Banking Test 1
Community Banks:
- Assets up to about $10 Bil - Privately owned, managed by board of directors - Geographically concentrated - Generally know their customers well
Partial solutions to control bank risk-taking:
- Bank supervision and regulation - Activity restrictions on banks - Risk-based deposit insurance pricing
What is a bank?
- Channels funds from savers to investors. - A depository institution that accepts demand deposits and makes business loans. - Qualifies for deposit insurance offered by the FDIC
Bank Holding Companies (BHC):
- Corporation chartered for the purpose of holding the stock of one or more banks. - Control of a bank is assumed when 25% or more of the stock is owned. - Must get approval from Federal Reserve board to control a bank. - 80% of banks are owned by BHCs
The Banking Act of 1933 (Glass-Steagall Act)
- Created the FDIC, which guaranteed deposits up to a maximum of $2,500 - Today the ceiling is $250,000 per account holder per account type - FDIC sets and collects premiums from banks based on their total deposits and risk
Dodd-Frank Wall Street Reform and Consumer Protection Act (July, 2010) The Economic Growth, Regulatory Relief and Consumer Protection Act (May, 2018)
- Established Consumer Financial Protection Bureau - Examines consumer compliance for banks with more than $10 billion in assets - Abolished Office of Thrift Supervision (OTS); shifted thrift supervision to OCC - Deposit insurance ceiling permanently raised to $250,000 - Systemic Risk Oversight - All BHCs over $50 billion plus certain nonbanks are subject to systemic risk supervision by the Fed - Implemented "Volcker Rule" that limits proprietary trading by a banking entity. - Requires securitizers to retain an un-hedged interest of >= 5% of the credit risk. - Standard mortgage assets are exempted. - Debit card interchange fee limits set by Fed.
Advantages of BHC:
- Evade bank regulatory restrictions - subsidiaries - Tax savings - dividends received from subsidiaries can qualify for 100% tax - deduction while personal dividends are taxable - profits and losses from subsidiaries are netted - help banks through difficult financial times with financing
When does a financial crisis erupt?
- Financial or economic environment changes suddenly - Financial institutions are severely impaired
Top 4 largest banks
- JPMorgan Chase Bank - Bank of America - Wells Fargo - Citibank
Bank Supervision and Regulation
- Office of the Comptroller of the Currency (OCC), established by the National Banking Acts of 1863-64. - Federal Deposit Insurance Corp. (FDIC), established by the Banking Act of 1933 - Federal Reserve, established by the Federal Reserve Act of 1913. - Each state has its own bank regulation department
LCBOs (Money-Center banks)
- Own at least one bank - Usually are publicly traded - Organizational chart (BHC structure) is complex - Significant international operations - Access to direct bond and equity markets
What are the differences between national and state charter?
- Regulators - Option on Fed membership - Ability to operate interstate banking operations efficiently
Federal funds sold
- Short-term interbank loans extended by a bank in the federal funds market. - Maturity is typically overnight. - Typically uncollateralized.
Reverse repurchase agreements (Reverse REPOs)
- Short-term loans where the lending bank takes temporary title to securities owned by the borrower as collateral. - Contract requires the lender to purchase the securities from the borrower and sell them back to the borrower at maturity
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
- allowed BHCs to acquire banks in any state after September 29, 1995. BHCs could merge bank charters across state lines after June 1, 1997. - restricts a BHC from controlling more than 10% of the nation's total deposits, or 30% of any single state's total deposits.
McFadden Act of 1927
- forced national banks to follow the same branching restrictions as state chartered banks. - Most banks could not branch across states or even within states until the 1980s.
Banks are declining in number because
- geograhpical deregulation is allowing them to merge - technological change and a decline in information costs has increased the economies of scale in banking
Why is there a decline in new charters?
