CHAPTER 4

ACTIVITIES AND CHARACTERISTICS UNDER DEPOSITORY

INSTITUTIONS
Objectives:
 Discuss the asset/liability problem on depository
institutions, interest rate risk, liquidity concerns,
commercial banks and bank services.
 Understand how bank funding utilized in the depository
institutions.
 Discuss the savings and loan associations.
 Discuss the saving and loan crises.
 Differentiate the savings bank and credit unions.
Asset/Liability Problem of Depository
Institutions
These institutions seek to earn spread income,
which is a positive spread or margin between the
return on their assets and the cost 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 asset long term. An increase in expected
interest rates will reduce the spread between the return
on assets and the deposits cots. Floating rate long-term
assets can reduce this problem since they make long-
term assets-behave like short-term funds that match
deposits term 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
the following:
✓ Attracting more deposits
✓ Borrowing from federal agency or other institution (Federal Funds
Market)
✓ Raising short-term funds in the money market
✓ 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 (FDIC). The assets of a bank are insured
by the FDIC.
Bank Services
Banks provide numerous services and are broadly defined as follows:
• Individual Banking – includes consumer lending, mortgage lending
(mortgage banking), credit card financing, brokerage services, student
loans and individual oriented financing investment services.
• 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 statue was repealed by the Gramm-Leach Bliley Act in
November 199.
Bank Funding
Funds are obtained mainly from three sources (1) deposits, (2) non
deposits, (3) common stock and retained earnings.
▪ Deposits. There are several types of deposit accounts.
Savings Deposits – pay interest, typically below market rates, and
can be withdrawn upon demand.
Time Deposits – also called certificate of deposits, 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.
The reserve ratio is the specified percentage of deposits in non-interest bearing
account at one of the Federal Reserve Banks that a bank must maintain. The dollar
amount based on the reserve ratio is required reserve.
▪ Borrowing at the Fed Discount Window.
The Federal Reserve is the bank of the 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 Non deposits Borrowing.
Other non deposits 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.
SAVINGS AND LOAN ASSOCIATIONS
Savings and loan associations 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 of federally chartered, and they are regulated by
the Office of Thrift Supervision (OFS). As in the case of banks,
their deposits are insured, but by the Savings Association
Insurance Fund (run by the FDIC). Traditionally, most savings
and loan asset have been in home mortgages, the long term
nature of which insulated the savings and loans from interest rate
risk for many years.
1.) Assets – traditionally, the only assets in which savings and loans were allowed to
invest have been mortgages, mortgage-backed securities, and US government
securities. Savings and Loans became one of the major buyers of junk bonds. Under
FIRREA, savings and Loans are no longer permitted to invest new money in junk
bonds.
2.) Funding – deregulation expanded the types of accounts that may be offered by
savings and loans: negotiable order of withdrawal (NOW) accounts, and money
deposit accounts (MMDA). Savings and Loans can raise funds from the money
market and have access to the Fed’s discount window.
3.) Regulation – federal savings and loans are chartered under the provisions of the
Home Owners Loan Act of 1933. Federally chartered savings and loans 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 Fed’s control over the money supply by imposing
deposit reserve requirements on savings and loans.
The Saving and Loan 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 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 savings and loans could not complete for such
funds.
2. Deregulation in the early 1980s lifted interest also rate restrictions, allowing
savings and loans 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 savings and loans could afford. Moreover, after years of being in a safe
market niche of home mortgages savings and loans 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 savings and loans went after high
return, high risk asset, 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.

SAVINGS BANKS
These financial institutions are similar to savings and loans 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.
CREDIT UNIONS
Credit Unions are the smallest and newest of the financial
depositors. They are either state of 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 the
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 saving and loan
crisis.