Chapter 1
Banking and the Financial Services Industry
Chapter Objectives
1. Describe the cause and consequences of the credit crisis of 2007 – 2009.
2. Describe the similarities and differences between a bank holding company and a
financial holding company.
3. Describe various banking models.
4. Describe various channels for delivering banking services.
Key Concepts
1. “Sub-Prime” mortgages led to much of the credit crisis of 2007 – 2009. Many
lenders made mortgages:
a. to borrowers with insufficient income to make the monthly payments,
b. with low teaser rates,
c. low payments resulting in negative amortization.
As these mortgages defaulted, many mortgage companies saw their capital depleted.
Declining real estate values had the largest impact in the areas that had the highest
run-up in property values. Larger banks tended to experience large losses while
many small banks did not.
2. After the failure of several large financial institutions, the government responded
by:
a. placing Fannie Mae and Freddie Mack into conservatorship,
b. loaning AIG over $150 billion,
c. temporarily increasing FDIC coverage to $250,000,
d. insuring money market mutual funds.
e. establishing the Troubled Asset Relief Program (TARP)
f. establishing the Term Asset-Backed Securities Loan Facility (TALF)
g. Investing $125 billion in several large U.S. banks,
h. promoting mortgage loan modifications.
3. Banks differ in terms of their size and the scope of products they offer. Global banks
offer a wide array of products and services globally. Super-Regional Banks are
similar to global banks but smaller in size and market penetration, while
Community Banks typically have a smaller trade area and total assets under $1
billion.
4. Banks are often part of a Bank Holding Company or a Financial Holding Company.
The primary advantage to forming a Financial Holding Company is that the entity
, can engage in a wide range of financial activities not permitted in the bank or in a
Bank Holding Company.
Financial Holding Companies are authorized to engage in:
a. underwriting and selling insurance and securities,
b. commercial banking,
c. merchant banking,
d. insurance company portfolio investment activities.
5. The Federal Reserve may not permit forming a Financial Holding Company if any of
its insured depository institution subsidiaries are:
a. not well capitalized,
b. not well managed,
c. did not receive at least a “Satisfactory” rating in its most recent CRA exam.
6. The consolidated financial statements of a holding company and its subsidiaries
reflect aggregate or consolidate performance. The parent typically pays very little in
income tax because 80 percent of the dividends from subsidiaries is exempt.
Taxable income from the remaining 20 percent and interest income is small relative
to deductible expenses.
7. Large Banks are typically organized as C-Corporations, while smaller banks are
organized as S-Corporations. S-Corporations receive favorable tax treatment
because the firm does not pay corporate income tax. The firm allocates income to
shareholders on a pro rata basis and each individual pays tax at personal tax rates
on the income allocated to them. Given the ability to avoid the double taxation at the
firm and individual level, many closely held banks have chose S-corporation status.
The primary limitation to qualifying for S-corporation status is a requirement that
the bank must have no more than 100 shareholders.
8. The principal advantage of being a depository institution is access to FDIC deposit
insurance. The primary disadvantage of operating as a bank (or Bank Holding
Company) is that the firm is subject to regulation as a bank.
9. There are major financial services business models: Transactions Banking and
Relationship Banking. Transactions banking involves providing 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 require little human input to manage. Relationship
banking emphasizes the total relationship between the banker and customer.
Relationship banks will often aggressively market noncredit products and services
to such customers in order to lock in the relationship.
, 10. Securitization is the process of converting assets into marketable securities. It
enables banks to move assets off balance sheet and increase fee income. It increases
competition for the types of standardized products, such as mortgages and other
credit-scored loans, and eventually lowers the prices paid by consumers by
increasing the supply and liquidity of these products. This Originate-to-Distribute
(OTD) approach of separating loan origination from ownership contributed to the
credit crisis of 2007 – 2009. Lenders who originated the loans knew they would not
own the loans long term, therefore, they were less concerned about the quality of
the assets originated. In order to grow their business and continue originating loans,
they increasingly made loans to less qualified borrowers. When the underlying
assets defaulted at higher-than-expected rates, investors in the securities did not
receive the promised payments. The net result is that liquidity largely dried up for
most securitizations.
11. Universal Banking refers to a structure for a financial services company in which the
company offers a broad range of financial products and services. It combines
traditional commercial banking that focused on loans and deposit gathering with
investment banking. The presumed advantage of universal banking is the ability to
cross-sell services among customers. U.S. firms that have tried to achieve this goal
of a “one-stop financial supermarket” have not outperformed more traditional
competitors.
12. Too Big to Fail: Regulators and government officials argue TBTF firms are too
connected to other large firms, and a failure could lead to a collapse of the global
financial system and ultimately to a severe global recession. Smaller organizations
are presumably less important economically and thus do not receive the same
assistance and may be allowed to fail. The Dodd-Frank Act attempts to address the
TBTF issue.
