Chapter 13. Financial Industry Chapter 13. Financial Industry StructureStructureChapter 13. Financial Industry Chapter 13. Financial Industry StructureStructure

• Bank Structure• Nondepository instituions

Insurance Pensions Finance companies GSEs

• Bank Structure• Nondepository instituions

Insurance Pensions Finance companies GSEs

Dual banking systemDual banking systemDual banking systemDual 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 1863 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 1863 federal charters for banks Comptroller of the Currency federal banknotes tax on state banknotes state banks survived by accepting

deposits

-- dual banking system

Decentralization and ConsolidationDecentralization and ConsolidationDecentralization and ConsolidationDecentralization and Consolidation

• Why so many small banks in U.S.?

• McFadden Act 1927 restricted intra and interstate

branching of national banks meant to protect small banks &

promote competition-- but protected inefficient banks-- limited economies of scale

• Why so many small banks in U.S.?

• McFadden Act 1927 restricted intra and interstate

branching of national banks meant to protect small banks &

promote 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-- ATMs repealed 1994 (Reigle-Neal)• Rising bank profitability

loopholes

-- bank holding companies

-- owned several banks

-- limited service banks

-- deposits or loans, not both

-- ATMs repealed 1994 (Reigle-Neal)• Rising bank profitability

ConsolidationConsolidationConsolidationConsolidation

• repeal of McFadden 1994 Reigle-Neal

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

• repeal of McFadden 1994 Reigle-Neal

• 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? Local job loss

• economies of scale

• diversification

• But risks with expansion? responsive to small customers? Local job loss

Bank Failures of the Great DepressionBank Failures of the Great DepressionBank Failures of the Great DepressionBank Failures of the 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

• Foreign branches (IBF)

• Edge Act corporations Subsidiary just for international

banking

• Acquire interests in foreign banks

• Foreign branches (IBF)

• Edge Act corporations Subsidiary just for international

banking

• Acquire interests in foreign banks

GlobalizationGlobalizationGlobalizationGlobalization

EurodollarsEurodollarsEurodollarsEurodollars

• US $ deposits in foreign banks

• Interbank lending in eurodollars LIBOR• A common swap floating rate

• US $ deposits in foreign banks

• Interbank lending in eurodollars LIBOR• A common swap floating rate

Banks of the futureBanks of the futureBanks of the futureBanks of the future

• Universal banks A full range of financial and

nonfinancial services Not yet in U.S.

• Universal banks A full range of financial and

nonfinancial services Not yet in U.S.

• Financial holding companies e.g. Citigroup Economies of scale• Lower average cost from large number

of same type of transactions Economies of scope• Lower average cost from large number

of related transactions

• Financial holding companies e.g. Citigroup Economies of scale• Lower average cost from large number

of same type of transactions Economies of scope• Lower average cost from large number

of related transactions

Nondepository Institutions:Nondepository Institutions:InsuranceInsuranceNondepository Institutions:Nondepository Institutions:InsuranceInsurance

• insurers bear risk that others pay to avoid underwrite risk receive premiums invest premiums face contingent liabilities

• insurers bear risk that others pay to avoid underwrite risk receive premiums invest premiums face contingent liabilities

Types of insuranceTypes of insuranceTypes of insuranceTypes of insurance

• Life Insurance term life insurance cash value life insurance

• Life Insurance term life insurance cash value life insurance

term life insuranceterm life insuranceterm life insuranceterm life insurance

• policy period

• death benefit if occurs w/in policy period

• no cash value

• policy period

• death benefit if occurs w/in policy period

• no cash value

cash value life insurancecash value life insurancecash value life insurancecash value life insurance

• whole life insurance death benefit cash value builds over life of

policy premiums cover

-- cost of insurance

-- investment capital

• whole life insurance death benefit cash value builds over life of

policy premiums cover

-- cost of insurance

-- investment capital

• Universal life insurance similar to whole life buildup of cash value may be used

to finance future premiums

• Universal life insurance similar to whole life buildup of cash value may be used

to finance future premiums

• variable life insurance policy holders chooses how to

invest premiums benefits/value depend on

investment returns

• variable life insurance policy holders chooses how to

invest premiums benefits/value depend on

investment returns

other issuesother issuesother issuesother issues

• For a group, mortality rate is predictable

• timing & amounts of claims are predictable Focus on longer term investments

• For a group, mortality rate is predictable

• timing & amounts of claims are predictable Focus on longer term investments

Property & CasualtyProperty & CasualtyProperty & CasualtyProperty & Casualty

• auto, home insurance

• timing/size of claims unpredictable

• separate industry

• auto, home insurance

• timing/size of claims unpredictable

• separate industry

Big losses for P&CBig losses for P&CBig losses for P&CBig losses for P&C

• 1992 Hurricane Andrew $15.5 billion today $30 billion

• 9/11 WTC attack $35 billion

• 1992 Hurricane Andrew $15.5 billion today $30 billion

• 9/11 WTC attack $35 billion

Pension FundsPension FundsPension FundsPension Funds

• Defined benefit plans

• Defined contribution plans

• Federal law does not require pensions, but does regulate them

• Defined benefit plans

• Defined contribution plans

• Federal law does not require pensions, but does regulate them

Defined benefit plansDefined benefit plansDefined benefit plansDefined benefit plans

