Financial Institutions

Asset Transformation

Purchase "Primary Securities" (e.g. equity, debt) from firms and sell "Secondary Securities" (e.g. deposits, insurance policies) to individuals.

Brokerage

Purchase or sell securities for commission or fees (reduce costs through economies of scale)

What is the QTL test?

Qualified Thrift Lender. The QTL test refers to a minimum amount of mortgage-related assets that a savings institution must hold to maintain its charter as a savings institution. The amount currently is 65 percent of total assets.

Non-interest Expenses

Salaries, cost of physical assets (e.g. land depreciation), goodwill (occurs when the bank purchases assets for more than their net market value; there is lots of goodwill in this industry because of M&A activity)

EF5 typical entity type

Securitization vehicles

EF5 definition

Securitization-based credit intermediation & funding of financial entities

Community Banks

Specialize in retail/consumer banking: Residential mortgages; consumer loans; financing mostly from deposits

Non-interest Income

Fees earned on deposits, loans and off-balance sheet activities; fees for advisory services

How do finance companies make money?

Finance companies make a profit by borrowing money at a rate lower than the rate at which they lend.

EF2 typical entity type

Finance companies, leasing companies, factoring companies, consumer credit companies

Factoring

Finance company purchase accounts receivables from a corporate firm at a discount in exchange for assuming the risk of collecting them

EF1 typical entity type

Fixed income funds, mixed funds, credit hedge funds, real estate funds

Commercial Banks

focus on commercial lending, oldest and still the largest group of FIs in terms of total assets

Savings Institutions (Thrifts)

focus on mortgage loans to households

Noncurrent loans (Nonperforming loans)

loans that are past due 90 days or more and are not accruing interest because of problems with the borrower

Overhead Efficiency

measures the ability to cover non-interest (operational) expenses with non-interest (fee) income

Profit Margin

measures the ability to pay expenses and generate net income from interest and noninterest income (total operating income)

Asset Utilization

measures the amount of interest and noninterest income generated per dollar of total assets

Credit Unions

non-profit, very small

diseconomies of scale

occur when the costs of joint production of FI services are higher than they would be if they were produced independently

Why are loans illiquid ?

only the bank holds the information needed to evaluate correctly how much they are worth

Federal Financial Institutions Examination Council (FFIEC)

prescribes uniform principles, standards, and report forms for depository institutions

mutual funds

provide investments that closely mimic diversified investments in the direct securities markets at a lower cost.

FDIC

provided government guarantee of nominal value of deposit claims in exchange of a flat insurance premium

X efficiencies

refer to cost savings due to greater managerial efficiency

Economies of scope

refer to the degree to which a firm can generate cost synergies by producing multiple financial service products

Why is ROA for the smaller banks generally larger than ROA for the large banks?

small banks have been able to control credit risk more efficiently and to operate with less overhead expense than large banks

CU equity

the accumulation of past earnings that is "owned" collectively by member depositors

Spread

the difference between the yield on earning assets & the cost of interest-bearing liabilities

Why do smaller banks tend to have a higher equity ratio?

they have more limited asset growth opportunities, generally have less diverse sources of funds, and historically have had greater profitability than larger banks

Economies of scale

to the degree to which a firm's average unit costs of producing financial services fall as its output of services increase

What advantages do finance companies have over commercial banks in offering services to small business customers?

(1) Finance companies are not subject to regulations that restrict the types of products and services they can offer. (2) Because they do not accept deposits, they do not have the severe regulatory monitoring. (3) They are likely to have more product expertise because they generally are subsidiaries of industrial companies. (4) Finance companies are more willing to take on riskier customers. (5) Finance companies typically have lower overhead than commercial banks.

Positives of shadow banking

-Alternative financing channel that is considered essential to the economy -Some (but not all) financing investments & adding liquidity when it might not otherwise be forthcoming -Help spur the economic growth

Negatives of shadow banking

-Concerns about risk to financial system -IF a shadow bank goes down: regulators are concerned that it can still take "safe" banks with it -BUT, does this reflect a greater unease about the: lack of visibility into the financial system? fragility of the financial system?

Tier 2 capital or supplementary capital includes

-allowance for loan loss reserves up to 1.25% percent of risk-weighted assets, -convertible and subordinated debt with max. caps.

Tier 1 or core capital includes

-book value of common equity, -retained earnings -qualifying perpetual preferred stock, and -minority interest in consolidated subsidiaries minus goodwill

Countercyclical Capital Buffer

0% - 2.5% common equity will be implemented according to national circumstances.

