Recall that the financial sector provides the efficient transfer of savings towards investment projects S + (Imports – Exports) = I + (G-T) Foreign Savings ($640B) Gross Domestic Savings ($1.8T) Gross Private Investment ($2T) Government Deficit ($400B) Gross Private Investment represents the purchase of new capital goods – one of the primary sources of growth in the economy
A majority of external funds raised by non-financial businesses come from bank loans. In particular, small businesses rely entirely on banks for financing
Loans Bank Depositors There is a moral hazard problem/adverse selection problem between both the bank and its depositors as well as between the bank and its potential loan customers
A bank can deal with this problem with:
Optimal Debt Contracts
This problem must be dealt with through regulation
Depository Institutions are broadly defined as businesses that accept deposits and make loans Depository Institutions Commercial Banks Savings & Loans Savings Banks Credit Unions
Deal almost exclusively in short term deposits and mortgages
Are generally mutual companies (depositors are the owners)
Are allowed to hold corporate equities/bonds
All Depository Institutions in the US are chartered Depository Institutions Commercial Banks Savings & Loans Savings Banks Credit Unions National Banks Comptroller of the Currency State Banks State Authority Federal Associations Office of Thrift Supervision State Associations State Authority Federal Unions National Credit Union Administration State Unions State Authority
Federal Reserve Membership (1913)
National Banks are Required to be members of the Federal Reserve System (Membership is optional for state banks)
Federal Reserve members are required to purchase stock in the federal reserve system.
Federal Reserve members provide input to the election of Federal Reserve Board Members
The Federal Reserve provides check clearing services
Of the 7,769 banks in 2003, a vast majority are non-member state banks
Federal Deposit Insurance (1934)
Federal reserve members are required to purchase deposit insurance. Insurance is optional for state banks (98% of all banks have deposit insurance)
FDIC insured banks are charged up to 27 cents per $100 of eligible deposits
All deposits up to $100,000 are insured by the FDIC.
A timeline of Banking Regulation 1863 1927 1933 1980 1956 1999 1994 Restrictions on activities Restrictions on Competition McFadden Act Banking Act Holding Company Act Monetary Control Act Riegle-Neal Holding Company Act Glass - Steagall Graham - Leach - Bliley Great Depression
Until the mid 1900’s, we were a nation of unit banks Main Office Branch Offices
Prohibited from interstate branching
Must comply with state branching rules
McFadden Act (1927)
68,000 7800 2000 13,000 12,500 1900 Total Branches Number of Banks Year
Following the great depression, the activities of commercial banks were severely restricted The Glass-Steagall Act of 1934 was designed to put a wall between commercial banking and investment banking
Commercial Banks are restricted from participating in equities markets
Interest rates on non- transaction deposits is restricted to be below 5.25%
No interest allowed on transaction deposits
Branching Restrictions could be avoided by forming holding companies Main Office Branch Offices Illegal under the McFadden Act Holding Company Subsidiaries Legal under the McFadden Act
The Bank Holding Company act allowed holding companies with only one bank to provide limited non-bank financial services on an interstate basis. This created a loophole around Glass-Steagall!! Holding Company Prior to Bank Holding Company Act Bank Bank Bank Holding Company After Bank Holding Company Act Non-Bank Branches Non- Bank Offices Collects deposits, but doesn’t make loans Makes loans, but doesn’t collect deposits Financial Services
Deregulation of the Financial Services sector began in the 1980’s.
