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 bank to have only 1 % of assets funded by equity capital. Maintaining equity capital equal to 5 % of assets as in Table 2.2 is more reasonable. Note that equity and subordinated long-term debt are both sources of capital. Equity provides the best protection against adverse events. (In our example, when the bank has $5 million of equity capital rather than $1 million it stays solvent and is unlikely to be liquidated.) Subordinated long-term debt-holders rank below depositors in the event of default, but subordinated debt does not provide as good a cushion for the bank as equity because it does not prevent the bank's insolvency.
As we shall see in Chapters 15 to 17, bank regulators have tried to ensure that the capital a bank keeps is sufficient to cover the risks it takes. The risks include market risks, credit risks, and operational risks. Equity capital is categorized as “Tier 1 capital” while subordinated long-term debt is categorized as “Tier 2 capital.”
2.3 DEPOSIT INSURANCE
To maintain confidence in banks, government regulators in many countries have introduced guaranty programs. These typically insure depositors against losses up to a certain level.
The United States with its large number of small banks is particularly prone to bank failures. After the stock market crash of 1929 the United States experienced a major recession and about 10,000 banks failed between 1930 and 1933. Runs on banks and panics were common. In 1933, the United States government created the Federal Deposit Insurance Corporation (FDIC) to provide protection for depositors. Originally, the maximum level of protection provided was $2,500. This has been increased several times and became $250,000 per depositor per bank in October 2008. Banks pay an insurance premium that is a percentage of their domestic deposits. Since 2007, the size of the premium paid has depended on the bank's capital and how safe it is considered to be by regulators. For well-capitalized banks, the premium might be less than 0.1 % of the amount insured; for under-capitalized banks, it could be over 0.35 % of the amount insured.
Up to 1980, the system worked well. There were no runs on banks and few bank failures. However, between 1980 and 1990, bank failures in the United States accelerated with the total number of failures during this decade being over 1,000 (larger than for the whole 1933 to 1979 period). There were several reasons for this. One was the way in which banks managed interest rate risk and we will talk about that in Chapter 9. Another reason was the reduction in oil and other commodity prices which led to many loans to oil, gas, and agricultural companies not being repaid.
A further reason for the bank failures was that the existence of deposit insurance allowed banks to follow risky strategies that would not otherwise be feasible. For example, they could increase their deposit base by offering high rates of interest to depositors and use the funds to make risky loans. Without deposit insurance, a bank could not follow this strategy because their depositors would see what they were doing, decide that the bank was too risky, and withdraw their funds. With deposit insurance, it can follow the strategy because depositors know that, if the worst happens, they are protected under FDIC. This is an example of what is known as moral hazard. We will talk about moral hazard further in Chapter 3. It can be defined as the possibility that the existence of insurance changes the behavior of the insured party. The introduction of risk-based deposit insurance premiums has reduced moral hazard to some extent.
During the 1980s, the funds of FDIC became seriously depleted and it had to borrow $30 billion from the U.S. Treasury. In December 1991, Congress passed the FDIC Improvement Act to prevent any possibility of the fund becoming insolvent in the future. Between 1991 and 2006, bank failures in the United States were relatively rare and by 2006 the fund had reserves of about $50 billion. However, FDIC funds were again depleted by the banks that failed as a result of the credit crisis that started in 2007.
2.4 INVESTMENT BANKING
The main activity of investment banking is raising debt and equity financing for corporations or governments. This involves originating the securities, underwriting them, and then placing them with investors. In a typical arrangement a corporation approaches an investment bank indicating that it wants to raise a certain amount of finance in the form of debt, equity, or hybrid instruments such as convertible bonds. The securities are originated complete with legal documentation itemizing the rights of the security holder. A prospectus is created outlining the company's past performance and future prospects. The risks faced by the company from such things as major lawsuits are included. There is a “road show” in which the investment bank and senior management from the company attempt to market the securities to large fund managers. A price for the securities is agreed between the bank and the corporation. The bank then sells the securities in the market.
There are a number of different types of arrangement between the investment bank and the corporation. Sometimes the financing takes the form of a private placement in which the