DEPOSITORY INSTITUTIONS:

Activities and Characteristics

CHAPTER: 4
Instructor: Mahwish Khokhar

INTRODUCTION

Depository Institutions include:

Commercial Banks
Saving & Loan Associations (S & L)
Saving Banks
Credit Unions

The deposits shows the liabilities (debts) of the DI. With

these funds DI make direct loans to various entities and
also invest in other securities.
The income of the DI are derived from two sources:
1. The income generated from loans and purchase of
securities
2. Fee Income

Contd..

The Saving & Loan Associations (S & L), Saving Banks and
Credit Unions are also called THRIFTS and are specialized kind
of DI.

At one time thrifts were not permitted to accept deposits

transferable by checks. Instead, they obtained funds by
tapping the saving of the households.

Since 1980s, thrifts have been allowed to accept and offer

negotiable deposits entirely equivalent to checking
accounts but their name is different which is NOW
ACCOUNT/SHARE DRAFT

Contd..

By law, investments that thrifts are actually allowed to make

are still limited as compared to Commercial Banks.

Recent legislation have however allowed the thrifts to expand

their range of investments, so that they can effectively
compete.

Depository Institutions are highly regulated because of the role

they play in the economy.

Demand drafts are the principle means that individuals and

business entities use for making payments, govt. implement
monetary policy through banking system.

ASSET/LIABILITY PROBLEM OF
DEPOSITORY INSTITUTIONS

DI seek to earn positive spread between the asset it

invest in (loans & securities) and the cost of its funds
(deposits and other sources). This spread is referred to
as SPREAD INCOME. In generating spread income
the DI are exposed to:

1. Credit Risk/Default Risk

2. Regulatory Risk
3. Interest Rate Risk

Contd..
1.

Interest Rate Risk: Suppose DI raise $100,000

million via deposits that have a maturity of one year
at 7%, this $100,000 million is invested in US
government securities that mature in 15 years at 9%.
DI will earn spread income of 2% (9% - 7% = 2%).
The spread income will depend on the interest rate
the DI will have to pay the depositor to raise
$100,000 after the deposit matures.

Contd..
From depositor 7%
INTEREST RATE

To investor 9%
SECURITY

PROFITS

1. If the interest rate declines, the spread will increase

and will ultimately increase the spread income.
2. If the interest rate rise, the spread income will
decrease and the DI will earn less.

Contd..
In

our example the DI have borrowed short and lent

long. Decline in IR will bring advantages and
disadvantages in case of the interest rate rise.

In

the case of long term borrowing and the short

term lending further, the rise in the interest rate will
benefit the DI and decline will bring losses to DI.
Example: Bank 9% and lending further 11%. If the
IR in borrowing rise to 10%, it will benefit DI
because it can further reinvest it in security with
higher yield.

Contd..
2.

Liquidity Concerns: The DI will always be

prepared to pay satisfy the depositor needs of
cash withdrawals. There are different ways
through which banks can satisfy the
withdrawal demands:
I. Attract additional deposits
II. Use existing securities as collateral for
borrowing from federal agency and other banks.
III.Raise short term funds in the money market
IV. Sell securities its owns.

Contd..
1.
2.

3.

4.

First one is self explanatory.

Second is banks are allowed to borrow at the discount
window of the federal reserve bank.
Using existing marketable securities as collateral to
raise funds in repurchase market.
Require the DI to invest in securities that are both liquid
and little price risk. The securities held for satisfying net
withdrawals and customer loans demand is sometimes
referred to as SECONDARY RESERVES.

By price risk I mean is buying at higher price

and selling at lower will result in losses.

COMMERCIAL BANKS
Read from the book (page 46).
BANK SERVICES: Commercial Banks provide
numerous services such as:
1. Individual Banking: It contains,

Consumer Lending
Residential Mortgage Lending
Consumer Installment Loans
Credit Card Financing
Automobile and Boat Financing
Brokerage Services
Students Loan
Individual Oriented Financial Services such as Personal
Trust and Investment Services.

Contd..
Interest

Income and Fee Income are generated

from mortgage lending ad credit card financing.

