Commercial Banking Midterm 1

What is the liquidity indicator approach to liquidity management?

The liquidity indicator approach uses financial ratios whose changes over time may reflect the changing liquidity position of the financial institution. Some of the ratios include cash position indicator, liquid securities indicator, net federal funds and repurchase agreements position, capacity ratio, pledged securities ratio, hot money ratio, deposit brokerage index and core deposit ratio, deposit composition ratio and loan commitments ratio. These ratios are used to estimate liquidity needs and to monitor changes in the liquidity position.

When is a financial firm asset sensitive? Liability sensitive?

A financial firm is asset sensitive when it has more interest-rate sensitive assets maturing or subject to repricing during a specific time period than rate-sensitive liabilities. A liability sensitive position, in contrast, would find the financial institution having more interest-rate sensitive deposits and other liabilities than rate-sensitive assets for a particular planning period.

Suppose a corporate bond an investments officer would like to purchase for her bank has a before-tax yield of 8.98 percent and the bank is in the 35 percent federal income tax bracket. What is the bond's after-tax gross yield? What after-tax rate of return must a prospective loan generate to be competitive with the corporate bond? Does a loan have some advantages for a lending institution that a corporate bond would not have?

After-tax gross yield on corporate bond = 8.98 percent × (1 − 0.35) = 5.84 percent. A prospective loan must generate a comparable yield to that of the bond to be competitive. However, granting a loan to a corporation may have the added advantage of bringing in additional service business for the bank that merely purchasing a corporate bond would not do. Also, the management may desire to keep good loan customers, or there can be changes in the state and local government credit quality. In such cases, the bank would probably be willing to accept a lower yield on the loan compared to the bond in anticipation of getting more total revenue from the loan relationship due to the sale of other bank services.

What guidelines should management keep in mind when it manages a financial firm's liquidity position?

It is important for a liquidity manager to: (a) keep track of the activities of all departments within the bank which use or supply funds; (b) know in advance the activities and plans of the bank's largest credit and funds-supplying customers; (c) set clear priorities and objectives in liquidity management; and (d) analyze on a continuing basis so as to react quickly to liquidity deficits and liquidity surpluses. Liquidity managers must know what all departments within the institution are doing because their activities affect the liquidity position and liquidity management decisions. The liquidity manager can make better decisions to profitably invest surplus liquid funds or avoid costly, last-minute borrowings if he or she knows what the bank's principal depositors and creditors will do in advance. By setting clear priorities and objectives, the liquidity manager has a better chance to make sound decisions plus an ability to act quickly to invest surpluses in order to gain maximum income or avoid costly deficits and prolonged borrowings.

Who are banking's chief competitors in the financial-services marketplace?

The closest competitors of banks in recent years (at least in terms of the similarity of their financial statements) are the thrift institutions. These include credit unions and savings associations. If we move a little further away from banks both in terms of what they do and the way their financial statements look, banks also compete with finance companies, life and property/casualty insurance companies, mutual funds, and security brokers and dealers.

How do you measure the dollar interest-sensitive gap? The relative interest-sensitive gap? What is the interest sensitivity ratio?

The dollar interest-sensitive gap is measured by taking the repriceable (interest-sensitive) assets minus the repriceable (interest-sensitive) liabilities over some set planning period. Common planning periods include 3 months, 6 months and 1 year. The relative interest-sensitive gap is the dollar interest-sensitive gap divided by the size of a financial institution (often total assets). The interest-sensitivity ratio is just the ratio of interest-sensitive assets to interest sensitive liabilities. Regardless of which measure you use, the results should be consistent. If you find a positive (negative) gap for dollar interest-sensitive gap, you should also find a positive (negative) relative interest-sensitive gap and an interest sensitivity ratio greater (less) than one.

What is the principal goal of money position management?

The money position management's goal is to ensure that the bank has sufficient legal reserves to meet its reserve requirements at a particular time, as imposed by the law and central bank regulation. For example, in the United States a qualified depository institution must hold the required level of legal reserves in the form of vault cash and, if this is not sufficient, in the form of deposits held in a reserve account at the Federal Reserve bank in the region. Smaller depository institutions and banks, who are not members of the Federal Reserve System, may be granted permission to hold their legal reserve deposits with a Fed-approved institution. The management also makes sure that it holds not more than the minimum legal requirement because excess legal reserves yield no income for the bank.

Other risks

d. Foreign Exchange and Sovereign Risk: the uncertainty that due to fluctuation in currency prices, assets denominated in foreign currencies may fall, forcing the write-down of these assets on its Balance Sheet. e. Off-Balance-Sheet Risk: the probability that the volume of off-balance-sheet commitments far exceeds the volume of conventional assets. f. Operational (Transactional) Risk: the uncertainty regarding a financial firm's earnings due to failures in computer systems, employee misconduct, floods, lightening strikes and other similar events. g. Legal and Compliance Risk: the uncertainty regarding a financial firm's earnings due to actions taken by our legal system or due to a violation of rules and regulations. h. Reputation Risk: the uncertainty due to public opinion or the variability in earnings due to positive or negative publicity about the financial firm. i. Strategic Risk: the uncertainty in earnings due to adverse business decisions, lack of responsiveness to industry changes, and other poor decisions by management. j. Capital Risk: the risk that the value of the assets will decline below the value of the liabilities. All of the other risks listed above can affect earnings and the value of the assets and liabilities and therefore can have an effect on the capital position of the firm.

What is a bank holding company?

A bank holding company is a corporation that holds an ownership interest in at least one bank but does not itself offer banking services. It is also allowed to own nonbank businesses as long as they are related to banking.

How is a financial institution's duration gap determined?

A bank's duration gap is determined by taking the difference between the dollar-weighted duration of a bank's assets portfolio and the dollar-weighted duration of its liabilities. The duration of the bank's assets can be determined by taking a weighted average of the duration of all of the assets in the bank's portfolio. The weight is the dollar amount of a particular type of asset out of the total dollar amount of the assets of the bank. The duration of the liabilities can be determined in a similar manner.

When is a financial institution adequately liquid?

A financial institution is adequately liquid if it has adequate cash available precisely when cash is needed, at a reasonable cost. Management can monitor the cash position over time, and also monitor what is happening to its cost of funds. One indicator of the adequacy of the liquidity position is its cost; a rising interest cost on borrowed funds, or transaction costs of time and money, and opportunity cost in the form of future earnings may reflect greater perceived risk for the borrowing bank as viewed by capital-market investors.

What are sweep accounts? Why have they led to a significant decline in the total legal reserves held at the Federal Reserve banks by depository institutions operating in the United States?v

A sweeps account is a service provided by banks where they sweep money out of accounts that carry reserve requirements (such as demand deposits and other checking accounts) into repurchase agreements, shares in money market funds, and savings accounts which do not carry reserve requirements overnight. This service lowers the bank's overall cost of funds while still allowing the customer access to their deposits for payments. These sweep arrangements account for nearly $500 billion in deposit balances today and therefore have significantly reduced the total reserve requirements of banks.

What is tax swapping? What is portfolio shifting? Give an example of each.

A tax swap involves exchanging one type of investment security for another when it is advantageous to do so in reducing the bank's current or future tax exposure. For example, the bank may sell lower-yielding securities at a loss in order to reduce its current taxable income, while simultaneously purchasing new higher-yielding securities in order to boost future returns on its investment portfolio or to replace taxable securities with tax-exempt securities. Portfolio shifting which involves selling certain securities out of a bank's portfolio, often at a loss, and replacing them with other securities, is usually carried out to gain additional current income, add to future income, or to minimize a bank's current or future tax liability. For example, the bank may shift its holdings of investment securities by selling off selected lower-yielding securities at a loss, and substituting higher-yielding securities in order to offset large amounts of loan income, thereby reducing their tax liability.

What are the principal differences among asset liquidity management, liability management, and balanced liquidity management?

Asset liquidity management is a strategy for meeting liquidity needs, used mainly by smaller financial institutions, that find it a less risky approach to liquidity management. In this strategy, liquid funds are stored in readily marketable assets that can be quickly converted into cash as needed. Liability management involves borrowing enough immediately spendable funds to cover all anticipated demands for liquidity. Borrowing liquidity is the most risky approach to solving liquidity problems because of the volatility of interest rates and the rapidity with which the availability of credit can change, although it carries the highest expected return along with the risk taken. Balanced liquidity management calls for using both asset liquidity management and liability management to cover a bank's liquidity needs. Under a balanced liquidity management strategy, some of the expected demands for liquidity are stored in assets, while other anticipated liquidity needs are backstopped by advance arrangements for lines of credit from potential suppliers of funds.

What do the following terms mean: Asset management? Liability management? Funds management?

Asset management refers to a banking strategy where management has control over the allocation of bank assets but believes the bank's sources of funds (principally deposits) are outside its control. The key decision area for management is not deposits and other borrowings but assets. The financial manager exercises control over the allocation of incoming funds by deciding who is granted loans and what the terms on those loans will be. Liability management is a strategy wherein greater control towards bank liabilities is exercised. This is done mainly by opening up new sources of funding and monitoring the volume, mix and cost of their deposits and non-deposit items. Funds management combines both asset and liability management approaches into a balanced liquidity management strategy. Effective coordination in managing assets and liabilities will help to maximize the spread between revenues and costs and control risk exposure.

Bacone National Bank has structured its investment portfolio, which extends out to four-year maturities, so that it holds about $11 million each in one-year, two-year, three-year, and four-year securities. In contrast, Dunham National Bank and Trust holds $36 million in one- and two-year securities and about $30 million in 8- to 10-year maturities. What maturity strategy is each bank following? Why do you believe that each of these banks has adopted the particular strategy it has as reflected in the maturity structure of its portfolio?

Bacone National Bank has structured its investment portfolio to include $11 million equally in each of four one-year maturity intervals. This is clearly a spaced-maturity or ladder policy. In contrast, Dunham National Bank holds $36 million in one and two-year securities and about $30 million in 8- and 10-year maturities, which is clearly a barbell strategy. Dunham National Bank pursues its strategy to provide both liquidity (from the short maturities) and high income (from the long maturities), while Bacone National is a small bank that needs less income fluctuations and a simple-to-execute strategy.

What are the principal money market and capital market instruments available to institutions today? What are their most important characteristics?

Banks purchase a wide range of investment securities. The principal money market instruments available to banks today are Treasury bills, short-term Treasury notes and bonds, federal agency securities, certificates of deposits issued by other depository institutions, international Eurocurrency deposits, bankers' acceptances, commercial paper, and short-term municipal obligations. The common characteristics of most these instruments are their safety and high marketability. Capital market instruments available to banks include U.S. Treasury notes and bonds, municipal notes and bonds, and corporate notes and bonds. The characteristics of these securities are their higher expected rate of return and capital gains potential.

Commerce National Bank reports interest-sensitive assets of $870 million andinterest-sensitive liabilities of $625 million during the coming month. Is the bank asset sensitive or liability sensitive? What is likely to happen to the bank's net interest margin if interest rates rise? If they fall?

Because interest-sensitive assets are larger than liabilities by $245 million, the bank is asset sensitive. If interest rates rise, the bank's net interest margin should rise as asset revenues increase more than the resulting increase in liability costs. On the other hand, if interest rates fall, the bank's net interest margin will fall as asset revenues decline faster than liability costs.

What is it that a lending institution wishes to protect from adverse movements in interest rates?

