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1. Learning Unit #19
Banking Industry and
Regulation

2. Objectives of Learning Unit
 Historical Development of the Banking System
 Structure of U.S. Commercial Banking Industry
 Bank Consolidation and Nationwide Banking
 Banking and Other Financial Service Industries
 Evolution of Banking Industry
 Financial Innovation
 Decline of Traditional Banking
 Asymmetric Information and Bank Regulation
 Banking Crisis
 U.S. Banking Crisis in 1980s
 Banking Crisis throughout the World

3. Historical Development of U.S. Banking
System
Banking systems in developed countries are
very similar, but the U.S. banking system has
several unique characteristics reflecting its
historical development of banking system.
Three unique characteristics of the U.S.
banking system are
 Structure of Central Bank
 Dual Banking System
 Multiple Regulatory Agencies

4. Central Bank in the U.S.
 The U.S. government has attempted to create
a central bank like those in other developed
countries (e.g. Bank of England, ) several
times, but failed.
 Bank of the United States from 1791 to 1811
 Second Bank of the united States from 1816
to 1836
 Federal Reserve System since 1931
 Many feared that a centralized banking power
in one hand might have too much power and
influence on the U.S. society.

5. Dual Banking System
 Dual banking system: Banks are chartered and
supervised by the federal government (Office of
the Comptroller of The Treasury Department) and
by the state governments (banking commissions).
 National banks are chartered by the federal
government.
 Since it is chartered by the federal government, it
can start its banking business anywhere in the U.S.
and can expand its business through out the U.S.
 State banks are chartered by the state governments.
 Since it is chartered by a state, it must operates its
banking business within the state.

6. Multiple Regulatory Agencies
Banks in the U.S. are regulated by multiple of
government agencies.
 Regulatory agencies which charter banks also
supervise banking activities of those chartered.
 Examine routinely banking activities.
 Establish and enforce banking laws.
 Banks are further regulated by the Fed and the FDIC
 The Federal Reserve sets banking rules to facilitate its
monetary policy and to act as bank for all other banks
in the U.S.
 The Federal Deposit Insurance Corporation sets own
requirement for insuring deposits at banks.

7. Time Line of the Early History of
Commercial Banking in the United States
The chart below shows several important historical
events in the U.S. banking system.

8. Banking Systems Abroad
In most developed countries
 There is only one central bank entity usually located
in its capital.
 Only central government has authority to charter
banks.
 Only one government agency (e.g. Treasury
Department, Finance Department) is responsible for
banking regulation, including establishing banking
laws, enforcing them, chartering banks, and
supervising them.
 Banks can operate throughout their country, so
foreign banks are very large relative to most U.S.
banks.

9. Highly Regulated U.S. Banking Industry
 Because of dual banking system and multiple
regulatory agencies in the U.S. banking system, the
U.S. banking system is one the most highly regulated
industry in the U.S.
 Each state has different banking regulation enforcing
both state banks and national banks. The federal
government sets another banking regulation, then the
Federal Reserves and FDIC.
 Many laws actually had tried to keep both national
and state banks align in their operations (so one does
not have any regulatory advantage over another).
This also reduced competition among banks, resulted
in so many inefficient small banks everywhere in the
U.S.

10. Structure of Commercial Banking
Industry in the U.S.
 There are about 6,500 commercial banks in the U.S. as
of 2011.
 Most of them are small in their assets holding and have
few or just one office.
 Top ten largest U.S. banks have about 50% of bank
assets in the industry.

11. Top Ten Largest Banks in the U.S.
Top ten largest banks are those well-know banks which
operate throughout the U.S. or in largest metropolitan
areas.
Note: FIA Card Service is a subsidiary of Bank of America since 2006

12. Interstate Banking Restriction
 McFadden Act of 1927 prohibited national
banks from branching across state lines and
forces all national banks to conform to the
branching regulations in the state of their
location.
 The law was intended to put national banks
and state banks on an equal footing.
 Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 repealed McFadden
Act.

