Chapter 13. Financial Industry Structure Bank Structure Nondepository instituions  Insurance  Pensions  Finance companies  GSEs Bank Structure Nondepository instituions  Insurance  Pensions  Finance companies  GSEs

Dual banking system banking at state level until Civil War  state charters, regulation  banknotes as local currency  failures, fraud were common banking at state level until Civil War  state charters, regulation  banknotes as local currency  failures, fraud were common

National Bank Act 1863  federal charters for banks  Comptroller of the Currency  federal banknotes  tax on state banknotes  state banks survived by accepting deposits -- dual banking system National Bank Act 1863  federal charters for banks  Comptroller of the Currency  federal banknotes  tax on state banknotes  state banks survived by accepting deposits -- dual banking system

Decentralization and Consolidation Why so many small banks in U.S.? McFadden Act 1927  restricted intra and interstate branching of national banks  meant to protect small banks & promote competition -- but protected inefficient banks -- limited economies of scale Why so many small banks in U.S.? McFadden Act 1927  restricted intra and interstate branching of national banks  meant to protect small banks & promote competition -- but protected inefficient banks -- limited economies of scale

 loopholes -- bank holding companies -- owned several banks -- limited service banks -- deposits or loans, not both -- ATMs  repealed 1994 (Reigle-Neal) Rising bank profitability  loopholes -- bank holding companies -- owned several banks -- limited service banks -- deposits or loans, not both -- ATMs  repealed 1994 (Reigle-Neal) Rising bank profitability

ConsolidationConsolidation repeal of McFadden  1994 Reigle-Neal Over 14,000 banks in 1985  less than 8,000 today repeal of McFadden  1994 Reigle-Neal Over 14,000 banks in 1985  less than 8,000 today

A good thing? economies of scale diversification But  risks with expansion?  responsive to small customers?  Local job loss economies of scale diversification But  risks with expansion?  responsive to small customers?  Local job loss

Bank Failures of the Great Depression , 1/3 of all U.S. banks failed Congress responded w/ legislation FDIC  federal insurance for bank deposits  banks pay premiums , 1/3 of all U.S. banks failed Congress responded w/ legislation FDIC  federal insurance for bank deposits  banks pay premiums

Glass-Steagall Act  separated permissible activities of commercial, investment banks  idea: limit risk for commercial banks  weakened over time  repealed 1999 Glass-Steagall Act  separated permissible activities of commercial, investment banks  idea: limit risk for commercial banks  weakened over time  repealed 1999

Foreign branches (IBF) Edge Act corporations  Subsidiary just for international banking Acquire interests in foreign banks Foreign branches (IBF) Edge Act corporations  Subsidiary just for international banking Acquire interests in foreign banks GlobalizationGlobalization

EurodollarsEurodollars US $ deposits in foreign banks Interbank lending in eurodollars  LIBOR A common swap floating rate US $ deposits in foreign banks Interbank lending in eurodollars  LIBOR A common swap floating rate

Banks of the future Universal banks  A full range of financial and nonfinancial services  Not yet in U.S. Universal banks  A full range of financial and nonfinancial services  Not yet in U.S.

Financial holding companies  e.g. Citigroup  Economies of scale Lower average cost from large number of same type of transactions  Economies of scope Lower average cost from large number of related transactions Financial holding companies  e.g. Citigroup  Economies of scale Lower average cost from large number of same type of transactions  Economies of scope Lower average cost from large number of related transactions

Nondepository Institutions: Insurance insurers bear risk that others pay to avoid  underwrite risk  receive premiums  invest premiums  face contingent liabilities insurers bear risk that others pay to avoid  underwrite risk  receive premiums  invest premiums  face contingent liabilities

Types of insurance Life Insurance  term life insurance  cash value life insurance Life Insurance  term life insurance  cash value life insurance

term life insurance policy period death benefit if occurs w/in policy period no cash value policy period death benefit if occurs w/in policy period no cash value

cash value life insurance whole life insurance  death benefit  cash value builds over life of policy  premiums cover -- cost of insurance -- investment capital whole life insurance  death benefit  cash value builds over life of policy  premiums cover -- cost of insurance -- investment capital

