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Discussion question:
Recently our economy has seen some interesting events in the banking space that resulted in the Recession around 2008 and recently the banking space has been affected by the COVID Pandemic and recovery. Let’s use this week to look at our reading, our knowledge of the current events and additional research of articles to discuss what happened to the Banks during these times. What has the government done to help recovery? Are there tell tale signs of distress? Could this all be avoided? What is the root cause of financial crisis? Etc. It’s an open discussion to review what was learned this week and apply it to the real world. Let’s see your take on it all.
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Replay and ONLY based on this article:
CHAPTER 3
FINANCIAL INSTITUTION DISTRESS DURING THE FINANCIAL CRISIS
Homeowners typically finance a portion of the purchase of their houses with mortgage loans. During the decade of the 2000s, banks and other mortgage lenders engaged in pooling together and packaging mortgage loans into mortgage-backed securities. As a result of the housing price bubble bursting in 2006, both home values and the mortgage-backed securities which were backed by those homes, declined sharply in price. Financial institutions and others that held these mortgages and mortgage-backed securities found that the value of these asset holdings declined so much that many of the institutions had inadequate equity capital to meet their liabilities causing them to be on the verge of financial failure.
The Federal Reserve and the U.S. Treasury assisted in the acquisition of weaker financial institutions by financially stronger institutions. For example, Bear Stearns was acquired by JPMorgan Chase & Company and Merrill Lynch was sold to Bank of America. However, Lehman Brothers was allowed to go bankrupt. Wells Fargo Bank purchased Wachovia Bank and JPMorgan Chase & Company purchased Washington Mutual.
TYPES AND ROLES OF FINANCIAL INSTITUTIONS
There are four major types of financial institutions—depository institutions, contractual savings organizations, securities firms, and finance firms. Financial institutions play a major role in directing savings to business firms. Individual savers and investors make deposits in commercial banks, purchase shares in mutual funds, pay premiums to insurance companies, and make contributions to pension funds. Commercial banks make loans to and purchase debt securities from business firms. Mutual funds, insurance companies, and pension funds purchase the debt and equity securities issued by business firms. Individual savers and investors may also directly purchase the securities of business firms through investment banks and brokerage firms.
OVERVIEW OF THE BANKING SYSTEM
A commercial bank accepts deposits, makes loans, and issues check-writing accounts to aid the making of purchases and the paying of bills. An investment bank helps businesses sell their securities to raise financial capital. These two “banks” are involved in the indirect transfer of money from savers to an investor (e.g., a business firm). The commercial bank accepts the deposits of savers in exchange for the bank’s securities (e.g., CDs). The bank then loans money to the business firm in exchange for the firm’s promise to repay the loan. In contrast, the investment bank markets the business firm’s securities to savers either by first purchasing the securities from the firm and then reselling the securities or by just marketing the securities directly to savers.
Banks and the banking system perform five functions: (1) accepting deposits, (2) granting loans, (3) issuing checkable deposit accounts, (4) clearing checks, and (5) creating deposit money. As U.S. banking moves to universal banking, the sixth function will be: (6) raising financial capital for businesses that we call investment banking. In accepting deposits, banks provide a safe place for the public to keep money for future use. The banking system puts the accumulated deposits to use through loans to persons and individuals having immediate use for them. This is the financial inter-mediation activity of depository institutions in the savings-investment process.
HISTORICAL DEVELOPMENT OF THE U.S. BANKING SYSTEM
During the colonial period there were small unincorporated banks that were established to ease the shortage of financial capital. The First Bank of the U.S. was chartered in 1791 for a period of 20 years. It served the nation by issuing notes, transferring funds from region to region, and curbing the excessive note issues of state banks. After a period of five years of chaotic banking after the charter of the First Bank expired, the Second Bank of the U.S. received a 20-year federal charter in 1816. A period of “wildcat” banking existed from 1836 to the Civil War. Thrift institutions formed in the early 1800s to provide “safe” depository institutions for savers and to provide home financing.
REGULATION OF THE BANKING SYSTEM
Legislation to govern the nation’s banking system is particularly important since it has had a profound effect not only on our depositories but also on the citizens in general. It should be noted that some legislative actions are now seen as principal causes of the difficulties depositories in general, and S&Ls in particular, experienced during the 1980s and the first-half of the 1990s.
Early laws focused first on establishing a system of federally-chartered and then a system of central banks. More recent legislation has focused on deregulating banking activities and improving the effectiveness of monetary policy. Important legislation includes:
• National Banking Act of 1864
• Federal Reserve Act of 1913
• Banking Act of 1933
• Depository Institutions Deregulation and Monetary Control Act of 1980
• Garn-St. Germain Depository Institutions Act of 1982
• Gramm-Leach-Bliley Act of 1999
• Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
Legislation passed in the early 1980s was designed to permit both greater competition for deposits and more flexibility in the holding of assets by depository institutions. However, this movement towards deregulation and increased competition led to some major problems. During the last-half of the 1980s and the first-half of the 1990s, well over 2,000 S&Ls were closed or merged into other organizations. Commercial banks also suffered some of the same difficulties as the S&Ls.
