Money and Banking Exam 1

Primary Functions of a Bank

Transfer funds from savers to borrowers by accepting deposits and advancing loans.

Secondary Functions of a Bank

Investment banking, insurance, financial planning, M&A advice, foreign exchange, and other financial products.

Causes of Global Financial Crisis 2007-2009

Mortgage defaults due to declining home prices, subprime borrowers receiving loans with teaser rates and negative amortization, and lenders using the Originate-to-Distribute (OTD) model.

Impacts of the Global Financial Crisis

Failures/collapses of major firms (Bear Stearns, Lehman Brothers, Countrywide, Washington Mutual, Wachovia), asset write-downs, and credit tightening

Government Response to Financial Crisis

• Fannie Mae and Freddie Mac put into conservatorship.

• Established TARP (Troubled Asset Relief Program), which purchased $125 billion in preferred stock across nine major banks.

• Fed purchased commercial paper directly, provided over $1 trillion in credit/loans/guarantees, allowed hedge funds to borrow, and increased FDIC coverage to $250,000.

Why would the Fed restrict forming an FHC?

The Fed may deny forming/converting to a Financial Holding Company (FHC) if any insured depository institution subsidiary:

1. Is not well capitalized or well managed.

2. Did not receive at least a "Satisfactory" rating on its most recent Community Reinvestment Act (CRA) exam.

Why does the parent company pay very little taxes?

• 80% of dividends received from subsidiaries are exempt from income tax under IRS regulations.

• With a consolidated tax return, the parent company can use taxable losses to offset subsidiary taxable income.

Bank Holding Company (BHC)

A company that owns controlling interest in one or more commercial banks.

One-Bank BHC vs. Multi-Bank BHC

A One-Bank BHC controls only one commercial bank; a Multi-Bank BHC controls two or more commercial banks.

Financial Holding Company (FHC)

A distinct holding company structure authorized to engage in a wider range of financial activities not permitted for BHCs (e.g., insurance underwriting, securities underwriting, merchant banking)

Originate to Distribute (OTD)

A model where lenders originate loans with the intention of selling/securitizing them immediately rather than holding them on their balance sheet, reducing their concern for long-term credit quality.

Securitization

The process of pooling assets with similar features (e.g., mortgages or credit card loans) and issuing securities collateralized by those cash flows to investors.

TARP troubled assit relief program

A government emergency bailout program created in 2008 where the U.S. Treasury supplied banks with liquidity/capital by purchasing preferred stock and distressed assets.

Bank Types

• Global Banks: Offer a wide array of products/services worldwide.

• Super-Regional Banks: Similar to global banks in scope, but smaller in size/market penetration.

• Community Banks: Smaller trade area focus with total assets under $1 billion.

S-Corp Bank

A bank structure with 100 or fewer shareholders that pays no corporate income tax; profits pass through directly to shareholders who pay individual personal tax rates, avoiding double taxation.

Transactions Banking vs Relationship Banking

• Transactions Banking: High-volume, standardized, technology-driven services (e.g., credit cards, checking) requiring little personal human input.

• Relationship Banking: Personal, long-term relationship focus where the lender offers customized credit and advisory services, often charging higher rates and holding loans in portfolio.

TBTF Too Big to Fail

Large financial institutions whose failure regulators believe would pose systemic risk to the overall economy, leading to implicit government guarantees, lower borrowing costs, and potential moral hazard.

5 goals and Functions of Depository Institution Regulation

• Ensure safety and soundness.

• Provide an efficient and competitive financial system.

• Maintain monetary stability.

• Maintain the integrity of the payment system.

• Protect consumers from credit abuse.

CAMELS - regulators evasluate banks on

• C - Capital Adequacy

• A - Asset Quality

• M - Management Quality

• E - Earnings Quality

• L - Liquidity Risk

• S - Sensitivity to Market Risk

memorandum of understanding

A formal regulatory document identifying violations and corrective action plans.

cease and desist order

A formal legal document ordering a firm to stop an unfair/unsafe practice under penalty of law.

