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1.The term savings association has replaced S&L to capture the change in the structure of the industry. In 1978, The Federal Home Loan Bank Board (FHLBB), at the time the main regulator of savings associations, began chartering federal savings banks insured by the Federal Savings and Loan Insurance Corporation (FSLIC). In 1982, the FHLBB allowed S&Ls to convert to federal savings banks, the title associated with this sector of the thrift industry was revised to reflect this change.
2. In the 1970s, these Regulation Q ceilings were usually set at rates of 5 ¼ or 5 ½ percent.
Net Interest Margin
Interest income minus interest expense divided by earning assets.
Disintermediation
Withdrawal of deposits from depository institutions to be reinvested elsewhere, e.g., money market mutual funds.
Regulation Q ceiling
An interest ceiling imposed on small savings and time deposits at banks and thrifts until 1986.
Regulator forbearance
A policy not to close economically insolvent FIs, allowing them to continue in operation.
Savings institutions
Savings associations and savings banks combined.
3. At the time of its dissolution in 1995, the RTC had resolved or closed more than 700 savings associations and savings banks at an estimated cost of $200 billion to U.S. taxpayers.
QTL test
Qualified thrift lender test that sets a floor on the mortgage related assets that thrifts can hold (currently, 65 percent).
4. The major enterprises are GNMA, FNMA, and FHLMC.
5. Failure to meet the 65 percent QTL test results in the loss of certain tax advantages and the ability to obtain Federal Home Loan Bank advances (loans).
6. The Federal Home Loan Bank System, established in 1932, consists of 12 regional Federal Home Loan Banks (set up to the Federal Reserve Bank system) that borrow funds in the national capital markets and use these funds to make loans to savings associations that are members of the Federal Home Loan Bank. The Federal Home Loan Banks are supervised by the Federal Home Loan Bank Board.
The Office of Thrift Supervision. Established in 1989 under the FIRREA, this office charters and examines all federal savings institutions. It also supervises the holding companies of savings institutions.
The FDIC. The FDIC oversees and managers the Savings Association Insurance Fund (SAIF), which was established in 1989 under the FIRREA in the weak of FSLIC insolvency. The SAIF provides insurance coverage for savings associations. Savings banks are insured under the FDIC’s Bank Insurance Fund (BIF) and are thus also subject to supervision and examination by the FDIC.
Other Regulators. State chartered savings institutions are regulated by state agencies—for example, the Office of Banks and Real Estate in Illinois—rather than the OTS.
7. The sharp drop in ROA and ROE in 1996 was the result of a $3.5 billion special assessment on SAIF deposits. Without these one-time charges, ROA would have been 0.89 percent rather than the – 0.02 percent in Figure 12-5, while ROE would have been 10.36 percent rather than – 0.26 percent.
8. Behind Travelers Group/Citicorp ($74 billion), and BaneOne/First Chicago NBD ($30 billion).
9. Ownership in corporate credit unions is represented by the deposit accounts of their member credit unions, with each member having equal voting rights.
10. AWANE is a trade association of companies that serve the automotive aftermarket through sales of auto parts and other items. It is the association member companies and firms related to the automotive business, as well as their owners and employees, that AWANE Credit Union serves through its common bond.
Tuesday, March 31, 2009
Thursday, March 12, 2009
Information / monitoring costs . although global expansion allow FI potential to better diversify its geography risk the absolute level of exposure in certain areas such as lending can be high, especially if the FI fail to diversify in an optimal fashion. Portfolio frontier ( see chapter21 ) . foreign activities may also be riskier for the simple reason that monitoring and information collection costs are often higher in foreign markets . for example, Japanese and German accounting standards differ significantly from the generally accepted accounting principles ( GAAP ) that U.S. firms use. In addition, language, legal, and cultural issues can impose additional transaction costs on international activities. Finally, because the regulatory environment is controlled locally and regulation imposes a different array of net cost in each market, a truly global FI must master the various rules and regulation in each market.
Nationalization / expropriation . to the extent that an FI expands by establishing a local presence through investing in fixed assets such as branches or subsidiaries, it faces the political risk that a change in government may lead to the nationalization of those fixed assets .31 if foreign FI in U.S. courts rather than from the nationalizing government. For example, the resolution of the outstanding claims of depository in City corp’s branches in Vietnam following the communist takeover and expropriation of those branches took many years .
Fixed costs . the fixed costs of establishing foreign organization may be extremely high . for example, a U.S.FI seeking an organizational presence in the London banking market faces real estate prices significantly higher than in New York. Such relative cost can be even higher if and F1 choose to enter by buying and existing U.K bank
30.one reason that Sumitomo bank took a limited partnership stake in Goldman Sachs in 1986 was to acquire knowledge and expertise about the management and valuation of complex financial instruments.
31. such nationalizations have occurred with some frequency in African countries
Rather than establishing a new operation because of the cost of acquiring U.K equities (i.e. paying an acquisition premium).these relative cost considerations become even more important if expected volume of business to be generated , and thus the revenue flows, from foreign entry are uncertain. The failure of U.S acquisition of U.K merchant banks to realize expected profits following in the 1986 deregulations in the United Kingdom is a good example of unrealized revenue expectations vis-à-vis the high fixed costs of entry and the cost of maintaining a competitive position.32
Global Banking Performance
While U.S depository institution performance deteriorated only slightly in the early 2000s, not all countries faired as well. In April 2001 the Japanese government announced plans for a government backed purchase of Y 11000 billion ($90 billion) of shares of Japanese banks as part of an increasingly desperate drive to avert a banking collapse, recover from a16 year low in the levels of Japanese equity markets, and stem the country’s real sector decline into recession .this was the third major attempt to bail out the banking system since 1998. previous attempts at bailing out the banking industry were unsuccessful. For example , in march 2001 Fitch investors service ( a major international rating agency ) put 19 of the biggest Japanese banks on their credit watch list. The purchase of bank shares was intended to offset losses from the writing off of the situation has been better in Europe .despite the slowdown in the U.S economy, European banks continued to perform well, even those banks without a significant presence in the United states J.P Morgan securities estimated than in the early 200s more than half of European banks loans outside western Europe were to North America . banks with the largest exposure included those with a retail presence ( Mortgages small business loans )such as ABN AMRO, deutsche bank and HSBC. In most cases, however, these exposure were less than 20 percent of their loan portfolios. There is some concern that economic slow down in the United state will spread to Europe in the 2000s, affecting the performance of all European banks. Indeed in mid 2001, economic growth rates in European Union countries started to fall.
32. however U.S banks and securities firms fared better since the Canadian deregulation of securities business in 1987 (see “Canada’s borrowing its Fat Fees Lures Wall Street” The New York Times , April 15, 1995, p. D1)
Summary
This chapter provided an overview of the major activities of commercial banks and recent trends in the banking industry. Commercial banks rely heavily on deposits to fund their activities, although borrowed funds are becoming increasingly important for the largest institutions. Historically, commercial banks have concentrated on commercial or business lending and on investing in securities. Differences between the asset and liability portfolio of commercial banks and other financial institutions, however , are being eroded due to competitive forces, consolidation, regulation, and changing financial and business technology. Indeed, in the early 2000s , the largest group of assets in commercial bank portfolios were mortgage related. The chapter examined the relatively large decline in the number of commercial banks in the last decade and reviewed reasons for the recent wave of bank mergers. Finally, the chapter provided an overview of this industry’s performance over the last decade and discussed several global issues in commercial banking.
Nationalization / expropriation . to the extent that an FI expands by establishing a local presence through investing in fixed assets such as branches or subsidiaries, it faces the political risk that a change in government may lead to the nationalization of those fixed assets .31 if foreign FI in U.S. courts rather than from the nationalizing government. For example, the resolution of the outstanding claims of depository in City corp’s branches in Vietnam following the communist takeover and expropriation of those branches took many years .
Fixed costs . the fixed costs of establishing foreign organization may be extremely high . for example, a U.S.FI seeking an organizational presence in the London banking market faces real estate prices significantly higher than in New York. Such relative cost can be even higher if and F1 choose to enter by buying and existing U.K bank
30.one reason that Sumitomo bank took a limited partnership stake in Goldman Sachs in 1986 was to acquire knowledge and expertise about the management and valuation of complex financial instruments.
31. such nationalizations have occurred with some frequency in African countries
Rather than establishing a new operation because of the cost of acquiring U.K equities (i.e. paying an acquisition premium).these relative cost considerations become even more important if expected volume of business to be generated , and thus the revenue flows, from foreign entry are uncertain. The failure of U.S acquisition of U.K merchant banks to realize expected profits following in the 1986 deregulations in the United Kingdom is a good example of unrealized revenue expectations vis-à-vis the high fixed costs of entry and the cost of maintaining a competitive position.32
Global Banking Performance
While U.S depository institution performance deteriorated only slightly in the early 2000s, not all countries faired as well. In April 2001 the Japanese government announced plans for a government backed purchase of Y 11000 billion ($90 billion) of shares of Japanese banks as part of an increasingly desperate drive to avert a banking collapse, recover from a16 year low in the levels of Japanese equity markets, and stem the country’s real sector decline into recession .this was the third major attempt to bail out the banking system since 1998. previous attempts at bailing out the banking industry were unsuccessful. For example , in march 2001 Fitch investors service ( a major international rating agency ) put 19 of the biggest Japanese banks on their credit watch list. The purchase of bank shares was intended to offset losses from the writing off of the situation has been better in Europe .despite the slowdown in the U.S economy, European banks continued to perform well, even those banks without a significant presence in the United states J.P Morgan securities estimated than in the early 200s more than half of European banks loans outside western Europe were to North America . banks with the largest exposure included those with a retail presence ( Mortgages small business loans )such as ABN AMRO, deutsche bank and HSBC. In most cases, however, these exposure were less than 20 percent of their loan portfolios. There is some concern that economic slow down in the United state will spread to Europe in the 2000s, affecting the performance of all European banks. Indeed in mid 2001, economic growth rates in European Union countries started to fall.
32. however U.S banks and securities firms fared better since the Canadian deregulation of securities business in 1987 (see “Canada’s borrowing its Fat Fees Lures Wall Street” The New York Times , April 15, 1995, p. D1)
Summary
This chapter provided an overview of the major activities of commercial banks and recent trends in the banking industry. Commercial banks rely heavily on deposits to fund their activities, although borrowed funds are becoming increasingly important for the largest institutions. Historically, commercial banks have concentrated on commercial or business lending and on investing in securities. Differences between the asset and liability portfolio of commercial banks and other financial institutions, however , are being eroded due to competitive forces, consolidation, regulation, and changing financial and business technology. Indeed, in the early 2000s , the largest group of assets in commercial bank portfolios were mortgage related. The chapter examined the relatively large decline in the number of commercial banks in the last decade and reviewed reasons for the recent wave of bank mergers. Finally, the chapter provided an overview of this industry’s performance over the last decade and discussed several global issues in commercial banking.
27.this bank began formal consolidated operations in 2002
28. A.N Berger, Q. Dai , S. Ongena , and D.C Smith, in “To what Extent will the banking industry be Globalized ? A study of bank nationally and reach European Nations. They find that foreign affiliates of multinational companies choose host nation banks for cash management services more often than home-nation or third-nation banks. They also find if a host nation is the choice of nationality, then the firm is much less likely to choose a global bank.
29. this, of course, assumes that stockholders are sufficiently undiversified to value FI s diversifying on their behalf.
28. A.N Berger, Q. Dai , S. Ongena , and D.C Smith, in “To what Extent will the banking industry be Globalized ? A study of bank nationally and reach European Nations. They find that foreign affiliates of multinational companies choose host nation banks for cash management services more often than home-nation or third-nation banks. They also find if a host nation is the choice of nationality, then the firm is much less likely to choose a global bank.
29. this, of course, assumes that stockholders are sufficiently undiversified to value FI s diversifying on their behalf.
20.in the case of bank supplied credit cards, the merchant normally is compensated very quickly but not in stantaneously (usually one or two days) by the credit card issuer. the bank then holds an account receivable against the card user. However , even short delay can represent an opportunity cost for the merchant.
21.for example, the U.S postal service estimates that $2.4 billion was spent on postage foe bills and bank statements in 1995 and that electronic billing will save $900 million of that within 10 years. See “ paying Bills without Any Litter “, “New York Times, July 5, 1996, pp D1-D3
22.in October 1998, city group announced a new internet service covering all areas of retail financial services. This will require it to scrap its existing computer system and build a whole new infrastructure. The new service will be know as E-city (see New York Times, October 5, 1998, pp C1-C4)
23.K.Furst, W.W Lang and D. E. Nolle find that , as of the third quarter of 1999, while only 20 percent of U.S national banks offered internet banking, these transactions accounted for almost 90 percent of the national banking system’s assets and 84 percent of the total number of small deposit accounts. See “internet Banking : developments and prospects” office of the comptroller of the currency, economic and policy analysis working paper 2000-9, September 2000
24. See R.J Sullivan, “How has the adoption of internet banking affected performance and risk in banks?” financial industry perspective, federal reserve bank of Kansas city, December 2000, pp 1-16
21.for example, the U.S postal service estimates that $2.4 billion was spent on postage foe bills and bank statements in 1995 and that electronic billing will save $900 million of that within 10 years. See “ paying Bills without Any Litter “, “New York Times, July 5, 1996, pp D1-D3
22.in October 1998, city group announced a new internet service covering all areas of retail financial services. This will require it to scrap its existing computer system and build a whole new infrastructure. The new service will be know as E-city (see New York Times, October 5, 1998, pp C1-C4)
23.K.Furst, W.W Lang and D. E. Nolle find that , as of the third quarter of 1999, while only 20 percent of U.S national banks offered internet banking, these transactions accounted for almost 90 percent of the national banking system’s assets and 84 percent of the total number of small deposit accounts. See “internet Banking : developments and prospects” office of the comptroller of the currency, economic and policy analysis working paper 2000-9, September 2000
24. See R.J Sullivan, “How has the adoption of internet banking affected performance and risk in banks?” financial industry perspective, federal reserve bank of Kansas city, December 2000, pp 1-16
Wednesday, March 4, 2009
Lanjutan Thrift Institution
In 1997, the banking Industry field two lawsuits in its push to restrict the growing competitive threat from credit unions. The first lawsuit (filed by four North Carolina banks and the American Bankers Association) challenged an occupation-based credit union’s (the AT&T Family Credit Union based in North Carolina) ability to accept members from companies unrelated to the firm that originally sponsored the credit union. In the second lawsuit, the American Bankers Association asked the courts to bar the federal government from allowing occupation-based credit unions to convert to community-based charters. Bankers argued in both lawsuits that such actions, broadening the membership base of credit unions, would further exploit an unfair advantage allowed through the credit union tax-exempt status. In February 1998, the Supreme Court sided with the banks in its decision that credit union could no longer accept members that were not a part of the “common bond” of membership. In April 1998, however, the U.S. House of Representatives overwhelmingly passed a bill that allowed all existing members to keep their credit union accounts. The bill was passed by the Senate in July 1998 and signed in to law by the president in August 1998. This legislation not only allowed CUs to keep their existing members but allowed CUs to accept new groups of members—including small businesses and low-income communities—that were not considered part of the “common bond” of membership by the Supreme Court ruling.
Balance Sheet and Recent Trends
As of 2001, 9,984 credit unions had assets of $505.5 billion. This compares to $192.8 billion in assets in 1988, or an increase of 162 percent over the period 1988-2001. Individually, credit unions tend to be very small, with an average asset size 0f $50.6 million in 2001 compared to $813.0 million for banks. The total assets of all credit unions are smaller than the largest U.S. banking organization(s). For example, Citigroup had $1,111.7 billion in total assets, J.P. Morgan Chase had $712.5 billion in total assets, and Bank of America had $619.9 billion in total assets. This compares to total credit union assets of $505.5 billion in 2001.
8 Table 12-6 shows the breakdown of financial assets and liabilities for credit unions as of year-end 2001. Given their emphasis on retail or consumer lending, discussed above, 36.8 percent of CU assets are in the form of small consumer loans (compared to 6.20 percent at savings associations, 3.38 percent at savings banks, and 14.96 percent at commercial banks) and another 28.5 percent are in the form of home mortgages (compared to 73.42 percent at savings associations, 73.72 percent at savings banks, and 35.44 percent at commercial banks). Together these member loans compose 65.3 percent of total assets. Figure 12-8 provides more detail on the composition of the loan portfolio for all CUs. Because of the common bond requirement on credit union customers, few business or commercial loans are issued by CUs.
Credit Unions also invest heavily in investment securities (23.5 percent of total assets in 2001 compared to 7.5 percent at savings associations, 11.5 percent at savings banks, and 27.4 percent at commercial banks). Figure 12-9 shows that 55.2 percent of the investment portfolio of CUs is in U.S. government Treasury securities or federal agency securities, while investments in order FIs (such as deposits of banks) totaled 33.8 percent of their investment portfolios. Their investment portfolio composition, along with cash holdings (3.9 percent of total assets), allow credit unions ample liquidity to meet their daily cash needs—such as share (deposit) withdrawals. Some CUs have also increased their off-balance sheet activities. Specially, unused loan commitments, including credit card limits and home equity lines of credit, totaled over $83 billion in 2001.
Credit union funding comes mainly from member deposits (almost 90 percent of total funding in 2001 compared to 60.7 for saving associations, 63.0 percent for savings banks, and 66.8 for commercial banks). Figure 12-10 presents the distribution of these deposits in 2001. Regular share draft transaction accounts (similar to NOW accounts at other depository institutions—see Chapters 11 and 13) accounted for 34.2 percent of all CU deposits, followed by certificates of deposits (27.0 percent of deposits), money market deposit accounts (15.9 percent of deposits), and share accounts (similar to passbook savings accounts at other depository institutions but so named to designated the deposit holders’ ownership status) (12.4 percent of deposits). Credit unions tend to hold higher levels of equity than other depository institutions. Since CUs are not stockholder owned, this equity is basically the accumulation of past earnings from CU activities that is “owned” collectively by member depositors. As will be discussed in Chapters 20 and 23, this equity protects a CU against losses on its loan portfolio as well as other financial and operating risks. In December 2001, CUs’ capital-to assets ratio was 9.22 percent compared to 8.21 percent for savings associations, 8.96 percent for savings banks, and 9.09 percent for commercial banks.
5Regulators
Like savings banks and saving associations, credit unions can be federally or state chartered. As of 2001, 61.3 percent of the 9,984 CUs were federally chartered and subject to National Credit Union Administration (NCUA) regulation (see Table 12-1), accounting for 55.2 percent of the total membership and 53.8 percent of total assets. In addition, through its insurance fund (the National Credit Union Share Insurance Fund, or NCUSIF), the NCUA provides deposit insurance guarantees of up to $100,000 for insured credit unions. Currently, the NCUSIF covers 98 percent of all credit union deposits.
Industry Performance
Like other depository institutions, the credit union industry has grown in asset size in the 1990s and early 2000s. Total assets grew from $281.7 billion in 1993 to $505.5 billion in 2001 (79.4 percent). In addition, CU membership increased from 63.6 million to over 79.4 million over the 1993-2001 period (24.8 percent). Assets growth was especially pronounced among the largest CUs (the 1,677 CUs with assets of over $50 million) as their assets increased by 17.4 percent in 2001. In contrast, the 2,957 credit unions with assets between $10 million and $20 million grew by only 4.1 percent and the 5,350 smaller credit unions decreased in asset size by 4.2 percent. Figure 12-11 shows the trend in ROA for CUs from 1993 through 2001. The industry experienced an ROA of 0.96 percent in 2001 compared to 1.08 percent for savings institutions and 1.13 percent for commercial banks. The decreased in ROA over the period is mostly attributed to earnings decreases at the smaller CUs. For example, the largest credit unions experienced an ROA of 1.03 percent in 2001, while ROA for the smallest credit unions was 0.34 percent. Smaller CUs generally have a smaller and less diversified customer base and have higher overhead expenses per dollar of assets. Thus, their ROAs have been hurt.
Given the mutual-ownership status of this industry, however, growth in ROA (or profits) is not necessarily the primary goal of CUs. Rather, as long as capital or equity levels are sufficient to protect a CU against unexpected losses on its credit portfolio as well as other financial and operational risks, this not-for-profit industry has a primary goal of serving the deposit and lending needs of its members. This contracts with the emphasis placed on profitability by stockholder-owned commercial banks and savings institutions
Summary
This chapter provided an overview of the major activities of savings associations, savings banks, and credit unions. Each of these institutions relies heavily on deposits to fund loans, although borrowed funds are becoming increasingly important for the largest of these institutions. Historically, while commercial banks have concentrated on commercial or business lending and on investing in securities, savings institutions have concentrated on mortgage lending and credit unions on consumer lending. These differences are being eroded due to competitive forces, regulation, and the changing nature of financial and business technology, so that the types of interest rate, credit, liquidity, and operational risks faced by commercial banks, savings institutions, and credit unions are becoming increasingly similar.
