Chapter 1:

Banking and
the Financial
Services
Industry

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 What is a Commercial Bank?

• A financial intermediary
• Engages in borrowing and lending
• Makes money from the interest spread
• Deals with large number of depositors and clients
• Heavily regulated
Difference between commercial bank and investment bank?
What is the investment bank?
Basic jobs of insurance bank, commercial bank and, investment bank?
Financial holding company
Financial crisis- how it happened?-how banks were rescued?
Securitization concept
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What is an Investment Bank?

• Engages in financial services

• Underwriting
• Financial advice
• M&A
• Restructuring
• Asset and wealth management
• Proprietary trading
• Brokerage

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What is an Insurance Company?

• Takes premium and guarantees payment in case of

mishap
• Various kinds
• Life insurance
• Pure
• Comprehensive
• Health/medical
• Car
• And many others
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Credit Crisis of 2007 - 2009

• Lenders Made “Sub-Prime” Mortgages

• Borrowers had insufficient income to make monthly
payments
• Many mortgages had “teaser” rates
• Low payments (which did not cover the interest owed)
resulting in negative amortization
• When home prices started to decline
• Many financial institutions involved in housing finance
began to realize losses from home mortgage defaults

5
Credit Crisis of 2007 - 2009

• Government Response
• Loaned over $150 billion to AIG, effectively taking
ownership of the insurance company
• Established Troubled Asset Relief Program (TARP), a
program to purchase toxic assets from financial
institutions
• Purchased $125 billion of preferred stock of nine large
U.S. banks
• Federal Reserve provided direct loans, guarantees, and
lines of credit to financial institutions that exceeded $1
trillion.

6
Credit Crisis of 2007 - 2009

• Impact on Banks and the Banking Environment

• Biggest impact of declining real estate values
concentrated in the areas that previously experienced the
largest increase in real estate values
• Many large banks experienced large losses while many
small banks did not

7
Global Financial Crisis of 2007 - 2009

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Longer Term Impact on Banks and the
Banking Environment
• Dramatic change in the structure and operations of
U.S. banks.
• Increased FDIC coverage to $250,000
• Promotion of mortgage loan modifications
• Asset write-downs and loan charge-offs in the U.S.
led to similar problems in other countries.

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How Do Banks Differ?

• Global Banks:
• Offer a wide array of products and services globally
• Super-Regional Banks:
• Similar to global banks but smaller in size and market
penetration
• Community Banks:
• Smaller trade area with total assets under $1 billion

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Trends in the Structure of Banks
• Banking industry has consolidated.
• Managers seek economies of scale and use technology to
offer products and services across markets.
• FDIC insures commercial bank deposits and serves
as one of the major bank regulatory organizations.
• An independent bank is a single organization that accepts
deposits and makes loans.

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Trends in the Structure of Banks –
Bank Holding Companies (BHC)
• Owns controlling interest in one or more
commercial banks.
• Prior to the enactment of interstate branching,
primary motivation was to circumvent restrictions.
• Primary motivation today is to broaden scope of
products that can be offered.
• Holding company is the parent and operating
entities are the subsidiaries.
• One-bank holding companies control only one bank.
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Trends in the Structure of Banks –
Bank Holding Companies (BHC)
• Multibank holding companies control at least two
commercial banks.
• Some treat subsidiaries like branches.
• Others allow subsidiaries to operate quasi-independently.
• Bank Holding Company Act of 1956 assigned
regulatory responsibility to the Federal Reserve.
• Under current regulations BHC can acquire nonbank
subsidiaries offering products and services closely
related to banking.
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Trends in the Structure of Banks

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Trends in the Structure of Banks

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Trends in the Structure of Banks

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Trends in the Structure of Banks –
Financial Holding Companies (FHC)
• Primary advantage is entity can engage in a wide
range of financial activities not permitted in the bank
or in a BHC including:
• Underwriting and brokerage
• Proprietary trading
• Asset Management
• Insurance
• Activities that are “complementary” to financial activities

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Trends in the Structure of Banks –
Financial Holding Companies (FHC)
• FHC can own a bank, BHC, thrift or thrift holding
company:
• Each of these companies owns subsidiaries, while the
parent financial holding company also owns other
subsidiaries directly.

