Bank Management, 5th edition. Timothy W. Koch and S.

Scott MacDonald
Copyright 2003 by South-Western, a division of Thomson Learning

FUNDAMENTAL FORCES OF CHANGE IN BANKING

Chapter 1

What makes a bank special?

Why do we call Bank of America a bank, Merrill Lynch a securities brokerage company and State Farm an insurance company?
The answer lies in our history; with the implementation of:

The Glass-Steagall Act which created three separate industries: commercial banking, investment banking, and insurance. The Bank Holding Act determined activities closely related to banking and limited the scope of activities a company could engage in if it owned a bank. The McFadden Act limited the geographic market of banking by allowing individual states to determine the extent to which a bank could branch intra- or interstate. As a result of these acts, the United States developed a unique banking system which had a large number of smaller banks; limited in the scope of products and services offered; and limited in the geographic areas covered by banks.

The banking industry is consolidating and diversifying simultaneously.

The traditional definition of a bank has been blurred

by the introduction of new products and a wave of mergers, which have dramatically expanded the scope of activities that banks engage in and where products and services are offered.

Formerly, a commercial bank was defined as a firm that both accepted demand deposits and made commercial loans. Today, these two products are offered by many financial services companies: including commercial banks, savings banks, credit unions, insurance companies, investment banks, finance companies, retailers, and pension funds.

What constitutes a bank, today is not as important

as what products and services are offered and in what geographic markets the financial services company competes in.

While competition has increased the number of firms offering financial products and services,
the removal of interstate branching restrictions in the U.S. has dramatically reduced the number of banks but increased the number of banking offices (primarily branches).
Consolidation, in turn, has increased the proportion

of banking assets controlled by the largest banks. Not surprisingly, the same trends appear globally. The United States currently has several banks that operate in all 50 states and many locales outside the U.S. The largest foreign banks have significant operations in the U.S. and throughout the world.

Increased competition

quickly changing the nature of commercial banking.

Competition also means geography no

longer limits a financial institutions trade area or the markets in which it competes. Individuals can open a checking account at: a traditional depository institution, a brokerage firm, or a nonbank firm, such as GE Capital, State Farm Insurance, and AT&T.

You can deposit money electronically, transfer funds from one account to another, purchase stocks, bonds and mutual funds, or even request and receive a loan from any of these firms.

Most allow you to conduct this business by phone, mail, or over the Internet.

Regulatory restrictions on products and services offerings worked effectively in promoting a safe banking system until the later half of the twentieth century.
Product innovations and technological advances of

the later half of the twentieth century allowed investment banking firms to circumvent the regulations restricting their banking activities.

In the late 1970s Merrill Lynch effectively created an interest bearing checking account, something banks had not been legally allowed to offer.

Junk bonds became an alternative financing source

for small business and other companies began to encroach upon the banks primary market.

Banks were heavily regulated

state banking agencies, the FDIC, the Federal Reserve and the Office of Comptroller of the Currency
Merrill Lynch was only regulated by the Securities

and Exchange Commission.

This allow investment companies to move into the banks market, circumventing Glass-Steagall and the Bank Holding Company Act

Not until the late 1980s and early 1990s did banks find

ways around Glass-Steagall using a Section 20 affiliate which allowed them to offer a limited amount of investment banking products and services.

During this same period, the rise in the U.S. stock market increased the average persons awareness of higher promised returns from mutual funds and stock transactions. This lead to a greater acceptance of non-FDIC insured deposit products (mutual funds and stocks) Banks, however, were generally restricted to offering CDs and savings accounts which increased the erosion of the banks share of the consumers investment wallet.

Branching restrictions were primarily responsible for the structure of the banking system.
This created a system of many more but

smaller banks as compared to other countries.

By the late 1990s, all branching restrictions were removed from the banking system and the number of independent banks was reduced by almost half, the number of branches increased by almost 50 percent and the size of the largest U.S. banks increased dramatically. In fact, by size rankings, U.S. banks did not reach the largest 10 banks in the world until the late 1990s and today, some of the largest banks in the world are U.S. banks.

