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