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Banking “Biodiversity” – Traditional vs. Non-traditional Banking: What are the Issues? Gregory F. Udell Indiana University.

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Presentation on theme: "Banking “Biodiversity” – Traditional vs. Non-traditional Banking: What are the Issues? Gregory F. Udell Indiana University."— Presentation transcript:

1 Banking “Biodiversity” – Traditional vs. Non-traditional Banking: What are the Issues? Gregory F. Udell Indiana University

2 Non-traditional vs. Traditional Banks Traditional Commercial Banks Non-traditional Banks Cooperative/Mutual Banks Gov’t-Owned Banks

3 Non-traditional vs. Traditional Banks Traditional Commercial Banks Non-traditional Banks Cooperative/Mutual Banks Gov’t-Owned Banks

4 Non-traditional vs. Traditional Banks Traditional Commercial Banks Non-traditional Banks Cooperative/Mutual Banks Gov’t-Owned Banks Our Focus

5 Motivation Non-traditional banks are globally significant -Represent about 40% of the global banking industry (La Porta, Lopez-de-Silanes, and Shleifer 2002) They may behave differently, including -Efficiency -Social welfare -Ethics -Agency problems They are sometimes regulated differently

6 A Personal Note I’m a relative newcomer to non-traditional banking – certainly relative to this panel! However, I’ve become quite interested in this segment of the industry recently -Recent work on cajas in Spain -I have served one term as a member of the supervisory sommittee of a medium-sized credit union in the U.S. -And, I was recently an expert witness in a large class action lawsuit on a consumer pricing issue which (arguably) pitted traditional banks against credit unions

7 Are Non-traditionals Different? What are the Research/Policy Questions? Are there differences in performance and efficiency? Is the existence of a non-traditional sector welfare improving? Are non-traditionals profit-maximizing? -What does their objective function look like? Are non-traditionals more “ethical”? Are they less sophisticated? Are they more easily “captured”? Are there differences in providing access to credit? -Do they behave differently during macro shocks? Are they affected by the same agency problems? Should they be regulated differently?

8 Are Non-traditionals Different? What are the Research/Policy Questions? Are there differences in performance and efficiency? Is the existence of a non-traditional sector welfare improving? Are non-traditionals profit-maximizing? -What does their objective function look like? Are non-traditionals more “ethical”? Are they less sophisticated? Are they more easily “captured”? Are there differences in providing access to credit? -Do they behave differently during macro shocks? Are they affected by the same agency problems? Should they be regulated differently? More questions than answers! – at least on some of these

9 Are Non-traditionals Different? What are the Research/Policy Questions? Are there differences in performance and efficiency? Is the existence of a non-traditional sector welfare improving? Are non-traditionals profit-maximizing? -What does their objective function look like? Are non-traditionals more “ethical”? Are they less sophisticated? Are they more easily “captured”? Are there differences in providing access to credit? -Do they behave differently during macro shocks? Are they affected by the same agency problems? Should they be regulated differently? Work by panelists on many of these issues: e.g., Leonardo & Giovanni

10 Presentation How should we think about non-traditionals? -Their objective function -Their governance -Their behavior Two case study examples related to my work and experience -Spain -U.S. These two cases will illuminate some policy and regulatory issues Concluding comments

11 How Should We Think About Non-traditionals? The objective function of traditional banks -The dominant paradigm in corporate finance is shareholder wealth maximization -However, there is a literature on the “economics of higher purpose” within privately-owned stock companies (see Thakor and Quinn 2014) -Individuals care about integrity, honesty, social identity and reputation (e.g., Akerlof and Kranton 2010, and Benabou and Tirole 2008) -Relative status (e.g., Akerlof and Yellen 1990, Goel and Thakor 2005, and Mui 1995) -Corporate social responsibility (e.g. Benabou and Tirole 2010) -Moral behavior (e.g. Benabou and Tirole 2011) -Intrinsic motivation (e.g. Benabou and Tirole 2003)

12 The Objective Function (cont.) “ Purpose is the deepest dimension within us – our central core or essence – where we have a profound sense of who we are, where we came from and where we’re going. Purpose is the quality we choose to shape our lives around. Purpose is a source of energy and direction.” Leider (1997) “I was drawn by the power that savoring a simple cup of coffee can have to connect people and create community.” Howard Schultz, founder of Starbucks “Great companies must have a noble cause. Then it’s the leader’s job to transform that noble cause into such an inspiring vision that it will attract the most talented people in the world to want to join it.” Steve Jobs, as narrated by John Sculley. Taken from Thakor and Quinn (2014)

