Consumer Bankers Association Conway Data, Inc. Countrywide Financial Corp. Credit Research Foundation Cfedit Union National Association Dailyii.com DefaultRisk.com ‘The Derivatives ‘Zine Deutsche Bundesbank Dresdner Bank Dun & Bradstreet Economagic.com ‘eFinancialCareers Ltd. Equifax European Banking Industry Committee European Central Bank Experian Fairlsaac FannieMae Farin & Associates The Federal Deposit Insurance Corporation Federal Financial Institutions Examination Council Federal Reserve Bank of Chicago Federal Reserve Bank of Cleveland Federal Reserve Bank of Kansas City Federal Reserve Bank of New York Federal Reserve Bank of Richmond Federal Reserve Bank of San Francisco Federal Reserve Bank of St. Louis Federal Reserve Discount Window Federal Trade Commission Federally Insured Saviags Network FHLB Boston Finance Encyclopedia Financial Institutions Center Financial Jobs Financial Managers Scciety Financial Pipeline Financial Security Assurance, Inc. FindLaw Freddie Mac FreeCreditDerivatives.com_ Futuresweb GE Capital Global Islamic Banking Consulting GMAC Financial Services Hedge Fund Center Home Loan Learning Center How to Advice HSBC HSH Associates BT iHlireBanking LLC www.cbanet.org, ‘www.conway.com ‘www.countrywide.com www.crfonline.org www.cuna.org www.institutionalinvestor.com www.defaultrisk.com www.margrabe.com www.bundesbank.de www.dresdner-bank.de www.dnb.com ‘www,economagic.com www.efinancialcareers.com www.equifax.com wwweubic.org wwweeb. int www.experian.com www-fairisaac.com www.fanniemae.com www.cyfi.com wwwfidic.gov wwwaffiec. gov www.chicagofed.org www.clevelandfed.org www.ke.frb.org wwwany.frb.org www.tichmondfed.org. www.frbsf.org www.stlouisfed.org www.irbdiscountwindow.org, wwwiite.gov wwwfisn.com wwwfhibboston:com www-finance-encyclopedia.com http://fic. wharton.upenn.edu www-financial-jobs.com wwwfimsinc.org www.finpipe.com www.fsa.com wwwlibrary.findlaw.com www.freddiemac.com www freecreditderivatives.com www.futuresweb.com www.gecapital.com www. globalislamicbanking.com www.gmacfs.com, www hedgefundcenter.com wwwhomeloanlearningcenter.com www.howtoadvice.com www.hsbcusa.com www.hsh.com www.intbantec.com www ihirebanking.com“So eeThe McGraw-Hill/Irwin Series in Finance, Insurance and Real Estate Stephen A. Ross Franco Malian Professor of Finance ‘end Beonomies Sloan Schl of Management Massachusets Insti of Technology Consuing Edtor FINANCIAL MANAGEMENT Adair Excel Applications for Corporate Finance First Edition Benninga and Sarig Corporate Finance: A Valuation Approach Block and Hiet Foundations of Financial Management ‘Twelfth Edition Brealey, Myers, and Allen Principles of Corporate Finance Eighth Edition Brealey, Myers and Marcus Fundamentals of Corporate Finance Fifth Edition Brooks FinGame Online 4.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation, Fifth Battion Chew ‘The New Corporate Finance: Where Theory Meets Practice Third Edition Chew and Gillan Corporate Governance atthe Cressroads: A Book of Readings First Edition DeMello (Cases in Finance Second Edition Grinblace and Titman, Financial Markets and Corporate Strategy Second Edition Helfer: ‘Techniques of Financial Analysis: ‘A Guide to Value Creation Eleventh Edition. 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FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom and Mahoney Pension Planning: Pension, Profit-Sharing, and Other Deferred ‘Compensation Plans [Ninth Eaton Altfes Personal Financial Planning First Edition Harrington and Niehaus ‘Risk Management and Insurance Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An Active “Approach-to Help You Develop Successfal- ancial Skills First Edition Kapoor, Dlabay, and Hughes Personal Finance Eighth Edition 1 A Value Approachcra BANK MANAGEMENT & FINANCIAL SERVICES International Edition 2008 [Exclusive rights by McGraw-Hill Education (Asia), for manufacture and export. This book cannot be re-exported from the country to which its sold by McGraw-Hill. ‘The International Edition is not available in North America. Published by McGraw-Hil/Irwin, a business unit of The McGraw-Hill Companies, Inc, 1221 Avenue of the Americas, New Yori, NY, 10020. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. ‘No pat of this publication may be reproduced or distributed in any form or by any ‘means, or stored ina database or retrieval system, without the prior written consent of The McGraw- Hill Companies, Inc. including, but not limited to, in any network or ther electronic storage or transmission, or broadcast for distance learning ‘Some ancillaries, including electronic and print components, may not be available to customers outside the United States. 10 09 08 07 06 05 04 03 20 09 08 07 CIF BIE 978-007-125938-5 or 007-125938-4 ‘When ordering this title, use ISBN: 978-007-125967-5 or MHID: 007-125967-8 (S&P card) Printed in Singapore ‘www.mbhe.comTo my family. —Peter S. Rose To my mother, Bertha Watson Hudgins (1920-2004). —Sylvia C. HudginsBrief Contents Preface xvii PART ONE Introduction to the Business of Banking and Financial-Services Management 1 1 An Overview of Banks and the Financial-Services Sector 3 2 The Impact of Government Policy and Regulation on Banking and the Financial-Services Industry 31 3° The Organization and Structure of Banking and the Financial-Services Industry 65 4 Establishing New Banks, Branches, ATMs, Telephone Services, and Web Sites 99 PART TWO Financial Statements and Financial Firm Performance 127 5 The Financial Statements of Banks and Their Principal Competitors 129 6 Measuring and Eveluating the Performance of Banks and Their Principal Competizors 163 PART THREE Asset-Liability Management Techniques and Hedging Against Risk 205 7 Asset-Liability Management: Determining and Measuring Interest Rates and Controlling Interest-Sensitive and Duration Gaps 207 8 ° Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset- Liability