Changes in market interest rates can damage a financial firm's profitability by increasing its cost of funds, by lowering its returns from earning assets and by reducing the value of the owners' investment. Therefore, a financial institution wishes to protect both the value of assets and liabilities, and the revenues and costs generated by both assets and liabilities from adverse movements in interest rates.

What types of investment securities do banks seem to prefer the most? Can you explain why?

Commercial banks clearly prefer these major types of investment securities: U. S government obligations, federal agency securities, and state and local government obligations, and asset-backed securities. They also hold small amounts of equities and other domestic and foreign debt securities (mainly corporate notes and bonds). They pick these types because they are best suited to meet the objectives of a bank's investment portfolio, such as a comparatively high yield, tax sheltering, reducing overall risk exposure, a source of liquidity, and generating income as well as diversifying their assets.

What are clearing balances? Of what benefit can clearing balances be to a depository that uses the Federal Reserve System's check-clearing network?

Depository institutions, along with holding a legal reserve account, also hold a clearing balance with the Fed to cover any checks or other debit items drawn against them. Any institution using the Federal Reserve check clearing system has to maintain a minimum balance with the Federal Reserve. The amount is determined by an agreement between the institution and its district Federal Reserve bank. The clearing balance can be a benefit because the institution earns credits from holding this balance with the Fed and this credit can be used to pay the fees the Fed charges for services.

Duration

Duration is a value- and time-weighted measure of maturity that considers the timing of all cash inflows from earning assets and all cash outflows associated with liabilities. It measures the average maturity of a promised stream of future cash payments. It is a direct measure of price risk.

Exactly how is a depository institution's legal reserve requirement determined?

Each reservable liability item is multiplied by the stipulated reserve requirement percentage set by the Federal Reserve Board to derive the bank's total legal reserve requirements. Thus, total required legal reserves is computed as follows: Reserve requirement on transaction deposits × Daily average amount of net transaction deposits over the computation period + Reserve requirement on nontransaction reservable liabilities × Daily average amount of nontransaction reservable liabilities over the computation periodCurrently nontransaction liabilities have a reserve requirement of zero. Once a depository institution determines its required reserve amount, it compares that figure to its actual daily average holdings of legal reserves. If total legal reserves held are greater than required reserves, the depository institution has excess reserves. Normally management of the financial firm will move quickly to invest any excess reserves to earn additional income. On the other hand, if it is determined that the institution has a reserve deficit, law and regulation normally require the institution to cover this deficit by acquiring additional legal reserves.

Why do financial firms face significant liquidity management problems?

Financial institutions are prone to liquidity management problems due to: (1) A maturity mismatch situation in which most depository institutions hold an unusually high proportion of liabilities subject to immediate payment, especially demand (checkable) deposits and money market borrowings. Whereas, they use these funds to make long-term credit available to their borrowing customers. The institution faces an imbalance between the maturity dates attached to their assets and the maturity dates of their liabilities. (2) The sensitivity of changes to their assets and liabilities values towards market interest-rate movements. When interest rates rise, some customers will withdraw their funds in search of higher returns elsewhere. Many loan customers may postpone new loan requests or speed up their drawings on those credit lines that carry lower interest rates. Thus, changing market interest rates affect both customer demand for deposits and customer demand for loans, each of which has a potent impact on a depository institution's liquidity position. (3) Their central role in the payments process is that financial firms must give high priority to meeting demands for liquidity. To fail in this area may severely damage public confidence in the institution.

How is the expected yield on most bonds determined?

For most bonds, determining the expected yield requires the calculation of the yield to maturity (YTM), if the bond is to be held to maturity or the planned holding period yield (HPY) between point of purchase and point of sale. YTM determines the yield on a bond that equalizes the market price of the bond with its expected stream of cash flows. However, many financial firms frequently do not hold all their investments to maturity. Some must be sold off early to accommodate new loan demand or to cover deposit withdrawals. To deal with this situation, the investments officer needs to calculate the holding period yield (HPY). The HPY is simply the rate of return (discount factor) that equates a security's purchase price with the stream of income expected until it is sold to another investor.

Peoples' Savings Bank has a cumulative gap for the coming year of + $135 million, and interest rates are expected to fall by two and a half percentage points. Can you calculate the expected change in net interest income that this thrift institution might experience? What change will occur in net interest income if interest rates rise by one and a quarter percentage points?

For the decrease in interest rates: Expected Change in Net Interest Income = $135 million × ( − 0.025) = − $3.38 million The net interest income will decrease by $3.38 million. For the increase in interest rates: Expected Change in Net Interest Income = $135 million × ( + 0.0125) = + $1.69 million The net interest income will increase by $1.69 million.

Can you explain the concept of gap management?

Gap management requires the management to perform analysis of the maturities and repricing opportunities associated with interest-bearing assets and with interest-bearing liabilities. When more assets are subject to repricing or will reach maturity in a given period than liabilities or vice versa, the bank has a gap between assets and liabilities and is exposed to loss from adverse interest-rate movements based on the gap's size and direction. If an organization is over exposed to interest rate fluctuation, the management will try and match the volume of assets that can be repriced, with the volume of liabilities.

What factors affect a financial-service institution's decision regarding the different maturities of securities it should hold?

In choosing among various maturities of short-term and long-term securities to hold, the financial institution needs to carefully consider the use of two key maturity management tools—the yield curve and duration. These two tools help management understand more fully the consequences and potential impact on earnings and risk of any particular maturity mix of securities they choose.

How has the tax exposure of various U.S. bank security investments changed in recent years?

In recent years, the government has treated interest income and capital gains from most bank investments as ordinary income for tax purposes. In the past, only interest was treated as ordinary income and capital gains were taxed at a lower rate. Tax reform in the United States has also had a major impact on the relative attractiveness of state and local government bonds due to declining tax advantages, lower corporate tax rates and fewer qualified tax-exempt securities.

What steps are needed to carry out the structure of funds approach to liquidity management?

In the first step, the institution's deposits and other funds sources are divided into categories based upon their estimated probability of being withdrawn. We can divide a bank's deposit and nondeposit liabilities into three categories. (1) "Hot money" liabilities refer to deposits and other borrowed funds that are very interest sensitive or that management is sure will be withdrawn during the current period. (2) Vulnerable funds refer to customer deposits of which a substantial portion will probably be withdrawn sometime during the current time period. (3) Stable funds are those funds that the management considers unlikely to be removed. In the second step, the liquidity manager must set aside liquid funds according to some desired operating rules. This liquidity reserve might consist of holdings of immediately spendable deposits in correspondent institutions plus investments in Treasury bills and repurchase agreements where the committed funds can be recovered in a matter of minutes or hours.

What forces cause interest rates to change? What kinds of risk do financial firms face when interest rates change?

Interest rates are determined, not by individual banks, but by the collective borrowing and lending decisions of thousands of participants in the money and capital markets. They are also impacted by changing perceptions of risk by participants in the money and capital markets, especially the risk of borrower default, liquidity risk, price risk, reinvestment risk, inflation risk, term or maturity risk, marketability risk, and call risk. Financial institutions can lose income or value no matter which way interest rates go. As market interest rates move, financial firms typically face at least two major kinds of interest rate risk—price risk and reinvestment risk. Price risk arises when market interest rates rise. Rising interest rates can lead to losses on security instruments and on fixed-rate loans as the market values of these instruments fall. Rising interest rates will also cause a loss to income if an institution has more rate-sensitive liabilities than rate-sensitive assets. Reinvestment risk rears its head when market interest rates fall. Falling interest rates will usually result in capital gains on fixed-rate securities and loans but an institution will lose income if it has more rate-sensitive assets than liabilities. Also, financial firms will be forced to invest incoming funds in lower-yielding earning assets, lowering their expected future income. A big part of managing assets and liabilities consists of finding ways to deal effectively with these two forms of risk.

What makes it so difficult to correctly forecast interest rate changes?

Interest rates cannot be set by an individual bank or even by a group of banks. They are determined by thousands of investors trading in the credit markets. Moreover, each market rate of interest has multiple components—the risk-free real interest rate plus various risk premiums. A change in any of these rate components can cause interest rates to change. This makes it virtually impossible to accurately forecast interest rate changes. To consistently forecast market interest rates correctly would require bankers to correctly anticipate changes in the risk-free real interest rate and in all rate components. Another important factor is the timing of the changes. To be able to take full advantage of their predictions, they also need to know when the changes will take place.

What are the advantages of using duration as an asset-liability management tool as opposed to interest-sensitive gap analysis?

Interest-sensitive gap only looks at the impact of changes in interest rates on the bank's net income. It does not take into account the effect of interest rate changes on the market value of the bank's equity capital position. Whereas, duration provides a single number which tells the bank their overall exposure to interest rate risk. Duration can be used for hedging against the interest rate risk, and it can also measure the sensitivity of the market value of financial instruments to changes in interest rates.

What key roles do investments play in the management of a depository institution?

Investment security portfolios perform many different roles that act as a necessary complement to the advantages loans provide. They help stabilize income when loan revenues fall. Investment in high-quality securities can be purchased and held to balance out the risk from loans. Investment in securities allow the bank or thrift institution to diversify into different localities than most of its loans permit, provide additional liquid reserves in case more cash is needed, provide collateral as called for by law and regulation to back government deposits. Security investments aid banks in reducing their exposure to taxes, and also help hedge against losses due to changing interest rates. Investment securities, unlike many loans, can be bought or sold quickly to restructure assets, hence providing flexibility to the banks. Over and above, the bank managers can also dress up the balance sheet and make a financial institution look financially stronger due to the high quality of many marketable securities.

What is money position management?

Money position management is the management of a financial institution's liquidity position that requires quick decisions which may have long-run consequences on profitability. Most large depository institutions have designated an officer of the firm as money position manager. A money position manager is responsible for ensuring that the institution maintains an adequate level of legal reserves. Legal reserve requirements apply to all qualified depository institutions, including commercial and savings banks, savings and loan associations, credit unions, and agencies and branches of foreign banks that offer transaction deposits or nonpersonal (business) time deposits or borrow through Eurocurrency liabilities.

How can the discipline of the marketplace be used as a guide for making liquidity management decisions?

No financial institution can tell for sure if it has sufficient liquidity until it has passed the market's test. Specifically, management should look at these signals: public confidence, stock price behavior, risk premiums on CDs and other borrowings, loss sales of assets, meeting commitments to credit customers, and borrowings from the Federal Reserve banks. If problems exist in any of these areas, management needs to take a close look at its liquidity management practices to determine whether changes are needed.

Why do depository institutions face pledging requirements when they accept government deposits?

Pledging requirements are in place to safeguard the deposit of public funds. At least the first $100,000 of public deposits is covered by federal deposit insurance; the rest must be backed up by bank holdings of U.S. Treasury and federal agency securities valued at their par values.

What are securitized assets? Why have they grown so rapidly in recent years?

Securitized assets are loans that are placed in a pool and, as the loans generate interest and principal income, that income is passed on to the holders of securities representing an interest in the loan pool. These loan-backed securities are attractive to many banks because of their higher yields. Also, guarantees are received from government agencies (in the case of most home-mortgage-backed securities) or from private institutions such as banks or insurance companies pledging to back credit card loans. The loan-backed securities are also attractive because of their relatively high liquidity and marketability of securities backed by loans compared to the liquidity and marketability of loans themselves.

What special risks do securitized assets present to institutions investing in them?

