Chapters 11 & 12 Banking Industry: Structure, Competition and Regulation

Financial Innovation Innovation is result of search for profits Response to Changes in Demand Major change is huge increase in interest-rate risk starting in 1960s Example: Adjustable-rate mortgages Financial Derivatives Response to Change in Supply Major change is improvement in computer technology 1. Increases ability to collect information 2. Lowers transaction costs Examples: 1. Bank credit and debit cards 2. Electronic banking facilities 3. Junk bonds 4. Commercial paper market 5. Securitization

Avoidance of Existing Regulations Regulations Behind Financial Innovation 1. Reserve requirements Tax on deposits = i  r 2. Deposit-rate ceilings (Reg Q till 1980) As i , loophole mine to escape reserve requirement tax and deposit-rate ceilings Examples 1. Money market mutual funds (Bruce Bent) 2. Sweep accounts © 2004 Pearson Addison-Wesley. All rights reserved

The Decline in Banks as a Source of Finance © 2004 Pearson Addison-Wesley. All rights reserved

Decline in Traditional Banking Loss of Cost Advantages in Acquiring Funds (Liabilities)   i  then disintermediation because 1. Deposit rate ceilings and regulation Q 2. Money market mutual funds 3. Foreign banks have cheaper source of funds: Japanese banks can tap large savings pool Loss of Income Advantages on Uses of Funds (Assets) 1. Easier to use securities markets to raise funds: commercial paper, junk bonds, securitization 2. Finance companies more important because easier for them to raise funds

Banks’ Response Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability in traditional banking 1. Expand lending into riskier areas: e.g., real estate 2. Expand into off-balance sheet activities 3. Creates problems for U.S. regulatory system Similar problems for banking industry in other countries © 2004 Pearson Addison-Wesley. All rights reserved

Structure of the Commercial Banking Industry © 2004 Pearson Addison-Wesley. All rights reserved

Table 1 Size Distribution of Insured Commercial Banks, September 30, 2008 © 2004 Pearson Addison-Wesley. All rights reserved 8

Ten Largest U.S. Banks © 2004 Pearson Addison-Wesley. All rights reserved

Branching Regulations Branching Restrictions: McFadden Act and Douglas Amendment Very anticompetitive Response to Branching Restrictions 1. Bank Holding Companies A. Allowed purchases of banks outside state B. BHCs allowed wider scope of activities by Fed C. BHCs dominant form of corporate structure for banks 2. Automated Teller Machines Not considered to be branch of bank, so networks allowed © 2004 Pearson Addison-Wesley. All rights reserved

Bank Consolidation and Number of Banks © 2004 Pearson Addison-Wesley. All rights reserved

Bank Consolidation and Nationwide Banking The number of banks has declined over the last 25 years Bank failures and consolidation. Deregulation: Riegle-Neal Interstate Banking and Branching Efficiency Act f 1994. 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. © 2004 Pearson Addison-Wesley. All rights reserved 12

Benefits and Costs of Bank Consolidation 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 © 2004 Pearson Addison-Wesley. All rights reserved 13

Separation of Banking and Other Financial Service Industries Erosion of Glass-Steagall Fed, OCC, FDIC, allow banks to engage in underwriting activities Gramm-Leach-Bliley Financial Modernisation Services Act of 1999: Repeal of Glass-Steagall 1. Allows securities firms and insurance companies to purchase banks 2. Banks allowed to underwrite insurance and engage in real estate activities 3. OCC regulates bank subsidiaries engaged in securities underwriting 4. 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

How Asymmetric Information Explains Banking Regulation 1. Government Safety Net and Deposit Insurance A. Prevents bank runs due to asymmetric information: depositors can’t tell good from bad banks B. Creates moral hazard incentives for banks to take on too much risk C. Creates adverse selection problem of crooks and risk-takers wanting to control banks D. Too-Big-to-Fail increases moral hazard incentives for big banks 2. Restrictions on Asset Holdings A. Reduces moral hazard of too much risk taking © 2004 Pearson Addison-Wesley. All rights reserved

How Asymmetric Information Explains Banking Regulation 3. Bank Capital Requirements A. Reduces moral hazard: banks have more to lose when have higher capital B. Higher capital means more collateral for FDIC 4. Bank Supervision: Chartering and Examination A. Reduces adverse selection problem of risk takers or crooks owning banks B. Reduces moral hazard by preventing risky activities 5. New Trend: Assessment of Risk Management 6. Disclosure Requirements A. Better information reduces asymmetric information problem © 2004 Pearson Addison-Wesley. All rights reserved

How Asymmetric Information Explains Banking Regulation 7. Consumer Protection A. Standardized interest rates (APR) B. Prevent discrimination: e.g., CRA 8. Restrictions on Competition to Reduce Risk-Taking A. Branching restrictions B. Separation of banking and securities industries in the past: Glass-Steagall International Banking Regulation 1. Bank regulation abroad similar to ours 2. Particular problem of regulating international banking e.g., BCCI scandal © 2004 Pearson Addison-Wesley. All rights reserved