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FIN401 Assignment 1
Banking Environment & Financial Sector
This assignment aims to ensure you can explain the unique role of banks in the financial system
and distinguish them from nonbank competitors
Please prepare a 2–3-page report (calculation-free, emphasizing explanation) in accordance with
these instructions:
 Pick Two Institutions:
One bank (e.g., Al Rajhi, JPMorgan Chase) / One nonbank financial firm (e.g.,
Vanguard, MetLife Insurance, or a mutual fund company).
 Research & Compare:
i. Services Provided (e.g., deposits, loans, insurance, investment products).
ii. Sources of Funds (deposits vs. investor capital).
iii. Regulation (who supervises them).
iv. Risks Faced (liquidity risk, credit risk vs. insurance risk, market risk).
v. Role in the Economy (intermediation, payments, savings, investments).
vi. Conclude: Why are banks considered special compared to other financial
firms? And what makes their role unique in supporting the economy?

Chapter One
An Overview of the Changing
Financial-Services Sector
McGraw-Hill/Irwin

Key Topics
• Powerful Forces Reshaping the Industry
• What Is a Bank?
• The Financial System and Competing FinancialService Institutions
• Old and New Services Offered to the Public
• Key Trends Affecting All Financial-Service Firms
• Appendix: Career Opportunities in Banking and
Financial Services
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1-2

Introduction
• Banks are the principal source of credit (loanable funds)
for millions of individuals and families and for many
units of government
• Worldwide banks grant more installment loans to
consumers (individuals and families) than any other
financial-service provider
• The assets held by U.S. banks represent about one-fifth
of the total assets
▫ In other nations banks hold half or more of all assets in the
financial system
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1-3

What Is a Bank?
• A bank can be defined in terms of:
1. The economic functions it performs
2. The services it offers its customers
3. The legal basis for its existence

• Historically, banks have been recognized for the great
range of financial services they offer
▫ Bank service menus are expanding rapidly today to include
investment banking, insurance protection, financial planning,
advice for merging companies, the sale of risk-management
services to businesses and consumers, and numerous other
innovative financial products
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1-4

EXHIBIT 1-1 The Many Different Kinds of Financial-Service
Firms Calling Themselves Banks

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1-5

What Is a Bank? (continued)
• Money-Centered Banks vs. Community Banks
▫ Money-center banks
▫ Industry leaders
▫ Cover whole regions, nations, and continents
▫ Offer the widest possible menu of financial services
▫ Acquire smaller businesses
▫ Face tough global competition

▫ Community banks
▫ Much smaller
▫ Service local communities and towns
▫ Offer a narrower, but often more personalized, menu of
financial services
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What Is a Bank? (continued)
• The Legal Basis for Banking
▫ A bank is any business offering deposits subject to
withdrawal on demand and making loans of a commercial or
business nature
▫ Congress then defined a bank as any institution that could
qualify for deposit insurance administered by the Federal
Deposit Insurance Corporation (FDIC)
▫ Under federal law in the U.S., a bank had come to be defined,
not so much by its array of service offerings, but by the
government agency insuring its deposits

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The Financial System and Competing
Financial-Service Institutions
• Roles of the Financial System
▫ The primary purpose of the financial system is to encourage
saving and to transfer those savings to individuals and
institutions planning to invest and needing credit to do so
▫ This process of encouraging savings and transforming savings
into investment spending causes the economy to grow, new
jobs to be created, and living standards to rise
▫ The financial system also provides a variety of supporting
services:
▫ Payment services
▫ Risk protection services
▫ Liquidity services
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The Financial System and Competing
Financial-Service Institutions (continued)
• The Competitive Challenge for Banks
▫ Lately, the financial market share that banking comprised has
fallen
▫ Some authorities in the financial-services field fear that this
apparent erosion of market share may imply that traditional
banking is dying
▫ Other experts counter that banking is not dying but changing by
offering new services and changing its form
▫ The banking industry’s largest customers have found ways
around banks to obtain the funds that they need
▫ Borrowing in the open market
▫ Perhaps banking is being “regulated to death”

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The Financial System and Competing
Financial-Service Institutions (continued)
• Leading Competitors with Banks
▫ Savings Associations
▫ Credit Unions
▫ Fringe Banks
▫ Money Market Funds
▫ Mutual Funds (Investment Companies)
▫ Hedge Funds
▫ Security Brokers and Dealers
▫ Investment Banks
▫ Finance Companies
▫ Financial Holding Companies
▫ Life and Property/Casualty Insurance Companies
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The Financial System and Competing
Financial-Service Institutions (continued)
• Leading Competitors with Banks
▫ Financial-service providers are converging in terms of
the services they offer
▫ The U.S. Financial Services Modernization (GrammLeach-Bliley) Act of 1999 has allowed many different
types of financial firms to offer the public one-stop
shopping for financial services
▫ The challenge of differentiating banks from other
financial-service providers is difficult today

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EXHIBIT 1–2 Comparative Size by Industry of Commercial
Banks and Their Principal Financial-Service Competitors

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Services Banks and Many of Their Closest
Competitors Offer the Public
• Services Banks Have Offered for Centuries
▫ Carrying Out Currency Exchange
▫ Discounting Commercial Notes and Making Business
Loans
▫ Offering Savings Deposits
▫ Safekeeping of Valuables and Certification of Value
▫ Supporting Government Activities with Credit
▫ Offering Checking Accounts (Demand Deposits)
▫ Offering Trust Services

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Services Banks and Many of Their Closest
Competitors Offer the Public (continued)
• Services Banks and Many of Their Financial-Service Competitors
Began Offering in the Past Century
▫
▫
▫
▫
▫
▫
▫
▫

Granting Consumer Loans
Financial Advising
Managing Cash
Offering Equipment Leasing
Making Venture Capital Loans
Selling Insurance Policies
Selling and Managing Retirement Plans
Dealing in Securities: Offering Security Brokerage and Investment
Banking Services
▫ Offering Mutual Funds, Annuities, and Other Investment Products
▫ Offering Merchant Banking Service
▫ Offering Risk Management and Hedging Services
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TABLE 1–1 The Many Different Roles Banks and Their
Closest Competitors Play in Today’s Economy

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TABLE 1–2 Some of the Leading Financial-Service Firms
around the Globe

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Key Trends Affecting All Financial-Service
Firms – Crisis, Reform, and Change
• Service Proliferation
• Rising Competition
• Government Deregulation and then Reregulation
• Crisis, Reform, and Change in Banking and Financial
Services
• An Increasingly Interest-Sensitive Mix of Funds
• Technological Change and Automation
• Consolidation and Geographic Expansion
• Convergence
• Globalization
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Quick Quiz
• What is a bank? How does a bank differ from most other financialservice providers?
• Why are some banks reaching out to become one-stop financialservice conglomerates? Is this a good idea?
• Which businesses are banking’s closest and toughest competitors?
What services do they offer that compete directly with banks’
services?
• What is happening to banking’s share of the financial marketplace
and why?
• How have banking and the financial-services market changed in
recent years? What powerful forces are shaping financial markets
and institutions today?
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Appendix: Career Opportunities in Banking
and Financial Services
• What different kinds of professionals work inside
financial firms?
▫ Loan Officers
▫ Credit Analysts
▫ Managers of Operations
▫ Branch Managers
▫ Systems Analyst
▫ Auditing and Control Personnel
▫ Trust Department Specialist
▫ Tellers
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Appendix: Career Opportunities in Banking
and Financial Services (continued)
• What different kinds of professionals work inside
financial firms?
▫ Security Analysts and Traders
▫ Marketing Personnel
▫ Human Resources Managers
▫ Investment Banking Specialists
▫ Bank Examiners and Regulators
▫ Regulatory Compliance Officers
▫ Risk Management Specialists
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Chapter Two
The Impact of Government Policy and
Regulation on the Financial-Services
Industry
McGraw-Hill/Irwin

