1. Commercial Banking Industry: Structure and Competition
Chapter 18
Commercial Banking Industry: Structure and Competition

2. Chapter Preview
We examine the historical development of the banking system, both in the U.S. and abroad. We then examine the role of financial innovation and its impact on competition. Topics include:
Historical Development of the Banking System
Financial Innovation and the Evolution of the Banking Industry
Structure of the U.S. Commercial Banking Industry
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3. Chapter Preview (cont.)
Bank Consolidation and Nationwide Banking
Separation of Banking and Other Financial Service Industries
International Banking
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4. Historical Development of the Banking Industry
The modern commercial banking industry began when the Bank of North America was chartered in Philadelphia in 1782.
The next slide provides a timeline of important dates in the history of U.S. banking prior to WWII.
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5. Historical Development of the Banking Industry
Figure Time Line of the Early History of Commercial Banking in the United States
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6. Historical Development of the Banking Industry
Outcome: Multiple Regulatory Agencies
Federal Reserve
FDIC
Office of the Comptroller of the Currency
State Banking Authorities
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7. Financial Innovation Innovation is result of search for profits
Response to Changes in Demand Conditions
Major change is huge increase in interest-rate risk starting in 1960s
Adjustable-Rate Mortgages are an example of the reply to interest-rate volatility
Banks also started using derivates to hedge risk
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8. Financial Innovation Response to Changes in Supply Conditions
Major change is improvement in computer technology
Increases ability to collect information
Lowers transactions costs
This lead to many innovations on the supply side, which we will discuss
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9. Financial Innovation: Credit and Debit Cards
Many store credit cards existed long before WWII.
Improved technology in the late 1960s reduced transaction costs making nationwide credit card programs profitable.
The success of credit cards led to the development of debit cards for direct access to checkable funds.
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10. Financial Innovation: Electronic Banking
Automatic Teller Machines (ATMs) were the first innovation on this front. Today, over 250,000 ATMs service the U.S. alone.
Automated Banking Machines combine ATMs, the internet, and telephone technology to provide “complete” service.
Virtual banks now exist where access is only possible via the internet.
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11. Financial Innovation: Electronic Payments
The development of computer systems and the internet has made electronic payments of bills a cost-effective method over paper checks or money.
The U.S. is still far behind some European countries in the use of this technology.
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12. Financial Innovation: E-Money
Electronic money, or stored cash, only exists in electronic form. It is accessed via a stored-value card or a smart card.
E-cash refers to an account on the internet used to make purchases.
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13. Financial Innovation: Junk Bonds
Prior to 1980, debt was never issued that had a junk rating. The only junk debt was bonds that had fallen in credit rating.
Michael Milken of Drexel Burnham assisted firms in issuing original-issue junk debt, and almost single-handedly created the market.
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14. Financial Innovation: Commercial Paper Market
Commercial paper refers to unsecured debt issued by corporations with a short original maturity.
Currently, over $1.3 billion is outstanding in the market.
The development of money market mutual funds assisted in the growth in this area.
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15. Financial Innovation: Securitization
Securitization refers to the transformation of illiquid assets into marketable capital market instruments.
Today, almost any type of private debt can be securitized. This includes home mortgages, credit card debt, student loans, car loans, etc.
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16. Financial Innovation: Avoidance of Existing Regulations
Regulations Behind Financial Innovation
Reserve requirements
Tax on deposits = I  rD
Deposit-rate ceilings (Reg Q)
As i , loophole mine to escape reserve requirement tax and deposit-rate ceilings
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17. Financial Innovation: Avoidance of Existing Regulations
Money Market Mutual Funds: allowed investors similar access to their funds as a bank savings accounts, but offered higher rates, especially in the late 1970s.
Sweep Accounts: Funds are “swept” out of checking accounts nightly and invested at overnight rates. Since they are no longer checkable deposits, reserve requirement taxes are avoided.
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18. Financial Innovation and the Decline in Traditional Banking
The traditional role of transforming short-term deposits into long-term loans has been greatly affected by financial innovation. As the next slide shows, the importance of commercial banks as a source of funds to nonfinancial borrowers has shrunk dramatically.
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19. Financial Innovation and the Decline in Traditional Banking
Figure Bank Share of Nonfinancial borrowings, 1960–2004
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20. Financial Innovation and the Decline in Traditional Banking
Loss of Cost Advantages in Acquiring Funds (Liabilities)
π  i  then disintermediation because
Deposit rate ceilings and regulation Q
Money market mutual funds
Foreign banks have cheaper source of funds: Japanese banks can tap large savings pool
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21. Financial Innovation and the Decline in Traditional Banking
Loss of Income Advantages on Uses of Funds (Assets)
Easier to use securities markets to raise funds: commercial paper, junk bonds, securitization
Finance companies more important because easier for them to raise funds
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22. Banks' Response
Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability in traditional banking
Expand lending into riskier areas (e.g., real estate)
Expand into off-balance sheet activities
Creates problems for U.S. regulatory system
Similar problems for banking industry in other countries
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23. Decline in Traditional Banking in Other Industrialized Countries
Forces similar to those in the U.S. have led to a similar decline in other industrialized countries.
For example, deregulation in Japan has led to new financial instruments, leading to disintermediation.
In many countries, as securities markets develop, banks also face competition from the products offered.
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24. Structure of the U.S. Commercial Banking Industry
Around 8,000 commercial banks currently exist in the U.S.
The tables on the next two slides shows various statistics for these banks as well as the ten largest U.S. banks.
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25. Structure of the Commercial Banking Industry
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FDIC statistics on banking

