Depository Institutions

1
Depository Institutions
2
Depository Institutions

• Main criteria is that a significant portion of
  the firms funds come from customer deposits.
• Examples include
• Commercial Banks
• Savings and Loans
• Credit Unions

3
Recent Trends

• The 1990s ended with the Fin Modernization Act
  (1999).
• During this time there has been a wave of mergers
  and acquisitions in the industry.
• The increased business services that Depository
  Institutions are now allowed to offer has created
  a desire for larger less regional institutions.

4
Largest Depository Institutions, Dec 31, 2003 by
total assets (billions)

• Dom
• Assets Assets Dep
• J.P Morgan Chase 1009 11.11 6.61
• Bank of America 870 9.58 9.82
• Citigroup 796 8.77 3.47
• Wells Fargo 380 4.19 4.62
• Wachovia Corp 362 3.99 4.09
• Washington Mutual 276 3.04 3.23
• US Bancorp 192 2.12 2.19
• National City Corp 132 1.45 1.17
• SunTrust 125 1.37 1.47
• ABN ARMCO 107 1.18 0.87

5
Traditional Services

• Depository Institutions have been traditionally
  been subject to a large amount of regulation that
  restricted their actions.
• Main business functions
• Consumer and Business Lending
• Savings Products
• Payment Services
• Main overlap with other FIs has been in Savings
  products That has changed dramatically in the
  last 10 years.

6
Key Regulatory Legislation

• National Currency and Bank Acts (1863-64)
• Set up system of federally chartering banks
  through US Treas Dept. or Comptroller of
  Currency or Administrator of National Banks
• Comptroller of the Currency examines all
  nationally chartered banks every 12 to 18 months
• Established pledging requirements for owners
  equity

7
Key Regulatory Legislation

• The Federal Reserve Act (1913)
• Established the Federal Reserve System as a
  lender of last resort
• Established network to clear and collect checks

8
Key Legislation

• McFadden Act (1927)
• National banks allowed branches in their original
  city.
• Branching across state lines forbidden unless
  allowed by state law
• Liberalized banks underwriting activities and
  allowed underwriting of corporate stocks and
  bonds

9
Legislation (continued)...

• 1933 Glass-Steagall
• Separates securities and banking activities
• Prohibited commercial banks from most
  underwriting of securities. 4 exceptions Munis,
  US govt, Private Placement and Real Estate Loans.
  Fear of conflict of interest
• Established FDIC
• National banks allowed to branch state wide if
  state chartered banks were allowed to do so.

10
Legislation (continued)...

• Bank Holding Company Act and subsequent
  amendments (1956 1966 and 1970)
• Specifies permissible activities and regulation
  by Fed Res of Bank Holding Cos.
• Bank Holding Companies must request Fed Approval
• Cos with 2 or more banks must register with Fed
  Res and file financial statements and submit to
  Fed Res review of their books
• 1970 Amendments to the Bank Holding Company Act
  Extension to one-bank holding companies

11
Legislation (continued)...

• 1970 International Banking Act Regulated foreign
  bank branches and agencies in USA
• 1980 Depository Institutions Deregulation and
  Monetary Control Act
• Phased out interest rate ceilings imposed by
  Regulation Q
• Goal was to make SLs, credit unions and other
  nonbank depository institutions more competitive.

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Legislation (continued)

• Depository Institutions Act (1982) Garn-St.
  Germain Depository Institutions Act)
• Allowed all federally supervised depository
  Institutions to sell deposit accounts equivalent
  to Money market mutual fund accounts
• Loan limits were liberalized for national banks,
  allowed lending of up to 15 of their capital
• FDIC could arrange mergers across state lines for
  failing institutions
• Competitive Equality in Banking Act (1987)
• Redefined bank to limit growth of nonbank banks.

