Banking Industry: Structure and Competition chapter 16 Mishkin & Eakins Across institutions and countries the basic functions of banks have a good deal of similarities. The US has a particularly diverse and well-developed banking system and, from a relative perspective, a very large number of banking institutions. This chapter covers the historical development of the banking system in the U.S. and also the development of the global banking system. Banking Industry: Structure and Competition

Historical Development of the Banking Industry Initially a great controversy over the role of the federal government. From the beginning foundations of this country there has been a great debate on the issue of states rights vs. federal rights. The “founding father” of the federalist movement was Alexander Hamilton and the federalists lobbied for a centralized banking system at the federal level. In 1791 the first central bank was established as the Bank of the United States. The states rights battle continued to wage and in 1811 states rights advocates successfully lobbied to have the charter of the bank withdrawn. The War of 1812 and a period of instability in the banking system led to the creation of the Second Bank of the United States being established in 1816. In the election of 1832, Andrew “Stonewall” Jackson as elected on a states rights platform and he led Congress to abolish the bank once again when its charter lapsed in 1836. Banks were still chartered but under the auspices of state governments rather than federal governments. Banks issued their own notes redeemable in bullion (gold or silver certificates) and we had no national currency until 1863. The patchwork of state regulation led to some bank failures and, of course, the solution was to once again establish federal control. The National Bank Act of 1863 created federally-chartered banks under the control of the Office of the Comptroller of Currency. It also placed a prohibitive tax on the issue of banknotes for state-chartered banks in an attempt to consolidate control at the federal level. State banks remained because they were able to attract the money of depositors and the rest “is history!” Outcome: Multiple Regulatory Agencies 1. Federal Reserve 2. FDIC 3. Office of the Comptroller of the Currency State Banking Authorities

Federal Regulation 1913 - Federal Reserve System created The economic collapse of the banking system during the Great Depression ushered in additional regulation. 1933 - Federal Deposit Insurance Corporation (FCIC) formed 1933 - Glass-Steagall Act of 1933 separating out commercial banking from investment banking In 1913 the Federal Reserve System was created and all national banks were required to become a part of it. State banks were not required to join and due to the costs of joining and distrust of the federal authorities most did not join. The economic collapse of the banking system during the Great Depression ushered in bank failure upon bank failure. Approximately 9000 banks closed their doors. In 1933 the Federal Deposit Insurance Corporation was formed. In addition, the Glass-Steagall Act of 1933 created a number of barriers in the banking industry. Basically, a strict firewall was constructed between investment banks and commercial banks. Commercial banks were no longer allowed to underwrite stocks and all debt issue was placed under the control of the regulatory authorities. Investment banks were prohibited from offering the same services a commercial banks. This effectively separated the two types of banking until the repeal of Glass-Steagall in 1999!

Structure of the Commercial Banking Industry Approximately 8600 Commercial Banks distribution above. This distribution is far more diverse that in most countries. Reasons for this is the protection of small banks by state and federal legislation. This is one place where a large number of suppliers indicates anti-competitive behavior due to barriers to entry. Deep populism and a distrust of large, especially large non-local banking institutions combined with the ongoing theme of states rights versus federalization of the banking system led to a labyrinth of overlapping banking regulatory authorities. Congress has historically resisted a more centralized system – not due to any principled reason concerning state rights anymore but the political power of the jobs and entities in the state regulatory appartik.

Ten Largest U.S. Banks List of the ten largest banks. Note that they hold about 37% of assets. Very low relative to other countries with more concentrated commercial banking. Due primarily to banking regulation and restrictions.

Branching Regulations Branching Restrictions: McFadden Act (1927) and Douglas Amendments (1956) Very anti-competitive results Response to Branching Restrictions 1. Bank Holding Companies (BHCs) 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. 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 McFadden Act of 1927 and Douglas Amendment of 1956 severely restricted branch banking – all banks were forced to comply with state legislation and the states used the law to exclude “foreign competition.” This laws protected local banks very effectively and customers were left with localized monopolies. Many Americans were not disturbed by this – deep populist political streak, memories of bank failures, envy of those with money, and the states rights movement all formed effective legislative and political barriers to competition in the banking industry in the nineteenth century through the mid-20th century. Responses over the years to Branching Restrictions Banks used the concept of “bank holding companies” to enable them to operate across state borders more effectively. The holding company owns other corporations. A. Allowed purchases of banks outside state – “hold” a bank in Florida, one in Georgia and one in Alabama and you can effectively open “branches” in each state. B. BHCs allowed wider scope of activities by Fed (e.g., investment services and advice, credit card services, expanded loan services, data processing and transmission of data services) C. BHCs dominant form of corporate structure for banks – over time, it became difficult to compete if you did not offer the widerrange of services which organizing as a bank holding companies created 2. Nonbank Banks Not subject to branching regulations, but loophole closed in 1987 The Bank Holding Act of 1956 defined banks as institution that both accept deposits and make loans. A loophole was created where you could have banks that did one or the other – as long as they didn’t do both – and Non-bank Banks were created! The loophole was exploited and then closed in 1987 by the Competitive Equality Bank Act. 3. Automated Teller Machines Not considered to be branch of bank, so networks allowed State and federal regulatory authorities found that ATMs were not considered branches so this technological innovation led to a wide expansion and the networking of these machines across the country and the world. Nationwide networks of these machines include Cirrus and NYCE.