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Trends in the Structure of Banks

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Trends in the Structure of Banks
• Holding Company Financial Statements:
• Consolidated financial statements of a holding company
and its subsidiaries reflect aggregate or consolidated
performance.

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Holding Company Financial Statements

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Holding Company Financial Statements

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Holding Company Financial Statements

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Holding Company Financial Statements

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Financial Services Business Models

• The principal advantage of being a depository

institution is access to FDIC deposit insurance.
• FDIC charges banks a premium for the insurance, which
ensures qualifying deposit holders that the FDIC will
guarantee the principal amount of each deposit up to the
maximum allowed, even if the bank fails.
• This allows depository institutions to pay low rates on
insured deposits and ensures that such deposits are
relatively stable in times of crisis.

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Financial Services Business Models

• Primary disadvantage of operating as a bank (or

BHC) is the firm is subject to regulation as a bank.
• Subject to safety and soundness exams to address risk
management and compliance exams which monitor
appropriate customer service.
• Prior to 2008, investment banks avoided regulation,
which allowed them to operate with lower equity capital
per dollar of risk assets and enter lines of business not
generally available to commercial banks
• The combined effect was greater financial leverage and business
operations in many high-risk areas such as proprietary trading

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Transactions Banking versus Relationship
Banking
• Transactions Banking:
• High frequency transactions services (checking accounts,
credit cards, and mortgage loans) with standardized
features that require little human input to manage.
• Lenders that generate sufficient volumes of these transactions
can offer them globally with limited investment in human capital.
• Encourages the use of technology to offer products at prices low
enough to discourage small competitors.
• These banks are generally large and compete across extensive
geographic and product markets.

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Transactions Banking versus Relationship
Banking
• Relationship Banking:
• Emphasizes personal relationships between banker and
customers.
• Lender adds value to the borrower during credit granting process
and may also provide expertise in other areas such as accounting,
business and tax planning.
• Other services are aggressively marketed to ensure relationships.
• Lending institutions generally charge higher rates and often hold
the loans in portfolio.
• Borrowers pay for the assurance that funds will be advanced as
needed with minimal repetitive negotiations.
• Customers often follow favorite banker to another bank.

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Securitization

• The process of pooling a group of assets with similar

features—for example, credit card loans or mortgages—and
issuing securities that are collateralized by the assets.
• Securities are sold to investors who receive the cash flows
from the loans net of servicing, guarantee, and trust fees.
• The entire process adds liquidity to the market because loan
originators regularly repeat it knowing investors will demand
the securities.

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Originate-to-Distribute (OTD) approach
• Lenders who originated loans knew they would not own
them long term making them less concerned about the
quality of assets originated.
• Loan originators paid based on volume and not
penalized for defaults.
• Resulted in loans being made to less qualified
borrowers and defaults that caused investors to not be
paid.
• Net result is that liquidity largely dried up for most
securitizations.
• Large institutions left with holding many of the low-quality
loans that resulted in write-downs and losses that depleted
capital.

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Universal Banking
• Structure for a financial services company in which
the company offers a broad range of financial
products and services.
• Combined traditional commercial banking that
focused on loans and deposit gathering with
investment banking.
• Underwrote securities, advised on mergers and
acquisitions, managed investment assets for customers,
took equity positions in companies, bought and sold
assets for a speculative profit, offered brokerage services,
and made loans and accepted deposits.

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Universal Banking
• Presumed advantage is the ability to cross-sell
services among customers.
• Participation in diverse products and services would
presumably increase the information advantage and allow
the bank to serve customers more efficiently and at
better prices.
• No consensus on success.
• U.S. firms that tried to achieve this goal of a “one-stop
financial supermarket” have not outperformed more
traditional competitors.

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Different Channels for Delivering Banking
Services
• Branch Banking:
• Retail outlet in which customers can conduct banking
business either face to face or electronically.
• Automated Teller Machines (ATM)
• Internet (Online) Banking:
• Primary appeal is convenience.
• Call Centers
• Mobile Banking

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