CAPITAL MARKET

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CAPITAL MARKET
lt CHAPTER 3 gt
DEPOSITORY INSTITUTIONS
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CONTENTS OF OUR PRESENTATION

• WHAT A DEPOSITORY INSTITUTION IS ?
• ASSEST/LIABILITY PROBLEM OF DEPOSITORY
  INSTITUTIONS
• Funding risk
• Liquidity concerns
• COMMERCIAL BANKS
• Bank services
• Bank funding
• Regulation
• Federal deposit insurance
• SAVING AND LOAN ASSOCIATIONS
• Assets
• Funding
• Regulation
• The SL Crisis
• SAVINGS BANKS
• CREDIT UNION

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Depository institutions include commercial
banks, saving and loan associations, savings
banks, and credit unions. These financial
intermediaries accept deposits. Deposits
represent the liabilities of the deposit
accepting institutions. With the funds raised
through deposits and other funding sources,
depository institutions make direct loans to
various entities and also invest in securities.
Their income is derived from two sources the
income generated from the loans they make and the
securities they purchase, and fee income.
SL, saving banks, and credit unions are
commonly called thrifts, which are specialized
types of depository institutions.
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Depository institutions are highly regulated
because of the important role they play in the
financial system. Demand deposit accounts provide
the principal means that individuals and business
entities use for making payments. Also, goverment
implements monetary policy through the banking
system. Because of their important role,
depository institutions are afforded special
privileges such as access to federal deposit
insurance and access to a goverment entity that
provides funds for liquidity or emergency needs.
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ASSET/LIABILITY PROBLEM OF DEPOSITORY
INSTITUTIONS Funding risk Liquidity
concerns
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ASSET/ LIABILITY PROBLEM OF DEPOSITORY INSTITUTION
The asset/liability problem that depository
institutions face is quite simple to explain,
althuogh not necessarily easy to solve. A
depository institutions seeks to earn a positive
spread between the asset in which it invest and
the cost of its funds. The spread is referred to
as spread income or margin. The spread income
allows the institutions to meet operating
expenses and earn a fair profit on its capital.
In generating spread income a depository
institutions faces several risks, including
credit risk, regulatory risk, and funding risk.
Credit risk , also called default risk refers to
the risk that a borrower will default on a loan
obligation to the depository institution or that
the issuer of a security that the depository
institutions holds will default on it obligation.
Regulatory risk is the risk that regulators will
change the rules and affect the earning of the
institution unfavorably.
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LIQUDITY CONCERNS

• In several ways
• Attract additional deposits,
• Use existing securities as collateral for
  borrowing from a federal agency or other
  financial institution,
• Sell securities that it owns,
• Raised short term funds in the money market.