Management 245 9 Risk Management Using Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives 281 PART FOUR Managing the Investment Portfolios and Liquidity Positions of Banks and Their Principal Competitors 307 10 The Investment Function in Banking and Financial-Services Management 309 11 Liquidity and Reserve Management: Strategies and Policies 347 PART FIVE Managing Sources of Funds for Banks and Their Principal Competitors 385 12 Managing and Pricing Deposit Services 387 13 Managing Nondeposit Liabilities and Other Sources of Borrowed Funds 417 14 Investment Banking, Insurance, and Other Sources of Fee Income 447 15 The Management of Capital 475Briaf Contents PART SIX 20 International Banking and the Future of Providing Loans to Businesses Banking and Financial Services 649 and Consumers 511 Dictionary of Banking and Financial-Service 16 Lending Policies end Procedures 513 Terms 679 17 Lending to Business Firms and Pricing Index 695 Business Loans 543 18 Consumer Loans, Credit Cards, and Real Estate Lending 583 PART SEVEN Managing the Future in a Global Marketplace 621 19. Acquisitions and Mergers in Financial- Services Management 623Contents Preface xvii PART ONE INTRODUCTION TO THE BUSINESS OF BANKING AND FINANCIAL- SERVICES MANAGEMENT 1 Chapter 1 An Overview of Banks and the Financial- Services Sector 3 Key Topics in This Chapter 3 1-1 Introduction 3 Powerful Forces Are Reshaping Banking and Financial Services Today 4 1-2 What Isa Bank? 4 1-3 The Financial System and Competing Financial- Service Institutions 8 Roles of the Financial System 8 The Competitive Challenge fr Banks 8 Leading Competitors with Banks 8 14 Services Banks and Many of Their Closest Competitors Offer the Public 12 Services Banks Have Offered throughout History 12 Services Banks and Many of Their Financial-Service Competitors Have Offered More Recently 14 Dealing in Securities: Offering Security Brokerage and Investment Banking Services 17 Convenience: The Siem Total of All Banking and Financial Sevices 18 1-5 Key Trends Affecting All Financial-Service Firms 20 1-6 The Plan of This Book 22 Summary 24 Key Terms 25 Problems and Projects 25 Internet Exercises 26 S&P Market Insight Challenge 27 Real Numbers for Real Banks: ‘The Very First Assignment 28 Selected References 28 Appendix: Career Opportunities in Financial Services 29 Chapter 2 ‘The Impact of Government Policy and Regulation on Banking and the Financial- Services Industry 31 Key Topics in This Chapter 31 2-1 Introduction 31 2-2 Banking Regulation 32 Pros and Cons of Strict Rules 32 ‘The Impact of Regulation—The Arguments for Strict Rules versus Lenient Rules 34 2.3 Major Banking Laws—Where and When the Rules Originated 35 Meet the “Parents”: The Legislation That Created Today's Bank Regulators 35 Instilling Social Graces and Morals—Social Responsibility Laws 40 Legislation Aimed at Allowing Interstate Banking: Where Can the "Kids" Play? 41 ‘The Gramm-Leach-Bliley Act (1999): What Are Acceptable Activities for Playtime? 43 ‘The USA Patriot and Bank Secrecy Acts: Fighting Terrorism and Money Laundering 44 Telling the Truth and Not Stretching It—The Sarbanes- Oxley Accounting Standards Act (2002) 45 2-4 The 21st Century Ushers In an Array of New Laws, Regulations, and Regulatory Strategies 46 2-5 The Regulation of Nonbank Financial-Service Firms Competing with Banks 51 Regulating the Thrift (Savings) Industry 51. Regulating Other Nonbank Financial Firms 52 Are Regulations Really Necessary in the Financial-Services Sector? 53 2-6 The Central Banking System: Its Impact on the Decisions and Policies of Financial Institutions 53 Organizational Structure of the Federal Reserve System 54 ‘The Central Bank's Principal Task: Making and Tmplementing Monetary Policy 55 Summary 59 Key Terms 60 Problems and Projects 60 Internet Exercises 61 S&P Market Insight Challenge 61Real Numbers for Real Banks: Assignment for Chapter 2 62 Selected References 62 Chapter 3 The Organization and Structure of Banking and the Financial-Services Industry 65 Key Topics in This Chapter 65 3-1 Introduction 65 3-1 The Organization and Structure of the Commercial Banking Industry 66 ‘Advancing Size and Concentration of Assets 66 Isa Counterrend Now under Way? 67 3.3 Internal Organization of the Banking Firm 68 Community Banks and Other Commueity-Oriented Financial Firms 68 Larger Banks—Money Cener, Wholesale and Retail 70 “Trends in Organization 7L 3.4 The Atray of Organizational Structures and “Types in the Banking Industry 71 Uni Banking Organization: 73 Branch Banking Organizations 74 Electronic Branching —Web Sites and Electronic Networks: ‘An Altemative ora Supplenent to Traditional Bank Branch Offices? 76 Bank Holding Company Organizations 78 3-5 Interstate Banking and the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 82 Research on Inerstate Banking 83 3.6 Two Alternative Types of Banking Organizations Available as the 21st Century Opened: Financial Holding Companies (FHCs) and Bank Subsidiaries 83 3-7 Mergers and Acquisitions Reshaping the Structure and Organization of the Financial-Services Sector 86 3-8 The Changing Organization and Structure of Banking's Principal Competitors 86 3-9 Efficiency and Size: Do Bigger Financial Firms Operate at Lower Cost? 88 Efficiency in Prodicing Financial Services 88 3-10 Financial Firm Goals: Their Impact on Operating Cost, Efficiency, and Performance 90 Summary 92 Key Terms 93 Problems and Projects 93 Internet Exercises 94 ‘S&P Market Insight Challenge 95 Real Numbers for Real Banks: ‘Assignment for Chapter 3.95 Selected References 96 Contents ix Chapter 4 Establishing New Banks, Branches, ATMs, Telephone Services, and Web Sites 99 Key Topics in This Chapter 99 4-L Introduction 99 4-2 Chartering a New (De Novo) Financial-Servic= Institution 100 4-3 The Bank Chartering Process in the United States 101 4-4 Questions Regulators Usually Ask the Organizers ofa New (De Novo) Bank 102 4-5 Factors Weighing on the Decision to Seek aNew Charter 103 4-6 Volume and Characteristics of New Bank Charters 104 4-7 How Well Do New Charters Perform? 