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Chapter 01 - An Overview of the Changing Financial-Services Sector CHAPTER 1 AN OVERVIEW OF THE CHANGING FINANCIAL-SERVICES SECTOR Goal of This Chapter: In this chapter you will learn about the many roles financial serviceproviders play in the economy today. You will examine how and why the banking...

Chapter 01 - An Overview of the Changing Financial-Services Sector CHAPTER 1 AN OVERVIEW OF THE CHANGING FINANCIAL-SERVICES SECTOR Goal of This Chapter: In this chapter you will learn about the many roles financial serviceproviders play in the economy today. You will examine how and why the banking industry and the financial services marketplace as a whole is rapidly changing, becoming new and different as we move forward into the future. You will also learn about new and old services offered to the public. Key Topics in This Chapter       Powerful Forces Reshaping the Industry What Is a Bank? The Financial System and Competing Financial-Service Institutions Old and New Services Offered to the Public Key Trends Affecting All Financial-Service Firms Appendix: Career Opportunities in Banking and Financial Services Chapter Outline I. II. III. Introduction: Powerful Forces Reshaping the Industry What Is a Bank? A. Defined by the Functions: B. Banks and their Principal Competitors C. Many Kinds of Banks D. Money-Centered Banks vs. Community Banks E. The Legal Basis for Banking The Financial System and Competing Financial-Service Institutions A. Roles of the Financial System B. The Competitive Challenge for Banks C. Leading Competitors with Banks 1. Savings Associations 2. Credit Unions 3. Fringe Banks 4. Money Market Funds 5. Mutual Funds 6. Hedge Funds 7. Security Brokers and Dealers 8. Investment Banks 9. Finance Companies 10. Financial Holding Companies 11. Life and Property/Casualty Insurance Companies 1-1 Chapter 01 - An Overview of the Changing Financial-Services Sector IV. Services Banks and Many of Their Closest Competitors Offer the Public A. Services Banks Have Offered for Centuries 1. Carrying Out Currency Exchanges 2. Discounting Commercial Notes and Making Business Loans 3. Offering Savings Deposits 4. 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 Banks and Many of Their Financial-Service Competitors Began Offering in the Past Cent ury 1. Granting Consumer Loans 2. Financial Advising 3. Managing Cash 4. Offering Equipment Leasing 5. Making Venture Capital Loans 6. Selling Insurance Policies 7. Selling and Managing Retirement Plans 8. Dealing in Securities: Offering Security Brokerage and Investment Banking Services 9. Offering Mutual Funds, Annuities, and Other Investment Products 10. Offering Merchant Banking Services 11. Offering Risk Management and Hedging Services C. Convenience: The Sum Total of All Banking and Financial Services V. Key Trends Affecting All Financial-Service Firms—Crises, Reform, and Change 1. Service Proliferation 2. Rising Competition 3. Government Deregulation and then Reregulation 4. Crisis, Reform, and Change in Banking and Financial Services 5. An Increasingly Interest-Sensitive Mix of Funds 6. Technological Change and Automation 7. Consolidation and Geographic Expansion 8. Convergence 9. Globalization VI. The Plan of This Book VII. Summary 1-2 Chapter 01 - An Overview of the Changing Financial-Services Sector Concept Checks 1-1. What is a bank? How does a bank differ from most other financial-service providers? A bank can be defined by what economic function it performs, what services it offers its customers, or the legal basis for its existence. Historically, banks have been offering a great range of financial services such as checking and debit accounts, credit cards, and savings plans. However, banks today are rapidly expanding their service offerings to include investment banking (security underwriting), insurance protection, financial planning, advisory service for merging companies, risk-management services, and numerous other innovative financial products. O ther financial service providers offer some of the similar financial services offered by a bank but not all of them within one institution. Although, many financial-service institutions are trying to be as similar to banks as possible in the services they offer. Not only financial service industries but several industrial companies have stepped forward in recent decades to control a bank or a bank like firms. (Checking accounts allow you to write checks, make online purchases and transfer money. Debit cards can only be used to withdraw cash and make purchases online or at stores. Fees. Checking accounts have monthly fees and other charges that could eat into your balance). Moreover, Like the name suggests, a checking account is generally used for making payments.... (You can still order paper checks, but sometimes you have to pay for them.) Debit cards look like credit cards, but they link to money you already have in the bank as opposed to borrowed money.) ……… A credit card is a card which allows people to buy items without cash. Each card has a unique number.... Payment using a credit card is one of the most common methods of electronic payment. Credit cards are usually small plastic cards with a unique number attached to an account. A savings account is a basic type of bank account that allows you to deposit money, keep it safe, and withdraw funds, all while earning interest. Savings accounts offered by most banks, credit unions, Securities underwriting is the process by which investment banks raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt capital). The services of an underwriter are typically used as part of a public offering in a primary market. 