Major Trends in Commercial Banking

(4)

1. Deregulation

2. Technology

3. Industry Structure

4. Financial Performance

Deregulation as a Major Trend

in Commercial Banking

(4)

1. Increased non-bank competition

2. Expanded service offerings

3. Increased funding costs and interest sensitivity.

4. Globalization/internationalization

Technology as a Major Trend

in Commercial Banking

(4)

1. Increased level of fixed costs

2. Less personal

3. Faster reaction time

4. More sophisticated products

Industry Structure as a Major Trend

in Commercial Banking

(3)

1. Over capacity

2. Increased firm size

3. Ownership consolidation

Financial Performance as a Major

Trend in Commercial Banking

(5)

1. Decreased operating margins

2. Need to recapitalize

3. Less emphasis on "credit"

4. Off-balance sheet activities

5. Increased interest rate sensitivity

Dual Nature of Bank Liquidity

(2)

1. Uncertain (stochastic) deposit withdrawals

2. Uncertain (stochastic) loan demand

Sources of Liquidity

(5)

1. Sell assets

2. Passive loan repayment and deposit inflows

3. Actively purchase deposits (liability mgmt) - brokers sell deposits to banks

4. Non-deposit borrowing (fed funds, discount window, notes and debentures, etc)

5. Back-up lines of credit (with other banks)

Asset Structure

(4)

1. Primary reserves

2. Secondary reserves

3. Loan portfolio

4. Investments for income and capital gains

Primary Reserves as part of Asset Structure

(5)

[Pure liquidity: low or non-earning assets; try to minimize]

1. Vault cash

2. CIPC (Cash items in process of collection) - i.e., checks pending clearance

3. Correspondent bank deposit balances (small banks keep deposits with larger banks)

4. Excess reserves (required reserves are not a source of liquidity, but excess reserves are)

5. Fed funds sold (short term)

Secondary Reserves as part of Asset Structure

(5)

1. "Buffer Stock" to smooth fluctuations in deposit flows and loan demands

2. Treasury bills and notes

3. Federal funds sold

4. Commercial paper

5. Banker's acceptances

Loan Portfolio as part of Asset Structure

(3)

[Primary sources of earnings]

1. High risk but high return (asymmetric risk/return)

2. Source of scheduled, but not certain, liquidity (bank knows when loan payments are coming in)

3. Wide range of assets (consumer, commercial, etc)

Investment for Income and Capital Gains as part of Asset Structure

(2)

1. Source of stable earnings and diversification

2. Security portfolio: e.g., high yield tax-exempt municiple securities (long-term investment portfolios)

5 Theories of Bank Management

(Evolution of Thought)

1. Commercial Loan Theory (traditional)

2. Shiftability Theory

3. Anticipated Income Theory

4. Liability Management

5. Integrated Asset/Liability Management

Banks should lend only on short-term, self-liquidating commercial paper ("real" bills doctrine)

Very limiting, narrow approach

Few loans to large, low-risk institutions

Short-term working capital loans

Bigger assets commercial banks own are mortgages

Liquidity is a function of ability to sell or shift assets at stable prices (long-term assets, such as bonds, as long as they can be sold)

OK to invest in loans/securities, e.g.

"Fallacy of Competition" - everyone did the same

Collateral approach

All loans, real or not, are paid out of future anticipated borrower cashflows

Mortgages, term loans, etc (3-5 year commercial loans)

Focus on cash flow rather than collateral

Recognizes both assets and liabilities as sources of needed liquidity

Bank's rate of growth becomes endogenous (management "target")

"purchased liquidity" (buy the funds needed)

Asset driven bank vs. deposit constrained bank

e.g., "maturity matching"

Bank makes $5 million 180 floating rate unsecured working capital loan funded with $5 million 180 day floating rate CD tied to both federal funds rate or LIBOR

1. Pool of funds approach

2. Hedging approach

3. Asset Allocaton model

All funds pooled toegether and allocated to specific investment and loan needs consistent with:

1. earnings and liquidity requirements

general investment priorities

Nature of liabilities dictates structure of assets

Explicitly recognizes liquidity needs tied to characterisitics of specific deposit or money sources (both loans and deposits)

Extablish independent liquidity-profitability centers within a back which recognizes defferences in reserve requirements and turn-over or variabilty in deposit rates

1. Demand deposits

2. Savings deposits

3. Time deposits

4. Capital

1. Primary reserves

2. Secondary reserves

3. Loans

4. Investment accounts

5. Fixed assets

Reflects hedging strategy

Commercial Banks              <5yrs          >5yrs

Assets                                92             8

Liabilities                            88            12

S&Ls

Assets                                 8             92

Liabilities                           92               8

1. Maturity, pricing structure and volitility of deposit and non-deposit funds

2. Business cycle - cyclical and seasonal nature of loan demand and deposit flow

3. Access to primary and secondary markets to sell assets

4. Access to money markets and emergency borrowing (back-up lines of credit, federal safety net)

1. Past poor management & fraud

2. Large portion of household savings

3. Provision of critical services: borrowers, savers, payment system, monetary policy

4. Systemic risk (contagion - "bank run")

5. Fear of financial concentration and political power

Types of Bank Regulation

(5)