104 4-8 Establishing Full-Service Branch Offices: Choosing Locations and Designing New Branches 105 Desirable Sites for New Branches 108 Branch Regulation 111 ‘The Changing Role of Financial Service Branch Offices 111 In-Store Branching 112 4-9 Establishing and Monitoring Automated Limited-Service Facilities 113 Point-of-Sale Terminals 113 ‘Automated Teller Machines (ATMs) 114 4-10 Home and Office Banking 116 ‘Telephone Banking and Call Centers 117 Inceret Banking 117 4-11 Financial-Service Facilities of the Future 119 Summary 121 Key Terms 122 Problems and Projects 122 Internet Exercises 123 ‘S&P Market Insight Challenge 124 Real Numbers for Real Banks: ‘Assignment for Chapter 4 124 Selected References 125 PART TWO FINANCIAL STATEMENTS AND FINANCIAL FIRM PERFORMANCE = 127 Chapter 5 The Financial Statements of Banks and Their Principal Competitors 129 Key Topics in This Chapter 129 5-1 Introduction 129x Contents 5-2 An Overview of Balance Sheets and Income Statements 130 5-3 The Balance Sheet (Report of Condition) 130 ‘The Principal Types of Accounts 130 Recent Expansion of Off-Bakmce-Sheet Items inBanking 141 The Problem of Book-Value Accounting 142 ‘Auadiing: Assuring Reliability of Financial Staements 144 5-4 Components of the Income Statement (Report of Income) 144 Financial Flows and Stocks 146 Comparative Income Statement Ratios for Different-Size Financial Firms 151 5-5 The Financial Statements of Leading Nonbank Financial Firms: A Comparison to Bank Statements 151 5-6 An Overview of Key Features of Financial Statements and Their Consequences 152 Summary 153 Key Terms 154 Problems and Projects 154 Internet Exercises 158 ‘S&P Market Insight Challenge 159 Real Numbers for Real Bans: Assignment for Chapter 5 160 Selected References 162 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 163 Key Topics in This Chapter 163 6-1 Introduction 163 6-2 Evaluating Performance 164 Determining Long-Range Objectives 164 Maximizing the Value ofthe Firm: A Key Objective for ‘Nearly All Financial-Servce insticwtions 164 Profitability Ratios: A Surrogate for Stock Values 166 Using Profitability Formudas for Banks and Other Financial-Service Companies 169 Breaking Down Equity Retns for Closer Analysis 170 Breakdown Analysis ofthe Return on Assets 174 What a Breakdown of Proftaviiy Measures Can TelUs 175 Measuring Risk in Banking ard Financial Services 176 Other Goals in Banking nd Financil-Services Management. 182 6-3 Performance Indicators among Banking’s Key Competitors 182 6-4 The Impact of Size on Performance 183 Size, Location, and Regulatory Bias in Analyzing the Performance of Banks and Competing Financial Instiwions 184 Using Financial Ratios and Other Analytical Tools to Track Bank Performance—The UBPR 185 Summary 194 Key Terms 195 Problems and Projects 195 Internet Exercises 200 S&P Market Insight Challenge 200 Real Numbers for Real Banks: Assignment for Chapter 6 201 Selected References 202 Appendix: Improving the Performance of Financial Firms through Knowledge: Sources of Information on. the Financial-Services Industry 203 PART THREE ASSET-LIABILITY MANAGEMENT TECHNIQUES AND HEDGING AGAINST RISK 205 Chapter 7 Asset-Liability Management: Determining and Measuring Interest Rates and Controlling Interest-Sensitive and Duration Gaps 207 Key Topics in This Chapter 207 7-1 Introduction 207 7-2 Asset-Liability Management Strategies 208 Asset Management Strategy 208 Liability Management Strategy 208 Fumds Management Strategy 209 7-3 Interest Rate Risk: One of the Greatest Asset- Liability Management Challenges 210 Forces Determining Interest Rates 210 The Measurement of Interest Rates 211 ‘The Components of Interest Rates 212 Responses to Interest Rate Risk 215 7-4 One of the Goals of Interest Rate Hedging 215 Inerest-Sensitive Gap Management 216 Duration Gap Management 226 75 The Concept of Duration 226 7-6 Using Duration to Hedge against Interest Rate Risk 228 7-1 The Limitations of Duration Gap Management 235 Summary 236 Key Terms 237Problems and Projects 237 Internet Exercises 240 S&P Market Insight Challenge 241 Real Numbers for Real Banks: Assignment for Chapter 7 241 Selected References 242 Chapter 8 Using Financial Futures, Options, Swaps, and Other Hedging Tools in Asset-Liability Management 245 Key Topics in This Chapter 245 8-1 Introduction 245 8-2 Uses of Derivative Contracts 246 8-3 Financial Futures Contracts: Promises of Future Security Trades at a Set Price 248 ‘The Shore Hedge in Fucwres 252 ‘The Long Hedge in Futures 253 8-4 Interest-Rate Options 259 8-5 Regulations and Accounting Rules for Bank Futures and Options Tradirg 264 8-6 Interest-Rate Swaps 266 8-7 Caps, Floors, and Collars 272 Invcerest-Race Caps 272 Incerest-Rave Floors 272 Inverest Race Collars 273 Summary 274 Key Terms 274 Problems and Projects 275 Internet Exercises 278 Real Numbers for Real Banks: ‘Assignment for Chapter 8. 