Week 8 (Chapter 11) Financial Systems
Week 8 (Chapter 11) Financial Systems FIN 3113
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Chapter 11 Commercial Banks: Industry Overview Part III Commercial Banks Chapter Eleven Commercial Banks: Industry Overview I. Chapter Outline 1. Commercial Banks as a Sector of the Financial Institutions Industry: Chapter Overview 2. Definition of a Commercial Bank 3. Balance Sheet and Recent Trends a. Assets b. Liabilities c. Equity d. Off Balance Sheet Activities e. Other Fee Generating Activities 4. Size, Structure, and Composition of the Industry a. Economies of Scale and Scope b. Bank Size and Concentration c. Bank Size and Activities 5. Industry Performance 6. Technology in Commercial Banking a. Wholesale Banking Services b. Retail Banking Services 7. Regulators a. Federal Deposit Insurance Corporation b. Office of the Comptroller of the Currency c. The Federal Reserve System d. State Authorities 8. Global Issues a. Advantages and Disadvantages of International Expansions b. Global Banking Performance 111 Chapter 11 Commercial Banks: Industry Overview Commercial Banks as a Sector of the Financial Institutions Industry: Chapter Overview Loans are the major asset of all banks and deposits are the primary funds source. The composition of the loan portfolio has changed over time and deposits are not as great a percentage of financing as in the past. 1. Definition of a Commercial Bank Banks are a subset of the three main types of DIs: banks, savings institutions, and credit unions. All three offer similar services. Banks will normally be larger, have a more diversified loan portfolio that includes more business lending and will have more sources of funds beyond deposits. Banks also play a unique role in our economy. The banking system is the conduit for monetary policy and banks are involved in much of the payments system and in credit allocation. Banks provide risk, maturity, denomination, and liquidity intermediation services to savers, helping to maximize the amount of funds available to potential borrowers. 2. Balance Sheet and Recent Trends a. Assets Major categories (2007 data) (Total Assets = $10,411 billion) Liquid assets Total cash assets (primarily vault cash, currency in the process of collection, correspondent balances and reserves at the Fed) comprised 4.39% of assets. Investment securities comprised about 28% of assets. U.S. government securities made up about 36% of the investment portfolio and about 10% of total assets. This investment portfolio is very safe and liquid. Loans Loans are the highest earning asset on the bank balance sheet. They are also the largest category. As of 2007 loans comprised 59% of total assets. The major loan types include: Bank loans by type % of Loans % of Assets Commercial and industrial loans 20.0% 11.7% Real estate loans 57.6% 33.7% Consumer loans 14.4% 8.4% Other loans 9.3% 5.4% Reserve for loan losses (1.2%) (0.69%) Reserves for unearned income (0.05%) (0.03%) 112 Chapter 11 Commercial Banks: Industry Overview The primary risk a bank faces is credit risk, and a bank is unlikely to be able to remain profitable if there are significant problems in the loan portfolio. Mortgage lending is increasing at most banks and C&I loans are declining. The former has occurred because of the demise of S&Ls and growth in the mortgage markets, particularly securitization. The latter is occurring because businesses have been able to procure alternative financing through the commercial paper market at rates below bank loans and because the public debt markets have grown rapidly. Other assets, primarily nonearning assets accounted for about 9.2% of total assets. (Numbers are rounded slightly, includes reserve for loan losses as per the text) b. Liabilities Major categories (2007 data) Deposits: Deposits are the largest source of funds. As of 2007 deposits comprised almost 66% of total funding. Transaction accounts are checking accounts (such as NOWs that pay interest or demand deposits that do not pay interest). Transaction deposits comprised 11% of total deposits. Transactions deposits are declining as a source of funding at banks. Nontransaction deposits include savings account, MMDAs and CDs. Nontransaction accounts made up 89% of total deposits. Passbook savings and retail CDs comprised 75% of total deposits, negotiable CDs ($100,000 or greater) were about 13.8% of total deposits. In the 1950s interest bearing sources of funds were under 25% of total funding; today most funds sources are interest bearing. What does this imply about the sensitivity of bank profits to interest rates today as compared to the past? This also illustrates why banks have sought to increase fee based sources of income. Borrowings and Other Liabilities include notes and bonds outstanding, fed funds borrowed, and repurchase liabilities and were 21% of total funding. The liabilities of banks tend to have less default risk than the assets and typically have a shorter maturity than the assets. That is, banks normally provide maturity and credit risk intermediation