An Overview of Banks and the Financial- Services Sector Key Topics in This Chapter + Powarful Forces Resh: + What is a Bank? + The Financial System and Competing Financial-Service Institutions * Old and New Services Offered to the Public + Key Trends Affecting All Financial-Service Firms + Appendix: Career Opportunities in Financial Services jing the Industry Introduction. ‘There is an old joke attributed to comedian Bob Hope that says “a bank is a financial insi- tution where you can borrow money only if you can prove you don’t need it.” Although many of a bank's borrowing customers may get the impression that old joke is more truth thaa fiction, the real story i that banks today readily provide hundreds of different services to millions of people, businesses, and governments all over the world. And many of these financial services are vital to our personal well-being and the well-being of the communi- tiesand nations where we live. Banks are the principal source of credit (loanable funds) for millions of individuals and families and for many units of government (school districts, cities, counties, etc.). More- over, for small businesses ranging from grocery stares to automobile dealers, banks ere often the major source of credie to stock shelves with merchandise or to fill a dealer's lot with new cars, When businesses and consumers must make payments for purchases of gocds and services, more often than not they use bank-supplied checks, credit or debit cards, or electronic accounts accessible through a Web site. And when they need financial information and financial advice, itis the banker to whom they turn most frequently for advice and counsel. More than any other financial-service firm, banks have a reputation for public rust. Worldwide, banks grant more installment loans to consumers (individuals and families) than any other financial-service provider. In most years, they are among the leading buy- ersof bonds and notes governments issue to finance public facilities, ranging from audito- riums and football stadiums to airports and highways. Banks are among the most important sources of short-term working capital for businesses and have become increasingly active 34 Part One Introduction tothe Business of Banking and Financial Seelces Management in recent years in making long-term business loans to fund the purchase of new plant and equipment. The assets held by U.S. banks represent about one-fifth of the total assets and an even larger proportion of the earnings of all U.S.-based financial-service institutions. In other nations—for example, in Japan—banks hold half or more of all assets in the financial system. The difference is because in the United States, many important non- bank financial-service providers can and do compete to meet the needs of businesses, consumers, and governments Powerful Forces Are Reshaping Banking and Financial Services Today As we begin our study of this important industry, we should keep in mind the great forces reshaping the whole financial-services sector. For example, most banks today are profitable— and, in fact in several recent quarters they have posted record earnings—but their market share of the financial-services marketplace is falling significantly. As the former chairman of Factoid the Federal Deposit Insurance Corporation (FDIC) noted recently, in 1980 insured con- What nation has the _me-cial banks and other depository financial institutions held more than 90 percent of grearest numberof Americans’ money—a share that had dropped to only about 45 percent as the 2st century ‘Anewer: The United oPened. Over the same time span, banks’ and other depositories’ share of USS. credit market States with about 7,800 _liabilittes fell from about 45 percent of the grand total to only about 25 percent (as reported commercial banks, by Powell (6) followed by Germany The industry is also consolidating rapidly with substantially fewer, but much larger, barks with close to 2,500, and other financial firms. For example, the number of U.S. commercial banks fell from abcut 14,000 to fewer than 8,000 between 1980 and 2005. The number of separately incorporated commercial banks in the United States has now reached the lowest level in more than a century, and much the same pattern of industry consolidation appears around the globe in most financial-service industries. Moreover, banking and the financial-services industry are rapidly globalizing and expe- riencing intense competition in marketplace after marketplace around the planet, not just between banks, but also involving security dealers, insurance companies, credit unions, finence companies, and thousands of other financial-service competitors. These financial heavyweights are all converging toward each other, offering parallel services and slugging it out for the public’ attention. If consolidation, globalization, convergence, and competi- ‘-sstion were not enough to keep an industry in turmoil, banking and its financial-service neighbors are also undergoing a technological revolution as the management of information and the production and distribution of financial services become increasingly electronic. For example, thanks to the Check 21 Act passed in the United States in 2004, even the familiar “paper check” is gradually being replaced with electronic images. People incress- ingly are managing their deposit accounts through the use of personal computers, cell phcnes, and debit cards, and there are virtual banks around the world that offer their ser- vices exclusively through the Internet. Clearly, if we ate to understand banks and their financial-service competitors and sze where they all are headed, we have our work cut out for us. But, then, you always wanted to tackle a big challenge, right? | 1-2 What Isa Bank? ‘As important as banks are to the economy as a whole and to the local communities they call home, there is still much confusion about what exactly a bank is. A bank can be defined in terms of (1) the economic functions it serves, (2) the services it offers its cus- tomers, or (3) the legal basis for its existence.Chapter! An Overview of Banks and the Financal‘Seruces Sector. 5 Certainly banks can be identified by the functions they perform in the economy. They are involved in transferring funds from savers to borrowers (financial intermediation) and in paying for goods and services. Historically, banks have been recognized for the great range of financial services they offer—from checking accounts and savings plans to loans for businesses, consumers, and. governments. However, bank service menus are expanding rapidly today to include invest- ment banking (security underwriting), insurance protection, financial planning, advice for meiging companies, the sale of risk-management services to businesses and consumers, and numerous other innovative services. Banks no longer limit their service offerings to traci- tional services but have increasingly become general financial-service providers. Unfortunately in our quest to identify what a bank is, we will soon discover that not only are the functions and services of banks changing within the global financial system, but their principal competitors are going through great changes as well. Indeed, many financial- service institutions—including leading security dealers, investment bankers, brokerage firms, credit unions, thrift institutions, mutual funds, and insurance companies—are trying to beas simnlat to banks as possible in the services they offer. Examples include Merrill Lynch, Dreyfus Corporation, and Prudential Insurance—all of which own banks or banklike firms. Moreover, if this were not confusing enough, several industrial companies have stepped forward in recent decades in an effor to control a bank and offer loans, credit cards, savings plans, and other ta- ditional banking services. Examples ofthese giant banking-market invaders include General Motors Acceptance Corporation (GMAC), GE Capital, and Ford Motor Credit, to name only a few. Even Wal-Mart, the world’ largest retailer, recently has explored the possibility of acquiring an industrial bank in Utah in an effort to expand its financial-service offerings! ‘American Express and Target already control banklike institutions. Bankers have not taken this invasion of their turf lying down. They are demanding relief from traditional rules and lobbying for expanded authority to reach into new markets all around the globe. For example, with large U.S. banks lobbying heavily, the United States Congress passed the Financial Services Modernization Act of 1999 (known more porularly as the Gramm-Leach-Bliley or GLB Act after its Congressional sponsors), allow- ing US, banks to enter the securities and insurance industries and permitting nonbank finencial holding companies to acquire and control banking firms. To add to the prevailing uncertainty about what a bank is, over the years literally dlozsns of organizations have emerged from the competitive financial marketplace proucly bearing the label of bank. As Exhibit 1-1 shows, for example, there are savings banks, invest- ment banks, mortgage banks, merchant banks, universal banks, and so on. In this text we will spend most of out time focused upon the most important of all banking institutions— the commercial bank—which serves both business and household customers all over the world. However, the management principles and concepts we will explore in the chapters that follow apply to many different kinds of “banks” as