CHAPTER 3

DEPOSITORY INSTITUTIONS:
ACTIVITIES AND CHARACTERISTICS

ASSET/LIABILITY PROBLEM OF DEPOSITORY INSTITUTIONS

These institutions seek to earn spread income, which is a positive spread or margin
between the returns on their assets and the costs of their liabilities. In generating spread
income, a depository institution faces several risks. These include credit
risk,regulatory risk, and interest rate risk.

Interest Rate Risk

Interest rate risk or funding risk is the mismatching of assets and liabilities in terms of
their maturities. For example, this can arise because the deposits are short-term and
assets long term. An increase in expected interest rates will reduce the spread between
the return on assets and the deposit costs. Floating rate long-term assets can reduce this
problem since they make long-term assets behave like short-term funds that match
deposit terms to maturity.

Liquidity Concerns

Liquidity concern is the possibility of withdrawal of funds by depositors or insufficient
funds available to meet lending needs. It can be handled by: (1) attracting more deposits;
(2) borrowing from federal agency or other institution (Federal Funds Market); (3)
raising short-term funds in the money market; (4) selling or liquidating securities and
other assets. Securities held for the purpose of satisfying net withdrawals and customer
loan demands are sometimes referred to as secondary reserves.

COMMERCIAL BANKS

Today, banks are regulated and supervised by several federal and state government
entities. At the federal level, supervision is undertaken by the Federal Reserve Board, the
Office of the Comptroller of the Currency, and the Federal Deposit Insurance
Corporation. The assets of a bank are insured by the Federal Deposit Insurance
Corporation.

As of 2d quarter 2007, 7350 commercial banks were operating in the United States. Only
about 25% were national banks, but these held the majority of the bank assets (65%).

Bank Services

Banks provide numerous services and are broadly defined as follows: (1) individual
banking; (2) institutional banking; (3) global banking.

Individual banking includes consumer lending, mortgage lending (mortgage
banking), credit card financing, brokerage services, student loans, and individual-
oriented financial investment services. Institutional banking Institutional banking
includes commercial real estate financing, leasing activities, and factoring. Global
banking includes corporate financing, capital market and foreign exchange products and
services. At one time, some of these activities were restricted by the Glass-Steagall
Act. But this statute was repealed by the Gramm-Leach-Bliley Act in November
1999.

Bank Funding

Funds are obtained mainly from three sources: (1) deposits, (2) nondeposit, (3) common
stock and retained earnings.

Deposits: There are several types of deposit accounts. Demand deposits (checking)
pay no interest and can be withdrawn upon demand. Savings deposits pay interest,
typically below market rates, and can be withdrawn upon demand. Time deposits, also
called certificates of deposit, have a fixed maturity date and pay either a fixed or
floating interest rate. The market for short-term debt obligations is called money market.
A money market demand account is designed to compete with money market mutual
funds.

Reserve requirements and borrowing in the federal funds
market: Thereserve ratio is the specified percentage of deposits in non-interest
bearing account at one of the 12 Federal Reserve Banks that a bank must maintain. The
dollar amount based on the reserve ratio is the required reserve. To determine the
reserve, the Federal Reserve has established a two-week period called the deposit
computation period. If actual reserves exceed required reserves, the difference is
referred to as excess reserves. Banks temporarily short of their required reserves can
borrow reserves from banks that have excess reserves. The market where banks can
borrow or lend reserves is called the federal funds market. The interest rate charged
to borrow funds is called the federal funds rate.

Borrowing at the Fed discount window: The Federal Reserve is the bank of last
resort. Banks temporarily short of funds can borrow from the Fed at its discount
window. Collateral is needed to borrow, and the Fed sets the criteria for collateral
quality. The interest rate that the Fed charges to borrow funds at the discount window is
called the discount rate.

Other nondeposit borrowing: Other nondeposit borrowing can be short term in the
form of issuing obligations in the money market, or intermediate to long term in the
form of issuing securities in the bond market. Banks that raise most of their funds from
the domestic and international money markets, relying less on depositors for funds, are
called money center banks. A regional bank is one that relies primarily on deposits
for funding.