In 1997, the banking Industry field two lawsuits in its push to restrict the growing competitive threat from credit unions. The first lawsuit (filed by four North Carolina banks and the American Bankers Association) challenged an occupation-based credit union’s (the AT&T Family Credit Union based in North Carolina) ability to accept members from companies unrelated to the firm that originally sponsored the credit union. In the second lawsuit, the American Bankers Association asked the courts to bar the federal government from allowing occupation-based credit unions to convert to community-based charters. Bankers argued in both lawsuits that such actions, broadening the membership base of credit unions, would further exploit an unfair advantage allowed through the credit union tax-exempt status. In February 1998, the Supreme Court sided with the banks in its decision that credit union could no longer accept members that were not a part of the “common bond” of membership. In April 1998, however, the U.S. House of Representatives overwhelmingly passed a bill that allowed all existing members to keep their credit union accounts. The bill was passed by the Senate in July 1998 and signed in to law by the president in August 1998. This legislation not only allowed CUs to keep their existing members but allowed CUs to accept new groups of members—including small businesses and low-income communities—that were not considered part of the “common bond” of membership by the Supreme Court ruling.
Balance Sheet and Recent Trends
As of 2001, 9,984 credit unions had assets of $505.5 billion. This compares to $192.8 billion in assets in 1988, or an increase of 162 percent over the period 1988-2001. Individually, credit unions tend to be very small, with an average asset size 0f $50.6 million in 2001 compared to $813.0 million for banks. The total assets of all credit unions are smaller than the largest U.S. banking organization(s). For example, Citigroup had $1,111.7 billion in total assets, J.P. Morgan Chase had $712.5 billion in total assets, and Bank of America had $619.9 billion in total assets. This compares to total credit union assets of $505.5 billion in 2001.
8 Table 12-6 shows the breakdown of financial assets and liabilities for credit unions as of year-end 2001. Given their emphasis on retail or consumer lending, discussed above, 36.8 percent of CU assets are in the form of small consumer loans (compared to 6.20 percent at savings associations, 3.38 percent at savings banks, and 14.96 percent at commercial banks) and another 28.5 percent are in the form of home mortgages (compared to 73.42 percent at savings associations, 73.72 percent at savings banks, and 35.44 percent at commercial banks). Together these member loans compose 65.3 percent of total assets. Figure 12-8 provides more detail on the composition of the loan portfolio for all CUs. Because of the common bond requirement on credit union customers, few business or commercial loans are issued by CUs.
Credit Unions also invest heavily in investment securities (23.5 percent of total assets in 2001 compared to 7.5 percent at savings associations, 11.5 percent at savings banks, and 27.4 percent at commercial banks). Figure 12-9 shows that 55.2 percent of the investment portfolio of CUs is in U.S. government Treasury securities or federal agency securities, while investments in order FIs (such as deposits of banks) totaled 33.8 percent of their investment portfolios. Their investment portfolio composition, along with cash holdings (3.9 percent of total assets), allow credit unions ample liquidity to meet their daily cash needs—such as share (deposit) withdrawals. Some CUs have also increased their off-balance sheet activities. Specially, unused loan commitments, including credit card limits and home equity lines of credit, totaled over $83 billion in 2001.
Credit union funding comes mainly from member deposits (almost 90 percent of total funding in 2001 compared to 60.7 for saving associations, 63.0 percent for savings banks, and 66.8 for commercial banks). Figure 12-10 presents the distribution of these deposits in 2001. Regular share draft transaction accounts (similar to NOW accounts at other depository institutions—see Chapters 11 and 13) accounted for 34.2 percent of all CU deposits, followed by certificates of deposits (27.0 percent of deposits), money market deposit accounts (15.9 percent of deposits), and share accounts (similar to passbook savings accounts at other depository institutions but so named to designated the deposit holders’ ownership status) (12.4 percent of deposits). Credit unions tend to hold higher levels of equity than other depository institutions. Since CUs are not stockholder owned, this equity is basically the accumulation of past earnings from CU activities that is “owned” collectively by member depositors. As will be discussed in Chapters 20 and 23, this equity protects a CU against losses on its loan portfolio as well as other financial and operating risks. In December 2001, CUs’ capital-to assets ratio was 9.22 percent compared to 8.21 percent for savings associations, 8.96 percent for savings banks, and 9.09 percent for commercial banks.
5Regulators
Like savings banks and saving associations, credit unions can be federally or state chartered. As of 2001, 61.3 percent of the 9,984 CUs were federally chartered and subject to National Credit Union Administration (NCUA) regulation (see Table 12-1), accounting for 55.2 percent of the total membership and 53.8 percent of total assets. In addition, through its insurance fund (the National Credit Union Share Insurance Fund, or NCUSIF), the NCUA provides deposit insurance guarantees of up to $100,000 for insured credit unions. Currently, the NCUSIF covers 98 percent of all credit union deposits.
Industry Performance
Like other depository institutions, the credit union industry has grown in asset size in the 1990s and early 2000s. Total assets grew from $281.7 billion in 1993 to $505.5 billion in 2001 (79.4 percent). In addition, CU membership increased from 63.6 million to over 79.4 million over the 1993-2001 period (24.8 percent). Assets growth was especially pronounced among the largest CUs (the 1,677 CUs with assets of over $50 million) as their assets increased by 17.4 percent in 2001. In contrast, the 2,957 credit unions with assets between $10 million and $20 million grew by only 4.1 percent and the 5,350 smaller credit unions decreased in asset size by 4.2 percent. Figure 12-11 shows the trend in ROA for CUs from 1993 through 2001. The industry experienced an ROA of 0.96 percent in 2001 compared to 1.08 percent for savings institutions and 1.13 percent for commercial banks. The decreased in ROA over the period is mostly attributed to earnings decreases at the smaller CUs. For example, the largest credit unions experienced an ROA of 1.03 percent in 2001, while ROA for the smallest credit unions was 0.34 percent. Smaller CUs generally have a smaller and less diversified customer base and have higher overhead expenses per dollar of assets. Thus, their ROAs have been hurt.
Given the mutual-ownership status of this industry, however, growth in ROA (or profits) is not necessarily the primary goal of CUs. Rather, as long as capital or equity levels are sufficient to protect a CU against unexpected losses on its credit portfolio as well as other financial and operational risks, this not-for-profit industry has a primary goal of serving the deposit and lending needs of its members. This contracts with the emphasis placed on profitability by stockholder-owned commercial banks and savings institutions
Summary
This chapter provided an overview of the major activities of savings associations, savings banks, and credit unions. Each of these institutions relies heavily on deposits to fund loans, although borrowed funds are becoming increasingly important for the largest of these institutions. Historically, while commercial banks have concentrated on commercial or business lending and on investing in securities, savings institutions have concentrated on mortgage lending and credit unions on consumer lending. These differences are being eroded due to competitive forces, regulation, and the changing nature of financial and business technology, so that the types of interest rate, credit, liquidity, and operational risks faced by commercial banks, savings institutions, and credit unions are becoming increasingly similar.
Friday, February 27, 2009
tugas afnita
do you understand?
1. what major assets commercial banks old?
2. what the major sources of funding for commercial banks are?
3. what OBS assets and liabilities are?
4. what other types of fee-generating activities banks participate in?
departments by less financially sophisticated investors. “pension fund assets are the second largest group of assets managed by the trust departments of commercial banks. The banks manage the pension funds, act as trustees for any bonds held by the pension funds, and act as transfer and disbursement agent for the pension funds.
Correspondent Banking.
Correspondent Banking is the provision of banking services to oher banks that do not have the staff resources to perform the services themselves. These services include check clearing and collection, foreign exchange trading, hedging services, and participation in large loan and security issuances. Correspondent Banking services are generally sold as package of services. Payment for the services is generally in the form of non interest bearing deposits held at the bank offering the correspondent services.
SIZE, STRUCTURE, AND COMPOSITION OF THE INDUSTRY
As of December 2001, the United States had 8080 commercial banks. Even though this may seem to be a large number, in fact the number of banks has been decreasing. For example, in 1984, the number of banks was 14483; in 1989 It was 12744. Figure 11-6 illustrates the number of bank mergers, bank failures and new charters for the period 1980 through December 2001. Notice that much of the change in the size, structure and composition of this industry is the result of mergers and acquisitions. It was not until the 1980s and 1990s that the regulators ( such as the Federal Reserve or state banking authorities) allowed banks to merge with other bank across state lines (interstate mergers) and it has only been since 1994 that Congress has passed legislation ( the REIGLE-Neal Act) easing branching by bank across state line. Finally, it has only been since 1987 that banks have possessed powers to underwrite corporate securities. (Full authority to enter the investment banking (and insurance) business was only received with the passage of the Financial Services Modernizations Act in 1999.Table 11-4 list some of the largest bank mergers in recent years.
MEGAMERGER = the merger of banks with assets of $ 1 billion or more
ECONOMIES OF SCALE = the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase for example, cost reduction in trading and other transaction services resulting from increased efficiency when these services are performed by Fls.
ECONOMIES OF SCOPE = the degree to which a firm can generate cost synergies by producing multiple financial service products.
Economies of Scale and Scope
An important reason for the consolidation of the banking industry is the search by banks to exploit potential cost and revenue economies scale and scope. Indeed, MEGAMERGERS ( mergers involving banks with assets of $1 billion or more) are often driven by the desire pf managers to achieve greater cost and revenue economies or savings. Cost economies may result from ECONOMIES OF SCALE ( where the unit or average cost of producing the bank’s services fall as the size of the bank expands), ECONOMIES OF SCOPE (where banks generate synergistic cost savings through joint use of inputs such as computer systems in producing multiple products), or managerial efficiency sources (often called X EFFICIENCIES because they are difficult to specify in a quantitative fashion). X EFFICIENCY are those cost savings not directly due to economies of scope or economies of scale. As such, they are usually attributed to superior management skills and other difficult-to-measure managerial factors. To date, the explicit identification of what composes these efficiencies remains to be established in the empirical banking literature.
ECONOMIES OF SCALE
As financial firms become larger, the potential scale and array of the technology in which they can invest generally expand. The larger FIs generally have the largest expenditures on technology-related innovations. For example, the Tower Group ( a consulting firm specializing in information technology) estimated that technology expense as a percent of non interest expense would be as high as 22 percent at the largest U.S. banks in the three-year period 1999-2001. As discuss below, internet banking is sure to be one of the major shaping the bank industry in the 21st century. The internet offers financial institutions a channel to customers that enables them to react quickly to customer needs, bring products to the market quickly, and respon more effectively to changing business conditions. However, this capability will come at a cost o financial institutions as they invest in the necessary technology.
If enhanced or improved technology lowers an FI’s average cost of financial service production, larger FIs may have an economy of scale advantage over smaller financial firms. Economies of scale imply that the unit or average cost of producing FI services in aggregate ( or some specific activity such as deposits or loans ) falls as the size of the FI expands.
Figure 11-7 depicts economies of scale for three FIs of different sizes. The average cost of producing an FIs output of financial serives is measured as
ACi = TCi / Si
Where
ACi = Average costs of the ith bank
TCi = Total costs of the ith bank
Si = Size of the bank measured by assets, deposits, or loans
The effect of improving operations or technology over time is to shift the AC curve downward ; see figure 11-8. AC1 is the hypothetical AC curve prior to cost –reducing innovations. AC2 reflects the cost-lowering effects of technology and consolidation on FIs.
The average cost to the largest FI ain figure 11-7 (size c) to produce financial services is lower than the cost to smaller firms B and A. This means that any given price for financial service firm products, firm C can make a higher profit than either B or A. Alternatively, firm C can undercut B and A in price and potentially gain a larger market share. For example, First Union Corporation’s $3.2 billion acquisition of Signet Banking Corporation was billed as a cost-saving acquisition. Because of overlapping operations in similar products area with Signet, First Union said it expected annual cost savings of approximately $240 million. In the framework of figure 11-7, Signet, firm A, might be operating at ACª and First Union might be represented as firm B operating at ACb. First Union and Signet had significant bank-office operations in Virginia that could be combined and consolidated. The consolidation of such overlapping activities would lower the average costs for the combined (larger) bank to point C in figure 11-7, operating at AC c. Similarly, the 2000 merger of J.P Morgan and Chase Manhattan to from J.P Morgan Chase was estimated to produce cost savings of $1.5 billion
The long-run implication of economies of scale on the banking sector is that the largest and most cost-efficient banks will drive out smaller financial institutions, leading to increased large-firm dominance and concentration in financial services production. Such an implication is reinforced if time-related operating or technological improvements increasingly benefit larger banks more than smaller banks. For example satellite technology and supercomputers, in which enormous technological advances are being made, may be available o the largest banks only. The effect of improving technology over time, which is biased toward larger projects, is to shift the AC curve downward over time but with a larger downward shift for larger banks. (see figure 11-8)
Technology investment are risky, however. If their future revenues do not cover their costs of development, they reduce the value of the bank and its net worth to the bank’s owner. On the cost side, large-scale investments may result in excess capacity problems and integration problems as well as cost overruns and cost control problems. Then, small banks with simple and easily managed computer systems, and those leasting time on large banks’ computer without bearing the fixed costs of installation and maintenance, may have an average cost advantage. In this case, technological investments of large-size banks result in higher average costs of financial service production, causing the industry to operate under conditions of diseconomies of scale.
DISECONOMIES OF SCALE is the costs of joint production of FI services are higher then they would be if they where produced independently.
Wells Fargo & Co.’s purchase of First Interstate Bancorp (in April 1996) is an example of potential diseconomies of scale due to the inability to integrate technologies of the two banks and a failure of a back-office system. Wells Fargo wanted to make the merger process easy for First Interstate costumers by allowing them to use up their old checks and deposit forms. Unfortunately, due to the merger, customer account numbers had been changed and Wells Fargo’s computer system had trouble keeping up with the integrated check-clearing system. Some deposits were not posted to the proper account and there was a deluge of improperly bounced checks. Further, Wells Fargo’s back-office operations were thinly staffed and unable to find where all misplaced deposits had gone. More than a year after the purchase, Wells Fargo was still having organization and systems problem integrating First Interstate. Promising to reimburse all customers for its accounting mistakes, Well Fargo eventually corrected the problem, incurring and operating loss of some $ 180 million.
COST ECONOMIES OF SCOPE. FIs are multi product firms producing services involving different technological and personnel needs. Investments in one financial service area (such as lending) may have incidental and synergistic benefits in lowering the costs to produce financial services in other areas (such as securities underwriting or brokerage). In 1999, regulators passed the Financial Services Modernization Act, which repealed laws that prohibited mergers between commercial banks and investment banks (as well as insurance companies). The bill, touted as the biggest change in the regulation of financial institutions in over 60 years, created a “ financial services holding company “ that can engage in banking activities and securities and insurance underwriting.
The result of this regulation and the rulings leading up to it was a number of mergers and acquisitions between commercial and investments banks an 1997 through 2001. Some of the largest mergers include UBS’s $12.o billion purchase of Paine Webber in 2000, Credit Suisse First Boston’s 2000 purchase of Donaldson Lufkin Jenrette for $11.5 billion in 2000, Citicorp’s $83 billion merger with Travelers Group in April 1998 (partially divested in 2002), Bankers Trust’s April 1997 acquisition of Alex Brown for $1.7 billion, and Bank of America’s June 1997 purchase of Robertson Stephens for $540 million (resold to Bank of Boston for $800 million in April 1998).¹¹ In each case the banks stated that one motivations for the acquisitions was the desire to establish a presence in the securities business as laws separating investment banking and commercial banking were changing. Also noted as a motivation in these acquisitions was the opportunity to expand business lines, taking advantage of economies scale and scope to reduce overall costs and merge the customer bases of the respective commercial and investment banks involved the acquisitions.
Similarly, computerization allows the storage of important information on customers and their needs that can be used by more than one service area. FIs’ abilities to generate synergistic cost savings through joint use of inputs in producing multiple products is called economies of scope, as opposed to economies of scale (see above).
Geographic diversification to achieve potential economies of scope was also a major factor in late 1998 when Deutsche Bank (of Germany) announced the acquisition of Bankers Trust to create the world’s largest financial services company as measured by assets ( the combined bank would have over $843 billion in total assets). Together, the two banks became one of the global leaders in investment banking. They also have one of the largest global trading businesses. All the time of the acquisition, it was expected to produce a gain of $1 billion through new revenue and cost savings.
REVENUES ECONOMIES OF SCOPE
In addition to economies of scope on the cost side, there are also economies of scope (or synergies) on the revenue side that can emanate from mergers and acquisitions. For example, CEO’s of both J. P. Morgan and Chase Manhattan stated that the success of their merger to form J. P. Morgan and Chase was dependent on revenue growth. The merger combine J. P. Morgan’s greater array of financial products with Chase’s broader client base. The merger added substantially to many businesses (such as equity underwriting, equity derivatives, and asset management) that Chase had been trying to build on its own through smaller deals and also gave it a bigger presence in Europe where investment and corporate banking are fast growing businesses.
Revenue synergies have three potential dimensions. First, acquiring an FI in a growing market may produce new revenues. Second, the acquiring bank’s revenue stream may become more stable if the asset and liability portfolio of the acquired (target) institution exhibits different product, credit, interest rate, and liquidity risk characteristics from the acquirer’s. For example, real estate loan portfolio have shown very strong regional cycles. Specifically, in the 1980’s, U.S. real estate declined in value in the Southeast, then in the Northeast, and then in California with a long and variable lag. Thus, a geographically diversified real estate portfolio may be far less risky than one in which both acquirer and target specialize in a single region. ¹² Recent studies confirm risk diversification gains from geographic diversification.¹³
Third, expanding into markets that are less than fully competitive offers an opportunity for revenue enhancement. That is, banks may be able to identify and expand geographically into those markets in which economic rents potentiallt exist but in which regulators will not view such entry as potentially anticompetitive. Indeed, to the extent that geographic expansions are viewed as enhancing an FI’s monopoly power by generating excessive rents, regulators may act to prevent a merger unless it produces potential efficiency gains that can not be reasonably achieved by other means. In recent years, the ultimate enforcement of antimonopoly laws and guidelines has fallen to the U.S. Department of Justice. In particular, the Department of Justice has established guidelines regarding the acceptability or unacceptability of acquisitions based on the potential increase in concentration in the market in which an acquisition takes place.
A large number of studies have examined economies of scale and scope in different financial service industry sectors. With respect to the banks, most of the early studies failed to find economies of scale for any but the smallest banks. More recently, better data sets and improved methodologies have suggested that economies of scale may exist for banks up to the $10 billion to $25 billion size range. Many large-regional and super-regional banks fall in this size range. With respect to economies of scope either among deposits, loans, and other traditional banking product areas or between on-balance-sheet products and off-balance-sheet products such as loans sales, the evidence that cost synergies exist is at beast quite weak.
COMMUNITY BANK = a bank that specializes in retail or consumer banking.
REIONAL OR SUPERREGIONAL BANK = A bank that engages in a complete array of wholesale commercial banking activities.
FEDERAL FUNDS MARKET = An inter bank market for short term borrowing and lending of bank reserves.
MONEY CENTER BANK = A bank that relies heavily on nondeposit or borrowed sources of funds.
BANK SIZE AND CONCENTRATION
Interestingly, a comparison of asset concentration by bank size (see Table 11-5) indicates that the recent consolidation in banking appears to have reduced the asset share of the smallest banks (under $1 billion) from 36.6 percent in 1984 to 15.9 percent in 2001. These small or community bank with less than $1 billion in asset size tend to specialize in retail or consumer banking, such as providing residential mortgages and consumer loans, and accessing the local deposit base. Clearly, this group of banks is decreasing both in number and importance.
The relative asset share of the largest banks (over $ 1 billion in size), on the other hand, increased from 63.4 percent in 1984 o 64.1 percent in 2001. The largest 10 U.S. banks as of March 2002 are listed in table 11-6. large banks engage in a more complete array of wholesale commercial banking activities, encompassing consumer and residential lending as well as commercial and industry lending (C&I loans) both regionally, super regionally and nationally. In addition, big banks have access to the markets for purchased funds, such as the inter bank or federal funds market, to finance their lending and investment activities. Some of the very biggest bank are often classified as being money center banks. Currently six banking organizations make up the money center bank group : Bank of New York, Bank One, Bankers Trust, Citigroup, J.P. Morgan Chase, and HSBC Bank USA (formerly Republic NY Corporation).
It is important to note that asset or lending size does not necessarily make a bank a money center bank. Thus, Bank of America Corporation, with $619.9 billion in assets in 2001 (he third largest U.S. bank organization), is not a money center bank, but HSBC Bank USA (with only $ 84.2 billion in assets) is a money center bank. The classification as a money center bank is partly based on its heavy reliance on non deposit or borrowed sources of funds. Specifically, a money center bank is a bank located in major financial center (e. g., New York) and heavily relies on both national and international money markets for its source of funds. In fact, because of its extensive retail branch network, Bank of America tends to be a net supplier of funds on the inter bank market (federal funds market). By contrast, money center banks such as J. P. Morgan Chase have no retail branches.
