Answers to Chapter 11

Questions:

1. A depository institution is a financial intermediary that obtains a significant proportion of its funds from
customer deposits. Industrial corporations tend to obtain a greater proportion of their funds from stockholders,
bondholders, and other types of creditors.

2. The major sources of funds for commercial banks in the U.S. are reported on the liability side of the balance
sheet:

Deposits: Transaction accounts (demand deposit and NOW accounts); and Time deposits (small savings accounts
and time deposits over $100,000).
Borrowed funds: Federal funds; Repurchase agreements; Eurodollar deposits; bankers acceptances, etc.
Equity: Common stock; long-term subordinated debt.

The major uses of funds for commercial banks in the U.S. are reported on the asset side of the balance sheet:

Loans: Commercial and industrial, real estate, and consumer.

Securities: Government (Federal and municipal) securities.
Cash: Vault cash; Reserves at the Federal Reserve Bank.

3. The principal asset types are securities, business loans, mortgages, and consumer loans. Over the longer term,
there has been a drop in securities and an increase in mortgages. As seen in Figure 11-4, through the mid-2000s,
there was a drop in business loans, an increase in securities holdings, and a continued increase in mortgages. Among
the reasons for this changing composition are the growth in the commercial paper market, the securitization of
mortgages, and the credit crunch of 1989-92. Credit or default exposure is the primary risk from these assets. The
financial crisis and the recession of 2008-2009 resulted in a reduction in all areas of lending and an increase in the
banks’ holdings of less risky securities investments (e.g., Treasury securities, federal funds, and U.S. government
agency securities).

4. Investment securities consist of items such as interest-bearing deposits purchased from other FIs, federal funds
sold to other banks, repurchase agreements, U.S. Treasury and agency securities, municipal securities issued by
states and political subdivisions, mortgage-backed securities, and other debt and equity securities. Investment
securities generate interest income for the bank and are also used for trading and liquidity management purposes.
Many investment securities held by banks are highly liquid, have low default risk, and can usually be traded in
secondary markets.

5. According to Table 11-1, the principal sources were deposits, borrowings and other liabilities. Of these, deposits
comprised 74.9% of total assets. The deposits consist of transaction accounts such as demand deposits and NOW
accounts and nontransaction accounts in the form of small savings accounts (time deposits) and large negotiable
certificates of deposits. The short term nature of these liabilities exposes the banks to interest rate risk.

6. Transaction accounts are checkable deposits that are either demand deposits or NOW accounts (negotiable order
of withdrawal accounts). Since their introduction in 1980, NOW accounts have dominated the transaction accounts
of banks. Demand deposits are still issued by banks because limitations are imposed on the ability of businesses to
hold NOW accounts. NOW accounts may only be held by individuals, sole proprietorships, nonprofit organizations,
governmental units, and pension funds. Historically, demand deposits were prohibited from paying interest. Thus,
businesses could not earn interest on their bank demand deposits. However, as of July 2011 the federal prohibition
against the payment of interest on demand deposits, including business checking accounts, was repealed.

7. Transaction accounts include demand deposits that may be held by anyone and NOW accounts that may not be
held by businesses. Retail savings accounts include passbook savings accounts and small, nonnegotiable time
deposits. Large time deposits include negotiable certificates of deposits that can be resold in the secondary market.
The importance of transaction and retail accounts is shrinking due to the direct investment in money market mutual
funds by individual investors. The changes in the deposit markets coincide with the efforts to constrain the growth
on the asset side of the balance sheet.
8. Deposit and nondeposit liabilities tend to have shorter maturities than assets such as loans. The maturity mismatch
creates varying degrees of interest rate risk and liquidity risk.

9. An off-balance-sheet activity is a transaction, contract, or commitment that a bank enters into but is not directly
accounted for on the bank’s balance sheet. They are often reported in the notes to the financial statement or on a
separate schedule. Examples of these are letters of credit, lines of credit, options, forwards, and swaps. Their
increase has been a result of increased competition from other financial institutions as well as other risk management
and regulatory incentives to move these activities off the balance sheet.

10. An off-balance-sheet (OBS) asset is an OBS in which an event occurs that moves this item onto the asset side of
the balance sheet. An off-balance-sheet liability is an OBS in which an event occurs that moves this item onto the
liability side of the balance sheet.

