Objectives:

1. Depository Institutions • Objectives: • Understand the activities of large, medium, and small commercial banks by analyzing their balance sheets. • Examine the balance sheets and activities of savings institutions (thrifts). • Examine the balance sheets and activities of credit unions. • Consider the major legislation affecting depository institutions and the regulators of these banks. • Analyze the impact of regulations on a bank’s cost of financing, return on equity, and the implications for a bank’s choice of investments.

2. Commercial Banks • Commercial banks, savings institutions, and credit unions make up the three major types of U.S. depository institutions. • As the name implies, commercial banks have historically focused on business lending. However, as advances in information technology allow large (and some medium-sized) firms to issue publicly traded securities, commercial lending has declined in importance. • The activities of commercial banks have broadened, with real estate and consumer lending growing in importance. Also, many banks rely on fee-generating off-balance sheet activities. • Mergers have reduced the number of U.S. commercial banks from over 14,000 in 1984 to less than 8,000 today.

3. Asset Composition of Commercial Banks 2003Q3 • Currently, there are approximately 7,712 commercial banks in the U.S. 419 banks have assets exceeding $1 billion, and they account for over 85 % of total commercial bank assets. • Large banks hold securities primarily as inventory for making markets in these securities and for hedging purposes. Small banks hold securities for investment purposes.

4. 10 Largest U.S. Bank Holding Companies 2003Q2 • Bank of America announced a merger with Fleet in October 2003. J.P. Morgan Chase announced a merger with Bank One in January 2004. In recent decades, the largest banks have grown via market extension mergers, not internal growth.

5. Commercial Bank Loans 2003Q3 Other 12 % Individual 16 % Real Estate 52 % Commercial & Industrial 20 %

6. Real estate loans include residential mortgages, commercial mortgages, and construction loans. • Loans to individuals include auto loans, credit card receivables, and personal loans. • Small banks’ commercial and industrial (C&I) loans tend to be to small businesses while large banks can make C&I loans to large corporations, often in the form of syndications.

7. Liability Composition of Commercial Banks 2003Q3 • Small banks rely on FDIC-insured retail (< $100,000) deposits, and have little other sources of financing besides equity capital. • Large (small) banks are net buyers (sellers) of federal funds. Most large banks cannot gather enough retail deposits to finance their assets. They rely on “purchased funds.”

8. Large banks obtain wholesale (large) deposits from their foreign branches at competitive interest rates (e.g., LIBOR). • Large banks may issue longer-maturity publicly-traded bonds. Often, for regulatory reasons, these bonds are subordinated (junior) to the bank’s other liabilities. • The proportion of funding that comes in the form of FDIC-insured deposits is much lower for large banks than for smaller banks. On average, insured deposits finance 31 % (62 %) of assets for banks with total assets greater (less) than $1 billion. • Large banks’ capital ratios tend to be lower than those of smaller banks.

9. Commercial Bank Deposits 2003Q3 Checkable (Demand) Deposits 14 % Foreign Deposits 14 % Retail CDs 14 % Wholesale CDs 12 % MMDA and Savings Deposits 46 % • Checkable deposits make up an increasing smaller proportion of bank financing. They are the only deposits subject to a 10% reserve requirement.

10. Increasingly, large banks’ earnings come from off-balance sheet activities. These activities include loan commitments, letters of credit, loan sales, asset securitization, and buying and selling derivative securities. • Large banks deal in derivatives such as swaps, forward and futures contracts, and options. These derivatives are primarily foreign exchange, fixed-income (interest rate), and credit derivatives.

11. Savings Institutions • Savings institutions, also referred to as “savings and loans” (S&Ls) or “thrifts” were established primarily to serve consumers by offering short-maturity savings deposits and using these funds to make residential mortgage loans. • Many thrifts began as mutual organizations that were legally owned by their depositors. Their net worth or equity capital derived from accumulated retained earnings. • However, in recent years many thrifts have converted to stock-issuing institutions that allows them to more easily raise equity capital from public investors.

