Recall that the financial sector provides the efficient transfer of savings towards investment projects S + (Imports – Exports) = I + (G-T) Foreign Savings ($640B) Gross Domestic Savings ($1.8T) Gross Private Investment ($2T) Government Deficit ($400B) Gross Private Investment represents the purchase of new capital goods – one of the primary sources of growth in the economy
A majority of external funds raised by non-financial businesses come from bank loans. In particular, small businesses rely entirely on banks for financing
Loans Bank Depositors There is a moral hazard problem/adverse selection problem between both the bank and its depositors as well as between the bank and its potential loan customers A bank can deal with this problem with: Credit Scoring Collateral Optimal Debt Contracts This problem must be dealt with through regulation
Depository Institutions are broadly defined as businesses that accept deposits and make loans Depository Institutions Commercial Banks Savings & Loans Savings Banks Credit Unions Non-Bank Thrifts Deal almost exclusively in short term deposits and mortgages Are generally mutual companies (depositors are the owners) Are allowed to hold corporate equities/bonds
All Depository Institutions in the US are chartered Depository Institutions Commercial Banks Savings & Loans Savings Banks Credit Unions National Banks Comptroller of the Currency State Banks State Authority Federal Associations Office of Thrift Supervision State Associations State Authority Federal Unions National Credit Union Administration State Unions State Authority
Federal Reserve Membership (1913) National Banks are Required to be members of the Federal Reserve System (Membership is optional for state banks) National Banks are Required to be members of the Federal Reserve System (Membership is optional for state banks) Federal Reserve members are required to purchase stock in the federal reserve system. Federal Reserve members are required to purchase stock in the federal reserve system. Federal Reserve members provide input to the election of Federal Reserve Board Members Federal Reserve members provide input to the election of Federal Reserve Board Members The Federal Reserve provides check clearing services The Federal Reserve provides check clearing services
Of the 7,769 banks in 2003, a vast majority are non- member state banks
Federal Deposit Insurance (1934) Federal reserve members are required to purchase deposit insurance. Insurance is optional for state banks (98% of all banks have deposit insurance) Federal reserve members are required to purchase deposit insurance. Insurance is optional for state banks (98% of all banks have deposit insurance) FDIC insured banks are charged up to 27 cents per $100 of eligible deposits FDIC insured banks are charged up to 27 cents per $100 of eligible deposits All deposits up to $100,000 are insured by the FDIC. All deposits up to $100,000 are insured by the FDIC.
A timeline of Banking Regulation 18631927 1933 1980 1956 1999 1994 Restrictions on activities Restrictions on Competition McFadden Act Banking Act Holding Company Act Monetary Control Act Riegle-Neal Holding Company Act Glass - Steagall Graham - Leach - Bliley Great Depression
Year Number of Banks Total Branches 190012,50013,000 2000780068,000 Until the mid 1900s, we were a nation of unit banks Main Office Branch Offices National Banks Prohibited from interstate branching Must comply with state branching rules McFadden Act (1927) State Banks Unit Banking Limited Branching Statewide Branching
Following the great depression, the activities of commercial banks were severely restricted The Glass-Steagall Act of 1934 was designed to put a wall between commercial banking and investment banking Glass-Steagall (1934) Commercial Banks are restricted from participating in equities markets Interest rates on non- transaction deposits is restricted to be below 5.25% No interest allowed on transaction deposits Regulation Q
Branching Restrictions could be avoided by forming holding companies Main Office Branch Offices Illegal under the McFadden Act Holding Company Subsidiaries Legal under the McFadden Act
The Bank Holding Company act allowed holding companies with only one bank to provide limited non-bank financial services on an interstate basis. This created a loophole around Glass-Steagall!! Holding Company Prior to Bank Holding Company Act Bank Holding Company After Bank Holding Company Act Non-Bank Branches Non- Bank Offices Collects deposits, but doesnt make loans Makes loans, but doesnt collect deposits Financial Services
Deregulation of the Financial Services sector began in the 1980s. The Monetary Control Act (1980) Began the phase out of interest rate ceilings at depository institutions Imposed uniform reserve requirements on Banks and Thrifts Riegle-Neal Interstate Banking and Branching Efficiency Act (1994) Allowed holding companies to acquire banks in any state Allowed banks to branch across state lines Financial Services Modernization Act (Graham Leach-Bliley) (1996) Permitted financial holding companies offering banking, insurance, securities and other services under one controlling corporation (allowed Citicorp to buy Travelers Insurance)
apital Adequacy Capital Adequacy sset Quality Asset Quality anagement Management arnings Earnings iquidity Liquidity ensitivity to Interest Rate Risk Sensitivity to Interest Rate Risk Problems with Monitoring Banks are monitored using the camels system. However, Its not always easy to accurately assess the risk a bank is taking on Off Balance Sheet Activities Derivatives Financial Guarantees (SLC) Asset Securitization In 1995, Barings Bank went bankrupt due to losses in the Derivatives market. At the time, it was holding $60B worth of derivative contracts – a staggering number when compared to Barings reported equity of $615M!! The CAMELS System
Problems with Restricting Activities Banks compete with other financial services companies as well as other banks!! During the late 1970s, market interest rates rose well above 10%, but banks were restricted by regulation Q to pay only 5.25% in savings accounts and 0% on checking accounts Banks Financial Companies Checking Accounts (0%) Money Markey Mutual Funds (10%) As households pulled their money out of banks, mortgage and small business lending was seriously curtailed!