Key Topics
• The Principal Reasons for Banking and FinancialServices Regulation
• Major Financial-Services Regulators and Laws
• The Riegle-Neal and Gramm-Leach-Bliley (GLB) Acts
• The Check 21, FACT, Patriot, Sarbanes-Oxley,
Bankruptcy Abuse, Federal Deposit Insurance
Reform, and Financial-Services Regulatory Relief
Acts
• Emergency Economic Stabilization Act and the Global
Credit Crisis
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Key Topics (continued)
• FINREG is passed into law to avoid severe disruption
in the financial system and deal with systemic rick
• Some Key Regulatory Issues Left Unresolved
• The Central Banking System
• Organization and Structure of the Federal Reserve
System and Leading Central Banks of Europe and
Asia
• Financial-Services Industry Impact of Central Bank
Policy Tools
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Introduction
• This chapter is devoted to a study of the complex regulatory
environment that governments around the world have
created for financial-service firms in an effort to:
▫ Safeguard the public’s savings
▫ Bring stability to the financial system
▫ Prevent abuse of financial-service customers

• Financial institutions must contend with some of the heaviest
and most comprehensive rules applied to any industry
• Regulation is an ugly word to many people
▫ Burdensome
▫ Costly
▫ Damaging to innovation and efficiency
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Banking Regulation
• Why are banks closely regulated?
▫ Banks are among the leading repositories of the public’s
savings
▫ Banks are closely watched because of their power to create
money in the form of readily spendable deposits by making
loans and investments
▫ Banks have a long history of involvement with federal, state,
and local governments

• In the United States, banks are regulated through a dual
banking system
▫ Both federal and state authorities have significant regulatory
powers
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TABLE 2–1 Banking’s Principal Regulatory Agencies and
Their Responsibilities

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Banking Regulation (continued)
• One of the earliest theories about regulation contends
that firms in regulated industries actually seek out
regulation
▫ It brings benefits in the form of monopolistic rents because
regulations often block entry into the regulated industry

• A more recent theory argues that regulations can
increase customer confidence, which may create greater
customer loyalty toward regulated firms
• There is an ongoing struggle between regulated firms
and the regulators
• Regulatory dialectic
▫ Financial-service managers will search to find ways around
new rules in order to reduce costs and allow innovation to
occur
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Major Banking Laws – Where and When the
Rules Originated
• National Currency and Bank Acts (1863–64)
▫ The first major federal government laws in U.S. banking
were the National Currency and Bank Acts, passed during the
Civil War
▫ These laws set up a system for chartering new national banks
through a newly created bureau inside the U.S. Treasury
Department, the Office of the Comptroller of the Currency
(OCC)
▫ The Comptroller not only assesses the need for and charters
new national banks but also regularly examines those
institutions
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Major Banking Laws – Where and When the
Rules Originated (continued)
• The Federal Reserve Act (1913)
▫ A series of financial panics in the late 19th and early 20th
centuries led to the creation of the Federal Reserve System
(the Fed)
▫ The Fed’s principal roles are to serve as a lender of last
resort and to help stabilize the financial markets and the
economy
▫ Their most important job today is to control money and
credit conditions to promote economic stability

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Major Banking Laws – Where and When the
Rules Originated (continued)
• The Banking Act of 1933 (Glass-Steagall)
▫ The Glass-Steagall Act defined the boundaries of commercial
banking by providing constraints that were effective for more
than 60 years
▫ This legislation separated commercial banking from
investment banking and insurance
▫ The Federal Deposit Insurance Corporation (FDIC) was
created to guarantee the public’s deposits up to a stipulated
maximum amount in order to enhance public confidence in
the banking system
▫ Initially $2,500 and today it is up to $250,000
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Major Banking Laws – Where and When the
Rules Originated (continued)
• The FDIC Improvement Act (1991)
▫ The FDIC was the object of criticism during the 1980s and
1990s
▫ This legislation permitted the FDIC to borrow from the
Treasury to remain solvent, called for risk-based insurance
premiums, and defined the actions to be taken when
depository institutions did not meet capital requirements
▫ Prior to 1993, the FDIC imposed fixed insurance premiums
on all deposits eligible for insurance coverage, regardless of
the riskiness of an individual depository institution’s balance
sheet
▫ This fixed-fee system led to a moral hazard problem
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Major Banking Laws – Where and When the
Rules Originated (continued)
• Social Responsibility Laws
▫ Consumer Credit Protection Act (known as Truth in Lending)
▫ Required that lenders spell out the customer’s rights and
responsibilities under a loan agreement
▫ Dodd-Frank Regulatory Reform bill
▫ Emphasized providing consumers with more complete and
understandable language to convey service prices and avoid
misleading information
▫ Equal Credit Opportunity Act
▫ Individuals and families could not be denied a loan merely
because of their age, sex, race, national origin, or religious
affiliation, or because they were recipients of public welfare
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Major Banking Laws – Where and When the
Rules Originated (continued)
• Social Responsibility Laws
▫ Community Reinvestment Act
▫ Prohibits U.S. banks from discriminating against customers
residing within their trade territories merely on the basis of the
neighborhood in which they lived
▫ Competitive Equality in Banking Act and the Truth in Savings
Act
▫ Require banks to more fully disclose their service policies and the
true rates of return offered on the public’s savings and the fees
associated with credit services

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TABLE 2–2 Regulators of U.S. Insured Banks

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Major Banking Laws – Where and When the
Rules Originated (continued)
• The Riegle-Neal Interstate Banking Law (1994)
▫ Repealed previous provisions that prevented full-service interstate
banking nationwide
▫ Major provisions of the Riegle-Neal Act included:
▫ Adequately capitalized and managed holding companies can
acquire banks anywhere in the United States
▫ Interstate holding companies may consolidate their affiliated
banks acquired across state lines into full-service branch offices
▫ No single banking company can control more than 10 percent of
nationwide deposits or more than 30 percent of deposits in a
single state (unless a state waives this latter restriction)
▫ For the first time in U.S. history, American banks could accept
deposits and follow their customers across state lines

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Major Banking Laws – Where and When the
Rules Originated (continued)
• The Financial Services Modernization Act (The Gramm-Leach-Bliley
Act (1999))
▫ One of the most important U.S. banking statutes signed into law
▫ Overturned long-standing provisions of the Glass-Steagall Act and
the Bank Holding Company Act
▫ Permitted banking companies to affiliate with insurance and
securities firms under common ownership
▫ Securities and insurance companies could form financial holding
companies that control one or more banks
▫ Banks were permitted to sell insurance and security services,
provided they conform to state and federal rules
▫ This law’s purpose was to allow qualified U.S. financial-service
companies to diversify their service offerings and reduce their
overall business risk exposure
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Major Banking Laws – Where and When the
Rules Originated (continued)
• The USA Patriot Act
▫ Made a series of amendments to the Bank Secrecy Act
▫ Passed originally in 1970 to combat money laundering
▫ Requires that financial-service providers establish the identity of
customers opening new accounts or holding accounts whose terms
are changed
▫ Usually accomplished by asking for a driver’s license or other
acceptable picture ID and obtaining the social security number of
the customer
▫ Service providers are required to check the customer’s ID against a
government-supplied list of terrorist organizations and report any
suspicious activity in a customer’s account

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The 21st Century Ushers in an Array of New Laws and
Regulations – FINREG, The Basel Agreement, and Other
Rules Around the Globe
• The FACT Act of 2003
• The Check Clearing for the 21st Century Act (Check 21 Act)
• The Bankruptcy Abuse Prevention and Consumer Protection Act of
2005
• The Federal Deposit Insurance Reform Act of 2005
• The Emergency Economic Stabilization Act of 2008
• The Credit Card Accountability, Responsibility, and Disclosure Act
of 2009
• The Dodd-Frank Wall Street Reform and Consumer Protection Act
of 2009 (FINREG)
• Basel I and II, and Basel III

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The 21st Century Ushers in an Array of New Laws and
Regulations – FINREG, The Basel Agreement, and Other
Rules Around the Globe (continued)
• Unresolved Regulatory Issues
▫ What should we do about the regulatory safety net set up to protect
small depositors from loss, usually through government-sponsored
deposit insurance?
▫ Can we train regulators to be as good as they need to be in a more
complex financial marketplace?
▫ With the financial-services industry consolidating and converging
into fewer, but bigger, firms, can we get by with fewer regulators?
▫ Can we simplify the current regulatory structure and bring greater
efficiency to the task?
▫ As financial firms reach their arms around the globe, what nation
or nations should regulate their activities?

