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					04-1&2
                                   BOSTON COLLEGE
                                      Prof. Edward J. Kane
                                       Weeks 04-1 and 04-2
                        Lecture Notes on Financial-Institution Management




         EXPANDING FOOTPRINT OF THE GENERIC FINANCIAL-SERVICES FIRM

I. Overview of Course Objectives and Procedures
       A. Assignments
              1. This course employs two kinds of textbooks: (a) the Dermine & Bissada text (available
                 at the bookstore) and (b) Classroom ―Slideshows‖ (and sometimes ―Lecture Notes‖)
                 that I distribute before class and post on WebCT and my Professor’s webpage on the
                 BC Server (http://www2.bc.edu/~kaneeb). Generally, students should read the text and
                 focus on the issues highlighted in the Slide Shows. My Lecture Notes and Slide Shows
                 supply an intuitive perspective that seeks to bring students into contact with changing
                 elements of financial-services competition.
              2. Exams will focus on the Notes and Slide Shows
                     a. In preparing for class, one should use the Slideshow to distinguish the big
                         picture from mere details. Because Lecture Notes are in outline form and
                         Each slideshow labels a sequence of core issues, the structure of a given
                         lecture can be found by extracting the major headings.
                                                                                            2
                  In preparing for an exam, make sure you can describe in your own words what
                  themes, issues, problems, concepts, distinctions, facts, calculations, or
                  managerial perspectives are being explained in each section. Then pass on
                  to the next level of detail: the uppercase letters. Consider what adaptations in
                  the logical flow would make sense to you and why you think they would
                  clarify the material.
              b. Time does not permit all relevant issues to be covered in the Slideshows.
                      Usually bracketed items (or paragraphs enclosed in a dotted box) are of
                  secondary importance and will be discussed only lightly (if at all) in class.
                  Their relevance to your career may become clear after you take some job
                  interviews.
B. The course is aimed at students who are seriously contemplating a career in the financial-
   services industry. My goal is to teach you to see the financial-services industry through my
   eyes as an arena for experiencing “financial fun.” My hope is that this perspective will help
   you to be more successful in your careers. To cover in one semester what I think is needed to
   ground such a career forces me to start at a level that may exceed your preparation at first and
   to move uncomfortably fast throughout the term. [E.g., this week I hope to cover at least the
   first 22 pages of these notes.] I recommend forming study groups and regularly rehashing
   the lectures and readings with one or more study partners.
C. The course has three broad objectives: to improve student interview performance
   (employability); to enhance performance in on-the-job training programs (early
   advancement); and to inculcate a careerlong positive attitude toward the need to cope with
   disruptive technological and regulatory change (long-term success).
       1. The fundamentals of financial services involve the exchange and verification of
           information and the making and enforcing of contractual deals. Each deal
           obligates the counterparties to exchange a mix of information, cash, and service
           flows today and at specified future dates. In principle, each deal can be viewed
           as an incremental balance sheet that creates wealth for both parties.
       2. While fundamentals seldom change, the observable techniques and contracting
           tools of doing business and the institutional shapes of the firms using them are
           “morphing” incessantly. Successful practitioners Listen for and Move to the
           Drumbeat of Evolutionary Change. Career benefits of being able to welcome and
                                                                                                        3
                     adapt to change are undeniable. Skills developed over one’s career must be reshaped
                     to deal with ever-changing technology and institutional settings. The careerlong
                     problem of adaptation resembles a game of musical chairs, except that most of the old
                     chairs are taken away in each round. As in science fiction, the few chairs put back
                     exhibit surprising deformations and are hard even for experienced players to mount.
                     -- It is helpful to imagine yourself transported back in time. You would have been
                        challenged to learn to transact via computer keyboards or plastic cards rather than
                        checks or with checks rather than currency and coin.
                     [-- Parallel evolution has occurred over time in trading systems, office configurations,
                        and network types.]
              3. Technology interacts with competitive pressures and the accounting, supervisory,
                     and regulatory system under which an institution operates. Regulatory systems
                     evolve more slowly than the information and contracting technology that regulated
                     institutions adopt. This delay is called “Regulatory Lag.”
II. Overview of Course Content. First weeks in any course are Foundational: principal goal is
   Establishing a Working Vocabulary. To be a professional, one must master the vocabulary of his or
   her profession.
       A. Issues Addressed this week focus on what financial institutions do and how they create
           and manage value by doing it. My goal is to deepen and expand your understanding of
           what employees do in financial-services firms (FSFs) and how an understanding of FSF
           balance sheets and income statements is an essential part of creating value.
              1. Let us start by asking: What is a Financial Institution?
                     -- Generically, an FSF is a firm whose government ―charter‖ allows it to produce
                        ―financial‖ services and contracts in a repeat-business context. An FSF is a
                        contracting vehicle for offering financial ―stuff‖ to a targeted class of customers.
                        Contracts and services are intertwined. ―Stuff‖ offered consists of information
                        and paper evidences of claims to returns from real assets and services that society
                        deems to be ―financial‖ in nature.
                     -- This definition saddles us with a circular use of ―financial‖ and with the need to
                        explain ―services,‖ ―contracts,‖ and ―charters.‖
                     -- Metaphorically, an FSF is an information and dealmaking factory. This metaphor
                        leads to a generic definition of an FSF: an organization that produces funds-
                                                                                            4
       management, informational and transactional products for a base of customers
       with whom it hopes to maintain a longstanding relationship. The three key
       words in this definition define the ―stuff‖ that has to be managed.
      What are Keys to a sturdy customer relationship? pricing, quality, access,
       flexibility, sensitivity, durability; competition.
      An FSF may usefully be viewed as a balance sheet, even though its definition
       does not turn upon the particular items that may be found there: cash, credit,
       loans, deposits, securities, insurance policies.
      Applicability of longstanding textbook and statutory definitions of a bank as an
       institution that included both commercial loans and demand deposits in its
       product line has been destroyed. Other species evolved close substitutes for the
       contracts that were once a bank’s ―signature products‖. E.g., NOWs, the payable-
       through drafts used by credit unions and cash-management accounts pioneered
       by Merrill-Lynch.
      The current statutory definition of a bank turns importantly on whether the
       ―Savings Association Insurance Fund‖ (which is itself threatened with being
       merged into the Bank Insurance Fund) can write the institution’s deposit
       insurance.]
2. What do we mean by a country's Financial Services Industry? The collection of
   firms that produce financial stuff in any country. Definition: The FS industry is best
   viewed as a unified market for diverse services and contracts that broadly (and
   sometimes creatively) substitute for one another, even though they are written by
   firms whose government ―charters‖ make them legally distinct.
      This definition presumes a prior understanding of the terms ―Financial Services,‖
       ―Contracts,‖ and ―Charter Types.‖
      ―Government charters‖ and particular ―contractual instruments‖ delineate the
       technological skill set and structure of the regulatory systems under which
       different FSFs are authorized to operate and under which their top managers have
       acquired experience.
          A charter is a document (the word traces etymologically to the Latin word for
       a ―little paper‖) issued by a government that dictates the conditions under which
       an FSF is organized and defines its rights, privileges, and duties.
                                                                                          5
           A contractual instrument is a prescribed way of recording bilateral or
       multilateral agreement on a ―deal.‖ It is designed to give each counterparty
       specific and enforceable rights and duties.




3. The generic definition of an FSF helps us to describe the nature of the FS business.

   -- Classroom Exercise: Using the list of different types of FSFs given above, name
       one of the largest U.S. or foreign firm of each type. What deal-making
       contractual instruments are the hallmark of each firm type? Would you be
       surprised to know that large U.S. banks name Charles Schwab & Co. as their most
       feared internet competitor? What foreign FSFs do important business in the U.S.?
   -- A course ―megatheme‖ is that the business of FS is ―collecting and managing
       information‖ and ―making and supporting deals.‖
   -- Four stages of deal-making:
        originating a contract;
          previously conducting a diligent analytical valuation of risk & return;
          funding the obligation conveyed by the contract
          Postdeal servicing of the contract.
   -- As Information Factories, FSFs make it their business to intermediate flows of
       information between customers that want to save some of their incomes (surplus
       spending units) and customers that want to spend in excess of their incomes
       (deficit units). This entails:
       - collecting information
       - verifying information
       - moving information
                                                                                                  6
                     for own account
                     for customer account
              - Post-deal monitoring and enforcement (a follow-on part of any deal).
           --Transactions become Exchanges of information: information moves across networks
              used for internal and external communications and for data-processing.
           -- FSFs produce information about a customer’s creditworthiness, transactions, and
              wealth allocation and information about an institution’s own net worth and risk
              exposures. This definition implies that an FSF’s managers manage four things:
              ―physical operations,‖ information flows, customer relationships, as well as
              portfolio risks and returns generated by the deals it makes. Evolution of
              Financial Service technology (technology = techniques by which things get done)
              has been dramatic: e.g., in credit-analysis and contracting protocols and in
              payments instruments such as cash, checks and electronic funds networks.
                 Nature of competitors and problems of maintaining confidentiality and
                  security of transactions evolve as the networks do.
           --Security issues differ between:
                 Closed transactions networks
                 Open networks.
           -- Range of natural competitors becomes wider and an institution’s potential product
              line and ―geographic reach‖ become unlimited. Equilibrium number and size
              distribution of FSFs change with technology.
           -- Course Theme: FSFs and telecommunications firms are natural competitors. Both
              are entities that establish networked relationships through which they collect,
              store, process, and transmit information for themselves and for customer
              accounts.

B. Financial-Institutions theorists partition Financial Firms by Distinctions between direct and
    indirect finance and between pure intermediaries, pure brokers, pure poolers of funds, and
    guarantors of contract performance. Definitions:
        1. The etymology of ―fin-ance‖ is rooted in the Latin word for an ―ending.‖ What does it
           mean to ―finance‖ another party? ANS. to fund or re-fund some of the counterparty’s
           hoped-for deficit spending, so that its plans can ―end‖ by coming true. Every student
           needs to understand and distinguish between:
              a. Internal Finance
                                                                                                 7
              b. Direct External Finance
              c. Indirect Finance, which involves a Financial Intermediary.
Key Definitions:
    Self-Finance means that a spending unit that intends to spend in excess of its income (―to
       become a deficit spending unit‖) draws down its accumulated wealth.
    Direct Finance means the deficit unit borrows from surplus spending units (SUs) and SUs
       hold the resulting debt or equity instruments and all associated risks.
 --Previous two activities bypass any need for credit analysis by financial firms. An FS industry
     exists only if value can be created by stepping into the deal in one of these ways:
    Writing a credit enhancement: a third party can bond a borrower’s performance by putting
       its own credit behind or alongside the borrower. E.g., the FDIC; a parent cosigning a
       teen’s auto loan or apartment lease.
      Acting as a pure intermediary: an outside party can buy assets for its own account and
       fund these holdings with its own debt and equity. Value added comes from difference in
       lending rate and funding rate: E.g., how did an old-fashioned S&L make profits?
      Acting as a pure broker: the third party can match buyers and sellers of assets for a fee,
       without taking a permanent position in the instruments traded: e.g., a stock broker.
      Selling Asset Participations: Mutual funds, ―wrap accounts,‖ and hedge funds exemplify
       the idea of a pure pooler who sells a pro rata share in an expertly managed and liquidity-
       enhanced portfolio whose diversification is manipulated deliberately. A pooled portfolio
       is funded with what we can call ―participation certificates.‖
       1. Classic Diagrams:
                a. Direct Finance Without Outside Credit Enhancement
                                                      Funds
           Surplus Spending Units     ------------------------------------>  Deficit Spending
           (e.g., savings for child’s                                               Units
              college education)           Info and Securities (i.e.,
                                           evidences of contractual         (e.g., home buyer)
                                                  obligations)
                                      <-----------------------------------
                     What information is exchanged pre-deal and post-deal?
                      1) Pre-Deal
                           Institution: (1) holds accounting data on its performance and
                             condition open for inspection; (2) uses marketing and customer-
                             relationship management policies to build confidence in its brands.
                           Customer: offers economic records & references, and undergoes
                             interview or submits written application.
                      2) What deal-making and support occurs post-deal?
                           Institution must record, execute, and receipt customer activity.
                                                                                  8
                Customer must update information and recontract as deal requires.


    b. Direct Finance With Credit Enhancement (i.e., bonding of contract
       performance)

                        Funds (&Info)
Surplus Spending    ----------------------->   Deficit Spending
      Units                                         Units
                     Securities (&Info)
                    <-----------------------
                                                         
                        Guarantee                Fees             CREDIT Enhancer
                      Contract (&Info)         (&Info)

                                                        
          For a credit enhancer to create value, its ―enhancement fee‖ must exceed
           the projected costs of the services it performs. The fee it can charge
           informed customers increases with its net worth and its reputation for
           fairness. Its costs are those of credit analysis, monitoring and contract
           enforcement.
          Why must an enhancer worry about Post-deal Monitoring and
           Restructuring?
    Query: How are information costs and deal-making negotiations changed by
        these real-world illustrations of credit enhancement?
         Cosigner for a loan or apartment lease
         Mortgage insurance
         FDIC deposit insurance
         Transacting for loans and deposits on the Internet
    c. Indirect Finance
                                                               Funds
                     Funds (&Info)                        & Monitoring
     Surplus       ------------------>                  ------------------>  Deficit
    Spending                              Financial                         Spending
      Units              Indirect      Intermediaries                        Units
                       Securities                       Direct Securities
                         (&Info)                              (&Info)
                   <------------------                  <------------------


          Financial intermediation aims to create value by borrowing and lending at
           the same time, while maintaining a sustainable wedge between the
           borrowing and lending interest rates. In its durability, intermediation
                                                                                               9
                    differs from interest-rate arbitrage
                   The equilibrium ―wedge‖ between an institution’s lending interest rate and
                    its funding cost compensates it for credit-evaluation, monitoring,
                    diversification, and payment services. Both the lending rate and funding
                    interest rate must count all implicit and explicit elements.
                            Bank Net Interest Margins
                              Average about 4.25%




                                                                      3.79



                                                                      12/2003




During the Stock-Market Boom, Nondeposit Methods of Funding Bank Loans Surged




                   Query: In the absence of federal deposit insurance, could an uninsured
                    intermediary finance itself completely with debt? NO. Why does an
                    intermediary need ownership capital? ANS. to establish credibility for its
                                                                                10
       promises to repay its creditors even in adverse circumstances. Similarly,
       the FDIC demands capital to control its own exposure to loss.
      Car-Rental Metaphor for a bank
       -- similarities? Products are taken out for a ride. Lenders want them back.
            Customers want the lender to have cars or funds to be at hand when
            and where they need them.
       -- differences? (Nature of customer relationships; tangibility of product;
            differences in risk control systems; funds are ―preleased‖ rather than
            ―owned‖ by rental agency.


       [Self-Study Item: It should become clear that intermediation services differ
           from: pooling services, brokering services, underwriting services,
          credit-rating services and credit-enhancement services. Explaining the
          distinctions between value creation in these services and risk-
          management strategies that support this value is a course-long quest.]
Queries: How do ―credit enhancers‖ (CEs) differ from ―financial
  intermediaries‖? Not at all in the nature of their credit analysis or monitoring.
  CEs differ in deal-making. They don’t hold the loan in their portfolio, but
  they still must fund and reserve for the loan’s loss exposure. The CE does not
  have to fund the entire debt of the DU. Suppose it is clear that at least half the
   value due at maturity can be extracted from the borrower even in the worst-
   case scenario. What obligations does the CE have to ―reserve‖ for and
   ―fund‖? ANS. The cost of covering the Risk that the Borrower will pay less
   half of the full amount due: The Danger of Partial Contract Nonperformance.
Further Query: Why aren’t credit enhancers’ profits competed away by Surplus
   Spending Units. ANS. The enhancement relieves surplus units of some of a
   lender’s information requirements: (1) to analyze the credit and to monitor the
   subsequent behavior of Deficit Spending Units and (2) to enforce the
   borrower’s contractual obligations. Enhancers lessen costs of monitoring
   ―sneaky‖ borrowers by centralizing the task of delegated monitoring so as to
   perform it more expertly and/or more cheaply. [E.g., tricks exercised by
   deadbeats and repossession professionals in the movie, Repo Man] Borrower
   willingness to accept tough FSF discipline rather than looser surplus-unit
   discipline is a ―signal‖ of creditworthiness.
   -- Institutional scale economies exist in extracting information. In class, we
        will review some war stories that illustrate the obscure venues that have to
        be examined and the clever ploys used in ―asset searches‖ for wealth
        hidden from banks or bankruptcy courts by deadbeat borrowers. Thorough
                                                                                                                  11
                                 investigations and clever tricks cannot easily be undertaken by the
                                 representative surplus spending unit.
                                 1. Finding offshore wealth in offbeat locations such as the Island of
                                     Vanuatu
                                 2. locating a skipped debtor by sending out a rebate check
                                 3. following the cash originally advanced in a now-delinquent loan
                                 4. doublechecking a deadbeat’s sudden spurt of conscience.
           Potential Exam Questions:
            How to characterize federal deposit insurance?
           -- The FDIC enhances the credit of banks and thrifts and the taxpayer enhances the credit
               of the FDIC.
                      d. Indirect Finance with FDIC Credit Enhancement




                            Funds                                     Funds &
  Surplus                                         Financial          Monitoring              Deficit
 Spending                                      Intermediaries                               Spending
                            Indirect                                      Direct
   Units                                                                Securities           Units
                           Securities                      monitoring &
                            (&Info)                                      (&Info)
                                                           enforcement
                                               Fees
                                             (&Info)                        FDIC
                  Guarantee Contract                                       CREDIT
                                                                           Enhancer                weak
                                                                                                   monitoring &
                                                                                                   enforcement
                                                                                (Little Info)
                                                                                No Fee

                                                                                         Taxpayers Credit
                                                                                          Enhancement


                What deal-making support and (―capital‖) post-deal should the FDIC and taxpayers
                 want?



                      e. Simple Passthrough Securitization
                                                                                        Funds &
               Funds (& Info)                   Funds (& Info)                         Monitoring
 Surplus                                                              Financial                             Deficit
                                   Conduit
Spending                                                           Intermediaries                        Spending Units
                                    Entity
  Units
                Collateralized                 Direct Securities                     Direct Securities
                 Securities                        (&Info)                               (&Info)
                  (&Info)
                                                                                                            12



                  Securitization of Bank Loans is an increasingly important financial service.
                        Securitization combines pooling services with Asset transformation. Core
                        Process of Securitization: (1) FSFs make or buy a diversified portfolio of loans;
                        (2) they sell these loans to a conduit entity; (3) the conduit issues securities
                        backed up by either bank guarantees, excess collateral, or a third-party guarantee;
                        (4) the conduit sells others a marketable claim to all or some of the enhanced cash
                        flows from the pool of original loans.
                    -- Securitized loans are “derivative” claims to designated portions of the
                          contractual cashflows that the underlying loan contracts generate. Some of the
                          biggest markets: mortgage passthroughs, CARS, CARDS.
                         How to illustrate Pure Brokers? Pure Poolers?


