1. Chapter 11, 4 th edition Chapter 12, 3 rd edition Commercial Banking Industry Structure

2. Preview This chapter examines the historical trends in the banking industry that help explain the unique structure of the U.S. system.

3. Overview US banking system very different from rest of the world. Many small banks. U.S. has about 7,000 commercial banks for a population of about 300 million. This is down from 14,000 in the mid 1980’s. Canada has 21 banks for about 36 million. Norway has 4 banks for 4.5 million.

7. Why is the US Unique? Need to look at the history of banking in the US.

8. Need to look back to the 1700’s Jefferson States rights Limit federal power No national or central bank State control of banking Hamilton Federal rights Expand Government and centralize power National or central bank Federal control of banking

9. Figure 1 Time Line of the Early History of Commercial Banking in the United States

10. Early History 1791 - Bank of the United States chartered for 20 years. First attempt at a central bank to controlled money supply and credit. Agricultural interest very skeptical of concentration of power in large eastern cities, advocated state charters. 1811 - charter not renewed. Defeated by states rights and agricultural interests.

11. Early History – 1800’s War of 1812 – need to raise funds, some felt need for a national/central bank. 1816 - second attempt at central bank. Second Bank of the United States chartered for 20 years this was only 5 years after the 1 st elapsed. 1832- Andrew Jackson elected. Congress votes to re-charter, Jackson, a strong advocate of states rights, vetoes.

12. Free Banking Era:1832- 1863 Banks chartered and regulated only by the states No national currency Banks issued private bank notes (that could be redeemed for gold) to attract funds Think about going to Tennessee with a bank note issued by a bank in Philadelphia. Money is supposed to reduce information cost and facilitate trade – not the case here! Poor regulation, many banks under capitalized, many failed, bank notes became worthless.

13. National Banking Act of 1863 Created federally chartered banks under supervision of the Office of the Comptroller of the Currency. Tried to eliminate state banks by imposing a 10% tax on state bank notes. Tax did eliminate bank notes but not state banks. Today we have a “dual banking system” 2,100 federally chartered banks with 50% of total bank assets.

14. Early History Summary Phobia against large banks and central banking which carried into the 20 th century. State banking system developed in the US rather than the typical national banking system in other countries. Federally chartered banks in 1863. Today, we have a dual banking system in the US.

15. 1900s 1913 - The Federal Reserve System 1927 - McFadden Act - prohibited branch banking across lines 1930 - 1933, the Great Depression - Banking Act of 1933/ Glass-Steagall Act - Set up the FDIC and deposit insurance. - Separated commercial and investment banking. - Restricted checkable deposits to commercial banks - Put interest rate ceilings on bank deposits ( Regulation Q )

16. McFadden Act - 1927 Proposed as being pro-competitive. Actually anti-competitive because small banks insulated from out-of-state competition. Some states had “unit banking” – No branches! Big Negative - banks tied to local economy as a result of McFadden Act. From 1930-1933, 9000 banks failed in the US(1/3), compared to 0 in Canada.

17. How to get around regulations prohibiting branching across state lines Bank Holding Companies - Allowed purchase of banks outside state Automated Teller Machines - Not considered to be branch of bank McFadden Act repealed in 1994 by Reigle-Neal Act

18. Key Legislation Affecting the U.S. Banking Industry 1913 Federal Reserve Act 1927 McFadden Act: Outlawed interstate branching and required national banks to abide by the laws of the state in which they operated. 1933 Glass-Steagall Act: Established federal deposit insurance and prohibited commercial banks from engaging in the insurance and securities businesses. 1994 Reigle-Neal Act: Repealed the McFadden Act 1999 Gramm-Leach-Bliley Act: Repealed the Glass-Steagall Act’s prohibition of mergers between commercial banks and insurance companies or securities firms.