well as to other financial-service institutions that provide similar services. ‘While we are discussing the many different kinds of banks, we should mention an impor- tan: distinction between banking types that will surface over and over again as we make our way through this text—community banks versus money-center banks. Money-center banks are giant industry leaders, spanning whole regions, nations, and continents, offering the widest possible menu of financial services, gobbling up smaller businesses, and facing tough competition from other giant financial firms around the globe. Community banks, on the other hand, are usually much smaller and service local communities, towns, and cities, offering a significantly narrower, but often more personalized, menu of financial servicesto the public. As we will see, community banks are declining in numbers, but they also ere proving to be tough competitors in the local areas they choose to serve.6 Part One Inoduction ro che Business of Banking and Financal-Servces Management EXHIBIT 1-1 ‘The Different Kinds of Financial-Ser Firms Calling ‘Themselves Banks Key URLs ‘The Federal Deposit Insurance Corporation not only insures deposits, but provides large amounts of data on individual banks. See especially ‘wwweldic.gov and swoewfdie.gov/bank index.html Name of Banking-Type Firm — Def n or Description Commercial banks: Sell posits and make loans to businesses and individuals ‘Money center banks: ‘Are large commercial banks based in leading financial centers (Community banks: ‘re smaller, localy focused commercial end savings banks Savings banks: Attract savings deposits and make loans to individuals and families Cooperative banks: Help fermers, ranchers, and consumers acquire goods and services ‘Mortgage banks: Provide mortgage loans on now homes but donot soll deposits Investment banks: Underwrite issues of new securities by thelr corporate customers ‘Merchant banks: Supply both debt and equity capital to businesses Industrial banks State-chartered loan companies ovmed by financial or nanfinancial, corporations Invornational banks: Are commercial banks presentin more than one nation ‘Wholesale banks: ‘Are larger commercial banks serving corporations and governments Retail banks: ‘Are smaller banks serving primarily households and small businesses Limited-purpose banks: Offer a narrow menu of services, such as creditcard companies and subprime lenders Bankors' banks: Supply services (e.g, check clearing and security trading) to banks ‘Minority banks: Focus primarily on customers belonging to minority groups National banks: Function under a federal charter through the Comptroller ofthe Currency Snte hanks Function under ehartar ised hy banking commissions inthe various states Insurod banks: Maintain deposits backed by federal deposit insurance plans (.g, the Folc) Bolong to the Federal Rosorve System ‘Are wholly or partially owned by a holding company ‘Virtual banks: Offer heir services only over the Internet, Fringe banks: Offer payday and tile loans, cash checks, or operate as pawn shops and rent-to-own firms sal banks: Offer vizualy al fnanctal services availabe in todays marketplace. ‘One final note in our search for the definition of banks concems the legal basis for their existence. When the federal government of the United States decided that it would regu- late and supervise banks more than a century ago, it had to define what was and what was not a bank for purposes of enforcing its rules. Afterall, if you plan to regulate banks you have to write down a specific description of what they are—otherwise, the regulated firms car. easily escape their regulators, claiming they aren’t really banks at all! The government finally settled on the definition still used by many nations today: A bank is any business offering deposits subject to withdrawal on demand (such as by writ- inga check or making an electronic transfer of funds) and making loans of a commercial or business nature (such as granting credit to private businesses secking to expand the inventory of goods on their shelves or purchase new equipment). Over a century later, during the 1980s, when hundreds of financial and nonfinancial institutions (such as J.C. Penney and Sears) were offering either, but not both, of these two key services and, there- fore, were claiming exemption from being regulated as a bank, the U.S. Congress decided to take another swing at the challenge of defining banking. Congress then defined a bank a8 any institution that could qualify for deposic insurance administered by the Federal Depcsit Insurance Corporation (FDIC). A clever move indeed! Under federal law in the United States a bank had come to be defined, not so much by its array of service offerings, but by the government agency insur- ing its deposits! Please stay tuned—this convoluted and complicated story undoubtedly will develop even more bizarre twists as the 21st century unfolds.A BRIEF HISTORY OF BANKING AND OTHER FINANCIAL-SERVICE FIRMS ‘As bast we can tll from historical records, bankingis the oldest of all financial-service professions. Where did these powerful finan- cial institutions come from? Linguistics (the science of language) and etymology the study ‘of word origins) tell us that the French word banque and the Itl- ian banca wore used centuries ago to refer to a “bench” or ‘money changers table.” This cescribes quite well what histori- ans have observed about the first bankers offering their services more than 2,000 years ago. They were money changers, situated usually ata table in the commercial district, aiding travelers by exchanging foreign coins for local money or discounting commer- cial notas fora fee, ‘The earliest bankers pledged a lot oftheir own money to sup- port these early venturas, but t wasn't long before the idea of attracting deposits and loaning out those same funds emerged. Loans were granted to shippers, landowners, and others at inter- est rates as low as 6 percent to as high as 48 percent a month for the riskiest ventures! Most ofthe early banks were Grek in origin. The banking industry gradually spread from the classical civi- lizations of Greece and Rome into Europe. It encountered religious ‘opposition during the Middle Ages primarily because loans to the poor often carriad high interest rates. However, as the Middle ‘Ages drew to @ close and the Renaissance began in Europe, the bulk of foans and deposits involved wealthy customers, which helped to reduce religious objections. The development of overland trade routes and improvements in navigation in the 15th, 16th, and 17th centuries gradually shifted the center of world commerce from the Mediterranean toward Europe and the British Isles. Quring this period, the seeds of the Industrial Revolution, which demanded a well-developed financial system, were planted. The adogtion of mass production required an expansion in glabal trade to absorb industrial output, which in turn required new methods for making payments and obtaining credit. Banks that could deliver on these needs grew rapidly, led by such institutions as the Medici Bank in Italy and the Hochstet- ter Bank in Germany. ‘The early banks in Europe wore places for the safekeeping of ‘wealth (such as gold and silver’ for 2 fee as people came to fear loss oftheir assets due to war, theft, or expropriation by govern- ment, Merchants shipping goods found it safer to place their payments of gold and silver in the nearest bank rather than risk- ing toss to pirates or storms at sea. In England government efforts to seize private holdings resulted in people depositing thair valuables in goldsmiths’ shops, which issued tokens ar cer tificates indicating the custoner had made a deposit. Soon, goldsmith certificates began to circulate as money because they ‘were more convenient and less risky to carry around than gold or other valuables. The goldsmiths also offered certification of value services—what we today call property appraisal. Cus- tomers would bring in their valuables to have an expert certify these items were real and not fakes. ‘When colonies were established in North and South Ameriza, (Old World banking practices entered the New World At first the colonists dealt primarily with established banks in the counties from which they had come. Later, state governments in the United States began chartering banking companies. The U.S. federal government became a major force in banking during the Civil War. The Office of the Comptroller of the Currency (OCC) was established in 1864, created by the U.S. Congress to charter national banks. This divided bank regulatory system, in wh ch both the federal government and the states play key roles in the ‘supervision of banking activity, has persisted in the United Staies to the present day. Despite banking’s long history and success, tough financial- service competitors have emerged over the past century or two, mostly from Europe, to challenge bankors at every turn, Among she oldest were life insurance companies—the first American cem- pany was chartered in Philadelphia in 1758. Property-casualty insurers emerged at roughly the same time, led by Lloyds of Lon- don in 1688, underwriting a wide range of risks to persons end property. ‘The 19th century ushered in a rash of now financial competi- tors, led by savings banks in Scotland in 1810. These institutions offered small savings deposits to individuals at a time when most commercial banks largely ignored this market segment. A simlar firm, the