1-2. Under U.S. law what must a corporation do to qualify and be regulated as a commercial bank? Under U.S. law, commercial banks must offer two essential services to qualify as banks for purposes of regulation and taxation, demand (checkable) deposits and grant commercial loans. More recently, Congress defined a bank as any institution that could qualify for deposit insurance administered by the Federal Deposit Insurance Corporation.( The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress to maintain stability and public confidence in the nation's financial system.) A money center bank is similar in structure to a standard bank; however, it's borrowing, and lending activities are with governments, large corporations, and regular banks. These types of financial institutions (or designated branches of these institutions) generally do not borrow from or lend to consumers. A community bank is a depository or lending institution that primarily serves businesses and individuals in a small geographic area. Community banks tend to emphasize personal relationships with their customers. 1-3 Chapter 01 - An Overview of the Changing Financial-Services Sector Big Bank Difference. Community banks are smaller than commercial banks. Instead of having branches across the country, they usually have only a few branches across a single region. Money tends to stay in the community. Commercial banks have the cash reserves to make larger business loans and the capacity for greater risk in making the loans.... Community banks frequently operate under legal restrictions to avoid investments that put your business money at risk. A credit derivative is a contract between two parties and allows a creditor or lender to transfer the risk of default to a third party. The contract transfers the credit risk that the borrower might not pay back the loan. A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark.... The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes Merchant banks: Providing foreign exchange services: Merchant banks are authorized dealers in the foreign exchange market and, as a result, they are engaged in the buying and selling of foreign exchange (forex) for commercial and other purposes.... They also provide services for both importers and exporters. 1-3. Why are some banks reaching out to become one-stop conglomerates? Is this a good idea, in your opinion? financial-service Banks and various financial institutions are converging in terms of the services they offer and embracing each other’s innovations. 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 second reason is the erosion of the bank’s market share for providing traditional services. Due to these reasons, the banks demanded for a relief from traditional rules and lobbying for an expanded authority to reach new markets around the globe. This has led the United States Congress to pass the Financial Services Modernization Act which has allowed banks to expand their role to be full-service providers. It is a beneficial step as it has led the U.S. banks to stay in the competition and increase the market share by entering into various new industries like the securities and insurance industries. 1-4. Which businesses are banking’s closest and toughest competitors? What services do they offer that compete directly with banks’ services? Among a bank’s closest competitors are savings associations, credit unions, fringe banks, money market funds, mutual funds, hedge funds, security brokers and dealers, investment banks, finance companies, financial holding companies, and life and property/casualty insurance companies. All of these financial service providers are converging and embracing each other’s innovations. The 1-4 Chapter 01 - An Overview of the Changing Financial-Services Sector Financial Services Modernization Act has allowed many of these financial service providers to offer the public one-stop shopping for financial services. A savings and loan association — also called an S&L, a thrift, or simply a savings and loan — is a financial institution similar to a bank that specializes in helping people get residential mortgages. Savings and loan associations can be owned either by their customers or by shareholders, but they were primarily meant to let the average person pool his money so that members could purchase homes. A credit union is a cooperative financial institution that is owned and controlled by its members.... Profits from the operations of a credit union are distributed to members in the form of dividends. The basic services of a credit union are to offer savings accounts and loans to members. The fringe banking industry includes payday lenders, which give customers short-term loans pending their next paychecks; pawnbrokers, which buy customers' property and allow them to repurchase it later at a higher cost; car-title lenders, which hold customers' titles as collateral for short-term loans; A money market fund is a mutual fund that invests in high-quality, short-term debt. The goal of a money market fund is to preserve capital while obtaining a nominal yield. A money market fund is often used by companies and institutions to manage their short-term cash needs. A mutual fund is a company that brings together money from many people and invests it in stocks, bonds, or other assets. The combined holdings of stocks, bonds, or other assets the fund owns are known as its portfolio. Each investor in the fund owns shares, which represent a part of these holdings. Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.... A reduction in risk, therefore, always means a reduction in potential profits. A simple hedge fund definition is: a hedge fund is an alternative investment that is designed to protect investment portfolios from market uncertainty, while generating positive returns in both up and down markets. Throughout time investors have looked for ways to maximize profits while minimizing risk. A broker-dealer (B-D) is a person or firm in the business of buying and selling securities for its own account or on behalf of its customers.... A brokerage acts as a broker (or agent) when it executes orders on behalf of its clients, whereas it acts as a dealer, or principal when it trades for its own account. An investment bank is a financial services company that acts as an intermediary in large and complex financial transactions.... It also has a role as a broker or financial adviser for large institutional clients such as pension funds 1-5 Chapter 01 - An Overview of the Changing Financial-Services Sector A finance company is a business which lends money to people and charges them interest while they pay it back. Unlike a bank, finance companies do not accept deposits. They just loan money, sometimes with fixed terms and sometimes not. A financial holding company (FHC) is a bank holding company that can offer non-banking financial services, such as insurance underwriting and investment advisory services A one-stop shop is a firm that offers a multitude of products or services to its customers, all under one roof. Compared to visiting a separate institution for each area of need, the one-stopshop saves the consumer a lot of time and effort 1-5. What is happening to banking’s share of the financial marketplace and why? What kind of banking and financial system do you foresee for the future if present trends continue? The Financial Services Modernization Act of 1999 allowed many of the banks’ closest competitors to offer a wide array of financial services thereby taking away market share from “traditional” banks. Because of the relatively liberal government regulations, banks with quality management and adequate capital can become conglomerate financial-service providers. The same will become true for security firms, insurers, and other financially oriented companies that wish to acquire bank affiliates. Hence, the banks and their closest competitors are converging into one-stop shopping for financial services and this trend should continue in the future. 1-6. What different kinds of services do banks offer the public today? What services do their closest competitors offer? 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 selling insurance policies and also buying and selling securities through security brokerage services, 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 savings plans like annuities or mutual funds. They also offer merchant banking services to large corporations and risk management and hedging services to help their customers combat risk exposure. All of these services are also offered by their financial-service competitors. Banks and their closest competitors are converging and becoming the financial department stores of the modern era. 1-6 Chapter 01 - An Overview of the Changing Financial-Services Sector Checkable deposits are a technical term for any demand deposit account against which checks or drafts of any kind may be written. (A demand deposit account means the owner can withdraw funds on demand, with no notice.) 1-7. What is a financial department store? A universal bank? Why do you think these institutions have become so important in the modern financial system? A financial department store is an institution where banking, insurance, and security brokerage services are unified under one roof. This recent trend to unify banking, insurance, and security brokerage services is often referred to as universal banking. The impressive array of services offered, and the service delivery channels used by modern financial institutions have added up to greater convenience for their customers, possibly meeting all their financial service needs at one location. A securities account sometimes known as a brokerage account is an account that holds financial assets such as securities on behalf of an investor with a bank, broker or custodian. Investors and traders typically have a securities account with the broker or bank they use to buy and sell securities. 1-7 Chapter 01 - An Overview of the Changing Financial-Services Sector 1-8. Why do banks and other financial intermediaries exist in modern society, according to the theory of finance? 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 provide a service of dividing up financial instruments into smaller units which would be readily affordable to millions of people. Banks accept risky loans from borrowers while issuing low risk securities to their depositors. Banks have been viewed in recent theory as suppliers of liquidity and transactions services that reduce costs for their customers and, through diversification, reduce risk. Banks are also critical in the payment system for goods and services and have played an increasingly important role as a guarantor and a risk management role for customers. 1-9. How have banking and the financial-services market changed in recent years? What powerful forces are shaping financial markets and institutions today? Which of these forces do you think will continue into the future? 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. However, under the new regulatory trend–reregulation, the government tightened the financial-services sector due to crises and market collapse in the previous few years. 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 and increase in returns on their money invested. 