CHAPTER 2

1. CHAPTER 2 DRIVERS OF CHANGE, INNOVATION, AND CONSOLIDATION IN THE FINANCIAL-SERVICES INDUSTRY Chapter 2

2. Learning Objectives • To understand … • 1. The drivers of change in the FSI as the components of TRICK • 2. Innovation as a diffusion process and the technological and contractual aspects of innovation • 3. Consolidation and corporate restructuring in the FSI, especially bank mergers Chapter 2

3. Chapter Theme • Heraclitus, the Greek philosopher, said: “All is flux, nothing stays still. Nothing endures but change.” • This chapter focuses on change in banking and the FSI and what drives it • Innovation and consolidation, among other things, reflect the effects of the changes driving banking and the FSI Chapter 2

4. COMPONENTS OF A DYNAMIC MODEL OF CHANGE: TRICK • Transparency • Risk exposure • Information technology • Competition for customers • Kapital adequacy • Model:TRICK + Rational Self-Interest => Financial Innovation Chapter 2

5. TRANSPARENCY Readily understood, clear, or easily detected with regard to financial statement information, disclosure, monitoring and discipline by holders of debt and equity contracts, market valuations, and accountability of managers, directors, and safety-net managers Chapter 2

6. RISK EXPOSURE (leads to) Risk-Management Techniques • Asset-Liability Management (ALM) • Credit Analysis • Derivatives: Futures, Forwards, Options, and Swaps • Securitization Chapter 2

7. Exposure to What? • The risks of banking • 1. Credit risk • 2. Interest-rate risk • 3. Liquidity risk • 4. Foreign-exchange risk • 5. Operational risk • 6. Solvency (capital-adequacy) risk depends on the risks above Chapter 2

8. INFORMATION TECHNOLOGY “The information standard has replaced the gold standard as the basis for world finance” - Walter Wriston Chapter 2

9. COMPETITONFOR CUSTOMERS Basic Ingredients to Attract Customers • Price • Convenience • Confidence (federal safety net/guarantee) Chapter 2

10. KAPITAL ADEQUACY • Market Discipline • Costs of financial distress and cost of funds • Regulatory Discipline • Risk-based capital requirements • Graham-Leach-Bliley Act of 1999 • Community Reinvestment Act (modernization tied to fairness) Chapter 2

11. INNOVATION AS A DIFFUSION PROCESS • Innovation -- the introduction of something new Ex: 1961 introduction of the first negotiable certificate of deposit • Preliminary Distinctions • .Invention vs. innovation • .Autonomous innovation vs. induced innovation • .Market-induced innovation vs. regulation-induced innovation Chapter 2

12. NEW TECHNOLOGY AND PRODUCT DIFFUSION • August 2000 Internet Penetration for U.S. Households = 41% • Top Ten Cities for Penetration: San Francisco (66%) Seattle (64%) San Diego (62%) Portland (62%) Washington D.C. And Boston (59%) Denver and Kansas City (57%) Orlando (56%) Baltimore (55%) Chapter 2

13. DIFFUSION OF E-BANKING • Except for ATMs, diffusion rate has been slow • “Paper currency and checks are still used for the overwhelming majority of consumer payments, while electronic transfer, such as those made over the ACH, account for a very small fraction. In contrast, for the major money and securities markets in this country, electronic payments are the rule rather than the exception” -- Edward W. Kelley, Jr. Chapter 2

14. INNOVATION AND THE DESIGN OF FINANCIAL CONTRACTS Two Basic Contracts of Banking 1. Deposit Account • Checking Accounts • Savings Accounts • Certificate of Deposits • Individual Retirement Accounts 2. Loan Agreement • Fixed or Adjustable Rate Mortgages • C&I Term Loans • Automobile Loans • Credit-Card Loans Chapter 2

15. The Blocks Zero Coupon Fixed Rate Variable Rate Amortized Can Be Viewed In Terms Of: Present Value Future Value Payment Interest Rate Number of Periods CREDIT EXTENTION BUILDING BLOCKS Chapter 2

