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CHAPTER 1 AN OVERVIEW OF BANKS AND THEIR SERVICES Goal of This Chapter: To help the reader discover the many roles banks play in the economy today and to highlight the powerful trends sweeping through the banking industry that are redefining the roles banks will play in the future. It is important to understand how recent trends in banking can affect a bank manager's decision making and why these decision makers must take these trends into account if their banks are to survive and prosper. Key Terms Presented in This Chapter Bank Nonbank Banks Currency Exchange Discounting Commercial Notes Savings Deposits Demand Deposit Trust (fiduciary) Services Payment Role Policy Role

Financial Advisory Services Cash-Management Services Equipment Leasing Service Insurance Policies Retirement Plans Security Brokerage Delegated Monitoring Intermediation Role Agency Role Guarantor Role

Chapter Outline I.Introduction:Sectors of the Economy Impacted by Banks II.What Is a Bank? A.Defined by the Functions It Serves and the Roles It Play: B.Nonbank Banks C.Defined by the Government Agency That Insures Its Deposits D.The Financial Firm Offering the Widest Range of Financial Services Ill.The Services Banks Offer the Public A.Services Banks Have Offered Throughout History 1.Carrying Out Exchanges of Currency 2.Discounting Commercial Notes and Making Business Loans 3.Offering Savings Deposits 4.The Safekeeping of Valuables and Certification of Value 5.Supporting Government Activities With Credit 6.Offering Checking Accounts (Demand Deposits) 7.Offering Trust Services B.Services Bankers Have Developed More Recently 1.Granting Consumer Loans 2.Financial Advising 3.Cash Management

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4.Offering Equipment Leasing 5.Making Venture Capital Loans 6.Selling Insurance Services 7.Selling Retirement Plans 8.Offering Security Brokerage Investment Services 9.Offering Mutual Funds and Annuities 10.Offering Merchant Banking Services 11.Convenience -- The Sum Total of all Bank Services IV.Trends Affecting All Banks A.Service Proliferation B.Rising Competition C.Deregulation D.Rising Funding Costs E.An Increasingly Interest-Sensitive Mix of Funds F.A Technological Revolution G.Consolidation and Geographic Expansion H.Globalization of Banking I. Increased Risk of Failure and the Weakening of Government Deposit Insurance Systems V.Are Banks Dying? VI.The Plan of This Book VII.Summary Concept Checks 1-1.What is a bank? A bank should be defined by what it does, in this case, banks are generally those financial institutions offering the widest range of financial services. 1-2.

Under current U.S. federal law what must a corporation do to qualify as a commercial bank?

Under U.S. law at the federal level, commercial banks must offer two essential services to qualify as banks for purposes of regulation and taxation, demand (checkable) deposits and commercial loans. Alternatively, U.S. financial institutions whose deposits are insured by the FOIC may be classified as banks. 1.3.

Why are banks increasingly reaching out to become one-stop financial service conglomerates? Is this a good idea in your opinion?

There are two reasons that banks are increasingly becoming one-stop financial service conglomerates. The first reason is the increased competition from other types of financial institutions and the erosion of banks’ traditional service areas. The second reason is the Financial Services Modernization Act which has allowed banks to expand their role to be full service providers.

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1-4.What different kinds of services do banks offer the public? Banks offer the widest range of services of any financial institution. They offer thrift deposits to encourage saving and checkable (demand) deposits to provide a means of payment for purchases of goods and services. They also provide credit through direct loans, by discounting the notes that business customers hold, and by issuing credit guarantees. Additionally, they make loans to consumers for purchases of durable goods, such as automobiles, and for home improvements, etc. Banks also manage the property of customers under trust agreements and manage the cash positions of their business customers. They purchase and lease equipment to customers as an alternative to direct loans. Many banks also assist their customers with buying and selling securities through discount brokerage subsidiaries, the acquisition and sale of foreign currencies, the supplying of venture capital to start new businesses, and the purchase of annuities to supply future funding at retirement or for other long-term projects such as supporting a college education. 1-5.Why do banks exist in modern society, according to the theory of finance? There are multiple approaches to answering this question. The traditional view of banks as financial intermediaries sees them as simultaneously fulfilling the financial-service needs of savers (surplus-spending units) and borrowers (deficit-spending units), providing both a supply of credit and a supply of liquid assets. A newer view sees banks as delegated monitors who assess and evaluate borrowers on behalf of their depositors and earn fees for supplying monitoring services. Banks also have been viewed in recent theory as suppliers of liquidity and transactions services that reduce costs for their customers and, through diversification, reduce risk. 1-6. How has banking changed in recent years? Banking is becoming a more volatile industry due, in part, to deregulation which has opened up individual banks to the full force of the financial marketplace. At the same time the number and variety of banking services has increased greatly due to the pressure of intensifying competition from nonbank financial-service providers and changing public demand for more conveniently and reliably provided services. Adding to the intensity of competition, foreign banks have enjoyed success in their efforts to enter countries overseas and attract away profitable domestic business and household accounts. 1-7

