McGraw-Hill/Irwin 2-1 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 2 Depository Institutions

McGraw-Hill/Irwin 2-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Overview of Depository Institutions  In this segment, we explore the depository FIs: Size, structure and composition Balance sheets and recent trends Regulation of depository institutions Depository institutions performance

McGraw-Hill/Irwin 2-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Products of U.S. FIs  Comparing the products of FIs in 1950, to products of FIs in 2003: Much greater distinction between types of FIs in terms of products in 1950 than in 2003 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)

McGraw-Hill/Irwin 2-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Specialness of Depository FIs  Products on both sides of the balance sheet Loans  Business and Commercial Deposits

McGraw-Hill/Irwin 2-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other outputs of depository FIs  Other products and services 1950: Payment services, Savings products, Fiduciary services  By 2003, products and services further expanded to include: Underwriting of debt and equity, Insurance and risk management products

McGraw-Hill/Irwin 2-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Size of Depository FIs  Consolidation has created some very large FIs  Combined effects of disintermediation, global competition, regulatory changes, technological developments, competition across different types of FIs

McGraw-Hill/Irwin 2-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Largest Depository Institutions Citigroup$1,208.9 J.P. Morgan Chase* Bank of America** Wells Fargo Wachovia Bank One* Washington Mutual Fleet Boston** U.S. Bancorp SunTrust Banks Total Assets ($Billions)

McGraw-Hill/Irwin 2-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 Mix of very large banks with very small banks

McGraw-Hill/Irwin 2-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Functions & Structural Differences  Functions of depository institutions Regulatory sources of differences across types of depository institutions.  Structural changes generally resulted from changes in regulatory policy. Example: changes permitting interstate branching  Reigle-Neal Act

McGraw-Hill/Irwin 2-10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Commercial Banks  Primary assets: Real Estate Loans: $2,272.3 billion C&I loans: $870.6 billion Loans to individuals: $770.5 billion Investment security portfolio: $1,789.3 billion  Of which, Treasury bonds: $1,005.8 billion  Inference: Importance of Credit Risk

McGraw-Hill/Irwin 2-11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Commercial Banks  Primary liabilities: Deposits: $5,028.9 billion Borrowings: $1,643.3 billion Other liabilities: $238.2 billion  Inference: Highly leveraged

McGraw-Hill/Irwin 2-12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Small Banks, Nation

McGraw-Hill/Irwin 2-13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Large Banks, Nation

McGraw-Hill/Irwin 2-14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Structure and Composition  Shrinking number of banks: 14,416 commercial banks in ,744 in ,769 in 2004  Mostly the result of Mergers and Acquisitions M&A prevented prior to 1980s, 1990s Consolidation has reduced asset share of small banks

McGraw-Hill/Irwin 2-15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Structure & Composition of Commercial Banks  Financial Services Modernization Act 1999 Allowed full authority to enter investment banking (and insurance)  Limited powers to underwrite corporate securities have existed only since 1987

McGraw-Hill/Irwin 2-16 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Composition of Commercial Banking Sector  Community banks  Regional and Super-regional Access to federal funds market to finance their lending activities  Money Center banks Bank of New York, Deutsche Bank (Bankers Trust), Citigroup, J.P. Morgan Chase, HSBC Bank USA  declining in number

McGraw-Hill/Irwin 2-17 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Balance Sheet and Trends  Business loans have declined in importance  Offsetting increase in securities and mortgages  Increased importance of funding via commercial paper market  Securitization of mortgage loans

McGraw-Hill/Irwin 2-18 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Some Terminology  Transaction accounts  Negotiable Order of Withdrawal (NOW) accounts  Money Market Mutual Fund  Negotiable CDs: Fixed-maturity interest bearing deposits with face values over $100,000 that can be resold in the secondary market.

McGraw-Hill/Irwin 2-19 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Off-balance Sheet Activities  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

McGraw-Hill/Irwin 2-20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Trading and Other Risks  Allied Irish / Allfirst Bank $750 million loss  National Australian Bank $450 million loss

McGraw-Hill/Irwin 2-21 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Fee-generating Activities  Trust services  Correspondent banking Check clearing Foreign exchange trading Hedging Participation in large loan and security issuances  Payment usually in terms of noninterest bearing deposits

McGraw-Hill/Irwin 2-22 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin 2-23 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For more detailed information on the regulators, visit:

McGraw-Hill/Irwin 2-24 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Regulatory Issues  Importance of Bank Holding Companies is increasing.  BHCs regulated by FRS.