- interstate banking encouraged a wave of bank mergers - Between 2008 and 2013, 489 commercial banks failed - Minimum efficient scale may be achieved at an asset range between $300 million and $10 billion
When a bank closes out its books at the end of a quarter? - net income not paid as dividends flows into retained earnings - securities gains are distributed to shareholders - provision expense flows into loan loss reserves - income taxes reduce the bank's interest income
- net income not paid as dividends flows into retained earnings
A bank holding company (BHC) is one that
- owns at least 25% of the stock of a bank - is a parent organization of at least one bank - cannot engage in traditional commerical activity such as manufacturing
Deposit insurance
- solves bank runs but creates moral hazard
A bank has $15 million in loan loss reserves at the beginning of the quarter. During the quarter, it adds $2.8 million in provision expense and it charges off $1.8 million in bad loans. The bank's loan loss reserves at the end of the quarter will be (only enter numbers to one decimal place, i.e. 7.4, do not use any symbols)
16
Equal Credit Opportunity Act of 1974
Access to credit must be equivalent regardless of age, sex, race, etc.
Which of these entities can accept demand deposits? - credit union - savings bank - commercial bank - savings and loan
All of the above
Gramm Leach Bliley Act (GLBA) of 1999
Authorized the Financial Holding Companies (FHCs)
Double leverage:
BHC borrows money to buy bank equity. Bank then expands assets and deposits
Community Reinvestment Act of 1977
Banks must serve customers in their market area and may not discriminate against customers in their neighborhoods by redlining.
Overnight repo rate
Borrowers sell security to lender. Give cash to borrower. Seller than repurchases cash with an interest
Match each CAMELS component with its definition
Capital adequacy - ability to absorb losses Asset quality -assessment of credit risk in bank assets Management quality - soundness of risk management policies and procedures Earnings - assessment of bank profitability Liquidity - ability of bank to meet its cash needs Sensitivity - measure of interest rate risk
Allowance for loan & leases losses (ALLL)
Contra-asset account to absorb expected loan losses Objective of ALLL is to absorb credit losses and protect equity
1800/200 rule:
Department of Justice generally will not challenge a merger transaction unless the pro forma HHI is greater than 1800 AND the change in HHI resulting from the transaction is greater than 200 points.
This liability typically constitutes the biggest share of liabilities as a percent of total assets at commercial banks. Less developed country loans. Deposits Federal Funds Sold Federal funds purchases Other borrowed funds
Deposits
CAMELS Examination Ratings
Each bank is examined every 12 to 18 months and rated 1 (best) to 5 (worst) on these components: Capital adequacy, Asset quality, Management quality, Earnings, Liquidity, Sensitivity
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
Established the Consumer Financial Protection Bureau (CFPB) to establish and enforce national consumer financial protection regulations
Provision expense
Expense item that flows into the loan loss reserves set aside to cover bad loans.
DoItAll, Inc. is a Bank Holding Company in the U.S. headquartered in Arkansas with two subsidiary banks. The first bank is a state chartered bank that is a member of the Federal Reserve. The second bank is a nationally chartered bank. This holding company and/or its banks are directly supervised by all of these agencies except - Federal Reserve - FDIC - Arkansas State Bank Department - OCC
FDIC
Currently the deposit insurance ceiling per individual per account type is $100,000
False
The primary purpose of fair lending regulation at banks is to ensure that every household can borrow similar amounts from banks depending only on their income.
False
The system of bank supervision and regulation has been completely effective at eliminating financial instability in the US since the Great Depression.
False
Nondeposit Borrowings
Fed funds purchased Repurchase agreements: securities sold under agreement to repurchase Acceptances outstanding Eurocurrency borrowings Subordinated debt Limited life preferred stock Other liabilities
From a bank's point of view, identify each financial instrument as an asset, liablity, or equity. - Federal funds purchased - Preferred stock - Savings deposit - Loan loss reserve - Municipal bond
Federal funds purchased - Liability Preferred stock - Equity Savings deposit - Liability Loan loss reserve - Asset Municipal bond - Asset
Consumer Credit Protection Act (Truth-in-lending) of 1968
Financial firms must state customers' rights and report lending terms and rates consistently.