279 ‘S&P Market Insight Challenge 280 Selected References 280 Chapter 9 Risk Management Using Asset- Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives 281 Key Topics in This Chapter 281 9-1 Introduction 281 9-2 Securitizing Loans and Other Assets 282 ‘The Beginnings of Securitizaton—The Home Morgage Market 285 Examples of Other Assets Thet Have Been Securitzed 287 ‘The Impact of Securitization upon Lending Insticutions 289 Regulators! Concems about Securitization 290 9-3 Sales of Loans to Raise Funds and Reduce Risk 290 Contents xi Reasons behind Loan Sales 292 ‘The Riss in Loan Sales 292 9-4 Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance 293 ‘The Structure of SLCs 294 ‘The Value and Pricing of Standby Letters 294 Sources of Risk with Standbys 295 Regulatory Concems about SLCs 295 Research Studies on Standby, Loan Sales, and Securitiations 296 9-5 Credit Derivatives: Contracts for Reducing (Credit Risk Exposure on the Balance Sheet 297 Credit Swaps 297 Credit Options 298 Credit Default Swaps (CDSs) 299 Credic-Linked Notes 300 Collateralized Debt Obligations (CDOs) 300 Risks Associated with Credit Derivatives 300 Summary 301 Key Terms 302 Problems and Projects 302 Internet Exercises 304 S&P Market Insight Challenge 304 Real Numbers for Real Banks: Assignment for Chapter 9 305 Selected References 305 PART FOUR MANAGING THE INVESTMENT PORTFOLIOS AND LIQUIDITY POSITIONS OF BANKS AND THEIR PRINCIPAL COMPETITORS 307 Chapter 10 ‘The Investment Function in Banking and Financial-Services Management 309 Key Topics in This Chapter 309 10-1 Introduction 309 10-2 Investment Instruments Available to Financial Firms 310 10-3 Popular Money Market Investment Instruments 311 Treasury Bills 311 Short-Term Treasury Notes and Bonds 313 Federal Agency Securities 313 Contfcates of Deposit 313 International Eurocuerrency Deposits 313 Bankers’ Acceptances 314 Commercial Paper 314 Short-Term Municipal Obligations 314xii Contents 10-4 Popular Capital Market Investment Instruments 315 Treasury Notes and Bonds 315 Municipal Notes and Bonds 315 Corporate Notes and Bonds 315 10-5 Investment Instruments Developed More Recently 316 10-6 Investment SecuritiesHeld by Banks 318 10-7 Factors Affecting Choice of Investment Securities 320 Expected Rate of Return 320 Tax Expose 321 Interest Rate Risk 326 Creditor Default Risk 326 Business Risk 328 Liquidity Risk 328 Call Risk 328 Prepayment Risk 328 Inflation Risk 330 Pledging Requirements 33. 10-8 Investment Maturity Strategies 331 10-9 Maturity Management Tools 334 The Yield Curve 334 Duration 336 Summary 338 Key Terms 339 Problems and Projects 339 Intemet Exercises 341 S&P Market Insight Challenge 342 Real Numbers for Real Banks: Assignment for Chapter 10 342 Selected References 345 Chapter 11 Liquidity and Reserve Management: Strategies and Policies 347 Key Topics in This Chapter 347 11-1 Introduction 347 11-2 The Demand for and Supply of Liquidity 348 11-3 Why Financial Firms Often Face Significant Liquidity Problems 350 11-4 Strategies for Liquidity Managers 351 Asset Liquidity Management (or Asset Conversion) ‘Strategies 351 Borrowed Liquidity (Liebiley) Management Swraegies 352 Balanced Liquidity Management Strategies 353 Guidelines fr Liquidity Managers 354 11-5 Estimating Liquidity Needs 354 “The Sources and Uses of Funds Approach 355 ‘The Strucure of Funds Approach 358 Liquidity Indicator Approach 362 ‘The Ultimate Standard for Assessing Liquidity Needs Signal from the Marketplace 364 11-6 Legal Reserves and Money Position Management 365 Regulations on Calculating Legal Reserve Requirements 365 Factors Influencing the Money Position 369) 11-7 Factors in Choosing among the Different Sources of Reserves 373 11-8 Central Bank Reserve Requirements around the Globe 375 Summary 375 Key Terms 376 Problems and Projects 376 Real Numbers for Real Banks: Assignment for Chapter 11 381 Internet Exercises 382 S&P Market Insight Challenge 382 Selected References 382 PART FIVE MANAGING SOURCES OF FUNDS FOR BANKS AND THEIR PRINCIPAL COMPETITORS 385 Chapter 12 Managing and Pricing Deposit Services 387 Key Topics in This Chapter 387 12-1 Introduction 387 12-2 Types of Deposits Offered by Banks and Other Depository Institutions 388 Transaction (Payments or Demand) Deposits 388 Nontransaction (Savings or Thrift) Deposits 389 12-3 Interest Rates Offered on Different Types of Deposits 390 ‘The Composiion of Deposits 391 The Ounership of Deposits 392 The Cost of Different Deposie Accounts 393 12-4 Pricing Deposit-Related Services 396 12-5 Pricing Deposits at Cost Plus Profit Margin 396 Estimating Deposit Sérice Costs 397 ‘An Example of Pooled-Funds Costing 397 12-6 Using Marginal Cost to Set Interest Rates on Deposits 399 Conditional Pricing 401 12-7 Pricing Based on the Total Customer Relationship and Choosing a Depository 405The Role That Pricing and Other Factors Play When ‘Customers Choose a Depository Institution to Hold Their Accounts 405 12-8 Basic (Lifeline) Banking: Key Services for Low-Income Customers 406 Summary 408 Key Terms 409 Problems and Projects 409 Internet Exercises 411 Real Numbers for Real Barks: Assignment for Chapter 12 412 S&P Market Insight Challenge 414 Selected References 414 Chapter 13 Managing Nondeposit Liabilities and Other Sources of Borrowed Funds 417 Key Topics in This Chapter 417 13-1 Introduction 417 13~2 Liability Management and the Customer Relationship Doctrine 417 13-3 Alternative Nondepesit Sources of Funds 420 Federal Funds Market ("Fes Funds") 420 Repurchase Agreements as aSource of Funds 423 Borrowing from the Federal Reserve Bank 425 Advances from the Federal Home Loan Banks 427 Development and Sale of Large Negotiable CDs 428 The Evrocurrency Deposit Market 429 Commercial Paper Market 431 Long-Term Nondeposit Funds Sources 431 13-4 Choosing among Alternative Nondeposit Sources 433 Measuring a Financial Firm’ Total Need for Nondeposit Funds: The Available FundsGep 433 Nondeposit Funding Sources: Factors to Consider 434 Summary 440 Key Terms 441 Problems and Projects 442 Internet Exercises 444 ‘S&P Market Insight Challenge 445 Real Numbers for Real Banks: Assignment for Chapter 13 445 Selected References 446 Chapter 14 Investment Banking, Insurance, and Other Sources of Fee Income 447 Key Topics in This Chapter 447 14-1 Introduction 447 Contents xii 14-2 Sales of Investment Banking Services 448 Key Investment Banking Services 449 Linkages beaueen Commercial and Invesement Banking 450 Possible Advantages and Disadvantages of Linking Commercial and Investment Banking 451 Key Issues for Investment Banks of the Future 452 14-3 Selling Investment Products to Consumers 453 Mutual Fiend Investment Products 454 Annuity Investment Products 455 