Market Structure and Regulation in the U.S. Banking Industry
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Market Structure and Regulation in the U.S. Banking Industry Presentation Transcript

  • 1. Market Structure and Regulation in the U.S. Banking Industry Professor Wayne Carroll Department of Economics University of Wisconsin-Eau Claire [email_address] Slides available at www.uwec.edu/carrolwd
  • 2. Roles of Banks in the Economy
    • Facilitate borrowing and lending
    • Facilitate payments
    • Risk management
      • Issue financial assets that allow firms to share risks
      • Provide guarantees and lines of credit
  • 3. Role of Banks in Lending Source: Available online at http://www.wiwi.uni-frankfurt.de/schwerpunkte/finance/wp/550.pdf
  • 4. Financial Intermediaries
    • “ Banks” include:
    • Commercial banks
    • Savings and loan associations (S&L’s)
      • Also sometimes called “thrifts” or “thrift institutions”
    • Credit unions
  • 5. Financial Intermediaries Assets at end of 2002 (in billions)
  • 6. Ownership of Banks
    • U.S. banks are privately owned – no banks are owned by the government.
    • In most cases a bank’s stock is held by a large number of investors, so a bank has many “owners.”
    • It is relatively easy to establish a new bank in the U.S.
  • 7. Bank Market Structure
    • There are a large number of banking firms in the U.S., but the number is falling due to mergers between banks.
    • Thousands of U.S. banks are very small, each having only a single office.
    • Many banks today have multiple branches or offices.
    • A “bank holding company” is a firm that owns one or more banking firms.
  • 8. Size Distribution of U.S. Banks Source: www2.fdic.gov/sod/index.asp $5,320,767 80,473 7,479 TOTALS $3,580,817 38,848 89 Greater than $10 Billion $427,340 6,601 120 $3 Billion to $10 Billion $338,909 6,856 275 $1 Billion to $3 Billion $265,540 6,322 494 $500 Million to $1 Billion $211,495 5,088 672 $300 Million to $500 Million $349,740 10,338 2,427 $100 Million to $300 Million $105,754 4,007 1,718 $50 Million to $100 Million $33,511 1,701 1,098 $25 Million to $50 Million $7,661 712 586 Less than $25 Million Offices Institutions Asset Size (as of June 30, 2006) Deposits (millions) Number of Commercial Banks  
  • 9. Bank Market Structure: An Example
    • Wells Fargo & Company is a bank holding company based in South Dakota (with historic roots in Minnesota and California). It includes:
      • 28 chartered bank companies
      • a total of over 3,000 branches in 23 states
  • 10. Some Wells Fargo branches
  • 11. Wells Fargo’s Broad Scope Source: www.wellsfargo.com/about/today1
  • 12. 20 Largest U.S. Banks (as of June 30, 2006) Source: www2.fdic.gov/sod/index.asp $40,014,000 354 New York The Bank of New York 20 $40,829,851 661 Pennsylvania Sovereign Bank 19 $43,081,270 387 Michigan Comerica Bank 18 $46,440,495 1 Delaware ING Bank, fsb 17 $50,657,812 2 Virginia Countrywide Bank, NA 16 $51,246,133 918 North Carolina Branch Banking and Trust Company 15 $52,331,967 3 Utah Merrill Lynch Bank USA 14 $57,231,022 1,397 Alabama Regions Bank 13 $57,327,323 957 Ohio Keybank, NA 12 $58,134,805 831 Pennsylvania PNC Bank, NA 11 $61,321,407 286 California World Savings Bank, FSB 10 $75,588,320 436 Delaware HSBC Bank USA, NA 9 $117,337,830 2,525 Ohio U.S. Bank, NA 8 $117,956,301 1,758 Georgia SunTrust Bank 7 $142,508,000 267 New York Citibank, NA 6 $209,927,984 2,167 Nevada Washington Mutual Bank 5 $298,672,000 3,200 South Dakota Wells Fargo Bank, NA 4 $306,348,000 3,136 North Carolina Wachovia Bank, NA 3 $434,752,000 2,679 Ohio JPMorgan Chase Bank, NA 2 $563,906,844 5,781 North Carolina Bank of America, NA 1 Deposits (thousands) Number of Offices State Headquartered Institution Name Rank
  • 13. A Simple Bank Balance Sheet
    • Assets
    • reserves
    • "loans"
      • securities
      • bank loans
    • Liabilities
    • deposits
    • borrowings
    • Bank capital (equity)
  • 14. Detailed Balance Sheet for the Banking Industry Source: Mishkin, Economics of Money, Banking, and Financial Markets, 7 th edition
  • 15. Two Important Ratios
    • Capital/asset ratio – bank capital as a percentage of bank assets.
