1. Market Structure and Regulation in the U.S. Banking Industry Professor Wayne Carroll Department of Economics University of Wisconsin-Eau Claire carrolwd@uwec.edu Slides available at www.uwec.edu/carrolwdwww.uwec.edu/carrolwd

2. Roles of Banks in the Economy Facilitate borrowing and lending Facilitate payments Risk management Issue financial assets that allow firms to share risks Provide guarantees and lines of credit

3. Role of Banks in Lending Source: Available online at http://www.wiwi.uni-frankfurt.de/schwerpunkte/finance/wp/550.pdf

4. Financial Intermediaries Banks include: Commercial banks Savings and loan associations (S&Ls) Also sometimes called thrifts or thrift institutions Credit unions

5. Financial Intermediaries Assets at end of 2002 (in billions)

6. Ownership of Banks U.S. banks are privately owned – no banks are owned by the government. In most cases a banks stock is held by a large number of investors, so a bank has many owners. It is relatively easy to establish a new bank in the U.S.

7. Bank Market Structure There are a large number of banking firms in the U.S., but the number is falling due to mergers between banks. Thousands of U.S. banks are very small, each having only a single office. Many banks today have multiple branches or offices. A bank holding company is a firm that owns one or more banking firms.

8. Size Distribution of U.S. Banks Commercial Banks Number of Deposits (millions) Asset Size (as of June 30, 2006)InstitutionsOffices Less than $25 Million586712$7,661 $25 Million to $50 Million1,0981,701$33,511 $50 Million to $100 Million1,7184,007$105,754 $100 Million to $300 Million2,42710,338$349,740 $300 Million to $500 Million6725,088$211,495 $500 Million to $1 Billion4946,322$265,540 $1 Billion to $3 Billion2756,856$338,909 $3 Billion to $10 Billion1206,601$427,340 Greater than $10 Billion8938,848$3,580,817 TOTALS7,47980,473$5,320,767 Source: www2.fdic.gov/sod/index.asp

9. Bank Market Structure: An Example Wells Fargo & Company is a bank holding company based in South Dakota (with historic roots in Minnesota and California). It includes: 28 chartered bank companies a total of over 3,000 branches in 23 states

10. Some Wells Fargo branches

11. Wells Fargos Broad Scope Source: www.wellsfargo.com/about/today1

12. 20 Largest U.S. Banks (as of June 30, 2006) RankInstitution Name State Headquartered Number of Offices Deposits (thousands) 1Bank of America, NANorth Carolina5,781$563,906,844 2JPMorgan Chase Bank, NAOhio2,679$434,752,000 3Wachovia Bank, NANorth Carolina3,136$306,348,000 4Wells Fargo Bank, NASouth Dakota3,200$298,672,000 5Washington Mutual BankNevada2,167$209,927,984 6Citibank, NANew York267$142,508,000 7SunTrust BankGeorgia1,758$117,956,301 8U.S. Bank, NAOhio2,525$117,337,830 9HSBC Bank USA, NADelaware436$75,588,320 10World Savings Bank, FSBCalifornia286$61,321,407 11PNC Bank, NAPennsylvania831$58,134,805 12Keybank, NAOhio957$57,327,323 13Regions BankAlabama1,397$57,231,022 14Merrill Lynch Bank USAUtah3$52,331,967 15Branch Banking and Trust CompanyNorth Carolina918$51,246,133 16Countrywide Bank, NAVirginia2$50,657,812 17ING Bank, fsbDelaware1$46,440,495 18Comerica BankMichigan387$43,081,270 19Sovereign BankPennsylvania661$40,829,851 20The Bank of New YorkNew York354$40,014,000 Source: www2.fdic.gov/sod/index.asp

13. A Simple Bank Balance Sheet Assets reserves "loans" securities bank loans Liabilities deposits borrowings Bank capital (equity)

14. Detailed Balance Sheet for the Banking Industry Source: Mishkin, Economics of Money, Banking, and Financial Markets, 7 th edition

15. Two Important Ratios Capital/asset ratio – bank capital as a percentage of bank assets. The average capital/asset ratio for U.S. banks was about 9% at the end of 2002. Reserve ratio – bank reserves as a percentage of checkable deposits.