Selling Investment Products 456 Risks and Redes for Selling Investment Products 457 14-4 Trust Services as a Source of Fee Income 458 14-5 Sales of Insurance-Related Products 460 Types of Insurance Products Sold Today 460 Rules Covering Insurance Sales by Federally Insured Depository Institutions 461 14-6 The Alleged Benefits of Financial-Services Diversification 462 ‘An Example ofthe Product-Line Diversifcaion Effect Reducing Risk 463, Potential Economies of Sale and Scope 464 14-7 Information Flows within the Financial Firm 466 Summary 468 Key Terms 469 Problems and Projects 469 Internet Exercises 470 S&P Market Insight Challenge 470 Real Numbers for Real Banks: Assignment for Chapter 14-471 Selected References 472 Chapter 15 ‘The Management of Capital 475 Key Topics in This Chapter 475 15-1 Introduction 475 15-2 The Many Tasks Capital Performs 476 15-3 Capital and Risk 477 Key Risks in Banking and Financial Institutions Management 477 Defenses against Risk 478 15-4 Types of Capital in Use 479 Relative Importance of Different Sources of Capital 479 15-5 One of the Great Issues in the History of Banking: How Much Capital Is Really Needed? 482 Regulatory Approach to Evaluating Capital Needs 482 15-6 The Basel Agreement on International Capital Standards: A Historie Contract among Leading Nations 483xiv. Contents Basel 484 Copital Requirements Auached to Derivatives 487 Basel Il: A New Capital Accord Unfolding 492 15-7 Changing Capital Standards Inside the United States 496 15-8 Planning to Meet Cagital Needs 498 Raising Capital Incernally <98 Raising Capital Externally 500 Summary 503 Key Terms 504 Problems and Projects 504 Internet Exercises 506 S&P Market Insight Challenge 507 Real Numbers for Real Banks: Assignment for Chapter 15 508 Selected References 508 PART SIX PROVIDING LOANS TO BUSINESSES AND CONSUMERS 511 Chapter 16 Lending Policies and Procedures 513 Key Topics in This Chapter 513 16-1 Introduction 513 16-2 Types of Loans 514 Factors Determining the Growth and Mix of Loans 515 16-3 Regulation of Lending 516 Establishing « Written Loan Policy 519 16-4 Steps in the Lending Process 520 16-5 Credit Analysis: What Makes a Good Loan? 521 1. Is the Borower Crediswonhy? 522 2. Can the Loan Agreement Se Properly Structured and Documented? 525 3. Cari the Lender Perfect Its Claim against the Borrower's Earnings and Any Assets That May Be Pledged as Collateral? 525 16-6 Sources of Information about Loan Customers 528 16-7 Parts ofa Typical Loan Agreement 531 16-8 Loan Review 532 16-9 Handling Problem Loan Situations 533 Summary 535 Key Terms 536 Problems and Projects 536 Intemet Exercises 538 S&P Market Insight Challenge 539 Real Numbers for Real Banks: Assignment for Chapter 16 539 Selected References 540 Chapter 17 Lending to Business Firms and Pricing Business Loans 543 Key Topics in This Chapter 543 17-1 Introduction 543 17-2 Brief History of Business Lending 544 17-3 Types of Business Loans 544 17-4 Short-Term Loans to Business Firms 544 Self Liguidacing Inventory Loans 544 Working Capital Loans 545 Iwerim Construction Financing 545 Security Dealer Financing 546 Retailer and Equipment Financing 546 Asset Based Financing 547 Syndicated Loans (SNCs) 547 17-5 Long-Term Loans to Business Firms 548 Term Business Loans 548 Revolving Credit Financing 548 Long-Term Project Loans 550 Loans to Suppert the Acquistion of Other Business Firms 550 17-6 Analyzing Business Loan Applications 550 Analysis of a Business Borrower's Financial Statements 551 17-7 Financial Ratio Analysis of a Customer's Financial Statements 552 ‘The Business Customer's Control over Expenses 554 Operating Efficiency: Measure ofa Business Firm's Performance Eifeciveness 554 ‘Marketability of the Customer's Product or Sewice 555 Coverage Ratios: Measuring the Adequacy of Barings 556 Liquidity Indicators for Business Customers 557 Profitability Indicators 558 ‘The Financial Leverage Factor as a Barometer ofa Business Firm's Capital Structure 558 17-8 Comparing a Business Customer's Performance to the Performance of Its Industry 559 Contingent Liabilities 560 17-9 Preparing Statements of Cash Flows from Business Financial Statements 562 Pro Forma Statements of Cash Flows ‘and Balance Sheets 564 The Loan Officer's Responsibility tothe Lending Institution and the Customer 56617-10 Pricing Business Loans 568 ‘The Cost-Plus Loan Pricing Method 569 ‘The Price Leadership Model 569 Below-Prime Market Pricing 571 Customer Proftabiliry Analysis (CPA) 572 Summary 575 Key Terms 576 Problems and Projects 576 Internet Exercises 580 S&P Market Insight Challenge 581 - Real Numbers for Real Barks: Assignment for Chapter 17 581 Selected References 582 Chapter 18 Consumer Loans, Credit Cards, and Real Estate Lending 583 Key Topics in This Chapter 583 18-1 Introduction 583 18-2 Types of Loans Granted to Individuals and Families 584 Residential Loans 584 Nonresidental Loans 585 Credit Card Loans and Revoluing Credit 585 New Credit Card Regulations 586 Debit Cards: A Partial Subsiewe for Credit Cards? 