Securitized assets often carry substantial prepayment risk, which arises when certain loans in the securitized-asset pool are paid off early by the borrowers (usually because interest rates have fallen and new loans can be substituted for the old loans at cheaper loan rates). Prepayment risk can significantly decrease the values of securities backed by loans and change their effective maturities, thus making the holder of the security receive diminished income. Also, a substantial weakness among these securitized assets is that, there can be a sharp deterioration in the underlying assets' (loans) market values when they experience a significant rise in default rates.

What factors should a money position manager consider in meeting a deficit in a depository institution's legal reserve account?

Some such factors are receiving more deposited checks in the institutions favor than checks drawn against it, receiving deposits made by the U.S. Treasury into a tax and loan account held at the bank, receiving credit from the Federal Reserve bank for checks previously sent for collection, and receiving credit from cash letters sent to the Fed, listing drafts received by the bank can help the depository institution in meeting a deficit. However, these are essentially noncontrollable, and management needs to anticipate and react quickly to them. Some of the controllable factors for increasing the legal reserves are selling securities, receiving interest payments on securities, borrowing reserves from the Federal Reserve Bank, purchasing Federal funds from other banks, selling securities under a repurchase agreement, and selling new CDs, Eurocurrency deposits, or other deposits to customers.

What are structured notes and stripped securities? What unusual features do they contain?

Structured notes usually are packaged investments, such as pools of federal agency securities, assembled by security dealers that offer customers flexible yields in order to protect their customers' investments against losses due to changing interest rates. Interest yield on such notes could be reset periodically based on a reference interest rate, such as a U.S. Treasury bond rate. Stripped securities represent a claim against either the principal or interest payments associated with a debt security. The expected cash flow from a Treasury note, Treasury bond or mortgage-backed security is separated into a stream of principal payments and a stream of interest payments, each of which may be sold as a separate security maturing on the day the payment is due. In particular, stripped securities offer interest-rate hedging possibilities to help protect an investment portfolio against loss from interest-rate changes.

What are the principal sources from which the supply of liquidity comes?

Supplies of funds stem principally from incoming deposits, sales of assets, particularly marketable securities, and repayments of outstanding loans. Liquidity also comes from the sale of nondeposit services and borrowings from the money market.

What forms of risk affect investments?

The following forms of risk affect investments: a. interest rate risk, b. credit or default risk, c. business risk, d. liquidity risk, e. prepayment risk, f. call risk, and g. inflation risk. Interest-rate risk captures the sensitivity of the value of investments to interest-rate movements while credit risk reflects the risk that the security issuer may default on either interest or principal payments. Business risk refers to the impact of credit conditions and the economy, where delinquent loans may rise as borrowers struggle to generate enough cash flow to pay the lender. Liquidity risk focuses on the price stability and marketability of investments. Prepayment risk is specific to certain types of investments and focuses on the fact that some loans, which the securities are based on, can be paid off early. Call risk refers to the early retirement of some government and corporate securities and inflation risk refers to the possible loss of purchasing power of interest income and repaid principal from a security or a loan.

Goal of hedging

The goal of hedging in banking is to freeze the spread between asset returns and liability costs and to offset declining values on certain assets by profitable transactions so that a target rate of return is assured.

What are the principal sources of liquidity demand for a financial firm?

The most pressing demands for liquidity arise principally from customers withdrawing money from their deposit accounts and credit requests from customers the institution wishes to keep, either in the form of new loan requests or drawings upon existing credit lines. However, demands for liquidity can also come from paying off previous borrowings, operating expenses. and payment of income taxes. The demand may also arise from payment of cash dividends to stockholders.

What factors have motivated financial institutions to develop funds management techniques in recent years?

The necessity to find new sources of funds in the 1970s and the risk management problems encountered with troubled loans and volatile interest rates in the 1970s and 1980s led to the concept of planning and control over both sides of a bank's balance sheet—the essence of funds management. The maturing of liability management techniques, coupled with more volatile interest rates and greater risk, eventually gave birth to the funds management approach.

Why do banks and other institutions choose to devote a significant portion of their assets to investment securities?

The primary function of most banks and other depository institutions is not to buy and sell bonds, but rather to make loans to businesses and individuals. After all, loans support business investment and consumer spending in local communities and provide jobs and income to thousands of community residents. However, many loans are illiquid—they cannot easily be sold or securitized prior to maturity. And loans are among the riskiest assets, generally carrying the highest customer default rates of any form of credit. Also, loan income is usually taxable for banks and selected other financial institutions, necessitating the search for tax shelters in years when earnings from loans are high. For all these reasons depository institutions, have devoted a significant portion of their asset portfolios—usually somewhere between a fifth to a third of all assets—to another major category of earning asset: investments in securities that are under the management of investments officers. These instruments typically include government bonds and notes; corporate bonds, notes, and commercial paper; asset-backed securities arising from lending activity; domestic and Eurocurrency deposits; and certain kinds of common and preferred stock permitted by law.

What impact has recent financial reform legislation had on raising short-term cash?

The recent passage of FINREG—the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2009 have increased the raising of short-term cash. This extensive legislation removed the long-standing prohibition against banks paying interest on commercial checking accounts which had stood for about 75 years. Recent research has suggested quite that banks benefit by granting interest on business deposits. Now bankers can compete for corporate deposits and more easily attract capital, which was going abroad more often than not, and bring cash accounts back to their home offices inside the United States.

How does the sources and uses of funds approach help a manager estimate a financial institution's need for liquidity?

The sources and uses of funds approach estimates future deposit inflows and estimated outflows of funds associated with expected loan demand and calculates the net difference between these items in each planning period. When sources and uses of liquidity do not match, there is a liquidity gap, measured by the size of the difference between sources and uses of funds. When sources of liquidity (for example, increasing deposits or decreasing loans) exceed uses of liquidity (for example, decreasing deposits or increasing loans) then the financial firm will have a positive liquidity gap (surplus). Its surplus liquid funds must be quickly invested in earning assets until they are needed to cover future cash needs. On the other hand, when uses exceed sources, a financial institution faces a negative liquidity gap (deficit). It now must raise funds from the cheapest and most timely sources available. Management can now begin planning, first evaluating the bank's stock of liquid assets to see which assets are likely to be available and then determining if adequate sources of borrowed funds are likely to be available.

What is the yield curve, and why is it important to know about its shape or slope?

The yield curve is the graphic picture of how interest rates vary with different maturities of loans viewed at a single point in time (and assuming that all other factors, such as credit risk, are held constant). The slope of the yield curve determines the spread between long-term and short-term interest rates. In banking most of the long-term rates apply to loans and securities (i.e., bank assets) and most of the short-term interest rates are attached to bank deposits and money market borrowings (i.e., bank liabilities). If the yield curve is upward sloping, then revenues from longer-term assets will outstrip expenses from shorter term liabilities. The result will normally be a positive net interest margin (interest revenues greater than interest expenses), which tends to generate higher earnings. In contrast, a relatively flat (horizontal) or negatively sloped yield curve often generates a small or even negative net interest margin, putting downward pressure on the earnings of financial firms that borrow short and lend long. Thus, the shape or slope of the yield curve has a profound influence on a bank's net interest margin or spread between asset revenues and liability costs.

What items on a bank's balance sheet and income statement can be used to measure its risk exposure? To what other financial institutions do these risk measures seem to apply?

There are several alternative measures of risk in banking and financial service firms. Capital risk is often measured by bank capital ratios, such as the ratio of total capital to total assets or total capital to risk assets. Credit risk can be tracked by such ratios as net loan losses to total loans or relative to total capital. Liquidity risk can be followed by using such ratios as cash assets and government securities to total assets or by purchased funds to total assets. Interest-rate risk may be indicated by such ratios as interest-sensitive assets to interest-sensitive liabilities or the ratio of money-market assets to money-market borrowings. These risk measures also apply to those nonbank financial institutions that are private, profit making corporations, including stockholder-owned thrift institutions, insurance companies, finance and credit card companies, security broker and dealer firms, mutual funds, and hedge funds.

What are the principal limitations of duration gap analysis? Can you think of some way of reducing the impact of these limitations?

There are several limitations with duration gap analysis. It is often difficult to find assets and liabilities of the same duration to fit into the financial-service institution's portfolio. In addition, some accounts such as deposits and others don't have well defined patterns of cash flows which make it difficult to calculate duration for these accounts. Duration gap models assume that a linear relationship exists between the market values (prices) of assets and liabilities and interest rates, which is not strictly true. Finally, duration analysis works best when interest rate changes are small and short and long term interest rates change by the same amount. If this is not true, duration analysis is not as accurate. Recent research suggests that duration balancing can still be effective, even with moderate violations of the technique's underlying assumptions. In this age of mergers and continuing financial-services industry consolidation, the duration gap concept remains a valuable managerial tool despite its limitations.

What are unit banks?

Unit banks offer their full menu of services from only one office (i.e., there aren't any branches). Although, they may operate any number of drive-in windows, and automated teller machines that are linked to the bank's computer system.

Explain the concept of weighted interest-sensitive gap. How can this concept aid management in measuring a financial institution's real interest-sensitive gap risk exposure?

Weighted interest-sensitive gap is based on the idea that not all interest rates change at the same speed and magnitude. Some are more sensitive than others. Interest rates on bank assets may change more slowly than interest rates on liabilities and both of these may change at a different speed and amount than those interest rates determined in the open market. In the weighted interest-sensitive gap methodology, all interest-sensitive assets and liabilities are given a weight based on their speed and magnitude (sensitivity) relative to some market interest rate. Fed Fund's loans, for example, have an interest rate which is determined in the market and which would have a weight of 1. All other loans, investments and deposits would have a weight based on their sensitivity relative to the Fed Fund's rate. To determine the interest-sensitive gap, the dollar amount of each type of asset or liability would be multiplied by its weight and added to the rest of the interest-sensitive assets or liabilities. Once the weighted total of the assets and liabilities is determined, a weighted interest-sensitive gap can be determined by subtracting the interest-sensitive liabilities from the interest-sensitive assets. This weighted interest-sensitive gap should be more accurate than the unweighted interest-sensitive gap. The interest-sensitive gap may change from negative to positive or vice versa and may change significantly the interest rate strategy pursued by the bank.

What types of securities are used to meet collateralization requirements?

When a bank borrows from the discount window of its district Federal Reserve Bank, it must pledge either federal government securities or other collateral acceptable to the Fed. Typically, banks will use U.S. Treasury and federal securities to meet these collateral requirements. Some municipal bonds (provided they are at least A-rated) can also be used to secure the federal government's deposits in depository institutions. If the bank raises funds through repurchase agreements (RPs), banks must pledge securities, typically U.S. Treasury and federal agency issues, as collateral in order to borrow at the low RP interest rate.

How can the yield curve and duration help an investments officer choose which securities to acquire or sell?

Yield curves possibly provide a forecast of the future course of short-term rates, telling us what the current average expectation is in the market. The yield curve also provides an indication of equilibrium yields at varying maturities and, therefore, gives an indication if there are any significantly underpriced or overpriced securities. Finally, the yield curve's shape gives the bank's investment officer a measure of the yield trade-off—how much yield can be earned replacing shorter-term securities with longer-term issues, or vice versa. Duration tells a bank about the price volatility of its earning assets and liabilities due to changes in interest rates. Higher values of duration imply greater risk to the value of assets and liabilities held by a bank. For example, a loan or security with a duration of 4 years stands to lose twice as much in terms of value for the same change in interest rates as a loan or security with a duration of 2 years.

How can you tell if you are fully hedged using duration gap analysis?