Can you explain why many of these changes have led to significant problems for bank managers and stockholders?

The net result of recent changes in banking has been to put greater pressure upon bank earnings, resulting in more volatile returns to bank stockholders and an increased bank failure rate. Some experts see banks' role and market share shrinking due to restrictive government regulations and intensifying competition. Banks have also become more innovative in their service offerings and in finding new sources of funding, such as off-balance-sheet transactions. The increased risk faced by banks today, therefore, has forced bank managers to more aggressively utilize a wide array of tools and techniques to improve and stabilize their earnings streams and manage the

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various risks they face. Problems and Projects 1. You have just been hired as the marketing officer for the new First National Bank of Vincent, a suburban banking institution that will soon be serving a local community of 120,000 people. The town is adjacent to a major metropolitan area with a total population of well over 1 million. Opening day for the newly chartered bank is just two months away, and the president and the board of directors are concerned that the new bank may not be able to attract enough depositors and good-quality loan customers to meet its growth and profit projections. Your task is to recommend the various services the bank should offer initially to build up an adequate customer base. You are asked to do the following: a. Make a list of all the services the new bank could offer, according to current regulations. b. List the type of information you will need about the local community to help you decide which of the possible services are likely to have sufficient demand to make them profitable. c. Divide the possible services into two groups--those you think are essential to customers and should be offered beginning with opening day, and those that can be offered later as the bank grows. d. Briefly describe the kind of advertising campaign you would like to run to help the public see how your bank is different from all the other financial service providers in the local area. Banks can offer, if they choose, a wide variety of financial services today. These services are listed below. However, unless they are affiliated with a larger bank holding company and can offer some of these services through that company, it may be more limited in what it can offer. Regular Checking Accounts NOW Accounts Passbook Savings Deposits Certificates of Deposit Money Market Deposits Automobile Loans Retirement Savings Plans Nonauto Installment Loans to Individuals Residential Real Estate Loans Home Improvement Loans Personal Trust Management Services Commercial Trust Services Institutional Trust Services Personal Financial Advising

Management Consulting Services Letters of Credit Business Inventory Loans Asset-Based Commercial Loans Discounting of Commercial Paper Plant and Equipment Loans Venture Capital Loans Leasing Plans for Business Property and Equipment Security Dealing and Underwriting Discount Security Brokerage Foreign Currency Trading and Exchange Personal Cash-Management Services

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Insurance Policy Sales (Mainly Credit-Life) Insurance Today (Except in Some States))

Standby Credit Guarantees Acceptance Financing

To help the new bank decide which services to offer it would be helpful to gather information about some of the following items in the local community: School Enrollments and Growth in School Enrollments Estimated Value of Residential and Commercial Property Retail Sales Percentage of Home Ownership Among Residents in the Area Number and Size (in Sales and Work Force) of Local Business Establishments Major Population Locations (i.e., Major Subdivisions, etc.) and Any Projected Growth Areas Population Demographics (i.e., Age Distribution of the Area) Projected Growth Areas of Industries in the Area Essential services the bank would probably want to offer right from the beginning include: Regular Checking Accounts Automobile and other Consumer-type Installment Loans NOW Accounts Passbook Savings Deposits

Home Improvement Loans Money Market Deposit Accounts Retirement Savings Plans Business Inventory Loans Discounting of High-Quality Commercial Notes