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Legislation (continued)

• Financial Institutions Reform Recovery and
  Enforcement Act (1989)
• Imposed restrictions on investment activities
• Replaced FSLIC with FDIC-SAIF
• Replaced FHLB with Office of Thrift Supervision
• Created Resolution Trust Corporation

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Legislation (continued)

• 1991 FDIC Improvement Act
• Fear of FDIC insolvency by end of 1991
• Ordered new measurement scale for describing
  financial condition of depository institution and
  when in violation to take prompt corrective
  action
• Risk-based deposit insurance premiums
• Limited too big to fail

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Legislation (continued)

• Riegle-Neal Interstate Banking and Branching
  Efficiency Act (1994)
• Permits BHCs to acquire banks in other states.
• Invalidates some restrictive state laws.
• Permits BHCs to convert out-of-state subsidiary
  banks to branches of single interstate bank.
• Newly chartered branches permitted interstate if
  allowed by state law.

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1999 Financial Services Modernization Act

• Financial Services Modernization Act
• Allowed banks, insurance companies, and
  securities firms to enter each others business
  areas
• Provided for state regulation of insurance
• Streamlined regulation of BHCs
• Prohibited FDIC assistance to affiliates and
  subsidiaries of banks and savings institutions
• Provided for national treatment of foreign banks
• ATM fees must be clearly disclosed
• Federal Crime to steal account information

17
Structural Changes
18
FDIC Institutions
19
Competition among FIs
20
Unresolved Issues

• Does regulatory approval limit the ability of
  banks to respond to new markets?
• Will functional regulation work (can regulatory
  agencies work together?)
• Can and will countries work together as
  institutions become more global?

21
Bank Size (by asset concentration)

• Community banks under 1billion in assets
  specialize in retail or consumer lending
• The asset share of banks over 1Billion has
  increased from 63.4 in 1984 to 83.9 in 2000.
• Large banks often have access to cheaper forms of
  cash.
• Money Center Banks Heavy reliance on nondeposit
  or borrowed funds.

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Balance Sheet

• Assets - four major categories
• Cash and deposits held at other institutions
• Government and private interest bearing
  securities
• Loans and leases
• Misc assets.
• Liabilities two major categories
• Deposits
• Non deposit borrowing

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Assets

• Cash (Primary Reserves)
• includes vault cash, reserves at the Fed Res,
  deposits at other banks, checks in the process of
  collection. Designed to meet liquidity needs
• Investment Securities
• Liquid portion (Secondary Reserves) ST Govt
  securities, money market securities, commercial
  paper, time deposits
• Income Generating portion Bonds notes and other
  securities (taxable and tax exempt).
• Trading account securities bank serve as a
  security dealer for state, federal and local
  govt obligations. Bank intends to sell these
  prior to maturity

24
Assets (continued)

• Loans
• Largest portion of assets form most banks
• Includes consumer, real estate, business, ag
  production, leases and foreign loans.
• Most statements include a gross loan amount and
  an allowance for loan loss (balance is built
  with deductions from current income, when a loan
  is uncollectable then balance is reduced.
  Therefore both the gross account and loss account
  change. And net income is not impacted.)

25
Assets (continued)

• Federal Funds sold and Securities Purchased under
  Repurchase agreements
• Short term loans
• Customers Liability on Acceptances
• A line of credit provided via a letter of credit
  backing purchases by the customer.
• Miscellaneous Assets
• Bank buildings, equipment, prepaid insurance etc.

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Assets, of Total Assets
27
Loans, of Total Loans
28
Loan Portfolios 2000
Real Estate 62.77
Real Estate 39.85
29
Liabilities

• Largest portion of liabilities is deposits
• Average ratio of equity to assets 8.49 (91.51
  of asses are financed by some type of debt..)
• Approximately 21 of deposits are transaction
  accounts (checkable deposits that cost little or
  no interest)
• Retail savings and time deposits have been
  declining due to competition form money market
  mutual funds

30
Deposits

• Non-interest bearing demand deposits
• Checking accounts with unlimited check writing
• Savings deposits
• NOW accounts
• Held only by individuals and nonprofit
  institutions pay interest and permit checks
• Money market deposit accounts
• Limited check writing ability and can pay
  interest
• Time deposits
• CDs with fixed maturity and interest rate

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Liabilities, of Total
32
Assets Vs. Liabilities

• Generally liabilities tend to be of shorter
  maturity than assets. This introduces interest
  rate risk and liquidity risk for depository
  institutions.

