Fluent Essays

Identify in 3 paragraphs, what do you think is an important Off-balance-sheet activity of a commercial bank? Please provide a focused answer and do extra research to support your answer. Be sure to include the external citation in your discussion post. [Read 11-4 first] 352 Part 3 Commercial Banks Overall, the liability structure of banks’ balance sheets tends to reflect a shorter matu- rity structure than that of their asset portfolio. Further, relatively more liquid instruments such as deposits and interbank borrowings are used to fund relatively less liquid assets such as loans. Thus, interest rate risk—or maturity mismatch risk—and liquidity risk are key exposure concerns for bank managers (see Chapters 19 through 24). Equity Commercial bank equity capital (11.3 percent of total liabilities and equity in 2013) con- sists mainly of common and preferred stock (listed at par value), surplus or additional paid-in capital, and retained earnings. Regulators require banks to hold a minimum level of equity capital to act as a buffer against losses from their on- and off-balance-sheet activi- ties (see Chapter 13). Because of the relatively low cost of deposit funding, banks tend to hold equity close to the minimum levels set by regulators. As we discuss in Chapters 13 and 22, this impacts banks’ exposure to risk and their ability to grow—both on and off the balance sheet—over time. Part of the Troubled Asset Relief Program (TARP) of 2008–2009 was the Capital Pur- chase Program, which was intended to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. Under the program, the Treasury purchased over $200 billion of senior preferred equity. The senior preferred shares rank senior to common stock should the bank be closed. In addition to capital injections received as part of the Capital Purchase Program, TARP provided additional emergency funding to Citigroup ($25 billion) and Bank of America ($20 billion). Through the summer of 2013, $245 billion of TARP capital injections had been allocated to depository institutions (DIs), of which $237 billion had been paid back plus a return of $35 billion in dividends and assessments to the government. The Notable Events from the Financial Crisis box describes the TARP Capital Purchase Program. As part of the 2010 Wall Street Reform and Consumer Protection Act, the largest banks are subject to annual stress tests, designed to ensure that the banks are properly capi- talized. Scenarios used as part of the stress tests range from mild to calamitous, with the most extreme including a 5 percent decline in gross domestic product, an unemployment rate of 12 percent, and a volatile stock market that loses half its value. The original stress test was announced in late February 2009 when the Obama administration announced that it would conduct a “stress test” of the 19 largest U.S. DIs, which would measure the abil- ity of these DIs to withstand a protracted economic slump (an unemployment rate above 10 percent and home prices dropping another 25 percent). Results of the stress test showed that 10 of the 19 DIs needed to raise a total of $74.6 billion in capital. Within a month of the May 7, 2009, release of the results the DIs had raised $149.45 billion of capital. As part of the 2013 stress tests, the worst-case scenario includes a peak unemployment rate of 12.1 percent, a drop in equity prices of more than 50 percent, a decline in housing prices of more than 20 percent, and a sharp market shock for the largest trading firms. Off-Balance-Sheet Activities The balance sheet itself does not reflect the total scope of bank activities. Banks conduct many fee-related activities off the balance sheet. Off-balance-sheet (OBS) activities are becoming increasingly important, in terms of their dollar value and the income they gen- erate for banks—especially as the ability of banks to attract high-quality loan applicants and deposits becomes ever more difficult. OBS activities include issuing various types of guarantees (such as letters of credit), which often have a strong insurance underwrit- ing element, and making future commitments to lend. Both services generate additional fee income for banks. Off-balance-sheet activities also involve engaging in derivative transactions—futures, forwards, options, and swaps. Under current accounting standards, such activities are not shown on the current balance sheet. Rather, an item or activity is an off-balance-sheet asset if, when a contingent LG 11-4 off-balance-sheet (OBS) asset When an event occurs, this item moves onto the asset side of the balance sheet