The Banking Act of 1933 (known as the Glass-Steagall Act) was repealed and replaced by the Gramm-Leach-Bliley Act of 1999 which allow commercial banks to again participate in investment banking activities and insurance underwriting. However, the 2007-08 financial crisis and the 2008-09 major economic recession led to a call for major changes in the regulation of financial institutions. The result was the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.
The S&L industry has always been a difficult one due to lending-long in the form of home mortgages while borrowing-short. Managers and officers were ill prepared for the consequences of deregulation. Thus, mismanagement was a major reason for the S&L collapse. In addition, greed and fraud on the part of some officers and managers contributed to the S&L industry collapse.
The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) was passed in 1989 to provide for the termination of the Federal Savings and Loan Insurance Corporation (FSLIC) and the formation of the Savings Association Insurance Fund (SAIF).
Insurance protection for deposits at depository institutions was started during the Great Depression of the 1930s with the Federal Deposit Insurance Corporation (FDIC) created in 1933 to protect deposits in banks. The FSLIC was formed to protect deposits in S&Ls (later replaced by the SAIF as noted above) and the National Credit Union Share Insurance Fund (NCUSIF) was created to protect deposits in credit unions. The limit on deposit account insurance was increased to $100,000 per account beginning in 1980. Today, the limit is $250,000 per account.
STRUCTURE OF BANKS
The U.S. is characterized as a “dual banking system” because commercial banks can obtain charters either from the federal government or from a state government. Federally chartered banks must be members of the Federal Reserve System and the Federal Deposit Insurance Corporation.
State laws regulate commercial banks in terms of the number of offices they are permitted and where the offices can be located. Today, all states provide either limited branch banking or state-wide branch banking.
A bank may be independently owned by investors or it may be owned by a holding company—either a one bank holding company or a multibank holding company.
THE BANK BALANCE SHEET
A balance sheet indicates an organization’s financial position as of a particular point in time. In other words, the balance sheet represents a “snap shot” of assets, liabilities, and stockholders’ equity. Before a bank or other depository institution can be formed, there must be some form of equity investment by the owners. This equity provides the base for attracting liabilities—in the case of depository institutions, accepting deposits. When there is a flow of funds derived from equity investment and depositors, commitment of the funds follows. Loans to borrowers are the basic element of the depository function; physical facilities for operations require a relatively small investment. Securities may be purchased if loan demand is inadequate or to provide diversity in the pattern of depository institution commitments. Cash, of course, serves both as a reserve and a source of funds for deposit withdrawals.
Stockholders’ equity is comprised of preferred stock, common stock, surplus, and retained earnings. When there is no preferred stock, stockholders’ equity and common equity are the same. Stockholders’ equity plus total liabilities equals total assets.
BANK MANAGEMENT
Banks are managed to make profits an increase the wealth of their owners. However, bank management must also consider the interests of depositors and bank regulators. Profitability often can be increased by taking on more risk at the expense of bank safety. Banks can fail either because of inadequate liquidity or by becoming insolvent.
Bank managers manage their bank’s riskiness in terms of bank liquidity (liquidity management) and bank solvency (capital adequacy management). Liquidity management is the management of a bank’s liquidity risk which is the likelihood that the bank will be unable to meet its depositor withdrawal demands and/or other liabilities when they are due. In deciding on how much liquidity risk is appropriate, bank managers make asset management and liability management decisions. Asset management includes the maintaining of adequate primary and secondary reserves. Liability management involves management of interest rate sensitive liabilities (such as negotiable CDs, commercial paper, and federal funds) to maintain a desired level of liquidity.
Adequate capital is necessary to ensure that banks remain solvent (i.e., assets are greater than liabilities) and be able to meet depositor demands and pay their debts as they come due. Adequate bank capital represents an important “cushion” against both credit risk and interest rate risk as they impact on bank solvency. Bank regulators set minimum capital ratio requirements for the banks and other depository institutions that they regulate.
INTERNATIONAL BANKING AND FOREIGN SYSTEMS
This subject continues to receive increased attention. The level of foreign banking operations in this country has increased dramatically, as have our own baking operations abroad.
Banks with headquarters in one country may open offices or branches in other countries. When banks operate in more than one country, we call this international banking. While most countries have central banking systems that operate much like the U.S. Federal Reserve System, some countries allow their banks to engage in both commercial banking and investment banking activities which is called universal banking. Germany is a universal banking country. The United Kingdom permits its banks to engage in both commercial and investment banking activities while Japan separates these two banking activities. Banks in the U.S. now can engage in both commercial and investment banking activities.
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