savings and loan association, appeared in the midwest em United States during the 1890s, encouraging household saving and financing the construction of new homes. Credit unions ware first chartered in Germany during the same era, providing savings accounts and low-cast credit to industrial workers. ‘Mutual funds—one of banking’s most successful compettors— ‘appearad in Belgium in 1822, These investment firms entered the United States in significant numbers during the 1920s, ware devastated by the Great Depression ofthe 1930s, and rose again to grow rapidly. A closely related insttution—the money market fund—surfaced in the 1970s to offer professional cash manaye- ment services ta households and institutions. These aggressive competitars attracted a huge volume of deposits away from banks and ultimately helped to bring about government derequ- lation of the banking industry. Finally, hedge funds appeared to offer investors a less regulated, more risky alternative to mutual funds, They grew explosively into the new centuryB_ Part One Introduction tothe Business of Banking and FinancalSeruces Management 1-3 The Financial System and Competing Financial-Service Institutions _) Factoid Did you know that the ‘umber of banks operating in the US. today represents less than a third of the number operating 100 yeats ago? Why do you think this is so? Key URLs Want to know more about savings associations? See especially the Office of ‘Thrift Supervision at wwwwots.treas.gov and the Federal Deposit Insurance Corporation at www.fdiegov. Roles of the Financial System Aswe noted at the opening of this chapter, bankers face challenges from all sides today as they reach out to their financial-service customers. Banks are only one part of a vast finen- cial system of markets and institutions that circles the globe. The primary purpose of this ever-changing financial system is to encowrage individuals and institutions to save and to trans- fer those savings to those individuals and institutions planning to invest in new projects. This process of encouraging savings and transforming savings into investment spending causes the economy to grow, new jobs to be created, and living standards to rise. But the financial system does more than simply transform savings into investment. It also provides a variety of supporting services essential to modem living. These include pey- ‘ment services that make commerce and markets possible (such as checks, credit cards, and interactive Web sites), risk protection services for those who save and venture to invest (including insurance policies and derivative contracts), liquidity services (making it posi- ble to convert property into immediately available spending power), and credit services or these who need loans to supplement their income The Competitive Challenge for Banks For many centuries banks were way out in front of other financial-service institutions in supplying savings and investment services, payment and risk protection services, liquidity, and loans. They dominated the financial system of decades past. But this is no longer as true today. Banking’s financial market share generally has fallen as other financial institu- tions have moved in to fight for the same turf. In the United States of a century ago, for example, banks accounted for more than two-thirds of the assets of all inancial-service providers. However, as Exhibit I~2 illustrates, that share has fallen to only about one-fifth of the assets of the USS. financial marketplace. Some authorities in the financial-services field suggest this apparent loss of market share may imply that traditional banking is dying. (See, for example, Beim [2] and the counterargument by Kaufman and Mote [3].) Certainly as financial markets become more efficient and the largest customers find ways around banks to obtain the funds they need (such as by borrowing in the open market), traditional banks may become less necessary. Some experts argue that the reason we still have thousands of banks scattered around the globe—perhaps many more than we need—is that governments often subsidize the indus- try through cheap deposit insurance and low-cost loans. Still others argue that banking’s market share is falling due to excessive government regulation, restricting the industry’ ability to compete. Perhaps banking is being “regulated to death,” which may hurt these customers who most heavily depend on banks for critical services—individuals and small businesses. Other experts counter that banking is not dying, but only changing —offeting new services and changing its form—to reflect what today’s market demands. Perhaps te traditional measures of the industry's importance (like total assets) no longer reflect how truly diverse and competitive bankers have become in the modern world. Leading Competitors with Banks Arrong the leading competitors with banks in wrestling for the loyalty of financial-service customers are such nonbank financial-service institutions as: Savings associations: Specialize in selling savings deposits and granting home mortgage loans and other forms of credit to individuals and families, illustrated by such financial firms as Atlas Savings and Loan Association (www.atlasbank.com),EXHIBIT 1-2 Comparative Size by Industry of Commercial Banks and Their Principal Financial-Service Competitors Source: Board of Gover {he Foleo! Ree Speen, wef Finds Aue of be Und Sau Frere 2005 jane 205, Key URLs To explore the character of the credit ‘union industry see ‘www.cuna.org and www.oceu.org Key URLs ‘The nature and characteristics of money market funds and other ‘mutual funds are explained at length in such sources 2s ‘www.smartmoney.com, wwwnici.org, www. ‘morningstar.com, and swww.marketwatch.com. Key URLs To learn more about security brokers and dealers see worw.sec.gov or www.investorguide. Chapter 1 An Overuew of Banks and the Financial Services Sector. 9 Total Financial Assets Percent of All Financial Financial-Service Institutions Held in 2005 (ill)* Assets Held in 2005 Depository Insitutions: Conmercalbanks™* ans 201% Savings inttutions*** 1688 aa Croft unions #70 15 Nondeposi Financial Insitutions: + Lifeinsurance companies 4308 95 Praperty/cesualty and other insurers 1197 28 4206 a8 Sta and locel government rotroment funds 2080 4 Federal government airement funds n 02 | Morey market funds 18H 42 Investment companies (mutual funds) sans 125 Finance companies 148 33 Mortgage companies 2 “ | Reel estate investment trusts 28 06. Security brokers and dealers 13H 45 ues financial service providers {indusing goverament-sponsored | enterprises, mrigage pools, payday | Tenders, te) 570 23 “otals 348 100.0% Notes Calurne may ot at ols det oudingeoe Figurs are othe fee ques of 2005, "Cones bnkig a ecorded here incloes US. careredconmetll banks foregn baking ois in che United Sates, bank folding compne and Kok operating in United Seats fled ese. Sang nsins ede tavings an lun scat, al nd federal saving bank, and cooperative banks ‘esr ile than one ter f ene percent Flatbush Savings and Loan Association (wwveflatbush.com) of Brooklyn, New York, Washington Mutual (www.wamu.com), and American Federal Savings Bank (www.americanfsb.com). Credit unions: Collect deposits from and make loans to their members as nonprofit, associations of individuals sharing a common bond (such as the same employer), including such firms as American Credit Union of Milwaukee (www.americancu.org) and Chicago Post Office Employees Credit Union (www.my-creditunion.com) Money market funds: Collect short-term, liquid funds from individuals and institutions and invest these monies in quality securities of short duration, including such firms as Franklin Templeton Tax-Free Money Fund (wwwfranklintempleton. com) and Scudder Tax-Free Money Fund (www.scudder.com). Mutual funds (investment companies): Sell shares to the public representing an interest in a professionally managed pool of stocks, bonds, and other securities, including such financial firms as Fidelity (www-fidelity.com) and ‘The Vanguard Group (www.vanguard.com). Hedge funds: Sell shares mainly to upscale investors in a broad group of different kinds of assets (including nontraditional investments in commodities, real estate, loans to new and ailing companies, and other risky assets); for additional information see such firms as Magnum Group (www.magnum.com) and Turn Key Hedge Funds (www.turnkeyhedgefunds.com). Security brokers and dealers: Buy and sell securities on behalf of their customers and for their own accounts, such as Merrill Lynch (www.ml.com) and Charles Schwab (www.Schwab.com)0 PartOne Inoduetion tothe Busines of Banking and Financial Seruces Management Key URL You can explore the world of investment banking more fully at worwallstrectprep. Key URL “Todlscover more about hedge funds see the Security and Exchange Cornmission’s Web ste at wwwisee.gov! answersfhedge-htm. Key URLs To explore the lite insurance and property/casualty insurance industries see especially woww.acli.com and wwwaiiorg. Key URLs. To learn more about finance companies see wwwinacrorg, wwwhsbeusa.com, and ‘www.capitalone.com. Investment banks; Provide professional advice to corporations and governments raising funds in the financial marketplace or seeking to make business acquisitions, including such prominent investment banking houses as Bear Stearns (www.bearstearns.com) and Morgan Stanley (www-morganstanley.com) Finance companies: Offer loans to commercial enterprises (such as auto and