Introduction The U.S. has about 6,800 commercial banks and roughly 16,000 depository institutions. For many years, most U.S. banks were unit banks, or banks without branches. The decline in the total number of banks and the increase in the number of banks with branches are not the only changes we have seen. 13-2
Introduction The crisis of 2007-2009 has transformed the U.S. financial industry. The failure or forced merger of several large banks and other depository institutions accelerated concentration. In July 2008, the U.S. government placed the two massive government-sponsored enterprises (GSEs) for housing finance in conservatorship. In September 2008, the four largest independent investment banks failed, merged, or became bank holding companies. 13-4
Introduction To understand the changing structure of the financial industry, we will discuss the services provided by both depository and nondepository financial institutions. They provide a broad menu or services including: Building and selling securities; Offering loans, insurance, and pensions; and Providing checking accounts, credit cards, and debit cards. 13-5
Banking Industry Structure To understand the structure of today’s banking industry, we need to trace it back to its roots. In this section we will learn that banking legislation is the reason we have so many banks in the U.S. We will look at the trend toward consolidation that has been steadily reducing the number of banks since the mid-1980’s. We will also briefly consider the effects of globalization. 13-6
A Short History of U.S. Banking To start a bank, one needs permission in the form of a bank charter. Until 1863, All bank charters were issued by state banking authorities, and There was no national currency so banks issued banknotes. These banknotes did not hold value from one place to another and banks regularly failed. 13-7
A Short History of U.S. Banking During the Civil War, Congress passed the National Banking Act of 1863. State banks were not eliminated, but did impose a 10% tax on their banknotes. The act created a system of federally chartered banks, or national banks. National banks could issue banknotes tax-free. 13-8
A Short History of U.S. Banking State banks devised another way to make money--demand deposits. This is how we got the dual-banking system we have today. Banks can choose whether to get their charters from the Comptroller of the Currency at the U.S Treasury or from state officials. 13-9
A Short History of U.S. Banking About 3/4 have a state charter and the rest a federal charter. Which charter a bank chooses depends on its profitability. State banks have more operational flexibility, which means a better chance of making a profit. If the Comptroller of the Currency won’t let a bank do something, they can always just change their charter. 13-10
A Short History of U.S. Banking The ability for banks to go back and forth between charters created what amounts to regulatory competition. This has accelerated innovation in the financial industry. Globalization, however, has increased competition between national government regulators. 13-11
A Short History of U.S. Banking The Great Depression lead to the Glass-Steagall Act of 1933. This legislation Created the Federal Deposit Insurance Corporation (FDIC), Severely limited the activities of commercial banks, Provided insurance to individual depositors, so they would not lose their savings in the event that a bank failed, and Restricted bank assets to certain approved forms of debt. 13-12
A Short History of U.S. Banking The law separated commercial banks from investment banks. Separating these two types of banks limited financial institutions from taking advantage of economies of scale and scope that might exist. This changed in 1999 with the Gramm-Leach-Bliley Financial Services Modernization Act which repealed the Glass-Steagall Act. 13-13
Competition and Consolidation There are roughly 6,800 commercial banks in the U.S. today, and that number has been shrinking. The number of banks with branches has changed significantly as well. Today’s banks not only have branches, they have many of them. The U.S. banking system is composed of a large number of very small banks and a small number of very large ones. 13-14
Competition and Consolidation The primary reason for this structure is the McFadden Act of 1927. This legislation required that nationally chartered banks meet the branching restrictions of the states in which they were located. Some states have laws forbidding branch banking, resulting in a large number of small banks. There was fear that large banks would drive small banks out of business, reducing the quality in smaller communities. 13-16
Competition and Consolidation The result was a fragmented banking system nearly devoid of large institutions. We ended up with a network of small, geographically dispersed banks that faced little competition - the opposite of what the act wanted. In many states, more efficient and modern banks were legally precluded from opening branches to compete with local banks. 13-17
Competition and Consolidation Small local banks were without competition. This lead to loan portfolios that were insufficiently diversified. At some points loans were not made because the bank had taken on too much risk. Lack of credit only hurt these communities. Bank managers did well, but the communities suffered. 13-18
Competition and Consolidation Some banks reacted to branching restrictions by creating bank holding companies. These are corporations that own a group of other firms. Can be thought of as a parent firm for a group of subsidiaries. Initially these were created as a way to provide nonbank financial services in more than one state. 13-19
Competition and Consolidation In 1956, Congress passed the Bank Holding Company Act. This allowed bank holding companies to provide various nonbank financial services. Technology has eroded the value of the local banking monopoly. In the 1970s and 1980s, states responded by loosening their branching restrictions. 13-20
Competition and Consolidation In 1994, Congress passed the Riegel-Neal Interstate Banking and Branching Efficiency Act. This legislation reversed restrictions from the McFadden Act. Since 1977, banks have been able to acquire an unlimited number of branches nationwide. The number of commercial banks has fallen nearly in half. 13-21
Competition and Consolidation Deregulation provided benefits for the economy. Banks became more profitable. Operation costs and loan losses fell. Interest rates paid to depositors rose. Interest rates charged to borrowers fell. The financial crisis of 2007-2009 has focused attention on the costs of deregulation. Do the benefits of deregulation outweigh the risks? 13-22
Pawnshops provide loans to people without access to the traditional financial system. A person brings something of value to the pawn shop in exchange for a short term loan. Because the loans are collateralized, the terms are often reasonable – better than payday loans, for example. 13-24