16. Information on U.S. Banks It is easy to get a lot of financial data on U.S. banks. A great source: www2.fdic.gov/idasp/index.asp

17. An Example: Data on Wells Fargo

18. What Can Go Wrong? Bank failure – the bank goes out of business. Bank depositors might lose some of their funds. Bank creditors might lose some of their investment Bank owners lose their capital. The bank suffers significant losses – the government might have to help.

19. Reasons for Bank Regulation Banks must be regulated because: a bank failure can be devastating to depositors. theres a risk of systemic failure: the failure of one bank can make it more likely that other banks will fail. depositors cant monitor how the bank invests their funds, creating a moral hazard problem. government assistance to a bank can be very costly.

20. Reasons for Bank Regulation Banks are less stable than other businesses because: bank liabilities tend to be short-term – many depositors could withdraw their funds with little notice. bank assets tend to be longer-term – reserves and other liquid assets are only a small share of the total. the behavior of depositors depends on their confidence that the bank is sound, and this confidence can be easily shaken.

21. A Closer Look at Bank Failure Two reasons for bank failure: The value of bank assets falls, so assets<liabilities. Deposit outflow: A large number of depositors withdraw their funds from the bank, exhausting the banks cash (reserves) and other liquid assets. Therefore a bank is more likely to fail if it has a low capital/asset ratio or a low reserve ratio.

22. A Closer Look at Bank Failure Tradeoff between higher income and a lower risk of failure: Holding other things constant, the banks net income is higher if its capital/asset ratio and reserve ratio are lower, since then it holds relatively more interest-earning assets. If the banks capital/asset ratio and reserve ratio are higher, its less likely that the bank will fail (so its less likely that the stockholders will lose their capital.)

23. A Closer Look at Bank Failure If there were no government regulation of banks: each bank would choose a capital/asset ratio and a reserve ratio to maximize the value of the bank. 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. market discipline

24. A Closer Look at Bank Failure But if there were no government regulation of banks: banks would choose capital/asset ratios and reserve ratios that are too low from societys standpoint. 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.

25. An Example: Continental Illinois Bank Continental Illinois Bank failed in 1984. The federal government paid billions of dollars to keep Continental Illinois from closing. This was the biggest bank resolution in U.S. history.

26. An Example: Continental Illinois Bank Before it failed, Continental Illinois Bank: was the largest bank in Chicago. was the seventh-largest bank in the U.S. had 57 offices in 14 states and 29 foreign countries.

27. An Example: Continental Illinois Bank Why did Continental Illinois fail? Starting in the late 1970s, the bank grew fast, with lots of loans to businesses. Poor quality loans Too many loans to firms in the oil industry Too many loans to borrowers in Latin America Continental Illinois is willing to do just about anything to make a deal. High cost of funds Large share of funds borrowed from other banks Relatively small reliance on domestic deposits Heavy borrowing in foreign money markets

28. An Example: Continental Illinois Bank The Banks Troubles By 1984 the banks nonperforming loans (loans on which payments were late) rose to $5.2 billion (over 10% of total loans). May 1984: an electronic bank run – depositors withdrew billions of dollars in deposits The FDIC and the Federal Reserve System pledged their support for the bank and lent over $5 billion.

29. An Example: Continental Illinois Bank Dangers Many smaller banks had deposits at Continental Illinois, so the failure of Continental Illinois could have caused some of them to fail, too. Other depositors (including many important corporations) could lose some of their funds Foreign investors would lose confidence in U.S. banks

30. An Example: Continental Illinois Bank Rescuing Continental Illinois Bank Continental Illinois Bank had $3 billion in insured deposits and $30 billion in uninsured deposits. The FDIC promised to guarantee all deposits. The FDIC assumed the Banks 3.5 billion debt to the Federal Reserve. The FDIC bought $1 billion in Continental Illinois stock – the FDIC owned the bank.

31. An Example: Continental Illinois Bank Lessons from Continental Illinois Bank Banks have an incentive to take on too much risk, so they need closer supervision The failure of a very large bank could have broader negative effects Rescuing a large bank can be expensive for the government Good sources: www.fdic.gov/bank/historical/managing/contents.pdf -- Part II, Chap. 4 www.fdic.gov/bank/historical/managing/contents.pdf http://www.fdic.gov/bank/historical/history/vol1.html -- Chap. 7 http://www.fdic.gov/bank/historical/history/vol1.html

