Market Structure and Regulation in the U.S. Banking Industry

1
Market Structure and Regulation in the U.S.
Banking Industry

• Professor Wayne Carroll
• Department of Economics
• University of Wisconsin-Eau Claire
• carrolwd_at_uwec.edu
• Slides available at www.uwec.edu/carrolwd

2
Roles of Banks in the Economy

• Facilitate borrowing and lending
• Facilitate payments
• Risk management
• Issue financial assets that allow firms to share
  risks
• Provide guarantees and lines of credit

3
Role of Banks in Lending
4
Financial Intermediaries

• Banks include
• Commercial banks
• Savings and loan associations (SLs)
• Also sometimes called thrifts or thrift
  institutions
• Credit unions

5
Financial IntermediariesAssets at end of 2002
(in billions)
6
Ownership of Banks

• U.S. banks are privately owned no banks are
  owned by the government.
• In most cases a banks stock is held by a large
  number of investors, so a bank has many owners.
• It is relatively easy to establish a new bank in
  the U.S.

7
Bank Market Structure

• There are a large number of banking firms in the
  U.S., but the number is falling due to mergers
  between banks.
• Thousands of U.S. banks are very small, each
  having only a single office.
• Many banks today have multiple branches or
  offices.
• A bank holding company is a firm that owns one
  or more banking firms.

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Size Distribution of U.S. Banks
9
Bank Market Structure An Example

• Wells Fargo Company is a bank holding
  company based in South Dakota (with historic
  roots in Minnesota and California). It includes
• 28 chartered bank companies
• a total of over 3,000 branches in 23 states

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Some Wells Fargo branches
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Wells Fargos Broad Scope
Source www.wellsfargo.com/about/today1
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20 Largest U.S. Banks (as of June 30, 2006)
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A Simple Bank Balance Sheet

• Assets
• reserves
• "loans"
• securities
• bank loans

• Liabilities
• deposits
• borrowings
• Bank capital (equity)

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Detailed Balance Sheet for the Banking
Industry
Source Mishkin, Economics of Money, Banking, and
Financial Markets, 7th edition
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Two Important Ratios

• Capital/asset ratio bank capital as a
  percentage of bank assets.
• The average capital/asset ratio for U.S. banks
  was about 9 at the end of 2002.
• Reserve ratio bank reserves as a percentage of
  checkable deposits.

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Information on U.S. Banks

• It is easy to get a lot of financial data on U.S.
  banks.
• A great source
• www2.fdic.gov/idasp/index.asp

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An Example Data on Wells Fargo
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What Can Go Wrong?

• Bank failure the bank goes out of business.
• Bank depositors might lose some of their funds.
• Bank creditors might lose some of their
  investment
• Bank owners lose their capital.
• The bank suffers significant losses the
  government might have to help.

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Reasons for Bank Regulation

• Banks must be regulated because
• a bank failure can be devastating to depositors.
• theres a risk of systemic failure the failure
  of one bank can make it more likely that other
  banks will fail.
• depositors cant monitor how the bank invests
  their funds, creating a moral hazard problem.
• government assistance to a bank can be very
  costly.

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Reasons for Bank Regulation

• Banks are less stable than other businesses
  because
• bank liabilities tend to be short-term many
  depositors could withdraw their funds with little
  notice.
• bank assets tend to be longer-term reserves and
  other liquid assets are only a small share of the
  total.
• the behavior of depositors depends on their
  confidence that the bank is sound, and this
  confidence can be easily shaken.

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A Closer Look at Bank Failure

• Two reasons for bank failure
• The value of bank assets falls, so
  assets
• Deposit outflow A large number of depositors
  withdraw their funds from the bank, exhausting
  the banks cash (reserves) and other liquid
  assets.
• Therefore a bank is more likely to fail if it
  has a low capital/asset ratio or a low reserve
  ratio.

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A Closer Look at Bank Failure

• Tradeoff between higher income and a lower risk
  of failure
• Holding other things constant, the banks net
  income is higher if its capital/asset ratio and
  reserve ratio are lower, since then it holds
  relatively more interest-earning assets.
• If the banks capital/asset ratio and reserve
  ratio are higher, its less likely that the bank
  will fail (so its less likely that the
  stockholders will lose their capital.)

