Bank Management & Financial Services, 9e-chỉnh sửa

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Introduction to Banking and Financial Services P A R T O N E
C H A P T E R O N E
An Overview of the
Changing Financial-
Services Sector
Key Topics in This Chapter
• Powerful Forces Reshaping the Industry
• What Is a Bank?
• The Financial System and Competing Financial-Service Institutions
• Old and New Services Offered to the Public
• Key Trends Affecting All Financial-Service Firms
• Appendix: Career Opportunities in Banking and Financial Services
1–1 Introduction
An old joke attributed to comedian Bob Hope says “a bank is a financial institution
where you can borrow money only if you can prove you don’t need it.” Although many
of a bank’s customers may get the impression that this old joke is more truth than fiction,
the real story is that banks today provide hundreds of different services to millions of
people, businesses, and governments all over the world. And many of these services are
vital to our personal well-being and the well-being of the communities and nations where
we live.
Banks are the principal source of credit (loanable funds) for millions of individuals
and families and for many units of government (school districts, cities, counties, etc.).
Moreover, for small businesses ranging from grocery stores to automobile dealers, banks
are often the major source of credit to stock shelves with merchandise or to fill a dealer’s
lot with new vehicles. When businesses and consumers must make payments for pur-
chases of goods and services, more often than not they use bank-supplied checks, credit
Factoid or debit cards, or electronic accounts accessible through a website, cell phone, or other
What nation has the network. And when they need financial advice, it is the banker to whom they turn most
greatest number of frequently for counsel. More than any other financial-service firm, banks have a reputa-
commercial banks? tion for public trust.
Answer: The United Worldwide, banks grant more installment loans to consumers (individuals and families)
States with about 6,600
commercial banks,
than any other financial-service provider. In most years, they are among the leading buyers
followed by Germany of bonds and notes governments issue to finance public facilities, ranging from auditoriums
with close to 2,500. and football stadiums to airports and highways. Banks are among the most important sources
1
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2 Part One Introduction to Banking and Financial Services
of short-term working capital for businesses and have become increasingly active in recent
years in making long-term business loans to fund the purchase of new plant and equipment.
The assets held by U.S. banks represent about one-fifth of the total assets and an even larger
proportion of the earnings of all U.S.-based financial-service institutions. In other nations—
for example, in Japan—banks hold half or more of all assets in the financial system. The dif-
ference is because in the United States, many important nonbank financial-service providers
can and do compete to meet the needs of businesses, consumers, and governments.
1–2 What Is a Bank?

As important as banks are to the economy as a whole and to the communities they call
home, there is still much confusion about what exactly a bank is. A bank can be defined in
terms of (1) the economic functions it performs, (2) the services it offers its customers, or
(3) the legal basis for its existence.
Certainly banks can be identified by the functions they perform in the economy. They
are involved in transferring funds from savers to borrowers (financial intermediation) and
in paying for goods and services.
Key Video Link Historically, banks have been recognized for the great range of financial services they
@ http://www offer—from checking and debit accounts, credit cards, and savings plans to loans for busi-
.cnbc.com/id/158
nesses, consumers, and governments. However, bank service menus are expanding rap-
40232?play=1&vi
deo=1543956844 idly today to include investment banking (security underwriting), insurance protection,
CNBC explores financial planning, advice for merging companies, the sale of risk-management services
whether Wal-Mart to businesses and consumers, and numerous other innovative financial products. Banks
could bring more no longer limit their service offerings to traditional services but have increasingly become
convenience and lower
general financial-service providers.
prices to the mutual
fund market. Unfortunately in our quest to identify what a bank is, we will soon discover that
not only are the functions and services of banks changing within the global financial
system, but their principal competitors are going through great changes as well. Indeed,
many financial-service institutions—including leading security dealers, investment
bankers, brokerage firms, credit unions, thrift institutions, mutual funds, and insurance
companies—are trying to be as similar to banks as possible in the services they offer.
Examples include Goldman Sachs, Dreyfus Corporation, and Prudential Insurance—
all of which control banks or banklike firms. During the financial crisis of 2007–2009
Goldman Sachs and Morgan Stanley transitioned from being among the highest ranked
investment banks to being commercial bank holding companies, accepting deposits
from the public.
Moreover, if this were not confusing enough, several industrial companies have stepped
forward in recent decades to control a bank and offer loans, credit cards, savings plans,
and other traditional banking services. Examples of these giant banking-market invaders
include General Electric, Harley-Davidson, and Ford Motor Company, to name a few.
Even Wal-Mart, the world’s largest retailer, recently has explored the development of
banklike services in an effort to expand its financial-service offerings! American Express,
Pitney-Bowes, United Health Group, and Target already control banklike institutions.
Bankers have not taken this invasion of their turf lying down. They are demanding
relief from traditional rules and lobbying for expanded authority to reach into new mar-
kets around the globe. For example, with large U.S. banks lobbying heavily, the United
States Congress passed the Financial Services Modernization Act of 1999 (known as the
Gramm-Leach-Bliley or GLB Act after its Congressional sponsors), allowing U.S. banks
to enter the securities and insurance industries and permitting nonbank financial holding
companies to control banking firms.
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Chapter One An Overview of the Changing Financial-Services Sector 3
Many Kinds of Banks To add to the prevailing uncertainty about what a bank is, over
the years literally dozens of organizations have emerged from the competitive financial
marketplace, proudly bearing the label of bank. As Exhibit 1–1 shows, for example, there
are savings banks, investment banks, mortgage banks, merchant banks, universal banks,
and so on. In this text we will spend most of our time focused upon the most important of
all banking institutions—the commercial bank—which serves both business and house-
hold customers with deposits and loans all over the world. However, the management prin-
ciples and concepts we will explore in the chapters that follow apply to many different
kinds of “banks” as well as to other financial-service institutions providing similar services.
Money-Centered Banks vs. Community Banks While we are discussing the

many different kinds of banks, we should mention an important distinction between
banking types that will surface over and over again as we make our way through this
text—community banks versus money-center banks. Money-center banks are industry
leaders, spanning whole regions, nations, and continents, offering the widest possible
menu of financial services, gobbling up smaller businesses, and facing tough competition
from other giant financial firms around the globe. Community banks, on the other hand,
are usually much smaller and service local communities and towns, offering a significantly
narrower, but often more personalized, menu of financial services to the public. As we
will see, community banks are declining in numbers, but they also are proving to be tough
competitors in the local areas they serve.
EXHIBIT 1–1 Name of Banking-Type Firm Definition or Description

The Many Different
Kinds of Financial- Commercial banks Sell deposits and make loans to businesses, individuals, and
Service Firms Calling institutions
Money center banks Largest commercial banks based in leading financial centers
Themselves Banks
Community banks Smaller, locally focused commercial and savings banks
Savings banks Attract savings deposits and make loans to individuals and families
Cooperative banks Help farmers, ranchers, and consumers acquire goods and services
Mortgage banks Provide mortgage loans on new homes but do not sell deposits
Investment banks Underwrite issues of new securities on behalf of their corporate
customers
Merchant banks Supply both debt and equity capital to businesses
Industrial banks State-chartered loan companies owned by other corporations that
provide credit and receive deposits
International banks Commercial banks present in more than one nation
Wholesale banks Larger commercial banks serving corporations and governments
Retail banks Smaller banks serving primarily households and small businesses
Limited-purpose banks Offer a narrow menu of services, such as credit card companies and
subprime lenders
Bankers’ banks Supply services (e.g., check clearing and security trading) to banks
Minority banks Focus primarily on customers belonging to minority groups
National banks Function under a federal charter through the Comptroller of the
Currency in the United States
State banks Function under charters issued by banking commissions in various
states
Insured banks Maintain deposits backed by federal deposit insurance plans (e.g., the
FDIC)
Member banks Belong to the Federal Reserve System
Affiliated banks Wholly or partially owned by a holding company
Virtual banks Offer their services only over the Internet
Fringe banks Offer payday and title loans, cash checks, or operate as pawn shops
and rent-to-own firms
Universal banks Offer virtually all financial services available in today’s marketplace
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Insights and Issues

A BRIEF HISTORY OF BANKING AND OTHER certificates began to circulate as money because they were
FINANCIAL-SERVICE FIRMS more convenient and less risky to carry around than gold or
According to historical records, banking is the oldest of all other valuables. Goldsmiths also offered certification of value
financial-service professions. Where did these powerful financial services—what we today call property appraisal. Customers
institutions come from? would bring in their valuables to have an expert certify these
Linguistics (the science of language) and etymology (the items were real and not fakes.
study of word origins) tell us the French word banque and the When colonies were established in America, Old World bank-
Italian banca were used centuries ago to refer to a “bench” or ing practices entered the New World. At first colonists dealt pri-
“money changer’s table.” This describes quite well what histori- marily with established banks in the countries from which they
ans have observed about the first bankers more than 2,000 years had come. Later, state governments in the United States began
ago. They were money changers, situated usually at a table in the chartering banking companies. The U.S. federal government
commercial district, aiding travelers by exchanging foreign coins became a major force in banking during the Civil War. The Office
for local money or replacing commercial notes for cash in return of the Comptroller of the Currency (OCC) was established in 1864,
for a fee. created by the U.S. Congress to charter national banks. This bank
The earliest bankers pledged their own money to support regulatory system, in which both the federal government and the
these early ventures, but it wasn’t long before the idea of attract- states play key roles in the supervision of banking activity, still
ing deposits from customers and loaning out those same funds exists in the United States to the present day.
emerged. Loans were granted to shippers, landowners, and oth- Despite banking’s long history and success, tough financial-
ers at interest rates as low as 6 percent to as high as 48 percent service competitors emerged over the past century or two, mostly
a month for the riskiest ventures! Most early banks were Greek or from Europe, to challenge bankers at every turn. Among the old-
Roman in origin. est were life insurance companies—the first American company
The banking industry gradually spread from Greece and Rome was chartered in Philadelphia in 1759. Property-casualty insur-
into Europe. It encountered religious opposition during the Middle ers emerged at roughly the same time, led by Lloyds of London in
Ages primarily because loans to the poor often carried the highest 1688, underwriting a wide range of risks to persons and property.
interest rates. However, as the Middle Ages drew to a close and The 19th century ushered in a rash of new financial competi-
the Renaissance began, the bulk of loans and deposits involved tors, led by savings banks in Scotland. These institutions offered
wealthy customers, which helped reduce religious objections. small savings deposits to individuals at a time when most commer-
The development of overland trade routes and improvements cial banks largely ignored this market. A similar firm, the savings
in navigation in the 15th, 16th, and 17th centuries gradually shifted and loan association, appeared in the midwestern United States
the center of world commerce from the Mediterranean toward during the 1830s, encouraging household saving and financing the
Europe and the British Isles. During this period, the seeds of the construction of new homes. Credit unions were first chartered in
Industrial Revolution, demanding a well-developed financial sys- Germany during the same era, providing savings accounts and
tem, were planted. The adoption of mass production required an low-cost credit to industrial workers.
expansion in global trade to absorb industrial output, which in Mutual funds—one of banking’s most successful
turn required new methods for making payments and obtaining competitors—appeared in Belgium in 1822. These investment
credit. Banks that could deliver on these needs grew rapidly, led firms entered the United States in significant numbers during the
by such institutions as Medici Bank in Italy and Hochstetter Bank 1920s, were devastated by the Great Depression of the 1930s,
in Germany. and rose again to grow rapidly. A closely related institution—the
The early banks in Europe were places for the safekeeping of money market fund—surfaced in the 1970s to offer professional
wealth (such as gold and silver) for a fee as people came to fear cash management services to households and institutions. These
loss of their assets due to war, theft, or expropriation by govern- aggressive competitors attracted a huge volume of deposits away
ment. Merchants shipping goods found it safer to place their pay- from banks and ultimately helped to bring about government
ments of gold and silver in the nearest bank rather than risking deregulation of the banking industry. Finally, hedge funds, private
loss to thieves or storms at sea. In England government efforts equity, and venture capital firms appeared to offer investors a less
to seize private holdings resulted in people depositing their valu- regulated, more risky, higher yielding alternative to mutual funds.
ables in goldsmiths’ shops, which issued tokens or certificates They grew explosively in the new century then ran into trouble
indicating the customer had made a deposit. Soon, goldsmith during the great credit crisis of 2007–2009.
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The Legal Basis for Banking One final note in our search for the meaning of the term
banks concerns the legal basis for their existence. When the federal government of the United
States decided it would regulate and supervise banks more than a century ago, it had to define
what was and what was not a bank for purposes of enforcing its rules. After all, if you plan to
regulate banks you have to write down a specific description of what they are—otherwise,
the regulated firms can easily escape their regulators, claiming they aren’t really banks at all!
The government finally settled on the definition still used by many nations today: A
Key URLs bank is any business offering deposits subject to withdrawal on demand (such as by writing a
The Federal Deposit check, swiping a plastic card through a card reader, or otherwise completing an electronic
Insurance Corporation
transfer of funds) and making loans of a commercial or business nature (such as granting credit
not only insures
deposits, but provides to private businesses seeking to expand the inventory of goods on their shelves or purchase
large amounts of data new equipment). Over a century later, during the 1980s, when hundreds of financial and
on individual banks. nonfinancial institutions (such as JC Penney and Sears) were offering either, but not both,
See especially of these two key services and, therefore, were claiming exemption from being regulated
www.fdic.gov and
as a bank, the U.S. Congress decided to take another swing at the challenge of defining
www.fdic.gov/bank
/index.html. banking. Congress then defined a bank as any institution that could qualify for deposit insurance
administered by the Federal Deposit Insurance Corporation (FDIC).
A clever move indeed! Under federal law in the United States a bank had come to be
defined, not so much by its array of service offerings, but by the government agency insur-
ing its deposits! The importance of FDIC deposit insurance was also highlighted during
the recent financial crisis, when investors sought out FDIC guarantees and massive funds
flowed into FDIC-insured accounts offered by banks and savings associations.
1–3 The Financial System and Competing Financial-Service Institutions

Roles of the Financial System
As we noted above, bankers face challenges from all sides today as they reach out to their
financial-service customers. Banks are only one part of a vast financial system of markets
and institutions that circles the globe. The primary purpose of this ever changing finan-
cial system is to encourage individuals and institutions to save and transfer those savings to those
Factoid individuals and institutions planning to invest in new projects and needing credit to do so. This
Did you know that process of encouraging savings and transforming savings into investment spending causes
the number of banks the economy to grow, new jobs to be created, and living standards to rise.
operating in the U.S. But the financial system does more than simply transform savings into investment. It
today represents less also provides a variety of supporting services essential to modern living. These include
than a third of the
number operating 100
payment services that make commerce and markets possible (such as checks, credit and
years ago? Why do you debit cards, and interactive websites), risk protection services for those who save and ven-
think this is so? ture to invest (including insurance policies and derivative contracts), liquidity services
(making it possible to convert property into immediately available spending power), and
Key URLs credit services for those who need loans to supplement their income.
Want to know
more about savings The Competitive Challenge for Banks
associations, which
closely resemble For many centuries banks were way out in front of other financial-service institutions in
commercial banks supplying savings and investment services, payment and risk protection services, liquid-
today? See especially ity, and loans. They dominated the financial system of decades past. But, lately, banking’s
the Office of Thrift financial market share frequently has fallen as other financial institutions have moved
Supervision at in to fight for the same turf. In the United States of a century ago, for example, banks
www.ots.treas.gov and
the Federal Deposit accounted for more than two-thirds of the assets of all financial-service providers. How-
Insurance Corporation ever, as Exhibit 1–2 illustrates, that share has fallen to just under one-quarter of the assets
at www.fdic.gov. of the U.S. financial marketplace, though recently banking’s share has risen somewhat.
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EXHIBIT 1–2 Total Financial Assets Percent of All Financial

Comparative Size
Financial-Service Institutions Held in 2010 (bill.)* Assets Held in 2010
by Industry of
Commercial Banks Depository Institutions:
and Their Principal Commercial banks** $14,411 24.6%
Financial-Service Savings institutions*** 1,245 2.1
Competitors Credit unions 903 1.5
Source: Board of Governors of Nondeposit Financial Institutions:
the Federal Reserve System, Life insurance companies 4,884 8.3
Flow of Funds Accounts of the
Property/casualty and other insurers 1,368 2.3
United States. Second Quarter
2010, September 2010. Private pension funds 5,323 9.1
State and local government retirement funds 2,557 4.4
Federal government retirement funds 1,311 2.2
Money market funds 2,760 4.7
Investment companies (mutual funds) 6,783 11.6
Closed-end and exchange-traded funds 230 0.4
Finance and mortgage companies 1,644 2.8
Real estate investment trusts 267 0.5
Security brokers and dealers 1,966 3.4
Other financial service providers
(including government-sponsored
enterprises, mortgage pools, issuers
of asset-backed securities, funding
corporations, payday lenders, etc.) 12,995 22.2
Totals 58,647 100.0%
Notes: Columns may not add to totals due to rounding error.

*Figures are for the second quarter of 2010.
**Commercial banking as recorded here includes U.S. chartered commercial banks, foreign banking offices in the United States, bank
holding companies, and banks operating in United States affiliated areas.
***Savings institutions include savings and loan associations, mutual and federal savings banks, and cooperative banks.
Some authorities in the financial-services field fear that this apparent erosion of market
share may imply that traditional banking is dying. (See, for example, Beim [2] and the
counterargument by Kaufman and Mote [3].) Certainly as financial markets become more
efficient and the largest customers find ways around banks to obtain the funds they need
(such as by borrowing in the open market), traditional banks may be less necessary in a
healthy economy. Some experts argue the reason we still have thousands of banks scat-
tered around the globe—perhaps more than we need—is that governments often subsidize
the industry through cheap deposit insurance and low-cost loans. Still others argue that
banking’s market share may be falling due to excessive government regulation, restricting
the industry’s ability to compete. Perhaps banking is being “regulated to death,” which may
hurt those customers who most heavily depend on banks for critical services—individuals
and small businesses. Other experts counter that banking is not dying, but only changing—
offering new services and changing its form—to reflect what today’s market demands.
Perhaps the traditional measures of the industry’s importance (like size as captured by total
assets) no longer reflect how truly diverse and competitive bankers have become in the
modern world.
Leading Competitors with Banks

Among leading competitors with banks in wrestling for the loyalty of financial-service
customers are such nonbank financial-service institutions as:
Savings associations: Specialize in selling savings deposits and granting home
mortgage loans and other forms of household credit to individuals and families,
illustrated by such financial firms as Atlas Savings (www.atlasbank.com), Flatbush
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Savings and Loan Association (www.flatbush.com) of Brooklyn, New York, and

American Federal Savings Bank (www.americanfsb.com).
Key URLs Credit unions: Collect deposits from and make loans to their members as nonprofit
To explore the associations of individuals sharing a common bond (such as the same employer),
character of the credit including such firms as American Credit Union of Milwaukee (www.americancu.org)
union industry see and Navy Federal Credit Union (www.navyfederal.org).
www.cuna.org and
www.ncua.gov. Fringe banks: Include payday lenders, pawn shops, and check-cashing outlets, offering
small loans bearing high risk and high interest rates to cover the immediate financial
Key URLs needs of cash-short individuals and families, such as First Cash Financial Services
The nature and (www.firstcash.com) and Pawn Trader (www.pawntrader.com).
characteristics of Money market funds: Collect liquid funds from individuals and institutions and invest
money market funds
these monies in quality securities of short duration, including such firms as Franklin
and other mutual funds
(investment companies) Templeton (www.franklintempleton.com) and DWS Investments (www.dws-
are explained at length investments.com).
in such sources as Mutual funds (investment companies): Sell shares to the public representing an
www.smartmoney.com,
interest in a professionally managed pool of stocks, bonds, and other securities,
www.ici.org, www
.morningstar.com, and including such financial firms as Fidelity (www.fidelity.com) and The Vanguard
www.marketwatch.com. Group (www.vanguard.com).
Hedge funds: Sell shares in a pool of assets mainly to upscale investors that typically
Key URLs include many different kinds of assets (including nontraditional investments in
To learn more about commodities, real estate, loans to new and ailing companies, and other risky assets);
security brokers and for additional information see such firms as the Magnum Group of Hedge Funds
dealers see www
.sec.gov or www
(www.magnum.com) and Turn Key Hedge Funds (www.turnkeyhedgefunds.com).
.investorguide.com. Security brokers and dealers: Buy and sell securities on behalf of their customers and
for their own accounts, such as Charles Schwab (www.Schwab.com). Recently brokers
Key URL like Schwab have become more aggressive in offering interest-bearing online checkable
You can explore the accounts that often post higher interest rates than many banks are willing to pay.
changing world of Investment banks: Provide professional advice to corporations and governments, help
investment banking
more fully at www clients raise funds in the financial marketplace, seek possible business acquisitions,
.wallstreetprep.com. and trade securities, including such prominent investment banking houses as
Goldman Sachs (www2.goldmansachs.com) and Raymond James Financial, Inc.
Key URL (www.raymondjames.com).
To discover more about Finance companies: Offer loans to commercial enterprises (such as auto and
hedge funds see the appliance dealers) and to individuals and families using funds borrowed in the open
Security and Exchange
Commission’s website at
market or from other financial institutions, including such financial firms as Guardian
www.sec.gov/answers Finance Company (www.guardianfinancecompany.com) and GMAC Financial
/hedge.htm. Services (www.gmacfs.com).
Financial holding companies (FHCs): Often include credit card companies, insurance
Key URLs and finance companies, and security broker/dealer firms operating under one
To explore the life corporate umbrella, including such leading financial conglomerates as GE Capital
insurance and property/ (www.gecapital.com) and UBS Warburg AG (www.ubs.com).
casualty insurance
industries see especially Life and property/casualty insurance companies: Protect against risks to persons or
www.acli.com and property and manage the pension plans of businesses and the retirement funds of
www.iii.org. individuals, including such industry leaders as Prudential Insurance (www.prudential
.com) and State Farm Insurance Companies (www.statefarm.com).
Key URL
To learn more about
Financial-service providers are converging in terms of the services they offer and
finance companies see embracing each other’s innovations. Legislation, such as the U.S. Financial Services
www.nacm.org. Modernization (Gramm-Leach-Bliley) Act of 1999, has allowed many of the financial
firms listed above to offer the public one-stop shopping for financial services.
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Thanks to relatively liberal government regulations, banks with quality management

and adequate capital can now truly become conglomerate financial-service providers. The
same is true for security firms, insurers, and other financially oriented companies that wish
to acquire bank affiliates.
Thus, many of the historic legal barriers in the United States separating banking from
other financial-service businesses have, like the walls of ancient Jericho, “come tumbling
down.” The challenge of differentiating banks from other financial-service providers is
difficult today. However, inside the United States at least, the Congress (like the govern-
ments of many other nations around the globe) has chosen to limit banks’ association
with industrial and manufacturing firms, fearing that allowing banking–industrial combi-
nations of companies might snuff out competition, threaten bankers with new risks, and
possibly weaken the safety net that protects depositors from loss whenever the banking
system gets into trouble.
Concept Check
1–1. What is a bank? How does a bank differ from most 1–4. Which businesses are banking’s closest and
other financial-service providers? toughest competitors? What services do they offer
1–2. Under U.S. law what must a corporation do to qual- that compete directly with banks’ services?
ify and be regulated as a commercial bank? 1–5. What is happening to banking’s share of the finan-
1–3. Why are some banks reaching out to become cial marketplace and why? What kind of banking
one-stop financial-service conglomerates? Is this a and financial system do you foresee for the future if
good idea, in your opinion? present trends continue?
The similarites across financial firms creates confusion in the public’s mind today over
what is or is not a bank. The safest approach is probably to view these historic finan-
cial institutions in terms of the many key services—especially credit, savings, payments,
financial advising, and risk protection services—they offer to the public. This multiplic-
ity of services and functions has led to banks and their nearest competitors being labeled
“financial department stores” and to such familiar advertising slogans as “Your Bank—a
Full-Service Financial Institution.”
1–4 Services Banks and Many of Their Closest Competitors Offer the Public
Banks, like their closest-competitors, are financial-service providers. As such, they play a
number of important roles in the economy. (See Table 1–1.) Their success hinges on their
ability to identify financial services the public demands, produce those services efficiently,
and sell them at a competitive price. What services does the public demand from banks
and their financial-service competitors today? In this section, we present an overview of
banking’s menu of services.
Services Banks Have Offered for Centuries

Carrying Out Currency Exchanges
History reveals that one of the first services banks offered was currency exchange. A
banker stood ready to trade one form of coin or currency (such as dollars) for another
(such as francs or pesos) in return for a service fee. Such exchanges have been important
to travelers over the centuries, because the traveler’s survival and comfort often depended
on gaining access to local funds.
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TABLE 1–1 The modern bank has had to adopt many roles to remain competitive and responsive to public needs.
The Many Different Banking’s principal roles (and the roles performed by many of its competitors) today include:
Roles Banks and
Their Closest The intermediation role Transforming savings received primarily from households into credit
Competitors Play (loans) for business firms and others in order to make investments in
new buildings, equipment, and other goods.
in Today’s Economy
The payments role Carrying out payments for goods and services on behalf of customers
(such as by issuing and clearing checks and providing a conduit for
electronic payments).
The guarantor role Standing behind their customers to pay off customer debts when those
customers are unable to pay (such as by issuing letters of credit).
The risk management role Assisting customers in preparing financially for the risk of loss to
property, persons, and financial assets.
The investment banking role Assisting corporations and governments in raising new funds, pursuing
acquisitions, and exploring new markets.
The savings/investment Aiding customers in fulfilling their long-range goals for a better life by
adviser role building and investing savings.
The safekeeping/certification Safeguarding a customer’s valuables and certifying their true value.
of value role
The agency role Acting on behalf of customers to manage and protect their property.
The policy role Serving as a conduit for government policy in attempting to regulate the
growth of the economy and pursue social goals.
Discounting Commercial Notes and Making Business Loans

Early in history, bankers began discounting commercial notes—in effect, making loans to
local merchants who sold the debts (accounts receivable) they held against their customers
to a bank in order to raise cash quickly. It was a short step from discounting commercial notes
to making direct loans for purchasing inventories of goods or for constructing new facilities—
a service that today is provided by banks and numerous other financial-service competitors.
Offering Savings Deposits

Key Video Link Making loans proved so profitable that banks began searching for ways to raise additional
@ http://www loanable funds. One of the earliest sources of these funds consisted of offering savings
.khanacademy.org
deposits—interest-bearing funds left with depository institutions for a specific period
/video/banking-
1?playlist=Finance of time. According to some historical records, banks in ancient Greece paid as high as
Khan Academy presents 16 percent in annual interest to attract savings deposits from wealthy patrons and then
a simplistic explanation made loans to ship owners sailing the Mediterranean Sea at loan rates double or triple the
of how a bank can serve rate paid to savings deposit customers. How’s that for a nice profit spread?
savers and borrowers by
creating savings deposits Safekeeping of Valuables and Certification of Value
and offering loans.
During the Middle Ages, bankers and other merchants (often called “goldsmiths”) began
the practice of holding gold and other valuables owned by their customers inside secure
vaults, thus reassuring customers of their safekeeping. These financial firms would assay
the market value of their customers’ valuables and certify whether or not these “valuables”
were worth what others had claimed.
Supporting Government Activities with Credit

During the Middle Ages and the early years of the Industrial Revolution, governments in
Europe discovered bankers’ ability to mobilize large amounts of funds. Frequently banks
were chartered under the proviso that they would purchase government bonds with a
portion of the deposits they received. This lesson was not lost on the fledgling American
government during the Revolutionary War. The Bank of North America, chartered by the
Continental Congress in 1781, was set up to help fund the struggle to make the United
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Insights and Issues

THE ROLE OF BANKS AND OTHER FINANCIAL the world—have minimum denominations of $1,000, beyond the
INTERMEDIARIES IN THEORY reach of many small savers and investors. Financial intermediar-
Banks, along with insurance companies, mutual funds, finance ies provide a valuable service in dividing up such instruments into
companies, and similar financial-service providers, are financial smaller units readily affordable for millions of people.
intermediaries. This term simply means a business that interacts Another contribution intermediaries make is their willingness
with two types of individuals and institutions in the economy: to accept risky loans from borrowers, while issuing low-risk secu-
(1) deficit-spending individuals and institutions, whose current rities to their depositors and other funds providers. These service
expenditures for consumption and investment exceed their cur- providers engage in risky arbitrage across the financial markets
rent receipts of income and who, therefore, need to raise funds and sell risk-management services as well.
externally through borrowing or issuing stock; and (2) surplus- Financial intermediaries satisfy the need for liquidity. Finan-
spending individuals and institutions whose current receipts of cial instruments are liquid if they can be sold quickly in a ready
income exceed their current expenditures on goods and services market with little risk of loss to the seller. Many households and
so they have surplus funds to save and invest. Intermediaries per- businesses, for example, demand large precautionary balances of
form the indispensable task of acting as a bridge between these liquid funds to cover possible future cash needs. Intermediaries
two groups, offering convenient financial services to surplus- satisfy this customer need by offering high liquidity in the financial
spending units in order to attract funds and then allocating those assets they provide, giving customers access to liquid funds pre-
funds to deficit spenders. In so doing, intermediaries accelerate cisely when needed.
economic growth by expanding the available pool of savings, low- Still another reason intermediaries have prospered is their
ering the risk of investments through diversification, and increas- superior ability to evaluate information. Pertinent data on finan-
ing the productivity of savings and investment. cial investments is limited and costly. Some institutions know
Intermediation activities will take place (1) if there is a posi- more than others or possess inside information that allows them
tive spread between the expected yields on loans that financial to choose profitable investments while avoiding the losers. This
intermediaries make to deficit spenders and the expected cost uneven distribution of information and the talent to analyze it is
of the funds intermediaries attract from surplus spenders; and known as informational asymmetry. Asymmetries reduce the effi-
(2) if there is a positive correlation between yields on loans and ciency of markets, but provide a profitable role for intermediaries
other assets and the cost of attracting funds. If an intermediary’s that have the expertise to evaluate potential investments.
asset yields and its fund-raising costs are positively correlated, Yet another view of why financial institutions exist in modern
this will reduce uncertainty over its expected profits and allow it society is called delegated monitoring. Most borrowers prefer to
to expand. keep their financial records confidential. Lending institutions are
An ongoing debate in finance concerns why financial inter- able to attract borrowing customers because they pledge confi-
mediaries exist at all. What services do they provide that other dentiality. For example, a bank’s depositors are not privileged to
businesses and individuals cannot provide for themselves? review the records of its borrowing customers. Depositors often
This question has proven difficult to answer. Research evi- have neither the time nor the skill to choose good loans over bad.
dence showing that our financial markets are reasonably efficient They turn the monitoring process over to a financial intermediary.
has accumulated in recent years. Information flows readily to Thus a depository institution serves as an agent on behalf of its
market participants and the prices of assets seem to be deter- depositors, monitoring the financial condition of those customers
mined in highly competitive markets. In a perfectly competitive who do receive loans to ensure that depositors will recover their
and efficient financial system, in which all participants have equal funds. In return for monitoring, depositors pay a fee to the lender
and open access to the financial marketplace, no one participant that is probably less than the cost they would incur if they moni-
can exercise control over prices, all pertinent information affect- tored borrowers themselves.
ing the value of various assets is available to all, transactions By making a large volume of loans, lending institutions acting
costs are not significant impediments to trading, and all assets as delegated monitors can diversify and reduce their risk expo-
are available in denominations anyone can afford, why would sure, resulting in increased safety for savers’ funds. Moreover,
banks and other financial-service firms be needed at all? when a borrowing customer has received the stamp of approval
Most current theories explain the existence of financial of a lending institution it is easier and less costly for that customer
intermediaries by pointing to imperfections in our financial sys- to raise funds elsewhere. This signals the financial marketplace
tem. For example, all assets are not perfectly divisible into small that the borrower is likely to repay his or her loans. This signaling
denominations that everyone can afford. To illustrate, market- effect seems to be strongest, not when a lending institution makes
able U.S. Treasury bonds—one of the most popular securities in the first loan to a borrower, but when it renews a maturing loan.
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States an independent nation. Similarly, the U.S. Congress created a whole new federal
banking system, agreeing to charter national banks provided these institutions purchased
government bonds to help fund the Civil War.
Offering Checking Accounts (Demand Deposits)
Factoid The Industrial Revolution ushered in new financial services, including demand deposit
What region of the services—a checking account that permitted depositors to write drafts in payment for
United States contains goods and services that the bank or other service provider had to honor immediately. These
the largest number of
banks? The Midwest. payment services, offered by not only banks but also credit unions, savings associations,
The smallest number of securities brokers, and other financial-service providers, proved to be one of the industry’s
banks? The Northeast. most important offerings because they significantly improved the efficiency of the payments
Why do you think this process, making transactions easier, faster, and safer. Today the checking account concept
is so? has been extended to the Internet, to the use of plastic debit cards that tap your checking
account electronically, and to “smart cards” that electronically store spending power.
Offering Trust Services
Key Video Link For many years banks and a few of their competitors (such as insurance and trust compa-
@ http://money.tips nies) have managed the financial affairs and property of individuals and business firms in
.net/Pages/T005229_
return for a fee. This property management function, known as trust services, involves
Choosing_the_Right_
Checking_Account__ acting as trustees for wills, managing a deceased customer’s estate by paying claims against
Video.html view a that estate, keeping valuable assets safe, and seeing to it that legal heirs receive their
Money Tips video and rightful inheritance. In commercial trust departments, trust-service providers manage
find out why checking pension plans for businesses and act as agents for corporations issuing stocks and bonds.
accounts are like tooth-
paste.
Services Banks and Many of Their Financial-Service
Competitors Began Offering in the Past Century
Granting Consumer Loans
Early in the 20th century bankers began to rely heavily on consumers (households) for
deposits to help fund their large corporate loans. In addition, heavy competition for busi-
ness deposits and loans caused bankers increasingly to turn to consumers as potentially
more loyal customers. By the 1920s and 1930s several major banks, led by the forerun-
ners of New York’s Citibank and by North Carolina’s Bank of America, had established
strong consumer household loan departments. Following World War II, consumer loans
expanded rapidly, though their rate of growth has slowed at times recently as bankers have
run into stiff competition for household credit accounts from nonbank service providers,
including credit unions and credit card companies.
Financial Advising
Filmtoid Customers have long asked financial institutions for advice, particularly when it comes to
What 2001 the use of credit and the saving or investing of funds. Many service providers today offer a
documentary recounts
wide range of financial advisory services, from helping to prepare financial plans for indi-
the creation of an
Internet company, viduals to consulting about marketing opportunities at home and abroad for businesses.
GovWorks.com, using
more than $50 million
Managing Cash
in funds provided by Over the years, financial institutions have found that some of the services they provide
venture capitalists? for themselves are also valuable for their customers. One of the most prominent is cash
Answer: Startup.com. management services, in which a financial intermediary agrees to handle cash collec-
tions and disbursements for a business firm and to invest any temporary cash surpluses in
interest-bearing assets until cash is needed to pay bills. Although banks tend to special-
ize mainly in business cash management services, many financial institutions today offer
similar services to individuals and families.
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Leading Nonbank Financial Firms That Have

Reached into Traditional Bank Service Markets
For several decades now bankers have watched as some of the world’s most aggressive nonbank
institutions have invaded banking’s traditional marketplace. Among the most successful and aggres-
sive of such companies are these:
American Express Company (http://home.americanexpress.com). American Express was one of the
first credit card companies in the United States and now serves millions of households and business
firms. It also owns an FDIC-insured industrial bank (American Express Centurion Bank) through which it
offers home mortgage and home equity loans, savings deposits, checking and retirement accounts, and
online bill paying. AEX is registered with the Federal Reserve Board as a financial holding company.
HSBC Finance Corporation (www.hsbcusa.com). Formerly Household International, HSBC Finance
was the world’s largest finance company before being acquired and renamed by one of the world’s
largest banks—HSBC Holdings. HSBC Finance offers credit to middle-class borrowers with less-than-
perfect credit ratings in Canada, Great Britain, and the United States. Credit cards, home mortgages,
auto loans, and insurance products are offered by this consumer lending affiliate of the gigantic
British bank called HSBC.
Countrywide Financial Corp. (www.countrywide.com). Countrywide has represented one of the
largest home mortgage lenders in the United States. Founded in New York in 1969, the company
pioneered banklike branches (known as “country stores”), based initially in California and then
spreading nationwide, subsequently forming a broker–dealer subsidiary, an insurance agency, and an
online lending unit. Then Countrywide bought Treasury Bank, NA, in Alexandria, Virginia, and, in turn,
was acquired by Bank of America.
Offering Equipment Leasing

Many banks and finance companies have moved aggressively to offer their business cus-
tomers the option to purchase equipment through a lease arrangement in which the lend-
ing institution buys the equipment and rents it to the customer. These equipment leasing
services benefit leasing institutions as well as their customers because the lender can
depreciate the leased equipment to save on taxes.
Key URL
Making Venture Capital Loans
For more information Increasingly, banks, security dealers, and other financial conglomerates have become
on the venture capital active in financing the start-up costs of new companies. Because of the added risk
industry see
involved this is generally done through a separate venture capital firm that raises money
www.nvca.org.
from investors to support young businesses in the hope of turning exceptional profits.
Selling Insurance Policies

Beginning with the Great Depression of the 1930s, U.S. banks were prohibited from
acting as insurance agents or underwriting insurance policies out of fear that selling
insurance would increase bank risk and lead to conflicts of interest in which custom-
ers asking for one service would be compelled to buy other services as well. However,
this picture of extreme separation between banking and insurance changed dramati-
cally as the new century dawned when the U.S. Congress tore down the legal barriers
between the two industries, allowing banking companies to acquire control of insur-
ance companies and, conversely, permitting insurers to acquire banks. Today, these
two industries compete aggressively with each other, pursuing cross-industry mergers
and acquisitions.
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Selling and Managing Retirement Plans

Banks, trust departments, mutual funds, and insurance companies are active in managing
the retirement plans most businesses make available to their employees. This involves
investing incoming funds and dispensing payments to qualified recipients who have
reached retirement or become disabled.
Dealing in Securities: Offering Security Brokerage

and Investment Banking Services
One of the most popular service targets in recent years, particularly in the United States,
and Japan, has been dealing in securities, executing buy and sell orders for security trading
customers (referred to as security brokerage services), and marketing new securities to
raise funds for corporations and other institutions (referred to as security underwriting or
investment banking services). With passage of the Gramm-Leach-Bliley Act in the fall
of 1999 U.S. banks were permitted to affiliate with securities firms. Two venerable old
industries, long separated by law, especially in the United States and Japan, were like two
out-of-control locomotives rushing toward each other, pursuing many of the same custom-
ers. Early in the 21st century, however, investment banks and commercial banks were
confronted with massive security and loan losses and some of the oldest investment insti-
tutions (such as Bear Stearns and Lehman Brothers) failed or were absorbed by commer-
cial banks. In 2008 two other prominent investment banks—Goldman Sachs and Morgan
Stanley—became commercial banking companies instead of just investment banks.
Offering Mutual Funds, Annuities, and Other Investment Products
Many customers have come to demand investment products from their financial-service
providers. Mutual fund investments and annuities offer the prospect of higher yields than
the returns often available on conventional bank deposits and are among the most sought-
after investment products. However, these product lines also tend to carry more risk than
do bank deposits, which are often protected by insurance.
Annuities consist of long-term savings plans that promise the payment of a stream of
income to the annuity holder beginning on a designated future date (e.g., at retirement). In
contrast, mutual funds are professionally managed investment programs that acquire stocks,
bonds, and other assets that appear to “fit” the funds’ announced goals. Recently many bank-
ing firms organized special subsidiary organizations to market these services or entered into
joint ventures with security brokers and insurance companies. In turn, many of bankers’ key
competitors, including insurance companies and security firms, have moved aggressively to
expand their offerings of investment services in order to attract customers away from banks.
Offering Merchant Banking Services

U.S. financial-service providers are following in the footsteps of leading financial institu-
tions all over the globe (for example, Barclays Bank of Great Britain and Deutsche Bank of
Germany) in offering merchant banking services to larger corporations. These consist of
the temporary purchase of corporate stock to aid the launching of a new business venture
or to support the expansion of an existing company. Hence, a merchant banker becomes
a temporary stockholder and bears the risk that the stock purchased may decline in value.
Offering Risk Management and Hedging Services

Many observers see fundamental changes going on in the banking sector with larger
banks (such as JP Morgan Chase) moving away from a traditionally heavy emphasis on
deposit-taking and loan-making toward risk intermediation—providing their customers
with financial tools to combat risk exposure in return for substantial fees. The largest
banks around the globe now dominate the risk-hedging field, either acting as dealers
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Some Leading Retailing and Industrial Firms

Reaching into the Financial-Services Sector
Banks and other financial-service firms have experienced a rising tide of competition from leading
manufacturing, retailing, and other businesses in recent decades. These companies based outside
the financial sector nevertheless have often been successful in capturing financial-service custom-
ers. Among the best known of such nonfinancial-based entities are these:
GE (www.gec.com). Thomas Edison created General Electric in the 1890s following his invention of
the electric light bulb. Today General Electric is made up of six businesses. Two of these businesses
compete in the financial services market—GE Commercial Finance and GE Money. If GE were a bank,
it would rank in the top 10 of all U.S. banks. GE Commercial Finance offers loans, operating leases,
fleet management, and financial programs to businesses around the world. GE Money provides
services to more than 130 million individuals. These financial services include home loans, insurance,
credit cards, and personal loans.
GMAC Financial Services (www.gmacfs.com). GMAC began in 1919 as a captive finance company,
financing the vehicles produced by General Motors by lending to both dealers and consumers. Today
GMAC Financial Services is a family of financial-service companies that not only finances purchases
of motor vehicles, but extends home mortgage loans, provides real estate brokerage services, makes
commercial loans, sells insurance on homes and autos, and provides banking services through GMAC
bank and a thrift institution. GMAC and its parent company, General Motors, ran into serious problems
in 2008–2009 and the GM organization was reorganized.
Wal-Mart (www.wal-mart.com/moneycenter). Wal-Mart is the largest consumer retailer on the planet;
however, it is not a bank. Just the same, the financial-services industry fears this competition and
continues to lobby for roadblocks to limit its banking activities. Wal-Mart has Money Centers in 1,000 or
more retail locations. In comparison to its discount and grocery businesses, financial services have higher
profit margins and have grown more quickly than its other goods and services. These in-store financial
services include check cashing, money orders, money transfers, and bill payments. It is also pioneering a
prepaid Visa card called the Money-Card and offers more traditional credit cards and investment services.
As always, the company is focused on low pricing and targets lower- to middle-income consumers.
(i.e., “market makers”) in arranging for risk protection for customers from third par-
ties or directly selling their customers the bank’s own risk-protection services. As we
will see later on, this popular financial service has led to phenomenal growth in such
risk-hedging tools as swaps, options, and futures contracts, but it has also given rise to less
stable market conditions frequently as illustrated by the recent credit crisis.
Convenience: The Sum Total of All Banking and Financial Services

