Historical Bank RegulationDefinition of Commercial BankAccept demand deposits and make commercial loans.Limitations on:Geographic ScopeProducts and Services

Goals and Functions of Bank RegulationEnsure the Safety and Soundness of BanksProvide an Efficient and Competitive Financial SystemProvide Monetary StabilityMaintain the Integrity of the Payments SystemProtect Consumers from Abuses

Safe, Sound, Efficient & Competitive SystemSupervision and ExaminationCAMELSCapitalAsset QualityManagement QualityEarnings QualityLiquiditySensitivity to Market Risk

Safe, Sound, Efficient & Competitive SystemSupervision and ExaminationMemorandum of UnderstandingFormal regulatory documentCease and Desist OrderLegal documentHas legal standing

Safe, Sound, Efficient & Competitive SystemNew ChartersDual Banking SystemOffice of the Comptroller of the CurrencyCharters national banksOffice of Thrift SupervisionCharters federal savings banks and savings associationsNational Credit Union AdministrationCharters federal credit unions

Safe, Sound, Efficient & Competitive SystemNew ChartersState Banking AuthoritiesCharter state banksState Savings AuthoritiesCharter state savings banksState Credit Union AuthoritiesCharter state credit unions

Safe, Sound, Efficient & Competitive SystemNational versus State CharterAll banks obtain FDIC deposit insurance as part of the chartering processNational banks must join the FedPrimary regulator is the OCC

Safe, Sound, Efficient & Competitive SystemNational versus State CharterState banks may join the FedState banks are regulated by their state banking authority.State banks also have a primary federal regulatorThe primary federal regulator of state banks that are members of the Fed is the Federal ReserveThe primary federal regulator of Non-Fed member state banks is the FDIC

Safe, Sound, Efficient & Competitive SystemCommercial Banks, Savings Institutions, and Credit UnionsCommercial BanksSpecialize in short-term business creditSavings InstitutionsSpecialize in real estate loansQualified Thrift LenderUnitary Thrift Holding CompanyCredit UnionsCommon Bond requirement

Safe, Sound, Efficient & Competitive SystemNon-Depository Financial CompaniesBrokerage housesMortgage companiesInsurance companiesFinance companies

Safe, Sound, Efficient & Competitive SystemFederal Deposit InsuranceDepositors are currently insured up to $100,000 per qualify account per insured bankOriginal limit in 1933 was $5,000FDIC maintains the deposit insurance fund at 1.25% of insured deposits.Currently, the fund is well-funded and over 90% of banks pay no insurance premium

Safe, Sound, Efficient & Competitive SystemShortcomings of Restrictive Bank RegulationDoes not prevent bank failureCannot eliminate economic riskDoes not guarantee that bank management will make good decisions

Monetary Stability & the Payments SystemThe Federal Reserve SystemFundamental FunctionsConduct monetary policyProvide and maintain the payments systemSupervise and regulate banking operationsOrganizationBoard of Governors12 Federal Reserve District Banks

Monetary Stability & the Payments SystemThe Federal Reserve SystemMonetary Policy ToolsOpen Market OperationsOpen market purchases (sales) increase (decrease) reserves & the money supplyDiscount RateDecreasing (Increasing) the discount rate makes bank borrowing less (more) expensive, which leads to an increase (decrease) in the money supplyReserve RequirementsDecreasing (Increasing) reserve requirements increases (decreases) the money supply

Monetary Stability & the Payments SystemCommercial Banks and the EconomyBanks are the primary conduit for monetary policyBanks are the primary source of credit for most small businesses and many individuals

Efficient and Competitive Financial SystemOrganizational Form of the Banking IndustryUnit banking versus Branch bankingBranching and Interstate ExpansionRiegle-Neal Act

Efficient and Competitive Financial SystemOrganizational Form of the Banking IndustryBank Holding CompaniesParentSubsidiariesOne-Bank Holding CompaniesMutli-Bank Holding Companies

Exhibit 1.10 Organizational structure of the BHC

Efficient and Competitive Financial SystemOrganizational Form of the Banking IndustryFinancial Holding CompaniesCan engage in financial activities not permitted in a bank or bank holding companyFederal Reserve may not permit a bank holding company to convert to a financial holding company if the bank holding company is not well capitalized, well managed, or did not receive a satisfactory rating on its most recent CRA exam.