or income is realized on the income statement. sau61663_ch11_346-371.indd 352sau61663_ch11_346-371.indd 352 29/05/14 9:17 PM29/05/14 9:17 PM Final PDF to printer 353 In the wake of Lehman Brothers’s bankruptcy, the U.S. Congress passed the Emergency Economic Stabilization Act (EESA) of 2008 to “restore the liquidity and stability to the financial system.” The Act authorized the Treasury Department to establish the Troubled Asset Relief Program (TARP) and to spend up to $700 billion to “bail out” the U.S. financial system. In the original plan presented by then-Secretary of the Treasury Henry Paulson, the government would use TARP funds to buy distressed assets in financial institutions. On October 14, 2008, Mr. Paulson announced a revision in TARP implementation in which the Treasury directly injected $250 billion of TARP funds (through the Capital Purchase Program [CPP]) into the U.S. banking system through the purchase of senior preferred stock and warrants in qualifying financial institutions (QFIs). The first $125 billion was to be invested in nine large, systemically important bank holding companies. The remaining $125 billion was to be made available for other banks. The amount of CPP capital that a QFI could apply for was restricted to between 1 percent and 3 percent of the QFI’s risk-weighted assets. The Treasury was paid a 5 percent dividend on the preferred stock in the first 5 years and a 9 percent dividend thereaf- ter. Over 700 of the approximate 8,300 depository institutions were accepted into CPP, receiving $245 billion in capital infusions. The largest investment was $25 billion and the smallest was $301,000. To apply for CPP investments, banks were asked to submit their applications to their primary federal regulator: the Federal Reserve (the Fed), the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), or the Office of Thrift Supervision (OTS). Based on recommendations from federal banking regulators, the Treasury made the final decision on whether or not to make the capital purchase. Many institutions decided to apply, while others opted out. Some were asked by federal regulators The TARP Program N O T A B L E E V E N T S F R O M T H E F I N A N C I A L C R I S I S not to apply. A large number of banks withdrew their applications. However, because the Treasury did not release details of the applicant list to the public, it is not known how many banks withdrew their TARP applications voluntarily despite being qualified and how many withdrew because they did not meet the requirements and were encouraged to withdraw by the banking regulators. The applica- tion period for publicly held financial institutions to participate in CPP closed on November 14, 2008. The final investment under the CPP was made in December 2009. To encourage banks to participate in CPP, the Treasury made the terms of CPP investments quite attractive. In the first nine CPP transactions, the Treasury paid $125 billion for financial claims worth only $89–$112 billion (these banks held over half of the banking industry’s assets). The Congressional Oversight Panel issued an evalu- ation report on February 6, 2009, concluding that “. . . (for) all capital purchases made in 2008 under TARP, the Treasury paid $254 billion, for which it received assets worth approximately $176 billion, a shortfall of $78 billion.” The attractive terms of CPP induced thousands of applicants, among which only about 700 financial institutions received any TARP funds. The Capital Purchase Program is often char- acterized as a program for “big banks.” Indeed, $163.5 billion of all CPP funds were allotted to the largest 19 banks. Further, many believe that small institutions were not able to and did not partici- pate in the program. In fact, because of financial obligations associated with CPP, federal regulators did not initially allow temporarily unhealthy com- munity banks to participate in CPP because such institutions would risk the Treasury’s investment. However, on May 13, 2009, Treasury Secretary Timothy Geithner announced that the Treasury would reopen the application window for participa- tion in the CPP to banks with total assets under $500 million and increase the amount that could be invested from 3 percent of risk-weighted assets to 5 percent of risk-weighted assets. In the end, smaller financial institutions make up the vast majority of participants in the CPP. By the time it closed on December 31, 2009, of the 707 applica- tions approved and funded by the Treasury through the CPP, over half were institutions with less than $500 million in assets. As the