services to savers by providing savers with safer, shorter maturity accounts while purchasing or creating longer term riskier claims. The banks in turn earn the interest rate spread between the rates charged on the assets and the rates paid on the liabilities. c. Equity 113 Chapter 11 Commercial Banks: Industry Overview Capital requirements specify the minimum amount of capital a bank must maintain (see Chapter 13 for specific requirements) under the Basle Accord. Information on the Basle Accord and recent changes can be found at the website of the Bank of International Settlements (BIS). In 2007 equity comprised 10.08% of total funding. Equity consists of common stock (par and surplus), preferred stock and retained earnings. Regulators define other accounts that may serve as equity for the purposes of calculating minimum capital requirements. 114 Chapter 11 Commercial Banks: Industry Overview Banks typically employ about 90% debt in their capital structure. Few nonfinancial firms allow their debt ratios to get over 50% (other than in Highly Levered Transactions). Nonfinancial firms in volatile industries often use little or no debt. DIs must employ a high amount of leverage to offer stockholders a satisfactory rate of return since their ROA is generally very low (in the 0.5%2% range). Their ROA is low because they primarily have paper assets and liabilities. Recall from microeconomics that in industries with nondifferentiable products, competition will force economic rents (NPVs) to zero. The ability of banks to use such high debt ratios arises from a) banks’ ability to closely manage and hedge risk and b) deposit insurance. Banks that do not learn to manage risk appropriately quickly fail when environmental factors change. Moreover, most bank creditors do not demand a risk premium in the form of higher deposit rates at risky banks because the government guarantees their deposits. This is an example of a market failure and the problem of moral hazard engendered by deposit insurance. d. Off Balance Sheet Activities Off balance sheet (OBS) assets and liabilities are activities that may lead to changes in on balance sheet assets and liabilities respectively, contingent upon some event occurring. Example of OBS activities include (ranked by size in 2007): Swap agreements Written or purchased options contracts Credit derivatives Forward & futures contracts other than for foreign exchange Commitments to buy or sell foreign exchange (spot or forward) Loan commitments Securities borrowed or lent Standby letters of credit e. Other Fee Generating Activities Much of this material is not in the text. Correspondent banking larger banks serve as agents for smaller banks, assisting in check clearing purchasing securities foreign exchange loan participations (both ways) obtaining and placing fed funds trust services obtaining brokered deposits (Jumbo C.D.s, Euro$) Leasing Banks may be able to use tax breaks from purchasing equipment that small/medium size businesses cannot. 1 It is questionable whether the size of these commitments can be compared in this way since the risks and likelihood of becoming an on balance sheet commitment varies dramatically for the different activities. 115 Chapter 11 Commercial Banks: Industry Overview Trust operations – Trust functions are offered only by larger banks, but trust services are made available at most banks through correspondent relationships. Trust operations are providing fiduciary services for a third party. Swap brokers Many larger banks act as swap brokers/swap partners helping financial institutions better match the interest sensitivity of their assets and liabilities. They take a fee for this service. Brokerage services Underwriting Underwriting income via bank subsidiaries. Banks can advise and manage mutual funds but cannot sponsor the fund. 3. Size, Structure, and Composition of the Industry As of December 2007 there were 7,282 commercial banks. This number has declined 42.86% since 1989. The decline is somewhat misleading because the number of bank offices including branches grew from 60,000 in 1984 to 83,000 in 2007. Industry consolidation has been occurring rapidly, largely via unassisted mergers, but total bank assets and the total number of banking facilities have grown at significant rates. Banking remains a growth industry. a. Economies of Scale and Scope The last few years have seen many megamergers (mergers of banks with over $1 billion in total assets). Text Table 113 contains a list. Primary reasons include cost and revenue economies and regulatory changes. Economies of scale and scope are generated by declines in unit costs required to produce bank activities as the bank gets larger or adds more services respectively. Cost economies of scale result from fixed costs spread over larger output as the bank grows. Institutions such as J.P. Morgan and Chase Manhattan estimated that their merger would result in cost savings of $1.5 billion. Cost economies of scope result from cost sharing when multiple products are offered. That is, as more products are added, costs do not rise proportionally with revenues. The Financial Services Modernization Act of 1999 (FSMA) allows banks to merge with insurance firms and investment banks for the first time since 1934. The 1998 merger of Citicorp and Travelers (a bank and an insurance firm) prompted the change. The merger of UBS and Paine Webber is another example of a merger that may exploit cost economies of scope. 