Declining non-interest income
These factors led to lower profits, ROE, ROA, and bank failures
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Analyzing Bank Performance
Depository Institution Failures Over 1,500 bank failures between 1985
and 1993 0 in 2005 or 2006 3 in 2007 Sharp increase in 2008 and 2009
26 in 2008 72 through mid-August 2009
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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 Estate Commercial Individual Agricultural Other loans in domestic offices Loans and leases in foreign offices
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Commercial Bank Financial Statements Bank Assets
Adjustment to Loans Gross Loans and Leases
minus Unearned Income Loan and Lease Loss (Allowance for
Loan Loss or ALL) equals
Net Loans and Leases
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Commercial Bank Financial Statements Bank Assets
Investment Securities Short-Term Investments
One year or less Examples:
Interest-Bearing Deposits Due from Other Banks
Fed Funds Sold Reverse Repos T-Bills
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Commercial Bank Financial Statements Bank Assets
Investment Securities Long-Term Investments
Over one year Examples:
T-Notes and T-Bonds Government Agency Issues Foreign and Corporate Bonds Mortgage-Backed Securities Municipal Securities: General Obligation Municipal Securities: Revenue
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Commercial Bank Financial Statements Bank Assets
Investment Securities Held-to-Maturity Trading Account Available-for-Sale
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Commercial Bank Financial Statements Bank Assets
Investment Securities Held-to-Maturity
Intent and ability to hold until maturity Recorded at cost (Book Value) Changes in value (unrealized gains or
losses) are NOT reflected on the balance sheet or income statement
May be a current or long-term asset, depending on maturity
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Commercial Bank Financial Statements Bank Assets
Investment Securities Trading Account
Objective is to generate trading profits Marked-to-Market Changes in value (unrealized gains and
losses) ARE reflected on the Income Statement
Always a current asset, regardless of maturity of the underlying security
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Commercial Bank Financial Statements Bank Assets
Investment Securities Available-for-Sale
For those securities that do not fall into the HTM or Trading categories
Market-to-Market Change 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
107
Commercial Bank Financial Statements Bank Assets
Non-Interest Cash and Due From Banks
Vault Cash Deposits held at the Federal Reserve Cash Items in Process of Collection
(CIPC) Largest component of this category
108
Commercial Bank Financial Statements Bank Assets
Other Assets Bank Premises OREO
Often foreclosed property Banker’s Acceptances
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Commercial Bank Financial Statements Bank Liabilities and Stockholder’s Equity
Transaction Accounts Demand Deposits
Pays no interest Available to all customers
NOW Accounts Pays “market” interest rate Not available to for-profit corporations
ATS 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
MMDAs Pays market interest rate Limited to six checks per month Available to all customers
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Commercial Bank Financial Statements Bank Liabilities and Stockholder’s
Equity Savings and Time Deposits
Savings Deposits No Maturity
Time Deposits (CDs) “Large” or Jumbo CDs
Negotiable “Small” CDs
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Commercial Bank Financial Statements Bank Liabilities and Stockholder’s
Equity Other Borrowings
Fed Funds Purchased Repurchase Agreements
Brokered Deposits Deposits Held in Foreign Offices
Issued by a bank subsidiary outside the U.S. Federal Home Loan Bank Borrowings Subordinated 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
sensitive Represent permanent funding base Made up of:
Demand Deposits NOW and ATS accounts MMDAs Savings Accounts “Small” Time Deposits
116
Commercial Bank Financial Statements Bank Liabilities and Stockholder’s
Equity Non-Core Deposits
Deposits that are very interest rate sensitive
AKA Volatile Liabilities Hot Money Purchased Liabilities Short-Term Non-Core Funding
117
Commercial Bank Financial Statements Bank Liabilities and Stockholder’s
Equity Non-Core Deposits
Consist of: Federal Funds Purchased Repos “Large” Time Deposits Brokered Time Deposits
118
Commercial Bank Financial Statements Bank Liabilities and Stockholder’s
Equity All Common and Preferred Equity
Preferred Stock Common Stock
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120