Branching restrictions were effective at reducing competition among depository institutions and promoting a safe banking system until the later half of the twentieth century.
These same branching restrictions,

however, prevented banks from geographically diversify their product and credit risk and quite possibly contributed the loss of several large Texas banks during the late 1980s.

The removal of branching restrictions during the later half of the twentieth century allowed banks to offer services anywhere in the country and lead to the creation of the first coast-to-coast bank forever changing the banks
market from local to global.
Merrill Lynch and

State Farm already operated branches across the nation and in comparison there were significantly fewer, but larger, investment and insurance companies. In addition to relaxation of branching restrictions, technological advances allowed banks to open electronic branches, first by using the ATM network and later by using the Internet.

This structural change is frequently attributed to deregulation of the financial services industry.
In fact, deregulation was a natural response to

increased competition between depository institutions and nondepository financial firms, and between the same type of competitors across world markets. In fact, some regulations can be credited for the development of new products to avoid regulationhence increased competition from firms not regulated like a bank; i.e., investment banks.

Five fundamental forces have transformed the financial services market

1. 2. 3. 4. 5.

Deregulation/re-regulation Financial innovation Securitization Globalization Advances in technology.

The latter factors actually represent responses to deregulation and re-regulation.

Historically, commercial banks have been the most heavily regulated companies in the United States
Regulations took many forms including : maximum interest rates that could be paid on deposits or charged on loans, minimum capital-to-asset ratios, minimum legal reserve requirements, limited geographic markets for full-service banking, constraints on the type of investments permitted, and restrictions on the range of products and services offered.

Banks and other market participants have consistently restructured their operations to circumvent regulation and meet perceived customer need
In response, regulators or lawmakers would

impose new restrictions, which market participants circumvented again. This process of regulation and market response (financial innovation) and imposition of new regulations (reregulation) is the regulatory dialectic.

Today banks are accessing the formerly forbidden areas of investment banking, by the repeal of the Glass-Steagall Act via the Financial Services Modernization Act (Gramm-Leach-Bliley Act of 1999).
The Gramm-Leach-Bliley Act effectively eliminates

the majority of the remaining restrictions that have separated commercial banking, investment banking and insurance industries for over 50 years. The Glass-Steagall Act shaped the structure, products and business models of the banking industry for the later half of the 20th century.

Increased competition
The McFadden Act of 1927 and the Glass-

Steagall Act of 1933 determined the framework within which financial institutions operated for the next 50 years.

The McFadden Act saw to it that banks would be sheltered from competition with other banks by extending state restrictions on geographic expansion to national banks. The Glass-Steagall Act forbade banks from underwriting equities and other corporate securities, thereby separating banking from commerce.

The fundamental forces of change increased competition

Competition for deposits

Competition for loans

Competition for payment services Competition for other financial services

Competition for deposits

High inflation abruptly ended the

guaranteed spread between asset yields and liability costs in the late 1970s. In 1973 several investment banks created money market mutual funds (MMMFs).

Without competing instruments, MMMFs increased from $10.4 billion in 1978 to almost $189 billion in 1981.

Congress passed legislation enabling banks

and thrifts to offer similar accounts including money market deposit accounts (MMDAs) and Super NOWs.

Competition for loans

Loan yields fell relative to borrowing costs,

as lending institutions competed for a decreasing pool of quality credits. High loan growth also raises bank capital requirements. Junk bonds, commercial paper, auto finance companies, credit unions, and insurance companies compete directly for the same good quality customers.

Competition for loans (continued)

As bank funding costs rose, competition for

loans put downward pressure on loan yields and interest spreads. Prime corporate borrowers have always had the option to issue commercial paper or long-term bonds rather than borrow from banks. Because the Glass-Steagall Act prevented commercial banks from underwriting commercial paper, banks lost corporate borrowers, who now bypassed them by issuing commercial paper at lower cost.

Competition for loans (continued)

The competition for loans comes in many

forms:

Commercial paper Captive automobile finance companies Other finance companies

The development of the junk bond market

extended loan competition to medium-sized companies representing lower-quality borrowers. The growth in junk bonds reduced the pool of good-quality loans and lowered risk-adjusted yield spreads over bank borrowing costs.

Today, different size banks generally pursue different strategies.