11. Off-balance-sheet activities include the issuance of guarantees that may be called into play at a future time, and
the commitment to lend at a future time if the borrower desires.

a. The activity becomes an asset or a liability upon the occurrence of a contingent event, which may not be in the
control of the bank. In most cases, the other party involved with the original agreement will call upon the bank to
honor its original commitment.
b. The initial benefit is the fee that the bank charges when making the commitment. If the bank is required to honor
the commitment, the normal interest rate structure will apply to the commitment as it moves onto the balance sheet.
Since the initial commitment does not appear on the balance sheet, the bank avoids the need to fund the asset with
either deposits or equity. Thus, the bank avoids possible additional reserve requirement balances and deposit
insurance premiums, while improving the earnings stream of the bank.

c. The primary risk to OBS activities on the asset side of the bank involves the credit risk of the borrower. In many
cases the borrower will not utilize the commitment of the bank until the borrower faces a financial problem that may
alter the credit worthiness of the borrower. Moving the OBS activity to the balance sheet may have an additional
impact on the interest rate and foreign exchange risk of the bank. Further, at the very heart of the financial crisis
were losses associated with off-balance-sheet mortgage-backed securities created and held by FIs. 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.
12. OBS activities include issuing various types of guarantees (such as letters of credit), which often have a strong
insurance underwriting 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.

13. Assets Liabilities and Equity

Cash $ 2,660 Demand deposits $ 5,939
Fed funds sold 110 NOW accounts 12,816
Investment securities 5,334 Savings deposits 3,292
Net loans 29,981 Certificates of deposit 9,853
Intangible assets 758 Other time deposits 2,333
Other assets 1,633 Short-term borrowing 2,080
Premises 1,078 Other liabilities 778
Total assets $41,554 Long-term debt 1,191
Equity 3,272
Total liab. and equity $41,554

This bank has funded the assets primarily with transaction and savings deposits. The certificates of deposit could be
either retail or corporate (negotiable). The bank has very little (5 percent) borrowed funds. On the asset side, about
72 percent of total assets is in the loan portfolio, but there is no information about the type of loans. The bank
actually is a small regional bank with $41.6 billion in assets, but the asset structure could easily be a community
bank if the numbers were denominated in millions, e.g., $41.6 million in assets.

14. The number of commercial banks has declined from 14,483 in 1984 to 6,048 in 2013. Consolidations in the
form of mergers and acquisitions and departures due to bank failures explain the decline. Many of the acquired
banks were banks that had failed or were failing.

15. Challenges have come from industrial loan corporations and shadow banks. For example, in mid-2005, Wal-
Mart filed an application with the FDIC to open a Utah-based “nonbank” bank (called an industrial loan bank),
stating that it wanted to use the bank to reduce the costs of processing electronic payments. Target, the retail chain,
made a similar banking license application stating that it would use the “bank” to issue business credit cards.
Target’s application was approved in 2005. However, Wal-Mart’s application led to an unprecedented wave of
opposition from regulators, the banking industry, and others, leading to the FDIC holding its first public hearings on
an application. In July 2006, the FDIC declared a six-month moratorium on approving any new ILC licenses, saying
it wanted to provide time to assess developments in the sector, including any need to improve regulatory oversight.
In October 2006, a bill was introduced before the U.S. Congress that would keep Wal-Mart and other retailers out of
the banking sector. Specifically, the bill would prohibit nonfinancial firms from owning industrial banks or ILCs,
thus barring Wal-Mart from obtaining ILC charters. At the end of 2006, the FDIC was considering an extension of
its moratorium, a move that would give Congress time to move forward with the bill. However, in March 2007,
Wal-Mart announced that it was withdrawing its application to open a bank.