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The first alternative self-explanatory. The
second concerns the privilege allowed to banks to
borrow at the discount window of the Federal
Reserve Banks. The third alternative, selling
securities that it owns, requires that the
depository institution invest a portion of its
funds in securities that are both liquid and have
little price risk. The fourth alternative
primarily includes using marketable
securities owned as collateral for raising in
the repurchase agreement market.
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COMMERCIAL BANKS
Bank services Bank funding Regulation Federal
deposit insurance
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Commercial Banks As of March 2001, 8,237
commercial banks were operating in the U.S. All
rational banks must be members of the Federal
Reserve System and must be insured by the Bank
Insurance Fund ( BIF), which is administered by
the Federal Deposit Insurance Corporation (FDIC).
Federal depository insurance began in the 1930s,
and the insurance program is administered by the
FDIC.BIF was created by the Financial
Institutions Reform , Recovery,and Enforcement
Act of 1989 (FIRREA)
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TABLE 3-1 Distribution of FDIC-Insured Commercial
Banks by Size
Asset Size
of Banks
of Banks
Assets
of Assets
Less than 25 million 1,016 12,33
16,903 0,27 25 to 50 million 1,636
19,86 61,068 0,97 50 to 100 million 2,107
25,58 151,517 2,40 100 to 300
million 2,307 28,01 388,908 6,16 300 to
500 milllion 459 5,57 174,586 2,77 50
0 to 1 billion 322
3,91 217,623 3,45 1 to 3 billion 219
2,66 366,722 5,81 3 to 10 billion 92
1,12 517,332 8,20 10 billion or more
79 0,96 4,416,155
69,98 Total institutions 8,237 100,00
6,310,814 100,00
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BANK SERVICES
1
Individual banking Institutional
banking Global banking
2
3
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Individual banking encompasses consumer
lending, residential mortgage lending, consumer
installment loans, credit card financing,automobil
e and boat financing, brokerage services,student
loans, and individual-oriented financial
investment services such as personal trust and
invesment services. Mortgage lending and credit
card financing generate interest and fee income.
Mortgage lending is often referred to as
mortgage banking. Brokerage services and
financial invesment services also generate fee
income.
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Loans to nonfinancial corporations, financial
corporations and goverment entities fall into the
category of institutional banking. Also included
in this category are commercial real estate
financing,leasing activities, and factoring. In
the case of leasing, a bank may be involved in
leasing equipment either as lessors, as lenders
to lessors , or as purchasers of leases.
Global banking covers a broad range of activities
involving corporate financing and capital market
and foreign exchange products and services.
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• Corporate financing involves two components
• The procuring of funds for a banks customers
• Advice on such matters as strategies for
  obtaining funds, corporate restructuring ,
  divestitures, and acquisitions

• Banks generate income in three ways
• The bid-ask spread,
• Capital gains on the securities or foreign
  currencies use in transactions,
• In the case of securities, the spread between
  interest income earned by holding the security
  and the cost of funding the purchase of that
  security.

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The financial products developed by banks to
manage risk also yield income. These product
include interest rate swaps, interest rate
agreement,currency swaps, forward contracts and
interest rate options.
17
BANK FUNDING

• The three sources of funds for banks
• Deposits
• Nondeposit borrowing
• Common stock and retained earning
• Banks are highly leveraged financial
  institutional , which means that most of their
  funds come from borrowing.

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Deposit Several types of deposit accounts are
available. Demand deposit pay no interest and can
be withdrawn upon demand. Time deposits,also
called certificates of deposit, set a fixed
maturity date and pay either a fixed or floating
interest rate. A money market demand account is
one that pays interest based on short term
interest rates. The market for short term debt
obligations is called the money market, which is
how these deposits get their name.
Reserve Requirements and Borrowing in the Federal
Funds Markets A bank can not invest 1for every
1 it obtains in deposits. Specified percentages
are called reserve ratios, and dolar amounts
based on them that are required to be kept on
deposit at a Federal Reserve Banks are called
required reserves. The reserve ratios are
establish by the Federal Reserve Board(the Fed).
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• Two types of deposits
• Transaction deposit
• Nontransaction deposit
• Demand deposits and what the Fed calls other
  checkable deposits are classified as transaction
  deposits. Saving and time deposits are
  nontransactions deposits.
• To compute required reserves, the Federal
  Reserve uses an established two-week period
  called the deposit computation period.

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Reserve requirements in each period are to be
satisfied by actual reserves. If actual reserves
exceed required reserves , the difference is
referred to as excess reserves. Bank temporarily
short of their required reserves can borrow
reserves from banks with excess reserves. The
market where banks borrow or lend reserves is
called the federal funds market. The interest
rate charge to borrow funds in this market is
called the federal funds rate.
21

• Borrowing at the Fed Discount Window
• The Federal Reserve Bank is the bankers bank.
• The Fed establishes the types of eligible
  collateral.
• Currently it includes
• Treasury securities, federal agency securities,
  and municipal securities, all with maturity of
  less than 6 months,
• Commercial and industrial loans with 90 days or
  less to maturity.
• The interest rate that the Fed charges to borrow
  funds at the discount window is called the
  discount rate.