13. There are several channels for delivering banking services including:
a. Branch Banking
b. Automated Teller Machines
c. Internet Banking
d. Call Centers
e. Mobile Banking
Teaching Suggestions
This chapter represents an opportunity to link bank management topics to current events.
As a semester project, students should be encouraged to keep a file or log of events from
recent newspapers or magazines that demonstrate the existence and impact of
deregulation/reregulation, financial innovation, securitization, globalization, and
technological advances. Students could be asked to i) keep a list of bank failures, and ii)
keep a record of bank mergers and acquisitions. Tracking mergers and acquisitions among
, financial companies stimulates considerable debate as to why firms are entering or exiting
specific lines of business, the costs and benefits of size or scale, advantages and
disadvantages of operations that cross country boundaries, etc. Regular reference to The
Wall Street Journal contributes to student understanding and interest.
Sample Projects and Assignments
Have students select a financial holding company and evaluate its organizational
chart. Identify the number and range of bank and non-bank subsidiaries.
Have students analyze the data in Exhibits 1.2 and 1.3 regarding the number of
institutions by type and asset size since 1997. The students should discuss the key
implications.
Have students keep a list of recent changes in banking regulations. The students
should discuss the key implications.
Answers to End-of-Chapter Questions
1.
Goldman Sachs – Converted to a bank holding company.
Bear Stearns – Acquired by J.P. Morgan Chase.
Morgan Stanley – Converted to a bank holding company.
Lehman Brothers – Allowed to fail.
Merrill Lynch – Acquired by Bank of America.
2.
Mortgages are loans that are secured by residential or commercial real estate.
As real estate prices started to decline, many institutions involved in mortgage
lending began to realize losses from mortgage defaults. This led to the failure of
many financial institutions.
Subprime loans are loans made to borrowers with low credit scores and thus a
higher-than-average risk of default. Various types of subprime mortgages were
offered to make the monthly payments affordable. When housing prices fell
dramatically, institutions were required to report writedowns.
Asset writedowns are when a financial institution formally recognizes that loans
they hold on their balance sheets are worth much less than the amount of funds
owed. The writedowns, in turn, depleted the lenders’ capital and forced them to
either sell assets or obtain external capital. Many financial institutions reacted
by restricting credit availability to businesses and individuals.
3. A bank holding company is essentially a shell organization that owns and manages
subsidiary firms. Any organization that owns controlling interest in one or more
commercial banks is a bank holding company (BHC). One-bank holding companies
(OBHCs) control only one bank, while multibank holding companies (MBHCs) control at
least two commercial banks. The motivation behind a BHC (one- or multi-) is the firm’s
Banking and the Financial Services Industry
Chapter Objectives
1. Describe the cause and consequences of the credit crisis of 2007 – 2009.
2. Describe the similarities and differences between a bank holding company and a
financial holding company.
3. Describe various banking models.
4. Describe various channels for delivering banking services.
Key Concepts
1. “Sub-Prime” mortgages led to much of the credit crisis of 2007 – 2009. Many
lenders made mortgages:
a. to borrowers with insufficient income to make the monthly payments,
b. with low teaser rates,
c. low payments resulting in negative amortization.
As these mortgages defaulted, many mortgage companies saw their capital depleted.
Declining real estate values had the largest impact in the areas that had the highest
run-up in property values. Larger banks tended to experience large losses while
many small banks did not.
2. After the failure of several large financial institutions, the government responded
by:
a. placing Fannie Mae and Freddie Mack into conservatorship,
b. loaning AIG over $150 billion,
c. temporarily increasing FDIC coverage to $250,000,
d. insuring money market mutual funds.
e. establishing the Troubled Asset Relief Program (TARP)
f. establishing the Term Asset-Backed Securities Loan Facility (TALF)
g. Investing $125 billion in several large U.S. banks,
h. promoting mortgage loan modifications.
3. Banks differ in terms of their size and the scope of products they offer. Global banks
offer a wide array of products and services globally. Super-Regional Banks are
similar to global banks but smaller in size and market penetration, while
Community Banks typically have a smaller trade area and total assets under $1
billion.
4. Banks are often part of a Bank Holding Company or a Financial Holding Company.
The primary advantage to forming a Financial Holding Company is that the entity
, can engage in a wide range of financial activities not permitted in the bank or in a
Bank Holding Company.
Financial Holding Companies are authorized to engage in:
a. underwriting and selling insurance and securities,
b. commercial banking,
c. merchant banking,
d. insurance company portfolio investment activities.
5. The Federal Reserve may not permit forming a Financial Holding Company if any of
its insured depository institution subsidiaries are:
a. not well capitalized,
b. not well managed,
c. did not receive at least a “Satisfactory” rating in its most recent CRA exam.
6. The consolidated financial statements of a holding company and its subsidiaries
reflect aggregate or consolidate performance. The parent typically pays very little in
income tax because 80 percent of the dividends from subsidiaries is exempt.
Taxable income from the remaining 20 percent and interest income is small relative
to deductible expenses.