      • The average capital/asset ratio for U.S. banks was about 9% at the end of 2002.
    • Reserve ratio – bank reserves as a percentage of checkable deposits.
  • 16. Information on U.S. Banks
    • It is easy to get a lot of financial data on U.S. banks.
    • A great source:
    • www2.fdic.gov/idasp/index.asp
  • 17. An Example: Data on Wells Fargo
  • 18. What Can Go Wrong?
    • “ Bank failure ” – the bank goes out of business.
      • Bank depositors might lose some of their funds.
      • Bank creditors might lose some of their investment
      • Bank owners lose their capital.
    • The bank suffers significant losses – the government might have to help.
  • 19. Reasons for Bank Regulation
    • Banks must be regulated because:
    • a bank failure can be devastating to depositors.
    • there’s a risk of systemic failure : the failure of one bank can make it more likely that other banks will fail.
    • depositors can’t monitor how the bank invests their funds, creating a moral hazard problem .
    • government assistance to a bank can be very costly.
  • 20. Reasons for Bank Regulation
    • Banks are less stable than other businesses because:
    • bank liabilities tend to be short-term – many depositors could withdraw their funds with little notice.
    • bank assets tend to be longer-term – reserves and other liquid assets are only a small share of the total.
    • the behavior of depositors depends on their confidence that the bank is sound, and this confidence can be easily shaken.
  • 21. A Closer Look at Bank Failure
    • Two reasons for bank failure:
    • The value of bank assets falls, so assets<liabilities.
    • Deposit outflow: A large number of depositors withdraw their funds from the bank, exhausting the bank’s cash (reserves) and other liquid assets.
    • Therefore a bank is more likely to fail if it has a low capital/asset ratio or a low reserve ratio.
  • 22. A Closer Look at Bank Failure
    • Tradeoff between higher income and a lower risk of failure:
    • Holding other things constant, the bank’s net income is higher if its capital/asset ratio and reserve ratio are lower , since then it holds relatively more interest-earning assets.
    • If the bank’s capital/asset ratio and reserve ratio are higher , it’s less likely that the bank will fail (so it’s less likely that the stockholders will lose their capital.)
  • 23. A Closer Look at Bank Failure
    • If there were no government regulation of banks :
    • each bank would choose a capital/asset ratio and a reserve ratio to maximize the value of the bank.
    • depositors would want to deposit their money in banks that are well managed, so banks would have an incentive to choose capital/asset ratios and reserve ratios that reduce the threat of bank failure.
      •  “ market discipline”
  • 24. A Closer Look at Bank Failure
    • But if there were no government regulation of banks :
    • banks would choose capital/asset ratios and reserve ratios that are too low from society’s standpoint.
    • banks would take on too much risk, so there would be too many bank failures, and the government would have to spend too much money to assist troubled banks.
  • 25. An Example: Continental Illinois Bank
    • Continental Illinois Bank failed in 1984.
    • The federal government paid billions of dollars to keep Continental Illinois from closing.
    • This was the biggest bank “resolution” in U.S. history.
  • 26. An Example: Continental Illinois Bank
    • Before it failed, Continental Illinois Bank:
    • was the largest bank in Chicago.
    • was the seventh-largest bank in the U.S.
    • had 57 offices in 14 states and 29 foreign countries.
  • 27. An Example: Continental Illinois Bank
    • Why did Continental Illinois fail?
    • Starting in the late 1970s, the bank grew fast, with lots of loans to businesses.
      • Poor quality loans
      • Too many loans to firms in the oil industry
      • Too many loans to borrowers in Latin America
      • “ Continental Illinois is willing to do just about anything to make a deal.”
