CHAPTER 3
DEPOSITORY INSTITUTIONS:
ACTIVITIES AND CHARACTERISTICS
ASSET/LIABILITY PROBLEM OF DEPOSITORY
INSTITUTIONS
These
institutions seek to earn spread income,
which is a positive spread or margin between the returns on their assets and
the costs of their liabilities. In generating spread income, a depository
institution faces several risks. These include credit risk, regulatory risk,
and interest rate risk.
Interest Rate Risk
Interest rate
risk or funding risk is the mismatching of assets and liabilities in terms of
their maturities. For example, this can arise because the deposits are
short-term and assets long term. An increase in expected interest rates will
reduce the spread between the return on assets and the deposit costs. Floating
rate long-term assets can reduce this problem since they make long-term assets
behave like short-term funds that match deposit terms to maturity.
Liquidity Concerns
Liquidity
concern is the possibility of withdrawal of funds by depositors or insufficient
funds available to meet lending needs. It can be handled by: (1) attracting
more deposits; (2) borrowing from federal agency or other institution (Federal
Funds Market); (3) raising short-term funds in the money market; (4) selling or
liquidating securities and other assets. Securities held for the purpose of
satisfying net withdrawals and customer loan demands are sometimes referred to
as secondary reserves.
COMMERCIAL BANKS
Today, banks
are regulated and supervised by several federal and state government entities.
At the federal level, supervision is undertaken by the Federal Reserve Board,
the Office of the Comptroller of the Currency, and the Federal Deposit
Insurance Corporation. The assets of a bank are insured by the Federal Deposit
Insurance Corporation.
As of 2d
quarter 2007, 7350 commercial banks were operating in the United States .
Only about 25% were national banks, but these held the majority of the bank
assets (65%).
Bank Services
Banks provide
numerous services and are broadly defined as follows: (1) individual banking;
(2) institutional banking; (3) global banking.
Individual
banking includes consumer lending, mortgage
lending (mortgage banking),
credit card financing, brokerage services, student loans, and
individual-oriented financial investment services. Institutional banking
Institutional banking includes commercial real estate financing, leasing
activities, and factoring. Global banking includes corporate financing, capital
market and foreign exchange products and services. At one time, some of these
activities were restricted by the Glass-Steagall
Act. But this statute was repealed by the Gramm-Leach-Bliley Act in November 1999.
Bank Funding
Funds are
obtained mainly from three sources: (1) deposits, (2) nondeposit, (3) common
stock and retained earnings.
Deposits: There are several types of
deposit accounts. Demand deposits
(checking) pay no interest and can be withdrawn upon demand. Savings deposits pay interest,
typically below market rates, and can be withdrawn upon demand. Time deposits, also called certificates of deposit, have a fixed
maturity date and pay either a fixed or floating interest rate. The market for
short-term debt obligations is called money market. A money market demand
account is designed to compete with money
market mutual funds.
Reserve requirements and borrowing in the
federal funds market: The reserve
ratio is the specified percentage of deposits in non-interest bearing
account at one of the 12 Federal Reserve Banks that a bank must maintain. The
dollar amount based on the reserve ratio is the required reserve. To determine the reserve, the Federal Reserve has
established a two-week period called the deposit
computation period. If actual reserves exceed required reserves, the
difference is referred to as excess
reserves. Banks temporarily short of their required reserves can borrow
reserves from banks that have excess reserves. The market where banks can
borrow or lend reserves is called the federal
funds market. The interest rate charged to borrow funds is called the federal funds rate.
Borrowing at the Fed discount window:
The Federal Reserve is the bank of last resort. Banks temporarily short of
funds can borrow from the Fed at its discount
window. Collateral is needed to borrow, and the Fed sets the criteria for
collateral quality. The interest rate that the Fed charges to borrow funds at
the discount window is called the discount
rate.
