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Chapter 3
What is Depository Institutions?
2. Fee income
Asset/Liability Problem of Depository Institutions
• It also faces several risks including credit risks, regulatory risks,
and funding (or interest rate) risk.
• Credit risk refers to the risk that a borrower will default on a loan
obligation to the depository institution or that issuer of a security
that the depository institution hold will default on its obligation.
• Regulatory risk is the risk that regulators will change the rules
and effect the earnings of the institution unfavorably.
• Funding Risk is the risk of inability to obtain the necessary
funding for the illiquid asset positions on the expected terms and
when required.
Credit Risk
• The risk that the obligor of a financial instrument held by a
financial institution will fail to fulfill its obligation on the due
date or at any time thereafter.
Settlement Risk
• The risk that when there is a settlement of a trade or
obligation, the transfer fails to take place as expected.
• It consists of counterparty risk (a form of credit risk) and form
of liquidity risk.
• Counterparty risk is the risk that a counterparty in a trade
fails to satisfy its obligation.
Liquidity Risk
• Means that the counterparty can eventually meet its obligation, but
not at the due date.
• It has 2 forms according to the International Financial Risk
Institute
1. Market Liquidity risk - risk that a financial institution is unable to transact in
a financial instrument at a price neat its market value.
2. Funding Liquidity risk – risk that the financial institution will be unable to
obtain funding to obtain cash flow necessary to satisfy its obligations.
Market Risk
• The risks to a financial institution’s economic well being that results
from an adverse movement in the market price of assets (debt
obligations, equities, commodities, currencies) it owns or the level or
the volatility of market prices.
Operational Risk
• Definedby bank regulators as “the risk of loss
resulting from inadequate or failed internal
processes, people and systems, or from external
events.
Legal Risk
• Therisk of loss resulting from failure to comply
with laws as well as prudent ethical standards
and contractual obligations.
Major Categories of Operational Risk
according to the cause of the loss event
• 1. Employee : loss events resulting from the actions or inactions of a person who
works for a firm.
• 2. Business Process : loss events arising from a firm’s execution of business
operations.
• 3. Relationships : loss events caused by the connection or contact that a firm has with
clients, regulators, or third parties. This category focuses on the interaction between
a firm and other entities; relationship risks involve both parties.
• 4. Technology : loss events due to piracy, theft, failure, breakdown, or other
disruption in technology, data or information; this category also includes technology
that fails to meet the intended business needs.
• 5. External : loss events caused by people or entities outside a firm; the firm cannot
control their actions.
• Several reports by regulators have recommended guidelines for controlling the risks of
financial institutions described above.
• Derivatives : Practices and principles – prepared by the Group of 30 in 1993.
• Derivatives are used to control risks.
• The report provides guidelines to help financial institutions and dealers in derivatives
to manage derivatives activity in order to benefit from the use of the these
instruments.
• These guidelines fall into five categories:
• 1. General policies for senior management
• 2. Valuation and market risk management
• 3. credit risk measurement and management
• 4. systems, operations, and control
• 5. recommendations for legislators, regulators, and supervisor.
COMMERCIAL
BANKS
BANK SERVICES
• Commercial banks provide numerous services in the US financial system.
The services can be broadly classified as follows;
1. Individual banking
2. Institutional banking
3. Global banking,
1. INDIVIDUAL BANKING
- Encompasses consumer lending, residential mortgage lending, consumer
installment loans, and individual-oriented financial investment services such as
personal trust and investment services.
- Mortgage lending is often referred to as “mortgage banking”.
2. INSTITUTIONAL BANKING
- Loans to nonfinancial corporations, financial corporations such as life
insurance companies, and government entities.
- Also included are commercial real state financing, leasing activities and
factoring.
- Loans and leasing generate interest income but other bank offer institutional
customers generate fee income.
3. GLOBAL BANKING
- Covers a broad range of activities involving corporate financing, capital
market and foreign exchange products and services.
- Most global banking activities generate fee income rather than interest
income.
• At one time, some of these activities were restricted by federal legislation.
More specifically, the banking Act of 1933 contained four sections barring
commercial banks from certain investment banking activities.
Deposits
• a sum of money placed or kept in a bank account, usually to gain interest.
• a sum payable as a first installment on the purchase of something or as a
pledge for a contract, the balance being payable later.
Types of deposits
Transaction and non
transaction deposits
Transactions deposits
• a term used by the Federal Reserve for checkable deposits and other
accounts that can be used directly as cash without withdrawal limits or
restrictions.
Demand deposits
Mutually owned
-means no stock is outstanding, so technically the depositors are
the owners.
At the Federal level, the primary regulator of S&Ls is the director of the
Office of Thrift Supervision (OTS), created in 1989 by FIRREA. Prior to the
creation of OTS, the primary regulator was the Federal Home Loan
Bank Board (FHLBB).
ASSETS
Traditionally, the assets in which S&Ls were allowed to invest were mortgages,
mortgage-backed securities, and government securities. Mortgage loans
include fixed rate mortgages and adjustable-rate mortgages. Although most
mortgage loans are for the purchase of homes, S&Ls do make construction
loans.
S&Ls can offer accounts that look similar to demand deposits and that do
pay interest called negotiable order of withdrawal (NOW) accounts. Unlike
demand deposits, NOW accounts pay interest. S&Ls were also allowed to
offer Money Market Deposit Accounts (MMDA).
S&Ls more actively raised funds in the money market. They can borrow in
the federal funds market and they have access to the Fed’s discount
window. S&Ls can also borrow from the Federal Home Loan Banks. These
borrowings, called advances, can be short–term or long–term in maturity ,
and the interest rate can be fixed or floating.
REGULATION
Home Owners Loan Act of 1933
- established the Federal Savings and Loan Insurance Corporation, which at that
time insured the deposits of federally chartered S&Ls up to $ 5,000 and allowed state
chartered S&Ls that could qualify to obtain the same insurance coverage.
S&Ls historically, were regulated with respect to the maximum interest rates on deposit
accounts, geographical operations, permissible activities ,and capital adequacy
requirements. In addition, they faced restrictions on the sources of non deposit funds
and liquidity requirements.
The maximum interest rate permitted on deposit accounts was phased out by the
Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA).
Although it allowed S&Ls to compete with other financial institution to raise funds, it also
raised their funding costs.
The maximum interest rate permitted on deposit accounts was phased out by the
Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA).
Although it allowed S&Ls to compete with other financial institution to raise funds, it also
raised their funding costs.
>Tangible capital
means the amount equal to total shareholders’ equity plus Funded debt, less the
value of intangible assets, all of the foregoing to be determined in accordance with
the FS and reports provided to lender.
SAVINGS BANKS
As institutions, savings banks are similar to, although much older than,
S&Ls. They can be either mutually owned (in which case they are
called mutual savings banks) or stock holder owned.
Most savings bank s operate under mutual form. Only 16 states in the
eastern United States charter savings banks . Although the total
deposits at savings banks are less than those of S&Ls, savings banks are
typically larger institutions. Assets structure of savings banks and S&Ls
are similar.
Residential Mortgages
-provide the principal assets of savings banks.
Savings banks portfolios include:
> Corporate bonds
> Treasury and government agency securities
> Municipal securities
> Common stocks
> Consumer loans
Deposits
-is the principal source of funds for savings bank.
Typically, the ratio of deposits to total assets is greater for savings banks
than for S&Ls. Savings banks offer the same types of deposit account as
S&Ls, and deposits can be insured by either the BID and SAIF.
CREDIT UNIONS
Credit unions
-are the smallest of the depository institutions. It can obtain either a
state or federal charter.