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A Closer Look at Bank Failure

• If there were no government regulation of banks
  
• each bank would choose a capital/asset ratio and
  a reserve ratio to maximize the value of the
  bank.
• depositors would want to deposit their money in
  banks that are well managed, so banks would have
  an incentive to choose capital/asset ratios and
  reserve ratios that reduce the threat of bank
  failure.
• ? market discipline

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A Closer Look at Bank Failure

• But if there were no government regulation of
  banks
• banks would choose capital/asset ratios and
  reserve ratios that are too low from societys
  standpoint.
• banks would take on too much risk, so there would
  be too many bank failures, and the government
  would have to spend too much money to assist
  troubled banks.

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An Example Continental Illinois Bank

• Continental Illinois Bank failed in 1984.
• The federal government paid billions of dollars
  to keep Continental Illinois from closing.
• This was the biggest bank resolution in U.S.
  history.

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An Example Continental Illinois Bank

• Before it failed, Continental Illinois Bank
• was the largest bank in Chicago.
• was the seventh-largest bank in the U.S.
• had 57 offices in 14 states and 29 foreign
  countries.

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An Example Continental Illinois Bank

• Why did Continental Illinois fail?
• Starting in the late 1970s, the bank grew fast,
  with lots of loans to businesses.
• Poor quality loans
• Too many loans to firms in the oil industry
• Too many loans to borrowers in Latin America
• Continental Illinois is willing to do just about
  anything to make a deal.
• High cost of funds
• Large share of funds borrowed from other banks
• Relatively small reliance on domestic deposits
• Heavy borrowing in foreign money markets

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An Example Continental Illinois Bank

• The Banks Troubles
• By 1984 the banks nonperforming loans (loans on
  which payments were late) rose to 5.2 billion
  (over 10 of total loans).
• May 1984 an electronic bank run depositors
  withdrew billions of dollars in deposits
• The FDIC and the Federal Reserve System pledged
  their support for the bank and lent over 5
  billion.

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An Example Continental Illinois Bank

• Dangers
• Many smaller banks had deposits at Continental
  Illinois, so the failure of Continental Illinois
  could have caused some of them to fail, too.
• Other depositors (including many important
  corporations) could lose some of their funds
• Foreign investors would lose confidence in U.S.
  banks

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An Example Continental Illinois Bank

• Rescuing Continental Illinois Bank
• Continental Illinois Bank had 3 billion in
  insured deposits and 30 billion in uninsured
  deposits. The FDIC promised to guarantee all
  deposits.
• The FDIC assumed the Banks 3.5 billion debt to
  the Federal Reserve.
• The FDIC bought 1 billion in Continental
  Illinois stock the FDIC owned the bank.

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An Example Continental Illinois Bank

• Lessons from Continental Illinois Bank
• Banks have an incentive to take on too much risk,
  so they need closer supervision
• The failure of a very large bank could have
  broader negative effects
• Rescuing a large bank can be expensive for the
  government
• Good sources
• www.fdic.gov/bank/historical/managing/contents.pdf
  -- Part II, Chap. 4
• http//www.fdic.gov/bank/historical/history/vol1.h
  tml -- Chap. 7

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Bank Regulation An Overview

• In the U.S. the government regulates banks in
  many ways
• Federal deposit insurance
• Imposing capital requirements (minimum
  capital/asset ratios)
• Imposing reserve requirements (minimum reserve
  ratios)
• Restricting the types of assets that banks may
  hold
• Performing bank examinations (periodic auditing
  reviews)

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Bank Regulation An Overview

• Primary bank regulators in the U.S.
• Office of the Comptroller of the Currency (OCC)
• part of the U.S. Department of the Treasury
• Federal Reserve System the U.S. central bank
• Federal Deposit Insurance Corporation (FDIC)
• State bank regulators

34
Federal Deposit Insurance

• The U.S. Congress created the Federal Deposit
  Insurance Corporation (FDIC) in 1933, after the
  bank failures in the Great Depression.
• Today the FDIC guarantees each bank deposit up to
  a maximum of 100,000.
• FDIC insurance is funded by a small fee paid by
  banks based on their deposits.

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Bank Failures in the Great Depression
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Effects of Federal Deposit Insurance

• Deposit insurance prevents bank runs
• Prevents losses by small depositors
• Reduces systemic risk in the banking system
• Deposit insurance gives banks incentives to
• hold riskier assets.
• hold less capital.
• manage the banks assets less carefully.

