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  1. 1. Lecture 19: Evolution of banking industry in the U.S. Mishkin Ch 10 – part A page 247-261
  2. 2. Introduction <ul><li>Features of banking industry in the U.S. </li></ul><ul><li>dual banking system </li></ul><ul><li>separation of investment banking and commercial banking </li></ul><ul><li>multiple regulatory agencies </li></ul><ul><li>decline of traditional banking </li></ul><ul><li>Explained by two forces in evolution of banks </li></ul><ul><li>Regulation </li></ul><ul><li>Financial Innovation </li></ul>
  3. 4. Regulation <ul><li>Alternation of federal chartered banks and state chartered banks in history. </li></ul><ul><li>Today, the U.S. has a dual banking system in which banks supervised by the federal government and banks supervised by the state coexist. </li></ul>
  4. 5. Regulation <ul><li>Glass-Steagall Act (Banking Act of 1933) is an important act: </li></ul><ul><ul><li>created the Federal Deposit Insurance Corporation (FDIC) to provide federal insurance to deposits </li></ul></ul><ul><ul><li>restricted interest payments on checkable deposits and interest rate ceilings were imposed on time deposit accounts ( regulation Q ) </li></ul></ul><ul><ul><li>imposed separation between commercial banking and investment banking </li></ul></ul>
  5. 6. Multiple regulatory agencies <ul><li>Comptroller of the Currency  national banks </li></ul><ul><li>The Fed and state banking authorities  state banks that are members of the Fed </li></ul><ul><li>Fed  bank holding companies </li></ul><ul><li>FDIC  insured state banks that are not Fed members </li></ul><ul><li>State banking authorities  state banks without FDIC insurance </li></ul>
  6. 7. Financial innovations <ul><li>Changes since 1960s </li></ul><ul><li>inflation and interest rates are at higher levels and more volatile </li></ul><ul><li>computer technology makes information production simple </li></ul><ul><li>significant new legislation has been enacted </li></ul><ul><li>Financial innovation is driven by bank’s desire to earn profits. Change in the financial environment lead to financial innovations. </li></ul>
  7. 8. Responses to changes in demand conditions: interest rate volatility <ul><li>Adjustable-rate mortgages </li></ul><ul><ul><li>Adjustable when market interest rate (6 month T-bill rate) change </li></ul></ul><ul><ul><li>Low initial interest rates make them attractive to home buyers; but still flexible to keep banks’ profits high when rates rise. </li></ul></ul><ul><li>Financial derivatives </li></ul><ul><ul><li>To hedge interest-rate risk </li></ul></ul>
  8. 9. Responses to changes in supply conditions: Information Technology <ul><li>improved computer technology leads to </li></ul><ul><li>lower transaction costs </li></ul><ul><li>easier for investors to acquire information, screening </li></ul><ul><li>bank credit and debit cards </li></ul><ul><li>electronic banking </li></ul><ul><li>junk bonds </li></ul><ul><li>commercial paper </li></ul><ul><li>securitization : e.g. mortgage-backed securities </li></ul>
  9. 10. Avoidance of regulations: loophole mining <ul><li>Reserve requirements </li></ul><ul><li>It is like a tax on deposits </li></ul><ul><li>interest-rate ceilings (regulation Q) </li></ul><ul><li>As i   disintermediation </li></ul><ul><li>loophole mine to escape these regulations: </li></ul><ul><li>money market mutual funds </li></ul><ul><ul><li>just like interest earning checking accounts for consumers </li></ul></ul><ul><ul><li>not subject to reserve requirements and interest rate ceilings </li></ul></ul>
  10. 12. Decline of traditional banking <ul><li>Traditional banking business : lending funded with deposits, traditional financial intermediation role of banking. </li></ul><ul><li>Information technology has lowered transaction costs for other financial institutions, increasing competition. </li></ul><ul><li>Decline in cost advantages in acquiring funds (liabilities): e.g. deposit rate ceiling  savors switch to mutual market funds, disintermediation. </li></ul><ul><li>Decline in income advantages on uses of funds (assets): information technology  easier screening  decreased need for loans. </li></ul>
  11. 13. Banks’ responses <ul><li>Banking industry and profitability not in decline. </li></ul><ul><li>Expand into new and riskier areas of lending </li></ul><ul><ul><li>Commercial real estate loans </li></ul></ul><ul><ul><li>Leveraged buyouts and corporate takeovers </li></ul></ul><ul><li>Pursue off-balance-sheet activities </li></ul><ul><ul><li>In the past, 7% of total bank income  now 44%! </li></ul></ul>