TARP CPP (hereafter TARP) program progressed, many, particularly healthy, banks real- ized that the costs of participating in TARP were higher than had been expected. As public outrage swelled over the rapidly growing cost of “bailing out” financial institutions, the Obama administra- tion and lawmakers attached more and more restrictions on banks that received TARP funds. For example, with the acceptance of TARP funds, banks were told to put off evictions and modify mortgages for distressed homeowners, let share- holders vote on executive pay packages, slash div- idends, and withdraw job offers to foreign citizens. Some bankers stated that conditions of the TARP program had become so onerous that they wanted to return the bailout money as soon as regulators set up a process to accept the repayments. For example, just three months after receiving TARP funds, Signature Bank of New York announced that because of new executive pay restrictions assessed as a part of the acceptance of TARP funds, it notified the Treasury that it intended to return the $120 million it had received. As a result, many banks, particularly those that were sufficiently healthy, repaid their TARP funds quickly. As of August 2013, banks had repaid $272 billion through principal and interest payment—representing a $27 billion positive return to taxpayers so far. In late 2008 few would have predicted that TARP would end up with a profit. Source: Authors’ research. sau61663_ch11_346-371.indd 353sau61663_ch11_346-371.indd 353 29/05/14 9:17 PM29/05/14 9:17 PM Final PDF to printer 354 Part 3 Commercial Banks event occurs, the item or activity moves onto the asset side of the balance sheet or an income item is realized on the income statement. Conversely, an item or activity is an off-balance-sheet liability if, when a contingent event occurs, the item or activity moves onto the liability side of the balance sheet or an expense item is realized on the income statement. By undertaking off-balance-sheet activities, banks hope to earn additional fee income to complement declining margins or spreads on their traditional lending business. At the same time, they can avoid regulatory costs or “taxes” since reserve requirements and deposit insurance premiums are not levied on off-balance-sheet activities (see Chapter 13). Thus, banks have both earnings and regulatory “tax-avoidance” incentives to undertake activities off their balance sheets. Off-balance-sheet activities, however, can involve risks that add to the overall insol- vency exposure of a financial intermediary (FI). Indeed, at the very heart of the financial crisis were losses associated with off-balance-sheet mortgage-backed securities created and held by FIs. These losses resulted in the failure, acquisition, or bailout of some of the largest FIs and a near meltdown of the world’s financial and economic systems. Thus, off-balance-sheet activities and instruments have risk-reducing as well as risk-increasing attributes, and, when used appropriately, they can reduce or hedge an FI’s interest rate, credit, and foreign exchange risks. We show the notional, or face, value of bank OBS activities and their distribution and growth for 1992 to 2013 in Table 11–2 . Notice the relative growth in the notional dollar value of OBS activities in Table 11–2 . By 2013, the notional value of OBS bank activities was $239,752.7 billion compared to the $13,362.6 billion value of on-balance-sheet activi- ties. The notional or face value of OBS activities does not accurately reflect the risk to the bank undertaking such activities. The potential for the bank to gain or lose on the contract is based on the possible change in the market value of the contract over the life of the con- tract rather than the notional or face value of the contract, normally less than 3 percent of the notional value of an OBS contract. The use of derivative contracts accelerated during the 1992–2013 period and accounted for much of the growth in OBS activity. Along with the growth in the notional value of OBS activities, banks have seen significant growth in the percentage of their total operating income (interest income plus noninterest income) coming from these off-balance-sheet activities. Indeed, the percentage of noninterest income to total operating income has increased from 22.66 percent in 1979 to 46.56 percent in 2013. As we discuss in detail in Chapter 23, the significant growth in derivative securities activities by com- mercial banks has been a direct response to the increased interest rate risk, credit risk, and foreign exchange risk exposures