Analyzing the Economics of Citigroup's Retail Banking Group, Citibank

Citibank is the retail banking arm of Citigroup (Citigroup). As such, it functions much like any other bank - an intermediary between borrower-spenders and lender-savers. Another way to look at the relationship between these borrower-spenders and lender-savers is to use an overlapping generations model. Once we do this, we can explore how the individual bank fits into this equation, and apply it to the real-world.

The overlapping generation model, in its simplest form, has one good, a consumption good. This good is endowment, and is roughly analogous to the sum total of goods consumed by a person in their working years. Each person lives for two periods, receives endowment in the first period, and nothing in the second period. Endowment, however, is non-durable, so the old will have no consumption, as there is no incentive for the young to trade endowment, as the old have nothing to trade.

This model is not yet complicated enough for a bank to exist yet, though. The next step involves money. Money is something that represents value. There are two types of issued currency - commodity currency, and fiat currency. Commodity currency has material value by itself. Fiat currency, however, has no intrinsic value. Once money is introduced into the overlapping generation money, young and old are both able to consume, as the old can trade money for endowment, and the young can trade endowment for money, thus allowing them to trade it back for endowment when old, and consume when old. We still do not need banks, though, as the economy trades freely, and everybody earns the same rate on money.

In order for this economy to demand a financial intermediary, there must be some other good. This good is capital. Like money, it can be traded for endowment to assure future consumption. In order for capital to be different from money, we will need to assume a three period lifespan. While money earns the same rate, and can be converted to endowment in the next period, capital matures in two periods, and at a higher rate.

Debts are not enforceable, and nobody can see how much immature capital anybody else has. In other words, nobody can borrow against their capital for second period consumption. As a result, money is still needed to provide second period consumption.

Now, assume that some agents can issue enforceable debts. If there is only one such agent, he will issue debt in period one, by borrowing 1 unit of a good to be paid back in period two at the same rate of return that money would provide (n). This good is then converted to capital. In the second period, the arbitrageur will borrow enough money to pay back the first creditor n units of good from another young agent. In the third period, the capital matures, and the debtor pays back the second creditor n², and enjoys costless profit, as the rate of return on money is less than the rate of return on capital.

This string of loans and repayments is analogous to what a bank does. It borrows money from people, invests it in capital, and pays a higher rate than the money would. What happens, though, is that there are many agents who can issue enforceable debts. In order to meet the demand for these IOUs, the rates paid by the banks must increase. This will continue until the rate paid on deposits is equal to the rate earned on capital, resulting in zero economic profit when the market reaches perfect competition.

The money that is on deposit with the bank becomes "inside" money. It is a liquid asset that has been issued by the bank. What happens is that fiat money loses all value, as it has been replaced by inside money. This is suboptimal, as governments need to be able to spend their fiat money for goods and services. To solve this issue, governments are able to set reserve requirements. This is a percentage of deposits that are required to be kept in fiat money, reducing the rate of return on the inside money, but also maintaining the value of the fiat currency. This model is concisely represented in the Champ and Freeman book, in chapters seven, eight, and twelve.

Another task that banks take on is the diversification of risk, as well as the mitigation of risks that stem from asymmetric information. The transactions costs for a bank are lower than that for any two given agents. In order for a loan to be made privately, the borrower and the lender would need to identify each other and meet. Once this is completed, the lender would need to do due diligence to establish whether the borrower would be able, willing, and likely to repay the loan. Then, the loan documents would have to be drafted, and properly executed. A bank, on the other hand, has a ready supply of lenders, and a ready supply of borrowers. The transactions costs are reduced because of economies of scale, as are the costs of closing and servicing the loan. This is discussed in chapter seventeen of the Eakins text.

The next level of complexity that a bank like Citibank would need to address is liquidity. Not all agents can wait a number of periods to call their loan to the bank (withdraw their deposits). As a result, a bank must have several types of inside money, ranging from high liquidity to low liquidity. In other words, the bank must provide many deposit products that have a range in accessibility. The deposit products that are less liquid will have rates approaching that of the rate of capital. The deposit products that are more easily accessed will have rates approaching the rate of money. This is a result of the depositor demanding a liquidity premium, a reinvestment premium, and an interest rate premium.

On the loan side, a similar set of rules exist, taking the type of loan, as well as the risk involved. Revolving debts, such as credit cards, will have a higher rate than a loan. Debt that is secured by an asset will be charged at a lower rate than debt that is not secured. The term is another factor. Longer term debt demands a higher interest rate. Lastly, the default risk of the borrower is used to determine the appropriate rate to charge.

