1. Bank’s balance sheet and income structure Chapter 7 An Overview of Bank Balance Sheet and measuring performance

2. Commercial Banks as a Sector of the Financial Institutions Industry Payment Savings Fiduciary Insurance Services Products Services Lending Underwriting Risk Mgmt _______________________________________________________________________ __________________ 1950 Depository InstitutionsXXXX Insurance CompaniesX*X Finance Companies*X Securities FirmsXXX Pension FundsX Mutual FundsX 2003 Depository InstitutionsXXXXXX Insurance CompaniesXXXXXX Finance CompaniesXXXX*X Securities FirmsXXXXXX Pension FundsXXXX Mutual FundsXXXX _______________________________________________________________________ __________________ Payment Savings Fiduciary Insurance Services Products Services Lending Underwriting Risk Mgmt _______________________________________________________________________ __________________ 1950 Depository InstitutionsXXXX Insurance CompaniesX*X Finance Companies*X Securities FirmsXXX Pension FundsX Mutual FundsX 2003 Depository InstitutionsXXXXXX Insurance CompaniesXXXXXX Finance CompaniesXXXX*X Securities FirmsXXXXXX Pension FundsXXXX Mutual FundsXXXX _______________________________________________________________________ __________________

3. Definition of a Commercial Bank Represent the largest group of depository institutions measured by asset size. Perform functions similar to those of savings institutions and credit unions - they accept deposits (liabilities) and make loans (assets) Liabilities include nondeposit sources of funds such as subordinated notes and debentures Loans are broader in range, including consumer, commercial, international, and real estate Regulated separately from savings institutions and credit unions Represent the largest group of depository institutions measured by asset size. Perform functions similar to those of savings institutions and credit unions - they accept deposits (liabilities) and make loans (assets) Liabilities include nondeposit sources of funds such as subordinated notes and debentures Loans are broader in range, including consumer, commercial, international, and real estate Regulated separately from savings institutions and credit unions

4. Differences in Balance Sheets Depository Institutions Nonfinancial Firms Assets Liabilities Loans Deposits Deposits Loans Other financial financial assets assets Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity Depository Institutions Nonfinancial Firms Assets Liabilities Loans Deposits Deposits Loans Other financial financial assets assets Other Other non- liabilities non- liabilities financial and financial and assets equity assets equity

5. Commercial Bank Balance Sheet Assets Total cash assets………………. $ 391.0 U.S. gov securities…………… $ 765.7 Fed Funds/Repurchase………. 317.6 Other…………………………. 413.9 Investment securities………….. 1,497.2 Interbank loans………………. 117.2 Loans exc. Interbank………… 3,778.1 Comm. and Indust…………..$ 982.5 Real estate…………………… 1,803.6 Individual……………………. 631.2 All other……………………… 360.8 Less: Reserve for losses……… 72.1 Total loans……………………… $3,823.2 Other assets…………………….. 857.8 Total assets…………………….. $6,569.2 Assets Total cash assets………………. $ 391.0 U.S. gov securities…………… $ 765.7 Fed Funds/Repurchase………. 317.6 Other…………………………. 413.9 Investment securities………….. 1,497.2 Interbank loans………………. 117.2 Loans exc. Interbank………… 3,778.1 Comm. and Indust…………..$ 982.5 Real estate…………………… 1,803.6 Individual……………………. 631.2 All other……………………… 360.8 Less: Reserve for losses……… 72.1 Total loans……………………… $3,823.2 Other assets…………………….. 857.8 Total assets…………………….. $6,569.2

6. Commercial Bank Balance Sheet Liabilities and Equity Transaction accounts…………… $1,376.5 Nontransaction accounts………... 3,015.5 Total deposits…………………… $4,391.6 Borrowings……………………… 1,348.6 Other liabilities………………….. 231.6 Total liabilities………………….. $5,971.8 Equity…………………………… 597.4 Liabilities and Equity Transaction accounts…………… $1,376.5 Nontransaction accounts………... 3,015.5 Total deposits…………………… $4,391.6 Borrowings……………………… 1,348.6 Other liabilities………………….. 231.6 Total liabilities………………….. $5,971.8 Equity…………………………… 597.4