Capital Requirements for Banks

Commercial banks are typically highly leveraged, i.e., equity constitutes a small fraction
(about 8%) of the banks assets. The organization that plays the primary role in
establishing risk and management guidelines for banks throughout the world is
theBasel Committee on Banking Supervision. The capital requirements that
resulted from other guidelines published by the Basel Committee are called the risk-
based capital requirements. In July 1988, the Basel Committee released its first
guidelines, the Capital Accord of 1988, commonly called Basel I Framework. In
June 2004, comprehensive amendments, Basel II Framework, were published to
improve on the rules as set forth in the Basel I Framework by bringing risk-based capital
requirements more in line with the underlying risks to which banks are exposed.

Credit risk and risk-based capital requirements: The risk-based capital
guidelines attempt to recognize credit risk by segmenting and weighting requirements.
First, capital is categorized as Tier 1 and Tier 2 capital. Tier 1 is the core capital. Tier 2
is the supplementary capital. Second, the guidelines establish a credit risk weight for
all assets.

SAVINGS AND LOAN ASSOCIATIONS

S&Ls originated to gather savings and pool depositor funds to finance home mortgages.
They are either mutually owned (by the depositor themselves) or stockholder-owned
(thereby making the depositors creditors of the firm). They are state or federally
chartered, and they are regulated by the Office of Thrift Supervision (OTS). As in the
case of banks, their deposits are insured, but by the Savings Association Insurance Fund
(run by the FDIC). Traditionally, most S&L assets have been in home mortgages, the
long-term nature of which insulated the S&Ls from interest rate risk for many years.
Since the early 1980s, however, they have made several other types of loans and
investments to some degree they compete with banks. Their funding has traditionally
come from several forms of savings accounts, such as NOW, MMDA, and time deposits.
Deregulation in the 1980s forced higher funding costs upon them.

Assets

Traditionally, the only assets in which S&Ls were allowed to invest have been mortgages,
mortgage-backed securities, and US government securities. S&Ls became one of the
major buyers of junk bonds. Under FIRREA, S&Ls are no longer permitted to invest
new money in junk bonds.

Funding

Deregulation expanded the types of accounts that may be offered by S&Ls: negotiable
order of withdrawal (NOW) accounts, and money deposit accounts (MMDA). S&Ls can
raise funds from the money market. They can borrow in the federal funds market and
have access to the Feds discount window. They also can borrow from the Federal Home
Loan Banks. These borrowings are called advances, which can be short term or
longterm in maturity.

Regulation

Federal S&Ls are chartered under the provisions of the Home Owners Loan Act of
1933. Federally chartered S&Ls are supervised by the Office of Thrift Supervisor. The
Depository Institutions Deregulation and Monetary Control Act of 1980 deregulated
interest rates on deposit accounts. It also expanded the Feds control over the money
supply by imposing deposit reserve requirements on S&Ls. Subsequent legislation not
only granted thrifts the right to offer money market demand accounts, but also
broadened the types of assets in which S&Ls could invest. Permission to raise funds in
the money market and the bond market was granted by the Federal Home Loan Board in
1975.

There are two sets of capital adequacy standards for S&Ls as for banks. The risk-
based capital guidelines are similar to those for banks. Instead of two tiers of capital,
there are three: Tier 1 (tangible capital), Tier 2 (core capital), and Tier 3 (supplementary
capital). As with commercial banks, there are risk-based requirements based on interest
rate risk.

The S&L Crisis

During the 1980s, many savings and loans failed or became technically insolvent.
Deposit insurance funds ran dry and federal help was needed to clean up the mess and
help the depositors. Several factors contributed to the crisis, but the following causes
were most apparent:

1. Disintermediation: as short-term interest rates rose in the money market depositors
withdrew their low-yield funds for higher-yield market investments such as MMDAs.
Because of interest rate restrictions the S&Ls could not compete for such funds.

2. Deregulation in the early 1980s lifted interest also rate restrictions, allowing S&Ls to
compete in the marketplace for short-term funds. But their long-term asset structure its
predominantly fixed-rate returns limited the cost increases for liabilities that S&Ls could
afford. Moreover, after years of being in a safe market niche of home mortgages S&Ls
suddenly found they had to compete directly with banks for funds and asset allocations.
Many such savings institutions were simply not up to the task.