It should be clear from the list of services we have described that not only are banks
and their financial-service competitors offering a wide array of comparable services
today, but that the service menu is growing. Newer service delivery methods like the
Internet, cell phones, and smart cards with digital cash are expanding and new ser-
vice lines are launched every year. Viewed as a whole, the impressive array of services
offered and the service delivery channels used by modern financial institutions add up
to greater convenience for their customers, possibly meeting all their financial-service
needs at one location. Banks and some of their competitors have become the financial
department stores of the modern era, working to unify banking, insurance, and secu-
rity brokerage services under one roof—a trend often called universal banking in the
United States and Great Britain, as Allfinanz in Germany, and as bancassurance in
France. Table 1–2 lists some of these financial department stores, including some of the
largest financial firms in the world.
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TABLE 1–2 Leading Banking-Oriented Firms Leading Global Nonbank Service Providers, Security
Some of the Leading
around the Globe Dealers, Brokers, and Investment Bankers
Financial-Service
Firms around the Mizuho Financial Group Ltd., Japan Merrill Lynch, USA (affiliated with Bank of America)
Globe Mitsubishi Banking Corp., UFJ, Japan Goldman Sachs, USA
Deutsche Bank AG, Germany Nomura Securities, Japan
Sources: Bank for International UBS AG, Switzerland Daiwa Securities, Japan
Settlements, Bank of England, Citigroup, Inc., USA
Bank of Japan, the European
HSBC Holdings PLC, Great Britain
Central Bank, and Board
of Governors of the Federal Lloyds TSB, Great Britain Insurance Companies
Reserve System. Industrial and Commercial Bank of China Nippon Life Insurance
BNP Paribus Group, France Axa/Equitable, Paris, France
Barclays PLC, London, Great Britain Metropolitan Life Insurance, USA
Bank of Montreal, Canada Prudential Financial Inc., USA
The Royal Bank of Scotland Group,
Great Britain
JP Morgan Chase & Company, USA
Bank of America Corp., USA Finance Companies
Australian & N.Z. Banking Group GMAC LLC
GE Capital, USA
Concept Check
1–6. What different kinds of services do banks offer the become so important in the modern financial
public today? What services do their closest com- system?
petitors offer? 1–8. Why do banks and other financial intermediaries
1–7. What is a financial department store? A universal exist in modern society, according to the theory of
bank? Why do you think these institutions have finance?
1–5 Key Trends Affecting All Financial-Service Firms—Crisis, Reform, and Change
The foregoing survey of financial services suggests that banks and many of their financial-
service competitors are currently undergoing sweeping changes in function and form. In
fact, the changes affecting the financial-services business today are so important that many
industry analysts refer to these trends as a revolution, one that may well leave financial
institutions of the next generation almost unrecognizable. What are the key trends reshap-
ing banking and financial services today?
Service Proliferation
Leading financial firms have been expanding the menu of services they offer to their cus-
tomers. This trend toward service proliferation has accelerated in recent years under the
pressure of competition from other financial firms, more knowledgeable and demand-
ing customers, and shifting technology. The new services have opened up new sources of
revenue—service fees, which are likely to continue to grow relative to more traditional
sources of financial-service revenue (such as interest earned on loans).
Rising Competition
The level and intensity of competition in the financial-services field have grown as finan-
cial institutions have proliferated their service offerings. For example, the local bank
offering business and consumer credit faces direct competition for these services today
from other banks, thrift institutions, securities firms, finance companies, and insurance
companies and agencies. Not surprisingly with all this competition, banks’ share of the
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financial-services marketplace has fluctuated significantly. For example, as reported by

the Federal Deposit Insurance Corporation (FDIC), insured depository institutions held
more than 90 percent of Americans’ spending money as recently as 1980—a market share
that had dropped to only about 40 percent as the 21st century opened. This trend toward
greater competition has acted as a spur to develop still more services for the future and to
reduce operating costs.
Government Deregulation and then Reregulation

Rising competition and the proliferation of financial services have been spurred on by
government deregulation—a loosening of government control—of the financial services
industry that began in the final decades of the 20th century and soon spread around the
globe. As we will see more fully in the chapters ahead, U.S. deregulation began with the
lifting of government-imposed interest rate ceilings on savings deposits in an effort to give
the public a fairer return on their savings. Almost simultaneously, the services that many
of banking’s key competitors, such as savings and loans and credit unions, could offer were
sharply expanded by legislation so they could remain competitive with banks. Such leading
nations as Australia, Great Britain, and Japan have recently joined the deregulation move-
ment, broadening the legal playing field for banks and other financial-service companies.
However, a new regulatory trend—so-called reregulation, or the tightening of govern-
ment rules for the financial-services sector—was part of the concessional response to the
near-collapse of the economy during the great 2007–2009 recession. Governments around
the globe began to restrict the taking on of new financial services and new markets and
focus more sharply on the dangers, the measurement, and tracking of systemic risk across
the whole financial system.
Crisis, Reform, and Change in Banking and Financial Services

In this chapter and all those that follow we will discover the great changes that are reshap-
ing the financial services marketplace and affecting its products, industry structure, and
jobs. The financial sector has been and is being buffeted by multiple forces, from econom-
ics to politics and everything in between. Nowhere is this more evident than changes
responding to the great recession and credit crisis of 2007–2009. The most obvious moti-
vators of change include:
*Speculation and market collapse in global real estate and mortgage markets.
*Innovation and invention (particularly in financial derivative contracts) that
occurred too fast and became literally uncontrollable.
*Weak monitoring as governments and regulators failed to adequately control the
winds of change blowing through the banking and financial institutions’ sector.
*The failure of hundreds of commercial and investment banks, principally in the
United States and in Europe.
You will find the principal discussion of these crisis-related events in:
*Chapter 2 (dealing with recent regulatory reform measures, including the Dodd-
Frank Wall Street Reform Act, new consumer protection agencies, changes in
central bank monetary policy and the auditing of central banks, new procedures
for liquidating troubled financial firms, and a new oversight body to track possible
systemic risk that might overwhelm the entire financial system);
*Chapter 3 (containing further provisions of the Dodd-Frank Wall Street Reform
Act, dealing with changes in the structure of banks and other depository institutions
and the increasing dominance of the largest financial firms);
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*Chapter 9 (addressing more issues in securitization, interest-rate and credit derivatives

in a changing world of greater transparency in the handling of risk management tools);
*Chapter 12 (looking at the changing rules of deposit insurance and the marketing of
deposits to the public);
*Chapter 14 (examining the shifting roles of fee-generating investment banking and
its consequences for the safety of depository institutions and the public);
*Chapter 15 (pointed at tough new capital management rules designed to protect the
world’s largest banks against risk, especially the new Basel III regulations); and
*Chapter 18 (dealing with new credit and debit card regulation to protect consumers
against limited disclosure of credit charges and other consumer expenses).
An Increasingly Interest-Sensitive Mix of Funds

Financial-service managers have discovered that they are facing a better-educated more
interest-sensitive customer today, whose loyalty can more easily be lured away by compet-
itors. Financial-service providers must now strive to be more competitive in the returns
they offer on the public’s money and more sensitive to changing public preferences with
regard to how savings are allocated.
Technological Change and Automation

Banks and many of their most serious competitors have been faced with higher oper-
ating costs in recent years and, therefore, have turned increasingly to automation and
the installation of sophisticated electronic systems to replace older, labor-based produc-
tion and delivery systems. This increased use of technology is especially evident in the
delivery of such services as dispensing payments and making credit available to qualified
customers. For example, thanks to the Check 21 Act passed in the United States in 2004
even the familiar “paper check” is gradually being replaced with electronic images. People
increasingly are managing their financial accounts through the use of personal computers,
cell phones, and credit and debit cards, and “virtual banks” around the globe offer their
services exclusively through the Internet.
The most prominent examples of major technological innovations in financial services
include automated teller machines (ATMs), cell phones, point of sale (POS) terminals,
and debit cards. ATMs give customers 24-hour access to their accounts for cash withdraw-
als and to a widening menu of other services. Also accessible well beyond “bankers’ hours”
are POS terminals in stores and shopping centers that replace paper-based means of pay-
ing for goods and services with rapid computer entries. Even more rapidly growing are
encoded debit cards that permit a customer to pay for purchases of goods and services with
the swipe of a card through an electronic card reader, while in some parts of the world cus-
tomers can pay for purchases simply by waving their cell phones over an electronic sensor
at some merchants’ cash registers or computers.
Thus, banking and financial services now comprise a more capital-intensive, fixed-cost
industry and a less labor-intensive, variable-cost industry than in the past. Some experts
believe that traditional brick-and-mortar buildings and face-to-face meetings with custom-
ers are becoming relics of the past, replaced almost entirely by electronic communications.
Technological advances such as these will significantly lower the per-unit costs associated
with high-volume transactions, but they will also tend to depersonalize financial services.
Consolidation and Geographic Expansion

Making efficient use of automation and other technological innovations requires a high
volume of sales. So financial-service providers have had to expand their customer base
through geographic expansion—reaching into new and more distant markets and increasing
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the number of service units sold in those expanding markets. The result has been an
increase in branching activity in order to provide multiple offices (i.e., points of contact)
for customers, the formation of financial holding companies that bring smaller institu-
tions into larger conglomerates offering multiple services in multiple markets, and recent
mergers among some of the largest bank and nonbank financial firms—for example,
JP Morgan Chase Bank with Bear Stearns, Bank of America with Merrill Lynch, and Bar-
clays Bank PLC with Lehman Brothers.
The financial crisis that burned from 2007 through 2009 fueled the consolidation
of financial institutions and kept the FDIC putting out fire after fire. Large depository
institutions, such as Countrywide, Wachovia, and Washington Mutual explored pos-
sible mergers with healthier and larger institutions, such as Bank of America, Wells
Fargo, and Citigroup. Smaller institutions, such as the First National Bank of Nevada
in Reno, were closed by regulators and their deposit accounts transferred to healthier
institutions, such as Mutual of Omaha Bank.
The number of small, independently owned financial institutions is declining and the
average size of individual banks, as well as securities firms, credit unions, finance companies,
and insurance firms, has risen significantly. For example, the number of U.S. commercial
banks fell from about 14,000 to fewer than 7,000 between 1980 and 2009. The number of
separately incorporated banks in the United States has now reached the lowest level in
more than a century. This consolidation of financial institutions has resulted in a decline in
employment in the financial-services sector as a whole.
Convergence
Service proliferation and greater competitive rivalry among financial firms have led to
a powerful trend—convergence, particularly on the part of the largest financial institu-
tions. Convergence refers to the movement of businesses across industry lines so that a
firm formerly offering perhaps one or two product line ventures into other product lines
to broaden its sales base. This phenomenon has been most evident among larger banks,
insurance companies, and security firms that have eagerly climbed into each other’s back-
yard with parallel service menus and are slugging it out for the public’s attention. Clearly,
competition intensifies in the wake of convergence as businesses previously separated into
different industries now find their former industry boundaries no longer discourage new
competitors. Under these more intense competitive pressures, weaker firms will fail or be
merged into companies that are larger with more services.
Factoid
Globalization
When in American The geographic expansion and consolidation of financial-service units have reached
history did the greatest well beyond the boundaries of a single nation to encompass the whole planet—a trend
number of banks fail?
called globalization. The largest financial firms in the world compete with each other for
Between 1929 and 1933,
when about one-third business on every continent. For example, huge banks headquartered in France (led by
(approximately 9,000) BNP Paribus), Germany (led by Deutsche Bank), Great Britain (led by HSBC), and the
of all U.S. banks failed United States (led by JP Morgan Chase) have become heavyweight competitors in the
or were merged out of global market for corporate and government loans. Deregulation has helped all these
existence.
institutions compete more effectively and capture growing shares of the global market
for financial services.
1–6 The Plan of This Book

The primary goal of this book is to provide the reader with a comprehensive understanding
of the financial-services industry and the role of banking in that industry. Through its seven
major parts we pursue this goal both by presenting an overview of the financial-services
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ETHICS IN BANKING AND FINANCIAL SERVICES
THE BAILOUT OF BEAR STEARNS because they couldn’t afford their monthly mortgage pay-
As we work our way through the chapters of this book we will ments.
discover that, from the dawn of history, the business of bank- Bear tried to reassure banks, other security dealer houses,
ing and financial services has rested on one absolutely funda- regulators, and the public that it could raise additional cash
mental principle—the principle of public trust. To attract funds to meet its near-term obligations and replenish its long-term
financial-service managers must maintain an aura of trust and capital base. However, rumors persisted that Bear was falling
confidence in their management of the public’s money. Once deeper into trouble, and its sources of borrowed cash simply
a financial firm loses that trust people and institutions begin began to dry up as other financial institutions refused to lend it
to place their savings and investments and their purchases additional funds or trade. The value of its stock fell like a stone.
of other financial services elsewhere. Ultimately the financial Fear began to spread that other investment banking houses
firm viewed as untrustworthy loses its customer base and col- might also be in serious trouble, perhaps resulting in a melt-
lapses. down among leading institutions in the financial system. Fear-
Few examples of the consequences of lost public trust ful of the possible consequences of an increasingly unstable
are more dramatic than the collapse of Bear Stearns, one of marketplace, the U.S. central bank, the Federal Reserve (“the
the oldest (founded in 1923) and best known investment bank- Fed”), stepped in and arranged a buyout of Bear by one of its
ing houses. Amid the great credit crisis of 2007–2009 rumors competitors, JP Morgan Chase & Co.—a deal supported by
began to spread on Wall Street that Bear was having trouble emergency loans from the Fed.
trying to raise sufficient cash to cover its obligations to other Thus, two huge financial institutions—the Fed and
Wall Street firms and to customers worldwide. The most per- JP Morgan Chase—that, at the time of Bear’s collapse, did
sistent rumor was that Bear was losing billions of dollars in have the public’s trust tried to prevent a “domino effect”—
asset value due to heavy investments in the subprime (low a series of collapses among industry leaders—from taking
credit quality) home loan market. Many of these lesser-quality place. Trust in financial firms is often hard to obtain but easy
home mortgage loans were being defaulted on and thousands to lose, as we will see over and over again in the pages of
of homeowners were simply walking away from their homes this book.
industry as a whole and by pointing the reader toward specific questions and issues that
bankers and their principal competitors must resolve every day.
Part One, consisting of Chapters 1 through 4, provides an introduction to the world
of banking and financial services and their functions in the global economy. We explore
the principal services offered by banks and many of their closest competitors, and we
examine the many ways financial firms are organized to bring together human skill, capi-
tal equipment, and natural resources to produce and deliver their services. Part One also
explains how and why financial-service providers are regulated and who their principal
regulators are. Part One concludes with an analysis of the different ways financial insti-
tutions deliver their services to the public, including chartering new financial firms,
constructing branches, installing ATMs and point-of-sale terminals, expanding call cen-
ters, using the Internet, and making transactions via cell phones and other portable elec-
tronic devices.
Part Two introduces readers to the financial statements of banks and their closest
competitors. Chapter 5 explores the content of balance sheets and income/expense
statements, while Chapter 6 examines measures of performance often used to gauge how
well banks and their closest competitors are doing in serving their stockholders and the
public. Among the most important performance indicators discussed are numerous mea-
sures of financial firm profitability and risk.
Part Three opens up the dynamic area of asset-liability or risk management (ALM).
Chapters 7, 8, and 9 describe how financial-service managers have changed their views
about managing assets, liabilities, and capital and controlling risk in recent years. These
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chapters take a detailed look at the most important techniques for hedging against chang-
ing market interest rates, including financial futures, options, and swaps. Part Three also
explores some of the newer tools to deal with credit risk and the use of off-balance-sheet
financing techniques, including securitizations, loan sales, and credit derivatives, which
pose newer sources of revenue and mechanisms for dealing with risk but also present pow-
erful and unique forms of risk exposure.
Part Four addresses two age-old problem areas for depository institutions and their
closest competitors: managing a portfolio of investment securities and maintaining
enough liquidity to meet daily cash needs. We examine the different types of invest-
ment securities typically acquired and review the factors that an investment officer
must weigh in choosing what assets to buy or sell. This part of the book also takes a crit-
ical look at why depository institutions and their closest competitors must constantly
struggle to ensure that they have access to cash precisely when and where they need it.
Part Five directs our attention to the funding side of the balance sheet—raising
money to support the acquisition of assets and to meet operating expenses. We present
the principal types of deposits and nondeposit investment products and review recent
trends in the mix and pricing of deposits for their implications for managing financial
firms today and tomorrow. Next, we explore all the important nondeposit sources of
short-term funds—federal funds, security repurchase agreements, Eurodollars, and the
like—and assess their impact on profitability and risk for financial-service providers.
This part of the book also examines the increasing union of commercial banking, invest-
ment banking, and insurance industries in the United States and selected other areas of
the world and the rise of bank sales of nondeposit investment products, including sales
of securities, annuities, and insurance. We explore the implications of the newer prod-
uct lines for financial-firm return and risk. The final source of funds we review is equity
capital—the source of funding provided by a financial firm’s owners.
Part Six takes up what many financial-service managers regard as the essence of their
business—granting credit to customers through the making of loans. The types of loans
made by banks and their closest competitors, regulations applicable to the lending pro-
cess, and procedures for evaluating and granting loans are all discussed. This portion of
the text includes expanded information about credit card services—one of the most suc-
cessful, but challenging, service areas for financial institutions today.
Finally, Part Seven tackles several of the most important strategic decisions that many
financial firms have to make—acquiring or merging with other financial-service providers
and following their customers into international markets. As the financial-services indus-
try continues to consolidate and converge into larger units, managerial decisions about
acquisitions, mergers, and global expansion become crucial to the long-run survival of
many financial institutions. This final part of the book concludes with an overview of the
unfolding future of the financial-services marketplace in the 21st century.
Concept Check
1–9. How have banking and the financial-services to significant problems for the management of
market changed in recent years? What powerful banks and other financial firms and for their stock-
forces are shaping financial markets and institu- holders?
tions today? Which of these forces do you think 1–11. What do you think the financial-services industry
will continue into the future? will look like 20 years from now? What are the
1–10. Can you explain why many of the forces you named implications of your projections for its manage-
in the answer to the previous question have led ment today?
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Summary In this opening chapter we have explored many of the roles played by modern banks
and their financial-service competitors. We have examined how and why the financial-
services marketplace is rapidly changing, becoming something new and different as we
move forward into the future.
Among the most important points presented in this chapter were these:
• Banks—the oldest and most familiar of all financial institutions—have changed greatly
since their origins centuries ago, evolving from moneychangers and money issuers to
become the most important gatherers and dispensers of financial information in the
economy.
• Banking is being pressured on all sides by key financial-service competitors—savings
and thrift associations, credit unions, money market funds, investment banks, security
brokers and dealers, investment companies (mutual funds), hedge funds, finance com-
panies, insurance companies, private equity funds, and financial-service conglomerates.
• The leading nonbank businesses that compete with banks today in the financial sector
offer many of the same services and, therefore, make it increasingly difficult to separate
banks from other financial-service providers. Nevertheless, the largest banks tend to
offer the widest range of services of any financial-service firm today.
• The principal functions (and services) offered by many financial-service firms today
include: (1) lending and investing money (the credit function); (2) making payments
www.mhhe.com/rosehudgins9e
on behalf of customers to facilitate their purchases of goods and services (the payments
function); (3) managing and protecting customers’ cash and other forms of customer
property (the cash management, risk management, and trust functions); and (4) assist-
ing customers in raising new funds and investing funds profitably (through the broker-
age, investment banking, and savings functions).
• Major trends affecting the performance of financial firms today include: (1) widening
service menus (i.e., greater product-line diversification); (2) the globalization of the
financial marketplace (i.e., geographic diversification); (3) the easing of government
rules affecting some financial firms (i.e., deregulation) while regulations subsequently
tighten around mortgage-related assets and other financial markets in the wake of a
recent credit crisis; (4) the growing rivalry among financial-service competitors (i.e.,
intense competition); (5) the tendency for all financial firms increasingly to look alike,
offering similar services (i.e., convergence); (6) the declining numbers and larger size of
financial-service providers (i.e., consolidation); and (7) the increasing automation of
financial-service production and delivery (i.e., technological change) in order to offer
greater convenience for customers, reach wider markets, and promote cost savings.
Key Terms bank, 2 life and property/ equipment leasing

community bank, 3 casualty insurance services, 12
money center bank, 3 companies, 7 insurance policies, 12
savings associations, 6 currency exchange, 8 retirement plans, 13
credit unions, 7 discounting commercial security brokerage
fringe banks, 7 notes, 9 services, 13
money market funds, 7 savings deposits, 9 security underwriting, 13
mutual funds, 7 demand deposit investment banking, 13
hedge funds, 7 services, 11 merchant banking
security brokers and trust services, 11 services, 13
dealers, 7 financial advisory government
investment banks, 7 services, 11 deregulation, 16
finance companies, 7 cash management reregulation, 16
financial holding services, 11 systemic risk, 16
companies, 7
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Problems 1. You recently graduated from college with a business degree and accepted a posi-
tion at a major corporation earning more than you could have ever dreamed. You
and Projects
want to (1) open a checking account for transaction purposes, (2) open a sav-
ings account for emergencies, (3) invest in an equity mutual fund for that far-off
future called retirement, (4) see if you can find more affordable auto insurance, and
(5) borrow funds to buy a condo, helped along by your uncle who said he was so
proud of your grades that he wanted to give you $20,000 towards a down payment.
(Is life good or what?) Make five lists of the financial service firms that could pro-
vide you each of these services.
2. Leading money center banks in the United States have accelerated their invest-
ment banking activities all over the globe in recent years, purchasing corporate debt
securities and stock from their business customers and reselling those securities to
investors in the open market. Is this a desirable move by banking organizations from
a profit standpoint? From a risk standpoint? From the public interest point of view?
How would you research these questions? If you were managing a corporation that
had placed large deposits with a bank engaged in such activities, would you be con-
cerned about the risk to your company’s funds? Why or why not?
3. The term bank has been applied broadly over the years to include a diverse set of
financial-service institutions, which offer different financial-service packages. Iden-
tify as many of the different kinds of banks as you can. How do the banks you have
identified compare to the largest banking group of all—the commercial banks? Why
do you think so many different financial firms have been called banks? How might
this confusion in terminology affect financial-service customers?
4. What advantages can you see to banks affiliating with insurance companies? How
might such an affiliation benefit a bank? An insurer? Can you identify any possible
disadvantages to such an affiliation? Can you cite any real-world examples of bank–
insurer affiliations? How well do they appear to have worked out in practice?
5. Explain the difference between consolidation and convergence. Are these trends in
banking and financial services related? Do they influence each other? How?
6. What is a financial intermediary? What are its key characteristics? Is a bank a type of
financial intermediary? What other financial-services companies are financial inter-
mediaries? What important roles within the financial system do financial intermedi-
aries play?
Internet Exercises
1. The beginning of this chapter addresses the question, “What is a bank?” (That is a
tough question!) A number of websites also try to answer the same question. Explore
the following websites and try to develop an answer from two different perspectives:
http://money.howstuffworks.com/bank1.htm
http://law.freeadvice.com/financial_law/banking_law/bank.htm
http://www.pacb.org/banks_and_banking/
a. In the broadest sense, what constitutes a bank?
b. In the narrowest sense, what constitutes a bank?
2. What services does the bank you use offer? Check out its website, either by Googling
or by checking the Federal Deposit Insurance Corporation’s website www.fdic.gov for
the banks’ name, city, and state. How does your current bank seem to compare with
neighboring banks in the range of services it offers? In the quality of its website?
3. In this chapter we discuss the changing character of the financial-services industry and the
role of consolidation. Visit the website http://www2.iii.org/financial-services-fact-book/ and
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look at mergers for the financial-services industry. What do the numbers tell us about
consolidation? How have the numbers changed over the last 5 years?
a. Specifically, which sectors of the financial-services industry have increased the
dollar amount of assets they control?
b. In terms of market share based on the volume of assets held, which sectors have
increased their shares (percentagewise) and which have decreased their shares?
4. As college students, we often want to know: How big is the job market? Visit the web-
site http://www2.iii.org/ and look at “employment and compensation” for the financial-
services industry. Answer the following questions using the most recent data on this site.
a. How many employees work in credit intermediation at depository institutions?
What is the share (percentage) of total financial-services employees?
b. How many employees work in credit intermediation at nondepository institutions?
What is the share (percentage) of total financial services employees?
c. How many employees work in insurance? What is the share (percentage) of total
financial-services employees?
d. How many employees work in securities and commodities? What is the share (per-
centage) of total financial-services employees?
5. What kinds of jobs seem most plentiful in the banking industry today? Make a brief
list of the most common job openings you find at various bank websites. Do any of
these jobs interest you? (See, for example, www.bankjobs.com.)
6. According to Internet sources mentioned earlier, how did banking get its start and
why do you think it has survived for so long? (Go to www.factmonster.com and
search “banking” and go to www.fdic.gov.)
7. In what ways do the following corporations resemble banks? How are they different
from banks of about the same asset size?
Charles Schwab Corporation (www.schwab.com)
State Farm Insurance (www.statefarm.com)
GMAC Financial Services (www.gmacfs.com)
REAL NUMBERS The Very First Case Assignment

FOR REAL BANKS
Identification of a bank to follow throughout the semester may create the Bank Holding Company Performance
(or perhaps for the rest of your life): Report (BHCPR) for the most recent year-end for your
chosen institution. The information found in the BHCPR
A. Choose a bank holding company (BHC) that is among the
is submitted to the Federal Reserve on a quarterly basis.
25 largest U.S. banking companies. Do not choose BB&T
To create this report you will use the pull-down menu to
of Winston Salem, North Carolina, because that BHC is
select the December date for the most recent year avail-
used for examples later on in the text. (Your instructor may
able and then click the “Create Report” button. From the
impose constraints to ensure that your class examines a
cover page of the BHCPR collect some basic information
significant number of institutions, rather than just a few.)
about your BHC and enter it in an Excel spreadsheet as
The list of the 50 largest U.S. BHCs is found at www.ffiec
illustrated. For illustrative purposes this basic spreadsheet
.gov/nic and may be accessed by clicking on the link “Top
was prepared using data for BB&T for December 31, 2010.
50 BHCs.”
C. Go to http://finance.yahoo.com/. Using the “Search/Get
B. Having chosen a BHC from the “Top 50” list, click on your Quotes” function find your BHC. Once you arrive at your
BHC’s active link and go to the website page where you BHC’s Quote Page, select Company Profile for the column
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REAL NUMBERS The Very First Case Assignment (continued)

FOR REAL BANKS
to the left. Read the “Business Summary.” In Chapter 1 we D. In conclusion, write several paragraphs on your BHC and its
discussed the traditional financial services that have been operations. Where does the BHC operate and what services
associated with commercial banking for decades and then the does the BHC offer its customers? This is an introduction and
services more recently added to their offerings. What does the all numerical analysis and interpretations will be saved for
Business Summary reveal about the types of services offered upcoming assignments.
by your BHC?
Selected For a review of the history of financial-service firms see especially:

References 1. Kindleberger, Charles P. A Financial History of Western Europe. Boston: Allen and
Unwin, 1984.
For a discussion of the changing role and market share of banks and their competitors see, for
example:
2. Beim, David U. “Why Are Banks Dying?” Columbia Journal of World Business, Spring
1992, pp. 2–12.
3. Kaufman, George G.; and Larry R. Mote. “Is Banking a Declining Industry? A His-
torical Perspective.” Economic Perspectives, Federal Reserve Bank of Chicago, May/
June 1994, pp. 2–12.
4. Poposka; Klimantina; Mark D. Vaughan; and Timothy J. Yeager. “The Two Faces
of Banking: Traditional Loans and Deposits vs. Complex Brokerage and Derivative
Securities.” The Regional Economist, Federal Reserve Bank of St. Louis, October 2004,
pp. 10–11.
5. Powell, Donald E.; Former Chairman of the Federal Deposit Insurance Corporation.
“South America and Emerging Risks in Banking.” Speech to the Florida Bankers Asso-
ciation, Orlando, Florida, October 23, 2002.
6. Prager, Robin A. “Determinants of the Location of Payday Lenders, Pawn Shops, and
Check-Cashing Outlets,” Finance and Economics Discussion Series, Federal Reserve
Board, Washington, D.C.
7. Rose, Peter S., and Milton Marquis. Financial Institutions and Markets. 11th ed. New
York: McGraw-Hill/Irwin, 2010. See especially Chapters 5, 14, and 17.
8. Santomero, Anthony M. “Banking in the 21st Century.” Business Review, Federal
Reserve Bank of Philadelphia, Third Quarter 2004, pp. 1–4.
9. Gunther; Jeffrey W.; and Anna Zhang. “Hedge Fund Investors More Rational than
Rash.” Economic Letter, Federal Reserve Bank of Dallas, August 2007, pp. 1–8.
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For a review of the theory of banking and financial intermediation see especially:
10. Rose, John T. “Commercial Banks as Financial Intermediaries and Current Trends in
Banking: A Pedagogical Framework.” Financial Practice and Education 3, no. 2 (Fall
1993), pp. 113–118.
11. Steindel, Charles. “How Worrisome Is a Negative Saving Rate?” Current Issues in
Economics and Finance, Federal Reserve Bank of New York, May 2007, pp. 1–7.
For an overview of the financial crisis around the globe beginning in 2007 see, in particular:
12. Federal Reserve Bank of Dallas, “The Financial Crisis: Connecting the Dots,” Annual
Report, 2008.
Appendix
Career Opportunities in Financial Services
Key URLs In this chapter, we have focused protect property, and for overseeing the operation of the
To see what kinds of on the great importance of banks human resources department. Managers in the operations
jobs are available in the and nonbank financial-service division need sound training in the principles of business
financial services field see
firms in the functioning of the management and in computers and management informa-
www.careers-in-finance tion systems, and they must have the ability to interact with
economy and financial system
.com/cb.htm and www
and on the many roles played by large groups of people.
.bankjobsearch.com.
financial firms in dealing with the
public. But banks and their competitors are more than just Key URL Branch Managers When
For opportunities in financial-service providers oper-
financial-service providers. They can also be the place for a
branch management, ate large branch office systems,
satisfying professional career. What different kinds of pro-
operations, and systems many of these functions are super-
fessionals work inside financial firms? management see,
vised by the manager of each
for example, www
Loan Officers Many financial managers begin their branch office. Branch managers
.bankstaffers.com.
careers accepting and analyzing loan applications submitted lead each branch’s effort to attract
by business and household customers. Loan officers make new accounts, calling on business firms and households in
initial contact with potential new customers and assist their local area. They also approve loan requests and resolve
them in filing loan requests and in developing a service customer complaints. Branch managers must know how to
relationship with a lending institution. Loan officers are motivate employees and how to represent their institution
needed in such important financial institutions as banks, in the local community.
credit unions, finance companies, and savings associations. Systems Analysts These computer specialists work with
officers and staff in all departments, translating their pro-
Key URLs Credit Analysts The credit ana- duction and information needs into programming language.
For jobs in lending lyst backstops the work of the The systems analyst provides a vital link between managers
and credit analysis see, loan officer by preparing detailed and computer programmers in making the computer an
for example, www written assessments of each loan
.bankjobs.com and effective problem-solving tool and an efficient channel
applicant’s financial position and for delivering customer services. Systems analysts need in-
www.scottwatson.com.
advises management on the wis- depth training in computer programming as well as courses
dom of granting any particular loan. Credit analysts and emphasizing business problem solving.
loan officers need professional training in accounting,
financial statement analysis, and business finance. Auditing and Control Personnel Keeping abreast of the
inflow of revenues and the outflow of expenses and tracking
Managers of Operations Managers in the operations divi- changes in the service provider’s financial position are the
sion are responsible for processing checks and clearing other responsibilities of auditors and accountants. These are some
cash items on behalf of their customers, for maintaining the of the most important tasks within a financial institution
institution’s computer facilities and electronic networks, for because they help guard against losses from criminal activity
supervising the activities of tellers, for handling customer and waste. Jobs as important as these require considerable
problems with services, for maintaining security systems to training in accounting and finance.
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Key URL Trust Department Specialists counsel employees on ways to improve their performance
For jobs in trust Specialists in a trust department aid and opportunities for promotion.
departments see, for companies in managing employee
example, www.ihire retirement programs, issuing securi- Key URLs Investment Banking Specialists
banking.com. Investment banking Banks are often heavily involved
ties, maintaining business records,
career opportunities are in assisting their business custom-
and investing funds. Consumers also receive help in manag- often found at www
ing property and in building an estate for retirement. Men ers with the issue of bonds and
.efinancialcareers.com stock to raise new capital, and they
and women employed in trust departments usually possess a and www.bankjobs
wide range of backgrounds in commercial and property law, frequently render advice on finan-
.com.
real estate appraisal, securities investment strategies, and cial market opportunities and on
marketing. mergers and acquisitions. This is the dynamic field of invest-
ment banking, one of the highest-paid and most challenging
Key URL Tellers One employee that most areas in the financial marketplace. Investment banking per-
For information about customers see and talk with at virtu- sonnel must have intensive training in accounting, econom-
teller jobs see www ally all depository institutions is the ics, strategic planning, investments, and international finance.
.bankjobs.com. teller—the individual who occupies
Key URLs Bank Examiners and Regulators
a fixed station within a branch office or at a drive-in window,
Information about Because banks are among the most
receiving deposits and dispensing cash and information. possible employment
Tellers must sort and file deposit receipts and withdrawal heavily regulated of all business
at key bank regulatory firms, there is an ongoing need for
slips, verify customer signatures, check account balances, agencies may be found,
and balance their own cash position at least once each day. men and women to examine the
for example, at www
Because of their pivotal role in communicating with custom- financial condition and operating
.federalreserve.gov
ers, tellers must be friendly, accurate, and knowledgeable /careers, www.fdic.gov procedures of banks and their clos-
about other departments and the services they sell. /about/jobs, or www est competitors and to prepare and
.occ.treas.gov. enforce regulations. Regulatory
Security Analysts and Traders Security analysts and agencies hire examiners from time
traders are usually found in a financial firm’s bond depart- to time, often by visiting college
ment and in its trust department. All financial institutions Key Video Link campuses or as a result of phone
have a pressing need for individuals skilled in evaluating @ www.occ.treas.gov calls and letters from applicants.
the businesses and governments issuing securities that the /jobs/careers_video.htm Examiners and regulators must
institution might buy and in assessing financial market con- get a firsthand view of have knowledge of accounting,
being an OCC National business management, economics,
ditions. Such courses as economics, money and capital mar-
Bank Examiner. and financial laws and regulations.
kets, and investment analysis are usually the best fields of
study for a person interested in becoming a security analyst
or security trader. Regulatory Compliance Officers Compliance personnel
must make sure the regulated financial firm is in compliance
Key URL Marketing Personnel With with state, national, and international rules. Training in
For opportunities in greater competition today, financial- business law, economics, and accounting is most useful here.
marketing see, for service providers have an urgent
example, www.ritesite need to develop new services and Risk Management Specialists These professionals moni-
.com. more aggressively sell existing tor each financial firm’s exposure to a variety of risks (espe-
services—tasks that usually fall primarily to the marketing cially market, credit, and operational risks) and develop
department. This important function requires an understand- strategies to deal with that exposure. Training in econom-
ing of the problems involved in producing and selling services ics, statistics, and accounting is especially important in this
and a familiarity with service advertising techniques. Course rapidly developing field.
work in economics, services marketing, statistics, and business In summary, with recent changes in services offered,
management is especially helpful in this field. technology, and regulation, the financial-services field
can be an exciting and challenging career. However, find-
Human Resources Managers A financial firm’s perfor- ing a good job in this industry will not be easy. Hundreds
mance in serving the public and its owners depends, more of smaller financial institutions are being absorbed by larger
than anything else, on the talent, training, and dedication ones, with subsequent reductions in staff. Nevertheless, if
of its management and staff. The job of human resources such a career path sounds interesting to you, there is no
managers is to find and hire people with superior skills and substitute for further study of the industry and its history,
to train them to fill the roles needed by the institution. services, and problems. It is also important to visit with cur-
Many institutions provide internal management training rent personnel working in financially oriented businesses to
programs directed by the human resources division or out- learn more about the daily work environment. Only then
source this function to other providers. Human resources can you be reasonably certain that financial services is a
managers keep records on employee performance and good career path for you.
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Financial Statements and Financial-Firm Performance P A R T T W O
C H A P T E R F I V E
The Financial
Statements of Banks
and Their Principal
Competitors
• An Overview of the Balance Sheets and Income Statements of Banks and Other Financial Firms
• The Balance Sheet or Report of Condition
• Asset Items
• Liability Items
• Recent Expansion of Off-Balance-Sheet Items
• The Problem of Book-Value Accounting and “Window Dressing”
• Components of the Income Statement: Revenues and Expenses
• Appendix: Sources of Information on the Financial-Services Industry
5–1 Introduction
The particular services each financial firm chooses to offer and the overall size of each
financial-service organization are reflected in its financial statements. Financial statements
are literally a “road map” telling us where a financial firm has been in the past, where it is
now, and, perhaps, where it is headed in the future. They are invaluable guideposts that
can, if properly constructed and interpreted, signal success or disaster. Unfortunately, much
the same problems with faulty and misleading financial statements that placed Enron and
Lehman Brothers in the headlines not long ago have also visited some financial-service
providers, teaching us to be cautious in reading and interpreting the financial statements
financial-service providers routinely publish.
The two main financial statements that managers, customers (particularly large deposi-
tors not fully protected by deposit insurance), and the regulatory authorities rely upon are
the balance sheet (Report of Condition) and the income statement (Report of Income). We
will examine these two important financial reports in depth in this chapter. Finally, we
explore some of the similarities and some of the differences between bank financial state-
ments and those of their closest competitors.
129
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130 Part Two Financial Statements and Financial-Firm Performance
5–2 An Overview of Balance Sheets and Income Statements

The two most important financial statements for a banking firm—its balance sheet, or
Report of Condition, and its income and expense statement, or Report of Income—may
be viewed as a list of financial inputs and outputs, as Table 5–1 shows. The Report of Con-
dition shows the amount and composition of funds sources (financial inputs) drawn upon
to finance lending and investing activities and how much has been allocated to loans,
securities, and other funds uses (financial outputs) at any given point in time.
In contrast, the financial inputs and outputs on the Report of Income show how much
it has cost to acquire funds and to generate revenues from the uses the financial firm has
made of those funds. These costs include interest paid to depositors and other creditors of
the institution, the expenses of hiring management and staff, overhead costs in acquiring
and using office facilities, and taxes paid for government services. The Report of Income
also shows the revenues (cash flow) generated by selling services to the public, including
making loans and servicing customer deposits. Finally, the Report of Income shows net
earnings after all costs are deducted from the sum of all revenues, some of which will be
reinvested in the financial firm for future growth and some of which will flow to stock-
holders as dividends.
TABLE 5–1 The Balance Sheet (Report of Condition)

Key Items on Bank
Financial Statements Assets—Uses of Funds Liabilities & Equity—Sources of
(includes financial outputs) Funds (includes financial inputs)
Cash and deposits in other institutions (primary reserves) (C) Deposits (demand, NOWs, money market,
Securities to provide liquidity (secondary reserves) and for savings, and time) (D)
investment (the income-generating portion) (S) Nondeposit borrowings (NDB)
Loans and leases (L) Equity capital from shareholders (stock,
Miscellaneous assets (buildings, equipment, etc.) (MA) surplus, and retained earnings) (EC)
Note: Total sources of funds must equal total uses of funds (Total assets 5 Total liabilities 1 Equity capital).
The Income Statement or Statement of Earnings and Expenses (Report of Income)

Revenues (financial outputs from making use of funds and other resources to produce and sell
services)
Interest income from loans and security investments
Noninterest income (fee income from miscellaneous sources)
Expenses (financial inputs—the cost of acquiring funds and other resources needed for the
sale of services)
Interest paid on deposits
Interest paid on nondeposit borrowings
Salaries and wages (employee compensation)
Overhead expense
Provision for possible loan losses (allocations to reserves for loan losses)
Miscellaneous expenses
Pretax net operating income (revenues – expenses listed above)
Taxes
Gains or losses from trading in securities
Net income (Pretax net operating income – taxes + securities gains – securities losses)
Note: Total revenues minus Total expenses equal Net earnings (Net income).
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Chapter Five The Financial Statements of Banks and Their Principal Competitors 131
5–3 The Balance Sheet (Report of Condition)

The Principal Types of Accounts
A balance sheet, or Report of Condition, lists the assets, liabilities, and equity capital
(owners’ funds) held by or invested in a bank or other financial firm on any given date.
Because financial institutions are simply business firms selling a particular kind of product,
the basic balance sheet identity
Assets 5 Liabilities 1 Equity capital (5–1)
must be valid for financial-service providers, just as would be true for nonfinancial
companies.
Key Video Link For banks and other depository institutions the assets on the balance sheet are of four
@ http://www major types: cash in the vault and deposits held at other depository institutions (C),
.khanacademy.org/
government and private interest-bearing securities purchased in the open market (S),
video/introduction-
to-balance- loans and lease financings made available to customers (L), and miscellaneous assets
sheets?playlist=Finance (MA). Liabilities fall into two principal categories: deposits made by and owed to various
get back to the basics customers (D) and nondeposit borrowings of funds in the money and capital markets
and hear descriptions (NDB). Finally, equity capital represents long-term funds the owners contribute (EC).
of Assets, Liabilities,
(See Table 5–1.) Therefore, the balance sheet identity for a depository institution can be
and Equity in the
context of an individual written:
purchasing a home.
C 1 S 1 L 1 MA 5 D 1 NDB 1 EC (5–2)
Cash assets (C) are designed to meet the financial firm’s need for liquidity (i.e.,
immediately spendable cash) in order to meet deposit withdrawals, customer demands
for loans, and other unexpected or immediate cash needs. Security holdings (S) are
a backup source of liquidity and include investments that provide a source of income.
Loans (L) are made principally to supply income, while miscellaneous assets (MA) are
usually dominated by fixed assets (plant and equipment) and investments in subsidiaries
(if any). Deposits (D) are typically the main source of funding for banks, and comparable
institutions with nondeposit borrowings (NDB) carried out mainly to supplement depos-
its and provide the additional liquidity that cash assets and securities cannot provide.
Finally, equity capital (EC) supplies the long-term, relatively stable base of financial
support upon which the financial firm will rely to grow and to cover any extraordinary
losses it incurs.
One useful way to view the balance sheet identity is to note that liabilities and equity
capital represent accumulated sources of funds, which provide the needed spending power
to acquire assets. A bank’s assets, on the other hand, are its accumulated uses of funds,
which are made to generate income for its stockholders, pay interest to its depositors, and
compensate its employees for their labor and skill. Thus, the balance sheet identity can be
pictured simply as:
Key URL
Key financial reports for
all publicly traded Accumulated uses Accumulated sources
companies are available of funds 5 of funds (5–3)
through Edgar at (assets) (liabilities and equity capital)
www.sec.gov.
Clearly, each use of funds must be backed by a source of funds, so that accumulated uses of
funds must equal accumulated sources of funds.
Of course, in the real world, balance sheets vary both in composition and complexity.
For instance, if you visit the FDIC’s Statistics for Depository Institutions (SDI) website,
you can generate the Report of Condition for a bank or for an aggregation of all banks
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TABLE 5–2 Balance Sheet & Other JP Morgan Chase BB&T Corp.
Highlighted Bank
Financial Data ($ million) (12/31/2009) (12/31/2009)
Financial Data
($ million) from Money market assets $ 854,899 $ 28,408
Investment securities 357,740 33,752
the FDIC (December
Commercial loans 112,816 14,351
31, 2009) Other loans 706,534 89,253
Total assets 2,031,989 165,764
Demand deposits 57,802 5,098
Time deposits 127,681 38,418
Long-term debt 56,109 7,970
Common equity 165,365 16,191
belonging to a holding company. On the other hand, you could go to the holding com-
pany’s website or the website of the U.S. Securities and Exchange Commission (www.sec
.gov) and access the balance sheet for the entire financial-services organization. These bal-
ance sheets are more complicated than the simple sources and uses statement we have just
discussed because each item on the balance sheet usually contains several components.
If you are looking for the simple highlights of a balance sheet for an individual finan-
cial firm, a good place to start is Standard & Poors’ Stock Report or, for banks in particu-
lar, government agency reports like those provided in the United States by the Board of
Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation.
In Table 5–2 you will find many of the key balance sheet items just discussed as reported
by the Federal Reserve Board for two very large U.S. financial-service corporations—
JP Morgan Chase & Co., based in New York City, and BB&T Corporation, based in
Winston-Salem, North Carolina. JP Morgan, one of the largest bank holding companies
in the world with more than $2 trillion in assets at the close of 2009, is compared with
BB&T Corp., which is among the largest domestic U.S. bank holding companies with
assets of more than $165 billion. BB&T is used in several of this text’s subsequent chapters
to illustrate real-world banking data.
In Table 5–3 you will find bank holding company data collected from the FDIC’s SDI
website for BB&T. The balance sheet figures reported by the FDIC for BB&T usually dif-
fer somewhat from the figures presented in Standard & Poor’s Stock Report, reflecting
in part differences in the components of the BB&T holding company that are included
in each report. For example, the FDIC report—a goverment report—includes only the
FDIC-insured bank affiliate. Let’s take a closer look at the principal components of this
banking firm’s Report of Condition.
Assets of the Banking Firm

