Banking and the

Financial
Services Industry
CHAPTER 1 BOOK 1
Introduction
Glass–Steagall Act created three separate lines of business within the
financial services industry
Commercial banking
Investment banking, and
Insurance

McFadden Act of 1927 - commercial bank could branch within and

outside its home state
Bank Holding Company Act of 1956 - business activities
To start a bank
Office of Comptroller of the Currency (OCC)
Global Financial Crisis of 2007–2009
Crises related to problem mortgages and other loans
“subprime” borrowers
Interest-only (IO)
Alt A
option adjustable-rate mortgages (option ARMs)
Negative amortization
originate-to-distribute (OTD approach)
Asset write-downs
 U.S. government took the following actions
from September through December of
2008:
Placed two government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac,
into conservatorship
Loaned American International Group (AIG) over $150 billion, effectively taking
ownership of the insurance company.
Insured money market mutual funds against default.
Authorized Bank of America to acquire Merrill Lynch
Approved Goldman Sachs, Morgan Stanley, MetLife and American Express to convert
to bank holding companies (BHCs) over a weekend.
• Authorized the Federal Reserve to purchase commercial paper directly from
companies such as General Electric.
• Increased Federal Deposit Insurance Corporation (FDIC) deposit coverage per
account for domestic deposits to $250,000 and provided unlimited coverage for
noninterest-bearing business deposits.
U.S. government took the following actions
from September through December of
2008:
 Passed the Troubled Asset Relief Program (TARP)–Capital Purchase
Program (CPP), which allowed financial institutions to sell preferred
stock to the U.S. Treasury.
 Purchased $125 billion of preferred stock in nine large U.S. banks
under the TARP–CPP program.
 Loaned large amounts to large U.S. financial institutions through the
Federal Reserve
Authorized large financial institutions and nonfinancial firms to sell
bonds that were FDIC-insured.
Allowed hedge funds to borrow from the Federal Reserve.
Impact on Banks and the Banking
Environment
Mortgage defaults and declining home prices are greatest in
geographic markets that experienced the greatest run-up in prices
during boom times.
While many of the largest banks that operate in national and
international markets realized large losses from the problem mortgage
assets, smaller banks operating only in local markets generally did not.
One result of the financial crisis was a dramatic change in the structure
and operations of U.S. banks.
The nature of competing firms also changed substantially.
Asset write-downs and loan charge-offs in the U.S. led to similar
problems in other countries.
How Do Banks Differ?
United States has had a multi-tiered commercial banking system
including
Global banks
Super-regional banks
Community banks
Trends in the Structure of
U.S. Banks
Independent bank
Thrifts
Bank holding company (BHC)
More than 25 percent of the voting shares
Interstate branching
Minimize costs and broaden the scope

One-bank holding companies (OBHCs)

