Off-balance-sheet activity

352 Part 3 Commercial Banks

Overall, the liability structure of banks’ balance sheets tends to reflect a shorter matu-

rity structure than that of their asset portfolio. Further, relatively more liquid instruments

such as deposits and interbank borrowings are used to fund relatively less liquid assets

such as loans. Thus, interest rate risk—or maturity mismatch risk—and liquidity risk are

key exposure concerns for bank managers (see Chapters 19 through 24).

Equity

Commercial bank equity capital (11.3 percent of total liabilities and equity in 2013) con-

sists mainly of common and preferred stock (listed at par value), surplus or additional

paid-in capital, and retained earnings. Regulators require banks to hold a minimum level of

equity capital to act as a buffer against losses from their on- and off-balance-sheet activi-

ties (see Chapter 13). Because of the relatively low cost of deposit funding, banks tend to

hold equity close to the minimum levels set by regulators. As we discuss in Chapters 13

and 22, this impacts banks’ exposure to risk and their ability to grow—both on and off the

balance sheet—over time.

Part of the Troubled Asset Relief Program (TARP) of 2008–2009 was the Capital Pur-

chase Program, which was intended to encourage U.S. financial institutions to build capital

to increase the flow of financing to U.S. businesses and consumers and to support the U.S.

economy. Under the program, the Treasury purchased over $200 billion of senior preferred

equity. The senior preferred shares rank senior to common stock should the bank be closed.

In addition to capital injections received as part of the Capital Purchase Program, TARP

provided additional emergency funding to Citigroup ($25 billion) and Bank of America

($20 billion). Through the summer of 2013, $245 billion of TARP capital injections had

been allocated to depository institutions (DIs), of which $237 billion had been paid back

plus a return of $35 billion in dividends and assessments to the government. The Notable

Events from the Financial Crisis box describes the TARP Capital Purchase Program.

As part of the 2010 Wall Street Reform and Consumer Protection Act, the largest

banks are subject to annual stress tests, designed to ensure that the banks are properly capi-

talized. Scenarios used as part of the stress tests range from mild to calamitous, with the

most extreme including a 5 percent decline in gross domestic product, an unemployment

rate of 12 percent, and a volatile stock market that loses half its value. The original stress

test was announced in late February 2009 when the Obama administration announced that

it would conduct a “stress test” of the 19 largest U.S. DIs, which would measure the abil-

ity of these DIs to withstand a protracted economic slump (an unemployment rate above

10 percent and home prices dropping another 25 percent). Results of the stress test showed

that 10 of the 19 DIs needed to raise a total of $74.6 billion in capital. Within a month of

the May 7, 2009, release of the results the DIs had raised $149.45 billion of capital. As

part of the 2013 stress tests, the worst-case scenario includes a peak unemployment rate of

12.1 percent, a drop in equity prices of more than 50 percent, a decline in housing prices of

more than 20 percent, and a sharp market shock for the largest trading firms.

Off-Balance-Sheet Activities

The balance sheet itself does not reflect the total scope of bank activities. Banks conduct

many fee-related activities off the balance sheet. Off-balance-sheet (OBS) activities are

becoming increasingly important, in terms of their dollar value and the income they gen-

erate for banks—especially as the ability of banks to attract high-quality loan applicants

and deposits becomes ever more difficult. OBS activities include issuing various types

of guarantees (such as letters of credit), which often have a strong insurance underwrit-

ing element, and making future commitments to lend. Both services generate additional

fee income for banks. Off-balance-sheet activities also involve engaging in derivative

transactions—futures, forwards, options, and swaps.

Under current accounting standards, such activities are not shown on the current

balance sheet. Rather, an item or activity is an off-balance-sheet asset if, when a contingent

LG 11-4

off-balance-sheet (OBS) asset

When an event occurs, this

item moves onto the asset

side of the balance sheet

or income is realized on the

income statement.

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353

In the wake of Lehman Brothers’s bankruptcy, the

U.S. Congress passed the Emergency Economic

Stabilization Act (EESA) of 2008 to “restore the

liquidity and stability to the financial system.”