    • High cost of funds
      • Large share of funds borrowed from other banks
      • Relatively small reliance on domestic deposits
      • Heavy borrowing in foreign money markets
  • 28. An Example: Continental Illinois Bank
    • The Bank’s Troubles
    • By 1984 the bank’s nonperforming loans (loans on which payments were late) rose to $5.2 billion (over 10% of total loans).
    • May 1984: an electronic “bank run” – depositors withdrew billions of dollars in deposits
    • The FDIC and the Federal Reserve System pledged their support for the bank and lent over $5 billion.
  • 29. An Example: Continental Illinois Bank
    • Dangers
    • Many smaller banks had deposits at Continental Illinois, so the failure of Continental Illinois could have caused some of them to fail, too.
    • Other depositors (including many important corporations) could lose some of their funds
    • Foreign investors would lose confidence in U.S. banks
  • 30. An Example: Continental Illinois Bank
    • Rescuing Continental Illinois Bank
    • Continental Illinois Bank had $3 billion in insured deposits and $30 billion in uninsured deposits. The FDIC promised to guarantee all deposits.
    • The FDIC assumed the Bank’s 3.5 billion debt to the Federal Reserve.
    • The FDIC bought $1 billion in Continental Illinois stock – the FDIC “owned” the bank.
  • 31. An Example: Continental Illinois Bank
    • Lessons from Continental Illinois Bank
    • Banks have an incentive to take on too much risk, so they need closer supervision
    • The failure of a very large bank could have broader negative effects
    • Rescuing a large bank can be expensive for the government
    • Good sources:
    • www.fdic.gov/bank/historical/managing/contents.pdf -- Part II, Chap. 4
    • http://www.fdic.gov/bank/historical/history/vol1.html -- Chap. 7
  • 32. Bank Regulation: An Overview
    • In the U.S. the government regulates banks in many ways:
    • Federal deposit insurance
    • Imposing capital requirements (minimum capital/asset ratios)
    • Imposing reserve requirements (minimum reserve ratios)
    • Restricting the types of assets that banks may hold
    • Performing bank examinations (periodic auditing reviews)
  • 33.
    • Primary bank regulators in the U.S.:
    • Office of the Comptroller of the Currency (OCC)
      • part of the U.S. Department of the Treasury
    • Federal Reserve System – the U.S. central bank
    • Federal Deposit Insurance Corporation (FDIC)
    • State bank regulators
    Bank Regulation: An Overview
  • 34. Federal Deposit Insurance
    • The U.S. Congress created the Federal Deposit Insurance Corporation (FDIC) in 1933, after the bank failures in the Great Depression.
    • Today the FDIC guarantees each bank deposit up to a maximum of $100,000.
    • FDIC insurance is funded by a small fee paid by banks based on their deposits.
  • 35. Bank Failures in the Great Depression
  • 36. Effects of Federal Deposit Insurance
    • Deposit insurance prevents bank runs
    • Prevents losses by small depositors
    • Reduces “systemic risk” in the banking system
    • Deposit insurance gives banks incentives to:
    • hold riskier assets.
    • hold less capital.
    • manage the bank’s assets less carefully.
  • 37. Incentive Effects of Deposit Insurance: A Closer Look
    • Deposit insurance increases the supply of deposits (within the insurance coverage limits).
    • Therefore banks can attract deposits more easily and can pay lower interest rates on their deposits even if they pursue risky strategies that increase the risk of bank failure.
    • As a result, deposit insurance reduces banks’ incentives to avoid risk.
  • 38. Capital Requirements
    • When there’s deposit insurance, banks have an incentive to hold too little capital.
    • Therefore the government imposes capital requirements to ensure that banks hold sufficient capital.
  • 39. Capital Requirements
    • A simple capital requirement would require that a bank’s capital/asset ratio be greater than or equal to a specified level.
    • Example: capital/asset ratio ≥ 0.05.
    • Problem: Not all assets are equally risky. A simple capital requirement gives a bank an incentive to hold more risky assets.