Small- to medium-size banks continue to

concentrate on loans but seek to strengthen the customer relationship by offering personal service. These same banks have generally rediscovered the consumer loan. The largest banks, in contrast, are looking to move assets off the balance sheet.

Regulatory capital requirements and the new corporate debt substitutes often make the remaining loans too expensive and too risky.

Loan concentrations: Consumer and commercial credits

Credit Risk Diversification
Commercial borrowers Consumer loans

80.0% 70.0%
69%
67% 65% 64% 62% 60% 58% 59% 60% 60% 59% 57% 55% 55% 57% 57%

Percent of loans

60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0%

38% 35% 36% 31% 33%

45% 45% 43% 43% 42% 43% 41% 40% 40% 41% 40%

Captive automobile finance companies

The three largest U.S. automobile

manufacturers as well as most foreign automobile manufactures are aggressively expanding in the financial services industry as part of their long-term strategic plans.

Competition for payment services

In an American Banker article, Diogo

Teixeira comment that: GE Capital has almost $300 billion of financial assets. GMAC has $12 billion of financial services revenue, more than Microsoft's total corporate revenue. Microsoft has no leasing subsidiary, takes no deposits, makes no loans, and offers not a single financial product -- in an age when everybody has financial products. Yet Microsoft is viewed as the threat, not GE Capital or GMAC.

Competition for payment services the impact of technology

Once the exclusive domain of banks and

other depository institutions, the nations payment system has become highly competitive. The real challenge for the Federal Reserve System and the banking industry is in the delivery of payment processing services. This competition is coming from emerging electronic payment systems, such as:

smart and stored-value cards automatic bill payment bill presentment processing

It's not just electronic payment systems that are eroding the banks traditional markets
Cash money can be acquired at any teller

machine all over the country. You can open a checking account, apply for a loan and receive the answer and funds electronically. Direct deposit of paychecks, credit cards, electronic bill payment, and smart cards means that competition for financial services goes well beyond the traditional banking services lines we think of from the recent past!

Although cash remains the dominate form of payment, the average payment size of cash is the smallest

Cash Cheques issued Electronic Transactions: ACH 6,900 ATM 13,200 Credit Card 20,000 Debit Card 9,275 Total retail electronic 49,375 Chips 58 Fed Wire 108 Total wholesale electronic 166 Total Electronic 49,541

Volume of Transactions % of Cashless Growth: % Total Payments 19952000 2000 2000 2000 550,000 82.3% #N/A 69,000 10.3% 58.2% 1.8% 1.0% 2.0% 3.0% 1.4% 7.4% 0.0% 0.0% 0.0% 7.4% 5.8% 11.1% 16.9% 7.8% 41.7% 0.0% 0.1% 0.1% 41.8% 14.6% 6.4% 6.0% 42.1% 10.7% 2.6% 7.3% 5.5% 10.7%

Value of Transactions % Growth: Average Total 1995- Transaction 1995 2000 2000 2000 Size 2000 #N/A 2,200,000 0.3% $ 4.00 73,515,000 85,000,000 10.9% 2.9% $ 1,231.88 12,231,500 20,300,000 656,600 800,000 879,000 1,400,000 59,100 400,000 13,826,200 22,900,000 310,021,200 292,147,000 222,954,100 379,756,000 532,975,300 671,903,000 546,801,500 694,803,000 2.6% 0.1% 0.2% 0.1% 2.9% 37.4% 48.6% 85.9% 88.8% 10.7% $ 2,942.03 4.0% $ 60.61 9.8% $ 70.00 46.6% $ 43.13 10.6% $ 463.80 -1.2% $ 5,037,017 11.2% $ 3,516,259 4.7% $ 4,047,608 4.9% $ 14,025

Competition for other bank services

Banks and their affiliates offer many

products and services in addition to deposits and loans.

Trust services Brokerage Data processing Securities underwriting Real estate appraisal Credit life insurance Personal financial consulting

Non-bank activities of banks

the Gramm-Leach-Bliley Act.
Since the Glass-Steagall and Bank Holding

Company acts, banks could not directly underwrite securities domestically. Today, a bank can enter this line of business by forming a financial holding company through provisions of the Gramm-LeachBliley Act.