Other nondeposit borrowing: Other
nondeposit borrowing can be short term in the form of issuing obligations in
the money market, or intermediate to long term in the form of issuing
securities in the bond market. Banks that raise most of their funds from the
domestic and international money markets, relying less on depositors for funds,
are called money center banks. A regional bank is one that relies
primarily on deposits for funding.
Capital Requirements for Banks
Commercial
banks are typically highly leveraged, i.e., equity constitutes a small fraction
(about 8%) of the bank’s assets. The organization that plays the primary role
in establishing risk and management guidelines for banks throughout the world
is the Basel Committee on Banking
Supervision. The capital requirements that resulted from other guidelines
published by the Basel Committee are called the risk-based capital requirements. In July 1988, the Basel Committee
released its first guidelines, the Capital
Accord of 1988, commonly called Basel
I Framework. In June 2004, comprehensive amendments, Basel II Framework, were published to improve on the rules as set
forth in the Basel I Framework by bringing risk-based capital requirements more
in line with the underlying risks to which banks are exposed.
Credit risk and risk-based capital
requirements: The risk-based capital guidelines attempt to recognize credit
risk by segmenting and weighting requirements. First, capital is categorized as
Tier 1 and Tier 2 capital. Tier 1 is the core
capital. Tier 2 is the supplementary
capital. Second, the guidelines establish a credit risk weight for all
assets.
SAVINGS AND LOAN ASSOCIATIONS
S&Ls
originated to gather savings and pool depositor funds to finance home
mortgages. They are either mutually owned (by the depositor themselves) or
stockholder-owned (thereby making the depositors creditors of the firm). They
are state or federally chartered, and they are regulated by the Office of
Thrift Supervision (OTS). As in the case of banks, their deposits are insured,
but by the Savings Association Insurance Fund (run by the FDIC). Traditionally,
most S&L assets have been in home mortgages, the long-term nature of which
insulated the S&Ls from interest rate risk for many years. Since the early
1980s, however, they have made several other types of loans and investments to
some degree they compete with banks. Their funding has traditionally come from
several forms of savings accounts, such as NOW, MMDA, and time deposits. Deregulation
in the 1980s forced higher funding costs upon them.
Assets
Traditionally,
the only assets in which S&Ls were allowed to invest have been mortgages,
mortgage-backed securities, and US government securities. S&Ls became one
of the major buyers of junk bonds.
Under FIRREA, S&Ls are no longer permitted to invest new money in junk
bonds.
Funding
Deregulation
expanded the types of accounts that may be offered by S&Ls: negotiable
order of withdrawal (NOW) accounts, and money deposit accounts (MMDA). S&Ls
can raise funds from the money market. They can borrow in the federal funds
market and have access to the Fed’s discount window. They also can borrow from
the Federal Home Loan Banks. These borrowings are called advances, which can be short term or longterm in maturity.
Regulation
Federal
S&Ls are chartered under the provisions of the Home Owners Loan Act of 1933. Federally chartered S&Ls are supervised
by the Office of Thrift Supervisor. The Depository Institutions Deregulation
and Monetary Control Act of 1980 deregulated interest rates on deposit
accounts. It also expanded the Fed’s control over the money supply by imposing
deposit reserve requirements on S&Ls. Subsequent legislation not only
granted thrifts the right to offer money market demand accounts, but also
broadened the types of assets in which S&Ls could invest. Permission to
raise funds in the money market and the bond market was granted by the Federal
Home Loan Board in 1975.
There are two
sets of capital adequacy standards
for S&Ls as for banks. The risk-based capital guidelines are similar to
those for banks. Instead of two tiers of capital, there are three: Tier 1
(tangible capital), Tier 2 (core capital), and Tier 3 (supplementary capital). As
with commercial banks, there are risk-based requirements based on interest rate
risk.
The S&L Crisis
During the
1980’s, many savings and loans failed or became technically insolvent. Deposit
insurance funds ran dry and federal help was needed to clean up the mess and
help the depositors. Several factors contributed to the crisis, but the
following causes were most apparent:
1.
