Chapter 10. The Banking Industry: Structure and Competition A Brief History Structure Thrifts International Banking The Decline of Traditional Banking A Brief History Structure Thrifts International Banking The Decline of Traditional Banking

I. A Brief History A. dual banking system banking at state level until Civil War state charters, regulation banknotes as local currency failures, fraud were common banking at state level until Civil War state charters, regulation banknotes as local currency failures, fraud were common

National Bank Act 1963 federal charters for banks Comptroller of the Currency federal banknotes tax on state banknotes state banks survived by accepting deposits -- dual banking system National Bank Act 1963 federal charters for banks Comptroller of the Currency federal banknotes tax on state banknotes state banks survived by accepting deposits -- dual banking system

B. A central bank U.S. had two prior central banks the Bank of the U.S. ( )) the Second Bank of the U.S. ( ) U.S. central banks not popular w/ ranchers & farmers states rights U.S. had two prior central banks the Bank of the U.S. ( )) the Second Bank of the U.S. ( ) U.S. central banks not popular w/ ranchers & farmers states rights

no central bank regular financial crises panic of bankers demanded a central bank Federal Reserve System (1913) no central bank regular financial crises panic of bankers demanded a central bank Federal Reserve System (1913)

C. Branching Restrictions McFadden Act 1927 restricted intra and interstate branching of national banks meant to protect small banks & increase competition repealed 1994 (Riegle-Neal) McFadden Act 1927 restricted intra and interstate branching of national banks meant to protect small banks & increase competition repealed 1994 (Riegle-Neal)

D. Great Depression , 1/3 of all U.S. banks failed Congress responded w/ legislation FDIC federal insurance for bank deposits banks pay premiums , 1/3 of all U.S. banks failed Congress responded w/ legislation FDIC federal insurance for bank deposits banks pay premiums

Glass-Steagall Act separated permissible activities of commercial, investment banks idea: limit risk for commercial banks weakened over time repealed 1999 Glass-Steagall Act separated permissible activities of commercial, investment banks idea: limit risk for commercial banks weakened over time repealed 1999

Regulation Q ceiling on interest rates on deposits no interest on checking deposits repealed 1980 Regulation Q ceiling on interest rates on deposits no interest on checking deposits repealed 1980

RegulatorsRegulators Comptroller of the Currency national banks Federal Reserve bank holding companies state member banks national banks (secondary) Comptroller of the Currency national banks Federal Reserve bank holding companies state member banks national banks (secondary)

FDIC nonmember state banks state regulators state banks (secondary) FDIC nonmember state banks state regulators state banks (secondary)

II. Bank Structure A. Decentralization & Consolidation McFadden Act resulted in many small banks meant to protect small banks & increase competition -- but protected inefficient banks -- limited economies of scale McFadden Act resulted in many small banks meant to protect small banks & increase competition -- but protected inefficient banks -- limited economies of scale

loopholes -- bank holding companies -- owned several banks -- limited service banks -- deposits or loans, not both -- ATMs repealed 1994 loopholes -- bank holding companies -- owned several banks -- limited service banks -- deposits or loans, not both -- ATMs repealed 1994

ConsolidationConsolidation bank failures in 1980s loopholes in McFadden repeal of McFadden Over 14,000 banks in 1985 less than 8,000 today bank failures in 1980s loopholes in McFadden repeal of McFadden Over 14,000 banks in 1985 less than 8,000 today

A good thing? economies of scale diversification But risks with expansion? responsive to small customers? economies of scale diversification But risks with expansion? responsive to small customers?

