Solution manual bank management and financial services 9th edition by rose, peter chap003

Chapter 03 - The Organization and Structure of Banking and the Financial-Services Industry

CHAPTER 3
THE ORGANIZATION AND STRUCTURE OF BANKING AND THE
FINANCIAL-SERVICES INDUSTRY
Goal of This Chapter: The goal of this chapter is to explore the different types of organizations
used in the banking and financial services industry, to see how changing public mobility and
changing demand for financial services, the rise of potent competition, and changing government
roles have changed the structure, size, and the types of organizations in this industry.
Key Topics in This Chapter
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The Organization and Structure of Banks and the Banking Industry
The Array of Organizational Structures in Banking: Unit, Branch, Holding
Company, and Electronic Services
Interstate Banking and the Riegle-Neal Act
The Financial Holding Company (FHC)
Mergers and Acquisitions
Banking Structure and Organization in Europe and Asia
The Changing Organization and Structure of Banking’s Principal Competitors
Economies of Scale and Scope and Expense Preference Behavior
Chapter Outline

I.

II.
III.

IV.

Introduction
The Organization and Structure of the Commercial Banking Industry
A.
Advancing Size and Concentration of Assets
B.
A Possible Countertrend
Internal Organization of the Banking Firm
A.
Community Banks and Other Community-Oriented Financial Firms
B.
Larger Banks—Money Center, Wholesale and Retail
C.
Trends in Organization
The Array of Organizational Structures and Types in the Banking Industry
A.
Unit Banking Organizations
B.
Branching Organizations
1.
Branching's Expansion
2.
Reasons behind Branching’s Growth
3.
Advantages and Disadvantages of Branch Banking
C.

Electronic Branching—Web Sites and Electronic Networks: An Alternative or a
Supplement to Traditional Bank Branch Offices?
D.
Holding Company Organizations
1.
Why Holding Companies Have Grown
2.
One-Bank Holding Companies
3.
Multibank Holding Companies
4.
Advantages and Disadvantages of Holding Companies

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Chapter 03 - The Organization and Structure of Banking and the Financial-Services Industry

V.

VI.

VII.
VIII.
IX.

X.

XI.

Interstate Banking Organizations and the Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994
A.
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
B.
Research on Interstate Banking
An Alternative Type of Banking Organization Available as the 21st Century Opened:
Financial Holding Companies (FHCs)
A.
Gramm-Leach-Bliley Act of 1999
B.
Financial Holding Companies
Mergers and Acquisitions Reshaping the Structure and Organization of the FinancialServices Sector
The Changing Organization and Structure of Banking’s Principal Competitors
A.
Consolidation
B.
Convergence
Efficiency and Size: Do Bigger Financial Firms Operate at Lower Cost?
A.
Efficiency in Producing Financial Services
1.
Economies of Scale
2.
Economies of Scope
3.
X-Efficiency
Financial Firm Goals: Their Impact on Operating Cost, Efficiency, and Performance
A.
Expense-Preference Behavior

B.
Agency Theory
C.
Corporate Governance
Summary of the Chapter
Concept Checks

3-1. How would you describe the size distribution of American banks and the concentration
of industry assets inside the United States? What is happening in general to the size distribution
and concentration of banks in the United States and in other industrialized nations and why?
Although the largest banks in the United States make up only 7.52 percent of all FDIC insured
banks, they control almost 89.43 percent of all the industry’s assets. Whereas, the smallest FDIC
insured banks in the U.S. account for 36.94 percent of the total banks, but they control only 1.19
percent of the industry’s assets. This development is a result of the strong trend towards
consolidation and convergence in the industry not only in the United States, but also globally and
can be explained by the increasing competitive pressures in the industry and the economies of
scale that prevail in banking.
3-2. Describe the typical organization of a smaller community bank and a larger money-center
bank. What does each major division or administrative unit within the organization do?
Small community banks, also known as retail banks, generally have four basic departments or
divisions centered on lending (the credit function), fund-raising and marketing, accounting and
operations, and perhaps, trust services. Daily operations are usually monitored by a cashier

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and/or auditor and by the vice presidents in charge of each department and division. Overall, the
small bank's organization chart is simple and uncomplicated.