Subordinated Debt

: Large banks may issue longer-maturity publicly-traded bonds

Risk-weighted assets

= risk weighted average of booked assets + risk weighted credit-risk equivalent amounts of off-B/S exposure

Negotiable CDs

Time deposits with a value greater than $100,000 (this is the cut-off to be fully insured by FDIC)

Basel Capital Accord of 1988 (implemented in 1992)

An agreement among bank regulators from many countries to impose a uniform set of risk-based capital adequacy standards on all internationally active banks.

Shadow Banking (broad definition)

Any non-bank, non-regulated financial company that does everything a bank does; "Nonbank Intermediation"; Large spectrum

Shadow Banking (narrow definition)

Any non-bank, non-regulated financial company that performs only credit intermediation; Credit is intermediated through a wide range of securitization and secured funding techniques:

Dual banking system

Banks in the US can choose to be nationally or state-chartered

Money Center Banks

Banks located in major financial centers; Rely heavily on nondeposit or borrowed sources of funds- Bank of New York; Deutsche Bank; Citigroup

What strategic changes have banks implemented to deal with changes in the financial services environment?

Banks of all sizes have increased the use of off-balance-sheet activities in an effort to generate additional fee income

Why is the ratio for ROE consistently larger for the large bank group?

Because large banks typically operate with less equity per dollar of assets, net income per dollar of equity is larger

EF3 typical entity type

Broker-dealers

Basic Function of Financial Institutions (FI)?

Channeling Funds from Savers (entities with a surplus of funds) to Borrowers (entities with a deficit of funds)

Real Estate Loans

Commercial loans to businesses that are secured by real estate; residential loans (e.g. home mortgages). They were very liquid due to securitization before the crisis

What factors caused the decrease in loan volume relative to other assets on the balance sheets of commercial banks?

Corporations have utilized the commercial paper markets with increased frequency rather than borrow from banks. In addition, many banks have sold loan packages directly into the capital markets (securitization) as a method to reduce balance sheet risks and to improve liquidity.

EF3 potential related risks

Create imperfect credit risk transfer

Consumer Loans

Credit cards; auto loans; student loans; etc

EF3 typical entity type

Credit insurance companies, financial guarantors, monolines

How does the liability maturity structure of a bank's balance sheet compare with the maturity structure of the asset portfolio?

Deposit and nondeposit liabilities tend to have shorter maturities than assets such as loans. The maturity mismatch creates varying degrees of interest rate risk and liquidity risk.

Capital (Net worth)

Difference between bank assets and liabilities; an important as a buffer against bankruptcy

Regional/Superregional Banks

Engage in complete array of wholesale banking activities, which include: Consumer/residential lending; commercial & industrial loans; Access to markets for purchased funds (e.g. fed funds)

Saving Institutions (S&Ls or "Thrifts")

Established primarily to pool short-maturity savings deposits and use them to make residential mortgage loans

Uniform Bank Performance Report (UBPR)

FFIEC allows banks to observe competitor financial statements

EF4 definition

Facilitation of credit creation

EF3 definition

Intermediation of market activities that is dependent on short-term funding or on secured funding of client assets

EF3 potential related risks

Liquidity risks depending on the funding model; also may have high leverage

EF2 definition

Loan provision that is dependent on short term funding

What are the major uses of funds for commercial banks in the United States?

Loans and investment securities continue to be the primary assets of the banking industry. Commercial loans are relatively more important for the larger banks, while consumer, small business loans, and residential mortgages are more important for small banks

Peer-to-peer (P2P) lending

Loans made privately through individuals who most often connect through a network of websites taking a fee about 5%; Do not take deposits AND do not even provide the actual loans

C&I Loans

Loans to businesses, not secured by real estate. These loans are generally illiquid due to the information collection and monitoring services of banks

Securities

Mainly U.S. Treasuries; municipal bonds; and investment grade corporate bonds. Also federal funds sold (selling excess reserves for short term) and reverse repos

EF1 definition

Management of collective investment vehicles with features that make them susceptible to runs

Net Interest Margin

Measures the difference between what a bank earns on its loans and investments (yield on earning assets) and what it pays on deposits and borrowings (cost of funding earning assets).

Return on Equity (ROE)

Measures the return (profitability) on each dollar of stockholders' equity

Return on Assets (ROA)

Net income generated per dollar of average assets invested during period

What types of activities are normally classified as off-balance-sheet (OBS) activities?

Off-balance-sheet activities include the issuance of guarantees that may be called into play at a future time, and the commitment to lend at a future time if the borrower desires.

