Presentation on theme: "Banking Industry: Structure and Competition"— Presentation transcript:
1 Banking Industry: Structure and Competition Chapter 12Banking Industry: Structure and Competition
2 Historical Development of the Banking System The first paper money, chiao-tzuissued in 10th century Szechwan, China (Lui, 1983)a bank receipt for iron Chinese coins deposited in Szechwan banks.it became the first fiat money when the Szechwan gov’t took it over in 1023In London,Goldsmiths began charging fees for safely storing gold coins.The receipts were redeemable to only the depositor unless ‘or bearer’ was printed next to the bearer’s name.The Bank of England began issuing paper pounds in 1694Pounds circulated as money because they were redeemable in gold.The pound became fiat money when the UK gold standard was abandoned in 1931
3 Historical Development of the Banking System The modern U.S. bank is a financial intermediaryit accepts deposits from saversit lends money to borrowers.it evolved from 16th century London goldsmiths.Goldsmiths had a history of safely storing goldTable (a) on the following slide shows a T-account for the first goldsmithThe value on the left is called reservesthe goldsmith is reserving it for its depositorsThe value on the right is called demand depositsdepositors can demand their gold coin at any time
4 Historical Development of the Banking System first gold coin deposit was made by John in the amount of £200the £200 is considered an asset and a liability as it is listed on both sides of the T-account.The value on the left is called reserves because the goldsmith is reserving it for its depositors.The value on the right is called demand deposits because depositors can demand their gold coin at any time.Was is not shown, is the fee that John pays the goldsmith.The goldsmith collects a fee for storing John’s gold coins
5 Historical Development of the Banking System Storing gold is profitableJohn’s employer pays him in gold coinJohn is willing to pay to have it safely kept by the goldsmithStoring it in one’s home or carrying it on one's person is riskyDepositing it at the goldsmith isn’t too inconvenientit is located near his village’s ale house and shops.Table (b) shows what happens after word spreads of the goldsmith safely storing John’s gold.Others deposit their gold in the goldsmith’s safeThe Goldsmith’s assets and liabilities rise to £1000As the proceeds from fees pile up,the goldsmith’s wealth growsstoring gold becomes his primary business.
7 Historical Development of the Banking System After observing the goldsmith’s growing affluenceJames inquires about borrowing gold sitting idle in the goldsmith’s safe to turn his alehouse into an innThe goldsmith accommodates the request ifhe believes depositors will keep their coins in his safe for the desired length of the loanthe inn will be profitableJames is willing and able to pay backthe principal, the borrowed gold coinsinterest, compensation for accepting credit risk.Because the gold coins are the property of others, making loans using demand deposits could be viewed as unscrupulous.The goldsmith offers to pay depositors interest.If net interest marginis negative, the goldsmith does not make a profit.is positive, the goldsmith hesitate because demand deposits can be withdrawn at any time.is high enough to encourage depositors to store gold coins for the length of the loan, the goldsmith safely securitizes the loan (time deposit, CDs),.
9 Historical Development of the Banking System After the goldsmith lends James gold (short with demand deposits)James paysJill £500 for building materialsJill deposits her £500 at the goldsmithBill £400 for his laborBill deposits his £400 at the goldsmithThe goldsmith’s liabilities increase by £900The goldsmith’s reserves increase from £100 to £1000Reserves ratio200/200 = 100%1000/1000 = 100%100/1000 = 10%1000/1900 = 52.6%(a)(b)(c)(d),.
11 Historical Development of the Banking System While making loans & storing gold coin deposits, the goldsmithdiscovers a reserves ratio of 0.2 is, under normal economic conditions, enough to balanceoutflows (gold withdrawals and gold payments from new loans)inflows (new gold deposits and loan payoffs in gold)the goldsmith will make loans untildemand deposits times the reserves ratio = quantity of gold coin presently held in reserve.The self-imposed reserves ratio is called the desired reserves ratio.Gold coin deposits have pushed the goldsmith’s reserves from £1000 to £10,000With a desired reserves ratio of 0.2, the goldsmith is comfortable with reserves backing just 20% of demand deposits.This is why the goldsmith has made £40,000 in loans to villagersThe goldsmith discovers that the paper receipts he has issued are circulating as moneyAs long as the receipts can be redeemed in gold coin, villagers consider the receipts money because they are as good as gold.The paper money is increasingly preferred to gold because it can be folded up in one’s pocket, and its use eliminates trips to the goldsmith.
