1. Chapter 1: Banking and the Financial Services Industry 1

2. Global Financial Crisis of 2007 - 2009 Economies began to weaken in mid-2007: Series of crises related to problem mortgages and loans. Mortgages did not require large enough monthly payments to pay off loans. Borrowers had insufficient income to qualify for loans they received. Lenders made loans with the intent to sell them – the originate-to-distribute approach – so as not to retain the credit risk. 2

3. Global Financial Crisis of 2007 - 2009 Multiple mortgage banks failures and defaults: Home price declines led to losses from mortgage defaults. Many high-risk borrowers whose income did not cover payment amounts that would repay their loans. Subprime borrower loans with teaser rates and interest only payments resulted in negative amortization. Sustained drop in housing prices led to large write-downs. Credit availability was restricted and terms were increasingly strict. 3

4. Global Financial Crisis of 2007 - 2009 Collapse and/or Failure of: Bear Stearns, Lehman Brothers, Countrywide, Washington Mutual and Wachovia Government Response: Fannie Mae and Freddie Mac placed into conservatorship Loaned AIG over $150 billion Insured money market mutual funds Authorized Bank of America to acquire Merrill Lynch Approved Goldman Sacs, Morgan Stanley, MetLife and American Express to convert to bank holding companies 4

5. Government Response (cont’d) Authorized the Federal Reserve to purchase commercial paper directly from companies such as General Electric Increased FDIC coverage to $250,000 for domestic deposits and to unlimited coverage for business deposits Established Troubled Asset Relief Program – TARP Purchased $125 billion of preferred stock in nine large U.S. banks Loaned large amounts to large U.S. financial institutions Authorized the sale of FDIC-insured bonds Allowed hedge funds to borrow from the Federal Reserve 5

6. Global Financial Crisis of 2007 - 2009 Large institutions less willing to make unsecured loans to other institutions. Interbank interest rates, such as the London Interbank Offer Rate (LIBOR) rates rose sharply. Spread between LIBOR and Treasury rates at record highs. U.S. and other countries fell into a recession. Housing values dropped and foreclosures reached historically high levels in some markets. Congress and FDIC promoted loan modifications for troubled borrowers. 6

7. Global Financial Crisis of 2007 - 2009 7

8. Impact on Banks and the Banking Environment Many of the largest banks that operate in national and international markets realized large losses: Subprime mortgages Private-label mortgage backed securities Loans to private equity firms involved in leverage buyouts Credit default swaps Speculative real estate loans Many small banks took significant losses on commercial real estate loans and write-downs. 8

9. Impact on Banks and the Banking Environment Dramatic change in the structure and operations of U.S. banks. Federal Reserve provided direct loans, guarantees, and lines of credit to financial institutions that exceeded $1 trillion. Asset write-downs and loan charge-offs in the U.S. led to similar problems in other countries. 9

10. How Do Banks Differ? Global Banks: Offer a wide array of products and services globally Super-Regional Banks: Similar to global banks but smaller in size and market penetration Community Banks: Smaller trade area with total assets under $1 billion 10

11. Trends in the Structure of Banks Banking industry has consolidated. Managers seek economies of scale and use technology to offer products and services across markets. FDIC insures commercial bank deposits and serves as one of the major bank regulatory organizations. An independent bank is a single organization that accepts deposits and makes loans. Thrifts are regulated by the OCC and were initially organized to emphasize mortgage lending to individuals. 11

12. Trends in the Structure of Banks – Bank Holding Companies (BHC) Owns controlling interest in one or more commercial banks. Prior to the enactment of interstate branching, primary motivation was to circumvent restrictions. Primary motivation today is to broaden scope of products that can be offered. Holding company is the parent and operating entities are the subsidiaries. One-bank holding companies control only one bank. 12

13. Trends in the Structure of Banks – Bank Holding Companies (BHC) Multibank holding companies control at least two commercial banks. Some treat subsidiaries like branches. Others allow subsidiaries to operate quasi-independently. Bank Holding Company Act of 1956 assigned regulatory responsibility to the Federal Reserve. Under current regulations BHC can acquire nonbank subsidiaries offering products and services closely related to banking. 13

14. Trends in the Structure of Banks 14

15. Trends in the Structure of Banks 15

16. Trends in the Structure of Banks 16

17. Trends in the Structure of Banks – Financial Holding Companies (FHC) Primary advantage is entity can engage in a wide range of financial activities not permitted in the bank or in a BHC including: Underwriting and selling insurance and securities Both commercial and merchant banking Insurance company portfolio investment activities Activities that are “complementary” to financial activities 17

18. Trends in the Structure of Banks – Financial Holding Companies (FHC) Fed may not permit forming an FHC (or converting a BHC to an FHC) if any of its insured depository institution subsidiaries: Not well capitalized or well managed Did not receive at least a “Satisfactory” rating in its most recent CRA exam FHC can own a bank, BHC, thrift or thrift holding company: Each of these companies owns subsidiaries, while the parent financial holding company also owns other subsidiaries directly. 18

19. Trends in the Structure of Banks 19

20. Trends in the Structure of Banks Holding Company Financial Statements: Consolidated financial statements of a holding company and its subsidiaries reflect aggregate or consolidated performance. Useful to examine parent company’s statements alone. Parent typically pays little income tax because 80% of dividends from subsidiaries is exempt. Under IRS provisions, each subsidiary pays taxes quarterly on its taxable income. With a consolidated tax return, parent company can use taxable income from its subsidiaries to offset its loss. 20