In contrast, the larger banks, practicing wholesale and retail banking, usually have many
specialized departments and divisions. It includes separate departments for different kinds of
loans, departments to manage security holdings and borrow in the money market, a division or
department to manage international operations, a marketing division, and a planning unit along
with other divisions.
3-3.

What trends are affecting the way banks and their competitors are organized today?

In general, banks are becoming larger and more complex organizations with more departments
and services and greater specialization. Deregulation and service innovation have accelerated this
trend as intense competition at home and abroad has encouraged banks to become larger
organizations, serving broader and more diversified market areas. Even small banks are
reorganizing to meet these challenges by being more efficient in meeting their broader-based
customer needs.
3-4.

What are unit banks?

Unit banks offer their full menu of services from only one office. Although, they may operate
any number of drive-in windows, and automated teller machines that are linked to the bank’s
computer system. These organizations are still common today.
3-5. What advantages might a unit bank have over banks of other organizational types? What
disadvantages?
Unit banks have the advantage of being less costly to operate because full-service branch offices
are an expensive way to grow. As unit banks tend to be relatively small, they seem to be able to
offer personalized services better than larger institutions. One disadvantage is the heavy
dependence of most unit institutions on a single market area, which increases their risk of failure.
Some authorities believe unit institutions may not be able to afford technologically advanced
service delivery systems.

3-6.

What is a branch banking organization?

A branch banking organization sells its full menu of services through several locations, including
a head office and one or more full-service branch offices. Regardless of its number of offices, it
is one corporation with one board of directors. However, each office has its own management
team with limited authority to make decisions on customer loan applications and other facts of
daily operation. Most such organizations also offer limited services drive-in windows, ATMs,
point-of-sale terminals, the Internet, and other advanced communications systems.
3-7.

What trend in branch banking has been prominent in the United States in recent years?

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Branch banking has become increasingly important with the great majority of states now
allowing statewide branching. Today, more states permit statewide branching and only a minority
restrict branching in some way. There was an increase in the number of branches in the 60’s, 70’s
and 80’s as the population from cities to suburban areas. As the 21st century began, there were
about 5,200 branch banking organizations in the United States, operating close to 80,000 fullservice branch office facilities. Though the number of U.S. commercial banks declined over the
last half-century, the number of full-service branch offices has soared.
However, in recent years the growth in full-service branches has slowed because of the skyrocketing costs of land and building office facilities. In addition, ATM’s and electronic networks
have taken over much of the routine banking transactions. There is not as much need for full
service branches as before.
3-8. Do branch banks seem to perform differently than unit banks? In what ways? Can you
explain any differences?

Branch banking has a number of important advantages. With offices spread over different areas
branch banks may achieve more stable earnings and revenue flows. They may be able to grow
faster because the additional offices can bring in more debt capital (principally deposits) with
which they grow. However, adding new branch offices can subject the bank to high fixed costs,
due to large and rising construction costs. This means the bank must work harder simply to reach
a break-even point. Moreover, branch offices that are poorly situated or that have the misfortune
to be located in an area whose economy is deteriorating may generate higher costs than revenues
and saddle the bank with persistent net losses.
3-9.

What is a bank holding company?

A bank holding company is a corporation that holds an ownership interest in at least one bank. It
is also allowed to own nonbank businesses as long as they are related to banking.
3-10. When must a holding company register with the Federal Reserve Board?
Under the terms of Bank Holding Company Act, if the company owns at least 25 percent of the
outstanding stock of at least one bank or otherwise exerts a controlling influence over at least one
bank, it must register with the Federal Reserve Board. Such a company must seek the Fed's
approval if it wishes to increase its share of ownership in those banks in which it already has an
interest or wishes to acquire additional banks or nonbank businesses.
3-11. What nonbank businesses are bank holding companies permitted to acquire under the
law?
The Bank Holding Company Act (as amended) requires a registered bank holding company to
acquire only those nonbank businesses that are "closely related to banking" and yield "public
benefits." Among the most popular of these nonbank businesses that have been approved for
holding-company acquisition include finance companies, mortgage banking firms, leasing