Cash and Due from Depository Institutions The first asset item normally listed
on a banking firm’s Report of Condition is cash and due from depository institutions. This
item includes cash held in the bank’s vault, any deposits placed with other depository
institutions (usually called correspondent deposits), cash items in the process of collection
(mainly uncollected checks), and the banking firm’s reserve account held with the Fed-
eral Reserve bank in the region. The cash and due from depository institutions account is
also referred to as primary reserves. This means that these assets are the first line of defense
against customer deposit withdrawals and the first source of funds to look to when a cus-
tomer comes in with a loan request. Normally, banks strive to keep the size of this account
as low as possible, because cash balances earn little or no interest income. Note that the
$1.6 billion in cash and due from other depository institutions listed in Table 5–3 for
BB&T Corporation represented only about 1 percent of its total assets of $165.76 billion
as of December 31, 2009.
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TABLE 5–3 BB&T Corporation

Report of Condition
(Balance Sheet) for Financial data is from the FDIC website for the Bank Holding Company. The dollar amounts represent
BB&T (Year-End combined amounts for all FDIC-insured bank and thrift subsidiaries and do not reflect nondeposit
2008 and 2009) subsidiaries or parent companies.
Date
Source: Federal Deposit
Insurance Corporation. Report of Condition (Note: Dollar figures in thousands) 12/31/2009 12/31/2008
Total assets $165,764,218 $152,015,025
Cash and due from depository institutions 1,623,978 1,686,586
Securities 33,252,255 32,363,928
Federal funds & reverse repurchase agreements 397,592 350,380
Gross loans and leases 106,207,386 98,668,626
(less) Loan loss allowance 2,600,670 1,574,079
(less) Unearned income 0 54,244
Net loans and leases 103,606,716 97,094,547
Trading account assets 1,098,289 1,187,305
Bank premises and fixed assets 1,582,808 1,580,037
Other real estate owned 1,623,417 558,263
Goodwill and miscellaneous other assets 21,681,734 16,112,189
Total liabilities and capital $165,764,218 $152,015,025
Total liabilities 149,523,597 135,933,616
Total deposits 114,991,286 98,655,439
Federal funds purchased & repurchase agreements 2,767,917 3,012,481
Trading liabilities 734,048 888,386
Other borrowed funds 17,310,621 16,315,465
Key URLs Subordinated debt 7,969,692 7,612,589
Among the most All other liabilities 5,750,483 9,449,306
complete sources for
Total equity capital $ 16,190,879 $ 16,037,182
viewing the financial Perpetual preferred stock 0 3,082,340
statements of individual Common stock 3,448,749 2,796,242
banks in the United Surplus 5,620,340 3,509,911
States are www4.fdic Undivided profits (retained earnings) 7,539,696 7,380,465
.gov/sdi and www.ffiec Miscellaneous equity capital components 2417,906 2731,776
.gov/nic/.
Investment Securities: The Liquid Portion A second line of defense to meet

demands for cash is liquid security holdings, often called secondary reserves or referenced
on regulatory reports as “investment securities available for sale.” These typically include
holdings of short-term government securities and privately issued money market securities,
including interest-bearing time deposits held with other banking firms and commercial
paper. Secondary reserves occupy the middle ground between cash assets and loans, earn-
ing some income but also held for the ease with which they can be converted into cash on
short notice. In Table 5–3, some portion of the $33.25 billion shown as securities held by
this banking firm in 2009 will serve as a secondary reserve to help deal with liquidity needs.
Investment Securities: The Income-Generating Portion Bonds, notes, and other

securities held primarily for their expected rate of return or yield are known as the income-
generating portion of investment securities. (These are often called held-to-maturity securi-
ties on regulatory reports.) Frequently investments are divided into taxable securities—for
example, U.S. government bonds and notes, securities issued by various federal agencies
(such as the Federal National Mortgage Association, or Fannie Mae), and corporate bonds
and notes—and tax-exempt securities, which consist principally of state and local govern-
ment (municipal) bonds. The latter generate interest income that is exempt from federal
income taxes.
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Investment securities may be recorded on the books of a banking firm at their original
cost or at market value, whichever is lower. Of course, if interest rates rise after the securi-
ties are purchased, their market value will be less than their original cost (book value).
Therefore, banks that record securities on their balance sheets at cost often include a par-
enthetical note giving the securities’ current market value. Accounting rules for banking
firms are changing—the trend is toward replacing original or historical cost figures with
current market values.
Trading Account Assets Securities purchased to provide short-term profits from

short-term price movements are not included in “Securities” on the Report of Condition.
They are reported as trading account assets. In Table 5–3, about $1.10 billion is reported
for BB&T. If the banking firm serves as a securities dealer, securities acquired for resale are
included here. The amount recorded in the trading account is valued at market.
Federal Funds Sold and Reverse Repurchase Agreements A type of loan account
listed as a separate item on the Report of Condition is federal funds sold and reverse repurchase
agreements. This item includes mainly temporary loans (usually extended overnight, with
the funds returned the next day) made to other depository institutions, securities dealers, or
even major industrial corporations. The funds for these temporary loans often come from
the reserves a bank has on deposit with the Federal Reserve Bank in its district—hence
the name federal funds, or, more popularly, “fed funds.” Some of these temporary credits are
extended in the form of reverse repurchase (resale) agreements (RPs) in which the banking
firm acquires temporary title to securities owned by the borrower and holds those securities
as collateral until the loan is paid off (normally after only a few days). In Table 5–3 BB&T
posted fed funds and reverse RPs of $398 million at year-end 2009.
Loans and Leases By far the largest asset item is loans and leases, which often account
for half to almost three-quarters of the total value of all bank assets. A bank’s loan account
typically is broken down into several groups of similar type loans. For example, one com-
monly used breakdown is by the purpose for borrowing money. In this case, we may see
listed on a banking firm’s balance sheet the following loan types:
1. Commercial and industrial (or business) loans.
2. Consumer (or household) loans; on regulatory reports these are referenced as Loans to
Individuals.
3. Real estate (or property-based) loans.
4. Financial institutions loans (such as loans made to other depository institutions as well
as to nonbank financial institutions).
5. Foreign (or international) loans (extended to foreign governments and institutions).
6. Agricultural production loans (or farm loans, extended primarily to farmers and ranch-
ers to harvest crops and raise livestock).
7. Security loans (to aid investors and dealers in their security trading activities).
8. Leases (usually consisting of the bank buying equipment for its business customers and
making that equipment available for the customer’s use for a stipulated period of time
in return for a series of rental payments—the functional equivalent of a regular loan).
As we will see in Chapter 16, loans can be broken down in other ways, too, such as by
maturity (i.e., short-term versus long-term), by collateral (i.e., secured versus unsecured),
or by their pricing terms (i.e., floating-rate versus fixed-rate loans).
The two loan figures—gross loans and leases and net loans and leases—nearly always
appear on bank balance sheets. The larger of the two, gross loans and leases, is the sum of
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Another Way of Classifying Banks: By the

Types of Assets They Hold
Recently the Federal Deposit Insurance Corporation and other regulatory agencies have been group-
ing depository institutions (DIs) by the make-up of their assets. The table below illustrates the differ-
ent types of U.S. FDIC-Insured DIs grouped by the types of assets they hold (Asset Concentrations):
Number of U.S.
Type of Bank Definition DIs in 2010*
International Assets over $10 billion with more than 25% of
assets in foreign offices 4
Agricultural Over 25% of total loans and leases in agricultural
loans and real estate loans secured by farmland 1,553
Credit Card Credit card loans and securitized receivables
over 50% of assets plus securitized receivables 21
Commercial Lenders Commercial and industrial loans and loans secured
by commercial real estate over 25% of total assets 4,355
Mortgage Lenders Residential mortgage loans and mortgage-backed
securities over 50% of total assets 745
Consumer Lenders Loans to individuals (including residential
mortgages and credit card loans) over 50% of
total assets 75
Other Specialized Assets under $1 billion and loans and leases less
than 40% of total assets 304
All Other Significant lending activity with no identified
asset concentrations 813
Total of All U.S. FDIC-Insured Depository Institutions, First Quarter 2010 7,932
Source: Federal Deposit Insurance Corporation, FDIC Quarterly, Vol. 4, No. 2.

*Figures are of the first quarter of 2010.
all outstanding IOUs owed to the banking firm, including net loans and leases plus loan
loss allowance. In Table 5–3 gross loans and leases amounted to $106.21 billion in the
Factoid most recent year, or about 65 percent of its total assets.
Did you know that the
total financial assets of Loan Losses The gross loan figure of $106.21 billion encompassed $103.61 billion in
the commercial banking net loans and leases plus $2.60 billion in loan loss allowance. Loan losses, both current and
industry operating in
the United States in
projected, are deducted from the amount of gross loans and leases. Under current U.S.
2011, totaling more tax law, depository institutions are allowed to build up a reserve for future loan losses,
than $14 trillion called the allowance for loan losses (ALL), from their flow of income based on their recent
based on data from loan-loss experience. The ALL, which is a contra-asset (negative) account, represents an
the US Flow of Funds accumulated reserve against which loans declared to be uncollectible can be charged off.
Accounts, first quarter
2011, was more than
This means that bad loans normally do not affect current income. Rather, when a loan is
twice the financial considered uncollectible, the accounting department will write (charge) it off the books
assets held by the by reducing the ALL account by the amount of the uncollectible loan while simultane-
entire thrift industry ously decreasing the asset account for gross loans.
(including savings For example, suppose a bank granted a $10 million loan to a property development com-
and loan associations,
savings banks, money
pany to build a shopping center and the company subsequently went out of business. If the
market funds, and credit bank could reasonably expect to collect only $1 million of the original $10 million owed, the
unions combined)? unpaid $9 million would be subtracted from total (gross) loans and from the ALL account.
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Key URL The allowance for possible loan losses is built up gradually over time by annual deduc-
The National tions from current income. These deductions appear on the banking firm’s income and
Information Center,
expense statement (or Report of Income) as a noncash expense item called the provision
which supplies financial
reports for bank holding for loan losses (PLL). For example, suppose a banking firm anticipated loan losses this year
companies, banks, of $1 million and held $100 million already in its ALL account. It would take a non-
savings and loan cash charge against its current revenues, entering $1 million in the provision for loan loss
associations, credit account (PLL) on its Report of Income. Thus:
unions, and
international banking
organizations, is Amount reported on the income and expense sttatement
reachable at Annual provision for loan loss expeense (PLL) $1 million, a noncash expense ittem
www.ffiec.gov/
nicpubweb/nicweb/
deducted from current revenues
nichome.aspx. ↓ Then adjust the banking firm’s balance sheet, in its ALL account, as follows:
Allowance for loan losses (ALL) 5 $100 million 1 $1 million (from PLL on the
current income and expense statement)
5 $101 million
Now suppose the bank subsequently discovers that its truly worthless loans, which
must be written off, total only $500,000. Then we would have:
Beginning balance in the allowance for

loan loss account (ALL) 5 $100 million
1 This year’s provision for loan losses (PLL) 5 1 $1 million
5 Adjusted allowance for loan losses (ALL) 5 $101 million
2 Actual charge-offs of worthless loans 2 $0.5 million
5 Net allowance for loan losses (ALL) 5 $100.5 million
after all charge-offs
At about the same time suppose that management discovers it has been able to recover
some of the funds (say $1.5 million) that it had previously charged off as losses on earlier
loans. Often this belated cash inflow arises because the banking firm was able to take pos-
session of and then sell the collateral that a borrower had pledged behind a defaulted loan.
These so-called recoveries, then, are added back to the allowance for loan loss account
(ALL) as follows:
Net allowance for loan losses (ALL) after all charge-offs 5 $100.5 million
1 Recoveries from previously charged-off loans 5 1 $1.5 million
5 Ending balance in the allowance for loan loss account (ALL) 5 $102.0 million
If writing off a large loan reduces the balance in the ALL account too much, manage-
ment will be called upon (often by examiners representing its principal regulatory agency)
to increase the annual PPL deduction (which will lower its current net income) in order
to restore the ALL to a safer level. Additions to ALL are usually made as the loan port-
folio grows in size, when any sizable loan is judged to be completely or partially uncol-
lectible, or when an unexpected loan default occurs that has not already been reserved.
The required accounting entries simply increase the contra-asset ALL and the expense
account PLL. The total amount in the loan loss reserve (ALL) as of the date of the Report
of Condition is then deducted from gross loans to help derive the account entry called
net loans on the banking firm’s balance sheet—a measure of the net realizable value of all
loans outstanding.
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Specific and General Reserves Many financial firms divide the ALL account into
two parts: specific reserves and general reserves. Specific reserves are set aside to cover a
particular loan or loans expected to be a problem or that represent above-average risk.
Management may simply designate a portion of the reserves already in the ALL account
as specific reserves or add more reserves to cover specific loan problems. The remain-
ing reserves in the loan loss account are called general reserves. This division of loan loss
reserves helps managers better understand their institutions need for protection against
current or future loan defaults. (See especially Walter [7] and O’Toole [5].)
Reserves for loan losses are determined by management; however, they are influenced
by tax laws and government regulations. The Tax Reform Act of 1986 mandated that
only loans actually declared worthless could be expensed through the loan loss provision
(PLL) expense item for large banking companies (with assets over $500 million) for tax
purposes. This has motivated a backward-looking rather than a forward-looking process.
In Chapter 15, we will see that total loan loss reserves (the ALL account) are counted
as supplemental capital up to 1.25 percent of a bank’s total risk-weighted assets. How-
ever, retained earnings (undivided profits) are counted fully as permanent capital. This
difference in regulatory treatment encourages management to build retained earnings at
the cost of the ALL account. Thus the dollar amount expensed through PLL and allo-
cated to the ALL account on the balance sheet is influenced by tax laws and government
regulations.1
International Loan Reserves The largest U.S. banks that make international loans
to lesser-developed countries are required to set aside allocated transfer-risk reserves (ATRs).
ATRs were created to help American banks deal with possible losses on loans made to
lesser-developed countries. Like the ALL account, the ATR is deducted from gross loans
to help determine net loans. These international-related reserve requirements are estab-
lished by the Intercountry Exposure Review Committee (ICERC), which consists of rep-
resentatives from the Federal Deposit Insurance Corporation, the Federal Reserve System,
and the Comptroller of the Currency.
Unearned Income This item consists of interest income on loans received from cus-
tomers, but not yet earned under the accrual method of accounting banks use today. For
example, if a customer receives a loan and pays all or some portion of the interest up
front, the banking firm cannot record that interest payment as earned income because the
customer involved has not yet had use of the loan for any length of time. Over the life of
1
The loan-loss reserve accounting method used in the United States, labeled LLR and described recently by Balla and
McKenna [1], appears to have ushered in a bundle of problems and encouraged experts to search for greater stability in
calculating bank loan-loss reserves. The current LLR method tends to increase loan-loss expense when the economy is
headed down into a recession and to reduce loan-loss expense when the economy is upward bound. Thus, the current
method seems to accentuate the business cycle, driving loan losses upward and earnings downward in a weakening
economy and doing just the opposite in a strengthening economy. Loan officers often seem to forget past recessions
and loan extravagantly when the economy is soaring, but run for cover, creating a credit crunch, when economic
conditions are stumbling. This behavior seemed especially evident during the 2007–2009 great recession when lenders
drastically shut down the spigot of credit. Many banks failed as the result of loan shortages that deepened economic
troubles.
Recently Spain began experimenting with a different loan-loss expensing method, sometimes called dynamic or
countercyclical provisioning (DP). It uses historical statistical methods to help even out loan-loss calculations over time
through quarterly adjustments. DP primarily has to do with the timing of loan-loss provisioning rather than its amount.
It encourages management to build up loan-loss reserves in good times and decrease them in adverse times. There is
interest in such an approach in the United States, though differences with Spain’s system might lead to problems in
implementation.
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the loan, the bank will gradually earn the interest income and will transfer the necessary
amounts from unearned discount to the interest income account.
Nonperforming (Noncurrent) Loans Banks have another loan category on their

books called nonperforming (noncurrent) loans, which are credits that no longer accrue
interest income or that have had to be restructured to accommodate a borrower’s changed
circumstances. A loan is placed in the nonperforming category when any scheduled loan
Key URL repayment is past due for more than 90 days. Once a loan is classified as “nonperforming,”
To view the services any accrued interest recorded on the books, but not actually received, must be deducted
offered and the recent from loan revenues. The bank is then forbidden to record any additional interest income
financial history of the
from the loan until a cash payment actually comes in.
Bank of America, one
of the best known and
largest banks in the
Bank Premises and Fixed Assets Bank assets also include the net (adjusted for
United States, see depreciation) value of buildings and equipment. A banking firm usually devotes only a
www.bankofamerica small percentage (less than 2 percent) of its assets to the institution’s physical plant—
.com. that is, the fixed assets represented by buildings and equipment needed to carry on daily
operations. In Table 5–3 BB&T has only about 1 percent of its assets ($1.58 billion)
devoted to premises and fixed assets. Indeed, the great majority of a bank’s assets are
financial claims (loans and investment securities) rather than fixed assets. However,
fixed assets typically generate fixed operating costs in the form of depreciation expenses,
property taxes, and so on, which provide operating leverage, enabling the institution to
boost its operating earnings if it can increase its sales volume high enough and earn more
from using its fixed assets than those assets cost. But with so few fixed assets relative to
other assets, banks cannot rely heavily on operating leverage to increase their earnings;
they must instead rely mainly upon financial leverage—the use of borrowed funds—to
boost their earnings and remain competitive with other industries in attracting capital.
Other Real Estate Owned (OREO) This asset category includes direct and indi-
rect investments in real estate. When bankers speak of OREOs, they are not talking about
two chocolate cookies with sweet white cream in the middle! The principal component
of OREO is commercial and residential properties obtained to compensate for nonper-
forming loans. While “kids” may want as many Oreos as possible, bankers like to keep the
OREO account small by lending funds to borrowers who will make payments in a timely
fashion.
Intangible and Miscellaneous (“Other”) Assets Most banking firms have some
purchased assets lacking physical substance but still generating income for the banks hold-
ing them. The most familiar of these intangibles is goodwill, which occurs when one firm
acquires another and pays more than the market value of the acquired firm’s net assets
(i.e., all its assets less all its liabilities). Other intangible assets include mortgage loan
Factoid
What U.S. financial- servicing rights and purchased credit card relationships that generate extra income for the
service industry comes financial firm managing aspects of these loans on behalf of another lending institution.
closest in total financial Near the bottom of the balance sheet on the asset side are other or miscellaneous
assets to the banking assets. This account typically includes investments in subsidiary firms, customers’ liabil-
industry?
ity on acceptances outstanding, income earned but not collected on loans, net deferred
Answer: Mutual funds
with about $8 trillion tax assets, excess residential mortgage servicing fees, and any remaining assets. If we add
in combined financial intangibles and miscellaneous assets together for BB&T and many other banks of compa-
assets early in 2011 rable size these residual assets may reach close to 10 percent of assets or even more.
from US Flow of Funds
Accounts, and private Liabilities of the Banking Firm
pension funds with
about $6 trillion in Deposits The principal liability of any bank is its deposits, representing financial claims
assets. held by businesses, households, and governments against the banking firm. In the event
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a bank is liquidated, the proceeds from the sale of its assets must first be used to pay off
the claims of its depositors (along with the IRS!). Other creditors and the stockholders
receive whatever funds remain. There are five major types of deposits:
1. Noninterest-bearing demand deposits, or regular checking accounts, generally permit

unlimited check writing. But, under federal regulations, they cannot pay any explicit
interest rate (though many banks offer to pay postage costs and offer other “free” ser-
vices that yield the demand-deposit customer an implicit rate of return).
2. Savings deposits generally bear the lowest rate of interest offered to depositors but may
be of any denomination (though most depository institutions impose a minimum size
requirement) and permit the customer to withdraw at will.
3. NOW accounts, which can be held by individuals and nonprofit institutions, bear inter-
est and permit drafts (checks) to be written against each account to pay third parties.
4. Money market deposit accounts (MMDAs) can pay whatever interest rate the offering
institution feels is competitive and have limited check-writing privileges attached.
No minimum denomination or maturity is required by law, though depository insti-
tutions must reserve the right to require seven days’ notice before any withdrawals
are made.
5. Time deposits (mainly certificates of deposit, or CDs) usually carry a fixed maturity
(term) and a stipulated interest rate but may be of any denomination, maturity, and
yield agreed upon by the offering institution and its depositor. Included are large
($100,000-plus) negotiable CDs—interest-bearing deposits that depository institutions
use to raise money from their most well-to-do customers.
The bulk of deposits are held by individuals and business firms. However, governments
(federal, state, and local) also hold substantial deposit accounts, known as public fund
deposits. Any time a school district sells bonds to construct a new school building, for
example, the proceeds of the bond issue will flow into its deposit in a local depository
institution. Similarly, when the U.S. Treasury collects taxes or sells securities to raise
funds, the proceeds normally flow initially into public deposits that the Treasury has
established in thousands of depository institutions across the United States. Major banks
also draw upon their foreign branch offices for deposits and record the amounts received
from abroad simply as deposits at foreign branches.
Clearly, as Table 5–3 suggests, many banking firms are heavily dependent upon their
deposits, which today often support between 60 and 80 percent of their total assets. In
the case of the bank we are analyzing, BB&T, total deposits of about $115 billion funded
almost 70 percent of its assets in the most recent year. Because these financial claims of
the public are often volatile and because they are so large relative to the owners’ capital
(equity) investment in the banking firm, the average depository institution has consider-
able exposure to failure risk. It must continually stand ready (be liquid) to meet deposit
withdrawals. These twin pressures of risk and liquidity force bankers to exercise caution
in their choices of loans and other assets. Failure to do so threatens the institution with
collapse under the weight of depositors’ claims.
Borrowings from Nondeposit Sources Although deposits typically represent the

largest portion of funds sources for many banks, sizable amounts of funds also stem from
miscellaneous liability accounts. All other factors held equal, the larger the depository
institution, the greater use it tends to make of nondeposit sources of funds. One reason
borrowings from nondeposit funds sources have grown rapidly in recent years is that
there are no reserve requirements or insurance fees on most of these funds, which lowers
the cost of nondeposit funding. Also, borrowings in the money market usually can be
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arranged in a few minutes and the funds wired immediately to the depository institution
that needs them. One drawback, however, is that interest rates on nondeposit funds are
highly volatile. As the great recession and credit crisis of 2007–2009 showed us, if there
is even a hint of financial problems at an institution trying to borrow from these sources,
its borrowing costs can rise rapidly, or money market lenders may simply refuse to extend
it any more credit.
Key Video Link The most important nondeposit funding source for most depository institutions, typi-
@ http://www cally, is represented by federal funds purchased and repurchase agreements. This account
.youtube.com/user/
tracks temporary borrowings in the money market, mainly from reserves loaned by
bionicturtledotcom#p/
u/30/wvXp8R77XF0 other institutions (federal funds purchased) or from repurchase agreements in which
see bionic turtle’s the financial firm has borrowed funds collateralized by some of its own securities from
detailed presentation another institution. Other borrowed funds that may be drawn upon include short-term
of what is a repurchase borrowings such as borrowing reserves from the discount windows of the Federal Reserve
agreement?
banks, issuing commercial paper, or borrowing in the Eurocurrency market from multinational
banks. In the worldwide banking system, Eurocurrency borrowings (i.e., transferable time
deposits denominated in a variety of currencies) represent the principal source of short-
term borrowings by banks. Many banks also issue long-term debt, including real estate
mortgages, for the purpose of constructing new office facilities or modernizing plant and
equipment. Subordinated debt (notes and debentures) are yet another source of funds
that are identified on the Report of Condition. This category includes limited-life pre-
ferred stock (that is, preferred stock that eventually matures) and any noncollateralized
borrowings. The other liabilities account serves as a catch-all of miscellaneous amounts
owed, such as a deferred tax liability and obligations to pay off investors who hold bank-
ers’ acceptances.
Equity Capital for the Banking Firm The equity capital accounts on a depository
institution’s Report of Condition represent the owners’ (stockholders’) share of the busi-
ness. Every new financial firm begins with a minimum amount of owners’ capital and then
borrows funds from the public to “lever up” its operations. In fact, financial institutions are
among the most heavily leveraged (debt-financed) of all businesses. Their equity (own-
ers’) capital accounts normally represent less than 10 percent of the value of their total
assets. In the case of BB&T, whose balance sheet appears in Table 5–3, the equity capital of
$16.19 billion in 2009 accounted for just under 10 percent of its total assets.
Bank capital accounts typically include many of the same items that other business
corporations display on their balance sheets. They list the total par (face) value of com-
mon stock outstanding. When that stock is sold for more than its par value, the excess
market value of the stock flows into a surplus account. Not many banking firms issue
preferred stock, which guarantees its holders an annual dividend before common stock-
holders receive any dividend payments. However, the bail-out plan that emerged during
the 2007–09 credit crisis included a program to get many U.S. banks to build up their
preferred stock position in order to strengthen their capital. Preferred stock is generally
viewed in the banking community as expensive to issue, principally because the annual
dividend is not tax deductible, and as a drain on earnings that normally would flow to
stockholders, though the largest bank holding companies have issued substantial amounts
of preferred shares in recent years.
Usually, the largest item in the capital account is retained earnings (undivided profits),
which represent accumulated net income left over each year after payment of stockholder
dividends. There may also be a contingency reserve held as protection against unfore-
seen losses, treasury stock that has been retired, and other (miscellaneous) equity capital
components.
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TABLE 5–4 The Composition of Bank Balance Sheets (Percentage Mix of Sources and Uses of Funds for
Year-End 2009)
Source: Federal Deposit Insurance Corporation.
Percentage of Total Assets for:
U.S. Banks U.S. Banks U.S. Banks

All U.S. with Less than with $100 Million with More than
Insured $100 Million in to $1 Billion in $1 Billion in
Assets, Liabilities, and Equity Capital Items Banks Total Assets Total Assets Total Assets
Total assets 100.00% 100.00% 100.00% 100.00%
Cash and due from depository institutions 8.25 8.99 6.50 8.42
Interest-bearing balances 6.46 5.09 4.22 6.71
Securities 18.57 21.46 18.74 18.52
Federal funds sold & reverse repurchase agreements 3.39 3.30 1.76 3.56
Net loans & leases 53.04 60.79 66.48 51.52
Loan loss allowance 1.80 1.05 1.30 1.87
Trading account assets 5.96 0.00* 0.05 6.66
Bank premises and fixed assets 0.93 1.82 1.94 0.82
Other real estate owned 0.30 0.68 0.09 0.24
Goodwill and other intangibles 3.44 0.33 0.52 3.78
All other assets 6.11 2.62 3.11 6.48
Life insurance assets 0.94 0.57 0.80 0.96
Total liabilities and capital 100.00 100.00 100.00 100.00
Total liabilities 88.78 88.40 90.36 88.63
Total deposits 70.36 84.17 82.61 68.84
Interest-bearing deposits 57.13 70.30 70.76 55.53
Deposits held in domestic offices 57.44 84.17 82.53 54.50
% insured (estimated) 53.55 89.01 83.12 49.39
Federal funds purchased & repurchase agreements 4.65 0.60 1.81 5.01
Trading liabilities 2.14 0.00* 0.00* 2.39
Other borrowed funds 7.86 3.02 5.06 8.22
Subordinated debt 1.31 0.00* 0.06 1.45
All other liabilities 2.46 0.61 0.72 2.66
Equity capital 11.22 11.60 9.74 11.18
Perpetual preferred stock 0.05 0.0* 0.06 0.05
Common stock 0.39 1.84 1.14 0.29
Surplus 8.39 5.43 4.83 8.80
Undivided profits 2.22 4.28 3.71 2.03
Note: Totals may not exactly equal 100 percent due to rounding.
*Less than 0.005.
Comparative Balance Sheet Ratios for Different Size Banks

The items discussed previously generally appear on all bank balance sheets, regardless of
size. But the relative importance of each balance sheet item varies greatly with bank size.
A good illustration of how bank size affects the mix of balance sheet items is shown in
Table 5–4. For example, larger banks tend to trade securities for short-term profits while
smaller, community-oriented banks do not. Smaller banks hold more investment securi-
ties and loans relative to assets than larger depository institutions. Smaller community
banks rely more heavily on deposits to support their assets than do larger depository insti-
tutions, while larger institutions make heavier use of money market borrowings (such as
the purchase of Eurocurrencies or federal funds). Clearly, the analyst examining a bank’s
financial condition must consider the size of the institution and compare it to other insti-
tutions of the same size and serving a similar market.
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Recent Expansion of Off-Balance-Sheet Items in Banking

The balance sheet, although a good place to start, does not tell the whole story about a
financial firm. For more of the story we must turn to “off-balance-sheet items” that will
be explored in greater detail in Chapters 8 and 9. Financial firms offer their customers a
number of fee-based services that normally do not show up on the balance sheet. Promi-
nent examples of these off-balance-sheet items include:
Factoid 1. Unused loan commitments, in which a lender receives a fee to lend up to a certain
Other than commercial amount of money over a defined period of time; however, these funds have not yet
banks what financial-
been transferred from lender to borrower.
service industry holds
the most deposits 2. Standby credit agreements, in which a financial firm receives a fee to guarantee repay-
received from the ment of a loan that a customer has received from another lender.
public?
3. Derivative contracts, in which a financial institution has the potential to make a profit
Answer: Savings and
loans and savings banks or incur a loss on an asset that it presently does not own. This category includes futures
at nearly $0.9 trillion in contracts, options, and swaps that can be used to hedge credit risk, interest rate risk,
early 2011. foreign exchange (currency) risk, commodity risk, and risk surrounding the ownership
of equity securities.
Filmtoid
What 1999 British The problem with these off-balance-sheet transactions is that they often expose a
drama tells the story financial firm to considerable risk that conventional financial reports simply won’t pick
of how one trader’s up. Unauthorized trading in derivatives has created notorious losses for financial institu-
risk exposure resulted tions around the world. For example, in 1995 Nicholas Leeson’s estimated losses from
in losses that closed
trading futures contracts amounted to $1.4 billion and led to the collapse of Barings—
the doors of England’s
oldest merchant bank, Great Britain’s 242-year-old merchant bank.
Barings? Off-balance-sheet items have grown so rapidly that, for the banking industry as a
Answer: Rogue Trader. whole, they exceed total bank assets many times over, as illustrated in Table 5–5. These
contingent contracts are heavily concentrated in the largest banks where their nominal
value recently was more than 20 times the volume of these banks’ on-balance-sheet
assets. Warning! Do not give too much relevance to the notional value of derivative con-
tracts for it is the gains or losses associated with these contracts that are important, not
their face amount. Off-balance-sheet activities can be used to either increase or decrease
a financial firm’s risk exposure.
Factoid The Financial Accounting Standard’s Board (FASB) Statement No. 133—Accounting
What has been the for Derivative Instruments and Hedging Activities—and its amendments, labeled FASB
leading source of new
138, are designed to make derivatives more publicly visible on corporate financial state-
funds for U.S. banks
thus far during the 21st ments and to capture the impact of hedging transactions on corporate earnings. Gains
century? or losses on derivative contracts must be marked to market value as they accrue, which
Answer: Savings affects a financial firm’s Report of Income and may increase the volatility of its earn-
deposits, particularly ings. Moreover, heavily regulated financial firms must connect their use of hedging con-
Money Market Deposit
tracts to actual risk exposures in their operations (thereby curbing speculative use of
Accounts.
derivatives).
The Problem of Book-Value Accounting

A broader public confidence issue concerns how bankers and other financial-firm manag-
ers have recorded the value of their assets and liabilities for, literally, generations. The
banking industry, for example, has followed the practice of recording assets and liabilities
at their original cost on the day they are posted or received. This accounting practice,
known as book-value, historical, or original cost accounting, has come under attack in recent
years. The book-value accounting method assumes all balance-sheet items will be held to
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TABLE 5–5 Examples of Off-Balance-Sheet Items Reported by FDIC-Insured Banks

Examples of Off-Balance-Sheet Items Reported by U.S.

Banks Arranged by Size Group (in thousands of dollars)
on December 31, 2009
FDIC-Insured FDIC-Insured
Banks Under Banks from FDIC-Insured
Total Volume $100 Million $100 Million to Banks Over
At All FDIC- in Total $1 Billion in $1 Billion in
Examples of Off-Balance-Sheet Items Insured Banks Assets Total Assets Total Assets
Total Unused Loan Commitments $ 5,403,446,468 $ 24,461,604 $ 266,822,358 $ 5,112,162,506
Derivatives:
Derivatives 236,362,309,107 430,238 22,852,503 236,339,026,366
Notional Amount of Credit Derivatives 14,472,182,181 0 28,014 14,472,154,167
Bank is Guarantor 7,087,433,101 0 24,499 7,087,408,602
Bank is Beneficiary 7,384,749,080 0 3,515 7,384,745,565
Interest rate contracts 196,526,148,120 422,721 22,632,044 196,503,093,355
(i.e., interest—rate swaps, futures, options)
Foreign exchange rate contracts 22,531,665,912 0 35,291 22,531,630,621
(i.e., currency swaps, commitments to purchase, and
currency options)
Contracts on other commodities and equities 2,832,312,894 7,517 157,154 2,832,148,223
(i.e., other swaps, futures, and options on commodities
and equities)
Total Off-Balance-Sheet Items Reported Here 241,765,755,575 24,891,842 289,674,861 241,451,188,872
Total Assets Shown on Balance Sheet 11,843,498,226 141,339,005 1,111,521,919 10,590,637,302
Off-balance-sheet items divided by assets (in percent) 2017% 18% 26% 2295%
maturity. It does not reflect the impact on a balance sheet of changing interest rates and
changing default risk, which affect both the value and cash flows associated with loans,
security holdings, and debt.
While we usually say that most assets are valued at historical or original cost, the tra-
ditional bank accounting procedure should really be called amortized cost. For example, if
a loan’s principal is gradually paid off over time, a bank will deduct from the original face
value of the loan the amount of any repayments of loan principal, thus reflecting the fact
that the amount owed by the borrowing customer is being amortized downward over time
as loan payments are received. Similarly, if a security is acquired at a discounted price
below its par (face) value, the spread between the security’s original discounted value and
its value at maturity will be amortized upward over time as additional income until the
security reaches maturity.
For example, if market interest rates on government bonds maturing in one year are
currently at 10 percent, a $1,000 par-value bond promising an annual interest (coupon)
rate of 10 percent would sell at a current market price of $1,000. However, if market
interest rates rise to 12 percent, the value of the bond must fall to about $980 so that the
investment return from this asset is also 12 percent.
Similarly, changes in the default risk exposure of borrowers will affect the market
value of loans. Clearly, if some loans are less likely to be repaid than was true when they
were granted, their market value must be lower. For example, a $1,000 loan for one year
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granted to a borrower at a loan rate of 10 percent must fall in market value if the bor-
rower’s financial situation deteriorates. If interest rates applicable to other borrowers in
the same higher risk class stand at 12 percent, the $1,000, one-year loan will decline
to about $980 in market value. Recording assets at their original (or historical) cost
and never changing that number to reflect changing market conditions does not give
depositors, stockholders, and other investors interested in buying the stock or debt of a
financial firm a true picture of the firm’s real financial condition. Investors could easily
be deceived.
Under the historical or book-value accounting system, interest rate changes do not
affect the value of a bank’s capital because they do not affect the value of its assets and
liabilities recorded at cost. Moreover, only realized capital gains and losses affect the book
values shown on a bank’s balance sheet. Banks can increase their current income and
their capital, for example, by selling assets that have risen in value while ignoring the
impact of any losses in value experienced by other assets still on the books.
In May 1993 FASB issued Rule 115, focused primarily upon investments in market-
able securities (i.e., stock and debt securities), probably the easiest balance sheet item
to value at market. The FASB asked banks to divide their security holdings into two
broad groups: those they planned to hold to maturity and those that may be traded
before they reach maturity. Securities a bank plans to hold to maturity could be valued
at their original cost while tradable securities could be valued at their current market
price. At the same time the Securities and Exchange Commission (SEC) asked lead-
ing banks actively trading securities to put any securities they expected to sell into
a balance sheet account labeled assets held for sale. These reclassified assets must be
valued at cost or market, whichever is lower at the time. The FASB and SEC seem
determined to eradicate “gains trading,” a practice in which managers sell securities
that have appreciated in order to reap a capital gain, but hold onto those securities
whose prices have declined and continue to value these lower-priced instruments at
their higher historical cost.
Key URL Currently, for regulatory purposes you will find securities identified as held-to-maturity
To learn more about or available-for-sale on the Report of Condition. Available-for-sale securities are reported
FASB 115 see www
at fair market value. When we examine the schedule for securities held by a banking com-
.fasb.org/st/summary/
stsum115.shtml. pany, we find that both the amortized cost and the market value are often reported.
Auditing: Assuring Reliability of Financial Statements

Key URL
To explore the concept U.S. banks (especially those holding $500 million or more in assets) are required to file
of fair market value with the FDIC and with the federal or state agency that chartered them financial state-
and how it’s measured ments audited by an independent public accountant within 90 days of the end of each fis-
see www.fasb.org/st/
summary/stsum156
cal year. Along with audited financial statements each depository institution must submit
.shtml. a statement concerning the effectiveness of its internal controls and its compliance with
safety and soundness laws. Moreover, an audit committee consisting entirely of outside
Factoid directors must review and evaluate the annual audit with management and with an inde-
Did you know that the
pendent public accountant.
volume of FDIC-insured
deposits reached a high Larger U.S. banks, with $3 billion or more in assets, must meet even more strin-
in 2010 at almost gent requirements for setting up outside audit committees, including requiring at least
$5.5 trillion? two audit committee members to have prior banking experience, prohibiting the most
significant customers from serving on such a committee, and mandating that audit com-
mittees have access to legal counsel that is independent of bank management. These
tough reporting rules are designed to prevent the FDIC’s insurance reserves from being
drained away by bank failures.
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Key Video Link Even tougher accounting and reporting rules emerged in the opening decode of the
@ http://www.youtube 21st century in the wake of the collapse of energy-trader Enron and dozens of reports of
.com/watch?v=19XA
corporate fraud. The Sarbanes-Oxley Accounting Standards Act mandates that CEOs
q7YMtmg&feature=
related hear Senator and CFOs of publicly traded corporations certify the accuracy of their institutions’ finan-
Paul Sarbanes speak cial reports. The publication of false or misleading information may be punished with
on the Sarbanes-Oxley heavy fines and even jail sentences. Internal auditing and audit committees of each
Accounting Standards institution’s board of directors are granted greater authority and independence in assess-
Act after 5 years.
ing the accuracy and quality of their institutions’ accounting and financial reporting
practices.
Concept Check
5–1. What are the principal accounts that appear on a million, privately issued money market instruments
bank’s balance sheet (Report of Condition)? of $5.2 million, deposits at the Federal Reserve
5–2. Which accounts are most important and which are banks of $20.1 million, cash items in the process
least important on the asset side of a bank’s bal- of collection of $0.6 million, and deposits placed
ance sheet? with other banks of $16.4 million. How much in pri-
5–3. What accounts are most important on the liability mary reserves does this bank hold? In secondary
side of a balance sheet? reserves?
5–4. What are the essential differences among demand 5–7. What are off-balance-sheet items, and why are
deposits, savings deposits, and time deposits? they important to some financial firms?
5–5. What are primary reserves and secondary 5–8. Why are bank accounting practices under attack
reserves, and what are they supposed to do? right now? In what ways could financial institutions
improve their accounting methods?
5–6. Suppose that a bank holds cash in its vault of $1.4
million, short-term government securities of $12.4
5–4 Components of the Income Statement (Report of Income)

An income statement, or Report of Income, indicates the amount of revenue received
and expenses incurred over a specific period of time. There is usually a close correlation
between the size of the principal items on a bank’s balance sheet (Report of Condition)
and the size of important items on its income statement. After all, assets on the balance
sheet usually account for the majority of operating revenues, while liabilities generate
many of a bank’s operating expenses.
The principal source of bank revenue generally is the interest income generated by
earning assets—mainly loans and investments. Additional revenue is provided by the fees
charged for specific services (such as ATM usage). The major expenses incurred in gene-
rating this revenue include interest paid out to depositors; interest owed on nondeposit
borrowings; the cost of equity capital; salaries, wages, and benefits paid to employees;
overhead expenses associated with the physical plant; funds set aside for possible loan
losses; and taxes owed.
The difference between all revenues and expenses is net income. Thus:
Net income 5 Total revenue items 2 Total expense items (5–4)
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Key Video Link where:

@ http://www
.khanacademy.org/
Revenue Items
video/banking-2—
a-bank-s-income-
statement?playlist= Cash assets 3 average yield on cash assets
Finance Learn more
about information 1 security investments 3 average yield on security investments
provided by a bank’s
income statement. 1 loans outstanding 3 average yield on loans
1 miscellaneous assets 3 average yield on miscellaneous assets
1 income from fees and trading account gains
Minus (–) Expense Items
Total deposits 3 average interest cost on deposits

1 nondeposit borrowings 3 average interest cost on nondeposit borrowings
1 owners’ capital 3 average cost of owners’ capital
1 employee salaries, wages, and benefits expense
1 overhead expense
1 provision for possible loan losses
1 miscellaneous expenses
1 taxes owed
The previous chart on revenue and expense items reminds us that financial firms inter-
ested in increasing their net earnings (income) have a number of options available to achieve
this goal: (1) increase the net yield on each asset held; (2) redistribute earning assets toward
those assets with higher yields; (3) increase the volume of services that provide fee income;
(4) increase fees associated with various services; (5) shift funding sources toward less-costly
borrowings; (6) find ways to reduce employee, overhead, loan-loss, and miscellaneous oper-
ating expenses; or (7) reduce taxes owed through improved tax management practices.
Of course, management does not have full control of all of these items that affect net
income. The yields earned on various assets, the revenues generated by sales of services,
and the interest rates that must be paid to attract deposits and nondeposit borrowings are
determined by demand and supply forces in the marketplace. Over the long run, the pub-
lic will be the principal factor shaping what types of loans the financial-service provider
will be able to make and what services it will be able to sell in its market area. Within the
broad boundaries allowed by competition, regulation, and the pressures exerted by public
demand, however, management decisions are still a major factor in determining the par-
ticular mix of loans, securities, cash, and liabilities each financial firm holds and the size
and composition of its revenues and expenses.
Financial Flows and Stocks