The Act authorized the Treasury Department

to establish the Troubled Asset Relief Program

(TARP) and to spend up to $700 billion to “bail

out” the U.S. financial system. In the original plan

presented by then-Secretary of the Treasury Henry

Paulson, the government would use TARP funds to

buy distressed assets in financial institutions. On

October 14, 2008, Mr. Paulson announced a revision

in TARP implementation in which the Treasury

directly injected $250 billion of TARP funds (through

the Capital Purchase Program [CPP]) into the U.S.

banking system through the purchase of senior

preferred stock and warrants in qualifying financial

institutions (QFIs). The first $125 billion was to be

invested in nine large, systemically important bank

holding companies. The remaining $125 billion was

to be made available for other banks. The amount

of CPP capital that a QFI could apply for was

restricted to between 1 percent and 3 percent of

the QFI’s risk-weighted assets. The Treasury was

paid a 5 percent dividend on the preferred stock in

the first 5 years and a 9 percent dividend thereaf-

ter. Over 700 of the approximate 8,300 depository

institutions were accepted into CPP, receiving $245

billion in capital infusions. The largest investment

was $25 billion and the smallest was $301,000.

To apply for CPP investments, banks were

asked to submit their applications to their primary

federal regulator: the Federal Reserve (the Fed),

the Federal Deposit Insurance Corporation (FDIC),

the Office of the Comptroller of the Currency

(OCC), or the Office of Thrift Supervision (OTS).

Based on recommendations from federal banking

regulators, the Treasury made the final decision

on whether or not to make the capital purchase.

Many institutions decided to apply, while others

opted out. Some were asked by federal regulators

The TARP Program

N O T A B L E E V E N T S F R O M T H E F I N A N C I A L C R I S I S

not to apply. A large number of banks withdrew

their applications. However, because the Treasury

did not release details of the applicant list to the

public, it is not known how many banks withdrew

their TARP applications voluntarily despite being

qualified and how many withdrew because they did

not meet the requirements and were encouraged

to withdraw by the banking regulators. The applica-

tion period for publicly held financial institutions to

participate in CPP closed on November 14, 2008.

The final investment under the CPP was made in

December 2009.

To encourage banks to participate in CPP,

the Treasury made the terms of CPP investments

quite attractive. In the first nine CPP transactions,

the Treasury paid $125 billion for financial claims

worth only $89–$112 billion (these banks held

over half of the banking industry’s assets). The

Congressional Oversight Panel issued an evalu-

ation report on February 6, 2009, concluding

that “. . . (for) all capital purchases made in 2008

under TARP, the Treasury paid $254 billion, for

which it received assets worth approximately $176

billion, a shortfall of $78 billion.” The attractive

terms of CPP induced thousands of applicants,

among which only about 700 financial institutions

received any TARP funds.

The Capital Purchase Program is often char-

acterized as a program for “big banks.” Indeed,

$163.5 billion of all CPP funds were allotted to the

largest 19 banks. Further, many believe that small

institutions were not able to and did not partici-

pate in the program. In fact, because of financial

obligations associated with CPP, federal regulators

did not initially allow temporarily unhealthy com-

munity banks to participate in CPP because such

institutions would risk the Treasury’s investment.

However, on May 13, 2009, Treasury Secretary

Timothy Geithner announced that the Treasury

would reopen the application window for participa-

tion in the CPP to banks with total assets under

$500 million and increase the amount that could

be invested from 3 percent of risk-weighted assets

to 5 percent of risk-weighted assets. In the end,

smaller financial institutions make up the vast

majority of participants in the CPP. By the time it

closed on December 31, 2009, of the 707 applica-

tions approved and funded by the Treasury through

the CPP, over half were institutions with less than

$500 million in assets.

As the TARP CPP (hereafter TARP) program

progressed, many, particularly healthy, banks real-

ized that the costs of participating in TARP were

higher than had been expected. As public outrage

swelled over the rapidly growing cost of “bailing

out” financial institutions, the Obama administra-

tion and lawmakers attached more and more

restrictions on banks that received TARP funds.