7. Balance Sheet Items Distribution of Assets, December 2001 ____________________________________________ Real Estate Loans27.4% C&I Loans15.0% U.S. government Securities11.2% Individual Loans9.6% Cash Assets5.9% All other Loans5.5% Interbank Loans1.8% Other Assets Less Reserve for Loan Losses 12.0% Distribution of Assets, December 2001 ____________________________________________ Real Estate Loans27.4% C&I Loans15.0% U.S. government Securities11.2% Individual Loans9.6% Cash Assets5.9% All other Loans5.5% Interbank Loans1.8% Other Assets Less Reserve for Loan Losses 12.0%

8. Balance Sheet Items Distribution of Liabilities, December 2001 ____________________________________________ Other Nontranaction Accounts37.4% Transaction Accounts21.0% Borrowings20.5% Equity9.1% Large Time Deposits8.5% Other Liabilities3.5% ____________________________________________ Distribution of Liabilities, December 2001 ____________________________________________ Other Nontranaction Accounts37.4% Transaction Accounts21.0% Borrowings20.5% Equity9.1% Large Time Deposits8.5% Other Liabilities3.5% ____________________________________________

9. Balance Sheet Items Assets –58.2% of assets are loans and 22.8% investment securities –While loans are the main revenue-generating assets, investment securities provide banks with liquidity. –The major risks faced by commercial bank managers are credit or default risk, liquidity risk, and ultimately insolvency risk. Assets –58.2% of assets are loans and 22.8% investment securities –While loans are the main revenue-generating assets, investment securities provide banks with liquidity. –The major risks faced by commercial bank managers are credit or default risk, liquidity risk, and ultimately insolvency risk.

10. Balance Sheet Items Assets –Business loans have dropped in importance since 1990. The same trend for securities holdings. –At the same time, mortgages have increased in importance. So as consumer loans. –Factors behind the trends: The growth of the commercial paper and the public bond markets, which have come alternative funding sources to commercial banks. The growth of the securitization of mortgage loans. Assets –Business loans have dropped in importance since 1990. The same trend for securities holdings. –At the same time, mortgages have increased in importance. So as consumer loans. –Factors behind the trends: The growth of the commercial paper and the public bond markets, which have come alternative funding sources to commercial banks. The growth of the securitization of mortgage loans.

11. Balance Sheet Items Liabilities –transaction accounts - the sum of noninterest-bearing demand deposits and interest-bearing checking accounts –NOW account - an interest-bearing checking account –negotiable CDs - fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market –The liability structure of banks’ balance sheets tends to reflect a shorter maturity structure than that of their asset portfolio. Further, relatively more liquidity instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans. Thus, interest rate risk, or maturity mismatch risk, and liquidity risk are key exposure concerns for bank managers. Liabilities –transaction accounts - the sum of noninterest-bearing demand deposits and interest-bearing checking accounts –NOW account - an interest-bearing checking account –negotiable CDs - fixed-maturity interest-bearing deposits with face values of $100,000 or more that can be resold in the secondary market –The liability structure of banks’ balance sheets tends to reflect a shorter maturity structure than that of their asset portfolio. Further, relatively more liquidity instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans. Thus, interest rate risk, or maturity mismatch risk, and liquidity risk are key exposure concerns for bank managers.

12. Balance Sheet Items Equity –common and preferred stock, surplus or additional paid-in capital, and retained earnings –9.1% of total liability and equity in December 2001 –Regulators require banks to hold a minimum level of equity capital to act as a buffer against losses from their on-or off-balance-sheet activities. Equity –common and preferred stock, surplus or additional paid-in capital, and retained earnings –9.1% of total liability and equity in December 2001 –Regulators require banks to hold a minimum level of equity capital to act as a buffer against losses from their on-or off-balance-sheet activities.