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The Regulation of Nonbank Financial-Service
Firms Competing with Banks
• Credit Unions
▫ National Credit Union Administration (NCUA)
• Savings and Loans and Savings Banks (“Thrifts”)
▫ State-chartered associations are supervised and examined by
state boards or commissions
▫ Federally chartered savings associations fall under the
jurisdiction of the Office of Thrift Supervision
▫ The Dodd-Frank Act merged the Office of Thrift Supervision
with the Office of the Comptroller of the Currency so that thrift
institutions and national banks would have the same regulatory
agency at the federal level

• Money Market Funds
▫ Securities and Exchange Commission (SEC)
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The Regulation of Nonbank Financial-Service
Firms Competing with Banks (continued)
• Life and Property/Casualty Insurance Companies
▫ State insurance commissions
▫ Recently the federal government has become somewhat more
involved in insurance
▫ When insurers form holding companies to acquire commercial
and investment banks or other federally regulated financial
businesses, they may come under the Federal Reserve’s review
▫ Under the Dodd-Frank Act, a new federal insurance office was
set up to help reduce the systemic risk caused by innovative, but
sometimes highly risky, activities of the largest insurers (such as
AIG) and prevent disruptive insurance failures

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The Regulation of Nonbank Financial-Service
Firms Competing with Banks (continued)
• Finance Companies
▫ Regulated at the state government level for many decades
▫ The depth of state regulation varies across the United States
▫ Most states focus upon the types and contents of loan agreements
they offer the public, the interest rates they charge (with some
states setting maximum loan rates), and the methods they use to
repossess property or to recover funds from delinquent
borrowers
▫ Relatively light state regulation has led to a recent explosion in
the number of small-loan companies
▫ The passage of the Dodd-Frank Act in 2010 caused many to close
as the maximum interest rates that these entities could charge
was drastically reduced
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The Regulation of Nonbank Financial-Service
Firms Competing with Banks (continued)
• Mutual Funds
▫ The U.S. Securities and Exchange Commission (SEC) requires
these businesses to register with that agency, submit periodic
financial reports, and provide investors with a prospectus that
reveals the financial condition, recent performance, and
objectives of each fund
• Security Brokers and Dealers and Investment Banks
▫ A combination of federal and state supervision applies to these
traders in financial instruments who buy and sell securities,
underwrite new security issues, and give financial advice
▫ The chief federal regulator is the SEC
▫ Requires these firms to submit periodic reports, limits the volume of
debt they take on, and investigates insider trading practices
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The Regulation of Nonbank Financial-Service
Firms Competing with Banks (continued)
• Hedge Funds, Private Equity Funds, and Venture Capital
Companies
▫ Some of the most lightly regulated of all financial institutions
▫ The SEC in the United States has broad oversight of the
information these firms provide to the public when they choose
to sell securities in the open market that are accessible to small
investors
▫ Regulation in this sector is virtually invisible, in part because it is
relatively new and because it normally does not seek out many
funds from small investors

▫ The Dodd-Frank Act of 2010 calls for greater separation
between commercial banks and these riskier private investors
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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
• The central bank of the United States is the Federal Reserve
System (the Fed)
• A central bank’s primary job is monetary policy
▫ Involves making sure the supply and cost of money and credit
from the financial system contribute to the nation’s economic
goals
▫ By controlling the growth of money and credit, the Fed and
other central banks around the globe try to ensure that the
economy grows at an adequate rate, unemployment is kept low,
and inflation is held down
• The Fed is free to pursue these goals because it does not depend
on the government for its funding
▫ Passes along most of its earnings to the U.S. Treasury
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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• The European Union also have a central bank – the European
Central Bank (ECB)
▫ It is relatively free and independent of governmental control as it
pursues its main goal of avoiding inflation
• In contrast, the Bank of Japan (BOJ), the People’s Bank of China
(PBC), and central banks in other parts of Asia appear to be under
close control of their governments
▫ Several of these countries have experienced higher inflation rates,
volatile currency prices, and other significant economic problems in
recent years
• Recent research suggests that more independent central banks
have been able to come closer to their nation’s desired level of
economic performance (particularly better control of inflation)

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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• Organizational Structure of the Federal Reserve System
▫ Board of Governors
▫ This governing body must contain no more than seven persons,
each selected by the president of the United States and confirmed
by the Senate for terms not exceeding 14 years
▫ The board chairman and vice chairman are appointed by the
president from among current board members, each for fouryear terms (though these appointments may be renewed)
▫ The board regulates and supervises the activities of the 12 district
Reserve banks and their branch offices
▫ It sets reserve requirements, approves all changes in the discount
(loan) rates posted by the 12 Reserve banks, and takes the lead in
the system in determining open market policy

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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• Organizational Structure of the Federal Reserve System
▫ Federal Open Market Committee (FOMC)
▫ The Federal Reserve Board members make up a majority of the
voting members of the FOMC
▫ The other voting members are 5 of the 12 Federal Reserve bank
presidents, who each serve one year in filling the remaining five
official voting seats on the FOMC
▫ Except for the president of the New York Federal Reserve
Bank, who is a permanent voting member
▫ Primary task is to set policies that guide the conduct of open
market operations
▫ The buying and selling of securities by the Federal Reserve
banks

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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• Organizational Structure of the Federal Reserve System
▫ There are 12 districts contained in the Federal Reserve System, with
a Federal Reserve Bank chartered in each district
▫ Key services that the Federal Reserve banks offer to depository
institutions in their districts:
1. Issuing wire transfers of funds between depository institutions
2. Safe-keeping securities owned by depository institutions and
their customers
3. Issuing new securities from the U.S. Treasury and selected
other federal agencies
4. Making loans to qualified depository institutions through the
“Discount Window”

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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• Organizational Structure of the Federal Reserve System
▫ Key services that the Federal Reserve banks offer to depository
institutions in their districts:
5. Dispensing supplies of currency and coin
6. Clearing and collecting checks and other cash items
7. Providing information to keep financial-firm managers and the
public informed about developments affecting the welfare of
their institutions
▫ All banks chartered by the Comptroller of the Currency (national
banks) and those few state banks willing to conform to the Fed’s
supervision and regulation are designated member banks
▫ Member institutions must purchase stock (up to 6 percent of their
paid-in capital and surplus) in the district Reserve bank and submit
to comprehensive examinations

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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• The Central Bank’s Principal Task: Making and Implementing
Monetary Policy
▫ A central bank’s principal function is to conduct money and credit
policy to promote sustainable growth in the economy and avoid
severe inflation
▫ To pursue these important objectives, most central banks use a
variety of tools to affect the legal reserves of the banking system,
the interest rates charged on loans made in the financial system, and
relative currency values in the global foreign exchange markets
▫ To influence the behavior of legal reserves, interest rates, and
currency values, central banks usually employ one or more of three
main tools: open market operations, the discount rate on loans to
qualified financial institutions, and legal reserve requirements on
various bank liabilities

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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• The Open Market Policy Tool of Central Banking
▫ Open market operations (OMO) have become the principal tool of
central bank monetary policy
▫ In the United States, OMO involves the buying and selling of U.S.
Treasury bills, bonds, and notes and selected federal agency
securities
▫ These transactions are conducted between the Fed’s trading desk
and selected primary dealers who meet the Fed’s qualifications
▫ OMO is considered to be the most important policy tool for many
central banks because it can be used every day and, if a mistake is
made or conditions change, its effects can be quickly reversed

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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• The Open Market Policy Tool of Central Banking
▫ Central bank sales of securities tend to decrease the growth of
deposits and loans within the financial system
▫ Interest rates tend to rise
▫ In contrast, central bank purchases of securities tend to increase
the growth of deposits and loans
▫ Interest rates tend to fall
▫ The FOMC targets the federal funds rate attached to overnight
loans of reserves between depository institutions in order to achieve
the Fed’s monetary policy goals
▫ In the hope that changes in the federal funds rate will spread to
other interest rates in the economy

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EXHIBIT 2–1 Leading Primary Dealers Authorized to Trade
Securities with the Federal Reserve in order to Assist with
Monetary Policy (April 2010)

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EXHIBIT 2–2 Example of a Federal Open Market Committee
(FOMC) Statement, Setting a Target for the Federal Funds Rate
to Be Achieved through Open Market Operations