A financial holding company owns a bank or bank holding company as well as an investment subsidiary. The investment subsidiary of a financial holding company is not restricted in the amount or type of investment underwriting engaged in.

Investment banking
Commercial banks consider

investment banking attractive because most investment banks:

already offer many banking services to prime commercial customers and high net worth individuals and sell a wide range of products not available through banks. can compete in any geographic market without the heavy regulation of the FRS, FDIC, and OCC. earn extraordinarily high fees for certain types of transactions and can put their own capital at risk in selected investments.

Investment banking
Investment banking encompasses

three broad functions:

1. 2. 3.

underwriting public offerings of new securities trading existing securities advising and financing mergers and acquisitions

Deregulation and re-regulation

Deregulation is the process of eliminating

regulations, such as the elimination of Regulation Q (interest rate ceilings imposed on time and demand deposits offered by depository institutions.)
Deregulation is often confused with

reregulation, which is the process of implementing new restrictions or modifying existing controls on individuals and activities associated with banking.

Efforts at deregulation and reregulation generally address:

Pricing issues removing price controls on the maximum interest rates paid to depositors and the rate charged to borrowers (usury ceilings). Allowable geographic market penetration The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 has eliminate branching restrictions. New products and services Gramm-Leach-Bliley Act of 1999 has dramatically expanded the banks product choices; i.e., insurance, brokerage services, and securities underwriting.

Financial innovation
Financial innovation is the catalyst behind

the evolving financial services industry.

Innovations take the form of new securities

and financial markets, new products and services, new organizational forms, and new delivery systems.
Regulation Q brought about financial

innovation as depository institutions tried to slow disintermediation.

Financial innovation (continued)

Banks developed new vehicles to compete

with Treasury bills, money market mutual funds, and cash management accounts. Regulators typically responded by imposing marginal reserve requirements against the new instrument, raising the interest rate ceiling, and then authorizing a new deposit instrument. Recent innovations take the form of new futures, options, options-on-futures, and the development of markets for a wide range of securitized assets.

Response of banks
One competitive response to asset quality

problems and earnings pressure has been to substitute fee income for interest income by offering more fee-based services. Banks also lower their capital requirements and reduce credit risk by selling assets and servicing the payments between borrower and lender rather than holding the same assets to earn interest. This process of converting assets into marketable securities is called securitization.

Securitization
Securitization is the process of converting

assets into marketable securities. It enables banks to move assets off-balance sheet and increase fee income. It increases competition for standardized products such as:

mortgages and other credit-scored loans

Eventually lowers the prices paid by

consumers by increasing the supply and liquidity of these products.

The objectives behind securitization include the following:

Free capital for other uses Improve ROE via servicing income Diversify credit risk Obtain new sources of liquidity Reduce interest rate risk Generally, any loan that can be credit scored can potentially be securitized. Securitization allows nonbank firms to originate loans, package them into pools, and sell securities collateralized by securities in the pools. This increases the competition for the securitized asset and will eventually lead to lower rates.

Off-balance sheet activities, asset sales and Enron

Enron engaged in questionable activities including

not reporting losses from business activities that the firm inappropriately moved off-balance sheet.

Enron was thus able to hide losses on the business activities and/or use its off-balance sheet activities to artificially inflate reported earnings.

Many banks also enter into agreements that do not

have a balance sheet reporting impact until a transaction is effected.

An example might be a long-term loan commitment to a potential borrower. Until the customer actually borrows the funds, no loan is reported on the banks assets. Obviously, off-balance sheet positions generate noninterest income but also entail some risk as the bank must perform under the contracts.

From 1999-2001, PNC moved out of certain lending businesses by selling off $20 billion in loans and reducing unfunded loan commitments by $25 billion
Jan. 02. , PNC took a $615 million charge as it wrote

down loans PNC took a $424 million charge for moving loans to the held for sale category Indicated it would sell about $3.1 billion in loans and $8.2 billion in letters of credit and unfunded commitments. PNCs stock price increased, the positive response echoed the markets sentiment that the sooner you recognize bad loans and move them off the balance sheet, the better. Late Jan. 02, the FED and SEC questioned the special third-party structure used to shift assets off the balance sheet. PNCs shares dropped--the use of such off-balance sheet accounting was reminiscent of the Enron fiasco. PNC reclassified its treatment of the problematic deals and lowered its reported income for 2001 several times. Earnings were restated due to new risks of special purpose vehicles.

