1. Banking in the U. S. ECO 473 Dr. D. Foster I. Asymmetric Information II. Structure

2. I. Problems of Asymmetric Information

3. Direct & Indirect Finance Most external financing is done through intermediaries.

4. Banks Reduce Transaction Costs Banks reduce the cost of acquiring assets. Many costs are fixed. Bank assets are highly liquid. Economies of scale.  e.g., using standard loan contracts as legal fees are averaged over many loans Transactions costs are very low for lines of credit.

5. Adverse Selection Those most eager to make a deal are the least desirable to the other party.  Bad risks want loans.  Firms with lots of risk want to sell bonds. Risk drives up interest rate & drives out low risk borrowers, if this problem persists.

6. Moral Hazard Post-contractual change in behavior that puts other party at increased risk.  Will borrower really be prudent and repay?  Will company really be prudent and max. profits?  Does insurance reduce vigilance? Markets cannot form if this persists.

7. Principal-Agent Problems The action of the agent is contrary to the desires of the principal.  Workers shirk at their jobs.  Managers are also agents - they work for owners- shareholders.  Can bond-holders and stock-holders really monitor the firm? Problems: Enron, Arthur Anderson

8. How do Banks Deal with Asymmetries? Screen borrowers.  Avoids free rider problems with information. Requirements for collateral and net worth.  Shifts risk to the borrower; avoids adverse selection.  Also, mitigates moral hazard. Imposing covenants and monitoring.  Reduces moral hazard. Variable interest rates and credit rationing.  Some tolerance for risk. Should the government get involved with asymmetries?

9. Investment Banks & Asymmetries They provide research on firms. They underwrite new securities. Advantages:  They work to show firms are not lemons.  Long-run reputation at stake. Disadvantages:  Are they serving the firm or the client?

10. II. Banking Structure in the United States

11. Institutions... Commercial Banks  “Money Center” banks  Regional (& Super-) banks  Community Banks Savings Institutions  Lost 50% of deposits 1989 - 2001  1980s - Congress relaxes lending rules Credit Unions  1934-strict member rules; relaxed since.  no fed’l tax -  deposit rates &  loan rates

12. Commercial Bank Assets ($ Billions), January 2009 Commercial & industrial loans 1,601.1 13.6% Consumer loans 869.8 7.4% Real estate loans 3,805.0 32.2% Interbank loans 389.8 3.3% Other loans 915.6 7.7% Total loans 7,581.3 64.1% U.S. government securities 1,273.0 10.8% Other securities 872.77.4% Total securities 2,145.7 18.2% Cash assets 967.3 8.2% Other assets 1,123.6 9.5% Total assets 11,817.9 100.0% June 2013 1,546.8 11.4% 1,136.5 8.4% 3,542.2 26.1% 123.5 0.9% 941.6 6.9% 7,302.8 53.9% 1,838.9 13.6% 891.16.6% 2,730.0* 20.1% 2,144.4 15.8% 1,383.8 10.2% 13,548.8 100.0% * $1,357.4 bill. is in mortgaged- backed securities (MBS)

13. Commercial Bank Liabilities and Equity Capital ($ Billions), January 2010 Transactions deposits 810.3 Small time and savings deposits 4,974.3 Large time deposits 1,865.8 Total deposits 7,650.4 Borrowings from banks $ 261.1 Other borrowings 1,636.6 Total borrowings 1,887.7 Trading liabilities 261.2 Other liabilities 399.1 Equity capital 1,273.4 Total liabilities & equity 11,451.8 7.1% 43.4% 16.2% 66.8% 2.2% 14.3% 16.5% 2.2% 3.5% 11.1% 100.0% June 2013 --- --- 7,882.158.2% 1,546.3 11.4% 9,428.469.6% 142.21.0% 1,385.110.2% 1,527.2* 11.3% 237.31.7% 448.43.3% 1,511.8 11.2% 13,548.8 100.0%

14. Commercial Bank Asset Allocations

15. Commercial Bank Liabilities and Equity Capital

16. Misc. Data on Banks & Savings Institutions (FDIC)

17. Misc. Data on Credit Unions (FDIC)

18. The Top Ten Banks* Based on Deposits in the United States (FRS) FRS *Bank Holding Companies As of March 31, 2014 Assets in thousands of dollars.