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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• Other Central Bank Policy Tools
▫ Many central banks are an important source of short-term loans
for depository institutions
▫ When the Fed loans reserves, the supply of legal reserves expands
temporarily, which may cause loans and deposits to expand
▫ When these discount window loans are repaid, the borrowing
institutions lose reserves and may be forced to curtail the growth
of their deposits and loans
▫ The loan rate charged by the Fed, the discount rate, is set by each
Reserve bank’s board of directors and must be approved by the
Federal Reserve Board

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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• Other Central Bank Policy Tools
▫ Central banks also occasionally use changes in reserve requirements
as a monetary policy tool
▫ Institutions must place a small percentage of each dollar of deposits
in reserve, either in the form of vault cash or in a deposit at the
central bank
▫ Raising reserve requirements means that financial firms must set
aside more of each incoming dollar of deposits into required
reserves, and less money is available to support making new loans
▫ On the other hand, lowering reserve requirements releases
reserves for additional lending
▫ Central banks rarely change reserve requirements
▫ Powerful impact, cannot easily be reversed and because banks
are less dependent on deposits as a source of funds

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The Central Banking System: Its Impact on the
Decisions and Policies of Financial Institutions
(continued)

• Other Central Bank Policy Tools
▫ One other important policy tool – moral suasion
▫ Through this policy tool, the central bank tries to bring
psychological pressure to bear on individuals and institutions to
conform to its policies
▫ Examples of moral suasion
▫ Central bank officials testifying before legislative committees to
explain what the bank is doing and what its objectives are
▫ Letters and phone calls sent to those institutions that seem to be
straying from central bank policies
▫ Press releases urging the public to cooperate with central bank
efforts to strengthen the economy

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Quick Quiz
• What key roles does the Federal Reserve System perform in the
banking and financial system?
• What is the principal job performed by the FDIC?
• What is the Glass-Steagall Act, and why was it important in
banking history?
• How have bank failures influenced recent legislation?
• How and why was the Dodd-Frank Regulatory Reform Act crafted
to reduce systemic risk in the financial system, promote fair
lending, protect consumers, and separate banks from key nonbank
firms in an effort to restore public confidence?
• What is monetary policy?
• What services does the Federal Reserve provide to depository
institutions?
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Chapter Three
The Organization and Structure of
Banking and the Financial-Services
Industry
McGraw-Hill/Irwin

Key Topics
• The Organization and Structure of Banks and the Banking
Industry
• The Array of Organizational Structures in Banking: Unit,
Branch, Holding Company, and Electronic Services
• Interstate Banking and the Riegle-Neal Act
• The Financial Holding Company (FHC)
• Mergers and Acquisitions
• Banking Structure and Organization in Europe and Asia
• The Changing Organization and Structure of Banking’s
Principal Competitors
• Economies of Scale and Scope and Expense Preference
Behavior

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Introduction
• Chapter 1 explored many of the roles and services of the
modern bank and competitors of banks
• Over the years, bankers and the managers of competing
financial institutions have evolved into different
organizational forms
• A financial institution’s role and size are not the only
determinants of how it is organized or how well it
performs
• In this chapter, we will discuss the causes that have
dramatically changed the structure, size, and types of
organizations dominating the financial-services industry
today
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The Organization and Structure of the
Commercial Banking Industry
• Advancing Size and Concentration of Assets
▫ Commercial banking is the dominant supplier of credit and
payments services to businesses and households
▫ Many banks in the United States are small by global
standards
▫ These smallest financial institutions, numerous as they are, held
little more than one percent of total industry assets

▫ In contrast, the American banking industry also contains
some of the largest financial service organizations on the
planet
▫ Citigroup, JP Morgan Chase, and the Bank of America hold
about 6 trillion dollars combined

▫ Thus, banking continues to be increasingly concentrated not
only in the smallest, but also in the very largest of all
financial firms

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EXHIBIT 3–1 The Structure of the U.S. Commercial
Banking Industry, December 31, 2009

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EXHIBIT 3–1 The Structure of the U.S. Commercial
Banking Industry, December 31, 2009

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Internal Organization of the Banking Firm
• The great differences in size across the
industry that have appeared in recent years
have led to marked differences in the way
banks and other service providers are
organized internally and in the variety of
financial services each institution sells in the
markets it chooses to serve

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EXHIBIT 3–2 Small and Medium-Size U.S. Banks Lose
Market Share to the Largest Banking Institutions

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Internal Organization of the Banking Firm
(continued)
• Community Banks and Other Community-Oriented
Financial Firms
▫ Devoted principally to the markets for smaller, locally based
deposits and loans and are often referred to as a retail bank
▫ Financial firms of this type stand in sharp contrast to wholesale
banks
▫ Close contact between top management and management and staff
of each division is common
▫ Community banks are usually significantly impacted by changes in
the health of the local economy and keeping up with new
regulations
▫ These institutions have been losing ground, both in numbers of
institutions and in industry shares
▫ Around 14,000 community banks in 1985 and about 6,000 in 2010
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EXHIBIT 3–3 Organization Chart for a Smaller Community
Bank

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Internal Organization of the Banking Firm
(continued)
• Larger Banks – Money Center, Wholesale and Retail
▫ A large money center bank is usually located in a large city
and has a focus towards wholesale or wholesale plus retail
▫ Some of the largest banks have moved toward the profitcentered or performance approach
▫ Each major department strives to maximize its contribution to
profitability or to some other performance indicator

▫ The largest money-center banks possess some important
advantages over community oriented institutions
▫ Better diversified – both geographically and by product line
▫ Can better withstand the risks of a fluctuating economy
▫ Able to raise huge amounts of financial capital at relatively low cost
▫ Can attract top managerial talent
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EXHIBIT 3–4 Organization Chart for a Money Center or
Wholesale Bank Serving Domestic and International Markets

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Internal Organization of the Banking Firm
(continued)
• Trends in Organization
▫ The tendency in recent years has been for most financial institutions
to become more complex organizations over time
▫ When a financial firm begins to grow, it usually adds new services
and new facilities

▫ Another significant factor influencing financial organizations today
is the changing makeup of the skills financial-service providers need
to function effectively
▫ Financial firms have needed growing numbers of people with
computer skills
▫ Call centers have grown in the industry to sell profitable services
and respond to customer problems
▫ Automated bookkeeping has reduced the time managers spend in
routine operations
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The Array of Organizational Structures and
Types in the Banking Industry
• There are so many different types of financial
institutions today that the distinctions between these
different types of organizations often get very
confusing
▫ Insured banks
▫ State chartered banks
▫ National banks
▫ Member banks

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EXHIBIT 3–5 U.S. Commercial Banks with Federal versus State
Charters, Membership in the Federal Reserve System, and Deposit
Insurance from the Federal Government (as of December 31, 2009)

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The Array of Organizational Structures and
Types in the Banking Industry (continued)
• Unit Banking Organizations
▫ Unit banks, one of the oldest kinds, offer all of their
services from one office
▫ Some services (such as taking deposits, cashing checks, or
paying bills) may be offered from limited-service facilities,
such as drive-up windows and automated teller machines
(ATMs)

▫ These organizations are still common today
▫ One reason for the large numbers of unit banks is the
continuing formation of new banks
▫ Many customers still seem to prefer smaller banks, which
often seem to know their customers better than larger banks

▫ Many new banks start out as unit organizations
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TABLE 3–1 Entry and Exit in U.S. Banking

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The Array of Organizational Structures and
Types in the Banking Industry (continued)
• Branching Organizations
▫ As a unit financial firm grows larger in size it usually decides at
some point to establish a branching organization
▫ They offer the full range of services from several locations,
including a head office and one or more full-service branch
offices
▫ Likely to offer limited services through a supporting network of
drive-in windows, ATMs, computers networked with the bank’s
computers, point-of-sale terminals in stores and shopping centers,
the Internet, and other advanced communications systems

▫ Senior management of a branching organization is usually
located at the home office, though each full-service branch has
its own management team with limited authority to make
decisions
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EXHIBIT 3–6 The Branch Banking Organization

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The Array of Organizational Structures and
Types in the Banking Industry (continued)
• Branching’s Expansion
▫ During the Great Depression of the 1930s, only one in five
American banks operated a full-service branch office
▫ By the beginning of the 21st century, the average U.S. bank
operated close to 12 full-service branch offices
▫ One contributing factor has been the exodus of population
from cities to suburban communities

▫ The passage of the Riegle-Neal Interstate Banking and
Branching Efficiency Act in 1994 provided the basis for
expansion
▫ However, in recent years new bank branch office expansion
appears to have slowed somewhat
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TABLE 3–2 Growth of Commercial Bank Branch Offices in
the United States

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The Array of Organizational Structures and
Types in the Banking Industry (continued)
• Electronic Branching – Websites and Electronic
Networks: An Alternative or a Supplement to
Traditional Bank Branch Offices?
▫ Electronic branches
▫ Internet banking services
▫ Automated teller machines (ATMs)
▫ Point-of-sale (POS) terminals
▫ Personal computers
▫ Call-center systems
▫ Virtual banks
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EXHIBIT 3–7 Electronic Banking Systems, Computer Networks,
and Web Banking: An Effective Alternative to Full-Service
Branches?