B. Commercial & Investment Banking separated by Glass Steagall 1933 commercial banks banned from -- corporate underwriting -- securities brokerage -- real estate sales -- insurance separated by Glass Steagall 1933 commercial banks banned from -- corporate underwriting -- securities brokerage -- real estate sales -- insurance

why? many believed investment activities led to bank failures of 1930s not really true… problems less diversification restricting economies of scale disadvantage w/ global competition why? many believed investment activities led to bank failures of 1930s not really true… problems less diversification restricting economies of scale disadvantage w/ global competition

Glass Steagall weakened over time bank holding companies Federal Reserve weakened restrictions repealed 1999 (Gramm-Leach-Bliley) Glass Steagall weakened over time bank holding companies Federal Reserve weakened restrictions repealed 1999 (Gramm-Leach-Bliley)

III. Thrift Industry S&Ls, credit unions dual banking systems Savings & Loans (1,049) FDIC insured own regulators: -- FHLBS -- OTS S&Ls, credit unions dual banking systems Savings & Loans (1,049) FDIC insured own regulators: -- FHLBS -- OTS

credit unions (10,000) < 10% of commercial bank assets $600 billion commercial banks $7.6 trillion regulator: NCUA own federal deposit insurance nonprofit credit unions (10,000) < 10% of commercial bank assets $600 billion commercial banks $7.6 trillion regulator: NCUA own federal deposit insurance nonprofit

IV. International Banking global economy means global banking often less regulation overseas alternative structures global economy means global banking often less regulation overseas alternative structures

Edge Act corporations subsidiary of U.S. bank overseas more favorable regulation subsidiary of U.S. bank overseas more favorable regulation

IBFsIBFs international banking facilities in the U.S. loans and deposits to foreign customers favorable regulation, tax status keep the business in the U.S. international banking facilities in the U.S. loans and deposits to foreign customers favorable regulation, tax status keep the business in the U.S.

Foreign banks in the U.S. Agency office not full service but less regulated Full service branch U.S. regulations U.S. subsidiary U.S. regulations Agency office not full service but less regulated Full service branch U.S. regulations U.S. subsidiary U.S. regulations

V. Decline of Traditional Banking traditional bank activities decline in profitability decline in importance traditional bank activities decline in profitability decline in importance

declining share of loans

rising profitability…..

but due to nontraditional activities share of income NOT from interest

why the decline? liability side: cost of acquiring funds has risen asset side: income generated has declined causes: financial innovation since 1970s liability side: cost of acquiring funds has risen asset side: income generated has declined causes: financial innovation since 1970s

Money market mutual funds substitute for checking account from investment companies pay interest not insured (but low risk) banks had to offer own version raised the cost of funds substitute for checking account from investment companies pay interest not insured (but low risk) banks had to offer own version raised the cost of funds

Junk bond market no market for new, low-rated debt prior to 1980 only for ratings of Baa (BBB) or better improvements in credit risk screening created market for new risky debt no market for new, low-rated debt prior to 1980 only for ratings of Baa (BBB) or better improvements in credit risk screening created market for new risky debt

before 1980 low-rated firms relied on banks after 1980 low-rated firms could borrow by issuing junk bonds junk bond markets competing with banks for lending business before 1980 low-rated firms relied on banks after 1980 low-rated firms could borrow by issuing junk bonds junk bond markets competing with banks for lending business

Commercial Paper easier to issue with improvements in credit risk screening demanded by money market mutual funds replaced corporate short-term borrowing from banks easier to issue with improvements in credit risk screening demanded by money market mutual funds replaced corporate short-term borrowing from banks

SecuritizationSecuritization transform illiquid loans into liquid debt securities individual loans bundled together debt securities issued, backed by pool of loans owners of security get a share of the loan payments transform illiquid loans into liquid debt securities individual loans bundled together debt securities issued, backed by pool of loans owners of security get a share of the loan payments

most often down with mortgages 2/3 of all mortgages securitized also down with auto loans, leases, credit cards most often down with mortgages 2/3 of all mortgages securitized also down with auto loans, leases, credit cards

the implication other financial institutions take a part of the lending process -- originate the loan -- service the loan -- issue and sell security finance companies that just specialize in originating loans the implication other financial institutions take a part of the lending process -- originate the loan -- service the loan -- issue and sell security finance companies that just specialize in originating loans

in total higher cost of obtaining funds due to competition from money market lower income from loans due to competition from -- junk bond market -- commercial paper market -- financial companies higher cost of obtaining funds due to competition from money market lower income from loans due to competition from -- junk bond market -- commercial paper market -- financial companies

Result of decline: bank failures

newer activities fee income credit cards commercial real estate newer activities fee income credit cards commercial real estate