Commercial Banking Ch. 2 Exam questions
Are low interest rates necessarily good for banks? Not necessarily. A better measure of impact of interest rates on bank profitability is the spread on rates
- Interest rate on assets - Interest rate on liabilities - Low cost on deposits only means low cost of liabilities (low cost of funds). If assets also have low interest rates, there is no obvious advantage to generally having low interest rates in the economy. - It is better to compare interest rates on assets versus interest rates on liabilities via the term structure where assets (producing strong revenes) are generally longer term than liabilities. If assets are generally longer term than liabilities, then a positive sloping term structure is, everything else constant, good for banks. (high revenue on assets, low costs on liabilities)yield
Using the information on ROE decomposition in Appendix 2A, calculate the ratio of equity to total assets for each of the two bank groups for the period 1990-2018. Why has there been such dramatic change in the values over this time period and why is there a difference in the size of the ratio for the two groups?
- The growth in the equity to total assets ratio has occurred primarily because of the increased profitability of the entire banking industry and (particularly during the financial crisis) the encouragement of regulators to increase the amount of equity financing in the banks. Increased fee income, reduced loan loss reserves, and a low, stable interest rate environment have produced the increased profitability which in turn has allowed banks to increase equity through retained earnings. -As deregulation of the financial services industry occurred during the 1990s, the position of banks as the primary financial services provider eroded. Banks of all sizes have increased the use of off-balance-sheet activities in an effort to generate additional fee income. Letters of credit, futures, options, swaps, and other derivative products are not reflected on the balance sheet, but do provide fee income for the banks.
Compare and contrast the performance of worldwide depository institutions during and after the financial crisis.
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Which categories of contingencies have had the highest annual growth rates?
Credit derivatives grew at the fastest rate of 26.51 percent, yet they have a relatively low outstanding balance of $4,340.4 billion. The rate of growth in the swaps area has been the second strongest at 16.18 percent, the dollar volume is large at $104,738.2 billion in 2018. Option contracts grew at an annual rate of 14.31 percent with a dollar value outstanding of $50,780.7 billion. Clearly the strongest growth involves derivative areas.
How did the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 reverse some of the key features of earlier legislation?
FIRREA rescinded some of the expanded thrift lending powers of the DIDMCA of 1980 and the Garn-St Germain Act of 1982. The Act also the FIRREA of 1989—abolished the FSLIC and created a new insurance fund (SAIF) under the management of the FDIC. In addition, the act created the Resolution Trust Corporation (RTC) to close the most insolvent savings associations. Further, the FIRREA strengthened the capital requirements of savings institutions and constrained their non-mortgage-related asset-holding powers under a newly imposed qualified thrift lender, or QTL, test that requires that all thrifts must hold portfolios that are comprised primarily of mortgages or mortgage products such as mortgage-backed securities. The FDICA of 1991 amended the DIDMCA of 1980 by introducing risk-based deposit insurance premiums in 1993 to reduce excess risk-taking. FDICA also provided for the implementation of a policy of prompt corrective actions (PCA) that allows regulators to close banks more quickly in cases where insolvency is imminent. Thus, the ill-advised policy of regulatory forbearance should be curbed.
What is the "common bond" membership qualification under which credit unions have been formed and operated? How does this qualification affect the operational objective of a credit union?
In organizing a credit union, members are required to have a common bond of occupation (e.g., police CUs) or association (e.g., university-affiliated CUs), or to cover a well-defined neighborhood, community, or rural district. The common bond policy allows anyone who meets a specific membership requirement to become a member of the credit union. The requirement normally is tied to a place of employment or residence. The primary objective of credit unions is to satisfy the depository and lending needs of their members. Because the common bond policy has been loosely interpreted, implementation has allowed credit union membership and assets to grow at a rate that exceeds similar growth in the commercial banking industry. Since credit unions are mutual organizations where the members are owners, employees essentially use saving deposits to make loans to other employees who need funds. Also, because credit unions are nonprofit organizations, their net income is not taxed and they are not subject to the local investment requirements established under the 1977 Community Reinvestment Act. This tax-exempt status allows CUs to offer higher rates on deposits, and charge lower rates on some types of loans, than do banks and savings institutions.