For example, with the acceptance of TARP funds,

banks were told to put off evictions and modify

mortgages for distressed homeowners, let share-

holders vote on executive pay packages, slash div-

idends, and withdraw job offers to foreign citizens.

Some bankers stated that conditions of the TARP

program had become so onerous that they wanted

to return the bailout money as soon as regulators

set up a process to accept the repayments. For

example, just three months after receiving TARP

funds, Signature Bank of New York announced

that because of new executive pay restrictions

assessed as a part of the acceptance of TARP

funds, it notified the Treasury that it intended to

return the $120 million it had received. As a result,

many banks, particularly those that were sufficiently

healthy, repaid their TARP funds quickly.

As of August 2013, banks had repaid

$272 billion through principal and interest

payment—representing a $27 billion positive return

to taxpayers so far. In late 2008 few would have

predicted that TARP would end up with a profit.

Source: Authors’ research.

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354 Part 3 Commercial Banks

event occurs, the item or activity moves onto the asset side of the balance sheet or

an income item is realized on the income statement. Conversely, an item or activity is an

off-balance-sheet liability if, when a contingent event occurs, the item or activity moves onto the liability side of the balance sheet or an expense item is realized on the income

statement.

By undertaking off-balance-sheet activities, banks hope to earn additional fee income

to complement declining margins or spreads on their traditional lending business. At the

same time, they can avoid regulatory costs or “taxes” since reserve requirements and

deposit insurance premiums are not levied on off-balance-sheet activities (see Chapter 13).

Thus, banks have both earnings and regulatory “tax-avoidance” incentives to undertake

activities off their balance sheets.

Off-balance-sheet activities, however, can involve risks that add to the overall insol-

vency exposure of a financial intermediary (FI). Indeed, at the very heart of the financial

crisis were losses associated with off-balance-sheet mortgage-backed securities created

and held by FIs. These losses resulted in the failure, acquisition, or bailout of some of

the largest FIs and a near meltdown of the world’s financial and economic systems. Thus,

off-balance-sheet activities and instruments have risk-reducing as well as risk-increasing

attributes, and, when used appropriately, they can reduce or hedge an FI’s interest rate,

credit, and foreign exchange risks.

We show the notional, or face, value of bank OBS activities and their distribution and

growth for 1992 to 2013 in Table 11–2 . Notice the relative growth in the notional dollar

value of OBS activities in Table 11–2 . By 2013, the notional value of OBS bank activities

was $239,752.7 billion compared to the $13,362.6 billion value of on-balance-sheet activi-

ties. The notional or face value of OBS activities does not accurately reflect the risk to the

bank undertaking such activities. The potential for the bank to gain or lose on the contract

is based on the possible change in the market value of the contract over the life of the con-

tract rather than the notional or face value of the contract, normally less than 3 percent of

the notional value of an OBS contract.

The use of derivative contracts accelerated during the 1992–2013 period and

accounted for much of the growth in OBS activity. Along with the growth in the notional

value of OBS activities, banks have seen significant growth in the percentage of their

total operating income (interest income plus noninterest income) coming from these

off-balance-sheet activities. Indeed, the percentage of noninterest income to total operating

income has increased from 22.66 percent in 1979 to 46.56 percent in 2013. As we discuss

in detail in Chapter 23, the significant growth in derivative securities activities by com-

mercial banks has been a direct response to the increased interest rate risk, credit risk, and

foreign exchange risk exposures they have faced, both domestically and internationally. In

particular, these contracts offer banks a way to hedge these risks without having to make

extensive changes on the balance sheet. However, these assets and liabilities also introduce

unique risks that must be managed. During the recent financial crisis, as mortgage borrow-

ers defaulted on their mortgages, financial institutions that held these “toxic” mortgages

and “toxic” credit derivatives (in the form of mortgage-backed securities) started announc-

ing huge losses on them. Losses from the falling value of OBS securities reached over $1

trillion worldwide through 2009.

