Depository Institutions

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

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.

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 $1009 11.11% 6.61% Bank of America $870 9.58% 9.82% Citigroup $796 8.77% 3.47% Wells Fargo $380 4.19% 4.62% Wachovia Corp $362 3.99% 4.09% Washington Mutual $276 3.04% 3.23% US Bancorp $192 2.12% 2.19% National City Corp $132 1.45% 1.17% SunTrust $125 1.37% 1.47% ABN ARMCO $107 1.18% 0.87% Source FDIC Future of Banking Study FOB-2004-02.1

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.

Key Regulatory Legislation National Currency and Bank Acts (1863-64) 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

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

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

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.

Legislation (continued)... Bank Holding Company Act and subsequent amendments (1956 1966 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

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.

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.

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

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”

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.

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

Structural Changes FDIC

FDIC Institutions Source FDIC

Competition among FI’s

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?

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.

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

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

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.)

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.

Assets, % of Total Assets www.FDIC.gov

Loans, % of Total Loans FDIC

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

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

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

Liabilities, % of Total Fedral Reserve Board

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

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

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.

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

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.

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.

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

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

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.

Financial Analysis of Depository Institutions Finance 129 Drake University

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

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

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

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

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

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

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

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

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

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

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

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

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+

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.

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

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 =

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

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.

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

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

Relationship between ROE and ROA

DuPont Identity

Decomposition

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

Example changes through time

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

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

Asset Utilization

Asset Utilization

Profit Margin

Decomposition of ROA

Decomposition of ROA Part 2

Decomposition of ROA Part 2

Other Important Ratios

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.

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

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

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)

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.

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

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

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)

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

UBPR Security National (Rose) Current Tot assets 6951 Tot equity 482 Net income 33 Last 6361 381 46

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

UBPR: Security National Current: Tot assets 6951 Tot equity 482 Net inc 33 Tot inc 604 Last: 6361 381 46 593

UBPR Security National Asset Utilization decreased form .0932 to .0869 and profit margin declined from .0776 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

UBPR Security National current non interest expense 72 Tot income 604 last 70 593 Burden (noninterest expense - noninterest income) from 52 to 50 while asset grew.