Banking in Clearvalley has long been dominated by the remote branches of international banks. Suspecting that these branches are uncompetitive, sloppily managed, and unresponsive to local needs, the Federal Reserve and Congress have approved a financial experiment–branch banking has been banned from Clearvalley and, in its place, arrangements have been made to establish a number of small independent financial institutions, run by bright, clear-headed entrepreneurs with no previous banking experience. These new institutions will be allowed to operate unfettered for 3 1/2 years and, then, their performance will be evaluated. (Each week during the semester represents a quarter of a year in the life of these financial institutions. Thus 14 weekly decisions span 3 1/2 years.)

Overall Environment

Clearvalley is like most financial environments–a mixture of predictable consequences and frequent surprises. Human behavior is usually rational, though often imperfectly anticipated. If, for example, a bank raises its deposit rates, this will tempt people to make more deposits, but the bank’s deposits may actually decline, perhaps because a downturn in the economy leaves people financially strapped or because competitors have offered even higher deposit rates.

The citizens of Clearvalley are, to some degree, a captive audience susceptible to anti-competitive exploitation. Depositors find it a chore to invest elsewhere and many borrowers know that it is difficult to borrow outside the valley. Local financial institutions may profit by agreeing informally to offer low deposit rates and charge high loan rates. However, any written or otherwise formal, binding agreement of this nature is a violation of the anti-trust laws and will subject the participating banks to substantial fines.

Capitalization

Each financial institution participating in this experiment begins with $5 million in cash and will acquire the necessary facilities (offices, computers, and so on) for either (a) a $3,000,000 payment now; or (b) $500,000 now and $400,000 per quarter for 7 more quarters. Each financial institution must, at all times, maintain a net worth equal to at least 5% of its total assets (including the constant $3,000,000 value of its facilities). This rule is enforced by prohibiting deposits that would cause total assets to exceed 20 times net worth.

Permitted Activities

Institutions seek deposits and invest these funds in loans, bonds, stocks, options, and futures.

Deposits

Each financial institution is authorized to offer two kinds of deposit accounts: transaction and saving. Each quarter, it specifies the deposit rates offered on each type of account and then accepts whatever deposits the public makes, subject only to the capitalization requirement that total assets not exceed 20 times net worth. If this capitalization rule curtails deposits, savings accounts will be the first to be rejected.

The public’s desire to make deposits depends on overall economic conditions (available income and so on), the market interest rates available on alternative investments (disintermediation), and on the competing rates offered by other financial institutions. There is some inertia (due to customer loyalty, convenience, and sloth), but sufficient rate differentials will, with time, lure depositors into or out of institutions. There is enough wealth in Clearvalley to provide every bank with deposits equal to 20 times net worth if all banks offer reasonably attractive deposit rates.

Since these are the only financial institutions in the area, they can profitably conspire to keep deposit rates low. Many depositors, particularly those with transaction accounts, believe that the convenience of local banking outweighs the higher rates that may be available elsewhere. Any local institution that breaks such a conspiracy by offering higher rates will gain deposits at the expense of the more loyal conspirators. The amount of deposits gained depends on the size of the rate differential–few customers will switch banks for an extra basis point.

Transaction accounts are generally more volatile than savings accounts due to the vagaries of people’s bill-paying habits. Transaction accounts are also subject to a 15% reserve requirement that must be satisfied by vault cash. Savings accounts have no reserve requirements. In addition, each additional $1,000 of transaction deposits raises an institution’s annual expenses (bookkeeping, tellers, and so on) by $20, while an additional $1000 of savings deposits increases annual expenses by $2.

Loans

During the initial quarter, all deposit funds will be automatically invested in 3-month Treasury bills. Thereafter, these financial institutions can offer 1-quarter and 20-quarter loans to three risk-classes of borrowers and can also offer 120-quarter real-estate loans:

For the 1-quarter loans with mild risk, the chances of default are, historically in Clearvalley, about 0.2%. With 20-quarter loans, the chances of a default at some point, usually later rather than sooner, are about 1.5%. Prime loans are somewhat safer and risky loans not so safe. For 30-year real-estate loans, the chances of eventual default are a bit less than 2%. In each case, the frequency of default depends on the state of the economy. Loan defaults, if any, occur at the beginning of the period and are a tax-deductible expense.

The 20-quarter and 120-quarter loans are amortized, fixed-rate loans with constant quarterly payments. Every quarter after the first, each financial institution must specify the

Loan demand is affected by the loan rates, prepayment penalties, and points charged by financial institutions. These loans are commitments to lend up to the maximum amount at the quoted interest rate. Each financial institution must be careful not to make commitments that exceed its available funds, forcing an unwanted liquidation of some assets and/or borrowing at penalty rates from the Federal Reserve, as explained below.