32. Bank Regulation: An Overview In the U.S. the government regulates banks in many ways: Federal deposit insurance Imposing capital requirements (minimum capital/asset ratios) Imposing reserve requirements (minimum reserve ratios) Restricting the types of assets that banks may hold Performing bank examinations (periodic auditing reviews)

33. Primary bank regulators in the U.S.: Office of the Comptroller of the Currency (OCC) part of the U.S. Department of the Treasury Federal Reserve System – the U.S. central bank Federal Deposit Insurance Corporation (FDIC) State bank regulators Bank Regulation: An Overview

34. Federal Deposit Insurance The U.S. Congress created the Federal Deposit Insurance Corporation (FDIC) in 1933, after the bank failures in the Great Depression. Today the FDIC guarantees each bank deposit up to a maximum of $100,000. FDIC insurance is funded by a small fee paid by banks based on their deposits.

35. Bank Failures in the Great Depression

36. Effects of Federal Deposit Insurance Deposit insurance prevents bank runs Prevents losses by small depositors Reduces systemic risk in the banking system Deposit insurance gives banks incentives to: hold riskier assets. hold less capital. manage the banks assets less carefully.

37. Incentive Effects of Deposit Insurance: A Closer Look Deposit insurance increases the supply of deposits (within the insurance coverage limits). 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. As a result, deposit insurance reduces banks incentives to avoid risk.

38. Capital Requirements When theres deposit insurance, banks have an incentive to hold too little capital. Therefore the government imposes capital requirements to ensure that banks hold sufficient capital.

39. Capital Requirements A simple capital requirement would require that a banks capital/asset ratio be greater than or equal to a specified level. Example: capital/asset ratio 0.05. Problem: Not all assets are equally risky. A simple capital requirement gives a bank an incentive to hold more risky assets.

40. Risk-weighted Capital Requirements At an international conference in Basel, Switzerland in 1988, bank regulators from the worlds affluent countries agreed to impose risk-weighted capital requirements: Classes of assets are assigned risk weights between 0% and 100%. Risk-free assets carry a weight of 0%, and more-risky assets carry higher weights. Capital requirements then set a minimum for the ratio of capital to risk-weighted assets.

41. Risk-weighted Capital Requirements: An Example AssetsAmountRisk weightWeighted assets Cash $10,000,0000% $0 T-bills$190,000,0000% $0 Municipal bonds $50,000,00020%$10,000,000 Mortgages$300,000,00050%$150,000,000 Home equity loans $40,000,000100%$40,000,000 TOTALS$590,000,000$200,000,000

42. In this example, if regulators require the bank to maintain its risk-weighted capital ratio at a level of at least 8%, then the banks capital must be at least $16,00,000 (or 8% of $200,000,000). If the bank acquires another $1 million in capital, it could invest up to: $12.5 million more in home-equity loans $25 million more in home mortgages $62.5 million more in municipal bonds So risk-weighted capital requirements give the bank an incentive to hold less-risky assets. Risk-weighted Capital Requirements: An Example

43. Proposed Capital Requirement Reform: Basel 2 Problem: Assets within a risk class might expose banks to different amounts of risk. 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. Basel 2 will take effect in some countries in 2007. http://www.bis.org/publ/bcbsca.htm

44. Reserve Requirements The Federal Reserve System requires banks to hold reserves that are greater than or equal to a specified percentage of their checkable deposits: 3% for smaller banks 10% for larger banks

45. Reserve Requirements But reserves are higher than they need to be to promote stability of the banking system. 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.

46. Restrictions on Asset Holdings B ank regulations include the following: Banks cannot hold common stock. Banks cannot invest too large a share of their deposits in a single loan or in loans to businesses in a single industry. Banks cannot lend funds to bank directors, managers, or principal shareholders at below- market rates.

47. Bank Examinations Banks are visited on a regular schedule by bank examiners from the OCC, the Federal Reserve System, the FDIC, or other agencies. Bank examiners review the banks financial statements and its confidential accounts. The results are summarized in a CAMELS rating given to the bank.

48. Bank Examinations Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk

49. CAMELS ratings 1Sound in every respect 2Fundamentally sound, but with modest weaknesses that can be corrected 3Moderately severe to unsatisfactory weaknesses; vulnerable if theres a business downturn 4Many serious weaknesses that have not been addressed; failure is possible but not imminent 5High probability of failure in the short term

50. Bank Examinations CAMELS ratings are disclosed to bank management, but not to the public. If the CAMELS rating for a bank is unfavorable, regulators can take actions like these: Require banks to disclose unfavorable information in their public financial statements Issue a cease and desist order requiring the bank to stop doing things that cause financial troubles and to correct problems. Impose fines (up to $1,000,000 per day).

