1. Commercial Banking Industry Structure
Chapter 12
Commercial Banking Industry Structure

2. US banking system very different from rest of the world.
Overview
US banking system very different from rest of the world.
Many small banks.
U.S. has about 7,000 commercial banks for a population of about 300 million. This is down from 14,000 in the mid 1980’s.
Canada has 21 banks for about 36 million.
Norway has 4 banks for 4.5 million.

4. Why is the US Unique?
Need to look at the history of banking in the US.

5. Need to look back to the 1700’s
Jefferson
States rights
Limit federal power
No national or central bank
State control of banking
Hamilton
Federal rights
Expand Government and centralize power
National or central bank
Federal control of banking

6. Figure 1 Time Line of the Early History of Commercial Banking in the United States

7. Early History
Bank of the United States chartered for 20 years. First attempt at a central bank to controlled money supply and credit.
Agricultural interest very skeptical of concentration of power in large eastern cities, advocated state charters.
charter not renewed. Defeated by states rights and agricultural interests.
That the Bank was to be a private company.
be forbidden to buy government bonds.
have a mandatory rotation of directors.
neither issue notes nor incur debts beyond its actual capitalization.
Only about 20% of currency in circulation

8. Early History – 1800’s
War of 1812 – need to raise funds, some felt need for a national/central bank.
second attempt at central bank. Second Bank of the United States chartered for 20 years (this was only 5 years later)
1832- Andrew Jackson elected. Congress votes to re-charter, Jackson, a strong advocate of states rights, vetoes.

9. Banks chartered and regulated only by the states No national currency
Free Banking Era:
Banks chartered and regulated only by the states
No national currency
Banks issued private bank notes (that could be redeemed for gold) to attract funds
Think about going to Tennessee with a bank note issued by a bank in Philadelphia. Money is supposed to reduce information cost and facilitate trade – not the case here!
Poor regulation, many banks under capitalized, many failed, bank notes became worthless.

10. National Banking Act of 1863
Created federally chartered banks under supervision of the Office of the Comptroller of the Currency.
Tried to eliminate state banks by imposing a 10% tax on state bank notes.
Tax did not eliminate state banks.
Did eliminate state bank notes.
State banks created demand deposits.
Today we have a “dual banking system”
2,100 federally chartered banks with 50% of total bank assets.

11. Early History Summary
Phobia against large banks and central banking which carried into the 20th century.
State banking system developed in the US rather than the typical national banking system in other countries.
Federally chartered banks in We have a dual banking system in the US

12. 1900s 1913 - The Federal Reserve System 1927 - McFadden Act
- prohibited branch banking across lines
, the Great Depression
- Banking Act of 1933/ Glass-Steagall Act
- Set up FDIC - deposit insurance.
- Separated commercial and investment
banking.
- Restricted checkable deposits to commercial banks
- Put interest rate ceilings on bank deposits (Regulation Q)

13. McFadden Act - 1927 Proposed as being pro-competitive.
Actually anti-competitive because small banks insulated from out-of-state competition.
Some states had “unit banking” – No branches!
Big Negative - banks tied to local economy as a result of McFadden Act.
From , 9000 banks failed in the US(1/3), compared to 0 in Canada.

14. How to get around regulations prohibiting branching across state lines
Bank Holding Companies
- Allowed purchase of banks outside state
Automated Teller Machines
- Not considered to be branch of bank
McFadden Act repealed in 1994 by Reigle-Neal Act

15. Key Legislation Affecting the U.S. Banking Industry
1913 Federal Reserve Act
1927 McFadden Act: Outlawed interstate branching and required national banks to abide by the laws of the state in which they operated.
1933 Glass-Steagall Act: Established federal deposit insurance and prohibited commercial banks from engaging in the insurance and securities businesses.
1994 Reigle-Neal Act: Repealed the McFadden Act
1999 Gramm-Leach-Bliley Act: Repealed the Glass-Steagall Act’s prohibition of mergers between commercial banks and insurance companies or securities firms.

16. Without a decline in overall profitability
Financial Innovation and the Decline of Traditional Banking – Attack on the balance sheet
Commercial bank importance as a source of funds to non-financial borrowers has fallen over time.
Without a decline in overall profitability 16

17. Financial Innovation and the Decline in Traditional Banking
40%
29%
20% 8%

18. Financial Innovation, Increased Competition for Sources of Funds
Prior to 1980s - Regulation Q
60% of bank funds were deposits (now 6%)
1970s - π↑ => i↑ (Fisher Equation)
Major Financial Innovation
Money Market Mutual Funds (MMMF)
Disintermediation – banks lost deposits to MMMF.
Regulation Q eliminated in 1980, but banks lost Cost Advantages in Acquiring Funds

19. Junk Bonds Commercial Paper
Financial innovations leading to increase in direct finance – Competition for Use of Funds
Junk Bonds
Commercial Paper
GE Capital is an example of a commercial finance company. At one point the largest issuer of commercial paper in the US.
Loans to buyers of GE products
Commercial paper

20. Financial Innovation: Junk Bonds
Prior to 1980, bonds were never issued that had a junk rating.
Only firms with Baa or better could direct finance in the bond market.
The only junk debt was bonds that had fallen in credit rating (so-called fallen angels).
With improvement in information technology in the 1970s it became easier for investors to screen out bad credit from good credit risks and willing to buy new issue debt rated < Baa.

21. Financial Innovation: Commercial Paper Market
Commercial paper refers to unsecured debt issued by corporations (non-financial and financial) with a short maturity.
Peaked at $2.2 trillion outstanding mid 2007.
As with junk bonds, improvement in information technology in the 1970s made it easier for investors to screen out bad credit from good credit risks
Also, the development of money market mutual funds in the 1970s contributed to growth by creating a market for commercial paper.

22. Commercial Paper Outstanding: 2001 - 2014

23. Commercial Paper and ABCP Outstanding: 2001 - 2014

24. Bank Response
Loss of cost advantages in raising funds and income advantages in making loans caused reduction in profitability in traditional banking
Two Responses:
Expanded into new and riskier areas of lending
Commercial real estate loans
Corporate takeovers and leveraged buyouts
Increased income from off-balance-sheet activities (non-interest income)
Trading activities

25. Bank Consolidation and Nationwide Banking
The number of banks has declined over the last 25 years
Combination of bank failures and consolidation.
Deregulation: Riegle-Neal Interstate Banking and Branching Efficiency Act f 1994.
Economies of scale and scope from information technology.
Not only a smaller number of banks but a shift in assets to much larger banks. 25

26. Bank Consolidation and Number of Banks

27. Another Example of Avoiding Regulation
Eurodollars
Dollar denominated deposits in foreign banks or foreign branches of US banks.
Sweep Accounts: Funds are “swept” out of checking accounts nightly and invested at overnight rates. Since they are no longer checkable deposits, reserve requirement is avoided.

28. Eurodollars DD= $1,000,000 Reserves= $100,000 DD= $1,000,000
New York Bank
Cayman Branch of NY Bank
DD= $1,000,000
Reserves= $100,000
DD= $1,000,000
Loans= $900,000
New York Bank
Borrow from Cayman Branch= $1,000,000
Loans= $1,000,000