Disintermediation: as short-term
interest rates rose in the money market depositors withdrew their low-yield
funds for higher-yield market investments such as MMDAs. Because of interest
rate restrictions the S&Ls could not compete for such funds.
2.
Deregulation in the early 1980s
lifted interest also rate restrictions, allowing S&Ls to compete in the
marketplace for short-term funds. But their long-term asset structure its
predominantly fixed-rate returns limited the cost increases for liabilities
that S&Ls could afford. Moreover, after years of being in a safe market
niche of home mortgages S&Ls suddenly found they had to compete directly
with banks for funds and asset allocations. Many such savings institutions were
simply not up to the task.
3.
Faced with rising liability costs,
many S&Ls went after high return, high risk assets, such as commercial real
estate and junk bonds. Such high default risk projects were undertaken prior to
an economic downturn. The result was depressed regions of the Southwest,
compounded by the fact that for a number of years, regulators did little to
ameliorate the problem. A major and costly bailout occurred in the early 1990s.
The Resolution Trust Corporation (RTC) was established in the FIRREA Act of
1989 and assigned the task to sell off the assets of the failed institutions.
SAVINGS BANKS
These
financial institutions are similar to S&Ls in some respects. They are
either mutually- or stockholder-owned and are either federally- or
state-chartered. But their asset portfolio is more diversified given that their
origin was primarily as a place for small deposits at a time when banks showed
little interest in taking small customer accounts. Yet, residential mortgages
now constitute a large part of their portfolio. These institutions have not
necessarily been immune from the factors that caused the S&L crisis. But as
a group they came out better because they were predominantly on the East Coast
and had more diversified asset portfolios.
CREDIT UNIONS
Credit unions are the smallest and
newest of the financial depositories. They are either state- or
federally-chartered. But they are mutual in organization. They exist for their
members’ savings and borrowing needs. The shares (deposits) are insured. Deposits
from members are by far their major source of funds, but they can borrow for
short-term liquidity needs. Their assets consist primarily of small consumer
loans made to their members. Time has been hard on them lately, since their
borrowing and lending activities are effectively restricted to their membership
bases. But their shorter-term and less risky loan portfolios have helped them
to avoid the S&L crisis.
Since 1970,
the shares of all federally chartered credit unions have been insured by the National Credit Union Share Insurance Fund
(NCUSIF) for up to $100,000 and $250,000 for retirement accounts, the same
as for commercial banks. The principal federal regulatory agency is the National Credit Union Administration (NCUA).
Playing a role similar to the Fed, the lender of last resort is the Central Liquidity Facility (CLF).
Credit unions can make investments in corporate
credit unions. Federal and state chartered credit unions are called natural person credit unions because
they provide financial services to qualifying members of the general public.
Corporate credit unions provide a variety of services only to national person
credit unions.
ANSWERS
TO QUESTIONS FOR CHAPTER 3
(Questions are
in bold print followed by answers.)
1. Explain
the ways in which a depository institution can accommodate withdrawal and loan
demand.
A depository
institution can accommodate loan and withdrawal demands first by having
sufficient cash on hand. In addition it can attract more deposits, borrow from
the Fed or other banks, and liquidate some of its other assets.
2. Why do
you think a debt instrument whose interest rate is changed periodically based
on some market interest rate would be more suitable for a depository
institution than a long-term debt instrument with a fixed interest rate?
This question
refers to asset-liability management by a depository institution. An adjustable
rate can eliminate or minimize the mismatch of maturity risk. As interest rates
rise, the institution would have to pay more for deposits, but would also
receive higher payments from its loan.
3. What is
meant by:
a. individual banking
b. institutional banking
c. global banking
a.
Individual banking is retail or
consumer banking. Such a bank emphasizes individual deposits, consumer loans
and personal financial trust services.
b.
An institutional bank caters more
to commercial, industrial and government customers. It issues deposits to them
and tries to meet their loan needs.
c.
A global bank encompasses many
financial services for both domestic and foreign customers. It is much involved
in foreign exchange trading as well as the financial of international trade and
investment.
