CHAPTER 2

Financial Services: Depository Institutions

Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.

 This chapter discusses depository FIs:

Ch 2-2
 Products of U.S. FIs
 Comparing the products of FIs in 1950, to
products of FIs in 2013:
– Much greater distinction between types of FIs in
terms of products in 1950 than in 2013
– Blurring of product lines and services over time
and wider array of services
– (Refer to Tables 2-1A and 2-1B in the text)

Ch 2-3
 Specialness of Depository FIs
 Products on both sides of the balance sheet
– Loans
 Business and Commercial
– Deposits

Ch 2-4
 Other outputs of depository FIs
 Other products and services 1950:
– Payment services, savings products, fiduciary
services
 By 2013, products and services further
expanded to include:
– Underwriting of debt and equity, insurance and
risk management products

Ch 2-5
 Size of Depository FIs
 Consolidation has created some very large FIs
 Combined effects of disintermediation, global
competition, regulatory changes, technological
developments, competition across different
types of FIs

Ch 2-6
Largest US Depository Institutions
Holding Company Assets
($Billions)
1. J.P.Morgan Chase 2,321.3
2. Bank of America 2,168.0
3. Citigroup 1,931.3
4. Wells Fargo 1,374.7
5. U.S. Bancorp 352.3
6. PNC Financial Services Corp. 301.1
7. Bank of NY Mellon 340.1
8. State Street Corp. 204.1
9. TD Bank 212.5
10. HSBC North America 320.8
Ch 2-7
 Commercial Banks
– Largest depository institutions are commercial
banks
– Differences in operating characteristics and
profitability across size classes
 Notable differences in ROE and ROA, as well as the
spread
– Mix of very large banks with very small banks

Ch 2-8
 Structure and Composition
 Shrinking number of banks:
– 14,416 commercial banks in 1985
– 12,744 in 1989
– 6,168 in 2012
 Mostly the result of Mergers and Acquisitions
– M&A prevented prior to 1980s, 1990s
– Consolidation has reduced asset share of small
banks

Ch 2-9
 Regulation, Functions & Structure
 Functions of depository institutions
– Regulatory sources of differences across types of
depository institutions
 Structural changes generally resulted from
changes in regulatory policy
– Example: Changes permitting interstate branching
 Riegle-Neal Act, 1994

Ch 2-10
Breakdown of Loan Portfolios

Ch 2-11
 Commercial Banks:
Asset Concentration
2012 Percent 1984 Percent
Size Assets of Total Assets of Total
All FDIC 13,069.9 100.0 2,508.9 100.0
Insured
$100M or Less 118.0 0.9 404.2 16.1
$100M - $1B 1,059.2 8.1 513.9 20.5
$1B - $10B 1,133.6 8.7 725.9 28.9
$10B or more 10,759.1 82.3 864.8 34.5

Ch 2-12
 Structure & Composition
of Commercial Banks
 Limited powers to underwrite corporate
securities have existed only since 1987
 Financial Services Modernization Act 1999
– Allowed full authority to enter investment banking
(and insurance)

Ch 2-13
 Composition of
Commercial Banking Sector

 Community Banks
 Regional and Super-regional
– Access to federal funds market to finance their
lending and investment activities
 Money Center Banks
– Bank of New York Mellon, Deutsche Bank (Bankers
Trust), Citigroup, J.P. Morgan Chase, HSBC Bank
USA
 Declining in number
Ch 2-14
 Balance Sheet and Trends
 Business loans have declined in importance
 Offsetting increase in securities and mortgages
 Increased importance of funding via
commercial paper market
 Securitization of mortgage loans
 Temporary effects: credit crunch during
recessions of 1989-92 and 2001-02

Ch 2-15
 Commercial Banks,
September 2012
 Primary assets:
– Real Estate Loans: $3,569.9 B
– C&I loans: $1,401.2 B
– Loans to individuals: $1,206.9 B
– Investment security portfolio: $3,909.3 B
– Of which, Treasury securities: $1,705.6 B
 Inference: Importance of Credit Risk

Ch 2-16
 Commercial Banks
 Primary liabilities:
– Deposits: $9,622.4 billion
– Borrowings: $1,568.6 billion
– Other liabilities: $378.2 billion
 Inference:
– Highly leveraged

Ch 2-17
 Some Terminology
 Transaction accounts
 Negotiable Order of Withdrawal (NOW)
accounts
 Money Market Mutual Funds
 Negotiable CDs

Ch 2-18
 Equity
 Commercial Banks equity capital
– 11.48 percent of total liabilities and equity (2012)
– TARP program 2008-2009 intended to encourage
increase in capital
 Citigroup $25 B
 BOA $20 B
– Through 2012: $245 B in capital injections
through TARP

Ch 2-19
 Off-Balance-Sheet Activities
 Heightened importance of off-balance-sheet
items
– OBS assets, OBS liabilities
– Regulatory incentives
– Risk control and risk producing
 Role of mortgage backed securities
 “Toxic” assets
 Expansion of oversight

Ch 2-20
 Major OBS Activities
– Loan commitments
– Standby letters of credit and letters of credit
– Futures, forwards, options, and swaps

