Contents PART ONE INTRODUCTION TO BANKING AND FINANCIAL SERVICES 1. Chapter 1

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2 Contents Preface xviii PART ONE INTRODUCTION TO BANKING AND FINANCIAL SERVICES 1 Chapter 1 An Overview of the Changing Financial- Services Sector 1 Key Topics in This Chapter Introduction What Is a Bank? The Financial System and Competing Financial- Service Institutions 5 Roles of the Financial System 5 The Competitive Challenge for Banks 5 Leading Competitors with Banks Services Banks and Many of Their Closest Competitors Offer the Public 8 Services Banks Have Offered for Centuries 8 Services Banks and Many of Their Financial-Service Competitors Began Offering in the Past Century' 11 Convenience: The Sum Total of All Banking and Financial Services Key Trends Affecting All Financial-Service Firms The Plan of This Book 18 Summary 20 Key Terms 21 Problems and Projects 21 Internet Exercises 22 S&P Market Insight Challenge 23 Real Numbers for Real Banks: The Very First Case Assignment 24 Selected References 25 Appendix: Career Opportunities in Financial Services 25 Chapter 2 The Impact of Government Policy and Regulation on the Financial-Services Industry 29 Key Topics in This Chapter Introduction Banking Regulation 30 Pros and Cons of Strict Rules 30 The Impact of Regulation The Arguments for Strict Rules versus Lenient Rules Major Banking Laws Where and When the Rules Originated 33 Meet the "Parents": The Legislation That Created Today's Bank Regulators 33 Instilling Social Graces and Morals Social Responsibility Laws 37 Legislation Aimed at Allowing Interstate Banking: Where Can the "Kids" Play? 39 The Gramm-Leach-Bliley Act (1999): What Are Acceptable Activities for Playtime? 40 The USA Patriot and Bank Secrecy Acts: Fighting Terrorism and Money Laundering 41 Telling the Truth and Not Stretching It The Sarbanes- Oxley Accounting Standards Act (2002) The 21st Century Ushers In an Array of New Laws, Regulations, and Regulatory Strategies The Regulation of Nonbank Financial-Service Firms Competing with Banks 49 Regulating the Thrift (Savings) Industry 49 Regulating Other Nonbank Financial Firms 50 Are Regulations Really Necessary in the Financial-Services Sector? The Central Banking System: Its Impact on the Decisions and Policies of Financial Institutions 52 Organisational Structure of the Federal Reserve System 52 The Central Bank's Principal Task: Making and Implementing Monetary Policy 54

3 x Contents Summary 58 Key Terms 59 Problems and Projects 59 Internet Exercises 60 S&.P Market Insight Challenge 60 Case Assignment for Chapter 2 61 Selected References 62 Chapter 3 The Organization and Structure of Banking and the Financial-Services Industry 65 Key Topics in This Chapter Introduction The Organization and Structure of the Commercial Banking Industry 66 Advancing Size and Concentration of Assets 66 Is a Countertrend Now under Way? Internal Organization of the Banking Firm 68 Community Banks and Other Community-Oriented Financial Firms 68 Larger Banks Mone^ Center, Wholesale and Retail 69 Trends in Organization The Array of Organizational Structures and Types in the Banking Industry 71 Unit Banking Organizations 72 Branching Organisations 73 Electronic Branching Web Sites and Electronic Networks: An Alternative or a Supplement to Traditional Bank Branch Offices? 76 Holding Company Organizations Interstate Banking Organizations and the Riegle- Neal Interstate Banking and Branching Efficiency Act of Research on Interstate Banking An Alternative Type of Banking Organization Available as the 21st Century Opened: Financial Holding Companies (FHCs) Mergers and Acquisitions Reshaping the Structure and Organization of the Financial-Services Sector The Changing Organization and Structure of Banking's Principal Competitors Efficiency and Size: Do Bigger Financial Firms Operate at Lower Cost? 87 Efficiency in Producing Financial Services Financial Firm