116 Chapter 11 Commercial Banks: Industry Overview Both of these economies derive from fixed costs arising from technology. As more customers and/or more services are added the cost per unit to provide the service (such as brokerage, financial planning, underwriting insurance, etc,) drops, improving profitability. 117 Chapter 11 Commercial Banks: Industry Overview Revenue economies of scale and scope also provide motives for mergers. Additional revenues can be generated via mergers by adding additional customers, moving into less competitive markets and stabilizing revenue by serving customers in different regions. The 2004 J.P. Morgan Chase acquisition of Bank One, added Bank One’s large credit card operations and retail network in an attempt to broaden Chase’s revenue sources. X efficiencies are cost savings that occur which are not attributable to economies of scale and scope. They may include managerial learning processes or other unspecified cost savings. Diseconomies of scale may also arise from mergers. It is notoriously difficult to manage large institutions that have different organizational cultures. Managerial hubris cannot be overlooked in discussing mergers. Managers tend to over estimate their ability to generate revenue and cost economies and tend to underestimate the complexities involved, including loss of employee morale when jobs are cut, technological problems in integrating different computer systems, problems in corporate culture, etc. In 2006 WalMart and Target applied for Industrial Loan Corporation (ILC) charters to provide certain banking services. ILCs are chartered in Utah and are not directly regulated by any banking regulator. ILCs may make commercial loans, and typically lend to higher risk corporate borrowers. WalMart’s stated rationale was to lower the cost of processing electronic payments and Target hoped to issue business credit cards. There were many vocal opponents of these applications and the FDIC established a moratorium on all ILC applications while Congress considers banning them. Allowing ILCs of this type further blurs the separation between commercial enterprises and banking and could potentially increase the risk of the banking system significantly. WalMart withdrew its application in 2007. b. Bank Size and Concentration The largest banks increasingly dominate the industry (see text or below) and the largest banks control the vast majority of industry assets. This is now true in all aspects of the financial services industries. Banks are often classified as 118 Chapter 11 Commercial Banks: Industry Overview money center banks which include the largest banks, typically located in New York city. Size alone however does not make a money center bank. These banks generally rely on nondeposit sources of funds and are heavily engaged in wholesale banking (with or without a retail banking presence) and involved in international markets. Wholesale banking refers to providing loans services to corporations and other institutions as well as acquiring nondeposit sources of funds. Retail banking is providing consumer oriented banking services such as loans and deposits. Money center banks include Bank of New York, Citigroup, J.P. Morgan Chase, HSBC Bank USA and Bankers Trust (owned by Deutsche Bank). superregional or regional banks that operate primarily in one or more regions of the country community banks that operate in local markets Summary of Text Figure 116 Size & Type % of total # % of total 2007 banks banks assets Community banks 93.2% 11.7% $110 billion 5.6% 10.4% ≥ $10 billion 1.2% 77.9% 100.0% 100.0% Notice the heavy concentration of assets among the largest banks. Nevertheless, thousands of small banks remain throughout the country, although more and more of these small institutions are being absorbed by mergers. Absorptions are running higher than new charters so the trend toward increasing concentration will continue. c. Bank Size and Activities Large banks generally are less liquid, are more heavily concentrated in loans and use more purchased sources of funds. They have greater access to brokered deposits and nondeposit liabilities and they tend to hold less equity. Large banks lend to more sophisticated corporate customers which means that their profit margins are often lower than for smaller banks that operate in more isolated, less competitive circumstances. A key ratio for bank management includes the net interest margin which is equal to the interest rate spread divided by earning assets. The interest rate spread is the interest earned on assets minus the interest paid on liabilities. Large banks typically pay higher salaries than smaller banks and have greater investments in facilities and in the provision of services. On the other hand large banks generate substantially more fee income than small banks. 