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The Array of Organizational Structures and
Types in the Banking Industry (continued)
• Holding Company Organizations
▫ A bank holding company is simply a corporation
chartered for the purpose of holding the stock of at
least one bank, often along with other businesses
▫ The growth of holding companies has been rapid in
recent decades
▫ The principal reasons for this rapid upsurge:
▫ Access to capital markets in raising funds
▫ Ability to use higher leverage
▫ Tax advantages
▫ Ability to expand into businesses outside banking
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TABLE 3–3 The 10 Largest Bank Holding Companies
Operating in the United States (Total Assets as Reported on
June 30, 2010)

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The Array of Organizational Structures and
Types in the Banking Industry (continued)
• Most registered bank holding companies in the United States are onebank companies
▫ However, these one-bank companies frequently control one or more
nonbank businesses as well
• The principal advantage for holding companies entering nonbank lines
of business is the prospect of diversifying sources of revenue and
profits and reducing risk exposure
• A minority of bank holding company organizations are multibank
holding companies
▫ Multibank companies control more than 70 percent of the total
assets of all U.S. banking organizations
• One dramatic effect of holding company expansion has been a sharp
decline in the number of independently owned banking organizations
• Banks acquired by holding companies are referred to as affiliated
banks
• Banks not owned by holding companies are known as independent
banks
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TABLE 3–4 The Most Important Nonbank Financially
Related Businesses That Registered Holding Companies
Can Acquire under U.S. Banking Regulations

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EXHIBIT 3–8 The Multibank Holding Company

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The Array of Organizational Structures and
Types in the Banking Industry (continued)
• Holding company banking has been blamed for reducing
competition by critics
• Supporters of the holding company movement claim
greater efficiency, more services, lower probability of
organizational failure, and higher and more stable profits
▫ The holding company as a whole tends to be more profitable
than banking organizations that do not form holding companies

• Moreover, the failure rate for holding company banks
appears to be below that of comparable-size independent
banks
• However, there is anecdotal evidence that multibank
holding companies may drain scarce capital from some
communities and weaken smaller towns and rural areas
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Interstate Banking Organizations and the Riegle-Neal
Interstate Banking and Branching Efficiency Act of 1994
• Riegle-Neal allows holding companies to acquire banks throughout the
United States without needing any state’s permission to do so and to
establish branch offices across state lines
• Why did the federal government eventually enact and the states
support interstate banking laws?
▫ The need to bring in new capital to revive struggling local economies
▫ The expansion of financial-service offerings by nonbank financial
institutions that faced few restrictions on their ability to expand nationwide
▫ A strong desire on the part of the largest financial firms to geographically
diversify their operations and open up new marketing opportunities
▫ The belief among regulators that larger financial firms may be more
efficient and less prone to failure
▫ Advances in the technology of financial-services delivery, permitting service
to customers over broader geographic areas
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An Alternative Type of Banking Organization Available
as the 21st Century Opened: Financial Holding
Companies (FHCs)
• Under the terms of the Gramm-Leach-Bliley (GLB) Act,
financial holding companies (FHCs) are defined as a special
type of holding company that may offer the broadest range of
financial services, including dealing in and underwriting
securities and selling and underwriting insurance
• With the FHCs, each affiliated financial firm has its own
▫ Capital
▫ Management
▫ Profits or losses separate from the profits or losses of other affiliates
of the FHC
▫ Some protection against companywide losses

• Led to consolidation and convergence within the industry
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EXHIBIT 3–9 The Financial Holding Company (FHC)

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TABLE 3–5 Leading Financial Holding Companies (FHCs)
Registered with the Federal Reserve Board

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Mergers and Acquisitions Reshaping the Structure and
Organization of the Financial-Services Sector
• The rise of branching, bank holding companies, and
financial holding companies has been fueled by multiple
factors
• Another powerful factor spurring these organizational
types forward is their ability to carry out mergers and
acquisitions
• Bigger companies have pursued smaller financial-service
providers and purchased their assets in great numbers
▫ Since 1980 more than 12,000 bank mergers have occurred in
the United States

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The Changing Organization and Structure of
Banking’s Principal Competitors
• Banking’s principal competitors – credit unions, savings
associations, finance companies, insurance firms, security
dealers, hedge funds, and other financial firms
• All are affected by powerful forces such as rising operating
costs and rapidly changing technology
• A notable exception until very recently has been hedge
funds
• All financial firms are starting to look alike, especially in
the menu of services offered
▫ Convergence

• Great structural and organizational changes have “spilled
over” into one financial-service industry after another

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Efficiency and Size: Do Bigger Financial
Firms Operate at Lower Cost?
• If not, then why have some financial institutions become
some of the largest businesses on the planet?
• Two possible sources of cost savings
▫ Economies of scale
▫ Economies of scope

• For financial firms, there is evidence for at least moderate
economies of scale in banking, though most studies find
only weak evidence or none at all for economies of scope
▫ Studies of selected nonbank financial firms often reach
conclusions that roughly parallel the results for banking firms

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3-36

EXHIBIT 3–10 The Most Efficient Sizes for Banks and
Selected Other Financial Firms

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3-37

Financial Firm Goals: Their Impact on
Operating Cost, Efficiency, and Performance
• Expense-Preference Behavior
▫ When the management of a financial firm decides that benefits for
managers (and not the stockholders or the public) should be the
primary objective of the company
▫ Opposite of cost control and efficiency
• Agency Theory
▫ Analyzes relationships between a firm’s owners (stockholders) and
its managers, who legally are agents for the owners
▫ Explores whether mechanisms exist in a given situation to compel
managers to maximize the welfare of their firm’s owners
• Lower agency costs and better company performance depend upon
the effectiveness of corporate governance
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Quick Quiz
• What trends are affecting the way banks and their competitors
are organized today?
• What trend in branch banking has been prominent in the
United States in recent years?
• What is a bank holding company?
• Are there any significant advantages or disadvantages for
holding companies or the public if these companies acquire
banks or nonbank business ventures?
• Can you see any advantages to allowing interstate banking?
What about potential disadvantages?
• What relationship appears to exist between bank size, efficiency,
and operating costs per unit of service produced and delivered?
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Chapter Four
Establishing New Banks, Branches,
ATMs, Telephone Services, and
Websites
McGraw-Hill/Irwin

Key Topics
•
•
•
•
•
•

Chartering New Financial-Service Institutions
The Performance of New Banks
Establishing Full-Service Branches and In-Store
Branching
Establishing Limited-Service Facilities
ATMs and Telephone Centers
The Internet and Online Banking

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Introduction
•
•
•
•
1.
2.
3.

Financial-service facilities are usually established today for
the convenience of customers
For most of the history of financial-service providers,
convenience has meant location
Customers’ views about what is convenient are changing
rapidly partly due to technology
In deciding how they will respond to customers’ changing
demands, financial firms today have several options:
Chartering new (de novo) financial institutions
Establishing new full-service branch offices
Setting up limited-service facilities

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Chartering a New (De Novo) Financial-Service
Institution
•
•
•

•
1.
2.
3.