Income statements are a record of financial flows over time, in contrast to the balance
sheet, which is a statement of stocks of assets, liabilities, and equity held at any given point
in time. Therefore, we can represent the income statement as a report of financial outflows
(expenses) and financial inflows (revenues).
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TABLE 5–6 Financial data is from the FDIC website for the bank holding company. (The dollar amounts represent
Report of Income combined amounts for all FDIC-insured bank and thrift subsidiaries, and do not reflect nondeposit
(Income Statement) subsidiaries or parent companies.) Note: All figures are expressed in thousands of dollars.
for BB&T (2008 and Report of Income 2009 2008
2009)
Total interest income $7,003,404 $7,290,250 j Financial inflows
Total interest expense 2,040,010 2,968,594 j Financial outflows
Insurance Corporation.
Net interest income 4,963,394 4,321,656
Provision for loan and lease losses 2,799,398 1,423,033 j Noncash financial outflows
Total noninterest income 3,480,685 3,058,826
Fiduciary activities 138,897 147,108 ⎫
Service charges on deposit accounts 689,973 672,924 ⎢
⎬ Financial inflows
Trading account gains & fees 89,139 98,529 ⎢
Additional noninterest income 2,562,727 2,140,265 ⎭
Total noninterest expense 4,689,516 3,901,830
Salaries and employee benefits 2,516,792 2,205,380
⎫
Premises and equipment expense 579,188 512,745 ⎬ Financial outflows
Additional noninterest expense 1,593,536 1,183,705 ⎭
Pretax net operating income 1,154,511 2,125,118
Securities gains (losses) 199,346 106,532 j Financial outflows
(if negative)
Applicable income taxes 158,815 549,984 j Financial outflows
Income before extraordinary items 853,783 1,518,623
Extraordinary gains (losses)—net 0 0 j Financial inflows
Net income 853,783 1,518,623
Of course, actual income reports are usually more complicated than this simple
statement because each item may have several component accounts. Most bank income
statements, for example, closely resemble the income statement shown in Table 5–6 for
BB&T, whose balance sheet we examined earlier. Table 5–6 is divided into four main
sections: (1) interest income, (2) interest expenses, (3) noninterest income, and (4) non-
interest expenses.
Interest Income
Not surprisingly, interest earned from loans and security investments accounts for the
majority of revenues for most depository institutions and for many other lenders as well.
In the case of BB&T its $7 billion in loan and investment revenues represented almost
70 percent of its total interest and noninterest income. It must be noted, however, that
the relative importance of interest revenues versus noninterest revenues (fee income) is
changing rapidly, with fee income generally growing faster than interest income on loans
and investments as financial-service managers work hard to develop more fee-based ser-
vices. Moreover, a deep economic recession over the 2007–2009 period resulted in a sharp
decline in loan and investment interest income.
Interest Expenses
The number one expense item for a depository institution normally is interest on deposits.
For the banking company we have been following interest on deposits accounted for more
than 60 percent of this bank’s total interest costs. Another important interest expense
item is the interest owed on short-term borrowings in the money market—mainly bor-
rowings of federal funds (reserves) from other depository institutions and borrowings
backstopped by security repurchase agreements—plus any long-term borrowings that have
taken place (including mortgages on the financial firm’s property and subordinated notes
and debentures outstanding).
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Net Interest Income

Total interest expenses are subtracted from total interest income to yield net interest
income. This important item is often referred to as the interest margin, the gap between the
interest income the financial firm receives on loans and securities and the interest cost
of its borrowed funds. It is usually a key determinant of profitability. When the interest
margin falls, the stockholders of financial firms will usually see a decline in their bottom
line—net after-tax earnings—and the dividends their stockholders receive on each share
of stock held may decrease as well.
Loan Loss Expense

As we saw earlier in this chapter, another expense item that banks and selected other
financial institutions can deduct from current income is known as the provision for loan
and lease losses. This provision account is really a noncash expense, created by a simple
bookkeeping entry. Its purpose is to shelter a portion of current earnings from taxes to
help prepare for bad loans. The annual loan loss provision is deducted from current rev-
enues before taxes are applied to earnings.
Under today’s tax laws, U.S. banks calculate their loan loss deductions using
either the experience method (in which the amount of deductible loan loss expense would
be the product of the average ratio of net loan charge-offs to total loans in the most
recent six years times the current total of outstanding loans) or the specific charge-off
method, which allows them to add to loan loss reserves from pretax income each year
no more than the amount of those loans actually written off as uncollectible. Expens-
ing worthless loans usually must occur in the year that troubled loans are judged to be
worthless. The largest banking companies are required to use the specific charge-off
method.
Noninterest Income
Key Video Link Sources of income other than interest revenues from loans and investments are called
@ http://www noninterest income (or fee income). The financial reports that banks are required to sub-
.cbs.com/thunder/
mit to regulatory authorities apportion this income source into four broad categories,
player/tv/index_prod
.php?partner=tvcom& as noted in the box on page 150. The breakdown includes: (1) fees earned from fidu-
pid=9nm_IKVjgdIUx ciary activities (such as trust services); (2) service charges on deposit accounts; (3) trad-
WNBFb7SPLRvt_ ing account gains and fees; and (4) additional noninterest income (including revenues
T9ZvMO watch from investment banking, security brokerage, and insurance services). Recently many
CBS news report that
financial-service providers have focused intently on noninterest income as a key target
examines increasing
fee income at banks for future expansion.
from the customer Trust services—the management of property owned by customers (such as cash, secu-
perspective. rities, land, and buildings)—are among the oldest fee-generating, nondeposit products
offered by financial institutions. For most of banking’s history trust departments were not
particularly profitable due to the space and high-price talent required. However, with
increasing public acceptance of charging fees for services rendered, trust departments
have become an increasingly popular source of noninterest income.
While trust department fees have been around for many years, the fees associated with
investment banking and insurance services represent somewhat newer revenue oppor-
tunities flowing from passage of the Gramm-Leach-Bliley (GLB) Act in 1999 and are
explored further in Chapter 14. By more aggressively selling services other than loans,
financial firms have opened up a promising new channel for boosting the bottom line on
their income statements, diversifying their revenue sources, and better insulating their
institutions from fluctuations in market interest rates. The $3.48 billion of noninterest
income reported by BB&T in Table 5–6 represented just over half of that bank’s total
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revenue. Roughly 70 percent of BB&T’s noninterest income came from a category called
“Additional Noninterest Income,” which brings together some of the newest sources of
fee income for banks.
Noninterest Expenses
The key noninterest expense item for most financial institutions is wages, salaries, and
employee benefits, often referred to as personnel expenses, which has been an important
expense item in recent years as leading financial firms have pursued top-quality college
graduates to head their management teams and lured experienced senior management
away from competitors. The costs of maintaining a financial institution’s properties and
rental fees on office space show up in the premises and equipment expense. The cost of
furniture and equipment also appears under the noninterest expense category, along with
numerous small expense items such as legal fees, office supplies, and repair costs.
Net Operating Income and Net Income

The sum of net interest income (interest income 2 interest expense) and net noninterest
income (noninterest income 2 noninterest expense 2 provision for loan losses) is called
pretax net operating income. Applicable federal and state income tax rates are applied to
pretax net operating income plus securities gains or losses to derive income before extraordi-
nary items.
Key Video Link Securities gains (losses) are usually small, but can be substantial for some financial
@ http://www firms at various times. For example, banks purchase, sell, or redeem securities during the
.carbonated.tv/biztech/
year, and this activity often results in gains or losses above or below the original cost (book
jpmorgan-net-beats
watch a Bloomberg value) of the securities. Regulators require that banks report securities gains or losses as
report on how a separate item; however, other income statements may record these gains or losses as a
JP Morgan Chase and component of noninterest income. A bank can use these gains or losses to help smooth
Co. beat analysts’ out its net income from year to year. If earnings from loans decline, securities gains may
estimates on earnings.
offset all or part of the decline. In contrast, when loan revenues (which usually are fully
taxable) are high, securities losses can be used to reduce taxable income.
Another method for stabilizing the earnings of financial institutions consists of nonre-
curring sales of assets. These one-time-only (extraordinary income or loss) transactions often
involve the sale of financial assets, such as common stock, or real property pledged as col-
lateral behind a loan upon which the lender has foreclosed. A financial firm may also sell
real estate or subsidiary firms that it owns. Such transactions frequently have a substantial
effect on current earnings, particularly if a lender sells property it acquired in a loan fore-
closure. Such property is usually carried on the lender’s books at minimal market value,
but its sale price may turn out to be substantially higher.
Concept Check
5–9. What accounts make up the Report of Income 5–12. Suppose a bank has an allowance for loan losses
(income statement of a bank)? of $1.25 million at the beginning of the year,
5–10. In rank order, what are the most important rev- charges current income for a $250,000 provision
enue and expense items on a Report of Income? for loan losses, charges off worthless loans of
5–11. What is the relationship between the provision for $150,000, and recovers $50,000 on loans previously
loan losses on a bank’s Report of Income and the charged off. What will be the balance in the allow-
allowance for loan losses on its Report of Condition? ance for loan losses at year-end?
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Principal Types of Noninterest (“Fee”) Income

Received by Many Financial Firms Today
FIDUCIARY ACTIVITIES
Income from services rendered by the financial firm’s trust department or by any of its consolidated
subsidiaries acting in any fiduciary capacity, such as:
1. Fees for managing and protecting a customer’s property.
2. Fees for recordkeeping for corporate security transactions and dispensing interest and dividend
payments.
3. Fees for managing corporate and individual pension and retirement plans.
SERVICE CHARGES ON DEPOSIT ACCOUNTS

Service charges on deposit accounts held in domestic offices, such as:
1. Checking account maintenance fees.
2. Checking account overdraft fees.
3. Fees for writing excessive checks.
4. Savings account overdraft fees.
5. Fees for stopping payment of checks.
TRADING ACCOUNT GAINS AND FEES

Net gains and losses from trading cash instruments and off-balance-sheet derivative contracts
(including commodity contracts) that have been recognized during the accounting period.
ADDITIONAL NONINTEREST INCOME
Includes the following noninterest income sources:
1. Investment banking, advisory, brokerage, and underwriting.
2. Venture capital revenue.
3. Net servicing fees.
4. Net securitization income.
5. Insurance commission fees and income.
6. Net gains (losses) on sales of loans.
7. Net gains (losses) on sales of real estate owned.
8. Net gains (losses) on sales of other assets (excluding securities).
Note: Categories and definitions, in part, are borrowed from SDI at www.FDIC.gov.
The key bottom-line item on any financial firm’s income statement is net income,
which the firm’s board of directors usually divides into two categories. Some portion of net
income may flow to the stockholders in the form of cash dividends. Another portion (usu-
ally the larger part) will go into retained earnings (also called undivided profits) in order to
provide a larger capital base to support future growth. We note in Table 5–6 that the bank
company we are studying in this chapter reported net income of less than $0.9 billion for
2009, a substantial decline from the previous couple of years due to a major economic
downturn.
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ETHICS IN BANKING
AND FINANCIAL SERVICES
THE COSMETICS OF “WINDOW DRESSING” Security dealers often engage in a similar practice called
AND “CREATIVE ACCOUNTING” “painting the tape,” which consists of temporarily buying
Some financial institutions are notorious for creating “better- or selling securities that have a relatively thin market and,
looking” financial statements. The “window dressing” of bal- therefore, tend to be more volatile in price. A few sales or pur-
ance sheets and income statements can occur at any time, but chases can have a significant impact on price in such a mar-
is most common at the end of a calendar quarter and espe- ket. Thus, such a transaction may dress up the firm’s financial
cially at the end of a fiscal year. statement at the end of the quarter and be reversed shortly
For example, managers may decide they want their firm to thereafter. Other financial firms may elect to temporarily sell
look “bigger,” giving it an apparent increase in market share. off some of their worst-performing assets so shareholders
This is often accomplished by the firm borrowing in the money won’t complain.
market using federal funds, certificates of deposit, or Eurocur- More than just a harmless game, “window dressing” can
rency deposits just prior to the end of the quarter or year and do real harm to investors and to the efficiency of the finan-
reversing the transaction a few hours or a few days later. cial marketplace. Activities of this sort work to conceal the
Alternatively, management may decide they want their true financial condition of the firms involved. Financial deci-
financial firm to look “financially stronger.” Recently, Ashikaga sion making may be flawed because investors must work with
Bank of Japan sued its management for alleged window dress- poor quality information. Regulators like the Securities and
ing of its year-end financial statements created in order to gen- Exchange Commission and the Federal Reserve System dis-
erate inflated profits, permitting the bank to declare a dividend courage such activity whenever they find evidence that finan-
to those who held its preferred stock. cial statements contain misleading information.
Comparative Income Statement Ratios for Different-Size Financial Firms

Like bank balance sheets, income statements usually contain much the same items for
both large and small financial firms, but the relative importance of individual income
and expense items varies substantially with the size of a bank or other financial insti-
tution. For example, as shown in Table 5–7, larger banks receive more of their total
income from noninterest fees (e.g., service charges and commissions) than do small
banks, while smaller banks rely more heavily on deposits than on money market bor-
rowings for their funding and, thus, pay out relatively more deposit interest per dollar
of assets than many larger banks. Any meaningful analysis of an individual financial
institution’s income statement requires comparisons with other firms of comparable size
and location.
5–5 The Financial Statements of Leading Nonbank Financial Firms:

A Comparison to Bank Statements
Key URLs While the balance sheet, income statement, and other financial reports of banks are
For regulatory financial unique, the statements of nonbank financial firms have, in recent years, come closer and
reports of savings
closer to what we see on bank statements. This is particularly true of thrift institutions—
associations, go to
www2.fdic.gov/ including credit unions and savings associations. Like banks, the thrifts’ balance sheet is
call_tfr_rpts/ and for dominated by loans (especially home mortgage loans and consumer installment loans),
credit unions visit deposits from customers, and borrowings in the money market. Also paralleling the bank-
www.ncua.gov. ing sector, the thrifts’ income statements are heavily tilted toward revenue from loans and
by the interest they must pay on deposits and money market borrowings.
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TABLE 5–7 The Composition of Bank Income Statements (Percentage of Total Assets Measured as of Year-End 2009)
Percentage of Total Assets for:

U.S. Banks U.S. Banks U.S. Banks
All U.S. with Less than with $100 Million with $1 Billion
Insured $100 Million in to $1 Billion in or More in
Income and Expense Items Banks Total Assets Total Assets Total Assets
Total interest income 4.07% 4.97% 5.00% 3.96%
Total interest expense 1.03 1.50 1.65 0.76
Net interest income 3.04 3.47 3.35 3.00
Provision for loan and lease losses 1.95 0.72 1.21 2.05
Total noninterest income 2.05 0.73 1.00 2.18
Fiduciary activities 0.21 0.08 0.01 0.22
Service charges on deposit accounts 0.35 0.32 0.33 0.35
Trading account gains & fees 0.20 0.00* 0.00* 0.22
Additional noninterest income 1.30 0.33 0.52 1.39
Total noninterest expense 2.98 3.45 3.25 2.95
Salaries and employee benefits 1.28 1.73 1.52 1.24
Premises and equipment expense 0.35 0.42 0.40 0.35
Additional noninterest expense 1.36 1.30 1.33 1.36
Pretax net operating income 0.15 0.02 0.11 0.18
Securities gains (losses) 20.01 0.03 0.02 20.01
Applicable income taxes 0.03 0.05 0.02 0.03
Income before extraordinary items 0.11 0.00* 20.11 0.13
Extraordinary gains—net 0.03 0.00* 0.00* 20.09
Net income 0.07 20.00* 20.11 0.09
Note: *Less than 0.005 percent.
Key URLs As we move away from the thrift group into such financial-service industries as finance
To learn more about companies, life and property/casualty insurers, mutual funds, and security brokers and
commercial bank
dealers, the financial statements include sources and uses of funds unique to the functions
similarities and
differences with their of these industries and to their often unusual accounting practices. For example, finance
major competitors company balance sheets, like those of banks, are dominated by loans, but these credit
in the insurance and assets are usually labeled “accounts receivable” and include business, consumer, and real
securities industries, estate receivables, reflecting loans made to these customer segments. Moreover, on the
see www.acli.com,
sources of funds side, finance company financial statements show heavy reliance, not on
www.iii.org, and
www.ici.org. deposits for funding, but on borrowings from the money market and from parent com-
panies in those cases where a finance company is controlled by a larger firm (e.g., as GE
Capital is controlled by General Electric).
Life and property/casualty insurance companies also make loans, especially to the business
sector. But these usually show up on insurance company balance sheets in the form of
holdings of bonds, stocks, mortgages, and other securities, many of which are purchased in
the open market. Key sources of funds for insurers include policyholder premium payments
to buy insurance protection, returns from investments, and borrowings in the money and
capital markets. Most of the insurance industry’s profits come from the investments they
make, not policyholder premiums.
In contrast, mutual funds hold primarily corporate stocks, bonds, asset-backed securities,
and money market instruments that are financed principally by their net sales of shares
to the public and from occasional borrowings. Security dealers and brokers tend to hold a
similar range of investments in stocks and bonds, financing these acquisitions by borrow-
ings in the money and capital markets and equity capital contributed by their owners. The
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Insights and Issues

Financial Statements of Financial Firms Compared In contrast, nonfinancial firms’ balance sheets typically have
to Nonfinancial Firms assets led by plant and equipment, accounts receivable from
As we wind up this chapter we should pause briefly to note how sales of goods and services on credit, and inventories of raw
the financial statements of financial firms, like JP Morgan Chase materials and goods for sale. Their liabilities, including both
and Wells Fargo, usually differ from those typically posted by non- short- and long-term debt, include accounts payable to acquire
financial firms, such as Boeing and Procter & Gamble. supplies needed in production and borrowings from financial
The balance sheets of financial firms are frequently domi- firms to meet payrolls, pay taxes, and handle other expenses.
nated on the asset side by loans (credit) and investments in gov- (Thus, loans extended by financial firms, recorded as assets, are
ernment and corporate bonds and stock and on the liability side recorded as liabilities for the nonfinancial firms receiving those
by deposits and nondeposit borrowings from the financial markets loans.) Revenues for nonfinancial companies usually flow in from
to support their lending and investing. Revenues of financial firms sales of goods and nonfinancial services (accounts receivable),
typically are led by interest earnings and dividends plus fees for while employees’ wages, salaries and benefits, depreciation of
financial services provided, while expenses are usually led by the plant and equipment, and the cost of borrowing often lead the
interest cost of borrowing loanable funds followed by employee expense list.
salaries and benefits.
Key Items in the Financial Statements of:

Financial Firms Nonfinancial Firms
Assets: Assets:
Loans and other forms of credit Plant and equipment
Investment securities Accounts receivable
Cash and near-cash instruments Inventories of goods for sale
Liabilities: Liabilities:
Deposits from the public Accounts payable
Nondeposit borrowings Borrowings from the financial sector
Revenues: Revenues:
Interest and dividend earnings Sales of goods
Fees from services provided and services
Expenses: Expenses:
Interest cost on borrowed funds Employee expenses
Employee expenses Depreciation of plant and equipment
Interest cost on borrowed funds
dealers also generate large amounts of revenue from buying and selling securities for their
customers, by charging underwriting commissions to businesses needing assistance with
new security offerings, and by assessing customers fees for financial advice. Increasingly,
banks are offering the same services, and their consolidated financial reports look very
much like those of these tough nonbank competitors.
5–6 An Overview of Key Features of Financial Statements

and Their Consequences
We have explored a substantial number of details about the content of bank financial
statements and the comparable statements of some of their closest competitors in this
chapter. Table 5–8 provides a useful overview of the key features of the financial state-
ments of financial institutions and their consequences for the managers of financial firms
and for the public.
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Concept Check
5–13. Who are banking’s chief competitors in the financial- 5–16. What are the key features or characteristics of the
services marketplace? financial statements of banks and similar financial
5–14. How do the financial statements of major nonbank firms? What are the consequences of these state-
financial firms resemble or differ from bank finan- ment features for managers of financial-service
cial statements? Why do these differences or simi- providers and for the public?
larities exist?
5–15. What major trends are changing the content of the
financial statements prepared by financial firms?
TABLE 5–8 Key Features of the Financial Statements Consequences for the Managers
Features and of Financial Institutions of Financial Institutions
Consequences of the
Financial Statements • Heavy dependence on borrowed funds supplied • The earnings and the very existence of financial
of Banks and Similar by others (including deposits and nondeposit institutions are exposed to significant risk if
borrowings); thus, many financial firms make those borrowings cannot be repaid when due.
Financial Firms
heavy use of financial leverage (debt) in an Thus, financial firms must hold a significant
effort to boost their stockholders’ earnings. proportion of high-quality and readily marketable
assets to meet their debt obligations.
• Most revenues stem from interest and dividends • Management must choose loans and
on loans and securities. The largest expense item investments carefully to avoid a high
is often the interest cost of borrowed funds, proportion of earning assets that fail to pay out
followed by personnel costs. as planned, damaging expected revenue
flows. Because revenues and expenses are
sensitive to changing interest rates,
management must be competent at protecting
against losses due to interest-rate movements
by using interest-rate hedging techniques.
• The greatest proportion of assets is devoted • With only limited resources devoted to fixed
to financial assets (principally loans and assets and, therefore, usually few fixed
securities). A relatively small proportion of assets costs stemming from plant and equipment,
is devoted to plant and equipment (fixed assets); financial firms’ earnings are less sensitive
thus, financial institutions tend to make limited to fluctuations in sales volume (operating
use of operating leverage. However, some revenues) than those of many other
larger financial firms gain additional operating businesses, but this limits potential earnings.
leverage by acquiring nonfinancial businesses (Banking, for example, tends to
and by constructing office buildings and leasing be a moderately profitable industry.)
office space.
Summary This chapter presents an overview of the content of bank financial statements, which
provide us with vital information that managers, investors, regulators, and other inter-
ested parties can use to assess each financial firm’s performance. The reader also is given a
glimpse at how selected nonbank firms’ financial statements compare with those issued by
banks. Several key points emerge in the course of the chapter:
• The two most important financial statements issued by depository institutions are the
balance sheet or Report of Condition and the income and expense statement or Report
of Income.
• Bank balance sheets report the value of assets held (usually broken down into such cat-
egories as cash assets, investment securities, loans, and miscellaneous assets), liabilities
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outstanding (including deposits and nondeposit borrowings), and capital or stockhold-

ers’ equity. The values recorded on the balance sheet are measured at a single moment
in time (such as the last day of the quarter or year).
• In contrast, the income and expense statement or Report of Income includes key sources
of revenue and operating expenses. Revenue sources for most financial firms typically
include loan and investment income and revenue from the sale of fee-generating
services. Major sources of operating expense include interest payments on borrowed
funds, employee wages, salaries and benefits, taxes, and miscellaneous expenses.
• The financial statements of nonbank financial firms (including thrift institutions, life
and property/casualty insurers, and security firms) are increasingly coming to resem-
ble bank financial statements and vice versa as these different industries rush toward
each other. Among the common features are heavy use of financial leverage (debt) to
finance their operations, the dominance of financial assets over real (physical) assets,
and the concentration of revenues from making loans and assisting businesses in selling
their securities. For most financial firms the key expense is usually interest expense on
borrowings, followed by personnel costs.
• By carefully reading the financial statements of banks and their competitors we learn
more about the services these institutions provide and how their financial condition
changes with time. These statements, when accurately prepared, provide indispensable
information to managers, owners, creditors, and regulators of financial-service
providers. Unfortunately, some financial institutions engage in “window dressing” and
other forms of data manipulation, which can send out misleading information.
Key Terms Report of Condition, 131 Report of Income, 145
Problems 1. Norfolk National Bank has just submitted its Report of Condition to the FDIC. Please
and Projects fill in the missing items from its statement shown below (all figures in millions of dollars):
Report of Condition
Total assets $4,000.00
Cash and due from depository institutions 90.00
Securities 535.00
Federal funds sold and reverse repurchase agreements 45.00
Gross loans and leases
Loan loss allowance 200.00
Net loans and leases 2,700.00
Trading account assets 20.00
Bank premises and fixed assets
Other real estate owned 15.00
Goodwill and other intangibles 200.00
All other assets 175.00
Total liabilities and capital
Total liabilities
Total deposits
Federal funds purchased and repurchase agreements 80.00
Trading liabilities 10.00
Other borrowed funds 50.00
Subordinated debt 480.00
All other liabilities 40.00
Total equity capital
Perpetual preferred stock 5.00
Common stock 25.00
Surplus 320.00
Undivided profits 70.00
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2. Along with the Report of Condition submitted above, Norfolk has also prepared a
Report of Income for the FDIC. Please fill in the missing items from its statement
shown below (all figures in millions of dollars):
Report of Income
Total interest income $200
Total interest expense
Net interest income 60
Provision for loan and lease losses
Total noninterest income 100
Fiduciary activities 20
Service charges on deposit accounts 25
Trading account gains & fees
Additional noninterest income 30
Total noninterest expense 125
Salaries and employee benefits
Premises and equipment expense 10
Additional noninterest expense 20
Pretax net operating income 15
Securities gains (losses) 5
Applicable income taxes 3
Income before extraordinary items

Extraordinary gains—net 2
Net income
3. If you know the following figures:
Total interest income $140 Provision for loan losses $5

Total interest expenses 100 Income taxes 4
Total noninterest income 75 Increases in bank’s undivided profits 6
Total noninterest expenses 90
Please calculate these items:
Net interest income Total operating revenues
Net noninterest income Total operating expenses
Pretax net operating income Dividends paid to common stockholders
Net income after taxes
4. If you know the following figures:
Gross loans $300 Trading-account securities $2

Allowance for loan losses 15 Other real estate owned 4
Investment securities 36 Goodwill and other intangibles 3
Common stock 5 Total liabilities 375
Surplus 15 Preferred stock 3
Total equity capital 30 Nondeposit borrowings 40
Cash and due from banks 10 Bank premises and equipment, net 20
Miscellaneous assets 25
Bank premises and equipment, gross 25
Please calculate these items:
Total assets Fed funds sold
Net loans Depreciation
Undivided profits Total deposits
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5. The Sea Level Bank has Gross Loans of $800 million with an ALL account of
$45 million. Two years ago the bank made a loan for $12 million to finance the Sun-
set Hotel. Two million dollars in principal was repaid before the borrowers defaulted
on the loan. The Loan Committee at Sea Level Bank believes the hotel will sell at
auction for $7 million and they want to charge off the remainder immediately.
a. The dollar figure for Net Loans before the charge-off is .
b. After the charge-off, what are the dollar figures for Gross Loans, ALL, and Net
Loans assuming no other transactions?
c. If the Sunset Hotel sells at auction for $10 million, how will this affect the perti-
nent balance sheet accounts?
6. For each of the following transactions, which items on a bank’s statement of income
and expenses (Report of Income) would be affected?
a. Office supplies are purchased so the bank will have enough deposit slips and other
necessary forms for customer and employee use next week.
b. The bank sets aside funds to be contributed through its monthly payroll to the
employee pension plan in the name of all its eligible employees.
c. The bank posts the amount of interest earned on the savings account of one of its
customers.
d. Management expects that among a series of real estate loans recently granted the
default rate will probably be close to 3 percent.
e. Mr. and Mrs. Harold Jones just purchased a safety deposit box to hold their stock
certificates and wills.
f. The bank collects $1 million in interest payments from loans it made earlier this
year to Intel Composition Corp.
g. Hal Jones’s checking account is charged $30 for two of Hal’s checks that were
returned for insufficient funds.
h. The bank earns $5 million in interest on the government securities it has held
since the middle of last year.
i. The bank has to pay its $5,000 monthly utility bill today to the local electric
company.
j. A sale of government securities has just netted the bank a $290,000 capital gain
(net of taxes).
7. For each of the transactions described here, which of at least two accounts on
a bank’s balance sheet (Report of Condition) would be affected by each
transaction?
a. Sally Mayfield has just opened a time deposit in the amount of $6,000, and these
funds are immediately loaned to Robert Jones to purchase a used car.
b. Arthur Blode deposits his payroll check for $1,000 in the bank, and the bank
invests the funds in a government security.
c. The bank sells a new issue of common stock for $100,000 to investors living in
its community, and the proceeds of that sale are spent on the installation of new
ATMs.
d. Jane Gavel withdraws her checking account balance of $2,500 from the bank and
moves her deposit to a credit union; the bank employs the funds received from
Mr. Alan James, who has just paid off his home equity loan, to provide Ms. Gavel
with the funds she withdrew.
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e. The bank purchases a bulldozer from Ace Manufacturing Company for $750,000
and leases it to Cespan Construction Company.
f. Signet National Bank makes a loan of reserves in the amount of $5 million to
Quesan State Bank and the funds are returned the next day.
g. The bank declares its outstanding loan of $1 million to Deprina Corp. to be
uncollectible.
8. The John Wayne Bank is developing a list of off-balance-sheet items for its call report.
Please fill in the missing items from its statement shown below. Using Table 5–5,
describe how John Wayne compares with other banks in the same size category
regarding its off-balance sheet activities.
Off-balance-sheet items for John Wayne Bank (in millions of $)

Total unused commitments $ 8,000
Standby letters of credit and foreign office guarantees 1,350
(Amount conveyed to others) –50
Commercial letters of credit 60
Securities lent 2,200
Derivatives (total) 100,000
Notional amount of credit derivatives 22,000
Interest rate contracts 54,000
Foreign exchange rate contracts

Contracts on other commodities and equities 1,200
All other off-balance-sheet liabilities 49
Total off-balance-sheet items
Total assets (on-balance sheet) 12,000
Off-balance-sheet assets 4 on-balance-sheet assets
9. See if you can determine the amount of Bluebird State Bank’s current net income
after taxes from the figures below (stated in millions of dollars) and the amount of its
retained earnings from current income that it will be able to reinvest in the bank. (Be
sure to arrange all the figures given in correct sequence to derive the bank’s Report of
Income.)
Effective tax rate 28%

Interest on loans $90
Employee wages, salaries, and benefits 13
Interest earned on government bonds and notes 9
Provision for loan losses 5
Overhead expenses 3
Service charges paid by depositors 3
Security gains/losses 27
Interest paid on federal funds purchased 5
Payment of dividends of $4 per share on 1 million outstanding
shares to be made to common stockholders
Interest paid to customers holding time and savings deposits 40
Trust department fees 3
10. Which of these account items or entries would normally occur on a bank’s balance
sheet (Report of Condition) and which on a bank’s income and expense statement
(Report of Income)?
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Federal funds sold Deposits due to banks

Addition to undivided Leases of business equipment
profits to customers
Credit card loans
Utility expense Interest received on credit card
loans
Vault cash Fed funds purchased
Allowance for loan losses Savings deposits
Depreciation on premises and equipment Provision for loan losses
Commercial and industrial loans Service charges on deposits
Repayments of credit card loans Undivided profits
Common stock Mortgage owed on the bank’s
buildings
Interest paid on money market deposits Other real estate owned
Securities gains or losses
11. You were informed that a bank’s latest income and expense statement contained the
following figures (in $ millions):
Net interest income $800

Net noninterest income 2500
Pretax net operating income 372
Security gains 100
Increases in bank’s undivided profits 200
Suppose you also were told that the bank’s total interest income is twice as large as its
total interest expense and its noninterest income is three-fourths of its noninterest
expense. Imagine that its provision for loan losses equals 3 percent of its total inter-
est income, while its taxes generally amount to 30 percent of its net income before
income taxes. Calculate the following items for this bank’s income and expense
statement:
Total interest income

Total interest expenses
Total noninterest income
Total noninterest expenses
Provision for loan losses
Income taxes
Dividends paid to common stockholders
12. Why do the financial statements issued by banks and by nonbank financial-service
providers look increasingly similar today? Which nonbank financial firms have bal-
ance sheets and income statements that closely resemble those of commercial banks
(especially community banks)?
13. What principal types of assets and funds sources do nonbank thrifts (including sav-
ings banks, savings and loans, and credit unions) draw upon? Where does the bulk of
their revenue come from, and what are their principal expense items?
14. How are the balance sheets and income statements of finance companies, insurers,
and securities firms similar to those of banks, and in what ways are they different?
What might explain the differences you observe?
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Internet Exercises
1. The regulators’ websites provide a wealth of information for bank holding companies
(BHCs). The FDIC’s Statistics for Depository Institutions (SDI) site (www2.fdic
.gov/sdi/) is the source of BB&T Corps. Report of Condition and Report of Income
presented in Tables 5–3 and 5–6. The data for bank holding companies provided at
the FDIC’s site represent combined amounts for all FDIC-insured bank and thrift
subsidiaries and do not reflect nondeposit subsidiaries of parent companies. Visit SDI
and search for information for Wells Fargo Corporation. What are the dollar amounts
of Total assets, Total liabilities, Total deposits, Net interest income, and Net income
for the most recent year-end?
More comprehensive holding company information can be found at the
National Information Center’s (NIC’s) website maintained by the Federal Finan-
cial Institutions Examination Council (FFIEC). Go to www.ffiec.gov/nicpubweb/
nicweb/nichome.aspx, click the button for “Top 50 BHCs,” and click the link for
Wells Fargo to collect the most recent year-end data from the BHCPR. What are
the dollar amounts of Total assets, Total liabilities, Total deposits (you will need
to sum the different types of deposits), Net interest income, and Net income? You
will see that there is more information available at this site, but it is a little more
challenging to sort through. You are interested in the first six pages of consolidated
information. Compare and contrast the information found for Wells Fargo at both
websites.
2. Data for individual banks are available at the FDIC’s site referenced in Internet
Exercise 1. Use SDI to collect the most recent year-end data for Wells Fargo Bank.
What are the dollar amounts of Total assets, Total liabilities, Total deposits, Net
interest income, and Net income? Compare and contrast the information found for
Wells Fargo’s home office with the BHC data collected in Exercise 1 above.
3. The Report of Condition has information about the sources and uses of funds.
Go to SDI ( www2.fdic.gov/sdi/ ) and pull up the Assets and Liabilities for the
Bank of America’s most recent year-end. Access the bank holding company
information.
a. Using the link for Other Real Estate Owned (OREO), identify and describe the
dollar composition of this item.
b. Using the link for Goodwill and Other Intangibles, identify and describe the dol-
lar composition of this item.
4. The Report of Income has information about revenues and expenses. Net interest
income is the difference between the Interest revenue and Interest expense. Using
SDI (www2.fdic.gov/sdi/) pull up the annual Income and Expense for the most
recent year-end for Bank of America—the bank holding company.
a. Using the link for Total interest income, identify and describe the dollar composi-
tion of this item.
b. Using the link for Total interest expense, identify and describe the dollar composi-
tion of this item.
5. Noninterest income and Expenses are detailed in the Report of Income. Using SDI
(www2.fdic.gov/sdi/) pull up the annual Income and Expense for Bank of America’s
most recent year-end.
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a. What components are combined to create the dollar amount of Noninterest

income? You will need to use the links for Trading account gains and fees and
Additional noninterest income to describe the dollar composition of this item.
b. What components are combined to create the dollar amount of Noninterest
expense? You will need to use the link for Additional noninterest expense to
describe the dollar composition of this item.
6. What similarities do you see between the balance sheets and income statements of
smaller community banks versus major money center banks? What are the principal
differences? For comparison purposes view the most recent financial reports of one
or more community banks in your hometown or local area, and compare them to
the financial reports filed most recently by such industry leaders as JP Morgan Chase
and Citigroup. You can find data for all FDIC insured institutions at SDI (www2
.fdic.gov/sdi/), and you can always search the institutions’ own websites.
7. Consulting the websites posted by Atlantic Commercial Credit Corporation (www
.atlanticcommercial.com), Goldman Sachs (www2.goldmansachs.com), State Farm
Insurance Companies (www.statefarm.com), and Wells Fargo Bank (www.wellsfargo
.com), what differences do you observe between the financial reports of the finance
company, Atlantic Commercial Credit Corporation; the securities dealer, Goldman
Sachs; the insurance industry leader, State Farm Insurance Companies; and one
of the leaders of the domestic U.S. banking industry, Wells Fargo? Are there any
important similarities among the financial statements of these different financial-
service providers?
Selected See the following for an overview of the components of financial statements prepared by banks
and their competitors:
References
1. Balla, Eliana, and Andrew McKenna. “Dynamic Provisioning: A Countercyclical
Tool for Loan Loss Revenues,” Economic Quarterly, Federal Reserve Bank of Rich-
mond, 95/4 (Fall 2009), pp. 383–418.
2. Bies, Susan Schmidt. “Fair Value Accounting,” Federal Reserve Bulletin, Winter 2005,
pp. 26–29.
3. Ennis, Huberto M. “Some Recent Trends in Commercial Banking,” Economic Quar-
terly, Federal Reserve Bank of Richmond, 90/2 (Spring 2004), pp. 41–61.
4. Federal Deposit Insurance Corporation. “Quarterly Banking Profile: Second Quarter,
2010” FDIC Quarterly, 4, no. 3 (2010), pp. 1–27.
5. O’Toole, Randy. “Recent Developments in Loan Loss Provisioning at U.S. Com-
mercial Banks,” FRBSF Economic Letter, Federal Reserve Bank of San Francisco,
no. 97–21 (July 27, 1997).
6. Shaffer, Sherrill. “Marking Banks to Market,” Business Review, Federal Reserve Bank
of Philadelphia, July/August 1992, pp. 13–22.
7. Walter, John R. “Loan-Loss Reserves,” Economic Review, Federal Reserve Bank of
Richmond, 77 (July/August 1991), pp. 20–30.
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REAL NUMBERS
Continuing Case Assignment for Chapter 5
FOR REAL BANKS
FIRST LOOK AT YOUR BHC’S FINANCIAL A. Add a spreadsheet entitled “Year-to-Year Comparisons” to
STATEMENTS your Excel workbook. Enter the data for your BHC in the
In Chapter 5, we focus most heavily on the financial statements format illustrated for BB&T.
for banking companies. As you read this chapter, you progress To fill in the dollar amounts for the Year-to-Year Compari-
through a lengthy, yet interesting, discussion of the items found sons spreadsheet, go to www2.fdic.gov/sdi and enter SDI.
on the Report of Condition (balance sheet) and the Report of You will create a report with two columns and you are pre-
Income (income statement). In the chapter you find financial sented with two pull-down menus. From the first pull-down
statements providing dollar amounts and then comparative menu, select “Bank Holding Company,” then enter your com-
financial statements where the ratios of items-to-assets are pany’s BHC number, and select the report date for the most
presented. The data was collected from Statistics for Deposi- recent year-end. From the second pull-down menu, repeat
tory Institutions at the FDIC’s website (www2.fdic.gov/sdi/) the process, only you will select reports for December, one
and organized into tables using Excel. You will first create year prior. Follow the cues to generate a report selecting to
financial statements using dollar figures collected from SDI for “View” in “Dollars” for the first spreadsheet. For the Report of
your banking company for year-to-year comparisons, and you Condition you will be able to enter most data directly from the
will then create financial statements for your banking company Assets and Liabilities report generated at the FDIC website;
and its Peer Group using the ratios of items-to-assets. however, you will have to explore the Net Loans and Leases
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REAL NUMBERS Continuing Case Assignment for Chapter 5 (continued)

FOR REAL BANKS
link to get Gross Loans and Leases and Unearned Income. For down menu, choose “Standard Peer Group” and select
the Report of Income, you will find the information you need in “All Commercial Banks with Assets of More than $10 Billion”
the section called “Income and Expense.” for the most recent year-end. You will repeat this process
using the last two pull-down menus, only you will select
B. Create a second worksheet in the same workbook, but
reports for December, one year prior. Follow the cues
collect data in “Percent of Assets” rather than in dollars.
to generate a report selecting to “View” in “Percent of
This will be useful for comparative analysis, and you will
Assets” and enter the same items as in Part A. By work-
collect data both for your BHC and a group of peer banks
ing with these statements, you will be familiarizing your-
as illustrated for BB&T. To fill in the percentages of total
self with real-world financial statements and developing
assets, return to www2.fdic.gov/sdi and enter SDI. This
the language to talk with finance professionals from all
time, you will create a report with four columns and you
types of financial institutions.
are presented with four pull-down menus. From the first
pull-down menu, select “Bank Holding Company,” then C. To develop an understanding of the relationships on the
enter your company’s BHC number and select the report Reports of Condition and Income and to double-check for
date for the most recent year-end. From the second pull- data collection errors, we will use our formula functions to
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FOR REAL BANKS
calculate total assets, total liabilities and capital, total liabilities, before extraordinary items, and net income. Then use the for-
total equity capital, net interest income, pretax net operating mula functions in Excel to create entries for the empty cells. For
income, income before extraordinary items, and net income, example, the formula for total liabilities used in Column D would
using the spreadsheet developed in Part A. First Step: copy be 5SUM(B20:B25). If the formulas and entries are correct, you
Columns B and C to Columns D and E. Second Step: clear the will get the same numerical values as in columns B and C, and
values in the cells containing total assets (i.e., Cells D4 and you can be reassured that you are developing an understanding
E4), total liabilities and capital, total liabilities, total equity capi- of the financial statements of banks and similar financial firms.
tal, net interest income, pretax net operating income, income
Appendix
Sources of Information on the Financial-Services Industry
The chapters that follow this one will provide many of the • Risk Management Association (RMA), Association of
tools needed for successful management of a financial insti- Risk Management and Lending Professionals at www
tution, but managers will always need more information .rmahq.org.
than textbooks can provide. Their problems and solutions • Independent Community Bankers of America at www
may be highly technical and will shift over time, often at .icba.org.
a faster pace than the one at which textbooks are written. • Credit Union National Association (CUNA) at www
The same difficulty confronts regulators and customers. .cuna.org.
They must often reach far afield to gather vital information • American Council of Life Insurance (ACLI) at www
in order to evaluate their financial-service providers and get .acli.org.
the best service from them.
• Investment Company Institute (ICI) at www.ici.org.
Where do the managers of financial institutions find the
information they need? One good source is the professional • Insurance Information Institute (III) at www.iii.org.
schools in many regions of the nation. Among the most In addition to the material provided by these and numer-
popular of these is the Stonier Graduate School of Bank- ous other trade associations, dozens of journals and books
ing, sponsored by the American Bankers Association. Other are released each year by book publishing houses, magazine
professional schools are often devoted to specific problem publishers, and government agencies. Among the most
areas, such as marketing, consumer lending, and commercial important of these recurring sources are the following:
lending. Each offers educational materials and often supplies
homework problems to solve. General Information on Banking and Competing
Beyond the professional schools, selected industry trade Financial-Service Industries
associations annually publish a prodigious volume of writ- • ABA Banking Journal (published by the American Bank-
ten studies and management guidelines for wrestling with ers Association at www.ababj.com).
important problems, such as developing and promoting new
• Risk Management and Lending Professionals Journal (pub-
services, working out problem assets, designing a financial
lished by the Risk Management Association at www
plan, and so on. Among the most popular trade associations
.rmahq.org).
publishing problem-solving information in the financial-
services field are: • ABA Bank Marketing Magazine at www.aba.com/
bankmarketing/.
• The American Bankers Association at www.aba.com.
• Bank Administration Institute at www.bai.org.
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Sources of Data on Individual Banks and Competing • Board of Governors of the Federal Reserve System at
Financial Firms www.federalreserve.gov.
• Uniform Bank Performance Reports (UBPR) (published • Federal Deposit Insurance Corporation (FDIC) at www
quarterly by the Federal Financial Institutions Examina- .fdic.gov.
tion Council at www.ffiec.gov). • Office of Thrift Supervision at www.ots.treas.gov.
• Historical Bank Condition and Income Reports (avail- • National Credit Union Administration at www.ncua
able from the National Technical Information Service .gov.
at www.ntis.org).
• American Banker Online (banking industry newspaper Basic Education in Banking and Financial Services
published by the American Bankers Association at for Both Bankers and Their Customers
www.americanbanker.com). • Consumer-Action at www.consumer-action.org.
• The Wall Street Journal (published by Dow Jones & Co., • Federal Reserve System at www.federalreserve.gov.
Inc., and online at www.wsj.com). • Federal Reserve Bank of Minneapolis at www.minnea-
polisfed.org.
Economic and Financial Trends Affecting Banking • Consumer Financial Protection Bureau at www.finan-
and the Financial Services Sector cialstability.gov.
• Survey of Current Business (published by the U.S.
Department of Commerce at www.bea.gov/scb). Industry Directories
• Federal Reserve Bulletin (published by the Board of Gov- Directories for many industries give lists of businesses in an
ernors of the Federal Reserve System and available at industry by name, city, state, and country of location. Some
www.federalreserve.gov/pubs/bulletin). of the more complete directories provide essential avenues
• National Economic Trends and Monetary Trends (all of contact for directory users, such as the names of key
published by the Federal Reserve Bank of St. Louis at officers within a firm and the company’s mailing address,
research.stlouisfed.org/publications/net/) telephone number, and e-mail address. More detailed direc-
tories have abbreviated financial statements of the firms
Books and Journals Focusing on Laws listed and may even have a historical sketch about each
and Regulations and International Developments firm. One common use of these directories is to pursue pos-
Affecting Banks and Other Financial-Service sible employment opportunities. Among the better-known
Providers industry directories are these:
• International Economic Conditions (published by the Fed- • The Bankers Almanac at www.bankersalmanac.com.
eral Reserve Bank of St. Louis at research.stlouisfed. • Investment Bankers Directory at www.investmentbanklist
org/publications/iet). .com.
• The Economist (London) (available by subscription; • International Insurance Directory (also described at www
information may be found at www.economist.com). .insurance-network.com).
Key Regulatory Agencies

