Depository Financial
Institutions
Chapter 12
The Fundamentals of Bank
Management
Banks are business firms that buy
(borrow) and sell (lend) money to make
a profit
Money is the raw material for banks—
Repackagers of money
Financial claims on both sides of
balance sheet
Liabilities—Sources of funds
Assets—Uses of funds
Bank Assets
Total loans increased from 53% of total
assets in 1970 to 62% in 1990—most
increase coming from mortgages
Decline in cash and investments in state and
local government securities
Holdings of federal government securities is
fairly constant—highly marketable and liquid
Counter-cyclical—increase during recessions and
decrease during expansions
Banks treat federal securities as a residual use of
funds
Commercial Bank Assets
Loans
Securities
Cash Assets
Loans (60.1%)
Commercial and Industrial Loans
(14.8%)
Consumer Loans (8.5%)
Real Estate Loans (28%)
Interbank Loans (Federal Funds)
(4.6%)
Securities (24.1%)
U. S. Government Securities
State and Municipal Bonds
Cash Assets (4.5%)
Vault cash.
Reserve deposits at the Federal Reserve
banks.
Correspondent balances.
Cash items in the process of collection.
Bank Assets
Banks are barred by law from
owning stocks—too risky
However, banks do buy stocks
for trusts they manage—not
shown among bank’s own
assets
Bank Liabilities
Percentage of funds from transactions
deposits has reduced from 43% in
1970 to 10% in 2002
Used to be major source of funds
Generally low interest (if any) paid on
demand deposits and increase in interest
paid on other types of assets has caused
this decline
Commercial Bank Liabilities
and Equity Capital
Transactions deposits. (9.5%)
Savings deposits and small-
denomination time deposits. (41.3%)
Deferred availability cash items.
Large-denomination time deposits.
(15.6%)
Purchased funds.
Other borrowings.
Bank Liabilities
Non-transaction deposits represented
47% of banks’ funds in 2002
Passbook savings deposits—traditional form of
savings
Time deposits—certificates of deposit with
scheduled maturity date with penalty for early
withdrawal
Money market deposit accounts—pay money
market rates and offer limited checking functions
Negotiable CDs—can be sold prior to maturity
Bank Liabilities
Miscellaneous Liabilities have experienced a
significant increase during past 25 years
Borrowing from Federal Reserve—discount borrowing
Borrowing in the federal funds market—unsecured loans
between banks, often on an overnight basis
Borrowing by banks from their foreign branches, parent
corporation, and their subsidiaries and affiliates
Repurchase Agreements—sell government securities with
agreement to re-purchase at later date
Securitization—Pooling loans into securities and
selling to raise new funds
Bank Capital (Equity)
Individuals purchase stock in bank
Bank pays dividends to stockholders
Serves as a buffer against risk
Equity capital has remained stable at 7%-8%,
but riskiness of bank assets has increased
Bank regulators force banks to increase their
capital position to compensate for the
increased risk of assets (loans)
Equity is most expensive source of funds so
bankers prefer to minimize the use of equity
Bank Profitability
Bank management must balance
between liquidity and profitability
Net Interest Income
Difference between total interest
income (interest on loans and interest on
securities and investments) and interest
expense (amount paid to lenders)
Closely analogous to a manufacturing
company’s gross profit
Bank Profitability
Net interest margin—net interest income
as a percentage of total bank assets
Factors that determine bank’s interest margin
Better service means higher rates on loans and
lower interest on deposits
Might have some monopoly power, but this is
becoming more unlikely due to enormous
competition from other banks and nonbank
competitors
Also affected by a bank’s risk—interest rate and
credit
Bank Profitability
Service charges and fees and other
operating income
Additional source of revenue
Become more important as banks have shifted
from traditional interest income to more
nontraditional sources on income
Salaries and wages
Banks are very labor-intensive
Pressure to reduce personnel and improve
productivity
Bank Profitability
Security gains/losses
Results from the fact that securities held for investment are
shown at historical cost
This may result in a gain or loss when the security is sold
Net Income after Taxes
Net Income less taxes
Return on Assets (ROA)—Net Income after taxes
expressed as a percentage of total assets
Return on Equity (ROE)—Net Income after taxes divided
by equity capital
Bank Risk
Leverage Risk
Leverage—Combine debt with equity to purchase assets
Leveraging with debt increases risk because debt requires
fixed payments in the future
The more leveraged a bank is, the less its ability to absorb a
loss in asset value
Leverage Ratio—Ratio of bank’s equity capital to total
assets [9% in 2002]
Regulators in US and other countries impose risk-based
requirements—riskier the asset, higher the capital
requirement
Bank Risk
Credit Risk
Possibility that borrower may default
Important for bank to get as much information as
possible about borrower—asymmetric information
Charge higher interest or require higher collateral
for riskier borrower
Loan charge-offs is a way to measure past risk
associated with a bank’s loans
Ratio of non-performing loans (delinquent 30
days or more) to total loans is a forward-
looking measure
Bank Risk
Interest Rate Risk
Mismatch in maturity of a bank’s assets and liabilities
Traditionally banks have borrowed short and lent long
Profitable if short-term rates are lower than long-term rates
Due to discounting, increasing interest rates will reduce the
present value of bank’s assets
Use of floating interest rate to reduce risk
The one-year re-pricing GAP is the simplest and most
commonly used measure of interest rate risk
Bank Risk
Trading Risk
Banks act as dealers in financial instruments such
as bonds, foreign currency, and derivatives
At risk of a drop in price of the financial
instrument if they need to sell before maturity
Difficult to develop a good measure of trading risk
since is it hard to estimate the statistical likelihood
of adverse price changes
Bank Risk
Liquidity Risk
Possibility that transactions deposits and savings account
can be withdrawn at any time
Banks may need additional cash if withdrawals significantly
exceed new deposits
Traditionally banks provided liquidity through the holding of
liquid assets (cash and government securities)
Historically these holdings were a measure of a bank’s
liquidity, but have declined as a percentage of total assets
during the past 30 years (41%-1970; 24%-2002)
During past 30 years banks have used miscellaneous
liabilities to increase their liquidity
Major Trends in Bank
Management
For most of the 20th century banks were
insulated from competition from other
financial institutions
US banking is in a period of transition due to
recent changes in the regulations
The Consolidation Within the Banking
Industry
McFadden Act of 1927
McFadden Act of 1927
Passed to prevent the formation of a few large, nationwide
banking conglomerates
Prohibited banks branching across state lines
Many states also had restrictions that limited or prohibited
branching within their state boundaries
Result—many, many small banks protected from competition
from larger national banks
Over the years a number of loopholes were exploited to reduce
effectiveness of law, primarily bank holding company—Parent
corporation that can hold one or more subsidiary banks
Riegle-Neal Interstate Banking and Branching Efficiency
Act [1994]—Overturned the McFadden Act
Economics of Consolidation
Is consolidation of banking industry
good or bad?