Mortgage

Lending is more popularly referred to

as Mortgage Banking.

Fee

Income is generated from brokerage

services and financial investment services.

Contd..
2.

Institutional Banking:

Loans to financial and nonfinancial

corporations and governmental entities fall
into the category of institutional banking.
It also includes commercial real estate
financing, leasing activities and factoring
(Banks purchase of accounts receivables).

Contd..
3.

Global Banking:

The banks start competing head-to-head with

investment banking (or securities) firm.
Global banking covers a broad range of
corporate financing and capital market and
foreign exchange products and services.
Most global banking activities generate fee
income rather than interest income.

Contd..
Banks

customers in need of foreign exchange

can take services of banks. In their role as
dealers, banks can generate income in three
ways:
1. Bid and Ask Spread
2. Capital Gains in the securities or foreign
currency banks have invested in.
3. In case of securities, the spread between
interest income by holding the security and
the cost of funding (purchase of the security).

Contd..
BANK FUNDING:
Banks generate funds from three sources:

1.
2.
3.

Deposits
Non-deposit Borrowing
Common Stock and Retained Earnings
Banks are highly leveraged financial institutions;
which means that most of their funding comes from
borrowing in first and the second step.

Contd..
1.

DEPOSITS: There are special kinds of deposit

accounts called demand deposits and checking
accounts. It pays no interest and can be withdrawn
upon demand.
Where, saving deposits pay interest typically below
market interest rates and have no specific maturity
and can be easily withdrawn upon demand.
Time deposits also called certificate of deposits have
a fixed maturity date pay either a fixed or floating
interest rate.

Contd..
Some

COD can be sold in the open market

before maturity while some cannot.
If the depositor wants to withdraw the funds
before maturity the depositor will have to pay
the penalty.
A money market deposit pays interest on
short-term interest rates. The market for short
term debt obligation is called the money
market. These are designed to compete with
the money market mutual funds.

Contd..
THE RESERVE REQUIREMENTS AND THE
BORROWING IN THE FEDERAL FUNDS
MARKET:
A bank cannot invest every $1 for every $1 it
possesses.
Every bank must maintain specified percentage of
deposits in non-interest bearing account at one of the
12 Federal Reserve Banks, these percentages are call
the RESERVE RATIOS and the $ amount based on
them are kept in non-interest bearing account are called
REQUIRED RESERVES.

Contd..
The
1.
2.

Fed defined two types of deposits:

Transaction Deposits
Non-transaction Deposits
Reserve Ratios are higher for transaction deposits
than for non-transaction deposits.
Demand deposits, Fed call it other checkable
deposits primarily known as Now Accounts are
classified as Transaction Deposits
Saving and time deposits are non-transactions
deposits.

Contd..
To arrive at the required reserves is not simple it is rather
complex process.
It is first done by computing average required reserves,
the federal reserves have established a two week period
called deposit computation period.
Reserves required in each period are to be satisfied by the
ACTUAL RESERVES, which are defined as the average
amount of reserves held at the close of business at federal
reserve bank.
Required reserve are the average amount of each type of
deposits held by the bank at the close of each business day
in the computation period MULTIPLIED by the reserve
required for each type.

Contd..
If the actual reserves exceeds the required reserves
the difference is called the EXCESS RESERVES.
There is opportunity associated with the excess
reserves. When the bank is short of required reserve
the banks will have to pay the penalties to the reserve
bank.
With excess reserves the banks can satisfy the
targeted reserve requirements.
The market where banks can borrow or lend reserves
is called federal funds market.
The interest rate charged to borrow in this market is
called the federal funds rate.

Contd..
BORROWING

AT THE FEDERAL
RESERVES WINDOW:

The

federal reserve bank is also called the

banker bank or the bank of last resort.
Banks short of funds can borrow from the Fed at
its discount window.
Collateral is necessary to borrow and Fed
determine the type of collateral the bank will
have to pay. The types of collaterals are:

Contd..
1.
2.

3.

Treasury Securities
Federal Agency Securities and Municipal Securities all with
maturity of 6 months.
Commercial and Industrial Loans with 90 days or less to
maturity.