12. Asset Composition of Savings Institutions 2003Q3 • Currently, savings institutions must satisfy a “qualified thrift lender” (QTL) test that constrains them to hold at least 65 % of their assets as mortgages or mortgage-backed securities. • Many S&Ls failed during the 1980s due to interest rate risk and bad commercial real estate lending. Due to failures, mergers, and changes to a bank charter, their numbers declined from over 4,000 prior to 1980 to around 1,400 today.

13. Savings Institution Loans 2003Q3 Other 1 % Individual 7 % Commercial & Industrial 5 % Real Estate 87 % • Real estate lending continues to comprise the vast majority of loans. Legislation in the early 1980s allows thrifts to make C&I and individual (consumer) loans.

14. Liability Composition of Savings Institutions 2003Q3 • Most thrifts rely on having a branch network that allows them to collect retail deposits. • A significant source of funding also comes from loans from the 12 regional Federal Home Loan Banks. Recently, commercial banks were also granted access to FHLB loans.

15. Savings Institution Deposits 2003Q3 Checkable (Demand) Deposits 26 % Wholesale CDs 27 % Retail CDs 9 % MMDA and Savings Deposits 38 %

16. During the early 1980’s, the Federal Reserve under Chairman Paul Volker raised market interest rates as it contracted the money supply and attempted to reduce inflation. • The long-maturity, fixed-rate mortgages held by thrifts declined greatly in value as these thrifts also were forced to pay higher rates on deposits in order to compete with other savings vehicles, such as money market mutual funds. • Many thrifts became insolvent but were not immediately closed due to forbearance by their regulator, the Federal Savings and Loan Insurance Corporation (FSLIC). Many gambled for resurrection (and lost) by engaging in risky commercial real estate lending. • The deposit insurance cost of these failures exceeded $160 B.

17. Credit Unions • Credit unions are mutually-organized, nonprofit depository institutions. • Deposits are referred to as “shares” because depositors are members of the credit union and legally “own” it. • Credit union.membership is restricted to individuals that have a “common bond” such as being an employee of the same firm, member of the same union or trade association, or resident of the same community. • The non-profit status of credit unions exempts them from corporate income taxes. Bankers have complained that this tax exemption gives credit unions an unfair advantage.

18. Asset Composition of Credit Unions 2002Q4 • Most credit unions are small, with an average asset size of around $57 million. • Besides making loans to their individual members, credit unions hold a significant amount of securities, such as Federal agency securities and bank CDs.

19. Loans of Credit Unions, 2002Q4 Other < 1 % Personal 12 % Credit Cards 6 % Auto 39 % Real Estate 43 %

20. Liability Composition of Credit Unions 2002Q4 • Deposit shares are comprised of • Share drafts: checking accounts • Regular shares: savings accounts • Money market shares: money market deposit accounts • As with other mutual depository institutions, equity capital represents the accumulated retained earnings of the credit union.

21. Deposits of Credit Unions, 2002Q4 Other 1 % Share Drafts 12 % IRA/Keogh Accounts 9 % CDs 24 % Regular Shares 36 % Money Market Shares 18 %

22. In 1998, legislation that liberalized the requirements for credit union membership was passed. This led to significant growth in the assets of credit unions, to the disappointment of community bankers. • The National Credit Union Administration regulates federally chartered credit unions and provides deposit insurance at the same level of protection (up to $100,000 per account) as the FDIC does for commercial banks and thrifts.

23. Major U.S. Bank Regulations • National Banking Act of 1863 • Created the Office of the Comptroller of the Currency (OCC) to charter and supervise National Banks, which had to hold reserves in Treasury bonds to help finance the Civil War. • Individual states already chartered and supervised their own banks. Thus, a "Dual Banking System" was begun. • 1913 Federal Reserve Act • Created the Federal Reserve which was given the power to supervise Federal Reserve member banks with state charters. OCC continued to supervise all National Banks which were required to become members of the Federal Reserve.