13. Bank Consolidation and
Nationwide Banking
 The U.S. had very large numbers of small
banks as compared with other developed
countries due to prohibition of the interstate
banking.
 Smaller U.S. banks were inefficient and lacks
economies of scale and scope.
 Banks got around this restriction by forming
bank holding companies.
 Bank holding companies: corporation that
owns several different companies and banks.

14. Bank Holding Companies
 Bank holding companies simply own stocks
of other companies and banks and operate
like a single companies with many regional or
sector divisions.
 Example:
Bank Holding Co.
Bank of NC Bank of SC Bank of GA
Insurance Investment Brokerage

15. Nationwide Banking
 Through mergers and consolidation, banks extend its
banking service areas way beyond their state lines
and into regions or nationwide.
 JPMorgan Chase & Co. is a result of mergers of Chase
Manhattan Bank (NY), Chemical Bank (NY), Manufactures
Hanover Bank (NY), J.P. Morgan (NY), First Chicago Bank
(IL), National Bank of Detroit (MI), Bank One (IL), First
Commerce Bank (LA).
 Bank of American is a result of mergers of North Carolina
National Bank (NC), Bankers Trust of SC (SC), C&S/Sovran
(GA, VA), Maryland National Bank (MD), Barnett National
Bank (FL), Boatmen’s Bancshares (MO, KS, OK, IA, AR, TX,
NM), Bank of America (CA, OR, WA, AZ, NM, OK, ID, IL),
FleetBoston (MA, RI, CT), LaSalle Bank (IL, MI, IN),
 Wells Fargo Bank (CA) acquired Wachovia Bank (NC) in
2008, which merged with First Union Bank (NC) in 2001.

16. Nationwide Banking
 Through mergers and consolidation, two types of
mega-banks emerged in the U.S.:
 Money center banks: Large banks located in key
financial centers (New Your City, Chicago).
 Citibank, J.P. Morgan Chase
 Super-regional banks: Bank holding companies whose
main business areas are not in the money center cities
(New York, Chicago).
 Bank of America, SunTrust Bank, U.S. Bankcorp.,
Wells Fargo, BB&T
 Both money center banks and super regional banks
are almost as large as those large banks in other
developed countries.

17. Number of Commercial Banks in the U.S.
 As a result of mergers and consolidations,
 A number of commercial banks has been declining since
1985.
 Several money center banks and super regional banks hold
majority of assets in the U.S.

18. Separation of banking and Other
Financial Service Industries
 The government attributed massive bank failures
during the Great Depression to the stock market
crash of 1929 which caused huge losses to the
brokerage division of banks (which operated both
investment banking, commercial banking, and
brokerage services at that time).
 Glass-Steagall Act of 1933 separated banking
business from other financial services by prohibiting
banks from underwriting securities and from
engaging in brokerage activities.
 Ex. J.P. Morgan Co. was split to Morgan Bank
(commercial banking) and Morgan Stanley Co.
(Investment banking).

19. Consolidation across Financial
Industries
 Mergers and consolidations are not limited among
banks, but across financial industries including
investment banks, stock brokers and dealers, and
insurance.
 Citigroup includes Citibank for banking services and Smith
Barney (combined with Salomon Brothers) for brokerage
services.
 Bank of America acquired MBNA in 2006 (Credit card
service), Countrywide in 2008 (Mortgage lending), Merrill
Lynch in 2009.

20. Consolidation across Financial
Industries
 Financial consolidation across financial industries
became possible through
 Bank holding companies which not only hold banks but
also related financial business firms.
 Gramm-Leach-Bliley Financial Services Modernization Act
of 1999 which repealed Glass-Steagall Act and allows
mergers across financial service industries.
 However, this law still prohibits non-financial firms such as
Wal-Mart to operate commercial banking and financial
services.