More recently activities of nonfinancial service firms that perform banking services have been termed shadow
banking. In the shadow banking system savers place their funds with money market mutual and similar funds, which
invest these funds in the liabilities of shadow banks. Borrowers get loans and leases from shadow banks rather than
from banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds
between net savers and net borrowers. However, instead of the bank serving as the middleman, it is the nonbank
financial service firm, or shadow bank, that intermediates. Further, unlike the traditional banking system, where the
complete credit intermediation is performed by a single bank, in the shadow banking system it is performed through
a series of steps involving many nonbank financial service firms. Finally, unlike shadow banks face significantly
reduced regulation than traditional banks. Because of the specialized nature involved in the credit intermediation
process performed shadow banks, these nonbank financial service firms can often perform the process more cost
efficiently than traditional banks. Further, because of the lower costs and lack of regulatory controls, shadow banks
can take on risks that traditional banks either cannot or are unwilling to take. Thus, the shadow banking system
allows credit to be available that might not otherwise have been generated through the traditional banking system.
While as of 2013, these shadow banks are unregulated by the federal government, the 2010 Wall Street Reform and
Consumer Protection Act called for regulators to be given broad authority to monitor and regulate nonbank financial
firms that pose risks to the financial system. As of 2013, U.S. regulators had outlined a process to identify nonbank
financial services firms that should receive increased oversight.

16. Money center banks operate in the global banking market. They are active in international lending and lending
to multinational corporations and usually have operations abroad. Moreover, they access international money
markets for funds to finance their global asset portfolios. Therefore, money center banks perform intermediation
services on a global scale.

Regional banks tend to concentrate more on domestic business than do money center banks. They are often market
makers for smaller commercial banks in their regions (correspondent banks), providing them with intermediation
and information services. They also service the large domestic corporations operating in their region.

Size alone, however, does not distinguish money center banks from regional banks. Money center banks tend to be
located in the major cities and are also net borrowers of funds in the interbank market. Thus, even though Bank of
America is large and located in Los Angeles, it is not classified as a money center because its extensive retail outlet
makes it a net supplier of funds in the interbank market. Small commercial banks tend to focus more on local
customers. They offer highly personalized service to smaller corporate and individual clients. They rely on regionals
and money center banks to obtain more sophisticated money management and information services on behalf of
their customers.
17. Community banks typically have assets under $1 billion and serve consumer and small business customers in
local markets. In 2013, 91.1 percent of the banks in the United States were classified as community banks. However,
these banks held only 8.8 percent of the assets of the banking industry. In comparison with regional and money-
center banks, community banks typically hold a larger percentage of assets in consumer and real estate loans and a
smaller percentage of assets in commercial and industrial loans. These banks also rely more heavily on local
deposits and less heavily on borrowed and international funds.

18. Small banks generally concentrate on the retail side of the businessClending and issuing deposits to consumers
and small businesses. In contrast, large banks engage in both retail and wholesale banking and often concentrate on
the wholesale side of the business. Further, small banks generally hold fewer off-balance-sheet assets and liabilities
than large banks. For example, while small banks issue some loan commitments and letters of credit, they rarely
hold derivative securities. Large banks= relatively easy access to purchased funds and capital markets compared to
small banks’ access is a reason for many of these differences. For example, large banks with easier access to capital
markets operate with lower amounts of equity capital than do small banks. Also, large banks tend to use more
purchased funds (such as fed funds) and have fewer core deposits (deposits such as demand deposits that are stable
over short periods of time) than do small banks. At the same time, large banks lend to larger corporations. This
means that their interest rate spreads (i.e., the difference between their lending rates and deposit rates) and net
interest margins (i.e., interest income minus interest expense divided by earning assets) have usually been narrower
than those of smaller regional banks, which were more sheltered from competition in highly localized markets and
lend to smaller, less sophisticated customers.

In addition, large banks tend to pay higher salaries and invest more in buildings and premises than small banks do.
Thus, their noninterest expenses are generally higher than small banks. They also tend to diversify their operations
and services more than small banks do. Large banks generate more noninterest income (i.e., fees, trading account,
derivative security, and foreign trading income) than small banks. Although large banks tend to hold less equity,
they do not necessarily return more on their assets. However, as the barriers to regional competition and expansion
in banking have fallen in recent years, the largest banks have generally improved their return on equity (ROE) and
return on asset (ROA) performance relative to small banks.