Goals: Their Impact on Operating Cost, Efficiency, and Performance 89 Summary 92 Key Terms 93 Problems and Projects 93 Internet Exercises 94 Case Assignment for Chapter 3 95 S&P Market Insight Challenge 96 Selected References 96 Chapter 4 Establishing New Banks, Branches, ATMs, Telephone Services, and Web Sites 99 Key Topics in This Chapter Introduction Chartering a New (De Novo) Financial-Service Institution The Bank Chartering Process in the United States Questions Regulators Usually Ask the Organizers of a New (De Novo) Bank Factors Weighing on the Decision to Seek a New Charter Volume and Characteristics of New Charters How Well Do New Charters Perform? Establishing Full-Service Branch Offices: Choosing Locations and Designing New Branches 106 Desirable Sites for New Branches 108 Branch Regulation 111 The Changing Role of Financial-Service Branch Offices 111 ln-store Branching Establishing and Monitoring Automated Limited-Service Facilities 113 Point-o/-Sa!e Terminals 113 Automated Teller Machines (ATMs) J Home and Office Banking 117 Telephone Banking and Call Centers 117 Internet Banking Financial-Service Facilities of the Future 120 Summary 123 Key Terms 123 Problems and Projects 124 Internet Exercises 125 Case Assignment for Chapter S&P Market Insight Challenge 126 Selected References 127

4 Contents xi PART TWO FINANCIAL STATEMENTS AND FINANCIAL-FIRM PERFORMANCE 129 Chapter 5 The Financial Statements of Banks and Their Principal Competitors 129 Key Topics in This Chapter Introduction An Overview of Balance Sheets and Income Statements The Balance Sheet (Report of Condition) 131 The Principal Types of Accounts 13 J Recent Expansion of Off-Balance-Sheet Items in Banking 140 The Problem of Book-Value Accounting 142 Auditing: Assuring Reliability of Financial Statements Components of the Income Statement (Report of Income) 145 Financial Flows and Stocks 146 Comparative Income Statement Ratios for Different-Size Financial Firms The Financial Statements of Leading Nonbank Financial Firms: A Comparison to Bank Statements An Overview of Key Features of Financial Statements and Their Consequences 153 Summary 154 Key Terms 155 Problems and Projects 155 Internet Exercises 160 S&P Market Insight Challenge 161 Case Assignment for Chapter Selected References 164 Appendix: Sources of Information on the Financial- Services Industry 164 Chapter 6 Measuring and Evaluating the Performance of Banks and Their Principal Competitors 167 Key Topics in This Chapter Introduction Evaluating Performance 168 Determining Long-Range Objectives 168. Maximizing the Value of the Firm: A Key Objective for Nearly All Financial-Service Institutions 169 Profitability Ratios: A Surrogate for Stock Values 171 Useful Profitability Formulas for Banks and Other Financial-Service Companies 173 Return on Equity and Its Principal Components 174 The Return on Assets and Its Principal Components 178 What a Breakdown of Profitability Measures Can Tell Us 180 Measuring Risk in Banking and Financial Services 181 Other Goals in Banking and Financial-Services Management Performance Indicators among Banking's Key Competitors The Impact of Size on Performance 189 Size, Location, and Regulatory Bias in Analyzing the Performance of Banks and Competing Financial Institutions 191 Summary 192 Key Terms 193 Problems and Projects 193 Internet Exercises 197 S&P Market Insight Challenge 198 Case Assignment for Chapter Selected References 200 Appendix: Using Financial Ratios and Other Analytical Tools to Track Financial-Firm Performance The UBPR and BHCPR 201 PART THREE TOOLS FOR MANAGING AND HEDGING AGAINST RISK 209 Chapter 7 Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques 209 Key Topics in This Chapter Introduction Asset-Liability Management Strategies 210 Asset Management Strategy 210 Liability Management Strategy 210 Funds Management Strategy Interest Rate Risk: One of the Greatest Management Challenges 211 Forces Determining Interest Rates 212 The Measurement of Interest Rates 213 The Components of Interest Rates 214 Responses to Interest Rate Risk 217

