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Banking
University of North Carolina School of Law
Broome, Lissa Lamkin

Banking_Broome_Fall 2010
Banking Outline
 
BUSINESS OF BANKING
 
1.       Two Unique Characteristics of Bank
a.        Financial Intermediation
b.       Transaction Accounts
 
2.       Financial Intermediation
a.        Matchmaking Service: pool financial resources from those with excess funds and make it available for use by others. Fees are charged for this service.   
b.       Two Types of Intermediaries
                                                               i.      Depository: banks, thrifts, credit unions
1.       Make deposits (primary source of funds) & make loans
                                                             ii.      Non-Depository: insurance co, pension funds, finance co
1.       Other than deposits; insurance premium, stocks, etc. 
c.        Intermediation v Direct Investment
                                                               i.      Intermediation: bank invests the pool of deposits provided by depositors at the bank
1.       Diversify risk – more funds to invest in variety of direct investments
2.       Safety – federally insured
3.       Greater Liquidity
4.       Expertise – in evaluating potential borrowers
5.       More lending opportunity – info and expertise
6.       Convenience
                                                             ii.      Direct Investment: individual with excess funds lends the funds directly to a borrower
1.       Better return
2.       Risky and Low Liquidity – direct investment is riskier and there may not be as much liquidity of the investment
3.       Lack of expertise – direct investor may be less experienced then an intermediary would be and thus is less able to measure the risk of the investment
 
3.       Transaction Accounts (checking accounts)
a.        Demand Deposit Accounts
                                                               i.      Money is available on demand
                                                             ii.      Checking accounts used to be a unique feature of banks (as opposed to thrifts and credit unions)
                                                           iii.      But now all three types of depository institutions offer some variation of demand deposit accounts
b.       Federally Insured Deposits
                                                               i.      Generally about 10% of deposits must be maintained at regional Federal Reserve bank
c.        Banks May Pay Interest on Checking Accounts
                                                               i.      Only for individual, not-for-profit entities or government entities
                                                             ii.      Reasons for Limitation: to restrict money market; prevent banks from engaging in destructive competition by bidding up deposit interest rates to attract deposits and having to make risky loans to earn high enough rate of return to make up for it
                                                           iii.      Dodd-Frank: business checking accounts may now earn interests. Since Fed is allowed to pay interest on their reserves too. Also, hoping that business will keep their money in the deposit account. Banks are so far paying only minimal interests, thus no risk of interest bidding.  
 
4.       Challenges to Intermediation Function of Banks
a.        Direct Investment
                                                               i.      Institutional investors lending directly to borrowers and bypassing the banks as intermediaries and cutting fees
                                                             ii.      Commercial Paper: companies lending to other companies from their excess funds
                                                           iii.      Securitization: companies selling accounts receivable instead of using it as a collateral to take out loans
                                                           iv.      Not subject to same regulations as banks
b.       But banks are now engaging in these activities too; joining the system and charging fees
 
5.       What Makes Banks Special
a.        Offer transaction accounts
                                                               i.      Capacity to incur and create liabilities that are payable on demand and that are readily transferable to third parties
b.       Backup source of liquidity for all other institutions
                                                               i.      Other class of institutions and financial market either directly or indirectly depend on the banking system as their standby or backup source of credit and liquidity  
c.        Transmission belt for monetary policy
                                                               i.      Fed uses banks to manipulate cash supplies
d.       Deposit insurance by the Fed
                                                               i.      Public’s confidence in the ability of banks to meet their deposit obligations
e.        Access to the discount window
 
6.       Banks Must have Charter to Operate
a.        Dual Charter System
                                                               i.      National banks are fewer in number, but larger in asset size
                                                             ii.      Most new banks are state chartered, nonmember banks
1.       Attributed to proliferation of regulations and costs associated with new regulatory compliance
b.       Most bank assets are held by holding companies
                                                               i.      Decrease in number of banks and savings institutions
                                                             ii.      Due to bank mergers, acquisition following the repeal of interstate banking and branching restrictions
                                                           iii.      When only few institutions are holding large number of deposits, should we rethink deposit insurance system?  Perhaps more regulation over big institutions (which we do over systemically significant BHC with >$50 billion); also now there’s new liability-based deposit insurance premium, rather than deposit-based.
 
