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Chapter 3 Banks and Other Financial Institutions © 2011 John Wiley and Sons Chapter Outcomes     Describe major financial institutions & their roles in the financial system Describe differences between commercial banking & investment banking Identify the functions of banks & of the banking system Describe the early history of U.S. depository institutions 2 Chapter Outcomes (Continued)    Discuss general regulation of the banking system & how depositors’ funds are protected Describe the structure of banks in terms of bank charters, branch banking, & bank holding companies Describe the bank balance sheet & the major account categories that it contains 3 Chapter Outcomes (Continued)     Discuss bank management in terms of bank liquidity & bank solvency Describe liquidity management in terms of managing assets & liabilities Briefly explain why and how bank capital is managed Describe the characteristics of several foreign banking systems 4 Types/Roles of Financial Institutions   Financial Intermediation: process by which savings are accumulated in depository institutions and then lent or invested Financial Institutions Categories: Depository Institutions Contractual Savings Organizations Securities Firms Finance Firms 5 Types/Roles of Financial Institutions   Figure 3.1 in text shows the types of major financial institutions as well as each institution’s primary source of funds Figure 3.2 in text depicts the process of directing savings and investments of individuals through financial institutions to business firms 6 Depository Institutions   Accept deposits from individuals and then lend pooled deposits to businesses, governments, and individuals Four Types: Commercial Banks Savings and Loan Associations Savings Banks Credit Unions 7 Depository Institutions   Commercial Banks: depository institutions that accept deposits, issue check-writing accounts, and make loans Thrift Institutions: noncommercial bank depository institutions that accumulate individual savings and primarily make consumer & mortgage loans 8 Depository (Thrift) Institutions   Savings Banks: accept the savings of individuals & lend pooled savings to individuals mainly in the form of mortgage loans Savings and Loan Associations: accept individual savings and lend pooled savings to individuals, (primarily in the form of mortgage loans) and businesses 9 Depository (Thrift) Institutions  Credit Unions: cooperative nonprofit organizations that exist primarily to provide member depositors with consumer credit 10 Contractual Savings Organizations   Organizations collect premiums and contributions from participants and provide insurance against major financial losses and retirement Two Types: Insurance Companies Pension Funds 11 Contractual Savings Organizations   Insurance Companies: provide financial protection to individuals and businesses for life, property, liability, & health uncertainties Pension Funds: receive contributions from employees and/or their employers and invest the proceeds on behalf of the employees for use during their retirement years 12 Securities Firms   Accept and invest individual savings and also facilitate the sale and transfer of securities between investors Three Types: Investment Companies (Mutual Funds) Investment Banking Firms Brokerage Firms 13 Securities Firms   Investment Companies: sell shares in their firms to individuals and others and invest the pooled proceeds in corporate and government securities Mutual Funds: open-end investment companies that can issue an unlimited number of their shares to their investors & use the pooled proceeds to purchase corporate and government securities 14 Securities Firms   Investment Banking firms: sell or market new securities issued by businesses to individual and institutional investors Brokerage Firms: assist individuals to purchase new or existing securities issues or to sell previously purchased securities 15 Finance Firms   Provide loans directly to consumers and businesses and help borrowers obtain mortgage loans on real property Two Types: Finance Companies Mortgage Banking Firms 16 Finance Firms   Finance Companies: provide loans directly to consumers and businesses or aid individuals in obtaining financing of durable goods and homes Mortgage Banking Firms: originate mortgage loans on homes and other real property by bringing together borrowers