No one can start a financial firm in most countries without the express
approval of federal or state authorities, sometimes both
In the case of banks, the public’s need for a new (de novo) bank in a
particular location must be demonstrated
Usually the founder stockholders must supply enough start-up capital to
cover several years and show that the proposed new institution will
achieve adequate levels of profitability
Government chartering agencies believe financial-service providers need
special scrutiny for several reasons:
They hold the public’s savings
Many financial firms are at the heart of the payments process to support
trade and commerce, so their failure could disrupt business activity
They have the ability to create money (through granting credit)ding
power), which suggests that chartering too many might

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The Bank Chartering Process in the United
States
•

•
•

•

Only the banking commissions in each of the 50 states and the
Office of the Comptroller of the Currency (OCC) can issue a
charter of incorporation to start a new U.S. bank
Generally, federal standards for receiving a bank charter are
more rigorous than the rules of state banking commissions
Organizers often seek a federal bank charter for the added
prestige it conveys in the minds of customers, especially large
depositors
The choice between pursuing a federal or a state charter
usually comes down to weighing the benefits and costs of each
for the particular bank and its location(s)

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The Bank Chartering Process in the United
States (continued)
•
▫
▫

▫

•
▫
▫
▫
▫

Benefits of Applying for a Federal (National) Charter
It brings added prestige due to stricter regulatory standards that may
attract larger deposits
In times of trouble, the technical assistance supplied to a struggling
institution by national authorities may be of better quality, giving the
troubled bank a better chance to survive
Federal rules can pre-empt state laws

Benefits of Applying for a State Charter
It is generally easier and less costly to secure a state charter and supervisory
fees are usually lower
The bank need not join the Federal Reserve System
Some states allow a bank to lend a higher percentage of its capital to a
single borrower
State-chartered banks may be able to offer certain services that national
banks may not be able to offer
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Questions Regulators Usually Ask the Organizers
of a New (De Novo) Bank
1.

3.
4.

What are the population and geographic boundaries of the
primary service area (PSA) from which the new financial
firm is expected to generate most of its account activity?
How many competing banks, credit unions, finance
companies, and other competitors are located within the
service area of the proposed new financial institution? What
are competitors’ services, hours of operation, and distances
from the proposed new institution?
What are the number, types, and sizes of businesses in the
area?
What are the traffic patterns in the area, adequacy of
roads, and geographic barriers to the flow of traffic?
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Questions Regulators Usually Ask the Organizers
of a New (De Novo) Bank (continued)
1.

3.
4.
5.

What is happening to population growth, incomes, types
of occupations represented, educational levels, and the age
distribution of residents in the proposed service area?
The organizers often are asked to describe the financial
history of the community served, the frequency with which
new financial firms have appeared and their track record
Who is to own any stock issued? What amount of stock
will be held by the organizers, directors, and officers?
How experienced are the organizers, management, and
board of directors of the new institution?
What are the organizers’ projections for deposits, loans,
revenues, operating expenses, and net income for the first
few years?
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Factors Weighing on the Decision to Seek a
New Charter
•

External factors the organizers should consider include:

a.
b.
c.

The level and growth of economic activity
The need for a new financial firm
The strength and character of competition in supplying
financial services

•

Internal factors the organizers should consider include:

d.
e.
f.

Qualifications and contacts of the organizers
Management quality
Pledging of capital to cover the cost of filing a charter
application and getting under way

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Volume and Characteristics of New Charters
•

•
•
•

•
•

The number of new depository institutions chartered in the United
States annually has averaged over a hundred new banking firms in
many recent years
There appears to be considerable public demand for more personalized
service sometimes not available from large financial firms
Analysis of charter approvals suggests that most new banks are
chartered in relatively large urban areas
As population increases relative to the number of financial firms
operating in a given state, increased numbers of new charters are
issued
The great recession of 2007-2009 tended to reduce bank chartering
activity
Significant increases in concentration ratios tend to reduce chartering
activity, as does the expansion of existing branch office networks
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How Well Do New Charters Perform?
•
•
•

•

Launching a new financial firm entails risk
Most new financial firms grow at a moderate to rapid rate
Despite a track record of loan losses that generally exceed
those of established banks, most new banks are often
profitable within two to three years after opening their
doors
Research also suggests that early performance is strongly
tied to the experience, financial strength, and market
contacts of those who put the organization together
New charterings have competitive effects that generally
serve the public interest

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How Well Do New Charters Perform?
(continued)
•

•
•
•

The most recently chartered banks show evidence of being
“financially fragile” and more prone to failure than
established banks
New banks tend to underperform established banks in
profitability and efficiency until they reach maturity
One reason for new banks’ tendency to underperform is
that they appear to be more vulnerable to real estate crises
Today new banks are more closely supervised by
government regulators than are established institutions
and tend to be examined more frequently

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Establishing Full-Service Branch Offices: Choosing
Locations and Designing New Branches
•

•
•
•

When an established financial institution wishes to enter
new markets or when its valued customers move, an
important vehicle for market entry is the creation of new
branch offices
Establishing branches is usually much cheaper than
chartering new financial-service corporations
The branching leader in the United States, the Bank of
America, has more than 6,000 U.S. offices of various kinds
The location, design, and services offered by a branch
office depend upon the preferences of customers and the
preferences of management and employees

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

EXHIBIT 4–1 Number of Insured Commercial Bank and
Branch Offices, 1935-2009 (as of Year-End)

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Establishing Full-Service Branch Offices: Choosing
Locations and Designing New Branches (continued)
•
1.
2.
3.
4.
5.
6.
7.
8.
9.

Desirable sites for full-service branch offices possess some
of the following characteristics

Heavy traffic count
Large numbers of retail stores
Populations that are of above-average age
A surrounding area that encompasses substantial numbers
of business owners, managers, and professional men and
women at work or in residence
A steady or declining number of service facilities operated
by financial-service competitors
Above-average population growth
Above-average population density
A relatively high target ratio of population per branch
Above-average levels of household income

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Establishing Full-Service Branch Offices: Choosing
Locations and Designing New Branches (continued)
•

To measure the target ratio of population per branch, the
following equation is used

•

The larger the population served by each office, the more
financial services are likely to be purchased, expanding
revenues and enhancing operating efficiency

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Establishing Full-Service Branch Offices: Choosing
Locations and Designing New Branches (continued)
•

The decision of whether or not to establish a branch office
is a capital-budgeting decision

▫

Requires a large initial cash outflow to fund the purchase or
lease of property and to begin operations
Branches are usually created with the expectation that future
net cash inflows (NCF) will be large enough to guarantee the
financial firm an acceptable return (E(r)) on its invested
capital

▫

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Establishing Full-Service Branch Offices: Choosing
Locations and Designing New Branches (continued)
•
a.

The variance around that expected return, which is due mainly to
fluctuations in economic conditions in the area served by the branch
The covariance of expected returns from the proposed new branch,
existing branches, and other assets previously acquired by the
offering institution

•

▫
▫

Other considerations when considering possible locations for new
branches:

The impact of a new branch’s expected return (RB) on the offering
institution’s total return (RT) from its existing branches and other
assets (ROA) can be found from
W is the proportion of total resources to be invested in new branch B
(1–W) is the proportion of the offering institution’s resources invested in
all of its other assets (OA)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Establishing Full-Service Branch Offices: Choosing
Locations and Designing New Branches (continued)
•

The marginal impact of a new branch on overall risk measured by the
variance of total return (RT):
where

▫

ρB,OA represents the correlation coefficient between the expected return
from the proposed new branch and the returns from other assets of the
offering institution
σB represents the standard deviation of the proposed new branch’s
expected return
σOA represents the standard deviation of return from other assets held by
the financial firm

▫

•

Geographic diversification can reduce overall risk exposure
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Establishing Full-Service Branch Offices: Choosing
Locations and Designing New Branches (continued)
•

Regulation in the United States recently has made it more
difficult to close full-service branch offices of depository
institutions

▫
▫

The FDIC Improvement Act of 1991
The Community Reinvestment Act of 1977

•

Many analysts see the roles played by branch offices evolving in
new directions today

▫
▫

Sales orientation
Cross-selling

•

Branches are coming to be viewed today less as mere deposit
gatherers and more as sources of fee-generating service sales
and for booking profitable assets

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Establishing Full-Service Branch Offices: Choosing
Locations and Designing New Branches (continued)
•

In-Store Branching

▫

A significant portion of financial-service branches today are located
inside supermarkets, shopping centers, and other retail establishments
These retail-oriented service facilities have only a few employees
Highly sales oriented
In-store branches typically are much less costly to build and maintain
and tend to become profitable about 12 months earlier than standalone facilities
Operate for longer hours
Can experience more traffic flow than conventional branches