• Office of the Comptroller of the Currency (OCC) at
www.occ.treas.gov.
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Managing Sources of Funds for a Financial Firm P A R T F I V E
C H A P T E R T W E L V E
Managing and Pricing

Deposit Services
• Types of Deposit Accounts Offered
• The Changing Mix of Deposits and Deposit Costs
• Pricing Deposit Services
• Conditional Deposit Pricing
• Rules for Deposit Insurance Coverage
• Disclosure of Deposit Terms
• Lifeline Banking
12–1 Introduction
Barney Kilgore, one of the most famous presidents in the history of Dow Jones & Company
and publisher of The Wall Street Journal, once cautioned his staff: “Don’t write banking
stories for bankers. Write for the bank’s customers. There are a hell of a lot more deposi-
tors than bankers.” Kilgore was a wise man, indeed. For every banker in this world there
are thousands upon thousands of depositors. Deposit accounts are the number one source
of funds at most banks.
Deposits are a key element in defining what a banking firm really does and what criti-
cal roles it really plays in the economy. The ability of management and staff to attract
transaction (checkable) and savings deposits from businesses and consumers is an impor-
tant measure of a depository institution’s acceptance by the public. Moreover, deposits
provide much of the raw material for making loans and, thus, may represent the ultimate
source of profits and growth for a depository institution. Important indicators of manage-
ment’s effectiveness are whether or not funds deposited by the public have been raised
at the lowest possible cost and whether sufficient deposits are available to fund all those
loans and projects management wishes to pursue.1
This last point highlights two key issues every depository institution must deal with in
managing the public’s deposits: (1) Where can funds be raised at lowest possible cost? and
(2) How can management ensure that the institution always has enough deposits to sup-
port lending and other services the public demands? Neither question is easy to answer,
especially in today’s competitive marketplace. Both the cost and amount of deposits that
depository institutions sell to the public are heavily influenced by the pricing schedules
1
Portions of this chapter are based on an article by Peter S. Rose in The Canadian Banker [3] and are used with permission
of the publisher.
397
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398 Part Five Managing Sources of Funds for a Financial Firm
and competitive maneuverings of other financial institutions offering similar services,

such as share accounts in money market mutual funds and credit unions, cash manage-
ment accounts offered by brokerage firms and insurance companies, and interest-bearing
investment accounts offered by many securities firms.
So challenging has it become today to attract significant new deposits that many finan-
cial firms have created a new executive position—chief deposit officer. Innovation in the
form of new types of deposits, new service delivery methods (increasingly electronic in
design), and new pricing schemes is accelerating today. Financial-service managers who
fail to stay abreast of changes in their competitors’ deposit pricing and marketing pro-
grams stand to lose both customers and profits. In this chapter we explore the types of
deposits that depository institutions sell to the public. We also examine how deposits are
priced, the methods for determining their cost to the offering institution, and the impact
of government regulation on the deposit function.
12–2 Types of Deposits Offered by Depository Institutions

The number and range of deposit services offered by depository institutions are impressive
indeed and often confusing for customers. Like a Baskin-Robbins ice cream store, deposit
plans designed to attract customer funds today come in 31 flavors and more, each plan
having features intended to closely match business and household needs for saving money
and making payments for goods and services.
Transaction (Payments or Demand) Deposits

Factoid One of the oldest services offered by depository institutions has centered on making
In 2003 for the first payments on behalf of customers. This transaction, or demand, deposit service requires
time in the history financial-service providers to honor immediately any withdrawals made either in person
of the United States
payments made by by the customer or by a third party designated by the customer to be the recipient of funds
checks written against withdrawn. Transaction deposits include regular noninterest-bearing demand deposits that do
transaction deposit not earn an explicit interest payment but provide the customer with payment services,
accounts were smaller safekeeping of funds, and recordkeeping for any transactions carried out by check, card,
in number than or via an electronic network, and interest-bearing demand deposits that provide all of the
electronic payments,
due principally to foregoing services and pay interest to the depositor as well.
the explosive growth
of debit cards and Noninterest-Bearing Transaction (Demand) Deposits
computer terminals Interest payments have been prohibited on regular checking accounts in the United States
which promise to since passage of the Glass-Steagall Act of 1933. Congress feared at the time that paying
expand sharply in the
new century. interest on immediately withdrawable deposits endangered bank safety—a proposition that
researchers have subsequently found to have little support. However, demand (transac-
tion) deposits are among the most volatile and least predictable of a depository institu-
tion’s sources of funds, with the shortest potential maturity, because they can be withdrawn
without prior notice. Most noninterest-bearing demand deposits are held by business firms.
In 2009 the U.S. Congress passed the Wall Street Reform and Consumer Protection Act,
allowing banks offering demand deposits to corporations to pay interest on these accounts.
Interest-Bearing Transaction Deposits

Many consumers today have moved their funds into other types of transaction deposits
that pay at least some interest return. Beginning in New England during the 1970s, hybrid
checking–savings deposits began to appear in the form of negotiable order of withdrawal
(NOW) accounts. NOWs are interest-bearing savings deposits that give the offering
depository institution the right to insist on prior notice before the customer withdraws
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Chapter Twelve Managing and Pricing Deposit Services 399
funds. Because this notice requirement is rarely exercised, the NOW can be used just
like a checking (transaction) account to pay for purchases of goods and services. NOWs
were permitted nationwide beginning in 1981 as a result of passage of the Depository
Institutions Deregulation Act of 1980. However, they could be held only by individuals
and nonprofit institutions. When NOWs became legal nationwide, the U.S. Congress
also sanctioned the offering of automatic transfers (ATS), which permit the customer to
preauthorize a depository institution to move funds from a savings account to a transac-
tion account in order to cover overdrafts. The net effect was to pay interest on transaction
balances roughly equal to the interest earned on a savings account.
Two other important interest-bearing transaction accounts were created in the United
Key URLs States in 1982 with passage of the Garn–St Germain Depository Institutions Act. Banks
Among the best sources and thrift institutions could offer deposits competitive with the share accounts offered by
for the current deposit
money market funds that carried higher, unregulated interest rates and are normally backed
interest rates offered by
many banks and thrift by a pool of high-quality securities. The result was the appearance of money market deposit
institutions are www accounts (MMDAs) and Super NOWs (SNOWs), offering flexible money market interest
.bankrate.com, www rates but accessible via check or preauthorized draft to pay for goods and services.
.imoneynet.com, MMDAs are short-maturity deposits that may have a term of only a few days, weeks,
www.fisn.com, and
or months, and the offering institution can pay any interest rate competitive enough to
bankcd.com.
attract and hold the customer’s deposit. Up to six preauthorized drafts per month are
allowed, but only three withdrawals may be made by writing checks. There is no limit to
the personal withdrawals the customer may make (though service providers reserve the
right to set maximum amounts and frequencies for personal withdrawals). Unlike NOWs,
MMDAs can be held by businesses as well as individuals.
Super NOWs were authorized at about the same time as MMDAs, but could be held
Key Video Link only by individuals and nonprofit institutions. The number of checks the depositor may
@ http://www write is not limited by regulation. However, offering institutions post lower yields on
.techrepublic.com/ SNOWs than on MMDAs because the former can be drafted more frequently by custom-
videos/news/the- ers. Incidentally, federal regulatory authorities classify MMDAs today not as transaction
future-of-check-
deposits/372900 view (payments) deposits, but as savings deposits. They are included in this section on transac-
a video about USAA’s tion accounts because they carry limited check-writing privileges.
mobile check deposit.
Mobile Apps—Impact on Transaction Deposits and Potential Customers
Finally, the hottest item in the transaction deposit field today appears to be the mobile
Key URLs check deposit. Designed principally for customers on the move, carrying camera-equipped
For further exploration smart phones (such as iPhone or BlackBerry), users take pictures of the front and back of
of mobile deposits and
endorsed checks, upload this information into their deposit account, regardless of their
mobile payments see
especially http://adage location, and receive instant confirmation of the posted deposit. Protection can be pro-
.com/digital/article? and vided by such security measures as two-factor login authentication; recent deposits may
www.mybank tracker be visible where the participating depository institution allows this visibility, and photo
.com/bank-news. clarity may be corrected and improved.
This mobile-deposit innovation has centered initially in the industry’s leaders, such as
JP Morgan Chase, USAA, and Bank of America. However, this service will likely soon be
offered by a host of smaller depository institutions, both banks and credit unions, advertis-
ing the capability to make deposits from homes, businesses, shopping centers, and thou-
sands of other, more convenient locations. Key questions for the future:
• With mobile-phone digital services who will want to write checks?
• What will be the use of building or operating branch offices and automated teller
machines (ATMs)?
• With phone delivery what is the compelling reason to actually visit a depository
institution?
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• What opportunities for attracting new deposits and new sources of revenue does
mobile-phone banking present to the industry?
• How many more phone users, compared to deposit holders, are there as prospective
customers around the globe?
Increasingly electronic payment services (such as PayPal) are capturing the consumer’s
money in place of banks and other depository institutions. Banking’s share of “swipe fees”
at store registers generally have declined as electronic transactions have taken over.
Nontransaction (Savings or Thrift) Deposits

Savings or thrift deposits are designed to attract funds from customers who wish to set
aside money in anticipation of future expenditures or for financial emergencies. These
deposits normally pay significantly higher interest rates than transaction deposits do.
While their interest cost is higher, thrift deposits are generally less costly to process and
manage on the part of offering institutions.
Key URLs
Issues in the deposit
Just as depository institutions for decades offered only one basic transaction deposit—
field often show up the regular checking account—so it was with savings plans. Passbook savings deposits
in such sources as the were sold to household customers in small denominations (frequently a passbook deposit
Financial Institutions could be opened for as little as $5), and withdrawal privileges were unlimited. While
Center at fic.wharton legally a depository institution could insist on receiving prior notice of a planned with-
.upenn.edu/fic/, Bank
Security Publications at
drawal from a passbook savings deposit, few institutions insisted on this technicality
www.banksecurity.com, because of the low interest rate paid on these accounts and because passbook deposits
and the Electronic tend to be stable anyway, with little sensitivity to changes in interest rates. Individu-
Funds Transfer Services als, nonprofit organizations, and governments can hold savings deposits, as can business
(EFTS) site maintained firms, but in the United States businesses could not place more than $150,000 in such a
by the Federal Trade
Commission at www
deposit.
.ftc.gov/bcp/edu/pubs/ Some institutions offer statement savings deposits, evidenced only by computer entry.
consumer/credit/cre The customer can get monthly printouts or electronic statements, showing deposits, with-
.pdf. drawals, interest earned, and the balance in the account. Many depository institutions,
however, still offer the more traditional passbook savings deposit, where the customer is
given a booklet or electronic message, showing the account’s balance, interest earnings,
deposits, and withdrawals, as well as the many rules that bind depository institution and
depositor.
For many years, wealthier individuals and businesses have been offered time deposits,
which carry fixed maturity dates (often covering 30, 60, 90, 180 or 360 days and 1 through
5 years or more) with fixed and sometimes fluctuating interest rates. More recently, time
deposits have been issued with interest rates adjusted periodically (such as every 90 days,
known as a leg or roll period). Time deposits must carry a minimum maturity of seven days
Key Video Link and normally cannot be withdrawn before that.
@ http://www Time deposits come in a wide variety of types and terms. However, the most popular of
.monkeysee.com/
all time deposits are CDs—certificates of deposit. CDs may be issued in negotiable form—the
play/16380-what-is-
a-cd learn the basics $100,000-plus instruments purchased principally by corporations and wealthy individuals
about CDs. that may be bought and sold any number of times prior to reaching their maturity—or in
nonnegotiable form—smaller denomination accounts that cannot be traded prior to matu-
rity and are usually acquired by individuals. Innovation has entered the CD marketplace
recently with the development of bump-up CDs (allowing a depositor to switch to a higher
interest rate if market interest rates rise); step-up CDs (permitting periodic upward adjust-
ments in promised interest rates); liquid CDs (allowing the depositor to withdraw some of
his or her funds without a withdrawal penalty); and index CDs (linking returns on these
certificates to stock market performance, such as returns on the Standard and Poor’s 500
stock index).
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Retirement Savings Deposits

In 1981, with passage of the Economic Recovery Tax Act, the U.S. Congress opened the
door to yet another deposit instrument—retirement savings accounts. Wage earners and
salaried individuals were granted the right to make limited contributions each year, tax
free, to an individual retirement account (IRA), offered by depository institutions, brokerage
firms, insurance companies, and mutual funds, or by employers with qualified pension or
profit-sharing plans. There was ample precedent for the creation of IRAs; in 1962, Con-
gress had authorized financial institutions to sell Keogh plan retirement accounts, available
to self-employed persons.
Key Video Link In 1997 the Congress, in an effort to encourage more saving for retirement, purchases
@ http://www.youtube of new homes, and childrens’ education, modified the rules for IRA accounts, allowing
.com/watch?v= individuals with higher incomes to make annual tax-deductible contributions to their
HhEJnjRRQVo Bill retirement accounts and families to set up new education savings accounts that could grow
Gerhard, Director of
Financial Services at
tax-free until needed to cover college tuition and other qualified educational expenses. At
AAA, provides a basic the same time the Tax Relief Act of 1997 created the Roth IRA, which allows individuals
introduction to IRAs. to make non-tax-deductible contributions to a savings fund that can grow tax free but pay
no tax on their investment earnings when withdrawn.
Concern by Congress over the fact that few workers still appeared to be saving for
retirement led to passage of the Pension Protection Act of 2006. This law makes it easier
for employers to automatically enroll their employees in retirement plans through payroll
deductions. In some cases workplace retirement plans periodically reallocate a worker’s pay-
roll savings into different retirement assets as circumstances change, even if the worker
herself doesn’t do so (known as a “default option”). These employer-engineered decisions
regarding employees’ retirement accounts are subject to the proviso that the manager run-
ning the retirement plan act not recklessly but as a “prudent person” would.
Today depository institutions in the United States hold about a quarter of all IRA and
Keogh retirement accounts outstanding, ranking second only to mutual funds. The great
appeal for the managers of depository institutions is the high degree of stability of IRA and
Keogh deposits—financial managers can generally rely on having these funds around for
several years. Moreover, many IRAs and Keoghs carry fixed interest rates—an advantage if
market interest rates are rising—allowing depository institutions to earn higher returns on
their loans and investments that more than cover the interest costs associated with IRAs
and Keoghs. (These retirement accounts were made more attractive to the public recently
when the U.S. Congress voted to increase FDIC insurance coverage to $250,000 for quali-
fied deposits.) Overall, however, Keogh and IRA retirement accounts represented less than
5 percent of the total deposits of U.S. FDIC-insured banks.
12–3 Interest Rates Offered on Different Types of Deposits

Each of the different types of deposits we have discussed typically carries a different rate
of interest. In general, the longer the maturity of a deposit, the greater the yield that must
be offered to depositors because of the time value of money and the frequent upward
slope of the yield curve. For example, NOW accounts and savings deposits are subject to
immediate withdrawal by the customer; accordingly, their offer rate to customers is among
the lowest of all deposits. In contrast, negotiable CDs and deposits of a year or longer to
maturity often carry the highest interest rates that depositories offer.
The size and perceived risk exposure of offering institutions also play an important
role in shaping deposit interest rates. For example, banks in New York and London, due
to their greater size and strength, typically are able to offer deposits at the lowest average
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interest rates, while deposit rates posted by other institutions are generally scaled upward
from that level. Other key factors are the marketing philosophy and goals of the offering
institution. Depository institutions that choose to compete for deposits aggressively will
post higher offer rates to bid deposits away from their competitors.
The Composition of Deposits

Factoid The largest of all depository institutions are commercial banks, whose $9.3 trillion
Virtual (Web-centered) in deposits in 2010 exceeded the deposits held by all nonbank depository institutions
banks generally offer (including thrifts and credit unions) by a ratio of more than four to one. By examining
higher deposit interest
rates than do traditional recent trends in bank deposits we can get a pretty good idea of recent changes in the mix
brick-and-mortar of deposits at all types of depository institutions in recent years.
banks. Why? In recent years, banks have been most able to sell time and savings deposits—interest-bearing
Answer: This is thrift accounts—to the public. As Table 12–1 shows, time and savings deposits represented
probably due to the more than four-fifths of the total deposits held by all U.S.-insured commercial banks by 2010.
somewhat greater
perceived risk of the Not surprisingly, then, interest-bearing deposits and nontransaction deposits, both of which
Web-based banks and include time and savings deposits, have captured the majority share of all deposit accounts. In
their frequent lack of contrast, regular demand deposits, which generally pay little or no interest and make up the
a complete menu of majority of transaction and noninterest-bearing deposits, have declined significantly to less
services. than 10 percent of total deposits inside the United States.
Indeed, as Gerdes et al. [1] observed, the volume of checks paid in the United States
Filmtoid fell from close to 50 billion in 1995 to only about 40 billion most recently due mainly to
What Christmastime the rise of electronic payments media, including credit and debit cards, Web-based pay-
ritual finds James
Stewart playing the
ments systems, and electronic wire transfers. However, most authorities argue that checks
manager of a small-town written against demand (transaction) deposits will continue to be important in the Amer-
thrift with funding ican payments system, though in parts of Europe (particularly in Finland, Germany, and
problems so severe that the Netherlands) electronic payments are rapidly moving upward.
core depositors are lined Bankers, if left to decide for themselves about the best mix of deposits, would generally
up to withdraw all their
money?
prefer a high proportion of transaction deposits (including regular checking or demand
Answer: It’s a accounts) and low-yielding time and savings deposits. These accounts are among the
Wonderful Life. least expensive of all sources of funds and often include a substantial percentage of core
deposits—a stable base of deposited funds that is not highly sensitive to market interest
rates (i.e., bears a low interest-rate elasticity) and tends to remain with a depository insti-
tution. While many core deposits (such as small savings accounts) can be withdrawn
immediately, they have an effective maturity often spanning years. Thus, the availability
of a large block of core deposits increases the duration of a depository institution’s liabili-
ties and makes that institution less vulnerable to swings in interest rates. The presence
TABLE 12–1 Percentages for All U.S. FDIC-Insured Banks

The Changing
Composition of Deposit Type or Category 1983 1987 1993 1998 2001 2007 2010*
Deposits in the Noninterest-bearing deposits 37.9% 20.5% 20.8% 19.5% 19.9% 16.4% 18.2%
United States Interest-bearing deposits 62.1 79.5 79.2 80.5 80.1 83.6 81.8
Total deposits 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Transaction deposits 31.9% 32.3% 33.4% 24.3% 21.2% 12.5% 12.3
Nontransaction deposits 68.1 67.7 66.6 75.7 78.8 87.5 87.7
Total domestic office deposits 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Demand deposits 25.4% 22.9% 20.2% 18.9% 19.0% 8.8% 8.7
Savings deposits** 30.2 36.2 41.2 43.5 48.0 55.1 64.3
Time deposits 44.4 40.9 38.6 37.6 33.0 36.1 27.0
Total domestic office deposits 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
*Figures based on data for September 30, 2010.

**The savings deposit figures include money market deposit accounts (MMDAs).
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of substantial amounts of core deposits in smaller banks helps explain why large banks
in recent years have acquired so many smaller banking firms—to gain access to a more
stable, less-expensive deposit base. In 2010, according to the FDIC, core deposits (prin-
cipally small savings and checkable accounts) represented 80 percent of total deposits at
the smallest (under $100 million in assets) U.S. banks compared to about 70 percent at
the largest ($1 billion in assets plus) U.S. banking firms. However, the combination of
inflation, government deregulation, stiff competition, and better-educated customers has
resulted in a dramatic shift in the mix of deposits that depository institutions are able to
sell, including a decline in core accounts.
Operating costs for institutions offering deposit services have soared in recent years.
For example, interest payments on deposits (both foreign and domestic) for all insured
U.S. commercial banks amounted to about $10 billion in 1970, but had jumped to more
than $200 billion in 2010. At the same time new, higher-yielding deposits proved to be
more interest sensitive than older, less-expensive deposits, thus putting pressure on man-
agement to pay competitive interest rates on their deposits. Depository institutions that
didn’t keep up with market interest rates had to be prepared for extra liquidity demands—
substantial deposit withdrawals and fluctuating deposit levels. Faced with substantial
interest cost pressures, many financial managers have pushed hard to reduce their institu-
tion’s noninterest expenses (e.g., by automating their operations and reducing the number
of employees on the payroll).
The Ownership of Deposits

The dominant holder of bank deposits inside the United States is the private sector—
individuals, partnerships, and corporations (IPC)—accounting for three-quarters of all
U.S. deposits. The next largest deposit owner is state and local governments (about
4 percent of the total), representing the funds accumulated by counties, cities, and other
local units of government. These deposits are often highly volatile, rising sharply when
tax collections roll in or bonds are sold, and falling precipitously when local government
payrolls must be met or construction begins on a new public building. Many depository
institutions accept state and local deposits as a service to their communities even though
these deposits frequently are not highly profitable.
Factoid Banks also hold comparatively small amounts of U.S. government deposits. In fact,
The more rapid the the U.S. Treasury keeps most of its operating funds in domestic banking institutions
turnover of population
in Treasury tax and loan (TT&L) accounts. When taxes are collected from the public
in a given market area,
the more intensive or Treasury securities are sold to investors, the government usually directs these funds
tends to be competition into TT&L deposits first, in order to minimize the impact of government operations
among depository on the financial system. The Treasury then makes periodic withdrawals (directing the
institutions in the sale money into its accounts at the Federal Reserve banks) when it needs to make expendi-
of deposit services and
tures. Today the Treasury pays fees to depository institutions to help lower the cost of
the more favorable loan
and deposit interest handling government deposits and receives interest on many of the balances held with
rates tend to be, depository institutions.
unless the relocation Another deposit category of substantial size is deposits held by foreign governments,
of depositors doesn’t businesses, and individuals, many of which are received in offshore offices. Foreign-owned
require a change of
deposits rose rapidly during the 1960s and 1970s, climbing to nearly one-fifth of total U.S.
depository institution.
bank deposits in 1980, reflecting the rapid growth in world trade and investments by
U.S. businesses abroad. However, foreign-owned deposits then declined as a proportion of
U.S. bank funds as domestic interest rates proved to be significantly cheaper. Moreover,
international crises, the tragedy of 9/11, and recent economic fluctuations encouraged Ameri-
can banks to scale down their overseas expansion plans. However, as the 21st century
unfolded, foreign deposits began to grow again due to the availability of higher-yielding
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E-BANKING AND E-COMMERCE
CHECK CLEARING FOR THE 21ST CENTURY ACT In 2004, the Check 21 Act became law, permitting depository
(CHECK 21) institutions to electronically transfer check images instead of
Paper checks are being processed much faster these days checks themselves, replacing originals with substitute checks.
and more businesses and consumers are going electronic. In These are photographed copies of the front and back of the origi-
past years depositors used to count on “float” time between nal check that can be processed as though they were originals.
the moment they wrote a check and the time funds were The front will say: “This is a legal copy of your check. You can
actually removed from their checking account. With float the use it in the same way you would use the original check.” Thus,
check writer could often beat the check back to his bank and substitute checks provide proof that you paid a bill just as would
deposit more money just in time. Today, however, funds often be the case if you had the original check.
get moved out of one account into another the same day. Check 21 carries a number of benefits for both depositors
Increasingly financial firms are capturing the float that used and depository institutions. It protects depositors against loss
to benefit depositors. from substitute checks. The depositor can contact his or her
At the heart of the newly emerging check system is a deposit institution to request a refund when the use of substi-
process known as electronic check conversion, which takes tute checks has led to an error that cost the depositor money.
information from the check you have written and electroni- Check 21 also benefits depository institutions by sharply reduc-
cally debits your account, often on the spot. Your check is not ing the cost of check clearing, especially in doing away with
sent through the normal clearing process used in the past. the necessity of shipping bundles of checks around the coun-
Indeed, some merchants will stamp “void” on your check and try. However, from the customer’s point of view more bounced
give it right back to you once they have electronically trans- checks and overdraft charges are likely. (For further informa-
ferred the data it contains. Moreover, more depository institution about Check 21 and the rights and obligations of deposi-
tions are neither returning checks to their deposit customers tors and institutions, see, especially, www.federalreserve.gov/
nor sending original checks to other depository institutions. check21.)
foreign investments, the continued expansion of several foreign economies (especially in

Asia), and a deep business recession in Europe and the United States.
Key URL The final major deposit ownership category is deposits of other banks, which include
To learn more about correspondent deposits, representing funds that depository institutions hold with each other
Check 21, to pay for correspondent services. For example, large metropolitan banks provide data
see http://www
.privacyrights.org/fs/ processing and computerized recordkeeping, investment counseling, participations in
fs30-check21.htm. loans, and the clearing and collection of checks and other drafts for smaller urban and
outlying depository institutions. An institution that holds deposits received from other
depositories will record them as a liability on its balance sheet under the label deposits due
to banks and other depository institutions. The institution that owns such deposits will record
them as assets under the label deposits due from banks and other depository institutions.
The Cost of Different Deposit Accounts

Other factors held constant, the managers of depository institutions would prefer to raise
funds by selling those types of deposits that cost the least amount of money or, when
revenues generated by the use of deposited funds are considered, generate the greatest net
revenue after expenses. If a depository institution can raise all of its funds from sales of the
cheapest deposits and then turn around and purchase the highest-yielding assets, it will
maximize its spread and, possibly, its net income. But what are the cheapest deposits? And
which deposits generate the highest net revenues?
Research based upon cost-accounting techniques suggests that checkable (demand or
transaction) deposits—including regular checking accounts, special checkbook deposits
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Real Banks, Real Decisions

WHO OFFERS THE HIGHEST DEPOSIT INTEREST RATES, AND WHY?
Customers interested in purchasing the highest-yielding interest-bearing deposits and the manag-
ers of depository institutions interested in discovering what deposit interest yields their competitors
are offering can consult newspapers or go online to key websites—for example, www.banx.com or
www.Bankrate.com.
Among the key types of deposit rate information available are these:
• The average yields (APY) offered on CDs purchased through security brokers who search the
marketplace every day for the highest yields available on large deposits (usually close to $100,000
in size).
• A list of those depository institutions offering the highest yields (APYs) on retail deposits (typically
$500 to $25,000 minimum denomination) and jumbo CDs (usually carrying an opening balance of
about $100,000 or even larger).
Among the depository institutions offering the highest deposit yields are usually leading credit
card and household lenders, such as Discover Bank, Ally Bank (formerly GMAC Bank), and E* Trade
Bank.
Why are the foregoing institutions generally among the leaders in offering deposit interest rates?
One reason is they expect to earn relatively high returns on their consumer and credit card loans,
giving them an ample margin over deposit costs.
In the case of Internet-based banking institutions these unique electronic firms must attract the
public away from more traditional institutions and often provide few services, so they must offer
exceptional deposit rates to attract the funds they need. Moreover, virtual banks typically have rela-
tively low fixed (overhead) costs, allowing these firms to bid higher for the public’s deposits.
On the negative side, however, many virtual banks have not been as successful in attracting cus-
tomers as have traditional depository institutions in recent years. Indeed, the most successful firms
at attracting customer deposits recently have been multichannel depository institutions—offering
both traditional and online services through the same institution—indicating that many customers
are more likely to use online services of financial firms that also are accessible in person through
traditional branch offices and automated teller machines.
(which often pay no interest), and interest-bearing checking accounts—are typically

among the lowest-cost deposits that depositories sell. While check processing and account
maintenance are major expense items, the absence of interest payments on many demand
(transaction) deposit accounts help keep their cost down relative to other sources of funds.
Moreover, check-processing costs should move substantially lower in the period ahead as
check imaging becomes more widely used. Paper checks are rapidly being supplanted by
electronic images, permitting greater storage capacity and faster retrieval, cutting costs
and improving service.
Especially popular in the new century have been automatic bill-paying services, including
online bill payment services offered by depository institutions and direct electronic debits
that you authorize out of your bank account and are carried out by a credit card company
or other merchant to whom you owe money. Increasingly it is becoming possible to pay
almost every bill without cutting a check or visiting a list of websites. Funds are simply
automatically “yanked out” of your account on the same day each month.
In fact, so significant has been the recent decline in paper check volume that the
Federal Reserve System announced recently that it was reducing the number of check
processing regions in the United States. This trend has gotten a favorable reception
from financial institutions hoping to reduce operating costs. However, check writing has
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generated substantial fee income for most offering institutions—a key source of revenue
that will have to be replaced with new revenue sources as the global financial system goes
more and more electronic.
Thrift deposits—particularly money market accounts, time deposits, and savings accounts—
generally rank second to demand deposits as the least costly deposits. Savings deposits are
relatively cheap because of the low interest rate they tend to carry—one of the lowest annual
interest yields (APY) offered—and, in many cases, the absence of monthly statements for
depositors. However, many passbook savings accounts have substantial deposit and withdrawal
activity as some savers attempt to use them as checking (transaction) accounts.
Key Video Link While demand (checking or transaction) deposits have about the same gross expenses per
@ www.eccho.org/ dollar of deposit as time (thrift) deposits do, the higher service fees levied against transaction-
check21_video.php account customers help to lower the net cost of checkable deposits (after service revenues are
see video created by
netted out) below the net cost of most time (thrift) accounts. This factor plus new government
the Electronic Check
Clearing House regulations help explain why depository institutions today are more aggressively pricing their
Organization (ECCH) checkable deposits, asking depositors to pay a bigger share of the activity costs they create
to learn more about when they write checks and transfer funds electronically. When we give each type of deposit
Check 21. credit for the earnings it generates through the making of loans and investments, checkable
(demand) deposits appear to be substantially more profitable than time deposits for the aver-
age depository institution. Moreover, interest expense per dollar of time deposits averages
about triple the interest expense associated with each dollar of demand (transaction) deposits.
Business transaction accounts, generally speaking, are considerably more profitable than
personal checking accounts. One reason is the lower interest expense generally associated with
commercial deposits. Moreover, the average size of a personal transaction account normally
is less than one-third the average size of a commercial account, so a depository institution
receives substantially more investable funds from commercial demand deposits. However,
competition posed by foreign financial-service firms for commercial transaction accounts has
become so intense that profit margins on these accounts often are razor thin in today’s market.
While the managers of depository institutions would prefer to sell only the cheapest
deposits to the public, it is predominantly public preference that determines which types of
deposits will be created. Depository institutions that do not wish to conform to customer
preferences will simply be outbid for deposits by those who do. At the same time, recent
deregulation of the financial markets has made it possible for more kinds of financial-
service firms to respond to the public’s deposit preferences.
Concept Check
12–1. What are the major types of deposit plans that 12–4. What are the consequences for the management
depository institutions offer today? and performance of depository institutions result-
12–2. What are core deposits, and why are they so ing from recent changes in deposit composition?
important today? 12–5. Which deposits are the least costly for depository
12–3. How has the composition of deposits changed in institutions? The most costly?
recent years?
12–4 Pricing Deposit-Related Services

We have examined the different types of deposit plans offered today and how the compo-
sition of deposits has been changing over time. An equally important issue remains: How
should depository institutions price their deposit services in order to attract new funds and
make a profit?
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Factoid In pricing deposit services, management is caught on the horns of an old dilemma. It
Several deposit-related needs to pay a high enough interest return to attract and hold customer funds, but must
fees charged by depository
avoid paying an interest rate so costly it erodes any potential profit margin. In fact, in
institutions have increased
faster than inflation in a financial marketplace that approaches perfect competition, the individual depository
recent years. These more institution has little control over its prices. It is the marketplace, not the individual finan-
rapidly rising bank fees cial firm, that ultimately sets prices. Financial institutions, like most other businesses, are
include charges for checks price takers, not price makers. In such a marketplace, management must decide if it wishes
returned for insufficient
to attract more deposits and hold all those it currently has by offering depositors at least
funds, stop-payment
orders, ATM-usage fees, the market-determined price, or whether it is willing to lose funds.
and overdraft fees.
12–5 Pricing Deposits at Cost Plus Profit Margin

The idea of charging the customer for the full cost of deposit-related services is relatively
new. In fact, until a few decades ago the notion that customers should receive most deposit-
related services free of charge was hailed as a wise innovation—one that responded to the
growing challenge posed by other financial intermediaries that were invading traditional
deposit markets. Many managers soon found reason to question the wisdom of this market-
ing strategy, however, because they were flooded with numerous low-balance, high-activity
accounts that ballooned their operating costs.
Key URL The development of interest-bearing checkable deposits (particularly NOWs) offered
Each year under law the financial managers the opportunity to reconsider the pricing of deposit services. Unfortunately,
Federal Reserve Board
many of the early entrants into this new market moved aggressively to capture a major share of
must conduct a survey
of retail fees charged by the customers through below-cost pricing. Customer charges were set below operating and over-
depository institutions head costs associated with providing deposit services. The result was a substantially increased
on deposits and other rate of return to the customer, known as the implicit interest rate—the difference between the
services. For an example true cost of supplying fund-raising services and the service fees actually assessed the customer.
of recent survey data on
In the United States, variations in the implicit interest rate paid to the customer were
service fees, see www
.federalreserve.gov/ the principal way most banks competed for deposits over the 50 years stretching from the
boarddocs/rptcongress/. Great Depression to the beginning of the 1980s. This was due to the presence of regula-
tory ceilings on deposit interest rates, beginning in 1933 with passage of the Glass-Steagall
Key URL Act. These legal interest rate ceilings (Regulation Q) were designed to protect depository
For more information institutions from “excessive” interest rate competition for deposits, which could allegedly
on the findings of
cause them to fail. Prevented from offering higher explicit interest rates, U.S. depositories
recent research about
the factors depositors competed instead by offering free bank-by-mail services, gifts ranging from teddy bears to
consider in choosing toasters, and convenient neighborhood branch offices.
depository institutions, Unfortunately, such forms of nonprice competition tended to distort the allocation of scarce
see, for example, www resources in the financial sector. Congress finally responded to these problems with passage
.federalreserve.gov/
of the Depository Institutions Deregulation Act of 1980, a federal law that called for a grad-
pubs/feds/.
ual phaseout of federal limits on the interest rates depositories could offer their customers.
Factoid Today, the responsibility for setting deposit prices has been transferred largely from public
Which type of depository
regulators to private decision makers—that is, to depository institutions and their customers.
institution—small banks
versus large banks, Deregulation has brought more frequent use of unbundled service pricing as greater com-
interstate banks versus petition has raised the average real cost of a deposit for deposit-service providers. This
single-state banks—tend means that deposits are usually priced separately from other services. And each deposit
to charge the highest service may be priced high enough to recover all or most of the cost of providing that
fees for deposit-related
service, using the following cost-plus pricing formula:
services? As noted by
Hannan [9], larger banks
Unit price Operating Estimated overhead Planneed
and interstate banks tend
to levy higher deposit- charged the expense expense alloccated profit margin
related fees, especially (12–1)
low-balance, insufficient
customer for each per unit of to the deposit- from each
funds, and stop-payment deposiit service depossit service service function service unit sold
fees.
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12-6 New Deposit Insurance Rules–Insights and Issues

SUMMARY OF DEPOSIT INSURANCE COVERAGE least $500,000 until arrangements can be made to transfer some of
PROVIDED BY THE FDIC the depositor’s funds to other institutions.
A major reason depository institutions are able to sell deposits at Insurance coverage may also be increased at a single institution
relatively low rates of interest compared to interest rates offered by placing funds under different categories of legal ownership. For
on other financial instruments is because of government-supplied example, a depositor with $250,000 in a savings deposit and another
deposit insurance. The Federal Deposit Insurance Corporation $250,000 in a time deposit might achieve greater insurance cover-
(FDIC) was established in 1934 to insure deposits and protect the age by making one of these two accounts a joint ownership account
U.S. money supply in those cases where depository institutions with his or her spouse. Also, if a family is composed of husband and
having FDIC membership failed. Insured depository institutions wife plus one child, for example, each family member could own
must display an official sign at each teller station, indicating they an account and each pair of family members could also hold joint
hold an FDIC membership certificate. accounts, resulting in insurance coverage up to $1,500,000 in total.
FDIC insurance covers only those deposits made in the United Only natural persons, not corporations or partnerships, can set up
States, though the depositor does not have to be a U.S. resident to insurance-eligible joint accounts.
receive FDIC protection. All types of deposits normally are covered Each co-owner of a joint account is assumed to have equal
up to at least $250,000 for each single account holder. As the table right of withdrawal and is also assumed to own an equal share of
below illustrates FDIC insurance coverage has increased substan- a joint account unless otherwise stated in the account record. No
tially in recent years in an effort to promote public confidence in the one person’s total insured interest in all joint accounts at the same
banking system and deal with inflation, among other factors. insured depository institution can exceed $250,000. For example,
suppose Mr. Jones has a joint account with Mrs. Jones amounting
FDIC Insurance Coverage Limits:
to $700,000. Then each is presumed to have a $350,000 share and
Standard Standard each would have maximum FDIC insurance coverage of $250,000
Year Coverage Limit Year Coverage Limit unless the deposit record shows that, for example, Mrs. Jones
1934 $ 2,500 1968–73 $ 20,000 owns $500,000 of the $700,000 deposit and Mr. Jones would be cov-
ered, therefore, for a maximum of only $200,000.
1934–49 5,000 1974–79 40,000
IRA and Keogh retirement deposits also became fully insured up
1950–65 10,000 1980–2007 100,000 to $250,000 with the passage of recent legislation. Deposits belong-
1966–68 15,000 2008 250,000* ing to pension and profit-sharing plans receive “pass-through insur-
Note: *Coverage of up to $250,000 was temporary in 2008 and 2009 and made ance” provided the individual participants’ beneficial interests are
permanent in 2010 with passage of the Dodd-Frank Wall Street Reform and ascertainable and the depository institution involved is at least
Consumer Protection Act. “adequately capitalized.”
Savings deposits, checking accounts, NOW accounts, Christ- Funds deposited by a corporation, partnership, or unincorporated
mas Club accounts, time deposits, cashiers’ checks, money orders, business or association are insured up to the maximum allowed by
officers’ checks, and any outstanding drafts normally are protected law and are insured separately from the personal accounts of the
by federal insurance. Certified checks, letters of credit, and travel- company’s stockholders, partners, or members. Funds deposited by
er’s checks for which an insured depository institution is primarily a sole proprietor are considered to be personal funds, however, and
liable also are insured if these are issued in exchange for money or are added to any other single-owner accounts the individual busi-
in return for a charge against a deposit. On the other hand, U.S. gov- ness owner has and are protected at least up to $250,000.
ernment securities, shares in mutual funds, safe deposit boxes, and The amount of insurance premiums each FDIC-insured deposi-
funds stolen from an insured depository institution are not covered tory institution must pay is determined by the volume of deposits
by FDIC insurance. Depository institutions generally carry private it receives from the public and by the insurance rate category in
insurance for these items. which each institution falls. Under the current risk-based deposit
Deposits placed in separate financial institutions are insured insurance system more risky depository institutions must pay higher
separately, each eligible for full coverage. However, deposits held insurance premiums. The degree of risk exposure is determined by
in more than one branch office of the same depository institution the interplay of two factors: (1) the adequacy of capital maintained
are added together to determine the total amount of insurance pro- by each depository institution and (2) the risk class in which the
tection available. If two formerly independent institutions merge, institution is judged to be according to its regulatory supervisors.
for example, and a depositor holds $250,000 in each of these two Well-capitalized, A-rated depositories pay the lowest deposit insur-
merging institutions, the total protection afforded this depositor ance fee per each $100 of deposit they hold, while undercapitalized,
would then be a maximum of $250,000, not $500,000, as it would have C-rated institutions pay the greatest insurance fees.
been before the merger. However, the FDIC normally allows a grace Twice each year the board of directors of the FDIC must decide
period so that, for a short time, a depositor with large deposits in what insurance rates to assess insured institutions. If the federal
two institutions that merge can receive expanded coverage up to at insurance fund falls below $1.25 in reserves per $100 in covered
(continued)
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12-6 New Deposit Insurance Rules–Insights and Issues (Continued)

deposits (known as the Designated Reserve Ratio [DRR]), the above—sometimes referred to as the “hard” target—may be
FDIC will raise its insurance fees. When the amount of reserves altered at the FDIC’s discretion to form a “soft” target—that is, the
exceeds the $1.25 per $100 standard, insurance fees may be low- FDIC has the authority to allow the DRR to range between 1.15 and
ered or eliminated. 1.50 percent of all insured deposits. Thus, the FDIC now has more
The boards of the FDIC and the National Credit Union Admin- flexibility in deciding when it needs to change insurance fees and
istration are authorized to increase the insurance limit every five the amount of depositor insurance protection that it provides.
years in order to protect against inflation, provided this seems
warranted. Moreover, the 1.25 percent required DRR mentioned Source: Federal Deposit Insurance Corporation.
Key Video Link

@ www.fdic.gov/
deposit/deposits/video/ Tying deposit pricing to the cost of deposit-service production, as Equation (12–1)
videos.html get a better does, has encouraged deposit providers to match prices and costs more closely and elimi-
understanding of the nate many formerly free services. In the United States, for example, more depositories are
ins and outs of deposit now levying fees for excessive withdrawals, customer balance inquiries, bounced checks,
insurance coverage by stop-payment orders, and ATM usages, as well as raising required minimum deposit bal-
watching this series of
videos for customers, ances. The results of these trends have generally been favorable to depository institutions,
depository institution with increases in service fee income generally outstripping losses from angry customers
employees, and bankers. closing their accounts.
12–7 Using Marginal Cost to Set Interest Rates on Deposits