Residential Real Estate Loans Certificates of Deposit As the bank grows, opportunities for the profitable sale of additional services usually increase, especially for trust services for individuals and smaller businesses and personal financial advising as well as some commercial (plant and equipment) loans and leases. Further growth may result in the expansion of commercial trust services as well as a widening variety of commercial loans and credit guarantees. The bank would want to develop an advertising campaign that sends a message to potential customers that the new bank is, indeed, different from its competitors. Small banks often have the advantage of offering highly personalized services in which their customers are known and recognized and services are tailored to each individual customer's special financial needs. Quality and reliability of banking service are often more important to individual customers than is price. A new bank must try to sell prospective customers, most of whom will come from other banks in the area, on personalized services, quality, and reliability - all three of which should be emphasized in its advertising program. 2. Leading money center banks in the United States have accelerated their investment banking activities all over the globe in recent years. They have also repeatedly asked the U.S. Congress for permission to offer more investment banking services in domestic markets, especially the ability to purchase corporate debt securities and stock from their business customers and resell those securities to investors in the open market. Is this a desirable move by these banking

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organizations from a profit standpoint? From a risk standpoint? From the public interest point of view? If you were managing a corporation that had placed large deposits with a bank engaged in such activities, would you be concerned about the risk to your company's funds? What could you do to better safeguard those funds? In the 1970's and early 1980's investment banking was so profitable that commercial bankers were lured into the investment banking business largely because of its greater profit potential than possessed by more traditional commercial banking activities. Later foreign banks, particularly the British and Japanese banking firms, began to attract away large corporate customers from U.S. banks, who were restrained by regulation from offering many investment banking services. Thus, U.S. banks ran into severe difficulty in simply trying to hold onto their traditional corporate credit and deposit accounts because they could not compete service-wise in the investment banking field. Today, banks are allowed to underwrite securities through either a subsidiary or through a holding company structure. This change occurred as part of the GrammLeach-Bliley Act (Financial Services Modernization Act). Unfortunately, if investment banking is more profitable than traditional banking product lines, it is also more risky, consistent with the basic tenet of finance that risk and return are directly related. That is why the Federal Reserve Board has placed such strict limits on the type of organization that can offer these services. Currently, the underwriting of most corporate securities must be done through a subsidiary or as a separate part of the holding company so that, in theory at least, the bank is not responsible for any losses incurred. For this reason there may be little reason for depositors (including large corporate depositors) to be concerned about risk exposure from investment banking. Moreover, the ability to offer such services may make U.S. banks more viable in the long run which helps their corporate customers who depend upon them for credit. On the other hand, opponents of investment banking powers for bank operations inside the U.S. have some reasonable concerns that must be addressed. There are, for example, possible conflicts of interest. Information gathered in the investment banking division could be used to the detriment of customers purchasing other bank services. For example, a customer seeking a loan may be told that he or she must buy securities from the bank's investment banking division in order to receive a loan. Moreover, banks could gain effective control over some nonblank industrial corporations which might subject them to added risk exposure and place industrial firms not allied with banks at a competitive disadvantage. As a result the Gramm-Leach-Bliley Act has built in some protections to prevent this from happening. 3. Many financial analysts have warned that the traditional bank - the maker of loans and acceptor of deposits - is doomed in the future due to the pirating of the best and largest bank customers by competing nonbank financial institutions, the growing tendency of even modestsize businesses to bypass banks for credit and borrow instead in the open market, and constraining regulations on the services banks are allowed to develop and offer. Do you agree with this assessment of traditional banking’s future? See if you can develop good arguments on both sides of the issue-for and against the survival of the traditional banking organization. Banks are subject to the discipline of the marketplace. If they do not change in order to keep up