▫
▫
▫
▫
▫

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Establishing and Monitoring Automated LimitedService Facilities (“Branchless Banking”)
•

There has been a recent spike in branchless banking
due to the high cost of chartering new financial firms
and setting up full-service branch offices

▫
▫
▫
▫

Point-of-sale (POS) terminals
Automated teller machines (ATMs)
Telephone banking
Internet-supplied services

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Establishing and Monitoring Automated LimitedService Facilities (“Branchless Banking”) (continued)
•

The Decision to Install a New ATM

▫
▫

Suppose ATMs cost $50,000 each and require $30,000 to install
A bank estimates that it will save $1.00 for each check that is not written
because customers will use the machine instead
Life expectancy is 10 years and it will handle 30,000 cash transactions/year
Cost of capital to finance the ATM’s purchase is 14%

▫
▫

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Banking in Homes, Offices, Stores, and on the
Street
•

Telephone Banking and Call Centers

▫

The telephone remains among the most popular channels for putting
customers in touch with financial-service providers today

•

Internet Banking

▫

Features include

▫
▫
▫
▫
▫
▫

Verify in real time account balances at any time and from any location
Move funds instantly from one account to another
Confirm that deposits of funds have been received, checks have cleared,
and online transactions have been completed
View and print images of checks that have passed through a customer’s
account
Submit an application for loans and credit cards
Carry out online bill paying

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Financial-Service Facilities of the Future
•

•
•

•

Despite continually advancing technology, most experts
seem to agree that the total number of financial-service
outlets industry wide may not decline significantly for a
time
The use of “digital cash” will permit customers to be their
own financial-service branches for certain transactions
Service providers are likely to evaluate the success of their
branch offices and limited-service facilities in terms of
profits and costs per square foot
Outsourcing of financial service delivery is likely to grow

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Quick Quiz
•

•
•
•

Why is the physical presence of a bank still important to many
customers despite recent advances in long-distance communications
technology?
Who charters new banks in the United States?
What are the advantages of having a national bank charter? A state
bank charter?
What kinds of information must the organizers of new national banks
provide the Comptroller of the Currency in order to get a charter?
Why might this required information be important?
What are the key factors the organizers of a new financial firm should
consider before deciding to seek a charter?
What are POS terminals, and where are they usually located?
What services do ATMs provide? What are the principal limitations of
ATMs as a service provider? Should ATMs carry fees? Why?
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

Chapter Five
The Financial Statements of Banks and
Their Principal Competitors
McGraw-Hill/Irwin

Key Topics
• An Overview of the Balance Sheets and Income Statements of
Banks and Other Financial Firms
• The Balance Sheet or Report of Condition
• Asset Items
• Liability Items
• Recent Expansion of Off-Balance-Sheet Items
• The Problem of Book-Value Accounting and “Window
Dressing”
• Components of the Income Statement: Revenues and Expenses
• Appendix: Sources of Information on the Financial-Services
Industry
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-2

Introduction
• The particular services each financial firm chooses to offer
and the overall size of each financial-service organization
are reflected in its financial statements
• Financial statements can be viewed as a “road map”
▫ Tell us where a financial firm has been in the past, where it is
now, and possibly where it is headed in the future

• The two main financial statements that managers,
customers, and the regulatory authorities rely upon are
▫ The balance sheet (Report of Condition)
▫ The income statement (Report of Income)

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-3

An Overview of Balance Sheets and Income
Statements
• The Report of Condition shows the amount and composition of funds
sources (financial inputs) drawn upon to finance lending and investing
activities and how much has been allocated to loans, securities, and
other funds uses (financial outputs) at any given point in time
• In contrast, the financial inputs and outputs on the Report of Income
show how much it has cost to acquire funds and to generate revenues
from the uses the financial firm has made of those funds
• The Report of Income also shows the revenues (cash flow) generated
by selling services to the public, including making loans and servicing
customer deposits
• The Report of Income shows net earnings after all costs are deducted
from the sum of all revenues, some of which will be reinvested in the
financial firm for future growth and some of which will flow to
stockholders as dividends
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-4

TABLE 5–1 Key Items on Bank Financial Statements

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-5

The Balance Sheet (Report of Condition)
• A balance sheet lists the assets, liabilities, and equity
capital (owners’ funds) held by or invested in a bank or
other financial firm on any given date

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-6

The Balance Sheet (Report of Condition)
(continued)
• For banks and other depository institutions the assets on the
balance sheet are of four major types:
▫ Cash in the vault and deposits held at other depository institutions (C)
▫ Government and private interest-bearing securities purchased in the open
market (S)
▫ Loans and lease financings made available to customers (L)
▫ Miscellaneous assets (MA)

• Liabilities fall into two principal categories:
▫ Deposits made by and owed to various customers (D)
▫ Nondeposit borrowings of funds in the money and capital markets (NDB)

• Equity capital represents long-term funds the owners contribute
(EC)

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-7

The Balance Sheet (Report of Condition)
(continued)
• Cash assets (C) are designed to meet the financial firm’s need for
liquidity
• Security holdings (S) are a backup source of liquidity and include
investments that provide a source of income
• Loans (L) are made principally to supply income
• Miscellaneous assets (MA) are usually dominated by fixed assets (plant
and equipment) and investments in subsidiaries (if any)
• Deposits (D) are typically the main source of funding for banks
▫ Nondeposit borrowings (NDB) are carried out mainly to supplement
deposits and provide the additional liquidity that cash assets and
securities cannot provide

• Equity capital (EC) supplies the long-term, relatively stable base of
financial support upon which the financial firm will rely to grow and
to cover any extraordinary losses it incurs
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-8

The Balance Sheet (Report of Condition)
(continued)
• One useful way to view the balance sheet identity is to note that
liabilities and equity capital represent accumulated sources of funds,
which provide the needed spending power to acquire assets
• A bank’s assets, on the other hand, are its accumulated uses of funds,
which are made to generate income for its stockholders, pay interest to
its depositors, and compensate its employees for their labor and skill
• Thus, the balance sheet identity can be pictured simply as:

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-9

TABLE 5–2 Highlighted Bank Financial Data ($ million)
from the FDIC (December 31, 2009)

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-10

TABLE 5–3 Report of Condition (Balance Sheet) for BB&T
(Year-End 2008 and 2009)

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-11

The Balance Sheet (Report of Condition)
(continued)
• Cash Assets
▫ Account is called Cash and Deposits Due from Bank
▫ Includes:
▫ Vault Cash
▫ Deposits with Other Banks (Correspondent Deposits)
▫ Cash Items in Process of Collection
▫ Reserve Account with the Federal Reserve

▫ Sometimes called primary reserves

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-12

The Balance Sheet (Report of Condition)
(continued)
• Investment Securities – The Liquid Portion
▫ Short Term Government Securities
▫ Privately Issued Money Market Securities
▫ Interest Bearing Time Deposits
▫ Commercial Paper

▫ Often called secondary reserves

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-13

The Balance Sheet (Report of Condition)
(continued)
• Investment Securities – The Income-Generating
Portion
▫ Taxable Securities
▫ U.S. Government Notes
▫ Government Agency Securities
▫ Corporate Bonds

▫ Tax-Exempt Securities
▫ Municipal Bonds

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-14

The Balance Sheet (Report of Condition)
(continued)
• Trading Account Assets
▫ Securities purchased to provide short-term profits from
short-term price movements
▫ Occurs when the bank acts as a securities dealer
▫ Valued at Market – FASB 115

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-15

The Balance Sheet (Report of Condition)
(continued)
• Federal Funds Sold and Reverse Repurchase Agreements
▫ Includes mainly temporary loans (usually extended overnight,
with the funds returned the next day) made to other
depository institutions, securities dealers, or major industrial
corporations
▫ The funds for these temporary loans often come from the
reserves a bank has on deposit with the Federal Reserve Bank
in its district
▫ “Fed funds”

▫ Some of these temporary credits are extended in the form of
reverse repurchase (resale) agreements (RPs) in which the
banking firm acquires temporary title to securities owned by
the borrower and holds those securities as collateral until the
loan is paid off
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-16

The Balance Sheet (Report of Condition)
(continued)
• Loan Accounts
▫ The Major Asset
▫ Gross Loans – Sum of All Loans
▫ Allowance for Possible Loan Losses
▫ Contra Asset Account
▫ For Potential Future Loan Losses

