1. Depository Institutions

2. Depository Institutions
Main criteria is that a significant portion of the firms funds come from customer deposits.
Examples include:
Commercial Banks
Savings and Loans
Credit Unions

3. Recent Trends The 1990’s ended with the Fin Modernization Act (1999).
During this time there has been a wave of mergers and acquisitions in the industry.
The increased business services that Depository Institutions are now allowed to offer has created a desire for larger less regional institutions.

4. Source FDIC Future of Banking Study FOB-2004-02.1
Largest Depository Institutions, Dec 31, 2003 by total assets (billions)
$ % %Dom
Assets Assets Dep
J.P Morgan Chase $ % 6.61%
Bank of America $ % 9.82%
Citigroup $ % 3.47%
Wells Fargo $ % 4.62%
Wachovia Corp $ % 4.09%
Washington Mutual $ % 3.23%
US Bancorp $ % 2.19%
National City Corp $ % 1.17%
SunTrust $ % 1.47%
ABN ARMCO $ % 0.87%
Source FDIC Future of Banking Study FOB

5. Traditional Services
Depository Institutions have been traditionally been subject to a large amount of regulation that restricted their actions.
Main business functions:
Consumer and Business Lending
Savings Products
Payment Services
Main overlap with other FI’s has been in Savings products – That has changed dramatically in the last 10 years.

6. Key Regulatory Legislation
National Currency and Bank Acts ( )
Set up system of federally chartering banks through US Treas Dept. or Comptroller of Currency or Administrator of National Banks
Comptroller of the Currency examines all nationally chartered banks every 12 to 18 months
Established pledging requirements for owners equity

7. Key Regulatory Legislation
The Federal Reserve Act (1913)
Established the Federal Reserve System as a lender of last resort
Established network to clear and collect checks

8. Key Legislation McFadden Act (1927)
National banks allowed branches in their original city.
Branching across state lines forbidden unless allowed by state law
Liberalized banks’ underwriting activities and allowed underwriting of corporate stocks and bonds

9. Legislation (continued)...
1933 Glass-Steagall:
Separates securities and banking activities
Prohibited commercial banks from most underwriting of securities. 4 exceptions: Munis, US govt, Private Placement and Real Estate Loans. Fear of conflict of interest
Established FDIC
National banks allowed to branch state wide if state chartered banks were allowed to do so.

10. Legislation (continued)...
Bank Holding Company Act and subsequent amendments ( and 1970)
Specifies permissible activities and regulation by Fed Res of Bank Holding Cos.
Bank Holding Companies must request Fed Approval
Co’s with 2 or more banks must register with Fed Res and file financial statements and submit to Fed Res review of their books
1970 Amendments to the Bank Holding Company Act: Extension to one-bank holding companies

11. Legislation (continued)...
1970 International Banking Act: Regulated foreign bank branches and agencies in USA
1980 Depository Institutions Deregulation and Monetary Control Act
Phased out interest rate ceilings imposed by Regulation Q
Goal was to make S&L’s, credit unions and other nonbank depository institutions more competitive.

12. Legislation (continued)…
Depository Institutions Act (1982) Garn-St. Germain Depository Institutions Act)
Allowed all federally supervised depository Institutions to sell deposit accounts equivalent to Money market mutual fund accounts
Loan limits were liberalized for national banks, allowed lending of up to 15% of their capital
FDIC could arrange mergers across state lines for failing institutions
Competitive Equality in Banking Act (1987)
Redefined bank to limit growth of nonbank banks.

13. Legislation (continued)…
Financial Institutions Reform Recovery and Enforcement Act (1989)
Imposed restrictions on investment activities
Replaced FSLIC with FDIC-SAIF
Replaced FHLB with Office of Thrift Supervision
Created Resolution Trust Corporation

14. Legislation (continued)…
1991 FDIC Improvement Act
Fear of FDIC insolvency by end of 1991
Ordered new measurement scale for describing financial condition of depository institution and when in violation to take “prompt corrective action”
Risk-based deposit insurance premiums
Limited “too big to fail”

15. Legislation (continued)…
Riegle-Neal Interstate Banking and Branching Efficiency Act (1994)
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.

16. 1999 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
ATM fees must be clearly disclosed
Federal Crime to steal account information

17. Structural Changes
FDIC

18. FDIC Institutions
Source FDIC

19. Competition among FI’s

20. Unresolved Issues
Does regulatory approval limit the ability of banks to respond to new markets?
Will functional regulation work (can regulatory agencies work together?)
Can and will countries work together as institutions become more global?

