Banking and Financial Institutions Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and fi- nancial instrument analysis, as well as much more.
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Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www. Library of Congress Cataloging-in-Publication Data Gup, Benton E. Banking and financial institutions : a guide for directors, investors, and counterparties / Benton E.
– (Wiley finance series) Includes bibliographical references and index. Banks and banking–United States. Financial institutions–United States.10973–dc22 2011005434 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 To Jean, Andy, Jeremy, Lincoln, and Carol Contents Preface xi Acknowledgments xv About the Author xvii CHAPTER 1 Lessons Learned from Banking Crises 1 International Financial Crises 1 What Caused the Crisis in the United States? 3 Lessons Learned from Financial Crises 13 CHAPTER 2 The Economic Role of Financial Intermediaries 21 The Economic and Financial System 21 Intermediation 23 Asset Management 32 Individuals 33 Interest Rates 34 Current Trends in Financial Intermediaries 35 The Changing Role of Banks 38 Alternative Financial Services 40 CHAPTER 3 The Evolving Legal Environment 41 What Is a Bank? 41 Why Are Banks Regulated? 42 Selected Banking Laws 47 Services Provided by Banks 50 What Bank Regulators Do 54 Is Prudential Bank Regulation Effective? 57 Appendix 3A: FDIC Definitions of Commercial Banks 64 Appendix 3B: Selected Banking Legislation 68 Recent Laws 74 vii viii CONTENTS CHAPTER 4 Asset/Liability Management 75 An Overview of Market Rates of Interest 75 The Effects of Interest Rate Risk on Income and Market Value 84 Managing Interest Rate Spreads 86 Duration Gap and Economic Value of Equity 88 Duration Gap Management Strategies 91 CHAPTER 5 Hedging and Risk Management 95 Derivatives 95 Risks Associated with Derivatives 96 Derivative Contracts by Product and Type 99 Hedging with Interest Rate Swaps 100 Hedging with Currency Swaps 102 Hedging with Options 104 Hedging with Futures 105 Covered Bonds 110 Special Purpose Vehicles 111 Enterprise Risk Management 112 Additional Educational Resources 114 CHAPTER 6 Commercial and Industrial Loans 115 The Role of Asymmetric Information in Lending 115 The Competitive Environment 116 The Board of Directors’ Written Loan Policy 120 Seven Ways to Make Loans 122 Collecting Loans 125 Principal Lending Activities 126 Collateral 131 The Lending Process 134 International Lending 145 Summary 147 CHAPTER 7 Real Estate and Consumer Lending 149 Real Estate Lending 149 Characteristics of Mortgage Loans 152 Consumer Lending 165 Finance Charges 174 Contents ix Annual Percentage Rate 176 Real Estate and Consumer Credit Regulation 180 If Credit Is Denied 182 Privacy Issues 182 Credit Card Accountability, Responsibility and Disclosure Act of 2009 (Credit CARD Act) 183 Conclusion 186 CHAPTER 8 Bank Capital: Capital Adequacy 189 Basel Capital Accords 193 Enterprise Risk Management and Economic Capital 199 Accounting Issues 202 What’s Next? 203 CHAPTER 9 Evaluating Bank Performance 207 Evaluating Publicly Traded Banks 207 Evaluating Commercial Banks 213 Appendix 9A: FDIC Bank Data Guide 227 CHAPTER 10 Payments Systems 229 Money 229 Legal Tender 229 Retail Payments 232 Large-Interbank Payments 241 CHAPTER 11 Other Financial Services 245 Cash Management Services 245 Trust Services, Private Wealth, and Asset Management 248 CHAPTER 12 A Guide to Islamic Banking 255 Islamic Banking, an Alternative Intermediation 255 Special Question on Intermediation by Banks 272 Future Direction 276 x CONTENTS CHAPTER 13 The View from the Top: Recommendations from a Superintendent of Banks 279 Tips for Bank Directors 279 Tips for Borrowers 280 Tips for Investors 280 What Lies Ahead 281 Notes 283 Glossary 309 References 335 Index 351 Preface he traditional role of commercial banks in the financial system, and how T they operate, has changed dramatically in recent years. The reasons for the changes include: 1.
Financial innovations such as credit default swaps, hedge funds, and securitization. Globalization of banks and financial systems. Some of the biggest bank holding companies in the United States are owned by foreign banks.1 Equally important, some of the biggest U. banks have global opera- tions.