What factors are given credit for the weak performance of commercial banks in the late 2000s?
In the late 2000s, the U.S. economy experienced its strongest recession since the Great Depression. Commercial banks' performance deteriorated along with the economy. Sharply higher loss provisions and a very rare decline in noninterest income were primarily responsible for the lower industry profits. Things got even worse in 2008. Net income for all of 2008 was $10.2 billion, a decline of $89.8 billion (89.8 percent) from 2007. The ROA for the year was 0.13 percent, the lowest since 1987. Almost one in four institutions (23.6 percent) was unprofitable in 2008, and almost two out of every three institutions (62.8 percent) reported lower full-year earnings than in 2007. Total noninterest income was $25.6 billion (11 percent), lower as a result of the industry's first ever full-year trading loss ($1.8 billion), a $5.8 billion (27.4 percent) decline in securitization income, and a $6.6 billion drop in proceeds from sales of loans, foreclosed properties, and other assets. Net loan and lease charge-offs totaled $38.0 billion in the fourth quarter, an increase of $21.7 billion (132.7 percent) from the fourth quarter of 2007, the highest charge-off rate in the 25 years that institutions have reported quarterly net charge-offs. As the economy improved in the second half of 2009, so did commercial bank performance. While rising loan-loss provisions continued to dominate industry profitability, growth in operating revenues, combined with appreciation in securities values, helped the industry post an aggregate net profit. Noninterest income was $4.0 billion (6.8 percent) higher than 2008 due to net gains on loan sales (up $2.7 billion) and servicing fees (up $1.9 billion). However, the industry was still feeling the effects of the long recession. Provisions for loan and lease losses totaled $62.5 billion, the fourth consecutive quarter that industry provisions had exceeded $60 billion. Net charge-offs continued to rise, for an 11th consecutive quarter.
How has the savings institution industry performed over the last several decades?
Like the commercial banking industry, savings institutions experienced record profits in the mid- to late 1990s as interest rates (and thus the cost of funds to savings institutions) remained low and the U.S. economy (and thus the demand for loans) prospered. The result was an increase in the spread between interest income and interest expense for savings institutions and consequently an increase in net income. In 1999, savings institutions reported $10.7 billion in net income and an annualized ROA of 1.00 percent. Only the $10.8 billion of net income reported in 1998 exceeded these results. However, the downturn in the U.S. economy resulted in a decline in savings institutions' profitability in 2000. Specifically, their ROA and ROE ratios fell slightly in2000 to 0.92 percent and 11.14 percent, respectively, from their 1999 levels. Despite an economic recession, this downturn was short-lived. Both ROA and ROE increased to record levels each year from 2001 through 2003. A flat (and at times even downward sloping) yield curve increased funding costs and contributed to decreased margins in the mid-2000s. The average ROA declined to 1.15 percent in 2005 and 0.99 percent in 2006, while ROE decreased to 10.40 percent in 2005 and 8.68 percent in 2006. In the late 2000s, as the U.S. economy experienced its strongest recession since the Great Depression, savings institutions' performance deteriorated. For all of 2007, net income was $6.0 billion, down $11.1 billion from 2006. The average ROA for the year was 0.13 percent, the lowest yearly average since 1989. In 2008, net income was -$8.6 billion. This was the first negative earnings year since 1991. The ROA for the year was -0.72 percent. However, only 5 savings institutions failed or were assisted during the year. In this group was Washington Mutual the largest savings institution, with over $300 billion in assets. Like commercial banks, as the economy improved in the second half of 2009 through 2018, so did savings institution performance. Savings institutions earned $1.4 billion in net income in the third quarter of 2009, up from -$18.3 million in the second quarter. This trend continued into 2010 as savings institutions earned $8.3 billion for the year, ROA for the industry was 0.65 percent and ROE 5.76 percent up from 0.14 percent and 1.31 percent respectively in 2009. By 2015, the industry ROA was 1.12 percent and ROE was 9.93 percent and in 2018, ROA and ROE increased further to 1.25 and 11.62 percent, respectively.