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Other Nondeposit Borrowing Most deposits have
short maturities. Bank borrowing in the federal
funds market and at the discount window of the
Fed is short term. Other nondeposit borrowing can
be short term in the form of issuing obligation
in the money market , or intermediate long term
in the form of issuing securities in the bond
market. Banks that raise most of their funds from
the domestic and international money markets,
relying less on depositors for fund , are called
money center banks. A regional bank , by
contrast, is one that relies primarily on deposit
for funding and makes less use of the money
markets to obtain funds.
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• REGULATION
• Because of special role that commercial
  banks play in the financial system , banks are
  regulated and supervised by several federal and
  state government entities.
• The regulations historically cover four
  areas
• Ceilings imposed on the interest rate that can be
  paid on deposit accounts.
• Geographical restrictions on branch banks.
• Permissiple activities for commercial banks.
• Capital requirements for commercial banks.

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Regulation of Interest Rates Even though
regulation of the interest rates that banks can
pay was eliminated for accounts other than demand
deposit. Federal regulation prohibit the payment
of interest on demand accounts. Until the 1960s,
market interest rates stayed below the ceiling.
As market interest rates rose abow the ceiling
and ceilings were extended to all depository
institutions after 1966, these institutions found
it difficult to compete with other financial
institution to attract funds. To circumvent the
ceilings on time deposits and recapture the lost
funds,banks developed the negotiable certificate
of deposit , which in effect had higher ceiling ,
and eventually no ceiling at all. As all
depository instutions fund it difficult to
compete in the 1970s, federal legislation in the
form of the Depository Instutions Regulation and
Monetary Control Act of 1980 gave banks relief.
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Geographical Restrictions The McFadden Act of
1927 allowed each state the right to set its own
rules on instrastate branch banking. In 1994
Congress passed the Riegle-Neal Interstate
Banking and Branching Efficiency Act permitting
adequately capitalized and managed bank holding
companies to acquire banks in any state subject
to certain limitations and approval by the
Federal Reserve. Starting in June 1997, this
legislation allowed interstate mergers between
adequately capitalized and managed banks, subject
to concentration limits and state laws.
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Permissible Activities for Commercial Banks The
key legislation is the Gramm-Leach-Bliley Act of
1999. The activities of banks and bank holding
companies are regulated by Federal Reserve Board,
which was charged with the responsibility of
regulating the activities of bank holding
companies by the Bank Holding Company Act of 1956.
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• Early legislation governing bank activities
  developed against the following background
• Certain commercial bank lending was believed to
  have reinforced the stock market crash of 1929.
• The stock market crash itself led to the
  breakdown of the banking system.
• Transactions between commercial banks and their
  securities affiliates led to abuses.