                        f. Pure Brokerage of Direct Finance

                                Funds                              Funds (less fee)
           Surplus                         Broker Helps Each                               Deficit
        Spending Units       Securities     Side Search and            Securities       Spending Units
                              (&Info)       Negotiates Deal             (&Info)


                               What information flows do the three parties need?



                        g. Pure Pooler
                                                           funds

                                           P              Securities
                                                                            Deficit Spending Unit #1
                                                           (&Info)
                        funds              O               funds
   Surplus
Spending Units     claims to pro           O              Securities
                                                                            Deficit Spending Unit #2
                   rata share of                           (&Info)
                                           L
                                                                                        •
                    returns, less                             •                         •
                                                              •                         •
                   management                                 •

                                           E
                                                           funds
                    fee (&Info)
                                                                            Deficit Spending Unit #N
                                                          Securities
                                           R               (&Info)
                                                                                                          13




                   -- Brokers reduce search and bargaining costs of direct finance for each side. They
                       find buyers and sellers without taking a position in instruments traded. They
                       compensate themselves by charging ―brokerage fees‖ to seller or buyer.
                   -- Poolers build and manage diversified portfolios and sell pro-rata shares in them on
                       behalf of surplus units. Two examples: mutual funds; Islamic Banks. Poolers sell
                       investment expertise along with a liquidity enhancement. They are typically
                       compensated by collecting portfolio-management fees from surplus units.
                   -- What information flows ought the pooler pass on to its customers? How is
                       managerial accountability for calculating share values accurately enforced in an
                       exchange traded mutual fund?


In some societies, costly Regulatory Restraints on deal-making activity have been imposed by
established State Religions. Two Examples: Medieval usury laws were based on a narrow reading of
Old Testament passages; modern Islamic Bank is based on the Koran’s prohibition of interest per se.
Respecting Religious Constraints on Financial Dealmaking
A generation ago, Asian and Middle Eastern Moslems worked as unskilled laborers in British factories.
Today they are one of Britain’s most prosperous ethnic minorities and are starting their own businesses.
Moslems’ growing wealth has not been lost on British bankers, who are developing financial
instruments to attract Moslem investors --while accommodating Islam’s prohibition of particular
activities and its ban on paying and collecting (explicit) interest. The first such instrument, the Crescent
Fund, was launched by Ritz Financial Services of London. Directed at Asian Moslems, the fund does
not put capital into accounts that pay a fixed rate of interest. Rather, it offers “participations” in the
fund’s “proceeds” from investing in a pool of long-term bonds of companies that do not engage in the
forbidden activities of gambling, brewing, or making porkproducts.
-Adapted from a story prepared by Gemini News Service, London


                   h. Hedge Fund (goes beyond pooling)
                      1) managers may sell stock and use leverage (i.e., invest borrowed funds to boost
                         returns)
                      2) individual investors must put in at least $150K.
                      3) managers are not regulated by SEC and not required to disclose trades made,
                         positions taken or losses experienced.
                      4) Incurs a definite risk of failure
                      5) managers may be able to secure preferential treatment from mutual funds
                         (scandal)
                                                                                           14
2. Students need to understand at an intuitive level how FSF dealmaking can create
   value and also creates risks that must be managed. E.g., Why does a financial
   intermediary deserve a net economic return?
   -- It can add desirable characteristics to contracts and reduce or eliminate at least
       one of three costs that arise in direct external finance:
          information costs
          transactions costs
          costs of having to hold concentrated exposure to a ―diversifiable‖ risk.
   -- Suppose a bank’s explicit RL = 10% and its explicit RD = 5%. Is the difference the
       ―pure profit‖ made on intermediation? NO. Other ―implicit‖ costs and returns
       exist that are ―not expressly stated in the bank’s contracts.‖ What ―implicit‖ costs
       and benefits should be taken into account in calculating the economic value that
       intermediation creates?
Query: Why doesn’t competition from participants in direct finance eliminate the value
   that a financial institution can create in each of the following activities:
       a. intermediation services?
       b. pooling services?
       c. post-loan monitoring?
       d. credit enhancement?

       It is useful to establish a common prologue to set up the individual
answers. In direct finance, a surplus spending unit funds a deficit spending
unit (DU) in exchange for the DU’s primary (or direct) obligation. The
surplus unit (SU) has 5 tasks: to search for candidate borrowers, to analyze
the credit of the DU, to bear the risk of nonperformance, to monitor postloan
behavior, and to enforce the DU’s performance of the contract until the debt
matures. The DU must cooperate (or at least appear to cooperate) in these
tasks. The interest rate the SU earns on its funds (iSU) is net of these deal-
making costs (CDF). The interest rate the DU pays (iDU) is gross of (i.e.,
includes) these costs. In direct finance, SU earns iSU = iDU -CDF.
       The larger are the deal-making costs of direct finance CDF , the more
opportunity there is for a financial institution to create value by adding
“contract enhancements” and executing elements of deal-making services
more expertly or more efficiently than DUs and SUs can on their own.
       The SU and DU can both be better off by using the individual service
as long as CDF minus any added implicit returns from FSF liquidity and
diversification enhancements (E), exceeds the sum of the financial
                                                                                     15
institution’s (lower) servicing cost (S) and allocated profit (). Institutionally
assisted finance can offer the SU as much as: iDU + E - (S+).
        a. Intermediation Services are characterized by the issuance of the
            “indirect debt” of a financial institution to the SU. This indirect
            debt is typically more liquid and (because of diversification and
            ownership capital) less subject to default risk than the direct or
            primary debt of DUs that the institution holds as assets. A range
            of economies of scale or economies of specialization in any aspects
            of information handling and deal-making is sufficient to allow
            intermediation services to earn a net return over all but the largest
            SUs can hope to extract on their own.
        b. Pooling Services are exemplified by the activities of a mutual fund.
            SUs buy a liquid pro rata share in a diversified portfolio of direct
            securities that is selected and administered by an expert
            professional manager. Liquidity, diversification, ownership
            capital, and investment expertise all add value to direct securities.
        c. Postloan Monitoring is necessary for efficient contract
            enforcement. Economies of scale appear to exist in collecting and
            analyzing information on borrower behavior and in expertly
            preventing or remedying defaults. Compared to unassisted direct
            finance, specialists in this activity can reduce loan losses by more
            than the fees they would charge a surplus unit.
        d. Credit Enhancement puts the credit of a financial institution
            alongside or behind the credit of a DU. In a high-quality credit
            enhancement, the SU faces virtually no risk of default. The
            enhancer accepts the loss exposure and expertly manages the risk
            by diversification, monitoring, and adaptive post-loan deal-
            making. A range of economies of scale or of specialization for
            these activities would mean that low-wealth SUs and DUs that are
            not well-known could be made better off by contracting via a
            credit enhancer.
Potential Grading Keys if Posed on an Exam:
 financial institutions offer cost reductions and contract enhancements
 define each service closely enough to avoid vagueness
 identify sources of cost reductions and contractual benefits to SUs or DUs
    in each case

3. How do accountants and economists define an intermediary’s net return on assets
   (ROA) and on ―ownership capital‖?
4.                        (Profit Margin) • Assets
              Return
       ROA                       Assets
              Assets
   Return on Equity Capital = ROE
                   A
       ROE  ROA 
                   N 
                                                                                                16

                             ROE Averages Just Under .15
                     Banking Industry performance based on Return
                              on Equity from 1993 to 2001
                  16.00
                        15.32                               15.39                   15.34
                  15.50
                                                14.84
                  15.00       14.63 14.69 14.53
                                                                              14.41
                  14.50                               14.05
      ROE Scale




                                                                  13.97
                  14.00
                                                                        13.35
                  13.50
                  13.00
                  12.50
                  12.00
                  11.50
                  11.00
                        1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

                                            Industry ROE Performance


                                               Source: Federal Reserve Bulletin (Spring 2004)


                                ROA Averages Over 1.2
                     Banking industry performance based on Return
                              on Assets from 1993 to 2001
                  1.50                                       1.31          1.321.39
                         1.201.15   1.181.201.25         1.14     1.181.17
ROA Scale




                  1.00

                  0.50

                  0.00
                      93
                      94
                      95
                      96
                      97
                      98
                      99
                      00
                      01
                      02
                      03
                    19
                    19
                    19
                    19
                    19
                    19
                    19
                    20
                    20
                    20
                    20




                                      Industry ROA Performance
                                     Source: Federal Reserve Bulletin (Spring 2004)
                                                                                         17
   Instructive Queries:
       How can a bank expect to earn an ROE of 20% with an ROA of only 1.2%?
         Why can JPM-Chase fund itself as cheaply as GE Capital when JPM-Chase’s
          leverage (A/N) is much higher? Why don’t the bank's creditors demand a
          higher rate?
4. The ―Accounting Income Statement‖ is the key to calculating Return. Economic
   Accounting would express the Incremental Profit on a Bank Loan in three lines:
       Revenue: Explicit plus implicit interest on the loan
       Cost: Implicit plus explicit interest cost on the deposits that fund the loan
       Profit: Revenue minus Cost
5. The Incremental Balance Sheet corresponding to this income statement would look
   like this:
        Loan               Funding Instruments
                           Increment to Stockholder Value


6. Concept of implicit interest is important. Definition: Something is only ―implicitly‖
   a form of x when it has the same character and effects as x, but is not actually stated
   or designated to be x. Hence, implicit interest covers all compensation paid to a
   creditor that the contract does not expressly label as interest. A June 3, 1996
   Supreme Court decision (Smiley vs Citibank) determined that the following credit-
  card expenses qualify legally as ―interest‖: membership fees; late-payment penalties;
  insufficient-fund charges; cash-advance fees; penalties for exceeding credit limits.
  Additional forms of implicit interest are not even collected in the ―coin of the realm.‖
  E.g., when a lender insists that a borrower hold its deposit accounts in the lending
  bank.
Query: Explain and illustrate the distinction between explicit and implicit elements of
  interest that flow between an institution and its customers in a banking relationship.
  Bank-Customer Relationship
      A banking relationship describes a chain of mutually beneficial past and future
   transactions that occur between a bank and any highly valued customer. The value of
   a relationship to each side deserves to be treated as an ―intangible‖ asset by that side.
   The gross value of the relationship would be found by capitalizing each party’s side of
   a roughly balanced two-way flow of mutual benefits that the bank and each
   longstanding customer derive from the knowledge and confidence they have acquired
   from dealing repeatedly with each other. The history of togetherness and projected
   value of continuing business constrain temptations of either party to engage in overly
   ―sharp‖, ―unfair‖, or unresponsive dealing in any individual transaction.
   Implicit versus Explicit Interest
                                                                                        18
    Interest is compensation paid for the use of someone else’s funds for a specified
period of time. In ordinary usage, ―explicit‖ refers to contractual items that are
express and clearly visible, whereas implicit items are ancillary fees or implied
understandings that are often not clearly delineated as interest. Explicit interest is
labeled as ―interest‖ and paid in the ―coin of the realm,‖ i.e., in cash or claims to cash.
Implicit interest is compensation for the use of funds that is received either as
contracting fees or as a flow of noncash goods or services. Competitive pressure
pushes the sum of implicit and explicit interest toward the going market rate of
return on a loan or deposit contract, irrespective of ceilings on explicit interest
rates that might apply. However, difficulties in observing concessions made to
other customers mask opportunities for banks to use implicit interest to engage
in discriminatory pricing.
    Implicit interest is an efficient element of deal-making. This is especially so for
households, who have to use after-tax income to pay explicit service charges. For
depositors, implicit interest includes merchandise premiums or convenient services a
deposit institution performs for its accountholders for less than its cost of producing
these services. Here are some examples of services that have been offered below their
production cost to depositors by banks at one time or another: checking privileges;
check clearing and other account activity; a network of office locations and off-
premises ATMs; free parking; extended office hours and other lightly priced service
expansions or innovations; and concessionary rates on loans or lines of credit offered
to large accountholders.
    On the lending side of a bank-customer relationship, banks pay implicit interest by
giving relationship customers a preferential loan rate. Banks charge implicit interest
by imposing: compensating balances; documentation and reporting-frequency
requirements; requirements for collateral or third-party guarantees; covenanted duties;
and stipulations requiring a borrower or its employees to do other business with the
bank. A bank’s total return on customer loans is increased by the value of the deposit
balances, renegotiation rights, and other business the relationship customer brings to
the bank.
Potential Grading Keys if posed on an exam
     Definition of interest as compensation that a party pays for the use of funds
    Explicit = Express & Visible Payment made in the coin of the realm
    Implicit = Fees and Understandings as to in-kind payments
      Examples from both sides of an FSF balance sheet
      Mutual Benefits in a relationship
      Market Pressure for relationships disciplines total returns on any particular
       financial contract
                                                                                                    19
C. Charter differences among FSFs have greatly lessened over the last 50 years. In particular,
   disjunctions between brokers and intermediaries and between direct and indirect finance have
   become incomplete, as specialized firms have merged into or been acquired by a
   conglomerate FSF. Accounting statements for banks need to recognize their expanding
   capacity to produce credit enhancements and pooling services as increasingly valuable
   "intangible" assets. These fee-based financial activities generate profits and force managers
   to cost out the desirability of offering credit-enhanced direct finance in place of indirect
   finance.
       [1. Self-Study Item: Plain-vanilla financial intermediation depends on sustaining a profit
           margin or wedge rooted in transactions-cost economies, contract-enforcement
           economies, and information-cost economies relative to costs of direct finance.
           Competitive pressure has driven the profitability of the intermediation-funded
           business in high-quality loans to so-called ―normal‖ levels. High accounting profits
           are being posted by banks during the expansion phase of the current business cycle by
           accruing as current income what are conceptually default premia for future losses on
           ―subprime‖ loans.
                  How to prove this? Need to adapt accounting tools to make them measure
                   bank profitability more accurately.
                      1) Measures of true economic returns (= economic value added, EVA)
                          must capture both Implicit and Explicit returns and costs
                      2) Standard accounting principles often neglect to record or misvalue
                          implicit items.
       2. Fee-based FSF services include various guidance, negotiating, credit-enhancement,
           and trading activities. In 2002, FDIC data indicate that noninterest income accounted
           for 42% of banking-industry revenue. [Counting additional ―implicit‖ fees, activity
           share for service fees would be even higher.]
              CEO of JPM opined in June 1999 that:
                   Banks are at a historic crossroads as they evaluate the profitability of their
               traditional lending business. Increasingly, banks can create value for shareholders
               by originating and structuring credits, bundling and unbundling risk, providing
               research, and handling trades – but not holding credits.
                                                                                            20
                 By then, J.P. Morgan was well along in its transformation from a loan holder
             to a creator, enhancer, and distributor of loans. It had cut its need for 'regulatory
             capital' in half.
            For global banks loan securitization is often fundamentally more cost-efficient
             than traditional lending. Global bank customers tend to be huge corporations and
             governments that can choose from a wide array of financing, from loans to issuing
             stocks and bonds. They can shop the world for the best deals. Global banks must
             compete in that highly competitive market with insurance companies and
             traditional investment banks.
      3. Four Broad Functional Areas co-exist in the ―Generic‖ FSF. These structural
         divisions are used as Headings in Table 1 of these notes.
             a. Transactions processing
             b. Intermediation of Funds (Qualitative Asset Transformation)
             c. Information Management and Distribution
             d. Systems and Product Support (in-house or outsourced).
                The first two areas are ―traditional‖ FSF Activities that are still usually
                 performed in-house. The third and fourth areas were traditionally ―support
                 functions‖ that are metamorphosing with information and deal-making
                 technology. We are seeing more ―VENDORING‖: outsourcing of support
                 functions to other FSFs and more outside sales of these services by individual
                 FSFs.
             Managerial Perspective: An invasion of areas 1 and 2 can be launched from data-
                 processing and communications firms that previously limited themselves to
                 functions c and d. This opportunity clarifies that FSFs and
                 telecommunications firms are natural competitors. Both are entities that
                 establish networked relationships through which they collect, verify, store,
                 process, and transmit information for customer accounts. Other examples of
                 nontraditional competitors for financial-services businesses are illustrated in
                 the table summarizing a series of American Banker articles on ―New
                 Bankers.‖
D. Managerial Perspectives:
      1. Disorderly financial wars reinforce the benefits for Managers and Analysts of
                                                                                           21
    employing a broad-enough concept of FSF to accommodate the expanding overlap
    and range of FSF activities: the fusion of markets and product lines

