< CHAPTER 3 >

1. CAPITAL MARKET < CHAPTER 3 > DEPOSITORY INSTITUTIONS

2. CONTENTS OF OUR PRESENTATION • WHAT A DEPOSITORY INSTITUTION IS ? • ASSEST/LIABILITY PROBLEM OF DEPOSITORY INSTITUTIONS • Funding risk • Liquidity concerns • COMMERCIAL BANKS • Bank services • Bank funding • Regulation • Federal deposit insurance • SAVING AND LOAN ASSOCIATIONS • Assets • Funding • Regulation • The S&L Crisis • SAVINGS BANKS • CREDIT UNION

3. Depository institutions include commercial banks, saving and loan associations, savings banks, and credit unions. These financial intermediaries accept deposits. Deposits represent the liabilities of the deposit accepting institutions. With the funds raised through deposits and other funding sources, depository institutions make direct loans to various entities and also invest in securities. Their income is derived from two sources ; the income generated from the loans they make and the securities they purchase, and fee income. S&L, saving banks, and credit unions are commonly called “thrifts”, which are specialized types of depository institutions.

4. Depository institutions are highly regulated because of the important role they play in the financial system. Demand deposit accounts provide the principal means that individuals and business entities use for making payments. Also, goverment implements monetary policy through the banking system. Because of their important role, depository institutions are afforded special privileges such as access to federal deposit insurance and access to a goverment entity that provides funds for liquidity or emergency needs.

5. ASSET/LIABILITY PROBLEM OF DEPOSITORY INSTITUTIONS Funding risk Liquidity concerns

6. ASSET/ LIABILITY PROBLEM OF DEPOSITORY INSTITUTION The asset/liability problem that depository institutions face is quite simple to explain, althuogh not necessarily easy to solve. A depository institutions seeks to earn a positive spread between the asset in which it invest and the cost of its funds. The spread is referred to as spread income or margin. The spread income allows the institutions to meet operating expenses and earn a fair profit on its capital. In generating spread income a depository institutions faces several risks, including credit risk, regulatory risk, and funding risk. Credit risk , also called default risk refers to the risk that a borrower will default on a loan obligation to the depository institution or that the issuer of a security that the depository institutions holds will default on it obligation. Regulatoryrisk is the risk that regulators will change the rules and affect the earning of the institution unfavorably.

7. LIQUDITY CONCERNS • In several ways ; • Attract additional deposits, • Use existing securities as collateral for borrowing from a federal agency or other financial institution, • Sell securities that it owns, • Raised short term funds in the money market.

8. The first alternative self-explanatory. The second concerns the privilege allowed to banks to borrow at the discount window of the Federal Reserve Banks. The third alternative, selling securities that it owns, requires that the depository institution invest a portion of its funds in securities that are both liquid and have little price risk. The fourth alternative primarily includes using marketable securities owned as collateral for raising in the repurchase agreement market.

9. COMMERCIAL BANKS Bank services Bank funding Regulation Federal deposit insurance

10. Commercial Banks; As of March 2001, 8,237 commercial banks were operating in the U.S. All rational banks must be members of the Federal Reserve System and must be insured by the Bank Insurance Fund ( BIF), which is administered by the Federal Deposit Insurance Corporation (FDIC). Federal depository insurance began in the 1930s, and the insurance program is administered by the FDIC.BIF was created by the Financial Institutions Reform , Recovery,and Enforcement Act of 1989 (FIRREA)

11. TABLE 3-1 Distribution of FDIC-Insured Commercial Banks by Size Asset Size # of Banks % of Banks Assets % of Assets Less than $25 million 1,016 12,33 16,903 0,27 $25 to 50 million 1,636 19,86 61,068 0,97 $50 to 100 million 2,107 25,58 151,517 2,40 $100 to 300 million 2,307 28,01 388,908 6,16 $300 to 500 milllion 459 5,57 174,586 2,77 $500 to 1 billion 322 3,91 217,623 3,45 $1 to 3 billion 219 2,66 366,722 5,81 $3 to 10 billion 92 1,12 517,332 8,20 $10 billion or more 79 0,96 4,416,155 69,98 Total institutions 8,237 100,00 6,310,814 100,00

