1. Chapter 10 Banking Industry: Structure and Competition

2. Introduction The operations of banks (how they get, use and manage money to make a profit) are the mostly the same throughout the world. In all countries, banks are financial intermediaries in the business of earning profits. When you think about the structure and operation of the banking industry, the United States, is a quite different from other countries mainly because there are so many banks. In this chapter we will look at the history of US banking and also the structure of the banking industry. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-2

3. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-3 Introduction – History of US Banking The US started with only a Central Bank but the States did not like the centralized power. So….. State banks were chartered by state governments National banks chartered by federal government beginning in 1863 Both exist together today – a duel banking system

4. Introduction – History (continued) The Federal Reserve (FED) was created in 1913 to promote a safer banking system  It was required that all banks become members of the Fed The banks are now regulated by the Fed Before 1933, the 2 functions of banking and investments were combined into one company which created many problems and a reason for the creation of the FED. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-4

5. Introduction – History (continued) Investment banking activities of commercial banks were blamed for bank failures during the Great Depression in the 1930’s  Banks were too integrated into financial markets Glass-Steagall Act was passed in 1933 to separate the two banking functions or operations  Limit risk Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-5

6. Introduction – History (continued0 Glass-Steagall Act was abolished in 1999 as an act of de-regulation from the government. Now securities firms and insurance companies could purchase banks Banks are now allowed to underwrite securities and engage in real estate activities Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-6

7. Introduction What is the main function of banks?  To move money from the unproductive activities to productive activities How do they do this? Two main functions:  Commercial banking Takes deposits and turn it into loans for businesses  Investment banking Underwrite securities (debt, equity); find people to invest in these assets

8. Evolution of the Banking Industry Must understand process of Financial Innovation Banks in the financial industry earn profits by buying and selling products  Develop products to satisfy needs of their customers  Innovate  Driven by desire to GET RICH Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-8

9. Evolution of the Banking Industry A change in the financial environment will cause financial institutions to develop more innovative financial products that will be profitable The above statement is defined as: Financial engineering Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-9

10. Evolution of the Banking Industry 3 reasons for financial innovation:  Response to changes in demand conditions  Response to changes in supply conditions  Avoid regulations Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-10

11. Responses to Changes in Demand Conditions: Interest Rate Volatility Interest Rate Volatility  Most significant change in economic environment that will alter demand  Large fluctuations lead to greater uncertainty about returns on investments The larger the movement in interest rates the larger the capital gain or loss Interest-rate risk Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-11

12. Responses to Changes in Demand Conditions: Interest Rate Volatility Increase in interest-rate risk  Create demand for products to reduce this risk Saw a change in the economic environment by an increased volatility in interest rates (instability)  Banks will innovate new profitable products to sell to investors to lower risk Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-12

13. Responses to Changes in Demand Conditions: Interest Rate Volatility Examples of two products:  Adjustable-Rate Mortgages – sold to financial institutions who were also looking to reduce interest rate risk Mortgage loans where the interest rate changes with market interest rates Flexible interest rates keep profits high when rates rise. Lower initial interest rates make them attractive to home buyers.  Financial Derivatives – used to hedge, or reduce, risk Value is derived from another security Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-13

14. Responses to Changes in Supply Conditions: Information Technology Improvement in technology is the driving force behind changes in supply conditions 2 effects:  Lowered the cost of processing financial transactions  Made it easier for investors to acquire information Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-14

15. Responses to Changes in Supply Examples:  Credit and Debit Cards  Electronic Banking – ATMs, online banking  Junk Bonds – an example of a financial product that was created as a result of technology allowing information to be easily accessible Before, firms that had a low-credit rating had a hard time raising money by selling bonds With the improvement in technology it became easier to detect good credit from bad credit Junk bond is a bond issued by a company with a low credit rating Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-15

16. Responses to Changes in Supply  Commercial paper – short-term debt security issued by large banks and corporations Corporations used to have to go to banks to get short-term funding Grown from $33 billion in 1970 to $1.6 trillion in 2005 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-16

17. Responses to Changes in Supply Conditions: Information Technology  Securitization – transforming illiquid assets into marketable securities Financial institutions will bundle together a portfolio of loans (mortgages) and sell them The buyer now receives the interest payments and principals which is the return on the security Because it is a bundle of loans, securitization helps diversify risk It also distributes risk Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-17

18. Avoidance of Regulations Financial industry is more heavily regulated than any other industry Government regulation leads to financial innovation by creating incentives for firms to get around regulations that restrict their ability to earn profits Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-18

19. Avoidance of Regulations Two sets of regulations have seriously restricted the ability of banks to make profits:  Reserve requirements – represent an opportunity cost since the Fed does not pay interest on them Almost like a tax  Restrictions on interest paid on deposits The government sets restrictions on how high banks set interest rates for deposits Banks need those deposits to make loans Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-19

20. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-20 Avoidance of Regulations Reserve requirements act as a tax on deposits  Sweep accounts Restrictions on interest paid on deposits led to disintermediation, the loss of deposits that banks can lend thus limiting profits.  Money market mutual funds

21. Financial Innovation and the Decline of Traditional Banking Financial institutions act as intermediaries  Take money from savers and distribute it to producers Take short-term deposits and make long- term loans Financial innovation makes the banking industry more competitive Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-21

22. Financial Innovation and the Decline of Traditional Banking The role of commercial banks in providing funding though loans has declined by 10% Comparing the size of bank’s balance sheet assets relative to other financial institutions  Commercial banks share of total assets has fallen from 40% in 1975 to 30% in 2005 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-22