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. There has been service proliferation and greater competitive rivalry among financial firms that has led to a powerful trend— convergence. Convergence refers to the movement of businesses across industry lines so that a firm formerly offering perhaps one or two product line ventures into other product lines to broaden its sales base. Apart from these changes, there has also been a considerable improvement in the technological automation leading banking and financial services to comprise of a more capital-intensive, fixed-cost industry and a less labor-intensive, variable-cost industry than in the past. The trends of convergence, consolidation, geographic expansion, and technological change will continue to proliferate in the future years. 1-10.Can you explain why many of the forces you named in the answer to the previous question have led to significant problems for the management of banks and other financial firms and for their stockholders? The net result of recent changes in banking and the financial services market has been to put greater pressure upon their earnings, resulting in more volatile returns to stockholders and an increased bank failure in providing those rates. Increased competition has led to a fluctuation in the bank’s share of the financial service marketplace. Technological advances have significantly 1-8 Chapter 01 - An Overview of the Changing Financial-Services Sector lowered the per-unit costs associated with high-volume transactions, but they have also depersonalized financial services. Due to consolidation of financial institutions, there has been a decline in employment in the financial-service sector as a whole. Due to the powerful trend of convergence, weaker firms fail or get merged into companies that are larger with more services. Institutions 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 institutions today, therefore, has forced managers to more aggressively utilize a wide array of tools and techniques to improve and stabilize their earnings streams and manage the various risks they face. Off-balance sheet transactions are assets or liabilities that are not booked on the balance sheet, but deferred or contingent. They allow a party to have the benefit of an asset while transferring its liabilities to another party. 1-11. What do you think the financial-services industry will look like 20 years from now? What are the implications of your projections for its management today? There appears to be a trend toward continuing consolidation and convergence. There are likely to be fewer financial service providers in the future and many of these will be very large and provide a broad range of financial services under one roof. In addition, global expansion will continue and will be critical to the survival of many financial service providers. Management of financial service providers will have to be more technologically astute and be able to make a more diverse set of decisions including decisions about mergers, acquisitions, and global expansion as well as new services to add to the firm. Problems and Projects 1-1. You recently graduated from college with a business degree and accepted a position at a major corporation earning more than you could have ever dreamed. You want to (1) open a checking account for transaction purposes, (2) open a savings account for emergencies, (3) invest in an equity mutual fund for that far-off future called retirement, (4) see if you can find more affordable auto insurance, and (5) borrow funds to buy a condo, helped along by your uncle who said he was so proud of your grades that he wanted to give you $20,000 towards a down payment. (Is life good or what?) Make five lists of the financial service firms that could provide you each of these services. (1) Financial service firms that provide checking account services include banks, fringe banks, credit unions, and savings and loan associations. Even securities brokers allow you to open checking accounts. Recently brokers such as Schwab have become more aggressive in offering interest-bearing online checkable accounts that often post higher interest rates than many banks are willing to pay. (2) To open a savings account, one could approach traditional commercial 1-9 Chapter 01 - An Overview of the Changing Financial-Services Sector banks, savings associations, credit unions, online brokerages, and credit unions. (3) For a retirement fund, one could choose from a plethora of defined benefit and defined contribution schemes from private pension funds. Banks, trust departments, mutual funds, and insurance firms offer a variety of retirement investment options including equity mutual funds. (4) For affordable auto insurance, one could use a traditional insurer such as Prudential Insurance, State Farm, financial holding companies, or approach some of the newer discount insurers including Geico and Progressive. Alternatively, one could use a reverse auction service such as Esurance to get the best rate. (5) To borrow funds to buy a condo one could approach a traditional bank, savings associations that specialize in granting home mortgage loans, or financial companies such as 1-10 Chapter 01 - An Overview of the Changing Financial-Services Sector GMAC. A reverse-auction site such as LendingTree might also be useful in this exercise. The borrower is not limited to a mortgage loan for financing the purchase of a condo. Other lending mechanisms are available to finance such purchases. Using a search engine can help identify top financial institutions in each of these areas. 1-2. Leading money center banks in the United States have accelerated their investment banking activities all over the globe in recent years, purchasing corporate debt securities and stock from their business customers and reselling those securities to investors in the open market. Is this a desirable move by banking organizations from a profit standpoint? From a risk standpoint? From the public interest point of view? How would you research these questions? 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? Why or why not? 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 nonbank 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. 