21. Holding Company Financial Statements 21

22. Holding Company Financial Statements 22

23. Holding Company Financial Statements 23

24. Holding Company Financial Statements 24

25. Holding Company Financial Statements 25

26. Holding Company Financial Statements 26

27. Organizational Structure – S-Corp Banks Have favorable tax treatment because a qualifying firm does not pay corporate income tax. Firm allocates income to shareholders on a pro rata basis. Each individual pays tax at personal tax rates on the allocated income. Many closely held banks have chosen this status to avoid double taxation. Primary limitation to qualifying for S-Corp status is a requirement that the bank must have no more than 100 shareholders. 27

28. Organizational Structure – S-Corp Banks 28

29. Financial Services Business Models The principal advantage of being a depository institution is access to FDIC deposit insurance. Credit unions are ensured by the National Credit Union Association (NCUA). FDIC charges banks a premium for the insurance, which ensures qualifying deposit holders that the FDIC will guarantee the principal amount of each deposit up to the maximum allowed, even if the bank fails. This allows depository institutions to pay low rates on insured deposits and ensures that such deposits are relatively stable in times of crisis. 29

30. Financial Services Business Models Primary disadvantage of operating as a bank (or BHC) is the firm is subject to regulation as a bank. Subject to safety and soundness exams to address risk management and compliance exams which monitor appropriate customer service. Prior to 2008, investment banks avoided regulation, which allowed them to operate with lower equity capital per dollar of risk assets and enter lines of business not generally available to commercial banks The combined effect was greater financial leverage and business operations in many high-risk areas such as proprietary trading 30

31. Transactions Banking versus Relationship Banking Transactions Banking: High frequency transactions services (checking accounts, credit cards, and mortgage loans) with standardized features that require little human input to manage. Lenders that generate sufficient volumes of these transactions can offer them globally with limited investment in human capital. Encourages the use of technology to offer products at prices low enough to discourage small competitors. These banks are generally large and compete across extensive geographic and product markets. Assets can be securitized if loan originators and rating agencies can successfully access underlying credit risk. 31

32. Transactions Banking versus Relationship Banking Relationship Banking: Emphasizes personal relationships between banker and customers. Lender adds value to the borrower during credit granting process and may also provide expertise in other areas such as accounting, business and tax planning. Other services are aggressively marketed to ensure relationships. Lending institutions generally charge higher rates and often hold the loans in portfolio. Borrowers pay for the assurance that funds will be advanced as needed with minimal repetitive negotiations. Customers often follow favorite banker to another bank. 32

33. Transactions Banking versus Relationship Banking Securitization: The process of pooling a group of assets with similar features—for example, credit card loans or mortgages—and issuing securities that are collateralized by the assets. Securities are sold to investors who receive the cash flows from the loans net of servicing, guarantee, and trust fees. The entire process adds liquidity to the market because loan originators regularly repeat it knowing investors will demand the securities. 33

34. Transactions Banking versus Relationship Banking Originate-to-Distribute (OTD) approach: Lenders who originated loans knew they would not own them long term making them less concerned about the quality of assets originated. Loan originators paid based on volume and not penalized for defaults. Resulted in loans being made to less qualified borrowers and defaults that caused investors to not be paid. Net result is that liquidity largely dried up for most securitizations. Large institutions left with holding many of the low-quality loans that resulted in write- downs and losses that depleted capital. 34

35. Universal Banking Structure for a financial services company in which the company offers a broad range of financial products and services. Combined traditional commercial banking that focused on loans and deposit gathering with investment banking. Underwrote securities, advised on mergers and acquisitions, managed investment assets for customers, took equity positions in companies, bought and sold assets for a speculative profit, offered brokerage services, and made loans and accepted deposits. 35

36. Universal Banking Presumed advantage is the ability to cross-sell services among customers. Participation in diverse products and services would presumably increase the information advantage and allow the bank to serve customers more efficiently and at better prices. No consensus on success. U.S. firms that tried to achieve this goal of a “one-stop financial supermarket” have not outperformed more traditional competitors. 36

37. Universal Banking 37

38. Universal Banking 38

39. Too Big to Fail Banks Financial crisis led to Federal Reserve and U.S. Treasury providing emergency credit and injecting capital into banks. Generally nation’s largest institutions received the most help while some smaller banks were allowed to fail. Market participants and analysts labeled the firms receiving the most aid as “Too Big to Fail” (TBTF). Government argued failure of those firms would lead to global recession and that smaller organizations were less important economically. 39

40. Too Big to Fail Banks Congress passed the Dodd-Frank Act in 2010. Attempts to address TBTF banks by creating a resolution process by which troubled institutions will be liquidated. Many market analysts believe TBTF banks will never be allowed to fail through anything resembling liquidation. Since the crisis market share has increased for large banks and decreased for smaller ones. Numerous studies indicate TBTF firms have implicit government guarantees which produce lower borrowing and operating costs. 40

41. Too Big to Fail Banks 41

42. Different Channels for Delivering Banking Services Branch Banking: Retail outlet in which customers can conduct banking business either face to face or electronically. Automated Teller Machines (ATM) Internet (Online) Banking: Primary appeal is convenience. Call Centers Mobile Banking 42