Exhibit 1.11Organizational structure of a financial holding company

Efficient and Competitive Financial SystemOrganizational Form of the Banking IndustryHolding Company Cash FlowParent companys net income is typically derived from dividends, interest, management fees from equity in subsidiaries, and interest paid on holding company debt.Parent company typically pays little in income tax since 80% of dividends from subsidiaries is exempt.

Efficient and Competitive Financial SystemOrganizational Form of the Banking IndustryNon-bank Activities Permitted By Bank Holding CompaniesClosely related to banking

Efficient and Competitive Financial SystemOrganizational Form of the Banking IndustryMergers and ConsolidationsMergers must be approved, dependent on the classification of the surviving bankOCC approves national bank mergersState member banks by the Federal ReserveState non-member banks by the FDIC

Efficient and Competitive Financial SystemOrganizational Form of the Banking IndustryMergers and ConsolidationsMotivation for mergers and consolidation:Cut costsImprove profitabilityIncrease competitive positionCross-sell financial products & services

Consumer ProtectionReg. BEqual Credit OpportunityCannot discriminate on the basis of sex, race, marital status, religion, age, or national origin.Reg. ZTruth-in-LendingRequires disclosure of:Effective interest rates, total interest paid, total of all paymentsWhy credit was denied

Trends in Federal Legislation & RegulationKey Federal Legislation: 1970 - 1993Depository Institutions Deregulation and Monetary Control Act of 1980DIDMCADepository Institutions Act of 1982Garn-St. GermainCompetitive Equality Banking Act of 1987

Trends in Federal Legislation & RegulationKey Federal Legislation: 1970 - 1993Financial Institutions Reform, Recovery, and Enforcement Act of 1989FIRREAFederal Deposit Insurance Corporation Improvement Act of 1991FASB 115Held-to-maturityTrading account securitiesAvailable-for-sale

Trends in Federal Legislation & RegulationKey Federal Legislation: 1994 - 2000Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994Gramm-Leach-Bliley Act of 1999Key Federal Legislation: 2001 2002USA Patriot Act (2001)Sarbanes-Oxley Act (2002)

Trends in Federal Legislation & RegulationCurrent Unresolved Regulatory IssuesCapital AdequacyIncreased capital requirements make banks safer, from a regulators perspectiveHowever, increasing capital requirements also has disadvantages:Equity is more expensive than debtMost banks do not have ready access to the equity marketsThis can lead to more consolidation

Trends in Federal Legislation & RegulationCurrent Unresolved Regulatory IssuesDeposit Insurance ReformToo Big to FailShould $100,000 insurance limit be increased?Non-bank Financial Services CompaniesShould banks that lend to hedge funds, like Long-Term Capital Management, be required to hold additional capital?

Trends in Federal Legislation & RegulationCurrent Unresolved Regulatory IssuesNew PowersReq. Q still prevents banks from paying explicit interest on commercial demand deposit accountsMost banks would like to be able to pay interest on commercial demand deposit accounts What are the costs and benefits?

Banking Business ModelsGlobal BanksInternational presenceNationwide BanksCoast-to-coast presenceSuper-Regional BanksExtensive operations in a limited geographic area of the U.S.Regional BanksSpecialty Banks

Exhibit 1.17 DISTRIBUTION OF THE NUMBER OF BANKS AND TOTAL ASSETS BY TOTAL ASSETS: 1995 - 2004

Number of Banks

Assets Size

< $100 M

$100M - $1B

$1B - $10B

> $10B

1995

10,242

7,123

2,741

331

63

(69.55%)

(26.76%)

(3.23%)

(0.62%)

1997

9,451

6,147

2,900

331

73

(65.04%)

(30.68%)

(3.50%)

(0.77%)

1999

8,580

5,157

3,029

318

76

(60.10%)

(35.30%)

(3.71%)

(0.89%)

2001

8,080

4,486

3,194

320

80

(55.52%)