Which of the following is true of off-balance-sheet activities? - They disproportionately hurt net income because the expenses generally exceed the revenues from these activities. - they include contingent activities recorded in the current balance sheet. - They generate fees for banks without exposure to any risk. - For a fee, the bank makes a commitment to provide a service to a customer, but there is no particular asset on the balance sheet that is tied to that commitment until the customer requests the service.
For a fee, the bank makes a commitment to provide a service to a customer, but there is no particular asset on the balance sheet that is tied to that commitment until the customer requests the service.
National vs State charter
In recent years, nationally chartered banks have held more deposits (55%) than state chartered banks (45%).
Loan rate: increases deposit rate: stays the same Net Margin:
Increase
Moral hazard
Insurance against an adverse event increases the probability that the event will occur because people's risk-taking incentives change once they are insured against an adverse event - Subprime mortgages, car insurance, bicycle helmets, air bags
Which of the following is NOT an off balance sheet activity for U.S. banks? When-issued securities. Loan commitments. Standby letters of credit. Interbank lending
Interbank lending
Net Interest Income
Interest income - Interest expense
Net interest income
Interest income - expense deposit
This asset typically constitutes the biggest share of assets at commercial banks. Bank premises Federal Funds Sold Loans OREO (Other Real Estate Owned) Cash
Loans
Income Statement
Net interest income (1) - Net noninterest expense (2) - Provision for loan loss (3) = Net operating income + Securities gains (4) - Taxes (5) = Net income
Deposit Accounts
Non interest-bearing demand deposits Savings deposits NOW accounts Money market deposit accounts (MMDA) Time deposits
Financial Holding Companies (FHCs)
Offer customers: - commercial banking - investment banking - insurance underwriting - merchant banking All FHCs are BHCs but the reverse is not true
Equity Capital
Preferred stock Common stock - Common stock outstanding - Capital surplus - Retained earnings (from undivided profits) - Treasury stock - Contingency reserve
Which of these is NOT a reason for supervision of commercial banks? - Promote financial stability to reduce the likelihood of a financial crisis - Protect bank shareholders from fraud or misrepresentation of accounting information - Ensure equal opportunity and fairness in access to credit - Protect the public's savings in the form of deposits
Protect bank shareholders from fraud or misrepresentation of accounting information
Fed fund, Government bonds, Negotiable Cds
Quantity set
Legal and Compliance Risk
Risk of earnings resulting from actions taken by the legal system. This can include unenforceable contracts, lawsuits or adverse judgments. Compliance risk includes violations of rules and regulations.
Credit Risk
Risk that bank loans will not be repaid in full.
Interest Rate Risk
Risk that changes in interest rates will adversely affect a bank's income and capital. - Savings and Loan crisis
Liquidity Risk
Risk that the bank will not have sufficient cash and borrowing capacity to meet deposit withdrawals, loan commitments, and other cash needs.
Market Risk
Risk that the market value of the bank's trading portfolio declines in value due to a change in interest rates or other market movements.
Insolvency (Leverage) Risk
Risk that the value of the bank's assets decline below the level of its liabilities, depleting capital. Higher levels of capital protect against bank failure.
Trading Account Assets
Securities purchased to provide short-term profits from short-term price movements - Valued (marked-to-market)
ALLL consists of:
Specific reserves: provisions set aside to cover expected losses on particular loans General reserves: provisions set aside to cover expected losses on as-yet unidentified loans
Investment Securities
Taxable securities - U.S. Government notes - Government agency securities - Corporate bonds Tax-exempt securities - Municipal bonds
All FHCs are BHCs but the reverse is not true.
True
BHCs are only permitted to engage in activities that are closely related to banking.
True
In a typical year, bank mergers are far more common than new bank charters.
True
Nationally chartered banks must be members of the Federal Reserve System. State chartered banks can choose whether or not they want to be a Fed member.
