Solution manual bank management and financial services 9th edition by rose, peter chap003

THE ORGANIZATION AND STRUCTURE OF BANKING AND THE FINANCIAL-SERVICES INDUSTRY Goal of This Chapter: The goal of this chapter is to explore the different types of organizations used in th

THE ORGANIZATION AND STRUCTURE OF BANKING AND THE

FINANCIAL-SERVICES INDUSTRY

Goal of This Chapter: The goal of this chapter is to explore the different types of organizations used in the banking and financial services industry, to see how changing public mobility and changing demand for financial services, the rise of potent competition, and changing government roles have changed the structure, size, and the types of organizations in this industry

Key Topics in This Chapter

 The Organization and Structure of Banks and the Banking Industry

 The Array of Organizational Structures in Banking: Unit, Branch, Holding Company, and Electronic Services

 Interstate Banking and the Riegle-Neal Act

 The Financial Holding Company (FHC)

 Mergers and Acquisitions

 Banking Structure and Organization in Europe and Asia

 The Changing Organization and Structure of Banking’s Principal Competitors

 Economies of Scale and Scope and Expense Preference Behavior

Chapter Outline

I Introduction

II The Organization and Structure of the Commercial Banking Industry

A Advancing Size and Concentration of Assets

B A Possible Countertrend

III Internal Organization of the Banking Firm

A Community Banks and Other Community-Oriented Financial Firms

B Larger Banks—Money Center, Wholesale and Retail

C Trends in Organization

IV The Array of Organizational Structures and Types in the Banking Industry

A Unit Banking Organizations

B Branching Organizations

1 Branching's Expansion

2 Reasons behind Branching’s Growth

3 Advantages and Disadvantages of Branch Banking

C Electronic Branching—Web Sites and Electronic Networks: An Alternative or a

Supplement to Traditional Bank Branch Offices?

D Holding Company Organizations

1 Why Holding Companies Have Grown

2 One-Bank Holding Companies

3 Multibank Holding Companies

4 Advantages and Disadvantages of Holding Companies

V Interstate Banking Organizations and the Riegle-Neal Interstate Banking and Branching

Efficiency Act of 1994

A Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

B Research on Interstate Banking

VI An Alternative Type of Banking Organization Available as the 21st Century Opened:

Financial Holding Companies (FHCs)

A Gramm-Leach-Bliley Act of 1999

B Financial Holding Companies

VII Mergers and Acquisitions Reshaping the Structure and Organization of the

Financial-Services Sector

VIII The Changing Organization and Structure of Banking’s Principal Competitors

A Consolidation

B Convergence

IX Efficiency and Size: Do Bigger Financial Firms Operate at Lower Cost?

A Efficiency in Producing Financial Services

1 Economies of Scale

2 Economies of Scope

3 X-Efficiency

X Financial Firm Goals: Their Impact on Operating Cost, Efficiency, and Performance

A Expense-Preference Behavior

B Agency Theory

C Corporate Governance

XI Summary of the Chapter

Concept Checks

3-1 How would you describe the size distribution of American banks and the concentration

of industry assets inside the United States? What is happening in general to the size distribution and concentration of banks in the United States and in other industrialized nations and why?

Although the largest banks in the United States make up only 7.52 percent of all FDIC insured banks, they control almost 89.43 percent of all the industry’s assets Whereas, the smallest FDIC insured banks in the U.S account for 36.94 percent of the total banks, but they control only 1.19 percent of the industry’s assets This development is a result of the strong trend towards

consolidation and convergence in the industry not only in the United States, but also globally and can be explained by the increasing competitive pressures in the industry and the economies of scale that prevail in banking

3-2 Describe the typical organization of a smaller community bank and a larger money-center bank What does each major division or administrative unit within the organization do?