33
Equity

• Usually about 8 to 10 of liabilities and equity
• Generally equity held is close to the minimum
  amount set by regulations

34
Off - Balance Sheet Activities

• Assets and Liabilities that will appear on the
  balance sheet or income statement if a contingent
  event occurs.
• Motivated by both earnings and regulatory (tax
  avoidance) incentives
• Expose the bank to added risk, but do not show up
  on traditional financial reports.

35
OBS Activities continued

• Standby Credit Agreements- bank pledges to
  guarantee repayment of a customers loan received
  from a third party
• Interest rate swaps exchange interest payments
  on debt securities with another party
• Financial futures and options
• Loan commitments pledge to lend up to a certain
  amount of funds
• Foreign exchange rate contracts

36
Other Fee Generating Activities

• Trust Services
• Management of estate assets and pension fund
  assets
• Correspondent Banking
• Providing banking services to smaller
  institutions that do not have the staff or
  expertise in those services.

37
Savings Associations

• Primarily deal with household saving and
  mortgages.
• Financing long term mortgages with short term
  deposits has been helped by a traditionally
  upward sloping yield curve.

38
SL Regulation

• Traditionally restricted in the type of accounts
  they could offer the regulation in the early
  1980s allowed SLs to become more competitive
  with commercial banks. Most notably the repeal
  of Regulation Q. Also allowed to offer NOW
  accounts and more market sensitive money market
  accounts

39
Savings Banks

• Originally organized as a mutual organization
  that also focused on mortgage lending
• Many are now switching to stock ownership

40
Credit Unions

• Nonprofit depository institutions that are
  mutually organized.
• Members must belong to a specific similar
  occupation, association or live in a given
  community.
• Earnings are designated to paying higher rates of
  return on deposits and to charging lower rates of
  interest on loans.

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Financial Analysis ofDepository Institutions

• Finance 129
• Drake University

42
Basic Financial Statements

• Report of Condition
• Balance Sheet
• Report of Income
• Income Statement
• Funds Flow Statement
• Sources and Uses of Funds
• Statement of Stockholders Equity

43
Balance Sheet

• Financial Outputs
• (uses of Bank Funds or Assets)
• Cash (primary reserves)
• Liquid Security Holdings
• (secondary Reserves)
• Investments in Securities
• Loans
• Consumer
• Real Estate
• Ag
• Fin Institutions
• Mics Loans
• Misc

• Financial Inputs
• (Sources of Funds or
• Liabilities and Owners Equity)
• Deposits from Public
• Demand
• NOWs
• Money markets
• Savings
• Time
• Nondeposit Borrowings
• Equity Capital
• Stock
• Surplus
• Retained Earnings
• Capital reserves

44
Balance Sheet continued

• As with any balance sheet
• Assets Liabilities Owners Equity
• or
• Accumulated uses Accumulated sources
• of bank funds of bank funds

45
Balance Sheet Components Assets

• The Cash Account
• includes Cash in the vault, deposits with other
  banks, cash items in the process of collection
  and reserve accounts with the Federal Reserve
• Traditionally banks attempt to keep this account
  as low as possible
• Primary reserves since it is banks first line of
  defense against withdrawls

46
Balance Sheet Components Assets

• Investment Securities the liquid portion
• Short term government securities and money market
  instruments
• secondary reserves
• Investment Securities Income Generating Portion
• Taxable and nontaxable
• Can be recorded at original cost or market value
  or the lower of the two
• trading account securities

47
Balance Sheet Components Assets

• Loans
• Largest Asset
• Generally broken down by purpose of loans
• Gross loans -- total of all outstanding
• Allowance for Loan losses (ALL account)
• PLL on income statement
• Gross minus ALL Net Loans
• Allocated Transfer Risks
• Unearned Discounts

48
Balance Sheet Components Assets

• ALL account
• often divided into two sections, specific
  reserves, and general reserves
• Tax reform Act of 1986
• only loans actually declared uncollectable can be
  expensed through the ALL accounts
• decreased use of ALL accounts
• Permanent capital