What are the major uses of funds for commercial banks in the United States? What are the primary risks to a bank caused by each of these? Which of the risks is most critical to the continuing operation of a bank?
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. Each of these types of loans creates credit, and to varying extents, liquidity risks for the banks. The security portfolio normally is a source of liquidity and interest rate risk, especially with the increased use of various types of mortgage-backed securities and structured notes. In certain environments, each of these risks can create operational and performance problems for a bank.
What are the benefits of OBS activities to a bank?
OBS activities generate fee income for banks. The initial benefit is the fee that the bank charges when making the commitment. By moving activities off the balance sheet, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business. At the same time, they can avoid regulatory costs or "taxes" since reserve requirements and deposit insurance premiums are not levied on off-balance-sheet activities. Thus, banks have both earnings and regulatory "tax avoidance" incentives to undertake activities off their balance sheets.
What types of activities are normally classified as off-balance-sheet (OBS) activities?
OBS activities include issuing various types of guarantees (such as letters of credit), which often have a strong insurance underwriting element, and making future commitments to lend. Both services generate additional fee income for banks. Off-balance-sheet activities also involve engaging in derivative transactions—futures, forwards, options, and swaps.
What are the risks of OBS activities to a bank?
Off-balance-sheet activities, however, can involve risks that add to the overall insolvency exposure of an FI. Indeed, at the very heart of the financial crisis were losses associated with off-balance-sheet mortgage-backed securities created and held by FIs. Losses resulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown of the world's financial and economic systems. However, off-balance-sheet activities and instruments have both risk-reducing as well as risk-increasing attributes, and, when used appropriately, they can reduce or hedge an FI's interest rate, credit, and foreign exchange risks.
What happened in 1979 to cause the failure of many savings institutions during the early 1980s? What was the effect of this change on the financial statements of savings associations?
Over the period October 1979 to October 1982, however, the Federal Reserve's restrictive monetary policy action led to a sudden and dramatic surge in interest rates, with rates on T-bills rising as high as 16 percent. This increase in short-term rates and the cost of funds had two effects. First, savings associations faced negative interest spreads or net interest margins in funding much of their fixed-rate long-term residential mortgage portfolios over this period. Second, they had to pay more competitive interest rates on savings deposits to prevent disintermediation and the reinvestment of those funds in money market mutual fund accounts. Their ability to do this was constrained by the Federal Reserve's Regulation Q ceilings, which limited the rates savings associations could pay on traditional passbook savings account and retail time deposits.
Why is the ratio for ROE consistently larger for the large bank group?
ROE is defined as net income divided by total equity, or ROA times the ratio of assets to equity. Because large banks typically operate with less equity per dollar of assets, net income per dollar of equity is larger.
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. an item or activity is an off-balance-sheet asset if, when a contingent event occurs, the item or activity moves onto the asset side of the balance sheet or an income item is realized on the income statement. Conversely, an item or activity is an off-balance-sheet liability if, when a contingent event occurs, the item or activity moves onto the liability side of the balance sheet or an expense item is realized on the income statement.
How do savings banks differ from savings associations? Differentiate in terms of risk, operating performance, balance sheet structure, and regulatory responsibility.
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. Both are regulated at both the state and federal level, with deposits insured by the FDIC's DIF.
Who are the major regulators of commercial banks? Which banks does each agency regulate?