13 The Objective Function (cont.) A recent model provides insight into the economics of principals and agents driven by both wealth and a higher purpose (Thakor and Quinn 2014 – “TQ”) -Based on extant models of agents working for principals who pursue a “higher purpose” (Delfgaauw and Dur 2007, Handy and Katz 1998, Glazer 2004, and Nyborg and Brekke 2010) -Agents work harder/invest more than strictly wealth maximizers -Complimentarity in TQ -Principals motivated by “higher purpose” relax budget constraints

14 The Objective Function (cont.) TQ model is not motivated by banking (i.e., it’s not specific to non-traditional banking) But, applying TQ to cooperatives seems logical -Depositors would be principals -Needs exploring though. Useful research exercise.

15 The Objective Function (cont.) TQ model is not motivated by banking (i.e., it’s not specific to non-traditional banking) But, applying TQ to cooperatives seems logical -Depositors would be principals -Needs exploring though. Useful research exercise. -From my credit union:

16 The Objective Function (cont.) TQ model is not motivated by banking (i.e., it’s not specific to non-traditional banking) But, applying TQ to cooperatives seems logical -Depositors would be principals -Needs exploring though. Useful research exercise. -From my credit union: It depends on what this means, e.g., max consumer surplus ala Hesse and Cihak (2007)?

17 The Objective Function (cont.) But, are we missing something? Answer: Yes! -Governance, conflict of interest, the contracting environment and regulation -No market for corporate control -Cooperatives/non-traditional banks still nested in layers of conflicts of interest associated with layers of contracting.

18 SMALL BUSINESS CREDIT AVAILABILITY AND RELATIONSHIP LENDING: THE IMPORTANCE OF BANK ORGANISATIONAL STRUCTURE From Berger and Udell (2002)

19 SMALL BUSINESS CREDIT AVAILABILITY AND RELATIONSHIP LENDING: THE IMPORTANCE OF BANK ORGANISATIONAL STRUCTURE Replaced with bank depositors – which changes the nature of the conflict of interest From Berger and Udell (2002)

20 Governance et al. The performance of non-traditionals likely ultimately depends on the solutions to these problems -An abundance of empirical evidence that the equilibrium for state-owned banks is not a good one -But, the evidence suggests that, globally, the story may be different for cooperatives (e.g., Becchetti, Ciciretti and Paolantonio 2014) So, how should we think about this empirically?

21 Governance et al. A good starting point: -Laeven and Levine (2009) -First cross-country empirical study connecting risk-taking, governance (i.e., ownership structure) and national bank regulation -Focuses on conflicts between managers and owners over risk in 48 different countries (250 banks) -Finds that the relationship between bank risk and capital regulations, deposit insurance policies and restrictions on bank activities depends on governance including, in particular, ownership concentration (more concentration => more risk)

22 Governance et al. (cont.) Key question: Can we adapt this analysis to non-traditionals, and specifically cooperatives? -Cooperatives may be different: exploitation of the deposit insurance put may be dominated by expense preference behavior or other inefficiencies -There are studies analyzing differences between cooperatives and traditional banks (e.g., Becchetti, Ciriretti and Paolantonio 2014, Altunbas et al. 2001) -But studies looking at differences (in governance ala Laeven and Levine 2009) within the cooperative sector seem lacking -e.g., studies like those that link risk taking and risk management governance ala Gopalan and Yerrimilli (2011) -e.g., degree of implicit/explicit government involvement

23 Some International Perspective: Two Case Studies For a non-Italian perspective let’s consider two cases: -U.S. -Spain May illuminate some of the issues that we noted before -Performance and efficiency -Welfare issues -Objectives -Ethical behavior -Regulatory capture -Access to credit -Nature of agency problems -Regulation/deregulation

24 The U.S. Case: Cooperative Banking in the U.S. Market structure History Performance Regulation/deregulation

25 The U.S. Case: Market Structure

26 The Cooperatives

27 The U.S. Case: Market Structure (and some history) Market structure – 3 types -Savings and Loan Associations (S&Ls) -Initially mostly cooperatives -However, many demutualized (e.g., Washington Mutual in 1983) -Tax exempt if 85% invested residential mortgages -Asset/Liability mismatch by 1979 due to prohibition against ARMs -Led to the S&L crisis -And product deregulation – 1982 Garn St. Germain Act -Origins in the Irish/English building societies -Many were local and ethnic in origin (e.g., Chicago’s Polish American Building and Loan) -Mutual Savings Banks -Located in the northeast U.S. -Mostly limited to consumer loans -Credit Unions -Historically limited on both spatial and product dimensions