3. Faced with rising liability costs, many S&Ls went after high return, high risk assets, such
as commercial real estate and junk bonds. Such high default risk projects were
undertaken prior to an economic downturn. The result was depressed regions of the
Southwest, compounded by the fact that for a number of years, regulators did little to
ameliorate the problem. A major and costly bailout occurred in the early 1990s. The
Resolution Trust Corporation (RTC) was established in the FIRREA Act of 1989 and
assigned the task to sell off the assets of the failed institutions.

SAVINGS BANKS

These financial institutions are similar to S&Ls in some respects. They are either
mutually- or stockholder-owned and are either federally- or state-chartered. But their
asset portfolio is more diversified given that their origin was primarily as a place for
small deposits at a time when banks showed little interest in taking small customer
accounts. Yet, residential mortgages now constitute a large part of their portfolio. These
institutions have not necessarily been immune from the factors that caused the S&L
crisis. But as a group they came out better because they were predominantly on the East
Coast and had more diversified asset portfolios.

CREDIT UNIONS

Credit unions are the smallest and newest of the financial depositories. They are either
state- or federally-chartered. But they are mutual in organization. They exist for their
members savings and borrowing needs. The shares (deposits) are insured. Deposits
from members are by far their major source of funds, but they can borrow for short-term
liquidity needs. Their assets consist primarily of small consumer loans made to their
members. Time has been hard on them lately, since their borrowing and lending
activities are effectively restricted to their membership bases. But their shorter-term and
less risky loan portfolios have helped them to avoid the S&L crisis.

Since 1970, the shares of all federally chartered credit unions have been insured by
theNational Credit Union Share Insurance Fund (NCUSIF) for up to $100,000
and $250,000 for retirement accounts, the same as for commercial banks. The principal
federal regulatory agency is the National Credit Union Administration (NCUA).
Playing a role similar to the Fed, the lender of last resort is the Central Liquidity
Facility (CLF). Credit unions can make investments in corporate credit unions.
Federal and state chartered credit unions are called natural person credit
unions because they provide financial services to qualifying members of the general
public. Corporate credit unions provide a variety of services only to national person
credit unions.

ANSWERS TO QUESTIONS FOR CHAPTER 3

(Questions are in bold print followed by answers.)


1. Explain the ways in which a depository institution can accommodate
withdrawal and loan demand.

A depository institution can accommodate loan and withdrawal demands first by having
sufficient cash on hand. In addition it can attract more deposits, borrow from the Fed or
other banks, and liquidate some of its other assets.

2. Why do you think a debt instrument whose interest rate is changed
periodically based on some market interest rate would be more suitable for
a depository institution than a long-term debt instrument with a fixed
interest rate?

This question refers to asset-liability management by a depository institution. An
adjustable rate can eliminate or minimize the mismatch of maturity risk. As interest
rates rise, the institution would have to pay more for deposits, but would also receive
higher payments from its loan.

3. What is meant by:
a. individual banking
b. institutional banking
c. global banking

a. Individual banking is retail or consumer banking. Such a bank emphasizes individual
deposits, consumer loans and personal financial trust services.
b. An institutional bank caters more to commercial, industrial and government customers.
It issues deposits to them and tries to meet their loan needs.
c. A global bank encompasses many financial services for both domestic and foreign
customers. It is much involved in foreign exchange trading as well as the financial of
international trade and investment.

4.
a. What is the Basel Committee for Bank Supervision?
b. What do the two frameworks, Basel I and Basel II, published by the Basel
Committee for Bank Supervision, address regarding banking?

a. It is the organization that plays the primary role in establishing risk and management
guidelines for banks throughout the world.
b. The frameworks set forth minimum capital requirements and standards.

5. Explain each of the following:
a. reserve ratio
b. required reserves

a. The reserve ratio is the percentage of deposits a bank must keep in a non-interest-
bearing account at the Fed.
b. Required reserves are the actual dollar amounts based on a given reserve ratio.