The key regulators are the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Federal Reserve System (FRS), and state bank regulators. Established in 1933, the Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks. In so doing, it levies insurance premiums on banks, manages the deposit insurance fund (which is generated from those premiums and their reinvestment), and conducts bank examinations. In addition, when an insured bank is closed, the FDIC acts as the receiver and liquidator, although the closure decision itself is technically made by the bank's chartering or licensing agency. Because of problems in the thrift industry and the insolvency of the savings association insurance fund (FSLIC) in 1989, the FDIC now manages the insurance fund for both commercial banks and savings associations; the fund is called the Depositors Insurance Fund or DIF.The Office of the Comptroller of the Currency (OCC) is the oldest U.S. bank regulatory agency. Its primary function is to charter so-called national banks as well as to close them. In addition, the OCC examines national banks and has the power to approve or disapprove their merger applications. Instead of seeking a national charter, however, banks can seek to be chartered by 1 of 50 individual state bank regulatory agencies. Historically, state chartered banks have been subject to fewer regulations and restrictions on their activities than national banks. This lack of regulatory oversight was a major reason many banks chose not to be nationally chartered. Many more recent regulations (such as the Depository Institutions Deregulation and Monetary Control Act of 1980) attempted to level the restrictions imposed on federal and state chartered banks. Not all discrepancies, however, were changed and state chartered banks are still generally less heavily regulated than nationally-chartered banks.In addition to being concerned with the conduct of monetary policy, the Federal Reserve, as this country's central bank, also has regulatory power over some banks and, where relevant, their holding company parents. Since 1980, all banks have had to meet the same noninterest-bearing reserve requirements whether they are members of the FRS or not. The primary advantage of FRS membership is direct access to the federal funds wire transfer network for nationwide interbank borrowing and lending of reserves. Finally, many banks are often owned and controlled by parent holding companies—for example, Citigroup is the parent holding company of Citibank (a national bank). Because the holding company's management can influence decisions taken by a bank subsidiary and thus influence its risk exposure, the FRS regulates and examines bank holding companies as well as the banks themselves.
How does the liability maturity structure of a bank's balance sheet compare with the maturity structure of the asset portfolio? What risks are created or intensified by these differences?
The liability structure of bank balance sheets tends to reflect a shorter maturity structure than does the asset portfolio with relatively more liquid instruments, such as deposits and interbank borrowings, used to fund less liquid assets such as loans. Thus, maturity mismatch or interest rate risk and liquidity risk are key exposure concerns for bank managers.
What factors are given credit for the strong performance of commercial banks in the early and mid-2000s?
The lowest interest rates in many decades helped bank performance on both sides of the balance sheet. On the asset side, many consumers continued to refinance homes and purchase new homes, an activity that caused fee income from mortgage lending to increase and remain strong. Meanwhile, the rates banks paid on deposits shrunk to all time lows. The result was an increase in bank spreads and net income In addition, the development and more comfortable use of new financial instruments such as credit derivatives and mortgage-backed securities helped banks ease credit risk off the balance sheets. Finally, information technology has helped banks manage their risk more efficiently.
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. In September 1995 bank holding companies were allowed to acquire banks in other In 1997, banks were allowed to convert out-of-state subsidiaries into branches of a single interstate bank. As a result, consolidations and acquisitions have allowed for the emergence of very large banks with branches across the country
What are the major sources of funds for commercial banks in the United States? How does this differ for small versus large banks?
The primary sources of funds are deposits and borrowed funds. Small banks rely more heavily on the local deposit base (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. The supply of nontransaction deposits is shrinking because of the increased use by small savers of higher-yielding money market mutual funds.
What factors are credited for the significant growth in derivative securities activities by banks?
The primary use of derivative products has been in the areas of interest rate, credit, and foreign exchange risk management. As banks and other financial institutions have pursued the use of these instruments, the international financial markets have responded by extending the variations of the products available to the institutions. However, derivative securities have not grown in significance since the financial crisis. Part of the Wall Street Reform and Consumer Protection Act, passed in 2010 in response to the financial crisis, is the Volker Rule which prohibits U.S. depository institutions (DIs) from engaging in proprietary trading (i.e., trading as a principal for the trading account of the bank). This includes any transaction to purchase or sell derivatives. Thus, only the investment banking arm of the business is allowed to conduct such trading. The Volcker Rule was implemented in April 2014 and banks had until July 21, 2015 to be in compliance. The result was a reduction in derivative securities held off-balance-sheet by these financial institutions. In June 2018, U.S. regulators agreed to simplify the Volker Rule. The changes made it easier for banks to trade for purposes of market making: banks buy, sell and hold as middlemen. The amount of trading done to hedge, or to offset risk, could also grow, i.e., the changes meant that banks would no longer be required to demonstrate how a trade is reducing a specific risk. Nor would traders have to certify their intent on transactions anymore. Further, banks with trading portfolios below $10 billion would receive less scrutiny. As a result, the amount of derivative securities held by banks began to grow: to $219,710.5 billion by September 2018.