Globalization
The gradual evolution of markets and

institutions so that geographic boundaries do not restrict financial transactions. Financial markets and institutions are becoming increasingly global in scope. Firms must recognize that businesses in other countries as well as their own are competitors, and that international events affect domestic operations.

Increased consolidation
The dominant trend regarding the structure

of financial institutions is that of consolidation. With the asset quality problems of Texas banks in the 1980, regulators authorized acquisitions by out-of-state banks. By 1998, effectively all interstate branching restrictions had been eliminated

this has lead to consolidation frenzy in which we have almost half as many banks as compared to the 1980s

The later half of the 1990s saw not only a large number of bank mergers but also several of the largest bank consolidations:
Citicorp merges with Travelers Chase Manhattan acquires Chemical Banking Chase Manhattan acquires J.P. Morgan Mellon Bank acquires Dreyfus NationsBank acquires BankAmerica Bank of New York acquires Irving Bank Corp Fleet Financial Group acquires BankBoston Bank One acquires First USA Southern National acquires BB&T Financial

The removal of restrictive branching laws as well as merger mania of the late 1990s has dramatically reduced the number of banks.
The primary factor leading the reduction in

the number of banks from a high of 14,364 in 1979 to about 8,000 at the beginning of 2002 can be attributed to the removal of branching restrictions provided by RiegleNeal Interstate Banking and Branching Efficiency Act of 1994

GE Capital Services is the financial subsidiary of General Electric

GECS divides its operations into two segments, Financing and

Specialty Insurance. The operations of GECS Financing are divided into four areas: Consumer services provides products such as private-label and
bank credit card loans, personal loans, time sales and revolving credit and inventory financing for retail merchants, auto leasing and inventory financing, mortgage servicing, and consumer savings and insurance services . Equipment management provides leases, loans, sales, and asset management services for commercial and transportation equipment. Mid-market financing provides loans and financing and operating leases for middle-market customers for a variety of equipment. Specialized financing provides loans and financing leases for major capital assets, commercial and residential real estate loans, and investments; and loans to and investments in management buyouts and corporate recapitalizations.

Specialty insurance provides U.S. and international property and

casualty reinsurance; specialty insurance and life reinsurance; financial guaranty insurance (principally on municipal bonds and structured finance issues); private mortgage insurance; and creditor insurance covering international customer loan repayments.

2001 GE Capital Services operating companies and lines of business

Segment Data (12/31/2001) General Electric Co. GECS Consumer Services Equipment Management Mid-Market Financing Specialized Financing Specialty Insurance All Other Sales (000s) 74,037,000 58,353,000 23,574,000 12,542,000 8,659,000 2,930,000 11,064,000 -416,000 Net Earnings 13,684,000 5,417,000 2,319,000 1,607,000 1,280,000 557,000 522,000 -699,000

Growth in GECS Revenues 1990 2001

70,000 60,000 50,000
Millions of Dollars

66,177 58,353 55,749 48,694 39,931

40,000
32,713

30,000 20,000
11,851 13,053 17,276 14,418 19,875

26,492

10,000 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: GEs Annual Report, 2001 (http://www.ge.com/)

Most of the legal and regulatory differences which have historically separated various types of depository institutions are gone.
Banks now compete with: traditional depository institution

local commercial bank, savings bank, or credit unions such as Charles Schwab or Merrill Lynch, such as GE Capital, State Farm Insurance, and AT&T.

brokerage firms

nonbank firm

All of these firms compete for business, pay and

charge market interest rates, and are generally not limited in the scope of products and services they offer or the geographic regions where they offer these products.

Bank Management, 5th edition. Timothy W. Koch and S. Scott MacDonald

Copyright 2003 by South-Western, a division of Thomson Learning

FUNDAMENTAL FORCES OF CHANGE IN BANKING

Chapter 1