Chapter 2 1

CHAPTER 2

DRIVERS OF CHANGE, INNOVATION, AND

CONSOLIDATION IN THE FINANCIAL-SERVICES

INDUSTRY

Chapter 2 2

Learning Objectives To understand …

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 3

Chapter Theme 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 4

COMPONENTS OF A DYNAMIC MODEL OF

CHANGE: TRICK

Transparency

Risk exposure

Information technology

Competition for customers

Kapital adequacy

Model: TRICK + Rational Self-Interest => Financial Innovation

Chapter 2 5

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 6

Risk-Management Techniques Asset-Liability Management (ALM)

Credit Analysis

Derivatives: Futures, Forwards, Options,

and Swaps

Securitization

RISK EXPOSURE (leads

to)

Chapter 2 7

Exposure to What? The risks of banking

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 8

“The information standard has replaced the gold standard as the basis for world finance”

- Walter Wriston

INFORMATION TECHNOLOGY

Chapter 2 9

Basic Ingredients to Attract Customers

Price

Convenience

Confidence (federal safety net/guarantee)

COMPETITON FOR CUSTOMERS

Chapter 2 10

Market Discipline Costs of financial distress and cost of funds

Regulatory Discipline Risk-based capital requirements

Graham-Leach-Bliley Act of 1999

Community Reinvestment Act

(modernization tied to fairness)

KAPITAL ADEQUACY

Chapter 2 11

INNOVATION AS A DIFFUSION PROCESS

Innovation -- the introduction of something new

Ex: 1961 introduction of the first negotiable certificate of deposit

Preliminary Distinctions1 .Invention vs. innovation2 .Autonomous innovation vs. induced innovation3 .Market-induced innovation vs. regulation-

induced innovation

Chapter 2 12

NEW TECHNOLOGY AND PRODUCT DIFFUSION

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 13

DIFFUSION OF E-BANKING

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 14

INNOVATION AND THE DESIGN OF FINANCIAL

CONTRACTS

Two Basic Contracts of Banking1.Deposit Account

Checking Accounts Savings Accounts Certificate of Deposits Individual Retirement Accounts

2.Loan Agreement Fixed or Adjustable Rate Mortgages C&I Term Loans Automobile Loans Credit-Card Loans

Chapter 2 15

CREDIT EXTENTION BUILDING BLOCKS

The Blocks

Zero Coupon

Fixed Rate

Variable Rate

Amortized

Can Be Viewed In Terms

Of:

Present Value

Future Value

Payment

Interest Rate

Number of Periods

Chapter 2 16

Background: TVM Formulas Panel B of Table 2-2 presents the

time-value-of-money (TVM) formulas on a pair-wise basis 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 17

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

Educating issuers, investors, and traders

Chapter 2 18

BACKGROUND TO BANK CONSOLIDATION

Within an industry within a country

Across industries within a country

Across countries but in the same

industry

Across countries and industries

Chapter 2 19

MOTIVES FOR CONSOLIDATION

Cost Economies Economies of Scale Economies of Scope

Market Power Managerial Agency Costs Exploitation of the Federal Safety

Net

Chapter 2 20

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

Chapter 2 21

M&A in Banking and the FSI Citigroup merger (1998) predated GLB Act

(1999) and helped force passage of the act JPM and Chase (2000) Bank of America and NationsBank (1998) Wells Fargo and Norwest (1998) Hostile takeovers (SunTrust failed in its bid

for Wachovia – First Union won the battle but lost its name)

Chapter 2 22

View Consolidation in Terms of the ROE Model 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 23

BANK ORGANIZATIONAL FORMS IN THE US

Independent Banks

One-Bank Holding Companies

Multi-Bank Holding Companies

Together, BHCs and independent banks are referred to as BANKING COMPANIES

Chapter 2 24

PHENOMENA DRIVING DECLINE IN # OF BANKING

COMPANIES

Mergers among BHCs BHCs acquiring viable independent banks The failure of independent banks during

the 1980s and 1990s

“The whole banking structure is turning into an oligopoly in which four or five institutions dominate any particular geographic-based market”

-- Furash

Chapter 2 25

A Long View 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 26

CONSOLIDATION

Mergers Takeovers and Hostile Takeovers Anti-Takeover Strategies

Shark Repellants Poison Pills Greenmail Golden Parachutes

Chapter 2 27

Competition and Access to Financial Services The Fed favors the industrial-

organizational (IO) model, which has the following linkages, given the conditions of supply and demand:

Market structure => Conduct => Performance

Chapter 2 28

MERGER AND ACQUISITION STRATEGIES

“Hit ‘em where they ain’t”Ex: KeyCorp and Interstate Banking

Buck the Merger TrendEx: SunTrust but then a failed hostile-

takeover attempt

Chapter 2 29

OPPORTUNTIES FOR COMMUNITY BANKS IN THE

MERGER ENVIRONMENT

Businesses are Worried About

Fewer Local Banks

(16%) Fewer Customized

Services (18%) Less Responsive to

Community (26%) Decline in Customer

Service (28%)

Community Banks are Worried About

Credit Unions (78%) Brokerage/Securities

Firms (63%) Other Community Banks

(60%) Mutual-Fund Companies

(52%) Regional / Money-Center

Banks (41%) Farm-Credit Banks (40%)

Chapter 2 30

Regulatory Concerns Safety Stability Structure (competition)

Chapter 2 31

Chapter Summary TRICK + Rational self-interest =>

Financial Innovation T = Transparency R = Risk exposure (=> risk

management) I = Information technology C = Competition for customers K = Kapital adequacy