CHAPTER 13

ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS

1. Approximately how many banks operate in the U.S.? Discuss trends in the number of banks versus the number of banking offices. What do these trends tell us about the future structure of the banking industry? Solution: There are currently about 7,400 banks in the U.S. More than three times as many operated in the 1920s. The financial collapse of the early 1930s reduced the number of banks to about 15,000. The number of banks continued to decline gradually until the 1960s, primarily because of mergers rather than failures. After 1960, the number of banks increased slightly, stabilizing at around 15,000 until the late 1980s. Then, in the late 1980s and early 1990s the number of banks declined as a result of failures and mergers. Since the early 1980s, however, the number of total banking offices (branches plus main offices) has been increasing despite the decrease in the number of banks. The reason is the increase in the number of branches. Even as the number of banks has decreased, geographic restrictions have relaxed in the past 25 years, resulting in more branches per bank. Although the number of banks has declined in recent years, the number of banking offices has grown dramatically because of a sharp increase in branching. In 1941, there were 3,564 branch offices. By 2006, there were more than 80,000 banking offices, of which about 73,000 were branch offices. As regulatory restrictions further relax, we will see further consolidation in the industry, which means fewer banks, but probably more branches. 2. The interest rate on borrowed funds is usually higher than the interest rate on small time deposits. Given that, why do large banks continue to rely more heavily on borrowed funds as a source of funds? Solution: The demand for loans at the largest institutions has outpaced the institutions ability to fund those loans with deposits. In addition, borrowed funds are a more flexible source of funds in that the funds can be raised quickly and retired quickly without catering to the preferences of depositors. 3. What are the major sources of bank funds? How do these differ between large and small banks? Solution: The most important source of funds is deposits, which are more important for small banks than large banks. Large banks get more of their funds directly from the money markets (borrowed funds) in the form of Fed Funds purchased and repurchase agreements. 4. How does the proportion of capital for a typical bank compare with that of a typical industrial firm? Do you believe banks have adequate capital? Why or why not? Solution: In general banks seem thinly capitalized (highly leveraged) compared to industrial firms. A typical bank is financed with less than 10% capital and even less for large banks. Most industrial firms are financed with 40% to 60% capital. Because most banks are prudently managed and all banks are highly regulated, their capital is probably adequate. Industrial firms do not have their primary operating debts insured by the government, nor is their liquidity guaranteed by the central bank. 5. Why do you think that small banks are financed by a higher proportion of capital than large banks? Solution: Large banks have direct access to the money markets, so equity is less important to them as a source of funds. Small banks tend to be managed more conservatively. 1. Why do you think small banks have a higher proportion of assets in investments than do large banks? Solution: Small banks rely more on investments for liquidity. Large banks are more able to buy liquidity directly in the money market. Small banks thus tend to have more assets invested in Treasuries, which are safe and highly liquid.

2. Describe a typical Fed Funds transaction. Why do you think small banks sell more Fed Funds as a proportion of total assets than large banks? Solution: A Fed Funds transaction is an unsecured loan of excess reserves from one bank to another, usually overnight. In general, small banks carry more excess reserves. Large banks carry fewer excess reserves because they have direct access to the money markets. 3. How does loan portfolio composition differ between large and small banks? Can you provide an explanation? Solution: Large banks have a much higher proportion of commercial loans, which they compete for in a national market. Smaller banks tend to operate in more local markets and have more of a retail emphasis. Smaller banks tend to have a higher proportion of agriculture and real estate loans than large banks, which have more of a wholesale emphasis. The loan portfolio of a small bank will be, to a large extent, a function of the local economy in which it operates. Small banks are also likely to be more conservatively managed, affecting their choices about what kinds of risk to underwrite, and under what conditions. Large banks may more willingly originate higher-risk assets with the intention of securitizing them. 4. What factors go into setting the loan interest rate? Explain how each factor affects the rate. Solution: The prime rate, the Fed Funds rate, Treasury rate, or LIBOR may serve as a banks base rate. It accounts for the banks expenses and a fair return to the banks shareholders, before adjusting for any special risk. Banks add or subtract from the base to price for a borrowers default risk and borrowing alternatives. An adjustment for the term of the loan may also be added. If the yield curve slopes upward, for example, banks would add a term premium to the base. 5. What customer characteristics do banks typically consider in evaluating consumer loan applications? How does each of these factors influence the decision of the bank to grant credit? Solution: Banks typically use the five Cs of credit: character (willingness to pay), capacity (cash flow), capital (wealth or net worth), collateral (security), and conditions (economic conditions). Character, capacity, capital, and collateral all have a positive influence on the banks decision. A customers sensitivity to poor economic conditions is a negative influence on the decision. Collateral is generally not a primary justification for extending credit. Rather, a credit decision justified in terms of the other four Cs will then be reinforced by adequate collateral. 1. What are the main factors a bank must consider when setting the interest rate to offer on deposits? Solution: There are two major factors. First, the bank must offer a high enough interest rate to attract and retain deposits. If deposit rates are too high, however, they squeeze the spread between the average return on assets and the average cost of liabilities. Second, to meet competition, banks not only have to lower rates charged on loans, but also have to increase rates on deposits. Bank managers should recognize that market forces ultimately determine deposit rates. 2. List and describe the major fee-based services offered by commercial banks. Solution: The major fee-based services are correspondent banking, trust services, investment products, and insurance products. Correspondent banking is the sale of banking services to other banks or nonbank financial institutions. Trust operations involve the banks acting in a fiduciary capacity for an individual or a legal entity. Trust typically involves holding and managing assets for the benefit of a third party. The investment and insurance products sold by banks involve the sale of brokerage services, mutual funds, or annuities through affiliated nonbank companies. 3. Discuss the uses of standby letters of credit (SLCs). What benefits do SLCs offer to a banks commercial customers?

Solution: In an SLC transaction, the bank acts as a third party in a commercial transaction between the banks customer and a beneficiary, substituting the banks creditworthiness for that of its customer. The bank guarantees the performance of the contract as stipulated by the terms of the SLC. 4. What are the major reasons that banks sell loans? Solution: First, to earn fee income for originating and servicing sold loans. Second, a bank may have a comparative advantage in booking certain types of loans and can use funds from loan sales to fund additional similar loans. Third, loan sales permit banks to diversify across a different set of loans than they originate and service. Finally, banks may sell loans to avoid regulatory burdens such as deposit insurance premiums, foregone interest on required reserves, and mandatory capital requirements. 5. What are the major benefits to banks of securitization? Solution: First, by selling rather than holding loans, banks reduce the amount of assets and liabilities, thereby reducing reserve requirements, capital requirements, and deposit insurance premiums. Second, securitization provides a source of funding loans that is less expensive than other sources. Finally, banks generate origination and loan servicing fees in the securitization process.