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Chapter 1

Banking and the


Financial Services
Industry

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whole or in part.
Credit Crisis of 2007 - 2009
Lenders Made Sub-Prime Mortgages
Borrowers had insufficient income to
make monthly payments
Many mortgages had teaser rates
Low payments resulting in negative
amortization
Multiple Mortgage Banks Fail
As the mortgages write-downs were
recognized, the mortgage banks
capital was depleted
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part. 2
Credit Crisis of 2007 - 2009
Collapse and/or Failure of:
BearStearns
Lehman Brothers
Countrywide
Washington Mutual
Wachovia

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part. 3
Credit Crisis of 2007 - 2009
Government Response
Fannie Mae and Freddie Mac placed
into conservatorship
Loaned AIG over $150 billion
Insured money market mutual funds
Created Commercial Paper Funding
Facility
Increased FDIC coverage to $250,000
Temporarily through 2009
2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 4
Credit Crisis of 2007 - 2009
Government Response
Established Troubled Asset Relief
Program TARP
Established Term Asset-Backed
Securities Loan Facility TALF
Invested $125 billion in nine large U.S.
banks
Promoted mortgage loan modifications

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part. 5
Credit Crisis of 2007 - 2009
Impact on Banks and the Banking
Environment
Biggest impact of declining real estate
values concentrated in the areas that
experienced the largest run-up in real
estate values
Many large banks experienced large
losses while many small banks did not

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part. 6
Credit Crisis of 2007 - 2009

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in
whole or in part. 7
Credit Crisis of 2007 - 2009
Impact on Banks and the Banking
Environment
Largest Investment Banks
Goldman Sachs and Morgan Stanley
Converted to Financial Holding Companies
Bear Stearns and Merrill Lynch
Absorbed by other financial institutions
Lehman Brothers
Failed

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part. 8
How Do Banks Differ?
Global Banks
Offer a wide array of products and
services globally
Super-Regional Banks
Similar to global banks but smaller in
size and market penetration
Community Banks
Smaller trade area with total assets
under $1 billion
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part. 9
How Do Banks Differ?

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 10
How Do Banks Differ?

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How Do Banks Differ?
Bank Holding Companies
Owns controlling interest in one or
more commercial banks
Parent Organization versus
Subsidiaries
One-Bank Holding Companies
Multibank Holding Companies

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part. 12
How Do Banks Differ?

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 13
How Do Banks Differ?
Financial Holding Companies
The primary advantage to forming an FHC
is that the entity can engage in a wide
range of financial activities not permitted
in the bank or in a BHC
Authorized to engage in:
Underwriting and selling insurance and
securities
Commercial banking

Merchant banking

Insurance company portfolio investment


activities

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part. 14
How Do Banks Differ?
Financial Holding Companies
Fed may not permit forming an FHC (or
converting a BHC to an FHC) if any of
its insured depository institution
subsidiaries are:
not well capitalized,
not well managed,

did not receive at least a Satisfactory

rating in its most recent CRA exam

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part. 15
How Do Banks Differ?
Financial Holding Companies
An FHC can own a bank or BHC or a
thrift or thrift holding company
Each of these companies owns
subsidiaries, while the parent financial
holding company also owns other
subsidiaries directly

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part. 16
How Do Banks Differ?

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How Do Banks Differ?
Holding Company Financial
Statements
The consolidated financial statements
of a holding company and its
subsidiaries reflect aggregate or
consolidate performance

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 18
How Do Banks Differ?

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 19
How Do Banks Differ?

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 20
How Do Banks Differ?

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 21
2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 22
How Do Banks Differ?