BANK SIZE AND ACTIVITIES
Bank size has a traditionally affected the types of activities and financial performance of commercial banks. Small banks generally concentrate on the retail side of the business making loans and issuing deposits o consumers and small businesses. In contrast, large banks engage in bot retail and wholesale banking and often concentrate on the wholesale side of the business. Further, small banks generally hold fewer off-balance sheet assets and liabilities than large banks. For example, while small banks issue some loans commitments and letters of credit, they rarely hold derivative securities. Large banks’ relatively easy access to purchased funds and capital markets compared to small banks’ access is a reason for many of these differences. For example, large banks with easier access to capital markets operate with lower amounts of equity capital than do small banks. Also, large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits (deposits such as demand deposits that are stable over short periods of time, see chapter 13) than do small banks. At the same time, large banks lend to large corporations. This means that their interest rate spreads (i. e., the difference between their lending rates and deposit rates) and net interest margins (i. e., interest income minus interes expense divided by earning assets) have usually been narrower than those of smaller regional banks, which are more sheltered from competition in highly localized markets and lend to smaller, less sophisticated customers.
In addition, large banks tend to pay higher salaries and invests more in buildings and premises than small banks do. They also tend to diversify their operations and services more than small banks do. Large banks generate more non interest income (i. e., fees, trading account, derivative security, and foreign trading income) than small banks. Although large banks tend to holdd less equity, they do not necessarily return more on their assets. However, as the barriers to regional competition and expansion in banking have fallen in recent years, the largest banks have generally improved their return to equity (ROE) and return on asset (ROA) performance relative to small banks (see figure 11-9). We discuss the impact of size on bank financial statements and performance in more dateil in chapter 13.
INTEREST RATE SPREAD = the differences between lending and deposit rates.
NET INTEREST MARGIN = interest income minus interes expense divided by earning assets.
INDUSTRY PERFORMACE
Table 11-7 presents selected performance ratios for the commercial banking industry for 1989 and 1993 throuh March 2002. With the economic expansion in the U.S. economy and falling interest rates throughout most of the 1990’s U.S. commercial banks flourished for most of the 1990s. In 1999 commercial bank earnings were a record $71.6 billion. More than two-third of all U.S. banks reported an ROA of 1 percent or higher, and the average ROA for all banks was 1.31 percent, up from 1.19 percent of the year 1998. This, despite continued financial problems in Southeast Asia, Russia, and South America.
With the economic downturn in the early 2000s, however, bank performance deteriorated slightly. For example commercial banks’ string of eight consecutive of record earnings ended in 2000 as their net income fell to $71.2 billion. Banks provision for loan losses rose to $9.5 billion in he fourth quarter of 2000, an increase of $3.4 billion (54.7 percent) from the level of a year earlier. This was the largest quarterly loss provision since the fourth quarter of 1991. Finally, the average ROA was 1.91 percent in 2000, down from 1.31 percent in 1999.
This downturn was short-lived, however. In 2001 net income of $74.3 billion easily surpassed the old record $71.6 billion and, in the first quarter of 2002, bank profits rose to a record $21.7 billion ($86.8 annualizes). This was the the first time the dropped slightly from 2000 to 1.15 percent, the first quarter 2002 average ROA rose sharply to 1.33 percent (the third highest quarterly ROA ever). The recovery was wide spread. The majority of banks (55.1 percent) reported higher ROAs compared to a year earlier and 64.0 percent of all banks reported higher net income. Only 6.7 percent of all banks reported losses in the first quarter of 2002.
Not all was positive for banks early 2002, however. Non current loans ( loans past due 90 days or more and loans that are not accruing interest because of problems of the borrower), particularly commercial and industrial loans (C&I) loans, continued to grow as the economy struggled to recover. At the end of the first quarter 2002, 2.61 percent of banks’ C&I loans were non current, the highest level since middle of 1993. Further, six insured commercial banks failed in the first quarter of 2002, the largest number of bank failure in a quarter since the third quarter of 1994. Finally, the number of banks on the FDIC’s “Problem List” increased from 95 to 102 in this quarter.
The performance in the late 1990s an even early 2000s is quite an improvement from the recessionary and high interest rate conditions in which the industry operated in the late 1980s. As reported in Table 11-7, the average ROA and ROE for commercial banks in March 2002 was 1.33 percent and 14.47 percent, respectively, compared to 1989 when ROA and ROE averaged 0.49 percent and 7.71 percent, respectively. Non current loans to assets ratio and net charge-offs (actual losses on loans and leases) to loans ratio averaged 0.97 percent and 1.14 percent, respectively, in 2002, versus 2.30 percent and 1.16 percent, respectively, in 1989. Net operating income (income before taxes and extraordinary items) grew at an annualized rate of 10.58 percent in the first quarter 0f 2002 versus a drop of 38.70 percent in 1989. Finally, note that in 2002 (through March 2002), six U.S. commercial banks failed versus 206 in 1989. As a result of such massive losses and failures in the industry, several regulations were
1. what major assets commercial banks old?
2. what the major sources of funding for commercial banks are?
3. what OBS assets and liabilities are?
4. what other types of fee-generating activities banks participate in?
departments by less financially sophisticated investors. “pension fund assets are the second largest group of assets managed by the trust departments of commercial banks. The banks manage the pension funds, act as trustees for any bonds held by the pension funds, and act as transfer and disbursement agent for the pension funds.
Correspondent Banking.
Correspondent Banking is the provision of banking services to oher banks that do not have the staff resources to perform the services themselves. These services include check clearing and collection, foreign exchange trading, hedging services, and participation in large loan and security issuances. Correspondent Banking services are generally sold as package of services. Payment for the services is generally in the form of non interest bearing deposits held at the bank offering the correspondent services.
SIZE, STRUCTURE, AND COMPOSITION OF THE INDUSTRY
As of December 2001, the United States had 8080 commercial banks. Even though this may seem to be a large number, in fact the number of banks has been decreasing. For example, in 1984, the number of banks was 14483; in 1989 It was 12744. Figure 11-6 illustrates the number of bank mergers, bank failures and new charters for the period 1980 through December 2001. Notice that much of the change in the size, structure and composition of this industry is the result of mergers and acquisitions. It was not until the 1980s and 1990s that the regulators ( such as the Federal Reserve or state banking authorities) allowed banks to merge with other bank across state lines (interstate mergers) and it has only been since 1994 that Congress has passed legislation ( the REIGLE-Neal Act) easing branching by bank across state line. Finally, it has only been since 1987 that banks have possessed powers to underwrite corporate securities. (Full authority to enter the investment banking (and insurance) business was only received with the passage of the Financial Services Modernizations Act in 1999.Table 11-4 list some of the largest bank mergers in recent years.
MEGAMERGER = the merger of banks with assets of $ 1 billion or more
ECONOMIES OF SCALE = the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase for example, cost reduction in trading and other transaction services resulting from increased efficiency when these services are performed by Fls.
ECONOMIES OF SCOPE = the degree to which a firm can generate cost synergies by producing multiple financial service products.
Economies of Scale and Scope
An important reason for the consolidation of the banking industry is the search by banks to exploit potential cost and revenue economies scale and scope. Indeed, MEGAMERGERS ( mergers involving banks with assets of $1 billion or more) are often driven by the desire pf managers to achieve greater cost and revenue economies or savings. Cost economies may result from ECONOMIES OF SCALE ( where the unit or average cost of producing the bank’s services fall as the size of the bank expands), ECONOMIES OF SCOPE (where banks generate synergistic cost savings through joint use of inputs such as computer systems in producing multiple products), or managerial efficiency sources (often called X EFFICIENCIES because they are difficult to specify in a quantitative fashion). X EFFICIENCY are those cost savings not directly due to economies of scope or economies of scale. As such, they are usually attributed to superior management skills and other difficult-to-measure managerial factors. To date, the explicit identification of what composes these efficiencies remains to be established in the empirical banking literature.
ECONOMIES OF SCALE
As financial firms become larger, the potential scale and array of the technology in which they can invest generally expand. The larger FIs generally have the largest expenditures on technology-related innovations. For example, the Tower Group ( a consulting firm specializing in information technology) estimated that technology expense as a percent of non interest expense would be as high as 22 percent at the largest U.S. banks in the three-year period 1999-2001. As discuss below, internet banking is sure to be one of the major shaping the bank industry in the 21st century. The internet offers financial institutions a channel to customers that enables them to react quickly to customer needs, bring products to the market quickly, and respon more effectively to changing business conditions. However, this capability will come at a cost o financial institutions as they invest in the necessary technology.
If enhanced or improved technology lowers an FI’s average cost of financial service production, larger FIs may have an economy of scale advantage over smaller financial firms. Economies of scale imply that the unit or average cost of producing FI services in aggregate ( or some specific activity such as deposits or loans ) falls as the size of the FI expands.
Figure 11-7 depicts economies of scale for three FIs of different sizes. The average cost of producing an FIs output of financial serives is measured as
ACi = TCi / Si
Where
ACi = Average costs of the ith bank
TCi = Total costs of the ith bank
Si = Size of the bank measured by assets, deposits, or loans
The effect of improving operations or technology over time is to shift the AC curve downward ; see figure 11-8. AC1 is the hypothetical AC curve prior to cost –reducing innovations. AC2 reflects the cost-lowering effects of technology and consolidation on FIs.
The average cost to the largest FI ain figure 11-7 (size c) to produce financial services is lower than the cost to smaller firms B and A. This means that any given price for financial service firm products, firm C can make a higher profit than either B or A. Alternatively, firm C can undercut B and A in price and potentially gain a larger market share. For example, First Union Corporation’s $3.2 billion acquisition of Signet Banking Corporation was billed as a cost-saving acquisition. Because of overlapping operations in similar products area with Signet, First Union said it expected annual cost savings of approximately $240 million. In the framework of figure 11-7, Signet, firm A, might be operating at ACª and First Union might be represented as firm B operating at ACb. First Union and Signet had significant bank-office operations in Virginia that could be combined and consolidated. The consolidation of such overlapping activities would lower the average costs for the combined (larger) bank to point C in figure 11-7, operating at AC c. Similarly, the 2000 merger of J.P Morgan and Chase Manhattan to from J.P Morgan Chase was estimated to produce cost savings of $1.5 billion
The long-run implication of economies of scale on the banking sector is that the largest and most cost-efficient banks will drive out smaller financial institutions, leading to increased large-firm dominance and concentration in financial services production. Such an implication is reinforced if time-related operating or technological improvements increasingly benefit larger banks more than smaller banks. For example satellite technology and supercomputers, in which enormous technological advances are being made, may be available o the largest banks only. The effect of improving technology over time, which is biased toward larger projects, is to shift the AC curve downward over time but with a larger downward shift for larger banks. (see figure 11-8)
Technology investment are risky, however. If their future revenues do not cover their costs of development, they reduce the value of the bank and its net worth to the bank’s owner. On the cost side, large-scale investments may result in excess capacity problems and integration problems as well as cost overruns and cost control problems. Then, small banks with simple and easily managed computer systems, and those leasting time on large banks’ computer without bearing the fixed costs of installation and maintenance, may have an average cost advantage. In this case, technological investments of large-size banks result in higher average costs of financial service production, causing the industry to operate under conditions of diseconomies of scale.
DISECONOMIES OF SCALE is the costs of joint production of FI services are higher then they would be if they where produced independently.
Wells Fargo & Co.’s purchase of First Interstate Bancorp (in April 1996) is an example of potential diseconomies of scale due to the inability to integrate technologies of the two banks and a failure of a back-office system. Wells Fargo wanted to make the merger process easy for First Interstate costumers by allowing them to use up their old checks and deposit forms. Unfortunately, due to the merger, customer account numbers had been changed and Wells Fargo’s computer system had trouble keeping up with the integrated check-clearing system. Some deposits were not posted to the proper account and there was a deluge of improperly bounced checks. Further, Wells Fargo’s back-office operations were thinly staffed and unable to find where all misplaced deposits had gone. More than a year after the purchase, Wells Fargo was still having organization and systems problem integrating First Interstate. Promising to reimburse all customers for its accounting mistakes, Well Fargo eventually corrected the problem, incurring and operating loss of some $ 180 million.
COST ECONOMIES OF SCOPE. FIs are multi product firms producing services involving different technological and personnel needs. Investments in one financial service area (such as lending) may have incidental and synergistic benefits in lowering the costs to produce financial services in other areas (such as securities underwriting or brokerage). In 1999, regulators passed the Financial Services Modernization Act, which repealed laws that prohibited mergers between commercial banks and investment banks (as well as insurance companies). The bill, touted as the biggest change in the regulation of financial institutions in over 60 years, created a “ financial services holding company “ that can engage in banking activities and securities and insurance underwriting.
The result of this regulation and the rulings leading up to it was a number of mergers and acquisitions between commercial and investments banks an 1997 through 2001. Some of the largest mergers include UBS’s $12.o billion purchase of Paine Webber in 2000, Credit Suisse First Boston’s 2000 purchase of Donaldson Lufkin Jenrette for $11.5 billion in 2000, Citicorp’s $83 billion merger with Travelers Group in April 1998 (partially divested in 2002), Bankers Trust’s April 1997 acquisition of Alex Brown for $1.7 billion, and Bank of America’s June 1997 purchase of Robertson Stephens for $540 million (resold to Bank of Boston for $800 million in April 1998).¹¹ In each case the banks stated that one motivations for the acquisitions was the desire to establish a presence in the securities business as laws separating investment banking and commercial banking were changing. Also noted as a motivation in these acquisitions was the opportunity to expand business lines, taking advantage of economies scale and scope to reduce overall costs and merge the customer bases of the respective commercial and investment banks involved the acquisitions.
Similarly, computerization allows the storage of important information on customers and their needs that can be used by more than one service area. FIs’ abilities to generate synergistic cost savings through joint use of inputs in producing multiple products is called economies of scope, as opposed to economies of scale (see above).
Geographic diversification to achieve potential economies of scope was also a major factor in late 1998 when Deutsche Bank (of Germany) announced the acquisition of Bankers Trust to create the world’s largest financial services company as measured by assets ( the combined bank would have over $843 billion in total assets). Together, the two banks became one of the global leaders in investment banking. They also have one of the largest global trading businesses. All the time of the acquisition, it was expected to produce a gain of $1 billion through new revenue and cost savings.
REVENUES ECONOMIES OF SCOPE
In addition to economies of scope on the cost side, there are also economies of scope (or synergies) on the revenue side that can emanate from mergers and acquisitions. For example, CEO’s of both J. P. Morgan and Chase Manhattan stated that the success of their merger to form J. P. Morgan and Chase was dependent on revenue growth. The merger combine J. P. Morgan’s greater array of financial products with Chase’s broader client base. The merger added substantially to many businesses (such as equity underwriting, equity derivatives, and asset management) that Chase had been trying to build on its own through smaller deals and also gave it a bigger presence in Europe where investment and corporate banking are fast growing businesses.
Revenue synergies have three potential dimensions. First, acquiring an FI in a growing market may produce new revenues. Second, the acquiring bank’s revenue stream may become more stable if the asset and liability portfolio of the acquired (target) institution exhibits different product, credit, interest rate, and liquidity risk characteristics from the acquirer’s. For example, real estate loan portfolio have shown very strong regional cycles. Specifically, in the 1980’s, U.S. real estate declined in value in the Southeast, then in the Northeast, and then in California with a long and variable lag. Thus, a geographically diversified real estate portfolio may be far less risky than one in which both acquirer and target specialize in a single region. ¹² Recent studies confirm risk diversification gains from geographic diversification.¹³
Third, expanding into markets that are less than fully competitive offers an opportunity for revenue enhancement. That is, banks may be able to identify and expand geographically into those markets in which economic rents potentiallt exist but in which regulators will not view such entry as potentially anticompetitive. Indeed, to the extent that geographic expansions are viewed as enhancing an FI’s monopoly power by generating excessive rents, regulators may act to prevent a merger unless it produces potential efficiency gains that can not be reasonably achieved by other means. In recent years, the ultimate enforcement of antimonopoly laws and guidelines has fallen to the U.S. Department of Justice. In particular, the Department of Justice has established guidelines regarding the acceptability or unacceptability of acquisitions based on the potential increase in concentration in the market in which an acquisition takes place.
A large number of studies have examined economies of scale and scope in different financial service industry sectors. With respect to the banks, most of the early studies failed to find economies of scale for any but the smallest banks. More recently, better data sets and improved methodologies have suggested that economies of scale may exist for banks up to the $10 billion to $25 billion size range. Many large-regional and super-regional banks fall in this size range. With respect to economies of scope either among deposits, loans, and other traditional banking product areas or between on-balance-sheet products and off-balance-sheet products such as loans sales, the evidence that cost synergies exist is at beast quite weak.
COMMUNITY BANK = a bank that specializes in retail or consumer banking.
REIONAL OR SUPERREGIONAL BANK = A bank that engages in a complete array of wholesale commercial banking activities.
FEDERAL FUNDS MARKET = An inter bank market for short term borrowing and lending of bank reserves.
MONEY CENTER BANK = A bank that relies heavily on nondeposit or borrowed sources of funds.
BANK SIZE AND CONCENTRATION
Interestingly, a comparison of asset concentration by bank size (see Table 11-5) indicates that the recent consolidation in banking appears to have reduced the asset share of the smallest banks (under $1 billion) from 36.6 percent in 1984 to 15.9 percent in 2001. These small or community bank with less than $1 billion in asset size tend to specialize in retail or consumer banking, such as providing residential mortgages and consumer loans, and accessing the local deposit base. Clearly, this group of banks is decreasing both in number and importance.
The relative asset share of the largest banks (over $ 1 billion in size), on the other hand, increased from 63.4 percent in 1984 o 64.1 percent in 2001. The largest 10 U.S. banks as of March 2002 are listed in table 11-6. large banks engage in a more complete array of wholesale commercial banking activities, encompassing consumer and residential lending as well as commercial and industry lending (C&I loans) both regionally, super regionally and nationally. In addition, big banks have access to the markets for purchased funds, such as the inter bank or federal funds market, to finance their lending and investment activities. Some of the very biggest bank are often classified as being money center banks. Currently six banking organizations make up the money center bank group : Bank of New York, Bank One, Bankers Trust, Citigroup, J.P. Morgan Chase, and HSBC Bank USA (formerly Republic NY Corporation).
It is important to note that asset or lending size does not necessarily make a bank a money center bank. Thus, Bank of America Corporation, with $619.9 billion in assets in 2001 (he third largest U.S. bank organization), is not a money center bank, but HSBC Bank USA (with only $ 84.2 billion in assets) is a money center bank. The classification as a money center bank is partly based on its heavy reliance on non deposit or borrowed sources of funds. Specifically, a money center bank is a bank located in major financial center (e. g., New York) and heavily relies on both national and international money markets for its source of funds. In fact, because of its extensive retail branch network, Bank of America tends to be a net supplier of funds on the inter bank market (federal funds market). By contrast, money center banks such as J. P. Morgan Chase have no retail branches.
BANK SIZE AND ACTIVITIES
Bank size has a traditionally affected the types of activities and financial performance of commercial banks. Small banks generally concentrate on the retail side of the business making loans and issuing deposits o consumers and small businesses. In contrast, large banks engage in bot retail and wholesale banking and often concentrate on the wholesale side of the business. Further, small banks generally hold fewer off-balance sheet assets and liabilities than large banks. For example, while small banks issue some loans commitments and letters of credit, they rarely hold derivative securities. Large banks’ relatively easy access to purchased funds and capital markets compared to small banks’ access is a reason for many of these differences. For example, large banks with easier access to capital markets operate with lower amounts of equity capital than do small banks. Also, large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits (deposits such as demand deposits that are stable over short periods of time, see chapter 13) than do small banks. At the same time, large banks lend to large corporations. This means that their interest rate spreads (i. e., the difference between their lending rates and deposit rates) and net interest margins (i. e., interest income minus interes expense divided by earning assets) have usually been narrower than those of smaller regional banks, which are more sheltered from competition in highly localized markets and lend to smaller, less sophisticated customers.
In addition, large banks tend to pay higher salaries and invests more in buildings and premises than small banks do. They also tend to diversify their operations and services more than small banks do. Large banks generate more non interest income (i. e., fees, trading account, derivative security, and foreign trading income) than small banks. Although large banks tend to holdd less equity, they do not necessarily return more on their assets. However, as the barriers to regional competition and expansion in banking have fallen in recent years, the largest banks have generally improved their return to equity (ROE) and return on asset (ROA) performance relative to small banks (see figure 11-9). We discuss the impact of size on bank financial statements and performance in more dateil in chapter 13.
INTEREST RATE SPREAD = the differences between lending and deposit rates.
NET INTEREST MARGIN = interest income minus interes expense divided by earning assets.