7.       Bank Income Statement
a.        Source of Income
                                                               i.      Traditionally, loan-based income; incomes earned from the interest charged on loans
1.       But deposits are short-term in nature
2.       Interest rate paid by the bank fluctuates with market interest ratesbut loans are often made at fixed rate
                                                             ii.      Now, fee-based income; earned from fees charged for other services. 
1.       Less subject to market interest rate fluctuations and thus more stable and predictable
b.       Expenses
                                                               i.      Bank’s highest non-interest expense= paying the employee
                                                             ii.      Reason why there were so many mergers and acquisitions over the past 20 years
                                                           iii.      Foreclosed property
 
8.       Balance Sheet
a.        Shows the valuation of the bank’s assets at the end of each quarter and annually
b.       Assets
                                                               i.      Cash, investments, loans
                                                             ii.      Investments includes government securities and real estate (bank premises)
                                                           iii.      Loans are usually the largest asset; offset by an estimate of the likely amount of loans that will not be repaid
c.        Liabilities
                                                               i.      Deposits, short-term and long-term debt
                                                             ii.      It is the amount bank owes to its creditors (depositors, short or long term creditors)
                                                           iii.      Most of bank’s liabilities are deposits
d.       Equity/Capital
                                                               i.      Amount paid to the bank by its SH when stock is initially issued, debt incurred by the bank that is subordinated to its other debt, and retained earnings
                                                             ii.      Capital is increased by increasing earnings, issuing more stock, or securing certain types of subordinated long term debt
                                                           iii.      Measures of How Well the Bank is Doing
1.       Overhead Efficiency Ratio
a.        OER = all noninterest expenses/income
b.       Lower the ratio, the better. 35-40% is as low as it really gets with most b

sticated structures to keep the money out of the vaults
                                                               i.      Money that is sitting in reserves is a cost on the economy since this money is not doing anything (like earning interest)
h.       Fractional reserve banking
                                                               i.      Only fraction of the money on deposit needs to be in reserve i.e. 10 % x A = $500 (A = new money created)
 
 
3.       Open Market Operations
a.        Open market operations add or subtract money from the economy on a dollar for dollar basis
                                                               i.      This makes open market operations really flexible
                                                             ii.      Now a principal tool of monetary policy to control money supply
b.       Affect supply of money by buying and selling govt securities (almost always US Treasury Bonds) by the FRB
c.        FOMC purchase will increase the money supply, FOMC sale will decrease the money supply
d.       The FRB performs open market operations in two ways: outright buying or selling of the securities (less common), or by temporarily altering reserves through repurchase agreements and matched sale-purchase transactions (more common)
e.        FOMC Members reflect both private and public interests
                                                               i.      7 members of the Board of governors
                                                             ii.      5 of the 12 Reserve Bank presidents
f.         Dodd-Frank: regional FRB presidents elected by member banks can’t vote for the president of their regional bank
 
4.       Discount Window (lender of the last resort)
a.        The Discount window is a buffer against unexpected day-to-day fluctuations in reserves demand and supply. When the demand for reserves is unexpectedly high, a bank can turn to the window so that it does not violate reserve requirements
b.       Way of increasing supply of “borrowed reserves” by lending to banks at discount rate
                                                               i.      Discounts rate could be raised or lowered to control bank’s aggressive lending
c.        Discount Rate: rate at which the FR makes loans to banks
d.       Federal Funds Rate: rate of interest banks get for lending excess deposits they have at the FRB to other banks
                                                               i.      Banks negotiate this rate and fed has no direct control of the Fed Funds rate
                                                             ii.      Fed can control the Fed Funds rate by use of open market operations
e.        Two Functions of Discount Window
                                                               i.      Complements open market operations in achieving the target federal funds rate. By making FR balances available to depository institutions when the supply of balances falls short of demand
                                                             ii.      Promote financial stability. Backup source of liquidity for individual depository institutions, usually overnight 
f.         In general, lower discount and fed funds rates increase the money supply since unexpected fluctuations will hurt less – since cost of borrowing money to meet reserve requirement is less
 
5.       Goals of Monetary Policy
a.        Promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates