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


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

  1. 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
  2. 2. Roles of Banks in the Economy <ul><li>Facilitate borrowing and lending </li></ul><ul><li>Facilitate payments </li></ul><ul><li>Risk management </li></ul><ul><ul><li>Issue financial assets that allow firms to share risks </li></ul></ul><ul><ul><li>Provide guarantees and lines of credit </li></ul></ul>
  3. 3. Role of Banks in Lending Source: Available online at
  4. 4. Financial Intermediaries <ul><li>“ Banks” include: </li></ul><ul><li>Commercial banks </li></ul><ul><li>Savings and loan associations (S&L’s) </li></ul><ul><ul><li>Also sometimes called “thrifts” or “thrift institutions” </li></ul></ul><ul><li>Credit unions </li></ul>
  5. 5. Financial Intermediaries Assets at end of 2002 (in billions)
  6. 6. Ownership of Banks <ul><li>U.S. banks are privately owned – no banks are owned by the government. </li></ul><ul><li>In most cases a bank’s stock is held by a large number of investors, so a bank has many “owners.” </li></ul><ul><li>It is relatively easy to establish a new bank in the U.S. </li></ul>
  7. 7. Bank Market Structure <ul><li>There are a large number of banking firms in the U.S., but the number is falling due to mergers between banks. </li></ul><ul><li>Thousands of U.S. banks are very small, each having only a single office. </li></ul><ul><li>Many banks today have multiple branches or offices. </li></ul><ul><li>A “bank holding company” is a firm that owns one or more banking firms. </li></ul>
  8. 8. Size Distribution of U.S. Banks Source: $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. 9. Bank Market Structure: An Example <ul><li>Wells Fargo & Company is a bank holding company based in South Dakota (with historic roots in Minnesota and California). It includes: </li></ul><ul><ul><li>28 chartered bank companies </li></ul></ul><ul><ul><li>a total of over 3,000 branches in 23 states </li></ul></ul>
  10. 10. Some Wells Fargo branches
  11. 11. Wells Fargo’s Broad Scope Source:
  12. 12. 20 Largest U.S. Banks (as of June 30, 2006) Source: $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. 13. A Simple Bank Balance Sheet <ul><li>Assets </li></ul><ul><li>reserves </li></ul><ul><li>&quot;loans&quot; </li></ul><ul><ul><li>securities </li></ul></ul><ul><ul><li>bank loans </li></ul></ul><ul><li>Liabilities </li></ul><ul><li>deposits </li></ul><ul><li>borrowings </li></ul><ul><li>Bank capital (equity) </li></ul>
  14. 14. Detailed Balance Sheet for the Banking Industry Source: Mishkin, Economics of Money, Banking, and Financial Markets, 7 th edition
  15. 15. Two Important Ratios <ul><li>Capital/asset ratio – bank capital as a percentage of bank assets. </li></ul><ul><ul><li>The average capital/asset ratio for U.S. banks was about 9% at the end of 2002. </li></ul></ul><ul><li>Reserve ratio – bank reserves as a percentage of checkable deposits. </li></ul>
  16. 16. Information on U.S. Banks <ul><li>It is easy to get a lot of financial data on U.S. banks. </li></ul><ul><li>A great source: </li></ul><ul><li> </li></ul>
  17. 17. An Example: Data on Wells Fargo
  18. 18. What Can Go Wrong? <ul><li>“ Bank failure ” – the bank goes out of business. </li></ul><ul><ul><li>Bank depositors might lose some of their funds. </li></ul></ul><ul><ul><li>Bank creditors might lose some of their investment </li></ul></ul><ul><ul><li>Bank owners lose their capital. </li></ul></ul><ul><li>The bank suffers significant losses – the government might have to help. </li></ul>
  19. 19. Reasons for Bank Regulation <ul><li>Banks must be regulated because: </li></ul><ul><li>a bank failure can be devastating to depositors. </li></ul><ul><li>there’s a risk of systemic failure : the failure of one bank can make it more likely that other banks will fail. </li></ul><ul><li>depositors can’t monitor how the bank invests their funds, creating a moral hazard problem . </li></ul><ul><li>government assistance to a bank can be very costly. </li></ul>
  20. 20. Reasons for Bank Regulation <ul><li>Banks are less stable than other businesses because: </li></ul><ul><li>bank liabilities tend to be short-term – many depositors could withdraw their funds with little notice. </li></ul><ul><li>bank assets tend to be longer-term – reserves and other liquid assets are only a small share of the total. </li></ul><ul><li>the behavior of depositors depends on their confidence that the bank is sound, and this confidence can be easily shaken. </li></ul>
  21. 21. A Closer Look at Bank Failure <ul><li>Two reasons for bank failure: </li></ul><ul><li>The value of bank assets falls, so assets<liabilities. </li></ul><ul><li>Deposit outflow: A large number of depositors withdraw their funds from the bank, exhausting the bank’s cash (reserves) and other liquid assets. </li></ul><ul><li>Therefore a bank is more likely to fail if it has a low capital/asset ratio or a low reserve ratio. </li></ul>
  22. 22. A Closer Look at Bank Failure <ul><li>Tradeoff between higher income and a lower risk of failure: </li></ul><ul><li>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. </li></ul><ul><li>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.) </li></ul>
  23. 23. A Closer Look at Bank Failure <ul><li>If there were no government regulation of banks : </li></ul><ul><li>each bank would choose a capital/asset ratio and a reserve ratio to maximize the value of the bank. </li></ul><ul><li>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. </li></ul><ul><ul><li> “ market discipline” </li></ul></ul>
  24. 24. A Closer Look at Bank Failure <ul><li>But if there were no government regulation of banks : </li></ul><ul><li>banks would choose capital/asset ratios and reserve ratios that are too low from society’s standpoint. </li></ul><ul><li>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. </li></ul>
  25. 25. An Example: Continental Illinois Bank <ul><li>Continental Illinois Bank failed in 1984. </li></ul><ul><li>The federal government paid billions of dollars to keep Continental Illinois from closing. </li></ul><ul><li>This was the biggest bank “resolution” in U.S. history. </li></ul>
  26. 26. An Example: Continental Illinois Bank <ul><li>Before it failed, Continental Illinois Bank: </li></ul><ul><li>was the largest bank in Chicago. </li></ul><ul><li>was the seventh-largest bank in the U.S. </li></ul><ul><li>had 57 offices in 14 states and 29 foreign countries. </li></ul>
  27. 27. An Example: Continental Illinois Bank <ul><li>Why did Continental Illinois fail? </li></ul><ul><li>Starting in the late 1970s, the bank grew fast, with lots of loans to businesses. </li></ul><ul><ul><li>Poor quality loans </li></ul></ul><ul><ul><li>Too many loans to firms in the oil industry </li></ul></ul><ul><ul><li>Too many loans to borrowers in Latin America </li></ul></ul><ul><ul><li>“ Continental Illinois is willing to do just about anything to make a deal.” </li></ul></ul><ul><li>High cost of funds </li></ul><ul><ul><li>Large share of funds borrowed from other banks </li></ul></ul><ul><ul><li>Relatively small reliance on domestic deposits </li></ul></ul><ul><ul><li>Heavy borrowing in foreign money markets </li></ul></ul>
  28. 28. An Example: Continental Illinois Bank <ul><li>The Bank’s Troubles </li></ul><ul><li>By 1984 the bank’s nonperforming loans (loans on which payments were late) rose to $5.2 billion (over 10% of total loans). </li></ul><ul><li>May 1984: an electronic “bank run” – depositors withdrew billions of dollars in deposits </li></ul><ul><li>The FDIC and the Federal Reserve System pledged their support for the bank and lent over $5 billion. </li></ul>
  29. 29. An Example: Continental Illinois Bank <ul><li>Dangers </li></ul><ul><li>Many smaller banks had deposits at Continental Illinois, so the failure of Continental Illinois could have caused some of them to fail, too. </li></ul><ul><li>Other depositors (including many important corporations) could lose some of their funds </li></ul><ul><li>Foreign investors would lose confidence in U.S. banks </li></ul>
  30. 30. An Example: Continental Illinois Bank <ul><li>Rescuing Continental Illinois Bank </li></ul><ul><li>Continental Illinois Bank had $3 billion in insured deposits and $30 billion in uninsured deposits. The FDIC promised to guarantee all deposits. </li></ul><ul><li>The FDIC assumed the Bank’s 3.5 billion debt to the Federal Reserve. </li></ul><ul><li>The FDIC bought $1 billion in Continental Illinois stock – the FDIC “owned” the bank. </li></ul>
  31. 31. An Example: Continental Illinois Bank <ul><li>Lessons from Continental Illinois Bank </li></ul><ul><li>Banks have an incentive to take on too much risk, so they need closer supervision </li></ul><ul><li>The failure of a very large bank could have broader negative effects </li></ul><ul><li>Rescuing a large bank can be expensive for the government </li></ul><ul><li>Good sources: </li></ul><ul><li> -- Part II, Chap. 4 </li></ul><ul><li> -- Chap. 7 </li></ul>
  32. 32. Bank Regulation: An Overview <ul><li>In the U.S. the government regulates banks in many ways: </li></ul><ul><li>Federal deposit insurance </li></ul><ul><li>Imposing capital requirements (minimum capital/asset ratios) </li></ul><ul><li>Imposing reserve requirements (minimum reserve ratios) </li></ul><ul><li>Restricting the types of assets that banks may hold </li></ul><ul><li>Performing bank examinations (periodic auditing reviews) </li></ul>
  33. 33. <ul><li>Primary bank regulators in the U.S.: </li></ul><ul><li>Office of the Comptroller of the Currency (OCC) </li></ul><ul><ul><li>part of the U.S. Department of the Treasury </li></ul></ul><ul><li>Federal Reserve System – the U.S. central bank </li></ul><ul><li>Federal Deposit Insurance Corporation (FDIC) </li></ul><ul><li>State bank regulators </li></ul>Bank Regulation: An Overview
  34. 34. Federal Deposit Insurance <ul><li>The U.S. Congress created the Federal Deposit Insurance Corporation (FDIC) in 1933, after the bank failures in the Great Depression. </li></ul><ul><li>Today the FDIC guarantees each bank deposit up to a maximum of $100,000. </li></ul><ul><li>FDIC insurance is funded by a small fee paid by banks based on their deposits. </li></ul>
  35. 35. Bank Failures in the Great Depression
  36. 36. Effects of Federal Deposit Insurance <ul><li>Deposit insurance prevents bank runs </li></ul><ul><li>Prevents losses by small depositors </li></ul><ul><li>Reduces “systemic risk” in the banking system </li></ul><ul><li>Deposit insurance gives banks incentives to: </li></ul><ul><li>hold riskier assets. </li></ul><ul><li>hold less capital. </li></ul><ul><li>manage the bank’s assets less carefully. </li></ul>
  37. 37. Incentive Effects of Deposit Insurance: A Closer Look <ul><li>Deposit insurance increases the supply of deposits (within the insurance coverage limits). </li></ul><ul><li>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. </li></ul><ul><li>As a result, deposit insurance reduces banks’ incentives to avoid risk. </li></ul>
  38. 38. Capital Requirements <ul><li>When there’s deposit insurance, banks have an incentive to hold too little capital. </li></ul><ul><li>Therefore the government imposes capital requirements to ensure that banks hold sufficient capital. </li></ul>
  39. 39. Capital Requirements <ul><li>A simple capital requirement would require that a bank’s capital/asset ratio be greater than or equal to a specified level. </li></ul><ul><li>Example: capital/asset ratio ≥ 0.05. </li></ul><ul><li>Problem: Not all assets are equally risky. A simple capital requirement gives a bank an incentive to hold more risky assets. </li></ul>
  40. 40. Risk-weighted Capital Requirements <ul><li>At an international conference in Basel, Switzerland in 1988, bank regulators from the world’s affluent countries agreed to impose risk-weighted capital requirements : </li></ul><ul><li>Classes of assets are assigned risk weights between 0% and 100%. </li></ul><ul><li>Risk-free assets carry a weight of 0%, and more-risky assets carry higher weights. </li></ul><ul><li>Capital requirements then set a minimum for the ratio of capital to risk-weighted assets. </li></ul>
  41. 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. 42. <ul><li>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). </li></ul><ul><li>If the bank acquires another $1 million in capital, it could invest up to: </li></ul><ul><ul><li>$12.5 million more in home-equity loans </li></ul></ul><ul><ul><li>$25 million more in home mortgages </li></ul></ul><ul><ul><li>$62.5 million more in municipal bonds </li></ul></ul><ul><li>So risk-weighted capital requirements give the bank an incentive to hold less-risky assets. </li></ul>Risk-weighted Capital Requirements: An Example
  43. 43. Proposed Capital Requirement Reform: Basel 2 <ul><li>Problem: Assets within a risk class might expose banks to different amounts of risk. </li></ul><ul><li>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. </li></ul><ul><li>Basel 2 will take effect in some countries in 2007. </li></ul><ul><li> </li></ul>
  44. 44. Reserve Requirements <ul><li>The Federal Reserve System requires banks to hold reserves that are greater than or equal to a specified percentage of their checkable deposits: </li></ul><ul><ul><li>3% for smaller banks </li></ul></ul><ul><ul><li>10% for larger banks </li></ul></ul>
  45. 45. Reserve Requirements <ul><li>But reserves are higher than they need to be to promote stability of the banking system. </li></ul><ul><li>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. </li></ul>
  46. 46. Restrictions on Asset Holdings <ul><li>B ank regulations include the following: </li></ul><ul><li>Banks cannot hold common stock. </li></ul><ul><li>Banks cannot invest too large a share of their deposits in a single loan or in loans to businesses in a single industry. </li></ul><ul><li>Banks cannot lend funds to bank directors, managers, or principal shareholders at below-market rates. </li></ul>
  47. 47. Bank Examinations <ul><li>Banks are visited on a regular schedule by bank examiners from the OCC, the Federal Reserve System, the FDIC, or other agencies. </li></ul><ul><li>Bank examiners review the bank’s financial statements and its confidential accounts. </li></ul><ul><li>The results are summarized in a “CAMELS” rating given to the bank. </li></ul>
  48. 48. Bank Examinations <ul><li>C apital adequacy </li></ul><ul><li>A sset quality </li></ul><ul><li>M anagement </li></ul><ul><li>E arnings </li></ul><ul><li>L iquidity </li></ul><ul><li>S ensitivity to market risk </li></ul>
  49. 49. CAMELS ratings <ul><li>1 Sound in every respect </li></ul><ul><li>2 Fundamentally sound, but with modest weaknesses that can be corrected </li></ul><ul><li>3 Moderately severe to unsatisfactory weaknesses; vulnerable if there’s a business downturn </li></ul><ul><li>4 Many serious weaknesses that have not been addressed; failure is possible but not imminent </li></ul><ul><li>5 High probability of failure in the short term </li></ul>
  50. 50. Bank Examinations <ul><li>CAMELS ratings are disclosed to bank management, but not to the public. </li></ul><ul><li>If the CAMELS rating for a bank is unfavorable, regulators can take actions like these: </li></ul><ul><ul><li>Require banks to disclose unfavorable information in their public financial statements </li></ul></ul><ul><ul><li>Issue a “cease and desist” order requiring the bank to stop doing things that cause financial troubles and to correct problems. </li></ul></ul><ul><ul><li>Impose fines (up to $1,000,000 per day). </li></ul></ul>
  51. 51. Bank Examinations
  52. 52. Bank Examinations <ul><li>Good sources on bank examinations and the FDIC: </li></ul><ul><li> </li></ul><ul><li> </li></ul>
  53. 53. The Banking Crisis of the 1980s <ul><li>Hundreds of savings and loan associations (S&L’s) and banks failed in the 1980s and early 1990s. </li></ul><ul><li>This episode illustrates: </li></ul><ul><ul><li>how changes in the market environment and a loosening of regulations can lead to a bank crisis. </li></ul></ul><ul><ul><li>how government regulators can handle widespread bank failures. </li></ul></ul><ul><ul><li>how regulations and supervisory standards can be improved to address new problems. </li></ul></ul>
  54. 54. Magnitude of the Crisis <ul><li>From 1980 through 1994, over 2,900 banks and S&L’s failed. </li></ul><ul><ul><li>1,617 banks with total assets of $302.6 billion </li></ul></ul><ul><ul><li>1,295 S&L’s with total assets of $621 billion </li></ul></ul><ul><li>On average, a bank or S&L failed every 15 days from 1980 to 1994. </li></ul><ul><li>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. </li></ul>