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Congress passed the Banking Act 1933. Four
sections of the 1933 act barred commercial banks
from certain invesment banking activities-Sections
16, 20,21 and 32. These four sections are
popularly referred to as the Glass-Steagall
Act. Bank could neither underwrite securities and
stock, nor act as dealers in the secondary market
for securities and stock , although Section 16
does provide two exceptions. Section 16 also
restricted the activities of banks in connection
with corporate securities such as corporate bonds
and commercial paper. Under Section 20 of the
Glass-Steagall Act, commercial bank that were
members of the Federal Reserve System were
prohibited from maintaining a securities firm.
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Section 21 prohibited any person,
firm,corperation,association,business trust, or
other similar organization that receives
deposits from engaging in the securities business
as defined in Section 16. Section 32 further
prevented banks from circumventing the
restrictions on securities activities. The
Glass-Steagall Act also imposed restrictions on
bank activities in insurance area. Specifically ,
it imposed restrictions on the underwritting and
selling of insurance. Capital Requirements for
Commercial Banks The capital structure of banks,
like that of all corporations , consist of equity
and debt
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Capital Requirements For Commercial Banks The
capital structure of banks,like that of all
corporations,consist of equity and debt.
Commercial banks, like some other depository
institutions and like investment banks,which it
discuss in chapter 5,are highly leveraged
institutions. that is, the ratio of equity
capital to total assets is low,typically less
than 8 in the case of banks. This level gives
rise to regulatory concern about potential
insolvency resulting from the low level of
capital provided by the owners. An additional
concern is that the amount of equity capital is
even less adequate because of potential
liabilities that do not appear on the banks
balance sheet. These so-called off-balance
sheet obligations include commitments such as
letters of credit and obligations on customized
interest rate agreements ( such as swaps,caps and
floors).
31
Prior to 1989, capital requirements for a bank
were based solely on its total assets. No
consideration was given to the types of assets.
In January 1989, the Federal Reserve adopted
guidelines for capital adequacy based on the
credit risk of assets held by the bank. These
guidelines are referred to as risk-based capital
requirements. The guidelines are based on a
framework adopted in July 1988 by the Basle
Committee on Banking Regulations and Supervisory
Practises, which consists of the central banks
and supervisory authorities of G-10 countries.
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The two principle objectives of the guidelines
are as follows 1.Regulators in the United
States and abroad sought greater consistency in
the evaluation of the capital adequacy of major
banks throughout the world. 2. Regulators tried
to establish capital adequacy standarts that
take into consideration the risk profile of the
bank.
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• The risk-based capital guidelines
  attempt to recognize credit risk by segmenting
  and weighting requirements.
• Capital consists of Tier 1 and Tier 2 capital,
  and minimum requirements are establish for each
  tier. Tier 1 capital is considered core capital
  (common stockholders equity, certain types of
  preferred stock, and minority interest in
  consolidated subsidiaries). Tier 2 capital called
  supplementary capital ( loan-loss
  reserves,perpetual debt, hybrid capital
  instruments etc.).
• The guidelines establish a credit risk weight for
  all assets. The weight depends on the credit
  associated with each asset.The four credit risk
  classifications for banksin the United States are
  0, 20, 50, and 100, arrived at on no
  particular scientific basis.

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Asset Book value(in
millions)
U.S Treasury securities
100 Municipal general
obligation bonds
100 Residential mortgages
500 Commercial loans

300 Total book value
1.000
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The risk- weighted assets are calculated as
follows
Book value (in millions)
Risk weight
Product (in million)
Asset
U.S Treasury securities
100 0
0 Municipal general obligation bonds 100
20 20 Residential
mortgages 500
50 250 Commercial loans
300
100 300 Risk-weighted assets

570
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Risk weight
Examples of Assets Including

• U.S. Treasury securities
• Mortgage backed securities issued by the
  Goverment National Mortgage Association
• Muncipal general obligation bonds
• Mortgage-backed securities issued by the Federal
  Home Loan Mortgage Corporation or the Federal
  National Mortgage Assocation
• Municipal revenue bonds
• Residental mortgages
• Commercial loans and commercial mortgage
• LCD loans
• Corporate bonds
• Municipal IDA bonds

0
20
50
100
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FEDERAL DEPOSiT INSURANCE Because of the
important economic role played by banks, the U.S
goverment sought a way to protect them against
depositors who, because of what they thought were
real or perceived problems with a bank, would
withdraw funds in a disruptive manner. Bank
panics occured frequently in the early 1930s,
resulting in the failure of banks that might have
survived economic difficulties except for
massive withdrawals. As the mechanism devised in
1933 to prevent a " run on a bank the U.S
goverment created federal deposit insurance. The
insurance was provided through a new agency, the
Federal Deposit Insurance Corporation.
38

• The Federal Deposit Insurance Corporation
  Improvement Act of 1991 ( FDICIA ) included a
  number of significiant reforms to improve the
  deposit insurance system. Despite the
  improvements, some major flaws remained,
  including two of particular concern
• First is the increase in the amount of the
  deposit coverage to 100,000.This coverage was
  set in 1980.The basic coverage increased five
  times since 1934, from 5,000 to 100,000.With
  the exception of the increase from 40,000 to
  100,000 in 1980, historically, these increases
  fundamentally reflected cost-of-living
  adjustment.
• Second flaw is the payment of insurance coverage
  the premiums charged by the FDIC for insurance
  coverage.
• The conflict with respect to premiums is that
  on the one hand FDICIA mandates that deposit
  insurance premiums should be priced according to
  the risk posed by a depository institution on
  the other hand, FDICIA mandates that the FDIC
  maintain a target level of reserves