• employer promised employee monthly payments during retirement

-- life contingent

-- choice of survivor benefits

• employer promised employee monthly payments during retirement

-- life contingent

-- choice of survivor benefits

How is payment determined?How is payment determined?How is payment determined?How is payment determined?

• formula salary

-- average last several years

-- average of best years years of service with sponsor

• formula salary

-- average last several years

-- average of best years years of service with sponsor

VestingVestingVestingVesting

• minimum years of service necessary to receive benefits complex federal rules about

vesting 5-7 years max for full vesting

• minimum years of service necessary to receive benefits complex federal rules about

vesting 5-7 years max for full vesting

Advantages Advantages Advantages Advantages

• (for employee)

• limited investment risk payments promised reguardless of

portfolio return but sponsor bankruptcy could

affect payment size

• (for employee)

• limited investment risk payments promised reguardless of

portfolio return but sponsor bankruptcy could

affect payment size

• no risk of outliving assets payments life contingent,

NOT lump sum

• no risk of outliving assets payments life contingent,

NOT lump sum

DisadvantagesDisadvantagesDisadvantagesDisadvantages

• lack of portability from job to job largest benefits accrue after 20

years DB plans encourage loyalty

• lack of portability from job to job largest benefits accrue after 20

years DB plans encourage loyalty

• lack of control how pension funds are invested is sponsor investing enough?

-- is pension fully funded?

• lack of control how pension funds are invested is sponsor investing enough?

-- is pension fully funded?

Defined Contribution PlansDefined Contribution PlansDefined Contribution PlansDefined Contribution Plans

• employee/individual contributes funds employer may match contributions

• employee chooses among investment options range of choice varies among

sponsors

• employee/individual contributes funds employer may match contributions

• employee chooses among investment options range of choice varies among

sponsors

• amount accumulated at retirement depends on investment performance

• lump sum at retirement decision about spending possible purchase an annuity

• amount accumulated at retirement depends on investment performance

• lump sum at retirement decision about spending possible purchase an annuity

types of DC planstypes of DC planstypes of DC planstypes of DC plans

• employer sponsored 401(k), 403(b), 414(h), 457

• individual IRA, Roth IRA

• employer sponsored 401(k), 403(b), 414(h), 457

• individual IRA, Roth IRA

Advantages (employee)Advantages (employee)Advantages (employee)Advantages (employee)

• portability value accumulates steadily balance rolled over to new plans

• cash value build up cash out (tax penalty) borrow against survivor benefits

• portability value accumulates steadily balance rolled over to new plans

• cash value build up cash out (tax penalty) borrow against survivor benefits

DisadvantagesDisadvantagesDisadvantagesDisadvantages

• employee bears investment risk

• retiree risks outliving assets• employee bears investment risk

• retiree risks outliving assets

• corporate defined contribution plans hold over 25% of assets as own

company stock

-- Enron 60%

-- Anheuser Bush, Coca Cola,

McDonald’s over 74% big lack of diversification

-- but easier to match 401(k) contributions w/ stock than w/cash

• corporate defined contribution plans hold over 25% of assets as own

company stock

-- Enron 60%

-- Anheuser Bush, Coca Cola,

McDonald’s over 74% big lack of diversification

-- but easier to match 401(k) contributions w/ stock than w/cash

GSEsGSEsGSEsGSEs

• Government charter to create private firms to intermediate debt markets

• Fannie Mae, Freddie Mac Home mortgages

• Sallie Mae Student loans

• Government charter to create private firms to intermediate debt markets

• Fannie Mae, Freddie Mac Home mortgages

• Sallie Mae Student loans

• All borrow short term (commercial paper)

• And lend long-term

• Implicit gov’t guarantee

• Highly leveraged: 30 to 1 High default rate could bankrupt

them

• All borrow short term (commercial paper)

• And lend long-term

• Implicit gov’t guarantee

• Highly leveraged: 30 to 1 High default rate could bankrupt

them