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
Source Available online at http//www.wiwi.uni-frankfurt.de/schwerpunkte/finance/wp/550.pdf
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.

8
Size Distribution of U.S. Banks
  Commercial Banks Commercial Banks Commercial Banks
Number of Number of Deposits (millions)
Asset Size (as of June 30, 2006) Institutions Offices Deposits (millions)
Less than 25 Million 586 712 7,661
25 Million to 50 Million 1,098 1,701 33,511
50 Million to 100 Million 1,718 4,007 105,754
100 Million to 300 Million 2,427 10,338 349,740
300 Million to 500 Million 672 5,088 211,495
500 Million to 1 Billion 494 6,322 265,540
1 Billion to 3 Billion 275 6,856 338,909
3 Billion to 10 Billion 120 6,601 427,340
Greater than 10 Billion 89 38,848 3,580,817
TOTALS 7,479 80,473 5,320,767
Source www2.fdic.gov/sod/index.asp Source www2.fdic.gov/sod/index.asp
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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

10
Some Wells Fargo branches
11
Wells Fargos Broad Scope
Source www.wellsfargo.com/about/today1
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20 Largest U.S. Banks (as of June 30, 2006)
Rank Institution Name State Headquartered Number of Offices Deposits (thousands)
1 Bank of America, NA North Carolina 5,781 563,906,844
2 JPMorgan Chase Bank, NA Ohio 2,679 434,752,000
3 Wachovia Bank, NA North Carolina 3,136 306,348,000
4 Wells Fargo Bank, NA South Dakota 3,200 298,672,000
5 Washington Mutual Bank Nevada 2,167 209,927,984
6 Citibank, NA New York 267 142,508,000
7 SunTrust Bank Georgia 1,758 117,956,301
8 U.S. Bank, NA Ohio 2,525 117,337,830
9 HSBC Bank USA, NA Delaware 436 75,588,320
10 World Savings Bank, FSB California 286 61,321,407
11 PNC Bank, NA Pennsylvania 831 58,134,805
12 Keybank, NA Ohio 957 57,327,323
13 Regions Bank Alabama 1,397 57,231,022
14 Merrill Lynch Bank USA Utah 3 52,331,967
15 Branch Banking and Trust Company North Carolina 918 51,246,133
16 Countrywide Bank, NA Virginia 2 50,657,812
17 ING Bank, fsb Delaware 1 46,440,495
18 Comerica Bank Michigan 387 43,081,270
19 Sovereign Bank Pennsylvania 661 40,829,851
20 The Bank of New York New York 354 40,014,000
Source www2.fdic.gov/sod/index.asp Source www2.fdic.gov/sod/index.asp
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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

17
An Example Data on Wells Fargo
18
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
  assetsltliabilities.
• 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
36
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.

37
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.

40
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
Assets Amount Risk weight Weighted assets
Cash 10,000,000 0 0
T-bills 190,000,000 0 0
Municipal bonds 50,000,000 20 10,000,000
Mortgages 300,000,000 50 150,000,000
Home equity loans 40,000,000 100 40,000,000
TOTALS 590,000,000 200,000,000
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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.

43
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

44
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

45
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.

46
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
52
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

53
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.

54
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
56
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

57
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.

58
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.

62
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.

65
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