28 The U.S. Case: Market Structure (Assets) Traditional banking growing while cooperatives shrinking

29 The U.S. Case: Market Structure (Assets) Traditional banking growing while cooperatives shrinking Mortgage lending by S&Ls replaced by lending from government banks (FANNIE and FREDDIE) and securitization

30 The U.S. Case: Market Structure (Assets) Traditional banking growing while cooperatives shrinking Credit Unions, however, growing: - 10% of household savings - 9% of all consumer loans % of non-revolving consumer loans - 6.2% of mortgage originations

31 The U.S. Case: The Credit Unions Good news – and bad news! The bad news -Expense preference behavior in the mutual segment of the S&L industry before the S&L crisis (Mester 1989) -but not after (Mester 1993) -Credit unions appear to have become less efficient recently (Wheelock and Wilson 2009) -Less cost-productive between 1989 and Small credit unions worse -scale inefficiencies affecting many small credit unions (Wheelock and Wilson 2010) -Sometimes vulnerable because of a lack of sophistication(?) -Penn Square fiasco in the 1980s -Oil patch lending -Corporate Credit Union fiasco in 2010 (potentially ultimately $50 billion in losses) -Private label subprime MBS

32 The U.S. Case: The Credit Unions (cont.) The good news -Credit unions discipline banks in small local markets (Feinberg 2001) -Large credit unions appear to have become a bit more scale efficient (Wheelock and Wilson 2009) -Anecdotal evidence that credit unions behave more “ethically” -All big banks changed their overdraft policies in the early 2000s to increase number of overdraft items per event -Banks typically charged $30.00 per item overdrawn -To exploit this, large banks changed check processing from smallest to largest to largest to smallest -Credit unions did much less of this than banks -16.3% of credit unions processed largest to smallest -27.7% of banks processed largest to smallest -53.7% of the largest banks processed largest to smallest -Including JPMorgan Chase, BoA, Citigroup and Wells Fargo

33 The U.S. Case: The Credit Unions (cont.) Regulatory issues -Tax exempt status an ongoing political issue -Credit unions significantly deregulated (relatively recently) -Effectively no longer constrained by the “common bond” requirement -The Credit Union Membership Access Act of 1998 allowed credit unions to accept members from unrelated groups -Massive consolidation followed: from 1969 peak of 23,866 to 8,662 in Credit unions significantly deregulated on the product side -Initially limited to short-term consumer loans -Now almost completely deregulated on the product side -Last barrier to full range commercial banking: commercial lending -Limited to 12.5% - proposed legislation to raise to 25%

34 The U.S. Case: The Credit Unions (cont.) Regulatory issues -Tax exempt status an ongoing political issue -Credit unions significantly deregulated (relatively recently) -Effectively no longer constrained by the “common bond” requirement -The Credit Union Membership Access Act of 1998 allowed credit unions to accept members from unrelated groups -Massive consolidation followed: from 1969 peak of 23,866 to 8,662 in Credit unions significantly deregulated on the product side -Initially limited to short-term consumer loans -Now almost completely deregulated on the product side -Last barrier to full range commercial banking: commercial lending -Limited to 12.5% - proposed legislation to raise to 25%

35 The U.S. Case: The Credit Unions (cont.) Regulatory issues -Tax exempt status an ongoing political issue -Credit unions significantly deregulated (relatively recently) -Effectively no longer constrained by the “common bond” requirement -The Credit Union Membership Access Act of 1998 allowed credit unions to accept members from unrelated groups -Massive consolidation followed: from 1969 peak of 23,866 to 8,662 in Credit unions significantly deregulated on the product side -Initially limited to short-term consumer loans -Now almost completely deregulated on the product side -Last barrier to full range commercial banking: commercial lending -Limited to 12.5% - proposed legislation to raise to 25% What is the effect on credit unions and their sense of community? (i.e., How does this affect their objective function?)

36 The U.S. Case: The Credit Unions (cont.) Regulatory issues -Tax exempt status an ongoing political issue -Credit unions significantly deregulated (relatively recently) -Effectively no longer constrained by the “common bond” requirement -The Credit Union Membership Access Act of 1998 allowed credit unions to accept members from unrelated groups -Massive consolidation followed: from 1969 peak of 23,866 to 8,662 in Credit unions significantly deregulated on the product side -Initially limited to short-term consumer loans -Now almost completely deregulated on the product side -Last barrier to full range commercial banking: commercial lending -Limited to 12.5% of assets - proposed legislation to raise to 25% (effectively unconstrained at this level)

37 The U.S. Case: The Credit Unions (cont.) Regulatory issues (cont.) -Arguably weaker prudential supervision -State regulators in the U.S. more lenient than federal regulators (Agarwal, Lucca, Seru and Trebbi 2014) -State regulators supervise about 40% of all credit unions -Nationally chartered credit unions have a national regulator (National Credit Union Administration - NCUA) -Not clear whether NCUA is a strong regulator -Corporate credit union scandal suggests not -Corp. credit unions invested in the lowest quality subprime MBS on behalf of credit union customers -Without NCUA intervention as many as 1,000 credit unions could have failed -Will a combination of potentially weak regulation and deregulation be problematic for the U.S. Credit union industry? -Spain my provide an answer!