Small community banks, also known as retail banks, generally have four basic departments or divisions centered on lending (the credit function), fund-raising and marketing, accounting and operations, and perhaps, trust services Daily operations are usually monitored by a cashier

small bank's organization chart is simple and uncomplicated

In contrast, the larger banks, practicing wholesale and retail banking, usually have many

specialized departments and divisions It includes separate departments for different kinds of loans, departments to manage security holdings and borrow in the money market, a division or department to manage international operations, a marketing division, and a planning unit along with other divisions

3-3 What trends are affecting the way banks and their competitors are organized today?

In general, banks are becoming larger and more complex organizations with more departments and services and greater specialization Deregulation and service innovation have accelerated this trend as intense competition at home and abroad has encouraged banks to become larger

organizations, serving broader and more diversified market areas Even small banks are

reorganizing to meet these challenges by being more efficient in meeting their broader-based customer needs

3-4 What are unit banks?

Unit banks offer their full menu of services from only one office Although, they may operate any number of drive-in windows, and automated teller machines that are linked to the bank’s computer system These organizations are still common today

3-5 What advantages might a unit bank have over banks of other organizational types? What disadvantages?

Unit banks have the advantage of being less costly to operate because full-service branch offices are an expensive way to grow As unit banks tend to be relatively small, they seem to be able to offer personalized services better than larger institutions One disadvantage is the heavy

dependence of most unit institutions on a single market area, which increases their risk of failure Some authorities believe unit institutions may not be able to afford technologically advanced service delivery systems

3-6 What is a branch banking organization?

A branch banking organization sells its full menu of services through several locations, including

a head office and one or more full-service branch offices Regardless of its number of offices, it

is one corporation with one board of directors However, each office has its own management team with limited authority to make decisions on customer loan applications and other facts of daily operation Most such organizations also offer limited services drive-in windows, ATMs, point-of-sale terminals, the Internet, and other advanced communications systems

3-7 What trend in branch banking has been prominent in the United States in recent years?

Branch banking has become increasingly important with the great majority of states now

allowing statewide branching Today, more states permit statewide branching and only a

minority restrict branching in some way There was an increase in the number of branches in the 60’s, 70’s and 80’s as the population from cities to suburban areas As the 21st century began, there were about 5,200 branch banking organizations in the United States, operating close to 80,000 full-service branch office facilities Though the number of U.S commercial banks

declined over the last half-century, the number of full-service branch offices has soared

However, in recent years the growth in full-service branches has slowed because of the sky-rocketing costs of land and building office facilities In addition, ATM’s and electronic networks have taken over much of the routine banking transactions There is not as much need for full service branches as before

3-8 Do branch banks seem to perform differently than unit banks? In what ways? Can you explain any differences?

Branch banking has a number of important advantages With offices spread over different areas branch banks may achieve more stable earnings and revenue flows They may be able to grow faster because the additional offices can bring in more debt capital (principally deposits) with which they grow However, adding new branch offices can subject the bank to high fixed costs, due to large and rising construction costs This means the bank must work harder simply to reach

a break-even point Moreover, branch offices that are poorly situated or that have the misfortune

to be located in an area whose economy is deteriorating may generate higher costs than revenues and saddle the bank with persistent net losses

3-9 What is a bank holding company?

A bank holding company is a corporation that holds an ownership interest in at least one bank It

is also allowed to own nonbank businesses as long as they are related to banking

3-10 When must a holding company register with the Federal Reserve Board?

Under the terms of Bank Holding Company Act, if the company owns at least 25 percent of the outstanding stock of at least one bank or otherwise exerts a controlling influence over at least one bank, it must register with the Federal Reserve Board Such a company must seek the Fed's approval if it wishes to increase its share of ownership in those banks in which it already has an interest or wishes to acquire additional banks or nonbank businesses

3-11 What nonbank businesses are bank holding companies permitted to acquire under the law?