26. Ten Largest U.S. Banks World’s 100 largest banks
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27. Branching Regulations
Branching Restrictions: Very Anti-competitive
Response to Branching Restrictions
Bank Holding Companies
Allowed purchases of banks outside state
BHCs allowed wider scope of activities by Fed
BHCs dominant form of corporate structure for banks
Automated Teller Machines
Not considered to be branch of bank, so networks allowed
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28. Bank Consolidation and Nationwide Banking
As the next slide shows, the number of commercial banks in the U.S. was very stable from 1934 through the mid-1980s. After that, the number of commercial banks began to fall dramatically.
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29. Bank Consolidation and Number of Banks
Figure Number of Insured Commercial Banks in the United States, 1934–2004
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Quarterly banking profile

30. Bank Consolidation and Nationwide Banking
Bank Consolidation: Why?
Branching restrictions weakened
Development of super-regional banks
Riegle-Neal Act of 1994
Allows full interstate branching
Promotes further consolidation
Future of Industry Structure
Will become more like other countries, but not quite:
Several thousand, not several hundred
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31. Bank Consolidation and Nationwide Banking
Are Bank Consolidation and Nationwide Banking a Good Thing?
Cons
Fear of decline of small banks and small business lending
Rush to consolidation may increase risk taking
Pros
Community banks will survive
Increase competition
Increased diversification of bank loan portfolios: lessens likelihood of failures
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32. Separation of Banking and Other Financial Service Industries
Case for Glass-Steagall
FDIC gives unfair advantage to banks
Allowing banks into underwriting is dangerous because FDIC promotes too much risk taking
Potential conflicts of interest
Case Against Glass-Steagall
Decreases competition
Unfair to banks
Hinders diversification
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33. Separation of Banking and Other Financial Service Industries
Erosion of Glass-Steagall
Fed, OCC, FDIC are allowing banks to engage in underwriting activities, under the Section 20 loophole in the act
Gramm-Leach-Bliley Act of 2002
Legislation to eliminate Glass-Steagall
States retain insurance regulation, while SEC oversees securities activities
OCC regulates subsidiaries that underwrite securities
Fed still oversees bank holding companies
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34. Separation of Banking and Other Financial Service Industries
Implications for Financial Consolidation
G-L-B will speed-up consolidation
Expect mergers between banks and other financial service providers to become more common
U.S. banks likely to become larger and more complex organizations
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35. Separation of Banking and Other Financial Service Industries
Separation in Other Countries
Universal banking: Germany
British-style universal banking
U.S./Japan separation
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36. International Banking
Why Rapid Growth
Rapid growth of international trade
Banks abroad can pursue activities not allowed in home country
Tap into Eurodollar market
U.S. Banks Overseas
Regulators
Federal Reserve (Regulation K)
Structure
Edge Act Corporations
International Banking Facilities
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37. International Banking
Foreign Banks in U.S.
Regulators
Same as for U.S. domestic banks
Structure
500 offices in U.S.
20% of total U.S. bank assets
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38. Ten Largest Banks in the World
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