13. Balance Sheet Items Off-Balance-Sheet activities –off-balance-sheet asset - when an event occurs, this item moves onto the asset side of the balance sheet or income is realized on the income statement –off-balance-sheet liability - when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement Off-Balance-Sheet activities –off-balance-sheet asset - when an event occurs, this item moves onto the asset side of the balance sheet or income is realized on the income statement –off-balance-sheet liability - when an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement

14. Balance Sheet Items Off-Balance-Sheet activities –By undertaking OBS activities, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business. –At the same time, they can avoid regulatory costs or “taxes” since reserve requirements and deposit insurance premiums are not levied on OBS activities. –OBS activities, however, can involve risks that add to the overall insolvency exposure of a FI: The failure of the U.K. investment bank Barings and the bankruptcy of Orange County in CA in the 1990s have been linked to FI’s OBS activities in derivatives. The 1997-98 Asian crisis left banks that had large position in the Asian-related derivative securities markets with large losses. Off-Balance-Sheet activities –By undertaking OBS activities, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business. –At the same time, they can avoid regulatory costs or “taxes” since reserve requirements and deposit insurance premiums are not levied on OBS activities. –OBS activities, however, can involve risks that add to the overall insolvency exposure of a FI: The failure of the U.K. investment bank Barings and the bankruptcy of Orange County in CA in the 1990s have been linked to FI’s OBS activities in derivatives. The 1997-98 Asian crisis left banks that had large position in the Asian-related derivative securities markets with large losses.

15. Balance Sheet Items Off-Balance-Sheet activities –The use of derivative contracts accelerated during the 1992-2001 period and accounted for much of the growth in OBS activity. The significant growth in derivative securities activities by banks have been a direct response to the increased interest rate risk, credit risk, and foreign exchange risk exposure they have faced. These contracts offer banks a way to hedge these risks without having to make extensive changes on the balance sheet. –The phenomenal increase has pushed regulators into imposing capital requirements on such activities and into explicitly recognizing an FI’s solvency risk exposure from pursuing such activities. Off-Balance-Sheet activities –The use of derivative contracts accelerated during the 1992-2001 period and accounted for much of the growth in OBS activity. The significant growth in derivative securities activities by banks have been a direct response to the increased interest rate risk, credit risk, and foreign exchange risk exposure they have faced. These contracts offer banks a way to hedge these risks without having to make extensive changes on the balance sheet. –The phenomenal increase has pushed regulators into imposing capital requirements on such activities and into explicitly recognizing an FI’s solvency risk exposure from pursuing such activities.

16. Balance Sheet Items Other Fee-Generating Activities: –Trust services generates fees by holding and managing individuals or corporations assets –Correspondent banking generates fees by provision of banking services to other banks Other Fee-Generating Activities: –Trust services generates fees by holding and managing individuals or corporations assets –Correspondent banking generates fees by provision of banking services to other banks

17. Size, Structure, and Composition of the Banking Industry As of Dec. 2001, there were 8,080 commercial banks, but the number of banks has been decreasing. Much of the change in the size, structure, and composition is the result of mergers and acquisitions: –It was not until the 1980s and 1990s that regulators allowed banks to merge with other banks across state lines (interstate mergers); –It has been since 1994 that Congress has passed legislation (the Reigle-Neal Act) easing branching by banks across state line. –It has only been since 1987 that banks have possessed powers to underwrite corporate securities. As of Dec. 2001, there were 8,080 commercial banks, but the number of banks has been decreasing. Much of the change in the size, structure, and composition is the result of mergers and acquisitions: –It was not until the 1980s and 1990s that regulators allowed banks to merge with other banks across state lines (interstate mergers); –It has been since 1994 that Congress has passed legislation (the Reigle-Neal Act) easing branching by banks across state line. –It has only been since 1987 that banks have possessed powers to underwrite corporate securities.