586 Rapid Consumer Loan Grouth 587 18-3 Characteristics of Consumer Loans 587 18-4 Evaluating a Consumer Loan Application 588 18-5 Example of a Consumer Loan Application 590 18-6 Credit Scoring Consumer Loan Applications 594 The FICO Scoring System 596 18-7 Laws and Regulations Applying to Consumer Loans 597 Customer Disclosure Requirements 598 Outlawing Credit Discriminction 599 Predatory Lending and Subprime Loans 600 18-8 Real Estate Loans 601 Differences between Real Estate Loans and Other Loans 601 Factors in Evaluating Applications for Real Estate Loans 602 Home Equity Lending 603 ‘The Most Controversial of Home Mortgage Loans: Interest-Only Mortgages 605 18-9 The Changing Envircnment for Consumer and Real Estate Lending 605 Contents xv 18-10 A New Federal Bankruptcy Code Appears 606 18-11 Pricing Consumer and Real Estate Loans: Determining the Rate of Interest and Other Loan Terms 607 “The Interest Rate Attached to Nonresidential Consumer Loans 607 Interest Rates on Home Moregoge Loans 610 Summary 612 Key Terms 613 Problems and Projects 614 Internet Exercises 617 S&P Market Insight Challenge 617 Real Numbers for Real Banks: Assignment for Chapter 18 618 Selected References 619 PART SEVEN MANAGING THE FUTURE IN A GLOBAL MARKETPLACE 621 Chapter 19 Acquisitions and Mergers in Financial- Services Management 623 Key Topics in This Chapter 623 19-1 Introduction 623 19-2 Mergers on the Rise 624 19-3 The Motives behind the Rapid Growth of Financial-Service Mergers 626 19-4 Selecting a Suitable Merger Partner 630 19-5 The Merger and Acquisition Route toGrowth 632 19-6 Methods of Consummating Merger Transactions 633, 19-7 Regulatory Rules for Bank Mergers in the United States 635 Justice Department Guidelines 636 ‘The Merger Decision-Making Process by U.S. Federal Regulators 638 19-8 Merger Rules in Europe 638 19-9 Making a Success of a Merger 638 19-10 Research Findings on the Impact of Financisl- Service Mergers 640 ‘The Financial and Economic Impact of Acquisitions and Mergers 641 Public Benefits from Mergers and Acquisitions 642 Summary 643 Key Terms 644 Problems and Projects 644vi Contents Internet Exercises 645 S&P Market Insight Challenge 646 Real Numbers for Real Banks: Assignment for Chapter 19 646 Selected References 647 Chapter 20 International Banking and the Future of Banking and Financial Services 649 Key Topics in This Chapter 649 20-1 Introduction 649 20-1 Types of International Banking Organizations 650 20-3 Regulation of International Banking 652 Goals of International Banking Regulation 652 US. Banks’ Activites Abrocd 653 Expansion and Regulation of Foreign Bank Activity inthe United States 653 ‘New Capital Regulations for Major Banks Werldwide 654 20-4 Services Supplied by Banks in International Markets 655 ‘Making Foreign Currencies Availabe to Customers 655 Hedging against Foreign Currency Risk Exposure 656 Other Tools for Reducing Currency Risk 659 Supplying Customers with Short- and Long-Term Credit or Credit Guarantees 660 Supplying Payments and Thr (Savings) Instruments to International Customers 662 Underwriting Customer Note and Bond Issues inthe Ewrobond Market 663 Proveeting Customers against Interest Rate Risk 663 Helping Customers Market Their Products through Export Trading Companies 664 20-5 Challenges for International Banks in Foreign Markets 665 Growing Customer Use of Securities Markets toRaise Funds 665 Developing Better Methods for Assessing Risk in International Lending 665. Adjusting 10 New Market Opportunities Created by Deregulation and New International Agreements 669 20-6 The Future of Banking and Financial Services 670 Summary 674 Key Terms 675 Problems and Projects 675 Internet Exercises 676 S&P Market Insight Challenge 677 Real Numbers for Real Banks: Assignment for Chapter 20.677 Selected References 677 Dictionary of Banking a Terms 679 Index 695 \d Financial-ServicePreface Banks lie at the heart of the world’s financial system. They represent the source we often visit to find a foan to purchase a new home or automobile, start a new business, or finance a college education. They execute our orders by check, plastic card, telephone, o elec- tronic network to pay for the many goods and services we buy daily. They provide credit cards that offer a convenient record of how we spend our money and invite us to “buy now and pay later.” They protect and manage our savings to help us prepare financially for a “rainy day,” for help with college expenses, and for the retirement years when we hope to experience a different side of life. They advise us on the investments we make, help guice our businesses in raising funds in the capital markets, and create markets where old loans are sold to raise cash for making new loans. But banks are not the only financial firms today that stand in the spotlight at the cen- ter ting of the financial system. In truth, for many of us it is no longer possible to separate banis from other financial firms. Whether its a security broker or dealer, insurance com- pany, credit union, family of mutual funds, finance company, or even retail stores like Tar- get and J.C. Penny—all seem to offer many of the same financial services and advertise for our business in about the same way. Moreover, some of the biggest and best known of what wwe sometimes call “nonbank"” institutions (such as Prudential, Met Life, State Farm, and Merrill Lynch) now own and operate their own banks, which in many cases are growing rapidly and recording solid profits. And knocking on the door is the world’s biggest retailer, Wal-Mart, which seems to be venturing into financial services with one new service after another, including credit cards, money orders, and money transfers. Wal-Mart seems to be testing the waters of the financial marketplace and perhaps getting ready for the biggest splash of all, creating or acquiring a bank if they can gain federal and state approval ‘There was a time—it seems like ages ago now-—when, if we wanted to study banking, we might ignore these other financial institutions, fierce competitors though they are, and som=~ how pretend they weren’e there. That time passed us by long ago and today compels us to explore the management principles and best practices not just of banks, but all the rest of the financial-services sector as well. The manager of any financial institution who ignores this highly competitive, kaleidoscopic financial-service environment won't be around the shop for long anymore. After all, consumers know which way the wind is blowing in the financial sys- temand now are cruising the Internet to find the best deals and don't seem to care a whole lot swhese name happens to be attached to the particular financial services they buy. OF course, banks, insurance companies, security