Part 1: Banking and the Forces of Change in the Financial-Services Industry

1. Part 1:Banking and the Forces of Change in the Financial-Services Industry • Chapter 1: Overview of Banking and the Financial-Services Industry • Chapter 2: Drivers of Change, Innovation, and Consolidation in the Financial-Services Industry • Chapter 3: Technology in Banking: E-Money, E-Banking, and E-Commerce Chapter 1

2. CHAPTER 1 OVERVIEW OF BANKING AND THE FINANCIAL-SERVICES INDUSTRY Chapter 1

3. LEARNING OBJECTIVES TO UNDERSTAND.... • The functions of a financial system and that “Banks do it” • How to judge the efficiency of a financial system and how it interacts with the real economy • Who the major players in the FSI are and how they are organized • The role of the federal safety net and the difference between regulatory discipline and market discipline • The dimensions of bank competition and how regulation shapes them Chapter 1

4. THE FUNCTIONS OF A FINANCIAL SYSTEM: Do Banks Do It? • Clear and settle payments to facilitate trade and commerce • Aggregate and disaggregate wealth and flows of funds so that both large-scale and small-scale projects can be financed • Transfer economic resources over time, space, and industries • Accumulate, process, and disseminate information for decision-making purposes • Provide ways for managing uncertainty and controlling risk • Provide ways for dealing with incentive and asymmetric-information problems that arise in financial contracting Chapter 1

5. JUDGING THE EFFICIENCY OF A FINANCIAL SYSTEM • Allocative Efficiency • Operational or Cost Efficiency • Informational or Price Efficiency Chapter 1

6. HOW THE FINANCIAL SECTOR AFFECTS THE REAL SECTOR • Credit Screening Activities • Credit Rationing • Creating Liquidity • Facilitate Trade and Investment Activities • Debt Restructurings • Feedback Role Chapter 1

7. PLAYERS IN THE FINANCIAL- SERVICES INDUSTRY • Financial Holding Companies Ex: Citigroup, American Express, Capital One Financial • Bank Holding Companies Ex: Bank of America, Wells Fargo, SunTrust • Community Banks • Securities Firms Ex: Merrill Lynch, MSDW, Charles Schwab • Thrift Institutions Ex: Washington Mutual, Charter One Financial, Dime Bancorp Chapter 1

8. PLAYERS IN THE FINANCIAL SERVICES INDUSTRY (Continued) • Insurance Companies Ex: Aetna, AFLAC, Allstate • Pension Funds • Finance Companies • Investment Funds • Nonfinancial Corporations • Venture Capitalists Chapter 1

9. THE “-IZATION” OF THE FSI • Institutionalization • Securitization • Globalization • Privatization • Modernization Chapter 1

10. TYPES AND CLASSES OF COMMERCIAL BANKS • National Banks -- Charters are issued by the Office of the Comptroller of the Currency (OCC) • State Banks -- chartered by states and D.C. • Fed-Member Bank -- Must be insured by the Federal Deposit Insurance Corporation • Bankers’ Banks • Pawnshops (“shadow banks”) Chapter 1

11. BANK HOLDING COMPANIES (BHCs) • Dominant Organizational Form in US is the BHC • One-Bank Holding Company • Multi-Bank Holding Company • Evolution to LCBOs and FHCs Chapter 1

12. MARKET CAPITALIZATION OF LARGE BHCs • Citigroup = $285 Billion • J.P. Morgan Chase Co = $96 Billion • Bank of New York = $37 Billion • These data are as of September 13, 2000 – update them. Have they recovered from the financial aftermath of the “Attack on America”? Chapter 1

13. THE FEDERAL SAFETY NET:Two Basic Components • Discount Window -- The lender of last resort for banks that encounter liquidity crises • Deposit Insurance -- Provided by the FDIC, provides public confidence to the banking system • The TBTF policy is implemented through these two components • Moral Hazard -- refers to behavior that is altered by the existence of insurance Chapter 1

14. HOW DOES THE SAFETY NET WORK? When banks experience financial difficulty, they... 1.Borrow funds from the lender of last resort, the Fed 2.The FDIC has time, called “forbearance”, to arrange a permanent solution to the bank’s problems, usually a merger with another viable bank in a purchase-and-assumption transaction 3.FDICIA (1991), however, calls for “prompt corrective action” or PCA Chapter 1

15. Principal-Agent Relations, Regulatory, Discipline, and Market Discipline • The key players in regulatory discipline are: • Taxpayers as principals • President/Congress as agents and then as principals • Regulators as agents and then as principals • Managers of insured depositories as agents and then as principals • See Figure 1-2 (p. 16) for additional details Chapter 1

16. TECHNIQUES FOR MANAGING THE SAFETY NET • Monitoring the value of the collateral • Restricting the kinds of assets acceptable as collateral, and • Charging risk-based premiums Chapter 1

17. THE “CAMEL” MODEL C = Capital Adequacy A = Asset Quality M = Management E = Earnings L = Liquidity (S = systemic risk, CAMELS) Chapter 1

18. Regulatory Dialectic or Struggle Model • Thesis • Antithesis • Synthesis Chapter 1

19. THE RISKS OF BANKING • Credit Risk • Interest-Rate Risk • Liquidity Risk • Foreign-Exchange Risk Chapter 1

20. Strength-in-Banking Equation • Strength = New powers + Firm supervision • New powers: GLB Act of 1999 (Modernization) • Firm supervision: Risk-based capital requirements (regulatory discipline) and market discipline Chapter 1

21. The Dimensions of FSI Competition • Price • User convenience/service • Public confidence • Both market forces and regulations shape these dimensions Chapter 1

22. Chapter Summary • Banks do it when it comes to the functions of a financial system • We judge financial systems in terms of their efficiency – allocative, operating (cost), and price • Banks are heavily regulated firms (e.g., risk-based capital requirements, CAMEL, etc.) and structured as holding companies – BHCs, LCBOs, and FHCs Chapter 1

23. Summary (continued) • Customers pick financial-services providers based on price, convenience, and confidence as shaped by market forces and regulators • As banks gain new powers (GLB Act of 1999) firm supervision by markets and regulators is required to maintain strength in banking Chapter 1

24. Summary (continued) • Principal-agent relations play a key role in understanding how regulatory and market disciplines work • The regulatory dialectic or struggle model captures the ongoing battle between regulated FSFs and their regulators – thesis, antithesis, and synthesis Chapter 1