  • 40. Risk-weighted Capital Requirements
    • At an international conference in Basel, Switzerland in 1988, bank regulators from the world’s affluent countries agreed to impose risk-weighted capital requirements :
    • Classes of assets are assigned risk weights between 0% and 100%.
    • Risk-free assets carry a weight of 0%, and more-risky assets carry higher weights.
    • Capital requirements then set a minimum for the ratio of capital to risk-weighted assets.
  • 41. Risk-weighted Capital Requirements: An Example $0 0% $10,000,000 Cash $0 0% $190,000,000 T-bills $10,000,000 20% $50,000,000 Municipal bonds $150,000,000 50% $300,000,000 Mortgages $40,000,000 100% $40,000,000 Home equity loans $200,000,000 $590,000,000 TOTALS Weighted assets Risk weight Amount Assets
  • 42.
    • In this example, if regulators require the bank to maintain its risk-weighted capital ratio at a level of at least 8%, then the bank’s capital must be at least $16,00,000 (or 8% of $200,000,000).
    • If the bank acquires another $1 million in capital, it could invest up to:
      • $12.5 million more in home-equity loans
      • $25 million more in home mortgages
      • $62.5 million more in municipal bonds
    • So risk-weighted capital requirements give the bank an incentive to hold less-risky assets.
    Risk-weighted Capital Requirements: An Example
  • 43. Proposed Capital Requirement Reform: Basel 2
    • Problem: Assets within a risk class might expose banks to different amounts of risk.
    • Bank regulators have designed a new system of bank capital requirements – Basel 2 – that will provide better incentives for banks to manage their risks in a way that promotes bank stability.
    • Basel 2 will take effect in some countries in 2007.
    • http://www.bis.org/publ/bcbsca.htm
  • 44. Reserve Requirements
    • The Federal Reserve System requires banks to hold reserves that are greater than or equal to a specified percentage of their checkable deposits:
      • 3% for smaller banks
      • 10% for larger banks
  • 45. Reserve Requirements
    • But reserves are higher than they need to be to promote stability of the banking system.
    • Today reserve requirements are more important in macroeconomic policy – they tie bank reserves to deposits, so the central bank can try to control deposits by controlling reserves.
  • 46. Restrictions on Asset Holdings
    • B ank regulations include the following:
    • Banks cannot hold common stock.
    • Banks cannot invest too large a share of their deposits in a single loan or in loans to businesses in a single industry.
    • Banks cannot lend funds to bank directors, managers, or principal shareholders at below-market rates.
  • 47. Bank Examinations
    • Banks are visited on a regular schedule by bank examiners from the OCC, the Federal Reserve System, the FDIC, or other agencies.
    • Bank examiners review the bank’s financial statements and its confidential accounts.
    • The results are summarized in a “CAMELS” rating given to the bank.
  • 48. Bank Examinations
    • C apital adequacy
    • A sset quality
    • M anagement
    • E arnings
    • L iquidity
    • S ensitivity to market risk
  • 49. CAMELS ratings
    • 1 Sound in every respect
    • 2 Fundamentally sound, but with modest weaknesses that can be corrected
    • 3 Moderately severe to unsatisfactory weaknesses; vulnerable if there’s a business downturn
    • 4 Many serious weaknesses that have not been addressed; failure is possible but not imminent
    • 5 High probability of failure in the short term
  • 50. Bank Examinations
    • CAMELS ratings are disclosed to bank management, but not to the public.
    • If the CAMELS rating for a bank is unfavorable, regulators can take actions like these:
      • Require banks to disclose unfavorable information in their public financial statements
      • Issue a “cease and desist” order requiring the bank to stop doing things that cause financial troubles and to correct problems.
      • Impose fines (up to $1,000,000 per day).
  • 51. Bank Examinations
  • 52. Bank Examinations
    • Good sources on bank examinations and the FDIC:
    • www.fdic.gov/regulations/examinations/index.html
    • www.fdic.gov/bank/analytical/banking/1999oct/1_v12n2.pdf
  • 53. The Banking Crisis of the 1980s
    • Hundreds of savings and loan associations (S&L’s) and banks failed in the 1980s and early 1990s.
    • This episode illustrates:
      • how changes in the market environment and a loosening of regulations can lead to a bank crisis.