6. Explain each of the following types of deposit accounts:
a. demand deposit
b. certificate of deposit
c. money market demand account

a. Demand deposits (checking accounts) do not pay interest and can be withdrawn at any
time (upon demand).
b. Certificates of Deposit (CDs) are time deposits which pay a fixed or variable rate of
interest over a specified term to maturity. They cannot be withdrawn prior to maturity
without a substantial penalty. negotiable CDs (large business deposits) can be traded so
that the original owner still obtains liquidity when needed.
c. Money Market Demand Accounts (MMDAs) are basically demand or checking accounts
that pay interest. Minimum amounts must be maintained in these accounts so that at
least a 7-day interest can be paid. Since many persons find it not possible to maintain
this minimum (usually around $2500) there are still plenty of takers for the non-
interest-bearing demand deposits.

7. How did the Glass-Steagall Act impact the operations of a bank?

The Glass-Steagall Act prohibited banks from carrying out certain activities in the
securities markets, which are principal investment banking activities. It also prohibited
banks from engaging in insurance activities.

8. The following is the book value of the assets of a bank:

Asset
Book Value
(in millions)
U.S. Treasury securities $ 50
Municipal general obligation
bonds
50
Residential mortgages 400
Commercial loans 200
Total book value $700

a. Calculate the credit risk-weighted assets using the following information:

Asset Risk Weight
U.S. Treasury securities 0%
Municipal general obligation
bonds
20
Residential mortgages 50
Commercial loans 100

b. What is the minimum core capital requirement?
c. What is the minimum total capital requirement?

a. The risk weighted assets would be $410


BV Weight Product
US T Sec. $50 0% 0
MB 50 20% 10
RM 400 50% 200
CL 200 100% 200
Total 700

410

b. The minimum core capital is $28 million (.04X700) i.e., 4% of book value.
c. Minimum total capital (core plus supplementary capital) is 32.8 million, .08X410, which
is 8% of the risk-weighted assets.

9. In later chapters, we will discuss a measure called duration. Duration is a
measure of the sensitivity of an asset or a liability to a change in interest
rates. Why would bank management want to know the duration of its assets
and liabilities?

a. Duration is a measure of the approximate change in the value of an asset for a 1%
change in interest rates.
b. If an asset has a duration of 5, then the portfolios value will change by approximately
5% if interest rate changes by 100 basis points.

10.
a. Explain how bank regulators have incorporated interest risk into capital
requirements.
b. Explain how S&L regulators have incorporated interest rate risk into
capital requirements.

a. The FDIC Improvement Act of 1991, required regulators of DI to incorporate interest
rate risk into capital requirements. It is based on measuring interest rate sensitivity of
the assets and liabilities of the bank.
b. The OST adopted a regulation that incorporates interest rate risk for S&L. It specifies
that if thrift has greater interest rate risk exposure, there would be a deduction of its
risk-based capital. The risk is specified as a decline in net profit value as a result of 2%
change in market interest rate.

11. When the manager of a banks portfolio of securities considers
alternative investments, she is also concerned about the risk weight
assigned to the security. Why?

The Basel guidelines give weight to the credit risk of various instruments. These weights
are 0%, 20%, 50% and 100%. The book value of the asset is multiplied by the credit risk
weights to determine the amount of core and supplementary capital that the bank will
need to support that asset.

12. You and a friend are discussing the savings and loan crisis. She states
that the whole mess started in the early 1980s.When short-term rates
skyrocketed, S&Ls got killedtheir spread income went from positive to
negative. They were borrowing short and lending long.
a. What does she mean by borrowing short and lending long?
b. Are higher or lower interest rates beneficial to an institution that borrows
short and lends long?

a. In this context, borrowing short and lending long refers to the balance sheet structure of
S&Ls. Their sources of funds (liabilities) are short-term (mainly deposits) and their uses
(assets) are long-term in nature (e.g. residential mortgages).
b. Since long-term rates tend to be higher than short-term ones, stable interest rates would
be the best situation. However, rising interest rates would increase the cost of funds for
S&Ls without fully compensating higher returns on assets. Hence a decline in interest
rate spread or margin. Thus lower rates, having an opposite effect, would be more
beneficial.

13. Consider this headline from the New York Times of March 26, 1933:
Bankers will fight Deposit Guarantees. In this article, it is stated that
bankers argue that deposit guarantees will encourage bad banking. Explain
why.

The barrier imposed by Glass-Steagall act was finally destroyed by the Gramm-Leach
Bliley Act of 1999. This act modified parts of the BHC Act so as to permit affiliations
between banks and insurance underwriters. It created a new financial holding company,
which is authorized to engage in underwriting and selling securities. The act preserved
the right of state to regulate insurance activities, but prohibits state actions that have
would adversely affected bank-affiliated firms from selling insurance on an equal basis
with other insurance agents.