119 Chapter 11 Commercial Banks: Industry Overview 4. Industry Performance Banks enjoyed excellent profitability during most of the 1990s, weaker performance in 2 the early 2000s, but record high performance in 2003 and on into 2004. In 2004 banks had an average ROA of 1.31% and a ROE of 14.01%, both figures were good. Bank ROA’s vary from 0.5% to 2% typically. Bank profitability had been high because of higher noninterest income and lower loan loss provisions. Consumer loan demand and demand for mortgage credit remained high in this time period as well. Banks also benefited from a long period of low interest rates and good economic growth with low inflation which encouraged borrowing. Credit card rates in particular did not fall as quickly as bank costs, improving bank margins. Better information technology helped reduce costs and the growth of credit derivatives and mortgage securitization helped banks to continue high lending volume while shifting risks to other entities. The yield on earning assets in 2004 was 5.18% and the cost of funding earning assets was 1.56%, giving a net interest margin of 3.62%which is quite good. 3 As interest rates rose in 2005 and 2006 bank profitability remained strong although increasing loan loss provisions and weaker trading revenue and servicing income kept 2006 profitability from reaching record highs. However the flattening yield curve, competitive pricing and increases in fund costs contributed to falling profit rates at banks. In late 2006 and in 2007 problems in mortgages also began to hurt banks. Foreclosure filings jumped 93% in July 2007 from July 2006. In the fourth quarter of 2007 loan loss provisions reached $31.3 billion, their highest level since 1991. This was a 300% increase from the fourth quarter in the prior year although seven large institutions accounted for over half the increase in loss provisions. Trading losses were $10.6 billion; the first ever quarterly net trading loss. Ten large institutions accounted for all the decline in trading earnings. Net interest income rose 11.8% from the prior year quarter. In all, net income for the fourth quarter of 2007 was the lowest reported since the same quarter in 1991. Earnings problems were widespread with 51% of all institutions reporting lower net income, but the depth of the decline was driven by a few large institutions. ROA for the quarter was only 0.18%, down from 1.20% in the 4 quarter of h the prior year. This was the lowest ROA since 1990 and ROE was only a dismal 1.74%. 4 The provision for loan losses is a charge to earnings based on management’s expectation of how many loans will go bad in the current quarter. Net charge offs are actual write offs. Net charges offs have reached five year highs in 2007, at $16.2 2 billion as compared to $8.5 billion in the fourth quarter of 2006. This yields an annualized net 5 charge off rate of 0.83%, the highest since 2002. 2 U.S. banks had less exposure to the late 1990s Russian and Asian crises than banks of other countries, 3presumably having learned their lesson from the LDC debt fiascoes of the 1970s and 1980s. Source FDIC Quarterly Banking Profile, Third Quarter 2004. 4 Data and analysis not in the text are from the FDIC Quarterly Banking Profile, Fourth Quarter 2007. 5 Ibid 1110 Chapter 11 Commercial Banks: Industry Overview Over the longer term, the industry probably still remains stronger today than it was in the late 1980s and early 1990s. For instance, two hundred and six banks failed in 1989; only three failed in 2007 although 76 are on the “Problem List,” the highest number since 2004. As of September 2007 about 56% of institutions were in the minimum risk Category and only 2.6% of institutions were in categories II, II or IV, with none in Category IV. 6 Improvements in risk management, still low interest rates and the additional oversight brought about by the FDIC Improvement Act of 1990 helped turn the banking industry around in the last decade. 5. Technology in Commercial Banking Technology is profoundly changing the banking industry, and the major changes are still ahead. Technology investments can generate operating efficiencies and economies of scale and scope. Internet and wireless communications constitute new methods of offering both existing and new financial services to current and potential customers at much lower costs than currently available. a. Products Available in Wholesale Banking Cash management services: Technology is allowing banks to offer corporate customers real time information of cash balances related to the following services: Controlled disbursement accounts – Accounts that allow the customer to know exactly which checks or payments will be withdrawn that day from the account. Real time account reconciliation Electronic lockboxes allow corporate customers to reduce the float time, in this context float is the time between when the customer pays the check and the corporation