      • how government regulators can handle widespread bank failures.
      • how regulations and supervisory standards can be improved to address new problems.
  • 54. Magnitude of the Crisis
    • From 1980 through 1994, over 2,900 banks and S&L’s failed.
      • 1,617 banks with total assets of $302.6 billion
      • 1,295 S&L’s with total assets of $621 billion
    • On average, a bank or S&L failed every 15 days from 1980 to 1994.
    • During this period, about one out of every six banks or S&L’s (holding a total of over 20% of the assets of the system) was closed or got government assistance.
  • 55. Magnitude of the Crisis: Number of Bank Failures Per Year
  • 56. Causes of the Banking Crisis
    • The banking crisis had many causes, including:
      • changes in the market environment
      • looser regulations that gave S&L’s more competitive options
  • 57. Causes of the Banking Crisis: Changes in the Market Environment
    • As a result of financial innovations in the 1960s and 1970s:
      • banks and S&L’s faced more competition from other financial firms (such as mutual funds).
      • new kinds of financial assets (such as futures and other derivatives) made it possible for investors (including banks and S&L’s) to take on more risk.
      • the financial market environment was more complicated and harder for regulators to monitor.
  • 58. Causes of the Banking Crisis: Changes in Regulation
    • The banking industry was partially deregulated in the early 1980s:
      • S&L’s had mostly been restricted to home mortgage lending before, but now they were allowed to invest in commercial real estate and consumer loans.
      • S&L’s were allowed to invest in junk bonds (low-quality, high-risk commercial bonds) and common stocks.
  • 59. Causes of the Banking Crisis: Changes in Regulation Source:www.fdic.gov/bank/historical/history/421_476.pdf
  • 60. Causes of the Banking Crisis
    • As a result, S&L’s held more risky assets, resulting in huge loan losses.
    • S&L management had little expertise in managing risks from new kinds of assets.
    • Regulators had little experience in monitoring the new risks.
    • Since S&L deposits (up to $100,000) were protected by federal deposit insurance, depositors had little incentive to monitor S&L risks.
  • 61. Regulatory Failures in the Crisis
    • Regulators of S&L’s did not close insolvent institutions and end the crisis quickly.
      • The deposit insurance fund wasn’t large enough to cover losses.
      • (The S&L deposit insurance fund had a balance of -$75 billion in 1988.)
      • Regulators wanted to encourage the growth of the S&L industry, not close S&L’s.
      • Regulators hoped the crisis would pass without revealing their failures.
  • 62. Managing the Crisis
    • In 1989 the government created the Resolution Trust Corporation (RTC) to handle S&L’s that were failing.
    • Functions of the RTC:
    • Took over assets of failing S&L’s and sold them to recover as much of their value as possible.
    • Issued bonds to fund the costs of covering S&L losses.
  • 63. Who Paid the Cost?
    • Bank and S&L stockholders
    • Some depositors who had large deposits that exceeded the deposit insurance limits
    • Taxpayers, who ultimately will pay higher taxes to pay off bonds that were issued to fund the costs of the crisis.
  • 64. Regulatory Reforms Following the Crisis
    • Some regulatory agencies that had not been effective were eliminated, and their powers were given to other agencies.
    • Earlier restrictions on assets holdings by S&L’s were reinstated.
    • S&L’s were required to raise their capital/asset ratios.
    • Now bank examiners visit banks more frequently than before.
    • Regulators were required to act more quickly when a bank or S&L is failing.
  • 65. Regulatory Reforms Following the Crisis Source:www.fdic.gov/bank/historical/history/421_476.pdf
  • 66. Lessons from the Banking Crisis
    • The U.S. banking crisis in the 1980s was similar to bank crises in other countries:
    • Financial liberalization allowed banks to take more risks, but there was not yet adequate government regulation and supervision of those risks.
    • A government “safety net” created moral hazard problems and eliminated some market discipline.
  • 67. The Banking Crisis of the 1980s
    • Two excellent sources:
    • Managing the Crisis: The FDIC and RTC Experience
    • www.fdic.gov/bank/historical/managing/index.html
    • History of the Eighties - Lessons for the Future
    • www.fdic.gov/bank/historical/history/index.html