19. Sources of Commercial Bank Revenues Commercial Bank Expenses

20. Equity as a Percentage of Bank Assets in the United States, 1840–Present

21. Evolution of theories of bank management & risk. Real bills doctrineReal bills doctrine Shiftability theoryShiftability theory Anticipated incomeAnticipated income Conversion of fundsConversion of funds Gap managementGap management Duration gap managementDuration gap management

22. Real bills doctrine – managing liquidity riskReal bills doctrine – managing liquidity risk Shiftability theory Anticipated income Conversion of funds Gap management Duration gap management  Make low-risk loans with high liquidity…  Lend to finance shipment of goods:  Lend to finance shipment of goods: -- paid off quickly to known buyer. -- earns low return.  Lend for production…  Lend for production… -- “self-liquidating” loans; repaid as sold. -- relatively low risk.

23. Real bills doctrine Shiftability theory – managing credit riskShiftability theory – managing credit risk Anticipated income Conversion of funds Gap management Duration gap management   Return with longer-term loans…   Return with longer-term loans… -- adds to the default risk. -- offset with purchases of gov’t. securities. - “Secondary reserves” add liquidity.  Popular until the Crash of 1929:  Popular until the Crash of 1929: -- falling prices means converting to cash involves a capital loss. -- exacerbated circumstances, as loans were going into default as well.

24. Real bills doctrine Shiftability theory Anticipated income - managing interest rate riskAnticipated income - managing interest rate risk Conversion of funds Gap management Duration gap management  Initiation of the “installment loan”…  Initiation of the “installment loan”… -- mitigates default risk through ongoing payments. -- gives the bank a highly predictable stream of income. -- has features that make it a “super- liquidating” loan.

25. Real bills doctrine Shiftability theory Anticipated income Conversion of funds - managing interest rate riskConversion of funds - managing interest rate risk Gap management Duration gap management  Match asset & liability maturities…  Match asset & liability maturities… -- long-term loans with CDs. -- short-term loans with deposits.  Events that change interest rates will be neutralized.

26. Real bills doctrine Shiftability theory Anticipated income Conversion of funds Gap Management – managing profit Duration gap managementGap Management – managing profit Duration gap management  Relate assets & liabilities by interest…  Relate assets & liabilities by interest… -- manage the “gap” to bank’s advantage. -- if r e is rising, then make gap positive. -- if r e is falling, then make gap negative.  Measure ave. time for payments (in or out)…  Measure ave. time for payments (in or out)… -- if positive and interest rates fall, bank profits rise. -- if negative and interest rates rise, profits rise.

27. Does Bank Size Matter? Economies of scale -- Efficient structure theory. -- Cost savings seem minor; mgt. savings. Concentration will... -- raise costs? -- lower costs? Consolidation stats (1990 vs. 2007): Community bank % of total bank assets: 22% v. 11% Top 10 bank % of total bank assets: 17% v. 40%

28. Universal Banking Banks own firms -- Better informed about financial condition. -- Conflict of interest? Firms own banks -- Does the FED regulate the firm as well? Banks do... Whatever (economies of scope): -- Insurance. -- Real estate. -- Stock brokers.

29. Banking in the U. S. ECO 473 Dr. D. Foster I. Asymmetric Information II. Structure

30. Case: Bank Branching in Illinois Very restrictive branching laws.Very restrictive branching laws.  “Unit banking” only, as per 1870 state constitution.  1967 - banks could build a “drive up” facility within 1500 feet of the unit bank.  1985 - banks could have 5 offices; 2 could be in other counties if within 10 miles.  1993 – prohibitions on branching removed. June, 2006 – 4,349 branch banking offices.June, 2006 – 4,349 branch banking offices.

31. Why deregulate? -- Tech. change. -- Failing banks. -- Profit potential. -- Legal environment.Why deregulate? -- Tech. change. -- Failing banks. -- Profit potential. -- Legal environment. Case: Bank Branching in Illinois