Bank Consolidation and Number of Banks For a host of reason (covered in next slide) we have seen a developing wave of bank consolidation. Between 1985 and 1992 we saw 3000 banks go away About ½ were failures and ½ were buy outs. Between 1992 and 1998 we saw another 2500 banks go away Less than 7% were bank failures Over 93% were buy outs and mergers The banking industry has been characterized by merger and consolidation activity

Bank Consolidation and Nationwide Banking Bank Consolidation: Why? 1. Branching restrictions weakened 2. Development of super-regional banks Riegle-Neal Act of 1994 1. Overturns McFadden and Douglas - allows for full interstate branching Promoted further consolidation due primarily to economics of scale (Examples: Bank of America and Banc One) Bank Consolidation: Why? Branching restrictions weakened – expansion became attractive to banks Economics of scale Diversification of assets and liabilities 2. Development of super-regional banks “Riegle-Neal Interstate Banking and Branching Efficiency Act” of 1994 Overturns McFadden and Douglas - allows for full interstate branching. As of June 1997 there a bank can merge branches located in other states into the bank and bank holding companies are not the only way to engage in branch banking. Holding companies are inefficient relative to one bank capable of interstate branch activity. The economies of scale promoted further consolidation (Examples: Bank of America and Banc One) Riegle-Neal opened up banking to a nation-wide system.

Future of Industry Structure in the United States Fewer and larger commercial banks We will become more like other countries, but not exactly similar due the effects of historical realities Research work expects several thousand institutions in the U.S. rather than the more typical several hundred

Bank Consolidation and Nationwide Banking Fear of decline of small banks and small business lending Fear of monopoly by public (no such fear by experts) 3. Rush to consolidation may increase risk taking Pros: 1. Community banks have and will continue to survive 2. Increased competition for banks means consumers gain the benefits of competition among suppliers 3. Increased diversification of bank loan portfolios will lessen the likelihood of bank failures

Separation of Banking and Securities Industries Erosion of 1933 Glass-Steagall Act provisions over time Glass-Steagall created many firewalls within the financial institution structure. Under the regulatory environment that developed commercial banking, real estate, investment brokerages, insurance and investment banking were all separated from one another. Competitive pressures had all of these institutions looking for ways to link one to the other and take advantages of economies of scope. Investment Brokerages opened money market funds and allowed customers to write checks on the accounts encroaching on commercial banking services yet under Glass Steagall the banks could not impinge into the activities of the investment houses In 1987 the FED opened a loophole which allowed banks to begin underwriting the issue of corporate securities. Restrictions were set in place but overturned in the courts. Financial institutions began dabbling in real estate and insurance International competition began and those banks were not subjected to all aspects of our regulatory environment or if based off-shore to none of the requirements.

Gramm-Leach-Bliley Financial Services Act of 1999 The 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 5. Banking institutions become larger and more complex As a result the facade of Glass-Steagall began to fall and in 1999 Glass-Steagall was repealed. Effects: 1. Allows securities firms and insurance companies to purchase banks 2. Banks allowed to underwrite insurance and engage in real estate activities 3. Office of the Comptroller of the Curency 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 5. Banking institutions become larger and more complex as a result of these changes

A Brief Overview - The Thrift Industry Beyond commercial banking… Savings and Loans Associations Mutual Savings Banks Credit Unions

Savings and Loans Regulators 1. Office of Thrift Supervision 2. Federal Home Loan Bank System (FHLBS) 3. FDIC’s Saving Association Insurance Fund (SAIF) 4. State banking authorities Structure Fewer restrictions on branching Strong vestiges of “single-purpose” origin A major source of of mortgage loans to finance single-family and multi-family housing. S&Ls began as a single-product industry focusing solely on home loans. Many of them are “mutual” institutions meaning they are owned by their depositors and thus they issue no stock. Innovation and competition has changed this and some S&Ls are now issuing stock just as commercial banks do. The institutions that do are much larger than traditional S&Ls.

S&Ls - Assets and Liabilities Primary Assets for S&Ls Mortgages (60.1%) US Govt and Federal Agency Securities (15.5%) State and Local Bonds (6.2%) Consumer credit (4.6%) Loans to business are only 1.9%. Primary liabilities for S&Ls Small time and savings deposits (41.4%) Checkable deposits (16.4%) Borrowings from the Federal Home Loan banks and other banks (14.2%) Large time deposits of over $100,000 (10.2%)

Mutual Savings Banks Regulators 1. FDIC 2. States Structure 1. 400 or so and similar to S&Ls Within state branching, regulations not restrictive, so there are few small MSBs Located primarily in the Northeast US May insure deposits with the FED: S&Ls may not Not as heavily invested in home mortgages as S&Ls