        Changes in contracting and transactional technology can suddenly open
    loopholes that support the development and expansion of innovative substitute
    categories of financial contracts and institutions. Over time, the substitution process
    can effectively destroy longstanding or government-conferred monopoly privileges.
    Two examples can illustrate how loopholes emerge and expand. Both relate to the
    transfer of funds households held in zero-interest demand-deposit accounts at banks
    to NOW accounts and brokerage cash-management accounts.
   Beginning in 1972, household checking accounts were slowly over-run by the NOW
    Account. Originated by a savings bank in Worcester, Massachusetts, NOWs first
    drew household business to Massachusetts banks from banks in neighboring states.
    Then in 1976 they were authorized as an ―experiment‖ for New England as a whole
    (including NY and NJ). Finally, lobbying pressure on Congress for nationwide
    authorization became irresistible in 1980. The legality of paying explicit interest on
    NOW’s innovation turned on the ways in which a NOW account is not strictly a
    demand deposit? Because institutions have the waivable right to require depositors to
    give advance notice of their intention to withdraw, interest on these accounts did not
    violate the federal prohibition against explicit interest on demand balances.
     On a second front, Merrill-Lynch instituted the Cash Management Account
        (CMA) at about the same time. The CMA links: transactions accounts; money-
        market fund shares; securities brokerage & safekeeping accounts; and credit
        accounts into single consolidated statement account.
       What of business demand deposits?
           Demand-deposit ―Sweep Accounts‖ are circumventing the legal prohibition of
        demand-deposit interest to offer explicit returns to business customers on balances
        against which checks may be written. In 1997, the Fed refused to approve bank
        proposals to create a NOW account for corporate customers. In the last several
        years, Congress has toyed with proposals to authorize demand-deposit interest
        again.

2. The generic definition of an FSF featured in this course focuses on information and
    deals embodied in the range of products offered to a targeted client base and on the
    mutuality of links between servicer and servicee. Modern FSFs use a combination of
    robotic and personal mechanisms to exchange information, set strategy, and effect
    transactions.
                                                                                    22

       The concepts we have reviewed create a foundation for defining a
―generic‖ FSF as a ―fully empowered‖ or complex banking organization (CBO).
In the U.S., the current statutory distinction between a bank and a thrift institution
turns importantly on whether the ―Savings Association Insurance Fund‖ can write
the institution’s deposit insurance. Because the SAIF is bound to be merged into
the Bank Insurance Fund (BIF), this definition will fade away.]

a. Surveys have identified Seven Commonsense Keys to customer-relationship
    management: pricing, quality, access, flexibility, sensitivity, durability;
    competitiveness.
     In managing these keys, managers find it helpful to distinguish between
       Front-Office, Middle-Office, and Back-Office Activities. FSFs are
       installing new Front-Office and Middle-Office Technologies. These
       technologies simultaneously impact Back-Office Strategies and
       workflows.
           Front offices are analogous to Delivery Systems; middle-offices
       resemble factories for making nonfinancial products; and Back Offices
       comprise locations where product-design and high-level coordinating
       activities occur.
b. Managerial Perspectives: Top managers must focus on profit generators:
   especially, client base, products, and mutuality of links between servicer and
   servicee. Modern FSFs use a combination of robotic and personal
   mechanisms to exchange information, set strategy, and effect transactions.
   Communication between the three types of office uses both evolved and
   traditional information media (examples: deposit slips, account statements,
   cable or satellite connections, computer tapes, keyboard, video displays,
   checks, receipts).
c. Even the technology of Inside and Outside Financial Crime is changing.
   [Whimsical image of modern bank robber sending a robot to hold-up an ATM.
   Robot is to punch in the hold-up note (information medium) and to try to scare
   ATM system into deciding to send loot to robot's owner by wire. Robot is the
   ―fall guy.‖ His boss is prepared to let police capture and jail the robot
   henchman. Of course, robotic armed robbery is less elegant than a hacker-
                                                                                                                 23
              type diversion of funds. In turn, wholly electronic crimes are less crude than
              laying in wait to ripoff ATM users or repairmen or using a forklift to hijack
              an ATM.


E. The Changing Competitive Landscape
Discussion of Tables 1, 2, and 3. Financial-Services subindustries are merely listed in
   Table 1. Consequences of the technology-led product-line fusion, globalization,
   and electronification (or digitalization) of markets is shown in other two tables.
          Long term redistribution of Relative Market Shares is tracked in Tables 2 and 2A
           the shrinking number of Banks in Individual Nations is shown in Table 3.
          Financial markets are experiencing worldwide consolidation and an expanding
           global presence of large banks from different nations. Parallel phenomena are
           occurring in regional markets, as evidenced by the ongoing consolidation of
           markets for FSF firms in subnational regions such as New England




 Stories on ‘New Bankers’ - American Banker(2000)
 Most companies have little direct connection to financial services but are hatching plans to make loans,
 take deposits, and more. The stories in the series access on archive: www.americanbanker.com.

  Oct. 6        Introduction               Overview of the new generation of nonbank companies trying to
                                           make a name in financial services.
  Oct. 6        Mail Boxes Etc.            A company that specializes in mailing parcels helps online
                                           banks take deposits.
  Oct. 13       Affinity Bank              A mobile home merchant opens a bank to serve people on the
                                           road.
  Oct. 20       State Farm                 An insurance giant trains its agents to sell banking products.
  Oct. 27       Priceline                  A company that sells airline tickets and hotel rooms online
                                           begins offering loans, credit cards, and insurance.
  Nov. 3        U.S. Postal Service        The post office gets into electronic bill payment and
                                           presentment.
  Nov. 10       BMW                        Luxury car retailer opens an internet bank.
  Nov. 17       United Parcel Service      Delivery firm opens corporate lending subsidiary.
  Nov. 22       AAA                        The auto club opens an online bank.
  Dec. 1        Retailers                  Department store like Target, Kmart, and Nordstrom are
                                           offering more financial services.
  Dec. 8        Web Portals                America Online, Yahoo, and Microsoft Network get into online
                                           account aggregation.
  Dec. 15       7-Eleven                   Convenience store chain sets up banking kiosks.
                                                                                                            20
                                                                                                            24

Throughout this course, the Commercial Bank is portrayed as an ever-expanding Species (or ―Flavor‖)
of FSF. It is ironic that U.S. banks' share of private domestic financial assets declines from the end of
WWII and through the 1990s. Despite becoming more generic, life-insurance companies have also
suffered a substantial long-term market-share decline. However, these reported declines in banking and
insurance are exaggerated, due to the affiliation of disparately chartered organizations in conglomerate
firms and the shifting of product lines toward off-balance-sheet products for banks and toward pension
products for life insurers. Data are further distorted by the shifting of selected business onto U.S. FSFs’
offshore books for regulatory and tax reasons.

               5. Metaphor for adaptive changes that cumulate over time: SCIENCE-FICTION OR
                  MYTHICAL SHAPE-SHIFTING.
                     a. INSTITUTIONAL SHAPE-SHIFTING resembles metamorphoses celebrated
                         in mythical seductions of maidens by Roman or Greek gods and in American
                         Indian Legends.
                     b. Expanding product lines of banks, brokers, and insurance companies reflect
                         economies of ―scope‖. Joint costs of maintaining network connections act to
                         encourage financial institutions to spread the costs over more services: to
                         become "assemblers of servicing packages".
04-1&2
                                                                              Week One
                                                                               Table 1

    This table characterizes the financial-services industry in terms of four functional areas. Within each, the principal activities and the
organizations providing them are identified.
    This breakdown defines the universe encompassed in the term ―financial services.‖ Emphasis is placed on those functions that are most likely to
be of interest from the point of view of changes in FSF or regulatory policy. Making the list more exhaustive can be conceived as a lifetime project.
    We stress that the industry is being characterized from the supply side of the market. Virtually all servicers are potential consumers of all services
offered.

         Transaction Processing               Intermediation of Funds                   Information Management and               Systems and Product Support
                                                                                                Distribution
Service Functions
    - Extend credit                    - Accept deposits / consolidation of       - Ensure liquidity                        - Communication
    - Transfer funds                      funds                                   - General Data-Processing                 - Equipment
    - Interchange & settlement         - Investment                               - Privacy                                 - Software
                                       - Asset and Liability Management           - Make Markets                            - Supplies
                                                                                  - Risk Management
                                                                                  - Risk sharing (insurance)
                                                                                  - Risk minimization (financial advice)
Service Providers
    Depository Institutions:           Depository Institutions:                   Service Bureaus                           Telecommunications Companies
      mutual savings banks                 mutual savings banks                   Brokers-dealers                              Equipment suppliers - manufacturers
      commercial banks                     commercial banks                       Investment banks                             third party
      savings & loan                       savings & loan                         Depository Institutions                   Software suppliers
      savings banks                        savings banks                             savings banks                             service bureaus
    Mortgage bankers                   Finance, Factoring & leasing companies        mutual savings banks                   Credit Card Manufacturers
    Bankcard companies                 Insurance companies                           savings & loans                        Encryption/security systems
    Retailers                          Brokers-dealers                               credit unions                          Depository Institutions
    Securities brokers                 Corp. treasurers’ offices                     commercial banks
    T&E cards                          Government                                 Check & credit guarantors / authorizers
    Travelers checks & money order     Mutual Funds                               Financial counselor
      companies                        Investment banks                           Mutual Funds
    Check & credit card processors     Private placement of debt & equity
    Service bureaus                        instruments
    Wire transder service provider     Commercial acceptance corporations
    ACHs                               Consumer finance corporations
     04-1&2



                                                  Table 2
                             Percentage Distribution of U.S. Financial Assets
                                by all Financial Service Firms: 1950-1995

                                                    1950      1960      1970         1980         1990           1995
  Depository Institutions (1)
Commercial Banks                                   51.2      38.2       38.6         34.3           27.7          24.9
   U.S.-Chartered                                  50.5      37.5       36.6         29.3           22.0          18.4
   Foreign Offices in U.S.                           0.4       0.6        0.7          2.3           3.0           3.7
   Bank Holding Companies                            0.0       0.0        1.1          2.4           2.5           2.6
   Banks in U.S. Possessions                         0.3       0.1        0.3          0.3           0.2           0.2
Savings Institutions                               13.4      18.7       18.7         18.3           11.4           5.7
   Savings and Loans                                 5.8     11.8       12.8         14.4            9.1           NA
   Savings Banks                                     7.6       6.9        5.9          3.9           2.2           NA
Credit Unions                                        0.3       1.1        1.3          1.6           1.8           1.7
  Contractual Intermediaries
Life Insurance Companies                           21.3      19.4       15.0         10.7           11.4          11.6
Other Insurance Companies                            4.0       4.4        3.7          4.2           4.4           4.1
Private Pension Funds (2)                            2.4       6.4        8.4        11.7           13.6          14.6
State and Local Government Retirement                1.7       3.3        4.5          4.5           6.1           7.7
Funds
  Others
Finance Companies                                    3.2       4.6        4.8          4.7           5.1           4.6
Mortgage Companies                                  NA        NA          NA           0.4           0.1           0.2
Mutual Funds (3)                                     1.1       2.9        3.5          1.4           5.0          10.3
Money Market Mutual Funds                            0.0       0.0        0.0          1.8           4.1           4.1
Closed-End Funds                                    NA        NA          NA           0.2           0.4           0.7
Security Brokers and Dealers                         1.4       1.1        1.2          1.0           2.2           3.1
REIT’s (4)                                           0.1       0.1        0.1          0.1           0.1           0.1
Issuers of Asset Backed Securities                   0.0       0.0        0.0          0.0           2.3           3.7
Bank Persoanl Trusts (5)                            NA        NA          NA           5.1           4.2           4.5
  Total Assets ($ Billions)                         294       597      1,340        5,910        12,017        15,387
      1. Commercial Banks consist of U.S. chartered commercial banks, domestic affiliates, Edge Act
          corporations, agencies and offices in U.S. include Edge Act corporations and Offices of foreign banks.
          IBF’s are excluded from domestic banking and include all savings and loan associations and federal
          savings banks insured by the Savings Association Insurance Fund. Bank Insurance Fund.
      2. Private pension funds include Federal Employees’ Retirement Thrift Savings Fund.
      3. Mutual funds are open-end investment companies (including unit investment trusts) that report to the
          Investment Compnay Institute.
      4. REIT’s are real estate investment trusts.
      5. Bank personal trusts are assets of individuals managed by bank trust departments and nondeposit
          noninsured trust companies.
      Note: The Flow of Funds Accounts were restructured in the second quarter of 1993.

     Source: 1950-1990 Calculations by James Barth from Flow of Funds Accounts, Board of Governors of the
     Federal Reserve System; updated by Tara Rice.
                                                                                     28



                                           Table 2A
                       Percentage Distribution of U.S. Financial Assets
                          by all Financial Service Firms: 1950-1999




Depository             1950      1960      1970      1980      1990       1993    1995    1999
Institution
Mutual Funds             1.1       2.9       3.5       1.4         5       9.3    10.3    14.8
Finance                  3.2       4.6       4.8       4.7       5.1       4.3     4.6     3.1
Companies
Savings                 13.4      18.7      18.7      18.3     11.4        6.7     5.7     3.8
Institutions
Pensions                 4.1       9.7      12.9      16.2     19.7       22.1    22.3    26.3
Insurance               25.3      23.8      18.7      14.2     15.8       15.7    15.7    13.1
Companies
Commercial Banks        51.2      38.2      38.6      34.3     27.7       25.1    24.9    19.6

     Source: Calculated from Flow of Funds Account by Tara Rice in August 2000.
                                                                                                       29



                                                Table 3
                             World-Wide Restructuring of Banking Competition
                                                                                                          Slide since each
        Number of banks in each country at yearend 1995                                                   country’s peak
  United States                                                                               12,067        -36%
      Germany                                                                       3,487                   -35
        Canada                                             1,030                                            -38
          Italy                                          941                                                -15
        France                                     593                                                      -43
         Japan                                 571                                                          -8
United Kingdom                               560                                                            -30
    Switzerland                        415                                                                  -17
      Australia                   370                                                                       -54
       Finland                   352                                                                        -44
         Spain              318                                                                             -16
   Netherlands             174                                                                              -13
       Belgium       150                                                                                    -8
       Norway       148                                                                                     -57
       Sweden      112                                                                                      -81
        Source: Bank for International Settlements, as reported in the June 13, 1996 American
                Banker.

