CH03 Depository Institutions - Activities and Characteristics.doc

Chapter 3 Depository Institutions: Activities and Characteristics ASSET/LIABILITY PROBLEM OF DEPOSITORY INSTITUTIONS These institutions seek to earn spread income, which is a positive spread or margin between the returns on their assets and the costs of their liabilities. In generating spread income, a depository institution faces several risks. These include credit risk, regulatory risk, and interest rate risk. Interest Rate Risk Interest rate risk or funding risk is the mismatching of assets and liabilities in terms of their maturities. For example, this can arise because the deposits are short-term and assets long term. An increase in expected interest rates will reduce the spread between the return on assets and the deposit costs. Floating rate long-term assets can reduce this problem since they make long-term assets behave like short-term funds that match deposit terms to maturity. Liquidity Concerns Liquidity concern is the possibility of withdrawal of funds by depositors or insufficient funds available to meet lending needs. It can be handled by: (1) attracting more deposits; (2) borrowing from federal agency or other institution (Federal Funds Market); (3) raising short-term funds in the money market; (4) selling or liquidating securities and other assets. Securities held for the purpose of satisfying net withdrawals and customer loan demands are sometimes referred to as secondary reserves. COMMERCIAL BANKS Today, banks are regulated and supervised by several federal and state government entities. At the federal level, supervision is undertaken by the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation. The assets of a bank are insured by the Federal Deposit Insurance Corporation. As of 2d quarter 2007, 7350 commercial banks were operating in the United States. Only about 25% were national banks, but these held the majority of the bank assets (65%). Bank Services Ban