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companies, insurance agencies, data processing firms, and several other businesses as well.
Increasingly as the 1990s began, bank holding companies sought approval to acquire failing
savings and loan associations which the Federal Reserve Board granted after a case-by-case
review. These S&L acquisitions were sanctioned by the U.S. Congress when the Financial
Institutions Reform, Recovery, and Enforcement Act was passed in 1989 and, with passage of the
Federal Deposit Insurance Corporation Improvement Act in 1991, bank holding companies were
granted permission to acquire even healthy savings and loan associations with Federal Reserve
Board approval. Today, the Gramm-Leach-Bliley Act allows financial services companies to be
affiliated with each other. This includes investment-banking activities which allow banks to
underwrite securities.
3-12. Are there any significant advantages or disadvantages for holding companies or the
public if these companies acquire banks or nonbank business ventures?
The ability of holding companies to acquire nonbank businesses has given them the capacity to
cross state lines even where state law prohibited entry by out-of-state banking firms. It also
allows a holding company to diversify across many different product lines to help stabilize the
company's net earnings. However, launching nonbank businesses can stretch holding-company
management too far and make it ineffective, resulting in damage to the performance of banks
belonging to the same holding company. The public may gain if holding companies are less
subject to failure than other types of financial service firms and are more efficient to operate.
However, the public may lose if the concentration of services in bank holding companies causes
the prices of those services to rise or if resources are drained away from local communities
causing slower growth of those communities.
3-13. What did the Riegle-Neal Interstate Banking Act do? Why was it passed into law?
In 1994 the U.S. Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency
Act which allows bank holding companies to acquire banks throughout the United States without
needing any state’s permission to do so and to establish branch offices across state lines in every
state (except in Montana). The interstate banking law reflects the need and belief for banking
firms to diversify into different geographic markets, demands of the public for financial service

providers that can follow businesses and individuals as they move across the landscape, bring in
new capital to revive struggling local economies, and advances the technology of financialservices delivery.
3-14. Can you see any advantages to allowing interstate banking? What about potential
disadvantages?
As far as problems are concerned, interstate banking threatens to increase the concentration of
banking resources in the U.S., especially among larger banks in various regions of the nation.
Increased concentration possibly could lead to higher prices and less service if the antitrust laws
are not fully enforced.
On the other hand, recent studies suggest that interstate mergers generate positive abnormal
returns on bank stock. In addition, these banks are not tied to one local economic area and appear

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to be less subject to failure. Interstate expansion may also bring greater stability by allowing
individual banking organizations to further diversify their operations across different markets,
offsetting losses that may arise in one market with gains in other markets.
3-15. How is the structure of the nonbank financial-services industry changing? How do the
organizational and structural changes occurring today among nonbank financial-service firms
parallel those experienced by the banking industry?
Almost all of banking’s top competitors are experiencing the same changes as banks. For
example, consolidation and convergence are occurring at a rapid pace. Generally, nonbank firms
have experienced the same dynamic structural and organizational revolution as banks and for
many of the same reasons. Intensifying competition, a widening gulf between the smallest and
largest firms, and greater exposure to the risks associated with more cumbersome organizations
striving to compete in a globally integrated financial marketplace, are some of the major
outcomes occurring in the industry.
3-16. What relationship appears to exist between bank size, efficiency, and operating costs per

unit of service produced and delivered? How about among nonbank financial-service providers?
For banks and nonbank financial service providers alike, economies of scale and economies of
scope if achieved can lead to significant savings in operating costs with increases in service
output. Economies of scale mean that costs per unit decrease as more units of the same service
are produced because of greater efficiencies in using the firm’s resources to produce multiple
units of the same service or service package. Economies of scope imply that as more different
services are provided, the operating cost reduces. This is because some resources are more
efficiently used in jointly producing multiple services than turning out one service.
3-17. Why is it so difficult to measure output and economies of scale and scope in the
financial-services industry? How could this measurement problem affect any conclusions
reached about firm size, efficiency, and expense behavior?
This is not an easy question to answer. A financial-service firm, regardless of its size, operating
as efficiently as it possibly can, raises an issue known as x-efficiency. Given the size of a
financial firm, is it operating near to or far away from its lowest possible operating cost?
Research evidence to date is not encouraging, suggesting that most banks, for example, do not
operate at their minimum possible cost. Rather, their degree of x-efficiency tends to be at least 20
to 25 percent greater in aggregate production costs than it should be under conditions of
maximum efficiency.
The financial service business is changing rapidly in form and content and thus one must remain
cautious about cost studies of financial firms. The statistical methodologies available today to
carry out cost studies have serious limitations and tend to focus upon a single point in time rather
than attempting to capture the dynamics of this ever changing industry.