                           6. Managerial Perspective: To understand the value-creation process,
                                 FSF management must investigate whether and how the entry of new
                                 competitors is supported by innovations in financial technology and in
                                 regulation. Technological Changes in Tools available for Information
                                 processing, communication, and transactions execution have lowered
                                 the costs of expanding an FSF’s geographic reach and product line. The
                                 extreme case is the Global Universal Bank. At the same time,
                                 expansion by product substitution at specialized firms is causing a de
                                 facto convergence in the contract forms used by different charter types.
                  D. Many ways exists to classify Financial-Services firms: by how authority is
                     exercised; by extent of asset transformation; by four p’s; by charter type.
                                                                            30



   Major differences in how authority is channeled within an FSF: FSF
   lines of authority are divided according to particular products in which
   FS are imbedded; according to the customers served; according to
   where inside or outside the firm the FS are priced; and according to the
   places where the FS are delivered.
1. Character of Asset Transformation: An important academic tradition
   distinguishes mere “brokerage activities” from financial activities that
   “transform” the risk or liquidity of another party’s contract.
   -- Music fans may find it helpful to compare brokerage services to
       selling tickets to a concert the broker arranges and to compare
       ―transformation‖ activities to recording the concert on a compact
       disc. A compact disc literally transforms acoustic sound into
       binary data and delivers a close and convenient substitute for an
       original performance. As a concert substitute, a digital CD provides
       a synthetic reassembly of rhythm, harmony, phrasing, tone, and
       affective qualities.
   -- Query: In going over the lists of services in Table 1 and Figure 1,
       ask yourselves to what extent a particular service is an
       informational, transactional, or funds-management activity that truly
       ―transforms‖ a particular financial instrument.
                                                                                           31




                                             - Transactions services (e.g., check-writing,
                                                  buying/selling securities, safekeeping,
                                                  etc.)
                                             - Financial advice (e.g., advice on where to
                                                  invest, portfolio management)
                                             - Screening and certification (e.g., bond
                                                  ratings; credit scoring; credit bureaus)
                                             - Origination of deals (e.g., bank initiating a
                       Brokerage                  loan to a borrower)
                                             - Issuance of contract (e.g., taking a security
                                                  offering to the market)
                                             - Funding (e.g., bank making a loan)
   Financial                                 - Miscellaneous (e.g., trust activities)
  Institution
                                             - Monitoring (e.g., bank monitoring
                                                borrower’s compliance with loan
                       Post-Deal
                                                covenants)
                        Support
                                             - Management expertise (e.g., a venture
                                                capitalist running a firm)
                                             - Guaranteeing (e.g., an insurance company
                       Qualitative
                                                providing insurance)
                         Asset
                     Transformation
                                              - Liquidity creation and claims transformation
                                                  (e.g., a bank making illiquid loans and
                                                  transforming them into deposit claims
                                                  which are liquid)
Fig. 1. Services provided by financial institutions. Source: Adapted from A.V. Thakor,
         ―Financial Intermediation and the Market for Credit‖ (1995)


                2. Managers find it convenient --as a matter of organizational architecture-
                   - to classify activities according to the four ―P’s of marketing:‖
                   Product, place, promotion, and price.
                       a. Product focus is what these Notes have been using. We spoke of
                           funds-management products, informational products, and
                           transactional products. Examples: deposits, loans, checks,
                           credit cards, advice, guarantees. (A reasonable exam question
                           might ask you to match various services with the customers,
                           products, or places that link to this service).
                       b. Customer focus: Finance is a repeat business. Profitability of
                                                                    32



   Building and Nurturing Durable Customer Relationships: Over
   time, managers must take charge of variation in the Base of
   customers with whom their FSF hopes to maintain a long-lived
   relationship.
        Examples of relationship-based ways of breaking down FSF
   activity: wholesale banking; retail or household banking;
   private banking; correspondent banking.
   -- Most FSFs are also fiduciaries (root word is fide, which is
       Latin for ―faith‖). Different opportunities for post-deal
       breaking of faith at: commercial banks; savings banks, credit
       unions, insurance companies as against communications
       companies and straightforward fee-for-service financial
       operations such as finance companies; credit-rating
       companies; credit bureaus.
c. Locational Focus: Historically, the distinction was between
    headquarters and branch offices. Then, as other kinds of offices
    and intercorporate connections (subsidiaries and holding-
    company affiliates) emerged, the very concept of ―place‖ in FS
   began deconstructing to that of an ―access point‖ for receiving
   services. Changing FSF Delivery Systems are now organized
   into Networks rather than by physical office locations. A
   ―network‖ is a ―net-like‖ system of connecting informational or
   control passageways.
Network Access Sites: System of Brick-and-Mortar offices vs.
   “Virtual bank” or ―telebank‖ for which concept of place
   deteriorates to little more than a ―website‖ and the networking is
   entirely electronic.
      By June 1999, 5,100 deposit institutions were offering on-
       line banking. 25% of websites were transactional. By
       yearend 2000, 55% even of the nation's smaller banks had
       sites and almost all of these were transactional.
d. Obvious dangers to which customers expose themselves in
   electronic transacting illustrate the importance of having a
                                                                  33



reputation for trustworthiness. For an FSF, establishing a
reputation for probity and reliability is paramount. Third-party
regulation enhances that reputation by putting a centralized
monitor’s reputation and resources behind the FSF. Cost of
ethical lapses to an FSF is high only if they become public.
Like getting caught cheating at cards or on exams. Point of
third-party monitoring, discipline, and standard setting is to
increase the odds that lapses will be caught and punished.
Credibility of the third party can further be enhanced if it is
willing to back up its certification of PSF soundness with a
guarantee to hold the FSF’s customers harmless from its own
monitoring mistakes. FDIC insurance does this for depositors
today.
   Economic efficiency of financial activity can be enhanced by
joint production of customer confidence or convenience with
an external supplier of financial regulatory services of good
repute. Query: In what ways can regulatory services save
resources: e.g., in check clearing? ANS. 1) By streamlining
the transactions network by standardizing contracts and
communication media and 2) by sparing customers from having
to undertake duplicate monitoring efforts. 3) Regulation can
also inhibit cartelization. For society regulatory arrangements
can in these ways increase at low cost the perceived quality of
FSF products. Customer perceptions of FSF quality increase
with their confidence in the outside pressure exerted on an FSF
to fulfill its contract obligations and with the convenience
customers experience in using an FSF’s products.
   The downside of government regulation is that
redistributional tax and subsidy flows are apt to develop as a
                                                                    34



political add-on generated by interest-group pressure.]
Electronic delivery of FS also sounds a course theme: that
Regulator tend to Lag Behind Events: ―Gray areas‖ exist today
about the applicability of regulatory protections that are bound
eventually to be offered to tele-customers.
   -- Advances in information technology are morphing bank
       product lines, risk-management activity, and service-
       delivery systems faster than regulators can analyze the
       risk exposures each innovation entails. The result is that
       weaknesses in a country’s regulatory structure expand
       and shape the risk exposures its bank managers pursue.
           In every country, the liabilities of deposit institutions
       enjoy implicit (if not explicit) government guarantees.
       Popular belief in the existence of government backup
       establishes a metaphorical ―safety net‖ for FSF
       stakeholders. Safety-net support distorts risk-taking at
       deposit institutions by supplanting at least some of the
       market’s interest in monitoring and disciplining an
       institution’s loss exposures.
           As guarantors of the safety net, taxpayers can be
       harmed by the interaction of changing risk-taking
       technologies with the loss-shifting opportunities
       afforded by implicit and explicit government guarantees.
       To protect society from such harm, government
       regulators contract with the public to monitor and
       control financial-institution risk exposures. But to
       assure that supervisors’ contractual duties are fulfilled,
       the character of the disciplinary performance of
                                                                             35



                 regulators must be well-defined and capable of being
                 monitored by taxpayers.
                     Despite loudly voiced government commitments to
                 financial stability, many countries have experienced
                 costly banking breakdowns in recent decades. The
                 World Bank and IMF are still seeking to identify
                 common features of these breakdowns and to draw
                 lessons about what went wrong.
3. Classification of FSFs by Charter Type.
       a. Major Types of FSF: commercial banks, savings banks, S&Ls,
          credit unions, investment banks, insurance companies, mutual
          funds, securities brokerages, sales finance companies. Each
          charter may be said to define a signature contract and a separate
          species of FSF.
          -- Two metaphors can serve as organizing principles for making
              this point. Both metaphors can accommodate the further
              entailment of a range of ―delivery vehicles.‖
              1) metaphor of breaking down a culture into its subcultures:
                 e.g., breaking the music scene in America into classical,
                 jazz, rock, rap, bluegrass, ethnic, and fusion. Share the
                 same ―delivery vehicles‖ of concerts, videos, CDs, tapes,
                 MTV, etc.
              2) metaphor of diverse flavors and chemical compositions
                 for generic ice cream (yogurt, sherbet, italian ice, fat-
                 free, etc.), with delivery vehicles of cones, sundaes,
                 paper cartons, banana splits, frappes, etc.
              3) N.B. FSF species tend to be differentiated by law rather
                 than logic: by the legal entailments of their government-
                 conferred operating charters.
                                                                                          36



                     b. Concept of Genus as a ―family‖ of similar items that is
                         supplemented by a Specific Difference to narrow the class
                         (animal vs. rational animal; ice cream vs. vanilla ice cream).
                         Every genus is a union of similar species that show a ―family‖
                         or ―class‖ resemblance. For the family of financial institutions
                         --as in an ice cream store-- many separate species exist.
                         -- generic financial services firm vs. individual FSF ―species‖
                     c. a generic FSF (sometimes called a ―universal bank‖) is prepared
                         to do financial business of any kind. = A generalization of the
                         less broadly chartered bank, securities firm, or insurance
                         company.
                     d. in most countries, each FSF species has as assigned team of
                         private and government regulators. Query: What useful
                         functions can a specialized regulator perform for banks? for
                         securities brokers?
                     Managerial Perspective: Charters are continuing to change and
                         the character of financial services themselves are changing even
                         faster. The particular charter an FSF holds makes little
                         difference any more, assuming that the firm’s managers are
                         preparing themselves for the future competitive environment.
                         The challenge is to ―live long and prosper.‖
                            The FS industry is splintering and reassembling. Charter-
                         based species are undergoing the equivalent of genetic mutation
                         and fusion. Paradoxically, banking, insurance, and securities
                         brokerage will remain profitable activities, but they won’t
                         necessarily be performed by the institutions we now call banks,
                         insurance companies, and brokerage firms.
III. Managerial Perspective: What Values and Risks are to be managed in a Generic
   Financial-Services Firm (FSF)? ANS. Those generated by Net Cash Flows from
                                                                                              37



Future Revenues and Costs. This means managing activities that make or kill profits.
   A. In principle, every FSF functions as a contradictory combination of a sharp-
       trading arbitrageur and a user-friendly service organization. Considered
       solely as a financial intermediary, an FSF earns arbitrage profits by sustaining
       opportunities to simultaneously buy in cheap markets for funds and sell in
       dear ones. To do this requires an organizational capacity to exploit one of
       five potentially successful profit generators and/or attack one of two profit
       killers.
           1. A loyal customer base;
           2. A distinctive strategy of product-line management (e.g., data mining for
                  new customers and branding new FSF products like the CMA);
           3. A skilled management team;
           4. A special organizational capacity to perform unique customer services
                  or standard services at low production cost;
           5. Political Clout: All FSFs consciously extract benefits from loopholes in
                  Government Regulation and Taxes. This is because loophole-free taxes
                  and regulation threaten to impose net burdens on value creation.
                  Exercising clout through licit and illicit lobbying activity can win
                  access to net subsidies from government. Please note that subsidies can
                  be implicit or explicit and intended or unintended.
                      In any regulated industry, managers regularly devote costly lobbying
                  resources to defending and winning favorable adjustments in regulatory
                  burdens or subsidies. Students of management should never forget that
                  ―political clout‖ is a profit generator in a regulated firm and also that
                  lobbying activity is subject to legal and ethical limits. All too often,
                  influencing officials entails at least a de facto corruption of a
                  government process. Conscientious managers must ask whether
                  stockholder benefits morally justify shafting customers or taxpayers.
           6. Two Profit Killers: Competition and burdens from Government Taxes
                                                                                      38



            and Regulation restrict FSF behavior. Competition from substitute
            contracts is also a major profit killer. It inevitably eats away at FSF
            species’ monopoly privileges.
       7.   None of these seven items appears on an FSF’s conventional balance
            sheet, though they manifestly influence how net income flows through
            the conventional income statement.
b. We propose to value an FSF’s stock as a claim on cash flows generated as
   ―value differences‖ between revenues and costs. Pressure on an FSF to alter
   previously successful strategies comes principally from uncontrolled forces that
   impact its profit generators and profit killers:
       1. changes in reputation
       2. changes in technology: invention vs. innovation
       3. changes in customer interest in using that technology
       4. changes in whom a given FSF must compete with
       5. changes in how the government taxes or regulates FSF activities.
                                                                                   39




Useful Metaphor for Financial-Services Competition
      A telling metaphor for the process of financial market invasion and
   counterinvasion is one of our culture’s classic oxymorons: CIVIL WARFARE.
   Civil wars are conflicts between factions or regions of a single country. They
   are rooted in organized opposition to established ways of doing things and
   typically spread themselves over many fronts. Today’s financial civil war is
   every bit as disorderly as the conflicts the world has observed in the former
   Yugoslavia, the former U.S.S.R., Korea, Ireland, and Palestine.
      In financial-industry conflicts, issues and enclaves evolve with market
   opportunities. FSF generals and regulatory officials must continually adapt
   their strategies to new technologies of information, communication, and
   contracting. These technologies are simultaneously expanding the range and
   overlap of potential activities.
                                                                               40



   Additional Self-Study Fragment:
          Regulators are seldom neutral ―peacekeepers.‖ Specialized
     regulators have an incentive to enforce loosely any statutes that their
     supporting political coalition dislikes. (Example of 55 MPH limit)
     Downward trends exist in the costs of circumventing any given
     restriction by using new technologies to make superficial adjustments
     of various kinds. These trends develop and steadily widen holes in the
     inherited fabric of regulation. More and bigger loopholes make it easier
     for an FSF to transfer or migrate portions of its business to less-
       aggressive regulatory regimes. This makes financial ―market
       structures‖ more fluid and in the short run tends to enrich creative
       players and diminish stodgy regulators.
   A look ahead: From this perspective, migrating from one regulator to
       another is not necessarily --or even usually-- bad for society. It need not
       create a competition in ―laxity‖. Regulated firms work to prevent the
       gross burdens of regulations from exceeding the regulatory benefits of
       confidence-building and networking services. So long as regulatory
       enterprises are accountable for the costs they impose on general
        taxpayers, the migration of regulated firms to more-favorable regimes
        generates market discipline. It pointedly educates regulators and
        legislators about inefficiencies in inherited regulatory structures and
        pressures them to jettison inefficient patterns of supervision and
        regulation far faster than they otherwise would.]
[Sidelight: It is also interesting to think about how a shooting war transforms a
region’s banking system. In Yugoslavia in 1996, separate private banking
systems sprung up in the three ethnic areas of control. The Bosnian
government refused to legalize the eight banks in Croat territory because they
suspected them to be illegally financed. As a result. banks in Croat western
Mostar could not clear payments with banks in Muslim eastern Mostar and
therefore, for a good while, settled accounts via Germany’s Deutsche
Bundesbank in Frankfurt. Eventually, an armored car crossed the Neretva
River, which divides Mostar, once a week with a load of German mark notes to
settle accounts.
                                                                                             41



                         The International Monetary Fund labored to create a state-wide
             central bank and a currency that Serbs, Croats, and Muslims could all accept. It
             had considered simply choosing the German mark, but concluded that a
             Bosnian currency would be an important symbol of national unity.]
IV. Roll Call of Major Perspectives, Concepts, and Tools Covered in First half of the
   course.
       A. Informational Tools: Balance Sheets and Income Statements are standardized
             ways of organizing and communicating information on values.
       B. Any FSF may be portrayed as if it were only a balance sheet. This tool helps
             us to distinguish one-sided operations (savings-holding ―piggy bank‖ vs. pure
             lender, such as a pawnbroker) from a truly ―two-sided institution‖ that deals
             simultaneously in asset contracts (such as loans) and liability contracts (such as
             deposits)

                1. Simplified Hypothetical Balance Sheet (in percentage of assets)
                             loans 55        deposits 92
                             securities 20 ..........................
                             hardware 5      residual ownership capital 8
                             buildings 5
                             cash 15
                2. Which items would not also appear on customers’ and owners’ balance
                    sheets as assets or liabilities? hardware, buildings. What of cash? It
                    would be found on the balance sheet of government institutions.
                3. Where might loan-loss reserves of 2 be recorded? ANS. Either as an
                    implicit charge against ownership capital or as a ―contra asset‖ against
                    loans.
                4. What information would the bank’s income statement have to present?
                    What revenues? What expenses?
                5. Query: What does it mean to say that State Street looks less and less
                    like a bank every day? ANS. Mix of business revenues & costs
                    generating their net income is shifting from profits on traditional
                    intermediation to customer fees for innovative forms of service.
                                                                                           42



       C. Elaborating the following three themes will occupy us throughout the course:
          Risk is the ―salt and sugar‖ of an FSF manager’s professional life, but it is not
          accounted for in the two standard accounting statements . FSF Risk
          Management is a multidimensional activity. Risk management entails: (1)
          analyzing, pricing, and diversifying risks; (2) avoiding uncompensated risk (=
          portfolio efficiency); and (3) conforming with government-enforced standards
          for ―safety and soundness.‖
              1. risk: chance of a bad outcome = financial injury
              2. risk is controlled (on the one hand) and compensated (on the other) by
                  returns offered on bonds and loans
                      a. (Weeks 3 & 4) credit risk: assessing chance of nonperformance
                         of promises exchanged = partial or complete ―default.‖ (Latin
                         root = credo underscores pre-eminent role of trust and character)
                             1) classical predictors of default: 5 C’s of Credit: character,
                                 capacity, capital, collateral, conditions (= vulnerability:
                                 downside exposure to changing economic
                                 circumstances). Expansion of electronic credit-scoring.