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with shifts in the publics': demand for banking services and to respond to service and pricing initiatives by their competitors, the banking institutions that we know today will gradually disappear to be replaced by other, more responsive financial-service providers. On the other hand, banks have been more adaptive in recent years due to deregulation and the importance of achieving adequate profitability in a more open and competitive financial marketplace if they are to keep and attract capital and remain viable. There will probably always be a need for certain basic financial services, particularly payments and thrift accounts and credit packages. Those banks that can offer these basic services efficiently with low production costs likely will continue to survive. However, changing technology will generate lower-cost ways of producing even basic financial services, requiring even traditional banks to keep up with new methods and techniques. In the final analysis, future survival will more likely depend on the institution's ability to serve the needs of its customers effectively and efficiently. Those institutions, regardless of size or scope of product/service offerings, that can deliver the products/services demanded by their customers at a competitive cost while still earning a reasonable return for their shareholders will survive. Those that cannot will very likely become casualties of the competitive struggle. Government regulation will play a key role here in impacting the amount of flexibility banks have in responding to shifting customer demand for financial services. 4. If $5 million in new reserves are deposited in the banking system and the public wishes to hold 35 percent of each new dollar of spendable funds in long-term savings instruments and 5 percent in pocket money (currency and coin), and reserve requirements on checkable deposits are established by the central bank at 20 percent, the deposit multiplier must be: 1 1 (RR + L) = (0.20 + 0.40) = 1.67. After the deposit of $5 million in new reserves, the banking system would be able to generate in new money the amount of: 1.67 x $5 million = $8.35 million. 5. The banking system generates new money totaling $116 million from new reserves deposited in the system of $25 million. The deposit multiplier must be $116 million/$25 million or 4.65. With no other leakages from the banking system, the required reserve ratio must be 21.5 percent. 6. Western National Bank receives a new deposit of $124,000 from one of its commercial customers. The customer places $44,000 in a commercial checking account which carries a legal reserve requirement of 10 percent and the remainder of the deposit in an 18-month certificate of deposit which has a zero legal reserve requirement (however, as a precaution the bank's management establishes a reserve of 2 percent against such deposits). How much of this new deposit can Western National Bank safely lend out to its borrowing customers? No single bank can safely lend out more than its excess reserves. From this particular deposit Western National Bank will have excess reserves of:

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Excess Reserves = $44,000 -0.10 x $44,000 + $80,000 -0.02 x $80,000 = $39,600 + $78,400 = $118,000. If the bank lends anymore than this amount it will fall short of meeting its reserve requirement. Web Site Problems 1. What services does the bank you use offer? Check out their web site, either by surfing the web using the bank’s name and location or checking out the Federal Deposit Insurance Corporation’s web site for the bank’s name, city and state mentioned earlier in this chapter. How does your current bank seem to compare with neighboring banks in the range of services it offers? In the quality of its web site? Bank of America has its own web site at www.bankofamerica.com. They offer a wide range of services and their web site appears to be very complete. Another bank in the area is Bank One. They also have a very complete web site at www.bankone.com and a wide range of services. 2. What kinds of jobs seem most plentiful in the banking industry today”? Check out the web sites discussed earlier . Make a brief list of the most common job openings. Do any of these seem to interest you? One of the most common jobs is as an analyst. There is a need for credit analysts, corporate analysts, equity analysts, etc. Accounting jobs are very common as well as loan officers and cash management officers. There is actually a wide variety of job opportunities available in banking. 3. According to sources on the world wide web, how did banking get its start and why has it lasted so long? What major event occurred in 1934 that has affected banking not only in the United States but in many other countries around the world ever since then? The best way to find this information is to search the web for the history of banking and money. From one source, the history of banking and money is given as the following: “The invention of banking preceded that of coinage. Banking originated in Ancient Mesopotamia where the royal palaces and temples provided secure places for the safe-keeping of grain and other commodities. Receipts came to be used for transfers not only to the original depositors but also to third parties. Eventually private houses in Mesopotamia also got involved in these banking operations and laws regulating them were included in the code of Hammurabi.” In the early 1930’s there were a series of banking crises. As a result, the FDIC was created in 1934. A brief history of the events that led to the creation of the FDIC can be found at the FDIC web site.

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4. Based on selected web sites what major trends are reshaping the banking industry today? The way to answer this question is to do a search on the web for major banking trends today. The answer to this question will change depending on what laws have been passed recently and other economic factors have been affecting banks or are expected to affect banks in the future. At this time one topic that is getting a lot of attention and is the subject of much speculation is the Financial Services Modernization Act and the impact this will have on banking.

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