Banking Industry: Structure and Competition (MISHKIN)

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BANKING INDUSTRY
Structure and Competition
C H A P T E R 1 3

The U.S. has about
• 6,500 Commercial banks,
• 1,100 Savings and Loan
associations,
• 400 Mutual Savings banks,
• and 7,500 credit unions
Introduction
Is the American Banking
System more competitive and
therefore more economically
efficient than of other
countries?

HISTORICAL
DEVELOPMENT
of the Banking System

Historical Development
Bank of North
America is
chartered
1782
1782

Bank of North
America is
chartered
1782
Bank Of The
United States
is chartered
1791
1782 1791

Bank of North
America is
chartered
1782
Bank Of The
United States
is chartered
1791
Second Bank Of The
United States is
chartered
1816
1782 1791 1816

Bank of North
America is
chartered
1782
Bank Of The
United States
is chartered
1791
Second Bank Of The
United States is
chartered
1816
1782 1791 1816 1836
Second Bank
charter lapsed
1836

National Bank Act
created a new
banking system
1863
1863

Federal Reserve Act
creates Federal
Reserve System
1913
1863 1913
National Bank Act
created a new
banking system
1863

Federal Reserve Act
creates Federal
Reserve System
1913
1863 1933
National Bank Act
created a new
banking system
1863
Banking Act (Glass-Steagall)
creates FDIC and separates
banking and securities industries
1933
1913

1933
• Prohibited commercial banks from
underwriting corporate securities
• Prohibited investment banks to perform
commercial bank activities
• Commercial banks have to sell off their
investment banking operations
• Investment banking discontinued their deposit
business
Glass-Steagall Act:

OCC : NATIONAL BANKS that own more than half of the
assets in the commercial banking system.
FED & STATE BANKING AUTHORITIES:
STATE BANKS (Members Of The FRSystem)
FED: BANK HOLDING COMPANIES & National Banks
MULTIPLE
REGULATORY AGENCIES

MULTIPLE
REGULATORY AGENCIES
FDIC & STATE BANKING AUTHORITIES:
STATE BANKS (w/ FDIC Insurance; not members of
FRSystem)
STATE BANKING AUTHORITIES:
STATE BANKS (w/o FDIC Insurance)

FINANCIAL INNOVATION
and the growth of the
SHADOW BANKING
SYSTEM

Traditional
Banking
Make long term
loans by issuing
short term
deposits
Declined and is
replaced by
Shadow Banking
System

SHADOW BANKING SYSTEM
• Bank lending has been replaced by lending via the
securities markets.
• Financial innovation is driven by the desire to earn
profits.
A change in the financial environment will stimulate a
search by financial institutions for innovations that are
likely to be profitable (FINANCIAL ENGINEERING)

Change in Financial Environment
1. Inflation and interest rates climbed sharply and
harder to predict
• Change in Demand conditions
2. Advancement of Computer Tech
• Change in Supply Conditions
3. Regulations became burdensome
----------------------------------------------------
FINANCIAL ENGINEERING (Research and Develop)

RESPONSES TO CHANGES IN THE
DEMAND CONDITION: Interest Rate Volatility
─ Large fluctuations in interest rates led to substantial capital gains and
losses and increased uncertainty on returns on investments
High volatility = High level of interest rate
risk
─ Demand for new financial products to lower risk increased

ADJUSTABLE RATE MORTGAGES
Mortgage loans on which interest rate changes when a
market interest rate changes
• Mortgage institutions earn higher interest
rates on existing mortgages when market
rates rise—keep profits high
• Issue lower initial interest rates to
make it more attractive to households
RESPONSES TO CHANGES IN THE DEMAND CONDITION

FINANCIAL DERIVATIVES
Ability to hedge interest risks
Future contracts: seller agrees to provide certain
standardized commodity to the buyer on a specific
future date at an agreed-on price
• Payoffs are linked to previously issued (i.e.
derived from) securities
RESPONSES TO CHANGES IN THE DEMAND CONDITION

RESPONSES TO CHANGES IN THE
SUPPLY CONDITION: Information Technology
Improvement in information technology have
• lowered the cost of processing financial transactions,
making it profitable for financial institutions to create new
financial products and services
• made it easier for investors to acquire information, thereby
making it easier for firms to issue securities

BANK CREDIT AND DEBIT CARDS
• Improved technology in the late 1960s reduced
transaction costs making nationwide credit card
programs profitable.
• The success of credit cards led to the
development of debit cards for direct access
to checkable funds.
RESPONSES TO CHANGES IN THE SUPPLY CONDITION