4.
a. What is the Basel
Committee for Bank Supervision?
b. What do the two
frameworks, Basel I and Basel II, published by the Basel Committee
for Bank Supervision, address regarding banking?
a.
It is the organization that plays
the primary role in establishing risk and management guidelines for banks
throughout the world.
b.
The frameworks set forth minimum
capital requirements and standards.
5. Explain
each of the following:
a. reserve ratio
b. required reserves
a.
The reserve ratio is the percentage
of deposits a bank must keep in a non-interest-bearing account at the Fed.
b.
Required reserves are the actual
dollar amounts based on a given reserve ratio.
6. Explain each of
the following types of deposit accounts:
a. demand deposit
b. certificate of deposit
c. money market demand
account
a.
Demand deposits (checking
accounts) do not pay interest and can be withdrawn at any time (upon demand).
b.
Certificates of Deposit (CDs) are
time deposits which pay a fixed or variable rate of interest over a specified
term to maturity. They cannot be withdrawn prior to maturity without a
substantial penalty. negotiable CDs (large business deposits) can be traded so
that the original owner still obtains liquidity when needed.
c.
Money Market Demand Accounts
(MMDAs) are basically demand or checking accounts that pay interest. Minimum
amounts must be maintained in these accounts so that at least a 7-day interest
can be paid. Since many persons find it not possible to maintain this minimum
(usually around $2500) there are still plenty of takers for the
non-interest-bearing demand deposits.
7. How did
the Glass-Steagall Act impact the operations of a bank?
The
Glass-Steagall Act prohibited banks from carrying out certain activities in the
securities markets, which are principal investment banking activities. It also
prohibited banks from engaging in insurance activities.
8. The
following is the book value of the assets of a bank:
Asset
|
Book
Value (in millions)
|
|
$ 50
|
Municipal general obligation bonds
|
50
|
Residential mortgages
|
400
|
Commercial loans
|
200
|
Total book value
|
$700
|
a. Calculate the credit
risk-weighted assets using the following information:
Asset
|
Risk Weight
|
|
0%
|
Municipal general obligation bonds
|
20
|
Residential mortgages
|
50
|
Commercial loans
|
100
|
b. What is the minimum core
capital requirement?
c. What is the minimum total
capital requirement?
a.
The risk weighted assets would be
$410
|
BV
|
Weight
|
Product
|
US T Sec.
|
$50
|
0%
|
0
|
MB
|
50
|
20%
|
10
|
RM
|
400
|
50%
|
200
|
CL
|
200
|
100%
|
200
|
Total
|
700
|
|
410
|
b.
The minimum core capital is $28
million (.04X700) i.e., 4% of book value.
c.
Minimum total capital (core plus
supplementary capital) is 32.8 million, .08X410, which is 8% of the
risk-weighted assets.
9. In later
chapters, we will discuss a measure called duration. Duration is a measure of
the sensitivity of an asset or a liability to a change in interest rates. Why
would bank management want to know the duration of its assets and liabilities?
a.
Duration is a measure of the
approximate change in the value of an asset for a 1% change in interest rates.
b.
If an asset has a duration of 5,
then the portfolio’s value will change by approximately 5% if interest rate
changes by 100 basis points.
10.
a. Explain how bank
regulators have incorporated interest risk into capital requirements.
b. Explain how S&L
regulators have incorporated interest rate risk into capital requirements.
a.
The FDIC Improvement Act of 1991,
required regulators of DI to incorporate interest rate risk into capital
requirements. It is based on measuring interest rate sensitivity of the assets
and liabilities of the bank.
b.
The OST adopted a regulation that
incorporates interest rate risk for S&L. It specifies that if thrift has
greater interest rate risk exposure, there would be a deduction of its
risk-based capital. The risk is specified as a decline in net profit value
as a result of 2% change in market interest rate.
11. When the
manager of a bank’s portfolio of securities considers alternative investments,
she is also concerned about the risk weight assigned to the security. Why?