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Commercial Bank Financial Statements Income Statement
Interest Income (II) Includes interest and fees from:
Loans Deposits at other institutions Trading Account Securities Municipal Securities
Estimated Tax Benefit = Municipal Interest Rate/(1 – Marginal
Tax Rate) = Tax-Equivalent Municipal Interest Income
123
Commercial Bank Financial Statements Income Statement
Interest Expense (IE) Includes interest paid on all interest-
bearing liabilities: NOW Accounts ATS Accounts MMDAs Savings Accounts Time Deposits Non-Core Liabilities Long-Term Debt
124
Commercial Bank Financial Statements Income Statement
Interest Income (II) minus
Interest Expense (IE) equals
Net Interest Income (NII)
125
Commercial Bank Financial Statements Income Statement
Non-Interest Income (OI) Includes:
Fiduciary (Trust) Income Deposit Service Charges Trading Revenues Investment Banking Fees and Commissions Insurance Commission Fees and Income Net Servicing Fees Net Gains (Losses) on Sales of Loans Other Net Gains (Losses)
126
Commercial Bank Financial Statements Income Statement
Non-Interest Expense (OE) Includes:
Personnel Occupancy Technology Utilities Deposit Insurance Premiums Intangible Amortizations Goodwill Imparement
127
Commercial Bank Financial Statements Income Statement
Non-Interest Expense (OE) minus
Non-Interest Income (OI) equals
Burden Non-interest expense is typically larger
than non-interest income Reducing the Burden will increase bank
profitability
128
Commercial Bank Financial Statements Income Statement
Provision for Loan and Lease Losses (PLL) Estimate of potential losses on loans Relationship between PLL and ALL
Beginning ALL (from Balance Sheet) plus
This year’s PLL (from Income Statement) minus
Charge-offs plus
Recoveries Equals
Ending ALL
129
Commercial Bank Financial Statements Income Statement
Provision for Loan and Lease Losses (PLL)
Relationship between PLL and ALL Recall, ALL is a contra-asset account
When a loan is charged off, Gross Loans and the ALL account are decreased by the same amount
130
Commercial Bank Financial Statements Income Statement
Net Interest Income (NII) minus
Burden minus
PLL plus
Realized Security Gains (Losses) (SG) equals
131
Commercial Bank Financial Statements Income Statement
Pre-Tax Net Operating Income (te) minus
Taxes (T) minus
Extraordinary Items equals
Net Income (NI)
132
Commercial Bank Financial Statements Income Statement
Total Revenue (TR) or Total Operating Income (TOI)
Includes: Interest Income Non-Interest Income Realized Security Gains (Losses)
Analogous to Net Sales
133
Commercial Bank Financial Statements Income Statement
Total Operating Expense (EXP) Includes
Interest Expense Non-Interest Expense PLL
Analogous to COGS + Operating Expenses
134
Commercial Bank Financial Statements Income Statement
NI = NII – Burden – PLL + SG – T
135
Relationship Between Balance Sheet & Income Statement Ai = Dollar magnitude of the ith asset
Lj = Dollar magnitude of the jth liability NW = Dollar magnitude of equity yi = Average pre-tax yield on the ith
asset cj = Average pre-tax cost on the jth
liability
NWLAm
jj
n
ii
11
n
iii Ay
1
IncomeInterest
m
ijj Lc
1
ExpenseInterest
136
Relationship Between Balance Sheet & Income Statement
137
Relationship Between Balance Sheet & Income Statement Net Interest Income
Changes with changes in: Composition Volume
SG - T LLBurden - PLcAyNet Incomem
ijj
n
iii
11
m
ijj
n
iii LcAy
11
IncomeInterest Net
138
Return on Equity Model
Profitability Analysis Return on Equity (ROE) Return on Assets (ROA)
Return on Equity Model
Profitability Analysis Return on Equity
Net Income/Average Total Equity ROA x EM
Net Income/Average Total Assets x
Average Total Assets/Average Total Equity
139
Return on Equity Model
Expense Ratio and Asset Utilization Asset Utilization (AU)
Total Revenue/Average Total Assets TR/aTA
Expense Ratio (ER) Total Operating Expenses/Average
Total Assets EXP/aTA
Tax Ratio (TAX) Taxes/Average Total Assets
140
Return on Equity Model
Expense Ratio and Asset Utilization Net Income/Average Total Assets
ROA = AU – ER – TAX
141
aTA
Taxes
aTA
EXP
aTA
TR
aTA
NIROA
142
Return on Equity Model
Expense Ratio and Asset Utilization Expense Ratio (ER)
Total Operating Expense/Average Total Assets
EXP/aTA
aTA
PLL
aTA
OE
aTA
IE
aTA
EXPER
143
Return on Equity Model
Expense Ratio and Asset Utilization Expense Ratio (ER)
IE can change due to changes in: Volume
Different levels of liabilities versus equity
Composition Different mix of liabilities
Rates
aTA
PLL
aTA
OE
aTA
IE
aTA
EXPER
144
Return on Equity Model
Expense Ratio (ER) Non-Interest Expense OE can change due to changes in:
Personnel Expenses Occupancy Expenses Technology Expenses Other Overhead Expenses
aTA
PLL
aTA
OE
aTA
IE
aTA
EXPER
145
Return on Equity Model
Income: Asset Utilization Components Total Revenue