INDUSTRY PERFORMACE
Table 11-7 presents selected performance ratios for the commercial banking industry for 1989 and 1993 throuh March 2002. With the economic expansion in the U.S. economy and falling interest rates throughout most of the 1990’s U.S. commercial banks flourished for most of the 1990s. In 1999 commercial bank earnings were a record $71.6 billion. More than two-third of all U.S. banks reported an ROA of 1 percent or higher, and the average ROA for all banks was 1.31 percent, up from 1.19 percent of the year 1998. This, despite continued financial problems in Southeast Asia, Russia, and South America.
With the economic downturn in the early 2000s, however, bank performance deteriorated slightly. For example commercial banks’ string of eight consecutive of record earnings ended in 2000 as their net income fell to $71.2 billion. Banks provision for loan losses rose to $9.5 billion in he fourth quarter of 2000, an increase of $3.4 billion (54.7 percent) from the level of a year earlier. This was the largest quarterly loss provision since the fourth quarter of 1991. Finally, the average ROA was 1.91 percent in 2000, down from 1.31 percent in 1999.
This downturn was short-lived, however. In 2001 net income of $74.3 billion easily surpassed the old record $71.6 billion and, in the first quarter of 2002, bank profits rose to a record $21.7 billion ($86.8 annualizes). This was the the first time the dropped slightly from 2000 to 1.15 percent, the first quarter 2002 average ROA rose sharply to 1.33 percent (the third highest quarterly ROA ever). The recovery was wide spread. The majority of banks (55.1 percent) reported higher ROAs compared to a year earlier and 64.0 percent of all banks reported higher net income. Only 6.7 percent of all banks reported losses in the first quarter of 2002.
Not all was positive for banks early 2002, however. Non current loans ( loans past due 90 days or more and loans that are not accruing interest because of problems of the borrower), particularly commercial and industrial loans (C&I) loans, continued to grow as the economy struggled to recover. At the end of the first quarter 2002, 2.61 percent of banks’ C&I loans were non current, the highest level since middle of 1993. Further, six insured commercial banks failed in the first quarter of 2002, the largest number of bank failure in a quarter since the third quarter of 1994. Finally, the number of banks on the FDIC’s “Problem List” increased from 95 to 102 in this quarter.
The performance in the late 1990s an even early 2000s is quite an improvement from the recessionary and high interest rate conditions in which the industry operated in the late 1980s. As reported in Table 11-7, the average ROA and ROE for commercial banks in March 2002 was 1.33 percent and 14.47 percent, respectively, compared to 1989 when ROA and ROE averaged 0.49 percent and 7.71 percent, respectively. Non current loans to assets ratio and net charge-offs (actual losses on loans and leases) to loans ratio averaged 0.97 percent and 1.14 percent, respectively, in 2002, versus 2.30 percent and 1.16 percent, respectively, in 1989. Net operating income (income before taxes and extraordinary items) grew at an annualized rate of 10.58 percent in the first quarter 0f 2002 versus a drop of 38.70 percent in 1989. Finally, note that in 2002 (through March 2002), six U.S. commercial banks failed versus 206 in 1989. As a result of such massive losses and failures in the industry, several regulations were
tugas asti
Figure 11.1Differences in Balance sheet of depository institutions and nonfinancial firms.
Depository Institutions
Assets Liabilities and equity
Loans deposits
Other financial
Assets
Other nonfinancial other liabilities and equity
Assets
Nonfinancial Institutions
Assets liabilities and equity
Deposits loans
Other financial assets
Other non financial other liabilities and equity
Asset
As we examine the structure of depository institutions and their financial statements,notice a distinguishing feature between them and nonfinancial firms illustrated in figure between them and nonfinancial firms illustrated in figure 11.1.Specifically,depository institutions major assets are loans (financial assets ) and their major liabilities are deposits.Just the opposite is true for nonfinancial firms,whose deposits are listed as assets on their balance sheets and whose loans are listed as liabilities.In contrast to depository institutions, nonfinancial firms’major assets are nonfinancial ( tangible ) assets such as buildings and machinery.Indeed,as illustrated in figure 11.2,depository institutions provide loans to and accept deposits form,nonfinancial firms ( and individuals ),while nonfinancial firms provide deposits to and obtain loans forms,depository institutions.
Figure 11.2 Interaction between Depository Institutions and non financial Firms
LOANS
DEPOSITS
Our attention in this chapter focuses on the largest sector of the depository institutions group,commercialbank,and in particular : 1.the size,structure,and composition of this industry group,2.its balance sheets and recent trends,3.the industry’s recent performance and,4.its regulator.
1.DEFINITION OF A COMMERCIAL BANK
Commercial banks represent the lsrgest group of depository institutions measured by assets size.They perform functions similar to those of savings institutions and credit unions—they accept deposits ( liabilities ) and make loans ( assets ).Commercial banks are distinguishable from savings institutions and credit unions,however in the size and composition of their loans and deposits.Specifically,while deposits are the major source funding ,commercial bank liabilities usually include several types of nondeposits sources such as subordinated notes and debentures.Moreover their loans are broader in range,including consumer, commercial, international and real estate loans.Commercial banks are regulated separately from savings institutions and credit unions.Within the banking industry,the structure and compotition of assets and liabilities also varies significantly for banks of different assets sizes.
BALANCE SHEETS AND RECENT TRENDS
How financial statements are used by regulators, stockholders, depositors, and creditors to evaluate bank performance.
2.ASSETS
Consider the aggregate balance sheet in table 11-2 and the percentage distributions( in figure 11.3) for all us commercial banks as of December 31,2001.The majority of the assets held by commercial banks are loans.Total loans amounted to $3823.2 billion or 58.2 % of total asset and fell into four broad classes : businees or commercial and industrial loans; commercial and residential real estate loans;individual loans, such as consumer loans for auto purchases and credit card loans ; and all other loans such as loans to emerging market countries.1 The reserver for loan and lease losses is a contra asset account representing an estimate by the bank’s management of the percentage of gross loans( and leases ) that will have to be “charged off” due to future defaults.
Investment securities consist of items such as interest bearing deposits purchased from other FIs,federal funds sold to other banks,repurchase agreements (RPs or repos),2 US Treasury and agency securities,municipal securities issued by states and political subdivisions, mortgage-backed securities and other debt andequity securities.In 2001,the investment portofolio totaled $ 1497,2 billion or 22,8 % of total assets.US government securities such as US Treasury bonds totaled $765.7 billion, with other securities making up the remainder.Investment securities generate interest income for the bank and are also used for trading and liquidity management purposes.Many investment securities held by banks are highly liquid,have low default risk and can usually be traded in secondary markets.
While loans are the main revenue-generating assets for banks,investment securities provide banks with liquidity.Unlike manufacturing companies,commercial banks and other financial institutions are exposed to high levels of liquidity risk.Liqudity risk is the risk that arises when financial institution’s liability holders such as depositors demand cash for the financial claims they hold with the financial institutions.Because of the extensive levels of deposits held by banks( see below ), they must hold significant amounts of cash and investments securities to make sure they can meet the demand from their liability holders if and when they liquidate the claims they hold.
A major inference we can draw from this assets structure ( and the importance of loans in this assets structure ) is that the major risks faced by modern commercial bank managers are credit or default risk, liquidity risk, and ultimately, insolvency risk.Because commercial banks are highly leveraged and therefore hold little equity( see below ) compared to total assets, even a relatively small amount of loan defaults can wipe out the equity of a bank,leaving it insolvent.Losses such as those due to defaults are charged off against the equity ( stockholders’ stake) in a bank.Additions to the reserve for loan and lease losses accounts ( and,in turn, the expense account, “provisions for losses on loans and leases” .) to meet expected defaults reduce retained earnings and, thus , reduce equity of the bank.Unexpected defaults are meant to be written off against the remainder of the bank’s equity.We look at recent loan performance below.
FIGURE 11-4
Figure 11-4 shows broad trends over the 1951-2000 period in the four principal earningh assets areas of commercial banks : business loans ( or commercial and industrial loans ), securities,mortgages, and consumer loans. Although business loans were the major assets on bank balance sheet between 1965 and 1990, they have dropped in importance ( as a proportion of the balance sheet) since 1990.At the same time, mortgages have increased in importance.These trends reflect a number of long term and temporary influences.Important long term influences have been the growth of the commercial paper market and the public bond market ,which have become competitive and alternative funding sources to commercial bank loans for major corporations.Another factor has been the securization of mortgage loans,which entails the pooling and packaging of mortgage loans for sale in the form of bonds.
3.LIABILITIES
Commercial banks have two major sources of funds ( other than the provided by owners and stockholders) : 1.deposiits and 2.borrowed or other liability funds.As noted above, a major difference between banks and other firms is their high leverage or debt to assets ratio.For example,banks had an average ratio of equity to assets of9,1 % in 2001 ; this implies that 90,9 % of assets were funded by debt, either deposits or borrowed funds.
Note that in table 11.2,which shows the aggregate balance of US banks, in December 2001,deposits amounted to $4391.6 billion ( 66.9 % of assets) and borrowings and other liabilities were $1348.6 and $231.6 biilion( 20.5% and 3.5% of total assets),respectively.Of the total stock of deposits,transaction accouns represented 21% of total deposits or 1376.5 biilion.Transaction accounts are checkable deposits that either bear nointerest ( demand deposit ) or are interest bearing( most commonly called negotiable order of withdrawal accounts or NOW accounts).Since their introduction in 1980, interest bearing checking accounts, especially NOW accounts, have dominated the transaction accounts of banks.Nevertheless since limitations are imposed on the ability of corporations to hold such accounts,3 and NOW accounts have minimum balance requirements, nponinterest-bearing demand deposits are still held.The second major segment of deposits is retail or household savings and time deposits, normally individual account holdings of less than $100.000.Important components of bank retail savings accounts are small nontransactions accounts,which include passbook savings accounts and retail time deposits. Small nontransactions accounts compose 56 % of total deposit.However this disguises an important trendin the supply of this deposits to banks.Spesifically the amount held of retail savings and time deposit has been falling inrecent years,largely as a result of competition from money market mutual funds.4 these funds pay a competitive rate of interest based on wholesale money market rates by pooling and investing funds.while requiring relatively small-denomination investments.
The third major segment of deposits funds is large time deposits ($ 100.000 or more );5 $100.000 is the cap for explicit coverage under FDIC provided deposit insurance.These deposits amounted to $556.2 billion or approximately 12.7% of total deposits in December 2001.These are primarily negotiable certificates of deposit ( deposit claims with promised interest rates fixed maturities of at least 14 days) that can be resold to outside investors in an organized secondary market.As such, they are usually distinguished from retail time deposits by their negotiability and secondary market liquidity.
Nondeposit liabilities comprise borrowings and other liabilities that total 26.5 % of all bank liabilities or $1.580,2 billion.These categories include a broad array of instruments sauch as purchases of federal funds ( bank reserves ) on the interbank market and repurchase agreements ( temporary swaps of securities for federal funds ) at the short end of the maturity spectrum, to the issuance of notes and bonds at the longer end.
Overall, the liability structure of banks’balance sheets tends to reflect a shorter maturity structure than that of their asset portofolio.Further,relatively more liquid instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans.Thus,interest rate risk-or maturity mismatch risk-and liquidity risk are key exposure concerns for bank managers.
4.EQUITY
Commercial bank equity capital ( 9,1 % of totalliabilities and equity in December 2001) consist mainly of common and preferred stock( listed at par value),surplus or additional paid in capital and retained earnings. 6.Surplus or additional paid in capital shows the difference between the stock’s par value and what the original stockholders paid when they bought the newly issued shares. Regulators require banks to hold a minimum level of equity capital to act as a buffer against losses from their on-and off balance sheet activities.Because of the relatively low cost of deposit funding,banks tend to hold equity close to the minimum levels set by regulators.This impacts banks’exposure to risk and their ability to grow –both onand off the balance sheet-over time.
Off-Balance sheet Activities
The balance sheet itself does not reflect the total scope of bank activities.Banks conduct many fee related activities off the balance sheet.Off Balance Sheet ( OBS ) activities are becoming increasingly important, in terms of their dollar value and the income they generate for banks-especially as the ability of banks to attract high quality loan apliicants and deposits becomes ever more difficult.OBS activities include issuing various types of guarantees ( such as letters of credit ), which often have a strong insurance underwriting element and making future commitmens to lend.Both service generate additional fee income for banks.OBS activities also involve engaging in derivative transactions—futures,forwards,options,and swaps.
Under current accounting standards,such activities are not shown on the current balance sheet.Rather,an item or activity is an OBS asset if, when a contingent event occurs, the item or activity moves onto the asset side of the balance sheet or an income item is realized on the income statement.Conversely,an item or activity is an OBS liability if,when a contingent event occurs, the item or activity moves onto the liability side of the balance sheet or an expense item is realized on the income statement
By undertaking OBS activities, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business.At the same time,they can avoid regulatory costs or taxes since reserve requirements and deposit insurance premiums are not levied on off balance sheet activities.Thus banks have both earnings and regulatory “tax avoidance” incentives to undertake activities off their balance sheets.
OBS activities,however can involve risks that add to the overall insolvency exposure of a financial intermediary (FI).Indeed, the failure of the UK investments bank Barings and banksruptcy of Orange County in California in the 1990s have been linked to FIs’ OBS activities in derivatives.More recently the1997-1998 Asian crisis l;eft banks that had large positions in the asian related derivative securities markets with large losses. For example, Chase Manhattan Corp. announced a 1998 third quarter earnings decrease of 15 %, due to losses in global market, including derivative securities.In the news box 11.1 highlights Enron’s search for new lines of credit shortly before it declared bankruptcy in December 2001.Banks that lent funds from these OBS lines received little, if any, of them back.However OBS activities and instruments have both risk reducing as well as risk increasing attributes and when used appropriately,they can reduce or hedge an FIs interest rate,credit,and foreign exchange risks.
We show the notional or face, value of bank OBS activities ,and their distribution and growth for 1992 to 2001in table 11.3.Notice the relative growth in the notional value of OBS activities in table 11.3.By year end 2001,the notional value of OBS bank activities was $51.409,9 billion compared to the $ 6569,2 billion value of on balance sheet activities.It should be noted that the notional or face value of OBS activities does not accurately reflect the risk to the bank undertaking such activities.The potensial for the bank to gain or lose on the contract is based on the possible change in the market value of the contract over the life of the contract rather than the notional or face value of the contract,normally less than 3 % of the of the notional value an OBS contract.7.The market value of a swap (today) is the difference between the present value of the cash flows (expected) to be received minus the present value of cash flows expected tobe paid.
The use of derivative contracts accelerated during the 1992-2000 period and accounted for much of the growth in OBS activity ( see figure 11-5).Figure 11.5 shows that this growth has occurred for all types of derivative contracts: futures and forwards, swaps, and options.The significant growth in derivative securities activities by commercial banks has been a direct response to the increased interst rate risk, credit risk, and foreign exchange risk exposures they have faced, both domestically and internationally.In particular, these contract offer banks a way to hedge these risks without having to make extensive changes on the balance sheet.
Although the simple notional dollar value of OBS items overestimates their risk exposure amounts,the increase in these activities is still nothing short of phenomenal.8.this overestimation of risk exposure occurs because the risk exposure from a contingent claim ( such as an option ) is usually less than its face value. Indeed, this phenomenal increase has pushed regulators into imposing capital requirements on such activities and into explicitly recognizing an FI’s solvency risk exposure from pursuing such activities.As noted in table 11.3 and figure 11.5,major types of OBS activities for US banks include loan commitments,letter of credit, loans sold,and derivative securities.A loan commitment is a contractual commitment to loan a certain maximum amount to a borrower at given interest rate terms over some contractual period in the future (e.g.,one year).Letters of credit are essentially guarantees that FIs sell to under write the future performance of the buyers of the guarantees.Commercial letters of credit are used mainly to assist a firm in domestic and international trade.The FIs role is to provide a formal guarantee that it will pay for the goods shipped or sold if the buyer of the goods defaults on its future payments.Standby letter of credit cover contingencies that are potentially more severe, less predictable or frequent and not necessarily trade related.Loans sold are loans that the FI originated and then sold to other investors that ( in some cases ) can be returned to the originating institution in the future if the credit quality of the loans deteriorates.Derivative securities are futures, forwards, swap, and option positions taken by the bakn for hedging snd other purposes.
Other Fee Generating Activities
Commercial banks engage in other fee generating activities that cannot easily be identified from analyzing their on and off balance sheet accounts.Two of these include trust services and correspondent banking.
Trust service. The trust department of a commercial bank holds and manages assets for individuals or corporations.Only the largest banks have sufficient staff to offer trust services.Individuals trusts represent about one half of all trust assets managed by commercial banks.These trusts include estate assets and assets delegated to bank trust
Transactions account
The sum of noninterest bearing demand deposits and interest bearing checking accounts.
NOW account
An interest- bearing checking account.
Negotiable CDs
Fixed maturity interst bearing deposits with face values of $ 100.000 or more that canbe resold in the secondary market.
Off Balance Sheet (OBS) Assets
When an event occurs this item moves onto the asset side of the balance sheet or income is realized on the income statement.
Off Balance Sheet Liability
When an event occurs this item moves onto the liability side of the balance sheet or an expense is realized on the income statement.
Table 11.2 Balance sheet
ASSETS
Total cash assets $391,0
US government securities $765,7
Federal Funds and repurchase agreement $317,6
Other $431,9
Investment Security $1497,2
Interbank Loans $117,2
Loans excluding interbank $3778,1
Commercial and industrial $982,5
Real estate $1803,6
Individual $631,2
All other $360,8
Less: Reserve for loan losses $72,1
Total loans $3823,2
Other assets $857,8
Total assets $6569,2
LIABILITIES AND EQUITIES
Transaction accounts $1376,5
Nontransaction Acoount $3051,5
Total Deposit $4391,6
Borrowings $1348,6
Other liabilities $231,6
Total liabilities $5971,8
Equities $597,4
Table 11.1.Products sold by US Financial Services Industry
function
Underwriting
Institutions Payment Savings Fiduciary Lending Issuance of Insurance and
Risk Mngmnt
Service products Services Business Consumer Equity Debt Products
1950
Depository Institutions
Insurance Companies
Finance Companies
Securities Firms
Pension Funds
Mutual Funds
2003
Depository Intitutions
Insurance Companies
Finance Companies
Securities Firms
Pension Funds
Mutual Funds
*Minor Involvement
+Selective Involvement via affiliates
Depository Institutions
Assets Liabilities and equity
Loans deposits
Other financial
Assets
Other nonfinancial other liabilities and equity
Assets
Nonfinancial Institutions
Assets liabilities and equity
Deposits loans
Other financial assets
Other non financial other liabilities and equity
Asset
As we examine the structure of depository institutions and their financial statements,notice a distinguishing feature between them and nonfinancial firms illustrated in figure between them and nonfinancial firms illustrated in figure 11.1.Specifically,depository institutions major assets are loans (financial assets ) and their major liabilities are deposits.Just the opposite is true for nonfinancial firms,whose deposits are listed as assets on their balance sheets and whose loans are listed as liabilities.In contrast to depository institutions, nonfinancial firms’major assets are nonfinancial ( tangible ) assets such as buildings and machinery.Indeed,as illustrated in figure 11.2,depository institutions provide loans to and accept deposits form,nonfinancial firms ( and individuals ),while nonfinancial firms provide deposits to and obtain loans forms,depository institutions.
Figure 11.2 Interaction between Depository Institutions and non financial Firms
LOANS
DEPOSITS
Our attention in this chapter focuses on the largest sector of the depository institutions group,commercialbank,and in particular : 1.the size,structure,and composition of this industry group,2.its balance sheets and recent trends,3.the industry’s recent performance and,4.its regulator.
1.DEFINITION OF A COMMERCIAL BANK
Commercial banks represent the lsrgest group of depository institutions measured by assets size.They perform functions similar to those of savings institutions and credit unions—they accept deposits ( liabilities ) and make loans ( assets ).Commercial banks are distinguishable from savings institutions and credit unions,however in the size and composition of their loans and deposits.Specifically,while deposits are the major source funding ,commercial bank liabilities usually include several types of nondeposits sources such as subordinated notes and debentures.Moreover their loans are broader in range,including consumer, commercial, international and real estate loans.Commercial banks are regulated separately from savings institutions and credit unions.Within the banking industry,the structure and compotition of assets and liabilities also varies significantly for banks of different assets sizes.
BALANCE SHEETS AND RECENT TRENDS
How financial statements are used by regulators, stockholders, depositors, and creditors to evaluate bank performance.