12. BANK SERVICES 1 Individual banking Institutional banking Global banking 2 3

13. Individual banking encompasses consumer lending, residential mortgage lending, consumer installment loans, credit card financing,automobile and boat financing, brokerage services,student loans, and individual-oriented financial investment services such as personal trust and invesment services. Mortgage lending and credit card financing generate interest and fee income. Mortgage lending is often referred to as “ mortgage banking”. Brokerage services and financial invesment services also generate fee income.

14. Loans to nonfinancial corporations, financial corporations and goverment entities fall into the category of institutional banking. Also included in this category are commercial real estate financing,leasing activities, and factoring. In the case of leasing, a bank may be involved in leasing equipment either as lessors, as lenders to lessors , or as purchasers of leases. Global banking covers a broad range of activities involving corporate financing and capital market and foreign exchange products and services.

15. Corporate financing involves two components; • The procuring of funds for a bank’s customers • Advice on such matters as strategies for obtaining funds, corporate restructuring , divestitures, and acquisitions • Banks generate income in three ways ; • The bid-ask spread, • Capital gains on the securities or foreign currencies use in transactions, • In the case of securities, the spread between interest income earned by holding the security and the cost of funding the purchase of that security.

16. The financial products developed by banks to manage risk also yield income. These product include interest rate swaps, interest rate agreement,currency swaps, forward contracts and interest rate options.

17. BANK FUNDING • The three sources of funds for banks ; • Deposits • Nondeposit borrowing • Common stock and retained earning • Banks are highly leveraged financial institutional , which means that most of their funds come from borrowing.

18. Deposit : Several types of deposit accounts are available. Demand deposit pay no interest and can be withdrawn upon demand. Time deposits,also called certificates of deposit, set a fixed maturity date and pay either a fixed or floating interest rate. A money market demand account is one that pays interest based on short term interest rates. The market for short term debt obligations is called the money market, which is how these deposits get their name. Reserve Requirements and Borrowing in the Federal Funds Markets: A bank can not invest $1for every $1 it obtains in deposits. Specified percentages are called reserve ratios, and dolar amounts based on them that are required to be kept on deposit at a Federal Reserve Banks are called required reserves. The reserve ratios are establish by the Federal Reserve Board(the Fed).

19. Two types of deposits: • Transaction deposit • Nontransaction deposit • Demand deposits and what the Fed calls “ other checkable deposits” are classified as transaction deposits. Saving and time deposits are nontransactions deposits. • To compute required reserves, the Federal Reserve uses an established two-week period called the deposit computation period.

20. Reserve requirements in each period are to be satisfied by actual reserves. If actual reserves exceed required reserves , the difference is referred to as excess reserves. Bank temporarily short of their required reserves can borrow reserves from banks with excess reserves. The market where banks borrow or lend reserves is called the federal funds market. The interest rate charge to borrow funds in this market is called the federal funds rate.

21. Borrowing at the Fed Discount Window: • The Federal Reserve Bank is the banker’s bank. • The Fed establishes the types of eligible collateral. • Currently it includes : • Treasury securities, federal agency securities, and municipal securities, all with maturity of less than 6 months, • Commercial and industrial loans with 90 days or less to maturity. • The interest rate that the Fed charges to borrow funds at the discount window is called the discount rate.

22. Other Nondeposit Borrowing : Most deposits have short maturities. Bank borrowing in the federal funds market and at the discount window of the Fed is short term. Other nondeposit borrowing can be short term in the form of issuing obligation in the money market , or intermediate long term in the form of issuing securities in the bond market. Banks that raise most of their funds from the domestic and international money markets, relying less on depositors for fund , are called money center banks. A regional bank , by contrast, is one that relies primarily on deposit for funding and makes less use of the money markets to obtain funds.