McGraw-Hill/Irwin 2-25 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Regulatory Legislation  1927 McFadden Act: Controls branching of national banks.  1933 Glass-Steagall: separates securities and banking activities, established FDIC, prohibited interest on demand deposits.  1956 Bank Holding Company Act and subsequent amendments specifies permissible activities and regulation by FRS of BHCs.

McGraw-Hill/Irwin 2-26 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Legislation (continued)...  1970 Amendments to the Bank Holding Company Act: Extension to one-bank holding companies  1970 International Banking Act: Regulated foreign bank branches and agencies in USA

McGraw-Hill/Irwin 2-27 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Legislation (continued)  1980 DIDMCA and 1982 DIA (Garn-St. Germain Depository Institutions Act) Mainly deregulation acts. Phased out Regulation Q.  1987 Competitive Equality in Banking Act (CEBA) Redefined bank to limit growth of nonbank banks.

McGraw-Hill/Irwin 2-28 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Legislation (continued)  1989 FIRREA Imposed restrictions on investment activities Replaced FSLIC with FDIC-SAIF Replaced FHLB with Office of Thrift Supervision Created Resolution Trust Corporation

McGraw-Hill/Irwin 2-29 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Legislation (continued)  1991 FDIC Improvement Act Introduced Prompt Corrective Action Risk-based deposit insurance premiums Limited “too big to fail”

McGraw-Hill/Irwin 2-30 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Legislation (continued)  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.

McGraw-Hill/Irwin 2-31 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved Financial Services Modernization Act  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

McGraw-Hill/Irwin 2-32 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Recent Legislative Changes  USA Patriot Act of 2001  Sarbanes-Oxley Act of 2002

McGraw-Hill/Irwin 2-33 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Industry Performance  Economic expansion and falling interest rates through 1990s  Brief downturn in early 2000 followed by strong performance improvements Record earnings $106.3 billion 2003  Only 3 failures in 2003 versus 206 in 1989 Serious concerns regarding expected interest rate increases

McGraw-Hill/Irwin 2-34 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Banking and Ethics  Bank of America and Fleet Boston Financial 2004  J.P. Morgan Chase and Citigroup 2003 role in Enron  Riggs National Bank and money laundering concerns 2003

McGraw-Hill/Irwin 2-35 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Savings Institutions  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.

McGraw-Hill/Irwin 2-36 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Savings Institutions: Recent Trends  Industry is smaller overall  Intense competition from other FIs mortgages for example  Concern for future viability

McGraw-Hill/Irwin 2-37 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary Regulators  Office of Thrift Supervision (OTS). Charters and examines all federal S&Ls.  FDIC-SAIF Fund. Oversees and manages Savings Association Insurance Fund (SAIF).

McGraw-Hill/Irwin 2-38 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For more information on the regulation of savings institutions, visit: Treasury FDIC

McGraw-Hill/Irwin 2-39 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Savings Banks  Mutual organizations Primarily East Coast Not exposed to the oil-based shocks of 1980s Real estate price exposure Demutualization  May be regulated at both state and federal level

McGraw-Hill/Irwin 2-40 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 56% federally chartered and subject to NCUA regulation.

McGraw-Hill/Irwin 2-41 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For information on credit unions visit: American Bankers Association

McGraw-Hill/Irwin 2-42 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Global Issues  Near crisis in Japanese Banking  Eight biggest banks reported positive six- month profits  China Deterioration, NPLs at 50% levels Opening to foreign banks (WTO entry)  German bank problems in early 2000s  Implications for future competitiveness

McGraw-Hill/Irwin 2-43 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites Federal Reserve Credit Union National Association FDIC National Credit Union Administration Office of Comptroller of the Currency Office of Thrift Supervision Wall Street Journal

McGraw-Hill/Irwin 2-44 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. *Financial Statement Analysis  Time series analysis of key ratios  ROE framework ROE = ROA × EM ROA = PM × AU