Includes: Interest Income (II) Non-Interest Income (OI) Realized Security Gains or Losses (SG)
aTA
SG
aTA
OI
aTA
II
aTA
TRA U
146
Return on Equity Model
Income: Asset Utilization Components II can change due to changes in:
Volume Different levels of earning assets to total
assets Earnings Base (EB) = Average Earning
Assets/aTA Composition
Different mix of earning assets Rates
aTA
SG
aTA
OI
aTA
II
aTA
TRA U
Return on Equity Model
Income: Asset Utilization Components Non-Interest Income (OI)
OI can change due to changes in: Fees Trust Activities Service Charges Other Non-Interest Income
147
aTA
SG
aTA
OI
aTA
II
aTA
TRA U
148
Return on Equity Model
Aggregate Profitability Measures Net Interest Margin (NIM)
Net Interest Income/Average Earning Assets
Spread Interest Income/Average Earning
Assets - Interest Expense/Average Interest-Bearing Liabilities
149
Return on Equity Model
Aggregate Profitability Measures Burden
(Non-Interest Expense – Non-Interest Income)/Average Earning Assets
Lower numbers are better
Efficiency Ratio Non-Interest Expense/(Net Interest
Income + Non-Interest Income) Lower numbers are better
150
151
Managing Risks and Returns
Risk Management Credit Risk Liquidity Risk Market Risk Operational Risk Reputation Risk Legal Risk
152
Managing Risks and Returns
Risk Management Credit Risk
Historical Loss Rate Gross Loan Losses (Charge-offs) Recoveries Net Losses
Charge-offs - Recoveries
153
Managing Risks and Returns
Risk Management Credit Risk
Expected Future Losses Past-Due Loans
Interest and Principal has not been paid but it is still accruing interest
30-89 days 90 days and over
Non-Performing Loans 90 days or more past-due
Non-Accrual Loans Not accruing interest
154
Managing Risks and Returns
Risk Management Credit Risk
Expected Future Losses Total Non-Current Loans
Non-Performing + Non-Accrual Loans Restructured Loans Classified Loans
Regulations force management to set aside reserves for loans that are clearly not going to be paid back
155
Managing Risks and Returns
Risk Management Credit Risk
Preparation for Losses Provision for Loan Loss
IRS versus FASB and Regulators Earnings Coverage of Net Losses
(Net Interest Income – Burden)/Net Loan and Lease Losses
Management can manipulate by delaying the recognition of bad loans
156
Managing Risks and Returns
Risk Management Credit Risk
Preparation for Losses Lack of Diversification High Loan Growth Country Risk
157
Managing Risks and Returns
Risk Management Liquidity Risk
Funding Liquidity Risk Inability to liquidate assts or raise required
funding Market Liquidity Risk
158
Managing Risks and Returns
Risk Management Liquidity Risk
Holding Liquid Assets Pledging Requirements Cash Assets
Not a good source of liquidity for a bank Ability to Borrow for Liquidity
Volatile Liabilities “Hot Money” versus Core Deposits
Large CDs Fed Funds Purchased Repos
159
Managing Risks and Returns
Risk Management Market Risk
Interest Rate Risk Asset or Liability is considered “rate
sensitive” if it can be re-priced during a particular time period
GAP/Earnings Sensitivity Analysis Changes in spread/NIM due to changes
in rates Duration GAP
Market Value of Equity Sensitivity
160
Managing Risks and Returns
Risk Management Market Risk
Equity and Security Price Risk Foreign Exchange Risk
Foreign Currency Translation Risk Commitments and Guarantees
denominated in a foreign currency
161
Managing Risks and Returns
Risk Management Operational Risk
Business Interruptions Transaction Processing Inadequate Information Systems Breaches in Internal Controls Client Liability
Legal Risk Reputation Risk
162
Managing Risks and Returns
Risk Management Capital or Solvency Risk
Risk of becoming insolvent Liabilities > Assets
Off-Balance Sheet Risk Tier 1 Capital
Common Equity + Non-cumulative Preferred Stock
Risk-Weighted Assets
163
Evaluating Bank Performance: An Application Profitability Analysis for PNC in 2007
164
165
166
167
168
169
Maximizing the Market Value of Bank Equity Effective Management of:
Assets Liabilities Off-Balance Sheet Activities Interest Rate Margin Credit risk Liquidity Non-Interest Expense Taxes
170
Maximizing the Market Value of Bank Equity CAMELS Ratings
Capital Adequacy Asset Quality Management Quality Earnings Liquidity Sensitivity to Market Risk
171
Maximizing the Market Value of Bank Equity CAMELS Ratings
Ratings from 1 (best) to 5 (worst) 1 & 2
Sound banks 3
Some underlying problems 4 & 5
Problem banks
172
173
Maximizing the Market Value of Bank Equity Performance Characteristics of Banks
by Size Large Banks versus Small Banks
Higher ROE Lower NIM Higher Charge-offs Lower Capital
174
175
Financial Statement Manipulation
Off-Balance Sheet Activities Window Dressing Preferred Stock Non-Performing Loans Allowance for Loan Losses Securities Gains and Losses Non-Recurring Extraordinary Items
Analyzing Bank Performance
176