2.ASSETS
Consider the aggregate balance sheet in table 11-2 and the percentage distributions( in figure 11.3) for all us commercial banks as of December 31,2001.The majority of the assets held by commercial banks are loans.Total loans amounted to $3823.2 billion or 58.2 % of total asset and fell into four broad classes : businees or commercial and industrial loans; commercial and residential real estate loans;individual loans, such as consumer loans for auto purchases and credit card loans ; and all other loans such as loans to emerging market countries.1 The reserver for loan and lease losses is a contra asset account representing an estimate by the bank’s management of the percentage of gross loans( and leases ) that will have to be “charged off” due to future defaults.
Investment securities consist of items such as interest bearing deposits purchased from other FIs,federal funds sold to other banks,repurchase agreements (RPs or repos),2 US Treasury and agency securities,municipal securities issued by states and political subdivisions, mortgage-backed securities and other debt andequity securities.In 2001,the investment portofolio totaled $ 1497,2 billion or 22,8 % of total assets.US government securities such as US Treasury bonds totaled $765.7 billion, with other securities making up the remainder.Investment securities generate interest income for the bank and are also used for trading and liquidity management purposes.Many investment securities held by banks are highly liquid,have low default risk and can usually be traded in secondary markets.
While loans are the main revenue-generating assets for banks,investment securities provide banks with liquidity.Unlike manufacturing companies,commercial banks and other financial institutions are exposed to high levels of liquidity risk.Liqudity risk is the risk that arises when financial institution’s liability holders such as depositors demand cash for the financial claims they hold with the financial institutions.Because of the extensive levels of deposits held by banks( see below ), they must hold significant amounts of cash and investments securities to make sure they can meet the demand from their liability holders if and when they liquidate the claims they hold.
A major inference we can draw from this assets structure ( and the importance of loans in this assets structure ) is that the major risks faced by modern commercial bank managers are credit or default risk, liquidity risk, and ultimately, insolvency risk.Because commercial banks are highly leveraged and therefore hold little equity( see below ) compared to total assets, even a relatively small amount of loan defaults can wipe out the equity of a bank,leaving it insolvent.Losses such as those due to defaults are charged off against the equity ( stockholders’ stake) in a bank.Additions to the reserve for loan and lease losses accounts ( and,in turn, the expense account, “provisions for losses on loans and leases” .) to meet expected defaults reduce retained earnings and, thus , reduce equity of the bank.Unexpected defaults are meant to be written off against the remainder of the bank’s equity.We look at recent loan performance below.
FIGURE 11-4
Figure 11-4 shows broad trends over the 1951-2000 period in the four principal earningh assets areas of commercial banks : business loans ( or commercial and industrial loans ), securities,mortgages, and consumer loans. Although business loans were the major assets on bank balance sheet between 1965 and 1990, they have dropped in importance ( as a proportion of the balance sheet) since 1990.At the same time, mortgages have increased in importance.These trends reflect a number of long term and temporary influences.Important long term influences have been the growth of the commercial paper market and the public bond market ,which have become competitive and alternative funding sources to commercial bank loans for major corporations.Another factor has been the securization of mortgage loans,which entails the pooling and packaging of mortgage loans for sale in the form of bonds.
3.LIABILITIES
Commercial banks have two major sources of funds ( other than the provided by owners and stockholders) : 1.deposiits and 2.borrowed or other liability funds.As noted above, a major difference between banks and other firms is their high leverage or debt to assets ratio.For example,banks had an average ratio of equity to assets of9,1 % in 2001 ; this implies that 90,9 % of assets were funded by debt, either deposits or borrowed funds.
Note that in table 11.2,which shows the aggregate balance of US banks, in December 2001,deposits amounted to $4391.6 billion ( 66.9 % of assets) and borrowings and other liabilities were $1348.6 and $231.6 biilion( 20.5% and 3.5% of total assets),respectively.Of the total stock of deposits,transaction accouns represented 21% of total deposits or 1376.5 biilion.Transaction accounts are checkable deposits that either bear nointerest ( demand deposit ) or are interest bearing( most commonly called negotiable order of withdrawal accounts or NOW accounts).Since their introduction in 1980, interest bearing checking accounts, especially NOW accounts, have dominated the transaction accounts of banks.Nevertheless since limitations are imposed on the ability of corporations to hold such accounts,3 and NOW accounts have minimum balance requirements, nponinterest-bearing demand deposits are still held.The second major segment of deposits is retail or household savings and time deposits, normally individual account holdings of less than $100.000.Important components of bank retail savings accounts are small nontransactions accounts,which include passbook savings accounts and retail time deposits. Small nontransactions accounts compose 56 % of total deposit.However this disguises an important trendin the supply of this deposits to banks.Spesifically the amount held of retail savings and time deposit has been falling inrecent years,largely as a result of competition from money market mutual funds.4 these funds pay a competitive rate of interest based on wholesale money market rates by pooling and investing funds.while requiring relatively small-denomination investments.
The third major segment of deposits funds is large time deposits ($ 100.000 or more );5 $100.000 is the cap for explicit coverage under FDIC provided deposit insurance.These deposits amounted to $556.2 billion or approximately 12.7% of total deposits in December 2001.These are primarily negotiable certificates of deposit ( deposit claims with promised interest rates fixed maturities of at least 14 days) that can be resold to outside investors in an organized secondary market.As such, they are usually distinguished from retail time deposits by their negotiability and secondary market liquidity.
Nondeposit liabilities comprise borrowings and other liabilities that total 26.5 % of all bank liabilities or $1.580,2 billion.These categories include a broad array of instruments sauch as purchases of federal funds ( bank reserves ) on the interbank market and repurchase agreements ( temporary swaps of securities for federal funds ) at the short end of the maturity spectrum, to the issuance of notes and bonds at the longer end.
Overall, the liability structure of banks’balance sheets tends to reflect a shorter maturity structure than that of their asset portofolio.Further,relatively more liquid instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans.Thus,interest rate risk-or maturity mismatch risk-and liquidity risk are key exposure concerns for bank managers.
4.EQUITY
Commercial bank equity capital ( 9,1 % of totalliabilities and equity in December 2001) consist mainly of common and preferred stock( listed at par value),surplus or additional paid in capital and retained earnings. 6.Surplus or additional paid in capital shows the difference between the stock’s par value and what the original stockholders paid when they bought the newly issued shares. Regulators require banks to hold a minimum level of equity capital to act as a buffer against losses from their on-and off balance sheet activities.Because of the relatively low cost of deposit funding,banks tend to hold equity close to the minimum levels set by regulators.This impacts banks’exposure to risk and their ability to grow –both onand off the balance sheet-over time.
Off-Balance sheet Activities
The balance sheet itself does not reflect the total scope of bank activities.Banks conduct many fee related activities off the balance sheet.Off Balance Sheet ( OBS ) activities are becoming increasingly important, in terms of their dollar value and the income they generate for banks-especially as the ability of banks to attract high quality loan apliicants and deposits becomes ever more difficult.OBS activities include issuing various types of guarantees ( such as letters of credit ), which often have a strong insurance underwriting element and making future commitmens to lend.Both service generate additional fee income for banks.OBS activities also involve engaging in derivative transactions—futures,forwards,options,and swaps.
Under current accounting standards,such activities are not shown on the current balance sheet.Rather,an item or activity is an OBS asset if, when a contingent event occurs, the item or activity moves onto the asset side of the balance sheet or an income item is realized on the income statement.Conversely,an item or activity is an OBS liability if,when a contingent event occurs, the item or activity moves onto the liability side of the balance sheet or an expense item is realized on the income statement
By undertaking OBS activities, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business.At the same time,they can avoid regulatory costs or taxes since reserve requirements and deposit insurance premiums are not levied on off balance sheet activities.Thus banks have both earnings and regulatory “tax avoidance” incentives to undertake activities off their balance sheets.
OBS activities,however can involve risks that add to the overall insolvency exposure of a financial intermediary (FI).Indeed, the failure of the UK investments bank Barings and banksruptcy of Orange County in California in the 1990s have been linked to FIs’ OBS activities in derivatives.More recently the1997-1998 Asian crisis l;eft banks that had large positions in the asian related derivative securities markets with large losses. For example, Chase Manhattan Corp. announced a 1998 third quarter earnings decrease of 15 %, due to losses in global market, including derivative securities.In the news box 11.1 highlights Enron’s search for new lines of credit shortly before it declared bankruptcy in December 2001.Banks that lent funds from these OBS lines received little, if any, of them back.However OBS activities and instruments have both risk reducing as well as risk increasing attributes and when used appropriately,they can reduce or hedge an FIs interest rate,credit,and foreign exchange risks.
We show the notional or face, value of bank OBS activities ,and their distribution and growth for 1992 to 2001in table 11.3.Notice the relative growth in the notional value of OBS activities in table 11.3.By year end 2001,the notional value of OBS bank activities was $51.409,9 billion compared to the $ 6569,2 billion value of on balance sheet activities.It should be noted that the notional or face value of OBS activities does not accurately reflect the risk to the bank undertaking such activities.The potensial for the bank to gain or lose on the contract is based on the possible change in the market value of the contract over the life of the contract rather than the notional or face value of the contract,normally less than 3 % of the of the notional value an OBS contract.7.The market value of a swap (today) is the difference between the present value of the cash flows (expected) to be received minus the present value of cash flows expected tobe paid.
The use of derivative contracts accelerated during the 1992-2000 period and accounted for much of the growth in OBS activity ( see figure 11-5).Figure 11.5 shows that this growth has occurred for all types of derivative contracts: futures and forwards, swaps, and options.The significant growth in derivative securities activities by commercial banks has been a direct response to the increased interst rate risk, credit risk, and foreign exchange risk exposures they have faced, both domestically and internationally.In particular, these contract offer banks a way to hedge these risks without having to make extensive changes on the balance sheet.
Although the simple notional dollar value of OBS items overestimates their risk exposure amounts,the increase in these activities is still nothing short of phenomenal.8.this overestimation of risk exposure occurs because the risk exposure from a contingent claim ( such as an option ) is usually less than its face value. Indeed, this phenomenal increase has pushed regulators into imposing capital requirements on such activities and into explicitly recognizing an FI’s solvency risk exposure from pursuing such activities.As noted in table 11.3 and figure 11.5,major types of OBS activities for US banks include loan commitments,letter of credit, loans sold,and derivative securities.A loan commitment is a contractual commitment to loan a certain maximum amount to a borrower at given interest rate terms over some contractual period in the future (e.g.,one year).Letters of credit are essentially guarantees that FIs sell to under write the future performance of the buyers of the guarantees.Commercial letters of credit are used mainly to assist a firm in domestic and international trade.The FIs role is to provide a formal guarantee that it will pay for the goods shipped or sold if the buyer of the goods defaults on its future payments.Standby letter of credit cover contingencies that are potentially more severe, less predictable or frequent and not necessarily trade related.Loans sold are loans that the FI originated and then sold to other investors that ( in some cases ) can be returned to the originating institution in the future if the credit quality of the loans deteriorates.Derivative securities are futures, forwards, swap, and option positions taken by the bakn for hedging snd other purposes.
Other Fee Generating Activities
Commercial banks engage in other fee generating activities that cannot easily be identified from analyzing their on and off balance sheet accounts.Two of these include trust services and correspondent banking.
Trust service. The trust department of a commercial bank holds and manages assets for individuals or corporations.Only the largest banks have sufficient staff to offer trust services.Individuals trusts represent about one half of all trust assets managed by commercial banks.These trusts include estate assets and assets delegated to bank trust
Transactions account
The sum of noninterest bearing demand deposits and interest bearing checking accounts.
NOW account
An interest- bearing checking account.
Negotiable CDs
Fixed maturity interst bearing deposits with face values of $ 100.000 or more that canbe resold in the secondary market.
Off Balance Sheet (OBS) Assets
When an event occurs this item moves onto the asset side of the balance sheet or income is realized on the income statement.
Off Balance Sheet Liability
When an event occurs this item moves onto the liability side of the balance sheet or an expense is realized on the income statement.
Table 11.2 Balance sheet
ASSETS
Total cash assets $391,0
US government securities $765,7
Federal Funds and repurchase agreement $317,6
Other $431,9
Investment Security $1497,2
Interbank Loans $117,2
Loans excluding interbank $3778,1
Commercial and industrial $982,5
Real estate $1803,6
Individual $631,2
All other $360,8
Less: Reserve for loan losses $72,1
Total loans $3823,2
Other assets $857,8
Total assets $6569,2
LIABILITIES AND EQUITIES
Transaction accounts $1376,5
Nontransaction Acoount $3051,5
Total Deposit $4391,6
Borrowings $1348,6
Other liabilities $231,6
Total liabilities $5971,8
Equities $597,4
Table 11.1.Products sold by US Financial Services Industry
function
Underwriting
Institutions Payment Savings Fiduciary Lending Issuance of Insurance and
Risk Mngmnt
Service products Services Business Consumer Equity Debt Products
1950
Depository Institutions
Insurance Companies
Finance Companies
Securities Firms
Pension Funds
Mutual Funds
2003
Depository Intitutions
Insurance Companies
Finance Companies
Securities Firms
Pension Funds
Mutual Funds
*Minor Involvement
+Selective Involvement via affiliates
tugas ami
Commercial banks
Commercial banks as a sector of the financial institutions industry overview
The products that modern financial institutions sell and the risks they face are becoming increasingly similar, as are the techniques they use to measure and manage these risks. The two panels in table 11-1 indicate the product sold by the financial service industry in 1950 and in 2003.Three major FI groups-commercial banks, savings institutions, and credit unions –are also called depository institutions because a significant proportion of their funds come from customer deposits. Chapters 11 through 14 describe depository institutions, their financial statement, and the regulation that govern their operations.
Depository institutions
P
art three of the text summarizes the operation of depository institutions. Chapter 11 describes the key characteristics and recent trends in the commercial banking sector.
Chapter 12 does the same for the thrift institutions sector. Chapter 13 describes the financial statement of a typical depository institutions and the rations used to analyze those statement .
Chapter 14 provides a comprehensive look at the regulation under which these financial institutions operate and, particularly, at the effect of recent changes in regulations.
7 . Technology in commercial banking
Certain to affect the future performance of commercial banks (as well as all financial institutions ) is the extent to which banks adopt the newest technology. Including the extent to which industry participants embrace the internet and online banking. Technological innovation has been a major concern of all types of financial institutions in recent years. Since the 1980s, banks, insurance companies, and investment companies have sought to improve operational efficiency whit major investment in internal and external communication, computer and expended technological infrastructure. Internet and wireless communications technologies are having a profound effect on financial services. These technologies are more than just new distribution channels-they are completely different way of providing financial service. Indeed, a global financial service firm such as Citigroup has operations in more than 100 countries connected in real time by a proprietary-owned satellite system.
Technology is important because well-chosen technological investment have the potential to increase both the FI’ s net interest margin –or the difference between interest income and interest expense-and other net income. Therefore , technology can directly improve profitability. The following subsections focus on some specific technology-based product found in modern retail and wholesale banking. Note that this list is far from complete.
Wholesale Banking Services
Probably the most important area on which technology has impacted wholesale or corporate customer services is a bank’s ability to provider cash management or working capital services. Cash management service needs have largely resulted from (1) corporate recognition that excess cash balances result in a significant opportunity cost due to lost or forgone interest and (2) corporate need to know cash or working capital positions on a real-time basis. Among the services that modern banks provider to improve the efficiency with which corporate clients manage their financial positions are these:
1. controlled disbursement accounts. An account feature that allows all payment to be made in a given day to be known in the morning. the bank informs the corporate client of the total funds it needs to meet disbursement, and the client wire transfers the amount needed. These checking accounts are debited early each day so that corporations can obtain an early insight into their net cash positions .
2. account reconciliation. A checking feature that records which of the firm’s checks have been paid by the bank .
3. lockbox services. A centralized collection service for corporate payments to reduce the delay in check clearing, or the float . in a typical lockbox arrangement, a local bank sets up a lockbox at the post office for a corporate client located outside the area. Local customers mail payment to the lockbox rather than to the out-of-town corporate headquarters. The bank collects these checks several times per day and deposits them directly into the customer’s account. Details of the transaction are wired to the corporate client.
4. electronic lockbox. Same as item 3 but the customers receives on-line payments for public utilities and similar corporation clients.
5. funds concentration. A service that redirects funds from accounts in a large number of different banks or branches to a few centralized accounts at one bank.
6. electronic funds transfer. Includes overnight payments via CHIPS or Fed wire , Automated payment of payrolls or dividends via automated clearinghouses (ACH s), and automated transmissions of payment massage by SWIFT, an international electronic massage service owned and operate by U.S. and European banks that instructs banks to make specific payments.
7. check deposit services. Encoding ,endorsing, microfilming, and handling customers’ checks.
8. electronic initiation of letters of credit. allows customers in a network to access bank computers to initiate letters of credits.
9. treasury management software. allows efficient management of multiple currency and security portfolios for trading and investment purposes.
10. electronic data interchange. A specialized applications of electronic mail, allowing businesses to transfer and transact invoice, purchase orders, and shipping notices automatically, using banks as clearinghouse.
11. facilitating business-to-business e-commerce. A few of the largest commercial banks have begun to offer firms the technology for electronic business-to-business commerce. The banks are essentially automating the entire information flow associated with the procurement and distribution of goods and services among businesses
12. Electronic billing. provides the presentment and collection services for companies that send out substantial volumes of recurring bills. banks combine the email capability of internet to send out bills with their ability to process payment electronically through the inter bank payment networks
13. verifying identities. using encryption technology a bank certifies the identities of its own account holders and serves at the intermediary through which its business customers can verify the identities of account holders at other banks
14. Assisting small business entries in e-commerce. helps smaller firms in setting up the infrastructure-interactive website and payment capabilities for engaging in commerce.
Retail banking services
Retail customers have demanded efficiency and flexibility in their financial transaction. using only checks or holding cash is often more expensive and time consuming than using retail oriented electronic payment technology, and increasingly , the internet. Some of the most important retail payment product innovations include the following
1. automated teller machines (ATM).allow customers 24 hours access to their checking accounts. they can play bills as well as withdraw cash from these machines. in addition, if the bank ATM’s are part of a bank network (such as CIRRUS,PLUS or HONOR) retail depositors can gain direct nationwide and in many cases international access to their deposit accounts by using the ATM of other bank in the network to draw on their accounts
2. point of sale debit (POS) cards. allow customers who choose not to use cash, checks, or credit cards for purchases to buy merchandise using debit card/point of sale (POS) terminals. the merchant avoids the check float and any delay in payment associated with credit card receivables since the bank offering the debit card/POS service immediately and directly transfer funds from customers deposit account to the merchants deposit account at the time of card use. unlike check or credit card purchases, the use of debit card results in an immediate transfer of funds from the customer’s account to the merchant’s account. Moreover, the customers never runs up a debit to the card issuer as is common with a credit card .
3. home banking. Connects customers to their deposit and brokerage accounts and provides such services as electronic securities trading and bill-playing service via personal computers.
4. preauthorized debits/credits. Includes direct deposit of payroll checks into bank accounts and direct payments of mortgage and utility bills.
5. paying bills via telephone. Allows direct transfer of funds from the customer’s bank account to outside parties either by voice command or by touch-tone telephone.
6. email billing. Allows customers to receive and pay bills by using the internet. Thus saving postage and paper.
7. on-line banking. Allows customers to conduct retail banking and investment services offered via the internet in some cases this involves building a new on-line internet only bank, such as Security First Network Bank of Atlanta.
8. smart cards ( stored-value cards ). Allows the customers to store and spend money for various transaction using a card that has a chip storage device, usually in the farm of strip. these have become increasingly popular at universities .
Early entrants into internet banking have been bank that have introduced new technology in markets with demographic and economic characteristic that help ensure customers acceptance, e.g., urban banks with a strong retail orientation that have tailored their internet offering to their retail customers. For example, in early 2001, city-group reported a total of 2.2 million online customers. Similarly, J. P. Morgan chase repotted a total of 750.000 online customers and wells Fargo 2.5 million. Bank of America reported it had been signing up 130.000 online customers per month in early 2001. these early entrants have generally developed their internet related product to gain access to non core , less traditional sources of funds. Bank that have invested internet banking as a complement to their existing services, have performed similar to those without internet banking, despite relatively high initial technology related expenses. in particular, these bank generally have higher non interest income (which offsets any increased technology expenses ) . further, the risk of banks offering internet related banking product appears to be similar to the risk of those bank without internet banking.
In addition to development of internet banking as a complement to the traditional services offered by commercial banks, a new segment of the industry has arisen that consist of internet-only banks, that is, these banks have no “brick and mortal” facilities, or are “bank without walls” in these banks, all business is conducted over the internet. However, internet-only banks have yet to capture more than a small fraction of the banking market. While ATMs and internet banking may potentially lower bank operating costs compared to employing full-service tellers, the inability of machines to address customers concerns and question flexible may drive retail customers away : revenue losses may counteract any cost-saving effect. Customers still want to interact with a person for many transaction. For example, a survey of the home buying and mortgage processing by the mortgage bankers association ( in 2000) found that, while 73 percent of home buyers used the internet to obtain information on mortgage interest rates, only 12 percent applied for mortgage via the internet and only 3 percent actually closed on a mortgage on the internet. as new technology is implemented, banks cannot ignore the issue of service quality and convenience. Indeed , the survival of small banks in the face of growing nation wide branching may well be due in part to customers’ beliefs that overall service quality is higher with tellers who provide a human touch rather than the internet banking and ATMs more common at bigger banks, even internet-only banks are recognizing this as “ virtual” bank such as security first network bank (the first internet-only bank) added 150 “ bricks” (branches ) in 2000. further, a new type of customers service will be needed; customers require prompt , well-informed support on technical issues as they increasingly conduct their financial business electronically.