ELECTRONIC BANKING
1. ATM – get cash, make deposits, transfer
funds, check balances; Available 24hrs a
day; increased customer convenience
2. Home banking – conduct bank
transactions without leaving home; linked
with the bank’s computer (by telephone/computer)

ELECTRONIC BANKING
3. Automated Banking Machine (ABM) –
combines in one location an ATM, access
to bank’s website, and telephone linked to
customer service
4. Virtual Bank – bank only exists in the
cyberspace; full set of banking services 24
hours a day

JUNK BONDS
IT: Easier screening, investors are willing to buy long-term debt securities
from less well-known corporations with lower credit ratings.
Junk bonds: a debt security that is poorly rated
because it has a high default risk.
Riskier investment than higher rated
bonds = higher returns that can attract
investors

COMMERCIAL PAPER MARKET
Commercial paper refers to unsecured debt issued by
large corporations with a short original maturity.
- Pays a fixed rate of interest
- Used by large banks to cover short-term receivables and
meet short-term financial obligations

COMMERCIAL PAPER MARKET
The development of money market mutual funds
assisted in the growth the commercial paper market.
Money market mutual fund invests solely in cash/cash
equivalent securities, which are also often referred to as
money market instruments. These investments are short-
term, very liquid investments with high credit quality.

SECURITIZATION
Securitization refers to the transformation of
illiquid assets into marketable capital market
instruments.
- Improvement in acquiring information made it
easier to sell capital market securities
- Low transaction cost: DIVERSIFY RISK
TROUGH BUNDLING OF LOANS

AVOIDANCE OF EXISTING REGULATIONS
Government regulations leads to financial innovation
by creating incentives for firms to search for
loopholes in the regulations that restrict them from
earning profit
Loophole Mining: process of avoiding
regulations

LOOPHOLE MINING
1) Reserve requirements that force banks to keep
a fraction of their deposits as reserves act as a tax
on deposits
2) Restrictions on interest paid on deposits led to
disintermediation
AVOIDANCE OF EXISTING REGULATIONS

MONEY MARKET MUTUAL FUNDS
issues shares that are redeemable at a
fixed price by writing checks
- Not legally deposits and so are not subject to
reserve requirements or prohibitions on interest
payments
AVOIDANCE OF EXISTING REGULATIONS: Financial Innovation

SWEEP ACCOUNTS
Any balances above a certain amount in a
corporations' checking account at the end of a
business day are “swept out” of the account and
invested in overnight securities that pay interest.
- Not classified as checkable deposit, not subject to
reserve requirements
AVOIDANCE OF EXISTING REGULATIONS: Financial Innovation

Financial
Innovation and
the Decline of
Traditional
Banking
↓ Cost advantage
= ↓ Liabilities
↓ Income
Advantages
= ↓ Assets

Decline in Cost Advantages
• Investors also sought Money Market Mutual
Funds with higher i
• Difficulty in Raising funds  supported the
elimination of Regulation Q ceilings on time
deposit i and allowed checkable deposit accounts
that paid interests

Decline in Income Advantages
Loss of Liabilities = Less Competitive
Financial Innovation  = Shadow Banking System 
1) Information Technology  = Issue securities to public 
• Increased demand for Commercial Paper Market
Funds that are cheaper than going to banks
• Finance Companies: depend on CPM Funds,
investors go to finance companies instead to
commercial banks

2) Junk Bonds  = Lower quality corporate
borrowers use less
commercial banks
= ↓ Loan Business of CBs

3) Securitization
Information technology  = ↓ Transaction cost
They can now bundle loans and sell it as securities
 Financial Innovation = ↓ Bank on credit operations
= ↓ Loan business
= ↓ income advantage
= ↓profit

Banks’ Response
EXPAND INTO NEW AND RISKIER AREAS OF
LENDING ( Risk Taking)
• Commercial real estate loans
• Corporate takeovers and leveraged buyouts
PURSUE OFF-BALANCE-SHEET ACTIVITIES
(More profitable—shadow banking system)
• Non-interest income activities – can result to excessive
risk taking

Decline In Traditional Banking In Other
Industrialized Countries
 Financial innovation and Deregulation
JAPAN:  New financial instruments = DISINETERMEDIATION
EUROPE: Innovation = ↓ barriers of forces on anticompetition
OTHER COUNTRIES: Faced  competition from the
expansion of securities markets and the growth of Shadow
Banking System

COUNTRIES WHERE SECURITIES MARKETS
HAVE NOT GROWN:
↓ Loan business: customers have access to foreign and off-
shore capital markets (Eurobond market)
SMALL ECONOMIES:
↓ Loan business =  International Securities market
• Securitization undercuts the profitability of traditional banking
.:. ↓ Traditional bankingUS =↓ Traditional bankingAbroad