Credit Unions Regulators 1. National Credit Union Administration (NCUA) 2. States Structure Because must have “common bond” among depositors Tax exempt status linked to “common bond” Mostly institutions are small with deposits < $10 million

Credit Unions Rapid growth over the last few decades… U.S. Assets in 1980 $68,974 m U.S. Assets in 1990 $221,759 m U.S. Assets in 1996 $336,452 m Worldwide in 1996 36,244 Credit Unions 89,658,210 Members $379.3 billion (U.S) in Assets

Credit Unions Primary Assets for Credit Unions Consumer Installment Loads (39.6%) Home mortgage and equity loans (25.3%) US Govt and Federal Agency Securities (18.9%) Time and Savings Deposits (4.9%) Primary liabilities for Credit Unions Small time and savings deposits (82.1%) Checkable deposits (11.34%) Large time deposits of over $100,000 (4.8%).

Separation – Other Countries Separation in Other Countries 1. Universal banking: Germany 2. British-style universal banking Japanese-style separation Universal Banking provides no separation among financial entities and banks are allowed to hold equity stakes in corporations. Universal Banking – British Style. Separate legal subsidiaries are more common Equity holdings by banks are less common Banking and Insurance combinations are less common Japan Separation Banking and Financial Services industry combinations are illegal Equity holdings by banks are common BHCs are illegal

International Banking Spectacular growth over the last 40 years 1. Rapid growth of international trade and multinational corporations 2. Banks abroad can pursue profitable activities that are precluded by the regulatory environment in home country 3. Tap into Eurodollar market Eurodollars are any US dollar deposits held outside of the US Over 90% of them are held as time deposits Huge market – over $5 trillion Why? US dollar is an international currency and a lot of international trade is carried out in dollars Eurodollars are “offshore” deposits and hence not subject to reserve requirements Helped to fuel expansion of US banks overseas

International Banking U.S. Banks Overseas 1. Regulators A. Federal Reserve (Regulation K) 2. Structure A. Edge Act Corporations International Banking Facilities Most foreign branches are in Latin America, London (Europe), Far East and Caribbean London remains a world financial center, Caribbean is a “tax haven” Regulation occurs under the Fed Edge Act Corporations: an alternative corporate structure sets up special subsidiaries to the bank International Banking Facilities were approved by the Fed in 1991. These facilities are in the US and can accept deposits from foreigners that are not subject to reserve requirements or restrictions on interest payments. They can also make loans to foreigners. Encouraged by states giving tax exempt status.

International Banking Foreign Banks in U.S. 1. Regulators Same as for U.S. domestic banks under the International Banking Act of 1978 Foreign Bank Supervision Act of 1991 2. Structure A. 500 offices in U.S. B. 20% of total U.S. bank assets

Ten Largest Banks in the World

Financial Innovation and Decline in Traditional Banking Innovations Increasing Competition 1. Money market mutual funds Avoids deposit rate ceilings and reserve requirements 2. Junk bonds Result of better information in credit markets 3. Commercial paper market Result of better information in credit markets and rise in money market mutual funds 4. Securitization Result of better information in credit markets and computer technology There are four major driving forces that have affected the banking system and industry in the US. 1. Money market mutual funds Avoids deposit rate ceilings and reserve requirements – they are not legally deposits and because these costs are avoided, they pay slightly higher rates. Historically, banks held to Regulation Q price ceilings (5.5% on deposits) – not an issue until the late 1970s and then a huge issue. 2. Junk bonds Result of better information in credit markets. Bonds with low ratings – clearly more risky. But upside – before junk bonds only well-established companies could use the debt market to raise funds. Junk bonds opened up the debt market to small and medium firms. Partly due to increased availability of financial information due to computerization and telecommunications. 3. Commercial paper market CP is short term debt security issued by large banks and corporations. Huge growth from $33 b in 1970 to $1200 b in 1999. Result of better information in credit markets allowing for better risk assessment and screening and the rise in money market mutual funds – a large pool of idle cash is costly to hold! They need to be liquid and holfd high quality securities – CP filled that role well. 4. Securitization Result of better information in credit markets and computer technology. The process of transforming illiquid assets into liquid assets. Take a home mortgage – if it is not liquid it represents a 30 year commitment. These used to be held in the balance sheet of banks for long periods – now we have developed secondary markets and increased liquidity. Computerization has lowered the transactions costs of this activity greatly. It also allows for more transparency. Banks “strip” the mortgages and sell of the interest payments and principal payments – get the mortgages off of the balance sheet and show a realized profit from the sale of the stripped out security.

The Decline in Banks as a Source of Finance

Bank Profitability

Share of Noninterest Income

Disintermediation – the decline of Traditional Banking Loss of Cost Advantages in Acquiring Funds (Liabilities) Disintermediation occurred due to 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 1. Deposit Rate Ceilings and Regulation Q held interest rate payments to deposits down. This was good for banks when rates were very low but a disaster in the 1970s. Bank profits were squeezed and the search for ways around reserve requirements and rate ceilings began in earnest. Once the genie was out of the bottle. 2. Money Market Mutual Funds 3. Foreign banks have cheaper source of funds: Japanese banks can tap large savings pool

Bank Failures

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