                            2) setting the price for credit granted: implicit vs. explicit
                                components of loan and deposit interest rates
                      b. (Week 5) Credit Risk Management
                            1) Loan-Loss Reserving
                            2) Syndication
                            3) Credit Derivatives
                      c. (Weeks 6 & 7) interest-rate risk and risk shifting via financial
                        engineering
V. Recap of Strategic Managerial Concerns So Far:
       A. Understanding why financial institutions and financial regulators exist.
       B. Linking an FSF’s Profit Generators and Profit Killers to Value-Creating and
          Risk-Management Strategies.
       C. Recognizing how changes in information and deal-making technology alter
          profit possibilities, create loopholes, lead to convergence in FSF types and
                                                                                              43



           product lines, and alter the identity of one’s close competitors

VI. Final Theme: the Globalization of Financial Intermediation changes the customer base
    and contract-enforcement process, but need not itself change the kinds of deals made.
       It is easy to construct a conprehensive Diagrammatic Perspective on Cross-Border
    Financial Intermediation (or global securitization)
       A. Basic diagram of bank-to-bank international financial intermediation. Focus
            is on interbank loans (use of cross-border branches, agencies, or affiliates can
            be generated by relabeling boxes #3 and #4):

           Box #1             Box #2             Box #3             Box #4             Box #5

         Surplus      Regional        Multinational    Regional                       Deficit
         Spending --> Deposit     --> Bank B in X, --> Bank C in -->                  Spending
         Unit in      Institution     Y or offshore    Country Y                      Unit in Y
         Country X    A in X          Center                                          or X


               0. Arrows portray movements of funds. Movement of contractual claims
                    (instruments) is in opposite direction.
               1. It is presumed that cost-adjusted interest-rate spreads govern choices
                    made at each contract-creating step. Potential for skipping any or all
                    subsequent contracting steps exists at every link.
               2. Self-Study Exercise: Draw Diagrams and Balance Sheets for the
                    following possible financial-intermediation connections. Each
                    effectively ―erases‖ or ―relabels‖ one or more ―boxes.‖
                       a. Surplus unit directly funds a deficit unit in Y or X: May be
                           conceived either as direct finance or disintermediation of a DU’s
                           existing debt. Parallel in possible "securitization" of deposit-
                           institution loans. Box #1 -----> Box #5.
                       b. Deposit institution A directly funds deficit unit in Y
                               1) via its domestic offices in X
                               2) via an offshore affiliated bank
                               3) via an interbank transfer to A’s foreign branch or
                                                                                    44



                          agency
                         Box #1 --> Box #2 --> Box #3 or #4 --> Box #5
                     4) via a corporate subsidiary or holding-company
                          affiliate in Y (use of a subsidiary or affiliate gives A and
                          option not to support losses) #1 --> #2 -->  #4 --> #5
              c. Deposit institution A lends directly to Bank C (erases Box #3)
                     1) out of its domestic offices in X
                     2) out of branch or agency offices in Y
                     3) out of the offices of a subsidiary or affiliate in Y
              d. Surplus unit in X directly funds Multinational Deposit Institution
                 B (erases Box #2)
                     1) via an offshore or home-country office
                     2) via offices it has established in X
              e. Surplus unit in X directly funds regional foreign institution C
                 (erases Boxes #2 and #3)
                     1) via C's offices in X
                     2) via C's home-country or other offshore offices
              f. Alternative funding instruments could be illustrated also:
                     1) deposits (insured vs. uninsured)
                     2) nondeposit debt. Bank sells securities: guaranteed (or
                          enhanced) vs. unguaranteed
                     3) equity instruments
              g. Expanded opportunities for capital flight from a potentially
                 troubled country (e.g., Chile, Peru or Argentina) to remote tax
                 and regulatory havens. What is ―smurfing‖? Hint: A type of
                 money laundering.
B. Self-Study Queries:
      Can you prepare a Diagram to Show Deposit-Institution Securitization
       (Pooling plus Credit Enhancement):
                                                                                          45



                1. With deposit-institution guarantees?
                2. With third-party guarantees?
               Can you diagram the following?
                1. Bank sale of uninsured deposits backed by specific asset collateral.
                2. Securities underwriting activity accomplished through the foreign
                   subsidiary of a U.S. bank.

VII. What Potential Quiz Questions Have We Covered So Far?
               What is an FSF generically?
               What is meant by External Finance?
               What is Direct Finance?
               What is Indirect Finance?
               What services may be called ―Financial‖?
               How can we Distinguish the following activities in pairwise fashion:
                intermediation; pooling; brokering; credit enhancement; deal-making; risk
                assessment; monitoring; valuation?
               Why does each of the activities just distinguished deserve a net economic
                return?
               What are an FSF’s Basic Elements = 5 Profit Generators and 2 Profit
                Killers?
               Why have Commercial Banks changed in Products, placement
                (networking), promotion, and pricing?
               What is Telebanking?
               What Benefits and Costs are Introduced by FSF Regulation?

VIII. Summary of Introductory Perspectives on Changing FSF Strategies
       A. Bank Managers face three overriding challenges: Changing competitive
          landscape; cost of supporting risk-taking with ownership capital; coping with
          regulatory change.

                1. Competitive Invasion of customer base: users of traditional loan and
                                                                                           46



                    deposit services have turned increasingly to nonbank substitutes for
                    these services. Many bankers fool themselves about why they lose
                    customers.


               Family-Feud-type List of Top Reasons Customers Leave a Bank
                             Reasons                                    Survey Says
  Threat to
                {
  Longevity
                     • Weakening financial condition of bank
                                                                               }
                                                                             80%



              {
                     • Inefficient operations services
Quality
  of
                     • Difficulty in negotiating credit terms and price
                     • Refusing to tailor credit arrangements                  }
                                                                             75%

Service                • Price for services too high
                       • Lack of personal attention                            }  65%
                  -- Less Frequent Reasons:



              {
                       • Bank becomes too small                                ( 38%)
                       • Too few cash management services                       ( 28%)
      Fit              • Lack of international capability                      ( 20%)
                       • Bank becomes too big                                   ( 18%)
               2. Supporting profitable risk-taking: ownership capital may be insufficient
                  to cover valuation losses and to sustain risks from ongoing operations.
                  E.g., Industry’s 1992-1993 recapitalization came mostly from falling
                  interest rates.
               3. Coping with regulatory change: regulatory changes are adding new
                  operating constraints: Community Reinvestment Act; truth in lending;
                  truth in saving.




         FIRST MINICASE: Countrywide Breaks Through Charter Barriers

                    Countrywide Web Plans a Step Closer to Fruition

                                Wednesday, April 11, 2001
                                  By Laura Mandaro

Countrywide Credit Industries Inc., which is trying to raise deposits to fund its branching
out from home lending to other banking services, is one step closer to launching the
Internet banking operation at the core of its diversification push.
                                                                                            47




On Tuesday, the company took another step in its evolution. Countrywide received
conditional approval from the Office of the Comptroller of the Currency to acquire
Treasury Bank, a $100 million-asset Washington, D.C., institution that would bring the
bank charter and lay the groundwork for the Internet strategy.

Armed with a bank charter, the Calabasas, Calif., mortgage lender plans to use the Internet
to expand into checking, savings, and other consumer banking services.

Countrywide sees the future banking company as an [universal] Internet bank, Clarence G.
Simmons 3d, president and chief operating officer of Countrywide Financial Holding Co.,
which would become a first-tier financial holding company upon Federal Reserve Board
approval.

Countrywide has been moving for years to increase its portfolio of products and services
beyond its origins in straight mortgage banking. Thanks to a mixture of acquisitions and
internal growth, roughly one-third of its earnings now come from outside mortgage
banking.

Buying a bank charter and building a bank also will give Countrywide a capability that its
commercial bank competitors have long enjoyed. With its own bank, it will be able to
move the $4 billion to $5 billion in escrow deposits Countrywide has kept in accounts at
other depository institutions to its own institution. This instant deposit base will provide an
immediate cost advantage to the Internet operation, Mr. Simmons said.

―Countrywide is a huge customer of banks,‖ Mr. Simmons said. With a bank charter and a
place to put those deposits, the company will have a cheap source of funding for its bank
operations. ―This allows us to use existing relationships to lower our cost of funding,‖ he
said.

When Countrywide filed to acquire Treasury Bank, the market’s initial reaction sent
Countrywide’s stock down 5%, as many investors viewed the news as a sign that a long-
rumored sale of Countrywide was not in the making.

(Countrywide officials have not said specifically that their company was for sale but co-
founder and chairman Angelo R. Mozilo — who for years had explicitly ruled out a sale
— softened that stance in an interview last May, when he said he no longer ruled out the
option. The company, according to published reports, last summer hired Goldman Sachs to
explore the possibility of a sale. The company declined to comment on the matter on
Wednesday.)

Michael McMahon, an analyst at Sandler O’Neill, said that a move into banking does not
necessarily mean management has rejected the idea of a sale. ―I think Countrywide has to
manage its affairs as if it’s going to be independent forever,‖ he said.
                                                                                         48




Through Effinity Financial Corp., a Countrywide subsidiary based in Alexandria, Va.,
Countrywide plans to create an Internet-based bank platform from which it can cross-sell a
variety of banking products to its existing 3 million customers.

Countrywide’s efforts come as Internet banking, always in flux, has seen some participants
bow out of the business. For example, Usabancshares.com in Philadelphia said in April it
would return to its community banking roots, while Houston-based Compubank in March
announced a sale of all of its assets to NetBank.

Mr. Simmons said Countrywide’s Internet effort should have some advantages over other
Internet-based banks because of its ties to the asset-producing machine of the parent
organization. ―Other Internet banks haven’t been as successful attracting assets as
deposits,‖ he said in an interview Tuesday. ―With the loan origination capabilities of
Countrywide and the affiliation of the bank, we have the opportunity to gain access to
tremendous asset origination capabilities.‖

―This is a way for Countrywide to gain a platform that will enable it to expand its banking
services down the road,‖ said Mr. McMahon.

Countrywide and Effinity applied to the OCC to acquire Treasury Bank in mid-August.
Mr. Simmons said the company’s primary interest was its charter. The company decided to
apply for an approval to buy a bank, rather seek approval for a de novo bank charter for a
variety of reasons - and expediency was one, he said.

The Internet-banking capabilities are being developed by Effinity Financial, which
Countrywide acquired a majority interest in last May. Pending regulatory approvals,
Treasury Bank’s name will be changed to Effinity Bank and its current business activities
aligned with Effinity Financial’s, Mr. Simmons said. Pending other approvals related to
Internet banking, Countrywide expects a rollout of the Internet bank sometime this year, he
said.

N.Y. Fed Adds Countrywide to Its List of Primary Dealers
From: American Banker
Friday, January 16, 2004
By Bloomberg News
Countrywide Financial Corp.'s securities unit on Thursday became a trader with the
Federal Reserve Bank of New York and is now required to bid at U.S. Treasury debt
auctions.
The New York Fed's Web site on Wednesday announced the designation of Countrywide
Securities Corp. as a U.S. government securities primary dealer. There are now 23 such
                                                                                           49



dealers.
"This is part of an effort to diversify operations of the broker-dealer and take advantage of
what has once again become a growth industry: U.S. Treasuries," said Grant Couch, a
managing director and the chief operating officer of the unit.
Countrywide, known for trading mortgage-backed and agency bonds, began trading
Treasuries about three months ago. Its Treasury trading operation is led by Susan Estes,
who has managed bond departments at Morgan Stanley and Deutsche Bank. She also
oversees the trading of bonds issued by Fannie Mae, Freddie Mac, and the Federal Home
Loan banks.
Last year Countrywide Securities' trading volume climbed 43%, to a record $2.9 trillion,
including trades with Countrywide Financial's mortgage banking unit.
Mergers and acquisitions on Wall Street have reduced the number of primary dealers in
recent years; there are now half as many as there were in 1988, when the government had a
smaller deficit and fewer debt sales.
J.P. Morgan Chase & Co.'s bid to purchase Bank One Corp. would further thin the ranks,
because both are primary dealers. J.P. Morgan Chase was formed through the mergers of
four firms, all of which were primary dealers - J.P. Morgan & Co., Chase Manhattan
Corp., Chemical Bank, and Manufacturers Hanover Trust Co.
The Fed uses primary dealers to control the amount of cash in the banking system. The
firms lend securities to the New York Fed when the central bank wants to add cash
through so-called repurchase agreements, and they take securities from the Fed when the
central bank wants to reduce the amount of money in the system.
In addition to being required to bid at Treasury auctions, primary dealers also stand ready
to buy and sell U.S. government debt.
Last year primary dealers traded $428.56 billion of Treasuries on an average day, 15.8%
more than they did in 2002 and 43.9% more than in 2001. They also traded $81.5 billion
of agency debt and $203.55 billion of mortgage-backed securities on an average day last
year, according to the Fed.
Zions First National Bank and Bank of Montreal's BMO Nesbitt Burns Inc. withdrew as
primary dealers in April 2002. Societe Generale's SG Cowen Securities Corp., which
withdrew in October 2001 after 28 months as a primary dealer, said it could be more
competitive without the constraints required by the Fed. Primary dealers must buy and sell
mortgage-backed securities and debt sold by Fannie and Freddie, as well as Treasuries.
                                                                                           50



Commercial - Next Up at Countrywide
Coastal Capital teamhired to build conduit lending business


From: American Banker
Friday, April 2, 2004
By Jody Shenn


Most of Countrywide Financial Corp.'s efforts to diversify over the years have leveraged
its powerhouse position and expertise in single-family home lending.
Until recently its investment banking unit stuck to home mortgage-related activities, such
as brokering servicing rights and underwriting and trading mortgage-backed securities.
Most of its insurance products are house-related, including captive mortgage reinsurance
and lender-placed homeowner's policies.
And its bank grew fast by taking deposits of funds held in escrow for servicing customers.
Now the Calabasas, Calif., company is trying what could be a bigger stretch: financing
commercial real estate.
On Thursday it hired the principals of Coastal Capital Partners LLC of Sausalito. The team
will work to build a commercial mortgage origination and securitization business.
Countrywide will engage in conduit lending, in which loans are originated with an eye
toward quick securitization - not to be held on its balance sheet. One similarity between
conduit lending and Countrywide's traditional domain is that they are both trading
businesses that rely on the secondary market.
In an interview Thursday, Ron Kripalani, the chief executive of the new division's
immediate parent, Countrywide Capital Markets Inc., said conduit lending is a "way of
leveraging our existing [securities] distribution network," as well as diversifying.
Countrywide's after-tax earnings nearly tripled last year, to $2.4 billion. But the sharp drop
in single-family originations nearly all forecasters are predicting as refinancings dry up
would make things more difficult for the company.
The commercial real estate group has a staff of 17 but plans to have as many as 40 workers
by yearend. It will originate loans nationwide through offices in New York, Chicago,
California, and Toledo, Ohio, Mr. Kripalani said.
He called multifamily lending a "logical extension" for the company but said it was not
limiting itself to financing apartments.
According to a Mortgage Bankers Association survey, multifamily lending made up 43%
of the commercial mortgage originations reported last year. Overall commercial
                                                                                              51



originations surged 34%, according to the survey.
Mr. Kripalani would not guess at how much lending the group would do this year. It is
focusing on the long term, he said. "We're going to do this methodically, like we've done
with every business."
His unit also includes Countrywide Securities Corp., which was named in January to the
New York Fed's list of primary dealers in U.S. Treasury bonds.
Before Countrywide hired the principals, Coastal provided a range of origination,
evaluation, and structuring advisory services for borrowers, lenders, issuers, and investors.
"We have participated on all sides of real estate equity and debt transactions - as lender,
borrower, owner, broker, seller, buyer, and securitizer," it says on its Web site.
Along with Stewart Ward, Boyd Fellows, Chris Tokarski, and Warren de Haan, the
Coastal principals who are now executive vice presidents of the group, Countrywide
picked up seven other employees.
The ability to hire a team of seasoned commercial mortgage mavens with experience
starting conduits presented "a great opportunity for us to really jump-start the business,"
Mr. Kripalani said.
Many of the new hires cut their teeth at Nomura Group, a pioneer in the commercial
mortgage-backed securities market.
Nomura and Credit Suisse First Boston Corp. "created this whole industry," said Jeffrey A.
Lenobel, the head of the real estate practice at the New York law firm Schulte, Roth &
Zabel LLP.
Like others in the industry, Nomura and Credit Suisse were baldy burnt during the 1998
global debt crisis, which caused Nomura to exit the business completely for a time.
The CMBS market has come a long way since then. In the last two years investors looking
for yield in a low interest rate environment have demonstrated a huge appetite for the
investment-grade bonds, and the number of buyers for the junk-grade tranches has roughly
doubled.
Still, some established conduit lenders sounded skeptical about the prospects for a new
entrant.
"I think they'll be shocked at how competitive it is," said Clay M. Sublett, the director of
commercial mortgage conduit lending at KeyBank, a unit of Cleveland's KeyCorp. "The
profits of 2003 definitely bring people out of the woodwork," but this year is shaping up to
be tougher.
"Everyone is projecting at least some kind of reasonable increase in production" for
themselves, he said. "But the overall prediction is that the total size of the market is not
                                                                                         52



              going to increase."
              Washington Mutual Inc., the second-largest single-family lender, continues
              to expand in commercial real estate lending, specifically the multifamily
              sector, where it now lends in the 15 of the top 50 markets. Last fall it
              opened offices in Boston, Miami and Washington.
              A Wamu spokeswoman said multifamily lending, which it entered in the
              late 1990s as a result of three acquisitions in California, has "been
              identified by the company as a primary growth area."
              Its commercial real estate originations climbed by about a third last year, to
              more than $10 billion.