Structure of the
U.S. COMMERCIAL
BANKING INDUSTRY

Size Distribution of Insured Commercial Banks,
March 30, 2011
36%
57%
7%
Lessthan$100M
$100M-$1B
Morethan$1B
SMALLBANKS
36%

Size Distribution of Insured Commercial Banks,
March 30, 2011

Ten Largest U.S. Banks, June 30, 2011

Restrictions on Branching
McFadden Act (1927) & Douglas’ Amendment
(1956)
➢Branching Restrictions (McFadden Act of 1927)
from across state lines
➢Allowed small banks to exist while restricted
national banks from branching

1)BANK HOLDING COMPANIES:
Corporation that owns several different companies
• Allowed purchases of banks outside state
• BHCs allowed wider scope of activities by Fed
• BHCs dominant form of corporate structure for
banks

2) ATM – enabled
banks to provide
customers with more
services over a wide
geographic area
Let it be owned by someone else
and paid for each transaction with
a fee – not a branch, no
regulations
↓ Cost
 Services
 Economies of
Scale/Scope
Geographical scope
 Profit

BANK CONSOLIDATION
and Nationwide Banking

1985 -1992: Bank Failures
• Number of banks declined by
3000—more than double the
number of failures
1997-2007:
• Number of commercial
banks decreased by a
little over 3800, most are
small banks
2007-2009:
Financial Crisis

BANK
CONSOLIDATION:
Banks created
larger entities by
merging or buying
other banks
Loophole mining reduced
effectiveness of
branching restrictions
• Resulted to the
formation of regional
compacts—banks in
one state can own
banks in other states in
the region.

Reasons why
banks wanted
to expand
across state
lines
Multistate
banking meant
that banks
could diversify
their loan
portfolio
1

Reasons why
banks wanted
to expand
across state
lines
By getting
bigger, banks
could take
advantage of
the economies
of scale and
reduce their per
unit costs
2

Reasons why
banks wanted
to expand
across state
lines
Through bank
consolidation,
economies of
scope also
increased the
combination of
products and
services banks
can provide.
3

Consequences
of Bank
Consolidation
1) Financial intermediaries
became more alike as they
encroached on each
other’s territory.
2) Consolidation resulted in
the development of large
complex financial
intermediaries

Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994
• Expanded regional compacts into a nationwide banking system
• Overturned McFadden Act and Douglas Amendments’ prohibition
of interstate banking
• coordinated.

Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994
• Bank holding companies can not only own banks in other states,
but also merge banks they own into one bank with branches on
different states.
• Economies of scale cannot be fully exploited through bank
holding company structure, but only by through branching
networks in which all of the bank’s operations are fully

Assumptions on the Future of the U.S. Banking
System
1. Only a couple of hundred banks left
2. Few large banks dominate
3. Bank consolidation surge will settle down and banks will increase to
several thousands rather than several hundred.
4. Shift in assets from smaller banks to larger banks
- Share of banks with less than $100M in assets is expected to halve
while of megabanks will be doubled.

Are Bank Consolidation and Nationwide Banking a
Good Thing?
Cons
1. Fear of decline of small banks and small business lending
2. Rush to consolidation may increase risk taking
Pros
1. Community banks will survive
2. Increase competition and efficiency
3. Take advantage of Economies of scale and scope
4. Increased diversification of bank loan portfolios: lessens
likelihood of failures

Separation of Banking and
Other Financial Service
Industries

Glass-Steagall Act of 1933
• allowed commercial banks to sell on-the-run
government securities
• prohibited underwriting / brokerage services,
real estate / insurance business
• prohibited other FIs from offering commercial
banking services

Erosion of Glass-Steagall
The development of money
market mutual funds
enabled brokerage firms to
provide deposit instruments.
01
In 1987, the Federal
Reserve allowed banking
affiliates to underwrite
securities, as long as
revenues did not exceed a
certain amount.
02

Erosion of Glass-Steagall
Regulatory agencies also allowed banks to
engage in some real estate and some
insurance activities.
03

Gramm-Leach-Bliley Financial Services
Modernization Act of 1999
─Legislation to eliminate Glass-Steagall
─It allowed financial institutions to operate both commercial and
investment banks.
States retain regulatory authority over insurance activities
Securities and Exchange Commission oversees securities
activities
OCC regulates subsidiaries that underwrite securities
Fed still oversees bank holding companies (under which all real
estate and insurance activities and large securities operations will
be housed)

Implications for Financial Consolidation
1. The Riegle-Neal Act and Gramm-Leach-Billey Act
=  Number of banking institution
=  Financial service activities
2. Information technology =  Economies of scope
• Mergers of banks with other financial service firms became more
common
• Megamergers
3. Banking institutions becomes larger and more complex
organizations
• Use the full range of financial service activities

Separation of Banking and Other
Financial Services throughout the World
Universal Banking (GE, NT, SW)
• No separation of banking and underwriting, insurance, real estate, etc.
• Allowed to own equity shares in commercial firms

British-style Universal Banking (UK, CA, AU)
Allow securities underwriting, but:
• Separate legal subsidiaries are more common
• Bank equity holdings are less common
• Combinations of banking and insurance firms are less common
• Commercial banks are increasingly being allowed to engage in securities
activities.