49
Balance Sheet Components Assets

• Federal Funds Sold and Securities Purchased under
  Resale Agreements
• Customers liability Acceptances
• Misc Assets

50
Balance Sheet Components Liabilities

• Deposits
• Noninterest bearing
• Savings
• NOW accounts
• Money Market Accounts
• Time Deposits
• Borrowings from Nondeposit sources
• Capital Accounts

51
Book vs. Fair Value

• Banks have traditionally recorded balance sheet
  entries at original cost (book value or
  historical cost accounting -- ammoritzed cost)
• Implies that interest rate fluctuations would not
  impact values
• Fair Value -- current market value

52
Arguments against Fair Value

• Possible increase in the volatility of earnings
• greater instability in stock prices of banks
• loss of bank capital cushions
• lack of resale market

53
Income Statement or Report of Income

• Revenue Items
• Interest Income (interest generated from loans
  normally accounts for most income (generally more
  than 2/3)
• Non interest income (fee income) Increasingly
  important.
• No interest income also includes securities gains
  (or losses). Now subject to standard tax rate

54
Report of IncomeExpenses

• Interest Expense
• largest expense is interest paid on deposits,
  often between 50 and 60 of total expenses
• fed funds borrowing and repurchase agreements
  have grown in importance.
• Non interest expense
• wages, salaries and other personnel expenses

55
Income

• Net Interest Income
• Total Interest Income -Total Interest Expense
• Also referred to as interest margin
• Net income
• Adds non interest income and subtracts no
  interest expense to interest income.

56
Income Statement

• Interest Income
• Interest on loans, Interest on securities, Other
  
• Interest Expense
• Deposit Interest, Short term debt, Long Term
  debt
• Net Interest Income
• Non interest Income
• Service Charges, Trust Department, Other
• Non interest Expense
• Wages, Net occupancy, Other operating expenses
• Income before taxes
• Provision for income taxes
• Net income after taxes

57
Funds - Flow Statement

• Dividends paid out to stockholders
• increase in banks assets
• decreases in bank liabilities
• Funds Used by the bank

• Funds from operations
• decreases in bank assets
• increases in bank liabilities
• Funds provided to the bank

58
Capital Account Statement

• Beginning Balance
• Net income
• - Dividends paid to shareholders
• New Shares of Stock issued
• - Purchases of treasury stock
• Balance at end of period

59
Common Characteristics of Banks Financial
Statements

• Heavy dependence on borrowed funds
• Earnings are exposed to risk if borrowings cannot
  be repaid
• Growing use of nondeposit borrowings
• Bank must hold a significant proportion of high
  quality and marketable securities
• Financial Assets are more important than plants
  and equipment
• few fixed costs and limited use of operating
  leverage.

60
Evaluating and Measuring Bank Performance

• Going to use ratio analysis to evaluate the
  performance of depository institutions

61
ROE and ROA

• ROE measure the rate of return flowing to the
  banks shareholders
• ROA measures managerial efficiency -- how well
  management converts assets into net earnings

62
Relationship between ROE and ROA
63
DuPont Identity
64
Decomposition
65
Decomposition

• Equity Multiplier
• Reflects the leverage or financing policies (the
  choice of debt or equity)
• Profit Margin
• Reflects the effectiveness of expense management
  control
• Asset utilization
• Reflects the ability to manage the mix and yield
  on the banks assets

66
Example changes through time
67
Average returns on Banks 1999
lt 100 Million 100 Million to 1 Billion 1Billion to 10 Billion gt 10 Billion
ROA 1.01 1.36 1.49 1.28
ROE 9.07 14.24 16.02 15.97
68
Asset Utilization and Profit Margin

• Both reflect Management decisions regarding
• Mix of funds raised and invested
• Size of Bank
• control of operating Expenses
• Pricing of Services
• Minimization of tax liability

69
Asset Utilization
70
Asset Utilization
71
Profit Margin
72
Decomposition of ROA
73
Decomposition of ROA Part 2
74
Decomposition of ROA Part 2
75
Other Important Ratios
76
Obtaining Information on Banks

• Data for banks is available from the Uniform Bank
  Performance Report (UBPR).
• UBPR developed by the Fed, FDIC, and office of
  the comptroller of Currency so that there would
  be a standardized way to compare institutions.
• Also peer group and state reports for comparable
  banks.