23. REGULATION • Because of special role that commercial banks play in the financial system , banks are regulated and supervised by several federal and state government entities. • The regulations historically cover four areas: • Ceilings imposed on the interest rate that can be paid on deposit accounts. • Geographical restrictions on branch banks. • Permissiple activities for commercial banks. • Capital requirements for commercial banks.

24. Regulation of Interest Rates: Even though regulation of the interest rates that banks can pay was eliminated for accounts other than demand deposit. Federal regulation prohibit the payment of interest on demand accounts. Until the 1960s, market interest rates stayed below the ceiling. As market interest rates rose abow the ceiling and ceilings were extended to all depository institutions after 1966, these institutions found it difficult to compete with other financial institution to attract funds. To circumvent the ceilings on time deposits and recapture the lost funds,banks developed the negotiable certificate of deposit , which in effect had higher ceiling , and eventually no ceiling at all. As all depository instutions fund it difficult to compete in the 1970s, federal legislation in the form of the Depository Instutions Regulation and Monetary Control Act of 1980 gave banks relief.

25. Geographical Restrictions: The McFadden Act of 1927 allowed each state the right to set its own rules on instrastate branch banking. In 1994 Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act permitting adequately capitalized and managed bank holding companies to acquire banks in any state subject to certain limitations and approval by the Federal Reserve. Starting in June 1997, this legislation allowed interstate mergers between adequately capitalized and managed banks, subject to concentration limits and state laws.

26. Permissible Activities for Commercial Banks : The key legislation is the Gramm-Leach-Bliley Act of 1999. The activities of banks and bank holding companies are regulated by Federal Reserve Board, which was charged with the responsibility of regulating the activities of bank holding companies by the Bank Holding Company Act of 1956.

27. Early legislation governing bank activities developed against the following background : • Certain commercial bank lending was believed to have reinforced the stock market crash of 1929. • The stock market crash itself led to the breakdown of the banking system. • Transactions between commercial banks and their securities affiliates led to abuses.

28. Congress passed the Banking Act 1933. Four sections of the 1933 act barred commercial banks from certain invesment banking activities-Sections 16, 20,21 and 32. These four sections are popularly referred to as the Glass-Steagall Act. Bank could neither underwrite securities and stock, nor act as dealers in the secondary market for securities and stock , although Section 16 does provide two exceptions. Section 16 also restricted the activities of banks in connection with corporate securities such as corporate bonds and commercial paper. Under Section 20 of the Glass-Steagall Act, commercial bank that were members of the Federal Reserve System were prohibited from maintaining a securities firm.

29. Section 21 prohibited any “ person, firm,corperation,association,business trust, or other similar organization” that receives deposits from engaging in the securities business as defined in Section 16. Section 32 further prevented banks from circumventing the restrictions on securities activities. The Glass-Steagall Act also imposed restrictions on bank activities in insurance area. Specifically , it imposed restrictions on the underwritting and selling of insurance. Capital Requirements for Commercial Banks: The capital structure of banks, like that of all corporations , consist of equity and debt…

30. Capital Requirements For Commercial Banks The capital structure of banks,like that of all corporations,consist of equity and debt. Commercial banks, like some other depository institutions and like investment banks,which it discuss in chapter 5,are highly leveraged institutions. that is, the ratio of equity capital to total assets is low,typically less than 8% in the case of banks. This level gives rise to regulatory concern about potential insolvency resulting from the low level of capital provided by the owners. An additional concern is that the amount of equity capital is even less adequate because of potential liabilities that do not appear on the bank’s balance sheet. These so-called “off-balance sheet” obligations include commitments such as letters of credit and obligations on customized interest rate agreements ( such as swaps,caps and floors).