How does the asset structure of credit unions compare with the asset structure of commercial banks and savings institutions? Refer to Tables 2-5, 2-9, and 2-12 to formulate your answer.
The relative proportions of all three types of depository institutions are similar, with almost 30 percent of total assets held as investment securities and over 50 percent as loans. Savings institutions' loans are predominantly mortgage related, nonmortgage loans of credit unions are predominantly consumer loans, and commercial banks hold more business loans than either savings institutions or credit unions. On the liability side of the balance sheet, credit unions differ from banks in that they have less reliance on large time deposits and they differ from savings institutions in that they have virtually no borrowings from any source. The primary sources of funds for credit unions are transaction and small time and savings accounts.
How do the asset and liability structures of a savings institution compare with the asset and liability structures of a commercial bank? How do these structural differences affect the risks and operating performance of a savings institution? What is the QTL test?
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. The large amount of longer-term fixed rate assets continues to cause interest rate risk, while the lack of asset diversity exposes the savings institution to credit risk. Savings institutions hold less cash and U.S. Treasury securities than do commercial banks. On the liability side, small time and saving deposits remain as the predominant source of funds for savings institutions, with some reliance on FHLB borrowing. The inability to nurture relationships with the capital markets also creates potential liquidity risk for the savings institution industry. The acronym QTL stands for 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.
What are the three major segments of deposit funding? How are these segments changing over time? Why? What strategic impact do these changes have on the profitable operation of a bank?
The three major segments of deposit funding are transaction accounts, retail savings accounts, and large time deposits. Transaction accounts are checkable deposits that 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. The importance of transaction and retail accounts is shrinking due to the direct investment in money market mutual funds by individual investors. These funds pay a competitive rate of interest based on wholesale money market rates by pooling and investing funds while requiring relatively small-denomination investments by mutual fund investors. The changes in the deposit markets have made theses traditionally low cost sources of funding more expensive and coincide with the efforts to constrain the growth on the asset side of the balance sheet.
How did the two pieces of regulatory legislation─the DIDMCA in 1980 and the DIA in 1982─change the profitability of savings institutions in the early 1980s? What impact did these pieces of legislation ultimately have on the risk posture of the savings institution industry? How did the FSLIC react to this change in operating performance and risk?
The two pieces of legislation expanded the deposit-taking and asset-investment powersof savings associations. The acts allowed savings institutions to offer new deposit accounts, such as NOW accounts and money market deposit accounts, in an effort to reduce the net withdrawal flow of deposits from the institutions. In effect this action was an attempt to reduce the liquidity problem. In addition, savings institutions were allowed to offer adjustable-rate mortgages and a limited amount of commercial and consumer loans in an attempt to improve the profitability performance of the industry. Although many savings institutions were safer, more diversified, and more profitable, the FSLIC did not foreclose many of the savings institutions which were insolvent. Nor did the FSLIC change its policy of assessing higher insurance premiums on companies that remained in high risk categories. Thus, many savings institutions failed, which caused the FSLIC to eventually become insolvent.
What factors normally are given credit for the revitalization of the banking industry during the decade of the 1990s?
With the economic expansion in the U.S. economy and falling interest rates throughout most of the 1990s, U.S. commercial banks flourished for most of that period. In 1999 commercial bank earnings were a record $71.6 billion. More than two-thirds of all U.S. banks reported a return on assets (ROA) of 1 percent or higher, and the average ROA for all banks was 1.31 percent, up from 1.19 percent for the year 1998.