appliance dealers) and to individuals and families using funds borrowed in the open market or from other financial institutions, including such well-known financial firms as Household Finance (www.household.com) and GMAC Financial Services (www.gmacfs.com). Financial holding companies: (FHCs) Often include credit card companies, insurance and finance companies, and security broker/dealer firms under one conporate umbrella as highly diversified financial-service providers, including such leading financial conglomerates as GE Capital (www.gecapital.com) and UBS Warburg AG (www.ubswarburg.com). Life and property/casualty insurance companies: Protect against risks to persons ot property and manage the pension plans of businesses and the retirement funds of individuals, including such industry leaders as Prudential Insurance (www.prudential. com) and State Farm Insurance Companies (www.statefarm.com). As suggested by Exhibit 1-3, all of these financial-service providers are converging in terms of the services they offer—rushing toward each other like colliding trains—and embracing each other’s innovations. Moreover, recent changes in government rules, such asthe U.S. Financial Services Modernization (Gramm-Leach-Bliley) Act of 1999, have allowed many of the financial firms listed above to offer the public one-stop shopping for firancial services. To bankers the financial-services marketplace appears to be closing in from all sides as the list of aggressive competitors grows. Thanks to more liberal government regulations, banks with quality management and adequate capital can now truly become conglomerate financial-service providers. The same is true for security firms, insurers, and other financially oriented companies that wish toacquire bank affiliates ‘Thus, the historic legal barriers in the United States separating banking from other financial- service businesses have, like the walls of ancient Jericho, “come tumbling down.” The challege of differentiating banks from other financial-service providers is greater than ever before. How- ever, inside the United States, Congress (like the governments of many other nations around the globe) has chosen to limit severely banks’ association with industrial and manufacturing firms, fearing that allowing banking-industrial combinations of companies might snuff out com- peition, threaten bankers with new risks, and possibly weaken the safety net that protects depositors from loss when the banking system gets into trouble. arene Gaeiie Ua Towdoes abankdifertrommast 14. Which businesses are bankin aivies provid Whe musta corp Hiebert sa ceramaritl Why cots PSChapter An Overview of Banks and che Financial Sesies Secor 11 EXHIBIT 1-3 | The Most Important Nonbank Competitors for Banks Bankers feel the impact of their fiercest nonbank competitors coming in from all directions, Offering customers credit, payments, and savings deposit Providing customers Credit Unions 8a coder, tnstfance . services often fuly ™ with long-term savings Other Theitt @ ‘Companies Y comparable to what banks plans, risk protection, compari io ination ean, and Pension Pans | nd erect ‘Supplying customers with areas to cash (liquidity) and ‘short- to medium-term loans for everything from dally household and operating expenses to the purchase of appliances and equipment v Finance Companies Providing investment and savings planning, executing security purchases and sales, and providing ‘credit cards to thelr customers Security Brokers and Dealers ‘Supplying professional Highly ‘that contro! | [offering A nt and - diversified tip cash management an¢ pene version muttiple |} many investing services for Mutual Funds on financial-service || financial || differen: Conglomerates firms | services longer-term savers providers ‘Advising cerporations and ‘governments on raising funds, Investment tentering naw markets, and planning |} Banks ‘acquisitions and mergers The result of all these recent legal maneuverings is state of confusion in the public's mind today over what is of is not a bank. The safest approach is probably to view these his- toric financial institutions in terms of the many key services—especially credit, savings, payments, financial advising, and risk protection services—they offer to the public. Tkis multiplicity of services and functions has led to banks and their nearest competitors being labeled “financial department stores” and to such familiar advertising slogans as “Your Bark—a Full-Service Financial Institution.”12 PartOne Inmoduction tothe Busines of Banking and Financial Seroices Management Feaee ferent Teodor bankhes had doptmany ls to renin conpotive and responsive pao needs Rais Eisen Eanking’s principal roles (and the roles performed by many of its competitors) today include: Their Closest The intermediation ole ‘Transforming savings received primarily from households int credit, Competitors Play (oans) for business fms and others in order to make investments in in the Economy new buildings, equipment, and other goods, The payments role Carrying out payment for goods and services on behalf of customers (such as by issuing and clearing checks and providing @ conduit for lectronic payments) ‘The guarantor role Standing behind their customers to payoff customer debts when those customers are unable to pay (such as by issuing loters of credit, ‘The isk management role ‘Assisting customers in preparing financially forthe risk of loss to property, persons, and financial assets. ‘The investment banking role ‘Assisting corporations and governments in marketing securities and ‘aising new funds. ‘The savings/investment ‘Aiding customers in flfiling their long-range goals for a better life by aivisor role buliding and investing savings. Thesafekeoping/certification. Safeguarding a customer's valuables and certifying thelr true value. of value role The agency role ‘Acting on behalf of customers to manage and protect their property The policy role ‘Serving as a conduit for government polcy in attempting to regulate the growth of the economy and pursue social goals. | 1-4 Services Banks and Many of Their Closest Competitors Offer the Public) Banks, like their neighboring competitors, are financial-service providers. As such, they pley a number of important roles in the economy. (See Table 1-1.) Their success hingeson their ability to identify the financial services the public demands, produce those services efficiently, and sell chem at a competitive price. What services does the public demend from banks and their financial-service competitors today? In this section, we present an overview of both banking's traditional and its modern service menu, Services Banks Have Offered throughout History Carrying Out Currency Exchanges History reveals that one of the frst services banks offered was currency exchange. A banket stood ready to trade one form of coin or currency (such as dollars) for another (such as francs cr pesos) in return for a service fee. Such exchanges have been important to travelers over the centuries, because the traveler's survival and comfort may depend on gaining access to local funds. In today's financial marketplace, trading in foreign currency is conducted primarily by the largest financial-service firms due to the risks involved and the expense required to carry out these transactions. Discounting Commercial Notes and Making Business Loans Early in history, bankers began discounting commercial notes—in effect, making loans to local merchants who sold the debts (accounts receivable) they held against their cus- tomers to a bank to raise cash quickly. It was-a short step from discounting commercial, notes to making direct loans for purchasing inventories of goods or for constructing new facilities—a service that today is provided by banks, finance companies, insurance firms, and other financial-service competitors. Offering Savings Deposits Meking loans proved so profitable that banks began searching for ways to raise addi- tional loanable funds. One of the earliest sources of these funds consisted of offering‘THE ROLE OF BANKS AND OTHER FINANCIAL INTERMEDIARIES IN THEORY Banks, along with insurance companies, mutual funds, finance companies, and similar financiabservice providers, are financial intermediaries. The term financial intermediary simply means @ business that interacts with twa types of individuals and institu- tions inthe economy: 1) defiitspendingindvidvels and institu- tions, whose current expenditures for consumption and investment excoad their current receipts of income and who, therefore, need to aise funds exteraly through borrowing a issuing stock; and (2) surplus-spending individuals end institutions whose curent receipts ofincome exceed their current expenditures on goods and services so they have surplus funds that can be saved and invasted. Intermodiaries perform the indispensable task of acting 28.8 bridge between these two groups, offering convenient finan- ‘ial sorvics to surplus-spandingunits in order to attract funds and then allocating those funds to deficit spenders. In so dang, inter- ‘mediaries accelerate economic crowth by expanding the avaiable poo! of savings, lowering the risk af investments through dversifi- cation, and increasing the productivity of savings and investment. Intermediation activities wil ike place (1) if there is a postive sproad betieen the expected yalds on loans that financial inter- mediaries make to deficit spendars and the expected cost ofthe funds intrmodiaries etract