8 regulators
While chapter 14 provides a detailed description of the regulation governing commercial banks and their impact on the banking industry, this section provides a brief overview of the regulators of this group of Fl S. Unlike other countries that have on or sometimes two regulators, U.S. banks may be subject to the supervision and regulation of as many as four separate regulators. These regulators provider the common rulers and regulation under which banks operate. They also monitor banks to ensure they abide by the regulation imposed. As discussed in chapter 4 it is the regulators’ job to among other things, ensure the safety and soundness of the banking system. The key commercial bank regulators are the federal deposit insurance corporation ( FDIC), the office of the comptroller of the currency (OCC), the federal reserve system (FRS), and state bank regulators. The next section discuss the principal role that each plays.
Federal deposit insurance corporation
Established in 1933, the federal deposit insurance corporation ( FDIC ) insures the deposit of commercial banks. In so doing, it levies insurance premium on banks
Manages the deposit insurance fund ( that is, generated from those premiums and their reinvestment ),and conduct bank examination. In addition, when an insured bank is closed, the FDIC acts as the receiver and liquidator, although the closure decision it self is technically made by the banks chartering or licensing agency ( see below ). Because of problems in the thrift industry and insolvency of the saving association insurance fund ( FSLIC ) in 1989 ( see chapter 14), the FDIC now manages both the commercial bank insurance fund the saving association insurance fund. The bank insurance funds is called BIF and the saving association fund is called the savings association insurance fund, or S A l F ( see chapter 12). The number of FDIC-BIF insured banks and the division between nationally and state-chartered banks is shown in figure 11-10.
Office of the comptroller of the currency
The office of the comptroller of the currency (OCC) is the oldest U.S. bank regulatory agency. Established in 1863, it is organized as a sub agency of the U.S. treasury its primary function is to charter nation banks as well as to close them. In addition, the OCC examines national banks and has the power to approve or disapprover their merger application instead of seeking a nation charter, however, banks can seek to be chartered by 1 of 50 individual state bank regulator agencies .
Historically, state chartered banks have been subject to fewer regulation and restriction on their activities than nation banks. This lack of regulatory oversight was a major reason many banks chose not to be nationally chartered. Many more recent regulation ( such as the depository institution deregulation and monetary control act 1980 ) attempted to level the restrictions imposed on federal and state chartered banks (see chapter 14 ). Not all discrepancies, however, were changed and state chartered bank are still generally less heavily regulated than nationally chartered banks. The choice of being a nationally chartered of state-chartered bank lies at the foundation of the dual banking system in the united states. Most large banks, such as city bank, choose nation charters, but others have state charters. For example, Morgan guaranty, the money center bank subsidiary of J.P. Morgan chase, is chartered as a state bank under state of New York law. At year-end 2001 2,137 banks were nationally chartered and 5,943 were state chartered, representing 26.4 percent and 73.6 percent, respectively, of all commercial bank assets.
Federal reserve system
In addition to being concerned with the conduct of monetary policy, the federal reserve, as this country’s central bank, also has regulatory power over some bank and where relevant, their holding company parents. All 2,137 nationally chartered banks shown in figure 11-10 are automatically members of the federal reserve system (FRS). In addition, 972 of the state-chartered banks have also chosen to become members. Since 1980, all banks have had to meet the same non interest- bearing reserve requirements whether they are members of the FRS or not. The primary advantage of FRS membership is direct access to the federal funds wire transfer network for nationwide inter bank borrowing and lending of reserves finally, many banks are often owned and controlled by parent holding companies-for example, city group is the parent holding company of city bank ( a nation bank). Because the holding company’s management can influence decision taken by a bank subsidiary and thus influence its risk exposure, the FRS regulates and examines bank holding companies as well as bank themselves .
State authorities
As mentioned above, banks may chose to be state-chartered rather than nationally chartered. State-chartered commercial banks are regulated by state agencies. State authorities perform similar function as the OCC performs for national banks.
9. Global issues
For the reasons discussed in earlier chapters, financial institutions are of central importance to the development and integration of market globally. However, U.S. financial institution must now compete not only with other domestic financial institution for are share of these markets but increasingly with foreign financial institution. Table 11-8 list the 20 largest banks in the world, measured by total asset, as of July 2001. only 3 of the top 20 banks are U.S. banks .the three-way merger between the industrial banks of Japan , Fuji bank, and Dai-Ichi Kangyo bank in 2000created the world’s largest banking group MIZOHU financial group with assets of over $1,29 billion table 11-9 list foreign bank office’ assets and liabilities held in the united state from 1992 through 2001. total foreign bank assets over this period increased from $509.3 billion to $850.9 billion. The world’s most globally active bank, based on the percent of their assets held outside their home countries, are listed in table 11-10. these include the big Swiss banks ( union bank of Switzerland and credit Swiss ) as well as one U.S. bank, American express bank. The two largest U.S. banks, Citigroup and J.P. Morgan chase ranked 28th ( with 36.41 percent of the their business overseas ) and 29th ( with 35.34 percent of their business overseas ), respectively .
Advantages and disadvantages of international expansion
International expansion has six major advantages:
Risk diversification as with domestic geographic expansion and F I’ s international activities potentially an enhance its opportunities to diversify the risk of its earning flows. Often domestic earning flows from financial services strongly linked to the state of the domestic economy. Therefore the last integrated the economies of the world are the greater is the potential for earning diversification through international expansion.
Economies of scale. To the extent that economies of scale exist. An FI can potentially lower is average operating costs by expanding is activities beyond domestic boundaries.
Innovation. An FI can generate extra returns from new product innovation if it can sell such services internationally rather than just domestically. For example, consider complex financial innovations, such as securitization, caps , floors, and options, that FI s have innovated in the united states and sold to new foreign market with few domestic competitors until recently .
Found source . international expansion allows an FI to search of funds. This is extremely important with the very thin profit margins in domestic and international wholesale banking it also reduces the risk of fund shortages ( credit rationing ) in any one market .
Customers relationship . international expansions also allow an FI to maintain contact with and service the needs of domestic multinational corporations. Indeed, one of the fundamental factors determining the growth of FI’ s in foreign countries has been the parallel growth of foreign direct investment and foreign trade by globally oriented multinational corporation from the FI’ s home country.
Regulatory avoidance . to the extent that domestic regulations such as activity restriction and reserve requirements impose constraints or taxes on the operations of an FI, seeking low-tax countries can allow an FI to lower its net regulatory burden and to increase is potential net profitability .
Commercial banks as a sector of the financial institutions industry overview
The products that modern financial institutions sell and the risks they face are becoming increasingly similar, as are the techniques they use to measure and manage these risks. The two panels in table 11-1 indicate the product sold by the financial service industry in 1950 and in 2003.Three major FI groups-commercial banks, savings institutions, and credit unions –are also called depository institutions because a significant proportion of their funds come from customer deposits. Chapters 11 through 14 describe depository institutions, their financial statement, and the regulation that govern their operations.
Depository institutions
P
art three of the text summarizes the operation of depository institutions. Chapter 11 describes the key characteristics and recent trends in the commercial banking sector.
Chapter 12 does the same for the thrift institutions sector. Chapter 13 describes the financial statement of a typical depository institutions and the rations used to analyze those statement .
Chapter 14 provides a comprehensive look at the regulation under which these financial institutions operate and, particularly, at the effect of recent changes in regulations.
7 . Technology in commercial banking
Certain to affect the future performance of commercial banks (as well as all financial institutions ) is the extent to which banks adopt the newest technology. Including the extent to which industry participants embrace the internet and online banking. Technological innovation has been a major concern of all types of financial institutions in recent years. Since the 1980s, banks, insurance companies, and investment companies have sought to improve operational efficiency whit major investment in internal and external communication, computer and expended technological infrastructure. Internet and wireless communications technologies are having a profound effect on financial services. These technologies are more than just new distribution channels-they are completely different way of providing financial service. Indeed, a global financial service firm such as Citigroup has operations in more than 100 countries connected in real time by a proprietary-owned satellite system.
Technology is important because well-chosen technological investment have the potential to increase both the FI’ s net interest margin –or the difference between interest income and interest expense-and other net income. Therefore , technology can directly improve profitability. The following subsections focus on some specific technology-based product found in modern retail and wholesale banking. Note that this list is far from complete.
Wholesale Banking Services
Probably the most important area on which technology has impacted wholesale or corporate customer services is a bank’s ability to provider cash management or working capital services. Cash management service needs have largely resulted from (1) corporate recognition that excess cash balances result in a significant opportunity cost due to lost or forgone interest and (2) corporate need to know cash or working capital positions on a real-time basis. Among the services that modern banks provider to improve the efficiency with which corporate clients manage their financial positions are these:
1. controlled disbursement accounts. An account feature that allows all payment to be made in a given day to be known in the morning. the bank informs the corporate client of the total funds it needs to meet disbursement, and the client wire transfers the amount needed. These checking accounts are debited early each day so that corporations can obtain an early insight into their net cash positions .
2. account reconciliation. A checking feature that records which of the firm’s checks have been paid by the bank .
3. lockbox services. A centralized collection service for corporate payments to reduce the delay in check clearing, or the float . in a typical lockbox arrangement, a local bank sets up a lockbox at the post office for a corporate client located outside the area. Local customers mail payment to the lockbox rather than to the out-of-town corporate headquarters. The bank collects these checks several times per day and deposits them directly into the customer’s account. Details of the transaction are wired to the corporate client.
4. electronic lockbox. Same as item 3 but the customers receives on-line payments for public utilities and similar corporation clients.
5. funds concentration. A service that redirects funds from accounts in a large number of different banks or branches to a few centralized accounts at one bank.
6. electronic funds transfer. Includes overnight payments via CHIPS or Fed wire , Automated payment of payrolls or dividends via automated clearinghouses (ACH s), and automated transmissions of payment massage by SWIFT, an international electronic massage service owned and operate by U.S. and European banks that instructs banks to make specific payments.
7. check deposit services. Encoding ,endorsing, microfilming, and handling customers’ checks.
8. electronic initiation of letters of credit. allows customers in a network to access bank computers to initiate letters of credits.
9. treasury management software. allows efficient management of multiple currency and security portfolios for trading and investment purposes.
10. electronic data interchange. A specialized applications of electronic mail, allowing businesses to transfer and transact invoice, purchase orders, and shipping notices automatically, using banks as clearinghouse.
11. facilitating business-to-business e-commerce. A few of the largest commercial banks have begun to offer firms the technology for electronic business-to-business commerce. The banks are essentially automating the entire information flow associated with the procurement and distribution of goods and services among businesses
12. Electronic billing. provides the presentment and collection services for companies that send out substantial volumes of recurring bills. banks combine the email capability of internet to send out bills with their ability to process payment electronically through the inter bank payment networks
13. verifying identities. using encryption technology a bank certifies the identities of its own account holders and serves at the intermediary through which its business customers can verify the identities of account holders at other banks
14. Assisting small business entries in e-commerce. helps smaller firms in setting up the infrastructure-interactive website and payment capabilities for engaging in commerce.
Retail banking services
Retail customers have demanded efficiency and flexibility in their financial transaction. using only checks or holding cash is often more expensive and time consuming than using retail oriented electronic payment technology, and increasingly , the internet. Some of the most important retail payment product innovations include the following
1. automated teller machines (ATM).allow customers 24 hours access to their checking accounts. they can play bills as well as withdraw cash from these machines. in addition, if the bank ATM’s are part of a bank network (such as CIRRUS,PLUS or HONOR) retail depositors can gain direct nationwide and in many cases international access to their deposit accounts by using the ATM of other bank in the network to draw on their accounts
2. point of sale debit (POS) cards. allow customers who choose not to use cash, checks, or credit cards for purchases to buy merchandise using debit card/point of sale (POS) terminals. the merchant avoids the check float and any delay in payment associated with credit card receivables since the bank offering the debit card/POS service immediately and directly transfer funds from customers deposit account to the merchants deposit account at the time of card use. unlike check or credit card purchases, the use of debit card results in an immediate transfer of funds from the customer’s account to the merchant’s account. Moreover, the customers never runs up a debit to the card issuer as is common with a credit card .
3. home banking. Connects customers to their deposit and brokerage accounts and provides such services as electronic securities trading and bill-playing service via personal computers.
4. preauthorized debits/credits. Includes direct deposit of payroll checks into bank accounts and direct payments of mortgage and utility bills.
5. paying bills via telephone. Allows direct transfer of funds from the customer’s bank account to outside parties either by voice command or by touch-tone telephone.
6. email billing. Allows customers to receive and pay bills by using the internet. Thus saving postage and paper.
7. on-line banking. Allows customers to conduct retail banking and investment services offered via the internet in some cases this involves building a new on-line internet only bank, such as Security First Network Bank of Atlanta.
8. smart cards ( stored-value cards ). Allows the customers to store and spend money for various transaction using a card that has a chip storage device, usually in the farm of strip. these have become increasingly popular at universities .
Early entrants into internet banking have been bank that have introduced new technology in markets with demographic and economic characteristic that help ensure customers acceptance, e.g., urban banks with a strong retail orientation that have tailored their internet offering to their retail customers. For example, in early 2001, city-group reported a total of 2.2 million online customers. Similarly, J. P. Morgan chase repotted a total of 750.000 online customers and wells Fargo 2.5 million. Bank of America reported it had been signing up 130.000 online customers per month in early 2001. these early entrants have generally developed their internet related product to gain access to non core , less traditional sources of funds. Bank that have invested internet banking as a complement to their existing services, have performed similar to those without internet banking, despite relatively high initial technology related expenses. in particular, these bank generally have higher non interest income (which offsets any increased technology expenses ) . further, the risk of banks offering internet related banking product appears to be similar to the risk of those bank without internet banking.
In addition to development of internet banking as a complement to the traditional services offered by commercial banks, a new segment of the industry has arisen that consist of internet-only banks, that is, these banks have no “brick and mortal” facilities, or are “bank without walls” in these banks, all business is conducted over the internet. However, internet-only banks have yet to capture more than a small fraction of the banking market. While ATMs and internet banking may potentially lower bank operating costs compared to employing full-service tellers, the inability of machines to address customers concerns and question flexible may drive retail customers away : revenue losses may counteract any cost-saving effect. Customers still want to interact with a person for many transaction. For example, a survey of the home buying and mortgage processing by the mortgage bankers association ( in 2000) found that, while 73 percent of home buyers used the internet to obtain information on mortgage interest rates, only 12 percent applied for mortgage via the internet and only 3 percent actually closed on a mortgage on the internet. as new technology is implemented, banks cannot ignore the issue of service quality and convenience. Indeed , the survival of small banks in the face of growing nation wide branching may well be due in part to customers’ beliefs that overall service quality is higher with tellers who provide a human touch rather than the internet banking and ATMs more common at bigger banks, even internet-only banks are recognizing this as “ virtual” bank such as security first network bank (the first internet-only bank) added 150 “ bricks” (branches ) in 2000. further, a new type of customers service will be needed; customers require prompt , well-informed support on technical issues as they increasingly conduct their financial business electronically.
8 regulators
While chapter 14 provides a detailed description of the regulation governing commercial banks and their impact on the banking industry, this section provides a brief overview of the regulators of this group of Fl S. Unlike other countries that have on or sometimes two regulators, U.S. banks may be subject to the supervision and regulation of as many as four separate regulators. These regulators provider the common rulers and regulation under which banks operate. They also monitor banks to ensure they abide by the regulation imposed. As discussed in chapter 4 it is the regulators’ job to among other things, ensure the safety and soundness of the banking system. The key commercial bank regulators are the federal deposit insurance corporation ( FDIC), the office of the comptroller of the currency (OCC), the federal reserve system (FRS), and state bank regulators. The next section discuss the principal role that each plays.
Federal deposit insurance corporation
Established in 1933, the federal deposit insurance corporation ( FDIC ) insures the deposit of commercial banks. In so doing, it levies insurance premium on banks
Manages the deposit insurance fund ( that is, generated from those premiums and their reinvestment ),and conduct bank examination. In addition, when an insured bank is closed, the FDIC acts as the receiver and liquidator, although the closure decision it self is technically made by the banks chartering or licensing agency ( see below ). Because of problems in the thrift industry and insolvency of the saving association insurance fund ( FSLIC ) in 1989 ( see chapter 14), the FDIC now manages both the commercial bank insurance fund the saving association insurance fund. The bank insurance funds is called BIF and the saving association fund is called the savings association insurance fund, or S A l F ( see chapter 12). The number of FDIC-BIF insured banks and the division between nationally and state-chartered banks is shown in figure 11-10.
Office of the comptroller of the currency
The office of the comptroller of the currency (OCC) is the oldest U.S. bank regulatory agency. Established in 1863, it is organized as a sub agency of the U.S. treasury its primary function is to charter nation banks as well as to close them. In addition, the OCC examines national banks and has the power to approve or disapprover their merger application instead of seeking a nation charter, however, banks can seek to be chartered by 1 of 50 individual state bank regulator agencies .
Historically, state chartered banks have been subject to fewer regulation and restriction on their activities than nation banks. This lack of regulatory oversight was a major reason many banks chose not to be nationally chartered. Many more recent regulation ( such as the depository institution deregulation and monetary control act 1980 ) attempted to level the restrictions imposed on federal and state chartered banks (see chapter 14 ). Not all discrepancies, however, were changed and state chartered bank are still generally less heavily regulated than nationally chartered banks. The choice of being a nationally chartered of state-chartered bank lies at the foundation of the dual banking system in the united states. Most large banks, such as city bank, choose nation charters, but others have state charters. For example, Morgan guaranty, the money center bank subsidiary of J.P. Morgan chase, is chartered as a state bank under state of New York law. At year-end 2001 2,137 banks were nationally chartered and 5,943 were state chartered, representing 26.4 percent and 73.6 percent, respectively, of all commercial bank assets.
Federal reserve system
In addition to being concerned with the conduct of monetary policy, the federal reserve, as this country’s central bank, also has regulatory power over some bank and where relevant, their holding company parents. All 2,137 nationally chartered banks shown in figure 11-10 are automatically members of the federal reserve system (FRS). In addition, 972 of the state-chartered banks have also chosen to become members. Since 1980, all banks have had to meet the same non interest- bearing reserve requirements whether they are members of the FRS or not. The primary advantage of FRS membership is direct access to the federal funds wire transfer network for nationwide inter bank borrowing and lending of reserves finally, many banks are often owned and controlled by parent holding companies-for example, city group is the parent holding company of city bank ( a nation bank). Because the holding company’s management can influence decision taken by a bank subsidiary and thus influence its risk exposure, the FRS regulates and examines bank holding companies as well as bank themselves .
State authorities
As mentioned above, banks may chose to be state-chartered rather than nationally chartered. State-chartered commercial banks are regulated by state agencies. State authorities perform similar function as the OCC performs for national banks.
9. Global issues
For the reasons discussed in earlier chapters, financial institutions are of central importance to the development and integration of market globally. However, U.S. financial institution must now compete not only with other domestic financial institution for are share of these markets but increasingly with foreign financial institution. Table 11-8 list the 20 largest banks in the world, measured by total asset, as of July 2001. only 3 of the top 20 banks are U.S. banks .the three-way merger between the industrial banks of Japan , Fuji bank, and Dai-Ichi Kangyo bank in 2000created the world’s largest banking group MIZOHU financial group with assets of over $1,29 billion table 11-9 list foreign bank office’ assets and liabilities held in the united state from 1992 through 2001. total foreign bank assets over this period increased from $509.3 billion to $850.9 billion. The world’s most globally active bank, based on the percent of their assets held outside their home countries, are listed in table 11-10. these include the big Swiss banks ( union bank of Switzerland and credit Swiss ) as well as one U.S. bank, American express bank. The two largest U.S. banks, Citigroup and J.P. Morgan chase ranked 28th ( with 36.41 percent of the their business overseas ) and 29th ( with 35.34 percent of their business overseas ), respectively .
Advantages and disadvantages of international expansion
International expansion has six major advantages:
Risk diversification as with domestic geographic expansion and F I’ s international activities potentially an enhance its opportunities to diversify the risk of its earning flows. Often domestic earning flows from financial services strongly linked to the state of the domestic economy. Therefore the last integrated the economies of the world are the greater is the potential for earning diversification through international expansion.
