Economics 370 Money and Banking

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Economics 370Money and Banking

• Instructor
• Ryan Herzog

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Chapter 10 Banking Industry Structure and
Competition

• Historical Development of the Banking System
• Financial Innovation and the Evolution of the
  Banking Industry
• Structure of the U.S. Commercial Banking Industry
• Bank Consolidation and Nationwide Banking
• Separation of the Banking and Other Financial
  Industries
• Thrift Industry Regulation and Structure
• International Banking

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Historical Development - Banks

• 1782 Bank of North America charted in
  Philadelphia
• 1791 Bank of the United States was created
• Established a national bank separate from state
• Acted as a private and central bank
• 1911 charter was not renewed due to concern over
  a central bank, Alexander Hamilton
• 1816 The Second Bank of the US was created
• Helped finance the War of 1812
• Again advocates, Andrew Jackson argued against a
  central bank in favor of states rights
• 1832 The Second Bank of the US lapses

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Historical Development - Banks

• State Banks
• Chartered by the state commission in which they
  operated, no interstate banking
• There was no national currency
• Banks issued banknotes which could be redeemed
  for gold
• Banks failed on a regular basis

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Historical Development - Banks

• National Bank Act of 1863
• Created federally chartered banks
• Created the Office of the Comptroller of the
  Currency
• Introduced heavy taxes on state banks intending
  to dry up funds for state banks
• Dual Banking System
• State banks were able to raise funds through
  deposits and today we have state and national
  banks

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Historical Development - Banks

• Federal Reserve 1913
• National banks were required to become members of
  the Federal Reserve System
• State banks had the option of joining the system
• Federal Deposit Insurance Corporation 1933
• Steamed from the 9,000 bank failures during the
  Great Depression
• Members of the Federal Reserve System were
  required to purchase insurance.

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Historical Development - Banks

• Glass-Steagall Act 1933
• Investment decisions by banks caused many
  failures
• Prevents commercial banks from underwriting and
  dealing in corporate securities, but allows for
  purchases of pre-approved debt securities
• Many commercial and investment banks seperated
• First National Bank of Boston spun of First
  Boston Corporation, which is now Credit Suisse
  First Boston
• J.P. Morgan discontinued investment banking and
  created Morgan Stanley.

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Historical Development - Regulation

• The Office of the Comptroller of the Currency
• Responsible for 1,850 national banks
• The Federal Reserve
• With state banking authorities oversee 900 banks
• The Federal Deposit Insurance Corporation
• With state banking authorities oversee 4,800
  state banks not part of the Federal Reserve

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Evolution of the Banking Industry

• Financial innovation is driven by the desire to
  earn profits
• A change in the financial environment will
  stimulate a search by financial institutions for
  innovations that are likely to be profitable
• Responses to change in demand conditions
  (inflation)
• Responses to changes in supply conditions
  (technology)
• Avoidance of regulations

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Responses to Changes in Demand Conditions
Interest Rate Volatility

• In the 1970s and 1980s interest rates
  fluctuated by more than 10
• Adjustable-rate mortgages - 1975
• Flexible interest rates keep profits high when
  rates rise
• Lower initial interest rates than the tradition
  fixed 30 year loan make them attractive to home
  buyers
• Financial Derivatives - 1975
• Ability to hedge interest rate risk
• Future Contracts - Payoffs are linked to
  previously issued securities

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Responses to Changes in Supply Conditions
Information Technology

• Bank credit and debit cards
• Improved computer technology lowers the
  transaction costs
• Nationwide cards were established after WWII
• Electronic banking
• ATM
• Home banking
• ABM automated banking machine
• Virtual banking

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Responses to Changes in Supply Conditions
Information Technology

• Junk bonds
• Before the 1980s only corporations with Baa
  ratings or higher could issue bonds
• Fallen Angels corporations that were initially
  rated above Baa but fell below
• With increases in technology and information
  investors started buying debt securities of
  lesser known corporations
• Commercial paper market Short term debt
  security
• Securitization
• Transforming illiquid financial assets into
  marketable capital securities
• Loans are bundled into small denominations sold
  to buyers and the buyers will receive portions of
  the interest and principle payments

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Avoidance of RegulationsLoophole Mining

• Reserve requirements act as a tax on deposits
• Lost profit is the interest the could be earned
• Restrictions on interest paid on deposits led to
  disintermediation
• Until 1980 checking accounts were prohibited from
  paying interest
• Deposit rate ceilings are still in affect today

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Loophole Mining

• Sweep Accounts
• Allows banks to avoid paying the tax on
  reserves
• At the end of each day corporate accounts with a
  balance above a certain amount are invested in
  overnight securities
• These securities pay interest rates higher than
  standard checking account, corporate account are
  prohibited from earning interest
• Money Market Mutual Funds
• Legally they are not checking accounts which
  means banks dont have to hold a portion as
  reserves
• Offer higher interest rates

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Decline of Traditional Banking

• As a source of funds for borrowers, market share
  has fallen
• Share of total financial intermediary assets has
  fallen
• No decline in overall profitability
• Increase in income from off-balance-sheet
  activities