and institutional investors 17 Overview of the Banking System  Commercial Bank: Accepts deposits, makes loans, and issues check-writing accounts  Investment Bank: Helps businesses sell their securities to raise financial capital  Universal Bank: Bank that engages in both commercial banking and investment banking activities 18 Commercial and Investment Banking Intermediation Activities Savers Money Commercial Bank Bank’s CDs Savers Money Firm’s Bond Money Firm’s Note Investment Bank Money Firm’s Bond Business Firms Business Firms 19 Commercial Banking Intermediation Activities 1. SAVERS deposit money in a Commercial Bank and receive, in return, Certificates of Deposit (or have savings accounts set up for them) 2. The Commercial Bank lends money to a Business Firm and receives, in return, the firm’s note which is a promise to repay the loan 20 Investment Banking Intermediation Activities 1. Savers provide money to an Investment Bank and receive, in return, the securities (e.g., bonds) issued by a Business Firm 2. The Investment Bank either first purchases the Business Firm’s securities (e.g., bonds) and resells them to Savers, or just “markets” the securities to Savers 21 Overview of the Banking System (Continued)   Glass-Steagall Act of 1933: Provided for separation of commercial banking and investment banking activities in the U.S. Gramm-Leach-Bliley Act of 1999: Repealed the separation of commercial banking and investment banking activities provided for in the Glass-Steagall Act 22 Processing or Clearing Checks Through the Banking System A “check” can be:    Presented directly to the bank on which it was written Presented through a bank clearinghouse and then to the bank on which it was written Cleared through a Federal Reserve Bank and then presented to the bank on which it was written 23 Historical Development of the U.S. Banking System      Early Chartered Banks First Bank of the United States Second Bank of the United States State Banks from 1836 to the Civil War Entry of Thrift Institutions 24 General Banking Legislation     National Banking Act of 1864 Federal Reserve Act of 1913 Depository Institutions Deregulation and Monetary Control Act of 1980 Garn-St. Germain Depository Institutions Act of 1982 25 Savings and Loan Crisis  What Happened? Mid-1980s to Mid-1990s: Over 2,000 S&Ls were closed or merged into other institutions  Why did it Happen? S&Ls failed due to (1) mismanagement and (2) greed that led to fraudulent activities on the part of some officers and managers 26 Nature of S&L Business Activities    S&Ls borrow short-term by accepting the deposits of savers and paying interest on the savings S&Ls, in turn, provide long-term mortgage loans to help finance homes The result is loan illiquidity and financing cost risk associated with rising short-term interest rates 27 Changing S&L Business Activities     Deregulation caused additional S&L operating difficulties In early 1980s, S&Ls were permitted to invest in a range of high-yielding investments including speculative office/commercial buildings and “junk” (low quality) bonds issued by businesses S&L managements were ill prepared for deregulation resulting in mismanagement Greed also resulted in fraudulent behavior on the part of some officers and managers 28 Legislative Changes to Address S&L Crisis   Federal Savings and Loan Insurance Corporation (FSLIC), the insurer of most S&L depositors since early 1930s, went bankrupt in early 1988 because of the number and size of S&L failures The Financial Institutions Reform, Recovery, and Enforcement Act was passed in 1989. FIRREA provided for the termination of the FSLIC and formed the Savings Association Insurance Fund (SAID) 29 Legislative Changes to Address S&L Crisis (continued)    FIRREA required S&Ls to commit more of their assets to home loans, restricted S&Ls from holding junk bonds, & allowed commercial banks to purchase S&Ls Congress created the Resolution Trust Corporation (RTC) in 1988 to take over and dispose of the assets of failed S&Ls by finding acquirers or through liquidations Congress shut down the RTC in 1995 30 Protection of Depositors’ Funds    The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to protect deposits in banks The Federal Savings and Loan Insurance Corporation (FSLIC) was created to protect deposits in S&Ls [replaced by SAIF in 1989] The National Credit Union Share Insurance Fund (NCUSIF) was