The Basel guidelines give
weight to the credit risk of various instruments. These weights are 0%, 20%,
50% and 100%. The book value of the asset is multiplied by the credit risk
weights to determine the amount of core and supplementary capital that the bank
will need to support that asset.
12. You and
a friend are discussing the savings and loan crisis. She states that “the whole
mess started in the early 1980s.When short-term rates skyrocketed, S&Ls got
killed—their spread income went from positive to negative. They were borrowing
short and lending long.”
a. What does she mean by
“borrowing short and lending long”?
b. Are higher or lower
interest rates beneficial to an institution that borrows short and lends long?
a.
In this context, borrowing short
and lending long refers to the balance sheet structure of S&Ls. Their
sources of funds (liabilities) are short-term (mainly deposits) and their uses
(assets) are long-term in nature (e.g. residential mortgages).
b.
Since long-term rates tend to be
higher than short-term ones, stable interest rates would be the best situation.
However, rising interest rates would increase the cost of funds for S&Ls
without fully compensating higher returns on assets. Hence a decline in
interest rate spread or margin. Thus lower rates, having an opposite effect,
would be more beneficial.
13. Consider
this headline from the New York Times of March 26, 1933: “Bankers will
fight Deposit Guarantees.” In this article, it is stated that bankers argue
that deposit guarantees will encourage bad banking. Explain why.
The barrier
imposed by Glass-Steagall act was finally destroyed by the Gramm-Leach Bliley
Act of 1999. This act modified parts of the BHC Act so as to permit
affiliations between banks and insurance underwriters. It created a new
financial holding company, which is authorized to engage in underwriting and
selling securities. The act preserved the right of state to regulate insurance
activities, but prohibits state actions that have would adversely affected
bank-affiliated firms from selling insurance on an equal basis with other
insurance agents.
14. How did
the Gramm-Leach-Bliley Act of 1999 expand the activities permitted by banks?
a.
Deposit insurance provides a
safety net and can thus make depositors indifferent to the soundness of the
depository recipients of their funds. With depositors exercising little
discipline through the cost of deposits, the incentive of some banks owners to
control risk-taking accrue to the owners. It becomes a “heads I win, tails you
lose” situation.
b.
One the positive side, deposit
insurance provides a comfort to depositors and thus attracts depositors to
financial institutions. But such insurance carries a moral hazard, it can be
costly and, unless premiums are risk-based, it forces the very sound banks to
subsidize the very risky ones.
15. The
following quotation is from the October 29, 1990 issue of Corporate
Financing Week:
Chase
Manhattan Bank is preparing its first asset-backed debt issue, becoming the
last major consumer bank to plan to access the growing market, Street
asset-backed officials
Said…Asset-backed
offerings enable banks to remove credit card or other loan receivables from
their balance sheets, which helps them comply with capital requirements.
a. What capital requirements
is this article referring to?
b. Explain why asset
securitization reduces capital requirements.
a.
The capital requirements mentioned
are risk based capital as specified under the Basel Agreement, which forces
banks to hold minimum amounts of equity against risk-based assets.
b.
Securitization effectively
eliminates high risk based loans from the balance sheet. The capital
requirements in the case of asset securitization are lower than for a straight
loan.
16. Comment
on this statement: The risk-based guidelines for commercial banks attempt to
gauge the interest rate risk associated with a bank’s balance sheet.
This statement
is incorrect. The risk-based capital guidelines deal with credit risk, not
interest-rate risk, which is the risk of adverse changes of interest rates on
the portfolio position.
17.
a. What is the primary asset
in which savings and loan associations invest?
b. Why were banks in a
better position than savings and loan associations to weather rising interest
rates?
a.
Savings and Loans invest primarily
in residential mortgages.
b.
During 1980's, although banks also
suffered from the effects of deregulation and rising interest rates, relatively
they were in a better position than S&L association because of their
superior asset-liability management.
18. What
federal agency regulates the activities of credit unions?
The principal
federal regulatory agency is the National Credit Union Administration.