banking industry: structure and competition chapter 10 – ec311 susanto

BANKING INDUSTRY: STRUCTURE AND COMPETITION

Chapter 10 – EC311 Susanto

The US Banking System

Several important features:

• Many more banks per capita than in other countries

• Regional nature of banks in the US

• Regulation shared between different levels of government

• Until recently, banks unable to operate in rest of the financial services industry (prohibited by Glass-Steagall Act)

10-3

Historical Development of the Banking Industry

Outcome: Multiple Regulatory Agencies1. Federal Reserve2. FDIC3. Office of the Comptroller of the Currency4. State Banking Authorities

Civil WarCivil War

War of 1812War of 1812

WW. IWW. I

WW. IIWW. II

Primary Supervisory Responsibility of Bank Regulatory Agencies

• Multiple regulatory agencies with overlapping jurisdiction.

• The Office of the Comptroller of the Currency (OCC) supervises national banks.

• Federal Reserve and state banking authorities supervises state banks that are members of the Federal Reserve System.

• Fed also regulates bank holding companies.

• FDIC: insured state banks that are not Fed members.

• State banking authorities: state banks without FDIC insurance.

20th Century Trends in the Evolution of the Banking Industry

• Shadow banking system: bank lending replaced by lending via the securities market increased competition

– Banks forced to innovate to stay competitive

• Financial innovation is driven by the desire to earn profits

• A change in the financial environment stimulates financial institutions' search for innovations likely to be profitable

– Responses to change in demand conditions – what do consumers expect?

– Responses to change in supply conditions – what can be supplied to consumers at reasonable cost?

– Avoidance of regulations also plays a role

Responses to Changes in Demand Conditions

• Adjustable-rate mortgages (response to interest rate volatility)– Flexible interest rates keep profits high when rates rise

– Lower initial interest rates are attractive to home buyers

• Financial Derivatives (response to interest rate volatility)– Ability to hedge interest rate risk

– Futures contract: a seller agrees to provide a standardized community to a buyer in an agreed upon future date for an agreed upon price

– Payoffs are linked to previously issued securities

– Financial derivatives: payments linked to (derived from) previously issued securities

• Electronic banking (response to technology advances)– Customers expect to be able to access accounts on the internet and not

to have to pay for this service

Responses to Changes in Supply Conditions: Information Technology

• Bank credit and debit cards

– Improved computer technology lowers transaction costs

– They become widely accepted and profitable for banks

• Electronic banking

– ATM, ABM (automated banking machine), virtual banking

• Junk bonds

– Long term corporate bonds with ratings below Baa

– Improvement in IT about firms make screening easier

– More investors are willing to buy long term debt security from less-well known companies with lower credit ratings

Responses to Changes in Supply Conditions: Information Technology

• Commercial paper market

– Short-term debt security issued by large banks and firms

– Fastest growing money market instruments

– IT makes screening good and bad corporations easier

– MMMF’s need to hold liquid, high quality, short-term assets

– Also fueled by the growth of pensions and other large funds

• Securitization

– To transform otherwise illiquid financial assets into marketable capital market securities

– Banks bundle portfolios of small loans, collect interest and principal payments and “pass them through” to 3rd parties

Avoidance of Regulations:Loophole Mining

• Reserve requirements act as a tax on deposits– Sweep accounts

• Restrictions on interest paid on deposits led to disintermediation– Money market mutual funds

© 2004 Pearson Addison-Wesley. All rights reserved 10-10

Avoidance of Existing Regulations

Regulations Behind Financial InnovationRestricted the bank’s ability to make profitsResulted in “loophole mining” and financial innovation

1. Reserve requirements Tax on deposits = i r

Opportunity cost: interest rates that could have been earned (because reserves don’t pay interest)2. Deposit-rate ceilings (Regulation Q) Interest rates paid to time deposits is limited; banks

not allowed to pay interest on corporate checking accountsAs i , loophole mine to escape reserve requirement tax and deposit-rate ceilings

© 2004 Pearson Addison-Wesley. All rights reserved 10-11

Avoidance of Existing Regulations

Financial Innovations for Loophole Mining1. Money market mutual funds

Issue shares redeemable at a fixed price by writing checksMMMF’s invest in short-term money market securities and pay interests to the account holders (higher than traditional deposits)Though they act like checking accounts, they are not legally depositsMMMF’s are not subject to reserve requirements or interest payment limits

2. Sweep accounts (overnight transfer into into time deposit)Any balance above a certain amount on a corporation’s checking account at the end of business day is transferred out and invested in overnight securities that pay interestSweep accounts are not subject to reserve requirements or interest payment limits

© 2004 Pearson Addison-Wesley. All rights reserved 10-12

The Decline in Banks as a Source of Finance

Decline of Traditional Banking

• Traditional role of banks: “borrow short, lend long”

– Make long-term loans from short-term deposits

• Financial innovations caused banks to lost income and cost advantages reduced profitability from 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

10-14

Decline in Traditional Banking

Loss of Cost Advantages in Acquiring Funds (Liabilities)

i then disintermediation1. Deposit rate ceilings and regulation Q (eliminated in 1980s)