Assignment: Please search the web to determine how Countrywide continues to
            evolve.


      SECOND MINICASE: the “Genericization” of Wal-Mart (in slideshow)




More Bankers Worry About Outside Competition
(Especially from Wal-Mart)
From: American Banker
Wednesday, March 5, 2003
By Katie Kuehner-Hebert

Companies like Wal-Mart Stores Inc. are really beginning to scare community banks,
according to a nationwide survey whose results are being released today.
                                                                                               53



Of the more than 500 bankers who responded to a questionnaire sent out late last year by
Grant Thornton LLP in Chicago, 26% said that they were concerned about the competitive
threat from nonfinancial companies like Wal-Mart, compared with 6% a year earlier.

"That is an astronomical jump," said Paul G. Pustorino, the managing partner of Grant
Thornton's financial institutions practice.

Apparently, bankers are paying attention to the headlines Wal-Mart has been making in its
repeated efforts to open a bank.

The most recent attempt was last year in California, where it petitioned the state to let it
take over the charter of a small industrial bank.

Legislation passed in September blocked those plans. The following month, however,
Federal Deposit Insurance Corp. Chairman Don Powell said at an American Bankers
Association conference that the fight over whether commercial companies like Wal-Mart
should own banks is far from over. Moreover, he made it clear that the FDIC has "not
traditionally been as opposed as some" to such changes.

Bankers certainly sense a threat and have been looking for ways to prepare for the new
competition.

"This just drives them to find additional sources of revenue streams," Mr. Pustorino said.
For example, 49% of the bankers who responded to the survey said they now offer
brokerage services, up from 45% a year earlier, and 43% said they have insurance services,
compared with 33%.

"When banks start offering these services, it also brings back more core deposits," Mr.
Pustorino said. "A good bit of customers prefer to keep everything under one roof," and
they would rather that roof be their bank's.

John G. Eilering, the president and chief executive officer of $232 million-asset Mount
Prospect National Bank in Illinois, expects the brokerage and insurance percentages to rise
by at least 10 percentage points by the time the next survey come out.

Mount Prospect has pocketed a portion of the commissions from insurance policy sales for
more than two years by outsourcing with a local agency.

In January it also began offering securities products through a deal with Vision Investment
Services Inc. of Oak Brook.

"We believe we can get a really good alternative source of income from these services,"
Mr. Eilering said. Last year the insurance business generated about $12,000 of fee income,
but he said he expects to earn up to $100,000 annually within five years from both the
insurance and brokerage offerings.
                                                                                         54



More banks are offering other products and services, too. In the survey, 58% said they
provide electronic bill payment, up from 49%, and 34% said they sell 529 college savings
plans, up from 24%.

                                                   Grant Thornton added questions about
                                                   corporate governance to the survey,
                                                   since the Sarbanes-Oxley Act - which
                                                   was passed last year in response to
                                                   scandals at Enron Corp., WorldCom
                                                   Inc., and other companies - now
                                                   requires many publicly traded banks to
                                                   comply with stepped-up reporting
                                                   guidelines.

                                                   In response to one of these questions,
                                                   25% of the bankers said that by the end
                                                   of this year they expect to have audit
                                                   committees composed solely of outside
                                                   directors, including at least one
                                                   "financial expert." Among bankers at
                                                   publicly held banks, the figure was
                                                   38%.

                                                   Forty-four percent of the bankers said
                                                   that they were considering taking out
                                                   more liability insurance for their banks
                                                   and boards. But 18% of all respondents
                                                   - and 11% at publicly held banks - said
                                                   that they did not feel compelled to do
anything specific in response to Sarbanes-Oxley.

The survey was mailed to more than 5,000 community banks and garnered 518 responses.
The statistical margin of error is around 5%.

Industrial Charter Gains Steam on the Hill

From: American Banker
Thursday, April 17, 2003
By Michele Heller

WASHINGTON - Despite vocal objections from Federal Reserve Board Chairman Alan
Greenspan and other policy heavyweights, efforts to expand the powers of industrial loan
companies are gaining traction in Congress.
                                                                                            55



The House passed a bill this month to let banks pay interest on business checking. The
measure includes a provision to let industrial loan companies offer negotiable order of
withdrawal accounts to corporate customers.

Separately, a broad regulatory relief bill moving through the House Financial Services
Committee would give banks and industrial loan companies the authority to use start-up
branches to cross state lines.

These bills are being pushed by lawmakers from some of the five states - such as
California and Utah - that offer industrial loan company charters and want to make them as
attractive as possible to nonbanks and others. But the effort is opposed by Mr. Greenspan
and other policymakers, who contend that expanding these charters will weaken the legal
wall that separates banking and commercial activities.

Rep. Jim Matheson, D-Utah, one of the sponsors of the amendment to the business-
checking bill that would let industrial loan companies offer NOW accounts (which pay
interest) to commercial users, said the provision was a matter of fairness. "It is about
offering two entities … parity in terms of offering the same service," he said April 1 on the
House floor.

But Mr. Greenspan, in a letter last month urging House Financial Services to reject the
amendment, said it would undermine existing law.

"This amendment would alter the structure of banking in the United States and be contrary
to two important national policies that Congress reaffirmed recently in the Gramm-Leach-
Bliley Act: one prohibiting the mixing of banking and commerce, and the other
establishing a federal prudential framework to assure that companies that own insured
banks operate in a safe and sound manner," he wrote.

Former House Banking Committee Chairman Jim Leach has raised similar concerns.

Their arguments failed in committee and in the full House.

Others say the debate is less philosophical, and more about a turf war between the Fed and
the states that offer the industrial loan charter.

The Fed has long objected to the industrial loan companies, because it regulates neither
them nor their holding companies. That was one of the reasons the central bank opposed
the provision in the regulatory relief bill to give industrial loan companies, along with
banks, de novo interstate branching authority.

"We continue to believe that Congress should not grant this new branching authority …
unless the owners of these institutions are subject to the same type of consolidated
supervision and activities restrictions as the owners of other insured banks," Fed Governor
Mark Olson told the committee at a March 27 hearing.
                                                                                            56



Batting for the industrial loan charter are lawmakers from California, Utah, and other
states that offer it, including Sen. Robert Bennett. The powerful Utah Republican, who
chairs the Senate Banking financial institutions subcommittee, last year blocked the Senate
from voting on an business-checking interest bill that did not give industrial loan
companies similar authority.

Another proponent is Rep. Ed Royce, R-Calif. "Contrary to the concerns raised by the
Federal Reserve, FDIC Chairman Don Powell … testified that there are no safety and
soundness concerns with this amendment and that the FDIC has no objection to an
authorization for ILCs … to pay interest on NOW accounts held by businesses," he said
during the debate on the House floor.

Gordon Miller, a counsel at the law firm of Hogan & Hartson LLP and a former counsel at
the Fed, said the charter needs help from its state delegations.

"Before, the only way a nonbank holding company could do anything like banking" was
with an industrial loan charter, he said. "Now there are broader affiliates that are possible.
For example, Merrill Lynch can now own a bank. It doesn't just have to own an ILC. So
the ILCs now have to" find ways "to be competitive."


Industrial Charter Could Be Wal-Mart's Way In
From: American Banker
Thursday, April 17, 2003
By Rob Blackwell

WASHINGTON - Wal-Mart Stores Inc. has failed in three attempts to enter the banking
business, but observers say the Bentonville, Ark.-based retail giant has not yet conceded a
strikeout.

Since 1999 national and state lawmakers have nixed two applications by Wal-Mart to
acquire financial institutions in Oklahoma and California. And this week Toronto-
Dominion Bank's TD Bank USA announced that it has been unable to overcome
regulatory obstacles in its proposed partnership with Wal-Mart to offer checking and
savings accounts in as many as 100 stores.

Community bank opponents, who claim its entry could overwhelm them, are already
predicting that Wal-Mart will try again.

"The problem with these financial services commercial mutants is that they can lose and
lose and lose, but they only have to win the battle once," said Kenneth Guenther, the
president of the Independent Community Bankers of America.

A spokesman for Wal-Mart said Wednesday that it had no immediate plans to pursue
another such purchase. He would not speculate beyond that.
                                                                                              57



Industrial loan companies are one of the few kinds of financial institutions that
nonfinancial firms can own, and two bills in Congress that would lift restrictions on them
could make them even more attractive, several observers said. [See related story.]

Last year Wal-Mart applied to buy Franklin Bank of California. After community bankers
mobilized against the application, a state law was passed preventing nonfinancial firms
from buying industrial loan companies there.

Such purchases are still legal in four other states - Colorado, Minnesota, Nevada, and Utah
- and Wal-Mart's opponents are trying to eliminate those alternatives.

Bankers are pushing a bill in Nevada that is similar to the California law. The bill passed
the state Assembly's Commerce and Labor Committee on Friday - but, according to
sources, only after an exemption was added to let Toyota Motor Corp. buy an industrial
loan company there. A vote in the full chamber is expected next week; it would then go to
the Senate for consideration.

If the Nevada legislation is enacted, bankers are expected to lobby for similar bills in the
remaining three states. They would probably face an uphill battle in Utah: As of the end of
2001 there were 53 industrial loan companies in the United States - 20 of them based
there.

Utah regulators and lawmakers have shown little inclination to change its industrial loan
charter. In an interview last year G. Edward Leary, the state's commissioner of financial
institutions, defended it, saying that he "would not like to see the appeal of this charter
diminished."

But many observers had not expected California to restrict their ownership either.

Randy Dennis, the president of DD&F Consulting in Little Rock, who advised Wal-Mart
on its attempts to buy Franklin Bank and a unitary thrift in Oklahoma in 1999, called the
California experience "frustrating" for him as well as for the retailer.

Mr. Dennis said Wal-Mart has been portrayed incorrectly. He argued that bank ownership
would simply be a way for it to save money on debit system processes - not to offer retail
services.

He added that the purchasing campaign, and the drive to partner with TD Bank USA and
local community banks, have been intended to help Wal-Mart customers - 20% of whom
do not have bank accounts, according to the company.

"I'm surprised sometimes at the strong feeling people have about Wal-Mart," Mr. Dennis
said. "They are interested in serving their customers and providing what their customers
ask for."
                                                                                            58



Legislative exceptions, such as the one for Toyota in Nevada's bill, are fundamentally
unfair, he said. "I just have this sense of fairness against the idea that anybody in the world
can own a bank but them."

Chris Armstrong, Toronto-Dominion's chief marketing officer, said the partnership deal
was called off because of a "regulatory challenge" from the Office of Thrift Supervision.
He would not discuss the objection in detail, but several sources said the OTS saw the
proposed partnership as giving Wal-Mart too much control over the branches, and thus
violating the ban on mixing banking and commerce.

Mr. Armstrong said there were no immediate plans to resurrect the deal, but he did not rule
out doing so later.

Wal-Mart could find another willing partner and attempt to overcome the regulatory
obstacles, observers said.

Most agreed the retailer would not quit.

"They are not going to wave the white flag and go home," said Bert Ely, an independent
analyst in Alexandria, Va. "So the first five attempts don't work. The next could give them
the foothold they want."




Assignment: Search web for further skirmishes between banks and Wal-Mart.
                                                                                                       59



                 THIRD MINICASE: Financial Holding Companies
Between Jan. 1, 2000 and April 30, 2001, a total of 545 bank holding companies have
elected to become financial holding companies (FHCs), a new corporate form established
by the Gramm-Leach-Bliley Act. Firms choosing to become FHCs --a process that merely
involves giving the Fed formal notice-- are eligible to combine under one roof the array of
banking, securities and insurance businesses made possible by Gramm-Leach-Bliley's
repeal of former Glass-Steagall Act restrictions on financial sector activities.

After an inaugural year marked by rising interest rates, falling stock prices and disputes
over important regulatory issues like merchant banking powers, the FHC industry remains
a work in progress. Nevertheless, several trends emerged within the fledgling sector:
    Following an initial burst of activity, the pace of FHC elections has tapered off. On March 11, 2000
      --the first day for elections under the Gramm-Leach-Bliley Act-- the Federal Reserve announced
      that 117 firms had chosen FHC status. Over the next three months, an additional 197 firms joined
      this group. Since then, the rate of FHC formation has slowed dramatically, with only 231
      companies adopting FHC status in the past eleven months.
     As a group, FHCs hold $4.87 trillion in domestic assets (based on yearend 1999 data) --nearly one-
      quarter of all private, non-pension assets in the U.S. financial sector. The new FHC industry ranges
      in size from Citigroup to Florida Business BancGroup ($9.5 million) of Tampa. Of the 545 FHCs,
      289 have less than $250 million in assets and only 43 have more than $10 billion in assets.
     Despite the relatively large number of FHCs of modest size, the fledgling industry has been top-
      heavy from its start. The half-dozen largest firms (Citigroup, J.P. Morgan Chase, BankAmerica,
      First Union, MetLife and Wells Fargo) account for more than half of all FHC assets. Among
      America's 25 biggest banking firms, only Chicago-based Bank One has not adopted FHC status.
     Under the Gramm-Leach-Bliley Act, insurance companies and securities firms can become FHCs
      after acquiring or setting up a bank holding company. But so far, only a handful of the 545 FHCs
      are primarily involved in a financial business other than banking. And only two companies among
      this handful --discount broker Charles Schwab and insurer MetLife-- are large players.
     Among Federal Reserve Districts, the Sixth (Atlanta) and Tenth (Kansas City) have recorded the
      greatest number of FHC elections (84 and 81, respectively). But firms in the New York Federal
      Reserve District account for more than two-fifths of all domestic FHC assets as well as a huge
      volume of offshore activities --providing the New York Fed with a daunting regulatory challenge in
      is role as frontline umbrella supervisor of the FHCs. Of 23 FHCs based outside the United States,
      the New York Fed supervises all but two.

Source: The Financial Markets Center web site. This site provides summary statistics on
the FHC industry as well as a running inventory of all FHCs and their assets on a Reserve
District-by-Reserve District basis at: www.fmcenter.org
Assignment: Use this website to determine how many FHCs exist today.




FHC HIGHLIGHTS
Number of FHC Elections since First Round on 3/11/00: 428
Largest U.S.-based FHC: Citigroup ($716.9 billion in assets at 12/31/99)
Smallest FHC: Florida Business BancGroup, Inc., Tampa, FL ($9.5 million in assets)
                                                                                                          60



Average Asset Size of FHCs: $8.9 billion
FHC Assets as Percentage of All U.S. Financial Sector Assets: 14 percent
FHC Assets as Percentage of All U.S. Private Non-Pension Financial Sector Assets:
   23 percent


     FIRMS1 ELECTING TO BECOME FINANCIAL HOLDING COMPANIES
         UNDER THE GRAMM-LEACH-BLILEY ACT (May 11, 2001)
                                FHCs by Asset-Size Category3
     Federal       FHCs in    <$50   $50m- $250m >$10b                  Total        Largest Banking Firm Not
    Reserve        District2   m     $250m -$10b                      Assets (in         Converted to FHC
     District                                                          billion)
Boston                12         0         8         2         2        $254       Citizen's Financial Group
New York              45         0         3        24         9       $2,039      Summit Bancorp
Philadelphia          24         1         7        16         0         $30       MBNA Corporation
Cleveland             46         2        16        21         7        $437       First Merit Corporation
Richmond              28         0        12        11         4       $1,017      All First Financial Corp.
Atlanta               84         5        45        26         8        $302       Synovus Financial Corp.
Chicago               64         4        32        22         5        $247       Bank One Corp.
St. Louis             42         4        22        15         1         $32       Union Planters Corp.
Minneapolis           35         4        20         9         2        $104       Victoria Financial Services
Kansas City           81        13        46        21         0         $46       UMB Financial Corp.
Dallas                43         8        19        16         0         $27       Southwest Bancorp of TX
San Francisco         41         0        18        18         5        $337       UnionBanCal Corp.
Total                545        41       248       201        43       $4,873
Source: Constructed from Federal Reserve; FFIEC; FDIC; company report by FOMC Alert (5-15-01)
1
  Firms include bank holding companies (BHCs) as well as nonbank enterprises.
2
  Larger than row totals form some districts because not all FHCs can be classified by asset size.
3
  Assets as of 12/31/99. Does not include assets held outside U.S. by foreign firms.