21. Consolidation across Financial
Industries: Cause and Effect
 Financial consolidation across financial industries
occurred and accelerated in 1980s and 1990s because
 Both banks and financial service firms pursuit more profits
by exploiting economies of scope and lowering transaction
and information costs by extending their services beyond
their industries.
 Financial innovations eroded a difference between
banking services and other financial services, resulting in
competition among banks, insurance companies,
brokerage firms.
 Competition with universal banking firms in Europe
 Financial consolidation across financial industries also
created conflicts-of-interest problems.

22. Universal Banking
 Universal banking is a financial service firm which
provides banking services as well as other financial
services. Universal banking firms may be organized
in two different ways:
 European style: Commercial banks provide a full
range of banking, securities, real estate, and
insurance services, all within a single legal entity.
 Europe (e.g. Deutsche Bank in Germany, UBS in
Switzerland).
 Bank holding company style: Bank holding
companies own and operate separate financial
service firms, including banks, securities, and
insurance.
 England, U.S., and Japan

23. Universal Banking
 Universal banking is often called as “financial
supermarket” (like Wal-Mart supercenter)
because under one roof customers can get all
types of financial services.
 It is more convenient and efficient for
customers who do not need to contact different
financial institutions or to move funds among
them.
 It is more efficient and profitable for financial
institutions which can share customer
information and operation resources and earn
multiple revenues from the same customers.

24. Evolution of Banking Industry
U.S. banking industry has seen significant
changes in recent years.
 Consolidation among banks and across financial
industries
 Financial innovation
 Decline in traditional banking business
 Changes in banking regulations

25. Financial Innovation
A change in the financial environment and technology
stimulates a search by financial institutions for
innovations that are likely to be profitable.
 Recent interest rate volatility and other economic and
market conditions necessitate financial institutions to
develop new products and engage in new activities.
 Ex. Adjustable-rate mortgages, financial derivatives
 Progress in information technology enables financial
institutions to develop new services and products.
 Ex. Debit cards, Online banking, securitization
 To expand its business beyond its industry a
financial institution needs to develop new products
which can avoid existing regulations.
 Ex. Money market mutual funds

26. Decline of Traditional Banking
 The U.S. banking industry has recently seen a
significant decline in its traditional banking
business (deposits & loans):
 On lending side, there is a significant decline in
bank share of total non-financial borrowing.
 On deposit side, there is a significant fall of
bank share in total financial intermediary assets.

27. Bank Share of Total Non-financial
Borrowing
Commercial bank share of total non-financial borrowing
declined from 40% in 1974 to 25% in 2011.

28. Relative Shares of Total Financial
Intermediary Assets
Bank share of total financial intermediary assets has
fallen from 60% in 1970 to below 35% in 2010.

29. Causes of Decline of Banking
Many competitions come from direct finance (other
financial service industries) through financial innovations.
 Liabilities side: depositors seek higher returns
 Money market mutual funds
 Assets side: borrowers seek lower cost of
borrowing
 Junk bonds
 Commercial papers
 Securitization

30. Banks’ Responses to Decline of Banking
Banks responded a decline in traditional banking
business and increased their profits by
 Expanding the traditional lending activities into
new and riskier areas
 Ex. Sub-prime mortgage loans & loan sales
 Pursuing new and more profitable off-balance-
sheet activities
 Ex. Securitization, derivative trading
 Consolidating with other financial service
industries
 Financial innovation

31. Share of Non-interest Income in Total
Bank Income

32. Recent Increase in Bank Failures
 There is a significant increase in bank failures
in late 1980s to early 1990s.
 Some of them resulted from decline of
traditional banking business due to increased
competition with non-banking financial
institutions.
 Other bank failures resulted from
mismanagement, taking too much risk, and
unfamiliar financial service business.

33. Bank Failures in the United States
Since the Great Depression in 1930s, bank failures
had been rare. However, there was an increase in
bank failures in late 1980s to early 1990s, and another
rise in bank failure since 2008.