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Incentive Effects of Deposit InsuranceA Closer
Look

• Deposit insurance increases the supply of
  deposits (within the insurance coverage limits).
  
• Therefore banks can attract deposits more easily
  and can pay lower interest rates on their
  deposits even if they pursue risky strategies
  that increase the risk of bank failure.
• As a result, deposit insurance reduces banks
  incentives to avoid risk.

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Capital Requirements

• When theres deposit insurance, banks have an
  incentive to hold too little capital.
• Therefore the government imposes capital
  requirements to ensure that banks hold sufficient
  capital.

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Capital Requirements

• A simple capital requirement would require that a
  banks capital/asset ratio be greater than or
  equal to a specified level.
• Example capital/asset ratio 0.05.
• Problem Not all assets are equally risky. A
  simple capital requirement gives a bank an
  incentive to hold more risky assets.

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Risk-weighted Capital Requirements

• At an international conference in Basel,
  Switzerland in 1988, bank regulators from the
  worlds affluent countries agreed to impose
  risk-weighted capital requirements
• Classes of assets are assigned risk weights
  between 0 and 100.
• Risk-free assets carry a weight of 0, and
  more-risky assets carry higher weights.
• Capital requirements then set a minimum for the
  ratio of capital to risk-weighted assets.

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Risk-weighted Capital RequirementsAn Example
42
Risk-weighted Capital RequirementsAn Example

• In this example, if regulators require the bank
  to maintain its risk-weighted capital ratio at a
  level of at least 8, then the banks capital
  must be at least 16,00,000 (or 8 of
  200,000,000).
• If the bank acquires another 1 million in
  capital, it could invest up to
• 12.5 million more in home-equity loans
• 25 million more in home mortgages
• 62.5 million more in municipal bonds
• So risk-weighted capital requirements give the
  bank an incentive to hold less-risky assets.

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Proposed Capital Requirement Reform Basel 2

• Problem Assets within a risk class might expose
  banks to different amounts of risk.
• Bank regulators have designed a new system of
  bank capital requirements Basel 2 that will
  provide better incentives for banks to manage
  their risks in a way that promotes bank
  stability.
• Basel 2 will take effect in some countries in
  2007.
• http//www.bis.org/publ/bcbsca.htm

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Reserve Requirements

• The Federal Reserve System requires banks to hold
  reserves that are greater than or equal to a
  specified percentage of their checkable deposits
• 3 for smaller banks
• 10 for larger banks

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Reserve Requirements

• But reserves are higher than they need to be to
  promote stability of the banking system.
• Today reserve requirements are more important in
  macroeconomic policy they tie bank reserves to
  deposits, so the central bank can try to control
  deposits by controlling reserves.

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Restrictions on Asset Holdings

• Bank regulations include the following
• Banks cannot hold common stock.
• Banks cannot invest too large a share of their
  deposits in a single loan or in loans to
  businesses in a single industry.
• Banks cannot lend funds to bank directors,
  managers, or principal shareholders at
  below-market rates.

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Bank Examinations

• Banks are visited on a regular schedule by bank
  examiners from the OCC, the Federal Reserve
  System, the FDIC, or other agencies.
• Bank examiners review the banks financial
  statements and its confidential accounts.
• The results are summarized in a CAMELS rating
  given to the bank.

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Bank Examinations

• Capital adequacy
• Asset quality
• Management
• Earnings
• Liquidity
• Sensitivity to market risk

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CAMELS ratings

• 1 Sound in every respect
• 2 Fundamentally sound, but with modest
  weaknesses that can be corrected
• 3 Moderately severe to unsatisfactory
  weaknesses vulnerable if theres a business
  downturn
• 4 Many serious weaknesses that have not been
  addressed failure is possible but not imminent
• 5 High probability of failure in the short term

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Bank Examinations

• CAMELS ratings are disclosed to bank management,
  but not to the public.
• If the CAMELS rating for a bank is unfavorable,
  regulators can take actions like these
• Require banks to disclose unfavorable information
  in their public financial statements
• Issue a cease and desist order requiring the
  bank to stop doing things that cause financial
  troubles and to correct problems.
• Impose fines (up to 1,000,000 per day).

