disappear. Individual states passed laws allowing banks from other states to enter and acquire local banks. (Maine was the first to do so in 1978.) Some states allowed free entry of other banks. Some allowed banks from other states to enter only if there were reciprocal agreements. (This means that state A allowed banks from state B to enter only if state B allowed banks from state A to do so.) In some cases, groups of states developed regional banking pacts that allowed interstate banking.
In 1994, the U.S. Congress passed the Riegel-Neal Interstate Banking and Branching Efficiency Act. This Act led to full interstate banking becoming a reality. It permitted bank holding companies to acquire branches in other states. It invalidated state laws that allowed interstate banking on a reciprocal or regional basis. Starting in 1997, bank holding companies were allowed to convert out-of-state subsidiary banks into branches of a single bank. Many people argued that this type of consolidation was necessary to enable U.S. banks to be large enough to compete internationally. The Riegel-Neal Act prepared the way for a wave of consolidation in the U.S. banking system (for example, the acquisition by JPMorgan of banks formerly named Chemical, Chase, Bear Stearns, and Washington Mutual).
As a result of the credit crisis which started in 2007 and led to a number of bank failures, the Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law by President Obama on July 21, 2010. This created a host of new agencies designed to streamline the regulatory process in the United States. An important provision of Dodd–Frank is what is known as the Volcker rule which prevents proprietary trading by deposit-taking institutions. Banks can trade in order to satisfy the needs of their clients and trade to hedge their positions, but they cannot trade to take speculative positions. There are many other provisions of Dodd–Frank and these are summarized in Section 16.4. Banks in other countries are implementing rules that are somewhat similar to, but not exactly the same as, Dodd–Frank. There is a concern that, in the global banking environment of the 21st century, U.S. banks may find themselves at a competitive disadvantage if U.S regulations are more restrictive than those in other countries.
2.2 THE CAPITAL REQUIREMENTS OF A SMALL COMMERCIAL BANK
To illustrate the role of capital in banking, we consider a hypothetical small community bank named Deposits and Loans Corporation (DLC). DLC is primarily engaged in the traditional banking activities of taking deposits and making loans. A summary balance sheet for DLC at the end of 2015 is shown in Table 2.2 and a summary income statement for 2015 is shown in Table 2.3.
TABLE 2.2 Summary Balance Sheet for DLC at End of 2015 ($ millions)
Table 2.2 shows that the bank has $100 million of assets. Most of the assets (80 % of the total) are loans made by the bank to private individuals and small corporations. Cash and marketable securities account for a further 15 % of the assets. The remaining 5 % of the assets are fixed assets (i.e., buildings, equipment, etc.). A total of 90 % of the funding for the assets comes from deposits of one sort or another from the bank's customers. A further 5 % is financed by subordinated long-term debt. (These are bonds issued by the bank to investors that rank below deposits in the event of a liquidation.) The remaining 5 % is financed by the bank's shareholders in the form of equity capital. The equity capital consists of the original cash investment of the shareholders and earnings retained in the bank.
Consider next the income statement for 2015 shown in Table 2.3. The first item on the income statement is net interest income. This is the excess of the interest earned over the interest paid and is 3 % of the total assets in our example. It is important for the bank to be managed so that net interest income remains roughly constant regardless of movements in interest rates of different maturities. We will discuss this in more detail in Chapter 9.
TABLE 2.3 Summary Income Statement for DLC in 2015 ($ millions)
The next item is loan losses. This is 0.8 % of total assets for the year in question. Clearly it is very important for management to quantify credit risks and manage them carefully. But however carefully a bank assesses the financial health of its clients before making a loan, it is inevitable that some borrowers will default. This is what leads to loan losses. The percentage of loans that default will tend to fluctuate from year to year with economic conditions. It is likely that in some years default rates will be quite low, while in others they will be quite high.
The next item, non-interest income, consists of income from all the activities of the bank other than lending money. This includes fees for the services the bank provides for its clients. In the case of DLC non-interest income is 0.9 % of assets.
The final item is non-interest expense and is 2.5 % of assets in our example. This consists of all expenses other than interest paid. It includes salaries, technology-related costs, and other overheads. As in the case of all large businesses, these have a tendency to increase over time unless they are managed carefully. Banks must try to avoid large losses from litigation, business disruption, employee fraud, and so on. The risk associated with these types of losses is known as operational risk and will be discussed in Chapter 23.
Capital Adequacy
One measure of the performance of a bank is return on equity (ROE). Tables 2.2 and 2.3 show that the DLC's before-tax ROE is 0.6/5 or 12 %. If this is considered unsatisfactory, one way DLC might consider improving its ROE is by buying back its shares and replacing them with deposits so that equity financing is lower and ROE is higher. For example, if it moved to the balance sheet in Table 2.4 where equity is reduced to 1 % of assets and deposits are increased to 94 % of assets, its before-tax ROE would jump up to 60 %.
TABLE 2.4 Alternative Balance Sheet for DLC at End of 2015 with Equity Only 1 % of Assets ($ millions)
How much equity capital does DLC need? This question can be answered by hypothesizing an extremely adverse scenario and considering whether the bank would survive. Suppose that there is a severe recession and as a result the bank's loan losses rise by 3.2 % of assets to 4 % next year. (We assume that other items on the income statement in Table 2.3 are unaffected.) The result will be a pre-tax net operating loss of 2.6 % of assets (0.6 – 3.2 = −2.6). Assuming a tax rate of 30 %, this would result in an after-tax loss of about 1.8 % of assets.
In Table 2.2, equity capital is 5 % of assets and so an after-tax loss equal to 1.8 % of assets, although not at all welcome, can be absorbed. It would result in a reduction of the equity capital to 3.2 % of assets. Even a second bad year similar to the first would not totally wipe out the equity.
If DLC has moved to the more aggressive capital structure shown in Table 2.4, it is far less likely to survive. One year where the loan losses are 4 % of assets would totally wipe out equity capital and the bank would find itself in serious financial difficulties. It would no doubt try to raise additional equity capital, but it is likely to find this difficult when in such a weak financial position. It is possible that there would be a run on the bank (where all depositors decide to withdraw funds at the same time) and the bank would be forced into liquidation. If all assets could be liquidated for book value (a big assumption), the long-term debt-holders would likely receive about $4.2 million rather than $5 million (they would in effect absorb the negative equity) and the depositors would be repaid in full.
Clearly, it is inadequate for a