You are fully hedged when the dollar weighted duration of the assets portfolio of the bank equals the dollar weighted duration of the liability portfolio. This means that the bank has a zero duration gap position when it is fully hedged. Of course, because the bank usually has more assets than liabilities the duration of the liabilities needs to be adjusted by the ratio of total liabilities to total assets to be entirely correct.

What maturity strategies do financial firms employ in managing their portfolios?

n choosing the maturity distribution of securities to be held in the financial firm's investment portfolio one of the following strategies typically is chosen by most institutions: a. The Ladder, or Spaced-Maturity, Policy b. The Front-End Load Maturity Policy c. The Back-End Load Maturity Policy d. The Barbell Strategy e. The Rate Expectations Approach The ladder or spaced-maturity strategy involves equally spacing out a bank's security holdings over its preferred maturity range to stabilize investment earnings. The front-end load maturity strategy implies that a bank will pile up its security holdings into the shortest maturities to have maximum liquidity and minimize the risk of loss due to rising interest rates. The back-end loaded maturity policy calls for placing all security holdings at the long-term end of the maturity spectrum to maximize potential gains if interest rates fall and to earn the highest average yields. The barbell strategy places a portion of the bank's security holdings at the short-end of the maturity spectrum and the rest at the longest maturities, thus providing both liquidity and maximum income potential. Finally, the rate expectations approach, the most aggressive of all maturity strategies, calls for shifting maturities toward the short end if rates are expected to rise and toward the long-end of the maturity scale if interest rates are expected to fall.

Net interest income

net interest income = total interest income - total interest expense

interest-rate risk

the possibility or probability that the interest rates will change, subjecting the bank to incur a lower margin of profit or a lower value for the firm's capital

Net loans and leases

net loans and leases = gross loans and leases - reserve/allowance for loan and lease losses

price risk

the probability or possibility that the value of bond portfolios and stockholders' equity may decline due to market prices movement against the financial firm

Liquidity risk

the probability that the bank will not have sufficient cash on hand in the volume needed precisely when cash demands arise

market risk

the probability that the market value of assets held by the bank will decline due to falling market prices. Market risk is composed of both price risk and interest rate risk.

Which financial-service firms are regulated primarily at the federal level and which at the state level? Can you see problems in this type of regulatory structure?

-Federal Credit Unions: They are supervised and examined by the National Credit Union Administration (NCUA). -Savings and Loans and Savings Banks ("Thrifts"): State-chartered associations are supervised and examined by state boards or commissions, whereas federally chartered savings associations fall under the jurisdiction of the Office of the Comptroller of the Currency (OCC), after the Dodd-Frank Regulatory Reform Act was passed in 2010. -Money Market Funds: They are regulated at a federal-level by the Securities and Exchange Commission. -Life and Property/Casualty Insurance Companies: State insurance commissions generally regulate the insurance companies with regard to the types of insurance policies sold, maximum premium rates, and etc. They are also federally regulated by the Securities and Exchange Commission with regard to the equity or debt securities sold by these companies. -Finance Companies: These businesses and consumer lenders have been regulated at the state government level for the types and contents of loan agreements offered, the interest rates charged, and the recovery procedures adopted. -Mutual Funds: These face close scrutiny from both federal and state regulation. The SEC also requires these businesses to register, submit periodic financial reports, and provide investors with a prospectus that reveals the financial condition, recent performance, and objectives of each fund. -Security Brokers and Dealers and Investment Banks: These are regulated at both federal and state levels. The chief federal regulator is the SEC and requires the firms to submit periodic reports, limits the volume of debt they take on, and investigates insider trading practices. -Hedge Funds, Private Equity Funds, and Venture Capital Companies: These face almost no kind of regulation, but the SEC does oversee the information these firms provide to the public. Some regulators and experts are concerned because they feel that state regulators might not have the expertise to deal with the new more complex financial firm that exists today. They are also concerned because the new 'functional' regulation is not necessarily coordinated between different regulatory agencies. Only time will tell if this functional regulatory structure is effective.

What are the reasons for regulating each of the key areas or functions of a bank?

-These areas are regulated, first of all, to primarily protect the safety of the depositors' funds so that the public has some assurance that its savings and transactions balances are secure. Thus, bank failure is viewed as something to be minimized. -There is also a concern for maintaining competition and for ensuring that the public has reasonable and fair access to banking services, especially credit and deposit services. -Banks and their closest competitors are also regulated because they provide individuals and businesses with loans that support consumption and investment spending. -The fact that governments rely upon banks to assist in conducting economic policy, in collecting taxes, and in dispensing government payments is also one of the reasons for regulation.

NOW account

A NOW account combines features of a savings account and a checking account, while a money market deposit account (MMDA) encompasses transactional powers similar to a regular checking account (though usually with limitations on the number of checks or drafts that may be written against the account) but also resembles a time deposit with an interest rate fixed for a brief period (such as weekly) but then becomes changeable over longer periods to reflect current market conditions.

What is a bank? How does a bank differ from most other financial-service providers?

A bank can be defined by what economic functions it performs, what services it offers its customers, or the legal basis for its existence. Historically, banks have been offering a great range of financial services such as checking and debit accounts, credit cards, and savings plans. However, banks today are expanding their service offerings to include investment banking, insurance protection, financial planning, advisory service for merging companies, risk-management services, and numerous other innovative products. Other financial service providers offer some of the similar financial services offered by a bank but not all of them within one institution. Although, many financial-service institutions are trying to be as similar to banks as possible in the services they offer. Not only financial service industries but several industrial companies have stepped forward in recent decades to control a bank or a bank-like form.

What factors influence the stock price of a financial-service corporation?

A bank's stock price is affected by all those factors affecting its profitability and risk exposure, particularly its rate of return on equity capital and risk to shareholder earnings. Research evidence over the years has found that the stock prices of financial institutions is sensitive to changes in market interest rates, currency exchange rates, and the strength or weakness of the economy. A bank can raise its stock price by working to achieve policies that increase future earnings, reduce risk, or pursue a combination of both actions.

What is a branch banking organization?

A branch banking organization sells its full menu of services through several locations, including a head office and one or more full-service branch offices. Regardless of its number of offices, it is one corporation with one board of directors. However, each office has its own management team with limited authority to make decisions on customer loan applications and other facts of daily operation. Most such organizations also offer limited services drive-in windows, ATMs, point-of-sale terminals, the Internet, and other advanced communications systems.

What is a financial department store? A universal bank? Why do you think these institutions have become so important in the modern financial system?

A financial department store is an institution where banking, insurance, and security brokerage services are unified under one roof. This recent trend to unify banking, insurance, and security brokerage services is often referred to as universal banking. The impressive array of services offered and the service delivery channels used by modern financial institutions have added up to greater convenience for their customers, possibly meeting all their financial-service needs at one location.

What is a primary dealer, and why are they important?

A primary dealer is a dealer in U.S. Treasury Bills and other securities that meets the Federal Reserve System requirements for trading directly with the Fed's trading desk inside the New York Federal Reserve. It is through these trades with primary dealers that the Federal Reserve carries out its monetary policy objectives and influences the economy including the supply of money, credit, and interest rates.

Of what benefit is agency theory in helping us understand the consequences of changing control of a financial-services firm? How can control by management as opposed to control by stockholders affect the behavior and performance of a financial-services provider?

Agency theory analyzes the relationship between a firm's owner (shareholder) and its managers (agents). It explores whether there is a mechanism to compel managers to act in the best interest and maximize the welfare of the firm's owners. Owners do not have access to all the information and cannot fully evaluate the performance of a manager. One way to reduce costs from agency problems is, to develop better systems for monitoring the behavior of managers and to put in place stronger incentives for managers to follow the wishes of owners. Another way to accomplish this is by tying management salaries more closely to the firm's performance or giving management access to valuable benefits (such as stock options). However, recent events suggest these steps may also encourage managers to take on greater risk.

How is the structure of the nonbank financial-services industry changing? How do the organizational and structural changes occurring today among nonbank financial-service firms parallel those experienced by the banking industry?

Almost all of banking's top competitors are experiencing the same changes as banks. For example, consolidation and convergence are occurring at a rapid pace. Generally, nonbank firms have experienced the same dynamic structural and organizational revolution as banks and for many of the same reasons. Intensifying competition, a widening gulf between the smallest and largest firms, and greater exposure to the risks associated with more cumbersome organizations striving to compete in a globally integrated financial marketplace, are some of the major outcomes occurring in the industry.

How would you describe the size distribution of American banks and the concentration of industry assets inside the United States? What is happening in general to the size distribution and concentration of banks in the United States and in other industrialized nations and why?

Although the largest banks in the United States make up only 7.52 percent of all FDIC insured banks, they control almost 89.43 percent of all the industry's assets. Whereas, the smallest FDIC insured banks in the U.S. account for 36.94 percent of the total banks, but they control only 1.19 percent of the industry's assets. This development is a result of the strong trend towards consolidation and convergence in the industry not only in the United States, but also globally and can be explained by the increasing competitive pressures in the industry and the economies of scale that prevail in banking.

Which businesses are banking's closest and toughest competitors? What services do they offer that compete directly with banks' services?

Among a bank's closest competitors are savings associations, credit unions, fringe banks, money market funds, mutual funds, hedge funds, security brokers and dealers, investment banks, finance companies, financial holding companies, and life and property/casualty insurance companies. All of these financial service providers are converging and embracing each other's innovations. The Financial Service Modernization Act has allowed many of these financial service providers to offer the public one-stop shopping for financial services.

What key areas or functions of a bank or other financial firm are regulated today?

Among the most important areas of banking subject to regulation are the adequacy of a bank's capital, the quality of its loans and security investments, its liquidity position, fund-raising options, services offered, and its ability to expand through branching and the formation of holding companies.

What services does the Federal Reserve provide to depository institutions?

Among the most important services provided by the Fed are checking clearing, the wiring of funds, shipments of currency and coin, safekeeping securities of depository institutions and their customers, issuing new securities from the U.S. Treasury and selected other federal agencies, loans from the Reserve banks to qualified depository institutions, and the supplying of information concerning economic and financial trends and issues. The Fed began charging for its services in order to help recover the added costs of deregulation which made more institutions eligible for Federal Reserve services and also to encourage the private marketplace to develop and offer similar services (such as check clearing and wire transfers).

Can you see any advantages to allowing interstate banking? What about potential disadvantages?

As far as problems are concerned, interstate banking threatens to increase the concentration of banking resources in the U.S., especially among larger banks in various regions of the nation. Increased concentration possibly could lead to higher prices and less service if the antitrust laws are not fully enforced. On the other hand, recent studies suggest that interstate mergers generate positive abnormal returns on bank stock. In addition, these banks are not tied to one local economic area and appear to be less subject to failure. Interstate expansion may also bring greater stability by allowing individual banking organizations to further diversify their operations across different markets, offsetting losses that may arise in one market with gains in other markets.

How have banking and the financial-services market changed in recent years? What powerful forces are shaping financial markets and financial institutions today? Which of these forces do you think will continue into the future?