24. Federal Reserve members provided banks with check clearing services and the ability to borrow from the Federal Reserve’s Discount Window. • However, Federal Reserve member banks were subject to higher reserve requirements. • McFadden Act of 1927 • National Banks were restricted to the same branching laws as state banks in the state where the National Bank is located. • Until the 1980s and 1990s, states restricted banks from branching across state lines. • Types of branching restrictions: 1.Statewide branching 2.Limited branching 3. No-branches (unitary)

25. Banking Acts of 1933&35 (Glass-Steagall Act) • Created the Federal Deposit Insurance Corporation (FDIC) to provide deposit insurance. FDIC insurance was required for all Fed members and optional for other banks. The FDIC became the primary regulator of non-Fed member banks. • Imposed more restrictive chartering requirements and capital adequacy standards for FDIC members. End of “free-banking.” • Imposed interest rate restrictions on deposits, such as the Regulation Q interest rate ceiling. • Separated investment banking from commercial banking: Investment banks could not accept deposits and the types of assets and activities of commercial banks restricted. For example, commercial banks could not underwrite or be dealers for non-government (corporate) securities.

26. Bank Holding Company Act of 1956, amended 1970. • To get around interstate banking restrictions, BHCs were formed after WWII. The Fed was put in charge of these BHCs and given power to specify which activities a BHC subsidiary could perform. • The Douglas Amendment prohibited a BHC from acquiring a bank in another state unless that state authorized the acquisition. • The 1970 amendment to the BHC Act also put “one bank BHCs” under Fed's supervision, which were not covered by 1956 law. • BHCs control over 90% of deposits in the U.S.

27. Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 • Federal Reserve given authority to set uniform reserve requirements for all depository institutions. Currently, 10 % of transactions deposits must be held as non-interest- bearing reserves (vault cash or reserve deposits at Fed). • Federal Reserve services (e.g., check clearing) must be priced at cost • Gradual elimination of deposit interest rate ceilings (Regulation Q). • Allowed commercial banks and savings institutions to provide many of the same services, such as offering demand deposits, commercial loans, and mortgages. • Increased deposit insurance coverage from $40,000 to $100,000.

28. Garn-St.Germain Depository Institutions Act of 1982 • Accelerated removal of deposit interest rate ceilings. Introduced MMDAs and NOW accounts. • The FDIC and FSLIC were given expanded powers to deal with bank and thrift failures. • Federal Reserve Board's Permission of Commercial Bank Underwriting (1980s-1990s) • Certain BHCs given permission to carry out securities business in a subsidiary so long as that subsidiary is not “principally engaged” in dealing or underwriting securities banned by Glass-Steagall. (The subsidiary's revenue from corporate underwriting was limited to 25 percent.) • In 9/1990, Morgan Guarantee became the first commercial bank to be given permission to underwrite corporate stocks and bonds.

29. Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 • Abolished the Federal Home Loan Bank Board and FSLIC and created Office of Thrift Supervision to regulate thrifts. FDIC took over control of deposit insurance for thrifts. • Authorization to raise up to $50 billion over three years by issuing 30-year bonds through a new agency, the Resolution Trust Corporation, in order to resolve failed thrifts and liquidate their assets. • This cost was in addition to approximately $50 billion already spent to resolve failed thrifts. The cost to taxpayers was approximately $60 billion, with the savings industry paying $66 billion through higher insurance premiums. • Capital standards were toughened for thrifts so that they equaled those of commercial banks.

30. Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 • Authorized the FDIC to borrow an additional $70 billion to resolve bank failures. • Mandates “prompt correction action”: a series of (book-value) capital levels that requires regulatory intervention, such as disallowing brokered deposits, limiting a bank’s rate of growth, eliminating dividends, forcing a new stock issue, or firing management. Banks are required to be closed when their capital falls below 2% of assets. • After 1/1/95, uninsured deposits (domestic > $100,00 and all foreign branch deposits) and other liabilities cannot be “de facto” insured during a bank failure unless approval given by Treasury Secretary, 2/3rds of FDIC Directors, and 2/3rds of Federal Reserve Board of Governors.

31. FDIC must draw up and implement by 1/1/94 a deposit insurance system that links an individual bank's premium to its risk. • Security firms given direct access to Fed Discount Window during financial distress. • Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. • Allows bank holding companies to acquire banks in any other state starting in October 1995. • Allows mergers between banks located in different states starting in June of 1997. The act will allow interstate banking organizations to consolidate into a single branch network and provide for a uniform standard for interstate expansion.