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Chapter 03 - The Organization and Structure of Banking and the Financial-Services Industry

3-18. What is expense-preference behavior? How could it affect the performance of a financial
firm?

Expense-preference behavior describes an approach where managers use the financial resources
of the firm to provide them with personal benefits not needed to produce and sell the products.
This behavior leads to increasing costs of production and declining returns to the firm’s owners.
Such expense-preference behavior may show up in the form of staffs larger than required to
maximize profits or excessively rapid growth, which causes expenses to get out of control.
3-19. Of what benefit is agency theory in helping us understand the consequences of changing
control of a financial-services firm? How can control by management as opposed to control by
stockholders affect the behavior and performance of a financial-services provider?
Agency theory analyzes the relationship between a firm’s owner (shareholder) and its managers
(agents). It explores whether there is a mechanism to compel managers to act in the best interest
and maximize the welfare of the firm’s owners. Owners do not have access to all the information
and cannot fully evaluate the performance of a manager.
One way to reduce costs from agency problems is, to develop better systems for monitoring the
behavior of managers and to put in place stronger incentives for managers to follow the wishes
of owners. Another way to accomplish this is by tying management salaries more closely to the
firm’s performance or giving management access to valuable benefits (such as stock options).
However, recent events suggest these steps may also encourage managers to take on greater risk.
3-20. What is corporate governance, and how might it be improved for the benefit of the
owners and customers of financial firms?
Corporate governance describes the relationships that exist among managers, the board of
directors, the stockholders, and other stakeholders of a corporation. Corporate governance can be
improved through larger boards of directors and a high proportion of outside directors. This will
expose managers to greater monitoring and discipline.
Problems and Projects
3-1. As a financial journalist, you are writing an article explaining how the U.S. market shares
of small, medium, and large banks have changed over the last 25 years. Utilize Exhibit 3–2 to
approximate the market shares for the years 1985, 1990, 1995, 2000, 2005, and 2010 for small,
medium, and large banks. Identify and discuss the three factors that appear to contribute most to
the trends you described.
It can be observed that, smaller banks continue to disappear and the biggest banks are gobbling

up greater industry shares each year. But there are signs that this pattern of change might slow
down in future years. 100 large U.S. banking organizations hold more than three-quarters of
industry wide assets and also their market share has risen recently. The top 100 U.S. banks held

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Chapter 03 - The Organization and Structure of Banking and the Financial-Services Industry

only about half of all U.S. domestic banking assets in 1980, but by 2010 their proportion of the
nation’s domestic banking assets had climbed to more than 90 percent.
Large banks have moved toward the profit-center approach, in which each major department
strives to maximize its contribution to profitability. Also large banks serve many different
markets with many different services, they are better diversified—both geographically and by
product line—to withstand the risks of a fluctuating economy.
The most dramatic changes in the banking industry of the past two decades has been the spread
of interstate banking as state and federal laws that paved the way for banking companies to
purchase or start branch offices in different states, making nationwide banking possible for the
first time in U.S. history. This trend reflects the need for banking firms to diversify into different
geographic markets and the demands of the public for financial firms that can follow businesses
and individuals as they move across the landscape.
Another major change in law and regulation was the passage of the Gramm-Leach-Bliley
(Financial Services Modernization) Act in 1999. This law has led to the formation of financial
holding companies (FHCs) entering into product lines (such as security and insurance
underwriting services) previously prohibited or restricted under federal law, paving the way for
onestop financial-service providers.
These are the few sweeping factors contributing to fundamental changes in the banking sector in
the past two decades.
3-2. Of the business activities listed here, which activities can be conducted through U.S.regulated holding companies today?
a. Data processing companies

b. Office furniture sales
c. Auto and truck leasing companies
d. General life insurance and property-casualty insurance sales
e. Savings and loan associations
f. Mortgage companies
g. General insurance underwriting activities
h. Professional advertising services
i. Underwriting of new common stock issues by nonfinancial corporations
j. Real estate development companies
k. Merchant banks
l. Hedge funds
Banks can perform most of the activities listed above. It may be easier to talk about the activities
they cannot do. They cannot sell office furniture and they cannot perform professional
advertising services. They can do just about everything else listed here.
3-3
You are currently serving as president and chief executive officer of a unit bank that has
been operating out of its present location for five years. Due to the rapid growth of households

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Chapter 03 - The Organization and Structure of Banking and the Financial-Services Industry

and businesses in the market area served by the bank and the challenges posed to your share of
this market by several aggressive competitors, you want to become a branch bank by establishing
satellite offices. Please answer the following questions:
a.