Ch 2-21
 Other Fee-Generating Activities
 Trust services
 Correspondent banking
– Check clearing
– Foreign exchange trading
– Hedging
– Participation in large loan and security issuances

Ch 2-22
 Key Regulatory Agencies
– FDIC
 Deposit Insurance Fund (DIF)
 Role in preventing contagious runs or panics
– OCC: Primary function is to charter national banks
– FRS: Monetary policy, lender of last resort
 National banks are automatically members of the FRS; state-
chartered banks can elect to become members
– State bank regulators
– Dual Banking System: Coexistence of national and state-
chartered banks

Ch 2-23
Bank Regulators

Ch 2-24
 Other Regulatory Issues
 Importance of Bank Holding Companies is
increasing

 BHCs regulated by FRS

Ch 2-25
 Key Regulatory Legislation
 1927 McFadden Act: Controls branching of
national banks
 1933 Glass-Steagall: Separates securities and
banking activities, established FDIC, prohibited
interest on demand deposits
 1956 Bank Holding Company Act and
subsequent amendments specifies permissible
activities and regulation by FRS of BHCs

Ch 2-26
 Legislation (continued)...
 1970 Amendments to the Bank Holding
Company Act: Extension to one-bank holding
companies
 1978 International Banking Act: Regulated
foreign bank branches and agencies in US

Ch 2-27
 Legislation (continued)…
 1980 DIDMCA and 1982 DIA (Garn-St.
Germain Depository Institutions Act)
– Mainly deregulation acts
– Phased out Regulation Q
– Authorized NOW accounts nationwide
– Increased deposit insurance from $40,000 to
$100,000
– Reaffirmed limitations on bank powers to
underwrite and distribute insurance products
Ch 2-28
 Legislation (continued)…
 1987 Competitive Equality in Banking Act (CEBA)
– Redefined bank to limit growth of nonbank banks
 1989 FIRREA
– Imposed restrictions on investment activities
– Replaced FSLIC with FDIC-SAIF
– Replaced FHLB with Office of Thrift Supervision
– Created Resolution Trust Corporation

Ch 2-29
 Legislation (continued)…
 1991 FDIC Improvement Act
– Introduced Prompt Corrective Action
– Risk-based deposit insurance premiums
– Limited “too big to fail”
– Extended federal regulation over foreign bank
branches and agencies

Ch 2-30
 Legislation (continued)…
 1994 Riegle-Neal Interstate Banking and
Branching Efficiency Act
– Permits BHCs to acquire banks in other states
– Invalidates some restrictive state laws
– Permits BHCs to convert out-of-state subsidiary
banks to branches of single interstate bank
– Newly chartered branches permitted interstate if
allowed by state law

Ch 2-31
1999 Financial Services Modernization Act
– Allowed banks, insurance companies, and
securities firms to enter each others’ business areas
– Provided for state regulation of insurance
– Streamlined regulation of BHCs
– Prohibited FDIC assistance to affiliates and
subsidiaries of banks and savings institutions
– Provided for national treatment of foreign banks

Ch 2-32
 2010 Wall Street Reform and Consumer
Protection Act
– Financial Services Oversight Council created
– Gov’t gained power to break up FIs that pose a risk
to the system
– Consumer Financial Protection Bureau created
– GAO to audit Federal Reserve Activities
– Nonbinding proxy on executive pay
– Clearinghouses for some derivatives

Ch 2-33
 Industry Performance
 Economic expansion and falling interest rates
through 1990s
 Brief downturn in early 2000 followed by
strong performance improvements
– Record earnings $106.3 billion 2003
 Performance remained strong through mid
2000s as interest rates rose
 Late 2000s: Strongest recession since 1930s

Ch 2-34
 Savings Institutions
 Comprised of:
 Savings and Loans Associations
 Savings Banks
– Effects of changes in Federal Reserve’s policy of
interest rate targeting combined with Regulation Q
and disintermediation
– Effects of moral hazard and regulator forbearance
– Qualified Thrift Lender (QTL) test

Ch 2-35
 Savings Institutions: Recent Trends
 Industry is smaller overall
 Intense competition from other FIs
– Mortgages, for example

Ch 2-36
 Primary Regulators
 Office of the Comptroller of Currency (OCC)
 FDIC-DIF Fund
– FDIC oversaw and managed Savings Association
Insurance Fund (SAIF)
– SAIF and BIF merged in January 2007 to form
DIF
– Same regulatory structure applied to commercial
banks

Ch 2-37
 Credit Unions
 Nonprofit DIs owned by member-depositors
with a common bond
 Exempt from taxes and Community
Reinvestment Act (CRA)
 Expansion of services offered in order to
compete with other FIs
 Claim of unfair advantage of CUs over small
commercial banks

Ch 2-38
Composition of Credit Union Deposits,
2012

Ch 2-39
 Global Issues
 Spread of US financial crisis to other
countries
 Many European banks saved from bankruptcy
through support of governments and central
banks
 Interest rates at or below 1 percent
 Links to the macroeconomy

Ch 2-40