Universal life insurance  similar to whole life  buildup of cash value may be used to finance future premiums Universal life insurance  similar to whole life  buildup of cash value may be used to finance future premiums

variable life insurance  policy holders chooses how to invest premiums  benefits/value depend on investment returns variable life insurance  policy holders chooses how to invest premiums  benefits/value depend on investment returns

other issues For a group, mortality rate is predictable timing & amounts of claims are predictable  Focus on longer term investments For a group, mortality rate is predictable timing & amounts of claims are predictable  Focus on longer term investments

Property & Casualty auto, home insurance timing/size of claims unpredictable separate industry auto, home insurance timing/size of claims unpredictable separate industry

Big losses for P&C 1992 Hurricane Andrew  $15.5 billion  today $30 billion 9/11 WTC attack  $35 billion 1992 Hurricane Andrew  $15.5 billion  today $30 billion 9/11 WTC attack  $35 billion

Pension Funds Defined benefit plans Defined contribution plans Federal law does not require pensions, but does regulate them Defined benefit plans Defined contribution plans Federal law does not require pensions, but does regulate them

Defined benefit plans employer promised employee monthly payments during retirement -- life contingent -- choice of survivor benefits employer promised employee monthly payments during retirement -- life contingent -- choice of survivor benefits

How is payment determined? formula  salary -- average last several years -- average of best years  years of service with sponsor formula  salary -- average last several years -- average of best years  years of service with sponsor

VestingVesting minimum years of service necessary to receive benefits  complex federal rules about vesting  5-7 years max for full vesting minimum years of service necessary to receive benefits  complex federal rules about vesting  5-7 years max for full vesting

AdvantagesAdvantages (for employee) limited investment risk  payments promised reguardless of portfolio return  but sponsor bankruptcy could affect payment size (for employee) limited investment risk  payments promised reguardless of portfolio return  but sponsor bankruptcy could affect payment size

no risk of outliving assets  payments life contingent, NOT lump sum no risk of outliving assets  payments life contingent, NOT lump sum

DisadvantagesDisadvantages lack of portability from job to job  largest benefits accrue after 20 years  DB plans encourage loyalty lack of portability from job to job  largest benefits accrue after 20 years  DB plans encourage loyalty

lack of control  how pension funds are invested  is sponsor investing enough? -- is pension fully funded? lack of control  how pension funds are invested  is sponsor investing enough? -- is pension fully funded?

Defined Contribution Plans employee/individual contributes funds  employer may match contributions employee chooses among investment options  range of choice varies among sponsors employee/individual contributes funds  employer may match contributions employee chooses among investment options  range of choice varies among sponsors

amount accumulated at retirement depends on investment performance lump sum at retirement  decision about spending  possible purchase an annuity amount accumulated at retirement depends on investment performance lump sum at retirement  decision about spending  possible purchase an annuity

types of DC plans employer sponsored  401(k), 403(b), 414(h), 457 individual  IRA, Roth IRA employer sponsored  401(k), 403(b), 414(h), 457 individual  IRA, Roth IRA

Advantages (employee) portability  value accumulates steadily  balance rolled over to new plans cash value build up  cash out (tax penalty)  borrow against  survivor benefits portability  value accumulates steadily  balance rolled over to new plans cash value build up  cash out (tax penalty)  borrow against  survivor benefits

DisadvantagesDisadvantages employee bears investment risk retiree risks outliving assets employee bears investment risk retiree risks outliving assets

corporate defined contribution plans  hold over 25% of assets as own company stock -- Enron 60% -- Anheuser Bush, Coca Cola, McDonald’s over 74%  big lack of diversification -- but easier to match 401(k) contributions w/ stock than w/cash corporate defined contribution plans  hold over 25% of assets as own company stock -- Enron 60% -- Anheuser Bush, Coca Cola, McDonald’s over 74%  big lack of diversification -- but easier to match 401(k) contributions w/ stock than w/cash

GSEsGSEs Government charter to create private firms to intermediate debt markets Fannie Mae, Freddie Mac  Home mortgages Sallie Mae  Student loans Government charter to create private firms to intermediate debt markets Fannie Mae, Freddie Mac  Home mortgages Sallie Mae  Student loans

All borrow short term  (commercial paper) And lend long-term Implicit gov’t guarantee Highly leveraged: 30 to 1  High default rate could bankrupt them All borrow short term  (commercial paper) And lend long-term Implicit gov’t guarantee Highly leveraged: 30 to 1  High default rate could bankrupt them