Japan Banking
• Some legal separation between banking and financial
services industries
• Allowed to hold equity in firms
• BHCs are illegal

Thrift Industry: Regulation
and Structure

─savings and loan
associations (S&Ls)
─mutual savings
banks
─credit unions
The regulation and
structure similar to
the commercial
banking industry.
We will look at each
type of institution
briefly:

Thrift Industry: S&Ls
• Can be chartered either by the federal government or by the states
• Federally chartered S&Ls: Members of Federal Home Loan Bank System
Office of Thrift Supervision:
• regulates federally insured S&Ls
• chartering agency for federally chartered S&Ls—approves mergers
and sets the rules for branching
• In the past, branching were permitted but later grown statewide then
nationwide.

Thrift Industry: S&Ls
FHLBS:
• Provide loans but can be paid through a longer period.
• Rates charged for these loans are also below the rates that S&Ls must pay
when they borrow in the open market.
• FHLBS loan program provides a subsidy to the savings and loans industry.
S&Ls now engage in many of the same activities as the
Commercial banks that having a separate charter and
regulatory apparatus no longer makes sense

Thrift Industry: Mutual Saving Banks
Approximately half are chartered by states
– Regulated by state in which they are located
– Deposit insurance provided by FDIC or state
insurance
Most have assets in excess of $25 million
since regulations are fairly liberal.

Thrift Industry: Credit Unions
• Small cooperative, tax-exempt, lending institutions
organized around a particular group of people.
• More than half are federally chartered.
• Regulated by the National Credit Union Administration
(NCUA)
• Deposit insurance provided by National Credit Union
Share Insurance Fund (NCUSIF)

Thrift Industry: Credit Unions
• Regulatory changes allow individual credit unions to
cater to a more diverse group of people by interpreting
the common bond requirement less strictly
• Branching across state lines and into other countries is
permitted for federally chartered credit unions (e.g.,
Navy Federal CU).

International Banking

International Banking
There are currently 100 American bank branches abroad,
with over $1.5 trillion in assets. In 1960, there were only 8
branches with less than $4 billion in assets. Why the rapid
growth?
1. Rapid growth of international trade
2. Banks abroad can pursue activities not allowed in
home country
3. Tap into Eurodollar market

Eurodollar Market
• Represents U.S. dollars deposited in banks outside
the U.S.
Many companies want these dollars:
─The dollar is widely used in international trade
─Dollars held outside the U.S. are not subject to U.S.
regulations
• To capture the profits from Eurodollar transactions, U.S.
banks opened abroad

Structure of U.S. Banking Overseas
Latin America & Far East
- Due to the importance of US Trades with the region
London
- Major international financial center and center of Eurodollar
market
Caribbean (Bahamas and Cayman Islands):
• Tax haven with minimum taxes and few restrictive regulations
• Primarily as bookkeeping centers, do not provide normal
banking services

Edge Act Corporation: special subsidiary primarily
for international banking.
• International activities of US banking
organizations are governed primarily by the
Federal Reserve's Regulation K.

International Banking Facilities (IBF—1981):
• Accepts time deposits of foreign investors
• Not subject to reserve requirements
• Make loans to foreigners only
• Have favorable local tax treatment
.:. To encourage US and foreign banks to do
more business in the US

Foreign banks in the US
Foreign banks in the US are setup as:
1) An agency office of a foreign bank: lend and
transfer of funds in the US
• Fewer regulations
2) A subsidiary of a U.S. bank
• Same regulation as a U.S. bank
3) a branch of a foreign bank—full service office
May form Edge Act corporations and IBFs.

Foreign banks in the US
Regulations (as of 1978 International Banking Act)
─Foreign banks could open new full-service branches ONLY
in the state they designate as their home state or in states
that allow the entry of out-of-state banks
Impact
─World financial markets became more integrated
─Encouraged bank consolidation abroad
─Importance of foreign banks in international banking

Ten Largest Banks in the World, 2012

Banking Industry: Structure and Competition (MISHKIN)

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