Banking Industry: Structure and Competition Chapter 12 Banking Industry: Structure and Competition

Historical Development of the Banking System The first paper money, chiao-tzu issued in 10th century Szechwan, China (Lui, 1983) a bank receipt for iron Chinese coins deposited in Szechwan banks. it became the first fiat money when the Szechwan gov’t took it over in 1023 In 1500-1600 London, Goldsmiths began charging fees for safely storing gold coins. The receipts were redeemable to only the depositor unless ‘or bearer’ was printed next to the bearer’s name. The Bank of England began issuing paper pounds in 1694 Pounds circulated as money because they were redeemable in gold. The pound became fiat money when the UK gold standard was abandoned in 1931

Historical Development of the Banking System The modern U.S. bank is a financial intermediary it accepts deposits from savers it lends money to borrowers. it evolved from 16th century London goldsmiths. Goldsmiths had a history of safely storing gold Table (a) on the following slide shows a T-account for the first goldsmith The value on the left is called reserves the goldsmith is reserving it for its depositors The value on the right is called demand deposits depositors can demand their gold coin at any time

Historical Development of the Banking System first gold coin deposit was made by John in the amount of £200 the £200 is considered an asset and a liability as it is listed on both sides of the T-account. The value on the left is called reserves because the goldsmith is reserving it for its depositors. The value on the right is called demand deposits because depositors can demand their gold coin at any time. Was is not shown, is the fee that John pays the goldsmith. The goldsmith collects a fee for storing John’s gold coins

Historical Development of the Banking System Storing gold is profitable John’s employer pays him in gold coin John is willing to pay to have it safely kept by the goldsmith Storing it in one’s home or carrying it on one's person is risky Depositing it at the goldsmith isn’t too inconvenient it is located near his village’s ale house and shops. Table (b) shows what happens after word spreads of the goldsmith safely storing John’s gold. Others deposit their gold in the goldsmith’s safe The Goldsmith’s assets and liabilities rise to £1000 As the proceeds from fees pile up, the goldsmith’s wealth grows storing gold becomes his primary business.

Historical Development of the Banking System

Historical Development of the Banking System After observing the goldsmith’s growing affluence James inquires about borrowing gold sitting idle in the goldsmith’s safe to turn his alehouse into an inn The goldsmith accommodates the request if he believes depositors will keep their coins in his safe for the desired length of the loan the inn will be profitable James is willing and able to pay back the principal, the borrowed gold coins interest, compensation for accepting credit risk. Because the gold coins are the property of others, making loans using demand deposits could be viewed as unscrupulous. The goldsmith offers to pay depositors interest. If net interest margin is negative, the goldsmith does not make a profit. is positive, the goldsmith hesitate because demand deposits can be withdrawn at any time. is high enough to encourage depositors to store gold coins for the length of the loan, the goldsmith safely securitizes the loan (time deposit, CDs) ,.

Historical Development of the Banking System

Historical Development of the Banking System After the goldsmith lends James gold (short with demand deposits) James pays Jill £500 for building materials Jill deposits her £500 at the goldsmith Bill £400 for his labor Bill deposits his £400 at the goldsmith The goldsmith’s liabilities increase by £900 The goldsmith’s reserves increase from £100 to £1000 Reserves ratio 200/200 = 100% 1000/1000 = 100% 100/1000 = 10% 1000/1900 = 52.6% (a) (b) (c) (d) ,.

Historical Development of the Banking System

Historical Development of the Banking System While making loans & storing gold coin deposits, the goldsmith discovers a reserves ratio of 0.2 is, under normal economic conditions, enough to balance outflows (gold withdrawals and gold payments from new loans) inflows (new gold deposits and loan payoffs in gold) the goldsmith will make loans until demand deposits times the reserves ratio = quantity of gold coin presently held in reserve. The self-imposed reserves ratio is called the desired reserves ratio. Gold coin deposits have pushed the goldsmith’s reserves from £1000 to £10,000 With a desired reserves ratio of 0.2, the goldsmith is comfortable with reserves backing just 20% of demand deposits. This is why the goldsmith has made £40,000 in loans to villagers The goldsmith discovers that the paper receipts he has issued are circulating as money As long as the receipts can be redeemed in gold coin, villagers consider the receipts money because they are as good as gold. The paper money is increasingly preferred to gold because it can be folded up in one’s pocket, and its use eliminates trips to the goldsmith.