Many financial analysts argue that, whenever possible, marginal cost—the added cost of
bringing in new funds—and not historical average cost, which looks at the past, should
be used to help price funds sources for a financial-service institution. The reason is that
Key URLs frequent changes in interest rates will make historical average cost a treacherous standard
To learn more about for pricing. For example, if interest rates are declining, the added (marginal) cost of rais-
FDIC deposit insurance ing new money may fall well below the historical average cost over all funds raised. Some
rules, see, especially,
loans and investments that looked unprofitable when compared to historical cost will now
www2.fdic.gov/edie
and the FDIC’s new look profitable when measured against the lower marginal interest cost we must pay today.
Learning Bank site, Conversely, if interest rates are on the rise, the marginal cost of today’s new money may
www.fdic.gov/about/ substantially exceed the historical cost of funds. If management books new assets based
learn/learning/index on historical cost, they may turn out to be unprofitable when measured against the higher
.html. You may also
marginal cost of raising new funds in today’s market.
wish to consult the
recently established Economist James E. McNulty [8] has suggested a way to use the marginal, or new money,
FDIC Call Center at cost idea to help a depository institution set the interest rates it will offer on new deposit
1-877-ASK-FDIC. accounts. To understand this marginal cost pricing method, suppose a bank expects to
raise $25 million in new deposits by offering its depositors an interest rate of 7 percent.
Management estimates that if the bank offers a 7.50 percent interest rate, it can raise
$50 million in new deposit money. At 8 percent, $75 million is expected to flow in, while
a posted deposit rate of 8.5 percent will bring in a projected $100 million. Finally, if the
bank promises an estimated 9 percent yield, management projects that $125 million in
new funds will result from both new and existing deposits that customers will keep in the
bank to take advantage of the higher rates offered. Let’s assume as well that management
believes it can invest the new deposit money at a yield of 10 percent. This investment
yield represents marginal revenue, the added operating revenue the bank will generate by
making new investments from new deposits. Given these facts, what deposit interest rate
should the bank offer its customers?
409
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Key URL As Table 12–2 shows, we need to know at least two crucial items to answer this ques-
To track the deposit tion: the marginal cost of moving the deposit rate from one level to another and the mar-
growth of any FDIC-
ginal cost rate, expressed as a percentage of the volume of additional funds coming into the
insured depository
institution, go to bank. Once we know the marginal cost rate, we can compare it to the expected additional
www2.fdic.gov/sdi/. revenue (marginal revenue) the bank expects to earn from investing its new deposits. The
items we need are:
Marginal cost Change in total cost New interrest rate Total funds
(12–2)
raised at new rate Oldd interest rate Total funds raised at old rate
and
Change in total cost
Marginal cost rate (12–3)
Addittional funds raised
Factoid For example, if the bank raises its offer rate on new deposits from 7 percent to 7.5 percent,
By 2010 total estimated Table 12–2 shows the marginal cost of this change: Change in total cost 5 $50 million
FDIC-insured deposits 3 7.5 percent 2 $25 million 3 7 percent 5 $3.75 million 2 $1.75 million 5 $2.00 mil-
reached a record
$6.2 trillion compared lion. The marginal cost rate, then, is the change in total cost divided by the additional
to only $4.3 trillion funds raised, or
three years before.”
$2 million
8 percent
$25 million
Notice that the marginal cost rate at 8 percent is substantially above the average
deposit cost of 7.5 percent. This happens because the bank must not only pay a rate
of 7.5 percent to attract the second $25 million, but it must also pay out the same 7.5
percent rate to those depositors who were willing to contribute the first $25 million at
only 7 percent.
Because the bank expects to earn 10 percent on these new funds, marginal revenue
exceeds marginal cost by 2 percent at a deposit interest cost of 8 percent. Clearly, the new
deposits will add more to revenue than they will to cost. The bank is justified (assuming
TABLE 12–2 Using Marginal Cost to Choose the Interest Rate to Offer Customers on Deposits
Example of a Bank Attempting to Raise New Deposit Funds
Marginal
Cost as a Expected
Expected Percentage Marginal Difference
Amounts of Average Total Marginal of New Revenue between
New Interest Interest Cost of Funds (return) Marginal Total Profits
Deposits the Bank Will Cost of New Attracted from Revenue and Earned
That Will Pay on New New Funds Deposit (marginal Investing the Marginal (after interest
Flow In Funds Raised Money cost rate) New Funds Cost Rate cost)
$ 25 7.0% $ 1.75 $1.75 7.0% 10.0% 13% $0.75
50 7.5 3.75 2.00 8.0 10.0 12% 1.25
75 8.0 6.00 2.25 9.0 10.0 11% 1.50
100 8.5 8.50 2.50 10.0 10.0 10 1.50
125 9.0 11.25 2.75 11.0 10.0 21% 1.25
Note: Figures in millions except percentages.
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its projections are right) in offering a deposit rate at least as high as 7.5 percent. Its total
profit will equal the difference between total revenue ($50 million 3 10 percent 5
$5 million) and total cost ($50 million 3 7.5 percent 5 $3.75 million), for a profit of
$1.25 million.
Scanning down Table 12–2, we note that the bank continues to improve its total profits,
with marginal revenue exceeding marginal cost, up to a deposit interest rate of 8.5 percent.
At that rate the bank raises an estimated $100 million in new money at a marginal cost
rate of 10 percent, matching its expected marginal revenue of 10 percent.
There, total profit tops out at $1.5 million. It would not pay the bank to go beyond this
point, however. For example, if it offers a deposit rate of 9 percent, the marginal cost rate
balloons upward to 11 percent, which exceeds marginal revenue by a full percentage point.
Attracting new deposits at a 9 percent offer rate adds more to cost than to revenue. Note,
too, that total profits at a 9 percent deposit rate fall back to $1.25 million. The 8.5 percent
deposit rate is clearly the best choice, given all the assumptions and forecasts made.
The marginal cost approach provides valuable information to the managers of depository
institutions, not only about setting deposit interest rates, but also about deciding just how
far the institution should go in expanding its deposit base before the added cost of deposit
growth catches up with additional revenues, and total profits begin to decline. When profits
start to fall, management needs either to find new sources of funding with lower marginal
costs, or to identify new assets promising greater marginal revenues, or both.
Conditional Pricing
The appearance of interest-bearing checking accounts in the New England states dur-
ing the 1970s led to fierce competition for customer transaction deposits among deposi-
tory institutions across the United States. Out of that boiling competitive cauldron came
widespread use of conditional pricing, where a depository sets up a schedule of fees in
which the customer pays a low fee or no fee if the deposit balance remains above some
minimum level, but faces a higher fee if the average balance falls below that minimum.
Thus, the customer pays a price conditional on how he or she uses a deposit account.
Conditional pricing techniques vary deposit prices based on one or more of these factors:
1. The number of transactions passing through the account (e.g., number of checks written,
deposits made, wire transfers, stop-payment orders, or notices of insufficient funds issued).
2. The average balance held in the account over a designated period (usually per month).
3. The maturity of the deposit in days, weeks, months, or years.
The customer selects the deposit plan that results in the lowest fees possible and/or the
maximum yields, given the number of checks he or she plans to write, or charges planned
to be made, the number of deposits and withdrawals expected, and the planned average
balance. Of course, the depository institution must also be acceptable to the customer
from the standpoint of safety, convenience, and service availability.
Economist Constance Dunham [7] has classified checking account conditional price
schedules into three broad categories: (1) flat-rate pricing, (2) free pricing, and (3) condi-
tionally free pricing. In flat-rate pricing, the depositor’s cost is a fixed charge per check, per
time period, or both. Thus, there may be a monthly account maintenance fee of $2, and
each check written or charge drawn against that account may cost the customer 10 cents,
regardless of the level of account activity.
Free pricing, on the other hand, refers to the absence of a monthly account mainte-
nance fee or per-transaction charge. Of course, the word free can be misleading. Even
if a deposit-service provider does not charge an explicit fee for deposit services, the cus-
tomer may incur an implicit fee in the form of lost income (opportunity cost) because the
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Insights and Issues

THE TRUTH IN SAVINGS ACT placed in a noninterest-bearing account?) if the customer does
In November 1991, the U.S. Congress passed the Truth in Savings not remember to renew his or her deposit. (Generally, customers
Act, which requires depository institutions to make greater disclo- must receive at least 10 days’ advance notice of the approaching
sure of the terms attached to the deposits they sell the public. On maturity date for deposits over one year to maturity that are not
September 14, 1992, the Federal Reserve Board issued Regulation automatically renewed.) If a change is made in terms that could
DD to spell out the rules that depositories must follow to conform reduce a depositor’s yield, a 30-day advance notice must be sent
with this law. to the depositor.
The Fed’s regulation stipulates that consumers must be fully Depository institutions must send to their customers the amount
informed of the terms on deposit plans before they open a new of interest earnings received, along with the annual percentage
account. A depository institution must disclose the minimum bal- yield earned. The annual percentage yield (or APY) must be calcu-
ance required to open the account, how much must be kept on lated using:
deposit to avoid paying fees or obtain the promised yield, how the
balance in each account is figured, when interest actually begins APY earned 100 [(1 Interest earned/Average account
to accrue, any penalties for early withdrawal, options available at balance)(365 / Day s in period) 1]
maturity, reinvestment and disbursement options, advance notice
where the account balance is the average daily balance kept in
of the approaching end of the deposit’s term if it has a fixed matu-
the deposit for the period covered by each account statement.
rity, and any bonuses available.
Customers must be informed of the impact of early withdrawals
When a consumer asks for the current interest rate the offer-
on their expected APY.
ing institution must provide that customer with the rate offered
For example, suppose a depositor had $1,500 in an interest-
within the most recent seven calendar days and also provide a
bearing account for the first 15 days and $500 in the account for
telephone number so consumers can get the latest offered rate
the remaining 15 days. The average daily balance in this case is
if interest rates have changed. On fixed-rate accounts offering
$1,000, or [($1,500 3 15 days 1 $500 3 15 days)/30 days]. Sup-
institutions must disclose to customers what period of time the
pose the account has been credited with $5.25 in interest for the
fixed rate will be in effect. On variable-rate deposits institutions
latest 30-day period. Then the APY earned is:
must warn consumers that interest rates can change, how fre-
quently they can change, how a variable interest rate is deter- APY 5 100 [(1 1 5.25/1000)365/30 2 1] 5 6.58 percent
mined, and specify if there are limits on how far deposit rates can
move over time. For all interest-bearing accounts the depository In determining the balance on which interest earnings are figured,
must disclose the frequency with which interest is compounded the depository institution must use the full amount of the principal
and credited. in the deposit for each day, rather than counting only the minimum
If a customer decides to renew a deposit that would not be balance that was in the account on one day during the statement
automatically renewed on its own, the renewed deposit is con- period. Methods that do not pay interest on the full principal bal-
sidered a new account, requiring full disclosure of terms. Custom- ance are prohibited. Deposit plans covered by the Truth in Sav-
ers must also be told if their account is automatically renewed ings Act are confined to those accounts held by individuals for a
and, if not, what will happen to their funds (e.g., will they be personal, family, or household purpose.
Factoid
Who cares most about the effective interest rate paid may be less than the going rate on investments of comparable
location of a depository risk. Many depository institutions have found free pricing decidedly unprofitable because
institution—high- it tends to attract many small, active deposits that earn positive returns for the offering
income or low-income institution only when market interest rates are high.
consumers? Recent Conditionally free deposits have come to replace both flat-rate and free deposit pric-
research suggests that low-
income consumers care ing systems in many financial-service markets. Conditionally free pricing favors large-
more about location in denomination deposits because services are free if the account balance stays above some
choosing an institution minimum figure. One of the advantages of this pricing method is that the customer, not
to hold their deposit, the offering institution, chooses which deposit plan is preferable. This self-selection pro-
while high-income cess is a form of market signaling that can give the depository institution valuable data on
customers appear to be
more influenced by the the behavior and cost of its deposits. Conditionally free pricing also allows the offering
size of the financial firm institution to divide its deposit market into high-balance, low-activity accounts and
holding their account. low-balance, high-activity accounts.
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Insights and Issues

HOW U.S. DEPOSITORY INSTITUTIONS SHOULD after the maturity date to withdraw the funds without being
DISCLOSE THE TERMS ON THEIR DEPOSIT SERVICES charged a penalty.
TO CUSTOMERS Both the Truth in Savings Act and the Federal Reserve’s Regu-
In order to help institutions selling deposit services in the United lation DD stipulate that advertising of deposit terms may not be
States conform to the Truth in Savings Act, the Federal Reserve misleading. If interest rates are quoted in an advertisement, the
Board provides managers with examples of proper disclosure institution must tell the public what the other relevant terms of
forms to use to inform customers of the terms being quoted on the deposit are, such as the minimum balance needed to earn the
their deposits. For example, the Fed has provided an example of a advertised yield and whether any fees charged could reduce the
proper disclosure form for certificates of deposit as shown below. depositor’s overall yield.
The Federal Reserve has recently developed sample adver-
Sample Disclosure Form for XYZ Savings Bank One-Year tisements to guide managers in making sure that advertising
Certificate of Deposit contains all the essential information the consumer needs. For
Rate Information The interest rate for your account is 5.20% with example, the sample advertisement form for CDs shown below
an annual percentage yield of 5.34%. You will be paid this rate until was developed recently by the Federal Reserve Board.
the maturity date of the certificate. Your certificate will mature on The sample advertisement illustrates the basic requirements
September 30, 2017. The annual percentage yield assumes interest for legitimate advertising of deposits under the Truth in Savings Act:
remains on deposit until maturity. A withdrawal will reduce earnings. (a) deposit rates must be quoted as annual percentage yields (APY),
Interest will be compounded daily and credited to your account (b) the dates and minimum balance required must be explicit, and
on the last day of each month. Interest begins to accrue on the (c) the depositor must be warned of penalties or fees that could
business day you deposit any noncash item (for example, checks). reduce the yield.
Minimum Balance Requirements You must deposit $1,000 to open

this account. You must maintain a minimum balance of $1,000 in Bank XYZ Always Offers You Competitive CD Rates!!
your account every day to obtain the annual percentage yield listed Annual Percentage
above. Certificate of Deposit Yield (APY)
5-year 6.31%
Balance Computation Method We use the daily balance method
4-year 6.07%
to calculate the interest on your account. This method applies a 3-year 5.72%
daily periodic rate to the principal in the account each day. 2-year 5.25%
1-year 4.54%
Transaction Limitations After the account is opened, you may
6-month 4.34%
not make deposits into or withdrawals from the account until the
90-day 4.21%
maturity date. APYs are offered on
Early Withdrawal Penalty If you withdraw any principal before accounts from 2010
through 2017.
the maturity date, a penalty equal to three months’ interest will be
The minimum balance to open an account and obtain the APY is
charged to your account.
$1,000. A penalty may be imposed for early withdrawal.
Renewal Policy This account will be automatically renewed For more information call: (202) 123-1234.
at maturity. You have a grace period of ten (10) calendar days
As an example of the use of conditional pricing techniques for deposits, the fees for
regular checking accounts and savings accounts posted by two banks are given in
Exhibit 12–1.
We note that Bank A in Exhibit 12–1 appears to favor high-balance, low-activity
checking deposits, while Bank B is more lenient toward smaller checking accounts. For
example, Bank A begins assessing a checking-account service fee when the customer’s
balance falls below $600, while Bank B charges no fees for checking-account services
until the customer’s account balance drops below $500. Moreover, Bank A assesses sig-
nificantly higher service fees on low-balance checking accounts than does Bank B—$5
to $10 per month versus $3.50 per month. On the other hand, Bank A allows unlimited
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EXHIBIT 12–1 Bank A Bank B

Example of the Use
Regular checking account: Regular checking account:
of Conditional Deposit
Minimum opening balance $100 Minimum opening balance $100
Pricing by Two If minimum daily balance is If minimum daily balance is
Banks Serving the $600 or more No fee $500 or more No fee
Same Market Area $300 to $599 $5.00 per mo. Less than $500 $3.50 per mo.
Less than $300 $10.00 per mo.
If the depositor’s collected monthly If checks written or ATM
balance averages $1,500, there is no fee transactions (debits)
No limit on number of checks written exceed 10 per month and
balance is below $500 $0.15 per debit
Regular savings account: Regular savings account:
Minimum opening balance $100 Minimum opening balance $100
Service fees: Service fees:
If balance falls below $200 $3.00 per mo. If balance falls below $100 $2.00 per mo.
Balance of $200 or more No fee Balance above $100 No fee
Fee for more than two Fee for more than three
withdrawals per month $2.00 withdrawals per month $2.00
Key URLs check writing from its regular accounts, while B assesses a fee if more than 10 checks or
A recently introduced withdrawals occur in any month. Similarly, Bank A assesses a $3 per month service fee if
Internet technology
a customer’s savings account dips below $200, while Bank B charges only a $2 fee if the
called aggregation allows
consumers to monitor customer’s savings balance drops below $100.
their checking and These price differences reflect differences in the philosophy of management and own-
savings accounts, their ers of these two banks and the types of customers each bank is seeking to attract. Bank A
other financial is located in an affluent neighborhood of homes and offices and is patronized primarily by
investments, personal
high-income individuals and businesses who usually keep high deposit balances, but also
borrowings, and recent
online purchases make many charges and write many checks. Bank B, on the other hand, is located across
through a single the street from a large university and actively solicits student deposits, which tend to have
website. See, for relatively low balances. Bank B’s pricing schedules are set up to accept low-balance depos-
example, www its, but the bank also recognizes that it needs to discourage excessive charges and check
.bankofamerica
writing by numerous small depositors, which would run up costs. It does so by charging
.com and corporate
.yodlee.com. higher per-check fees than Bank A. In these two instances we can see that deposit pricing
policy is sensitive to at least two factors:
1. The types of customers each depository institution plans to serve—each institution estab-
lishes price schedules that appeal to the needs of individuals and businesses represent-
ing a significant portion of its market area.
2. The cost that serving different types of depositors will present to the offering institution—
most institutions today price deposit plans in such a way as to cover all or at least a
significant portion of anticipated service costs.
12–8 Pricing Based on the Total Customer Relationship

and Choosing a Depository
Related to the idea of targeting the best customers for special treatment is the notion
of pricing deposits according to the number of services the customer uses. Customers who
purchase two or more services may be granted lower deposit fees compared to the fees
charged customers having only a limited relationship to the offering institution. The
idea is that selling a customer multiple services increases the customer’s dependence on
the institution and makes it harder for that customer to go elsewhere. In theory at least,
relationship pricing promotes greater customer loyalty and makes the customer less sensi-
tive to the prices posted on services offered by competing financial firms.
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TABLE 12–3 Factors in Household and Business Customers’ Choice of a Financial Firm for Their Deposit Accounts
(ranked from most important to least important)
Source: Based on studies by the Federal Reserve Board, Survey of Consumer Finances.
In Choosing a Financial Firm to In Choosing a Financial Firm to In Choosing a Financial Firm to

Hold Their Checking (Transaction) Hold Their Savings Deposits, Supply Their Deposits and Other
Accounts, Households Consider Households Consider Services, Business Firms Consider
1. Convenient location. 1. Familiarity. 1. Financial health of lending
2. Availability of many other 2. Interest rate paid. institution.
services. 3. Transactional convenience (not 2. Whether bank will be a reliable
3. Safety location). source of credit in the future.
4. Low fees and low minimum 4. Location. 3. Quality of bank officers.
balance. 5. Availability of payroll deduction. 4. Whether loans are competitively
5. High deposit interest rates. 6. Fees charged. priced.
5. Quality of financial advice given.
6. Whether cash management and
operations services are provided.
The Role That Pricing and Other Factors Play When Customers
Choose a Depository Institution to Hold Their Accounts
To be sure, deposit pricing is important to financial firms offering this service. But how
important is it to the customer? Are interest rates and fees the most critical factors a
customer considers when choosing an institution to hold his or her deposit account? The
correct answer appears to be no.
Households and businesses consider multiple factors, not just price, in deciding where
to place their deposits, recent studies conducted at the Federal Reserve Board, the
University of Michigan, and elsewhere suggest. As shown in Table 12–3, these studies
Concept Check
12–6. Describe the essential differences between the 12–9. How can the historical average cost and mar-
following deposit pricing methods in use today: ginal cost of funds approaches be used to help
cost-plus pricing, conditional pricing, and relation- select assets (such as loans) that a depository
ship pricing. institution might wish to acquire?
12–7. A bank determines from an analysis of its cost- 12–10. What factors do household depositors rank most
accounting figures that for each $500 minimum- highly in choosing a financial firm for their check-
balance checking account it sells, account ing account? Their savings account? What about
processing and other operating costs will average business firms?
$4.87 per month and overhead expenses will run 12–11. What does the 1991 Truth in Savings Act require
an average of $1.21 per month. The bank hopes to financial firms selling deposits inside the United
achieve a profit margin over these particular costs States to tell their customers?
of 10 percent of total monthly costs. What monthly 12–12. Use the APY formula required by the Truth in Sav-
fee should it charge a customer who opens one of ings Act for the following calculation. Suppose
these checking accounts? that a customer holds a savings deposit in a sav-
12–8. To price deposits successfully, service providers ings bank for a year. The balance in the account
must know their costs. How are these costs deter- stood at $2,000 for 180 days and $100 for the
mined using the historical average cost approach? remaining days in the year. If the savings bank
The marginal cost of funds approach? What are the paid this depositor $8.50 in interest earnings for
advantages and disadvantages of each approach? the year, what APY did this customer receive?
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ETHICS IN BANKING
THE CONTROVERSY OVER DEPOSIT OVERDRAFT to get signed up even before you use the service. Then, if the
PROTECTION lender has to cover your bad checks, you will have to pay off
Financial managers, customers, and government regulators the loan the lender extended to you (normally within 30 days)
have weighed in recently on one of the most controversial ser- plus pay a substantial contract interest rate (say, 18 percent).
vices financial institutions offer today. That service is overdraft The combined charges plus short-term nature of the overdraft
protection (sometimes called “bounce protection”). If you acci- loan may force you to pay an actual interest rate (measured by
dentally overdraw your deposit account, this service is designed the APR) of 200 percent or more! To some observers these loans
to make sure your incoming checks and drafts are paid and that resemble predatory lending, especially for low-income individu-
you avoid excessive NSF (not sufficient funds) fees. als who may need short-term credit just to get by each month.
There are a variety of these deposit protection plans, but Moreover, customers, knowing they will be covered if they
most commonly your bank will set you up with a line of credit spend too much, may tend to run repeated overdrafts, winding
(say, $1,000) in return for an annual fee (perhaps $25 to $50 per up paying large amounts of interest instead of preparing for
year). Another type of overdraft plan calls for you to maintain the possibility of overdrafts by building up their savings. More-
a second account from which the financial-service provider over, feeling they are safe, people may tend to avoid balancing
will transfer enough money to pay any overdrafts. What’s so their account statement each month, making more frequent
controversial about that? overdrafts likely. Faced with adverse public and regulators’
After all, as long as you don’t write checks or drafts that comments some financial firms have reduced or eliminated
are too large and go beyond your credit limit the financial- their overdraft fees.
service provider pays all your overdrafts and saves you from Still, this is a service that has remained popular, especially
insufficient funds charges both from the service provider and in recent years when most NSF fees have been sharply on
from the merchants who received your bad checks. Some- the rise at a pace faster than the rate of inflation. Customers
times just one bad check can run up $50 or more in fees, never seem to like the convenience, particularly in making sure their
mind the hassle of contacting the merchant who received your most important bills (e.g., home mortgage payment and utility
bad check and straightening things out. bills) get paid on time. For the financial-service provider it is
Priced correctly, deposit overdraft protection can bring in an important source of fee income that flows through to the
substantial revenues for the financial firm. You pay a fee just bottom line and increases profits.
Factoid contend that households generally rank convenience, service availability, and safety above
There is research evidence price in choosing which financial firm will hold their transaction account. Moreover,
today that the interest
familiarity, which may represent not only name recognition but also safety, ranks above the
rates banks pay on deposits
and the account fees interest rate paid as an important factor in how individuals and families choose a deposi-
they charge for deposit tory institution to hold their savings account.
services do influence Indeed, surveys indicate that household customers tend to be extremely loyal to their
which depository depository institutions—about a third reported never changing their principal bank of
institution a customer
deposit. When an institutional affiliation is changed, it appears to be due mainly to cus-
chooses to hold his or
her account. Interestingly, tomer relocation, though once a move occurs many customers seem to pay greater atten-
rural financial-service tion to competing institutions and the relative advantages and disadvantages they offer as
markets appear to be more well as pricing. Three-quarters of the households surveyed recently by the University of
responsive to interest Michigan’s Survey Research Center cited location as the primary reason for staying with
rates and fees than do
the financial firm they first chose.
urban markets, on average.
Business firms, on the other hand, prefer to leave their deposits with financial
Factoid institutions that will be reliable sources of credit and, relatedly, are in good financial
Recent research suggests shape. They also rate highly the quality of officers and the quality of advice they
that at least half of all
receive from financial-service managers. Recent research suggests that financial-
households and small
businesses hold their service providers need to do a better job of letting their customers know about the
primary checking cost pressures they face today and why they need to charge fully and fairly for any
account at a depository services customers use.
institution situated
within three miles of
their location.
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12–9 Basic (Lifeline) Banking: Key Services

for Low-Income Customers
Our overview in this chapter would not be complete without a brief look at a controversial
social issue—basic (or lifeline) banking. Should every adult citizen be guaranteed access
to certain basic financial services, such as a checking account or personal loan? Is there
a minimum level of financial service to which everyone is entitled? Can an individual
today really function—secure adequate shelter, food, education, a job, and health care—
without access to certain financial services?
Some authorities refer to this issue as lifeline banking because it originated in the contro-
versy surrounding electric, gas, and telephone services. Many people believe these services
are so essential for health and comfort they should be provided at reduced prices to those
who could not otherwise afford them. The basic, or lifeline, banking issue catapulted to
nationwide attention during the 1980s and 1990s when several consumer groups, such as
the Consumers Union and AARP, first studied the problem and campaigned actively for
resolution of the issue. Some depositories have been picketed and formal complaints have
been lodged with federal and state regulatory agencies.
Key URL The dimensions of the lifeline banking issue have been hinted at in several recent
To examine the most consumer surveys (see, for example, Good [4]). During the 1990s inquiries by the Federal
recent FDIC survey of Reserve indicated that about 12 percent of Americans had neither checking nor savings
“unbanked” and
“underbanked” accounts and about 15 percent had no transaction deposits. A more up-to-date FDIC pop-
U.S. households see ulation survey (12), carried out in 2010 in conjunction with the U.S. Census, found that a
especially www.fdic substantial segment of the U.S. population is either (1) “unbanked” (i.e., with no deposits
.gov/householdsurvey/. or loans of any kind), about 8 percent or 9 million households; or (2) “underbanked” (i.e.,
having access to some critical services but not others), amounting to about 18 percent or
21 million households. Among the “underbanked” are those families relying on expensive
payday loans, check cashing firms, pawnshops, and money order services to pay their bills.
Racial and ethnic minorities are substantially more likely than the general population
to be “underbanked.” Moreover, most families in this situation report the lowest incomes,
little formal education, and often represent single-parent households that do not have
trust in the banking system. Yet, only a minority of banks seem concerned about this issue.
Many members of the unbanked population represent potentially profitable customers
for traditional financial-service providers. Among the financial services most in demand
are wire transfers or remittances of money sent to loved ones elsewhere. For example, thou-
sands of documented and undocumented workers regularly wire billions of dollars annu-
ally from the United States to families and friends in Latin America. It has been estimated
that the wire-transfer market generates well over $100 billion in business annually for
participating financial firms.
One of the most serious problems individuals outside the financial mainstream face
is lack of access to a deposit account. Many of these potential deposit customers do not
have Social Security numbers or other acceptable ID required to open an account under
current U.S. law (especially the USA Patriot Act). Others who can submit acceptable ID
find most conventional deposit plans too expensive to meet their needs.
Without a checking or savings account, few people can get approval for credit because
most lending institutions prefer to make loans to those customers who keep deposits with
them. Yet access to credit is essential for most families to secure adequate housing, medical
care, and other important services. Several depository institutions have responded to this
problem with basic deposit plans that allow users to cash some checks (such as Social Secu-
rity checks), make a limited number of personal withdrawals or write a small number
of checks (such as 10 free checks or charges per month), or earn interest on even the
smallest balances. As yet, few laws compel financial institutions to offer basic services,
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except in selected states—for example, Illinois, Massachusetts, Minnesota, Pennsylvania,

and Rhode Island—though many states have debated such legislation.
Key Video Link Another component was added to this dilemma when the U.S. Congress passed the
@ http://www.cnn Debt Collection Improvement Act in 1996 and when the U.S. Treasury launched its
.com/video/?/video/ Electronic Funds Transfer program in 1999. Both events require that government pay-
living/2009/12/02/ ments, such as paychecks and Social Security checks, eventually be delivered via electronic
taylor.household.
bank.accounts.cnn
means. This, of course, implies that some sort of deposit account be available in the recipi-
watch a CNN report ent’s name in which these funds can be placed.
providing details about What, if anything, should government do? Even if new legislation is not forthcoming, do
the “underbanked” financial institutions have a responsibility to serve all customers within their communities?
population. These are not easy questions to answer. Most financial-service providers are privately owned
corporations responsible to their stockholders to earn competitive returns. Providing financial
services at prices so low they do not cover production costs interferes with that important goal.
However, the issue of lifeline banking may not be that simple because many financial
firms are not treated in public policy like other private firms. For example, entry into
the banking industry is regulated, with federal and state regulatory agencies compelled
by law to consider “public convenience and needs” in permitting new banks to be estab-
lished. Moreover, the Community Reinvestment Act of 1977 requires regulatory agencies
to consider whether a covered financial organization applying to set up new branch offices
or merge with another institution has really made an “affirmative effort” to serve all seg-
ments of the communities in which it operates.
This most recent legal requirement to fully serve the local community may include the
responsibility to offer lifeline financial services. Moreover, depository institutions receive
important aid from the government that grants them a competitive advantage over other
financial institutions. One of the most important of these aids is deposit insurance, in
which the government guarantees most of the deposits these institutions sell. If deposi-
tory institutions benefit from insurance backed ultimately by the public’s taxes, do they
have a public responsibility to offer some services that are accessible to all? If yes, how
should they decide which customers should have access to low-price services? Should they
insist on imposing a means test on customers? Someone must bear the cost of producing
services. Who should bear the cost of lifeline services? Answers to these questions are not
readily apparent, but one thing is certain: These issues are not likely to go away.
Concept Check
12–13. What is lifeline banking? What pressures does 12–14. Should lifeline banking be offered to low-income
it impose on the managers of banks and other customers? Why or why not?
financial institutions?
Summary Deposits are the vital input for banks and their closest competitors, the thrift institutions—
the principal source of financial capital to fund loans and security investments and help
generate profits. The most important points this chapter has brought forward include:
• In managing their deposits financial firms must grapple with two key questions centered
upon cost and volume. Which types of deposits will help minimize the cost of fund-raising?
How can a depository institution raise sufficient deposits to meet its fund-raising needs?
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• The principal types of deposits offered by depository institutions today include

(1) transaction (or payments) accounts, which customers use primarily to pay for pur-
chases of goods and services; and (2) nontransaction (savings or thrift) deposits, which
are held primarily as savings to prepare for future emergencies and for the expected
yield they promise. Transaction deposits include regular checking accounts, which
often bear no interest return, and interest-bearing transaction deposits (such as
NOWs), which usually pay a low yield and, in some cases, limit the number of
checks or other drafts that can be written against the account. Nontransaction
deposits include certificates of deposit (CDs), savings accounts, and money market
accounts.
• Transaction deposits often are among the most profitable deposit services because of
their nonexistent or low interest rates and the higher service fees these accounts usually
carry. In contrast, nontransaction, or thrift, deposits generally have the advantage of a
more stable funding base that allows a depository institution to reach for longer-term
and higher-yielding assets.
• The most popular deposit-pricing methods today is conditional pricing. In this case the
interest rate the customer may earn and the fees he or she may be asked to pay are
conditional on the intensity of use of deposit services and the balance in the account.
In contrast, the cost-plus pricing method calls for estimating all operating and overhead
costs incurred in providing each service and adds a margin for profit. Under marginal
cost pricing, the offering institution will set its price at a level just sufficient to attract
new funds and still earn a profit on the last dollar of new funds raised. Finally, relation-
ship pricing calls for assessing lower fees or promising more generous yields to those
customers who are the most loyal.
• Recently new rules have entered the deposit market. The Truth in Savings Act
requires banks and thrift institutions to make full and timely disclosure of the terms
under which each deposit service is offered. This includes information on minimum-
balance requirements, how deposit balances are determined, what yield is promised,
what the depositor must do to earn the promised return, and any penalties or fees that
might be assessed.
• Finally, one of the most controversial issues in modern banking—lifeline banking—
continues to be debated in the deposit-services industry. Depository institutions have
been asked in several states to offer low-cost financial services, especially deposits and
loans, for those customers unable to afford conventional services. Some institutions
have responded positively with limited-service, low-cost accounts, while others argue
that most financial firms are profit-making corporations that must pay close attention
to profitability and cost of each new service.
Key Terms transaction deposit, 398 time deposits, 400 relationship pricing, 414
NOW accounts, 398 core deposits, 402 basic (lifeline)
money market deposit cost-plus pricing, 407 banking, 417
accounts, 399 Federal Deposit Insurance
Super NOWs, 399 Corporation (FDIC), 408
thrift deposits, 400 conditional pricing, 411
passbook savings Truth in Savings Act, 412
deposits, 400
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Problems 1. Rhinestone National Bank reports the following figures in its current Report of
Condition:
and Projects
Assets (millions) Liabilities and Equity (millions)
Cash and interbank deposits $ 50 Core deposits $ 50
Short-term security investments 15 Large negotiable CDs 150
Total loans, gross 400 Deposits placed by brokers 65
Long-term securities 150 Other deposits 45
Other assets 10 Money market liabilities 195
Total assets $625 Other liabilities 70
Equity capital 55
Total liabilities and equity capital $625
a. Evaluate the funding mix of deposits and nondeposit sources of funds employed by
Rhinestone. Given the mix of its assets, do you see any potential problems? What
changes would you like to see management of this bank make? Why?
b. Suppose market interest rates are projected to rise significantly. Does Rhinestone
appear to face significant losses due to liquidity risk? Due to interest rate risk? Please
be as specific as possible.
2. Kalewood Savings Bank has experienced recent changes in the composition of its
deposits (see the following table; all figures in millions of dollars). What changes
have recently occurred in Kalewood’s deposit mix? Do these changes suggest
possible problems for management in trying to increase profitability and stabilize
earnings?
One Two Three

This Year Years Years
Year Ago Ago Ago
Types of Deposits Held
Regular and special checking accounts $235 $294 $337 $378
Interest-bearing checking accounts 392 358 329 287
Regular (passbook) savings deposits 501 596 646 709
Money market deposit accounts 863 812 749 725
Retirement deposits 650 603 542 498
CDs under $100,000 327 298 261 244
CDs $100,000 and over 606 587 522 495
3. First Metrocentre Bank posts the following schedule of fees for its household and
small-business transaction accounts:
• For average monthly account balances over $1,500, there is no monthly maintenance
fee and no charge per check or other draft.
• For average monthly account balances of $1,000 to $1,500, a $2 monthly mainte-
nance fee is assessed and there is a 10¢ charge per check or charge cleared.
• For average monthly account balances of less than $1,000, a $4 monthly maintenance
fee is assessed and there is a 15¢ per check or per charge fee.
What form of deposit pricing is this? What is First Metrocentre trying to accomplish
with its pricing schedule? Can you foresee any problems with this pricing plan?
4. Fine-Tuned Savings Association finds that it can attract the following amounts of
deposits if it offers new depositors and those rolling over their maturing CDs at the
interest rates indicated below:
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Expected Volume Rate of Interest

of New Deposits Offered Depositors
$10 million 2.00%
15 million 2.25
20 million 2.50
24 million 2.75
26 million 3.00
Management anticipates being able to invest any new deposits raised in loans yielding
5.50 percent. How far should this thrift institution go in raising its deposit interest rate
in order to maximize total profits (excluding interest costs)?
5. New Day Bank plans to launch a new deposit campaign next week in hopes of bringing
in from $100 million to $600 million in new deposit money, which it expects to invest at
a 4.25 percent yield. Management believes that an offer rate on new deposits of 2 percent
would attract $100 million in new deposits and rollover funds. To attract $200 million, the
bank would probably be forced to offer 2.25 percent. New Day’s forecast suggests that $300
million might be available at 2.50 percent, $400 million at 2.75 percent, $500 million at
3.00 percent, and $600 million at 3.25 percent. What volume of deposits should the insti-
tution try to attract to ensure that marginal cost does not exceed marginal revenue?
6. R&R Savings Bank finds that its basic transaction account, which requires a $1000
minimum balance, costs this savings bank an average of $3.25 per month in servicing
costs (including labor and computer time) and $1.25 per month in overhead expenses.
The savings bank also tries to build in a $0.50 per month profit margin on these
accounts. What monthly fee should the bank charge each customer?
Further analysis of customer accounts reveals that for each $100 above the $500
minimum in average balance maintained in its transaction accounts, R&R Savings
saves about 5 percent in operating expenses with each account. (Note: If the bank
saves about 5 percent in operating expenses for each $100 held in balances above the
$500 minimum, then a customer maintaining an average monthly balance of $1,000
should save the bank 25 percent in operating costs.) For a customer who consistently
maintains an average balance of $1,200 per month, how much should the bank charge
in order to protect its profit margin?
7. Lucy Lane maintains a savings deposit with Monarch Credit Union. This past year
Lucy received $10.75 in interest earnings from her savings account. Her savings
deposit had the following average balance each month:
January $450 July $450

February 350 August 425
March 300 September 550
April 550 October 600
May 225 November 625
June 400 December 500
What was the annual percentage yield (APY) earned on Lucy’s savings account?
8. The National Bank of Mayville quotes an APY of 2.75 percent on a one-year money
market CD sold to one of the small businesses in town. The firm posted a balance of
$2,500 for the first 90 days of the year, $3,000 over the next 180 days, and $3,700 for
the remainder of the year. How much in total interest earnings did this small business
customer receive for the year?
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Internet Exercises
1. Your education has paid off. You have stepped five years into the future and are
reviewing your bank accounts. The money has just piled up. You have a joint account
with your fianceé containing $265,000 to be used for your first home. You have a joint
account with your mother containing $255,000, and you have an account in your own
name with $155,000 for the necessities of life. All three accounts are at the Monarch
National Bank. Go to the following FDIC website www2.fdic.gov/edie and have Edie
determine the insurance coverage. How much is uninsured? Can you describe the rules
determining coverage?
2. How has the composition of deposits changed at your favorite local depository
institution over the past 10 years? You can find this deposit information for banks
and savings institutions at the FDIC’s website. Utilize the Statistics on Deposi-
tory Institutions link at www2.fdic.gov/sdi. Using the points made in this chapter,
explain why your local institution’s mix of deposits is changing the way it is. How
can depository institution managers influence the trends occurring in the composi-
tion of their deposits?
3. Which depository institutions currently quote the highest interest rates on checking
accounts? Savings accounts? Money market deposits? Three- and six-months CDs?
Visit www.fisn.com, bankcd.com and www.banx.com for the answers.
4. Compare your local depository institution’s interest rates on six-month and one-year
certificates of deposit (check newspaper ads, call its customer service line, or visit its
website) with the best rates on these same savings instruments offered by depository
institutions quoting the highest deposit interest rates in the United States. (See web-
sites listed in Exercise 3.) Why do you think there are such large interest-rate differ-
ences between your local institution and those posting the highest interest rates?
REAL NUMBERS Continuing Case Assignment for Chapter 12

FOR REAL BANKS
YOUR BANK’S DEPOSITS: VOLATILITY AND COST (SDI) to create a four-column report of your bank’s infor-
Chapter 12 examines the major source of funds for depository mation and peer group information across years. In this
institutions—deposits. The importance of attracting and maintain- part of the assignment, for Report Selection use the pull-
ing deposits as a stable and low-cost source of funds cannot be down menu to select Total Deposits and view this in Per-
overstated. This chapter begins by describing the different types centages of Total Assets. To assess the overall importance
of deposits, then explains why a depository institution’s manage- of deposits as a source of funding, focus on total deposits
ment is concerned with cost, volatility (risk of withdrawals), and to total assets. From the Total Deposits report you will col-
the trade-off between the two. In this assignment, you will be lect information to break down deposits in several ways:
comparing the character of your bank’s deposits across time (1) total deposits into domestic deposits versus foreign;
and with its peer group of banks to glean information concerning (2) total deposits into interest-bearing deposits versus
the cost and stability of this source of funds. Chapter 12’s assign- noninterest-bearing deposits; and (3) domestic deposits
ment is designed to develop your deposit-related vocabulary and into their basic types. All the data for rows 109–123 are
to emphasize the importance of being able to attract funds in the available from the Total Deposits report; however, you will
form of deposits, which is unique to banks and thrift institutions. have to derive NOW accounts in row 120 by subtracting
demand deposits from transaction deposits. Finally, we will
The Character and Cost of Your Bank’s Deposits—Trend
go to the Interest Expense report and gather information
and Comparative Analysis
on the proportion of interest paid for foreign and domestic
A. Data Collection: Once again the FDIC’s website located at deposits to total assets. Enter the percentage information
www2.fdic.gov/sdi/ will provide access to the data needed for these items as an addition to the spreadsheet for com-
for your analysis. Use Statistics on Depository Institutions parisons with the peer group as follows:
(continued)
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FOR REAL BANKS
B. Having collected all the data for rows 109–125, you will Deposits provide a significant portion of the funding
calculate the entries for rows 126 and 127. For exam- for bank holding companies. In 2010 more than 70 percent
ple, the entry for cell B126 is created using the formula of BB&T’s assets were funded by deposits and in 2009
function B124/B113. more than 71 percent of their assets were funded by
C. Compare the columns of row 109. How has the reliance on deposits. These ratios may be compared to 68.22 percent
deposits as a source of funds changed across periods? of deposits-to-total assets for the peer group of institu-
Has your bank relied more or less on depositors than the tions in 2010 and 68.20 percent of deposits-to-total assets
average bank in the peer group? for the peer group of institutions in 2009. This indicates
D. Use the chart function in Excel and the data by columns that BB&T is more reliant on deposits than its peer group,
in rows 113 through 116 to create a group of four bar as illustrated by the associated column chart.
charts illustrating the reliance on deposits as a source of In the above exhibit, we see that BB&T receives a
funds and drawing attention to the breakdown of foreign greater proportion of funds from domestic deposits than
versus domestic and interest-bearing versus noninterest- the Peer Group of Institutions in both 2010 and 2009 and
bearing deposits. You will be able to select the block and a smaller proportion of funds from foreign deposits than
create the chart with just a few clicks of the mouse, sav- the Peer Group of Institutions in both years. In aggre-
ing it as a separate sheet to insert into your document. gate, BB&T has a greater proportion of interest-bearing
Remember to provide titles, labels, and percentages; deposits than the peer group and a comparable propor-
otherwise, we have something reminiscent of abstract tion of noninterest-bearing deposits. The average interest
art. Write one or two paragraphs for your BHC summa- cost on domestic interest-bearing deposits for BB&T for
rizing the breakdown of deposits. Paragraphs describing 2010 is 1.12 percent, which is 40 basis points above the
deposits at BB&T in 2010 and 2009 illustrate how to write peer group average of 0.72 percent. However, for foreign
your financial data. interest-bearing deposits the average interest cost for
(continued)
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FOR REAL BANKS
Breakdown of Deposits-to-Total Assest
80%
70%
60%
50%
40%
30%
20%
10%
0%
12/31/2010 12/31/2010 12/31/2009 12/31/2009
BB&T Peer Group BB&T Peer Group
Noninterest-bearing deposits (foreign) Noninterest-bearing deposits (domestic)

Interest-bearing deposits (foreign) Interest-bearing deposits (domestic)
BB&T in 2010 was 0 percent—a whopping 60 basis points group. This time we will utilize the column charts that
lower than the peer group’s average interest cost. For domes- sum to 100 percent to focus on composition by types of
tic interest-bearing deposits in 2009, BB&T paid 32 basis domestic deposits, rather than the contribution to fund-
points above the peer group’s average interest cost of 1.12 ing sources as illustrated in Part D. By choosing different
percent. These changes in pricing deposits help to explain types of charts we can focus our discussions on particular
how BB&T maintained their deposit base. In fact the propor- issues, emphasizing what we view to be most important.
tion of domestic deposits-to-total assets for BB&T declined The above column chart illustrates BB&T’s deposit com-
only slightly from 69.47 percent to 67.04 percent. position relative to its peer group for 2010 and 2009.
E. Once again use the chart function in Excel and the data Using your column chart as a supportive graphic, write one
by columns in rows 119 through 123 to create a group or two paragraphs describing your BHC’s domestic deposit
of four columns charts illustrating the types of domes- composition with inferences concerning interest costs and
tic deposits supporting assets for your BHC and its peer deposit volatility (withdrawal risk).
Domestic Deposits Composition: A Comparison of