39
A depository institution is assigned to one of
nine categories based on a two-step process. The
first is a capital group assignment based on
capital ratios and the second is a supervisory
subgroup assignment based on other relevant
information.
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TABLE3-3 FDICs Risk Ratings Assigned to
Depository Institutions
Capital Group Descriptions
Group 1
Group 2 Group 3
well capitalized Total risk-based capital ratio
equal to or grater than 10 Tier 1 risk-based
capital ratio equal or greater than 6 Tier 1
leverage capital ratio equal to or greater than 5
Adequately capitalized Not well
capitalized Total risk-basedcapital ratio equal
to or greater than 8 Tier 1 risk-based capital
ratio equal to or greater than 4 Tier 1 leverage
capital ratio equal to or greater than 4
Undercapitalized Neither well capitalized nor
adequately capitalized Supervisory subgroup
assignments for members of the BIF and the SAIF
are made in accordance with section 327.4(a)(2)of
the FDICs Rules and regulations. See following
Supervisory Subgroup descriptions.
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• In order to deal with the conflict noted earlier
  with respect to setting deposit insurance
  premiums, an expected loss pricing system
  would take into consideration
• The differences in risk across depository
  institutions
• The ability to generate revenue sufficient to pay
  fort he costs of insuring deposits
• The expcted loss price for a depository would
  depend on three factors
• The probability of default for that bank ,
• Exposure,
• Loss severity ( or loss given default)