The TARP gave the U.S. Treasury funds to buy “toxic” mortgages and other securi-

ties from financial institutions. However, the TARP plan was slow to be instituted and not

all FIs chose to participate in the program. Better capitalized FIs wanted to hold on to

their troubled OBS securities rather than sell them and record losses. Despite this, inves-

tors impounded the values of these toxic securities into the market prices of FIs that held

them. As a result, early 2009 saw a plunge in the market values of financial institutions.

Banks such as Citigroup, Bank of America, and J. P. Morgan Chase traded at less than book

value as investors had little confidence in the value of their assets. As a result, a new plan,

announced on February 10, 2009, involved a number of initiatives, including offering fed-

eral insurance to banks against losses on bad assets. In addition, the Treasury, working with

the Federal Reserve, FDIC, and private investors, created the Public-Private Investment

off-balance-sheet (OBS) liability

When an event occurs, this

item moves onto the liability

side of the balance sheet or

an expense is realized on the

income statement.

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Chapter 11 Commercial Banks: Industry Overview 355

1992 2004 2007 2010 2013 Distribution

2013

Percentage Increase from 1992 through

2013

Commitments to lend $ 1,272.0 $ 5,686.4 $ 7,236.9 $ 5,113.5 $ 5,344.6 2.2% 320.2%

Future and forward contracts

(excludes FX)

On commodities and

equities 26.3 123.7 251.2 245.3 332.5 0.1 1,164.3

On interest rates 1,738.1 6,923.0 9,116.9 23,987.0 31,216.0 13.0 1,696.0

Notional amount of credit

derivatives 8.6 1,909.3 15,862.8 14,150.8 13,900.8 5.8 161,537.2

Standby contracts and other

option contracts

Option contracts on

interest rates 1,012.7 15,340.8 20,984.4 27,015.4 25,871.0 10.8 2,454.7

Option contracts on

foreign exchange 494.8 1,627.2 4,024.7 3,336.0 5,617.1 2.4 1,035.2

Option contracts on

commodities 60.3 1,020.2 2,715.9 1,723.7 2,249.2 0.9 3,630.0

Commitments to buy FX

(includes $U.S.), spot,

and forward 3,015.5 4,969.2 10,057.9 12,316.2 15,046.1 6.3 399.0

Standby LCs and foreign

office guarantees 162.5 391.3 1,139.6 525.3 594.8 0.3 266.0

(amount of these items

sold to others via

participations) (14.9) (66.5) (220.5) (89.4) (148.1)

Commercial LCs 28.1 29.5 29.7 27.7 23.5 0.0 - 16.4

Participations in acceptances 1.0 0.9 0.1 0.1 0.0 0.0 - 100.0

Securities borrowed or lent 107.2 1,073.1 2,052.2 1,029.5 984.3 0.4 818.2

Other significant

commitments and

contingencies 25.7 44.0 173.1 168.2 240.3 0.1 835.0

Notional value of all

outstanding swaps 2,122.0 52,909.2 103,091.1 149,319.6 138,332.5 57.7 6,419.0

Total $ 10,200.3 $ 92,047.8 $ 176,763.5 $ 238,958.3 $ 239,752.7 100% 2,250.4

Total assets

(on-balance-sheet items) $ 3,476.4 $ 8,244.4 $ 11,176.1 $ 12,065.5 $ 13,362.6 284.4

TABLE 11–2 Aggregate Volume of Off-Balance-Sheet Commitments and Contingencies by U.S. Commercial Banks (in billions of dollars)

FX  =  Foreign exchange, LC  =  Letter of credit.

Sources: FDIC, Statistics on Banking, various issues. www.fdic.gov

Fund (PPIF) to acquire real estate–related OBS assets. By selling to PPIF, financial insti-

tutions could reduce balance sheet risk, support new lending, and help improve overall

market functioning. The PPIF facility was initially funded at $500 billion with plans to

expand the program to up to $1.25 trillion over time. After several months of discussion,

in July 2009, the government had selected nine financial firms to manage a scaled-down

program, investing $30 billion to start the fund. The selected firms had 12 weeks to raise

$500 million of capital each from private investors willing to invest in FIs’ toxic assets.