OCC

Office of the Comptroller of the Currency - charters national commercial banks and federal thrifts

State Authorities

Charter state banks

federal reserve

primary regulator for state-chartered fed member banks

FDIC

Primary federal regulator for state-chartered fed member banks

FDIC

primary federal regulator for state chartered non-member banks

NCUA

Charters and regulates federal credit unions

commercial banks

specialize in business credit, mortgages, and consumer loans

thrifts

specialize in real estate/housing loans and must maintain at least 65% of assets in housing related assets under the Qualified Thrift Lender test

farm credit system

non-depository institution created in 1916 to support agricultural credit needs in rural america

deposit insurance

fdic insures commercial banks/thrifts up to $250,000. NCUSIF insures credit unions.

bank Failures

OCC oficially declares an institution insolvent, and the FDIC acts as the receiver to liquidate or sell it

Federal Reserve System

Central Bank composed of 12 regional reserve banks. acts as lender of last resort and conducts monetary policy

monetary policy tools

• Open Market Operations: Primary/most flexible tool; FOMC buys securities (injects liquidity) or sells securities (withdraws liquidity).

• Discount Rate: Adjusts the cost of borrowing directly from the Fed.

• Reserve Requirements: Adjusts the ratio of deposits banks must keep on reserve.

role of depository institutions

Act as the primary conduit of monetary policy, facilitate economic growth, and serve as the main source of credit for small businesses.

Dodd- Frank Act highlights

• Requires mortgage securitizers to retain 5% credit risk unless loans meet Qualified Mortgage standards.

• Includes the Volcker Rule (prohibits proprietary trading).

• Repealed Regulation Q (allowed interest on demand deposits).

• Eliminated "Too Big To Fail" bailouts by making FDIC receiver to liquidate failing firms.

• Permanently extended FDIC insurance to $250,000

TBTF and Moral Hazard

• Creates a dual-class system (Large banks protected vs. Small bank creditors taking losses).

• Creates Moral Hazard—large banks take excess risks believing government will bail them out due to systemic economic threats.

Bank asset categories

• Loans: Largest asset category, generates highest interest revenue.

• Investment Securities: Provides liquidity and secondary interest income.

• Non-interest Cash & Due from Banks: Vault cash, Fed reserves, cash items in process of collection.

• Other Assets: OREO (Other Real Estate Owned) and physical premises.

liabilities

• Core Deposits: Stable, low-cost deposits (Demand deposits, NOW, ATS, MMDAs, savings, small CDs under $250k).

• Non-Core (Volatile) Liabilities: Price-sensitive funds (Jumbo CDs > $250k, Fed funds purchased, Repo agreements, FHLB borrowings)

bank risk : credit risk

Risk of default/nonpayment on loans. Measured via nonperforming loans and past-due loans.

bank risk: liquidity risk

Risk of being unable to meet cash/withdrawal obligations promptly. Short-term securities and core deposits mitigate this.

bank risk: market risk

Exposure to adverse movements in interest rates, security prices, or foreign exchange rates.

Bank risk: operational, reputational, legal, solvency risks

Internal process/system failures, bad publicity, contractual/legal issues, or market assets dropping below liabilities.

off-balance sheet activities

Commitments, letters of credit, and derivatives that carry risk without appearing directly on the balance sheet.

non-interest income and bank size

• Large banks generate significantly more non-interest income (fiduciary fees, trading, investment banking, securitization) than small/community banks.

• Largest/Most stable source: Deposit service charges and other fee-based transaction services.

non-interest expense (overhead)

Includes personnel, occupancy, and operating expenses. Lower overhead is better.

20% of customers generate 80% of bank profits

• High-Value Customer: Account Revenues > Account Expenses + Target Profit

• Value Customer: Account Revenues = Account Expenses + Target Profit.

• Low-Value Customer: Account Revenues< Account Expenses + Target Profit