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 23
How Do Banks Differ?
Holding Company Financial
Statements
While the consolidated financial
statements of a holding company and
its subsidiaries reflect aggregate
performance, it is useful to examine
the parent companys statements
alone

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part. 24
2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in
whole or in part. 25
How Do Banks Differ?
Holding Company Financial Statements
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
Under IRS provisions, each subsidiary actually
pays taxes quarterly on its taxable income
With a consolidated tax return, however, the
parent company can use taxable income from
its subsidiaries to offset its loss

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part. 26
Organizational Structure and
Financial Services Business Model
S-Corporation Banks
Have favorable tax treatment because a
qualifying 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 opportunity to avoid double taxation at
the firm and individual level, many closely held
banks have chosen 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

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part. 27
Organizational Structure and
Financial Services Business Model
S-Corporation Banks

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part. 28
Organizational Structure and
Financial Services Business Model
Financial Services Business Models
The principal advantage of being a
depository institution is access to FDIC
deposit insurance
The FDIC charges banks a premium for the
insurance, which ensures qualifying deposit
holders that the FDIC will guarantee the
principal amount of each deposit up to the
maximum allowed
The existence of deposit insurance allows
depository institutions to pay low rates on
insured deposits and ensures that such
deposits are relatively stable in times of crisis

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part. 29
Organizational Structure and
Financial Services Business Model
Financial Services Business Models
The primary disadvantage of operating as a
bank (or BHC) is that the firm is subject to
regulation as a bank
Prior to 2008, investment banks avoided
regulation as banks, which allowed them to
operate with substantially lower equity
capital per dollar of risk assets and enter
lines of business not generally available to
commercial banks
The combined effect was greater financial
leverage and business operations in many
high-risk areas such as proprietary trading

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part. 30
Organizational Structure and
Financial Services Business Model
Transactions Banking Versus
Relationship Banking
Transactions Banking
Involves the provision of 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

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 31
Organizational Structure and
Financial Services Business Model
Transactions Banking Versus
Relationship Banking
Relationship Banking
Emphasizes the personal relationship
between the banker and customer
For example, the key feature of a loan that
is relationship driven is that the lender
adds real value to the borrower during the
credit granting process
In addition to the provision of funds, the
lender may provide expertise in
accounting, business, and tax planning

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part. 32
Organizational Structure and
Financial Services Business Model
Transactions Banking Versus
Relationship Banking
Relationship Banking
Lending institutions generally charge
higher rates and often hold the loans in
portfolio
Aggressively market noncredit

products and services to such


customers in order to lock in the
relationship
2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 33
Organizational Structure and
Financial Services Business Model
Transactions Banking Versus Relationship
Banking
Securitization
The process of pooling a group of assets with
similar featuresfor example, credit card
loans or mortgagesand issuing securities
that are collateralized by the assets
The securities are sold to investors who receive the
cash flows from the loans net of servicing,
guarantee, and trust fees
The entire process adds liquidity to the market
because the loan originators regularly repeat the
process knowing that investors will demand the
securities

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part. 34
Organizational Structure and
Financial Services Business Model
Transactions Banking Versus
Relationship Banking
Originate-to-Distribute (OTD)
When loan origination is separated
from ownership
The flaw is that lenders who originated the
loans knew they would not own the loans
long term
They were, therefore, less concerned about
the quality of the assets originated

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part. 35
Organizational Structure and
Financial Services Business Model
Transactions Banking Versus
Relationship Banking
Originate-to-Distribute (OTD)
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

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part. 36
Organizational Structure and
Financial Services Business Model
Universal Banking
Refers to a structure for a financial services
company in which the company offers a
broad range of financial products and
services
Combined traditional commercial banking
that focused on loans and deposit gathering
with investment banking
Underwrote securities, advised on mergers
and acquisitions, managed investment assets
for customers, took equity positions in
companies, bought and sold assets for a
speculative profit, offered brokerage services,
and made loans and accepted deposits

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part. 37
Organizational Structure and
Financial Services Business Model
Universal Banking
The presumed advantage of universal
banking is the ability to cross-sell
services among customers
Participation in diverse products and
services would presumably increase
the information advantage and allow
the bank to serve customers more
efficiently and at better prices

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part. 38
Organizational Structure and
Financial Services Business Model
Universal Banking
There is no consensus on whether
universal banking is successful
U.S. firms that tried to achieve this
goal of a one-stop financial
supermarket have not outperformed
more traditional competitors

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 39
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whole or in part. 40
Different Channels for Delivering
Banking Services
Branch Banking
Automated Teller Machines
Internet (Online) Banking
Call Centers
Mobile Banking

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in
part. 41
Chapter 1

Banking and the


Financial Services
Industry

2014 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in
whole or in part.