From a practical point of view, with an indeterminate number of periods, managing deposits and loans can be a difficult process. Determining the products to offer and setting the rates on each product is an enormous undertaking, with vast consequences for overpaying on deposits, commonly resulting in bank failure. (Belongia and Gilbert, 905)

Citibank offers many different loan products, and many different deposit products. For loan products, there is a wide range from credit cards to mortgages, with many things in between. This debt can be broken into two types - secured, and unsecured. Secured debts are backed up by collateral, an asset that can be taken and sold by the bank in the event of default. This collateral can be almost any asset, but typically would be an automobile, real estate, a deposit account, or treasury securities. Secured loans make up approximately 65% of Citibank's loan structure with about 53% of these loans being mortgages on 1-4 family residences. (FDIC)

Secured loans can take several forms, including fixed-term loans and revolving credit products. Fixed-term loans amortize over a pre-determined period. An example of this would be an automobile loan, a mortgage loan, or a home equity line of credit. More obscurely, boat loans, airplane loans, and deposit-secured loans are considered fixed-term financing. Revolving secured credit will typically be in one of two categories, home equity lines of credit and secured credit cards.

Another type of loan is an unsecured loan. Approximately 47% of Citibank's loans are unsecured, including 6% of the portfolio being in credit cards, about 15% in "other" unsecured loans, and most of the balance in commercial unsecured loans. Some of these unsecured loans are revolving, like credit cards and personal lines of credit. Others have fixed loans, like personal loans and CRA (Community Reinvestment Act) home-improvement loans (FDIC).

Deposits are just as complicated as loans. The two main types of deposit products are savings-time products and demand deposit products. A savings-time account is a limited-access account, such as a savings account or a certificate of deposit. As the liquidity on these accounts is lower, they pay a higher rate. The number of pre-authorized withdrawals that are not done in person from a savings-time account is limited to six per calendar month. (While a savings account has a variable interest rate, a certificate of deposit is an agreement between the bank and a customer that a specified amount of interest will be paid on a specific balance for a specific period. A callable CD can be called by the bank under certain, pre-agreed situations, and any CD can be broken by the customer at any time, but there is an interest penalty assessed. (Citibank 19)

A demand deposit account is a liquid account, typically allowing check writing. Three examples of demand deposit accounts are checking accounts, money market accounts, and negotiable order of withdrawal accounts. Checking accounts are completely liquid, with no limitation on transactions, although they typically do not pay interest. Money market accounts are a cross between a checking account and a savings account. While this account is subject to the same transaction limits as a savings account, the account can be accessed by check. A negotiable order of withdrawal account is strictly a checking account, but the check clearing process is different, which allows the bank to pay interest on credit balances (Real Estate Settlement Procedures Act 7087)

For Citibank, 11% of the deposits are in demand deposit/transactional accounts, 56% of the deposit dollars are in money market accounts, 2.5% are in savings accounts, and just over 30% of the deposit base is in certificate of deposits. As a result, most of the deposit base is earning interest, and about a third of it is earning a fixed rate of insurance. This rate structure has a profound impact on the lending rates. (FDIC)

Now, given how Citibank fits into the economy as an agent capable of writing debts that can be enforced, and how Citibank is an agent capable of efficiently overcoming asymmetric information. Also, Citibank is able to use its economies of scale to calculate risk and overcome asymmetric information and adverse selection problems. As such, it is able to return a higher rate on internal money than can be returned on fiat money. Furthermore, the loans that are originated by Citibank represent a slightly more complicated form of the capital represented by the overlapping generations model. As shown by this institution, the overlapping generation model, while fairly simplistic, accurately reflects reality.

Works Cited

Michael T. Belongia and R. Alton Gilbert. "The Effects of Management Decisions on Agricultural Bank Failures". American Journal of Agricultural Economics 72.4 (Nov. 1990): 901-910.

Champ, Bruce, and Freeman, Scott. Modeling Monetary Economies. New York: Cambridge University Press, 2001.

Citibank, NA website. 2007. Client Manual, Consumer Accounts. 04/24/2008
https://web.da-us.citibank.com&BVP=/cgibin/citifi/scripts/ &BV_UseBVCookie=yes>.

Citigroup, Inc. website. 2007. Our Brands. 04/24/2008 .

Federal Deposit Insurance Corporation. FDIC: Institution Directory, Citibank, National Association Las Vegas, NV. 12/2007.

Mishkin, Frederic S, and Eakins, Stanley G. Financial Markets + Institutions, fifth edition. New York: Pearson Addison Wesley, 2006.

Real Estate Settlement Procedures Act of 1974, FDIC Stat. 6500.7087-7090.