from surplus spenders; and (2)if there is 8 positive correlation between the yields on loans and other assets and the cost of attracting funds. fan intermediary’ asset vialds and its fund-eising costs ae positively corelated, this wll reduce uncertainy abouts expected profits an allow ito expand. ‘An ongoing debate in finance concerns why financial interme diaries exist at al. What services do they provide that other bust nesses and individuals cannot provide for themselves? This question has proven dificult to answer. Research evi- dence showing that ur financial markets are reasonably efficient has accumulated in recent years. Funds and information flow readily to market participants, ard the prices of assets seam to be determined in highly compatitive markets. Ina perfectly compet tivo and efficient financial system, in which all participants have equal and open access tothe financial marketplace, no one par- ticipant can exercise contro over prices, all pertinentinformation affecting the value of various assets is avilable to all, transac- tions costs are not significant impediments to trading, and all assets are available in denominations anyone can afford, why would banks and other financial-service firms be needed at all? Most current theories expla the existence of financial iter- metiaros by pointing to mperfestons in ou nancial system. For example, all assets are not erfe:t divisible into small denomina- tions that everyone can afford. To ilustrate, marketable US. Tea- sury bonds—one ofthe most popular securities in the world—have ‘minimum denominations of $1,000, which is beyond the reach of ‘many small savers and investors. Financial intermediaries provide ‘a valuable service in dividing up such instruments into smaller urits ‘that are readily affordable fr millions of people. Another contribution that intermediaries make is their willing ness to accept risky loans from borrowers, while issuing low-risk securities to their depositors and other funds providers. These service providers engage in risky arbitrage across the financial ‘markets and sel risk-management services as well. Financial intermediaries satisfy the need for liquidity. Financial instruments are liquid if they can be sold quickly in a ready market with little risk of loss to the seller, Many households and busi- nesses, for example, demand large precautionary balances of fq- uid funds to cover future cash needs. Intermediaries satisty tris customer need by offering high liquidity in the financial assets they provide, giving customers access to liquid funds precisaly ‘when they are needed. Still another reason intermediaries have prospered is their superior ability to evaluate information, Pertinent data on financial investments is limited and costly. Some institutions know more than others or possess inside information that allows them to choose profitable invastments while avoiding the losers. This uneven distribution of information and the talent to analyze itis known as informational asymmetry. Asymmetries reduce the efi cioncy of markets, but provide a profitable role far intermediaries that have the expertise to evaluate potential investments. Yet another view of why financial institutions exist in modern society is called delegated monitoring. Most borrowers prefer to keep their financial records confidential. Lending institutions are able to attract borrawing customers because they pledge conf entiality. For example, a bank’s depositors are not privileged to review the records ofits borrowing customers. Depositors often hhave neither the time nor the skill to choose good loans over bad. They turn the monitoring process over ta a financial intermediary. ‘Thus a depositary institution serves as an agent on behalf of ts depositors, monitoring the financial condition of those customers who do receive loans to ensure that depositors will recover their funds. In return far manitoring, depositors pay a fee tothe lender that is probably less than the cost they would incur if they meni- tored borrowers themselves. By making a large volume of loans, lending institutions acting as delegated monitors can diversify and reduce their risk expo- sure, resulting in increased safety for savers’ funds. Moreover, ‘when a borrowing customer has received the stamp of approval of a lending institution itis easier and less costly for that cus- ‘tomer to raise funds elsewhere, This signals the financial market place that the borrower is likely to repay his or her loans. This signaling effect seems to be strongest, not when a landing inst tution makes the first oan to a borrower, but when it renews @ ‘maturing foan4H PartOne Tnvoducton tothe Business of Banking and Financial Services Management Factoid ‘What region of the United States contains the largest number of banks? The Midwest. ‘The smallest number of banks? The Northeast. Why do you think this savings deposits— interest-bearing funds left with depository institutions for a period of time. According to some historical records, banks in ancient Greece paid as high as 16 per- cent in annual interest to attract savings deposits from wealthy patrons and then made loans to ship owners sailing the Mediterranean Sea at loan rates double or triple the rate bankers were paying to their savings deposit customers. How's that for a nice profit spread? Safekeeping of Valuables and Certification of Value During the Middle Ages, banks and other merchants (often called “goldsmiths”) began the practice of holding gold and other valuables owned by their customers inside secure vaults, thus reassuring customers of their safekeeping. These financial firms would assay the mar- ket value of their customers’ valuables, especially gold and jewelry, and certify whether or net these “valuables” were worth what others had claimed. Supporting Government Activities with Credit During the Middle Ages and the early years of the Industrial Revolution, governments in Europe noted bankers’ ability to mobilize large amounts of funds. Frequently banks were chartered under the proviso that they would purchase government bonds with a portion of the deposits they received. This lesson was not lost on the fledgling American government during the Revolutionary War. The Bank of North America, chartered by the Continen- tal Congress in 1781, was set up to help fund the struggle to throw off British rule and make the United States a sovereign nation. Similarly, during the Civil War the U.S. Con- gress created a whole new federal banking system, agreeing to charter national banks pro- vided these institutions purchased government bonds to help fund the war. Offering Checking Accounts (Demand Deposits) The Industrial Revolution ushered in new financial services and new service providers Probably the most important of the new services developed during this period was the demand deposit—a checking account that permitted the depositor to write drafts in pay- ‘ment for goods and services that the bank or other service provider had to honor immedi- ately. Demand deposit services proved to be one of the financial-service industry's most important offerings because it significantly improved the efficiency of the payments process, making transactions easier, faster, and safer. Today the checking account concept hhas been extended to the Internet, to the use of plastic debit cards that tap your checking account electronically, and to “smart cards” that electronically store spending power. Teday payment-on-demand accounts are offered not only by banks, but also by savings associations, credit unions, securities firms, and other financial-service providers. Offering Trust Services For many years banks and a few of their competitors (such as insurance and trust compa- nies) have managed the financial affairs and property of individuals and business firms in return for a fee. This property management function is known as trust services. Providers of this service typically act as trustees for wills, managing a deceased customer's estate by paying claims against that estate, keeping valuable assets safe, and seeing to it that legal heirs receive their rightful inheritance. In commercial trust departments, trust-service providers manage security portfolios and pension plans for businesses and act as agents for corporations issuing stocks and bonds. Services Banks and Many of Their Financial-Service Competitors Have Offered More Recently Granting Consumer Loans Historically, banks did not actively pursue loan accounts from individuals and families, believing that the relatively small size of most consumer loans and their relatively highFilmtoid ‘What 2001 documentary recounts the creation of an Inceret company, GovWorks.com, using more than $50 million in funds provided by venture capit Answer: Startup.com, Key URL For more information. ‘on the venture capital industry see Chapter An Overeiew of Banks and the Financial Sereices Sector. 