The Bank Holding Company Act (as amended) requires a registered bank holding company to acquire only those nonbank businesses that are "closely related to banking" and yield "public benefits." Among the most popular of these nonbank businesses that have been approved for holding-company acquisition include finance companies, mortgage banking firms, leasing

Increasingly as the 1990s began, bank holding companies sought approval to acquire failing savings and loan associations which the Federal Reserve Board granted after a case-by-case review These S&L acquisitions were sanctioned by the U.S Congress when the Financial Institutions Reform, Recovery, and Enforcement Act was passed in 1989 and, with passage of the Federal Deposit Insurance Corporation Improvement Act in 1991, bank holding companies were granted permission to acquire even healthy savings and loan associations with Federal Reserve Board approval Today, the Gramm-Leach-Bliley Act allows financial services

companies to be affiliated with each other This includes investment-banking activities which allow banks to underwrite securities

3-12 Are there any significant advantages or disadvantages for holding companies or the public if these companies acquire banks or nonbank business ventures?

The ability of holding companies to acquire nonbank businesses has given them the capacity to cross state lines even where state law prohibited entry by out-of-state banking firms It also allows a holding company to diversify across many different product lines to help stabilize the company's net earnings However, launching nonbank businesses can stretch holding-company management too far and make it ineffective, resulting in damage to the performance of banks belonging to the same holding company The public may gain if holding companies are less subject to failure than other types of financial service firms and are more efficient to operate However, the public may lose if the concentration of services in bank holding companies causes the prices of those services to rise or if resources are drained away from local communities causing slower growth of those communities

3-13 What did the Riegle-Neal Interstate Banking Act do? Why was it passed into law?

In 1994 the U.S Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act which allows bank holding companies to acquire banks throughout the United States without needing any state’s permission to do so and to establish branch offices across state lines in every state (except in Montana) The interstate banking law reflects the need and belief for banking firms to diversify into different geographic markets, demands of the public for financial service providers that can follow businesses and individuals as they move across the landscape, bring in new capital to revive struggling local economies, and advances the technology of financial-services delivery

3-14 Can you see any advantages to allowing interstate banking? What about potential

disadvantages?

As far as problems are concerned, interstate banking threatens to increase the concentration of banking resources in the U.S., especially among larger banks in various regions of the nation Increased concentration possibly could lead to higher prices and less service if the antitrust laws are not fully enforced

On the other hand, recent studies suggest that interstate mergers generate positive abnormal returns on bank stock In addition, these banks are not tied to one local economic area and appear

to be less subject to failure Interstate expansion may also bring greater stability by allowing individual banking organizations to further diversify their operations across different markets, offsetting losses that may arise in one market with gains in other markets

3-15 How is the structure of the nonbank financial-services industry changing? How do the organizational and structural changes occurring today among nonbank financial-service firms parallel those experienced by the banking industry?

Almost all of banking’s top competitors are experiencing the same changes as banks For

example, consolidation and convergence are occurring at a rapid pace Generally, nonbank firms have experienced the same dynamic structural and organizational revolution as banks and for many of the same reasons Intensifying competition, a widening gulf between the smallest and largest firms, and greater exposure to the risks associated with more cumbersome organizations striving to compete in a globally integrated financial marketplace, are some of the major

outcomes occurring in the industry

3-16 What relationship appears to exist between bank size, efficiency, and operating costs per unit of service produced and delivered? How about among nonbank financial-service providers? For banks and nonbank financial service providers alike, economies of scale and economies of scope if achieved can lead to significant savings in operating costs with increases in service output Economies of scale mean that costs per unit decrease as more units of the same service are produced because of greater efficiencies in using the firm’s resources to produce multiple units of the same service or service package Economies of scope imply that as more different services are provided, the operating cost reduces This is because some resources are more efficiently used in jointly producing multiple services than turning out one service

3-17 Why is it so difficult to measure output and economies of scale and scope in the

financial-services industry? How could this measurement problem affect any conclusions

reached about firm size, efficiency, and expense behavior?

This is not an easy question to answer A financial-service firm, regardless of its size, operating

as efficiently as it possibly can, raises an issue known as x-efficiency Given the size of a

financial firm, is it operating near to or far away from its lowest possible operating cost?