Most prime customers are established firms that can borrow nationwide, either from large banks or by issuing bonds. Many borrowers outside the prime class are local businesses and individuals with little access to outside borrowing. Local banks can conspire to charge high interest rates to these non-prime customers. Some will cease borrowing, but most will acquiesce to high loan rates. Of course, any bank that charges substantially lower loan rates will be rewarded with a flock of customers, while the conspirators find that they are unable to loan as much money as hoped.

Loan demand depends not only on rates between banks but also on the relative rates on 1-quarter and 20-quarter loans within a bank. A bank that charges unreasonably high rates on short-term loans and low rates on long-term loans will find few short-term borrowers. Borrowers cannot, however, switch between risk classes. A risky borrower cannot borrow at the prime rate and, thus, financial institutions can charge substantially different loan rates to different risk classes.

The most important influences on the demand for real estate loans are the state of the economy, loan rates, and (for those able to raise funds elsewhere) market interest rates. If all local banks charge high mortgage rates, most borrowers have only one alternative, to borrow nothing at all.

Each quarter may bring not only new loans but also the prepayment of old loans. Banks receive the funds from loan prepayments at the beginning of the period; prepayment penalties are taxable income. The prepayment of 20-quarter loans depends primarily on the size of the prepayment penalty and prevailing interest rates relative to the original loan rate. Mortgage prepayments depend more on such demographic happenstance as geographic moves, death, and marital status.

Securities

These financial institutions are authorized to purchase bonds after the first period, stocks after the second period, and a variety of option and futures contracts after three periods. They are price takers participating in a nationwide, competitive securities market. They can buy and sell as much as they want at national prices, but cannot set prices and yields.

Every period, each institution will be given tables showing the latest prices on the available securities. All of the bonds are initially rated BBB or higher. Revisions in bond ratings are unpredictable, though analysts currently estimate that, for AA bonds, there is about a 1.5% chance that the rating will be raised during the quarter and a 1.5% chance that the rating will be lowered; the chances that a 20-year AA bond will eventually slide into default are about 2%. These various probabilities are somewhat lower for higher-rated bonds and higher for those with lower ratings. Actual experience will depend on the economy and on unexpected events within each company.

Transaction costs (for buying or selling securities, but not for holding securities when they mature) are as follows:

These transaction costs include the spread between bid and ask prices, as well as explicit expenses, but, for simplicity, are considered completely tax deductible during the period of the transaction.

Bookkeeping

Each institution will be given quarterly reports of income and expenses, assets and liabilities. They may find their own internal forecasts useful in projecting cash flow, designing investment strategies, and satisfying the following balance-sheet constraints:

Federal Reserve Borrowing

Banks with the liquidity problems can borrow from the Fed on the following terms:

The consecutive-quarter rule applies if a bank borrows any amount in consecutive quarters; for example, a bank that borrows $100,000 one quarter and $1.5 million the next will pay the T-bill rate the first quarter and the T-bill rate + 2% the second quarter.

Institutions with capitalization problems usually have to borrow heavily from the Federal Reserve to replace funds withdrawn by depositors. Such institutions will be put on the Fed’s "problem list" and prohibited from making any option or futures transactions, other than the liquidation of existing positions.

Taxes

Taxes are computed and paid quarterly. Losses, if any, can be carried forward or backward. The financial institution’s portfolio is subject to a 34% tax on all net profits: interest income and capital gains (whether realized or not), less interest, transaction, and other expenses. The initial $3,000,000 facilities acquisition will be depreciated (straight-line) over 31 1/2 years. If a team chooses to pay for their facilities over 8 quarters, the implicit interest is tax deductible. Points are treated as taxable income in the quarter the loan is made. Teams need not compute their own taxes, but may find it useful for comparing alternative strategies and forecasting cash flow.

Confidential Memoranda

In addition to its quarterly decisions, each financial institution must prepare a typed confidential memorandum briefly explaining the rationale for these decisions. This memo should be viewed as a rational, persuasive justification to an impartial board of directors. It can remind of past successes, explain disappointments, and anticipate future performance. It will be judged by its persuasiveness. Misspelled words, incoherent logic, circular reasoning, and repetitive babbling are not persuasive. Although decisions are made by the entire team, individual team members will take turns writing the weekly memos (which must identify the author).

Management Teams

The managers of each institution will most likely divide up responsibilities: perhaps one person in charge of deposits and bonds, another loans, and a third stocks. Each institution’s organization should reflect the work that needs to be done and the diverse talents of the management team. Teams need to be in frequent contact, at least once weekly, and preferably more often, to coordinate efforts, maintain kindred spirits, and discourage procrastination.

Performance Measurement

At the end of the semester, each institution will be judged by comparing its net worth to the net worth of the other institutions and relative to a passive strategy of rolling over 3-month Treasury bills throughout the semester. Net worth will be measured in two ways, by book value as shown in the weekly balance sheets and by the market value of the bank, as estimated by an independent outside auditor.