5 xii Contents 7-4 One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin 218 Interest-Sensitive Gap Management as a Risk- Management Tool 219 Problems with Interest-Sensitive GAP Management The Concept of Duration as a Risk- Management Tool 228 What Is Duration? 229 Price Sensitivity to Changes in Interest Rates and Duration 230 Convexity and Duration Using Duration to Hedge against Interest Rate Risk The Limitations of Duration Gap Management 238 Summary 239 Key Terms 240 Problems and Projects 240 Internet Exercises 243 Case Assignment for Chapter S&P Market Insight Challenge 245 Selected References 246 Chapter 8 Risk Management: Financial Futures, Options, Swaps, and Other Hedging Tools 247 Key Topics in This Chapter Introduction Uses of Derivative Contracts 248 ' 8-3 Financial Futures Contracts: Promises of Future Security Trades at a Set Price 250 t The Short Hedge in Futures 255 The Long Hedge in Futures Interest-Rate Options Regulations and Accounting Rules for Bank Futures and Options Trading Interest-Rate Swaps Caps, Floors, and Collars 275 Interest-Rate Caps 275 Interest-Rate Floors 276 Interest-Rate Collars 276 Summary 277 Key Terms 278 Problems and Projects 278 Internet Exercises 281 Case Assignment for Chapter S&P Market Insight Challenge 283 Selected References 283 Chapter 9 Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives 285 Key Topics in This Chapter Introduction Securitizing Loans and Other Assets 286 The Beginnings of Securitization The Home Mortgage Market 289 Examples of Other Assets That Have Been Securitized 291 The Impact of Securitization upon Lending Institutions 293 Regulators' Concerns about Securitization Sales of Loans to Raise Funds and Reduce Risk 295 Reasons behind Loan Sales 296 The Risks in Loan Sales Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance 297 The Structure of SLCs 298 The Value and Pricing of Standby Letters 298 Sources of Risk with Standbys 299 Regulatory Concerns about SLCs 300 Research Studies on Standbys, Loan Sales, and Securitizations Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet 301 Credit Swaps 301 Credit Options 302 Credit Default Swaps (CDSs)' 303 Credit-Linked Notes 305 Collateralized Debt Obligations (CDOs) 305 Risks Associated with Credit Derivatives 306 Summary 307 Key Terms 307 Problems and Projects 307 Internet Exercises 309 S&P Market Insight Challenge 310 Case Assignment for Chapter Selected References 311

6 Contents xiii PART FOUR MANAGING INVESTMENT PORTFOLIOS AND LIQUIDITY POSITIONS FOR FINANCIAL FIRMS 313 Chapter 10 The Investment Function in Financial- Services Management 313 Key Topics in This Chapter Introduction Investment Instruments Available to Financial Firms Popular Money Market Investment Instruments 315 Treasury Bills 315 Short-Term Treasury Notes and Bonds 317 Federal Agency Securities 317 Certificates of Deposit 317 International Eurocurrency Deposits 317 Bankers'Acceptances 318 Commercial Paper 318 Short-Term Municipal Obligations Popular Capital Market Investment Instruments 319 Treasury Notes and Bonds 319 Municipal Notes and Bonds 319 J Corporate Notes and Bonds Investment Instruments Developed More Recently 320 Structured Notes 320 Securitized Assets Investment Securities Held by Banks Factors Affecting Choice of Investment Securities 324 Expected Rate of Return 324 Tax Exposure 325 Interest Rate Risk 329 Credit or Default Risk 330 Business Risk 331 Liquidity Risk 332 Call Risk 332 Prepayment Risk 332 Inflation Risk 334 Pledging Requirements Investment Maturity Strategies Maturity Management Tools 338 The Yield Curve 338 Duration 340 Summary 342 Key Terms 343 Problems and Projects 343 Internet Exercises 345 Case Assignment for Chapter S&P Market Insight Challenge 346 Selected References 349 Chapter 11 Liquidity and Reserves Management: Strategies and Policies 351 Key Topics in This Chapter Introduction The Demand for and Supply of Liquidity Why Financial Firms Often Face Significant Liquidity Problems Strategies for Liquidity Managers 355 Asset Liquidity Management (or Asset Conversion) Strategies 355 Borrowed Liquidity (Liability) Management Strategies 356 Balanced Liquidity Management Strategies 357 Guidelines for Liquidity Managers Estimating Liquidity Needs 358 The Sources and Uses of Funds Approach 359 The Structure of Funds Approach 362 Liquidity Indicator Approach 366 The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace Legal Reserves and Money Position Management 370 Regulations on Calculating Legal Reserve Requirements 370 Factors Influencing the Money Position Factors in Choosing among the Different Sources of Reserves Central Bank Reserve Requirements around the Globe 380 Summary 380 Key Terms 381 Problems and Projects 381 N Internet Exercises 385

7 xiv Contents Case Assignment for Chapter S&P Market Insight Challenge 387 Selected References 387 PART FIVE MANAGING SOURCES OF FUNDS FOR A FINANCIAL FIRM 389 Chapter 12 Managing and Pricing Deposit Services 389 Key Topics in This Chapter Introduction Types of Deposits Offered by Banks and Other Depository Institutions 390 Transaction (Payments or Demand) Deposits 390 Nontransaction (Savings or Thrift) Deposits 391 Retirement Savings Deposits Interest Rates Offered on Different Types of Deposits 393 The Composition of Deposits 393 The Ownership of Deposits 394 The Cost of Different Deposit Accounts Pricing Deposit-Related Services Pricing Deposits at Cost Plus Profit Margin Using Marginal Cost to Set Interest Rates on Deposits 400 ' Conditional Pricing Pricing Based on the Total Customer Relationship and Choosing a Depository 406 The Role That Pricing and Other Factors Play When Customers Choose a Depository Institution to Hold Their Accounts Basic (Lifeline) Banking: Key Services for Low-Income Customers 408 Summary 410 Key Terms 411 Problems and Projects 411 Internet Exercises 413 Case Assignment for Chapter S&P Market Insight Challenge 417 Selected References 417 Chapter 13 Managing Nondeposit Liabilities 419 Key Topics in This Chapter 13-1 Introduction Liability Management and the Customer Relationship Doctrine Alternative Nondeposit Sources of Funds 422 Federal Funds Market ("Fed Funds") 422 Repurchase Agreements as a Source of Funds 425 Borrowing from Federal Reserve Banks 428 Advances from Federal Home Loan Banks 429 Development and Sale of Large Negotiable CDs 430 The Eurocurrency Deposit Market 432 Commercial Paper Market 433 Long-Term Nondeposit Funds Sources Choosing among Alternative Nondeposit Sources 435 Measuring a Financial Firm's Total Need for Nondeposit Funds: The Available Funds Gap 435 Nondeposit Funding Sources: Factors to Consider 436 Summary 443 Key Terms 444 Problems and Projects 444 Internet Exercises 446 S&P Market Insight Challenge 447 Case Assignment for Chapter Selected References 449 Chapter 14, Investment Banking, Insurance, and Other Sources of Fee Income 451 Key Topics in This Chapter Introduction Sales of Investment Banking Services 452 Key Investment Banking Services 453 Linkages between Commercial and Investment Banking 455 Possible Advantages and Disadvantages of Linking Commercial and Investment Banking 456 Key Issues for Investment Banks of the Future Selling Investment Products to Consumers 458 Mutual Fund Investment Products 458 Annuity Investment Products 460 The Track Record for Sales of Investment Products 460 Risks and Rules for Selling Investment Products Trust Services as a Source of Fee Income Sales of Insurance-Related Products 464 Types of Insurance Products Sold Today 465 Rules Covering Insurance Sales by Federally Insured Depository Institutions 466