they have faced, both domestically and internationally. In particular, these contracts offer banks a way to hedge these risks without having to make extensive changes on the balance sheet. However, these assets and liabilities also introduce unique risks that must be managed. During the recent financial crisis, as mortgage borrow- ers defaulted on their mortgages, financial institutions that held these “toxic” mortgages and “toxic” credit derivatives (in the form of mortgage-backed securities) started announc- ing huge losses on them. Losses from the falling value of OBS securities reached over $1 trillion worldwide through 2009. The TARP gave the U.S. Treasury funds to buy “toxic” mortgages and other securi- ties from financial institutions. However, the TARP plan was slow to be instituted and not all FIs chose to participate in the program. Better capitalized FIs wanted to hold on to their troubled OBS securities rather than sell them and record losses. Despite this, inves- tors impounded the values of these toxic securities into the market prices of FIs that held them. As a result, early 2009 saw a plunge in the market values of financial institutions. Banks such as Citigroup, Bank of America, and J. P. Morgan Chase traded at less than book value as investors had little confidence in the value of their assets. As a result, a new plan, announced on February 10, 2009, involved a number of initiatives, including offering fed- eral insurance to banks against losses on bad assets. In addition, the Treasury, working with the Federal Reserve, FDIC, and private investors, created the Public-Private Investment off-balance-sheet (OBS) liability When an event occurs, this item moves onto the liability side of the balance sheet or an expense is realized on the income statement. sau61663_ch11_346-371.indd 354sau61663_ch11_346-371.indd 354 04/07/14 1:06 PM04/07/14 1:06 PM Final PDF to printer Chapter 11 Commercial Banks: Industry Overview 355 1992 2004 2007 2010 2013 Distribution 2013 Percentage Increase from 1992 through 2013 Commitments to lend $ 1,272.0 $ 5,686.4 $ 7,236.9 $ 5,113.5 $ 5,344.6 2.2\% 320.2\% Future and forward contracts (excludes FX) On commodities and equities 26.3 123.7 251.2 245.3 332.5 0.1 1,164.3 On interest rates 1,738.1 6,923.0 9,116.9 23,987.0 31,216.0 13.0 1,696.0 Notional amount of credit derivatives 8.6 1,909.3 15,862.8 14,150.8 13,900.8 5.8 161,537.2 Standby contracts and other option contracts Option contracts on interest rates 1,012.7 15,340.8 20,984.4 27,015.4 25,871.0 10.8 2,454.7 Option contracts on foreign exchange 494.8 1,627.2 4,024.7 3,336.0 5,617.1 2.4 1,035.2 Option contracts on commodities 60.3 1,020.2 2,715.9 1,723.7 2,249.2 0.9 3,630.0 Commitments to buy FX (includes $U.S.), spot, and forward 3,015.5 4,969.2 10,057.9 12,316.2 15,046.1 6.3 399.0 Standby LCs and foreign office guarantees 162.5 391.3 1,139.6 525.3 594.8 0.3 266.0 (amount of these items sold to others via participations) (14.9) (66.5) (220.5) (89.4) (148.1) Commercial LCs 28.1 29.5 29.7 27.7 23.5 0.0 - 16.4 Participations in acceptances 1.0 0.9 0.1 0.1 0.0 0.0 - 100.0 Securities borrowed or lent 107.2 1,073.1 2,052.2 1,029.5 984.3 0.4 818.2 Other significant commitments and contingencies 25.7 44.0 173.1 168.2 240.3 0.1 835.0 Notional value of all outstanding swaps 2,122.0 52,909.2 103,091.1 149,319.6 138,332.5 57.7 6,419.0 Total $ 10,200.3 $ 92,047.8 $ 176,763.5 $ 238,958.3 $ 239,752.7 100\% 2,250.4 Total assets (on-balance-sheet items) $ 3,476.4 $ 8,244.4 $ 11,176.1 $ 12,065.5 $ 13,362.6 284.4 TABLE 11–2 Aggregate Volume of Off-Balance-Sheet Commitments and Contingencies by U.S. Commercial Banks (in billions of dollars) FX  =  Foreign exchange, LC  =  Letter of credit. Sources: FDIC, Statistics on Banking, various issues. www.fdic.gov Fund (PPIF) to acquire real estate–related OBS assets. By selling to PPIF, financial insti- tutions could reduce balance sheet risk, support new lending, and help improve overall market functioning. The PPIF facility was initially funded at $500 billion with plans to expand the program to up to $1.25 trillion over time. After several months of discussion, in July 2009, the government had selected nine financial firms to manage a scaled-down program, investing $30 billion to start the fund. The selected firms had 12 weeks to raise $500 million of capital each from private investors willing to invest in FIs’ toxic assets. The total investment would be matched by the federal government. The purchase of $1.25 trillion in OBS mortgage-backed securities was completed in March 2010. Although the simple notional