19. Bank size has traditionally affected the types of activities and financial performance of commercial banks.
Large banks’ relatively easy access to purchased funds and capital markets compared to small banks’ access is a
reason for many of these differences. For example, large banks with easier access to capital markets operate with
lower amounts of equity capital than do small banks. Also, large banks tend to use more purchased funds (such as
fed funds) and have fewer core deposits than do small banks. At the same time, large banks lend to larger
corporations. This means that their interest rate spreads have usually been narrower than those of smaller regional
banks, which were more sheltered from competition in highly localized markets and lend to smaller, less
sophisticated customers. In addition, large banks tend to pay higher salaries and invest more in buildings and
premises than small banks do. They also tend to diversify their operations and services more than small banks do.
Large banks generate more noninterest income than small banks. Although large banks tend to hold less equity, they
do not necessarily return more on their assets. However, as the barriers to regional competition and expansion in
banking have fallen in recent years the largest banks’ have generally improved their return on equity (ROE) and
return on asset (ROA) performance relative to small banks. Both the ROAs and ROEs of banks of all sizes dropped
significantly during the financial crisis of 2008-2009.

20. With the economic expansion in the U.S. economy and falling interest rates throughout most of the 1990s, U.S.
commercial banks have flourished for most of the 1990s. In 1999 commercial bank earnings were a record $71.6
billion. More than two-thirds of all U.S. banks reported an ROA of 1 percent or higher, and the average ROA for all
banks was 1.31 percent, up from 1.19 percent for the year 1998. With the economic downturn in the early 2000s,
however, bank performance deteriorated slightly. For example, commercial banks’ string of eight consecutive years
of record earnings ended in 2000 as their net income fell to $71.2 billion. Banks’ provision for loan losses rose to
$9.5 billion in the fourth quarter of 2000, an increase of $3.4 billion (54.7 percent) from the level of a year earlier.
This was the largest quarterly loss provision since the fourth quarter of 1991. Finally, the average ROA was 1.19
percent in 2000, down from 1.31 percent in 1999.

This downturn was short-lived, however. In 2001, net income of $74.3 billion easily surpassed the old record of
$71.6 billion and net income rose further to $106.3 billion in 2003. Moreover, in 2003, both ROA and ROE reached
all-time highs of 1.40 percent and 15.34 percent, respectively. The two main sources of earnings strength in 2003
were higher noninterest income (up $18.9 billion, 10.3 percent) and lower loan loss provisions (down $14.2 billion,
or 27.6 percent). The greatest improvement in profitability occurred at large institutions, whose earnings had been
depressed in the early 2000s by credit losses on loans to corporate borrowers and by weakness in market sensitive
noninterest income. Only 5.7 percent of all institutions were unprofitable in 2003, the lowest proportion since 1997.
In 2004, a combination of continued strength in consumer loan demand and growing demand for commercial loans
added to the growth of earnings. The third quarter of 2004 saw the sixth time in seven quarters that industry earnings
set a new record. Further, at the end of September noncurrent loans fell to their lowest level since the end of 2000.

Several explanations have been offered for the strong performance of commercial banks during the early 2000s.
First, the Federal Reserve cut interest rates 13 times during this period. Lower interest rates made debt cheaper to
service and kept many households and small firms borrowing. Second, lower interest rates made home purchasing
more affordable. Thus, the housing market boomed throughout the period. Third the development of new financial
instruments such as credit derivatives and mortgage backed securities helped banks shift credit risk from their
balance sheets to financial markets and other FIs such as insurance companies. Finally improved information
technology helped banks manage their risk better.

As interest rates rose in the mid-2000s, performance did not initially deteriorate significantly. Third quarter 2006
earnings represented the second highest quarterly total ever reported by the industry and more than half of all banks
reported higher earnings in the third quarter of 2006 than in the second quarter. However, increased loan loss
provisions, reduced servicing income, and lower trading revenue kept net income reported by commercial banks
from setting a new record for the full year. Further, mortgage delinquencies, particularly on subprime mortgages,
surged in the last quarter of 2006 as home owners who stretched themselves financially to buy a home or refinance a
mortgage in the early 2000s fell behind on their loan payments as interest rates rose. Despite these weaknesses, the
industry’s core capital ratio increased to 10.36 percent, the highest level since new, risk-based capital ratios were
implemented in 1993. Finally, no FDIC-insured banks failed during 2005 or 2006. Both the number and assets of
“problem” banks were at historical lows.