created to protect deposits in credit unions 31 Protection of Depositors’ Funds (continued)    Deposit account insurance has been increased over time--it reached $100,000 in 1980 and currently is $250,000 Bank Insurance Fund: Collects annual insurance premiums from commercial banks to create the pool of funds available to FDIC for covering insured depositors Federal Deposit Insurance Corporation Improvement Act of 1991: Provides for differences in deposit premiums based on the relative riskiness of banks 32 Structure of Banks: Bank Charters   DUAL BANKING SYSTEM: Commercial banks can obtain charters either from the federal government or a state government FEDERALLY CHARTERED BANKS: Must have “national” in their titles and be members of the Federal Reserve System and the Federal Deposit Insurance Corporation 33 Structure of Banks: Branch Banking    UNIT BANKING: Exists when a bank can have only one fullservice office LIMITED BRANCH BANKING: Allows additional banking offices within a defined distance of a bank’s main office STATEWIDE BRANCH BANKING: Allows banks to operate offices throughout a state 34 Structure of Banks: Bank Holding Companies    HOLDING COMPANY: A firm that owns and controls other organizations or firms ONE BANK HOLDING COMPANY: Permits a firm (OBHC) to own and control only one bank MULTIBANK HOLDING COMPANY: Permits a firm (MBHC) to own and control two or more banks 35 The Bank Balance Sheet: Assets     Cash and Balances Due from Depository Institutions (about 7% of total assets) Securities (about 18% of total assets) Loans (about 59% of total assets) Other Assets (about 16% of total assets) 36 Types of Bank Loans      Loans Secured by Real Estate Loans to Depository Institutions Commercial and Industrial Loans Loans to Individuals Other Loans 37 The Bank Balance Sheet: Liabilities and Owners’ Capital    Deposits (about 68% of total) Other Liabilities (about 24% of total) Owners Capital (about 8% of total) 38 Types of Bank Deposits    TRANSACTION ACCOUNTS: Demand Deposits NOW Accounts NONTRANSACTIONAL ACCOUNTS: Time Deposits Savings Deposits FOREIGN DEPOSITS 39 Bank Management: Basic Concepts   BANK LIQUIDITY: Reflects ability to meet depositor withdrawals and to pay off other liabilities when due BANK SOLVENCY: Reflects ability to keep the value of a bank’s assets greater than its liabilities 40 Liquidity Management   ASSET MANAGEMENT: Maintaining “primary reserves” & “secondary reserves” to help meet depositor withdrawal demands and other liabilities when due LIABILITY MANAGEMENT: Adjusting interest rates on rate sensitive liabilities like CDs to help maintain a desired level of liquidity 41 Capital Management: Three Ratios   EQUITY CAPITAL RATIO (ECR): Equity Capital/Total Assets TIER 1 RATIO (T1R): (Common Equity + Trust-Preferred Securities – Intangible Assets)/RiskAdjusted Assets Where: asset accounts are risk-weighted, with higher rates for riskier loans, to arrive at risk-adjusted assets 42 Capital Management: Three Ratios  TOTAL CAPITAL RATIO (TCR): (Tier 1 Capital + Tier 2 Capital)/RiskAdjusted Assets Where: Tier 2 Capital equals a bank’s loanloss reserve amount + other qualifying securities such as subordinated debt and preferred stock + net unrealized gains on marketable securities 43 Capital Management Ratio Examples   Basic Information: a bank has total assets = $100 million; risk-adjusted assets = $80 million; owners’ equity = $4.5 million; Trust-preferred securities = $0.5 million; loan loss reserve = $1 million; & subordinated debt = $1.5 million Equity Capital Ratio = ($4.5 million)/ $100 million = 4.5% 44 Capital Management Ratio Examples   Tier 1 Ratio = ($4.5 million + $0.5 million)/$80 million = $5 million/$80 million = 6.3% Total Capital Ratio = ($5 million + $1 million + $1.5 million)/$80 million = $7.5 million/$80 million = 9.4% 45 International Banking and Foreign Systems   INTERNATIONAL BANKING: Exists when banks operate in more than one country INTERNATIONAL BANKING ACT OF 1978: Provided more consistent regulation of banks across countries 46 International Banking and Foreign Systems (Continued)   UNIVERSAL BANKING: Banks may engage in both commercial banking and investment banking activities BANKING DEVELOPMENTS: Germany, and now the United States, are universal banking countries 47 Web Links      www.citibank.com www.chase.com www.stlouisfed.org www.federalreserve.gov www.sba.gov 48