firms, and other financial-service providers have not taken these recent events lying down. The most aggressive are strug- sling to be ever bigger, more cost competitive and efficient, increasingly globalized, selling their wares by television, satellite, and the Web and reaching into every city and conti- nent on the planet. Some observers say there is no room anymore for the “small fry” n financial services—the small bank, modest-size finance company, store-front insurance agency, etc, situated just down the street. Yet, strangely, thousands of these “small fr” financial firms ate still with us and, in every year that passes, still more new small firms appeat with their financial weapons in hand, ready to joust, often quite successfully, with, the biggest financial companies around, ‘Thus, writing a book about financial-service institutions today is a daunting challenge. We have to present the principles of sound management and best practice, arming ourPreface reeders with the knowledge they need to grapple with the biggest and the smallest financial- service providers, the narrow focused boutiques and the highly service-diversified giants, the regulated and the unregulated financial providers, the familiar financial institutions and those not so well-known but just emerging to grab a piece of the financial-services pi. Sounds tough, doesn’t it? ‘Yes, writing about and studying financial institutions is a tough job, but it’s also adven- turous and exciting! Financial services is an industry we ignore at our personal and profes- sional peril. We must learn how to be comfortable with our knowledge of these firms end the services they offer because each of us as individuals and as professionals in our chosen field must rely upon their services as essentials that will shape our future. Moreover, some of us may need to know even more about financial firms because they often represent an attractive career opportunity. After all, financial-service providers are becoming more and more creative, more and more sensitive about how to “sell” their products instead of just sitting there and waiting for a customer to walk in the door or key into their Web site. Securing a job and a career in this dynamic sector of the economy ‘might be a fascinating and challenging alternative for you to explore. Hopefully this book will help you decide whether banking and financial services offers a real career opportu nity that meets your needs and interests New and Continuing Trends Covered in the Seventh Edition ) ‘The great changes that are reshaping banking and financial services today are captured inall patts of this new seventh edition of Bank Management & Financial Services. Among the key treads to watch for as you progress through this new edition of the text are the following: * Expanded coverage of the growing controversy over the walls erected by the United Stas, Japan, and other nations separating banking and commerce in order to safeguard the publi’s funds and Wal-Mart's possible future expansion into banking and financial services (see espe- cially Chapters 1, 2, and 20). * A more in-depth look at nonbank financial institutions, especially investment banks, insurance companies, and finance companies and their increasingly aggressive role within the financial system. Investment banking, in particular, has been given sub- stantially greater prominence in this new edition with greater emphasis on the inter- action between commercial and investment banking firms (particularly in Chaptets 2,3, and 14). ‘+ Expanded coverage of the increasingly dominating role played today by financial holding sompanies (FHCs), bringing together banks, insurance companies, investment banks, and other financial firms under the same corporate umbrella, FHCs now hold the majority of assets reported by all American financial institutions (see especially Chapters 2, 3, and 4) * Examination of the emergence of virtual banks—their strategies, services, and competi sive limitations (particularly in Chapters 3 and 4) © A more in-depth analysis of Basel II as the largest banks around the world come under new capital guidelines laid down by the recently revised Basel Agreement among leed- ing nations, including an expanded discussion of value at risk (VaR), internal model- ing, and stress testing (see especially Chapter 15). * An exploration of newly recognized forms of risk in banking and financial services, nncluding operational risk, compliance and legal risk, reputational risk, and strategic risk (particularly in Chapters 6 and 15).Preface xix Expanded coverage of the securitization process and credit drivatives—devices aimed at reducing risk exposure and providing new sources of revenue for financial institutions (Gee especially Chapter 9). Expanded coverage of international banking and the critical roles played by foreign central banks, especially the central banks of China, Japan, and the Buropean Community, where ve take a close look at their similarities and differences with the Federal Reserve Sys- tem in the United Seates (particularly in Chapters 2 and 20). The presentation of new information on the use of futures and options contracts to track central bank monetary policy and its possible impact on the management of financial institutions working to control interest rate risk (see especially Chapter 8). Exploration of the banking industry sructe in other leading nations outside the United States, especially looking at the varied structure of banking and financial services inside China, Japan, and leading nations of Western Burope (particularly in Chapters 3 and 20). Expanded discussion of possible simplification ofthe regulatory structure of the United States, Great Britain, and other industrialized nations in an effort to more efficiently use regulatory resources and increase regulatory effectiveness in a financial marketplace