Banking is becoming a more volatile industry due, in part, to deregulation which has opened up individual banks to the full force of the financial marketplace. However, under the new regulatory trend-reregulation, the government tightened the financial-services sector due to crises and market collapse in the previous few years. At the same time, the number and variety of banking services has increased greatly due to the pressure of intensifying competition from nonbank financial-service providers and changing public demand for more conveniently and reliably provided services and increase in returns on their money invested. Adding to the intensity of competition, foreign banks have enjoyed success in their efforts to enter countries overseas and attract away profitable domestic business and household accounts. There has been service proliferation and greater competitive rivalry among financial firms that has led to a powerful trend— convergence. Convergence refers to the movement of businesses across industry lines so that a firm formerly offering perhaps one or two product line ventures into other product lines to broaden its sales base. Apart from these changes, there has also been a considerable improvement in the technological automation leading banking and financial services to comprise of a more capital-intensive, fixed-cost industry and a less labor-intensive, variable-cost industry than in the past. The trends of convergence, consolidation, geographic expansion, and technological change will continue to proliferate in the future years.

Why are some banks reaching out to become one-stop financial-service conglomerates? Is this a good idea, in your opinion?

Banks and various financial institutions are converging in terms of the services they offer and embracing each other's innovations. There are two reasons that banks are increasingly becoming one-stop financial service conglomerates. The first reason is the increased competition from other types of financial institutions and the second reason is the erosion of the bank's market share for providing traditional services. Due to these reasons, the banks demanded for a relief from traditional rules and lobbying for an expanded authority to reach new markets around the globe. This has led the US Congress to pass the Financial Services Modernization Act which has allowed banks to expand their role to be full service providers. It is a beneficial step as it has led the US banks to stay in the competition and increase the market share by entering into various new industries like the securities and insurance industries.

How do the financial statements of major nonbank financial firms resemble or differ from bank financial statements? Why do these differences or similarities exist?

Banks have very similar financial statements to credit union and savings associations. The only difference may be in the structure of their loan portfolio. Credit unions probably have more loans to individuals and savings associations may have more real estate loans as well as loans to individuals. More differences exist between banks and other major competitors. These differences exist because of each company's unique function. Finance companies have loans but on their balance sheet they are called "accounts receivables". In addition, they show heavy reliance on money market borrowings instead of deposits. Insurance companies are different in that the loans they make to businesses show up on the balance sheet as bonds, stocks, mortgages and other securities. On the liability side, insurance companies receive the majority of their funds from insurance premiums paid by customers for insurance protection. Mutual funds hold primarily corporate stocks, bonds, asset-backed securities and money market instruments and their liabilities consist primarily of units of the mutual fund sold to the public. Security brokers and dealers tend to hold a similar range of securities funded by borrowings in the money and capital markets.

Why should banks and other corporate financial firms be concerned about their level of profitability and exposure to risk?

Banks in the U.S. and most other countries are like private businesses that must attract capital from the public to fund their operations. If profits are inadequate or if risk is excessive, they will have greater difficulty in obtaining capital and their funding costs will grow, eroding profitability. Bank stockholders, depositors, and bank examiners representing the regulatory community are all interested in the quality of bank performance. The stockholders are primarily concerned with profitability as a key factor in determining their total return from holding bank stock, while depositors (especially large corporate depositors) and examiners typically focus on bank risk exposure.

What different kinds of services do banks offer the public today? What services do their closest competitors offers?

Banks offer the widest range of services of any financial institution. -They offer thrift deposits to encourage saving and checkable (demand) deposits to provide a means of payment for purchases of goods and services. -They also provide credit through direct loans, by discounting the notes that business customers hold, and by issuing credit guarantees. -Additionally, they make loans to consumers for purchases of durable goods, such as automobiles, and for home improvements, etc. -Banks also manage the property of customers under trust agreements and manage the cash positions of their business customers. -They purchase and lease equipment to customers as an alternative to direct loans. -Many banks also assist their customers with selling insurance policies -They also assist in buying and selling securities through security brokerage services, the acquisition and sale of foreign currencies, the supplying of venture capital to start new businesses, and the purchase of annuities to supply future funding at retirement or for other long-term savings plans like annuities or mutual funds. -They also offer merchant banking services to large corporations and risk management and hedging services to help their customers combat risk exposure. All of these services are also offered by their financial-service competitors. Banks and their closest competitors are converging and becoming the financial department stores of the modern era.

What advantages can you see to banks affiliating with insurance companies? How might such an affiliation benefit a bank? An insurer? Can you identify any possible disadvantages to such an affiliation? Can you cite any real-world examples of bank-insurer affiliations? How well do they appear to have worked out in practice?

Banks used to sell insurance services to their customers on a regular basis before the beginning of the Great Depression. Beginning with the Great Depression of the 1930s, U.S. banks were prohibited from acting as insurance agents or underwriting insurance policies out of fear that selling insurance would increase bank risk. However, the separation between banking and insurance changed dramatically as the new century dawned when the U.S. Congress removevd the legal barriers between the two industries, allowing banking companies to acquire control of insurance companies and, conversely, permitting insurers to acquire banks. Today, these two industries compete aggressively with each other, pursuing cross-industry mergers and acquisitions. Before Glass-Steagall, banks used to sell insurance services to their customers on a regular basis. In particular, banks would sell life insurance to loan customers to ensure repayment of the loan in case of death or disablement. The right to sell insurances to customers again benefits banks in allowing them to offer their customers complete financial packages from financing the home or car to insure it, from giving investment advice to selling life insurance policies and annuities for retirement planning. Generally, a bank customer who is already purchasing a service from a bank might feel compelled to purchase an insurance product, as well. On the other hand, insurance companies sometimes have a negative image, which makes it more difficult to sell certain insurance products. Combining their products with the trust that people generally have in banks will make it easier for them to sell their products. The most prominent example of a bank-insurer affiliation is the merger of Citicorp and Traveler's Insurance to Citigroup. However, given that Citigroup has sold Traveler's Insurance indicates that the anticipated synergy effects did not materialize.

What is a financial intermediary?

Banks, along with insurance companies, mutual funds, finance companies, and similar financial-service providers are financial intermediaries. In their function as intermediaries they act as a bridge between the deficit and surplus spending units by offering financial services to the surplus spending individuals and then allocating those funds to the deficit spending individuals. Financial intermediaries accelerate economic growth by expanding the available pool of savings, lowering the risk of investments through diversification, increasing the productivity of savings and investments, satisfying the need for liquidity, and evaluation of financial information.

How did the Federal Reserve and selected other central banks expands their policy tools to deal with the great credit crisis of 2007-2009? Did their efforts work satisfactorily?

Besides the traditional policy tools of open market operations, discount rates, reserve requirements, and moral suasion, the Federal Reserve established two new policy tools in 2007 and 2008 to help stem the damage created by the home mortgage crisis. The Term Auction Facility (TAF) and the Term Securities Lending Facility (TSLF) were designed to make loans to depository institutions and securities dealers for periods of approximately one month to increase the supply of liquidity in the financial markets and expand credit for businesses and consumers. Four other central banks—the British, Canadian, Swiss, and European central banks—supported the Fed's action and moved in parallel fashion to encourage their countries' banks to expand the supply of credit.

Do branch banks seem to perform differently than unit banks? In what ways? Can you explain any differences?

Branch banking has a number of important advantages. With offices spread over different areas, branch banks may achieve more stable earnings and revenue flows. They may be able to grow faster because the additional offices can bring in more debt capital (principally deposits) with which they grow. However, adding new branch offices can subject the bank to high fixed costs, due to large and rising construction costs. This means the bank must work harder simply to reach a break-even point. Moreover, branch offices that are poorly situated or that have the misfortune to be located in an area whose economy is deteriorating may generate higher costs than revenues and saddle the bank with persistent net losses.

What trend in branch banking has been prominent in the United States in recent years?

Branch banking has become increasingly important with the great majority of states now allowing statewide branching. Today, more states permit statewide branching and only a minority restrict branching in some way. There was an increase in the number of branches in the 60's, 70's and 80's as the population from cities to suburban areas. As the 21st century began, there were about 5,200 branch banking organizations in the United States, operating close to 80,000 full-service branch office facilities. Though the number of U.S. commercial banks declined over the last half-century, the number of full-service branch offices has soared. However, in recent years the growth in full-service branches has slowed because of the sky-rocketing costs of land and building office facilities. In addition, ATM's and electronic networks have taken over much of the routine banking transactions. There is not as much need for full service branches as before.

What is the difference between convergence and consolidation?

Consolidation refers to increase in the size of financial institutions. The number of small, independently owned financial institutions is declining and the average size of individual banks, as well as securities firms, credit unions, finance companies, and insurance firms, has risen significantly. Convergence is the bringing together of firms from different industries to create conglomerate firms offering multiple services. Clearly, these two trends are related. In their effort to compete with each other, banks and their closest competitors have acquired other firms in their industry as well as across industries to provide multiple financial services in multiple markets.

What is corporate governance, and how might it be improved for the benefit of the owners and customers of financial firms?

Corporate governance describes the relationships that exist among managers, the board of directors, the stockholders, and other stakeholders of a corporation. Corporate governance can be improved through larger boards of directors and a high proportion of outside directors. This will expose managers to greater monitoring and discipline.

Demand deposits

Demand deposits are regular checking accounts against which a customer can write unlimited checks or make any number of personal withdrawals. Regular checking accounts do not bear interest under current U.S. law and regulation.

What is expense-preference behavior? How could it affect the performance of a financial firm?

Expense-preference behavior describes an approach where managers use the financial resources of the firm to provide them with personal benefits rather than to maximize the value of the firm. This behavior leads to increasing costs of production and declining returns to the firm's owners. Such expense-preference behavior may show up in the form of staffs larger than required to maximize profits or excessively rapid growth, which causes expenses to get out of control.

Explain how the FACT, Check 21, 2005 Bankruptcy, Financial Services Regulatory Relief, and Federal Deposit Insurance Reform Acts are likely to affect the revenues and costs of financial firms and their services to customers.

FACT requires the Federal Trade Commission to make it easier for individuals victimized by identity theft to file a theft report and requires credit bureaus to help victims resolve the problems. This should make it easier for customers to handle identity theft problems and may reduce costs to the financial institutions that serve these customers. Financial institutions should be able to spend less on reimbursing customers for theft problems and perhaps the instances of identity theft will also be reduced at the same time. Check 21 allows financial institutions to send substitute checks to other banks to clear checks rather than paper checks. The substitute checks can be electronic images that can be transferred in an instant at a much lower cost to other institutions. This should reduce costs to institutions as they do not have to have an employee physically transfer checks anymore. In addition, financial institutions should know more quickly whether a check is good and this should reduce fraud and other costs associated with bad checks. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 requires all higher income borrowers who have gone bankrupt to pay back at least a portion of the money they have borrowed. Such bankrupts will be required to make payment plans rather than have all of their debts forgiven. This should lower bad debt costs to financial institutions and may lower borrowing costs for all borrowers. The Financial Services Regulatory Relief Act of 2006 loosens regulations on depository institutions, adds selected new service powers to these institutions, and grants the Federal Reserve authority to pay interest on depository institutions' legal reserves if deemed necessary. The Federal Deposit Insurance Reform Act raised the deposit insurance limit for certain retirement accounts and allowed regulators to periodically adjust deposit insurance limits for inflation. This should allow investors to put more money into insured deposit accounts and may allow banks to have a more stable and reliable source of funds for loans and other investments. This will probably have the effect of increasing bank revenues and/or reducing expenses for the bank. For all of these new laws, the effect should be to make the bank more profitable because of higher revenues and/or lower expenses. At the same time these new laws allow financial institutions to better serve their customers.

What relationship appears to exist between bank size, efficiency, and operating costs per unit of service produced and delivered? How about among nonbank financial-service providers?