34. Banking Regulation
The government heavily regulates the banking and
financial industries to increase the information available to
investors and to ensure the soundness of the financial
system. Eight basic categories of banking regulation are
 Government safety net
 Restrictions on bank asset holdings
 Capital requirements
 Chartering and bank examination
 Assessment of risk management
 Disclosure requirements
 Consumer protection
 Restrictions on competition

35. Government Safety Net
 To prevent bank run an resulting bank failure,
the government set up the FDIC in 1934.
 Currently, the FDIC (Federal Deposit
Insurance Company) insures deposits at
member banks up to $100,000.
 Before 1934, when a bank failed, depositors
lost all of their deposits. This created misery
to many citizens in the U.S. during the Great
Depression.
 Because deposits are insured, depositors feel
safe, so they do not need to rush to a failing
bank to withdraw their deposits.

36. Bank Run and Bank Panic
 Bank run: A large number of depositors withdraw
their deposits in fear that the bank might fail and they
might loose their deposits.
 Bank run may occur when a bank becomes insolvency.
 Bank panic: Many banks suffer bank runs at the
same time.
Bank run during the Great Depression Bank run in 2008

37. FDIC
 Although a membership of the FDIC prevents a bunk
run, a bank may fail if its loss is too large to recover.
Then, the FDIC will handle a failing bank in two
different ways:
 Pay-off method: the FDIC lets a bank fail and pay off
deposits.
 NetBank of Atlanta failed in 2007 and FDIC paid up to
an insured amount to each depositor.
 Purchase-and-assumption method: the FDIC takes
over failing bank’s management, reorganizes the bank,
and merges it with a sound bank.
 Failed Continental Illinois National Bank and Trust in
1984 was operated by the FDIC until its acquisition by
Bank of America in 1994.

38. FDIC Insurance Funds
 The FDIC collects the insurance premiums from insured
banks and uses the insurance funds to pay off insured
deposits if a bank fails.
 As of 2008, the FDIC holds $52 billion of insurance funds
and insures $7 trillion of deposits.
 Many large banks have more than hundreds of million
dollar deposits. (e.g. Bank of America had more than $800
million of deposits as of 2007)
 A failure of IndyMac Bank of CA in 2008 may cost the FDIC
$4 to $8 billion.
 Too big to fail policy
 It is too costly for FDIC to let a large bank fail.
 If a large bank fails, the FDIC may not have enough
insurance funds to pay off all insured deposits.
 The FDIC is more like to take the purchase-and-
assumption method when a large bank fails.

39. Asymmetric Information and Deposit
Insurance
Like any other insurance companies, the FDIC faces the
problems of adverse selection and moral hazard.
 Deposit insurance creates a moral hazard problem.
 Banks may take excessive risk since its deposits are
insured (e.g. Who care if I fails my bank?).
 Depositors do not care about riskiness of bank’s operation
since their deposits are insured (e.g. Should I concern my
bank’s financial condition? Not really!).
 Deposit insurance creates an adverse selection.
 Risk-taking entrepreneurs want to start banking since
depositors may not check carefully about bank
management but only concern with interest rates (e.g. Con
men offer extremely high interest rates to gather funds from
greedy depositors).

40. Restrictions on Bank Asset Holdings
 The government restricts banks to hold types of assets
and amount of each asset.
 Banks are not allowed to hold corporate stocks and junk
bonds. Banks are discouraged to hold too much risky
loans.
 Banks are encouraged to hold a certain amount of liquid
assets.
 The government restriction of bank asset holdings is
intended to reduce moral hazard of taking too much risk.
 Without restriction, a risk-prone bank CEO may take
excessive risk to make more profits (and more
compensations for him).

41. Capital Requirements
 Risk-based capital requirement: The government
requires the minimum amount of capital relative to
bank’s assets and its risk.
 If a bank holds a large amount of assets, it will be required
to hold more capital in case of default of large loans.
 If a bank holds risky assets, it will be required to hold
more capital in case of many defaults together.
 The capital requirement is intended to reduce the moral
hazard problem of taking too much leverage.
 With higher capital, a bank has more to lose when it fails.
 Higher capital means more collateral for FDIC in case of
bank failure.