Commercial banks’ performance deteriorated again in the late 2000s as the U.S. economy experienced its strongest
recession since the Great Depression. For all of 2007, net income was $105.5 billion, a decline of $39.8 billion (27.4
percent) from 2006. Less than half of all institutions (49.2 percent) reported increased earnings in 2007, the first time in
23 years that a majority of institutions had not posted full year earnings increases. The average ROA for the year was
0.93 percent, the lowest yearly average since 1991, and the first time in 15 years that the industry’s annual ROA had
been below 1 percent. Sharply higher loan loss provisions and a very rare decline in noninterest income were primarily
responsible for the lower industry profits. Things got even worse in 2008. Net income for all of 2008 was $10.2 billion,
a decline of $89.8 billion (89.8 percent) from 2007. This was the lowest annual earnings total since 1989, when the
industry earned $10.0 billion. The ROA for the year was 0.13 percent, the lowest since 1987. Almost one in four
institutions (23.6 percent) was unprofitable in 2008, and almost two out of every three institutions (62.8 percent)
reported lower full-year earnings than in 2007. Total noninterest income was $25.6 billion (11 percent), lower as a
result of the industry’s first ever full-year trading loss ($1.8 billion), a $5.8 billion (27.4 percent) decline in
securitization income, and a $6.6 billion drop in proceeds from sales of loans, foreclosed properties, and other assets.
Net loan and lease charge-offs totaled $38.0 billion in the fourth quarter, an increase of $21.7 billion (132.7 percent)
from the fourth quarter of 2007. This was the highest charge-off rate in the 25 years that institutions have reported
quarterly net charge-offs. Twenty-four commercial banks failed or were assisted during the year, the largest number of
failed and assisted institutions in a year since 1993. At year-end 2008, 252 institutions were on the FDIC’s “Problem
List,” up from 76 institutions at the end of 2007.

As the economy improved in the second half of 2009, so did commercial bank performance. While loan loss
provisions continued to surge, growth in operating revenues, combined with appreciation in securities values, helped
the industry post a net profit. Commercial banks earned $2.8 billion in net income in the third quarter of 2009, more
than three times the $879 million from 2008. Growth in net interest income, lower realized losses on securities and
other assets, higher noninterest income, and lower noninterest expenses, all contributed to the increase in net
income. The average net interest margin in the third quarter was 3.51 percent, the highest quarterly average since the
third quarter of 2005. Almost two-thirds of all institutions (62.1 percent) reported higher NIMs than in the second
quarter. Realized losses on securities and other assets totaled $4.1 billion, which was $3.8 billion less than the $7.9
billion in losses the industry experienced a year earlier. Noninterest income was $4.0 billion (6.8 percent) higher
than 2008 due to net gains on loan sales (up $2.7 billion) and servicing fees (up $1.9 billion).However, the industry
was still feeling the effects of the long recession. Provisions for loan and lease losses totaled $62.5 billion, the fourth
consecutive quarter that industry provisions had exceeded $60 billion. Net charge-offs continued to rise, for an 11th
consecutive quarter. Commercial banks charged off $50.8 billion in the quarter, an increase of $22.6 billion (80.5
percent) over the third quarter of 2008. Net charge-offs were higher than 2008 at 60 percent of all institutions.
Further, 140 commercial banks failed in 2009. This is the largest number of failures since 1992. The number of
commercial banks on the FDIC’s “Problem List” rose from 416 to 552 during the third quarter of 2009, and total
assets of “problem” institutions increased from $299.8 billion to $345.9 billion. Both the number and assets of
“problem” institutions were at the highest level since the end of 1993.

As the economy improved in the second half of 2009, so did commercial bank performance. While loan loss
provisions continued to surge, growth in operating revenues, combined with appreciation in securities values, helped
the industry post a net profit. Commercial banks earned $2.8 billion in net income in the third quarter of 2009, more
than three times the $879 million from 2008. Growth in net interest income, lower realized losses on securities and
other assets, higher noninterest income, and lower noninterest expenses all contributed to the year-over-year
increase in net income. The average net interest margin (NIM) in the third quarter was 3.51 percent, the highest
quarterly average since the third quarter of 2005. Almost two-thirds of all institutions (62.1 percent) reported higher
NIMs than in the second quarter. Realized losses on securities and other assets totaled $4.1 billion, which was $3.8
billion less than the $7.9 billion in losses the industry experienced a year earlier. Noninterest income was $4.0
billion (6.8 percent) higher than 2008 due to net gains on loan sales (up $2.7 billion) and servicing fees (up $1.9
billion). However, the industry was still feeling the effects of the long recession. Provisions for loan and lease losses
totaled $62.5 billion, the fourth consecutive quarter that industry provisions had exceeded $60 billion. Net charge-
offs continued to rise, for an 11th consecutive quarter. Commercial banks charged off $50.8 billion in the quarter, an
increase of $22.6 billion (80.5 percent) over the third quarter of 2008. Net charge-offs were higher than 2008 at 60
percent of all institutions. As a result, the full year 2009 ROA and ROE for 2009 fell to 0.09 and 0.85 percent,
respectively. Further, 120 commercial banks failed in 2009. This was the largest number of failures since 1992. The
number of commercial banks on the FDIC’s “Problem List” rose from 416 to 552 during the third quarter of 2009
and total assets of “problem” institutions increased from $299.8 billion to $345.9 billion. Both the number and assets
of “problem” institutions were at their highest levels since the end of 1993.