18. Economies of Scale and Scope Economies of scale - the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase Economies of scope - the degree to which a firm can generate cost synergies by producing multiple financial service products Megamerger - the merger of banks with assets of $1 billion or more X efficiencies - cost savings due to the greater managerial efficiency of the acquiring firm Economies of scale - the degree to which a firm’s average unit costs of producing financial services fall as its output of services increase Economies of scope - the degree to which a firm can generate cost synergies by producing multiple financial service products Megamerger - the merger of banks with assets of $1 billion or more X efficiencies - cost savings due to the greater managerial efficiency of the acquiring firm

19. Measuring Economies of Scale Economies of scale imply that the unit or average costs of producing FI services in aggregate falls as the size of the FI expands: AC i = TC i S i Where: AC i = Average costs of the ith bank TC i = Total costs of the ith bank S i = Size of the bank measured by assets, deposits or loans Economies of scale imply that the unit or average costs of producing FI services in aggregate falls as the size of the FI expands: AC i = TC i S i Where: AC i = Average costs of the ith bank TC i = Total costs of the ith bank S i = Size of the bank measured by assets, deposits or loans

20. Economies of Scale and the Effect of Technology Improvement Average Cost Old Technology AC 1 New Technology AC 2 Size 0 Average Cost Old Technology AC 1 New Technology AC 2 Size 0

21. Economies of Scale The long-run implication of economies of scale on the banking industry is that the largest and most cost-efficient banks will drive out smaller financial institutions, leading to increased large-firm dominance and concentration in financial services production. Such an implication is reinforced if time-related operating or technological improvements increasingly benefit larger banks more than small banks. The effect of improving technology over time, which is biased toward larger projects, is to shift the AC curve downward over time but with a larger downward shift for larger banks. The long-run implication of economies of scale on the banking industry is that the largest and most cost-efficient banks will drive out smaller financial institutions, leading to increased large-firm dominance and concentration in financial services production. Such an implication is reinforced if time-related operating or technological improvements increasingly benefit larger banks more than small banks. The effect of improving technology over time, which is biased toward larger projects, is to shift the AC curve downward over time but with a larger downward shift for larger banks.

22. Economies of Scope FIs are multi-product firms producing services involving different technological and personnel needs. Investments in one financial service area (such as lending) may have incidental and synergistic benefits in lowering the costs of producing financial services in other areas. –In 1999, regulators passed the Financial Services Modernization Act leading to a number of mergers and acquisitions between commercial and investment banks in 1997 through 2001. –Computerization allows the storage of important information on customers and their needs that can be used by more than one service area. FI’s abilities to generate synergistic cost savings through joint use of inputs in producing multiple products in called economies of scope. FIs are multi-product firms producing services involving different technological and personnel needs. Investments in one financial service area (such as lending) may have incidental and synergistic benefits in lowering the costs of producing financial services in other areas. –In 1999, regulators passed the Financial Services Modernization Act leading to a number of mergers and acquisitions between commercial and investment banks in 1997 through 2001. –Computerization allows the storage of important information on customers and their needs that can be used by more than one service area. FI’s abilities to generate synergistic cost savings through joint use of inputs in producing multiple products in called economies of scope.

23. Economies of Scope Examples to Achieve Economies of Scope: –UBS’s $12 billion purchase of Paine Webber in 2000; –Credit Suisse First Boston’s 2000 purchase of Donaldson Lufkin Jenrette for $11.5 billion; –Citicorp’s $83 billion merger with Travelers Group in April 1998; –Deutsche Bank acquired Bankers Trust to create he world’s largest financial services company for geographic diversification. Examples to Achieve Economies of Scope: –UBS’s $12 billion purchase of Paine Webber in 2000; –Credit Suisse First Boston’s 2000 purchase of Donaldson Lufkin Jenrette for $11.5 billion; –Citicorp’s $83 billion merger with Travelers Group in April 1998; –Deutsche Bank acquired Bankers Trust to create he world’s largest financial services company for geographic diversification.