The

interest rate that Fed charges to lend funds is called

the DISCOUNT RATE. The Fed charges this rate
periodically to implement monetary policy.
Continuous borrowing is considered as a weakness of the
banks or the exploitation if the interest differential for
profit maximization. This is the reason why Fed
determine the amount to lend.

Contd..
OTHER NON-DEPOSIT BORROWING: Banks
borrow at federal funds market and the discount
window of Fed in short term.
Non-deposit borrowing can be short term in the form
of issuing obligations in the money market or
intermediate or long term when issued in the bond
market. Example is Repo, repurchase agreement.
Banks that raise most of their funds from the domestic
and international money markets rely less on the funds
of the depositors are called money center banks.
Where regional banks rely primarily on depositors
money.

Contd..
REGULATION:
The

role played by the banks in the regulation

of the financial system is very important. The
banks are regulated and supervised by several
federal and state/governmental agencies.

At

the federal level the supervision is

undertaken by the federal reserve board, the
office of the comptroller of the currency and
the federal deposit insurance corporation.

Contd..
Much

of the legislations are from 1930s but

the nature of the financial markets and
commercial banking has changed since 20
years.
These regulations cover four areas:
1. Regulation of Interest Rates: Regulation Q
at one time imposed ceiling on he maximum
interest rate that could be paid by the bank
on deposits other than demand deposits.

Contd..
Until

1960s the IR stayed below the ceiling so it

virtually had no impact on the ability of the
banks to compete with other financial
institutions but as the IR rose banks found it
difficult to compete after 1966.

To

avoid the ceiling on the time deposits and to

recapture the lost funds, the banks develop
negotiable COD which had higher ceiling and
then eventually no ceiling and they opened
branches outside US to avoid the ceiling.

Contd..
In

1970s it was difficult for the DI to compete

with the money market, so the Depository
Institutions and Monetary Control Act of
1980 gave relief to the banks.

Gran-St

Germain Act of 1982 permitted banks

to offer money market accounts that wee
similar to those offered y money market funds.

Contd..
2.

Geographical Restriction: The McFadden Act of

1927 allowed each state the right to set its own
rules on intrastate branch banking.
This regulation was intended to prevent large
banks from expanding geographically and thereby
forcing out or taking over smaller banks.
There are some states where banks cannot establish
branches statewide are called unit-banking states
and also the reciprocate.
1994 congress passed Riegle-Neal Interstate
Banking and Branching Efficiency Act permitting
the adequately capitalized banks to takeover the
smaller banks.

Contd..
3.

PERMISSIBLE ACTIVITIES FOR

COMMERCIAL BANKS:
Gramm-Leach Bliley Act of 1999 have made certain
changes to permissible activities.
Read from the book

Contd..
4.

CAPITAL REQUIREMENTS FOR

COMMERCIAL BANKS:
Capital structure of the banks consists of EQUITY
and DEBT and are highly leveraged institutions.
The ratio of equity capital is 8% to total assets
which is low and creates insolvency problems.
Prior to 1989, capital requirements for banks were
based on the total assets and no consideration was
given to the types of assets.

Contd..

In January 1989, the federal reserve adopted guidelines

for the capital adequacy based on the credit of the
assets held by the banks. These guidelines are referred
to as credit risk based capital requirements.

However, the guideline are based on the July 1988

Basle Committee on Banking Regulations and
Supervisory Practices which consists of the central
bank and the supervisory authorities of G-10 countries.

Contd..
The

risk based capital guidelines attempted to

recognize the credit risk by segmenting and
weighting requirements.

1.

Capital is defined as:

Tier 1
Tier 2
Where minimum requirements are established
for each Tier.

Contd..
Tier 1 is the core capital and it consists of
shareholders equity, preferred stock and minority
interest in the consolidated subsidiaries.
Tier 2 capital is also called supplementary capital
and it includes:

Loan-loss reserves
Certain types of preferred stock
Perpetual debts (debt with no maturity date)
Hybrid capital instruments
Equity contract notes
Subordinated debt

Thank You =)