7. Large Banks are typically organized as C-Corporations, while smaller banks are
organized as S-Corporations. S-Corporations receive favorable tax treatment
because the firm does not pay corporate income tax. The firm allocates income to
shareholders on a pro rata basis and each individual pays tax at personal tax rates
on the income allocated to them. Given the ability to avoid the double taxation at the
firm and individual level, many closely held banks have chose S-corporation status.
The primary limitation to qualifying for S-corporation status is a requirement that
the bank must have no more than 100 shareholders.
8. The principal advantage of being a depository institution is access to FDIC deposit
insurance. The primary disadvantage of operating as a bank (or Bank Holding
Company) is that the firm is subject to regulation as a bank.
9. There are major financial services business models: Transactions Banking and
Relationship Banking. Transactions banking involves providing 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 require little human input to manage. Relationship
banking emphasizes the total relationship between the banker and customer.
Relationship banks will often aggressively market noncredit products and services
to such customers in order to lock in the relationship.
, 10. Securitization is the process of converting assets into marketable securities. It
enables banks to move assets off balance sheet and increase fee income. It increases
competition for the types of standardized products, such as mortgages and other
credit-scored loans, and eventually lowers the prices paid by consumers by
increasing the supply and liquidity of these products. This Originate-to-Distribute
(OTD) approach of separating loan origination from ownership contributed to the
credit crisis of 2007 – 2009. Lenders who originated the loans knew they would not
own the loans long term, therefore, they were less concerned about the quality of
the assets originated. In order to grow their business and continue originating loans,
they increasingly made loans to less qualified borrowers. When the underlying
assets defaulted at higher-than-expected rates, investors in the securities did not
receive the promised payments. The net result is that liquidity largely dried up for
most securitizations.
11. Universal Banking refers to a structure for a financial services company in which the
company offers a broad range of financial products and services. It combines
traditional commercial banking that focused on loans and deposit gathering with
investment banking. The presumed advantage of universal banking is the ability to
cross-sell services among customers. U.S. firms that have tried to achieve this goal
of a “one-stop financial supermarket” have not outperformed more traditional
competitors.
12. Too Big to Fail: Regulators and government officials argue TBTF firms are too
connected to other large firms, and a failure could lead to a collapse of the global
financial system and ultimately to a severe global recession. Smaller organizations
are presumably less important economically and thus do not receive the same
assistance and may be allowed to fail. The Dodd-Frank Act attempts to address the
TBTF issue.
13. There are several channels for delivering banking services including:
a. Branch Banking
b. Automated Teller Machines
c. Internet Banking
d. Call Centers
e. Mobile Banking
Teaching Suggestions
This chapter represents an opportunity to link bank management topics to current events.
As a semester project, students should be encouraged to keep a file or log of events from
recent newspapers or magazines that demonstrate the existence and impact of
deregulation/reregulation, financial innovation, securitization, globalization, and
technological advances. Students could be asked to i) keep a list of bank failures, and ii)
keep a record of bank mergers and acquisitions. Tracking mergers and acquisitions among
, financial companies stimulates considerable debate as to why firms are entering or exiting
specific lines of business, the costs and benefits of size or scale, advantages and
disadvantages of operations that cross country boundaries, etc. Regular reference to The
Wall Street Journal contributes to student understanding and interest.
Sample Projects and Assignments
Have students select a financial holding company and evaluate its organizational
chart. Identify the number and range of bank and non-bank subsidiaries.
Have students analyze the data in Exhibits 1.2 and 1.3 regarding the number of
institutions by type and asset size since 1997. The students should discuss the key
implications.
Have students keep a list of recent changes in banking regulations. The students
should discuss the key implications.
Answers to End-of-Chapter Questions
1.
Goldman Sachs – Converted to a bank holding company.
Bear Stearns – Acquired by J.P. Morgan Chase.
Morgan Stanley – Converted to a bank holding company.
Lehman Brothers – Allowed to fail.
Merrill Lynch – Acquired by Bank of America.
2.
Mortgages are loans that are secured by residential or commercial real estate.
As real estate prices started to decline, many institutions involved in mortgage
lending began to realize losses from mortgage defaults. This led to the failure of
many financial institutions.
Subprime loans are loans made to borrowers with low credit scores and thus a
higher-than-average risk of default. Various types of subprime mortgages were
offered to make the monthly payments affordable. When housing prices fell
dramatically, institutions were required to report writedowns.
Asset writedowns are when a financial institution formally recognizes that loans
they hold on their balance sheets are worth much less than the amount of funds
owed. The writedowns, in turn, depleted the lenders’ capital and forced them to
either sell assets or obtain external capital. Many financial institutions reacted
by restricting credit availability to businesses and individuals.
3. A bank holding company is essentially a shell organization that owns and manages
subsidiary firms. Any organization that owns controlling interest in one or more
commercial banks is a bank holding company (BHC). One-bank holding companies
(OBHCs) control only one bank, while multibank holding companies (MBHCs) control at
least two commercial banks. The motivation behind a BHC (one- or multi-) is the firm’s