      FOURTH MINICASE: Changing Landscape of Competition Among Banks

Rivals Ready to Woo Fleet Customers
American Banker Friday, February 27, 2004
By Geeta Sundaramoorthy
New England Banking companies are drawing up marketing plans to attract customers
they say the latest Fleet deal will shake free.
The Charlotte colossus Bank of America Corp. is expected to complete its purchase of
FleetBoston Financial Corp. by mid-spring. Executives from New England's other large
banks are vying for disgruntled Fleet customers, as they have over the last decade after
repeated acquisitions by Fleet in the region.
Banknorth Group of Portland, Maine, Citizens Financial Group of Providence, R.I., and
Sovereign Bancorp of Philadelphia plan major marketing offensives in the coming months,
                                                                                        61



each trying to cast itself as the New England bank. All three have been busy buying
smaller competitors and say they will keep hunting for fill-in deals.
All three claim to have benefited from Fleet's merger integration stumbles in the past. And
Sovereign owes practically its entire New England presence to Fleet, which sold it $12
billion of deposits and 270 branches in 2000 as part of its merger with BankBoston Corp.
The race to be the dominant local bank in New England - a market characterized by high
household incomes and strong middle-market banking activity - set off a merger wave.
Since 2001 there have been 48 deals in the region, including the pending purchase of Fleet,
according to data from SNL Financial.
Combined with Fleet, Bank of America would be the market leader, with 23.7% of New
England deposits. After pending deals, Citizens would have 12.8%, Banknorth 6.6%, and
Sovereign 6.5%, according to data from SNL Financial and Sandler O'Neill & Partners LP.
(This ranking excludes State Street Corp., which numbers among the leaders in deposits
but no longer does retail or commercial banking.)
Analysts and bankers said they expect acquisitions in the region to continue. And
eventually, says Mark Fitzgibbons, an analyst with Sandler O'Neill, Citizens, Banknorth,
Sovereign, and Webster Financial Corp. of Waterbury, Conn., will command enough of
the market to make themselves takeover targets by larger out-of-region companies.
"There will be a second wave of consolidation," he said.
For now, however, the three contenders are drafting game plans for getting business away
from Bank of America.
Banknorth, Citizens (owned by Royal Bank of Scotland), and Sovereign all emphasize that
they have decentralized models, positioning themselves as community banks empowered
to make decisions locally instead of having to wait for approvals from a distant
headquarters. This approach also helps Pennsylvania-based Sovereign and Citizens (which
is owned by Royal Bank of Scotland) cast themselves as local banks.
Sovereign's chief executive officer, Jay Sidhu, spends time in New England wooing
potential customers by regularly meeting with state chambers of commerce and political
leaders. In the last two to three years the company has also spent about $30 million
developing new products. On Thursday, it unveiled a multimillion-dollar sponsorship with
the Boston Red Sox, and it is preparing to roll out a new branding campaign in New
England in the next few months.
In a telephone interview, Mr. Sidhu insisted that his $43.5 billion-asset company is as
local as any of the homegrown New England banks, because customers "look at where the
decisions are made."
                                                                                         62



Meanwhile, Citizens, with $73 billion of assets, has grown in the region by acquisitions in
Connecticut and Massachusetts. Robert Mahoney, its vice chairman in charge of New
England banking, said it is organized by state, and each state has a local president and
management. "That is what customers want," he said, echoing comments made by
Sovereign executives in the market. "They want local decisions and the convenience of a
large bank."
Citizens also uses community outreach, giving each of its branches up to $3,000 to spend
as it pleases on the local community.
Banknorth, which now calls itself the region's largest home-grown bank, has substantially
increased its marketing spending and is set to begin a direct-mail campaign aimed at Fleet
customers. In mid-January it began an advertising campaign featuring a local celebrity,
Boston Bruins defenseman Ray Bourque.
Each of these banks claims to have gained ground at Fleet's expense. The Commonwealth
of Massachusetts switched its account to Sovereign at the beginning of the year, after
several years with Fleet, a move Sovereign executives like to bring up.
Mr. Sidhu has said several times that Sovereign expects to increase its loans and deposits
by $1 billion in the next few years, some by way of acquisition, but some by successfully
courting Fleet customers.
Jim Schepker, a spokesman for Fleet, said that though it lost some of the commonwealth's
business, it is not losing New England business in general. He pointed out that last year,
while other banks were claiming that Fleet's customers were defecting to them, its core
deposits actually rose 11%.
Bank of America has no branch overlap in the region, Mr. Schepker added, so the market
disruption others predict is unlikely to happen.
Gerard Cassidy, an analyst with Royal Bank of Canada's RBC Capital Markets, pointed
out that New England regional community banks have campaigned aggressively to attract
customers each time there has been a big bank merger or acquisition, however, there is no
evidence that the big banks have lost meaningful numbers of customers.
Even if Sovereign managed to get $200 million worth of business from former Fleet
customers, Mr. Cassidy said, that loss would be like a rounding error for a Bank of
America, whose post-merger assets would be nearly $1 trillion.
"It is good for Sovereign, but is [B of A chief executive] Kenneth Lewis losing sleep over
it? Of course not," Mr. Cassidy said.
Sovereign and Citizens have been reiterated that their strategy for growth does not depend
on runoff from the Fleet deal. Mr. Mahoney said Citizens has grown 15% to 20% annually
                                                                                              63



for years. Mr. Sidhu said Sovereign will grow 10% to 15% a year with or without Fleet
customers.
The contestants also acknowledge that they would need to be quick on their feet to capture
Fleet customers or solidify their market position.
William Ryan, Banknorth's chief executive, said in a recent interview with American
Banker that his company must act fast, because once the integration is completed, Bank of
America could emerge as an even stronger competitor than Fleet.



B of A is a better retail bank than Fleet, he said, "so there is a possibility of them actually
increasing market share."




FDIC State-of-Banking Study Argues for New Yardsticks
American Banker Thursday, March 25, 2004
By Barbara A. Rehm
WASHINGTON - Banking may be down, but it's not out.
At least that's how the Federal Deposit Insurance Corp. sizes up the industry after taking a
hard look at the way commercial banks have adjusted to the evolution of the credit
                                                                                            64



markets.
To be sure, as nonfinancial debt has soared since the early 1980s, commercial banks' share
of the market has plunged, to roughly 20% of the total today. But in a study due out today,
the FDIC argues that traditional market-share measures miss the boat. The way people and
businesses borrow has changed so much - particularly because of securitization - that other
yardsticks such as noninterest income or even overall earnings are needed.
"Banking is evolving but does not appear to be declining," the report concludes. "Although
commercial banking's on-balance-sheet activity has declined as a piece of the credit-
market pie, the industry's off-balance-sheet activities are a growing source of income."
"The Evolving Role of Commercial Banks in U.S. Credit Markets" is the first of a half-
dozen studies expected to be published over the next six to eight weeks by the agency,
which is trying to spark debate over the future of banking.
The research "will stimulate discussion among bankers and regulators about the trends we
see in banking today and their future implications," FDIC Chairman Don Powell said
Wednesday. "This information will affect the decisions we make in the coming years to
ensure a healthy industry and a responsible regulatory approach."
In a speech scheduled for Friday, Mr. Powell is expected to lay out some of the public-
policy choices raised by the agency's research including how best to supervise megabanks
and how fiercely to guard the line between banking and commerce.
The agency began this effort in early 2003, and it is clearly part of Mr. Powell's strategy to
bolster the FDIC's reputation as the source of information about the banking industry.
In an interview Wednesday, Art Murton, the director of the FDIC's division of insurance
and research, said forthcoming reports will cover consolidation generally; the creation of
megabanks; the future of community banks including a look at the impact of rural
depopulation; monoline lenders; and payments systems.
After the business-oriented papers are released, the agency expects to issue one or more
papers on the public-policy issues raised by these trends.
"We think now is a good time to take stock of the trends that took place in the times of
crisis and prosperity and offer our thinking on what these trends may mean for the future,"
Mr. Murton said. "While we've seen significant changes, we think there is more to come."
The first study was authored by Katherine Samolyk, a PhD economist in Mr. Murton's
division who specializes in credit market research. Her 45-page report concludes that
though securitization has siphoned industry assets to the balance sheets of many other
types of financial services firms, commercial banks still play a key, if less direct, role in
the loans being pooled.
                                                                                           65



"Balance-sheet data on who is funding loans can be a poor proxy for who is providing the
financial services associated with the credit flows," according to the study.
"Commercial banks provide significant services in originating, servicing, and enhancing
the liquidity and quality of credit that is ultimately funded elsewhere," it states. "Hence,
market-share measures based on balance-sheet data are likely to understate the importance
of banks to a greater extent than even a decade ago."
Ms. Samolyk turns to the exceptional growth in noninterest income as proof. The
commercial banking industry's noninterest income relative to net operating revenue
increased to 42% in 2003 from 18% in 1980, according to the study.
Banks formerly reported fee income as a bulk number, but in 2001 the government
required a finer breakdown. Fees from servicing and securitizing loans made up 17.8% of
total noninterest income that year while fees from other relatively new sources - trading,
investment banking, and insurance - added another 13%.
More broadly, Ms. Samolyk notes that banking's share of total industry profits has held
steady - not what one might expect given the shrinkage in on-balance-sheet lending.
But of the profits posted by publicly traded financial companies, banks and thrifts
averaged 44% from 1992 to 2002 - comparable to their share before the problems that
plagued the industry during the 1980s.
Ms. Samolyk also found that commercial banks' share of business lending has remained
stable at 30% for five decades.
However, she found banks are approaching business customers differently, including "a
notable shift … from shorter-term lending not secured by real estate to loans secured by
business real estate."
"This shift partly reflects increased competition from the commercial paper market,
finance companies, and asset-securitization," she wrote. "The shift also reflects the
continuing comparative advantage in business real estate lending, a form of lending less
well suited to the standardization necessary for asset securitization."
According to her research, banking's share of nonfinancial debt peaked at 30% in 1974 and
has steadily declined, hitting 20% in 1992 and remaining fairly flat since then. Meanwhile,
competitors such as mutual funds, asset-backed securities issuers, and government-
sponsored enterprises like Fannie Mae have expanded. [See chart page 1.]
According to the study, GSEs and federally related mortgage pools now fund nearly half of
all outstanding home-mortgage debt, up from 35% a decade ago and 10% in 1983.
Looking just at consumer debt, Ms. Samolyk found the banking industry's share has
declined to roughly one-third from nearly 50% in 1994. Securitized pools hold another
                                                                                          66



third while finance companies, thrifts, and credit unions have the balance. Ms. Samolyk
said credit unions "have fared the best among traditional intermediaries in terms of
maintaining market share."
The report, an appendix, and 17 pages of charts are available at www.fdic.gov.
                                                                                           67




Preemption Just Piece of the Puzzle
From: American Banker
Tuesday, April 13, 2004
By Barbara A. Rehm


WASHINGTON - Quick, name a big state-chartered thrift.
Can't? It's because there aren't many.
It wasn't always that way. Until 1980 state-chartered thrifts outnumbered those with
federal charters - 2,009 to 1,984. But then the state charter began a slow, steady decline as
the Office of Thrift Supervision (and its predecessor) promoted the federal charter's power
to preempt state laws.
Today there are just 113 state-chartered thrifts, compared with 808 federal ones. The five
largest federal thrifts hold 42% of the industry's $1.09 trillion of assets, and the OTS'
budget is so dependent on these institutions' retaining their federal charters that critics
claim the agency cannot afford to tick them off, leading to passive supervision.
Is preemption's next victim the state banking charter? Will the Office of the Comptroller
of the Currency soon find itself captive to a handful of large national banks?
That's the scenario being outlined by a loud and growing set of critics who condemn the
                                                                                              68



OCC's latest moves to preempt state laws.
"There is no doubt that if this does not change, I don't think there will be a single, large
multistate bank operating under a state charter," Arthur E. Wilmarth Jr., a law professor at
George Washington University, testified April 7 as the Senate Banking Committee probed
the effect of the OCC's moves.
"If the federal rules stand, within the next several years you will rapidly see what happened
in the thrift industry - the state charters will dwindle to almost nothing," Prof. Wilmarth
said in a follow-up interview. "The national banks may not realize what they are setting
themselves up for. They will have nowhere to go if they don't like what that regulator is
doing."
The demise of the dual banking system has been predicted before, most recently in the
mid-1990s, when Congress swept away state barriers to interstate banking.
But over the last five years more banks have actually dropped their national charters in
favor of state charters than vice versa. According to the Federal Deposit Insurance Corp.,
125 national banks with $97 billion of assets have converted to state charters, while 70
state banks with $78 billion of assets have adopted national charters.
Five-year trends at national and state banks move in the same direction - there are fewer
companies, which are larger and more profitable. Yet the magnitude of the trends add
interesting detail.
While there are 18.6% fewer national banks, or 2,001, than there were in 1998, the ranks
of state banks have shrunk only 8.7%, to 5,768 companies. Assets held by national banks
soared 35% over that period, to $4.3 trillion, but state bank assets increased even more -
46.5%, to $3.31 trillion.
Annual net income at national banks ballooned 67%, to $63 billion, but state banks were
not far behind, with a 64% jump, to $39.6 billion.
In an interview, Comptroller of the Currency John D. Hawke Jr. defended his agency's
moves to preserve a single set of rules governing national banks - and dismissed as
"nonsense" the idea that preemption could destroy the dual banking system.
"Preemption has been around for 140 years in the national banking system, and there has
been tremendous equilibrium in the system," Mr. Hawke said.
In fact, if either side has an advantage, he says it is the states. State-chartered banks do not
have to pay for exams done by the Federal Reserve and the FDIC, which share with state
banking departments the responsibility for ensuring the safe and sound operation of state
banks.
"State banks get about $1 billion a year in federal subsidies that national banks don't get,"
                                                                                           69



Mr. Hawke said. "If Diana is really concerned about the dual banking system, she ought to
work with us to equalize the playing field on the fees banks have to pay for supervision."
"Diana" is Diana Taylor, New York's banking superintendent and one of Mr. Hawke's
most determined detractors.
"The idea that suddenly the sky is falling, and Diana Taylor is playing Chicken Little, is
really nonsense," Mr. Hawke said. "There is no evidence that the equilibrium in the dual
banking system is going to be affected by anything we did."
(The OCC in January put the crowning touch on years of rules delineating its authority to
preempt state and local moves to curb national bank operations.)
Still, there is no denying the national charter has attracted a majority of the industry's
assets, and some observers say consolidation - not preemption - will doom the dual
banking system.
Of the 50 largest banks, 26 hold national charters. Seven of the top 10 use national
charters, and that number will soon jump to eight when HSBC Bank USA converts from a
New York state charter.
That will leave only J.P. Morgan Chase Bank and SunTrust Bank.
JPMorgan Chase is moving its non-New York deposits to a federal thrift charter and
refuses to say what it will do with its New York state charter once its acquisition of Bank
One Corp., which uses a national charter, is completed. But outsiders predict JPMorgan
Chase will bleed assets from its state charter and finally flip to a national charter in 2006,
when Bank One's leader, James Dimon, takes the helm.
That leaves SunTrust as the only top 10 state charter not in doubt. Executives of the
Atlanta bank did not want to be interviewed for this story, but a spokesman said it has no
intention of abandoning its Georgia state charter. "The charter we have works for us, and
we don't have any plans to change it."
While experts agree that banks have switched into and out of the national charter for years,
few envision any of the largest banks surrendering their federal charter. It simply offers too
much convenience for companies operating in large chunks of the country.
Beyond the top 10, there are more question marks and defections. Take Regions Bank,
which has an Alabama state charter and is combining with the nationally chartered Union
Planters Bank. A Regions Financial Corp. spokeswoman said the decision of which charter
to use is one of many merger questions still to be worked out.
Colonial Bank in Montgomery, Ala., quietly switched to a national charter in August. On
Monday, a bank spokesman said its president, Flake Oakley, did not want to explain why
the unit of Colonial BancGroup Inc., a $16.2 billion-asset holding company operating in
                                                                                            70



six states, made the move.
And while the split among the top 50 is relatively even, the asset count is lopsided. The
national banks among the top 50 hold 74% of the $6.8 trillion of total assets.
"The major force weakening the dual banking system is the ongoing consolidation of the
industry," said Kenneth A. Guenther, a consultant to the Independent Community Bankers
of America.
John W. Ryan, the executive vice president of the Conference of State Bank Supervisors,
blames preemption, but he agreed consolidation is a factor.
Take, for example, the possibiilty that large national banks buy half of the state-chartered
top 50 banks. "Think about what that means in terms of the concentration of power and
risk in one regulator. There are more and more assets in fewer and fewer institutions. If
you look at the OCC, it takes action against the little guys." The major national banks have
become "too big to criticize."
What are the dangers of entrusting oversight of so much of the industry's assets to one
agency?
Ms. Taylor has a long list. For starters, she argues that the skills needed by state regulators
to supervise large, complex banks will atrophy and that over time the states will lose the
ability to police the biggest banks.
"State supervisors' ability to oversee the large complicated institutions could deteriorate,"
she said in a speech March 25. "The fate of these very important institutions would then be
left in the hands of an individual where literally an act of Congress is required to change
something he does, as we have found out. The chair of the OCC has a huge amount of
power, with very little oversight."
She called on Congress to block the OCC rules "before a wave of bank charter flips
seriously wounds or destroys the dual banking system."
(Sen. John Edwards, D-N.C., and Rep. Barney Frank, D-Mass., are pushing resolutions
that would overturn the OCC's rules. But the lawmakers are working on tight deadlines:
the House has until mid-May to act, while the Senate has until June.)
Ms. Taylor also warned her audience of bankers that future comptrollers might not be as
accommodating as Mr. Hawke.
Prof. Wilmarth, who is a paid consultant for CSBS, the national association of state
banking commissioners, made the same point in his Senate testimony: "I think the large
banks may well regret what they are now pursuing … when they get a regulator from
which there is no exit, no option."
The OCC is already captive to its largest customers, he said in an interview. "I can't find a
                                                                                            71



single tough enforcement action taken against a large national bank."
Robert Garsson, an OCC spokesman, denied it is hesitant to take action.
"We take consumer protection very seriously, regardless of the size of the bank," he said
Monday. "We will take aggressive enforcement actions if we need to."
That often is not necessary, because when the OCC passes complaints along to national
banks, they "take very quick steps to fix things," Mr. Garsson said.
Beyond the state regulators, Prof. Wilmarth also questioned whether the Fed and the FDIC
will be able to retain their bank supervision roles.
"At some point it is going to be hard for the FDIC and the Fed to say, 'We should have
significant supervisory roles' if all the banks hold national charters," he said. "The balance
of regulatory power has followed the balance of chartering power."
Prof. Wilmarth also said when it comes to supervisors, more is better. He pointed to the
securities business, where state authorities uncovered conflicts of interest and preferential
treatment for lucrative customers.
"The mutual fund scandals are object lessons - all those scandals were exposed by state
regulators. The states had their own incentives and authority to go after abuses and protect
their consumers," he said. The Securities and Exchange Commission - "maybe they were
just stretched too thin."
Neil Milner, the president of the Conference of State Bank Supervisors, agrees with Mr.
Hawke that the popularity of both state and national charters ebbs and flows over time. But
he also says the OCC has overreached, broadening its preemption authority too much.
                                                    National standards are fine, but state
                                                    regulators should still get to enforce
                                                    them, he said. National bank
                                                    subsidiaries should still be required to
                                                    get state licenses, and state regulators
                                                    should still have access to companies
                                                     operating in their jurisdictions.
                                                     "We need to keep the options open so
                                                     that even the biggest institutions have
                                                     reasons to have either charter," Mr.
                                                     Milner said. "Neither charter should be
the charter of choice for all institutions."
72
                                                                                           73