The Monetary Control Act (1980)
Began the phase out of interest rate ceilings at depository institutions
Imposed uniform reserve requirements on Banks and Thrifts
Riegle-Neal Interstate Banking and Branching Efficiency Act (1994)
Allowed holding companies to acquire banks in any state
Permitted financial holding companies offering banking, insurance, securities and other services under one controlling corporation (allowed Citicorp to buy Traveler’s Insurance)
C apital Adequacy A sset Quality M anagement E arnings L iquidity S ensitivity to Interest Rate Risk Problems with Monitoring Banks are monitored using the camels system. However, It’s not always easy to accurately assess the risk a bank is taking on
Off Balance Sheet Activities
Financial Guarantees (SLC)
In 1995, Barings Bank went bankrupt due to losses in the Derivatives market. At the time, it was holding $60B worth of derivative contracts – a staggering number when compared to Baring’s reported equity of $615M!! The CAMELS System
Problems with Restricting Activities Banks compete with other financial services companies as well as other banks!! During the late 1970’s, market interest rates rose well above 10%, but banks were restricted by regulation Q to pay only 5.25% in savings accounts and 0% on checking accounts As households pulled their money out of banks, mortgage and small business lending was seriously curtailed! Money Markey Mutual Funds (10%) Checking Accounts (0%) Financial Companies Banks
Problems with Restricting Competition (Branching) Restricting entry gives banks limited monopoly power, they can use this to increase profits at the customers expense! Banking is a decreasing cost industry (i.e. large startup costs, but small marginal costs). By forcing banks to remain small and local, they are forced to operate at an inefficiently small scale! By forcing banks to remain in a confined geographical location, you are forcing them to take on idiosyncratic (area specific) risk!
Globalization - the Final Frontier Since the 1970’s, there has been tremendous growth in international trade World Trade (in Trillions of $s)
Globalization - the Final Frontier Even more impressive is the growth in foreign exchange Currency Transactions (in Trillions of $s)
US Banks Operating Abroad Subsidiaries : Governed by Federal Reserve Regulation K – must be involved in business “closely related to banking. International Banking Facilities : Accepts time deposits and makes loans to foreign households & firms. Exempt from reserve requirements, but may not do business in the US. Edge Act Corporations : Makes loans/accepts deposits. Can deal with both US and foreign citizens , but is limited to international trade transactions Branches : Offer a full line of banking services, but are subject to foreign laws US Banks locate facilities abroad to aid in international trade as well as to avoid regulation and taxes
Foreign Banks Operating in the US Agency Office : Can’t accept deposits from US citizens, but can transfer funds from abroad and make loans in the US Subsidiaries : Treated as a US bank. Subject to all US regulations. Subsidiaries may also set up edge act corporations and international lending facilities Branches : Offers a full range of banking services for US citizens Likewise for Foreign Banks…
Important Dates in International Banking 1930 1978 1988 1991 Bank for International (BIS) Settlements Created International Banking Act Basle Accords I Foreign Bank Supervision Act BCCI Scandal
Bank of England Federal Reserve United States Under whose jurisdiction do international banks fall? (it’s a gray area ) United Kingdom
Regulating International Banking
International Banking Act (1978)
Brought foreign banks operating in the US under federal regulation for the first time
Foreign banks, however, were not monitored as closely as US banks
Foreign Bank Supervision Act (1991)
Passed shortly after the BCCI scandal
Gave the Federal Reserve and the Comptroller of the Currency greater control over foreign banks operating in the US
Bank For International Settlements (1930)
Established to handle German WWI reparations, the BIS has become a center for international cooperation.
Played a central role in the Bretton Woods Exchange Rate System
Integral in the Establishment of the Euro
The BIS is like a central bank for central banks.
Risk weighted assets The Basle Accords established uniform capital requirements for banks around the world. Equity capital was required to equal at least 4% of a bank’s risk weighted assets. Asset Risk Weight Cash and equivalents 0 Government securities 0 Interbank loans 0.2 Mortgage loans 0.5 Ordinary loans 1.0 Standby letters of credit 1.0
Top Ten World Banks $851 Bank of America + First Union (US) $851 UBS (Switzerland) $1,097 JP Morgan + Bank One (US) $1,080 Mizuho Financial Group (Japan) $844 Sumitomo Mitsui (Japan) $1,497 Citigroup (US) $744 BNP Paribas (France) $759 HSBC (UK) $781 Mitsubishi Tokyo (Japan) $795 DeutscheBank (Germany) Assets (Billions) Bank
Problems with International Regulation
The key issue is that the banking industry in Japan and Europe is Fundamentally different from the US.
Unlike the US, European Banks are allowed to engage in securities markets (universal banking)
In fact, in Europe, banks are generally significant shareholders in European companies.
Banks rely much more on equity than deposits.
Japanese industry is organized into industrial groups (keiretsu)
These “groups” are both vertically and horizontally integrated and are comprised of a very large number of companies:
Sumitomo has 15 divisions ranging from electronics to mining to consumer goods.
Sumitomo controls assets equal to $50T.
Each “group” has its own bank which handles its finances. This “main” bank