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SAVING AND LOAN ASSOCIATIONS
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Assets Fundings Regulations The SL Crisis
44
SLs represent a fairly old institution. The
provision of funds for financing the purchase of
a home motivated the creation of SLs. The
collateral for the loan would be the home being
financed. SLs are either mutually owned or
operate under corporate stock ownership.
Mutually owned means no stock is outstanding, so
technically the depositors are the owners. To
increase the ability of SLs to expand the
sources of funding available to bolster their
capital, legislation facilitated the conversion
of mutually owned companies into a corporate
stock ownership structure. Like banks,SLs are
now subject to reserve requirements on deposits
established by the Fed. Prior to the passage of
FIRREA, federal deposit insurance for SLs was
provided by the Federal Savings and Loan
Insurance Corporation(FSLIC). The Saving
Association Insurance Fund (SAIF) replace FSLIC
and is administered by the FDIC.
45
ASSETS The only assets in which SLs were
allowed to invest were mortgage, mortgage-backed
securities,and goverment securities. Mortgage
loans include fixed-rate mortgages and adjustable
rate mortgages. Although most mortgage loans are
for the purchase of homes, SLs do make
construction loans.
46
Although SLs enjoyed a comparative advantage in
originating mortgage loans,they lacked the
expertise to make commercial and corporate loans.
Rather than make an invesment in acquiring those
skills,SLs took an alternative approach and
invested in corporate bonds because these bonds
were classified as corporate loans. More
specifically, SLs became one of the major buyers
of noninvesment-grade corporate bonds,more
popularly referred to asjunk bonds or high
yield bonds. Under FIRREA, SLs are no longer
permitted to invest new money in junk bonds.
47
SLs invest in short-term assets for operational
and regulatory purposes. All SLs with federal
deposit insurance must satisfy minimum liquidity
requirements. These requirements are specified by
the Office of Thrift Supervision.
48
FUNDING Prior to 1981, the bulk of the
liabilities of SLs consisted of passbook savings
accounts and time deposits. The interest rate
that could be offered on these deposits was
regulated. SLs were given favored treatment over
banks with respect to the maximum interest rate
they could pay depositors-they were permitted to
pay an interest rate 0.5 higher, later reduced
to 0.25. With the deregulation of interest rates
discussed earlier in this chapter, banks and SLs
now compete head-to-head for deposits.
49
Since the early 1980s, however, SLs can offer
accounts that look similar to demand deposits and
that do pay interest call negotiable order of
withdrawal(NOW) accounts. Unlike demand deposits,
NOW accounts pay interest SLs were also allowed
to offer money market deposits accounts(MMDA)
50
Since the 1980s, SLs more actively raised funds
in the money market. They can borrow in the
federal funds market and they have access to the
Feds discount window. SLs can also borrow from
the Federal Home Loan Banks. These borrowing
called advances, can be short-term or long-term
in maturity and the interest rate can be fixed or
floating.
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REGULATION
Federal SLs are chartered under the provision of
the Home Owners Loan Act of 1933.
As in bank regulation. SLs historically were
regulated with respect to the maximum interest
rate on deposit accounts, geographical
operations, permissible activities and capital
adequacy requirements.
52
Two sets of capital adequacy standards apply to
SLs, as they do for anks. SLs are also subject
to two ratio tests based on core capital and
tangible capital. The risk based capital
guidelines are similar to those imposed on banks.
Instead of two tiers of capital , however,
SLs deal with three Tier 1 tangible
capital Tier 2 core capital Tier 3
supplementary capital
53
THE SL CRISIS
Until the early 1980s, SLs and all other lenders
financed housing through traditional mortgages at
interest rates fixed for the life of the loan.
The period of the loan was typically long,
frequently up to 30 years. Funding for these
loan,by regulation, came from deposits having a
maturity considerably shorter than the loans. As
explained earlier, this sittuation creates the
funding risk of lending long and borrowing short.
It is extremely risky, although regulators took a
long time to understand it.
54
No problem arises of course if interest rates are
stable or declining, but if interest rates rise
above the interest rate on the mortgage loans,a
negative spread results,which must lead
eventually into insolvency. Regulators at first
endeavored to shield the SL industry from the
need to pay high interest rate without losing
deposits by imposing a ceiling on the interst
rate that would be paid by SLs and by their
immediate competiors, the other depository
institutions. However the approach did not and
coukd not work.
55
With the high volatility of interest rates in the
1970s,followed by the historically high level of
interest rates in the early 1980s, all depository
institutions began to lose funds competitors
exempt from ceiling, such as the newly formed
money market funds this development forced some
increase in ceilings.
56
The ceilings in place since the middle of the
1960s did not protect the SLs they began to
suffer from diminished profits and increasingly
from operating losses. A large fraction of SLs
became technically insolvent as rising interest
rates eroded the market value of their assets to
the point where they fell short of the
liabilities.
57
SAVING BANKS As institutions, saving banks
are similar to, although much older than,
SLs.They can be either mutually owned(in which
case they are called mutual savings banks) or
stockholders owned.
58
Although the total deposits at saving banks are
less than those of SLs, savings banks are
typically larger institutions.Asset structures of
saving banks and SLs are similar.Residential
mortgages provide the principal assets of saving
banks.Because states permitted more portfolio
diversification than federal regulatorsof SLs,
savings bank portfolios weathered funding risk
far better than SLs.Savings bank porfolios
include corporate bonds, Treasury and goverment
securities, municipal securities, common
stock,and consumer loans. The principal
source of funds for savings banks is
deposits.Typically, the ratio of deposits to
total assets is greater for savings banks than
for SLs.Savings banks offer the same types of
deposit accounts as SLs, and deposits can be
insured by either the BID or SAIF.
59
CREDIT UNIONS Credit unions are the
smallest of the depository institutions.Credit
unions can obtain either a state or federal
charter.Their unique aspect is the common bond
requirement for credit union membership.According
to the statutes that regulate federal credit
unions, membership in a federal credit union
shall be limited to groups having a common bond
of occupation or association , or to groups
within a well-defined neighborhood, community, or
rural district.
60
Credit union assets consist of small consumer
loans, residential mortgages loans, and
securities.Regulations 703 and 704 of NCUA set
forth the types of investments in which a credit
union may invest.They can make investments in
corporate credit unions . What is a corporate
credit union?One might think that a corporate
credit union is a credit union set up by
employees of a corporation.It is not.Federal and
state-chartered credit unions are referred to as
natural person credit unions because they
provide financial services to qualifying members
of the general public.In constrast, corporate
credit unions provide a variety of investment
services, as well as payment systems, only to
natural person credit unions
61
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