1. Entry, geographic expansion, failure - chartering, branching, mergers

2. Product line - no investment banking or insurance

3. Pricing - Maximum deposit rates (Reg Q) and loan rates (usury laws)

4. Minimum capital requirements

5. Operating procedures - Lending limits, truth in lending, CRA

Community Reinvestment Act

- Banks not allowed to "redline" community

- Dollars invested by the community must be reinvested

Results of Bank Regulation

(6)

1. Very stable fincial system

2. Large number of institutions

3. Substitution of non-price for price competition

4. Moderate profitability

5. No incentive for innovation (incentive to circumvent regulation)

6. Inefficient regulation - dual banking system ("cat & mouse" game)

Reasons:

- Local control (state v federal)

- Competition (better regulation)

Federal or National Charter:

- Granted by Comptroller of the Currency

- Must join Federal Reserve

- Must have deposit insurance

- 1,000 of the largest banks (National by name)

State Charter

- Less rigid regulation and supervision

Capital adequacy -

Asset quality -

Management -

Earnings -

Liquidity -

Sensitivity -

Capacity - the borrowers ability to pay

Collateral - the quality of the assets that back the loan

Condition - circumstances that led to the need for funds

Capital - difference between the value of the borrowers assets and its liabilities

Character - borrower's willingness to repay the loan as measured by payment history and credit report

1. Consolidation - weak v strong firms

2. Decline in profit margins

3. Unbundled products and prices

4. Innovative products; enter new markets

5. Need to recapitalize

6. Greater risk but greater reward

7. Shift from utility to competative industry

Federal Reserve Act - 1913

- Lender of last resort

McFadden Act - 1927

- Limited branching

- Up to state to regulate within boundaries; could not go outside

Banking Act of 1933 (Glass-Steagall Act)

- Designed to limit "excessive" competition, which leads to risk taking

- Limits on entry and mergers; no security underwriting; price control on deposits

"Cracks" in the Protective Wall 

• Economic expansion/rising loan demand
• Growing competition for funds (non-banks)
• Volatile interest rates
• Declining market share
• Innovative banking products (NCDs, repos, euro deposits, "non-bank" banks)
• "Cat & mouse" game with regulators
• Inefficient, costly, time consuming

• Phased out deposit rate ceilings
• Broadened deposit insurance coverage
• Legalized NOW accounts (interest bearing consumer checking accts)
• Expanded S&L powers (orig limited to mortgages) to make consumer loans, offer credit cards and trust powers
• Equalized and lowered reserve requirements
• Extended access to fed payment system & priced services

aka "Save the Thrift Industry Act"

• Authorized MMDAs
  • insured deposits ($100,000)
  • competative rates
  • limited checking capability
• Expanded S&L powers further
  • consumer and commercial lending
  • can issue corporate demand deposits
  • relaxation of geographic restrictions for emergency regulator mergers

• Banking concentration has generally declined
  • especially states that allow branching
  • anti-trust laws reduce monopoly power
• Progressive small banks will prosper
• Larger banks provide:
  • more services
  • better diversified
  • no evidence of "deposit drain"
• Branching and interstate networks lead to increased service accessibility

Advantages:

• Deposit growth/diversification
• Better management
• Expanded services
• Expanded legal lending limit (max loan to single borrower)

Major Bank Laws:

McFadden Act -1927

Nationally chartered banks subject to same regulation as state chartered banks

Liberalized national bank securities underwriting activities

Major Bank Laws:

Banking Act of 1933

aka Glass-Steagall Act

Prohibited banks from underwriting securities except:

• Municiple general obligation bonds
• US government bonds
• private placements
• Real estate loand

Established FDIC to insure bank deposits

Major Bank Laws:

Bank Holding Company Act - 1956

Restricted the banking and non-banking acquisition activities of MBHCs

Empowered the Federal Reserve to regulate MBHCs by:

• determining permissible activities
• exercising supervisory authority
• exercising chartering authority
• conducting bank examinations

Major Bank Laws:

Depository Instistutions Deregulation & Monetary Control Act  - 1980

Phased out interest rate ceilings

Authorized NOW accounts

Introduced uniform reserve requirements for state and federal chartered banks

Increased deposit insurance coverage to $100,000

Allowed federally chartered thrifts to make consumer and commercial loans

Major Bank Laws:

Garn-St. Germain Act - 1982

Introduced MMDAs and NOWs as interest bearing savings accounts with check writing capabilities

Allowed federally chartered thrifts more excessing lending and demand deposit-taking powers

Allowed sound commercial banks to acquire failing savings banks

Reaffirmed limitations on bank powers to underwrite and distribute insurance

Major Bank Laws:

Riegle-Neal Interstate Banking & Branching Efficiency Act - 1994

Permitted bank holding companies to acquire banks in other states

Invalidated state laws that only allowed interstate banking on a regional or reciprocal basis

Allowed MBHCs to convert out of state subsidiary banks into branches of a single interstate bank

Newly chartered banks allowed to interstate if allowed by state law