Problems with Restricting Competition (Branching) Restricting entry gives banks limited monopoly power, they can use this to increase profits at the customers expense! Banking is a decreasing cost industry (i.e. large startup costs, but small marginal costs). By forcing banks to remain small and local, they are forced to operate at an inefficiently small scale! By forcing banks to remain in a confined geographical location, you are forcing them to take on idiosyncratic (area specific) risk!
Since the 1970s, there has been tremendous growth in international trade World Trade (in Trillions of $s)
Even more impressive is the growth in foreign exchange Currency Transactions (in Trillions of $s)
US Banks Operating Abroad Subsidiaries: Governed by Federal Reserve Regulation K – must be involved in business closely related to banking. International Banking Facilities: Accepts time deposits and makes loans to foreign households & firms. Exempt from reserve requirements, but may not do business in the US. Edge Act Corporations: Makes loans/accepts deposits. Can deal with both US and foreign citizens, but is limited to international trade transactions Branches: Offer a full line of banking services, but are subject to foreign laws US Banks locate facilities abroad to aid in international trade as well as to avoid regulation and taxes
Foreign Banks Operating in the US Agency Office: Cant accept deposits from US citizens, but can transfer funds from abroad and make loans in the US Subsidiaries: Treated as a US bank. Subject to all US regulations. Subsidiaries may also set up edge act corporations and international lending facilities Branches: Offers a full range of banking services for US citizens Likewise for Foreign Banks…
Important Dates in International Banking 193019781988 1991 Bank for International (BIS) Settlements Created International Banking ActBasle Accords I Foreign Bank Supervision Act BCCI Scandal
Bank of England Federal Reserve United States Under whose jurisdiction do international banks fall? (its a gray area ) United Kingdom
Regulating International Banking International Banking Act (1978) Brought foreign banks operating in the US under federal regulation for the first time Foreign banks, however, were not monitored as closely as US banks Foreign Bank Supervision Act (1991) Passed shortly after the BCCI scandal Gave the Federal Reserve and the Comptroller of the Currency greater control over foreign banks operating in the US
Bank For International Settlements (1930) Established to handle German WWI reparations, the BIS has become a center for international cooperation. Established to handle German WWI reparations, the BIS has become a center for international cooperation. Played a central role in the Bretton Woods Exchange Rate System Played a central role in the Bretton Woods Exchange Rate System Integral in the Establishment of the Euro Integral in the Establishment of the Euro The BIS is like a central bank for central banks. The BIS is like a central bank for central banks.
Risk weighted assets AssetRisk Weight Cash and equivalents0 Government securities0 Interbank loans0.2 Mortgage loans0.5 Ordinary loans1.0 Standby letters of credit1.0 The Basle Accords established uniform capital requirements for banks around the world. Equity capital was required to equal at least 4% of a banks risk weighted assets.
Top Ten World Banks BankAssets (Billions) Citigroup (US)$1,497 JP Morgan + Bank One (US)$1,097 Mizuho Financial Group (Japan)$1,080 Bank of America + First Union (US)$851 UBS (Switzerland)$851 Sumitomo Mitsui (Japan)$844 DeutscheBank (Germany)$795 Mitsubishi Tokyo (Japan)$781 HSBC (UK)$759 BNP Paribas (France)$744
Problems with International Regulation The key issue is that the banking industry in Japan and Europe is Fundamentally different from the US. The key issue is that the banking industry in Japan and Europe is Fundamentally different from the US.
European Banking Unlike the US, European Banks are allowed to engage in securities markets (universal banking) Unlike the US, European Banks are allowed to engage in securities markets (universal banking) In fact, in Europe, banks are generally significant shareholders in European companies. In fact, in Europe, banks are generally significant shareholders in European companies. Banks rely much more on equity than deposits. Banks rely much more on equity than deposits.
Japanese Banking Japanese industry is organized into industrial groups (keiretsu) Japanese industry is organized into industrial groups (keiretsu) Mitsubishi Mitsubishi Mitsui Mitsui Sumitomo Sumitomo Fuyo Fuyo Daiichii Daiichii Kangyo Kangyo Sanwa Sanwa
Japanese Banking These groups are both vertically and horizontally integrated and are comprised of a very large number of companies: These groups are both vertically and horizontally integrated and are comprised of a very large number of companies: Sumitomo has 15 divisions ranging from electronics to mining to consumer goods. Sumitomo has 15 divisions ranging from electronics to mining to consumer goods. Sumitomo controls assets equal to $50T. Sumitomo controls assets equal to $50T.
Japanese Banking Each group has its own bank which handles its finances. This main bank Each group has its own bank which handles its finances. This main bank Owns equity in member firms Owns equity in member firms Monitors member firms Monitors member firms Provides credit for member firms. Provides credit for member firms.