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CHAPTER 2 DRIVERS OF CHANGE, INNOVATION, AND CONSOLIDATION IN THE FINANCIAL-SERVICES INDUSTRY Chapter 2 CHAPTER 2 DRIVERS OF CHANGE, INNOVATION, AND CONSOLIDATION IN THE FINANCIAL-SERVICES INDUSTRY Chapter 2 1

Learning Objectives n To understand … n n n 1. The drivers of change Learning Objectives n To understand … n n n 1. The drivers of change in the FSI as the components of TRICK 2. Innovation as a diffusion process and the technological and contractual aspects of innovation 3. Consolidation and corporate restructuring in the FSI, especially bank mergers Chapter 2 2

Chapter Theme n n n Heraclitus, the Greek philosopher, said: “All is flux, nothing Chapter Theme n n n Heraclitus, the Greek philosopher, said: “All is flux, nothing stays still. Nothing endures but change. ” This chapter focuses on change in banking and the FSI and what drives it Innovation and consolidation, among other things, reflect the effects of the changes driving banking and the FSI Chapter 2 3

COMPONENTS OF A DYNAMIC MODEL OF CHANGE: TRICK n Transparency n Risk exposure n COMPONENTS OF A DYNAMIC MODEL OF CHANGE: TRICK n Transparency n Risk exposure n Information technology n Competition for customers n Kapital adequacy n Model: TRICK + Rational Self-Interest => Financial Innovation Chapter 2 4

TRANSPARENCY Readily understood, clear, or easily detected with regard to financial statement information, disclosure, TRANSPARENCY Readily understood, clear, or easily detected with regard to financial statement information, disclosure, monitoring and discipline by holders of debt and equity contracts, market valuations, and accountability of managers, directors, and safety-net managers Chapter 2 5

RISK EXPOSURE (leads to) Risk-Management Techniques n Asset-Liability Management (ALM) n Credit Analysis n RISK EXPOSURE (leads to) Risk-Management Techniques n Asset-Liability Management (ALM) n Credit Analysis n Derivatives: Futures, Forwards, Options, and Swaps n Securitization Chapter 2 6

Exposure to What? n The risks of banking n n n 1. Credit risk Exposure to What? n The risks of banking n n n 1. Credit risk 2. Interest-rate risk 3. Liquidity risk 4. Foreign-exchange risk 5. Operational risk 6. Solvency (capital-adequacy) risk depends on the risks above Chapter 2 7

INFORMATION TECHNOLOGY “The information standard has replaced the gold standard as the basis for INFORMATION TECHNOLOGY “The information standard has replaced the gold standard as the basis for world finance” - Walter Wriston Chapter 2 8

COMPETITON FOR CUSTOMERS Basic Ingredients to Attract Customers n Price n Convenience n Confidence COMPETITON FOR CUSTOMERS Basic Ingredients to Attract Customers n Price n Convenience n Confidence (federal safety net/guarantee) Chapter 2 9

KAPITAL ADEQUACY n Market Discipline n n Costs of financial distress and cost of KAPITAL ADEQUACY n Market Discipline n n Costs of financial distress and cost of funds Regulatory Discipline n Risk-based capital requirements n Graham-Leach-Bliley Act of 1999 n Community Reinvestment Act (modernization tied to fairness) Chapter 2 10

INNOVATION AS A DIFFUSION PROCESS Innovation -- the introduction of something new n Ex: INNOVATION AS A DIFFUSION PROCESS Innovation -- the introduction of something new n Ex: 1961 introduction of the first negotiable certificate of deposit Preliminary Distinctions n 1 2 3 . Invention vs. innovation. Autonomous innovation vs. induced innovation. Market-induced innovation vs. regulation-induced innovation Chapter 2 11

NEW TECHNOLOGY AND PRODUCT DIFFUSION n n August 2000 Internet Penetration for U. S. NEW TECHNOLOGY AND PRODUCT DIFFUSION n n August 2000 Internet Penetration for U. S. Households = 41% Top Ten Cities for Penetration: San Francisco (66%) Seattle (64%) San Diego (62%) Portland (62%) Washington D. C. And Boston (59%) Denver and Kansas City (57%) Orlando (56%) Baltimore (55%) Chapter 2 12

DIFFUSION OF E-BANKING n n Except for ATMs, diffusion rate has been slow “Paper DIFFUSION OF E-BANKING n n Except for ATMs, diffusion rate has been slow “Paper currency and checks are still used for the overwhelming majority of consumer payments, while electronic transfer, such as those made over the ACH, account for a very small fraction. In contrast, for the major money and securities markets in this country, electronic payments are the rule rather than the exception” -- Edward W. Kelley, Jr. Chapter 2 13

INNOVATION AND THE DESIGN OF FINANCIAL CONTRACTS Two Basic Contracts of Banking 1. Deposit INNOVATION AND THE DESIGN OF FINANCIAL CONTRACTS Two Basic Contracts of Banking 1. Deposit Account n n Checking Accounts Savings Accounts Certificate of Deposits Individual Retirement Accounts 2. Loan Agreement n n Fixed or Adjustable Rate Mortgages C&I Term Loans Automobile Loans Credit-Card Loans Chapter 2 14

CREDIT EXTENTION BUILDING BLOCKS The Blocks Can Be Viewed In Terms Of: n Zero CREDIT EXTENTION BUILDING BLOCKS The Blocks Can Be Viewed In Terms Of: n Zero Coupon n Present Value n Fixed Rate n Future Value n Variable Rate n Payment Amortized n Interest Rate n Number of Periods n Chapter 2 15