The global financial crisis that began in 2007. It continued to have negative repercussions around the world in 2011. New laws, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and new regulations that emerged from it. Simply stated, the way that banks and financial institutions operate is changing.
This book examines how they operate in the context of these and other changes. The book consists of 13 chapters and a glossary of the terms used in it. Chapter 1, “Lessons Learned from Banking Crises,” explains that banking crises are not new. They have been going on since biblical times, and they are not unique to the United States.
Real estate booms and busts are a common cause of financial crises. The chapter explains why they may happen again. Chapter 2 explains the economic role of financial intermediaries—the financial institutions that bring borrowers and savers together. It used to be that commercial banks were the primary financial intermediary, but their role has changed in recent years.
A large part of what banks used to do is now being done by so-called shadow banks. Chapter 3 delves into the evolving legal environment. Banks can do only what the laws allow them to do. This chapter examines the major laws affecting banks and bank regulation.
There are a lot of laws that banks have to comply with unless they can figure out legal ways around those laws—regulatory arbitrage. xi xii PREFACE Chapter 4 is about asset and liability management (ALM). Banks earn most of their income from the difference between their borrowing and lend- ing rates. In 2010, market rates of interest were at record low levels, and they can only increase over time.
This chapter explains how banks can deal with this and related issues. Chapter 5 explains how banks can hedge some of their interest rate and credit risks by using various types of derivatives contracts, options, and futures. It also covers the use of special purpose vehicles (SPVs) and enterprise risk management (ERM). Chapter 6 covers the process of commercial and industrial (C&I) lend- ing.
These C&I loans are made to business concerns. The chapter covers how banks make loans, the types of C&I loans, the role of collateral, and other factors. Chapter 7 is about real estate and consumer lending. Recall from Chap- ter 1 that real estate loans were a key factor in the financial crisis.
For many banks, real estate loans account for most of their lending activities. This chapter explains some of the major features of real estate lending. It also covers consumer lending. One extremely important part of this chapter is how annual percentage rates (APRs) are computed on consumer loans.
It also discusses real estate and consumer credit regulations. Chapter 8 involves bank capital. Banks are very highly leveraged when compared with nonfinancial corporations. The high degree of leverage con- tributed to the large number of bank failures in recent years.
However, because of new international and domestic standards, their capital ratios have increased. But is it adequate? This chapter deals with these issues. Chapter 9 evaluates the financial performance of banks. Bank regulators require them to file periodic financial reports that are available to the public.
This chapter explains how to evaluate their financial statements and their financial performance. Chapter 10 explores the payments systems. Payments are the heart of the financial system, and they can take many different forms. Payments sys- tems include cash, checks, credit cards, informal value transfer systems (e., Hawalas), wire transfers, and other means of payment.
While most pay- ments are legal, bankers and others have to report money laundering and suspicious activities to federal authorities—or suffer the consequences. Fail- ure to comply with the bank secrecy act/anti-money laundering (BSA/AML) laws can result in large fines (e., $110 million) and going to jail. Chapter 11 explains some of the other financial services offered by banks. These include cash management services for business concerns, trust services, private wealth management, and correspondent banking.
Chapter 12 is a guide to Islamic banking written by Professor Mohamed Ariff. Mohamed Ariff held a chair in finance and headed the finance faculty Preface xiii at Monash University in Melbourne, Australia, before moving to Bond Uni- versity, where he is currently professor of finance. While Islamic banking is widely used in more than 80 countries around the world, it is new to the United States. banks are beginning to offer Islamic banking services, and this chapter explains some of the essential features.
In Chapter 13, John Harrison (Superintendent of Banks, Alabama State Department of Banking) gives some tips for bank directors, borrowers, and investors in banks. He also explains what lies ahead. And finally, the language of banking and finance can be very confusing. The Glossary provides convenient brief definitions of the finance jargon used in this book.
Acknowledgments want to thank Professor Mohamed Ariff for writing Chapter 12 about I Islamic banking and John Harrison, Alabama State Bank Commissioner, for providing his insights about the banking issues in Chapter 13. xv About the Author rofessor Benton E. Gup holds the Robert Hunt Cochrane/Alabama P Bankers Association Chair at the University of Alabama, Tuscaloosa. Gup is the author or editor of 29 books, and his articles on financial subjects have appeared in leading finance journals.
His most recent books are The Valuation Handbook (with Rawley Thomas), 2010, and The Fi- nancial and Economic Crises: An International Perspective, 2010.