Depository Institutions: Activities and Characteristics

Depository institutions include commercial banks (or simply banks), savings and loan associations (S8Ls),
savings banks, and credit unions. All are financial intermediaries that accept deposits. These deposits
represent the liabilities (debt) of the deposit-accepting institution. With the funds raised through
deposits and other funding sources, depository institutions both make direct loans to various entities
and invest in securities.

Their income is derived from two sources: (1) the income generated from the loans they make and the
securities they purchase, and (2) fee income.

It is common to refer to S&Ls, savings banks, and credit unions as thrifts, which are specialized types of
depository institutions. At one time, thrifts were not permitted to accept deposits transferable by check
(negotiable), or, as they are more popularly known, checking accounts. Instead, they obtained funds
primarily by tapping the savings of households. Since the early 1980s, however, thrifts have been
allowed to offer negotiable deposits entirely equivalent to checking accounts, although they bear a
different name (NOW accounts, share drafts). By law, the investments that thrifts are permitted to make
have been much more limited than those permitted to banks. Recent legislation, however, has expanded
the range of investments allowed by thrifts so that they can compete more effectively with banks.

 NOW accounts, A negotiable order of withdrawal, is a type of deposit account that provides
interest and allows the depositor to write drafts against the money that is held on deposit.

Depository institutions are highly regulated because of the important role that they play in the country's
financial system. Demand deposit accounts are the principal means that individuals and business entities
use for making payments, and government monetary policy is implemented through the banking system.
Because of their important role, depository institutions are afforded special privileges such as access lo
federal deposit insurance and access to a government entity that provides funds for liquidity or
emergency needs.

ASSET/LIABILITY PROBLEM OF DEPOSITORY INSTITUTIONS

The asset/liability problem that depository institutions face is quite simple to explain-although not
necessarily easy to solve. A depository institution seeks to earn a positive spread between the assets it
invests in (loans and securities) and the cost of its funds (deposits and other sources). The spread is
referred to as spread income or margin. The spread income should allow the institution to meet
operating expenses and earn a fair profit on its capital.

In generating spread income, a depository institution faces several risks. These include credit risk,
regulatory risk, and interest rate risk. Credit risk, also called default risk, refers to the risk that a
borrower will default on a loan obligation to the depository institution or that the issuer of a security
that the depository institution holds will default on its obligation. Regulatory risk is the risk that
regulators will change the rules so as to adversely impact the earnings of the institution.
Interest Rate Risk
All depository institutions face interest rate risk. Managers of a depository Institution who have
particular expectations about the future direction of interest rates will seek to benefit from these
expectations. Those who expect interest rates to rise may pursue a policy to borrow funds for a long-
time horizon (that is, to borrow long) and lend funds for a short time horizon (to lend short). If interest
rates are expected to drop, managers may elect to borrow short and lend long.

The problem of pursuing a strategy of positioning a depository institution based on expectations is that
considerable adverse financial consequences will result if those expectations are not realized. The
evidence on interest rate forecasting suggests that it is a risky business. We doubt if there are managers
of depository institutions who have the ability to forecast interest rate moves so consistently that the
institution can benefit should the forecast be realized. The goal of management is to lock in a spread as
best as possible, not to wager on interest rate movements.

Inherent in any balance sheet of a depository institution is interest rate risk exposure.

Managers must be willing to accept some exposure, but they can take various measures to address the
interest rate sensitivity of the institution's liabilities and its assets. Regulators impose restrictions on the
degree of interest rate risk a depository institution may be exposed to. A depository institution will have
an asset/liability committee that is responsible for monitoring the interest rate risk exposure. There are
several strategies for controlling interest rate risk.

Liquidity Concerns
Besides facing credit risk and interest rate risk, a depository institution must be prepared to satisfy
withdrawals of funds by depositors and to provide loans to customers. There are several ways that a
depository institution can accommodate withdrawal and loan demand:

(1) attract additional deposits, (2) use existing securities as collateral for borrowing from a federal agency
or other financial institution such as an investment bank, (3) raise short-term funds in the money market,
or (4) sell securities that it owns.

The first alternative is self-explanatory. The second has to do with the privilege that banks are allowed to
borrow at the discount window of the Federal Reserve Banks. The third alternative primarily includes
using marketable securities owned as collateral to raise funds in the repurchase agreement market.

The fourth alternative, selling securities that it owns, requires that the depository institution invest a
portion of its funds in securities that are both liquid and have little price risk. By price risk, we refer to
the prospect that the selling price of the security will be less than its purchase price, resulting in a loss.

 Price risk is the risk of a decline in the value of a security or an investment portfolio excluding a
downturn in the market, due to multiple factors. Price risk hinges on a number of factors,
including earnings volatility, poor management, industry risk, and price changes. A poor business
 model that isn't sustainable, a misrepresentation of financial statements, inherent risks in the
cycle of an industry, or reputation risk due to low confidence in business management are all
areas that will affect the value of a security.

In general, short-term securities entail little price risk. It is therefore short-term, or money market, debt
obligations that a depository institution will hold as an investment to satisfy withdrawals and customer
loan demand. It does this by lending federal funds. The term to maturity of the securities it holds affects
the amount that depository institutions can borrow from some federal agencies because only short-term
securities are acceptable collateral.

Securities held for the purpose of satisfying net withdrawals and customer loan demands are sometimes
referred to as secondary reserves.

 Secondary reserves are reserves held by depository institutions in excess of those mandated by
reserve requirements. These reserves are often held in the form of assets that can be quickly
and easily converted to cash and are used to meet unanticipated obligations.
 Reserves are designed to be a safety buffer for banks, who might not anticipate the need for
extra capital in their daily operations. The idea of excess reserves was created alongside an
incentive called interest on excess reserves, in which the Federal Reserve paid banks interest on
funds that exceeded reserve requirements.

Financial institutions that carry excess reserves are thought to have an extra measure of safety in the
event of sudden loan loss or significant cash withdrawals by customers.

A disadvantage of holding secondary reserves is that securities with short maturities offer a lower yield
than securities with a longer maturity in most interest rate environments. The percentage of a
depository institution's assets held as secondary reserves will depend both on the institution's ability to
raise funds from the other sources and on its management's risk preference for liquidity (safety) versus
yield.

Depository institutions hold liquid assets not only for operational purposes, but also because of the
regulatory requirements.