BB&T with Peers
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
12/31/2010 12/31/2010 12/31/2009 12/31/2009
BB&T Peer Group BB&T Peer Group
Total time deposits Other savings deposits Money markets deposits
(excluding MMDAs) accounts (MMDAs)
NOW accounts Demand deposits
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Selected For a discussion of recent trends in deposit services, see these sources:
References 1. Gerdes, Geoffrey R.; Jack K. Walton II; May X. Liu; and Darrel W. Parke. “Trends
in the Use of Payment Instruments in the United States.” Federal Reserve Bulletin,
Spring 2005, pp. 180–201.
2. Santomero, Anthony M. “The Changing Patterns of Payments in the United States.”
Business Review, Federal Reserve Bank of Philadelphia, Third Quarter 2005, pp. 1–8.
3. Rose, Peter S. “Pricing Deposits in an Era of Competition and Change.” The Canadian
Banker, vol. 93, no. 1 (February 1986), pp. 44–51.
For a discussion of the controversy over lifeline banking services, see:
4. Good, Barbara A. “Bringing the Unbanked Aboard.” Economic Commentary, Federal
Reserve Bank of Cleveland, January 15, 1999.
For a discussion of the role of depositors in disciplining bank risk taking and bank behavior, see
especially:
5. Vaughan, Mark D.; and David C. Wheelock. “Deposit Insurance Reform: Is It Déjà
Vu All Over Again?” The Regional Economist, Federal Reserve Bank of St. Louis,
October 2002, pp. 5–9.
6. Federal Deposit Insurance Corporation. “Privatizing Deposit Insurance: Results of the
2006 FDIC Study.” FDIC Quarterly 1, no. 2 (2007), pp. 23–32.
For a discussion of deposit pricing techniques, see these studies:
7. Dunham, Constance. “Unraveling the Complexity of NOW Account Pricing.” New
England Economic Review, Federal Reserve Bank of Boston, May/June 1983, pp. 30–45.
8. McNulty, James E. “Do You Know the True Cost of Your Deposits?” Review, Federal
Home Loan Bank of Atlanta, October 1986, pp. 1–6.
For a discussion of recent trends in deposit service availability and service fees, see:
9. Hannan, Timothy H. “Retail Fees of Depository Institutions, 1994–99.” Federal
Reserve Bulletin, January 2001, pp. 1–11.
For a discussion of the impact of the Truth in Savings Act on the cost of bank regulatory compli-
ance, see:
10. Elliehausen, Gregory, and Barbara R. Lowrey. The Cost of Implementing Consumer
Financial Regulation: An Analysis of the Experience with the Truth in Savings Act. Staff
Study No. 170, Board of Governors of the Federal Reserve System, December 1997.
For an international view of reaching out to unbanked customers, see, for example:
11. Skelton, Edward C. “Reaching Mexico’s Unbanked, “Economic Letter, Federal Reserve
Bank of Dallas, vol. 5, no. 7 (July 2008), pp. 1–8.
For a close view of the Federal Deposit Insurance Corporation’s most recent study of unbanked
and underbanked customers see in particular:
12. Federal Deposit Insurance Corporation. “Findings from the FDIC Survey of Bank
Efforts to Serve the Unbanked and Underbanked,” FDIC Quarterly, vol. 3, no. 2
(First Quarter 2009), pp. 39–47.
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Providing Loans to Businesses and Consumers P A R T S I X
C H A P T E R S I X T E E N
Lending Policies and

Procedures: Managing
Credit Risk
• Types of Loans Banks and Competing Lenders Make
• Factors Affecting the Mix of Loans Made
• Regulation of Lending
• Creating a Written Loan Policy
• Steps in the Lending Process
• Loan Review and Loan Workouts
16–1 Introduction
J. Paul Getty, once the richest man in the world, observed: “If you owe the bank $100,
that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” To be
sure, lending to businesses, governments, and individuals is one of the most important
services banks and their competitors provide, and it is also among the riskiest as the recent
global credit crisis has demonstrated.
However, risky or not, the principal reason many financial firms are issued charters of
incorporation by state and national governments is to make loans to their customers.1
Lenders are expected to support their local communities with an adequate supply of credit
for all legitimate business and consumer financial needs and to price that credit reason-
ably in line with competitively determined market interest rates.
Indeed, making loans to fund consumption and investment spending is the principal
economic function of banks and their closest competitors. How well a lender performs in
fulfilling the lending function has a great deal to do with the economic health of its region,
because loans support the growth of new businesses and jobs within the lender’s market
area. Moreover, loans frequently convey information to the marketplace about a borrower’s
credit quality, often enabling a borrower whose loan is approved to obtain more and some-
what cheaper funds from other sources as well.
Despite all the benefits of lending for both lenders and their customers, the lending
process bears careful monitoring at all times. When a lender gets into serious financial
1
Portions of this chapter are based upon Peter S. Rose’s article in The Canadian Banker [1] and are used with the permission
of the publisher.
521
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522 Part Six Providing Loans to Businesses and Consumers
trouble, its problems usually spring from loans that have become uncollectible due to
mismanagement, illegal manipulation, misguided policies, or an unexpected economic
downturn. No wonder, then, that when examiners appear at a regulated lending institu-
tion they conduct a thorough review of its loan portfolio. Usually this involves a detailed
analysis of the documentation and collateral for the largest loans, a review of a sample of
small loans, and an evaluation of loan policies to ensure they are sound and prudent in
order to protect the public’s money.
16–2 Types of Loans

What types of loans do banks and their closest competitors make? The answer, of course, is
that banks and their principal competitors make a wide variety of loans to a wide variety
of customers for many different purposes—from purchasing automobiles and buying new
furniture, taking dream vacations, or pursuing college educations to constructing homes
and office buildings. Fortunately, we can bring some order to the diversity of lending by
grouping loans according to their purpose—what customers plan to do with the proceeds
of their loans. At least once each year, the Federal Reserve System, the FDIC, and the
Comptroller of the Currency require each U.S. bank to report the composition of its
loan portfolio by purpose of loan on a report form known as Schedule A, attached to its
balance sheet. Table 16–1 summarizes the major items reported on Schedule A for all U.S.
banks at the close of 2010.
We note from Table 16–1 that loans may be divided into seven broad categories,
delineated by their purposes:
Factoid 1. Real estate loans are secured by real property—land, buildings, and other structures—
In the most recent and include short-term loans for construction and land development and longer-term
years which financial loans to finance the purchase of farmland, homes, apartments, commercial structures,
institution has been the
number-one lender in
and foreign properties.
the U.S. economy? 2. Financial institution loans include credit to banks, insurance companies, finance
Answer: Commercial companies, and other financial institutions.
banks, followed by
insurance companies,
3. Agricultural loans are extended to farms and ranches to assist in planting and harvesting
savings institutions, crops and supporting the feeding and care of livestock.
finance companies, 4. Commercial and industrial loans are granted to businesses to cover purchasing
and credit unions, inventories, paying taxes, and meeting payrolls.
according to the Federal
Reserve’s Flow of Funds 5. Loans to individuals include credit to finance the purchase of automobiles, mobile
Accounts. homes, appliances, and other retail goods, to repair and modernize homes, and to cover
the cost of medical care and other personal expenses, and are either extended directly
to individuals or indirectly through retail dealers.
6. Miscellaneous Loans include all loans not listed above, including securities’ loans.
7. Lease financing receivables, where the lender buys equipment or vehicles and leases
them to its customers.
Of the loan categories listed, the largest in dollar volume is real estate loans, accounting
for just over half of total bank loans among U.S. banking firms. The next largest category
is loans to individuals, followed closely by commercial and industrial (C&I) loans, each repre-
senting about one-fifth of the total.
Factors Determining the Growth and Mix of Loans

While Table 16–1 indicates the relative amounts of different kinds of loans for the whole
banking industry, loan portfolio mix usually differs markedly from institution to institu-
tion. One of the key factors in shaping an individual lender’s loan portfolio is the profile
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Chapter Sixteen Lending Policies and Procedures: Managing Credit Risk 523
TABLE 16–1 Percentage of Total Loan Portfolio

Loans Outstanding
for All FDIC-Insured Amount for All Percentage of Smallest U.S. Largest U.S.
Banks as of December Bank Loans FDIC-Insured Total Loans for Banks (less than Banks (over
31, 2010 Classified by Purpose U.S. Banks All FDIC-Insured $100 million $1 billion
(consolidated of Loan ($ billions) U.S. Banks in total assets) in total assets)
domestic and foreign Real estate loans a $3,650.4 55.3% 66.0% 55.7%
offices) Loans to depository
institutions b 102.4 1.6 0.1 1.7
Loans to finance
agricultural production 59.1 0.9 11.0 0.4
Commercial and
industrial loans c 1,123.1 17.0 14.0 17.4
Loans to individuals d 1,128.1 19.5 7.4 20.4
Miscellaneous loans e 334.8 5.1 1.0 5.6
Lease financing receivables 99.6 1.5 0.4 1.7
Total (gross) loans and
leases shown on U.S.
banks’ balance sheet $6,597.5 100.0% 100.0% 100.0%
Notes:
a
Construction and land development loans, loans to finance one- to four-family, homes. multifamily residential property loans, non-farm
nonresidential property loans, and foreign real estate loans.
b
Loans to commercial banks and other foreign and domestic depository institutions and acceptances of other banks.
c
Credit to construct business plant and equipment, loans for business operating expenses, loans for other business uses, including
international loans and acceptances.
d
Loans to purchase autos, credit cards, mobile home loans, loans to purchase consumer goods, loans to repair and modernize residences,
all other personal installment loans, single payment loans, and other personal loans.
e
Includes loans to foreign governments and state and local governments and acceptances of other banks. Columns may not add exactly
to totals due to rounding error.
of characteristics of the market area it serves. Each lender must respond to the demands for
credit arising from customers in its own market. For example, a lender serving a subur-
ban community with large numbers of single-family homes and small retail stores will
normally have mainly residential real estate loans, automobile loans, and credit for the
purchase of home appliances and for meeting household expenses. In contrast, a lender
situated in a central city surrounded by office buildings, department stores, and manufac-
turing establishments will typically devote the bulk of its loan portfolio to business loans
designed to stock shelves with inventory, purchase equipment, and meet business payrolls.
Of course, lenders are not totally dependent on the areas they serve for all the loans
they acquire. They can purchase whole loans or pieces of loans from other lenders, share
in loans with other lenders (known as participations), or even use credit derivatives to
offset the economic volatility inherent in loans from their trade territory (as we saw in
Chapter 9, for example). These steps can help reduce the risk of loss if the areas served
incur severe economic problems. However, most lenders are chartered to serve selected
markets and, as a practical matter, most of their loan applications normally will come from
these areas.
Key Video Link Lender size is also a key factor shaping the composition of a loan portfolio. For example,
@ http://www the volume of capital held by a depository institution normally determines its legal lending
.allbusiness.com/
limit to a single borrower. Larger banks are often wholesale lenders, devoting the bulk
company-activities-
management/ of their credit portfolios to large-denomination loans to business firms. Smaller banks,
financial/12630997-1 on the other hand, tend to emphasize retail credit, in the form of smaller-denomination
.html watch Sam personal cash loans and home mortgage loans extended to individuals and families as well
Thacker with Business as smaller business loans.
Finance Solutions Table 16–1 reveals some of the differences between the largest and smallest U.S. banks
discuss whether a small
business should use a big in loan portfolio mix. The smallest banks (under $100 million in total assets) are more
bank or a small bank for heavily committed to real estate and agricultural loans than the largest banking firms
financing. (over $1 billion in assets), which tend to be more heavily committed to commercial loans
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and loans to individuals. The experience and expertise of management in making different
types of loans also shape the composition of a loan portfolio, as does the lending institu-
tion’s loan policy, which often prohibits loan officers from making certain kinds of loans.
We should also note that the composition of loans varies with the type of lending insti-
tution involved. For example, while commercial banks typically extend large numbers of
commercial and industrial (business) loans, savings associations and credit unions tend to
emphasize home mortgage and personal installment loans. In contrast, finance companies
favor business inventory and equipment loans and also grant large amounts of household
credit to purchase appliances, furniture, and automobiles.
Finally, loan mix at any particular lending institution depends heavily upon the expected
yield that each loan offers compared to the yields on all other assets the lender could
acquire. Other factors held equal, a lender would generally prefer to make loans bearing
the highest expected returns after all expenses and the risk of loan losses are taken into
account. Recent research suggests that gross yields (i.e., total revenue received divided
by loan volume) typically have been higher among credit card loans, installment loans
(mainly to households and smaller businesses), and real estate loans. However, when
net yields (with expenses and loss rates deducted from revenues received) are calculated,
real estate and commercial loans often rank high relative to other loan types, helping to
explain their popularity among some lenders, though most major types of loans (especially
real estate and consumer loans) have recently passed through serious problems associated
with the recent global credit crisis of 2007–2009.
Concept Check
16–1. In what ways does the lending function affect the 16–4. A lender’s cost accounting system reveals that its
economy of its community or region? losses on real estate loans average 0.45 percent
16–2. What are the principal types of loans made by of loan volume and its operating expenses from
banks? making these loans average 1.85 percent of loan
16–3. What factors appear to influence the growth and volume. If the gross yield on real estate loans is
mix of loans held by a lending institution? currently 8.80 percent, what is this lender’s net
yield on these loans?
Lender size appears to have a significant influence on the net yield from different kinds
of loans. Smaller banks, for example, seem to average higher net returns from granting real
estate and commercial loans, whereas larger banks appear to have a net yield advantage in
making credit card loans. Of course, customer size as well as lender size can affect relative
loan yields. For example, the largest banks make loans to the largest corporations where
loan rates are relatively low due to generally lower risk and the force of competition; in
contrast, small institutions lend money primarily to the smallest-size businesses, whose
loan rates tend to be much higher than those attached to large corporate loans. Thus, it
is not too surprising that the net yields on commercial loans tend to be higher among the
smallest lending institutions.
As a general rule, a lending institution should make those types of loans for which it
is the most efficient producer. The largest banks appear to have a cost advantage in mak-
ing nearly all types of real estate and installment loans and large lenders are generally the
lowest-cost producers of credit card loans. While the smallest lenders appear to have few
cost advantages relative to larger institutions for almost any type of loan, these smaller
lenders are frequently among the most effective at controlling loan losses, perhaps because
they often have better knowledge of their customers.
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16–3 Regulation of Lending

Lending institutions are among the most closely regulated of all financial-service
institutions. Not surprisingly, the mix, quality, and yield of the loan portfolio are heavily
influenced by the character and depth of regulation. Any loans made are subject to exami-
nation and review and many are restricted or even prohibited by law.
Key URLs For example, banks are frequently prohibited from making loans collateralized by their
To discover more own stock. The total volume of real estate loans granted by a U.S. national bank cannot
facts about the rules exceed that bank’s capital and surplus or 70 percent of its total time and savings deposits,
and regulations
whichever is greater. An unsecured loan to a single customer normally cannot exceed
of lending see, for
example, the Federal 15 percent of a single national bank’s unimpaired capital and surplus account. This is
Financial Institutions known as a bank’s legal lending limit, enforced by state or federal law depending upon
Examination Council at which agency issued the bank’s charter of incorporation. The lending limit may be further
www.ffiec.gov/press increased to 25 percent of unimpaired capital and surplus if the loan amount exceeding
.htm, the Federal
the 15 percent limit is fully secured by marketable securities.
Deposit Insurance
Corporation at www Bankers have found ways to reduce the impact of these limits in order to increase the
.fdic.gov, and the amount of credit they can grant their customers, such as participating with one or more
Federal Reserve System other lenders in the same loan. Moreover, many banks today create and join bank holding
at www.federalreserve companies to enhance their ability to handle larger loans. Banks affiliated with a hold-
.gov.
ing company can secure company support up to 10 percent of each affiliate’s capital and
surplus or up to 20 percent of capital and surplus for all the company’s affiliates combined.
Factoid Loans to a bank’s officers extended for purposes other than funding education or the
Banks chartered purchase of a home or that are not fully backed by U.S. government securities or deposits
by the U.S. federal
government (i.e.,
are limited to the greater of 2.5 percent of the bank’s capital and unimpaired surplus or
national banks) have $25,000, but cannot exceed $100,000. State-chartered banks face similar restrictions on
their lending rules set insider loans in their home states and from the Federal Deposit Insurance Corporation.
by federal law (see, for The Sarbanes-Oxley Act of 2002 requires that loans to insiders be priced at market value
example, 12 USC 84) rather than being subsidized by the lending institution.
and are supervised by
The Community Reinvestment Act (1977) requires selected lenders to make “an affir-
the Comptroller of the
Currency. In contrast, mative effort” to meet the credit needs of individuals and businesses in their trade territo-
states normally set the ries so that no areas of the local community are discriminated against in seeking access to
legal lending limits for credit. Moreover, under the Equal Credit Opportunity Act (1974), no individual can be
the banks they charter. denied credit because of race, sex, religious affiliation, age, or receipt of public assistance.
Disclosure laws require that the borrower be quoted the “true cost” of a loan, as reflected
in the annual percentage interest rate (APR) and all required charges and fees for obtain-
Key Video Link
@ http://www.youtube ing credit, before the loan agreement is signed.2
.com/watch?v=ev8H In the field of international lending, special regulations have appeared in recent years
8sAD3Ro&feature= in an effort to reduce the risk exposure associated with granting loans overseas. In this
relmfu view a video: field lenders often face significant political risk from foreign governments passing restric-
“Banking on the Future: tive laws or seizing foreign-owned property, and substantial business risk due to lack of
Celebrating 30 Years
of CRA” for a better knowledge concerning foreign markets. U.S. law in the form of the International Lending
understanding of how and Supervision Act requires U.S. banks to make public any credit exposures to a single
communities could be country that exceed 15 percent of their primary capital or 0.75 percent of their total
discriminated against. assets, whichever is smaller. This law also imposes restrictions on the fees lenders may
charge a troubled international borrower to restructure a loan.
The quality of a loan portfolio and the soundness of its policies are the areas federal
and state regulators look at most closely when examining a lending institution. Under the
Uniform Financial Institutions Rating System used by federal examiners, each banking
2
See Chapter 18 for a more detailed discussion of antidiscrimination and disclosure laws applying to bank loans to
individuals and families.
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firm is assigned a numerical rating based on the quality of its asset portfolio, including its
loans. The examiner may assign one of these ratings:
1 5 strong performance
2 5 satisfactory performance
3 5 fair performance
4 5 marginal performance
5 5 unsatisfactory performance
The better a bank’s asset-quality rating, the less frequently it will be subject to examina-
tion by banking agencies, other factors held equal.
Examiners generally look at all loans above a designated minimum size and at a random
sample of small loans. Loans that are performing well but have minor weaknesses because
Key URLs the lender has not followed its own loan policy or has failed to get full documentation
Information about the from the borrower are called criticized loans. Loans that appear to contain significant
regulation of lending weaknesses or that represent what the examiner regards as a dangerous concentration of
around the world credit in one borrower or in one industry are called scheduled loans. A scheduled loan is a
can be gathered from
such sources as the warning to management to monitor that credit carefully and to work toward reducing the
Bank for International lender’s risk exposure from it.
Settlements at www When an examiner finds loans that carry an immediate risk of not paying out as
.bis.org and the libraries planned, these credits are adversely classified. Typically, examiners will place adversely
of the World Bank classified loans into one of three groupings: (1) substandard loans, where the loans’ margin
and the International
Monetary Fund at jolis of protection is inadequate due to weaknesses in collateral or in the borrower’s repayment
.worldbankimflib.org/ abilities; (2) doubtful loans, which carry a strong probability of an uncollectible loss to
external.htm. the lending institution; and (3) loss loans, regarded as uncollectible and not suitable to
be called bankable assets. A common procedure for examiners is to multiply the total of
all substandard loans by, say 0.20, the total of all doubtful loans by 0.50, and the total of
all loss loans by 1.00, then sum these weighted amounts and compare their grand total
with the lender’s sum of loan-loss allowances and equity capital. If the weighted sum of
all adversely classified loans appears too large relative to loan-loss allowances and equity
capital, examiners are likely to demand changes in the lender’s policies and procedures or,
possibly, require additions to loan-loss allowances and capital. Financial institutions that
disagree with examiner classifications of their loans may appeal these rulings.
Of course, the quality of loans is a major component of asset quality but is only one
dimension of a lender’s performance that is rated under the Uniform Financial Institu-
tions Rating System. Numerical ratings are assigned based on examiner judgment about
capital adequacy, asset quality, management quality, earnings record, liquidity position,
and sensitivity to market risk exposure. All six dimensions of performance are com-
bined into one overall numerical rating, referred to as the CAMELS rating. The letters in
CAMELS are derived from
Capital adequacy Earnings record

Asset quality Liquidity position
Management quality Sensitivity to market risk
Depository institutions whose overall CAMELS rating is toward the low, riskier end of the
numerical scale—an overall rating of 4 or 5—tend to be examined more frequently than
the highest-rated institutions, those with ratings of 1, 2, or 3.3
3
Some authorities in the bank examination field add the letter I to CAMELS, indicating the increasing importance of
information technology for sound bank management, especially in offering online financial services.
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One final note on the examination process today: Rapidly changing technology and
the emergence of very large financial institutions appear to have weakened the effective-
ness of traditional examination procedures. An added problem is that examinations for
most regulated lenders tend to occur no more frequently than once a year and the decay in
the quality of examination information over time can be rapid, especially among weakly
performing or poorly managed lending institutions. Accordingly, regulators are beginning
to turn more toward market forces as a better long-run approach to monitoring behavior
and encouraging lenders to manage their institutions prudently. The emerging emphasis in
examination is to rely more heavily upon “private market discipline” in which such factors
as borrowing costs, stock prices, and other market values are used as “signals” as to how
well a lender is performing and to help examiners determine if they need to take a close
look at how a lending institution is managing its loans and protecting the public’s funds.4
Examination strategies have tightened up in the wake of the great recession of 2007–2009.
Establishing a Good Written Loan Policy

Key URL One of the most important ways a lending institution can make sure its loans meet regula-
For an interesting tory standards and are profitable is to establish a written loan policy. Such a policy gives
source of information loan officers and management specific guidelines in making individual loan decisions and
about trends in lending in shaping the overall loan portfolio. The actual makeup of a lender’s loan portfolio should
and loan policies, see
the Senior Loan Officer reflect what its loan policy says. Otherwise, the loan policy is not functioning effectively
Opinion Survey at and should be either revised or more strongly enforced.
www.federalreserve What should a written loan policy contain? The examinations manual which the Fed-
.gov/boarddocs/ eral Deposit Insurance Corporation gives to new examiners suggests the most important
SnLoanSurvey. elements of a well-written loan policy. These include:
1. A goal statement for the entire loan portfolio (i.e., statement of the characteristics of
a good loan portfolio in terms of types, maturities, sizes, and quality of loans).
2. Specification of the lending authority given to each loan officer and loan committee
(measuring the maximum amount and types of loan that each employee and commit-
tee can approve and what signatures of approval are required).
3. Lines of responsibility in making assignments and reporting information.
4. Operating procedures for soliciting, evaluating, and making decisions on customer
loan applications.
5. The required documentation that is to accompany each loan application and what
must be kept in the lender’s files (financial statements, security agreements, etc.).
6. Lines of authority detailing who is responsible for maintaining and reviewing the
institution’s credit files.
7. Guidelines for taking, evaluating, and perfecting loan collateral.
8. Procedures for setting loan rates and fees and the terms for repayment of loans.
9. A statement of quality standards applicable to all loans.
10. A statement of the preferred upper limit for total loans outstanding (i.e., the maxi-
mum ratio of total loans to total assets allowed).
11. A description of the lending institution’s principal trade area, from which most loans
should come, and how well the lender is serving its area.
12. Procedures for detecting and working out problem loan situations.
4
In order to more closely monitor the condition of depository institutions between regular examinations the regulatory
agencies today frequently use off-site monitoring systems. For example, the FDIC has employed SCOR—the Statistical
CAMELS Off-Site Rating—which forecasts future CAMELS ratings quarterly, based on 12 key financial ratios tracking equity
capital, loan-loss exposure, earnings, liquid assets, and loan totals. See especially Collier et al. [5].
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Concept Check
16–5. Why is lending so closely regulated by state and 16–7. What should a good written loan policy contain?
federal authorities?
16–6. What is the CAMELS rating, and how is it used?
Key URLs Other authorities would add to this list such items as specifying what loans the lender
To learn more about would prefer not to make, such as loans to support the construction of speculative housing
how loan officers
or loans to support leveraged buyouts (LBOs) of companies by a small group of insiders
are educated see,
for example, the who typically make heavy use of debt (leverage) to finance the purchase, as well as a list of
Risk Management preferred loans (such as short-term business inventory loans that may be self-liquidating).
Association (RMA) A written loan policy carries a number of advantages for the lending institution adopt-
at www.rmahq.org. ing it. It communicates to employees what procedures they must follow and what their
If you are interested
responsibilities are. It helps the lender move toward a loan portfolio that can successfully
in a possible career in
lending see especially blend multiple objectives, such as promoting profitability, controlling risk exposure, and sat-
www.jobsinthemoney isfying regulatory requirements. Any exceptions to the loan policy should be fully docu-
.com and www.bls.gov/ mented, and the reasons why a variance from loan policy was permitted should be listed.
oco/cg/cgs027.htm. While any loan policy must be flexible due to continuing changes in economic conditions
and regulations, violations of loan policy should be infrequent events.
16–4 Steps in the Lending Process

1. Finding Prospective Loan Customers
Most loans to individuals arise from a direct request from a customer who approaches a
member of the lender’s staff and asks to fill out a loan application. Business loan requests,
on the other hand, often arise from contacts the loan officers and sales representatives
make as they solicit new accounts from firms operating in the lender’s market area.
Increasingly the lending game is becoming a sales position. Sometimes loan officers will
call on the same company for months before the customer finally agrees to give the lend-
ing institution a try by filling out a loan application. Most loan department personnel fill
out a customer contact report similar to the one shown in Table 16–2 when they visit
a prospective customer’s place of business. This report is updated after each subsequent
visit, giving the next loan officer crucial information about a prospective client before any
other personal contacts are made.
Key Video Link 2. Evaluating a Prospective Customer’s Character and Sincerity of Purpose
@ http://www
Once a customer decides to request a loan, an interview with a loan officer usually follows,
.allbusiness.com/
legal/consumer-law- giving the customer the opportunity to explain his or her credit needs. That interview
consumer-credit- is particularly important because it provides an opportunity for the loan officer to assess
reporting/12313831-1 the customer’s character and sincerity of purpose. If the customer appears to lack sincerity in
.html view a video acknowledging the need to adhere to the terms of a loan, this must be recorded as weigh-
that outlines how an
ing against approval of the loan request.
entrepreneur would
establish business credit
to finance a small 3. Making Site Visits and Evaluating a Prospective Customer’s Credit Record
business. If a business or mortgage loan is applied for, a loan officer often makes a site visit to assess
the customer’s location and the condition of the property and to ask clarifying questions.
The loan officer may contact other creditors who have previously loaned money to this
customer to see what their experience has been. Did the customer fully adhere to previous
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TABLE 16–2 Name of customer:

Sample Customer
Address: Telephone: ( )
Contact Report
Lender personnel making most recent contact:
(results of previous
Names of employees making previous contacts with this customer:
calls on a customer)
Does this customer currently use any of our services? Yes No
Which ones?
If a business firm, what officials with the customer’s firm have we contacted?
If an individual, what is the customer’s occupation?

Approximate annual sales: $ Size of labor force:
Who provides financial services to this customer at present?
What problems does the customer have with his/her current financial service relationship?
What financial services does this customer use at present? (Please check)
Line of credit Funds transfers
Term loan Cash management services
Checkable deposits Other services
What services does this customer not use currently that might be useful to him or her?
Describe the results of the most recent contact with this customer:
Recommended steps to prepare for the next call (e.g., special information needed):
loan agreements and, where required, keep satisfactory deposit balances? A previous pay-
ment record often reveals much about the customer’s character, sincerity of purpose, and
sense of responsibility in making use of credit extended by a lending institution.
4. Evaluating a Prospective Customer’s Financial Condition

If all is favorable to this point, the customer is asked to submit several crucial documents
the lender needs in order to fully evaluate the loan request, including complete financial
statements and, in the case of a corporation, board of directors’ resolutions authorizing
the negotiation of a loan with the lender. Once all documents are on file, the lender’s
credit analysis division conducts a thorough financial analysis of the applicant, aimed at
determining whether the customer has sufficient cash flow and backup assets to repay the
loan. The credit analysis division then prepares a brief summary and recommendation,
which goes to the appropriate loan committee for approval. On larger loans, members
of the credit analysis division may give an oral presentation and discussion will ensue
between staff analysts and the loan committee over the strong and weak points of a loan
request.
5. Assessing Possible Loan Collateral and Signing the Loan Agreement

If the loan committee approves the customer’s request, the loan officer or the credit com-
mittee will usually check on the property or other assets to be pledged as collateral in order
to ensure the lending institution has immediate access to the collateral or can acquire title
to the property involved if the loan agreement is defaulted. This is often referred to as
perfecting the lender’s claim to collateral. Once the loan officer and loan committee are
satisfied that both the loan and the proposed collateral are sound, the note and other
documents that make up a loan agreement are prepared and signed by all parties to the
agreement.
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6. Monitoring Compliance with the Loan Agreement

and Other Customer Service Needs
Is this the end of the process? Can the loan officer put the signed loan agreement on the
shelf and forget about it? Hardly! The new agreement must be monitored continuously
to ensure the terms of the loan are being followed and all required payments of principal
and interest are being made as promised. For larger commercial credits, the loan offi-
cer will visit the customer’s business periodically to check on the firm’s progress and see
what other services the customer may need. Usually a loan officer or other staff member
enters information about a new loan customer in a computer file known as a customer
profile. This file shows what services the customer is currently using and contains other
information required by management to monitor a customer’s condition and financial
service needs.
16–5 Credit Analysis: What Makes a Good Loan?

The division or department responsible for analyzing and making recommendations on the
fate of most loan applications is the credit department. Experience has shown that this depart-
ment must satisfactorily answer three major questions regarding each loan application:
1. Is the borrower creditworthy? How do you know?
2. Can the loan agreement be properly structured and documented so the lending institu-
tion and those who supply it with funds are adequately protected and the borrower has
a high probability of being able to service the loan without excessive strain?
3. Can the lender perfect its claim against the assets or earnings of the customer so that,
in the event of default, the lender’s funds can be recovered rapidly at low cost and with
low risk?
Let’s look at each of these three key issues in the “yes” or “no” decision a lending institu-
tion must make on every loan request.
1. Is the Borrower Creditworthy? The Cs of Credit

The question that must be dealt with before any other is whether or not the customer can
service the loan—that is, pay out the credit when due, with a comfortable margin for error.
This usually involves a detailed study of the critical aspects of a loan application: charac-
ter, capacity, cash, collateral, and conditions. In addition to the five Cs of credit just listed,
some lending experts add a sixth C—control. All of the Cs of credit must be satisfactory for
the loan to be a good one from the lender’s point of view. (See Table 16–3.)
Character
Filmtoid The loan officer must be convinced the customer has a well-defined purpose for request-
What 1999 film, ing credit and a serious intention to repay. If the officer is not sure why the customer is
recounting the early requesting a loan, this purpose must be clarified to the lender’s satisfaction. The loan offi-
days of Apple and
Microsoft, finds a clean-
cer must determine if the purpose is consistent with the lending institution’s loan policy.
shaven Steve Jobs in Even with a good purpose, however, the loan officer must determine that the borrower has
search of funding for a responsible attitude toward using borrowed funds, is truthful in answering questions, and
Apple Computers and will make every effort to repay what is owed. Responsibility, truthfulness, serious purpose,
explaining the beard and serious intention to repay all monies owed make up what a loan officer calls character.
had to go, “Banks don’t
like beards”?
If the lender feels the customer is insincere in promising to use borrowed funds as planned
Answer: Pirates of and in repaying as agreed, the loan should not be made, for it will almost certainly become
Silicon Valley. a problem credit.
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TABLE 16 –3 Six Basic Cs of Lending

Source: Peter S. Rose, “Loans in a Troubled Economy,” The Canadian Banker 90, no. 3 (June 1983), p. 55.
Character Capacity Cash Collateral Conditions Control

Customer’s past payment Identity of customer and Take-home pay for an Ownership of assets Customer’s current Applicable laws and
record guarantors individual; past position in industry and regulations regarding the
earnings, dividends, and expected market share character and quality of
sales record for a acceptable loans
business firm
Experience of other Copies of Social Security Adequacy of past and Vulnerability of assets to Customer’s performance Adequate documentation
lenders with this cards, driver’s licenses, projected cash flows obsolescence vis-à-vis comparable firms for examiners who may
customer corporate charters, in same industry review the loan
resolutions, partnership
agreements, and other legal
documents
Purpose of loan Description of history, legal Availability of liquid reserves Liquidation value of assets Competitive climate for Signed acknowledgments
structure, owners, nature of customer’s product and correctly prepared loan
operations, products, and documents
principal customers and
suppliers for a business
borrower
Customer’s track record in Turnover of payables, Degree of specialization in Sensitivity of customer and Consistency of loan request
forecasting business or accounts receivable, and assets industry to business cycles with lender’s written loan
personal income inventory and changes in technology policy
Credit rating Capital structure and Liens, encumbrances, and Labor market conditions in Inputs from noncredit
leverage restrictions against property customer’s industry or personnel (such as
market area economists or political
experts) on external
factors affecting loan
repayment
Presence of cosigners or Expense controls Leases and mortgages issued Impact of inflation on
guarantors of the against property and equipment customer’s balance sheet
proposed loan and cash flow
Coverage ratios Insurance coverage Long-run industry or job
outlook
Recent performance of Guarantees and warranties Regulations and political
borrower’s stock and price- issued to others and environmental factors
earnings (P/E) ratio affecting the customer
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and/or his or her job,
business, and industry
Management quality Lender’s relative position as
creditor in placing a claim
against borrower’s assets
Recent accounting changes Probable future financing needs
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Capacity
The loan officer must be sure the customer has the authority to request a loan and the
legal standing to sign a binding loan agreement. This customer characteristic is known
as the capacity to borrow money. For example, in most areas a minor (e.g., under age
18 or 21) cannot legally be held responsible for a credit agreement; lenders would have
great difficulty collecting on such a loan. Similarly, the loan officer must be sure the rep-
resentative from a corporation asking for credit has proper authority from the company’s
board of directors to negotiate a loan and sign a credit agreement binding the company.
Usually this can be determined by obtaining a copy of the resolution passed by a corpo-
rate customer’s board of directors, authorizing the company to borrow money. Where a
business partnership is involved, the loan officer must ask to see the firm’s partnership
agreement to determine which individuals are authorized to borrow for the firm. A loan
agreement signed by unauthorized persons could prove to be uncollectible and result in
substantial losses for the lending institution.
Cash
This feature of any loan application centers on the question: Does the borrower have
the ability to generate enough cash—in the form of cash flow—to repay the loan? In
general, borrowing customers have only three sources to draw upon to repay their loans:
(a) cash flows generated from sales or income, (b) the sale or liquidation of assets, or
(c) funds raised by issuing debt or equity securities. Any of these sources may provide suf-
ficient cash to repay a loan. However, lenders have a strong preference for cash flow as the
principal source of loan repayment because asset sales can weaken a borrowing customer
and make the lender’s position as creditor less secure. Moreover, shortfalls in cash flow
are common indicators of failing businesses and troubled loan relationships. This is one
reason current banking regulations require that the lender document the cash flow basis
for approving a loan.
What is cash flow? In an accounting sense, it is usually defined as
Net Profits
Noncash Expenses
(or total
Cash flow 5 1 (especially
revenues less all
depreciation)
cash expenses)
This is often called traditional cash flow and can be further broken down into:
Sales Revenues 2 Cost of Goods Sold 2 Selling, General and

Cash flow 5
Administrative Expenses 2 Taxes Paid in Cash 1 Noncash Expenses
with all of the above items (except noncash expenses) figured on the basis of actual cash
inflows and outflows instead of on an accrual basis.
For example, if a business firm has $100 million in annual sales revenue, reports
$70 million in cost of goods sold, carries annual selling and administrative expenses of
$15 million, pays annual taxes amounting to $5 million, and posts depreciation and other
noncash expenses of $6 million, its projected annual cash flow would be $16 million. The
lender must determine if this volume of annual cash flow will be sufficient to comfortably
cover repayment of the loan as well as deal with any unexpected expenses.
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In this slightly expanded format, traditional cash flow measures point to at least five
major areas loan officers should look at carefully when lending money to business firms or
other institutions. These are:
1. The level of and recent trends in sales revenue (which reflect the quality and public
acceptance of products and services).
2. The level of and recent changes in cost of goods sold (including inventory costs).
3. The level of and recent trends in selling, general, and administrative expenses (includ-
ing the compensation of management and employees).
4. Any tax payments made in cash.
5. The level of and recent trends in noncash expenses (led by depreciation expenses).
Adverse movements in any of these key sources and uses of cash demand inquiry and sat-
isfactory resolution by a loan officer.
A more revealing approach to measuring cash flow is often called the direct cash
flow method or sometimes cash flow by origin. It answers the simple but vital question:
Why is cash changing over time? This method divides cash flow into three principal
sources:
1. Net cash flow from operations (the borrower’s net income expressed on a cash rather
than an accrual basis).
2. Net cash flow from financing activity (which tracks cash inflows and outflows associated
with selling or repurchasing borrower-issued securities).
3. Net cash flow from investing activities (which examines outflows and inflows of cash
resulting from the purchase and sale of the borrower’s assets).
This method of figuring cash flow and its components can be extremely useful in ferreting
out the recent sources of a borrower’s cash flow. For example, most lenders would prefer
that most incoming cash come from operations (sales of product or service). If, on the
other hand, a substantial proportion of incoming cash arises instead from sale of assets
(investing activities) or from issuing debt (financing activities), the borrower may have
even less opportunity to generate cash in the future, presenting any prospective lender
with added risk exposure if a loan is granted.
Collateral
Key Video Link In assessing the collateral aspect of a loan request, the loan officer must ask, Does the
@ http://www borrower possess adequate net worth or own enough quality assets to provide adequate
.cbsnews.com/video/ support for the loan? The loan officer is particularly sensitive to such features as the age,
watch/?id=3756665n condition, and degree of specialization of the borrower’s assets. Technology plays an
watch a 60-Minutes
segment entitled
important role here as well. If the borrower’s assets are technologically obsolete, they will
“House of Cards” have limited value as collateral because of the difficulty of finding a buyer for those assets
that documents what should the borrower’s income falter.
happens when the
value of collateral falls
significantly. Conditions
The loan officer and credit analyst must be aware of recent trends in the borrower’s line of
work or industry and how changing economic conditions might affect the loan. A loan can
look very good on paper, only to have its value eroded by declining sales or income in a reces-
sion or by high interest rates occasioned by inflation. To assess industry and economic condi-
tions, most lenders maintain files of information—newspaper clippings, magazine articles, and
research reports—on the industries represented by their major borrowing customers.
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Control
Factoid In addition to the traditional five Cs of credit that we have just reviewed some loan experts
Who is the number-one add a sixth factor—control. The control element centers on such questions as whether
originator of loans to changes in law and regulation could adversely affect the borrower and whether the loan
households (consumers)
request meets the lender’s and the regulatory authorities’ standards for loan quality. The
in the United States?
Answer: Commercial control factor also considers the adequacy of the supporting documentation that accom-
banks, followed by panies each loan and whether a proposed loan seems consistent with current loan policy.
finance companies,
credit unions, and 2. Can the Loan Agreement Be Properly Structured and Documented?
savings institutions.
The critical Cs of credit discussed above aid the loan officer and the credit analyst in
answering the broad question: Is the borrower creditworthy? Once that question is
answered, however, a second issue must be faced: Can the proposed loan agreement be
structured and documented to satisfy the needs of both borrower and lender?
The loan officer is responsible not only to the borrowing customer but also to deposi-
tors and other creditors as well as the stockholders and must seek to satisfy the demands
of all. This requires, first, drafting a loan agreement that meets the borrower’s need for
funds with a comfortable repayment schedule. The borrower must be able to comfortably
handle any required loan payments, because the lender’s success depends fundamentally
on the success of its borrowing customers. If a major borrower gets into trouble because of
an inability to service a loan, the lending institution may find itself in serious trouble as
well. Proper accommodation of a customer may involve lending more or less money than
Key URL
Numerous software requested (because many customers do not know their own financial needs) over a longer
companies have or shorter period than requested. Thus, a loan officer must be a financial counselor to
recently developed customers as well as a conduit for loan applications.
advanced tools to A properly structured loan agreement must protect the lender and those individuals
assess stresses in lender
and institutions the lender represents by imposing certain restrictions (covenants) on
portfolios. See, for
example, www borrower activities. This is especially necessary when these activities seriously threaten
.bankerstoolbox.com/ recovery of lenders’ funds. The process for recovering a lender’s funds must be carefully
our-solutions.php? spelled out in any loan agreement.
3. Can the Lender Perfect Its Claim against the Borrower’s Earnings
and Any Assets That May Be Pledged as Collateral?
Reasons for Taking Collateral
While borrowers with impeccable credit ratings often borrow unsecured (with no specific
collateral pledged behind their loans except their reputation and continuing ability to
generate earnings), most borrowers at one time or another will be asked to pledge some
of their assets or to personally guarantee repayment of their loans. Getting a pledge of
certain borrower assets as collateral behind a loan really serves two purposes for a lender.
If the borrower cannot pay, the pledge of collateral gives the lender the right to seize and
sell those assets designated as loan collateral, using the proceeds of the sale to cover what
the borrower did not pay back. Second, collateralization gives the lender a psychological
advantage over the borrower. Because specific assets may be at stake (such as the cus-
tomer’s automobile or home), a borrower feels more obligated to work hard to repay his or
her loan and avoid losing valuable assets. Thus, the third key question faced with many
Key URLs loan applications is, Can the lender perfect its claim against the assets, earnings, or income
For an overview of of a borrowing customer?
modern loan risk The goal of a lender taking collateral is to precisely define which borrower assets are
evaluation techniques,
see, for example, www
subject to seizure and sale and to document for all other creditors to see that the lender
.msci.com/ and www has a legally enforceable claim to those assets in the event of nonperformance on a loan.
.defaultrisk.com. When a lender holds a claim against a borrower’s assets that stands superior to the claims
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of other lenders and to the borrower’s own claim, we say that lender’s claim to collateral
has been perfected. Lending institutions have learned that the procedures necessary for
establishing a perfected claim on someone else’s property differ depending on the nature
of assets pledged by the borrower and depending on the laws of the state or nation where
the assets reside. For example, a different set of steps is necessary to perfect a claim if
the lender has actual possession of the assets pledged (e.g., if the borrower pledges a
deposit already held in the bank or lets the lender hold some of the customer’s stocks and
bonds) as opposed to the case where the borrower retains possession of the pledged assets
(e.g., an automobile). Yet another procedure must be followed if the property pledged is
real estate—land and buildings.
Common Types of Loan Collateral
Examples of the most popular assets pledged as collateral for loans include the following:
Accounts Receivable. The lender takes a security interest in the form of a stated
percentage (usually somewhere between 40 and 90 percent, depending on perceived
quality) of the face amount of accounts receivable (sales on credit) shown on a
business borrower’s balance sheet. When the borrower’s credit customers send in cash
to retire their debts, these cash payments are applied to the balance of the borrower’s
loan. The lending institution may agree to lend still more money as new receivables
arise from the borrower’s subsequent sales to its customers, thus allowing the loan to
continue as long as the borrower has need for credit and continues to generate an
adequate volume of sales and loan repayments.
Factoring. A lender can purchase a borrower’s accounts receivable based upon some
percentage of their book value. Moreover, because the lender takes over ownership
of the receivables, it will inform the borrower’s customers that they should send their
payments to the purchasing institution. Usually the borrower promises to set aside
funds in order to cover some or all of the losses the lending institution may suffer from
any unpaid receivables.
Inventory. In return for a loan a lender may take a security interest against the current
amount of inventory of goods or raw materials a business borrower owns. Usually a
lending institution will advance only a percentage (30 to 80 percent is common) of the
estimated market value of a borrower’s inventory in order to leave a substantial cushion
in case the inventory’s value declines. The inventory pledged may be controlled
completely by the borrower, using a floating lien approach. Another option, often used
for auto and truck dealers or sellers of home appliances, is called floor planning, in
which the lender takes temporary ownership of any goods placed in inventory and the
borrower sends payments or sales contracts to the lender as goods are sold.5
Real Property. Following a title search, appraisal, and land survey, a lending institution
may take a security interest in land and/or improvements on land owned by the
borrower and record its claim—a mortgage—with the appropriate government agency in
order to warn other lenders that the property has already been pledged (i.e., has a lien
against it) and help defend the original lender’s position against claims by others.
5
Lenders seeking closer control over a borrower’s inventory may employ warehousing in which goods are stored and
monitored by the lender or by an independent agent working to protect the lender’s interest. (The warehouse site may
be away from the borrower’s place of business—a field warehouse.) As the inventory grows, warehouse receipts are
issued to the lending institution, giving it a legal claim. The lender will make the borrower a loan equal to some agreed-
upon percentage of the expected market value of the inventory covered by the warehouse receipts. When the public buys
goods from the borrowing firm, the lender surrenders its claim so the company’s product can be delivered to its customers.
However, the customer’s cash payments go straight to the lending institution to be applied to the loan’s balance. Because of
the potential for fraud or theft, loan officers may inspect a business borrower’s inventory periodically to ensure the loan is
well secured and that proper procedures for protecting and valuing inventory are being followed.
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Concept Check
16–8. What are the typical steps followed in receiving a of $0.7 million this year versus $0.6 million last
loan request from a customer? year. What is this firm’s projected cash flow for
16–9. What three major questions or issues must a this year? Is the firm’s cash flow rising or falling?
lender consider in evaluating nearly all loan What are the implications for a lending institution
requests? thinking of loaning money to this firm? Suppose
16–10. Explain the following terms: character, capacity, sales revenue rises by $0.5 million, cost of goods
cash, collateral, conditions, and control. sold decreases by $0.3 million, while cash tax
payments increase by $0.1 million and noncash
16–11. Suppose a business borrower projects that it
expenses decrease by $0.2 million. What hap-
will experience net profits of $2.1 million, com-
pens to the firm’s cash flow? What would be the
pared to $2.7 million the previous year, and will
lender’s likely reaction to these events?
record depreciation and other noncash expenses
For example, public notice of a mortgage against real estate may be filed with the
county courthouse or tax assessor/collector in the county or region where the property
resides. The lender may also take out title insurance and insist the borrower purchase
insurance to cover damage from floods and other hazards, with the lending institution
receiving first claim on any insurance settlement made.
Personal Property. Lenders often take a security interest in automobiles, furniture
and equipment, jewelry, securities, and other forms of personal property a borrower
owns. A financing statement may be filed with state or local governments in those
cases where the borrower keeps possession of any personal property pledged as
collateral during the term of a loan. To be effective, the financing statement must be
signed by both the borrower and an officer of the lending institution. On the other
hand, a pledge agreement may be prepared (but will usually not be publicly filed) if
the lender or its agent holds the pledged property, giving the lending institution the
right to control that property until the loan is repaid in full. Various states in the
United States have adopted the Uniform Commercial Code (UCC), which spells out
how lenders can perfect liens and how borrowers should file collateral statements.
Typically financial statements that detail collateral associated with a loan are filed in
one location, such as the secretary of state’s office in the debtor’s home state.
Personal Guarantees. A pledge of the stock, deposits, or other personal assets held by
the major stockholders or owners of a company may be required as collateral to secure
a business loan. Guarantees are often sought in lending to smaller businesses or to
firms that have fallen on difficult times. Then, too, getting pledges of personal assets
from the owners of a business gives the owners an additional reason to want their firm
to prosper and repay their loan.
In general, good collateral for the purpose of protecting the lender should be durable,
easy to identify, marketable, stable in value, and standardized as much as possible to per-
mit ease of recovery and sale.
Other Safety Devices to Protect a Loan