Economies of scale. To the extent that economies of scale exist. An FI can potentially lower is average operating costs by expanding is activities beyond domestic boundaries.
Innovation. An FI can generate extra returns from new product innovation if it can sell such services internationally rather than just domestically. For example, consider complex financial innovations, such as securitization, caps , floors, and options, that FI s have innovated in the united states and sold to new foreign market with few domestic competitors until recently .
Found source . international expansion allows an FI to search of funds. This is extremely important with the very thin profit margins in domestic and international wholesale banking it also reduces the risk of fund shortages ( credit rationing ) in any one market .
Customers relationship . international expansions also allow an FI to maintain contact with and service the needs of domestic multinational corporations. Indeed, one of the fundamental factors determining the growth of FI’ s in foreign countries has been the parallel growth of foreign direct investment and foreign trade by globally oriented multinational corporation from the FI’ s home country.
Regulatory avoidance . to the extent that domestic regulations such as activity restriction and reserve requirements impose constraints or taxes on the operations of an FI, seeking low-tax countries can allow an FI to lower its net regulatory burden and to increase is potential net profitability .
Wednesday, February 25, 2009
Thrift Institutions
1.Three categories of Thrift Institutions :
Chapter Overview
Thrift institutions comprise three different groups of Fl s : saving associations, saving banks, and credit unions. Thrift institutions were first created in the early 1800s in response to commercial banks’ concentration on serving the needs of business (commercial) enterprises rather than the needs of individuals requiring borrowed funds to purchase homes. Thus, the first thrifts pooled individual savings and invested them mainly in mortgages and other securities. While today’s thrifts generally perform services similar to commercial banks, they are still grouped separately because they provide important residential mortgage lending and other financial services to households. Figure 12-1 illustrates key asset side differences among the three types of thrift institutions. Historically, savings associations have concentrated primarily on residential mortgages, while savings bank have been operated as more diversified institutions, with a large concentration of residential mortgages assets but holding commercial loans, corporate bonds, and corporate stock as well. Credit unions have historically focused on consumer loans funded with member deposits. Each category of thrift includes federally chartered and state chartered institutions. Table 12-1 shows the number of each type of thrift as of year-end 2001. This chapter reviews these three types of depository institutions. For each group, we examine (1) their size, structure, and composition, (2) their balance sheets and recent trends, (3) their regulators, and (4) recent industry performance.
Savings Associations
Size, Structure , and Composition of the industry
The savings associations industry prospered throughout most of the 20th century. Savings associations were historically referred to as savings and loan (S&L) associations. However, in the 1980s, federally chartered savings banks appeared in the United States. These institutions have the same regulators and regulations as the traditional savings and loans, Together they are referred to as savings associations. These specialized institutions made long-term residential mortgages usually backed by the short-term deposits of small savers. This strategy was successful largely because of the federal Reserve’s policy of smoothing or targeting interest rates, especially in the post World War II period up until the late 1970s (see Chapter 4), and the generally stable and upward-sloping shape of the yield curve of the term structure of interest rates (see Chapter 2). During some periods, such as the early 1960s, the yield curve did slope downward but for most of the post-World War II period, the upward –sloping yield curve meant that the interest rates on savings associations’ 30-year residential mortgages assets exceeded the rates they paid on their short-term deposit liabilities. Moreover, significant shocks to interest rates were generally absent because of the Fed’s policy of interest rate smoothing and the fact that the world’s economies were far less integrated compared with today’s economies.
2. At the end of the slightly fewer than 4,000 savings associations existed, with assets of approximately $0.6 trillion. During the October 1970 to October 1982 period, however, the Federal Reserve radically changed its monetary policy strategy by targeting bank reserves rather than interest rates, in an attempt to lower the underlying rate of inflation ( see Chapter 4 for more details ). The Fed’s restrictive monetary policy actions led to a sudden and dramatic surge in interest rates, with rates on T-bills and bank certificates of deposits rising as high as 16 percent. This increase in short-term rates and the cost of fund had two effects. First, many savings association faced negative interest spreads or net interest margins (interest income minus interest expense divided by earning assets) in funding much of their long-maturity, fixed-rate residential mortgages in their portfolios. For example, a 12 percent 30-year mortgage was having to be funded by a 15 percent 3-month CD. Second, they had to pay more competitive interest rates on deposits to prevent disintermediation and the reinvestment of these funds in money market mutual fund accounts. Their ability to do this was constrained by the Federal Reserve’s Regulation Q ceilings, which limited ( albeit to a lesser extent for saving institutions than commercial banks ) the interest rates that savings associations could pay on the traditional passbook savings account and retail time deposits that small savers held. Thus, many small depositors, especially the more sophisticated, withdrew their funds from savings association deposit accounts (that were paying less than market interest rates because of Regulations Q) and invested directly in unregulated money market mutual fund accounts (where they could earn market interest rates).
Partly to overcome the adverse effects of rising rates and disintermediation on the savings association industry, Congress passed two major acts in the early 1980s revising the permitted scope of savings associations’ activities : the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 and the Garn-St. GERMAIN Depository Institutions Act (GSGDIA) of 1982 (see Chapter 14); these expanded savings associations’ deposit-taking and asset investment powers. On the liability side, savings associations were allowed to offer interest-bearing transaction accounts, called NOW accounts, and to issue more market rate-sensitive liabilities such as money market deposit accounts (MMDAs) to limit disintermediation and to compete with mutual funds. On the asset side of the balance sheet, they were allowed to offer floating-or-adjustable-rate mortgages and, to a limited extent, expand into consumer real estate development and commercial lending. Note the structural shifts in savings associations, the new powers created safer and more diversified institutions.
For a small but significant group, however, whose earnings and shareholders’ capital was being eroded in traditional areas of asset and liability business, the new regulations meant the opportunity to take more asset side risks which, if they paid off, could return the institution to profitability. However, in the mid-1980s, real estate and land prices in Texas and the Southwest collapsed. This was followed by economic downturns in the Northeast and Western states of the United States. Many borrowers with mortgage loans issued by savings associations in these areas defaulted. In other words, the risks incurred by many of these institutions did not pay off. This risk-taking behavior was accentuated by the policies of the federal insurer of savings associations deposits, FSLIC. It chose not to close capital-depleted, economically insolvent savings associations (a policy of regulator forbearance) and to maintain deposit insurance premium assessments independent of the risk taken by the institutions (see Chapter 14). As a result, an alarming number (1,248) of savings association failures occurred in the 1982-1992 period (peaking at 316 in 1989), alongside a rapid decline in asset growth of the industry. Figure 12-2 shows the number of failures, mergers, and new charters of savings institutions (savings associations and savings banks combined) from 1984 through 2001. Notice the large number of failures from 1987 through 1992 and the decline in the number of new charters.
In the 1980s, the large number of savings association failures depleted the resources of the FSLIC to such an extent that by 1989 it was massively insolvent. For example, between 1980 and 1988, 514 thrifts failed, at an estimated cost of $42.3 billion. Moreover, between 1989 and 1992 an additional 734 thrifts failed, at a cost of $78 billion. As a result, Congress passed an additional piece of legislation: the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989. This legislation abolished the FSLIC and created a new savings association insurance fund (SAIF) under the management of he FDIC (with the help of a $100 billion infusion of funds by the U.S. government). FIRREA also replaced he Federal Home Loan Bank Board with the Office of Thrift Supervision (OTS) as the main regulator of federally chartered savings associations. In addition, the act created the Resolution Trust Corporation (RTC) to close and liquidated the most insolvent savings institutions. The FIRREA also strengthened the capital requirements of savings associations and constrained their non-mortgage-related asset investment powers under a revised qualified thrift lender test, or QTL test (discussed below). Following FIRREA, Congress further enacted the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The FDICIA of 1991 introduced risk-based deposit insurance premiums (starting in 1993) in an attempt to limit excessive risk taking by savings association owners. It also introduced a prompt corrective action (PCA) policy, such that regulators could close thrifts and banks faster (see Chapter 14). In particular, if a savings association’s ratio of its owners’ equity capital to its assets fell below 2 percent, it had to be closed down or recapitalized within three months.
As a result of closing weak savings associations and strengthening their capital requirements, the industry is now significantly smaller both in terms of numbers and asset size. Specifically, the number of savings associations decreased from 2,600 in 1989 to 1,176 in 2001 (by 55 percent) and asset have decreased from $1.2 trillion to $906 billion (by 24 percent) over the same period.
Balance Sheets and Recent Trends
Even in its new smaller state, the future viability of the savings association industry in traditional mortgage lending areas is a matter of debate. This is due partly to intense competition for mortgages from other financial institutions such as commercial banks and specialized mortgage bankers. It is also due to the securitization of mortgages into mortgage-backed security pools by government-sponsored enterprises, which we discuss in Chapters 7 and 25. In addition, long-term mortgage lending exposes FIs ti significant credit, interest rate, and liquidity risks.
3 Column (1) of Table 12-3 shows the balance sheet for the savings association industry at year-end 2001. On this balance sheet, mortgages and mortgage-backed securities (securitized pools of mortgages) represent 73.42 percent of total assets. This compares to 35.44 percent in commercial banks. Figure 12-3 shows the distribution of mortgage-related assets for all savings institutions (savings associations and savings bank) as of December 2001. As noted earlier, the FIRREA uses the QTL test to establish a minimum holding of 65 percent in mortgage-related assets for savings associations. Reflecting the enhanced lending powers established under the 1980 DIDMCA and 1982 GSGDIA, commercial loans and consumer loans amounted to 2.71 and 6.20 percent of savings association assets, respectively, compared to 14.96 percent and 9.61 percent at commercial banks. Finally, savings associations are required to hold cash and investment securities for liquidity purposes and to meet regulator-imposed reserve requirements (see Chapter 14). In December 2001, cash and investment securities (U.S. Treasury securities and federal agency obligations; federal funds and repos; and bonds, notes, debentures, and other securities) holding amounted to 10.95 percent of total assets compared to 33.36 percent at commercial banks.
4 On the liability side of the balance sheet, small time and savings deposits are still the predominant source of funds, with total deposits accounting for 60.74 percent of total liabilities and net worth. This compares to 66.85 percent at commercial banks. The second most important source of funds is borrowing from the 12 Federal Home Loan Banks (FHLBs), which the institutions themselves own. Because of their size and government-sponsored status, FHLBs have access to the wholesale capital market for notes and bonds and can relend the funds borrowed in these markets to savings associations at a small markup over wholesale cost. Other borrowed funds include repurchase agreements and direct federal fund borrowings.
Finally, net worth is the book value of the equity holders’ capital contribution; it amounted to 8.21 percent in 2001. This compares to 9.09 percent at commercial banks. Historically, most savings associations (and saving banks) were established as mutual organizations (in which the depositors are the legal owners of the institution and no stock is issued). As a mutual organization, member deposits represent the equity of the savings association. Since there are no stockholders, and thus no demand for equity investment returns, mutual organizations are generally less risky than stock-chartered organizations—mutual savings association managers can concentrate on low-risk investments and the prevention of failure rather than higher risk investments needed to produce higher required returns on stockholders’ investments. However, through time many savings associations (and savings banks) have switched from mutual to stock charters (in which the holders of the stock or equity are the legal owners of the institution rather than depositors as under the mutual charter). This is mainly because stock ownership allows savings institutions to attract capital investment from outside stockholders beyond levels achievable at a mutual institution. Figure 12-4 shows this trend in mutual versus stock charters and asset size for savings institutions from 1988 through 2001.
In May 2002, the Office of Thrift Supervision (OTS) proposed new rules that would increase the documentation required when a mutually chartered organization applies for conversion to a stock charter. The new rule would require the thrift to demonstrate a need for new capital, instead of merely explaining how the new capital would be deployed. The institution would also be asked to describe its experience with growth and expansion into other business lines, and demonstrate that it would be able to achieve a reasonable return on equity. These changes are expected to reduce the number of mutual thrifts converting to stock charters.
Savings Banks
Size, Structure, and Composition of the Industry
Traditionally, savings banks were established as mutual organizations in states that permit such organizations. These states were largely confined to the East Coast—for example, New York, New Jersey, and the New England states. As a result, savings banks (unlike savings associations) were not affected by the oil-based economic ups and downs of Texas and the Southwest in the 1980s. The crash in New England real estate values in 1990-1991 presented equally troubling problems for this group, however. Indeed, many of the failures of savings institutions (see Figure 12-2) were of savings banks rather than savings associations. As a result, like savings associations, savings banks have decreased in both size and number. In December 2001, 357 savings banks had $393 billion In assets: $248 billion of their deposits are insured by the FDIC under the BIF (Bank Insurance Fund). FDIC insurance under the BIF is just one characteristic that distinguishes savings banks from savings associations, whose deposits are insured under by the FDIC under the SAIF (Savings Association Insurance Fund).
Balance Sheets and Recent Trends
Notice the major similarities and differences between savings associations and savings banks in Table 12-3, which shows their respective assets and liabilities as of year-end 2001. Savings banks (in the second column of Table 12-3)have a heavy concentration (73.72 percent) of mortgage loans and mortgage-backed securities (MBSs). This is slightly more than the savings associations’ 73.42 percent in these assets and much more than commercial banks (35.44 percent). Over the years, savings banks have been allowed greater freedom to diversify into corporate bonds and stocks; their holdings in these assets are 7.50 percent compared to 2.21 percent for savings associations. On the liability side, the major difference is that savings banks generally (although this was not the case in 2001, as shown in Table 12-3) rely less heavily on deposits than savings associations and therefore savings banks have fewer borrowed funds. Finally, the ratio of the book value of net worth to total assets for savings banks stood at 8.96 percent (compared to 8.21 percent for savings associations and 9.09 percent for commercial banks) in 2001.
5. Regulators of Savings Institutions
The three main regulators of savings institutions are the Office of Thrift Supervision (OTS), the FDIC, and state regulators.
The Office of Thrift Supervision. Established in 1989 under the FIRREA, this office charters and examines all federal savings institutions. It also supervises the holding companies of savings institutions.
The FDIC. The FDIC oversees and managers the Savings Association Insurance Fund (SAIF), which was established in 1989 under the FIRREA in the weak of FSLIC insolvency. The SAIF provides insurance coverage for savings associations. Savings banks are insured under the FDIC’s Bank Insurance Fund (BIF) and are thus also subject to supervision and examination by the FDIC.
Other Regulators. State chartered savings institutions are regulated by state agencies—for example, the Office of Banks and Real Estate in Illinois—rather than the OTS.
6 Savings Association and Savings Bank Recent Performance
Like Commercial banks, savings institutions (savings associations and savings banks) experienced record profits in the mid-to late 1990s as interest rates (and thus the cost of funds to savings institutions) remained low and the U.S. economy (and thus the demand for loans) prospered. The result was an increase in the spread between interest income and interest expense for savings institutions and consequently an increase in net income. Despite an economic slowdown in the United States in the early 2000s, savings institutions continued to earn record profits. Figure 12-5 reports ROAs and ROEs for the industry from 1988 through December 2001. In the fourth quarter of 2001, savings institutions reported a record $3.8 billion in net income and the highest ever annualized ROA of 1.16 percent (this compares to an ROA of 1.13 percent over the same period for commercial banks—see Chapter 11). For the entire year 2001, savings institutions earned a record $13.3 billion in profits, with an ROA of 1.08 percent (the highest since 1946). The industry’s net interest margins rose in response to a steeper yield curve: the cost of funding earning assets declined by only 46 basis points. However, noncurrent loans (those with an interest payment over 90 days past due) as a percent of total loans rose to above 0.6 percent and net charge-offs in 2001 were almost twice those in 2000. Equity capital as a percent of total assets was 8.44 percent, down from its all time high of 8.94 percent in 1998, largely due to rapid asset growth by these banks. Table 12-4 presents several performance ratios for the industry for 1989 and 1993 through 2001.
Like the commercial banking industry, savings institutions have experienced substantial consolidation in the 1990s. For example, the 1998 acquisition of H.F. Ahmanson & Co. by Washington Mutual Inc. for almost $10 billion was the fourth largest bank/thrift merger completed in 1998. Washington mutual was the third largest savings institution in the United States early in 1997, while Ahmanson was the largest savings institution. In 1997, Washington Mutual bought Great Western to become the largest thrift in the country. Then, in March 1998, Washington Mutual bought Ahmanson to combine the two largest U.S. thrifts. In December 2001, Washington Mutual (the largest savings institution in the United States) had total assets at $223 billion, ranking seventh of all depository institutions (banks and thrifts). Table 12-5 shows the industry consolidation in number and asset size over the period 1992-2001. Notice that over this period, the biggest savings institutions (over $5 billion) grew in number from 29 to 44 and their control of industry assets grew from 32.3 percent to 63.7 percent.
Larger savings institutions have also enjoyed superior profitability compared to smaller savings institutions. The 576 small thrifts (with assets less than $100 million) had an average annualized ROA of 0.64 percent for the year 2001, while the larger (stock-owned) institutions reported an ROA of 1.17 percent. One major reason for this size-based difference in ROA is that larger savings institutions (unlike money center banks relative to smaller commercial banks) have virtually no asset investments or offices in foreign markets and countries and have consequently not suffered from recent crises in emerging markets and countries like Argentina that have so harmed the profitability of some money center banks. Despite the recent resurgence of this industry, as discussed in In the News box 12-1, its future is still uncertain.
7 Credit Unions
Credit Union (CUs) are not-for-profit depository institutions mutually organized and owned by their members (depositors). Credit unions were first established in the United States in the early 1900s as self-help organizations intended to alleviate widespread poverty. The first credit unions were organized in the Northeast, initially in Massachusetts. Members paid an entrance fee and put up funds to purchase at least one deposit share. Members were expected to deposit their savings in the CU, and these funds were lent only to other members.
This limit in the customer base of CUs continues today as, unlike commercial banks and savings institutions, CUs are prohibited from serving the general public. Rather, in organizing a credit union, members are required to have a common bond of occupation (e.g., police CUs), association (e.g., university-affiliated CUs), or cover a well-defined neighborhood, community, or rural district. CUs may, however, have multiple groups with more than one type of membership. Each credit union decides the common bond requirements (i.e., which groups it will serve) with the approval of the appropriate regulator (see below). To join a credit union individuals must then be a member of the approved group(s).
The primary objective of credit unions is to satisfy the depository and borrowing needs of their members. CU number deposits (called shares, representing ownership stakes in the CU) are used to provide loans to other members in need of funds. Earnings from these loans are used to pay interest on member deposits. Because credit unions are not-for-profit organizations., their earnings are not taxed. This tax-exempt status allows CUs to offer higher rates on deposits and charge lower rates in some types of loans compared to banks and savings institutions, whose earnings are taxable.
Size, Structure, and Composition of the Industry
Credit unions are the most numerous of the institutions (9,984 in 2001) that compose the depository institutions segment of the FI industry. (Figure 12-6 shows the number of credit unions, their total assets, and number of members from 1993 through 2001.) Moreover, CUs were less affected by the crisis that affected commercial banks and savings institutions in the 1980s. This is because traditionally more than 40 percent of their assets have been in small consumer loans, often for amounts less than $10,000, which are funded mainly by member deposits. This combination of relatively matched credit risk and maturity in the asset and liability portfolios left credit unions less exposed to credit and interest rate risk than commercial banks and savings institutions. In addition, CUs tend to hold large amounts of government securities (almost 20 percent of their assets in 2001) and relatively small amounts of residential mortgages. CUs’ lending activities are funded mainly by deposits contributed by their almost 80 million members.
The nation’s credit union system consists of three distinct tiers: the top tier at the national level (U.S. Central Credit Union); the middle tier at the state or regional level (corporate credit unions); and the bottom tier at the local level (credit unions). Figure 12-7 illustrates this structure, with the services conducted between various entities identified via arrows. Corporate credit unions are financial institutions that are cooperatively owned by their member credit unions. The 34 corporate credit unions serve their members primarily by investing and lending excess funds (unloaned deposits) that member credit unions place with them. Additional services provided by corporate credit unions include automated settlement, securities safekeeping, data processing, accounting, and payment services. As of 2001, credit unions had over $19 billion (3.9 percent of total assets) invested in corporate credit unions. The U.S. Central Credit Union serves as a “corporate’s corporate” – providing investment and liquidity services to corporate credit unions. The central Credit Union acts as a corporate credit unions’ main provider of liquidity. It invest their surplus funds and provides financial services and operational support.
In recent years, to attract and keep customers, CUs have expanded their services to compete with commercial banks and savings institutions. For example, many CUs now offer mortgages, credit lines, and automated teller machines. Some credit unions also offer business and commercial loans to their employer groups. For example, in the late 1990s, AWANE (Automotive Wholesalers Association of New England) Credit Union’s business loans represented 13.6 percent of its lending and the CU participated actively in the Small Business Administration loan programs, which enabled it to sell a portion of those loans. In addition, commercial real estate lending accounted for 29.5 percent of AWANE’s total lending.