1% default rate would make such lending unprofitable, Accordingly, other financial-service providers—especially credit unions, savings and loans, and finance companies—soon moved in to focus on the consumer. Early in this century, however, bankers began to rely more heavily on consumers for deposits to help fund their large corporate loans. In addi- tion, heavy competition for business deposits and loans caused bankers increasingly to tura to the consumer as a potentially more loyal customer. By the 1920s and 1930s severe! major banks, led by one of the forerunners of New York's Citibank and by the Bank of ‘America, had established strong consumer loan departments. Following World War 1: consumer loans were among the fastest-growing forms of bank credit. Their rate of growta has dowed recently, though, as bankers have run into stiff competition for consumer credit accounts from nonbank service providers. Financial Advising Customers have long asked financial institutions for advice, particularly when it comes to the use of credit and the saving or investing of funds. Many service providers today offera ‘wide range of financial advisory services, from helping to prepare tax returns and finar- cial plans for individuals to consulting about marketing opportunities at home and abroad for usiness customers. ‘Managing Cash Over the years, financial institutions have found that some of the services they provide for themselves are also valuable for their customers. One of the most prominent is eash management services, in which a financial intermediary agrees to handle cash collections and disbursements for a business firm and to invest any temporary cash surpluses in interest- bearing assets until cash is needed to pay bills. Although banks tend to specialize mainly in business cash management services, many financial institutions are offering similar services to consumers. Offering Equipment Leasing Many banks and finance companies have moved aggressively to offer their business cus- tomers the option to purchase equipment through a lease arrangement in which the lend- ing institution buys the equipment and rents it to the customer. These equipment leasing services benefit leasing institutions as well as their customers because, as the real owner of the leased equipment, the lessor can depreciate it for additional tax benefits. ‘Making Venture Capital Loans Increasingly, banks, security dealers, and other financial conglomerates have becorte active in financing the start-up costs of new companies. Because of the added risk involved in such loans, this is generally done through a separate venture capital firm that raises money from investors to support young businesses in the hope of turning a profit when. those firms are sold or go public. Selling Insurance Policies For many years bankers have sold credie life insurance to their customers receiving loars, guaranteeing repayment if borrowers die or become disabled. Moreover, during the 19th and early 20th centuries, many bankers sold insurance and provided financial advice to their customers, literally serving as the local community's all-around financial-service store. However, beginning with the Great Depression of the 1930s, U.S. banks were pro- hibited from acting as insurance agents or underwriting insurance policies. For exampl:, banks in most cases couldn't provide automobile or homeowners’ coverage or general life and health insurance protection. Congress acted out of fear that selling insurance would increase bank risk and lead to conflicts of interest in which customers asking for one ser- vice would be compelled to buy other services as well.For several decades now bankers have watched as some of the world’s most aggressive nonbank institutions have invaded banking’s traditional marketplace. Among the most successful and aggres- sive of such companies are these: ‘Merrill Lynch & Co, (werviml.com).* Merril is one ofthe largest security trading and underwriting firms on the planet and serves asan adviser to corporations and governments on every continent Beginning as an investment frm in 1885, Merril now competes directly with banks in offering money market accounts and online banking services to both businesses and households. Itwas one ofthe first nonbank fms to adopt the holding company form and acquire or establish effilates dealing in government securities, asset management, and the management of mutual funds. During the 197Cs Morrill lynch organized one of the largest of all money market funds and today also controls en industrial bank ‘American Express Company {http:/home.americanexpress.com):* Amarican Expross was one of the first credit card companies in the United Statos and now serves millions of households and business firms. italso owns en FDIC-insured industrial bank (American Express Centurion Bank) through which itoffors home mortgage and home equity oane, savings daposite, chocking and retirement accounts, and online bill paying. AEXis registered with the Federal Reserve Board as a financial holding company. Houschold International (www.household.com)* Households the largest nance company in the ‘world, offering personal loans as well as financial assistance to businesses requiring inventory financing. Reaching over 80 milion customers in Canada, the United States, and Great Britain, Household competes directy with banks in offering creditcard, auto financing, home mortgages, and erat ife insurance. It also operates a joint venture with an insurance company to offer tam life and auto insurance coverage. During 202, Household International announced is acquisition by HSBC of London, one ofthe wort’ largest banks. Countrywide Financial Corp. (www.countrywide.com). Countrywide is the largest home mortgage lender in the United States. Founded in New Yorkin 196, the company pioneered banklike branches {known as “country stores”), based initially in California and then spreading nationwide, subsequently forming a broker-dealer subsidiary, on insurance agency, and an online lending uit. Subsequent Countrywide bought Treasury Bank, NA in Alexandria, Virginia. ““ndleats thie nancial fim is ineluded inthe Educational Version of SRP Market insight Many bankers arranged to have insurance companies sell policies to customers by renting space in bank lobbies. This picture of extreme separation between banking and insurance changed dramatically in 1999 when the U.S. Congress passed the Gramm-Leach-Bliley (GLB) Act and tore down the legal barriers between the two industries, allowing bank hold- ing companies to acquire control of insurance companies and, conversely, permitting insur ance companies to acquire banks. Today, these two industries are competing aggressively with each other, pursuing cross-industry mergers and acquisitions, Selling Retirement Plans Banks, trust departments, mutual funds, and insurance companies are active in managing the retirement plans that most businesses make available to their employees, investing incoming funds and dispensing payments to qualified recipients who have reached retire- ment or become disabled. Banks and other depository institutions sell retirement plans (such as IRAs and Keoghs) to individuals holding these deposits until the funds are needed for income after retirement.Chapter 1 An Overview of Banks and the Financil-Services Secor 17 Dealing in Securities: Offering Security Brokerage and Investment Banking Services One of the biggest of all banking service targets in recent years, particularly in the United Staces, has been dealing in securities, executing buy and sell orders for security trading cus- tomers (referred to as security brokerage services) and marketing new securities to rae funds for corporations and other institutions (referred to as security underwriting or invest- ment banking services), However, much of this security brokerage and security underwriting activity was prohibited in the United States due to the separation of commercial and investment banking by the Glass-Steagall Act, passed in 1933. With the passage of the Gremm-Leach-Bliley Act in the fall of 1999, however, banks are now permitted to affiliate with securities firms and secucity firms can acquire banks. Two venerable old industries, long separated by law, especially in the United States and Japan, are now like two out-of-control locomotives rushing toward each other, pursuing many of the same customers Offering Mutual Funds and Annuities Many customers have come to demand investment products from their financial-service providers. Mutual fund investments and annuities that offer the prospect of higher yiekis than the tetumns often available on conventional bank deposits are among the most sought-after investment products. However, these product lines also tend to carry mere risk than do bank deposits. ‘Annuities consist of long-term savings plans that promise the payment of a stream of income to the annuity holder beginning on a designated future date (e.g., at retirement). In contrast, mutual funds ate professionally managed investment programs that acquite stocks, bonds, and other assets that appear to “ft” the funds’ announced goals (such as to ‘maximize current income or to achieve long-term capital appreciation). Recently many banking firms have organized special subsidiary organizations to market these services ot entered into joint ventures with security brokers and insurance companies. In tur, many of bankers’ key competitors, including insurance companies and security firms, have moved aggressively to expand their public offerings of fixed and variable annuity plans and broaden their menu of investment services in order to attract customers away from banks Offering Merchant Banking Services USS. financial-service providers are following in the footsteps of leading financial institu- tions all over the globe (for example, Barclays Bank of Great Britain and Deutsche Bank of Germany) in offering merchant banking services to larger corporations. These consist of the temporary purchase of corporate stock to aid the launching of a new business