42. Chartering and Bank Examination
 A bank must be chartered and regularly examined by the
government.
 The regulatory agency evaluates each application of new bank
(e.g. soundness of business plan and background of bank
executives).
 The charter agency regularly examines bank’s financial reports
and performs on-site evaluation (e.g. Is a bank complying to its
requirement? Is a bank operating soundly?).
 A bank chartering is intended to reduce the adverse
selection problem and prevent crooks from opening a bank
or risk-taking person from starting an unsound bank.
 A bank examination is intended to reduce the moral
hazard problem of engaging in risky activities.
 If examiners find any irregularity on bank’s financial statements or
not complying to its requirement, the regulatory agency can make
a directional order or close the bank.

43. Assessment of Risk Management
 CAMELS rating system: a bank rating system that a bank
supervisory agency uses to evaluate riskiness of bank
according to six factors.
 Capital adequacy
 Asset quality
 Management quality
 Earnings
 Liquidity
 Sensitivity to market risk
 During regular examination the supervisory agency
evaluates a bank’s operation in the CAMELS rating
system and use to identify banks that are in need of
attention.

44. Implementation of Risk Management
Assessment
 After the financial crisis of 2008, the federal government
implemented various measures to evaluate the risk of
banking.
 Stress test: Evaluate losses and net worth of bank under
dire scenarios and used to recommend adequate levels
of capital.
 Value-at-risk (VaR): Measure the size of the loss on a
trading portfolio in very unlikely situation (e.g. probability
to occur such situation is less than 1%).
 Mark-to-market accounting: Assets held by banks are
periodically evaluated at current market prices rather than
historical book values.

45. Disclosure Requirements
 The government requires each bank to disclose its
financial statement regularly.
 Disclosure requirements are intended to reduce the
asymmetric information problem by providing more and
better information about a bank.
 With more information, shareholders, creditors, and
depositors can monitor and evaluate banks.
 If a banks has an unsound operation, its shareholders may
ask its management team to change its operation.
 If a bank is operating unsoundly, no other banks or
corporations will be willing to lend funds to the bank.
 If a bank is insolvent, depositors may avoid the bank or
move any amount over insured amount from their accounts
to another bank.

46. Consumer Protection
 Both depositors and borrowers must be given enough
information to protect themselves.
 “Truth in lending” under Consumer Protection Act: Banks
should not confuse or trick consumers
 Standardized interest rates (APR)
 Disclosure of total financial charge
 Prevent or reduce lending discrimination
 CRA (Community Reinvestment Act) requires banks to
make loans in all areas where they get deposits. It
promotes more lending in poor neighborhood, where banks
are reluctant to lend due to high risk.
 Prohibit predatory lending
 Some lenders take an advantage of poor credit borrowers
and charge extraordinary high interest rates (e.g. Payday
lenders who often charge over 500% interest rate).

47. Restrictions on Competition
 Glass-Steagall Act of 1933 was intended to make
banks safer, but by prohibiting financial institutions in
other financial industries from engaging in banking
business it restricted competition in the banking
industry.
 McFadden Act of 1927 was intended to give equal
standing between national and state banks, but by
restricting national banks to cross state lines it
restricted competition in local banking markets.
 These anti-competitive restrictions in the banking
industry have been repealed to foster more competition
in the banking industry.
 Competition is believed to promote more efficient
operation and enforce sound banking system.

48. Systemic Risk
 Systemic risk is the risk of collapse of an entire financial
system or entire market, as opposed to risk associated with
any one individual entity, group or component of a system.
 During the financial crisis of 2008, the global financial
system was about collapse – causing many large global
financial institutions to fail simultaneously.
 All financial institutions have similar assets and liabilities,
so adverse economic events affect assets or liabilities of
most financial institutions together.
 Fire sales of assets by one institution to save itself may
cause distress to other financial; institutions.
 Due to complex financial ties (e.g. derivatives), a fall of one
institution can spread to many other institutions.
 Ex. AIG and Citi, JPMorgan Chase, Bank of America through
CDSs

49. Major Banking Legislation in the U.S.
Pre-Depression and post-Depression banking
registrations to ensure safety of financial system.