Historical Development of the Banking System

Historical Development of the Banking System The system described above is called fractional reserve banking because reserves are a fraction of demand deposits Such a system is inherently risky bank profits increase as the reserves ratio falls. the goldsmith works less and less as an artisan and increasingly more as a banker as her banking operations expand. Balancing his T-account and reviewing loan applications is time consuming, but is necessary to ensure a desired reserves ratio of 0.2 If the economy over-performs for a long period, the goldsmith may lower the desired reserves ratio to 0.1 more profitable £10,000 in gold are backing £100,000 in demand deposits. more interest-bearing loans (5%) are made (from £40,000 to £90,000) interest payments increases by 125% more riskier An unexpected event, like the Little Ice Age (1560-1850) A collapse in firm revenue slows inflows of new gold deposits More out-migration increases outflows of gold

Historical Development of the Banking System The Fed sets the required reserves ratio of 0.1 on checkable demand deposits in the U.S.’s fractional reserve banking system This makes banks’ T-accounts slightly different than the goldsmith’s Reserves and loans are still listed on the asset side The bank’s outstanding loans of $40,000, is split: government, consumers, and businesses. This means the bank voluntarily lends out all but $10,000 of the $50,000 in checkable demand deposits. Reserves split into required reserves & excess reserves Required reserves ratio = 10% Excess reserves ratio = 10% Desired reserves ratio = 20%

Historical Development of the Banking System Bank of North America chartered in 1782 Controversy over the chartering of banks. National Bank Act of 1863 creates a new banking system of federally chartered banks Office of the Comptroller of the Currency Dual banking system Federal Reserve System is created in 1913. Government’s perspective The Mises Institutes’ perspective Free Banking (Lawrence White) Free Banking The Mises Institute’s perspective

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design. – F.A. Hayek

Historical Development of the Banking System Figure 1

The Federal Reserve System Primary Supervisory Responsibility of Bank Regulatory Agencies Federal Reserve and state banking authorities: 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.

Financial Innovation 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 Financial engineering Responses to Changes in Demand Conditions: Interest Rate Volatility Adjustable-rate mortgages Flexible interest rates keep profits high when rates rise Lower initial interest rates make them attractive to home buyers Financial Derivatives Ability to hedge interest rate risk Payoffs are linked to previously issued (i.e. derived from) securities. Responses to Changes in Supply Conditions: Information Technology Bank credit and debit cards improved computer technology lowers transaction costs Electronic banking ATM, home banking, ABM and virtual banking Junk bonds Commercial paper market

Financial Innovation Responses to Changes in Supply Conditions: Information Technology (continued) Securitization To transform otherwise illiquid financial assets into marketable capital market securities. Securitization played an especially prominent role in the development of the subprime mortgage market in the mid 2000s. Avoidance of Existing Regulations Loophole Mining Reserve requirements act as a tax on deposits Restrictions on interest paid on deposits led to disintermediation Money market mutual funds Sweep accounts Decline of Traditional Banking As a source of funds for borrowers, market share has fallen Commercial banks’ share of total financial intermediary assets has fallen No decline in overall profitability Increase in income from off-balance-sheet activities

Financial Innovation Decline of Traditional Banking Bank’s Response As a source of funds for borrowers, market share has fallen Commercial banks’ share of total financial intermediary assets has fallen No decline in overall profitability Increase in income from off-balance-sheet activities 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 Bank’s Response Expand into new and riskier areas of lending Commercial real estate loans Corporate takeovers and leveraged buyouts Pursue off-balance-sheet activities Non-interest income Concerns about risk

Structure of the U.S. Commercial Banking Industry Restrictions on branching McFadden Act and state branching regulations. Response to ranching restrictions Bank holding companies. Automated teller machines.

Structure of the U.S. Commercial Banking Industry 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 Savings Banks Approximately half are chartered by states Regulated by state in which they are located Deposit insurance provided by FDIC or state insurance 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)

Bank Share of Total Nonfinancial Borrowing Structure of the U.S. Commercial Banking Industry Bank Share of Total Nonfinancial Borrowing Figure 2 Source: Federal Reserve Flow of Funds; www.federalreserve.gov/releases/z1/Current/z1.pdf. Flow of Funds Accounts; Federal Reserve Bulletin.

Structure of the U.S. Commercial Banking Industry Table 1 Table 2

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. 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

Bank Consolidation and Nationwide Banking 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 U.S. Supreme Court validated the Fed’s action in 1988 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

Bank Consolidation and Nationwide Banking Figure 3 Number of Insured Commercial Banks in the United States (Third Quarter) Source: www2.fdic.gov/qbp/qbpSelect.asp?menuitem=STAT.

International Banking Universal banking No separation between banking and securities industries 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 Some legal separation Allowed to hold substantial equity stakes in commercial firms but holding companies are illegal Rapid growth Growth in international trade and multinational corporations Global investment banking is very profitable Ability to tap into the Eurodollar market

International Banking 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 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

International Banking 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 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

International Banking Table 3