ven- ture or to support the expansion of an existing company. Hence, a merchant banker becomes a temporary stockholder and beats the risk that the stock purchased may decline in value. In practice, merchant banking services often encompass the identification of pos- sible merger targets for a corporate customer, providing that customer with strategic mar- keting advice Offering Risk Management and Hedging Services Many observers see fundamental changes going on in the banking sector with larger banks (such as J.P. Morgan Chase and Citibank) moving away from a traditionally heavy emphasis on deposit-taking and loan-making toward risk intermediation—providing theit customers with financial tools to combat risk exposure in return for substantial fees. The largest banks around the globe now dominate the tisk-hedging field, either acting as dealers (i.e., serving as “market makers”) in arranging for risk protection for the banks’ customers from third parties or directly selling their customers the bank's ownBanks and other financial-service firms have experienced a rising tide of campetitian from leading ‘manufacturing, retailing, and other businesses in recent decades. These companies based autside the financial sector nevertheless have often been successful in capturing financial-service cus- tomers, Among the best known of such nonfinancial-based entitis are these: BE Capital (www. gecapital.com)-* The predecessor of GE Capital was Set up during the 1990s as a captive finance company of ts parent, General Electric, to provide financing so that consumers and appliance and equipment dealers could afford GE products. The firm branched out as it graw to finance more than just GE products. Today it offers such diverse services as leasing airplanes, autos, and ol tenkers; credit cards; equity investments; and insurance. if GE Copital were a bank it would rank the top 10 of all U.S, banks, In 2002 GE announced that GE Capital would become four separste businesses—GE Commercial Finance, GE Consumer Finance, GE Equipment Management, and GE Insurance. General Electric also owns Monogram Credit Card Bank MAC Financial Services (www.gmacts.com). GMAC began in 1819 as a captive finance company, ‘inancing the vehicles produced by General Motors by ending to both deslers and consumers, Today MAC Financial Servicas isa family of financial-rervira companies that not only finance purchases of ‘motor vehicles, but extend home mortgage loans, provide real estate brokerage services, make sommercial loans, sell insurance on homes and autos, and provide banking services through GMAC. sank and a thriftinsttution, ‘Wal-Mart (www.wal-mart.com/financial-services).* The largest consumer retailer onthe planet ‘odgy offering several financial services through its more than 3.500 stores, is Wal-Mart. Working argely through cooperative ventures with such companies as MoneyGram, Discover Card, and SunTrust, Wal-Mart cashes payroll checks, sells money orders, and provides wire transfers of funds to Mexico thas allocated space to allow some banks to set up bank branch offices in nearly 1,000 of és superstores and applied for an industrial bank charter, ‘nests thi ems included in the Educational Version of S8P's Market Insight. risk-protection contracts (i.e., acting as “matched traders") in which bankers take on their customers’ risk exposure and find creative ways to protect theit own insti- tutions from that exposure. As we will see later on, this popular financial service has led to phenomenal growth in such risk-hedging tools as swaps, options, and futures contracts. Convenience: The Sum Total of All Banking and Financial Services It should be clear from the list of services we have described that not only are banks and ther financial-service competitors offering a wide array of comparable services today, but tha: service menu is growing rapidly. New service delivery methods like the Intemet, cell phenes, and smart cards with digital cash are expanding and whole new service lines are being launched every year. Viewed a8 a whole, the impressive array of services offered and theservice delivery channels used by modern financial institutions add up to greater con- venience for their customers, who can satisfy virtually all their financial-service needs at cone location. Banks and some of their competitors have become the financial department stores of the modern era, working to unify banking, fiduciary, insurance, and security br>- keerage services under one roof—a trend often referred to as universal banking in theChapter 1 An Overuew of Banks and the Financial-Servces Sector. 19 TABLE 1-2 aeee iis Leading Letting Banking-Oriented Firms Leading Global Nonbank Service Providers, Security Financial Service * around the Globe Dealers, Brokers, and Investment Bankers Firms around the Miz Financial Group Ld, Japan Morrill lynch, USA* Glebe Mitsubishi Banking Cor, Japan” Goldman Sachs, USA* Deutsche Bank AG, Germany Nomura Securities, Japan SoucesBankforInterasions!_ UES AG, Switzerland Daiwa Secures, Japan Seulemens BnkofEreond, — Ciigroup, In, USA Bank of oan and Bo of Governor the eles HSBC Holdings PLC, Great Britain* Reeve Sem. Ucyds TSB, Great Britain Insurance Companies Industrial and Commercial Bankof China Nippon Life Insurance BNP Paribus Group, France ‘AxafEquitable, Paris, France Barclays PLC, London, Great Britain® Metropolitan Life Insurence, USA* Bank of Montreal, Canada Prudential insurance, USA Canadian Imperial Bank of Cmnmorce 4.P. Morgan Chase & Company, USA® Bink of America Corp, USA" Finance Companies Agricultural Bank of China Household international, USA" Aistalian & NZ, Banking Group GE Capita, USA* "Tn pain he Edel Venion of SAPs Market loi United States and Great Britain, as allfinanz in Germany, and as bancassurance in France. Table 1-2 lists some of these financial department stores, including some of the very largest banks and competing nonbank financial firms in the world, while Table 1-3 lists the largest banks operating in the United States. ee a Bank Name Location of Headquarters Total Assets ($ bill Operating in the 4.2. Morgan Chase Bank, NA Columbus, Ohio. $983 United States Bank of America, NA Charlotte, North Carolina 838 (Toe snects os Ciibank, NA, New York City, Now York 685 Wachovia Bank, NA Charlote, North Carolina 185 reported for March Wills Fargo Bank, NA, Sioux Flls, South Dakota 367 31, 2005) Fieot National Bonk Providence, Rhode Island 23 Source National fvomacon US. Bank, NA Gincinnat, Ohio 188 Center, Federal Reeve HSBC Bank USA, NA ‘Wilmington, Delaware 138 Sytem Washington, DC SunTrust Bank ‘Afonta, Georgia 195 (hase BankUSA,N.A. Newark, Deleware 8 Ste Street Bank and Trust Company Boston, Massachusetts 8 KeyBank, NA. Cleveland, Ohio & ‘Nowe The designation A means Nations Asoiaton inating hath nk aig this designation i atonal hak hore by the Office of che Comer the Cureney in Washington, D.C as eps to most other tanks which are chareedby ‘What different kinds of services do banks offer the become so important in’ the modern financia Pie a) ec system? Cece Why. do banks and other financial intermediaries Ae coe ae i Porro ny bank? Why do you think these institutions hav ce20 PartOne Introduction tothe Busines of Banking and Financal-Seies Management (1-5 Key Trends Affecting All Financial-Service Firms) The foregoing survey of financial services suggests that banks and many of their financial- service competitors are currently undergoing sweeping changes in function and form. In fac, the changes affecting the financial-services business today are so important that many industry analysts refer to these trends as a revolution, one that may well leave financial institutions of the next generation almost unrecognizable. What are the key trends reshep- ing banking and financial services today? Sewice Proliferation Léeding financial firms have been rapidly expanding the menu of services they offer to their customers. This trend toward service proliferation has accelerated in recent years under the pressure of increasing competition from other financial firms, more knowledge- able and demanding customers, and shifting technology. The new services have opened up new sources of revenue—service fees (called fee income), which are likely to continue to grow relative to more traditional sources of financial-service revenue (such as the interest earned on loans). Rising Competition ‘The level and intensity of competition in the financial-services field have grown as finan- cial institutions have proliferated their service offerings. For example, the local bank offer- ing business and consumer credit, savings and retirement plans, and financial counseling faces direct competition forall of these services today from other banks, thrift institutions like Washington Mutual, securities firms like Merrill Lynch, finance companies like GE Capital, and insurance companies and agencies like Prudential. This trend toward rising competition has acted as a spur to develop still more services for the future and to reduce operating costs. Government Deregulation Rising competition and the proliferation of financial services have been spurred on by government deregulation—a loosening of government control—of the financial services industry that began more than two decades ago and has spread around the globe. As we will see more fully in the chapters ahead, U.S. deregulation began with the lifting of government-imposed interest rate ceilings on savings deposits in an effort to