Research evidence to date is not encouraging, suggesting that most banks, for example, do not operate at their minimum possible cost Rather, their degree of x-efficiency tends to be at least 20

to 25 percent greater in aggregate production costs than it should be under conditions of maximum efficiency

The financial service business is changing rapidly in form and content and thus one must remain cautious about cost studies of financial firms The statistical methodologies available today to carry out cost studies have serious limitations and tend to focus upon a single point in time rather than attempting to capture the dynamics of this ever changing industry

3-18 What is expense-preference behavior? How could it affect the performance of a financial

firm?

Expense-preference behavior describes an approach where managers use the financial resources

of the firm to provide them with personal benefits not needed to produce and sell the products This behavior leads to increasing costs of production and declining returns to the firm’s owners Such expense-preference behavior may show up in the form of staffs larger than required to maximize profits or excessively rapid growth, which causes expenses to get out of control

3-19 Of what benefit is agency theory in helping us understand the consequences of changing

control of a financial-services firm? How can control by management as opposed to control by stockholders affect the behavior and performance of a financial-services provider?

Agency theory analyzes the relationship between a firm’s owner (shareholder) and its managers (agents) It explores whether there is a mechanism to compel managers to act in the best interest and maximize the welfare of the firm’s owners Owners do not have access to all the information and cannot fully evaluate the performance of a manager

One way to reduce costs from agency problems is, to develop better systems for monitoring the behavior of managers and to put in place stronger incentives for managers to follow the wishes

of owners Another way to accomplish this is by tying management salaries more closely to the firm’s performance or giving management access to valuable benefits (such as stock options) However, recent events suggest these steps may also encourage managers to take on greater risk

3-20 What is corporate governance, and how might it be improved for the benefit of the

owners and customers of financial firms?

Corporate governance describes the relationships that exist among managers, the board of directors, the stockholders, and other stakeholders of a corporation Corporate governance can be improved through larger boards of directors and a high proportion of outside directors This will expose managers to greater monitoring and discipline

Problems and Projects 3-1 As a financial journalist, you are writing an article explaining how the U.S market shares

of small, medium, and large banks have changed over the last 25 years Utilize Exhibit 3–2 to approximate the market shares for the years 1985, 1990, 1995, 2000, 2005, and 2010 for small, medium, and large banks Identify and discuss the three factors that appear to contribute most to the trends you described

It can be observed that, smaller banks continue to disappear and the biggest banks are gobbling

up greater industry shares each year But there are signs that this pattern of change might slow down in future years 100 large U.S banking organizations hold more than three-quarters of industry wide assets and also their market share has risen recently The top 100 U.S banks held

only about half of all U.S domestic banking assets in 1980, but by 2010 their proportion of the nation’s domestic banking assets had climbed to more than 90 percent

Large banks have moved toward the profit-center approach, in which each major department strives to maximize its contribution to profitability Also large banks serve many different markets with many different services, they are better diversified—both geographically and by product line—to withstand the risks of a fluctuating economy

The most dramatic changes in the banking industry of the past two decades has been the spread

of interstate banking as state and federal laws that paved the way for banking companies to purchase or start branch offices in different states, making nationwide banking possible for the first time in U.S history This trend reflects the need for banking firms to diversify into different geographic markets and the demands of the public for financial firms that can follow businesses and individuals as they move across the landscape

Another major change in law and regulation was the passage of the Gramm-Leach-Bliley

(Financial Services Modernization) Act in 1999 This law has led to the formation of financial holding companies (FHCs) entering into product lines (such as security and insurance

underwriting services) previously prohibited or restricted under federal law, paving the way for onestop financial-service providers

These are the few sweeping factors contributing to fundamental changes in the banking sector in the past two decades

3-2 Of the business activities listed here, which activities can be conducted through U.S.-regulated holding companies today?