dollar value of OBS items overestimates their risk expo- sure amounts, the increase in these activities is still nothing short of phenomenal. Indeed, this phenomenal increase has pushed regulators into imposing capital requirements on sau61663_ch11_346-371.indd 355sau61663_ch11_346-371.indd 355 29/05/14 9:17 PM29/05/14 9:17 PM Final PDF to printer 356 Part 3 Commercial Banks such activities and into explicitly recognizing an FI’s solvency risk exposure from pur- suing such activities. We describe these capital requirements in Chapter 13. Further, as a result of the role derivatives played in the recent financial crisis, the 2010 Wall Street Reform and Consumer Protection Act has called for a revamping of the U.S. financial reg- ulatory system that includes extending regulatory oversight to unregulated OTC derivative securities. The regulation requires that all over-the-counter derivatives contracts be subject to regulation, and that all derivatives dealers be subject to supervision. It also empowers regulators to enforce rules against manipulation and abuse. Other Fee-Generating Activities Commercial banks engage in other fee-generating activities that cannot be easily identi- fied from analyzing their on- and off-balance-sheet accounts. Two of these include trust services and correspondent banking. Trust Services. The trust department of a commercial bank holds and manages assets for individuals or corporations. Only the largest banks have sufficient staff to offer trust ser- vices. Individual trusts represent about one-half of all trust assets managed by commercial banks. These trusts include estate assets and assets delegated to bank trust departments by less financially sophisticated investors. Pension fund assets are the second largest group of assets managed by the trust departments of commercial banks. The banks manage the pension funds, act as trustees for any bonds held by the pension funds, and act as a transfer and disbursement agent for the pension funds. We discuss pension funds in more detail in Chapter 18. Correspondent Banking. Correspondent banking is the provision of banking services to other banks that do not have the staff resources to perform the services themselves. These services include check clearing and collection, foreign exchange trading, hedging services, and participation in large loan and security issuances. Correspondent banking services are generally sold as a package of services. Pay- ment for the services is generally in the form of noninterest-bearing deposits held at the bank offering the correspondent services (see Chapter 12). D O Y O U U N D E R S T A N D : 3. What major assets commercial banks hold? 4. What the major sources of funding for commercial banks are? 5. What OBS assets and liabilities are? 6. What other types of fee-generating activities banks participate in? SIZE, STRUCTURE, AND COMPOSITION OF THE INDUSTRY As of 2013, the United States had 6,048 commercial banks. Even though this may seem to be a large number, in fact the number of banks has been decreasing. For example, in 1984, the number of banks was 14,483. 4 Figure  11–5 illustrates the number of bank mergers, bank failures, and new charters for the period 1980 through 2013. Notice that much of the change in the size, structure, and composition of this industry is the result of mergers and acquisitions. As we discuss in Chapter 13, strict regulations imposed on commercial banks over much of the last century limited geographical diversification opportunities. As a result, commercial bank operational areas were often narrow (and specialized) and the number of commercial banks was large. It was not until the 1980s and 1990s that regula- tors (such as the Federal Reserve or state banking authorities) allowed banks to merge with other banks across state lines (interstate mergers), and it has only been since 1994 that Congress has passed legislation (the Reigle-Neal Act) easing branching by banks across state lines. Finally, it has only been since 1987 that banks have possessed powers to under- write corporate securities. (Full authority to enter the investment banking [and insurance] business was received only with the passage of the Financial Services Modernization Act in 1999.) We discuss the impact that changing regulations have had on the ability of commercial banks to merge and branch in Chapter 13. LG 11-5 4. However, during this period the number of offices has risen, from 60,000 in 1984 to over 88,000 in 2013. sau61663_ch11_346-371.indd 356sau61663_ch11_346-371.indd 356 29/05/14 9:17 PM29/05/14 9:17 PM Final PDF to printer