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FIN 701 (3)
Chapter 2

Chapter 2 Deposit-Taking Institutions.docx

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Ryerson University
FIN 701
Patricia Mc Graw

FIN701 Financial Institutions Management CHAPTER 2 Deposit-Taking Institutions  Banks, trusts and loans, credit unions, and caisses poplaires – also called deposit-taking institutions (DTIs)  There are nine financial service powerhouses in Canada called “full-service” FIs, including the Big Six banks (BMO, Bank of Nova Scotia, CIBC, National Bank of Canada, RBC, and TD) and the three largest insurance companies (Manulife Financial, Great-West Life Company, and Sun Life Financials) BANKS Size, Structure, and Composition of the Industry  FIs allowed to operate as banks in Canada governed by the Bank Act and regulated at federal level by the Office of the Superintendent of Financial Institutions (OSFI)  Banks divided into domestic chartered banks (Schedule I banks) and foreign banks whose activities are restricted: i. Subsidiaries of foreign banks (Schedule II banks) ii. Foreign bank full-service branches (Schedule III banks) that may only accept deposits over $150,000 iii. Foreign bank lending branches that are only allowed to provide lending services in Canada  Large Canadian banks (equity > $5 billion) must be widely held; no one person may hold more than 20% of voting shares  Banks fund themselves in national market and international interbank markets and lend to larger corporations o Bank spreads – difference between lending and deposit rates – subject to both North American market and global market conditions o Lending based on LIBOR, the interest rate charged to customers represents a market-based cost of funds Balance Sheet and Recent Trends Assets  Four principle earning assets areas of banking: Canadian securities, business loans, mortgages, and personal loans  Two influences of change in the decline of assets: 1. Disintermediation whereby companies who have their own credit ratings are able to bypass a financial intermediary and go directly to the market to raise funds 2. Securitization of mortgages – removal of assets from BS by creating a contract that is sold in the financial market place (pooling of mortgage loans for sale in the form of bonds)  Large portion of bank asset structure are loans and mortgages, which increases credit or default risk exposure o Banks are highly leveraged and hold little equity compared to total assets, even a relatively small number of loan defaults could decrease equity of a bank, moving it towards insolvency Liabilities  Banks are highly leveraged and have two major sources of funds other than equity: deposits and borrowed or other liability funds o Demand deposits – deposits held at an FI that can be withdrawn by the depositor without notice o Notice deposits – deposits held at FI that require notification to FI before withdrawal; if notice period not met, depositor could be denied access to the funds o Fixed-term deposits – deposits held at FI that cannot be withdrawn by depositor prior to maturity date; often deposits may be withdrawn prior to maturity with a penalty being paid by depositor  Accounts are insured by Canadian Deposit Insurance Corporation (CDIC), deposit insurance company for DTIs  Liability structure reflects shorter maturity structure than assets portfolio, with more liquid instruments such as deposits and inter-banking borrowings – short-term loans received from other FIs, usually overnight – used to fund less liquid assets o Maturity mismatch, interest rate risk and liquidity risk key exposures Equity  OSFI requires banks to hold minimum level of equity capital to act as buffer against losses from their on- and off-BS activities Off-Balance-Sheet Activities  Off-balance-sheet (OBS) include issuing various types of guarantees (such as letters of credit), which often have a strong insurance underwriting element, and making future commitments to lend, which generate additional fee income  OBS also engages in derivative transactions – futures, forwards, options, and swaps  Item is OBS asset or OBS liability when contingent event occurs, item moves onto asset or liability side of balance sheet or an income or expense item is realized on the income statement FIN701 Financial Institutions Management  OBS helps banks earn additional fee income to complement margins or spread on traditional leading business and avoid regulatory costs or “taxes” since deposit insurance premiums are not levied on OBS activities  OBS activities have risk-reducing and risk-increasing attributes, and can reduce or hedge FI’s interest rate, credit, and foreign exchange risks o Potential gain or loss is based on possible change in market value (difference between PV of cash flow expected to be received minus PV of cash flow expected to be paid) over the life of the contract o Exposure limited since contracts have maturity of less than one year and are over the counter rather than exchange-traded Other Activities Trust Services  Federally regulated governed by OSFI under the Trust and Loans Companies Act  Trusts offer similar services to banks (EX. Deposit-taking, loans), as well as fiduciary activities such as administering estates, trusts, and pension plans  Banks prohibited from providing fiduciary services directly, so they offer these services through their subsidiaries  Advantage of offering deposit
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