24. Economies of Scope Some mergers and acquisitions are for the economies of scope on the revenue side. –The merger of J.P. Morgan and Chase Manhattan combined J.P. Morgan;s greater array of financial products with Chase’s broader client base. Revenue synergies have three dimensions: –1. Acquiring an FI in a growing market may product new revenues; –2. The Acquiring bank’s revenue stream may become more stable if the asset and liability portfolio of the acquired institution exhibits different product, credit, interest rate, and liquidity risk characteristics from the acquirer’s. –3. Expanding into markets that are less than fully competitive offers an opportunity for revenue enhancement. Some mergers and acquisitions are for the economies of scope on the revenue side. –The merger of J.P. Morgan and Chase Manhattan combined J.P. Morgan;s greater array of financial products with Chase’s broader client base. Revenue synergies have three dimensions: –1. Acquiring an FI in a growing market may product new revenues; –2. The Acquiring bank’s revenue stream may become more stable if the asset and liability portfolio of the acquired institution exhibits different product, credit, interest rate, and liquidity risk characteristics from the acquirer’s. –3. Expanding into markets that are less than fully competitive offers an opportunity for revenue enhancement.

25. Some Evidence on the Economies of Scale and Scope Most of the Early studies failed to find economies of scale for any but the smaller banks. Recent studies show that economies of scale may exist for banks up to the $10 billion to $25 billion size range. With respect to economies of scope either among deposits, loans, and other traditional banking product areas or between on-balance-sheet products and off-balance-sheet products such as loans sales, the evidence that cost synergies exist is at best quite weak. Most of the Early studies failed to find economies of scale for any but the smaller banks. Recent studies show that economies of scale may exist for banks up to the $10 billion to $25 billion size range. With respect to economies of scope either among deposits, loans, and other traditional banking product areas or between on-balance-sheet products and off-balance-sheet products such as loans sales, the evidence that cost synergies exist is at best quite weak.

26. Bank Size and Concentration Community bank - a bank that specializes in retail or consumer banking Regional or superregional bank - a bank that engages in a complete array of wholesale commercial banking activities Federal funds market - an interbank market for short-term borrowing and lending of bank reserves Money center bank - a bank that relies heavily on nondeposit or borrowed sources of funds Community bank - a bank that specializes in retail or consumer banking Regional or superregional bank - a bank that engages in a complete array of wholesale commercial banking activities Federal funds market - an interbank market for short-term borrowing and lending of bank reserves Money center bank - a bank that relies heavily on nondeposit or borrowed sources of funds

27. Bank Size and Concentration U.S. Bank Asset Concentration, 1984 vs. 2001 20011984 __________________________ __________________________ % of % of % of % of Number Total Assets Total Number Total Assets Total ______________________________________________________________________ All FDIC 8,080 $6,559.2 14,483 $2,508.9 Insured Banks 1. Under $100m 4,48655.5% 221.6 3.4% 12,04483.2% 404.2 16.1% 2. $100m-$1b 3,19439.5 819.4 12.5 2,16114.9 513.9 20.5 3. $1b-$10b 320 4.0 915.4 13.9 254 1.7 725.9 28.9 4. $10b or more 80 1.0 4,612.8 70.2 24 0.2 864.7 34.5 ________________________________________________________________ ______ U.S. Bank Asset Concentration, 1984 vs. 2001 20011984 __________________________ __________________________ % of % of % of % of Number Total Assets Total Number Total Assets Total ______________________________________________________________________ All FDIC 8,080 $6,559.2 14,483 $2,508.9 Insured Banks 1. Under $100m 4,48655.5% 221.6 3.4% 12,04483.2% 404.2 16.1% 2. $100m-$1b 3,19439.5 819.4 12.5 2,16114.9 513.9 20.5 3. $1b-$10b 320 4.0 915.4 13.9 254 1.7 725.9 28.9 4. $10b or more 80 1.0 4,612.8 70.2 24 0.2 864.7 34.5 ________________________________________________________________ ______