1-11 Chapter 01 - An Overview of the Changing Financial-Services Sector 1-3. The term bank has been applied broadly over the years to include a diverse set of financialservice institutions, which offer different financial-service packages. Identify as many of the different kinds of banks as you can. How do the banks you have identified compare to the largest banking group of all—the commercial banks? Why do you think so many different financial firms have been called banks? How might this confusion in terminology affect financial-service customers? The general public tends to classify anything as a bank that offers some sort of financial service, especially deposit and loan services. Other institutions that are often referred to as a bank without being one are savings associations, credit unions, fringe banks, money market funds, mutual funds, hedge funds, security brokers and dealers, investment banks, finance companies, financial holding companies, and life and property/casualty insurance companies. All of these institutions offer some of the services that a commercial bank offers, but generally not the entire scope of services. Since providers of financial services are normally called banks by the general public they are able to take away business from traditional banks and it is of utmost importance for commercial banks to clarify their unique position among financial services providers. 1-4. What advantages can you see to banks affiliating with insurance companies? How might such an affiliation benefit a bank? An insurer? Can you identify any possible disadvantages to such an affiliation? Can you cite any real-world examples of bank-insurer affiliations? How well do they appear to have worked out in practice? Banks used to sell insurance services to their customers on a regular basis before the beginning of the Great Depression. Beginning with the Great Depression of the 1930s, U.S. banks were prohibited from acting as insurance agents or underwriting insurance policies out of fear that selling insurance would increase bank risk. However, the separation between banking and insurance changed dramatically as the new century dawned when the U.S. Congress removevd the legal barriers between the two industries, allowing banking companies to acquire control of insurance companies and, conversely, permitting insurers to acquire banks. Today, these two industries compete aggressively with each other, pursuing cross-industry mergers and acquisitions. Before Glass-Steagall, banks used to sell insurance services to their customers on a regular basis. In particular, banks would sell life insurance to loan customers to ensure repayment of the loan in case of death or disablement. The right to sell insurances to customers again benefits banks in allowing them to offer their customers complete financial packages from financing the home or car to insure it, from giving investment advice to selling life insurance policies and annuities for retirement planning. Generally, a bank customer who is already purchasing a service from a bank might feel compelled to purchase an insurance product, as well. On the other hand, insurance companies sometimes have a negative image, which makes it more difficult to sell certain insurance products. Combining their products with the trust that people generally have in banks will make it easier for them to sell their products. 1-12 Chapter 01 - An Overview of the Changing Financial-Services Sector The most prominent example of a bank-insurer affiliation is the merger of Citicorp and Traveler’s Insurance to Citigroup. However, given that Citigroup has sold Traveler’s Insurance indicates that the anticipated synergy effects did not materialize. 1-5. Explain the difference between consolidation and convergence. Are these trends in banking and financial services related? Do they influence each other? How? Consolidation refers to increase in the size of financial institutions. The number of small, independently owned financial institutions is declining and the average size of individual banks, as well as securities firms, credit unions, finance companies, and insurance firms, has risen significantly. Convergence is the bringing together of firms from different industries to create conglomerate firms offering multiple services. Clearly, these two trends are related. In their effort to compete with each other, banks and their closest competitors have acquired other firms in their industry as well as across industries to provide multiple financial services in multiple markets. 1-6. What is a financial intermediary? What are its key characteristics? Is a bank a type of financial intermediary? What other financial-services companies are financial intermediaries? What important roles within the financial system do financial intermediaries play? A financial intermediary is a business that interacts with deficit spending individuals and institutions and surplus spending individuals and institutions. For this reason, any financial service provider (including banks) is considered a financial intermediary. Banks, along with insurance companies, mutual funds, finance companies, and similar financial-service providers are financial intermediaries. In their function as intermediaries they act as a bridge between the deficit and surplus spending units by offering financial services to the surplus spending individuals and then allocating those funds to the deficit spending individuals. Financial intermediaries accelerate economic growth by expanding the available pool of savings, lowering the risk of investments through diversification, increasing the productivity of savings and investments, satisfying the need for liquidity, and evaluation of financial information. 1-13