19. Financial Innovation and the Decline of Traditional Banking – Attack on the balance sheet Commercial bank importance as a source of funds to non-financial borrowers has fallen over time. Without a decline in overall profitability

20. Bank Share of Total Nonfinancial Borrowing: 1960–2014 Source: Federal Reserve Bank of St. Louis, FRED data base: http://research.stlouisfed.org/fred2/; https://www2.fdic.gov/hsob/index.asp. 40% 20% 28% 5%

21. Financial Innovation, Increased Competition for Sources of Funds Prior to 1980s - Regulation Q 60% of bank funds were deposits (now 6%) 1970s - π↑ => i↑ ( Fisher Equation) Major Financial Innovation Money Market Mutual Funds (MMMF) Disintermediation – banks lost deposits to MMMF. Mishkin says this is disintermediation. Regulation Q eliminated in 1980, but banks lost Cost Advantages in Acquiring Funds

22. Financial innovations leading to increase in direct finance – Competition for Use of Funds Junk Bonds Commercial Paper GE Capital is an example of a commercial finance company. At one point the largest issuer of commercial paper in the US. Commercial paper Loans to buyers of GE products

23. Financial Innovation: Junk Bonds Prior to 1980, bonds were never issued that had a junk rating. Only firms with Baa or better could direct finance in the bond market. The only junk debt was bonds that had fallen in credit rating (so-called fallen angels). With improvement in information technology in the 1970s it became easier for investors to screen out bad credit from good credit risks and willing to buy new issue debt rated < Baa.

24. Financial Innovation: Commercial Paper Market Commercial paper refers to unsecured debt issued by corporations (non-financial and financial) with a short maturity. Peaked at $2.2 trillion outstanding mid 2007. As with junk bonds, improvement in information technology in the 1970s made it easier for investors to screen out bad credit from good credit risks Also, the development of money market mutual funds in the 1970s contributed to growth by creating a market for commercial paper.

25. 13-25 Commercial Paper Outstanding: 2001 - 2014

26. 13-26 Commercial Paper and ABCP Outstanding: 2001 - 2014

27. Bank Response Banks loss cost advantages in raising funds and income advantages in making loans reduction in profitability in traditional banking Two Responses: Expanded into new and riskier areas of lending Commercial real estate loans Corporate takeovers and leveraged buyouts Increased income from off-balance-sheet activities (non-interest income) Trading activities

28. Bank Consolidation and Nationwide Banking The number of banks has declined over the last 25 years Combination of bank failures and consolidation. Deregulation: Riegle-Neal Interstate Banking and Branching Efficiency Act f 1994. Economies of scale and scope from information technology. Not only a smaller number of banks but a shift in assets to much larger banks.

29. Figure 3 Number of Insured Commercial Banks in the United States, 1934–2014 (Third Quarter) Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

30. 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

31. Examples of Avoiding Regulation Eurodollars Dollar denominated deposits in foreign banks or foreign branches of US banks. Sweep Accounts: Funds are “swept” out of checking accounts nightly and invested at overnight rates. Since they are no longer checkable deposits, reserve requirement is avoided.

32. Eurodollars New York BankCayman Branch of NY Bank DD= $1,000,000Reserves= $100,000 Loans= $900,000 DD= $1,000,000 Borrow from Cayman Branch= $1,000,000 Loans= $1,000,000 New York Bank

33. Separation of the Banking and Other Financial Service Industries Erosion of Glass-Steagall 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

34. Banking Act of 1933 SEC. 20. After one year from the date of the enactment of this Act, no member bank shall be affiliated in any manner described in section 2 (b) hereof with any corporation, association, business trust, or other similar organization engaged principally in the issue, flotation, underwriting, public sale, or distribution at wholesale or retail or through syndicate participation of stocks, bonds, debentures, notes, or other securities. http://www.pbs.org/wgbh/pages/frontline/sho ws/wallstreet/weill/demise.html

35. 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 Separation of the Banking and Other Financial Service Industries