For banks and nonbank financial service providers alike, economies of scale and economies of scope if achieved can lead to significant savings in operating costs with increases in service output. Economies of scale mean that costs per unit decrease as more units of the same service are produced because of greater efficiencies in using the firm's resources to produce multiple units of the same service or service package. Economies of scope imply that as more different services are provided, the operating cost reduces. This is because some resources are more efficiently used in jointly producing multiple services than turning out one service.

What is the relationship between the provision for loan losses on a bank's Report of Income and the allowance for loan losses on its Report of Condition?

Gross loans equal the total of all loans currently outstanding that are recorded on the bank's books. Net loans are equal to gross loans less any interest income on loans already collected by the bank but not yet earned and also less the allowance for loan-loss account (or bad-debt reserve). The allowance for loan losses is built up gradually over time by an annual noncash expense item that is charged against the bank's current income, known as the provision for loan losses. The dollar amount of the annual loan-loss provision plus the amount of recovered funds from any loans previously declared worthless (charged off) less any loans charged off as worthless in the current period is added to the allowance for loan losses account. If current charge-offs of worthless loans exceed the annual loan-loss provision plus any recoveries on previously charged-off loans, the annual net figure becomes negative and is subtracted from the allowance-for-loan-losses account.

The Trading Desk at the Federal Reserve Bank of New York elects to sell $100 million in U.S. government securities to its list of primary dealers. If other factors are held constant, what is likely to happen to the supply of legal reserves available? To deposits and loans? To interest rates?

If the trading desk sells $100 million in U.S. Government securities, the supply of total legal reserves will decrease by $100 million, some of which will probably be taken from the reserve accounts of the dealers purchasing the securities. Deposits and loans will decrease by a multiple of the new reserves and, initially at least, market interest rates should rise.

What did the Riegle-Neal Interstate Banking Act do? Why was it passed into law?

In 1994 the U.S. Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act which allows bank holding companies to acquire banks throughout the United States without needing any state's permission to do so and to establish branch offices across state lines in every state (except in Montana). The interstate banking law reflects the need and belief for banking firms to diversify into different geographic markets, demands of the public for financial service providers that can follow businesses and individuals as they move across the landscape, bring in new capital to revive struggling local economies, and advances the technology of financial-services delivery.

What changes have occurred in US banks' authority to cross state lines?

In 1994, the Riegle-Neal Interstate Banking and Efficiency Act was passed. This law is complicated but allows bank holding companies with adequate capital to acquire banks or bank holding companies anywhere in U.S. territory. No bank holding company can control more than 10% of the deposits at the national level and more than 30% of the deposits at the state level (unless a state waives this latter restriction). Bank holding companies are also not allowed to cross state lines solely for the purpose of collecting deposits. Banks must adequately support their local communities by providing loans there. Bank holding companies are also allowed to offer a number of interstate services without necessarily having branches in the state by allowing affiliated banks to act as agents for the bank holding in other states. This law also allows foreign banks to branch in the U.S. under the same rules as domestic banks. However, the U.S. Banks still face a few restrictions on their branching activity.

What trends are affecting the way banks and their competitors are organized today?

In general, banks are becoming larger and more complex organizations with more departments and services and greater specialization. Deregulation and service innovation have accelerated this trend as intense competition at home and abroad has encouraged banks to become larger organizations, serving broader and more diversified market areas. Even small banks are reorganizing to meet these challenges by being more efficient in meeting their broader-based customer needs.

Suppose that a bank is expected to pay an annual dividend of $4 per share on its stock in the current period and dividends are expected to grow 5 percent a year every year, and the minimum required return-to-equity capital based on the bank's perceived level of risk is 10 percent. Can you estimate the current value of the bank's stock?

In this constant dividend growth rate problem, the current value of the bank's stock would be: P0 = ( 4 * (1 + 1.05)) / (0.10 - 0.05) = $84

Why must we be concerned about privacy in the sharing and use of a financial-service customer's information? Can the financial system operate efficiently if sharing nonpublic information is forbidden? How far should we go in regulating who gets access to private information?

It is important to be concerned about how private information is shared because it is possible to misuse the information. For example, if an individual's medical condition is known to the bank through its insurance division, the bank may deny a loan based on this confidential information. They can also share this information with outside parties unless the customer states in writing that this information cannot be shared. On the other hand, there could be much duplication of effort if no sharing of information is allowed. This would lead to inefficiencies and higher costs to consumers. In addition, sharing of information would allow targeting of services to particular customer needs. At this point, no one is quite sure what information and how it will be shared. It appears that there will eventually be a compromise between customers' needs for privacy and the financial-services company's need to share that information.

Monetary policy

Monetary policy consists of regulation and control over the growth of money and credit in an attempt to pursue broad economic goals such as full employment, reduction of inflation, and sustainable economic growth. Its principal tools are open market operations, changes in the discount (lending) rate, and changes in reserve requirements behind deposits.

How does the FDIC deal with most failures?

Most bank failures are handled by getting another bank to take over the deposits and clean assets of failed institutions--a process known as purchase and assumption. Those that are small or in such bad shape that no suitable bids are received from other banks are closed and the insured depositors are paid off--a deposit payoff approach. Larger failures may sometimes be dealt with by open bank assistance where the FDIC loans money to the troubled bank and may order a change in management as well. Large failing money-center banks may also be taken over and operated as "bridge banks" by the FDIC until disposed of.

In what ways is the regulation of nonbank financial institutions different from the regulation of banks in the United States? How are they similar?

Most nonbank financial institutions are considered "vested with the public interest" and therefore, face as close supervision from federal and state supervisors as banks do. However, some institutions are solely regulated at the federal level while others are only regulated at the state level.

What are off-balance-sheet items and why are they important to some financial firms?

Off-balance-sheet items are usually transactions that generate fee income for a bank (such as standby credit guarantees) or help hedge against risk, (such as financial futures contracts) but do not show up on the balance sheet. They are important as a supplement to income from loans and to help a bank reduce its exposure to interest-rate and other types of risk.

What new regulatory issues remain to be resolved now that interstate banking is possible and security and insurance services are allowed to commingle with banking?

One issue is concerned with what we should do about the governmental safety net. We need to balance risk taking by financial firms with safety for depositors. We must also consider the issue of how to protect taxpayers, if financial firms are allowed to take on more risk. Another issue that needs to be resolved is what to do about financial conglomerates. We need to be sure that financial conglomerates do not use the resources of the bank to prop another aspect of their business. In addition, regulators need to be better trained to adequately regulate the more complex organizations and functional regulation needs to be reviewed periodically to make sure it is working. Another thing that must be resolved is whether banking and commerce should be mixed. Should a bank sell cars along with credit cards and other financial services?

How does the Fed affect the banking and financial system through open market operations (OMO)? Why is OMO the preferred tool for many central banks around the globe?

Open market operations consist of the buying and selling of securities by the central bank in an effort to influence and shape the course of interest rates and the growth of money and credit. Open-market operations, therefore, affect bank deposits—their volume and growth—as well as the volume of lending and the interest rates attached to bank borrowings and loans as well as the value of bank stock. OMO is the preferred tool, because it is also the central bank's most flexible tool. It can be used every day and any mistakes can be quickly reversed.

What are primary reserves and secondary reserves, and what are they supposed to do?

Primary reserves consist of cash, including a bank's vault cash and checkable deposits held with other banks or any other funds such as reserves with the Federal Reserve banks that are accessible immediately to meet demands for liquidity made against the bank. Secondary reserves consist of assets that pay some interest (though usually pay returns that are much lower than earned on other assets, such as loans) but their principal feature is ready marketability. Most secondary reserves are marketable securities such as short term government securities and private securities such as commercial paper. Both primary and secondary reserves are held to keep the bank in readiness to meet demands for cash (liquidity) from whatever source those demands may arise.

How have bank failures influenced recent legislation?

Recent bank failures have caused huge losses to federal insurance reserves and damaged public confidence in the banking system. Recent legislation has tried to address these issues by providing regulators with new tools to deal with the failures, such as the bridge bank device, and by granting banks, through regulation, somewhat broader service powers and more avenues for geographic expansion through branch offices and holding companies in order to help reduce their risk exposure. In addition, the increase in bank failures has led to a focus on the insurance premiums banks pay through the FDIC Improvement Act..

What is the return on assets (ROA), and why is it important? Might the ROA measure be important to banking's key competitors?

Return on assets is the ratio of net income over total assets. The rate of return secured on a bank's total assets indicates the efficiency of its management in generating net income from all of the resources (assets) committed to the institution. This would be important to banks and their major competitors.

What is return on equity capital, and what aspect of performance is it supposed to measure? Can you see how this performance measure might be useful to the managers of financial firms?

Return on equity capital is the ratio of net income over total equity capital. It represents the rate of return earned on the funds invested in the bank by its stockholders. They expect to earn a suitable profit over the risk of their investment. Return on equity capital can also be calculated using the return on assets as follows: ROE = ROA * (Total Assets / Total Equity Capital) This ROE-ROA relationship illustrates the fundamental trade-off between risk and return. This equation reminds us that the return to a financial firm's shareholders is highly sensitive to how its assets are financed—the proportion of debt and owner's capital used. Constructing a risk-return trade-off table can help the managers understand how much leverage (debt relative to equity) must be used to achieve a financial institution's desired rate of return to its stockholders.

Savings deposits

Savings deposits bear interest (normally, they carry the lowest rate paid on bank deposits) but may be withdrawn at will (though most depository institutions impose a minimum size requirement).

Describe the typical organization of a smaller community bank and a larger money-center bank. What does each major division or administrative unit within the organization do?

Small community banks, also known as retail banks, generally have four basic departments or divisions centered on lending (the credit function), fund-raising and marketing, accounting and operations, and perhaps, trust services. Daily operations are usually monitored by a cashier and/or auditor and by the vice presidents in charge of each department and division. Overall, the small bank's organization chart is simple and uncomplicated. In contrast, the larger banks, practicing wholesale and retail banking, usually have many specialized departments and divisions. It includes separate departments for different kinds of loans, departments to manage security holdings and borrow in the money market, a division or department to manage international operations, a marketing division, and a planning unit along with other divisions.

Suppose a bank has an ROA of 0.80 percent and an equity multiplier of 12X. What is its ROE? Suppose this bank's ROA falls to 0.60 percent. What size equity multiplier must it have to hold its ROE unchanged?v

The bank's ROE is: ROE = 0.80 percent ×12 = 9.60 percent. If ROA falls to 0.60 percent, the bank's ROE and equity multiplier can be determined from: ROE = 9.60 percent = 0.60 percent × Equity multiplier Equity Multiplier = 9.60 percent / 0.60 percent = 16X

What nonbank businesses are bank holding companies permitted to acquire under the law?

The Bank Holding Company Act (as amended) requires a registered bank holding company to acquire only those nonbank businesses that are "closely related to banking" and yield "public benefits." Among the most popular of these nonbank businesses that have been approved for holding-company acquisition include finance companies, mortgage banking firms, leasing companies, insurance agencies, data processing firms, and several other businesses as well. Increasingly as the 1990s began, bank holding companies sought approval to acquire failing savings and loan associations which the Federal Reserve Board granted after a case-by-case review. These S&L acquisitions were sanctioned by the U.S. Congress when the Financial Institutions Reform, Recovery, and Enforcement Act was passed in 1989 and, with passage of the Federal Deposit Insurance Corporation Improvement Act in 1991, bank holding companies were granted permission to acquire even healthy savings and loan associations with Federal Reserve Board approval. Today, the Gramm-Leach-Bliley Act allows financial services companies to be affiliated with each other. This includes investment-banking activities which allow banks to underwrite securities.

