Chapter 10. The Banking Industry:Chapter 10. The Banking Industry:Structure and CompetitionStructure and Competition

Chapter 10. The Banking Industry:Chapter 10. The Banking Industry:Structure and CompetitionStructure and Competition

• A Brief History

• Structure

• Thrifts

• International Banking

• The Decline of Traditional Banking

• A Brief History

• Structure

• Thrifts

• International Banking

• The Decline of Traditional Banking

I. A Brief HistoryI. A Brief HistoryA. dual banking systemA. dual banking systemI. A Brief HistoryI. A Brief HistoryA. dual banking systemA. dual banking system

banking at state level until Civil War• state charters, regulation• banknotes as local currency• failures, fraud were common

banking at state level until Civil War• state charters, regulation• banknotes as local currency• failures, fraud were common

• National Bank Act 1963• federal charters for banks• Comptroller of the Currency• federal banknotes• tax on state banknotes• state banks survived by accepting

deposits

-- dual banking system

• National Bank Act 1963• federal charters for banks• Comptroller of the Currency• federal banknotes• tax on state banknotes• state banks survived by accepting

deposits

-- dual banking system

B. A central bankB. A central bankB. A central bankB. A central bank

• U.S. had two prior central banks• the Bank of the U.S. (1791-1811))• the Second Bank of the U.S.

(1816-63)

• U.S. central banks not popular w/• ranchers & farmers• states rights

• U.S. had two prior central banks• the Bank of the U.S. (1791-1811))• the Second Bank of the U.S.

(1816-63)

• U.S. central banks not popular w/• ranchers & farmers• states rights

• 1863-1907• no central bank• regular financial crises• panic of 1907

--bankers demanded a central bank

• Federal Reserve System (1913)

• 1863-1907• no central bank• regular financial crises• panic of 1907

--bankers demanded a central bank

• Federal Reserve System (1913)

C. Branching RestrictionsC. Branching RestrictionsC. Branching RestrictionsC. Branching Restrictions

• McFadden Act 1927• restricted intra and interstate

branching of national banks• meant to protect small banks &

increase competition• repealed 1994

(Riegle-Neal)

• McFadden Act 1927• restricted intra and interstate

branching of national banks• meant to protect small banks &

increase competition• repealed 1994

(Riegle-Neal)

D. Great DepressionD. Great DepressionD. Great DepressionD. Great Depression

• 1930-33, 1/3 of all U.S. banks failed

• Congress responded w/ legislation

• FDIC• federal insurance for bank

deposits• banks pay premiums

• 1930-33, 1/3 of all U.S. banks failed

• Congress responded w/ legislation

• FDIC• federal insurance for bank

deposits• banks pay premiums

• Glass-Steagall Act• separated permissible activities of

commercial, investment banks• idea: limit risk for commercial

banks• weakened over time• repealed 1999

• Glass-Steagall Act• separated permissible activities of

commercial, investment banks• idea: limit risk for commercial

banks• weakened over time• repealed 1999

• Regulation Q• ceiling on interest rates on

deposits• no interest on checking deposits• repealed 1980

• Regulation Q• ceiling on interest rates on

deposits• no interest on checking deposits• repealed 1980

RegulatorsRegulatorsRegulatorsRegulators

• Comptroller of the Currency • national banks

• Federal Reserve• bank holding companies• state member banks• national banks (secondary)

• Comptroller of the Currency • national banks

• Federal Reserve• bank holding companies• state member banks• national banks (secondary)

• FDIC• nonmember state banks

• state regulators• state banks (secondary)

• FDIC• nonmember state banks

• state regulators• state banks (secondary)

II. Bank StructureII. Bank StructureA. Decentralization & ConsolidationA. Decentralization & ConsolidationII. Bank StructureII. Bank StructureA. Decentralization & ConsolidationA. Decentralization & Consolidation

McFadden Act resulted in many small banks • meant to protect small banks &

increase competition

-- but protected inefficient banks

-- limited economies of scale

McFadden Act resulted in many small banks • meant to protect small banks &

increase competition

-- but protected inefficient banks

-- limited economies of scale

• loopholes

-- bank holding companies

-- owned several banks

-- limited service banks

-- deposits or loans, not both

-- ATMs• repealed 1994

• loopholes

-- bank holding companies

-- owned several banks

-- limited service banks

-- deposits or loans, not both

-- ATMs• repealed 1994

ConsolidationConsolidationConsolidationConsolidation

• bank failures in 1980s

• loopholes in McFadden

• repeal of McFadden

• Over 14,000 banks in 1985• less than 8,000 today

• bank failures in 1980s

• loopholes in McFadden

• repeal of McFadden

• Over 14,000 banks in 1985• less than 8,000 today

A good thing?A good thing?A good thing?A good thing?

• economies of scale

• diversification

• But• risks with expansion?• responsive to small customers?

• economies of scale

• diversification

• But• risks with expansion?• responsive to small customers?