▫ Net Loans
▫ Unearned Discount Income
▫ Nonperforming Loans

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-17

The Balance Sheet (Report of Condition)
(continued)
• Types of Loans
▫ Commercial and industrial (or business) loans
▫ Consumer (or household) loans
▫ Real estate (or property-based) loans
▫ Financial institutions loans
▫ Foreign (or international) loans
▫ Agricultural production loans
▫ Security loans
▫ Leases

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-18

The Balance Sheet (Report of Condition)
(continued)
• Loan Losses
Beginning Allowance for Loan Losses
+ This Year’s Provision for Loan Loss
= Adjusted Allowance for Loan Losses
– Actual Charge-Offs of Worthless Loans
+ Recoveries from Previous Charge-Offs
= Ending Allowance for Loan Losses

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-19

The Balance Sheet (Report of Condition)
(continued)
• Specific and General Reserves
▫ Specific Reserves
▫ Set aside to cover a particular Loan
▫ Designate a portion of ALL or
▫ Add more reserves to ALL

▫ General Reserves
▫ Remaining ALL

▫ Determined by management but influenced by taxes and
government regulation
▫ Loans to lesser developed countries require allocated
transfer reserves
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-20

The Balance Sheet (Report of Condition)
(continued)
• Miscellaneous Assets
▫ Bank Premises and Fixed Assets
▫ Other Real Estate Owned (OREO)
▫ Goodwill and Other Intangibles

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-21

The Balance Sheet (Report of Condition)
(continued)
• Liabilities of the Banking Firm
▫ Deposits
▫ Non interest-Bearing Demand Deposits
▫ Savings Deposits
▫ Now Accounts
▫ Money Market Deposit Accounts (MMDA)
▫ Time Deposits

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-22

The Balance Sheet (Report of Condition)
(continued)
• Liabilities of the Banking Firm
▫ Nondeposit Borrowings
▫ Fed Funds Purchased
▫ Securities Sold Under Agreement to Repurchase (Repurchase
Agreements)
▫ Acceptances Outstanding
▫ Eurocurrency Borrowings
▫ Subordinated Debt
▫ Limited Life Preferred Stock
▫ Other Liabilities

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-23

The Balance Sheet (Report of Condition)
(continued)
• Equity Capital of the Banking Firm
▫ Preferred Stock
▫ Common Stock
▫ Common Stock Outstanding
▫ Capital Surplus
▫ Retained Earnings (Undivided Profits)
▫ Treasury Stock
▫ Contingency Reserve

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-24

TABLE 5-4 The Composition of Bank Balance Sheets (Percentage
Mix of Sources and Uses of Funds for (Year-End 2009)

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-25

The Balance Sheet (Report of Condition)
(continued)
• Recent Expansion of Off-Balance-Sheet (OBS) Items
in Banking
▫ Unused Commitments
▫ Standby Credit Agreements
▫ Derivative Contracts
▫ Futures Contracts
▫ Options
▫ Swaps

▫ OBS transactions expose a firm to counterparty risks
▫ OBS items have grown so rapidly that, for the banking
industry as a whole, they exceed total bank assets many
times over
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-26

TABLE 5–5 Examples of Off-Balance-Sheet Items Reported
by FDIC-Insured Banks

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-27

The Balance Sheet (Report of Condition)
(continued)
• The Problem with Book-Value Accounting
▫ Original (historical, book-value) cost
▫ Amortized cost
▫ Market-value
▫ Held-to-maturity and available-for-sale securities
▫ Window Dressing
▫ Auditing Financial Statements
▫ Audit Committees
▫ Sarbanes-Oxley Accounting Standards Act

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-28

Components of the Income Statement (Report
of Income)
• Indicates the amount of revenue received and
expenses incurred over a specific period of time
• Shows how much it has cost to acquire funds and to
generate revenues from the uses of funds in the Report
of Conditions
• Shows the revenues (cash flow) generated by selling
services to the public
• Shows net earnings after all costs are deducted from
the sum of all revenues

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-29

Components of the Income Statement (Report
of Income) (continued)

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-30

Components of the Income Statement (Report
of Income) (continued)
• Income statements are a record of financial flows over
time
• Therefore, we can represent the income statement as a
report of financial outflows (expenses) and financial
inflows (revenues)
• Four main sections
1.
2.
3.
4.

Interest income
Interest expenses
Noninterest income
Noninterest expenses

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-31

TABLE 5–6 Report of Income (Income Statement) for BB&T
(2008 and 2009)

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-32

Components of the Income Statement (Report
of Income) (continued)
• Net Interest Income = Interest Income – Interest
Expenses
• Interest Income Sources
▫ Interest and Fees on Loans
▫ Taxable Securities Revenue
▫ Tax-Exempt Securities Revenue
▫ Other Interest Income

• Interest Expense Sources
▫ Deposit Interest Costs
▫ Interest on Short-Term Debt
▫ Interest on Long-Term Debt
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-33

Components of the Income Statement (Report
of Income) (continued)
• Net Noninterest Income = Noninterest Income –
Noninterest Expenses
• Noninterest Income Sources
▫ Fees Earned from Fiduciary Activities
▫ Service Charges on Deposit Accounts
▫ Trading Account Gains and Fees
▫ Additional Noninterest Income

• Noninterest Expense Sources
▫ Wages, Salaries, and Employee Benefits
▫ Premises and Equipment Expense
▫ Other Operating Expenses
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-34

The Financial Statements of Leading Nonbank Financial
Firms: A Comparison to Bank Statements
• The financial statements of nonbank financial firms
have, in recent years, come closer and closer to what we
see on bank statements
▫ Especially true of thrift institutions
▫ Thrifts’ balance sheet are dominated by loans, deposits
from customers, and borrowings in the money market
▫ Thrifts’ income statements are heavily tilted toward
revenue from loans and by the interest they must pay on
deposits and money market borrowings

▫ Other groups in the financial-service industries such as
finance companies, life and property/casualty insurers,
mutual funds, and security brokers and dealers
▫ Their financial statements include sources and uses of
funds unique to the functions of these industries

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-35

TABLE 5–7 The Composition of Bank Income Statements
(Percentage of Total Assets Measured as of Year-End 2009)

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-36

An Overview of Key Features of Financial
Statements and Their Consequences
• Table 5–8 provides a useful overview of the key
features of the financial statements of financial
institutions and their consequences for the managers
of financial firms and for the public

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-37

TABLE 5–8 Features and Consequences of the Financial
Statements of Banks and Similar Financial Firms

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-38

Quick Quiz
• What are the principal accounts that appear on a bank’s balance sheet
(Report of Condition)?
• Which accounts are most important and which are least important on
the asset side of a bank’s balance sheet? What accounts are most
important on the liability side of a balance sheet?
• What are primary reserves and secondary reserves, and what are they
supposed to do?
• What accounts make up the Report of Income (income statement of a
bank)?
• What is the relationship between the provision for loan losses on a
bank’s Report of Income and the allowance for loan losses on its
Report of Condition?
• What are the key features or characteristics of the financial statements
of banks and similar financial firms?
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

5-39

Chapter Six
Measuring and Evaluating the
Performance of Banks and Their
Principal Competitors
McGraw-Hill/Irwin

Key Topics
• Stock Values and Profitability Ratios
• Measuring Credit, Liquidity, and Other Risks
• Measuring Operating Efficiency
• Performance of Competing Financial Firms
• Size and Location Effects
• Appendix: Using Financial Ratios and Other
Analytical Tools to Track Financial Firm
Performance – The UBPR and BHCPR
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

6-2

Introduction
• This chapter focuses on the most widely used indicators of
the quality and quantity of bank performance and their
principal competitors
• Focus on the most important dimensions of performance –
profitability and risk
• Financial institutions are simply businesses organized to
maximize the value of the shareholders’ wealth invested in
the firm at an acceptable level of risk
• Must continually be on the lookout for new opportunities
for revenue growth, greater efficiency, and more effective
planning and control
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

6-3

Evaluating Performance
• Performance must be directed toward specific objectives
• A fair evaluation of any financial firm’s performance should
start by evaluating whether it has been able to achieve the
objectives its management and stockholders have chosen
• A key objective is to maximize the value of the firm

McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

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