The total investment would be matched by the federal government. The purchase of

$1.25 trillion in OBS mortgage-backed securities was completed in March 2010.

Although the simple notional dollar value of OBS items overestimates their risk expo-

sure amounts, the increase in these activities is still nothing short of phenomenal. Indeed,

this phenomenal increase has pushed regulators into imposing capital requirements on

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356 Part 3 Commercial Banks

such activities and into explicitly recognizing an FI’s solvency risk exposure from pur-

suing such activities. We describe these capital requirements in Chapter 13. Further, as

a result of the role derivatives played in the recent financial crisis, the 2010 Wall Street

Reform and Consumer Protection Act has called for a revamping of the U.S. financial reg-

ulatory system that includes extending regulatory oversight to unregulated OTC derivative

securities. The regulation requires that all over-the-counter derivatives contracts be subject

to regulation, and that all derivatives dealers be subject to supervision. It also empowers

regulators to enforce rules against manipulation and abuse.

Other Fee-Generating Activities

Commercial banks engage in other fee-generating activities that cannot be easily identi-

fied from analyzing their on- and off-balance-sheet accounts. Two of these include trust

services and correspondent banking.

Trust Services. The trust department of a commercial bank holds and manages assets for individuals or corporations. Only the largest banks have sufficient staff to offer trust ser-

vices. Individual trusts represent about one-half of all trust assets managed by commercial

banks. These trusts include estate assets and assets delegated to bank trust departments by

less financially sophisticated investors. Pension fund assets are the second largest group

of assets managed by the trust departments of commercial banks. The banks manage the

pension funds, act as trustees for any bonds held by the pension funds, and act as

a transfer and disbursement agent for the pension funds. We discuss pension funds

in more detail in Chapter 18.

Correspondent Banking. Correspondent banking is the provision of banking services to other banks that do not have the staff resources to perform the services

themselves. These services include check clearing and collection, foreign exchange

trading, hedging services, and participation in large loan and security issuances.

Correspondent banking services are generally sold as a package of services. Pay-

ment for the services is generally in the form of noninterest-bearing deposits held

at the bank offering the correspondent services (see Chapter 12).

D O Y O U U N D E R S T A N D :

3. What major assets commercial

banks hold?

4. What the major sources of funding

for commercial banks are?

5. What OBS assets and liabilities are?

6. What other types of fee-generating

activities banks participate in?

SIZE, STRUCTURE, AND COMPOSITION OF THE INDUSTRY

As of 2013, the United States had 6,048 commercial banks. Even though this may seem to

be a large number, in fact the number of banks has been decreasing. For example, in 1984,

the number of banks was 14,483. 4 Figure  11–5 illustrates the number of bank mergers,

bank failures, and new charters for the period 1980 through 2013. Notice that much of the

change in the size, structure, and composition of this industry is the result of mergers and

acquisitions. As we discuss in Chapter 13, strict regulations imposed on commercial banks

over much of the last century limited geographical diversification opportunities. As a

result, commercial bank operational areas were often narrow (and specialized) and the

number of commercial banks was large. It was not until the 1980s and 1990s that regula-

tors (such as the Federal Reserve or state banking authorities) allowed banks to merge with

other banks across state lines (interstate mergers), and it has only been since 1994 that

Congress has passed legislation (the Reigle-Neal Act) easing branching by banks across

state lines. Finally, it has only been since 1987 that banks have possessed powers to under-

write corporate securities. (Full authority to enter the investment banking [and insurance]

business was received only with the passage of the Financial Services Modernization Act

in 1999.) We discuss the impact that changing regulations have had on the ability of

commercial banks to merge and branch in Chapter 13.

LG 11-5

4. However, during this period the number of offices has risen, from 60,000 in 1984 to over 88,000 in 2013.

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