How large should a bank be
Large enough to offer wide menu of products
Focus on a niche at which they are successful
Despite dramatic decrease in number of
banks and banking organizations, number of
banking offices (including savings institutions)
has remained remarkable stable
Economics of Consolidation
Economies of Scale—Banks become more efficient
as they get larger
Economies of Scope—Offering a multitude of
products is more efficient [traditional and non-
traditional products]
Little empirical evidence to support either types of
economies
Possibly merger or expansion provided
opportunity to become more efficient—
something they should have done prior to the
merger
Nontraditional Banking
Traditionally commercial bank accepted
demand deposits and made business loans
Under the regulation of the Federal Reserve,
bank holding companies provide banks with
more regulatory freedom
However, activity is limited to activities
closely related to banking
The Glass-Steagall Act (1933)
Separated commercial banks from investment
banking—banks forced to choose
Before 1999, commercial banks could not
underwrite corporate debt and equity
Commercial banks challenged restrictions--
investment banks were starting to act like
commercial banks
Circumventing Glass-Steagall—a number of
rulings by Federal Reserve eroded the distinction
between commercial and investment banks
The Gramm-Leach-Bliley Act (1999) repealed the
Glass-Steagall Act
Globalization
American Banks Abroad
Rapid expansion of US banks into foreign
countries
Growth of foreign trade
American multinationals with operations abroad
Edge Act (1919)
Permitted US banks to establish special
subsidiaries to facilitate involvement in
international financing
Exempt from the McFadden Act’s prohibition
against interstate banking
Globalization
Foreign Banks in the United States
Many large and well-known banks in the US are
foreign-owned
Organizational forms of foreign banks
Branch—integral part of foreign bank and carries bank’s
name, full service
Subsidiary—legally separate with its own charter, full
service
Agencies—make loans but cannot accept deposits
Representative Offices—make contact with potential
customers of parent corporation
Foreign Banks in the United States
Prior to 1978 foreign banks operating in
the US were largely unregulated
International Banking Act of 1978
Foreign banks subject to same federal
regulations as domestic banks
Established banks were grandfathered and
not subject to the law
Eurodollars
Foreign banks were exempt from Regulation Q and
could offer higher interest than US banks
Eurodollar deposits made in foreign banks were
denominated in US dollars, which eliminated the
foreign exchange risk for Americans
American banks opened foreign branches:
Gain access to Eurodollars
Borrow abroad during periods of tight money by the FED
“Shell” branches are created in tax haven countries
(Bahamas and Caymans) who have almost zero
taxation and no regulation
Eurobonds
Corporate and foreign government
bonds sold:
Outside borrowing corporation’s home
country
Outside country in whose money principal
and interest are denominated
Number of tax advantages and
relatively little government regulation
Domestically Based International
Banking Facilities (IBF)
Offers both US and foreign banks comparable
conditions as foreign countries to lure
offshore banking back to US
IBF is a domestic branch that is regulated by
Fed as if it were located overseas.
No reserve or deposit insurance
requirements
Essentially bookkeeping operations with no
separate office
IBFs Cont.
Many states exempt income from IBFs from
state and local taxes
IBFs are not available to domestic
residents, only business that is
international in nature with respect to
sources and uses of funds
Foreign subsidiaries of US multinationals can
use IBFs provided funds to not come from
domestic sources and not used for domestic
purposes
Nonbank Depository
Institutions—The Thrifts
Comprised of savings and loan associations,
mutual savings banks, and credit unions
Principal source of funds for all three thrifts is
consumer deposits
Savings and Loans (S&L’s)
Invest principally in residential mortgages
This industry basically collapsed during the 1980s
Most S&L’s have converted their charters to
commercial banks
The Thrifts
Mutual Savings Banks
Located mostly in the East
Operate like S&L’s, with more power to make
consumer loans
This industry suffered same decline as S&L’s
Credit Unions
Basically unaffected by the problems in the 1980s
since they did not have mortgages on their
balance sheets
Organized around a common group and are
generally quite small