EF2 potential related risks

Often lending concentrated in cyclical sectors; maturity transformation risks

Capital Conservation Buffer

Outside of periods of stress, 2.5% common-equity (on top of Tier 1 capital) to withstand future periods of stress bringing the total common equity requirements to 7%

Time Deposits

Pay higher interest but are less liquid than MMDAs and passbook accounts (with maturities of at least 14 days).

Passbook Savings and Money Market Deposit Accounts

Pay interest and are liquid since the holder can withdraw funds anytime. MMDAs have limitations on the number of transaction

EF1 potential related risks

Pooiling of client $, makes entities to susceptible to runs

EF5 potential related risks

Potential risks depending on activities performed

What happened in 1979 to cause the failure of many savings institutions during the early 1980s?

The Federal Reserve changed its reserve management policy to combat the effects of inflation, a change which caused the interest rates on short-term deposits to increase dramatically more than the rates on long-term mortgages.

How does an OBS activity move onto the balance sheet as an asset or liability?

The activity becomes an asset or a liability upon the occurrence of a contingent event, which may not be in the control of the bank. In most cases, the other party involved with the original agreement will call upon the bank to honor its original commitment.

How do savings banks differ from savings associations?

The asset structure of savings banks is similar to the asset structure of savings associations with the exception that savings banks are allowed to diversify by holding a larger proportion of corporate stocks and bonds. Savings banks rely more heavily on deposits and thus have a lower level of borrowed funds.

Demand Deposits

The bank must give you your funds on demand and cannot pay interest on them

What are the benefits of OBS activities to a bank?

The initial benefit is the fee that the bank charges when making the commitment. If the bank is required to honor the commitment, the normal interest rate structure will apply to the commitment as it moves onto the balance sheet.

What are the main features of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994? What major impact on commercial banking activity occurred from this legislation?

The main feature of the Riegle-Neal Act of 1994 was the removal of barriers to interstate banking. As a result, consolidations and acquisitions have allowed for the emergence of very large banks with branches across the country.

What factors normally are given credit for the revitalization of the banking industry during the decade of the 1990s?

The most prominent reason was the lengthy economic expansion in both the U.S. and many global economies during the entire decade of the 1990s. This expansion was assisted in the U.S. by low and falling interest rates during the entire period.

Credit-risk Equivalent

The on-balance sheet equivalent credit risk exposure of an off-balance sheet item.

What is the primary function of finance companies? How do finance companies differ from commercial banks?

The primary function of finance companies is to make loans to individuals and corporations. Finance companies do not accept deposits, but borrow short- and long-term debt, such as commercial paper and bonds, to finance the loans.

What are the risks of OBS activities to a bank?

The primary risk to OBS activities on the asset side of the bank involves the credit risk of the borrower. In many cases the borrower will not utilize the commitment of the bank until the borrower faces a financial problem that may alter the credit worthiness of the borrower.

What are the major sources of funds for commercial banks in the United States?

The primary sources of funds are deposits and borrowed funds. Small banks rely more heavily on transaction, savings, and retail time deposits, while large banks tend to utilize large, negotiable time deposits and nondeposit liabilities such as federal funds and repurchase agreements.

How do the asset and liability structures of a savings institution compare with the asset and liability structures of a commercial bank?

The savings institution industry relies on mortgage loans and mortgage-backed securities as the primary assets, while the commercial banking industry has a variety of loan products, including mortgage products.

Transaction Deposits

They are deposits that you can write a check against; the most liquid kind of deposits. Banks hold a certain % of them on reserve at the FED

Finance Companies

They are like depository institutions (provide consumer lending, business lending and mortgage financing), with two key differences: Their liabilities are composed of commercial paper and long-term debt (rather than deposits) AND They were regulated very lightly till 2009-- lend to too risky customers compared to bank loan portfolios (e.g. subprime lender).

NOW (Negotiable Order of Withdrawal) Accounts

They pay interest but revert to the status of a demand deposit if the funds fall below a minimum balance

What are the three major segments of deposit funding?

Transaction accounts include deposits that do not pay interest and NOW accounts that pay interest. Retail savings accounts include passbook savings accounts and small, nonnegotiable time deposits. Large time deposits include negotiable certificates of deposits that can be resold in the secondary market.

Why should firms use FIs instead of directly raising funds from individuals?

Without FIs: Low level of fund flows

Provisions for Loan Losses

a deduction from current income that represents expectations of future losses on loans

Equity Multiplier (EM)

a measure of leverage. Large values indicate large amounts of debt financing

megamerger

a merger of commercial banks with assets of $1 billion or more

Loan Loss Allowance

a reserve set up by banks to cover any potential losses from bad loans

Financial statement analysis

based on accounting ratios; involves a combination of time series analysis and cross-sectional analysis