14. How did the Gramm-Leach-Bliley Act of 1999 expand the activities
permitted by banks?

a. Deposit insurance provides a safety net and can thus make depositors indifferent to the
soundness of the depository recipients of their funds. With depositors exercising little
discipline through the cost of deposits, the incentive of some banks owners to control
risk-taking accrue to the owners. It becomes a heads I win, tails you lose situation.
b. One the positive side, deposit insurance provides a comfort to depositors and thus
attracts depositors to financial institutions. But such insurance carries a moral hazard, it
can be costly and, unless premiums are risk-based, it forces the very sound banks to
subsidize the very risky ones.

15. The following quotation is from the October 29, 1990 issue ofCorporate
Financing Week:
Chase Manhattan Bank is preparing its first asset-backed debt issue,
becoming the last major consumer bank to plan to access the growing
market, Street asset-backed officials
SaidAsset-backed offerings enable banks to remove credit card or other
loan receivables from their balance sheets, which helps them comply with
capital requirements.

a. What capital requirements is this article referring to?
b. Explain why asset securitization reduces capital requirements.

a. The capital requirements mentioned are risk based capital as specified under the Basel
Agreement, which forces banks to hold minimum amounts of equity against risk-based
assets.
b. Securitization effectively eliminates high risk based loans from the balance sheet. The
capital requirements in the case of asset securitization are lower than for a straight loan.

16. Comment on this statement: The risk-based guidelines for commercial
banks attempt to gauge the interest rate risk associated with a banks
balance sheet.

This statement is incorrect. The risk-based capital guidelines deal with credit risk, not
interest-rate risk, which is the risk of adverse changes of interest rates on the portfolio
position.

17.
a. What is the primary asset in which savings and loan associations invest?
b. Why were banks in a better position than savings and loan associations to
weather rising interest rates?

a. Savings and Loans invest primarily in residential mortgages.
b. During 1980's, although banks also suffered from the effects of deregulation and rising
interest rates, relatively they were in a better position than S&L association because of
their superior asset-liability management.

18. What federal agency regulates the activities of credit unions?

The principal federal regulatory agency is the National Credit Union Administration.


5 Written Questions
1. ...
2. 1. the income is generated from the loans they make and securities they purchase
2. fee income
3. depository institution originally set up to serve small savers overlooked by commercial
banks
4. bank whose main functions are to accept deposits, lend money, and transfer funds
among banks, individuals, and businesses
5. 1. They are regulated by several federal and state governement enitities.
2. They are regulated by Comptroller of the Currency, Federal Reserve Board, Federal
Deposit Insurance Corporations
3. The regulations imposed are reserve requirement and capital requirement

5 Multiple Choice Questions
1. ...
a. savings banks
b. credit union
c. Liquidity Concerns
d. Commercial bank
2. ...
. Basel II Framwork
a. Commercial bank
b. savings banks
c. credit union
3. State-chartered or federally chartered financial intermediary that accepts deposits from
the public and invests those funds primarily in residential mortgage loans.
. Interest Rate Risk
a. savings banks
b. savings and loan association
c. credit union
4. 1. interet rate risk
2. Liquidity Concerns
. What is the asset or liability problems that all depository instituion face?
a. What is the capital requirement imposed on commercial banks?
b. What is the role of depository institutions?
c. What is the capital requirement imposed on saving and loan associations?
5. ...
. What is the role of depository institutions?
a. savings and loan association
b. What is the capital requirement imposed on saving and loan associations?
c. What is the funding sources available to commercial banks and thrifts?
5 True/False Questions
1. credit union A financial institution owned by its members that provides savings and
checking accounts and other services to its membership at low fees.
True False
2. Basel I Framework depository institution originally set up to serve small savers
overlooked by commercial banks
True False
3. What is the funding sources available to commercial banks and thrifts? ...
True False
4. What is the role of depository institutions? 1. raise funds from depositors and other
funding resources
2. make direct loans
True False
5. What is the capital requirement imposed on commercial banks? 1. deposits
2. borrowing at the Fed discount window
3. other non deposit borrowing
True False