31. Prior to 1989, capital requirements for a bank were based solely on it’s total assets. No consideration was given to the types of assets. In January 1989, the Federal Reserve adopted guidelines for capital adequacy based on the credit risk of assets held by the bank. These guidelines are referred to as risk-based capital requirements. The guidelines are based on a framework adopted in July 1988 by the Basle Committee on Banking Regulations and Supervisory Practises, which consists of the central banks and supervisory authorities of G-10 countries.

32. The two principle objectives of the guidelines are as follows: 1.Regulators in the United States and abroad sought greater consistency in the evaluation of the capital adequacy of major banks throughout the world. 2. Regulators tried to establish capital adequacy standarts that take into consideration the risk profile of the bank.

33. The risk-based capital guidelines attempt to recognize credit risk by segmenting and weighting requirements. • Capital consists of Tier 1 and Tier 2 capital, and minimum requirements are establish for each tier. Tier 1 capital is considered core capital (common stockholders’ equity, certain types of preferred stock, and minority interest in consolidated subsidiaries). Tier 2 capital called supplementary capital ( loan-loss reserves,perpetual debt, hybrid capital instruments etc.). • The guidelines establish a credit risk weight for all assets. The weight depends on the credit associated with each asset.The four credit risk classifications for banksin the United States are 0%, 20%, 50%, and 100%, arrived at on no particular scientific basis.

34. Asset Book value(in millions) U.S Treasury securities $ 100 Municipal general obligation bonds 100 Residential mortgages 500 Commercial loans 300 Total book value $1.000

35. The risk- weighted assets are calculated as follows: Book value (in millions) Risk weight Product (in million) Asset U.S Treasury securities $ 100 0% $ 0 Municipal general obligation bonds 100 20 20 Residential mortgages 500 50 250 Commercial loans 300 100 300 Risk-weighted assets $570

36. Risk weight Examples of Assets Including 0% • U.S. Treasury securities • Mortgage backed securities issued by the Goverment National Mortgage Association • Muncipal general obligation bonds • Mortgage-backed securities issued by the Federal Home Loan Mortgage Corporation or the Federal National Mortgage Assocation • Municipal revenue bonds • Residental mortgages • Commercial loans and commercial mortgage • LCD loans • Corporate bonds • Municipal IDA bonds 20% 50% 100%

37. FEDERAL DEPOSıT INSURANCE Because of the important economic role played by banks, the U.S goverment sought a way to protect them against depositors who, because of what they thought were real or perceived problems with a bank, would withdraw funds in a disruptive manner. Bank panics occured frequently in the early 1930s, resulting in the failure of banks that might have survived economic difficulties except for massive withdrawals. As the mechanism devised in 1933 to prevent a " run on a bank” the U.S goverment created federal deposit insurance. The insurance was provided through a new agency, the Federal Deposit Insurance Corporation.

38. The Federal Deposit Insurance Corporation Improvement Act of 1991 ( FDICIA ) included a number of significiant reforms to improve the deposit insurance system. Despite the improvements, some major flaws remained, including two of particular concern: • First is the increase in the amount of the deposit coverage to $100,000.This coverage was set in 1980.The basic coverage increased five times since 1934, from $5,000 to $100,000.With the exception of the increase from $40,000 to $100,000 in 1980, historically, these increases fundamentally reflected cost-of-living adjustment. • Second flaw is the payment of insurance coverage – the premiums charged by the FDIC for insurance coverage. • The conflict with respect to premiums is that on the one hand FDICIA mandates that deposit insurance premiums should be priced according to the risk posed by a depository institution; on the other hand, FDICIA mandates that the FDIC maintain a target level of reserves

39. A depository institution is assigned to one of nine categories based on a two-step process. The first is a capital group assignment based on capital ratios and the second is a supervisory subgroup assignment based on other relevant information.