77
UBPR

• Goal is to provide uniform reporting of
  information
• Developed by the Federal Financial Institutions
  Examination Councils quarterly reports.
• Available online at www.FFIEC.org

78
Using the UBPR

• Compare across years
• each report has 5 years of data
• Year end or current quarter plus 1 year prior to
  current and three previous years
• Compare to peer groups
• also available are peer groups reports based on
  both size of bank and geographic location
• Allows you to benchmark

79
UBPR Security National

• Table 5-5 from Rose
• Total Assets increased by 600 million, rate of
  9.3
• all types of loan rose except ones hit by
  economic downturn (lines 1-11)
• decrease in short term securities, increase in
  long term, maybe seeking higher yields (lines 14
  and 18)
• Large increase in US treasury Securities (line
  24) and municipal securities (line 25)

80
UBPR Security National

• Table 5-6 in Rose
• Deposits increased except for sectors hit by
  economic down turn.
• Large increase in need for federal funs and
  repurchase agreements (line 10). Indicate that
  loans and securities grew faster than deposits.
  Also may reduce profitability since it is an
  expensive source of funds.

81
UBPR Security National

• Table 5-7 in Rose
• Loans increased as a percentage of assets, but on
  average still less than peer group (line 1).
  Loans are high yielding -- may reduce income.
• Holds more long term 18.57 than average of 8.95
  (line 5). Higher market risk due to interest rate
  sensitivity. Fewer short term securities 2.54
  than average 3.41 (line 10).
• Low amount of non interest bearing cash deposits
  from other banks and deposits due (line 13)
  indicates higher liquidity risk. May force
  increased borrowing in fed funds market. And
  increased liquidity risk

82
UBPR Security National

• Table 5-7 in Rose
• Smaller portion of checkable deposits which are a
  cheap source of funds (line 19)
• Also smaller portion of core deposits (demand,
  NOW, savings accounts, money market and time
  deposits less than 100,000) (line 23). Assumed
  to be stable source of funds decreasing chance of
  illiquidity

83
UBPR Security National

• Table 5-8 in Rose
• Interest income increased by 7 million or 1.2
  (line 15), interest expense increase by 18
  million or 14.6 (line 23)
• Net interest income declined by 6.3 (line 24)
• Interest on borrowed money increased by 10 (line
  20)
• Interest paid on large CDs increased by 14.6
  (line16)
• Provision for loan losses increased by 83 (line
  28)
• Non interest income increased by 22.2 (line 25)
• Net income decreased by 28.3 (line 37)

84
UBPR Sec Nat

• Recent Year
• NIM (165/6951) 2.37
• Last year
• NIM (176/6361) 2.77
• Peer Group (table 5-9)
• NIM Recent year 3.91 Last year 3.66
• The industry increased while security national
  decreased, both much lower than average

85
UBPR Security National (Rose)

• Current Tot assets 6951 Tot equity 482 Net
  income 33
• Last 6361 381 46

86
UBPR Security National

• From last slide
• ROA declined and the equity multiplier declined
• Higher equity multiplier is riskier, but here the
  decrease is helping to decrease profitability.
• Alternative EM definition 1/EM is the of
  assets that can default before insolvency

87
UBPR Security National

• Current Tot assets 6951 Tot equity 482 Net inc
  33 Tot inc 604
• Last 6361
  381 46 593

88
UBPR Security National

• Asset Utilization decreased form .0932 to .0869
  and profit margin declined from .0776 to .0546
• Decline in profit margin and equity multiplier
  are the largest.
• Profit margin hurt by increased provision for
  loan losses and increase in applicable income
  taxes
• Pretax income declined by 11 Net income declined
  by 28 higher tax burden and lower adjustment

89
UBPR Security National

• current non interest expense 72 Tot income 604
• last 70 593
• Burden (noninterest expense - noninterest income)
  from 52 to 50 while asset grew.