13 Historical Development of the Banking System The system described above is called fractional reserve banking because reserves are a fraction of demand depositsSuch a system is inherently riskybank profits increase as the reserves ratio falls.the goldsmith works less and less as an artisan and increasingly more as a banker as her banking operations expand.Balancing his T-account and reviewing loan applications is time consuming, but is necessary to ensure a desired reserves ratio of 0.2If the economy over-performs for a long period, the goldsmith may lower the desired reserves ratio to 0.1more profitable£10,000 in gold are backing £100,000 in demand deposits.more interest-bearing loans (5%) are made (from £40,000 to £90,000)interest payments increases by 125%more riskierAn unexpected event, like the Little Ice Age ( )A collapse in firm revenue slows inflows of new gold depositsMore out-migration increases outflows of gold
14 Historical Development of the Banking System The Fed sets the required reserves ratio of 0.1 on checkable demand deposits in the U.S.’s fractional reserve banking systemThis makes banks’ T-accounts slightly different than the goldsmith’sReserves and loans are still listed on the asset sideThe bank’s outstanding loans of $40,000, is split: government, consumers, and businesses.This means the bank voluntarily lends out all but $10,000 of the $50,000 in checkable demand deposits.Reserves split into required reserves & excess reservesRequired reserves ratio = 10%Excess reserves ratio = 10%Desired reserves ratio = 20%
15 Historical Development of the Banking System Bank of North America chartered in 1782Controversy over the chartering of banks.National Bank Act of 1863 creates a new banking system of federally chartered banksOffice of the Comptroller of the CurrencyDual banking systemFederal Reserve System is created in 1913.Government’s perspectiveThe Mises Institutes’ perspectiveFree Banking (Lawrence White)Free BankingThe Mises Institute’s perspective
16 The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design. – F.A. Hayek
17 Historical Development of the Banking System Figure 1
18 The Federal Reserve System Primary Supervisory Responsibility of Bank Regulatory AgenciesFederal Reserve and state banking authorities:state banks that are members of the Federal Reserve System.Fed also regulates bank holding companies.FDIC: insured state banks that are not Fed members.State banking authorities: state banks without FDIC insurance.
19 Financial InnovationFinancial innovation is driven by the desire to earn profitsA change in the financial environment will stimulate a search by financial institutions for innovations that are likely to be profitableFinancial engineeringResponses to Changes in Demand Conditions: Interest Rate VolatilityAdjustable-rate mortgagesFlexible interest rates keep profits high when rates riseLower initial interest rates make them attractive to home buyersFinancial DerivativesAbility to hedge interest rate riskPayoffs are linked to previously issued (i.e. derived from) securities.Responses to Changes in Supply Conditions:Information TechnologyBank credit and debit cards improved computer technology lowers transaction costsElectronic bankingATM, home banking, ABM and virtual bankingJunk bondsCommercial paper market
20 Financial Innovation Responses to Changes in Supply Conditions: Information Technology (continued)SecuritizationTo transform otherwise illiquid financial assets into marketable capital market securities.Securitization played an especially prominent role in the development of the subprime mortgage market in the mid 2000s.Avoidance of Existing RegulationsLoophole MiningReserve requirements act as a tax on depositsRestrictions on interest paid on deposits led to disintermediationMoney market mutual fundsSweep accountsDecline of Traditional BankingAs a source of funds for borrowers, market share has fallenCommercial banks’ share of total financial intermediary assets has fallenNo decline in overall profitabilityIncrease in income from off-balance-sheet activities
21 Financial Innovation Decline of Traditional Banking Bank’s Response As a source of funds for borrowers, market share has fallenCommercial banks’ share of total financial intermediary assets has fallenNo decline in overall profitabilityIncrease in income from off-balance-sheet activitiesDecline in cost advantages in acquiring funds (liabilities)Rising inflation led to rise in interest rates and disintermediationLow-cost source of funds, checkable deposits, declined in importanceDecline in income advantages on uses of funds (assets)Information technology has decreased need for banks to finance short-term credit needs or to issue loansInformation technology has lowered transaction costs for other financial institutions, increasing competitionBank’s ResponseExpand into new and riskier areas of lendingCommercial real estate loansCorporate takeovers and leveraged buyoutsPursue off-balance-sheet activitiesNon-interest incomeConcerns about risk
22 Structure of the U.S. Commercial Banking Industry Restrictions on branchingMcFadden Act and state branching regulations.Response to ranching restrictionsBank holding companies.Automated teller machines.