True
The Federal Reserve can control the money supply more accurately because required reserves sets boundaries on the ability of banks to create new credit.e
True
Without deposit insurance, the banking system is inherently unstable because of the fractional reserve system.
True
Operational Risk
Uncertainty regarding a bank's earnings due to failures in computer systems, errors, misconduct by employees, floods, lightening strikes and similar events or risk of loss due to unexpected operating expenses.
Other loan accounts
Unearned discount income - Loan income received but not yet earned under accrual accounting Nonperforming loans - Loans that are 90 days or more past due or are no longer accruing interest
Behavioral biases
We are inherently myopic and use overweight recent information - Strong economic growth will continue so businesses will suffer few losses
Cash Assets (primary reserve)
account called cash and deposits due from bank - Vault cash - Deposits with other banks (correspondent deposits) - Cash items in process of collection - Reserve account with the federal reserve
Community banks
account for the great majority of the commercial banks but collectively hold only a small portion of overall industry assets
Partial solutions to limit bank risk-taking include: - bank supervision and regulation - activity restrictions on banks - risk-based deposit insurance pricing - all of the above
all of the above
Risk-based deposit insurance - was introduced in the US in 1993 - means that riskier banks pay higher premiums than safer banks - is a way to reduce moral hazard risk-taking incentives of banks - penalizes banks for taking greater risk - all of the above
all of the above
The Gramm Leach Bliley Act of 1999
allowed qualified BHCs to become Financial Holding Companies (FHCs), which allowed them to conduct investment banking, insurance underwriting, and merchant banking in subsidiaries separate from the commercial bank(s).
Moral hazard is
an adverse consequence of deposit insurance
Credit risk
appears low when business are profitable and consumers have wealth.
High sensitivity means that
borrowers will be more caution when looking at loan rates - except when there are differences in credit card rates
The Federal Reserve conducts monetary policy through the banking system primarily by - raising or lowering the discount rate - buying and selling government bonds from primary dealers, which changes the amount of liquidity in the banking system - changing required reserves frequently - all of the above
buying and selling government bonds from primary dealers, which changes the amount of liquidity in the banking system
The Federal Reserve conducts monetary policy through the banking system primarily by: - raising or lowering the discount rate - buying and selling government bonds from primary dealers, which changes the amount of liquidity in the banking system - changing required reserves frequently - all of the above
buying and selling government bonds from primary dealers, which changes the amount of liquidity in the banking system
Securities (the Liquid Portion)
called secondary reserves - Short term government securities - Privately issued money market securities - Interest bearing time deposits - Commercial paper
BHCs exist to:
centralize many back office operations to better achieve economies of scale
Non- interest expense rises
due to payroll expense and asset increase
Unlike BHCs, Financial holding companies (FHCs) have no restrictions on offering these activities:
full service investment banking such as equity and bond underwriting
Net loans =
gross loans - ALLL
Income taxes
income taxes are applied to the bank's net operating income plus securities gains.
Leverage
increases in periods of economic growth
Growth in net interest income and non-interest income
increases net operating revenue
The solution that the US banking system has taken to prevent a wave of bank runs is to: - introduce FDIC deposit insurance - require banks to hold at least 10% of their deposits on hand as cash. - require banks to become members of the Federal Reserve System - all of the above
introduce FDIC deposit insurance
Unit bank
is a community bank with just one office.
Return on average Net income assets (ROA)
net income / average assets
return on equity
net income/ average equity
Net interest margin
net interest income/ average earnings assets
Non interest expense
non interest expense - non interest income
A> L+E
raise rates on loans lower rates on deposits reduce federal funds sold - Rate set
A primary role of a commercial bank is to
safekeep people's cash and valuables
A bank has a securities to assets ratio of 3.5% at year-end 2014. At year-end 2015, that same ratio is 2.8%. We can accurately say that during the year
securities holdings at the bank as a percent of assets have declined by 70 basis points. securities holdings at the bank as a percent of assets have declined by 0.7 percentage points.
Branch banks
several branches in addition to their home office.