Eco 342 Chapter 4 Depository Institutions

Chapter 4 Depository Institutions

commonly referred to as "banks"
bank holding co.—stock in more than one bank
chapters 4, 7-9 refer to financial intermediaries
transform market assets into more preferred assets, which become their liability

I. Asset/Liability problem

What are assets and liabilities?

assets are the uses of funds for banks (direct investment for the bank)

loans, cash reserves, securities

liabilities are sources of funds for banks (indirect investment for the public)

deposits
borrowing from the Federal Reserve or other banks
commercial paper

Maturity intermediation and interest rate risk

people prefer to borrow long term and lend short term, so banks borrow short and lend long to bridge this maturity gap to maximize the funding and saving opportunities that are available
a bank depends heavily on spread income or margin. This is the difference between the interest paid by the bank for liabilities and the interest received by the bank on from assets
Maturity intermediation and dependence on spread income expose banks to interest rate risk

rising short term rates reduces the positive spread between borrowing and lending rate, and the spread may even become negative
example:

May 1970 30 year mortgage 9.10%, 6 month CD 8 %
May 1981 6 month CD 18.27%

today banks use derivatives to manage their interest rate risk

Liquidity

banks need to hold some cash and liquid assets to satisfy withdrawals, provide loans
tradeoff between liquidity of short-term assets and higher yields for long-term assets

II. Commerical Banks

Background

state or federal charter—dual banking system, ONLY in US
1988- 13,137 , 2000- 8,375, 75% state chartered
all insured by FDIC

Regulators

Federal Reserve System (member banks, all federal, some state)
Comptroller of the Currency (federal)
FDIC (nonmember state)
state agencies

Bank Services

individuals

consumer loans, residential mortgages, credit cards, student loans, auto loans, investment advice

institutions

commercial loans, leasing, pension fund management, cash management

global

multinational corporate financing, exchange rate activities

activities yield interest and fee income, but banks increasingly turn to fee income (not subject to interest rate risk)

Balance Sheet

Assets (2003)

Loans 64%

Securties (mostly US) 25%
Cash 5%
Other 6%

Liabilities

Deposits 65%

checking
savings
time deposits (CDs)

Other borrowing 28%

Fed (discount loans)
other banks (federal funds)
financial mkts (commerical paper)

Capital 7%

common stock
preferred stock
retained earnings

money center banks rely on money markets to raise funds
regional banks rely on deposits to raise funds

Regulation

much regulation dates back to 1930s but has been altered in past 20 years
Repealed legislation

Regulation Q (1933)

prohibited interest on checking deposits and put an interest-rate ceiling on other deposits
made it difficult for banks to compete with other nondepository institutions in the 1970s when market rates rose above the ceiling
phased out in 1980

McFadden Act (1927)

prohibited interstate bank branching
designed to protect small state banks, but forced banks to be inefficiently small and protected marginal banks
resulted in US having decentralized banking structure—many small banks instead of fewer, larger banks
repealed 1994, resulting in a large increase in merger activity

Glass-Steagall Act (1933)

separated commercial banking from the securities industry (investment banking) and insurance industry-ONLY in US

belief that abuses between securities and commercial banking led to crash of 1929

Federal Reserve regulated permissible activities
substantially weakened in 1980s, 1990s,
repealed 1999

advantages for global competition, diversification and economies of scale

Other current regulation

FDIC (1933)

deposit insurance up to $100,000 today (originally $2500)
effective in preventing bank panics, but creates moral hazard for both banks and depositors
since 1989, covers both commercial banks and S&Ls, both federal and state charters
since 1991, premiums are risk-adjusted

Capital Requirements

ratio of equity capital to assets
cushion against insolvency due to investment losses
since 1989, requirements based on risk-weighted assets (8%)

low risk assets get small weight, high risk assets get large weight

U.S. Treasury securities get weight of 0%
residential mortgages get a weight of 50%
commercial loans get a weight of 100%

risk weighted assets small for banks with low risk assets, so capital requirement is smaller
risk weighted assets large for banks with high risk assets, so capital requirement is largers

III. Savings & Loans (Savings Associations, Savings Banks)

Background

state or federal charter (56% federal)

1988 3,438; 1998 1,687

created in 1933, primarily to facilitate mortgages
regulators

FSLIC 1933-1989, FDIC since 1989
Office of Thrift Supervision (OTS) since 1989 (federal charters)
state agencies
Federal Reserve

Balance Sheet

assets traditionally mortgages and U.S. government securities, expanded 1982
liabilities traditionally savings accounts and CDs, expanded in 1980

regulation Q ceilings were slightly higher for S&Ls

S&L Crisis

problems for S&Ls in 1970s

rising, fluctuating inflation leads to rising fluctuating interest rates
short-term interest rates rise above the rates on older long-term fixed rate mortgages, causing losses
short-term rates rise above regulation Q ceilings, causing a loss of deposits

deregulation

DIDMCA (1980), Garn-St. Germain (1982)
expanded asset choices to include consumer, commercial loans, and corporate, municipal securities
expanded liability choices to include NOW accounts and money market accounts
phased out regulation Q

continuing problems

does not solve problems with older money-losing mortgages
regulators do not close insolvent S&Ls because the insurance fund lacks sufficient funds

S&Ls engage in fraudulent, high-risk behavior that causes problem to worsen

S&L bailout 1989, 1991

federal government issues bonds to raise money to liquidate insolvent S&Ls
created OTS to regulate S&Ls and Resolution Trust Corp. (RTC) to liquidate insolvent S&Ls
re-restricted asset choices for S&Ls
dissolved FSLIC into FDIC
increased FDIC oversight, and risk-based FDIC premiums
projected cost $500 billion over 40 years; present value cost $175 billion

IV. Credit Unions

Background

members must have "common bond" to organize a credit union
nonprofit, member owned
large in number (over 10,000) but small in total assets (less than 10% of commercial bank assets)
federal or state charter but most regulation at federal level

NCUA

NCUSIF or state insurance fund for deposits

Balance Sheet

assets consist mostly of consumer loans, residential mortgages, gov’t securities
liabilities consist mostly of member deposits