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24. Financial Innovation and the Decline of Traditional Banking Traditional role of banking in financial intermediation – banks making loans that are funded by deposits – is playing a lesser role in the financial system However, bank profitability is still high  Innovating newer ways to make money Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-24

25. Financial Innovation and the Decline of Traditional Banking Decline in cost advantages in acquiring funds (liabilities)  Rising inflation led to rise in interest rates in the 1970’s Made investors want to take money out of banks and put into higher yielding assets Disintermediation  At the time, bank regulations put a maximum banks could pay in interest on deposits  Checkable deposits, low-cost source of funds, declined in importance Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-25

26. Financial Innovation and the Decline of Traditional Banking Decline in income advantages on uses of funds (assets)  Information technology has decreased need for banks to finance short-term credit needs or to issue loans Commercial paper market  Information technology has lowered transaction costs for other financial institutions, increasing competition Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-26

27. Financial Innovation and the Decline of Traditional Banking Both a decline in cost advantages and a decline in income advantages causes banks to pursue other areas of profitability 2 alternatives:  Keep traditional banking activities and expand into new and riskier areas of lending  Pursue new off-balance sheet activities that are more profitable  Off-balance sheet activities involve trading financial instruments and making money from fees and loan sales, that make profits but don’t show up on the balance sheets. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-27

28. Financial Innovation and the Decline of Traditional Banking Trade-off with a decline in traditional banking:  Banks are forced to be innovative and develop new lines of business However  A new direction of banking, such as the pursuance of off-balance sheet activities, leads to increased risk taking The more risks banks have, the more risks financial markets have, the more risks an economy has Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-28

29. Separation of the Banking and Other Financial Service Industries Glass-Steagall Act was an important feature of the structure of the banking industry in the United States Abolished in 1999 Now securities firms and insurance companies could purchase banks Banks are now allowed to underwrite securities and engage in real estate activities Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-29

30. International Banking In 1960, 8 U.S. banks had offices in foreign countries and total assets was $4 billion Now, 100 U.S. banks have offices abroad with assets totaling more than $1.5 trillion Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-30

31. International Banking This growth in international banking is explained by 3 factors:  Growth in international trade and multinational corporations Loan in a foreign currency to operate their factories Exchange foreign currency  Profitable  American banks want to get a piece of the growing Eurodollar market Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-31

32. 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-32

33. Eurodollar Market The total amount of Eurodollars outstanding is $5.2 trillion One of the most important financial markets in the world Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-33

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35. 10 Largest US Banks 2013 BankCity, StateAssets Holding 1. Bank of AmericaCharlotte, NC2.3 trillion 2. JP Morgan ChaseNew York City, NY2.1 “ 3. CitigroupNew York City, NY2.0 “ 4. Wells FargoSan Francisco, CA1.2 “ 5. Goldman SachsNew York City, NY881 billion 6. Morgan StanleyNew York City, NY820 “ 7. Met LifeNew York City, NY566 “ 8. Barclays Group USWilmington, DE428 “ 9. Taunus Corp New York City, NY364 “ American holdings for Deutsche Bank, Germany 10. HSBCNew York City, NY345 “ North American holdings for Kong Kong Bank Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-35

36. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-36 Bank Consolidation The number of banks has declined over the last 25 years  Bank failures  Consolidation  Deregulation—Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994  Economies of scale and scope from information technology Results may be not only a smaller number of banks but a shift in assets to much larger banks

37. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-37 Benefits and Costs of Bank Consolidation Benefits  Increased competition, driving inefficient banks out of business  Increased efficiency also from economies of scale and scope  Lower probability of bank failure from more diversified portfolios Costs  Elimination of community banks may lead to less lending to small business  Banks expanding into new areas may take increased risks and fail

38. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-38 Thrift Industry: Regulation and Structure Savings and Loan Associations  Chartered by the federal government or by states  Most are members of Federal Home Loan Bank System (FHLBS)  Deposit insurance provided by Savings Association Insurance Fund (SAIF), part of FDIC  Regulated by the Office of Thrift Supervision Mutual Banks  Approximately half are chartered by states  Regulated by state in which they are located  Deposit insurance provided by FDIC or state insurance

39. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-39 Thrift Industry: Regulation and Structure (cont’d) Credit Unions  Tax-exempt  Chartered by federal government or by states  Regulated by the National Credit Union Administration (NCUA)  Deposit insurance provided by National Credit Union Share Insurance Fund (NCUSIF)

40. 10 Largest Banks in the World BankCountryAssets Holding 1. Deutsche BankGermany2.8 trillion 2. HSBCUnited Kingdom2.6 “ 3. BNP ParibasFrance2.5 “ 4. ICBC China2.4 “ 5. UFJ Financial GroupJapan2.4 “ 6. Credit AgricoleFrance2.4 “ 7. The Barclays GroupUnited Kingdom2.4 “ 8. Royal Bank of Scotland United States2.3 “ 9. JP Morgan ChaseUnited States2.3 “ 10. Bank of AmericaUnited States2.1 “ Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-40

41. Summary Chapter 10 1.The history of banking in the US has left us with a dual banking system with banks chartered by the states and the federal government. 2.A change in the banking environment will lead financial institutions to look for innovations. The cost of innovations has led to a decline in traditional banking. 3.Since the 1980’s bank consolidation has been occurring at a fast pace Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-41

42. Summary Chapter 10 3. (Cont.). The first phase was a result of bank failures and reduced effectiveness. The 2 nd phase has come by information technology. Most economists believe bank consolidations will outweigh the costs. 4. Due to the Glass-Steigel Act in 1999 commercial banking and the security industry can now be together again. 5. With the fast growth of world trade since 1960, international banking has grown at a rapid pace. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10-42