28. Bank Size and Concentration Top 10 U.S. Banks Listed by Total Asset Size, Q1 2001 BankTotal Assets ($b) _________________________________________________ _______ Citigroup$1,111.7 J.P. Morgan Chase 712.5 Bank of American 619.9 Wachovia 319.9 Wells Fargo 311.5 Bank One 262.9 Taunus (Bankers Trust) 227.2 Fleet Boston 192.0 ABN AMRO North American 171.8 U.S. Bancorp 164.7 _________________________________________________ _______ Top 10 U.S. Banks Listed by Total Asset Size, Q1 2001 BankTotal Assets ($b) _________________________________________________ _______ Citigroup$1,111.7 J.P. Morgan Chase 712.5 Bank of American 619.9 Wachovia 319.9 Wells Fargo 311.5 Bank One 262.9 Taunus (Bankers Trust) 227.2 Fleet Boston 192.0 ABN AMRO North American 171.8 U.S. Bancorp 164.7 _________________________________________________ _______

29. Bank Size and Activities Large banks have easier access to capital markets and can operate with lower amounts of equity capital Large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits Large banks lend to larger corporations which means that their interest rate spread is narrower –the difference between lending and deposit rates Large banks are more diversified and generate more noninterest income Large banks have easier access to capital markets and can operate with lower amounts of equity capital Large banks tend to use more purchased funds (such as fed funds) and have fewer core deposits Large banks lend to larger corporations which means that their interest rate spread is narrower –the difference between lending and deposit rates Large banks are more diversified and generate more noninterest income

30. Industry Performance Provision for loan losses - bank management’s recognition of expected bad loans for the period Net charge-offs - actual losses on loans and leases Net operating income - income before taxes and extraordinary items Noncurrent loans - loans past due 90 days or more and loans not accruing interest Provision for loan losses - bank management’s recognition of expected bad loans for the period Net charge-offs - actual losses on loans and leases Net operating income - income before taxes and extraordinary items Noncurrent loans - loans past due 90 days or more and loans not accruing interest

31. Industry Performance Selected Indicators for U.S. Commercial Banks, 1989, 1993 through March 2002 2002 2001 1999 1997 1995 1993 1989 ________________________________________________________________________________ No. of institutions8,0058,0808,5799,1439.940 10,958 12,709 ROA (%)1.331.151.311.241.17 1.22 0.49 ROE (%)14.7713.0914.0214.7114.68 15.67 7.71 Noncurrent loans 0.970.920.630.660.85 1.61 2.30 to assets (%) Net charge-offs1.140.940.610.640.49 0.85 1.16 to loans (%0) Asset growth2.985.205.389.547.53 5.72 5.38 rate (%) Net operating10.58-1.6120.4012.487.48 35.36 -38.70 income growth (%) No. of failed/63716 42 206 assisted institutions ________________________________________________________________________________ Selected Indicators for U.S. Commercial Banks, 1989, 1993 through March 2002 2002 2001 1999 1997 1995 1993 1989 ________________________________________________________________________________ No. of institutions8,0058,0808,5799,1439.940 10,958 12,709 ROA (%)1.331.151.311.241.17 1.22 0.49 ROE (%)14.7713.0914.0214.7114.68 15.67 7.71 Noncurrent loans 0.970.920.630.660.85 1.61 2.30 to assets (%) Net charge-offs1.140.940.610.640.49 0.85 1.16 to loans (%0) Asset growth2.985.205.389.547.53 5.72 5.38 rate (%) Net operating10.58-1.6120.4012.487.48 35.36 -38.70 income growth (%) No. of failed/63716 42 206 assisted institutions ________________________________________________________________________________

32. Regulators Federal Deposit Insurance Corporation (FDIC) –insures the deposits of commercial banks Office of the Comptroller of the Currency (OCC) –function is to charter national banks as well as close them –has the power to approve/disapprove of mergers Federal Reserve System –requires all banks to meet the same noninterest-bearing reserve requirements State Authorities –performs for state chartered banks similar functions as the OCC does for national banks Federal Deposit Insurance Corporation (FDIC) –insures the deposits of commercial banks Office of the Comptroller of the Currency (OCC) –function is to charter national banks as well as close them –has the power to approve/disapprove of mergers Federal Reserve System –requires all banks to meet the same noninterest-bearing reserve requirements State Authorities –performs for state chartered banks similar functions as the OCC does for national banks