As the economy continued to slowly recover in 2010 through 2013, so did bank performance. The 2010 industry
ROA and ROE increased to 0.65 percent and 5.86 percent, respectively. By 2013, industry ROA and ROE increased
to 1.12 percent and 10.06 percent, respectively, the highest since 2007. In first quarter of 2013, increases in
noninterest income combined with decreases in noninterest expense and loan loss provisions, outweighed declining
net interest income and resulted in industry earnings at an all-time high of $40.3 billion. Provisions for loan and
lease losses fell to $11.0 billion, a decline of $3.3 billion (23.2 percent) from the previous year and the lowest
quarterly loss provision since first quarter 2007. The number of insured institutions on the FDIC's "Problem List"
declined for an eighth consecutive quarter, from 651 to 612, while assets of problem banks declined from $233
billion to $213 billion.

21. While ROA and ROE at all banks dropped significantly during the financial crisis, the biggest banks have been
the most profitable, while the smallest banks have experienced the lowest levels of ROA and ROE

22. The key regulators are the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the
Currency (OCC), the Federal Reserve System (FRS), and state bank regulators.

The Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks. In so doing, it levies
insurance premiums on banks, manages the deposit insurance fund, and conducts bank examinations. In addition,
when an insured bank is closed, the FDIC acts as the receiver and liquidator, although the closure decision itself is
technically made by the bank=s chartering or licensing agency such as the OCC. Because of problems in the thrift
industry and the insolvency of the savings and loan (S&L) insurance fund (FSLIC) in 1989, the FDIC now manages
both the commercial bank insurance fund and the S&L insurance fund. The Bank Insurance fund is called BIF and
the S&L fund is called the Savings Association Insurance Fund, or SAIF.

The Office of the Comptroller of the Currency (OCC) is the oldest U.S. bank regulatory agency. Its primary function
is to charter so-called national banks as well as to close them. In addition, the OCC examines national banks and has
the power to approve or disapprove their merger applications. Instead of seeking a national charter, however, banks
can seek to be chartered by 1 of 50 individual state bank regulatory agencies. Historically, state chartered banks
have been subject to fewer regulations and restrictions on their activities than national banks. This lack of regulatory
oversight was a major reason many banks chose not to be nationally chartered. Many more recent regulations (such
as the Depository Institutions Deregulation and Monetary Control Act of 1980) attempted to level the restrictions
imposed on federal and state chartered banks. Not all discrepancies, however, were changed and state chartered
banks are still generally less heavily regulated than nationally-chartered banks.

In addition to being concerned with the conduct of monetary policy, the Federal Reserve, as this country’s central
bank, also has regulatory power over some banks and, where relevant, their holding company parents. Since 1980,
all banks have had to meet the same noninterest-bearing reserve requirements whether they are members of the FRS
or not. Because the holding company’s management can influence decisions taken by a bank subsidiary and thus
influence its risk exposure, the FRS regulates and examines bank holding companies as well as the banks
themselves.

State-chartered commercial banks are regulated by state agencies. State authorities perform similar functions as the
OCC performs for national banks.

23. Established in 1933, the Federal Deposit Insurance Corporation (FDIC) insures the deposits of member banks.
In so doing, it levies insurance premiums on member banks, manages the deposit insurance fund, and conducts bank
examinations. In addition, when an insured bank is closed, the FDIC acts as the receiver and liquidator, although the
closure decision itself is technically made by the bank chartering or licensing agency such as the OCC. Because of
the problems in the thrift industry and the insolvency of the savings institutions’ fund (the FSLIC) in 1989, the FDIC
now manages both the commercial bank insurance fund and the S&L insurance fund. The Deposit Insurance fund is
called DIF.