32. Gramm-Leach-Bliley Act of 1999 • Repealed many provisions of the Glass-Steagall Act that separated commercial and investment banking activities. • A bank holding company can convert to a financial services holding company to offer a variety of financial activities in separately capitalized subsidiaries. These include lending, insurance underwriting, securities underwriting and dealing, and financial advice services. However, only traditional banking activities, such as lending, can be in subsidiaries that issue insured deposits. • Well-capitalized National banks may set up subsidiaries that engage in investment banking activities, such as securities underwriting, that are not allowed by other banks. The subsidiaries could be financed by insured deposits, but the banks would be more tightly regulated.

33. Summary of Depository Institutions’ Primary Federal Regulators • National Bank: OCC, a department of the U.S. Treasury. • State Chartered Bank, Federal Reserve member: Federal Reserve. • State Chartered Bank, not a Federal Reserve member: FDIC • Savings Institution: Office of Thrift Supervision (OTS), a department of the U.S. Treasury • Credit Union: National Credit Union Administration. • For information and data on depository institutions, check out each of these regulator’s web sites.

34. The Effects of Regulation on Banks’ Cost of Financing • There are at least two types of regulation that can affect depository institutions’ cost of financing their assets. • Reserve Requirements: The Fed sets a minimum reserve requirement on deposits. Currently, the regulation requires 10 % of transactions deposits to be held in the form of non-interest-bearing reserves, 0 % for all other liabilities. • Capital requirements: A minimum level of equity capital must finance non-reserve assets. Currently, most obligations of firms or individuals must be financed with at least 8 % equity (92 % can be financed by debt). • Reserve requirements are costly because required reserves pay no return. Capital requirements are costly because equity capital has a tax disadvantage relative to debt.

35. To see this, suppose that a proportion, , of deposits must be held as reserves and a proportion k of non-reserve assets must be financed with equity capital. Define the following: • D = deposits • E = equity capital • R = reserves • N = non-reserve assets, such as loans or investments. • The reserve requirement is • The capital requirement is • or

36. For example, suppose  = 0.10, k = 0.08, and N = 100. Then Bank Balance Sheet Liabilities Assets E = 8.00 D = 102.22 N = 100.00 R = 10.22

37. Based on this financial structure, let us now calculate the bank’s earnings (income) after taxes. • Suppose the bank’s rate of return on its non-reserve assets is rNand the rate that it pays on deposits is rD. It also faces a corporate tax rate of t. Then its earnings after interest expense and taxes is • We can use our previous formulas to substitute for N and D to re-write this expression for earnings as

38. From this, we see that the bank’s return on equity (ROE), which is simply earnings divided by equity, is • For example, suppose that rN = 0.06, rD = 0.05, and t = 0.30. Then • Thus, this bank’s ROE is 7.8 percent.

39. For the special case of a zero reserve requirement, which would be the case if non-transaction deposits such as CDs financed a bank’s assets, we have • Now consider the situation of a (large) money center bank that relies on “purchased funds” (such as wholesale CDs) to finance its assets. This source of funding requires the bank to pay a competitive money market interest rate, say rD = rM. Thus, this bank’s return on equity would be

40. Further, consider this money-center bank’s choice of assets. Suppose that it purchases a money market investment, such as commercial paper, paying the competitive money market rate rN = rM. The bank’s ROE from this investment is • The implication is that the money-center bank’s ROE would be less than the competitive return, so that it would never wish to invest in competitive securities purely for investment purposes. To obtain an ROE at least equal to rM, this bank would need to make loans that earn a return rN > rM.

41. The choice of assets could differ if the bank is a community bank that funds its assets by issuing retail deposits paying a less-than-competitive rate rD < rM. Such a bank might be described as “deposit rich” in that it enjoys substantial market (monopoly) power in its retail deposit market. • If, in addition, this community bank is faced with limited lending opportunities (it is “loan poor”), it may be profitable for the bank to invest in money market instruments, rN = rM. Its ROE would them be • which may exceed rM if rDis sufficiently low.

42. In summary, it would never be profitable for a money center bank to invest in money market instruments. To obtain a competitive ROE, it needs to make investments (loans) earning a return higher than the competitive money market rate. • In contrast, a (small) community bank that is deposit rich but loan poor might find it profitable to use its below-market-rate retail deposits to purchase funds (money market instruments).