38 The Spanish Case: The Cajas Cajas were the Spanish savings banks -Essentially a form of cooperatives -Appear to have been relatively efficient before deregulation -Key component of the domestic Spanish banking system before the crisis -The entire industry failed creating a fiscal disaster for Spain

39 The Spanish Case: The Cajas Cajas were the Spanish savings banks -Essentially a form of cooperatives -Appear to have been relatively efficient before deregulation -Key component of the domestic Spanish banking system before the crisis -The entire industry failed creating a fiscal disaster for Spain -Key point: A potential lesson regarding the deregulation of the the non- traditional banking sector in an environment characterized by a weak regulatory infrastructure and a weak and vulnerable goverance mechanism.

40 The Spanish Case: The Cajas Cajas were the Spanish savings banks -Essentially a form of cooperatives -Appear to have been relatively efficient before deregulation -Key component of the domestic Spanish banking system before the crisis -The entire industry failed creating a fiscal disaster for Spain -Key point: A potential lesson regarding the deregulation of the the non- traditional banking sector in an environment characterized by a weak regulatory infrastructure and a weak and vulnerable goverance mechanism. What does this tell us about U.S. credit union deregulation?

41 The Spanish Case: The Cajas (cont.) Pre-Crisis History -Existed for 100 years -Established by -local governments -churches and/or -welfare societies -Private foundations with no owners -either retain profits, or -pay “social dividends” -Purpose: -promote savings by middle- and working-class people -provide lending to small businesses from the same city or province

42 The Spanish Case: The Cajas (cont.) Cajas were nearly 50% of the Spanish banking system –The cajas were a colossal disaster –The majority of the 2010 and 2011 European stress test failures were cajas banks –Failed cajas were bailed out and force-merged, e.g., Bankia a conglomeration of 7 cajas –43 of 45 cajas (in existence in 2009) restructured (only 2 small ones remain independent) –All SBs had to convert to banks –Gov‘t hoped-for synergies illusory –Continued revelation of massive losses swamp any synergies –Estimated total SB losses range as high as 153 billion euros –Bankia former board members all prosecuted for fraud –Now creates a TBTF problem

43 The Spanish Case: The Cajas (cont.) The cajas are a very interesting experiment –In theory depositor-controlled, but gov‘t-controlled in practice After spatial deregulation, cajas expanded rapidly –Beginning in 1975 and ending in 1988 spatial scope extended from state level to provincial level to nationwide –Expansion associated with explosive growth in lending to real estate and construction firms Expansion was associated with a significant increase in risk in lending portfolios, particularly in real estate (Illueca, Norden and Udell 2014) -Weak governance played a role -Facilitated by political influence -Specifically, increased political influence resulted in: -higher ex ante risk -higher ex post risk (i.e., default) -Led to cross-border bottom feeding instead of cherry picking

44 17 regions, 52 provinces

45 Depositors Local governments Founders Employees Depositors Regional governments Local governments Founders Employees Deregulation Led to Shift in Governance

46 Depositors Local governments Founders Employees Depositors Regional governments Local governments Founders Employees Deregulation Led to Shift in Governance Consolidation of control: for 50% of SBs, one regional government had a stake on average of 20% Diffuse

47 The Spanish Case: The Cajas (cont.)

48 Risk: higher for firms borrowing from cajas out of home region and higher yet if cajas politically influenced (same party in both regions) The Spanish Case: The Cajas (cont.)

49 Conclusion Compelling research on the performance of cooperatives/savings banks compared to commercial banks -Suggests that cooperatives are efficient on average compared to traditional banks -Suggests that cooperatives add value in traditional banking activities I think there is room for more theoretical and empirical work on the issue of the “economics of higher purpose” as it relates to cooperatives -Possibly based on Thakor and Quinn (2014) -More evidence on ethical behavior (e.g., overdraft charges in U.S.) Room for more research on differences across institutions within the cooperative/savings banks sector Lessons from the Spain and the U.S. -Particularly concern over regulation and deregulation


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