8 Contents xv 14-6 The Alleged Benefits of Financial-Services Diversification 467 An Example of the Product-Line Diversification Effect Reducing Risk 467 Potential Economies of Scale and Scope Information Flows within the Financial Firm 470 Summary 472 Key Terms 473 Problems and Projects 473 Internet Exercises 474 Case Assignment for Chapter S&P Market Insight Challenge 476 Selected References 477 Chapter 15 The Management of Capital 479 Key Topics in This Chapter Introduetion The Many Tasks Capital Performs Capital and Risk 481 Key Risks in Banking and Financial Institutions' Management 481 Defenses against Risk Types of Capital in Use 483 Relative Importance of Different Sources of Capital One of the Great Issues in the History of Banking: How Much Capital Is Really Needed? 486 Regulatory Approach to Evaluating Capital Needs The Basel Agreement on International Capital Standards: A Historic Contract among Leading Nations 488 Base! I 488 Capital Requirements Attached to Derivatives 491 Basel II: A New Capital Accord Unfolding Changing Capital Standards Inside the United States Planning to Meet Capital Needs 502 Raising Capital Internally 502 Raising Capital Externally 504 Summary 507 Key Terms 508 Problems and Projects 508 Internet Exercises 511 S&P Market Insight Challenge 511 Case Assignment for Chapter Selected References 512 PART SIX PROVIDING LOANS TO BUSINESSES AND CONSUMERS 515 Chapter 16 Lending Policies and Procedures: Managing Credit Risk 515 Key Topics in This Chapter Introduction Types of Loans 516 Factors Determining the Growth and Mix of Loans Regulation of Lending 519 Establishing a Good Written Loan Policy Steps in the Lending Process Credit Analysis: What Makes a Good Loan? Is the Borrower Creditworthy? The Cs of Credit Can the Loan Agreement Be Properly Structured and Documented? Can the Lender Perfect Its Claim against the Borrower's Earnings and Any Assets That May Be Pledged as Collateral? Sources of Information about Loan Customers Parts of a Typical Loan Agreement Loan Review Loan Workouts 537 Summary 539 Key Terms 539 Problems and Projects 540 Internet Exercises 542 S&P Market Insight Challenge 542 Case Assignment for Chapter Selected References 544 Chapter 17 Lending to Business Firms and Pricing Business Loans 547 Key Topics in This Chapter Introduction Brief History of Business Lending Types of Business Loans Short-Term Loans to Business Firms 548 Self-Liquidating Inventory Loans 548 Working Capital Loans 549 Interim Construction Financing 549 Security Dealer Financing 550 Retailer and Equipment Financing 550

9 xvi Contents Asset-Based Financing 551 Syndicated Loans (SNCs) Long-Term Loans to Business Firms 552 Term Business Loans 552 Revolving Credit Financing 552 Long-Term Project Loans 553 Loans to Support the Acquisition of Other Business Firms Leveraged Buyouts Analyzing Business Loan Applications 554 Analysis of a Business Borrower's Financial Statements Financial Ratio Analysis of a Customer's Financial Statements 556 The Business Customer's Control over Expenses 558 Operating Efficiency: Measure of a Business Firm's Performance Effectiveness 558 Marketability of the Customer's Product or Service 559 Coverage Ratios: Measuring the Adequacy of Earnings 560 Liquidity Indicators for Business Customers 561 Profitability Indicators 562 The Financial Leverage Factor as a Barometer of a Business Firm's Capital Structure Comparing a Business Customer's Performance to the Performance of Its Industry 563 Contingent Liabilities Preparing Statements of Cash Flows from Business Financial Statements 566 Pro Forma Statements of Cash Flows and Balance Sheets 569 The Loan Officer's Responsibility to the Lending Institution and the Customer Pricing Business Loans 573 The Cost-Plus Loan Pricing Method 573.', The Price Leadership Model 574 y Below-Prime Market Pricing 576 Customer Profitability Analysis (CPA) 576 Summary 580 Key Terms 581 Problems and Projects 581 Case Assignment for Chapter Internet Exercises 585 S&P Market Insight Challenge 586 Selected References 586 Chapter 18 Consumer Loans, Credit Cards, and Real Estate Lending 589 Key Topics in This Chapter Introduction Types of Loans Granted to Individuals and Families 590 Residential Loans 590 Nonresidential Loans 591 Credit Card Loans and Revolving Credit 591 New Credit Card Regulations 592 Debit Cards: A Partial Substitute for Credit Cards? 