Why were the Sarbanes-Oxley, Bank Secrecy, and USA Patriot Acts enacted in the United States? What impact are these laws and their supporting regulations likely to have on the financial-services sector?

The Bank Secrecy Act (passed originally in 1970 to combat money laundering) requires any cash transaction of $10,000 or more be reported to the government and was passed to prevent money laundering by criminal organizations. The USA Patriot Act was enacted after the attacks of September 11 and is designed to find and prosecute terrorists. It made a series of amendments to the Bank Secrecy Act. Both acts require banks and financial service providers to establish the identity of any customer opening or changing accounts in the United States. Many banks are however concerned about the cost of compliance. The Sarbanes-Oxley Accounting Standards Act came as a response to the disclosure of manipulation of corporate financial reports and questionable dealings among leading commercial firms, banks and accounting firms. It prohibits false or misleading information about the financial performance of banks and other financial service providers and generally tries to enforce higher standards in the accounting profession.

What is the principal role of the Comptroller of the Currency (OCC)?

The Comptroller of the Currency charters and supervises the activities of national banks through its policy-setting and examinations. In addition, the Comptroller's office must approve all applications for the establishment of new branch offices and any mergers where national banks are involved. The Comptroller can close a national bank that is insolvent or in danger of imposing substantial losses on its depositors.

How can changes in the central bank loan (discount) rate and reserve requirements affect the operations of depository institutions? What happens to the legal reserves of the banking system when the Fed grants loans through the discount window? How about when these loans are repaid? What are the effects of an increase in reserve requirements?

The Discount Window is the department in each Federal Reserve Bank that receives requests to borrow reserves from banks and other depository institutions which are eligible to obtain credit from the Fed for short periods of time. The rate charged on such loans is called the discount rate. Reserve requirements are the amount of vault cash and deposits at the Federal Reserve banks that depository institutions raising funds from sources of reservable liabilities (such as checking accounts, business CDs, and borrowings of Eurodollars from abroad) must hold. If the Fed grants loans worth $200 million to borrowing institutions from the discount window, their total reserves will rise by the amount of the discount window loan, but then will fall when the loan is repaid. Increasing reserve requirement means that depository institutions must keep more vault cash and reserves with the Federal Reserve for each deposit account they hold. This would have the effect of making less money available for loans. Since this has a multiplicative effect on the economy, it can have a severe effect on the total amount of loans made and on the growth of the money supply that results.

How did the Equal Credit Opportunity Act and the Community Reinvestment Act address discrimination?

The Equal Credit Opportunity Act stated that individuals could not be denied a loan because of their age, sex, race, national origin or religious affiliation or because they were recipients of public welfare. The Community Reinvestment Act prohibited banks from discriminating against customers based on the neighborhood in which they lived.

Why did the federal insurance system run into serious problems in the 1980s and 1990s? Can the current federal insurance system be improved? In what ways?

The FDIC, which insures U.S. bank deposits up to a certain level, was not designed to deal with system-wide failures or massive numbers of failing banks. Yet, the 1980s ushered in more bank closings than in any period since the Great Depression of the 1930s, bringing the FDIC to the brink of bankruptcy. Also, the FDIC's policy of charging the same insurance fees to all banks regardless of their risk exposure encouraged more banks to gamble and accept greater risk. The recent FDIC Improvement Act legislation has targeted this last area, with movement toward a risk-based insurance schedule and greater insistence on maintaining adequate long-term bank capital. However, even today, the federal government sells relatively cheap deposit insurance that may still encourage greater risk taking.

How did the Federal Reserve change the policy and practice of the discount window recently? Why was this change made?

The Fed created two new loan types, primary and secondary credit, which replaced the existing adjustment and extended credit. -Primary credit is extended to sound borrowing institutions at a rate slightly higher than the federal funds rate. -Secondary credit is extended to institutions that do not qualify for primary credit for temporary funding needs at a rate slightly above the prime rate. In 2003, the Fed began setting the discount rate slightly above its target federal funds rate to promote greater stability. In 2007 and 2008, the Fed's discount window was opened wide in an effort to provide additional liquidity to banks under pressure from the home mortgage crisis. These changes were implemented to encourage greater use of the discount window and to bring greater stability to the federal funds rate and to the money market as a whole.

What is the principal job performed by the FDIC?

The Federal Deposit Insurance Corporation (FDIC) insures the deposits of bank customers, up to a total of $250,000 per account owner, in banks that qualify for a certificate of federal insurance coverage. This is to enhance public confidence in the banking system. The FDIC is a primary federal regulator (examiner) of state-chartered, non-member banks. It requires all insured depository institutions to submit reports on their financial condition.

What key roles does the Federal Reserve System perform in the banking and financial system?

The Federal Reserve System supervises and examines the activities of state-chartered banks that choose to become members of its system and qualify for Federal Reserve membership and regulates the acquisitions and activities of bank holding companies. However, the Fed's principal responsibility is monetary policy—the control of money and credit growth in order to achieve broad economic goals. It also serves as a lender of last resort by providing temporary loans to depository institutions facing financial emergencies. The system helps stabilize the financial markets and the economy in order to preserve public confidence.

What is happening to banking's share of the financial marketplace and why? What kind of banking and financial system do you foresee for the future if present trends continue?

The Financial Services Modernization Act of 1999 allowed many of banks' closest competitors to offer a wide array of financial services thereby taking away market share from "traditional" banks. Because of the relatively liberal government regulations, banks with quality management and adequate capital can become conglomerate financial-service providers. The same will become true for security firms, insurers, and other financially oriented companies that wish to acquire bank affiliates. Hence, the banks and their closest competitors are converging into one-stop shopping for financial services and this trend should continue into the future.

What is the Glass-Steagall Act, and why was it important in banking history?

The Glass-Steagall Act, passed by the U.S. Congress in 1933, was one of the most comprehensive pieces of banking legislation in American history. It created the Federal Deposit Insurance Corporation to insure smaller-size bank deposits, imposed interest-rate ceilings on bank deposits, and separated commercial banking from investment banking, thereby removing commercial banks from underwriting the issue and sale of corporate stocks and bonds in the public market. There are many people who feel that banks should have some limitations on their investment banking activities. These analysts focus on two main areas. First, they suggest that this service may cause problems for customers using other bank services. For example, a bank may require a customer getting a loan to purchase securities of a company it is underwriting. This potential conflict of interest concerns some analysts. The second concern deals with whether the bank can gain effective control over an industrial organization. This could make the bank subject to additional risks or may give unaffiliated industrial organizations a competitive disadvantage. Today, banks can underwrite securities as part of the Gramm-Leach Bliley Act (Financial Services Modernization Act). However, congress built in several protections to make sure that banks do not take advantage of customers. In addition, banks are prevented from affiliating with industrial firms under this law.

What accounts make up the Report of Income (income statement of a bank)?

The Report of Income includes all sources of bank revenue (loan income, investment security income, revenue from deposit service fees, trust fees, and miscellaneous service income) and all bank expenses (including interest on all borrowed funds, salaries, wages, and employee benefits, overhead costs, loan loss expense, taxes, and miscellaneous operating costs.) The difference between operating revenues and expenses (including tax obligations) is referred to as net income.

Are there any significant advantages or disadvantages for holding companies or the public if these companies acquire banks or nonbank business ventures?

The ability of holding companies to acquire nonbank businesses has given them the capacity to cross state lines even where state law prohibited entry by out-of-state banking firms. It also allows a holding company to diversify across many different product lines to help stabilize the company's net earnings. However, launching nonbank businesses can stretch holding-company management too far and make it ineffective, resulting in damage to the performance of banks belonging to the same holding company. The public may gain if holding companies are less subject to failure than other types of financial service firms and are more efficient to operate. However, the public may lose if the concentration of services in bank holding companies causes the prices of those services to rise or if resources are drained away from local communities causing slower growth of those communities.

What principal types of assets and funds sources do nonbank thrifts (including savings banks, savings and loans, and credit unions) draw upon? Where does the bulk of their revenue come from, and what are their principal expense items?

The assets of nonbank thrifts are dominated by loans (especially mortgages and consumer installment loans) and their funding comes primarily from deposits and money market borrowings. As a result, most of their revenue is generated by their loans and most of their expenses are interest expenses on the deposits and the money market borrowings.v

Suppose a bank has an allowance for loan losses of $1.25 million at the beginning of the year, charges current income for a $250,000 provision for loan losses, charges off worthless loans of $150,000, and recovers $50,000 on loans previously charged off. What will be the balance in the allowance for loan losses at year-end?

The balance in the allowance for loan loss (ALL) account at year end will be: Beginning ALL = $1.25 million Plus: Annual Provision for Loan Losses = +0.25 million Recoveries on Loans Previously Charged Off = +0.05 million Minus: ChargeOffs of Worthless Loans = −0.15 million Ending ALL = $1.40 million

Suppose that a bank holds cash in its vault of $1.4 million, short-term government securities of $12.4 million, privately issued money market instruments of $5.2 million, deposits at the Federal Reserve banks of $20.1 million, cash items in the process of collection of $0.6 million, and deposits placed with other banks of $16.4 million. How much in primary reserves does this bank hold? In secondary reserves?

The bank holds primary reserves of: Vault Cash + Deposits at the Fed + Cash Items in Collection + Deposits With Other Banks = $1.4 mill. + $20.1 mill. + $0.6 mill. + $16.4 mill.= $38.5 million The bank has secondary reserves of: Short-term Government Securities + Private Money Market Instruments = $12.4 mill. + $5.2 mill.= $17.6 million

If a bank has a net interest margin of 2.50%, a noninterest margin of −1.85%, and a ratio of provision for loan losses, taxes, security gains, and extraordinary items of −0.47%, what is itsROA?

The bank's ROA must be: ROA = Net interest margin + Noninterest margin - Ratio of provision for loan losses, taxes, security gains, and extraordinary itemsR OA = 2.5 percent + (−1.85 percent) - (−0.47 percent) = 1.12 percent

A bank estimates that its total revenues will amount to $155 million and its total expenses (including taxes) will equal $107 million this year. Its liabilities total $4,960 million while its equity capital amounts to $52 million. What is the bank's return on assets? Is this ROA high or low? How could you find out?

The bank's return on assets would be: ROA = NI / Total Assets = ($155 - $107) / ($4,960 + $52) = 0.96% The size of this bank's ROA should be compared with the ROA's of other banks similar in size and location to determine whether this bank's ROA is high or low.

Suppose a bank reports that its net income for the current year is $51 million, its assets total $1,144 million, and its liabilities amount to $926 million. What is its return on equity capital? Is the ROE you have calculated good or bad? What information do you need to answer this last question?

The bank's return on equity capital should be: ROE = NI / Total Equity Capital = $51 / ($1,144 - $926) = 23.39% In order to evaluate the performance of the bank, you have to compare its ROE to the ROE of some major competitors or the industry average.

What major trends are changing the content of the financial statements prepared by financial firms?