40. TABLE3-3 FDIC’s Risk Ratings Assigned to Depository Institutions Capital Group Descriptions Group 1: Group 2: Group 3: “well capitalized” Total risk-based capital ratio equal to or grater than 10% Tier 1 risk-based capital ratio equal or greater than 6% Tier 1 leverage capital ratio equal to or greater than 5% “Adequately capitalized” Not well capitalized Total risk-basedcapital ratio equal to or greater than 8% Tier 1 risk-based capital ratio equal to or greater than 4% Tier 1 leverage capital ratio equal to or greater than 4% “Undercapitalized” Neither well capitalized nor adequately capitalized Supervisory subgroup assignments for members of the BIF and the SAIF are made in accordance with section 327.4(a)(2)of the FDIC’s Rules and regulations. See following Supervisory Subgroup descriptions.

41. In order to deal with the conflict noted earlier with respect to setting deposit insurance premiums, an “ expected loss “ pricing system would take into consideration: • The differences in risk across depository institutions • The ability to generate revenue sufficient to pay fort he costs of insuring deposits • The expcted loss price for a depository would depend on three factors: • The probability of default for that bank , • Exposure, • Loss severity ( or loss given default)

42. SAVING AND LOAN ASSOCIATIONS

43. Assets Fundings Regulations The S&L Crisis

44. S&Ls represent a fairly old institution. The provision of funds for financing the purchase of a home motivated the creation of S&Ls. The collateral for the loan would be the home being financed. S&Ls are either mutually owned or operate under corporate stock ownership. “ Mutually owned” means no stock is outstanding, so technically the depositors are the owners. To increase the ability of S&Ls to expand the sources of funding available to bolster their capital, legislation facilitated the conversion of mutually owned companies into a corporate stock ownership structure. Like banks,S&Ls are now subject to reserve requirements on deposits established by the Fed. Prior to the passage of FIRREA, federal deposit insurance for S&Ls was provided by the Federal Savings and Loan Insurance Corporation(FSLIC). The Saving Association Insurance Fund (SAIF) replace FSLIC and is administered by the FDIC.

45. ASSETS The only assets in which S&Ls were allowed to invest were mortgage, mortgage-backed securities,and goverment securities. Mortgage loans include fixed-rate mortgages and adjustable rate mortgages. Although most mortgage loans are for the purchase of homes, S&Ls do make construction loans.

46. Although S&Ls enjoyed a comparative advantage in originating mortgage loans,they lacked the expertise to make commercial and corporate loans. Rather than make an invesment in acquiring those skills,S&Ls took an alternative approach and invested in corporate bonds because these bonds were classified as corporate loans. More specifically, S&Ls became one of the major buyers of noninvesment-grade corporate bonds,more popularly referred to as”junk” bonds or “high yield” bonds. Under FIRREA, S&Ls are no longer permitted to invest new money in junk bonds.

47. S&Ls invest in short-term assets for operational and regulatory purposes. All S&Ls with federal deposit insurance must satisfy minimum liquidity requirements. These requirements are specified by the Office of Thrift Supervision.

48. FUNDING Prior to 1981, the bulk of the liabilities of S&Ls consisted of passbook savings accounts and time deposits. The interest rate that could be offered on these deposits was regulated. S&Ls were given favored treatment over banks with respect to the maximum interest rate they could pay depositors-they were permitted to pay an interest rate 0.5% higher, later reduced to 0.25%. With the deregulation of interest rates discussed earlier in this chapter, banks and S&Ls now compete head-to-head for deposits.

49. Since the early 1980s, however, S&Ls can offer accounts that look similar to demand deposits and that do pay interest call negotiable order of withdrawal(NOW) accounts. Unlike demand deposits, NOW accounts pay interest S&Ls were also allowed to offer money market deposits accounts(MMDA)

50. Since the 1980s, S&Ls more actively raised funds in the money market. They can borrow in the federal funds market and they have access to the Fed’s discount window. S&Ls can also borrow from the Federal Home Loan Banks. These borrowing called advances, can be short-term or long-term in maturity and the interest rate can be fixed or floating.