51. Bank Examinations

52. Good sources on bank examinations and the FDIC: www.fdic.gov/regulations/examinations/index.html www.fdic.gov/bank/analytical/banking/1999oct/1_v12n2.pdf

53. The Banking Crisis of the 1980s Hundreds of savings and loan associations (S&Ls) and banks failed in the 1980s and early 1990s. This episode illustrates: how changes in the market environment and a loosening of regulations can lead to a bank crisis. how government regulators can handle widespread bank failures. how regulations and supervisory standards can be improved to address new problems.

54. Magnitude of the Crisis From 1980 through 1994, over 2,900 banks and S&Ls failed. 1,617 banks with total assets of $302.6 billion 1,295 S&Ls with total assets of $621 billion On average, a bank or S&L failed every 15 days from 1980 to 1994. During this period, about one out of every six banks or S&Ls (holding a total of over 20% of the assets of the system) was closed or got government assistance.

55. Magnitude of the Crisis: Number of Bank Failures Per Year

56. Causes of the Banking Crisis The banking crisis had many causes, including: changes in the market environment looser regulations that gave S&Ls more competitive options

57. Causes of the Banking Crisis: Changes in the Market Environment As a result of financial innovations in the 1960s and 1970s: banks and S&Ls faced more competition from other financial firms (such as mutual funds). new kinds of financial assets (such as futures and other derivatives) made it possible for investors (including banks and S&Ls) to take on more risk. the financial market environment was more complicated and harder for regulators to monitor.

58. Causes of the Banking Crisis: Changes in Regulation The banking industry was partially deregulated in the early 1980s: S&Ls had mostly been restricted to home mortgage lending before, but now they were allowed to invest in commercial real estate and consumer loans. S&Ls were allowed to invest in junk bonds (low-quality, high-risk commercial bonds) and common stocks.

59. Causes of the Banking Crisis: Changes in Regulation Source:www.fdic.gov/bank/historical/history/421_476.pdf

60. Causes of the Banking Crisis As a result, S&Ls held more risky assets, resulting in huge loan losses. S&L management had little expertise in managing risks from new kinds of assets. Regulators had little experience in monitoring the new risks. Since S&L deposits (up to $100,000) were protected by federal deposit insurance, depositors had little incentive to monitor S&L risks.

61. Regulatory Failures in the Crisis Regulators of S&Ls did not close insolvent institutions and end the crisis quickly. The deposit insurance fund wasnt large enough to cover losses. (The S&L deposit insurance fund had a balance of -$75 billion in 1988.) Regulators wanted to encourage the growth of the S&L industry, not close S&Ls. Regulators hoped the crisis would pass without revealing their failures.

62. Managing the Crisis In 1989 the government created the Resolution Trust Corporation (RTC) to handle S&Ls that were failing. Functions of the RTC: Took over assets of failing S&Ls and sold them to recover as much of their value as possible. Issued bonds to fund the costs of covering S&L losses.

63. Who Paid the Cost? Bank and S&L stockholders Some depositors who had large deposits that exceeded the deposit insurance limits Taxpayers, who ultimately will pay higher taxes to pay off bonds that were issued to fund the costs of the crisis.

64. Regulatory Reforms Following the Crisis Some regulatory agencies that had not been effective were eliminated, and their powers were given to other agencies. Earlier restrictions on assets holdings by S&Ls were reinstated. S&Ls were required to raise their capital/asset ratios. Now bank examiners visit banks more frequently than before. Regulators were required to act more quickly when a bank or S&L is failing.

65. Regulatory Reforms Following the Crisis Source:www.fdic.gov/bank/historical/history/421_476.pdf

66. Lessons from the Banking Crisis The U.S. banking crisis in the 1980s was similar to bank crises in other countries: Financial liberalization allowed banks to take more risks, but there was not yet adequate government regulation and supervision of those risks. A government safety net created moral hazard problems and eliminated some market discipline.

67. The Banking Crisis of the 1980s Two excellent sources: Managing the Crisis: The FDIC and RTC Experience www.fdic.gov/bank/historical/managing/index.html History of the Eighties - Lessons for the Future www.fdic.gov/bank/historical/history/index.html