The content of the financial statements of financial firms is changing for several reasons. One trend that has affected the financial statements of financial firms is the call for those statements to reflect the true market value of the assets held by the financial firm. More accounts are being listed at the lower of historical cost or market value so that investors can get a better understanding of the true value of the firm. Another trend that is affecting financial firms is the increased use of off-balance sheet items. The notional amount of these items is sometimes surpassing the value of the items on the balance sheet, especially for larger financial institutions. This has led regulators to change their reporting requirements for financial firms and there are likely to be additional requirements in the future. Another trend that is affecting financial firms is the convergence of the various types of financial firms. In addition, financial firms are becoming larger and more complex and more financial holding companies are formed. These are also leading to changes in the content and structure of the financial statements of financial firms.

What are the key features or characteristics of the financial statements of banks and similar financial firms? What are the consequences of these statement features for managers of financial-service providers and for the public?

The financial statements of financial-service firms exhibit three main characteristics that have important consequences for managers of these firms and the public. The first characteristic of these firms is that they have lower operating leverage. They have small amounts of buildings, equipment and other fixed assets. Operating leverage adds risk to the firm and firms with large amount of operating leverage can face large fluctuations in net income and earnings per share for small changes in revenues. Financial-service firms do not have this problem. However, financial service firms have large amounts of financial leverage. Financial leverage comes from how the firm finances its assets. If a firm borrows a lot, it faces a larger financial leverage and has a larger amount of risk as a result. Financial service firms finance approximately 90% of their assets with debt, and therefore face significant financial leverage. Small changes in revenues can lead to large changes in net income and earnings per share as a result. In addition, changes in interest rates can have significant effects on the net income and capital position of financial firms. Finally, most of the liabilities of financial firms are short term. This means that financial firms can face significant liquidity problems. A sudden demand by depositors for funds can lead to large problems for financial firms.

The term bank has been applied broadly over the years to include a diverse set of financial-service institutions, which offer different financial-service packages. Identify as many of the different kinds of banks as you can. How do the banks you have identified compare to the largest banking group of all—the commercial banks? Why do you think so many different financial firms have been called banks? How might this confusion in terminology affect financial-service customers?

The general public tends to classify anything as a bank that offers some sort of financial service, especially deposit and loan services. Other institutions that are often referred to as a bank without being one are savings associations, credit unions, fringe banks, money market funds, mutual funds, hedge funds, security brokers and dealers, investment banks, finance companies, financial holding companies, and life and property/casualty insurance companies. All of these institutions offer some of the services that a commercial bank offers, but generally not the entire scope of services. Since providers of financial services are normally called banks by the general public they are able to take away business from traditional banks and it is of utmost importance for commercial banks to clarify their unique position among financial services providers.

What individuals or groups are likely to be interested in these dimensions of performance for a financial institution?

The individuals or groups likely to be interested in the dimensions i.e., profitability and risk are - other banks lending to a particular bank, borrowers, large depositors, holders of long-term debt capital issued by banks, bank stockholders, and bank examiners representing the regulatory community.

What are the principal accounts that appear on a bank's balance sheet (Report of Condition)?

The principal asset items on a bank's Report of Condition are loans, investments in marketable securities, cash, and miscellaneous assets. The principal liability items are deposits and nondeposit borrowings in the money and capital market. Equity capital supplied by the stockholders rounds out the accumulated sources of funds for a bank.

What are the most important components of ROA, and what aspects of a financial institution's performance do they reflect?

The principal components of ROA are: a. Total Interest Income less Total Interest Expense divided by Total Assets, measuring a bank's success at intermediating funds between borrowers and lenders. b. Provision for Loan Losses divided by Total Assets, which measures management's ability to control loan losses and manage a bank's accrual expense. c. Noninterest Income less Noninterest Expenses divided by Total Assets, which indicates the ability of management to control salaries and wages, other noninterest costs of operations and generate income from handling customer transactions. d. Applicable Taxes divided by Total Assets, which is an index of tax management effectiveness, measures the financial firm's share of the cost of government securities.

How are the balance sheets and income statements of finance companies, insurers, and securities firms similar to those of banks, and in what ways are they different? What might explain the differences you observe?

The main similarities between the nonbank competitors of banks can be found on the asset side of their balance sheets. All of the above rely on loans and securities, although they normally label them differently. The main difference is the source of funds. None of the aforementioned competitors can draw upon deposits and have to rely on money market, other borrowings and equity. These differences are rooted in the nature of their line of business and underlying regulations.

What changes in regulation did the Gramm-Leach-Bliley (Financial Services Modernization) Act bring about? Why?

The most important aspect of the law is to allow U.S. banks, insurance companies, and securities companies to affiliate with each other either through a holding company structure or through a bank subsidiary. The purpose of this law is to: -allow these companies to diversify their service offerings -reduce their overall risk exposure -offer customers the convenience of one-stop shopping

Why do the managers of financial firms often pay close attention today to the net interest margin and noninterest margin? To the earnings spread?

The net interest margin (NIM) indicates how successful the bank has been in borrowing funds from the cheapest sources and in maintaining an adequate spread between its returns on loans and security investments and the cost of its borrowed funds. If the NIM rises, loan and security income must be rising or the average cost of funds must be falling or both. A declining NIM is undesirable because the bank's interest spread is being squeezed, usually because of rising interest costs on deposits and other borrowings and increased competition today. In contrast, the noninterest margin reflects the banks spread between its noninterest income (such as service fees on deposits) and its noninterest expenses (especially salaries and wages and overhead expenses). For most banks the noninterest margin is negative. Management will usually attempt to expand fee income, while controlling closely the growth of noninterest expenses in order to make a negative noninterest margin less negative. The earnings spread measures the effectiveness of the bank's intermediation function of borrowing and lending money, which, of course, is the bank's primary way of generating earnings. As competition increases, the spread between the average yields on assets and the average cost of liabilities will be squeezed, forcing the bank's management to search for alternative sources of income, such as fees from various services the bank offers.

Can you explain why many of the forces you named in the previous question have led to significant problems for the management of banks and other financial firms and for their stockholders?

The net result of recent changes in banking and the financial services market has been to put greater pressure upon their earnings, resulting in more volatile returns to stockholders and an increased bank failure in providing those rates. Increase competition has led to a fluctuation in the bank's share of the financial service market place. Technological advances have significantly lowered the per-unit costs associated with high-volume transactions, but they have also depersonalized financial services. Due to consolidation of financial institutions, there has been a decline in employment. Due to the powerful trend of convergence, weaker firms fail or get merged into companies that are larger with more services. Institutions have also become more innovative in their service offerings and in finding new sources of funding, such as off-balance-sheet transactions. The increased risk faced by institutions today, therefore, has forced managers to more aggressively utilize a wide array of tools and techniques to improve and stabilize their earnings streams and manage the various risks they face.

What are the principal components of ROE, and what does each of these components measure?

The principal components of ROE are: a. The net profit margin or the Net after-tax income to Total operating revenues which reflects the effectiveness of a bank's expense control program and service pricing policies; b. The degree of asset utilization or the ratio of Total operating revenues to Total assets which measures the effectiveness of the bank's portfolio management policies, especially the mix and yield on assets; and, c. The equity multiplier or the ratio of Total assets to Total equity capital which measures a bank's use of leverage in funding its operations: the sources chosen to fund the financial institution (debt or equity).

Why do the financial statements issued by banks and by nonbank financial-service providers look increasingly similar today? Which nonbank financial firms have balance sheets and income statements that closely resemble those of commercial banks (especially community banks)?

The resemblance between bank and nonbank financial service providers is caused by the intense competition between the sectors. Both groups of financial firms are offering more and more similar services and that development is widely reflected in their respective financial statements. This is particularly true for nonbank thrift institutions like credit unions and savings associations. Their balance sheets are dominated by loans, by deposits, and borrowings in the money market. In addition, the income statements are heavily tilted towards revenues on loans and interest expenses on their deposits and money market borrowings.

Why are bank accounting practices under attack right now? In what ways could financial institutions improve their accounting methods?

The traditional practice of banks has been to record the value of assets and liabilities at their value on the day the accounts were originally created and not change those values over the life of the account. The Securities and Exchange Commission and Financial Accounting Standard's Board started questioning this practice in the 1980's because they were concerned that investors in bank securities would be misled about the true value of the bank. Using this historical value accounting method may in fact conceal a bank that is insolvent in a current market value sense. The biggest controversy centered on the banks' investment portfolio which would appear to be easy to value at its current market price. At a minimum, banks could help themselves by marking their investment portfolio to market. This would give investors an indication of the true value of the bank's investment portfolio. Banks could also consider using the lower of historical or market value for other accounts on the balance sheet.

Why do banks and other financial intermediaries exist in modern society, according to the theory of finance?

The traditional view of banks as financial intermediaries sees them as simultaneously fulfilling financial-service needs of savers and borrowers, providing both a supply of credit and a supply of liquid assets. A newer view sees banks as delegated monitors who assess and evaluate borrowers on behalf of their depositors and earn fees for supplying monitoring services. Banks also provide a service of dividing up financial instruments into smaller units which would be readily affordable to millions of people. Banks accept risky loans from borrowers while issuing low risk securities to their depositors. Banks have been viewed in recent theory as suppliers of liquidity and transaction services that reduct costs for their customers and, through diversification, reduce risk. Banks are also critical in the payment system for goods and services and have played an increasingly important role as a guarantor and a risk management role for customers.

What do you think the financial-services industry will look like 20 years from now? What are the implications of your projections for its management today?

There appears to be a trend toward continuing consolidation and convergence. There are likely to be fewer financial service providers in the future and many of these will be very large and provide a broad range of financial services under one roof. In addition, global expansion will continue and will be critical to the survival of many financial service providers. Management of financial service providers will have to be more technologically astute and be able to make a more diverse set of decisions including decisions about mergers, acquisitions and global expansion as well as new services to add to the firm.

Time deposits

Time deposits carry a fixed maturity and the bank may impose a penalty if the customer withdraws funds before the maturity date is reached. The interest rate posted on time deposits is negotiated between the bank and its deposit customer and may be either fixed or floating.

Under U.S. law what must a corporation do to qualify and be regulated as a commercial bank?

Under U.S. law, commercial banks must offer two essential services to qualify as banks for purposes of regulation and taxation, demand (checkable) deposits and grant commercial loans. More recently, Congress defined a bank as any institution that could qualify for deposit insurance by the Federal Deposit Insurance Corporation.

When must a holding company register with the Federal Reserve Board?

Under the terms of Bank Holding Company Act, if the company owns at least 25 percent of the outstanding stock of at least one bank or otherwise exerts a controlling influence over at least one bank, it must register with the Federal Reserve Board. Such a company must seek the Fed's approval if it wishes to increase its share of ownership in those banks in which it already has an interest or wishes to acquire additional banks or nonbank businesses.

What advantages might a unit bank have over banks of other organizational types? What disadvantages?What advantages might a unit bank have over banks of other organizational types? What disadvantages?

Unit banks have the advantage of being less costly to operate because full-service branch offices are an expensive way to grow. As unit banks tend to be relatively small, they seem to be able to offer personalized services better than larger institutions. One disadvantage is the heavy dependence of most unit institutions on a single market area, which increases their risk of failure. Some authorities believe unit institutions may not be able to afford technologically advanced service delivery systems.

Credit risk

he probability that the loans and securities the bank holds will not pay out as promised

Can you make a case for having only one regulatory agency for financial-service firms?

Yes. Problems in one area such as security brokerage services or insurance may eventually lead to problems in the traditional banking area or vice versa. One regulatory agency might be more likely to find these overlapping problems and prevent them before they cause the collapse of the entire organization. In addition, one regulatory agency may be able to better identify and prevent the inherent conflicts of interest that exist when a large financial conglomerate is formed.