Question 14.P.1: Suppose the management of the First National Bank of New Yor...

a. Based on what you read in this chapter, list as many potential advantages as you can that might come to First National as a result of adding these services to its menu?

First National may be able to supplement traditional sources of income with the new fee income that they generate. In addition, they may be able to reduce the risk of the overall institution by adding services that are not very correlated with their traditional services. They may find that some of these services are less interest rate sensitive than traditional services. They may be able to generate economies of scale and scope from offering these services. The production cost per unit tends to drop as the firm gets larger. It may also be cheaper to jointly produce two or more services than having to produce each service separately.

b. What potential disadvantages might the bank encounter from selling these fee-generating services?

There are many potential disadvantages. Investment banking activities tend to be much more volatile than commercial banking activities and there is not much job security in this area. In selling investment products and because of their reputation, customers may hold First National to a higher standard than a securities broker. First National could also get involved in costly lawsuits filed by disappointed investors. In addition, First National needs to be sure to comply with all regulations concerning selling investments products. Customers could confuse First National’s traditional products with their investment products if First National does not disclose the differences between their traditional products and the newer services they are offering. The same things are true if they offer insurance products. First National must be clear about the difference between the insurance products they offer and the other services they offer.

c. Are there risks to the bank from developing and offering services such as these? If so, can you think of ways to lower the bank’s risk exposure from offering these new services?

First National faces the risk of a customer becoming angry because the return they receive is not as good as they expected. They also face the risk these customers may feel they have been misled about these products and sue the bank. First National must also be careful to be in full compliance with all regulations. The bank can prevent some of this by counseling each customer as to the risks involved in these products and have them sign a form stating that they understand the risks involved in these products.

d. What might happen to the size and volatility of revenues, expenses and profitability from selling fee-based services like those mentioned above?

It is possible that the revenues will rise and expenses will fall, increasing the return to the bank. In addition, it is possible that the volatility of the bank’s earnings will decrease. It depends, in part, on how correlated the new services are with the old services. If they are not correlated returns can actually rise and volatility decease from adding the new services.