collects. Funds concentration allows sweeping of funds from various accounts into one centrally managed account. Electronic funds transfer via CHIPS or Fedwire, automated payments via ACHs and automated message transfers via SWIFT Automated check deposit services Electronically generated letters of credit Access to treasury management software Electronic invoicing interchange between businesses Electronic B2B commerce Electronic billing Verification of identities in transactions 6 Ibid 1111 Chapter 11 Commercial Banks: Industry Overview b. Products Available in Retail Banking ATMs and ATM networks Point of sale cards Home banking Preapproved debits or credits Paying bills by phone Email billing Online banking Smart cards Online banking services are beginning to grow at a much more rapid pace. By the mid 2000s about 77% of Wachovia’s customers used online banking services followed by J.P. Morgan Chase at 60%, Citigroup and Bank of America with 53% and Washington Mutual with 25%. I suspect that this usage is somewhat limited. Availability, security and cost of high speed Internet remain issues, but the younger generation in particular seems increasingly willing to use online bank services. This area will probably continue to suffer from overcapacity and customer resistance for some time. Internet only banks have not thrived. Customers still desire to interact with people for many transactions and appear to prefer to deal with established banks, even if they plan to use electronic banking functions. 6. Regulators a. Federal Deposit Insurance Corporation The FDIC, created in 1933, manages the deposit insurance funds for the thrift and banking industries. The FDIC examines banks and disposes of failed bank and savings association assets. b. Office of the Comptroller of the Currency The OCC has been around since the Civil War. The OCC grants national charters, although banks may be state chartered instead. The OCC examines national banks and approves or disapproves their merger applications. Prior to 1863 the U.S. had only state chartered banks. In an attempt to help finance the Civil War, the National Banking Acts of 1863 and 1864 created nationally chartered banks that the federal government could more tightly regulate. The laws required nationally chartered banks to hold U.S. government bonds to collateralize their bank notes. This allowed the government to finance the rest of the war. The acts did not outlaw state banking and as a result we have a dual banking system today. 1112 Chapter 11 Commercial Banks: Industry Overview About twentythree percent of federally insured banks are nationally chartered banks; the remainder is state chartered. Nationally chartered banks must be members of the Fed and must be FDIC insured. State chartered banks have a choice on both. State chartered banks may have less regulations imposed upon them and state chartered banks cannot use the word ‘national’ in their name. 1113 Chapter 11 Commercial Banks: Industry Overview c. The Federal Reserve System About 35% of federally insured banks are members of the Federal Reserve and 65% are not. Fed membership allows banks direct access to the FedWire system. The Fed regulates bank holding company activities. d. State Authorities State chartered banks are regulated by state banking authorities. Federally insured state chartered banks pass into receivership of the FDIC if they fail. 7. Global Issues Of the top 20 global banks in the world ranked by asset size, only 3 are U.S. banks (Citigroup, J.P. Morgan Chase and Bank America). In 2007 Royal Bank of Scotland Group, Banco Santander of Spain and Fortis NV jointly purchased ABN Amro Holdings for $101 billion, the largest bank acquisition ever. The three buyers will split up ABN Amro into three pieces over the next three years. This result is an artifact of U.S. bank regulations that have promoted small community banks. If one looked at lists of the most profitable and sophisticated banks, one would find more U.S. banks on that list. The advantages of globalizing operations include: Additional risk diversification by including operations in other economies Economies of scale and scope U.S. banks have been global industry leaders in generating innovative new products such as OTC derivatives not developed by overseas banks Expanded funds sources Maintenance of customer relationships as many corporate customers have gone global and have needed banking services for their overseas operations Avoidance of domestic regulations The U.S. tends to be the most tightly regulated market and engaging in overseas operations allows U.S. banks to operate with less scrutiny Disadvantages of globalization of banking services include: Greater information production and monitoring costs involved in evaluating overseas loans and investments. The U.S. generally has higher disclosure requirements than most other countries. Overseas operations may face expropriation or repatriation problems. The fixed costs to enter foreign markets may be quite high and may not be easily recovered once an investment is made. 1. 1114