1. ...
INCORRECT: You gave no answer
POSSIBLE ANSWERS: Interest Rate Risk, What is the capital requirement imposed on
commercial banks?, Liquidity Concerns, Basel II Framwork, What is the capital
requirement imposed on saving and loan associations? or Basel I Framework
2. 1. the income is generated from the loans they make and securities they purchase
2. fee income
INCORRECT: You gave no answer
ANSWER: How does a depository instituition generates income?
3. depository institution originally set up to serve small savers overlooked by commercial
banks
INCORRECT: You gave no answer
ANSWER: savings banks
4. bank whose main functions are to accept deposits, lend money, and transfer funds
among banks, individuals, and businesses
INCORRECT: You gave no answer
ANSWER: Commercial bank
5. 1. They are regulated by several federal and state governement enitities.
2. They are regulated by Comptroller of the Currency, Federal Reserve Board, Federal
Deposit Insurance Corporations
3. The regulations imposed are reserve requirement and capital requirement
INCORRECT: You gave no answer
ANSWER: Who regulates commercial banks and thrifts and the types of regulations
imposed?
5 Multiple Choice Questions
1. ...(No Answer)
a. savings banks
b. credit union
c. CORRECT: Liquidity Concerns
d. Commercial bank
2. ...(No Answer)
. CORRECT: Basel II Framwork
a. Commercial bank
b. savings banks
c. credit union
3. State-chartered or federally chartered financial intermediary that accepts deposits from
the public and invests those funds primarily in residential mortgage loans.(No Answer)
. Interest Rate Risk
a. savings banks
b. CORRECT: savings and loan association
c. credit union
4. 1. interet rate risk
2. Liquidity Concerns(No Answer)
. CORRECT: What is the asset or liability problems that all depository instituion face?
a. What is the capital requirement imposed on commercial banks?
b. What is the role of depository institutions?
c. What is the capital requirement imposed on saving and loan associations?
5. ...(No Answer)
. What is the role of depository institutions?
a. savings and loan association
b. CORRECT: What is the capital requirement imposed on saving and loan
associations?
c. What is the funding sources available to commercial banks and thrifts?
5 True/False Questions
1. credit union A financial institution owned by its members that provides savings and
checking accounts and other services to its membership at low fees.
This is true. You gave no answer.
2. Basel I Framework depository institution originally set up to serve small savers
overlooked by commercial banks
This is false. You gave no answer.
It should be Basel I Framework ....
3. What is the funding sources available to commercial banks and thrifts? ...
This is false. You gave no answer.
It should be What is the funding sources available to commercial banks and
thrifts? 1. deposits
2. borrowing at the Fed discount window
3. other non deposit borrowing.
4. What is the role of depository institutions? 1. raise funds from depositors and other
funding resources
2. make direct loans
This is true. You gave no answer.
5. What is the capital requirement imposed on commercial banks? 1. deposits
2. borrowing at the Fed discount window
3. other non deposit borrowing
This is false. You gave no answer.
It should be What is the capital requirement imposed on commercial banks? ....


What is the role of depository institutions?
1. raise funds from depositors and other funding resources
2. make direct loans

How does a depository instituition generates income?
1. the income is generated from the loans they make and
securities they purchase
2. fee income

Commercial bank
bank whose main functions are to accept deposits, lend
money, and transfer funds among banks, individuals, and
businesses

savings and loan association
State-chartered or federally chartered financial intermediary
that accepts deposits from the public and invests those funds
primarily in residential mortgage loans.

savings banks
depository institution originally set up to serve small savers
overlooked by commercial banks

credit union
A financial institution owned by its members that provides
savings and checking accounts and other services to its
membership at low fees.

What is the asset or liability problems that all depository
instituion face?
1. interet rate risk
2. Liquidity Concerns

Who regulates commercial banks and thrifts and the types
of regulations imposed?
1. They are regulated by several federal and state
governement enitities.
2. They are regulated by Comptroller of the Currency, Federal
Reserve Board, Federal Deposit Insurance Corporations
3. The regulations imposed are reserve requirement and
capital requirement
What is the funding sources available to commercial banks
and thrifts?
1. deposits
2. borrowing at the Fed discount window
3. other non deposit borrowin