B. Commercial & Investment B. Commercial & Investment Banking Banking

B. Commercial & Investment B. Commercial & Investment Banking Banking

• separated by Glass Steagall 1933• commercial banks banned from

-- corporate underwriting

-- securities brokerage

-- real estate sales

-- insurance

• separated by Glass Steagall 1933• commercial banks banned from

-- corporate underwriting

-- securities brokerage

-- real estate sales

-- insurance

• why?• many believed investment activities

led to bank failures of 1930s• not really true…

• problems• less diversification• restricting economies of scale• disadvantage w/ global competition

• why?• many believed investment activities

led to bank failures of 1930s• not really true…

• problems• less diversification• restricting economies of scale• disadvantage w/ global competition

• Glass Steagall weakened over time• bank holding companies• Federal Reserve weakened

restrictions

• repealed 1999

(Gramm-Leach-Bliley)

• Glass Steagall weakened over time• bank holding companies• Federal Reserve weakened

restrictions

• repealed 1999

(Gramm-Leach-Bliley)

III. Thrift IndustryIII. Thrift IndustryIII. Thrift IndustryIII. Thrift Industry

• S&Ls, credit unions

• dual banking systems

• Savings & Loans (1,049)• FDIC insured• own regulators:

-- FHLBS

-- OTS

• S&Ls, credit unions

• dual banking systems

• Savings & Loans (1,049)• FDIC insured• own regulators:

-- FHLBS

-- OTS

• credit unions (10,000)• < 10% of commercial bank assets• $600 billion• commercial banks $7.6 trillion

• regulator: NCUA• own federal deposit insurance• nonprofit

• credit unions (10,000)• < 10% of commercial bank assets• $600 billion• commercial banks $7.6 trillion

• regulator: NCUA• own federal deposit insurance• nonprofit

IV. International BankingIV. International BankingIV. International BankingIV. International Banking

• global economy means global banking

• often less regulation overseas

• alternative structures

• global economy means global banking

• often less regulation overseas

• alternative structures

Edge Act corporationsEdge Act corporationsEdge Act corporationsEdge Act corporations

• subsidiary of U.S. bank overseas

• more favorable regulation• subsidiary of U.S. bank overseas

• more favorable regulation

IBFsIBFsIBFsIBFs

• international banking facilities

• in the U.S.

• loans and deposits to foreign customers

• favorable regulation, tax status• keep the business in the U.S.

• international banking facilities

• in the U.S.

• loans and deposits to foreign customers

• favorable regulation, tax status• keep the business in the U.S.

Foreign banks in the U.S.Foreign banks in the U.S.Foreign banks in the U.S.Foreign banks in the U.S.

• Agency office• not full service• but less regulated

• Full service branch• U.S. regulations

• U.S. subsidiary• U.S. regulations

• Agency office• not full service• but less regulated

• Full service branch• U.S. regulations

• U.S. subsidiary• U.S. regulations

V. Decline of Traditional BankingV. Decline of Traditional BankingV. Decline of Traditional BankingV. Decline of Traditional Banking

• traditional bank activities• decline in profitability• decline in importance

• traditional bank activities• decline in profitability• decline in importance

declining share of loansdeclining share of loansdeclining share of loansdeclining share of loans

rising profitability…..rising profitability…..rising profitability…..rising profitability…..

but due to nontraditional activitiesbut due to nontraditional activitiesbut due to nontraditional activitiesbut due to nontraditional activities

share of incomeNOT from interest

why the decline?why the decline?why the decline?why the decline?

• liability side:• cost of acquiring funds has risen

• asset side:• income generated has declined

• causes:• financial innovation since 1970s

• liability side:• cost of acquiring funds has risen

• asset side:• income generated has declined

• causes:• financial innovation since 1970s

Money market mutual fundsMoney market mutual fundsMoney market mutual fundsMoney market mutual funds

• substitute for checking account from investment companies• pay interest• not insured (but low risk)

• banks had to offer own version• raised the cost of funds

• substitute for checking account from investment companies• pay interest• not insured (but low risk)

• banks had to offer own version• raised the cost of funds

Junk bond marketJunk bond marketJunk bond marketJunk bond market

• no market for new, low-rated debt prior to 1980• only for ratings of Baa (BBB) or

better

• improvements in credit risk screening created market for new risky debt

• no market for new, low-rated debt prior to 1980• only for ratings of Baa (BBB) or

better

• improvements in credit risk screening created market for new risky debt

• before 1980• low-rated firms relied on banks

• after 1980• low-rated firms could borrow by

issuing junk bonds

• junk bond markets competing with banks for lending business

• before 1980• low-rated firms relied on banks

• after 1980• low-rated firms could borrow by

issuing junk bonds

• junk bond markets competing with banks for lending business

Commercial PaperCommercial PaperCommercial PaperCommercial Paper

• easier to issue with improvements in credit risk screening

• demanded by money market mutual funds

• replaced corporate short-term borrowing from banks

• easier to issue with improvements in credit risk screening

• demanded by money market mutual funds

• replaced corporate short-term borrowing from banks

SecuritizationSecuritizationSecuritizationSecuritization

• transform illiquid loans

into liquid debt securities

• individual loans bundled together

• debt securities issued, backed by

pool of loans• owners of security get a share of

the loan payments

• transform illiquid loans

into liquid debt securities

• individual loans bundled together

• debt securities issued, backed by

pool of loans• owners of security get a share of

the loan payments

• most often down with mortgages• 2/3 of all mortgages securitized

• also down with auto loans, leases, credit cards

• most often down with mortgages• 2/3 of all mortgages securitized

• also down with auto loans, leases, credit cards

• the implication• other financial institutions take a

part of the lending process

-- originate the loan

-- service the loan

-- issue and sell security• finance companies that just

specialize in originating loans

• the implication• other financial institutions take a

part of the lending process

-- originate the loan

-- service the loan

-- issue and sell security• finance companies that just

specialize in originating loans

in totalin totalin totalin total

• higher cost of obtaining funds• due to competition from money

market

• lower income from loans• due to competition from

-- junk bond market

-- commercial paper market

-- financial companies

• higher cost of obtaining funds• due to competition from money

market

• lower income from loans• due to competition from

-- junk bond market

-- commercial paper market

-- financial companies

Result of decline:Result of decline:Result of decline:Result of decline:

• bank failures• bank failures

• newer activities• fee income• credit cards• commercial real estate

• newer activities• fee income• credit cards• commercial real estate