24. The primary advantages of FRS membership are direct access to the federal funds wire transfer network for
nationwide interbank borrowing and lending of reserves.

25. Bank Type OCC FRB FDIC SB Comm

(a) Yes Yes
(b) Yes Yes Yes
(c) Yes Yes Yes
(d) Yes Yes Yes
(e) Yes Yes Yes

26. International expansion has six major advantages:

Risk Diversification. As with domestic geographic expansions, an FI=s international activities potentially enhance
its opportunity to diversify the risk of its earning flows. Often domestic earnings flows from financial services are
strongly linked to the state of that economy. Therefore, the less integrated the economies of the world are, the
greater is the potential for earnings diversification through international expansions.
Economies of Scale. To the extent that economies of scale exist, an FI can potentially lower its average operating
costs by expanding its activities beyond domestic boundaries.
Innovations. An FI can generate extra returns from new product innovations if it can sell such services
internationally rather than just domestically. For example, consider complex financial innovations, such as
securitization, caps, floors, and options, that FIs have innovated in the United States and sold to new foreign markets
with few domestic competitors until recently.
Funds Source. International expansion allows an FI to search for the cheapest and most available sources of funds.
This is extremely important with the very thin profit margins in domestic and international wholesale banking. It
also reduces the risk of fund shortages (credit rationing) in any one market.
Customer Relationships. International expansions also allow an FI to maintain contact with and service the needs
of domestic multinational corporations. Indeed, one of the fundamental factors determining the growth of FIs in
foreign countries has been the parallel growth of foreign direct
investment and foreign trade by globally oriented multinational corporations from the FI=s home country.
Regulatory Avoidance. To the extent that domestic regulations such as activity restrictions and reserve
requirements impose constraints or taxes on the operations of an FI, seeking low regulatory tax countries can allow
an FI to lower its net regulatory burden and to increase its potential net profitability.

Disadvantages. International expansion has three major disadvantages:

Information/Monitoring Costs. Although global expansions allow an FI the potential to better diversify its
geographic risk, the absolute level of exposure in certain areas such as lending can be high, especially if the FI fails
to diversify in an optimal fashion. For example, the FI may fail to choose a loan portfolio combination on the
efficient portfolio frontier (see chapter 21). Foreign activities may also be riskier for the simple reason that
monitoring and information collection costs are often higher in foreign markets. For example, Japanese and German
accounting standards differ significantly from the generally accepted accounting principles that U.S. firms use. In
addition, language, legal, and cultural issues can impose additional transaction costs on international activities.
Finally, because the regulatory environment is controlled locally and regulation imposes a different array of net
costs in each market, a truly global FI must master the various rules and regulations in each market.
Nationalization/Expropriation. To the extent that an FI expands by establishing a local presence through investing
in fixed assets such as branches or subsidiaries, it faces the political risk that a change in government may lead to the
nationalization of those fixed assets. If foreign FI depositors take losses following a nationalization, they may seek
legal recourse from the FI in U.S. courts rather than from the nationalizing government. For example, the resolution
of the outstanding claims of depositors in Citicorp=s branches in Vietnam following the Communist takeover and
expropriation of those branches took many years.
Fixed Costs. The fixed costs of establishing foreign organizations may be extremely high. For example, a U.S. FI
seeking an organizational presence in the Tokyo banking market faces real estate prices some five to six times
higher than in New York. Such relative costs can be even higher if an FI chooses to enter by buying an existing
Japanese bank rather than establishing a new operation, because of the considerable cost of acquiring Japanese FI
equities measured by price-earnings ratios. These high acquisition costs exist despite the significant bank loan
problems of Japanese banks in recent years and the secular decline in Japanese share prices. These relative cost
considerations become even more important if the expected volume of business to be generated and, thus the
revenue flows from foreign entry are uncertain. The failure of U.S. acquisitions to realize expected profits following
the 1986 deregulation in the United Kingdom is a good example of unrealized revenue expectations vis à vis the
high fixed costs of entry and the costs of maintaining a competitive position.