1. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-1 2 Chapter The Financial Services Industry: Depository Institutions

2. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-2 Overview of Depository Institutions u In this segment, we explore the depository FIs: Size, structure and composition Balance sheets and recent trends Regulation of depository institutions Depository institutions performance

3. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-3 Products of U.S. FIs u Comparing the products of FIs in 1950, to products of FIs in 2000: Much greater distinction between types of FIs in terms of products in 1950 than in 2000 Blurring of product lines and services over time Wider array of services offered by all FI types Refer to Tables 2-1A and 2-1B in the text

4. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-4 Size of Depository FIs u Consolidation has created some very large FIs u Combined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs

5. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-5 Largest Depository Institutions, 2000 by total assets (billions) Citigroup$804.3 J.P. Morgan Chase 707.5 BankAmerica 671.7 Banc One 283.4 First Union 246.6 Wells Fargo 241.1 Washington Mutual 190.8 Fleet Boston 179.1 SunTrust Banks 100.6 HSBC 87.1

6. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-6 Depository Institutions Commercial Banks »Largest depository institutions are commercial banks. »Differences in operating characteristics and profitability across size classes. Notable differences in ROE and ROA as well as the spread Thrifts »S&Ls »Savings Banks »Credit Unions

7. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-7 Functions and Structural Differences u Functions of depository institutions Regulatory sources of differences across types of depository institutions. u Structural changes generally resulted from changes in regulatory policy. Example: changes permitting interstate branching »Reigle-Neal Act

8. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-8 Commercial Banks u Primary assets: Real Estate Loans: $1,670.3 billion C&I loans: $1,048.2 billion Loans to individuals: $609.7 billion Other loans: $367.5 billion Investment security portfolio: $1,662.0 billion »Of which, Treasury bonds: $710.0 billion u Inference: Importance of Credit Risk

9. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-9 Commercial Banks u Primary liabilities: Deposits: $4,176.6 billion Borrowings: $1,532.5 billion Other liabilities: $401.0 billion u Inference: Highly leveraged

10. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-10 Small Banks, Nation

11. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-11 Large Banks, Nation

12. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-12 Structure and Composition u Shrinking number of banks: 14,416 commercial banks in 1985 12,744 in 1989 8,315 in 2000 u Mostly the result of Mergers and Acquisitions M&A prevented prior to 1980s, 1990s Consolidation has reduced asset share of small banks

13. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-13 Structure and Composition of Commercial Banks u Financial Services Modernization Act 1999 Allowed full authority to enter investment banking (and insurance) u Limited powers to underwrite corporate securities have existed only since 1987

14. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-14 Composition of Commercial Banking Sector u Community banks u Regional and Super-regional Access to federal funds market to finance their lending activities u Money Center banks Bank of New York, Bank One, Bankers Trust, Citigroup, J.P. Morgan/Chase, HSBC Bank USA »declining in number

15. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-15 Balance Sheet and Trends u Business loans have declined in importance u Offsetting increase in securities and mortgages u Increased importance of funding via commercial paper market u Securitization of mortgage loans

16. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-16 Some Terminology u Transaction accounts u Negotiable Order of Withdrawal (NOW) accounts u Money Market Mutual Fund u Negotiable CDs: Fixed-maturity interest bearing deposits with face values over $100,000 that can be resold in the secondary market.

17. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-17 Off-balance sheet activities u Heightened importance of off-balance sheet items Large increase in derivatives positions is a major issue Standby letters of credit Loan commitments When-issued securities Loans sold

18. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-18 Other Fee-generating Activities u Trust services u Correspondent banking Check clearing Foreign exchange trading Hedging Participation in large loan and security issuances »Payment usually in terms of noninterest bearing deposits

19. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-19 Key Regulatory Agencies FDIC (BIF and SAIF) OCC: Primary function is to charter national banks. FRS: monetary policy, lender of last resort. »National banks are automatically members of the FRS. State-chartered banks can elect to become members. State bank regulators Dual Banking System: Coexistence of nationally and state-chartered banks.

20. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-20 Web Resources u For more detailed information on the regulators, visit: http://www.fdic.gov http://www.occ.treas.gov http://federalreserve.gov Web Surf

21. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-21 Other Regulatory Issues u Importance of Bank Holding Companies is increasing. u BHCs regulated by FRS.

22. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-22 Key Regulatory Legislation u 1927 McFadden Act: Controls branching of national banks. u 1933 Glass-Steagall: separates securities and banking activities. u 1956 Bank Holding Company Act and subsequent amendments specifies permissible activities and regulation by FRS of BHCs.

23. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-23 Legislation (continued)... u 1970 Amendments to the Bank Holding Company Act: Extension to one-bank holding companies u 1970 International Banking Act: Regulated foreign bank branches and agencies in USA

24. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-24 Legislation (continued) u 1980 DIDMCA and 1982 DIA (Garn-St. Germain Depository Institutions Act) Mainly deregulation acts. Phased out Regulation Q. u 1987 Competitive Equality in Banking Act (CEBA) Redefined bank to limit growth of nonbank banks.

25. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-25 Legislation (continued) u 1989 FIRREA Imposed restrictions on investment activities Replaced FSLIC with FDIC-SAIF Replaced FHLB with Office of Thrift Supervision Created Resolution Trust Corporation

26. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-26 Legislation (continued) u 1991 FDIC Improvement Act Introduced Prompt Corrective Action Risk-based deposit insurance premiums Limited “too big to fail”

27. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-27 Legislation (continued) u 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act Permits BHCs to acquire banks in other states. Invalidates some restrictive state laws. Permits BHCs to convert out-of-state subsidiary banks to branches of single interstate bank. Newly chartered branches permitted interstate if allowed by state law.

28. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-28 1999 Financial Services Modernization Act u Financial Services Modernization Act Allowed banks, insurance companies, and securities firms to enter each others’ business areas Provided for state regulation of insurance Streamlined regulation of BHCs Prohibited FDIC assistance to affiliates and subsidiaries of banks and savings institutions Provided for national treatment of foreign banks

29. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-29 Industry Performance u Economic expansion and falling interest rates through 1990s Commercial banks record earnings of $71.6 billion u Downturn in early 2000s Reduction in performance Increased provision for loan losses u Only 6 failures in 2000 versus 206 in 1989 Technology risks remain

30. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-30 Savings Institutions u Comprised of: »Savings and Loans Associations »Savings Banks Effects of changes in Federal Reserve’s policy of interest rate targeting combined with Regulation Q and disintermediation. Effects of moral hazard and regulator forbearance. Qualified Thrift Lender (QTL) test.

31. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-31 Savings Institutions: Recent Trends u Industry is smaller overall u Intense competition from other FIs mortgages for example u Concern for future viability

32. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-32 Primary Regulators u Office of Thrift Supervision (OTS). Charters and examines all federal S&Ls. u FDIC-SAIF Fund. Oversees and manages Savings Association Insurance Fund (SAIF).

33. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-33 Web Resources u For more information on the regulation of savings institutions, visit: Treasury www.ots.treas.gov FDIC www.fdic.gov Web Surf

34. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-34 Savings Banks u Mutual organizations Primarily East Coast Not exposed to the oil-based shocks of 1980s Real estate price exposure Demutualization u May be regulated at both state and federal level

35. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-35 Credit Unions Nonprofit depository institutions owned by member-depositors with a common bond. Exempt from taxes and Community Reinvestment Act (CRA). Expansion of services offered in order to compete with other FIs. Approximately 2/3 federally chartered and subject to NCUA regulation.

36. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-36 Web Resources u For information on credit unions visit: American Bankers Association www.aba.com Web Surf

37. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-37 Global Issues u Near crisis in Japanese Banking u 19 of the biggest Japanese banks on credit watch list u European banks continued to perform well u Implications for future competitiveness

38. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-38 Other Trends u Number of banks continues to decline. u Increase in off-balance-sheet activities. u Increase in income derived from fees-for- service rather than spread income. u Increased competition between banks and across financial services sectors. u Increased competition from foreign FIs.

39. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-39 Pertinent Websites www.federalreserve.gov www.cuna.org www.fdic.gov www.occ.treas.gov www.ots.treas.gov www.us-banker.com Web Surf

40. ©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 2-40 *Financial Statement Analysis u Time series analysis of key ratios u ROE framework ROE = ROA × EM ROA = PM × AU