As CUs have expanded in membership, size and services, bankers claim that CUs unfairly compete with small banks that have historically been the major lender in small towns and local communities. For example, the American Bankers Association claimed that the tax exemption for CUs gives them the equivalent of a $1 billion a year subsidy. The response of the Credit Union National Association (CUNA) is that any cost to taxpayers from CUs’ tax-exempt status is more than passed on to their members and society at large through favorable interest rates on deposits and loans. For example, CUNA estimates that the benefits of CU membership can range from $200 to $500 a year per member or, with almost 70 million members, a benefit of $14 billion to $35 billion per year.
1.Three categories of Thrift Institutions :
Chapter Overview
Thrift institutions comprise three different groups of Fl s : saving associations, saving banks, and credit unions. Thrift institutions were first created in the early 1800s in response to commercial banks’ concentration on serving the needs of business (commercial) enterprises rather than the needs of individuals requiring borrowed funds to purchase homes. Thus, the first thrifts pooled individual savings and invested them mainly in mortgages and other securities. While today’s thrifts generally perform services similar to commercial banks, they are still grouped separately because they provide important residential mortgage lending and other financial services to households. Figure 12-1 illustrates key asset side differences among the three types of thrift institutions. Historically, savings associations have concentrated primarily on residential mortgages, while savings bank have been operated as more diversified institutions, with a large concentration of residential mortgages assets but holding commercial loans, corporate bonds, and corporate stock as well. Credit unions have historically focused on consumer loans funded with member deposits. Each category of thrift includes federally chartered and state chartered institutions. Table 12-1 shows the number of each type of thrift as of year-end 2001. This chapter reviews these three types of depository institutions. For each group, we examine (1) their size, structure, and composition, (2) their balance sheets and recent trends, (3) their regulators, and (4) recent industry performance.
Savings Associations
Size, Structure , and Composition of the industry
The savings associations industry prospered throughout most of the 20th century. Savings associations were historically referred to as savings and loan (S&L) associations. However, in the 1980s, federally chartered savings banks appeared in the United States. These institutions have the same regulators and regulations as the traditional savings and loans, Together they are referred to as savings associations. These specialized institutions made long-term residential mortgages usually backed by the short-term deposits of small savers. This strategy was successful largely because of the federal Reserve’s policy of smoothing or targeting interest rates, especially in the post World War II period up until the late 1970s (see Chapter 4), and the generally stable and upward-sloping shape of the yield curve of the term structure of interest rates (see Chapter 2). During some periods, such as the early 1960s, the yield curve did slope downward but for most of the post-World War II period, the upward –sloping yield curve meant that the interest rates on savings associations’ 30-year residential mortgages assets exceeded the rates they paid on their short-term deposit liabilities. Moreover, significant shocks to interest rates were generally absent because of the Fed’s policy of interest rate smoothing and the fact that the world’s economies were far less integrated compared with today’s economies.
2. At the end of the slightly fewer than 4,000 savings associations existed, with assets of approximately $0.6 trillion. During the October 1970 to October 1982 period, however, the Federal Reserve radically changed its monetary policy strategy by targeting bank reserves rather than interest rates, in an attempt to lower the underlying rate of inflation ( see Chapter 4 for more details ). The Fed’s restrictive monetary policy actions led to a sudden and dramatic surge in interest rates, with rates on T-bills and bank certificates of deposits rising as high as 16 percent. This increase in short-term rates and the cost of fund had two effects. First, many savings association faced negative interest spreads or net interest margins (interest income minus interest expense divided by earning assets) in funding much of their long-maturity, fixed-rate residential mortgages in their portfolios. For example, a 12 percent 30-year mortgage was having to be funded by a 15 percent 3-month CD. Second, they had to pay more competitive interest rates on deposits to prevent disintermediation and the reinvestment of these funds in money market mutual fund accounts. Their ability to do this was constrained by the Federal Reserve’s Regulation Q ceilings, which limited ( albeit to a lesser extent for saving institutions than commercial banks ) the interest rates that savings associations could pay on the traditional passbook savings account and retail time deposits that small savers held. Thus, many small depositors, especially the more sophisticated, withdrew their funds from savings association deposit accounts (that were paying less than market interest rates because of Regulations Q) and invested directly in unregulated money market mutual fund accounts (where they could earn market interest rates).
Partly to overcome the adverse effects of rising rates and disintermediation on the savings association industry, Congress passed two major acts in the early 1980s revising the permitted scope of savings associations’ activities : the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 and the Garn-St. GERMAIN Depository Institutions Act (GSGDIA) of 1982 (see Chapter 14); these expanded savings associations’ deposit-taking and asset investment powers. On the liability side, savings associations were allowed to offer interest-bearing transaction accounts, called NOW accounts, and to issue more market rate-sensitive liabilities such as money market deposit accounts (MMDAs) to limit disintermediation and to compete with mutual funds. On the asset side of the balance sheet, they were allowed to offer floating-or-adjustable-rate mortgages and, to a limited extent, expand into consumer real estate development and commercial lending. Note the structural shifts in savings associations, the new powers created safer and more diversified institutions.
For a small but significant group, however, whose earnings and shareholders’ capital was being eroded in traditional areas of asset and liability business, the new regulations meant the opportunity to take more asset side risks which, if they paid off, could return the institution to profitability. However, in the mid-1980s, real estate and land prices in Texas and the Southwest collapsed. This was followed by economic downturns in the Northeast and Western states of the United States. Many borrowers with mortgage loans issued by savings associations in these areas defaulted. In other words, the risks incurred by many of these institutions did not pay off. This risk-taking behavior was accentuated by the policies of the federal insurer of savings associations deposits, FSLIC. It chose not to close capital-depleted, economically insolvent savings associations (a policy of regulator forbearance) and to maintain deposit insurance premium assessments independent of the risk taken by the institutions (see Chapter 14). As a result, an alarming number (1,248) of savings association failures occurred in the 1982-1992 period (peaking at 316 in 1989), alongside a rapid decline in asset growth of the industry. Figure 12-2 shows the number of failures, mergers, and new charters of savings institutions (savings associations and savings banks combined) from 1984 through 2001. Notice the large number of failures from 1987 through 1992 and the decline in the number of new charters.
In the 1980s, the large number of savings association failures depleted the resources of the FSLIC to such an extent that by 1989 it was massively insolvent. For example, between 1980 and 1988, 514 thrifts failed, at an estimated cost of $42.3 billion. Moreover, between 1989 and 1992 an additional 734 thrifts failed, at a cost of $78 billion. As a result, Congress passed an additional piece of legislation: the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989. This legislation abolished the FSLIC and created a new savings association insurance fund (SAIF) under the management of he FDIC (with the help of a $100 billion infusion of funds by the U.S. government). FIRREA also replaced he Federal Home Loan Bank Board with the Office of Thrift Supervision (OTS) as the main regulator of federally chartered savings associations. In addition, the act created the Resolution Trust Corporation (RTC) to close and liquidated the most insolvent savings institutions. The FIRREA also strengthened the capital requirements of savings associations and constrained their non-mortgage-related asset investment powers under a revised qualified thrift lender test, or QTL test (discussed below). Following FIRREA, Congress further enacted the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The FDICIA of 1991 introduced risk-based deposit insurance premiums (starting in 1993) in an attempt to limit excessive risk taking by savings association owners. It also introduced a prompt corrective action (PCA) policy, such that regulators could close thrifts and banks faster (see Chapter 14). In particular, if a savings association’s ratio of its owners’ equity capital to its assets fell below 2 percent, it had to be closed down or recapitalized within three months.
As a result of closing weak savings associations and strengthening their capital requirements, the industry is now significantly smaller both in terms of numbers and asset size. Specifically, the number of savings associations decreased from 2,600 in 1989 to 1,176 in 2001 (by 55 percent) and asset have decreased from $1.2 trillion to $906 billion (by 24 percent) over the same period.
Balance Sheets and Recent Trends
Even in its new smaller state, the future viability of the savings association industry in traditional mortgage lending areas is a matter of debate. This is due partly to intense competition for mortgages from other financial institutions such as commercial banks and specialized mortgage bankers. It is also due to the securitization of mortgages into mortgage-backed security pools by government-sponsored enterprises, which we discuss in Chapters 7 and 25. In addition, long-term mortgage lending exposes FIs ti significant credit, interest rate, and liquidity risks.
3 Column (1) of Table 12-3 shows the balance sheet for the savings association industry at year-end 2001. On this balance sheet, mortgages and mortgage-backed securities (securitized pools of mortgages) represent 73.42 percent of total assets. This compares to 35.44 percent in commercial banks. Figure 12-3 shows the distribution of mortgage-related assets for all savings institutions (savings associations and savings bank) as of December 2001. As noted earlier, the FIRREA uses the QTL test to establish a minimum holding of 65 percent in mortgage-related assets for savings associations. Reflecting the enhanced lending powers established under the 1980 DIDMCA and 1982 GSGDIA, commercial loans and consumer loans amounted to 2.71 and 6.20 percent of savings association assets, respectively, compared to 14.96 percent and 9.61 percent at commercial banks. Finally, savings associations are required to hold cash and investment securities for liquidity purposes and to meet regulator-imposed reserve requirements (see Chapter 14). In December 2001, cash and investment securities (U.S. Treasury securities and federal agency obligations; federal funds and repos; and bonds, notes, debentures, and other securities) holding amounted to 10.95 percent of total assets compared to 33.36 percent at commercial banks.
4 On the liability side of the balance sheet, small time and savings deposits are still the predominant source of funds, with total deposits accounting for 60.74 percent of total liabilities and net worth. This compares to 66.85 percent at commercial banks. The second most important source of funds is borrowing from the 12 Federal Home Loan Banks (FHLBs), which the institutions themselves own. Because of their size and government-sponsored status, FHLBs have access to the wholesale capital market for notes and bonds and can relend the funds borrowed in these markets to savings associations at a small markup over wholesale cost. Other borrowed funds include repurchase agreements and direct federal fund borrowings.
Finally, net worth is the book value of the equity holders’ capital contribution; it amounted to 8.21 percent in 2001. This compares to 9.09 percent at commercial banks. Historically, most savings associations (and saving banks) were established as mutual organizations (in which the depositors are the legal owners of the institution and no stock is issued). As a mutual organization, member deposits represent the equity of the savings association. Since there are no stockholders, and thus no demand for equity investment returns, mutual organizations are generally less risky than stock-chartered organizations—mutual savings association managers can concentrate on low-risk investments and the prevention of failure rather than higher risk investments needed to produce higher required returns on stockholders’ investments. However, through time many savings associations (and savings banks) have switched from mutual to stock charters (in which the holders of the stock or equity are the legal owners of the institution rather than depositors as under the mutual charter). This is mainly because stock ownership allows savings institutions to attract capital investment from outside stockholders beyond levels achievable at a mutual institution. Figure 12-4 shows this trend in mutual versus stock charters and asset size for savings institutions from 1988 through 2001.
In May 2002, the Office of Thrift Supervision (OTS) proposed new rules that would increase the documentation required when a mutually chartered organization applies for conversion to a stock charter. The new rule would require the thrift to demonstrate a need for new capital, instead of merely explaining how the new capital would be deployed. The institution would also be asked to describe its experience with growth and expansion into other business lines, and demonstrate that it would be able to achieve a reasonable return on equity. These changes are expected to reduce the number of mutual thrifts converting to stock charters.
Savings Banks
Size, Structure, and Composition of the Industry
Traditionally, savings banks were established as mutual organizations in states that permit such organizations. These states were largely confined to the East Coast—for example, New York, New Jersey, and the New England states. As a result, savings banks (unlike savings associations) were not affected by the oil-based economic ups and downs of Texas and the Southwest in the 1980s. The crash in New England real estate values in 1990-1991 presented equally troubling problems for this group, however. Indeed, many of the failures of savings institutions (see Figure 12-2) were of savings banks rather than savings associations. As a result, like savings associations, savings banks have decreased in both size and number. In December 2001, 357 savings banks had $393 billion In assets: $248 billion of their deposits are insured by the FDIC under the BIF (Bank Insurance Fund). FDIC insurance under the BIF is just one characteristic that distinguishes savings banks from savings associations, whose deposits are insured under by the FDIC under the SAIF (Savings Association Insurance Fund).
Balance Sheets and Recent Trends
Notice the major similarities and differences between savings associations and savings banks in Table 12-3, which shows their respective assets and liabilities as of year-end 2001. Savings banks (in the second column of Table 12-3)have a heavy concentration (73.72 percent) of mortgage loans and mortgage-backed securities (MBSs). This is slightly more than the savings associations’ 73.42 percent in these assets and much more than commercial banks (35.44 percent). Over the years, savings banks have been allowed greater freedom to diversify into corporate bonds and stocks; their holdings in these assets are 7.50 percent compared to 2.21 percent for savings associations. On the liability side, the major difference is that savings banks generally (although this was not the case in 2001, as shown in Table 12-3) rely less heavily on deposits than savings associations and therefore savings banks have fewer borrowed funds. Finally, the ratio of the book value of net worth to total assets for savings banks stood at 8.96 percent (compared to 8.21 percent for savings associations and 9.09 percent for commercial banks) in 2001.
5. Regulators of Savings Institutions
The three main regulators of savings institutions are the Office of Thrift Supervision (OTS), the FDIC, and state regulators.
The Office of Thrift Supervision. Established in 1989 under the FIRREA, this office charters and examines all federal savings institutions. It also supervises the holding companies of savings institutions.
The FDIC. The FDIC oversees and managers the Savings Association Insurance Fund (SAIF), which was established in 1989 under the FIRREA in the weak of FSLIC insolvency. The SAIF provides insurance coverage for savings associations. Savings banks are insured under the FDIC’s Bank Insurance Fund (BIF) and are thus also subject to supervision and examination by the FDIC.
Other Regulators. State chartered savings institutions are regulated by state agencies—for example, the Office of Banks and Real Estate in Illinois—rather than the OTS.
6 Savings Association and Savings Bank Recent Performance
Like Commercial banks, savings institutions (savings associations and savings banks) experienced record profits in the mid-to late 1990s as interest rates (and thus the cost of funds to savings institutions) remained low and the U.S. economy (and thus the demand for loans) prospered. The result was an increase in the spread between interest income and interest expense for savings institutions and consequently an increase in net income. Despite an economic slowdown in the United States in the early 2000s, savings institutions continued to earn record profits. Figure 12-5 reports ROAs and ROEs for the industry from 1988 through December 2001. In the fourth quarter of 2001, savings institutions reported a record $3.8 billion in net income and the highest ever annualized ROA of 1.16 percent (this compares to an ROA of 1.13 percent over the same period for commercial banks—see Chapter 11). For the entire year 2001, savings institutions earned a record $13.3 billion in profits, with an ROA of 1.08 percent (the highest since 1946). The industry’s net interest margins rose in response to a steeper yield curve: the cost of funding earning assets declined by only 46 basis points. However, noncurrent loans (those with an interest payment over 90 days past due) as a percent of total loans rose to above 0.6 percent and net charge-offs in 2001 were almost twice those in 2000. Equity capital as a percent of total assets was 8.44 percent, down from its all time high of 8.94 percent in 1998, largely due to rapid asset growth by these banks. Table 12-4 presents several performance ratios for the industry for 1989 and 1993 through 2001.
Like the commercial banking industry, savings institutions have experienced substantial consolidation in the 1990s. For example, the 1998 acquisition of H.F. Ahmanson & Co. by Washington Mutual Inc. for almost $10 billion was the fourth largest bank/thrift merger completed in 1998. Washington mutual was the third largest savings institution in the United States early in 1997, while Ahmanson was the largest savings institution. In 1997, Washington Mutual bought Great Western to become the largest thrift in the country. Then, in March 1998, Washington Mutual bought Ahmanson to combine the two largest U.S. thrifts. In December 2001, Washington Mutual (the largest savings institution in the United States) had total assets at $223 billion, ranking seventh of all depository institutions (banks and thrifts). Table 12-5 shows the industry consolidation in number and asset size over the period 1992-2001. Notice that over this period, the biggest savings institutions (over $5 billion) grew in number from 29 to 44 and their control of industry assets grew from 32.3 percent to 63.7 percent.
Larger savings institutions have also enjoyed superior profitability compared to smaller savings institutions. The 576 small thrifts (with assets less than $100 million) had an average annualized ROA of 0.64 percent for the year 2001, while the larger (stock-owned) institutions reported an ROA of 1.17 percent. One major reason for this size-based difference in ROA is that larger savings institutions (unlike money center banks relative to smaller commercial banks) have virtually no asset investments or offices in foreign markets and countries and have consequently not suffered from recent crises in emerging markets and countries like Argentina that have so harmed the profitability of some money center banks. Despite the recent resurgence of this industry, as discussed in In the News box 12-1, its future is still uncertain.
7 Credit Unions
Credit Union (CUs) are not-for-profit depository institutions mutually organized and owned by their members (depositors). Credit unions were first established in the United States in the early 1900s as self-help organizations intended to alleviate widespread poverty. The first credit unions were organized in the Northeast, initially in Massachusetts. Members paid an entrance fee and put up funds to purchase at least one deposit share. Members were expected to deposit their savings in the CU, and these funds were lent only to other members.
This limit in the customer base of CUs continues today as, unlike commercial banks and savings institutions, CUs are prohibited from serving the general public. Rather, in organizing a credit union, members are required to have a common bond of occupation (e.g., police CUs), association (e.g., university-affiliated CUs), or cover a well-defined neighborhood, community, or rural district. CUs may, however, have multiple groups with more than one type of membership. Each credit union decides the common bond requirements (i.e., which groups it will serve) with the approval of the appropriate regulator (see below). To join a credit union individuals must then be a member of the approved group(s).
The primary objective of credit unions is to satisfy the depository and borrowing needs of their members. CU number deposits (called shares, representing ownership stakes in the CU) are used to provide loans to other members in need of funds. Earnings from these loans are used to pay interest on member deposits. Because credit unions are not-for-profit organizations., their earnings are not taxed. This tax-exempt status allows CUs to offer higher rates on deposits and charge lower rates in some types of loans compared to banks and savings institutions, whose earnings are taxable.
Size, Structure, and Composition of the Industry
Credit unions are the most numerous of the institutions (9,984 in 2001) that compose the depository institutions segment of the FI industry. (Figure 12-6 shows the number of credit unions, their total assets, and number of members from 1993 through 2001.) Moreover, CUs were less affected by the crisis that affected commercial banks and savings institutions in the 1980s. This is because traditionally more than 40 percent of their assets have been in small consumer loans, often for amounts less than $10,000, which are funded mainly by member deposits. This combination of relatively matched credit risk and maturity in the asset and liability portfolios left credit unions less exposed to credit and interest rate risk than commercial banks and savings institutions. In addition, CUs tend to hold large amounts of government securities (almost 20 percent of their assets in 2001) and relatively small amounts of residential mortgages. CUs’ lending activities are funded mainly by deposits contributed by their almost 80 million members.
The nation’s credit union system consists of three distinct tiers: the top tier at the national level (U.S. Central Credit Union); the middle tier at the state or regional level (corporate credit unions); and the bottom tier at the local level (credit unions). Figure 12-7 illustrates this structure, with the services conducted between various entities identified via arrows. Corporate credit unions are financial institutions that are cooperatively owned by their member credit unions. The 34 corporate credit unions serve their members primarily by investing and lending excess funds (unloaned deposits) that member credit unions place with them. Additional services provided by corporate credit unions include automated settlement, securities safekeeping, data processing, accounting, and payment services. As of 2001, credit unions had over $19 billion (3.9 percent of total assets) invested in corporate credit unions. The U.S. Central Credit Union serves as a “corporate’s corporate” – providing investment and liquidity services to corporate credit unions. The central Credit Union acts as a corporate credit unions’ main provider of liquidity. It invest their surplus funds and provides financial services and operational support.
In recent years, to attract and keep customers, CUs have expanded their services to compete with commercial banks and savings institutions. For example, many CUs now offer mortgages, credit lines, and automated teller machines. Some credit unions also offer business and commercial loans to their employer groups. For example, in the late 1990s, AWANE (Automotive Wholesalers Association of New England) Credit Union’s business loans represented 13.6 percent of its lending and the CU participated actively in the Small Business Administration loan programs, which enabled it to sell a portion of those loans. In addition, commercial real estate lending accounted for 29.5 percent of AWANE’s total lending.
As CUs have expanded in membership, size and services, bankers claim that CUs unfairly compete with small banks that have historically been the major lender in small towns and local communities. For example, the American Bankers Association claimed that the tax exemption for CUs gives them the equivalent of a $1 billion a year subsidy. The response of the Credit Union National Association (CUNA) is that any cost to taxpayers from CUs’ tax-exempt status is more than passed on to their members and society at large through favorable interest rates on deposits and loans. For example, CUNA estimates that the benefits of CU membership can range from $200 to $500 a year per member or, with almost 70 million members, a benefit of $14 billion to $35 billion per year.
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