50. Major Banking Legislation in the U.S.
S&L Crisis-period legislations: Deregulation and
Re-regulation of banks.

51. Major Banking Legislation in the U.S.
Post-S&L crisis legislations: Strengthening and
improving safety of Banks

52. Major Banking Legislation in the U.S.
Financial Globalization period legislations:
Deregulation of financial industry

53. Major Banking Legislation in the U.S.
Post financial crisis of 2008: Re-regulation of
financial industry

54. Banking Crises in the U.S.
 The U.S. economy has experienced several
banking and financial crises in this and last
centuries.
 Panic of 1907
 The Great Depression 1929-1939, including
Bank holiday in 1933
 Savings & Loan Associations Crisis in 1980s
 Sub-prime mortgage loan crisis in 2007-
ongoing

55. Oversea Banking Crisis
 Banking crisis is not limited in the U.S.
 Almost every economy in the world has
experienced banking and financial crises.
 Developed countries such as the U.S. and
Western European countries have
experienced occasional banking crises.
 Developing countries and newly industrialized
countries, such as China, central and South
American countries, Eastern Asian countries,
and former socialist countries, have
experienced chronic banking and financial
crises.

56. Banking Crises Everywhere

57. Banking Crisis History in the World
Banking crises are often
very costly to economies.
On-going banking crisis in
China has cost 47% of its
annual GDP already, while
Japan has lost 24%.
During Asian financial crisis
in 1997 through 2002,
Indonesia lost 55% of its
GDP, while Thailand lost
35% and Korea lost 28%.
Even though S&Ls crisis
was costly for taxpayers,
but its effect on the U.S.
economy was relatively
limited, only 3% of annual
GDP of the U.S.

58. Banking Crisis in History in the World
Banking crises in 2008
have been very costly to
world economy, in particular
Europe.
These crises lead to
recessions in many
European countries since
2008.

59. Dodd-Frank Bill of 2010
 Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010 overhauled
the out-dated financial regulation.
 Financial innovations, deregulation, and
globalization in 1990s and 2000s made the
existing regulation ineffective.
 Unregulated derivatives (e.g. CDSs)
 Unregulated shadow banking system (e.g.
hedge funds)
 Regulatory holes among multiple regulatory
agencies
 Disclosure & conflict of interest problems

60. Dodd-Frank Bill of 2010
Intended to prevent another financial crisis by
Consumer Protection: Create the Consumer Financial
Protection Bureau within the Fed (but independent from the
Fed) to enforce regulations against predatory lending and
miss-information of financial services.
Resolution Authority: Enable the FDIC, the Fed, SEC, and
newly created FIO (Federal Insurance Office) to orderly
liquidation of non-bank financial institutions.
Systematic Risk Regulation: Create a Financial Stability
Oversight Council to monitor the systemic risk.
Volcker Rule: Ban on proprietary trading by commercial
banks, whereby deposits are used to trade on the bank's
own accounts for own profits.
Derivatives: Require more derivatives to be traded on
exchange and cleared through clearinghouses.

61. Future Regulation after Dodd-Frank Act
Dodd-Frank Act left out some important regulatory
issues which need to be addressed:
Capital Requirement: Banks and other financial institutions
must hold adequate capital relative to riskiness of assets
held. Question is how much?
Compensation: Failed institutions’ executive earned
tremendous compensations in short period by taking too
much risk, but were not held financially liable after institution’s
failures. How to make them more accountable?
Government-Sponsored Enterprises (GSEs): What to do
with almost-failed Fannie Mae and Freddie Mac?
Credit-Rating Agencies: How to mitigate the regulatory
reliance of inaccurate ratings?
Overregulation: Too little regulation caused the financial
crisis, but too much regulation creates inefficiency.

62. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University