When inflation rises (e.g., in the late 1960s) investors seek out investments with higher yields disintermediation

– Money market mutual funds

An attractive alternative to non-interest bearing checking accounts

Loss of Income Advantages on Uses of Funds (Assets)– Easier to use securities markets to raise funds: commercial paper,

junk bonds, securitization growth of shadow banking system

– Finance companies more important because easier for them to raise funds lend to same businesses as banks lower market share

– Banks lose information advantage because default risk is easier to evaluate

© 2004 Pearson Addison-Wesley. All rights reserved 10-15

Banks’ Response

Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability of traditional banking

1.Expand lending into riskier areas– Commercial real estate loans– Corporate takeovers and leveraged buyouts

2. Expand into off-balance sheet activities– Non-interest income– Concerns about risk

Creates problems for U.S. regulatory system: need to keep up

10-16

Structure of the Commercial Banking Industry

10-17

Structure of the Commercial Banking Industry

20082008

© 2004 Pearson Addison-Wesley. All rights reserved 10-18

Ten Largest U.S. Banks, 2003

Ten Largest U.S. Banks, March 2011

10-19

Branching Regulations

Branching Restrictions:

• Until relatively recently some states allowed NO branching across state lines

• McFadden Act (1927) prevents banks from branching across state lines– Allowed small banks to stay in business and remain competitive

• Douglas Amendment (1956) – Made banks conform to state laws wherever they have HQ

RESULT: Anticompetitive banking system

Response to Branching Restrictions

1. Bank Holding Companies (supervised by Fed ) now dominant form of corporate structure for banks

– Allows purchases of banks in other states

– BHCs allows wider scope of activities (credit cards, leasing, data processing)

– BHCs can issue commercial paper allowing greater liability management

2. Nonbank Banks

Not subject to branching regulations, but loophole closed in 1987

3. Automated Teller Machines

Not considered to be branch of bank, so networks allowed

Figure 3 Number of Insured Commercial Banks in the United States, 1934–2008 (3rd Quarter)

Source: www2.fdic.gov/qbp/qbpSelect.asp?menuitem=STAT.

Banking Consolidation

• Why the fall in the number of banks?

- 1985-92 : mostly bank failures

- 1992 onwards : banking consolidation (mergers)

- 2007 onwards : bank failures

• Mergers occurring at both regional and national level

– Deregulation: Riegle-Neal Act of 1994; Glass-Steagall repealed in 1999

– Economies of scale and scope from IT (high initial cost)

• Currently about 7,000 banks, more than any other country– Historically strong anticompetitive forces in the US banking industry

– Public hostility to larger banks (historically, in farming communities)

• Current trend: consolidation towards nationwide banking

© 2004 Pearson Addison-Wesley. All rights reserved 10-24

Bank Consolidation and Nationwide Banking

Bank Consolidation: Why?

1. Branching restrictions weakened

2. Development of super-regional banks

Riegle-Neal Act of 1994

1. Allows full interstate branching

2. Promotes further consolidation

Results may be not only a smaller number of banks but a shift in assets to much larger banks.

© 2004 Pearson Addison-Wesley. All rights reserved 10-25

Bank Consolidation and Nationwide Banking

Bank Consolidation: A Good Thing?

Cons:

1. Fear of decline of small banks and small business lending

2. Rush to consolidation may increase risk taking

Pros:

1. Community banks have survived since branching laws removed

2. Increase competition, increase efficiency

3. Increased diversification of bank loan portfolios: lessens likelihood of failures

© 2004 Pearson Addison-Wesley. All rights reserved 10-26

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 bank failures, even “too big to fail”

Separation of the Banking and Other Financial Service Industries

• Erosion of Glass-Steagall Act

– 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 (late 1980s)

– U.S. Supreme Court validated the Fed’s action in 1988

10-28

Separation of Banking and Other Financial Service Industries

Gramm-Leach-Bliley Financial Modernization Services Act of 1999: Repeal of Glass-Steagall1. Allows securities firms and insurance companies to

purchase banks2. Banks allowed to underwrite insurance and engage in

real estate activities3. OCC regulates bank subsidiaries engaged in securities

underwriting4. Fed oversee bank holding companies under which all real

estate, insurance and large securities operations are housed

Implications: Banking institutions become larger and more complex

Separation in Other Countries

1. Universal banking: Germany, Netherlands, Switzerland- Banks can hold stocks in companies- Banks can supply any financial service

2. British-style universal banking: UK, Canada, Australia- Banks usually do not hold stocks in companies- Legal separation required- No holding companies permitted

1. Japan/Korea separationJapan (Keiretsu) – Banks allowed to hold stocks: some banks are part of industrial conglomerates

10-30

Thrift Industry

Type Regulators Structure

Savings and Loans Office of Thrift Supervision Fewer restrictions on branching

Federal Home Loan Bank System (FHLBS)

FDIC’s Saving Association Insurance Fund (SAIF)

State banking authorities

Mutual Savings Banks FDICWithin state branching, regulations not restrictive, so there are few small MSBs

State banking authorities

Credit Unions National Credit Union Administration (NCUA) Chartered by federal government or states

Common bond of depositors, most are

small with deposits < $10 million