16. Background: TVM Formulas • Panel B of Table 2-2 presents the time-value-of-money (TVM) formulas on a pair-wise basis • 1. PV and FV of a lump sum • 2. FV of an annuity (payment) and annuity repaying a future amount • 3. PV of an ordinary annuity and annuity repaying a present value (loan-recovery factor, e.g., for a mortgage payment) Chapter 2

17. THE COSTS OF INNOVATIVE FINANCIAL PRODUCTS AND REPUTATIONAL CAPITAL • Legal, accounting, regulatory, and tax advisors • Computer systems for pricing and trading • Capital and personnel to support market-making, and • Educating issuers, investors, and traders Chapter 2

18. BACKGROUND TO BANK CONSOLIDATION • Within an industry within a country • Across industries within a country • Across countries but in the same industry • Across countries and industries Chapter 2

19. MOTIVES FOR CONSOLIDATION • Cost Economies • Economies of Scale • Economies of Scope • Market Power • Managerial Agency Costs • Exploitation of the Federal Safety Net Chapter 2

20. Alternative Merger Hypotheses • HypothesisSource of value creation • Information Undervaluation • Market power Horizontal mergers • Synergy Cost efficiencies • Taxes Tax (financial) synergy • Inefficient mgm Mismanagement • Earnings diversification Higher cash flows Chapter 2

21. M&A in Banking and the FSI • Citigroup merger (1998) predated GLB Act (1999) and helped force passage of the act • JPM and Chase (2000) • Bank of America and NationsBank (1998) • Wells Fargo and Norwest (1998) • Hostile takeovers (SunTrust failed in its bid for Wachovia – First Union won the battle but lost its name) Chapter 2

22. View Consolidation in Terms of the ROE Model • ROE = ROA x EM • ROA = PM x AU • Profitability (accounting) measures are: PM, ROA, ROE • Sales, turnover, or utilization measure is: AU • Leverage factor is: EM Chapter 2

23. BANK ORGANIZATIONAL FORMS IN THE US • Independent Banks • One-Bank Holding Companies • Multi-Bank Holding Companies Together, BHCs and independent banks are referred to as BANKING COMPANIES Chapter 2

24. PHENOMENA DRIVING DECLINE IN # OF BANKING COMPANIES • Mergers among BHCs • BHCs acquiring viable independent banks • The failure of independent banks during the 1980s and 1990s “The whole banking structure is turning into an oligopoly in which four or five institutions dominate any particular geographic-based market” -- Furash Chapter 2

25. A Long View • YearUnit banksBranch banksTotal • 1935 13,329 796 14,125 • 2000 2,733 5,848 8,581 • Change -10,596 5,052 -5,544 • Counting ATMs, point-of-sale systems, automated clearing houses (for direct deposit), and opportunities for home banking via the Internet numerous e-based systems for delivering financial services also exist, besides the traditional brick-and-mortar banks and branches Chapter 2

26. CONSOLIDATION • Mergers • Takeovers and Hostile Takeovers • Anti-Takeover Strategies • Shark Repellants • Poison Pills • Greenmail • Golden Parachutes Chapter 2

27. Competition and Access to Financial Services • The Fed favors the industrial-organizational (IO) model, which has the following linkages, given the conditions of supply and demand: • Market structure => Conduct => Performance Chapter 2

28. MERGER AND ACQUISITION STRATEGIES • “Hit ‘em where they ain’t” Ex: KeyCorp and Interstate Banking • Buck the Merger Trend Ex: SunTrust but then a failed hostile-takeover attempt Chapter 2

29. Businesses are Worried About Fewer Local Banks (16%) Fewer Customized Services (18%) Less Responsive to Community (26%) Decline in Customer Service (28%) Community Banks are Worried About Credit Unions (78%) Brokerage/Securities Firms (63%) Other Community Banks (60%) Mutual-Fund Companies (52%) Regional / Money-Center Banks (41%) Farm-Credit Banks (40%) OPPORTUNTIES FOR COMMUNITY BANKS IN THE MERGER ENVIRONMENT Chapter 2

30. Regulatory Concerns • Safety • Stability • Structure (competition) Chapter 2

31. Chapter Summary • TRICK + Rational self-interest => Financial Innovation • T = Transparency • R = Risk exposure (=> risk management) • I = Information technology • C = Competition for customers • K = Kapital adequacy Chapter 2