21. Bank Size (by asset concentration)
Community banks – under $1billion in assets specialize in retail or consumer lending
The asset share of banks over $1Billion has increased from 63.4% in 1984 to 83.9% in 2000.
Large banks often have access to cheaper forms of cash.
Money Center Banks – Heavy reliance on nondeposit or borrowed funds.

22. Balance Sheet Assets - four major categories
Cash and deposits held at other institutions
Government and private interest bearing securities
Loans and leases
Misc assets.
Liabilities – two major categories
Deposits
Non deposit borrowing

23. Assets Cash (Primary Reserves) – Investment Securities
includes vault cash, reserves at the Fed Res, deposits at other banks, checks in the process of collection. Designed to meet liquidity needs
Investment Securities
Liquid portion (Secondary Reserves) – ST Gov’t securities, money market securities, commercial paper, time deposits
Income Generating portion – Bonds notes and other securities (taxable and tax exempt).
Trading account securities – bank serve as a security dealer for state, federal and local gov’t obligations. Bank intends to sell these prior to maturity

24. Assets (continued) Loans Largest portion of assets form most banks
Includes consumer, real estate, business, ag production, leases and foreign loans.
Most statements include a gross loan amount and an allowance for loan loss (balance is built with deductions from current income, when a loan is uncollectable then balance is reduced. Therefore both the gross account and loss account change. And net income is not impacted.)

25. Assets (continued)
Federal Funds sold and Securities Purchased under Repurchase agreements
Short term loans…
Customers Liability on Acceptances
A line of credit provided via a letter of credit backing purchases by the customer.
Miscellaneous Assets
Bank buildings, equipment, prepaid insurance etc.

26. Assets, % of Total Assets

27. Loans, % of Total Loans
FDIC

28. Loan Portfolios 2000
Real Estate
62.77%
Real
Estate
39.85%
FDIC

29. Liabilities Largest portion of liabilities is deposits
Average ratio of equity to assets = 8.49% (91.51% of asses are financed by some type of debt..)
Approximately 21% of deposits are transaction accounts (checkable deposits that cost little or no interest)
Retail savings and time deposits have been declining due to competition form money market mutual funds

30. Deposits Non-interest bearing demand deposits Savings deposits
Checking accounts with unlimited check writing
Savings deposits
NOW accounts
Held only by individuals and nonprofit institutions pay interest and permit checks
Money market deposit accounts
Limited check writing ability and can pay interest
Time deposits
CD’s with fixed maturity and interest rate

31. Liabilities, % of Total
Fedral Reserve Board

32. Assets Vs. Liabilities
Generally liabilities tend to be of shorter maturity than assets. This introduces interest rate risk and liquidity risk for depository institutions.

33. Equity Usually about 8 to 10 % of liabilities and equity
Generally equity held is close to the minimum amount set by regulations

34. Off - Balance Sheet Activities
Assets and Liabilities that will appear on the balance sheet or income statement if a contingent event occurs.
Motivated by both earnings and regulatory (tax avoidance) incentives
Expose the bank to added risk, but do not show up on traditional financial reports.

35. OBS Activities continued
Standby Credit Agreements- bank pledges to guarantee repayment of a customers’ loan received from a third party
Interest rate swaps – exchange interest payments on debt securities with another party
Financial futures and options
Loan commitments – pledge to lend up to a certain amount of funds
Foreign exchange rate contracts

36. Other Fee Generating Activities
Trust Services
Management of estate assets and pension fund assets
Correspondent Banking
Providing banking services to smaller institutions that do not have the staff or expertise in those services.

37. Savings Associations
Primarily deal with household saving and mortgages.
Financing long term mortgages with short term deposits has been helped by a traditionally upward sloping yield curve.

38. S&L Regulation
Traditionally restricted in the type of accounts they could offer the regulation in the early 1980’s allowed S&L’s to become more competitive with commercial banks. Most notably the repeal of Regulation Q. Also allowed to offer NOW accounts and more market sensitive money market accounts

39. Savings Banks
Originally organized as a mutual organization that also focused on mortgage lending
Many are now switching to stock ownership

40. Credit Unions
Nonprofit depository institutions that are mutually organized.
Members must belong to a specific similar occupation, association or live in a given community.
Earnings are designated to paying higher rates of return on deposits and to charging lower rates of interest on loans.

41. Financial Analysis of Depository Institutions
Finance 129
Drake University

42. Basic Financial Statements
Report of Condition
Balance Sheet
Report of Income
Income Statement
Funds Flow Statement
Sources and Uses of Funds
Statement of Stockholders Equity

43. Balance Sheet Financial Outputs Financial Inputs
(uses of Bank Funds or Assets)
Cash (primary reserves)
Liquid Security Holdings
(secondary Reserves)
Investments in Securities
Loans
Consumer
Real Estate Ag
Fin Institutions
Mics Loans
Misc
Financial Inputs
(Sources of Funds or
Liabilities and Owners Equity)
Deposits from Public
Demand
NOW’s
Money markets
Savings
Time
Nondeposit Borrowings
Equity Capital
Stock
Surplus
Retained Earnings
Capital reserves

44. Balance Sheet continued
As with any balance sheet
Assets = Liabilities + Owners Equity or
Accumulated uses Accumulated sources
of bank funds of bank funds =

45. Balance Sheet Components Assets
The Cash Account
includes: Cash in the vault, deposits with other banks, cash items in the process of collection and reserve accounts with the Federal Reserve
Traditionally banks attempt to keep this account as low as possible
Primary reserves since it is banks first line of defense against withdrawls

46. Balance Sheet Components Assets
Investment Securities: the liquid portion
Short term government securities and money market instruments
secondary reserves
Investment Securities Income Generating Portion
Taxable and nontaxable
Can be recorded at original cost or market value or the lower of the two
trading account securities

47. Balance Sheet Components Assets
Loans
Largest Asset
Generally broken down by purpose of loans
Gross loans -- total of all outstanding
Allowance for Loan losses (ALL account)
PLL on income statement
Gross minus ALL = Net Loans
Allocated Transfer Risks
Unearned Discounts

48. Balance Sheet Components Assets
ALL account
often divided into two sections, specific reserves, and general reserves
Tax reform Act of 1986
only loans actually declared uncollectable can be expensed through the ALL accounts
decreased use of ALL accounts
Permanent capital

49. Balance Sheet Components Assets
Federal Funds Sold and Securities Purchased under Resale Agreements
Customers liability Acceptances
Misc Assets

50. Balance Sheet Components Liabilities
Deposits
Noninterest bearing
Savings
NOW accounts
Money Market Accounts
Time Deposits
Borrowings from Nondeposit sources
Capital Accounts

51. Book vs. “Fair Value”
Banks have traditionally recorded balance sheet entries at original cost (book value or historical cost accounting -- ammoritzed cost)
Implies that interest rate fluctuations would not impact values
Fair Value -- current market value

52. Arguments against Fair Value
Possible increase in the volatility of earnings
greater instability in stock prices of banks
loss of bank capital cushions
lack of resale market

53. Income Statement or Report of Income
Revenue Items
Interest Income (interest generated from loans normally accounts for most income (generally more than 2/3)
Non interest income (fee income) Increasingly important.
No interest income also includes securities gains (or losses). Now subject to standard tax rate

54. Report of Income Expenses
Interest Expense
largest expense is interest paid on deposits, often between 50 and 60% of total expenses
fed funds borrowing and repurchase agreements have grown in importance.
Non interest expense
wages, salaries and other personnel expenses+

55. Income Net Interest Income Net income
= Total Interest Income -Total Interest Expense
Also referred to as interest margin
Net income
Adds non interest income and subtracts no interest expense to interest income.

56. Income Statement Interest Income
Interest on loans, Interest on securities, Other
Interest Expense
Deposit Interest, Short term debt, Long Term debt
Net Interest Income
Non interest Income
Service Charges, Trust Department, Other
Non interest Expense
Wages, Net occupancy, Other operating expenses
Income before taxes
Provision for income taxes
Net income after taxes

57. Funds - Flow Statement = Dividends paid out to stockholders
+ increase in banks assets
+ decreases in bank liabilities
Funds Used by the bank
Funds from operations
+ decreases in bank assets
+ increases in bank liabilities
Funds provided to the bank =

58. Capital Account Statement
Beginning Balance
+ Net income
- Dividends paid to shareholders
+ New Shares of Stock issued
- Purchases of treasury stock
Balance at end of period

59. Common Characteristics of Banks Financial Statements
Heavy dependence on borrowed funds
Earnings are exposed to risk if borrowings cannot be repaid
Growing use of nondeposit borrowings
Bank must hold a significant proportion of high quality and marketable securities
Financial Assets are more important than plants and equipment
few fixed costs and limited use of operating leverage.