increasingly char- acterized by much larger, but fewer, financial firms (see especially Chapters 2, 15, and 20). Examination of the new Check 21 Act and the dramatic changes going on inside the payments system, especially the rapid growth of electronic information and electronic money transfers and the increasingly widespread use of digital imaging and substitute checks (particularly in Chapters 2, 12, and 18). Exploration of the FACT Act and its emerging role in grappling with the vexing prob- lem of identity theft plaguing many consumers seeking access to financial services anc resenting financial institutions with significant financial losses and damage to their rublic credibility (see especially Chapters 2 and 18). Expanded coverage of the controversial issues surrounding customer privacy and cus- tomer security, including the search for new ways for financial institutions to perform ‘customer authentication (particularly in Chapters 4, 14, and 18). Examination of the causes and possible consequences of the recently passed U.S. Bani- ruptey Abuse Prevention and Consumer Protection Act, the first major change in the fed- cecal bankruptcy code in neatly 30 years (see especially Chapters 2 and 18). Discussion of the controversial Bank Secrecy and Patriot Acts in the United States ard similar laws in Great Britain and their application to the financial services sector, including the costs that must be borne by financial institutions attempting to carry out the customer surveillance requirements of these laws (particularly in Chapter 2) Introduction to the new FDIC Insurance Reform Act of 2005, which calls for increasing faderal insurance coverage on retirement deposits of various types and for the possible indexing of deposit insurance protection for the effects of inflation (see especially Chapters 2 and 12). Increased attention to FICO credit scoring and the crucial role credit bureaus play today ia the consumer lending process (particularly in Chapter 18) Expanded coverage of the real estate mortgage market and the rapid development of newer and mote controversial mortgage instruments, including interest-only (option) tome mortgage loans that may place new home owners under significant financial stress (see especially Chapter 18). ‘Anin-depth look at the growing array of fee income sources among financial firms (par- ticularly in Chapters 5 and 14)vox Preface Pedagogical Features of the Seventh Edition: Enhancing Teaching and Learning © New or expanded coverage of several unique dimensions of today’s financial-services environment, including the intense competition now under way between banking and captive finance companies (especially in Chapter 17), economies of scope and the diversifi- cation of financial services (particularly in Chapter 14), and the identification of key infor- ‘mation sources for international bankers (especially in Chapter 20). © An exploration of some of the most exotic financial instruments developed in recent, years, including option mortgages, equity-linked CDs, trust-preferred securities, equity- indexed annuities, dynasty trusts, exchange-traded funds, and range notes, to name afew (see especially Chapters 10, 14, 15, and 18). © An examination of the risks associated with duration and interest-sensitive gaps with spe- cial emphasis on the challenges facing Fannie Mae (FNMA) and Freddie Mac (FHLMC) in the residential mortgage market (particularly in Chapters 7, 8, and 9). ‘© Movement of the important chapter on establishing new financialservice delivery channels, (which in earlier editions was Chapter 18) into Part One of the new edition (now Chapter 4), dealing with the chartering of new banks, the expansion df branch offices, ATM-provided services, telephone services, and Internet-based services. This is where we can leam about the most important service-delivery vehicles through which financial firms reach out to the public and provide those financial services most in demand (see especially Chapters 3 and 4), ‘Ethics remains a key issue in the new edition along with the continuing controversy over the Sarbanes/Oxley Accounting Standards Act, and there are several boxes that take us on a tour of important ethical issues in finance (for example, in Chapters 2, 3, and 14), + A new section at the conclusion of the final chapter that takes a glimpse at the furure of banking and the financial-services industry, reviewing several of the key trends preserted in earlier chapters and projecting how those ongoing trends may reshape the future of this vital industry and the future of us all (Chapter 20). This new seventh edition is a combination of time-tested tools for more effective teaching ard learning plus new features that enhance both teaching and learning. Among the new educational features of the seventh edition are: ‘+ Many new problems and newly revised problems, including Excel problems, expanding upon the extensive set of exercises and problems from previous editions. ‘© More URLs in the margins of the textual material that point the reader to new infor- mational Web site adventures in financial services. * Retention and expansion in the new edition of the factoids and filmtoids that were so popular in the previous edition. © Narrowing of box material to the most crucial topics, including informational bexes labeled E-Banking and E-Commerce, Real Banks, Real Decisions, Insights and Issues, and Ethics in Banking and Financial Services Al chapters in the seventh edition, as in previous editions, have several key elements designed to help the reader. These include: Pert Openers which describe the material Chapter Introductions that set the about to be presented in the chapters of tone and list the most important topics each of the seven parts of the text and that will be addressed in the book's pint out the significance of what is about _ chapters tobe learned.