Background: TVM Formulas n Panel B of Table 2 -2 presents the timevalue-of-money (TVM) Background: TVM Formulas n Panel B of Table 2 -2 presents the timevalue-of-money (TVM) formulas on a pair-wise basis n n n 1. PV and FV of a lump sum 2. FV of an annuity (payment) and annuity repaying a future amount 3. PV of an ordinary annuity and annuity repaying a present value (loan-recovery factor, e. g. , for a mortgage payment) Chapter 2 16

THE COSTS OF INNOVATIVE FINANCIAL PRODUCTS AND REPUTATIONAL CAPITAL Legal, accounting, regulatory, and tax THE COSTS OF INNOVATIVE FINANCIAL PRODUCTS AND REPUTATIONAL CAPITAL Legal, accounting, regulatory, and tax advisors · Computer systems for pricing and trading ¸ Capital and personnel to support market -making, and ¹ Educating issuers, investors, and traders ¶ Chapter 2 17

BACKGROUND TO BANK CONSOLIDATION n Within an industry within a country n Across industries BACKGROUND TO BANK CONSOLIDATION n Within an industry within a country n Across industries within a country n Across countries but in the same industry n Across countries and industries Chapter 2 18

MOTIVES FOR CONSOLIDATION n Cost Economies n n n Economies of Scale Economies of MOTIVES FOR CONSOLIDATION n Cost Economies n n n Economies of Scale Economies of Scope Market Power Managerial Agency Costs Exploitation of the Federal Safety Net Chapter 2 19

Alternative Merger Hypotheses n n n n Hypothesis Source of value creation Information Undervaluation Alternative Merger Hypotheses n n n n Hypothesis Source of value creation Information Undervaluation Market power Horizontal mergers Synergy Cost efficiencies Tax (financial) synergy Inefficient mgm Mismanagement Earnings diversification Higher cash flows Chapter 2 20

M&A in Banking and the FSI n n n Citigroup merger (1998) predated GLB M&A in Banking and the FSI n n n Citigroup merger (1998) predated GLB Act (1999) and helped force passage of the act JPM and Chase (2000) Bank of America and Nations. Bank (1998) Wells Fargo and Norwest (1998) Hostile takeovers (Sun. Trust failed in its bid for Wachovia – First Union won the battle but lost its name) Chapter 2 21

View Consolidation in Terms of the ROE Model n n n ROE = ROA View Consolidation in Terms of the ROE Model n n n ROE = ROA x EM ROA = PM x AU Profitability (accounting) measures are: PM, ROA, ROE Sales, turnover, or utilization measure is: AU Leverage factor is: EM Chapter 2 22

BANK ORGANIZATIONAL FORMS IN THE US n Independent Banks n One-Bank Holding Companies n BANK ORGANIZATIONAL FORMS IN THE US n Independent Banks n One-Bank Holding Companies n Multi-Bank Holding Companies Together, BHCs and independent banks are referred to as BANKING COMPANIES Chapter 2 23

PHENOMENA DRIVING DECLINE IN # OF BANKING COMPANIES n n n Mergers among BHCs PHENOMENA DRIVING DECLINE IN # OF BANKING COMPANIES n n n Mergers among BHCs acquiring viable independent banks The failure of independent banks during the 1980 s and 1990 s “The whole banking structure is turning into an oligopoly in which four or five institutions dominate any particular geographicbased market” -- Furash Chapter 2 24

A Long View n n n Year Unit banks Branch banks. Total 1935 13, A Long View n n n Year Unit banks Branch banks. Total 1935 13, 329 796 14, 125 2000 2, 733 5, 848 8, 581 Change -10, 596 5, 052 -5, 544 Counting ATMs, point-of-sale systems, automated clearing houses (for direct deposit), and opportunities for home banking via the Internet numerous e-based systems for delivering financial services also exist, besides the traditional brick-and-mortar banks and branches Chapter 2 25

CONSOLIDATION n Mergers n Takeovers and Hostile Takeovers n Anti-Takeover Strategies n Shark Repellants CONSOLIDATION n Mergers n Takeovers and Hostile Takeovers n Anti-Takeover Strategies n Shark Repellants n Poison Pills n Greenmail n Golden Parachutes Chapter 2 26

Competition and Access to Financial Services n n The Fed favors the industrialorganizational (IO) Competition and Access to Financial Services n n The Fed favors the industrialorganizational (IO) model, which has the following linkages, given the conditions of supply and demand: Market structure => Conduct => Performance Chapter 2 27

MERGER AND ACQUISITION STRATEGIES n “Hit ‘em where they ain’t” Ex: Key. Corp and MERGER AND ACQUISITION STRATEGIES n “Hit ‘em where they ain’t” Ex: Key. Corp and Interstate Banking n Buck the Merger Trend Ex: Sun. Trust but then a failed hostile-takeover attempt Chapter 2 28

OPPORTUNTIES FOR COMMUNITY BANKS IN THE MERGER ENVIRONMENT Community Banks are Worried About Businesses OPPORTUNTIES FOR COMMUNITY BANKS IN THE MERGER ENVIRONMENT Community Banks are Worried About Businesses are Worried About n n Fewer Local Banks (16%) Fewer Customized Services (18%) Less Responsive to Community (26%) Decline in Customer Service (28%) n n n Chapter 2 Credit Unions (78%) Brokerage/Securities Firms (63%) Other Community Banks (60%) Mutual-Fund Companies (52%) Regional / Money-Center Banks (41%) Farm-Credit Banks (40%) 29

Regulatory Concerns n n n Safety Stability Structure (competition) Chapter 2 30 Regulatory Concerns n n n Safety Stability Structure (competition) Chapter 2 30

Chapter Summary n n n TRICK + Rational self-interest => Financial Innovation T = Chapter Summary n n n TRICK + Rational self-interest => Financial Innovation T = Transparency R = Risk exposure (=> risk management) I = Information technology C = Competition for customers K = Kapital adequacy Chapter 2 31