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Decline of Traditional Banking

• Decline in cost advantages in acquiring funds
  (liabilities)
• Rising inflation led to rise in interest rates
  and disintermediation
• Low-cost source of funds, checkable deposits,
  declined in importance
• Decline in income advantages on uses of funds
  (assets)
• Information technology has decreased need for
  banks to finance short-term credit needs or to
  issue loans
• Information technology has lowered transaction
  costs for other financial institutions,
  increasing competition

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Banks Responses

• Expand into new and riskier areas of lending
• Commercial real estate loans
• Leveraged buyouts
• Corporate takeovers
• Pursue off-balance-sheet activities
• Non-interest income
• Concerns about risk

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Branching

• McFadden Act 1927
• With state branching regulations prohibited
  branching across state lines and forced all
  national banks to conform to the branching
  regulations of the state in which they were
  located
• Coastal states allowed banks to open branches
  throughout a given state
• Many states prevented large national banks
  opening near state banks

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Response to Branching

• Bank Holding Companies
• Own shares of many different banks
• Can engage in many banking activities
• Automated Teller Machines
• Are not considered branch
• At first banks did not own the ATMs

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Bank Consolidation

• The number of banks has declined over the last 25
  years
• Bank failures
• Consolidation
• Deregulation
• Riegle-Neal Interstate Banking and Branching
  Efficiency Act of 1994 overturns the McFadden Act
  which prohibited interstate banking
• Economies of scale and scope from information
  technology
• Results may be not only a smaller number of banks
  but a shift in assets to much larger banks

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Benefits and Costs of Bank Consolidation

• Benefits
• Increased competition, driving inefficient banks
  out of business
• Increased efficiency also from economies of scale
  and scope
• Lower probability of bank failure from more
  diversified portfolios
• Costs
• Elimination of community banks may lead to less
  lending to small business
• Banks expanding into new areas may take increased
  risks and fail

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Separation of Banking and Other Financial Services

• Glass-Steagall Act of 1933
• Prohibited commercial banks from underwriting
  corporate securities or engaging in brokerage
  activities
• Section 20 loophole was allowed by the Federal
  Reserve enabling affiliates of approved
  commercial banks to underwrite securities as long
  as the revenue did not exceed a specified amount
• U.S. Supreme Court validated the Feds action in
  1988

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Separation of Banking and Other Financial
Services (contd)

• Gramm-Leach-Bliley Financial Services
  Modernization Act of 1999
• Abolishes Glass-Steagall
• States regulate insurance activities
• SEC keeps oversight of securities activities
• Office of the Comptroller of the Currency
  regulates bank subsidiaries engaged in
  securities underwriting
• Federal Reserve oversees bank holding companies

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Three Basic World Frameworks

• Universal banking - Germany
• No separation between banking and securities
  industries
• Banks can own equity in corporations
• British-style universal banking
• May engage in security underwriting
• Separate legal subsidiaries are common
• Bank equity holdings of commercial firms are less
  common
• Few combinations of banking and insurance firms

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Three Basic World Frameworks (contd)

• Some legal separation
• Seen in Japan
• Allowed to hold substantial equity stakes in
  commercial firms
• Bank holding companies are illegal

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Thrift Industry Regulation and Structure

• Savings and Loan Associations
• Chartered by the federal government or by states
• Most are members of Federal Home Loan Bank System
  (FHLBS)
• Deposit insurance provided by Savings Association
  Insurance Fund (SAIF), part of FDIC
• Regulated by the Office of Thrift Supervision
• Mutual Banks
• Approximately half are chartered by states
• Regulated by state in which they are located
• Deposit insurance provided by FDIC or state
  insurance

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Thrift Industry Regulation and Structure
(contd)

• Credit Unions
• Tax-exempt
• Chartered by federal government or by states
• Regulated by the National Credit Union
  Administration (NCUA)
• Deposit insurance provided by National Credit
  Union Share Insurance Fund (NCUSIF)

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International Banking

• Rapid growth
• Growth in international trade and multinational
  corporations
• Global investment banking is very profitable
• Ability to tap into the Eurodollar market

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Eurodollar Market

• Dollar-denominated deposits held in banks outside
  of the U.S.
• Most widely used currency in international trade
• Offshore deposits not subject to regulations
• Important source of funds for U.S. banks

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Structure of U.S. Banking Overseas

• Shell operation
• Edge Act corporation
• International banking facilities (IBFs)
• Not subject to regulation and taxes
• May not make loans to domestic residents

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Foreign Banks in the U.S.

• Agency office of the foreign bank
• Can lend and transfer fund in the U.S.
• Cannot accept deposits from domestic residents
• Not subject to regulations
• Subsidiary U.S. bank
• Subject to U.S. regulations
• Owned by a foreign bank

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Foreign Banks in the U.S. (contd)

• Branch of a foreign bank
• May open branches only in state designated as
  home state or in state that allow entry of
  out-of-state banks
• Limited-service may be allowed in any other state
• Subject to the International Banking Act of 1978
• Basel Accord (1988)
• Example of international coordination of bank
  regulation
• Sets minimum capital requirements for banks