Commercial Banking Structure, Regulation and Performance Chapter 15 © 2003 South-Western/Thomson Learning

Slide 2 Learning Objectives  Who regulates whom in banking system and why  What a bank holding company is and why virtually all large banks are now organized as holding companies  What is a financial holding company  Nature of and reasons for the recent wave of bank mergers  Profitability of the banking system in recent years

Slide 3 Banking Regulatory Structure  Glass-Steagall Act of 1933  Banking legislation  Enacted in response to Great Depression  Established Regulation Q interest rate ceilings  Separated commercial and investment banking  Created the FDIC  Regulation Q  Interest rate ceilings on deposits at commercial banks  Established during the Great Depression  Phased out after 1980

Slide 4 Banking Regulatory Structure  Federal Deposit Insurance Corporation (FDIC)  Federal agency  Insures the deposits of banks and savings associations  Comptroller of Currency  Federal agency  Charters national banks

Slide 5 Banking Regulatory Structure  Chartered  Given permission to engage in business of commercial banking  Banks must obtain charter before opening  Commercial banks in U.S. are chartered  National Bank  Bank that has received charter from Comptroller of Currency (federal government)  Dual Banking System  System whereby a bank may have either a national or state charter

Slide 6 Regulatory Responsibilities  FDIC regulates:  State-chartered, insured non-Fed members  Insured branches of foreign banks  Comptroller of Currency regulates:  National banks that are not bank holding companies  Federally chartered branches of foreign banks

Slide 7 Regulatory Responsibilities  Fed regulates:  State-chartered, insured members of the Fed  All bank holding companies  All financial holding companies  Branches of foreign banking organizations operating in U.S. and their parent bank  States regulate:  State-chartered, non-FDIC-insured banks that are not Fed members

Slide 8 Structure of Commercial Banking System  Regulators  Interested in monitoring, influencing, controlling structure of market for banking services  Control entry into market  Control mergers among existing firms  Control branching in effort to maintain many small firms

Slide 9 Structure of Commercial Banking System  McFadden Act  Outlawed interstate branching  Made national banks conform to the intrastate branching laws of states in which they were located  Interstate Banking and Branching Efficiency Act (IBBEA)  Signed into law in September 1994 by Congress  Allows unimpeded, nationwide branching

Slide 10 Bank Holding Companies  Bank Holding Company  Corporation that owns several firms - at least one is a bank  Owns one - one-bank holding company  Owns more than one – multi-bank holding company  Many banks organize into holding companies to:  Circumvent restrictions on branching, thus seek out sources and uses of funds in other geographical markets  Diversify into other product areas, thus providing public with a wider array of financial services, while reducing risk associated with limiting operations to traditional banking services

Slide 11 Exhibit 15–5 Allowable Activities for Bank Holding Companies (Federal Reserve Regulation Y, Revised January 1, 2001)

Slide 12 Bank Holding Companies  Organizing into holding company allows banks to:  Circumvent prohibitions on intrastate and interstate branching (which now have been virtually eliminated)  Participate in activities that otherwise would be barred such as:  Data processing  Leasing  Investment counseling  Servicing out-of-state loans  Almost all large banks are owned by holding companies

Slide 13 Financial Holding Companies  Financial Holding Companies  Engage in broader array of financial- related activities than bank holding companies  Securities underwriting & dealing  Insurance agency and underwriting activities  Merchant banking activities  Other activities that Fed determines to be financial or incidental to financial activities  Any non-financial activity that Fed determines is complementary to financial activity and doesn’t pose a substantial risk

Slide 14 Bank Holding Companies and Financial Holding Companies  Merchant Banking  Direct equity investment (purchasing of stock) by a bank in a start-up or growing company

Slide 15 Ongoing Changes in Structure of Banking Industry  Increased competition in financial services industry  Considerable erosion in domain and effectiveness of many long-standing financial regulations  Significant increase in share of total bank assets controlled by largest banks  Pace and dollar volume of mergers increased significantly

Slide 16

Slide 17 Evolution of International Banking  Increase in international borrowing and lending by domestic banks  Many foreign banks made significant inroads into U.S. markets by the 1980s.  Agency of a Foreign Bank  U.S. Banking office of foreign bank  Can borrow funds only in wholesale and money markets  Not allowed to accept retail deposits

Slide 18 Bank Management: Managing Risk and Profits  Primary function of a bank loan officer is to evaluate or assess the default risk associated with lending to particular borrowers  firms  individuals  domestic and foreign governments

Slide 19 Managing Risk and Profits  Asymmetric Information  Potential borrower knows more about the risks and returns of an investment project than bank loan officer  Adverse Selection Problem  When least desirable borrowers pursue a loan most diligently

Slide 20 Managing Risk and Profits  Moral Hazard Problem  When borrower has incentive to use proceeds of loan for more risky venture after loan is funded  Bank manager must manage interest rate risk  Adjustable-(Variable-) Rate Loan  When interest rate on loan is adjusted up or down as cost of funds rises or falls  Banks can use financial futures, options and swaps to manage interest rate risk

Slide 21 Bank Performance  Nonbanks  Other intermediaries and nonfinancial companies that have taken increasing share of intermediation Banks are facing increasing competition from other FIs and nonfinancial corporations in a global environment.