FDIC Sees Giants Gaining, Trouble for Rural Banks
American Banker Tuesday, May 18, 2004
By Barbara A. Rehm
WASHINGTON - That the industry's largest players keep getting bigger is not news, but
research due out today from the Federal Deposit Insurance Corp. puts that conventional
wisdom in stark relief.
The FDIC found the 25 largest banks stole deposit share from both community and
regional banks in every one of four types of markets: urban, large metro suburban, small
metro, and rural.
For instance, in urban areas the top 25 controlled 61.6% of the deposits at yearend, more
than double their share in 1985. Meanwhile regional banks' share shrank to 29.4%, from
54.5%, and community banks lost more than half their share, to 9%.
In large suburban areas, the top 25 had 41% of the deposits at yearend, up from 8.6% in
1985. The shares of both community and regional banks fell roughly 16 percentage points
each, to 22% and 37%, respectively.
                                                                                          74



"The numbers do not lie. The large banks are eating the lunch of smaller institutions, but
that's not the whole story," Fred Carns, a deputy director in the FDIC's division of
insurance and research, said in an interview Monday.
"Community bank performance has been quite good, and they continue to be very
important lenders to some key sectors, like small-business and agriculture. But the pie has
grown so much, and it's the big banks that have taken that growth."
As part of the Future of Banking series, the FDIC is releasing three papers today - all
focused on community banks. One covers the history of community banking, its current
performance, and its prospects. A second examines the declining number of banking
companies and concludes that the trend is slowing. The third focuses on the impact of rural
depopulation, with a particular eye on the Great Plains states.
The goal of the series is to spark debate, which could lead to policy changes, about the
industry's prospects. For instance, the concentration of assets in large banks has prompted
the agency to consider changes to the way it determines insurance premiums.
FDIC Chairman Donald Powell has floated the idea of a two-tier system of both premiums
and regulation. He is expected to return to the topic in a speech scheduled for Wednesday.
From 1985 through 2003 the ranks of community banks and thrifts were thinned nearly
50%, to 7,337. By 2013, the FDIC forecasts, the number of insured institutions will range
from 6,480 to 7,167, or 17.4% to 8.6% fewer than today's 7,842.
Breaking the industry down into four asset-size categories, the FDIC said only the $10
billion-plus segment is expected to expand in the next 10 years. The FDIC expects this
largest-bank category to increase to 95 institutions by 2013, from 71 today.
Meanwhile, the number of banks with less than $100 million of assets is expected to
decline by 43.4%, to 1,483.
Still, the rate of decline in the number of banking organizations is slowing and is expected
to slow further, the FDIC said.
"We project that the long decline ... may even grind to a halt within the next five to 10
years," the FDIC said.
A flip side to the consolidation story is the explosion in banks being formed. Since 1992,
1,250 banks have been created, and the FDIC said 1,100 of these are still operating
independently. Only four have failed, the agency said.
The biggest challenges facing community banks, the FDIC said, are finding and retaining
qualified employees, competing with credit unions and larger banks, and shouldering the
cost of government regulation.
In its paper on rural depopulation, the FDIC found 779 of the nation's 3,141 counties
                                                                                          75



shrank between the 1970 and the 2000 censuses. At yearend there were 1,451 community
banks, with $132 billion of assets, headquartered in rural communities with declining
populations, the FDIC said.
Most of these counties are in four areas: the Great Plains states, the upper Midwest, middle
southern states, and Appalachia.
The Great Plains states, east of the Rockies and west of the Mississippi River, are the most
vulnerable. Forty-six percent of the banks headquartered there are in counties with
declining populations.
One of the biggest reasons, the FDIC said, is technological advances that have allowed
farmers to do more work with fewer people. A second key factor, the agency said, is the
"Wal-Mart effect": People moving to counties that have giant retailers' franchise stores.
Community banks in the shrinking counties face problems on both sides of the balance
sheet, in gathering deposits and lending.
"We foresee increasing consolidation in depopulating rural areas, potentially dramatically
altering the number of institutions over the next 20 years," according to the paper on rural
areas.
"Community bank consolidation in these areas has yet to outpace that elsewhere in the
nation, but two factors are reaching a critical juncture," the FDIC said. First, the "large
pocket of very elderly in rural depopulating counties threatens to significantly weaken
community bank funding bases." Second, "the lack of succession plans due to the absence
of younger, capable bank managers in some areas could leave many retiring bank owners
with no option but to sell."
While strategic options are limited for banks in these counties, two possibilities are
branching into more economically vibrant areas and cutting costs, the FDIC said.
The FDIC's first Future of Banking study, released in late March, covered the evolution of
the U.S. credit markets and the role commercial banks play. The next study will focus on
small-dollar payments systems.



                       FIFTH MINICASE: Accounting Reforms

PNC Retools Its Financial Reporting
Changes are meant to highlight growth in consumer banking

From: American Banker
                                                                                         76



Thursday, April 8, 2004
By Geeta Sundaramoorthy
To improve disclosure and capital management, PNC Financial Services Group Inc. is
changing some accounting methods, including how it allocates capital to various
operating units.
The Pittsburgh company expects the changes to reduce volatility in retail banking earnings
and make it easier for analysts and others to separate the performance of its core
businesses from its asset and liability management activities.
PNC spent two years improving its internal controls, risk management programs, and
accounting practices after the Federal Reserve Bank of Cleveland and the Securities and
Exchange Commission raised objections to its accounting for some off-balance-sheet
activities.
Chief financial officer William Demchak said in a telephone interview Tuesday that the
new reporting structure is unrelated to the regulatory troubles but is "another step" toward
improving disclosures. Mr. Demchak, who joined PNC in 2002 from J. P. Morgan Chase
& Co., said he had been talking about making the changes from early in his tenure.
The $71 billion-asset company told analysts of its plan during a conference call Monday. It
will report first-quarter results April 21 using the new format.
Securities earnings that once were reported as part of its retail banking division will be
reported separately. PNC is also consolidating wholesale divisions to reduce "noise" and
implementing risk-based capital allocation.
Gains and losses from securities trading and mortgage warehouse will be removed from
the regional community banking division and be included in the "other" category on the
company's income statement, Mr. Demchak told analysts. "This would give you a cleaner
view of the businesses' performances."
In the interview he said PNC had reported "a lot of volatility in the retail community
banking line item because we would have securities gains or losses or we might buy or sell
wholesale mortgages." By including securities gains with retail bank earnings, he said, "we
were masking the underlying performance" of the retail business.
PNC was unique in allocating profits from such asset and liability management to business
lines, Mr. Demchak said.
The company is also consolidating wholesale banking activities, including corporate
lending and banking and real estate finance, into one business. Reporting them separately,
as it has done, was "too noisy," Mr. Demchak said.
                                                                                            77




Management discussion and analysis will now address client acquisitions, lending trends,
and fee income for the whole segment, he said.
Mr. Demchak acknowledged that the changes will make the "other" category in the
financial statements more complex; eventually, PNC will probably divide "other" into
several line items, he said.
Had the new accounting been applied to 2003 earnings, the retail bank's results would
have been 21.5% lower than reported and the wholesale bank's 27% higher. Analysts were
given two years' worth of reworked data for historical comparisons, Mr. Demchak said.
Jason Goldberg, an analyst with Lehman Brothers, said the changes would make
comparing the businesses much easier.
Richard Bove, an analyst with Hoefer & Arnett, said the changes will seem to shift PNC's
regional community bank's efforts to core deposits. "We see the new direction of PNC to
be to emphasize its deposit gathering and nonlending business activity," he wrote in a
research report.
To better reflect risk levels, PNC also changed the way it allocates capital to each
business. It previously determined allocations through comparisons with similar
companies; now it has developed its own analytical model.
Each division will now pay or receive funds for each transaction on a cost base related to
the London interbank offered rate. For example, the retail bank would lend funds gathered
from deposits to the wholesale bank at Libor.
Mr. Bove wrote that a rise in interest rates would therefore help PNC's retail bank but not
the wholesale bank. But he said the wholesale operation could benefit by charging a higher
premium, which would mean making higher-risk loans.
Mr. Demchak said the changes will raise the retail division's return on equity and reduce
that of the wholesale unit but not affect ROE and other ratios at the holding-company
level.


April 17, 2004
Big Auditing Firm Gets 6-Month Ban on New Business
By FLOYD NORRIS

Ernst & Young, the big accounting firm, was barred yesterday from accepting any new
audit clients in the United States for six months after a judge found that the firm acted
improperly by auditing a company with which it had a highly profitable business
                                                                                          78



relationship.
The unusual order, which included a $1.7 million fine, brought to an end a bitter fight in
which the Securities and Exchange Commission had contended that Ernst violated rules on
auditor independence by jointly marketing consulting and tax services with an audit client,
PeopleSoft Inc.
"The overwhelming evidence," wrote Brenda P. Murray, the chief administrative law
judge at the S.E.C., is that Ernst's "day-to-day operations were profit-driven and ignored
considerations of auditor independence." She said the firm "committed repeated violations
of the auditor independence standards by conduct that was reckless, highly unreasonable
and negligent."
The rebuke to Ernst, which said it would not appeal the decision, is the latest
embarrassment for one of the Big Four accounting firms, which have come under heavy
criticism and increased regulation as a result of accounting scandals in recent years. Those
scandals led to the demise of Arthur Andersen, which had formerly been among the Big
Five.
The judge was harshly critical of the Ernst partner who was in charge of independence
issues, saying he kept no written records and had failed to learn enough facts before saying
the relationships between Ernst and PeopleSoft were proper. That partner, Edmund
Coulson, was chief accountant of the S.E.C. before he joined Ernst in 1991.
Ernst's consulting and tax practices used PeopleSoft software in their business, and the two
companies participated in some joint promotion activities. Ernst contended that it should
be viewed as a customer of PeopleSoft in the relationship, but the judge said it went far
beyond that.
She noted that Ernst had billed itself in marketing materials as an "implementation
partner" of PeopleSoft and had earned $500 million over five years from installing
PeopleSoft programs at other companies, which use the software to manage payroll,
human resources and accounting operations.
She issued a cease-and-desist order against the firm, saying it had refused to admit it had
done anything wrong and that there was no reason to believe it would not violate the rules
again. She also fined it $1,686,500, the total amount of audit fees the company received
from PeopleSoft in the years that were involved, plus interest of $729,302, and ordered
that an outside monitor be brought in to assure the firm complied with the rules in the
future.
S.E.C. officials said the decision would send a message to other firms. "Auditor
independence is one of the centerpieces of ensuring the integrity of the audit process," said
                                                                                          79



Paul Berger, an associate director of the commission's enforcement division, adding that
the judge's decision "vindicates our view that Ernst & Young engaged in a business
relationship that clearly violated" the rules.
Ernst, based in New York, had previously denounced the commission for seeking a ban on
new business, saying any such punishment was completely unwarranted. But last night the
firm said it would accept the ruling and would not appeal. It had the right to appeal to the
full S.E.C. and then to federal courts if the commission ruled against it.
"Independence is the cornerstone of our practice and our obligation to the public," said
Charlie Perkins, a spokesman for Ernst & Young. "We are fully committed to working
closely with an outside consultant in the review of our independence policies and
procedures."
Mr. Perkins said the firm had decided not to appeal because it wanted to put the matter
behind it, and emphasized that it would be able to continue serving its existing clients.
The six-month suspension appears to match the longest suspension on signing new
business ever imposed on a leading accounting firm.
In 1975, Peat Marwick, a predecessor of KPMG, agreed to accept a similar six-month
suspension as part of a settlement of charges it had failed to properly audit five companies,
including Penn Central, the railroad that went bankrupt.
In 1978, an administrative law judge imposed a similar suspension on Ernst & Ernst, a
predecessor of Ernst & Young, after finding that it had conducted bad audits. But the full
S.E.C. reduced the penalty to a censure, calling the suspension too severe.
In 1976, Seidman & Seidman, a firm that ranks below the top firms in terms of size of
business, accepted a six-month bar after the commission found it had failed to properly
audit clients that included the Equity Funding Corporation of America, which engaged in a
fraud that was then one of the largest ever.
This case, unlike those, did not involve bad audits. There was no accusation that Ernst's
audits of PeopleSoft were inaccurate, only that the accounting firm violated rules requiring
that it be independent from its audit clients.
In the 1990's, auditing firms greatly expanded their consulting businesses and chafed under
independence rules that many considered outmoded. They fought efforts to tighten those
rules in 2000 and managed to get the commission to weaken rules it had proposed.
Since then, however, some of the firms, including Ernst, have sold most of their consulting
businesses.
The Sarbanes-Oxley Act, passed in 2002, established the Public Company Accounting
Oversight Board, which regulates and inspects accounting firms and has issued new rules
                                                                                            80



on auditor independence. Those rules did not play a role in this case because it concerned
audits from 1994 through 1999.
Ernst declined to say how many new audit clients it typically added in a six-month period.
The exact date the suspension will begin was not clear and could be important. Companies
that switch auditors often do so soon after an audit is completed, which is about now for
companies that report on a calendar-year basis. The ban will affect companies that file
reports with the S.E.C., whether they are based in the United States or other countries.
Arthur W. Bowman, editor of The Accounting Report by Art Bowman, a newsletter, said
the firm might add 100 new audit clients a year but that it was unclear how much its
revenue would suffer. "It certainly doesn't do well for the firm's public image, but it doesn't
do much to the firm's bottom line," he said, noting that some partners of the firm earned
annual compensation of more than $1.7 million, the amount of the fine.
Ernst & Young's relationship with PeopleSoft, which is based in Pleasanton, Calif.,
appears to have been very profitable for the accounting firm, which installed computer
software for consulting customers. "In 1998," the judge wrote, Ernst "earned $150 million
from implementing PeopleSoft software and $372,000 from auditing PeopleSoft's
financials."
PeopleSoft replaced Ernst as its auditor in 2000, after the S.E.C. investigation that led to
yesterday's decision had begun. It then hired Arthur Andersen and moved to KPMG in
2002 after Andersen collapsed.
Mr. Perkins, the Ernst spokesman, said most of the relationship with PeopleSoft had been
in the consulting division that was sold and that the remainder was in the company's tax
practice. He said the tax practice no longer was involved with PeopleSoft.
Most of the arguments over auditor independence have dealt with questions of what
services other than auditing could be provided by the accounting firm to its clients.
Significant business relationships have long been barred, even to the extent of not allowing
auditors to invest in mutual funds that their firms audit.
The current rules on auditor independence bar auditing firms from performing some
services for audit clients but allow others if the company's audit committee approves of
them. Some institutional investors have mounted campaigns to vote against directors that
allow such relationships.

				
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