What laws and regulations have a bearing on where you might be able to locate the new
facilities and what services you may offer?

b.

Based on the content of this chapter, what advantages would your branch be likely to
have over the old unit bank? What disadvantages are likely to come with adding branch
offices? Any ideas on how you might minimize these disadvantages?

c.

Would it be a good idea to form a holding company? Based on the material in this
chapter, what advantages could a holding company bring to your bank? Disadvantages?

a.
In general, the bank would have to seek approval from their chief regulating agency for
any major actions that the bank takes. National banks have get approval from the Comptroller of
the Currency. State member banks have to get approval from the Federal Reserve, and state
banks with insurance who are not members of the Federal Reserve would have to seek approval
from the FDIC. All other banks would have to have approval of the state banking commission.
However, depending on the services offered, the Gramm-Leach-Bliley Act may apply. The
Gramm-Leach-Bliley Act allows banks to offer many different services either as subsidiaries of
the parent bank or under the financial holding company structure. In this case, the Federal
Reserve must approve of the services and the structure of the bank.
b.
Branch banking has a number of important advantages. With offices spread over different
areas, branch banks may achieve more stable earnings and revenue flows. They may be able to
grow faster because the additional offices can bring in more debt capital (principally deposits)
with which to grow. However, research evidence accumulated in recent years suggests that
adding new branch offices can subject the bank to high fixed costs, due to large and rising
construction costs, which means the bank must work harder simply to reach a break-even point.
Moreover, branch offices that are poorly situated or that have the misfortune to be located in an

area whose economy is deteriorating may generate higher costs than revenues and saddle the
bank with persistent net losses.
c.
Formation of a holding company has a number of potential advantages. It may help lower
the taxes earned by the whole banking organization and open up the possibility of acquiring
nonbank businesses that help to diversify the bank's operations and reduce the risk to its earnings
and long-run viability. The problem with starting a holding company , same as opening new
branches, are the costs involved (including legal fees, the cost of registering with the Federal
Reserve Board, and underwriting costs as new stock is issued).
3-4. Suppose you are managing a medium-size branch banking organization (holding about
$25 billion in assets) with all of its branch offices located within the same state. The board of
directors has asked you to look into the possibility of the bank offering limited security trading
and investment banking services as well as insurance sales. What laws open up the possibility of
offering the foregoing services and under what circumstances may they be offered? What do you

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Chapter 03 - The Organization and Structure of Banking and the Financial-Services Industry

see as the principal benefits from and the principal stumbling blocks to successful pursuit of such
a project?
The Gramm-Leach-Bliley Act of 1999 allows banks to offer selected nonbank financial services.
The bank could offer these services either as a financial holding company or through bank
subsidiaries. The financial holding company form seems to have the advantage because of limits
on how large subsidiaries can be and because each affiliated firm would have its own capital and
its own profits and losses that are separate from the profits and losses of any other part of the
firm. However, fewer than 500 firms have achieved financial holding company status suggesting
that this may be an expensive proposition that would be difficult for medium sized banking firms
to undertake.

3-5. First Security Trust National Bank of Boston is considering making aggressive entry into
the People’s Republic of China, possibly filing the necessary documents with the government in
Beijing to establish future physical and electronic service facilities. What advantages might such
a move bring to the management and shareholders of First Security? What potential drawbacks
should be considered by the management and board of directors of this bank?
China is a huge market and entering into the Chinese market now may give this bank an
advantage over other banks. They will already have the necessary contacts and understanding of
the Chinese system when it becomes a more open economy in the future. However, there is
considerable risk. It could be years before the economy becomes more open so profit
opportunities might be slow to develop. In addition, the government could change its mind about
allowing foreign banks ownership in China and seize any assets held by foreign banks. Finally,
the system is dominated by large government owned banks and it may be difficult to compete
with these banks. The Chinese government could give preferential treatment to these government
banks at the expense of the private sector.

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