a Data processing companies

b Office furniture sales

c Auto and truck leasing companies

d General life insurance and property-casualty insurance sales

e Savings and loan associations

f Mortgage companies

g General insurance underwriting activities

h Professional advertising services

i Underwriting of new common stock issues by nonfinancial corporations

j Real estate development companies

k Merchant banks

l Hedge funds

Banks can perform most of the activities listed above It may be easier to talk about the activities they cannot do They cannot sell office furniture and they cannot perform professional

advertising services They can do just about everything else listed here

3-3 You are currently serving as president and chief executive officer of a unit bank that has been operating out of its present location for five years Due to the rapid growth of households

this market by several aggressive competitors, you want to become a branch bank by establishing satellite offices Please answer the following questions:

a What laws and regulations have a bearing on where you might be able to locate the new

facilities and what services you may offer?

b Based on the content of this chapter, what advantages would your branch be likely to

have over the old unit bank? What disadvantages are likely to come with adding branch offices? Any ideas on how you might minimize these disadvantages?

c Would it be a good idea to form a holding company? Based on the material in this

chapter, what advantages could a holding company bring to your bank? Disadvantages?

a In general, the bank would have to seek approval from their chief regulating agency for any major actions that the bank takes National banks have get approval from the Comptroller of the Currency State member banks have to get approval from the Federal Reserve, and state banks with insurance who are not members of the Federal Reserve would have to seek approval from the FDIC All other banks would have to have approval of the state banking commission However, depending on the services offered, the Gramm-Leach-Bliley Act may apply The Gramm-Leach-Bliley Act allows banks to offer many different services either as subsidiaries of the parent bank or under the financial holding company structure In this case, the Federal Reserve must approve of the services and the structure of the bank

b Branch banking has a number of important advantages With offices spread over different areas, branch banks may achieve more stable earnings and revenue flows They may be able to grow faster because the additional offices can bring in more debt capital (principally deposits) with which to grow However, research evidence accumulated in recent years suggests that adding new branch offices can subject the bank to high fixed costs, due to large and rising construction costs, which means the bank must work harder simply to reach a break-even point Moreover, branch offices that are poorly situated or that have the misfortune to be located in an area whose economy is deteriorating may generate higher costs than revenues and saddle the bank with persistent net losses

c Formation of a holding company has a number of potential advantages It may help lower the taxes earned by the whole banking organization and open up the possibility of acquiring nonbank businesses that help to diversify the bank's operations and reduce the risk to its earnings and long-run viability The problem with starting a holding company , same as opening new branches, are the costs involved (including legal fees, the cost of registering with the Federal Reserve Board, and underwriting costs as new stock is issued)

3-4 Suppose you are managing a medium-size branch banking organization (holding about

$25 billion in assets) with all of its branch offices located within the same state The board of directors has asked you to look into the possibility of the bank offering limited security trading and investment banking services as well as insurance sales What laws open up the possibility of offering the foregoing services and under what circumstances may they be offered? What do you

see as the principal benefits from and the principal stumbling blocks to successful pursuit of such

a project?

The Gramm-Leach-Bliley Act of 1999 allows banks to offer selected nonbank financial services The bank could offer these services either as a financial holding company or through bank subsidiaries The financial holding company form seems to have the advantage because of limits

on how large subsidiaries can be and because each affiliated firm would have its own capital and its own profits and losses that are separate from the profits and losses of any other part of the firm However, fewer than 500 firms have achieved financial holding company status suggesting that this may be an expensive proposition that would be difficult for medium sized banking firms

to undertake

3-5 First Security Trust National Bank of Boston is considering making aggressive entry into the People’s Republic of China, possibly filing the necessary documents with the government in Beijing to establish future physical and electronic service facilities What advantages might such

a move bring to the management and shareholders of First Security? What potential drawbacks should be considered by the management and board of directors of this bank?

China is a huge market and entering into the Chinese market now may give this bank an

advantage over other banks They will already have the necessary contacts and understanding of the Chinese system when it becomes a more open economy in the future However, there is considerable risk It could be years before the economy becomes more open so profit

opportunities might be slow to develop In addition, the government could change its mind about allowing foreign banks ownership in China and seize any assets held by foreign banks Finally, the system is dominated by large government owned banks and it may be difficult to compete with these banks The Chinese government could give preferential treatment to these government banks at the expense of the private sector