60. Evaluating and Measuring Bank Performance
Going to use ratio analysis to evaluate the performance of depository institutions

61. ROE and ROA
ROE measure the rate of return flowing to the banks shareholders
ROA measures managerial efficiency -- how well management converts assets into net earnings

62. Relationship between ROE and ROA

63. DuPont Identity

64. Decomposition

65. Decomposition Equity Multiplier Profit Margin Asset utilization
Reflects the leverage or financing policies (the choice of debt or equity)
Profit Margin
Reflects the effectiveness of expense management control
Asset utilization
Reflects the ability to manage the mix and yield on the banks assets

66. Example changes through time

67. Average returns on Banks 1999
< $100 Million
$100 Million to $1 Billion
$1Billion to $10 Billion
> $10 Billion
ROA
1.01%
1.36%
1.49%
1.28%
ROE
9.07%
14.24%
16.02%
15.97%
Rose, Commercial Bank Managment McGraw Hill

68. Asset Utilization and Profit Margin
Both reflect Management decisions regarding:
Mix of funds raised and invested
Size of Bank
control of operating Expenses
Pricing of Services
Minimization of tax liability

69. Asset Utilization

70. Asset Utilization

71. Profit Margin

72. Decomposition of ROA

73. Decomposition of ROA Part 2

74. Decomposition of ROA Part 2

75. Other Important Ratios

76. Obtaining Information on Banks
Data for banks is available from the Uniform Bank Performance Report (UBPR).
UBPR developed by the Fed, FDIC, and office of the comptroller of Currency so that there would be a standardized way to compare institutions.
Also peer group and state reports for comparable banks.

77. UBPR Goal is to provide uniform reporting of information
Developed by the Federal Financial Institutions Examination Council’s quarterly reports.
Available online at

78. Using the UBPR Compare across years Compare to peer groups
each report has 5 years of data
Year end or current quarter plus 1 year prior to current and three previous years
Compare to peer groups
also available are peer groups reports based on both size of bank and geographic location
Allows you to benchmark

79. UBPR: Security National
Table 5-5 from Rose
Total Assets increased by $600 million, rate of 9.3%
all types of loan rose except ones hit by economic downturn (lines 1-11)
decrease in short term securities, increase in long term, maybe seeking higher yields (lines 14 and 18)
Large increase in US treasury Securities (line 24) and municipal securities (line 25)

80. UBPR: Security National
Table 5-6 in Rose
Deposits increased except for sectors hit by economic down turn.
Large increase in need for federal funs and repurchase agreements (line 10). Indicate that loans and securities grew faster than deposits. Also may reduce profitability since it is an expensive source of funds.

81. UBPR: Security National
Table 5-7 in Rose
Loans increased as a percentage of assets, but on average still less than peer group (line 1). Loans are high yielding -- may reduce income.
Holds more long term 18.57% than average of 8.95% (line 5). Higher market risk due to interest rate sensitivity. Fewer short term securities 2.54% than average 3.41% (line 10).
Low amount of non interest bearing cash deposits from other banks and deposits due (line 13) indicates higher liquidity risk. May force increased borrowing in fed funds market. And increased liquidity risk

82. UBPR: Security National
Table 5-7 in Rose
Smaller portion of checkable deposits which are a cheap source of funds (line 19)
Also smaller portion of core deposits (demand, NOW, savings accounts, money market and time deposits less than 100,000) (line 23). Assumed to be stable source of funds decreasing chance of illiquidity

83. UBPR: Security National
Table 5-8 in Rose
Interest income increased by 7 million or 1.2% (line 15), interest expense increase by 18 million or 14.6% (line 23)
Net interest income declined by 6.3% (line 24)
Interest on borrowed money increased by 10% (line 20)
Interest paid on large CD’s increased by 14.6% (line16)
Provision for loan losses increased by 83% (line 28)
Non interest income increased by 22.2% (line 25)
Net income decreased by 28.3% (line 37)

84. UBPR Sec Nat: Recent Year: NIM = (165/6951) = 2.37% Last year
Peer Group (table 5-9)
NIM Recent year 3.91% Last year = 3.66%
The industry increased while security national decreased, both much lower than average

85. UBPR Security National (Rose)
Current Tot assets Tot equity Net income 33
Last

86. UBPR: Security National
From last slide:
ROA declined and the equity multiplier declined
Higher equity multiplier is riskier, but here the decrease is helping to decrease profitability.
Alternative EM definition: 1/EM is the % of assets that can default before insolvency

87. UBPR: Security National
Current: Tot assets Tot equity 482 Net inc 33 Tot inc 604
Last:

88. UBPR Security National
Asset Utilization decreased form to and profit margin declined from to .0546
Decline in profit margin and equity multiplier are the largest.
Profit margin hurt by increased provision for loan losses and increase in applicable income taxes
Pretax income declined by 11% Net income declined by 28% higher tax burden and lower adjustment

89. UBPR Security National
current non interest expense 72 Tot income 604
last
Burden (noninterest expense - noninterest income) from 52 to 50 while asset grew.