Depository Institutions Class 2 January 6th, 2010 Deposit Takers (chapter 2) Commercial Banks, Finance Companies and Credit Unions. Commercial Banks are the biggest among the three and differ somewhat in terms of composition of liabilities and assets. All take deposits (liabilities) and make loans (assets). However, some of the large commercial banks rely more on purchased funds as opposed to deposits. Also, commercial banks do more of the big real estate and corporate lending. Money Center vs. Regional Banks Typical Depository Liability side is composed of demand and time deposits with some purchased funds. Asset side consists of consumer (including credit card receivables), commercial, and real estate loans. Large commercial banks do everything from consumer lending to large corporate loans and project finance. Large commercial banks are typically larger than what their asset size would suggest due to the “wholesale nature” of much of their business. Business Banking vs Retail Banking Commercial or business banking is where banks serve businesses from the “mom and pop” enterprise(a.k.a. small business) to the middle market customer, to the nationwide corporation, to the global multinational corporation. Retail or consumer banking is of course serving individuals and households taking care of “personal” financial needs. Both are housed in what is called a commercial bank. Wholesale Banking Underwriting of Corporate Loans with sell down to other FI’s. Asset Securitization – packaging of small consumer obligations, such as car loans, credit card receivables and mortgages with sale of these assets or off balance sheet treatment. The above activities however had not been traditional commercial banking functions until recently since they “disintermediate” the commercial bank which is more typical of what investment banks and securities companies do. Who is really the biggest bank in the world? Not Mizuho or any of the other Japanese Banks! (Warehousing of assets, overexposure to single customers, inflexibility…) i.e. asset size is not a good measure! Banks are much better measured in terms of market capitalization or net income since asset size does not capture the wholesale business and other fee generating businesses which have become key to a commercial bank’s success. Quirky regulations US Banks were handicapped for decades by overly strict banking regulations particularly with respect to geography. Many banks such as the old First National Bank of Chicago could only open retail branches in a 10 city block area in downtown Chicago. These regulations led to unfortunate consequences. Instead of having a few large banks with economies of scale, the US market evolved into an environment where several thousand banks operated in very small markets. For some commercial banks, offshore activities seemed to be the answer in the 70’s and 80’s where there are less restrictions in terms of opening branches and offering retail and corporate services. International Expansion International expansion for most US banks was a doomed strategy. They had no real means of competing with local institutions in the foreign market since those banks had bigger branch networks (hence access to cheap retail deposits) and better understanding of local market conditions. Sending US employees overseas was expensive as often were the costs of hiring good employees. Local Consolidation Other banks just increased their size in a limited geography such as Midwest farm belt, Texas Oil-patch, and Northeast/Midwest Rustbelts. Again a doomed strategy since it resulted in an over-concentration in specific indigenous industries with too much of a risk correlation among borrowers. Where we are today Due to relaxation in regulations, there are approximately 6,000 commercial banks compared to over 14,000 twenty years ago. More importantly, banks with USD 10 billion or more in assets account for more than 80% of FDIC insured industry assets compared to 35% more than 20 years ago. The top 3 (Citi, BofA, and JPM Chase) account for over half of all commercial banking assets! Today (continued) ROE of the big banks has been getting better until the recent crisis, but do they have bigger downside risks? Smaller community banks (less than $100 million in assets) look as if they can’t compete. Small to medium sized regional banks ($100 million to $1 billion) have mixed results. The larger regional banks are doing well and probably have lower downside risk. What does the current crisis mean for the different banks? Removal of barriers to consolidation. The Banking Acts of 1933 (Glass-Steagall – separation of commercial and investment banking businesses) Bank Holding Company Act 1956 (restricted activities of multi-banking holding companies) 1994 Interstate Banking and Branching Efficiency Act and 1999 Financial Services Improvement Act (creation of financial services holding companies). Off-Balance Sheet Activities Total on-balance-sheet items were about 30% of off-balance-sheet items in 1992. Today they are less than 10% of total off-balance sheet items. These are notional numbers and much of the exposure is offset in each bank’s portfolio i.e. the at risk amounts of these off balance sheet numbers are relatively small (we will revisit this later in the course). What are some of these off-balance sheet activities? Futures and Forward Contracts Credit Derivatives Option Contracts on Interest Rates Standby Letters of Credit (commitments to lend should certain conditions materialize) Swaps (interest rate and currency = majority). Trust Business Hold and manage assets for individuals and corporations In other countries there are often implied or outright guarantees on these assets hence these really should not be considered off-balance-sheet since the bank would still bear the risk. Excellent Performance (until recently!) Industry has had healthy profits as a whole. 1989 was a bad year as large commercial banks started to write-off their LDC exposure. ROA and ROE measures have been remarkably strong and healthy for the last 15 years. Timing issues of income recognition. Current Crisis Anti-tying legislation Relationships The “encouragement” of corporate customers to do other fee generating business in return for commercial bank loans is a big legal and moral dilemma for banks. Commercial Banks competitive advantage over Investment Banks is their balance sheet and ability to offer loans. Global Issues Global Banks/Global Commerce Breakdown of Borders/Offshore vs Onshore Global corporations earn money “offshore” and therefore can choose to deal with Financial Institutions offshore thus circumventing onshore regulations. Head to Head Competition US vs Other Global Players Generally more sophisticated and better managed today; not so true several years ago. Savings Institutions Savings Banks and Associations (provide important lending services such as mortgages and consumer loans and receive household savings). S&L’s now called Savings Associations provided long-term mortgages at fixed rates while raising short term deposits to fund these loans. Sudden rise in interest rates in the early 80’s caused congress to change legislation to help S&L’s survive. Adjustable rate mortgages on the asset side and NOW accounts and Money Market savings accounts on the liability side allowed the industry to survive. The S&L Crisis A large number of S&L’s abused their status as FSLIC insured, and offered very high rates to attract funds and then reinvested in very high risk schemes. Regional economic crises led to the collapse of many of these S&L’s Moral Hazard of guaranteeing bank deposits. The end of S&L’s? Savings Banks and Credit Unions Mutual Organizations where borrowers are also the owners. Disappearing and insignificant in terms of share of FI market. Like savings banks, Credit Unions are more of curiosity factor than significant in terms of their position on the financial landscape. They are numerous (almost 10,000) and profitable but are very limited in activity and are generally very small. They do mostly consumer lending and invest surplus in government securities. Some fill important social/welfare needs by providing lending and deposit taking activities in areas where traditional commercially driven FI’s would not normally go.