1. 1 Lecture 19: Evolution of banking industry in the U.S. Mishkin Ch 10 – part A page 247-261

2. 2 Introduction Features of banking industry in the U.S. 1. dual banking system 2. separation of investment banking and commercial banking 3. multiple regulatory agencies 4. decline of traditional banking Explained by two forces in evolution of banks 1. Regulation 2. Financial Innovation

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4. 4 Regulation Alternation of federal chartered banks and state chartered banks in history. Today, the U.S. has a dual banking system in which banks supervised by the federal government and banks supervised by the state coexist.

5. 5 Regulation Glass-Steagall Act (Banking Act of 1933) is an important act:  created the Federal Deposit Insurance Corporation (FDIC) to provide federal insurance to deposits  restricted interest payments on checkable deposits and interest rate ceilings were imposed on time deposit accounts (regulation Q)  imposed separation between commercial banking and investment banking

6. 6 Multiple regulatory agencies Comptroller of the Currency  national banks The Fed and state banking authorities  state banks that are members of the Fed Fed  bank holding companies FDIC  insured state banks that are not Fed members State banking authorities  state banks without FDIC insurance

7. 7 Financial innovations Changes since 1960s 1. inflation and interest rates are at higher levels and more volatile 2. computer technology makes information production simple 3. significant new legislation has been enacted Financial innovation is driven by bank’s desire to earn profits. Change in the financial environment lead to financial innovations.

8. 8 Responses to changes in demand conditions: interest rate volatility Adjustable-rate mortgages  Adjustable when market interest rate (6 month T-bill rate) change  Low initial interest rates make them attractive to home buyers; but still flexible to keep banks’ profits high when rates rise. Financial derivatives  To hedge interest-rate risk

9. 9 Responses to changes in supply conditions: Information Technology improved computer technology leads to 1. lower transaction costs 2. easier for investors to acquire information, screening bank credit and debit cards electronic banking junk bonds commercial paper securitization: e.g. mortgage-backed securities

10. 10 Avoidance of regulations: loophole mining Reserve requirements It is like a tax on deposits interest-rate ceilings (regulation Q) As i   disintermediation loophole mine to escape these regulations: money market mutual funds  just like interest earning checking accounts for consumers  not subject to reserve requirements and interest rate ceilings

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12. 12 Decline of traditional banking Traditional banking business: lending funded with deposits, traditional financial intermediation role of banking. Information technology has lowered transaction costs for other financial institutions, increasing competition. 1. Decline in cost advantages in acquiring funds (liabilities): e.g. deposit rate ceiling  savors switch to mutual market funds, disintermediation. 2. Decline in income advantages on uses of funds (assets): information technology  easier screening  decreased need for loans.

13. 13 Banks’ responses Banking industry and profitability not in decline. 1. Expand into new and riskier areas of lending  Commercial real estate loans  Leveraged buyouts and corporate takeovers 2. Pursue off-balance-sheet activities In the past, 7% of total bank income  now 44%!