Multi-bank holding companies (MBHCs)
Financial Holding
Companies
The Glass–Steagall Act effectively separated commercial banking from
investment banking.
However, it left open the possibility of banks engaging in investment
banking activities through a Section 20 affiliate so long as the bank was
not “principally engaged” in these activities.
The Fed resolved the issue of “principally engaged” initially by allowing
banks to earn only 5 percent of the revenue in their securities affiliates,
which increased to 10 percent in 1989 and 25 percent in 1997.
The Gramm–Leach–Bliley Act of 1999 repealed the restrictions on
banks affiliating with securities firms under the Glass–Steagall Act and
allowed affiliations between banks and insurance underwriters
Financial Holding
Companies
The law created a new financial holding company that was authorized
to engage in underwriting and selling insurance and securities,
conducting both commercial and merchant banking, investing in and
developing real estate, and performing other “complementary
activities.”
The primary advantage to forming an FHC is that the entity can engage
in a wide range of financial activities not permitted in the bank or in a
BHC.
Some of these activities include insurance and securities underwriting
and agency activities, merchant banking, and insurance company
portfolio investment activities. Activities that are “complementary” to
financial activities also are authorized.
Financial Holding
Companies
The primary disadvantage to forming an FHC, or converting a BHC to
an FHC, is that the Fed may not permit a company to form an FHC if any
one of its insured depository institution subsidiaries is not well
capitalized or well managed, or did not receive at least a satisfactory
rating in its most recent Community Reinvestment Act (CRA) exam.
The U.S. Congress enacted the Community Reinvestment Act in 1977
to help ensure that lenders made credit available in the same
communities, or trade areas, in which they conduct other business.
An FHC can own a bank or BHC or a thrift or thrift holding company.
S Corporation Banks
and C Corporation Banks
Banks also differ in terms of their federal income tax treatment.
In 1997, the U.S. Congress passed legislation that allowed commercial
banks that met fairly restrictive criteria to choose to operate as S
Corporations (S Corps) for income tax purposes.
In contrast with C Corporations (C Corps), S Corps have favorable tax
treatment, because a qualifying firm does not pay corporate income tax.
The firm allocates income to shareholders on a pro rata (percentage of
ownership) basis, and each individual owner pays tax at personal tax
rates on the income allocated to them.
The primary limitation to qualifying for S Corp status is a requirement
that the underlying bank must have no more than 100 shareholders.
Financial Services Business
Models
What constitutes a bank varies across countries.
The early definition within the U.S. for regulatory purposes stipulated
that a commercial bank was an entity that both accepted demand
(noninterest-bearing) deposits and made loans to businesses.
A firm that did only one of these or none of these avoided regulation as
a bank.
The principal advantage of being a depository institution (commercial
bank, savings bank, or credit union) has long been access to FDIC deposit
insurance (credit unions are insured by the National Credit Union
Association [NCUA]).
In response to the financial crisis, Congress increased deposit insurance
to $250,000 per account for both the FDIC and NCUA.
 Transactions Banking versus
Relationship Business Models
Neither borrowers nor lenders have sufficient independent information about the
riskiness of the opposite party participating in a loan transaction; therefore, a bank, as
an intermediary.
Transactions banking involves the provision of transactions services such as checking
accounts, credit card loans, and mortgage loans that occur with high frequency and
exhibit standardized features. Because the products are highly standardized, they can
be critiqued mechanically and require little human input to manage.
One of the appealing features of the transactions model is a firm’s ability to
securitize the underlying assets created. Securitization refers to 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.
Relationship banking, as the label suggests, emphasizes the personal relationship
between the banker and customer. For example, the key feature of a loan that is
relationship driven and not transactions driven is that the lender adds real value to
the borrower during the credit granting process.
 Too Big to Fail Banks
The financial crisis led the Federal Reserve and U.S. Treasury to take unique steps
to prevent an economic collapse.
As discussed previously, one strategy involved providing emergency credit to
institutions that faced serious funding problems.
Generally, the institutions that received the greatest loans, guarantees, and
equity investments were the nation’s largest institutions.
At the same time, bank regulators allowed many smaller banking organizations
that found themselves in trouble to fail.
Market participants and analysts quickly labelled the largest firms receiving the
greatest and immediate government aid as “Too Big to Fail” or TBTF.
Regulators and government officials argued that these firms were too connected
to other large firms, and a failure would lead to a collapse of the global financial
system and ultimately to a severe global recession.
Different Channels for
Delivering Banking Services
Suppose that you are among a group of individuals who want to start a
new bank. One of the critical decisions that you will make is which
customers your bank will target and how you will deliver banking
products and services to them.
Today, one of your choices will include offering services in the
traditional manner via face-to-face visits between customers and the
bank’s tellers, customer service representatives, and loan officers either
in a bank’s home office or branches.
Alternatively, you may offer many of the same services via automated
teller machines (ATMs), the Internet, call centers, and mobile (cell
phone) banking.
Different Channels for
Delivering Banking Services
Branch Banking
Automated Teller Machines
Internet (Online) Banking
Call Centers
Mobile Banking
Different Channels for
Delivering Banking Services
Different delivery channels appeal to different types of customers.
Typically, younger customers prefer channels that offer the greatest
convenience such that they never have to enter a bank building.
This benefits the bank by reducing labor costs and potentially
represents a real source of fee income.
Older customers, however, often prefer face-to-face contact.
Not surprisingly, older customers generally have the largest deposit
accounts and thus represent highly profitable relationships even after
the high cost of the branch delivery system is taken into account.