23 Structure of the U.S. Commercial Banking Industry Thrift Industry: Regulation and StructureSavings and Loan AssociationsChartered by the federal government or by statesMost are members of Federal Home Loan Bank System (FHLBS)Deposit insurance provided by Savings Association Insurance Fund (SAIF), part of FDICRegulated by the Office of Thrift SupervisionMutual Savings BanksApproximately half are chartered by statesRegulated by state in which they are locatedDeposit insurance provided by FDIC or state insuranceCredit UnionsTax-exemptChartered by federal government or by statesRegulated by the National Credit Union Administration (NCUA)Deposit insurance provided by National Credit Union Share Insurance Fund (NCUSIF)
24 Bank Share of Total Nonfinancial Borrowing Structure of the U.S. Commercial Banking IndustryBank Share of Total Nonfinancial BorrowingFigure 2Source: Federal Reserve Flow of Funds; Flow of Funds Accounts; Federal Reserve Bulletin.
25 Structure of the U.S. Commercial Banking Industry Table 1Table 2
26 Bank Consolidation and Nationwide Banking The number of banks has declined over the last 25 yearsBank failures and consolidation.Deregulation: Riegle-Neal Interstate Banking and Branching Efficiency Act f 1994.Economies of scale and scope from information technology.Results may be not only a smaller number of banks but a shift in assets to much larger banks.BenefitsIncreased competition, driving inefficient banks out of businessIncreased efficiency also from economies of scale and scopeLower probability of bank failure from more diversified portfoliosCostsElimination of community banks may lead to less lending to small businessBanks expanding into new areas may take increased risks and fail
27 Bank Consolidation and Nationwide Banking Erosion of Glass-Steagall ActProhibited commercial banks from underwriting corporate securities or engaging in brokerage activitiesSection 20 loophole was allowed by the Federal Reserve enabling affiliates of approved commercial banks to underwrite securities as long as the revenue did not exceed a specified amountU.S. Supreme Court validated the Fed’s action in 1988Gramm-Leach-Bliley Financial Services Modernization Act of 1999Abolishes Glass-SteagallStates regulate insurance activitiesSEC keeps oversight of securities activitiesOffice of the Comptroller of the Currency regulates bank subsidiaries engaged in securities underwritingFederal Reserve oversees bank holding companies
28 Bank Consolidation and Nationwide Banking Figure 3 Number of Insured Commercial Banks in the United States (Third Quarter)Source: www2.fdic.gov/qbp/qbpSelect.asp?menuitem=STAT.
29 International Banking Universal bankingNo separation between banking and securities industriesBritish-style universal bankingMay engage in security underwritingSeparate legal subsidiaries are commonBank equity holdings of commercial firms are less commonFew combinations of banking and insurance firmsSome legal separationAllowed to hold substantial equity stakes in commercial firms but holding companies are illegalRapid growthGrowth in international trade and multinational corporationsGlobal investment banking is very profitableAbility to tap into the Eurodollar market
30 International Banking Eurodollar MarketDollar-denominated deposits held in banks outside of the U.S.Most widely used currency in international tradeOffshore deposits not subject to regulationsImportant source of funds for U.S. banksU.S. Banking OverseasShell operationEdge Act corporationInternational banking facilities (IBFs)Not subject to regulation and taxesMay not make loans to domestic residents
31 International Banking Foreign Banks in the U.S.Agency office of the foreign bankCan lend and transfer fund in the U.S.Cannot accept deposits from domestic residentsNot subject to regulationsSubsidiary U.S. bankSubject to U.S. regulationsOwned by a foreign bankBranch of a foreign bankMay open branches only in state designated as home state or in state that allow entry of out-of-state banksLimited-service may be allowed in any other stateSubject to the International Banking Act of 1978Basel Accord (1988)Example of international coordination of bank regulationSets minimum capital requirements for banks