give the public a fairer return on their savings. Almost simultaneously, the services many of bank- ings key competitors, such as savings and loans and credit unions, could offer were sharply expanded by legislation so they could remain competitive with banks. Such leading nations as Australia, Canada, Great Britain, and Japan have recently joined the deregula- tion movement, broadening the legal playing field for banks, security dealers, and other financial-service companies operating in a freer and more competitive matketplace. An Increasingly Interest-Sensitive Mix of Funds Government deregulation of the financial sector has mace it possible for customers to ean higher and more flexible rates of return on their savings and payments accounts. Massive amounts of funds have flowed from older, low-yielding savings instruments and noninterest- bearing checking accounts into newer high-yielding accounts whose rates of return could be changed with market conditions. Thus, bankers and their closest competitors found themselves with an increasingly interest-sensitive mix of funds. Financial-service managers have discovered that they are facing a better-educated, as well as more interest-sensitive, customer today, whose loyalty can more easily be lured awey by aggressive competitors. Financial-service providers must now strive to be mereChapter) An Overview of Banks and the Financial Services Sector 21 competitive in the returns they offer on the public’s money and more sensitive to chang- ing public preferences with regard to how savings are allocated. Technological Change and Automation Banks and many of their most serious competitors (for example, insurance companies) have been faced with higher operating costs in recent years and, therefore, have turned increasingly to automation and the installation of sophisticated electronic systems to replace older, labor-based production and delivery systems. This move toward greater tech- nological change is especially evident in the delivery of such services as dispensing pay- ments and making credit available to qualified customers. The most prominent examples of major technological innovations in financial servizes include automated tellet machines (ATMs), cell phones, point of sale (POS) terminals, and debit cards. There are well over 300,000 ATMs in the United States today and a compara- ble number in Europe, giving customers 24-hour access to their accounts for cash with- drawals and deposits and to a widening menu of other services. Also accessible well beyend “ankers' hours” are POS terminals in stores and shopping centers that replace paper-based ‘means of paying for goods and services with rapid computer entries. Even more rapidly growing are encoded debit cards that permit a customer to pay for purchases of goods end. services with the swipe of a card through an electronic card reader, while in some parts of the world customers can pay for purchases simply by waving their cell phones, which con- tain embedded chips, over an electronic sensor at some merchants’ cash tegisters. Thus, banking and financial services now comprise a more capital-intensive, fuxed-cost industry and a less labor-intensive, variable-cost industry than in the past. Some experts believe that traditional brick-and-mortar buildings and face-to-face meetings with cus- tomers eventually will become relics of the past, replaced almost entirely by electronic communication. Service production and delivery would then be fully automated. Techno- logical advances such as these will significantly lower the per-unit costs associated with high-volume transactions, but they will tend to depersonalize financial services and result in further loss of jobs as capital equipment is substituted for labor. Recent experience sug- gests, however, that fully automated financial services for all customers may be a long time coming, A substantial proportion of customers still prefer personalized service and the ofportunity to consult personally, one to one, with their financial advisor. Consolidation and Geographic Expansion Making efficient use of automation and other technological innovations requires a high vclume of sales, So financial-service providers have had to expand their customer base by reaching into new and more distant markers and by increasing the number of service units sold. The result has been a dramatic increase in branching activity in order to provide rnultiple offices (ie., points of contact) for customers, the formation of financial holding ccmpanies that bring smaller institutions into larger conglomerates offering multiple ser- vices in multiple markets, and mergers between some of the largest bank and nonbank financial firms, such as J. P. Morgan Chase with Bank One, Bank of America with Fleet Boston Financial Group and MBNA, and Deutsche Bank of Germany with Bankers T-ust Company of New York. “The number of small, independently owned financial institutions is declining and the average size of individual banks, as well as securities firms, credit unions, finance compa nies, and insurance firms, has risen significantly. This consolidation of financial institutions thas resulted in a decline in employment in the financial-services sector. Convergence Service proliferation and greater competitive rivalry among financial firms have led to a powerful trend, toward convergence, particularly on the part of the largest financialI | 1-6 The Plan of This Book_) 2 PartOne Introduction eo the Busines of Banking ane Financal-Servces Management Factoid ‘When in American history did the greatest numberof banks fail? Between 1929 and 1933, when about one-third (approximately 9,000) of all US. banks failed for were merged out of institutions: Convergence refers to the movement of businesses across industry lines so that a firm formerly offering only one product line ventures into other product lines -0 broaden its sales base. This phenomenon has been most evident among larger banks, insurance companies, and security broker/dealer firms that have eagerly climbed into each other's backyard. Clearly, competition intensifies in the wake of convergence 3s businesses previously separated into different industries now find their former industry boundaries no longer discourage new competitors. Under these more intense competi- tive pressures, weaker firms will fail or he merged into companies that are ever larger and offer more diverse services Globalization The geographic expansion and consolidation of financial-service units have reached well beyond the boundaries of a single nation to encompass the whole planet—a trend called lobulization. The largest financial firms in the world compete with each other for business on every continent. For example, huge banks headquartered in France (led by BNP Paribus), Getmany (led by Deutsche Bank), Great Britain (led by HSBC), and the United States (led by Citigroup and J. P. Morgan Chase) have become heavyweight competitors in the global market for corporate and government loans. Deregulation has helped all these institutions compete more effectively and capture growing shares of the global mar- ket or financial services. ‘The primary goal of this book is to provide the reader with a comprehensive understanding of the financial-services industry and the role of banking in that industry. Through its seven ‘major parts we pursue this goal both by presenting an overview of the financial-services industry as a whole and by pointing the reader toward specific questions and issues that bankers and their principal competitors must resolve every day. Fart One, consisting of Chapters 1 through 4, provides an introduction to the world of banking and financial services and their functions in the global economy. We explore the principal services offered by banks and many of their closest competitors, and we examine the many ways financial firms are organized to bring together human skill, capital equip- ment, and natural resources to produce and deliver their services, Part One also explains how and why banks and other financial-service providers are regulated and who their principal regulators are. Part One concludes with an analysis of the different ways finan cial institutions deliver their services to the public, including the chartering of new finan cial firms, constructing branches, installing ATMs and point-of-sale terminals, expansion of call centers, and use of the Internet. Part Two introduces readers to the financial statements of banks and their closest com petitors. Chapter 5 explores the content of balance sheets and income/expense statements, while Chapter 6 examines measures of performance often used to gauge how well banks and their closest competitors are doing in serving their stockholders and the public. Among the most important performance indicators discussed are numerous measures of financial firm profitability and risk. Part Three opens up the dynamic area of asset-liability management (ALM). Chapters 7, 8yand 9 describe how financial-service managers have changed their views about man- aging assets, liabilities, and capital and controlling rsk in recent yeurs. These chapters take a detailed look at the most important techniques for hedging against changing market interest rates, including financial futures, options, and swaps. Part Three also explores some of the newer tools to deal with credit risk and the use of off-balance-sheet financing techniques, including securitizations, loan sales, and credit derivatives.