Many loan officers argue that the collateral a customer pledges behind a loan is just
one of the safety zones a lending institution must wrap around the funds it has loaned
for adequate protection. As Exhibit 16–1 indicates, most loan officers prefer to have at
least two safety zones—ideally, three—around the funds they have placed at risk with
the customer. The primary safety zone is income or cash flow—the preferred source
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EXHIBIT 16–1
Safety Zones Personal guarantees and pledges made by the
Surrounding Funds
Loaned in Order to
Protect a Lender
Strength of the customer's balance sheet
Customer's expected profits, income,
The amount owed the lender

that is exposed to risk equals
the principal amount of the
loan plus interest owed
minus any deposits maintained
by the customer
or cash flow
liquidity and collateral pledged
owners of a business firm or by cosigners to a loan
from which the customer will repay the loan. The second consists of strength on the
customer’s balance sheet, in the form of assets that can be pledged as collateral or liquid
assets that can be sold for cash in order to fill any gaps in the customer’s cash flow.
Finally, the outer safety zone consists of guarantees from a business firm’s owners to sup-
port a loan to their firm or from third-party cosigners who pledge their personal assets
to back another person’s loan.
16–6 Sources of Information about Loan Customers

A lender often relies heavily on outside information to assess the character, financial posi-
tion, and collateral of a loan customer (see Table 16–4). Such an analysis begins with a
review of information the borrower supplies in the loan application. How much money
is being requested? For what purpose? What other obligations does the customer have?
What assets might be used as collateral to back up the loan?
Key URLs The lending institution may contact other lenders to determine their experience with
Among the most the borrowing customer. Were all scheduled payments in previous loan agreements made
important websites on time? Were deposit balances kept at adequate levels? In the case of a household borrower
for financial data and
analysis of firms and
one or more credit bureaus will be contacted to ascertain the customer’s credit history. How
industries of particular much was borrowed previously and how well were those earlier loans handled? Is there any
use to loan officers are evidence of slow or delinquent payments? Has the customer ever declared bankruptcy?
Dun and Bradstreet Most business borrowers of any size carry credit ratings on their bonds and other debt
at www.dnb.com and securities and on the firm’s overall credit record. Moody’s and Standard & Poor’s assigned
RMA at www.rmahq
.org/ (see Annual
credit ratings reflect the probability of default on bonds and shorter-term notes. Dun &
Statement Studies Bradstreet provides overall credit ratings for several thousand corporations. It and other
link). firms and organizations provide benchmark operating and financial ratios for whole
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TABLE 16–4 Information about Consumers (Individuals and Families) Borrowing Money
Sources of Customer-supplied financial statements
Information Credit bureau reports on a borrower’s credit history
Frequently Used Experience of other lenders with the borrower
in Loan Analysis Verification of employment with a borrower’s employer
and Evaluation by Verification of property ownership through local government records
The World Wide Web
Lenders and Loan
Committees Information about Businesses Borrowing Money
Financial reports supplied by the borrowing firm
Copies of boards of directors’ resolutions or partnership agreements authorizing borrowing
Credit ratings supplied by Dun & Bradstreet, Moody’s Investor Service, Standard & Poor’s Corporation, Fitch, etc.
The New York Times and The New York Times Index
The Wall Street Journal, Fortune, and other business publications
Risk Management Associates (RMA) or Dun & Bradstreet industry averages
The World Wide Web
Information about Governments Borrowing Money
Governmental budget reports
Credit ratings assigned to government borrowers by Moody’s, Standard & Poor’s Corporation, etc.
The World Wide Web
Information about General Economic Conditions Affecting Borrowers
Local newspapers and the Chamber of Commerce
The Wall Street Journal, The Economist, and other general business publications
U.S. Department of Commerce
Central bank business data series (as in the Federal Reserve Bulletin)
The World Wide Web
industries so the borrower’s particular operating and financial ratios in any given year can
be compared to industry standards.
One of the most widely consulted sources of data on business firm performance is Risk
Management Associates, founded as RMA in Philadelphia in 1914 to exchange credit
information among business lending institutions and to organize conferences and publish
educational materials to help train loan officers and credit analysts. While RMA began in
the United States, its members have spread over much of the globe with especially active
groups in Canada, Great Britain and western Europe, Hong Kong, and Mexico. RMA has
published several respected journals and studies, including Creative Considerations, Lending
to Different Industries, and the RMA Journal, to help inform and train credit decision makers.
Another popular RMA publication is its Annual Statement Studies: Financial Ratio
Benchmarks, which provides financial performance data on businesses grouped by industry
and by size. Loan officers who are members of RMA submit financial performance infor-
mation based on data supplied by their borrowing business customers. RMA then groups
this data and calculates average values for selected performance ratios. Among the ratios
published by RMA and grouped by industry and firm size are
Current assets to current liabilities (the current ratio).
Current assets minus inventories to current liabilities (the quick ratio).
Sales to accounts receivable.
Cost of sales to inventory (the inventory turnover ratio).
Earnings before interest and taxes to total interest payments (the interest coverage ratio).
Fixed assets to net worth.
Total debt to net worth (the leverage ratio).
Profits before taxes to total assets and to tangible net worth.
Total sales to net fixed assets and total assets.
RMA also calculates common-size balance sheets (with all major asset and liability
items expressed as a percentage of total assets) and common-size income statements (with
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profits and operating expense items expressed as a percentage of total sales) for different
size groups of firms within an industry. Recently the association published a second vol-
ume of its statement studies series called Annual Statement Studies: Industry Default Proba-
bilities and Cash Flow Measures, which reported on the risk exposure of about 450 different
industries, estimated default probabilities for one- and five-year intervals, and tracked at
least four different measures of cash flow—a key element in any lending decision.
RMA also offered lenders a Windows-based version of its statement studies series which
permited a credit analyst or loan officer to do a spreadsheet analysis—arraying the loan
customer’s financial statements and key financial and operating ratios over time relative
to industry averages based upon data from more than 150,000 financial statements. This
Windows-based system enabled a loan officer to counsel his or her borrowing customer,
pointing out any apparent weaknesses in the customer’s financial or operating situation
compared to industry standards. This credit analysis routine was also available to business
firms planning to submit a loan request to a lending institution so business owners could
personally evaluate their firm’s financial condition from the lender’s perspective.
Today RMA operates RMA University, which provides risk management information and
training in a variety of useful formats, including online and onsite presentations. Included
within the RMA University curricula are lenders’ conferences, forums, roundtables, web-
seminars, and open-enrollment courses devoted to multiple dimensions of risk exposure.
Another important array of useful information relevant to lenders’ professional needs is
provided by the well-known Dun & Bradstreet Credit Services. This credit-rating agency
collects information on several million firms in more than 800 different business lines.
D&B prepares detailed financial reports on individual borrowing companies for its sub-
scribers. For each firm reviewed, the D&B Business Information Reports provide a credit
rating, a financial and management history of the firm, a summary of recent balance sheet
and income and expense statement trends, its terms of trade, and the location and con-
dition of the firm’s facilities. D & B also operates a Country Risk Line to help businesses
assess risk when entering foreign countries.
In evaluating a credit application, the loan officer must look beyond the customer to
the economy of the local area for smaller loan requests and to the national or international
economy for larger credit requests. Many loan customers are especially sensitive to the
fluctuations in economic activity known as the business cycle. For example, auto dealers,
producers of commodities, home builders, and security dealers and brokers face cyclically
sensitive markets for their goods and services. This does not mean lending institutions should
not lend to such firms. Rather, they must be aware of the vulnerability of their borrowers
to cyclical changes and structure loan terms to take care of such fluctuations in economic
conditions. Moreover, for all business borrowers it is important to develop a forecast of
future industry conditions. The loan officer must determine if the customer’s projections for
the future conform to the outlook for the industry as a whole. Any differences in outlook
must be explained before a final decision is made about approving or denying a loan request.
16–7 Parts of a Typical Loan Agreement

The Promissory Note
When a lending institution grants a loan to one of its customers, such an extension of
credit is accompanied by a written contract with several different parts. First, the promissory
note, signed by the borrower, specifies the principal amount of the loan. The face of the
note will also indicate the interest rate attached to the principal amount and the terms
under which repayment must take place (including the dates on which any installment
payments are due).
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ETHICS IN BANKING
LENDING THE OLD FASHIONED WAY—IS IT higher credit ratings and better rates of return than many
MAKING A COMEBACK? other available investments. Unfortunately, the high credit
For roughly half a century lenders have been passing through ratings awarded loan-backed securities by rating firms
a revolution in their methods of supplying credit to the public. proved grossly overblown and the values of loan-backed
Through much of their earliest history lenders generated prof- securities eventually plummeted as a credit crisis rocked
its by lending the traditional way. Funds were raised mainly global markets.
by selling deposits to the public at one interest rate and then Despite the developing problems in world credit markets
lending those funds to borrowers at a higher interest rate. lenders continued to search for even more exotic ways to
The bulk of lender’s profits came from the margin or spread lend and make money. The mortgage loan market—the larg-
between deposit rates and loan rates. These margins were est domestic financial marketplace—drew the bulk of lender
nearly always positive and regulated by strict government attention and governments encouraged the growth of home
rules that set maximum interest rate ceilings. In this environ- lending to provide housing for lower-income families. Some
ment most lenders served as both loan originators and loan lenders took full advantage of this situation, granting new
keepers, as any loans granted were most often kept on the loans without documenting borrower income or even consid-
originating lender’s balance sheet. ering customers’ monthly budgets to see if they could handle
Beginning in the 1970s and 1980s, however, a new financial the loans requested. Other lenders opted not to fully disclose
system began to unfold with new laws loosening many of the the terms of more risky loans they were offering, including the
old rules so that deposit rates, loan rates, and lending margins fact that many such loans carried variable interest rates that
became more flexible, but also more risky. Subsequently new would soon rise, causing sharp increases in monthly payments
laws appeared, permitting depository institutions to cross state and driving some buyers out of their homes. All of this was
lines and spread their lending activities ultimately around the made possible because mortgage lenders faced few rules and
world. The new, more liberal government rules ushered in a little protection was required for home buyers.
wave of innovation as lenders became more creative in their In the new home mortgage environment lenders were
thinking about how to make money from lending money. encouraged to sell individual loans and packages of loans
With looser external controls the traditional lending model and to buy instead mortgage-loan-backed securities, shift-
was replaced by a new lending model with fewer rules, but ing much of the risk of lending to capital market investors
more risk. A growing roster of financial firms adopted com- around the globe. In effect, conventional lenders had become
puter algorithms (such as credit scoring) to evaluate their securities traders. When the home mortgage market began to
borrowing customers. The traditional role of the loan officer melt down in 2007 through 2009 and beyond, many investors
in personally visiting clients and assessing their character dumped large quantities of mortgage-loan-backed securities
faded, increasingly replaced by impersonal, high-volume and their prices cratered. Many homeowners began losing
computer methods that awarded points for various borrower their homes and international investors were in panic as the
characteristics, including each borrower’s loan repayment value of their loan-backed investments declined. Some high-
record. The borrower’s numerical score in points became the flying lenders were headed for bankruptcy.
basis of approval or denial of a loan with borrower and lender More recently, legislators and regulators have begun to
not usually confronting each other. (See Chapter 18 for a fuller take a serious look at the newer models of loan production,
explanation of credit scoring techniques.) blaming the latest credit crisis, in part, on “streamlined” loan
Moreover, deposits became less important as a source of practices that had become the norm. Some experts decided
lender funding. Lenders were still originators of most loans what was needed was a more effective balance between old
but quickly sold many of the loans they made off their balance and new lender models. Regulators began to discuss the need
sheets to global investors. As Mizen [6] explains, loan sales for lenders to know their customers better, for loan originators
increasingly were used to raise new cash to make still more to retain more of the risk on loans they sell to other investors,
loans, etc. The ability to sell off loans made originating lenders and for fuller disclosure to customers about loan terms and
less concerned about borrowers’ ability to repay their loans their consequences for the welfare of the borrower. In short,
and therefore less sensitive to risk. both new and old lending methods may be beginning to merge
Also, many lenders, instead of selling off one loan at a in an effort to find safer and fairer practices for lending money
time, packaged many of their loans into pools and arranged in the 21st century. Finally, there must be greater coordination
for the sale of securities collateralized by these loan pools among financial regulators in Europe, the United States, and
in markets all over the world. Eager investors snapped up Asia to deal more effectively with rapid swings in financial
these loan-backed securities because they generally carried innovation and loan risk.
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Key Video Link The promissory note is a negotiable instrument. This customer-signed note represents
@ http://www.5min that part of the loan process where money is created. When a borrower defaults, lenders
.com/Video/
generally sue for recovery of their funds based on the content of this note.
Understanding-
a-Master-Loan- Loan Commitment Agreement
Promissory-
Note-155736650 In addition, larger business and home mortgage loans often are accompanied by loan
watch a short video commitment agreements, in which the lender promises to make credit available to the
describing a master borrower over a designated future period up to a maximum amount in return for a com-
promissory note mitment fee (usually expressed as a percentage—such as 0.5 percent—of the maximum
associated with a
student loan.
amount of credit available). This practice is common in the extension of short-term
business credit lines, where, for example, a business customer may draw against a maxi-
mum million dollar credit line as needed over a given period (such as six months).
Collateral
Loans may be either secured or unsecured. Secured loans contain a pledge of some of the
borrower’s property behind them (such as a home or an automobile) as collateral that
may have to be sold if the borrower has no other way to repay the lender. Unsecured loans
have no specific assets pledged behind them; these loans rest largely on the reputation
and estimated earning power of the borrower. Secured loan agreements include a section
describing any assets pledged as collateral to protect the lender’s interest, along with an
explanation of how and when the lending institution can take possession of the collat-
eral in order to recover its funds. For example, an individual seeking an auto loan usually
must sign a chattel mortgage agreement, which means the borrower temporarily assigns the
vehicle’s title to the lender until the loan is paid off. Alternatively, home buyers sign a
residential mortgage agreement that assigns home ownership claims to mortgage lenders.
Covenants
Most formal loan agreements contain restrictive covenants, which are usually one of two
types:
1. Affirmative covenants require the borrower to take certain actions, such as periodically
filing financial statements with the lending institution, maintaining insurance cover-
age on the loan and on any collateral pledged, and maintaining specified levels of
liquidity and equity.
2. Negative covenants restrict the borrower from doing certain things without lender
approval, such as taking on new debt, acquiring additional fixed assets, participating in
mergers, selling assets, or paying excessive dividends to stockholders.
Recently the use of loan covenants appears to be shrinking somewhat (especially for
business loans) due to intense competition among lenders, the sale of loans off lenders’
balance sheets, and increased market volatility, making it harder for borrowers to meet
performance targets.
Borrower Guaranties or Warranties
In most loan agreements, the borrower specifically guarantees or warranties that the infor-
mation supplied in the loan application is true and correct. The borrower may also be
Key URL required to pledge personal assets—a house, land, automobiles, and so on—behind a busi-
For more information ness loan or against a loan consigned by a third party. Whether collateral is posted or not,
about loan accounting the loan agreement must identify who or what institution is responsible for the loan and
and disclosure of obligated to make payment.
problem loans in an
international setting Events of Default
see especially www.bis
.org/forum/research Finally, most loans contain a section listing events of default, specifying what actions or
.htm. inactions by the borrower would represent a significant violation of the terms of the loan
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agreement and what actions the lender is legally authorized to take in order to secure
recovery of its funds. The events-of-default section also clarifies who is responsible for
collection costs, court costs, and attorney’s fees that may arise from litigation of the loan
agreement.
16–8 Loan Review

What happens to a loan agreement after it has been endorsed by the borrower and the
lending institution? Should it be filed away and forgotten until the loan falls due and the
borrower makes the final payment? Obviously that would be a foolish thing for any lender
to do because the conditions under which each loan is made are constantly changing, pos-
sibly affecting the borrower’s financial strength and his or her ability to repay. Fluctuations
in the economy weaken some businesses and increase the credit needs of others, while
individuals may lose their jobs or contract serious health problems, imperiling their ability
to repay outstanding loans. The loan department must be sensitive to these developments
and periodically review all loans until they reach maturity.
While most lenders today use a variety of different loan review procedures, a few gen-
eral principles are followed by nearly all lending institutions. These include:
1. Carrying out reviews of all types of loans on a periodic basis—for example, routinely
examining the largest loans outstanding every 30, 60, or 90 days, along with a random
sample of smaller loans.
2. Structuring the loan review process carefully to make sure the most important features
of each loan are checked, including
a. The record of borrower payments to ensure the customer is not falling behind the
planned repayment schedule.
b. The quality and condition of any collateral pledged behind the loan.
c. The completeness of loan documentation to make sure the lender has access to any
collateral pledged and possesses the full legal authority to take action against the
borrower in the courts if necessary.
d. An evaluation of whether the borrower’s financial condition and forecasts have
changed, which may have increased or decreased the borrower’s need for credit.
e. An assessment of whether the loan conforms to the lender’s loan policies and to the
standards applied to its loan portfolio by examiners from the regulatory agencies.
3. Reviewing the largest loans most frequently because default on these credit agreements
could seriously affect the lender’s own financial condition.
4. Conducting more frequent reviews of troubled loans, with the frequency of review
increasing as the problems surrounding any particular loan increase.
5. Accelerating the loan review schedule if the economy slows down or if the industries
in which the lending institution has made a substantial portion of its loans develop
significant problems (e.g., the appearance of new competitors or shifts in technology
that will demand new products and delivery methods).
Loan review is not a luxury but a necessity for a sound lending program. It not only
helps management spot problem loans more quickly but also acts as a continuing check on
whether loan officers are adhering to their institution’s own loan policy. For this reason,
and to promote objectivity in the loan review process, many of the largest lenders separate
their loan review personnel from the loan department itself. Loan reviews also aid senior
management and the lender’s board of directors in assessing the institution’s overall expo-
sure to risk and its possible need for more capital in the future.
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16–9 Loan Workouts

Inevitably, despite the safeguards most lenders build into their loan programs, some loans
will become problem loans. Usually this means the borrower has missed one or more prom-
ised payments or the collateral pledged behind a loan has declined significantly in value.
Often such problems arise due to an excessive emphasis on the quantity rather than the
quality of loans booked. While each problem loan situation is somewhat different, several
features common to most such situations should warn a lending institution that troubles
have set in (see Table 16–5):
1. Unusual or unexplained delays in receiving promised financial reports and payments or
in communicating with bank personnel.
2. For business loans, any sudden change in methods used by the borrowing firm to
account for depreciation, make pension plan contributions, value inventories, account
for taxes, or recognize income.
3. For business loans, restructuring outstanding debt or eliminating dividends, or experi-
encing a change in the customer’s credit rating.
4. Adverse changes in the price of a borrowing customer’s stock.
5. Losses in one or more years, especially as measured by returns on the borrower’s assets
(ROA), or equity capital (ROE), or earnings before interest and taxes (EBIT).
6. Adverse changes in the borrower’s capital structure (equity/debt ratio), liquidity (cur-
rent ratio), or activity levels (e.g., the ratio of sales to inventory).
7. Deviations of actual sales, cash flow, or income from those projected when the loan
was requested.
8. Unexpected or unexplained changes in customer deposit balances.
TABLE 16–5 The manual given to bank and thrift examiners by the FDIC discusses several telltale indicators of problem
Warning Signs of loans and poor lending policies:
Weak Loans and Poor
Lending Policies
Indicators of a Indicators of Inadequate or
Source: Federal Deposit Weak or Troubled Loan Poor Lending Policies
Insurance Corporation,
Bank Examination Policies, Irregular or delinquent loan payments Poor selection of risks among borrowing
Washington, D.C., selected Frequent alterations in loan terms customers
years. Poor loan renewal record (little Lending money contingent on possible
reduction of principal when the loan is renewed) future events (such as a merger)
Unusually high loan rate (perhaps an attempt Lending money because a customer
to compensate the lender for a high-risk loan) promises a large deposit
Unusual or unexpected buildup of the Failure to specify a plan for loan liquidation
borrowing customer’s accounts receivable High proportion of loans outside the lender’s
and/or inventories trade territory
Rising debt-to-net-worth (leverage) ratio Incomplete credit files
Missing documentation (especially missing Substantial self-dealing credits (loans to
financial statements) insiders—employees, directors, or
Poor-quality collateral stockholders)
Reliance on reappraisals of assets to increase Tendency to overreact to competition
the borrowing customer’s net worth (making poor loans to keep customers from
Absence of cash flow statements or going to competing lending institutions)
projections Lending money to support speculative
Customer reliance on nonrecurring sources purchases
of funds to meet loan payments (e.g., selling Lack of sensitivity to changing economic
buildings or equipment) conditions
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Factoid What should a lender do when a loan is in trouble? Experts in loan workouts—the
What are the principal process of recovering funds from a problem loan situation—suggest the following steps:
causes of failure among
banks and thrift 1. Lenders must always keep the goal of loan workouts firmly in mind: to maximize the
institutions? chances for recovery of funds.
Answer: Bad loans,
management error, 2. Rapid detection and reporting of any problems with a loan are essential; delay often
criminal activity, and worsens a problem loan situation.
adverse economic 3. The loan workout responsibility should be separate from the lending function to avoid
conditions.
possible conflicts of interest for the loan officer.
4. Loan workout specialists should confer with the troubled customer quickly on possible
options, especially for cutting expenses, increasing cash flow, and improving manage-
ment control. Precede this meeting with a preliminary analysis of the problem and its
possible causes, noting any special workout problems (including the presence of com-
peting creditors). Develop a preliminary plan of action after determining the lending
institution’s risk exposure and the sufficiency of loan documents, especially any claims
against the customer’s collateral other than that held by the lender.
5. Estimate what resources are available to collect the troubled loan, including the esti-
mated liquidation values of assets and deposits.
6. Loan workout personnel should conduct a tax and litigation search to see if the bor-
rower has other unpaid obligations.
Key Video Link 7. For business borrowers, loan personnel must evaluate the quality, competence, and
@ http://www.bing integrity of current management and visit the site to assess the borrower’s property and
.com/videos/watch/ operations.
video/parsing-
treasurys-loan- 8. Loan workout professionals must consider all reasonable alternatives for cleaning up the
modification-report/ troubled loan, including making a new, temporary agreement if loan problems appear to
6ap1kxe?q=loan+modi be short-term in nature or finding a way to help the customer strengthen cash flow (such
fication+filterui:durat as reducing expenses or entering new markets) or to infuse new capital into the business.
ion-medium&FROM= Other possibilities include finding additional collateral; securing endorsements or guar-
LKVR5&GT1=LKV
antees; reorganizing, merging, or liquidating the firm; or filing a bankruptcy petition.
R5&FORM=LKVR3
watch a CNBC report Of course, the preferred option nearly always is to seek a revised loan agreement that
on loan modifications
gives both the lending institution and its customer the chance to restore normal opera-
following the recent
financial crisis. tions. Indeed, loan experts often argue that even when a loan agreement is in serious
trouble, the customer may not be. This means that a properly structured loan agreement
rarely runs into irreparable problems. However, an improperly structured loan agreement
can contribute to a borrower’s financial problems and be a cause of loan default.
One of the most powerful examples of how inappropriately constructed loan agree-
ments can cause problems for both borrower and lender occurred recently in the subprime
home mortgage market. Thousands of home buyers signed on with little knowledge
Concept Check
16–12. What sources of information are available today 16–15. What are some warning signs to management
that loan officers and credit analysts can use in that a problem loan may be developing?
evaluating a customer loan application? 16–16. What steps should a lender go through in trying to
16–13. What are the principal parts of a loan agreement? resolve a problem loan situation?
What is each part designed to do?
16–14. What is loan review? How should a loan review
be conducted?
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about the changeable terms of their home loans, many of which carried variable loan
rates. When home loan rates eventually were raised significantly, tens of thousands of
homeowners could no longer repay their loans and some lenders foreclosed, resulting in
many borrowers losing their homes. Recently some lenders have negotiated loan mod-
ifications with home buyers, offering credit terms more appropriate for the borrower’s
circumstances.
Summary This chapter has focused on lending policies and procedures and the many different types
of loans lenders offer their customers. It makes these key points:
• Making loans is the principal economic function of lending institutions. Loans support
communities by providing credit to finance the development of new businesses, sustain
existing activities, and create jobs so that living standards can grow over time.
• Lending is also risky, because loan quality is affected by both external and internal fac-
tors. External factors include changes in the economy, natural disasters, and regulations
imposed by government. Internal factors affecting loan risk include management errors,
illegal manipulation, and ineffective lending policies.
• The risk of loss in the lending function is at least partially controlled by (a) government
regulation and (b) internal policies and procedures. Regulatory agencies send out teams of
examiners to investigate lending procedures and the quality of loans within each lend-
ing institution. Among depository institutions today a five-point CAMELS rating sys-
tem is used to evaluate the risk exposure of lenders based upon the quantity and quality
of their capital, assets, management, earnings, liquidity, and sensitivity to market risk.
• Risk is also controlled by creating and following written policies and procedures for
processing each credit request. Written loan policies should describe the types of loans
the lender will and will not make, the desired terms for each type of loan, the necessary
documentation before approval is granted, how collateral is to be evaluated, desired
pricing techniques, and lines of authority for loan approvals.
• Lenders consider multiple factors in approving or denying each loan request: (1) char-
acter (including loan purpose and borrower honesty); (2) capacity (especially the legal
authority of the borrower to sign a loan agreement); (3) cash (including the adequacy
of income or cash flow); (4) collateral (including the quality and quantity of assets to
backstop a loan); (5) conditions (including the state of the economy); and (6) control
(including compliance with the lender’s loan policy and regulations).
• Most lending decisions center around three key issues: (1) Is the borrower creditwor-
thy? (2) Can the loan agreement be properly structured to protect the lender and the
public’s funds? (3) Can a claim against the borrower’s assets or earnings be perfected in
the event of loan default?
• Finally, a sound lending program must make provision for the periodic review of all
outstanding loans. When this loan review process turns up problem loans, they may be
turned over to a loan workout specialist who must investigate the causes of the problem and
work with the borrower to find a solution that maximizes chances for recovery.
Key Terms real estate loans, 522 commercial and industrial retail credit, 523
financial institution loans, 522 CAMELS rating, 526
loans, 522 loans to individuals, 522 cash, 532
agricultural loans, 522 wholesale lenders, 523 cash flow, 532
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promissory note, 539 collateral, 541 events of default, 541

loan commitment restrictive covenants, 541 loan review, 542
agreements, 541 warranties, 541 loan workouts, 544
Problems 1. The lending function of depository institutions is highly regulated and this chap-
ter gives some examples of the structure of these regulations for national banks. In
and Projects
this problem you are asked to apply those regulations to Red Rose National Bank
(RRNB). Red Rose has the following sources of funds: $300 million in capital and
surplus, $325 million in demand deposits, $680 million in time and savings deposits,
and $200 million in subordinated debt.
a. What is the maximum dollar amount of real estate loans that RRNB can grant?
b. What is the maximum dollar amount RRNB may lend to a single customer?
2. Motivation Corporation, seeking renewal of its $12 million credit line, reports the
data in the following table (in millions of dollars) to Hot Springs National Bank’s
loan department. Please calculate the firm’s cash flow as defined earlier in this chap-
ter. What trends do you observe, and what are their implications for the decision to
renew or not renew the firm’s line of credit?
Projections for
20X1 20X2 20X3 20X4 Next Year
Cost of goods sold $5.1 $5.5 $5.7 $5.8 $6.0
Selling and administrative expenses 8.0 8.0 8.0 8.1 8.2
Sales revenues 7.9 8.5 9.2 9.4 9.8
Depreciation and other noncash expenses 11.2 11.2 11.1 11.0 11.0
Taxes paid in cash 4.4 4.6 4.9 4.8 4.8
3. Parvis Manufacturing and Service Company holds a sizable inventory of dryers and
washing machines, which it hopes to sell to retail dealers over the next six months.
These appliances have a total estimated market value currently of $30 million. The
firm also reports accounts receivable currently amounting to $24,650,000. Under the
guidelines for taking collateral discussed in this chapter, what is the minimum size loan
or credit line Parvis is likely to receive from its principal lender? What is the maximum
size loan or credit line Parvis is likely to receive?
4. Under which of the six Cs of credit discussed in this chapter does each of the following
pieces of information belong?
a. First National Bank discovers there is already a lien against the fixed assets of one
of its customers asking for a loan.
b. Xron Corporation has asked for a type of loan its lender normally refuses to make.
c. John Selman has an excellent credit rating.
d. Smithe Manufacturing Company has achieved higher earnings each year for the
past six years.
e. Consumers Savings Association’s auto loan officer asks a prospective customer,
Harold Ikels, for his driver’s license.
f. Merchants Center National Bank is concerned about extending a loan for another
year to Corrin Motors because a recession is predicted in the economy.
g. Wes Velman needs an immediate cash loan and has gotten his brother, Charles, to
volunteer to cosign the note should the loan be approved.
h. ABC Finance Company checks out Mary Earl’s estimate of her monthly take-
home pay with Mary’s employer, Bryan Sims Doors and Windows.
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i. Hillsoro Bank and Trust would like to make a loan to Pen-Tab Oil and Gas Com-
pany but fears a long-term decline in oil and gas prices.
j. First State Bank of Jackson seeks the opinion of an expert on the economic outlook
in Mexico before granting a loan to a Mexican manufacturer of auto parts.
k. The history of Membres Manufacture and Distributing Company indicates the
firm has been through several recent changes of ownership and there has been a
substantial shift in its principal suppliers and customers in recent years.
l. Home and Office Savings Bank has decided to review the insurance coverages
maintained by its borrowing customer, Plainsman Wholesale Distributors.
5. Butell Manufacturing has an outstanding $11 million loan with Citicenter Bank for
the current year. As required in the loan agreement, Butell reports selected data items
to the bank each month. Based on the following information, is there any indica-
tion of a developing problem loan? About what dimensions of the firm’s performance
should Citicenter Bank be concerned?
One Two Three Four

Current Month Months Months Months
Month Ago Ago Ago Ago
Cash account (millions of dollars) $33 $57 $51 $44 $43
Projected sales (millions of dollars) $298 $295 $294 $291 $288
Stock price per share
(monthly average) $6.60 $6.50 $6.40 $6.25 $6.50
Capital structure (equity/debt ratio
in percent) 32.8% 33.9% 34.6% 34.9% 35.7%
Liquidity ratio (current assets/
current liabilities) 1.10x 1.23x 1.35x 1.39x 1.25x
Earnings before interest and taxes
(EBIT; in millions of dollars) $15 $14 $13 $11 $13
Return on assets (ROA; percent) 3.32% 3.25% 2.98% 3.13% 3.11%
Sales revenue (millions of dollars) $290 $289 $290 $289 $287
Butell has announced within the past 30 days that it is switching to new methods
for calculating depreciation of its fixed assets and for valuing inventories. The firm’s
board of directors is planning to discuss at its next meeting a proposal to reduce stock
dividends in the coming year.
6. Identify which of the following loan covenants are affirmative and which are negative
covenants:
a. Nige Trading Corporation must pay no dividends to its shareholders above $3 per
share without express lender approval.
b. HoneySmith Company pledges to fully insure its production line equipment
against loss due to fire, theft, or adverse weather.
c. Soft-Tech Industries cannot take on new debt without notifying its principal lend-
ing institution first.
d. PennCost Manufacturing must file comprehensive financial statements each
month with its principal bank.
e. Dolbe King Company must secure lender approval prior to increasing its stock of
fixed assets.
f. Crestwin Service Industries must keep a minimum current (liquidity) ratio of 1.53
under the terms of its loan agreement.
g. Dew Dairy Products is considering approaching Selwin Farm Transport Company
about a possible merger but must first receive lender approval.
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7. Please identify which of the basic Cs of lending—character, capacity, cash, collateral,

conditions, and control—applies to each of the loan factors listed here:
Insurance coverage Asset liquidation

Competitive climate for customer’s Inflation outlook
product Adequate documentation
Credit rating Changes in accounting standards
Corporate resolution Written loan policy
Liquid reserves Coverage ratios
Asset specialization Purpose of loan
Driver’s license Laws and regulations that apply to the
Expected market share making of loans
Economists’ forecasts Wages in the labor market
Business cycle Changes in technology
Performance of comparable firms Obsolescence
Guarantees/warranties Liens
Expense controls Management quality
Inventory turnover Leverage
Projected cash flow History of firm
Experience of other lenders Customer identity
Social Security card Payment record

Price-earnings ratio Partnership agreement
Industry outlook Accounts receivable turnover
Future financing needs Accounts payable turnover
Internet Exercises
1. If you wanted to find out about regulations applying to bank lending, where would
you look on the Web? Why do you think this area has become so important lately?
(See, for example, www.ffiec.gov.)
2. If you wanted to find out more about the evaluation of loan portfolios during onsite
examinations, the FDIC provides an online copy of its Division of Supervision Man-
ual of Examination Policies at www.fdic.gov/regulations/safety/manual. Go to this
site and find the link for Loan Appraisal and Classification (linked to “Loans”), then
answer the following question: What are “special mention” assets?
REAL NUMBERS Continuing Case Assignment for Chapter 16

FOR REAL BANKS
YOUR BANK’S LOAN PORTFOLIO: LOANS Trend and Comparative Analysis

CLASSIFIED BY PURPOSE A. Data Collection: We have collected information for gross
Chapter 16 is an overview of lending with a focus on poli- loans and leases and net loans and leases. Now we will
cies and procedures. Table 16–1 illustrates the composition further break down gross loans and leases based on
of the industry’s (all FDIC-insured U.S. banks) loan portfo- purpose. Use SDI to create a four-column report of your
lio, highlighting the differences between small banks (less bank’s information and the peer group information across
than $100 million in total assets) and large banks (more than years. For report selection, you will access the “Net Loans
$1 billion in total assets). In this assignment we will be doing and Leases” report found at www2.fidc.gov/sdi. We sug-
a similar analysis for your banking company compared to the gest that you continue to collect percentage information
peer group of very large banks (more than $10 billion in total for ease of entry. Enter this data into the spreadsheet used
assets). for peer group comparisons as illustrated using BB&T’s
2010 and 2009 information.
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FOR REAL BANKS
**All other loans is calculated using the data collected from the SDI as follows: B155 5 B157-B150-B154.
B. Use the chart function in Excel and the data by columns how your BHC’s loan portfolio composition has changed
in rows 149 through 155 to create four pie charts illustrat- over time.
ing the loan portfolio composition by purpose for your BHC An example of such a paragraph is provided for BB&T
and its peer group. Your pie charts should include titles as follows:
and labels. For instance, the following are pie charts com- Bank holding companies depend on their loan portfolios
paring BB&T’s year-end loan portfolio for 2010 and 2009. for a significant portion of their profit generation. In the
C. Write one paragraph interpreting the pie charts for your following pie charts we see the composition of BB&T’s
BHC using a bulleted list to focus the reader’s attention on loan portfolio illustrated graphically for 2010 and 2009:
BB&T Loan Composition by Purpose (12/31/2010) BB&T Loan Composition by Purpose (12/31/2009)
Lease financing receivables All other loans** Lease financing receivables All other loans**
1% 7% 1% 5%
Loans to individuals Loans to individuals
10% 9%
Commercial and
Commercial and industrial loans
industrial loans 14%
13%
Farm loans
Farm loans
0%
0%
Loans to depository Loans to depository
institutions and acceptances institutions and acceptances
of other banks of other banks
0% Real Estate loans 0% Real Estate loans
69% 71%
In the above pie charts the two most significant Overall the composition of BB&T’s loan portfolio
changes in composition across years are: changed very little from year-end 2009 to year-end
1. All other loans increased from 5 percent of the 2010.
loan portfolio in 2009 to 7 percent in 2010. D. Write one paragraph comparing the pie charts of your BHC
2. Real estate loans were down from 71 percent of with its peer group for the most recent year-end data. Use
gross loans in 2009 to 69 percent of gross loans the same format as above, incorporating a bulleted list to
in 2010. emphasize differences.
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3. Are you interested in becoming a loan officer? A credit analyst? Go to the Bureau of
Labor Statistics’ site at www.bls.gov/oco/cg/cgs027.htm and read about the banking
industry. What is the outlook for positions as loan officers and credit analysts? What
could you expect in terms of earnings?
4. Suppose you were hired as a consultant by a lending institution’s loan department
to look at the quality of its controls designed to minimize credit risk. You know this
lender is concerned that its principal government supervisory agency is going to take
a hard look shortly at how the loan department is managed and the risks in its loan
portfolio. Where on the Internet could you look to find some guidelines on how to
control and manage credit risk? List two or three suggestions for credit risk control
that you found at the website or sites you investigated. For example, you may wish to
check www.fdic.gov and www.bis.org.
Selected For a review of procedures for identifying and working out problem loans situations, see:
References 1. Rose, Peter S. “Loans in Trouble in a Troubled Economy.” The Canadian Banker 90,
no. 3 (June 1983), pp. 52–57.
2. Taylor, Jeremy D. “Understanding Industry Risk: Parts 1, 2, and 3.” Journal of Lending
and Credit Risk Management, August, September, and October 1996.
For an analysis of the impact of changing technology on lending, visit the following:
3. Rose, Peter S. “Lenders and the Internet.” Journal of Lending and Credit Risk Manage-
ment, June 1997, pp. 31–40.
For a more detailed review of bank examination and supervision of lending, see:
4. Hirtle, Beverly J.; and Jose A. Lopez. “Supervisor Information and the Frequency of
Bank Examinations.” Economic Policy Review, Federal Reserve Bank of New York,
April 1999, pp. 1–19.
5. Collier, Charles, Sean Forbush, David A. Nuxoll, and John O’Keefe. “The SCOR
System of Off-Site Monitoring: Its Objectives, Functioning and Performance.” FDIC
Banking Review, Federal Deposit Insurance Corporation 15, no. 3 (2003), pp. 17–32.
For an explanation of how modern lending procedures and credit risk management techniques led
to a global credit crisis, originate and distribute loan methods, and risky subprime mortgage lend-
ing practices, see especially:
6. Mizen, Paul. “The Credit Crunch of 2007–2008: A Discussion of the Background,
Market Reactions, and Policy Response.” Review, Federal Reserve Bank of St. Louis,
September–October 2008, pp. 531–567.
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Confirming Pages

Introduction to Banking and Financial Services P A R T O N E

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2 Part One Introduction to Banking and Financial Services

1–2 What Is a Bank?

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Chapter One An Overview of the Changing Financial-Services Sector 3

Money-Centered Banks vs. Community Banks While we are discussing the

EXHIBIT 1–1 Name of Banking-Type Firm Definition or Description

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Insights and Issues

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Chapter One An Overview of the Changing Financial-Services Sector 5

1–3 The Financial System and Competing Financial-Service Institutions

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6 Part One Introduction to Banking and Financial Services

EXHIBIT 1–2 Total Financial Assets Percent of All Financial

Notes: Columns may not add to totals due to rounding error.

Leading Competitors with Banks

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Chapter One An Overview of the Changing Financial-Services Sector 7

Savings and Loan Association (www.flatbush.com) of Brooklyn, New York, and

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8 Part One Introduction to Banking and Financial Services

Thanks to relatively liberal government regulations, banks with quality management

Services Banks Have Offered for Centuries

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Chapter One An Overview of the Changing Financial-Services Sector 9

Discounting Commercial Notes and Making Business Loans

Offering Savings Deposits

Supporting Government Activities with Credit

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Insights and Issues

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Chapter One An Overview of the Changing Financial-Services Sector 11

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Leading Nonbank Financial Firms That Have

Offering Equipment Leasing

Selling Insurance Policies

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Chapter One An Overview of the Changing Financial-Services Sector 13

Selling and Managing Retirement Plans

Dealing in Securities: Offering Security Brokerage

Offering Merchant Banking Services

Offering Risk Management and Hedging Services

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Some Leading Retailing and Industrial Firms

Convenience: The Sum Total of All Banking and Financial Services

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Chapter One An Overview of the Changing Financial-Services Sector 15

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16 Part One Introduction to Banking and Financial Services

financial-services marketplace has fluctuated significantly. For example, as reported by

Government Deregulation and then Reregulation

Crisis, Reform, and Change in Banking and Financial Services

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Chapter One An Overview of the Changing Financial-Services Sector 17

*Chapter 9 (addressing more issues in securitization, interest-rate and credit derivatives

An Increasingly Interest-Sensitive Mix of Funds

Technological Change and Automation