  55. 55. Magnitude of the Crisis: Number of Bank Failures Per Year
  56. 56. Causes of the Banking Crisis <ul><li>The banking crisis had many causes, including: </li></ul><ul><ul><li>changes in the market environment </li></ul></ul><ul><ul><li>looser regulations that gave S&L’s more competitive options </li></ul></ul>
  57. 57. Causes of the Banking Crisis: Changes in the Market Environment <ul><li>As a result of financial innovations in the 1960s and 1970s: </li></ul><ul><ul><li>banks and S&L’s faced more competition from other financial firms (such as mutual funds). </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>the financial market environment was more complicated and harder for regulators to monitor. </li></ul></ul>
  58. 58. Causes of the Banking Crisis: Changes in Regulation <ul><li>The banking industry was partially deregulated in the early 1980s: </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>S&L’s were allowed to invest in junk bonds (low-quality, high-risk commercial bonds) and common stocks. </li></ul></ul>
  59. 59. Causes of the Banking Crisis: Changes in Regulation
  60. 60. Causes of the Banking Crisis <ul><li>As a result, S&L’s held more risky assets, resulting in huge loan losses. </li></ul><ul><li>S&L management had little expertise in managing risks from new kinds of assets. </li></ul><ul><li>Regulators had little experience in monitoring the new risks. </li></ul><ul><li>Since S&L deposits (up to $100,000) were protected by federal deposit insurance, depositors had little incentive to monitor S&L risks. </li></ul>
  61. 61. Regulatory Failures in the Crisis <ul><li>Regulators of S&L’s did not close insolvent institutions and end the crisis quickly. </li></ul><ul><ul><li>The deposit insurance fund wasn’t large enough to cover losses. </li></ul></ul><ul><ul><li>(The S&L deposit insurance fund had a balance of -$75 billion in 1988.) </li></ul></ul><ul><ul><li>Regulators wanted to encourage the growth of the S&L industry, not close S&L’s. </li></ul></ul><ul><ul><li>Regulators hoped the crisis would pass without revealing their failures. </li></ul></ul>
  62. 62. Managing the Crisis <ul><li>In 1989 the government created the Resolution Trust Corporation (RTC) to handle S&L’s that were failing. </li></ul><ul><li>Functions of the RTC: </li></ul><ul><li>Took over assets of failing S&L’s and sold them to recover as much of their value as possible. </li></ul><ul><li>Issued bonds to fund the costs of covering S&L losses. </li></ul>
  63. 63. Who Paid the Cost? <ul><li>Bank and S&L stockholders </li></ul><ul><li>Some depositors who had large deposits that exceeded the deposit insurance limits </li></ul><ul><li>Taxpayers, who ultimately will pay higher taxes to pay off bonds that were issued to fund the costs of the crisis. </li></ul>
  64. 64. Regulatory Reforms Following the Crisis <ul><li>Some regulatory agencies that had not been effective were eliminated, and their powers were given to other agencies. </li></ul><ul><li>Earlier restrictions on assets holdings by S&L’s were reinstated. </li></ul><ul><li>S&L’s were required to raise their capital/asset ratios. </li></ul><ul><li>Now bank examiners visit banks more frequently than before. </li></ul><ul><li>Regulators were required to act more quickly when a bank or S&L is failing. </li></ul>
  65. 65. Regulatory Reforms Following the Crisis
  66. 66. Lessons from the Banking Crisis <ul><li>The U.S. banking crisis in the 1980s was similar to bank crises in other countries: </li></ul><ul><li>Financial liberalization allowed banks to take more risks, but there was not yet adequate government regulation and supervision of those risks. </li></ul><ul><li>A government “safety net” created moral hazard problems and eliminated some market discipline. </li></ul>
  67. 67. The Banking Crisis of the 1980s <ul><li>Two excellent sources: </li></ul><ul><li>Managing the Crisis: The FDIC and RTC Experience </li></ul><ul><li> </li></ul><ul><li>History of the Eighties - Lessons for the Future </li></ul><ul><li> </li></ul>