(39.53%)

(3.96%)

(0.99%)

2003

7,769

3,911

3,434

341

83

50.34%

44.20%

4.39%

1.07%

2004

7,630

3,655

3,530

360

85

(47.90%)

(46.26%)

(4.72%)

(1.11%)

Total Assets

Asset Size

< $100 M

$100M - $1B

$1B - $10B

> $10B

1995

$4,116

$310

$668

$1,077

$2,061

(7.54%)

(16.22%)

(26.17%)

(50.07%)

1997

$4,642

$277

$711

$995

$2,658

(5.97%)

(15.32%)

(21.45%)

(57.27%)

1999

$5,735

$243

$755

$915

$3,823

(4.23%)

(13.16%)

(15.96%)

(66.65%)

2001

$6,569

$222

$819

$915

$4,613

(3.37%)

(12.47%)

(13.93%)

(70.22%)

2003

$7,603

$201

$910

$947

$5,545

(2.64%)

(11.97%)

(12.46%)

(72.93%)

2004

$8,413

$189

$953

$973

$6,297

(2.25%)

(11.33%)

(11.57%)

(74.85%)

Banking Business ModelsSpecialty BanksAlso known as:Community BanksIndependent BanksTypically have less than $1 billion in assetsOrganization

Exhibit 1.18 Organizational structure of an independent bank

Banking Business ModelsSpecialty BanksPersonnelSenior Credit OfficerCashier/Chief Financial OfficerSenior Operations OfficerSenior Investment OfficerBranch Area Executive

Fundamental Forces of ChangeDeregulation/ReregulationFinancial InnovationSecuritizationGlobalizationAdvances in Technology

Fundamental Forces of Change Role of RegulationRegulatory DialecticProcess of regulation, market response, and reregulationFinancial Innovation

Fundamental Forces of Change Increased CompetitionFor DepositsInterest rate ceilings and inflationFor LoansCommercial paperJunk bondsCredit scoringCredit derivatives

Fundamental Forces of Change:Off-Balance Sheet ActivitiesLoan CommitmentsLoan guaranteesStandby Letters of CreditInterest Rate SwapsFutures, Forwards & OptionsLeases

Fundamental Forces of Change: Impact of Nonbank CompetitionCaptive Finance CompaniesGeneral Finance CompaniesFund their loans by issuing commercial paper and long-term bonds. Their cost of funds is higher than a banks, but they charge higher rates.

Fundamental Forces of Change: Competition for Payments ServicesCredit CardsDebit CardsPrepaid CardsCHIPSACH

Fundamental Forces of Change: Competition for Other Bank ServicesTrust ServicesBrokerage ServicesData ProcessingReal Estate AppraisalCredit Life InsurancePersonal Financial Consulting

Fundamental Forces of: Change Investment BankingNational Full-Line FirmsInvestment Banking FirmsUnderwriterUnderwriter syndicateBroker versus Dealer

Fundamental Forces of Change: Deregulation and Re-regulationDeregulationEliminating existing regulationsReregulationImplementing new restrictions on banking activities

Fundamental Forces of Change: Financial InnovationInnovation may be caused by a bank wanting to:Enter into a new geographic marketEnter into a new product marketDeliver services less expensivelyEtc.

Fundamental Forces of Change: SecuritizationSecuritizationThe process of converting assets into marketable securitiesMortgagesCredit card receivables

Fundamental Forces of Change: GlobalizationGlobalizationIs the evolution of markets and institutions where geographic boundaries do not restrict financial transactions or competition

Fundamental Forces of Change:TechnologyAdvances in TechnologyAdvances in technology increase the scope of the global market place and competitionAdvances in technology also reduce the need for an intermediary by providing easy access to informationIncreasing competition by reducing the cost of being an information intermediary

William Chittenden edited and updated the PowerPoint slides for this edition.

FUNDAMENTAL FORCES OF CHANGE IN BANKINGChapter 1Bank Management, 6th edition. Timothy W. Koch and S. Scott MacDonaldCopyright 2006 by South-Western, a division of Thomson LearningWilliam Chittenden edited and updated the PowerPoint slides for this edition.