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Bank Examinations
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Bank Examinations

• Good sources on bank examinations and the FDIC
• www.fdic.gov/regulations/examinations/index.html
• www.fdic.gov/bank/analytical/banking/1999oct/1_v1
  2n2.pdf

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The Banking Crisis of the 1980s

• Hundreds of savings and loan associations (SLs)
  and banks failed in the 1980s and early 1990s.
• This episode illustrates
• how changes in the market environment and a
  loosening of regulations can lead to a bank
  crisis.
• how government regulators can handle widespread
  bank failures.
• how regulations and supervisory standards can be
  improved to address new problems.

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Magnitude of the Crisis

• From 1980 through 1994, over 2,900 banks and
  SLs failed.
• 1,617 banks with total assets of 302.6 billion
• 1,295 SLs with total assets of 621 billion
• On average, a bank or SL failed every 15 days
  from 1980 to 1994.
• During this period, about one out of every six
  banks or SLs (holding a total of over 20 of
  the assets of the system) was closed or got
  government assistance.

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Magnitude of the CrisisNumber of Bank Failures
Per Year
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Causes of the Banking Crisis

• The banking crisis had many causes, including
• changes in the market environment
• looser regulations that gave SLs more
  competitive options

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Causes of the Banking CrisisChanges in the
Market Environment

• As a result of financial innovations in the
  1960s and 1970s
• banks and SLs faced more competition from other
  financial firms (such as mutual funds).
• new kinds of financial assets (such as futures
  and other derivatives) made it possible for
  investors (including banks and SLs) to take on
  more risk.
• the financial market environment was more
  complicated and harder for regulators to monitor.

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Causes of the Banking CrisisChanges in
Regulation

• The banking industry was partially deregulated in
  the early 1980s
• SLs had mostly been restricted to home mortgage
  lending before, but now they were allowed to
  invest in commercial real estate and consumer
  loans.
• SLs were allowed to invest in junk bonds
  (low-quality, high-risk commercial bonds) and
  common stocks.

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Causes of the Banking CrisisChanges in
Regulation
Sourcewww.fdic.gov/bank/historical/history/421_47
6.pdf
60
Causes of the Banking Crisis

• As a result, SLs held more risky assets,
  resulting in huge loan losses.
• SL management had little expertise in managing
  risks from new kinds of assets.
• Regulators had little experience in monitoring
  the new risks.
• Since SL deposits (up to 100,000) were
  protected by federal deposit insurance,
  depositors had little incentive to monitor SL
  risks.

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Regulatory Failures in the Crisis

• Regulators of SLs did not close insolvent
  institutions and end the crisis quickly.
• The deposit insurance fund wasnt large enough to
  cover losses.
• (The SL deposit insurance fund had a balance of
  -75 billion in 1988.)
• Regulators wanted to encourage the growth of the
  SL industry, not close SLs.
• Regulators hoped the crisis would pass without
  revealing their failures.

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Managing the Crisis

• In 1989 the government created the Resolution
  Trust Corporation (RTC) to handle SLs that were
  failing.
• Functions of the RTC
• Took over assets of failing SLs and sold them
  to recover as much of their value as possible.
• Issued bonds to fund the costs of covering SL
  losses.

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Who Paid the Cost?

• Bank and SL stockholders
• Some depositors who had large deposits that
  exceeded the deposit insurance limits
• Taxpayers, who ultimately will pay higher taxes
  to pay off bonds that were issued to fund the
  costs of the crisis.

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Regulatory Reforms Following the Crisis

• Some regulatory agencies that had not been
  effective were eliminated, and their powers were
  given to other agencies.
• Earlier restrictions on assets holdings by SLs
  were reinstated.
• SLs were required to raise their capital/asset
  ratios.
• Now bank examiners visit banks more frequently
  than before.
• Regulators were required to act more quickly when
  a bank or SL is failing.

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Regulatory Reforms Following the Crisis
Sourcewww.fdic.gov/bank/historical/history/421_47
6.pdf
66
Lessons from the Banking Crisis

• The U.S. banking crisis in the 1980s was similar
  to bank crises in other countries
• Financial liberalization allowed banks to take
  more risks, but there was not yet adequate
  government regulation and supervision of those
  risks.
• A government safety net created moral hazard
  problems and eliminated some market discipline.

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The Banking Crisis of the 1980s

• Two excellent sources
• Managing the Crisis The FDIC and RTC Experience
• www.fdic.gov/bank/historical/managing/index.html
• History of the Eighties - Lessons for the Future
• www.fdic.gov/bank/historical/history/index.html