593 Rapid Consumer Loan Growth: Rising Debt-to-income Ratios Characteristics of Consumer Loans Evaluating a Consumer Loan Application Example of a Consumer Loan Application Credit Scoring Consumer Loan Applications 599 The FICO Scoring System Laws and Regulations Applying to Consumer Loans 603 Customer Disclosure Requirements 604 Outlawing Credit Discrimination 604 Predatory Lending and Subprime Loans Real Estate Loans 607 Differences between Real Estate Loans and Other Loans 608 Factors in Evaluating Applications for Real Estate Loans 608 Home Equity Lending 610 The Most Controversial of Home Mortgage Loans: Interest-Only and Adjustable Mortgages and the Recent Mortgage Crisis A New Federal Bankruptcy Code as Bankruptcy Filings Soar Pricing Consumer and Real Estate Loans: Determining the Rate of Interest and Other Loan Terms 614 The Interest Rate Attached to Nonresidential Loans 615 Interest Rates on Home Mortgage Loans 618 Summary 621 Key Terms 621 Problems and Projects 622 Internet Exercises 625 S&P Market Insight Challenge 625 Case Assignment for Chapter Selected References 626 Consumer PART SEVEN MANAGING THE FUTURE IN A GLOBAL MARKETPLACE 629 Chapter 19 Acquisitions and Mergers in Financial- Services Management 629 Key Topics in This Chapter Introduction Mergers on the Rise 630

10 Contents xvii 19-3 The Motives behind the Rapid Growth of Financial-Service Mergers Selecting a Suitable Merger Partner The Merger and Acquisition Route to Growth Methods of Consummating Merger Transactions Regulatory Rules for Bank Mergers in the United States 641 Justice Department Guidelines 642 The Merger Decision-Making Process by U.S. Federal Regulators Merger Rules in Europe and Asia Making a Success of a Merger Research Findings on the Impact of Financial- Service Mergers 648 The Financial and Economic Impact of Acquisitions and Mergers 648 Public Benefits from Mergers and Acquisitions 650 Summary 651 Key Terms 652' Problems and Projects 652 Internet Exercises 654 S&P Market Insight Challenge 654 Case Assignment for Chapter Selected References 655 Chapter 20 International Banking and the Future' of Banking and Financial Services 659 Key Topics in This Chapter Introduction Types of International Banking Organizations Regulation of International Banking 663 Goals of International Banking Regulation 663 U.S. Banks' Activities Abroad 663 Expansion and Regulation of Foreign Bank Activity in the United States 664 New Capital Regulations for Major Banks Worldwide Services Supplied by Banks in International Markets 666 Making Foreign Currencies Available to Customers 666 Hedging against Foreign Currency Risk Exposure 667 Other Toob for Reducing Currency Risk 670 Supplying Customers with Short- and Long-Term Credit or Credit Guarantees 671 Supplying Payments and Thrift (Savings) Instruments to International Customers 672 Underwriting Customer Note and Bond Issues in the Eurobond Market 674 Protecting Customers against Interest Rate Risk 674 Helping Customers Market Their Products through Export Trading Companies Challenges for International Banks in Foreign Markets 676 Growing Customer Use of Securities Markets to Raise Funds in a More Volatile and Risky World 676 Developing Better Methods for Assessing Risk in International Lending 677 Adjusting to New Market Opportunities Created by Deregulation and New International Agreements The Future of Banking and Financial Services 682 Summary 686 Key Terms 687 Problems and Projects 688 Case Assignment for Chapter Internet Exercises 690 S&P Market Insight Challenge 690 Selected References 690 Dictionary of Banking and Financial-Service Terms 693 Index 711