Globalization of Banking There are a number of ways banks can operate in foreign countries, depending on factors such as the legal environment. Open a foreign branch that offers the same services as those in the home country. Banks can create an international banking facility (IBF), which allows it to accept deposits from and make loans to foreigners outside the country. The bank can create a subsidiary called an Edge Act corporation, which is established specifically to engage in international banking transactions. 13-25
Globalization of Banking Alternatively, a bank holding company can purchase a controlling interest in a foreign bank. Foreign banks can take advantage of similar options. All the competition has made banking a tougher business. 13-26
Globalization of Banking One of the most important aspects of international banking is the eurodollar market. Eurodollars are dollar-denominated deposits in foreign banks. Originally the euromarket was a response to restrictions on the movement of international capital that were instituted with the Bretton Woods system of exchange rate management. 13-27
Globalization of Banking To ensure the pound would retain its value, the British government imposed restrictions on the ability of British banks to finance international transactions. In an attempt to evade these restrictions, London banks began to offer dollar deposits and dollar-denominated loans to foreigners. The result was what we know today as the eurodollar market. 13-28
Globalization of Banking The Cold War accelerated this when the Soviet government, fearing that the U.S. government might freeze or confiscate their deposits, shifted them from New York to London. In 1960, U.S. tried to prevent dollars from leaving the country by increasing costs for foreigners to borrow dollars in the U.S. In the early 1970s, domestic interest rate controls and high inflation made domestic deposits less attractive than eurodollar deposits. 13-29
Globalization of Banking • The eurodollar market in London is one of the biggest and most important financial markets in the world. • The interest rate at which banks lend each other eurodollars is called the London Interbank Offered Rate (LIBOR). • This is the standard against which many private loan rates are measured. • The gap between the LIBOR and expected Fed policy interest rate provides a key measure of the intensity and persistence of the liquidity crisis. 13-30
The Future of Banks In November of 1999, the Gramm-Leach-Bliley Financial Services Modernization Act went into effect. This effectively repealed the Glass-Steagall Act of 1933. It allowed a commercial bank, investment bank, and insurance company to merge and form a financial holding company. To serve all their customers’ financial needs, bank holding companies are converting to financial holding companies. 13-31
The Future of Banks Financial holding companies are a limited form of universal banks. These are firms that engage in nonfinancial as well as financial activities. In the U.S., different financial activities must be undertaken in separate subsidiaries and financial holding companies are still prohibited from making equity investments in nonfinancial companies.
The Future of Banks Owners and managers of these financial firms cite three reasons to create them: Their range of activities, if properly managed, permits them to be well diversified. These firms are large enough to take advantage of economies of scale. These companies hope to benefit from economies of scope.
The Future of Banks Thanks to recent technological advances, almost every service traditionally provided by financial intermediaries can now be produced independently, without the help of a large organization. As we survey the financial industry, we see the two trends running in opposite directions.
Nondepository Institutions There are five categories of nondepository institutions: Insurance companies; Pension funds; Securities firms, including brokers, mutual-fund companies, and investment banks; Finance companies, and Government-sponsored enterprises. Nondepository institutions also include an assortment of alternative intermediaries, such as pawnshops. 13-35
Insurance Companies Modern forms of insurance can be traced back to around 1400, when wool merchants insured their overland shipments from London to Italy for 12 to 15 percent of their value. The first insurance codes were developed in Florence in 1523, specifying the standard provisions for a general insurance policy. They also stipulated procedures for handling fraudulent claims in an attempt to reduce the moral hazard problem. 13-37
Insurance Companies In 1688, Lloyd’s of London was established and began to insure ships on trade routes. To obtain insurance, a ship’s owner would: Write the details of the proposed voyage, Add the amount he was willing to pay for the service, and Circulate the paper among the patrons at Lloyd’s coffeehouse. Interested individuals would decide how much to risk and sign their names - the underwriters. 13-38
Insurance Companies Underwriting implied unlimited liability. To participate in this insurance market, individuals known as names join together in groups called syndicates. When a new contract is offered, several syndicates sign up for a portion of the risk in return for a portion of the premiums. 13-39
Insurance Companies Today Lloyd’s provides insurance through the more conventional structure of a limited liability company. The losses of individual investors in a syndicate are limited to an amount of their initial investment, and No person is exposed to the possibility of financial ruin.
Two Types of Insurance At the most basic level, all insurance companies operate like Lloyd’s. They accept premiums from policyholders in exchange for the promise of compensation if certain events occur. For the individual policy holder, insurance is a way to transfer risk.
Two Types of Insurance In terms of the financial system as a whole, insurance companies specialize in three of the five functions performed by intermediaries. They pool small premiums and make large investment with them; They diversify risks across a large population; and They screen and monitor policyholders to mitigate the problem of asymmetric information.
Two Types of Insurance Insurance companies offer two types of insurance: Life insurance. Property and casualty insurance. While a single company may provide both kinds of insurance, the two businesses operate very differently.
Two Types of Insurance Life insurance comes in two basic forms. Term life insurance provides a payment ot the policy holder’s beneficiaries in the event of the insured’s death at any time during the policy’s term. Generally renewable every year as long as the policyholder is less than 65 years old. Whole life insurance is a combination of term life insurance and a savings account. The policyholder pays a fixed premium over his/her lifetime in return for a fixed benefit when the policyholder dies.
Two Types of Insurance Most whole life policies can be cashed in at any time. Whole life insurance tends to be an expensive way to save, though, so its use as a savings vehicle has declined markedly as people have found cheaper alternatives.
Two Types of Insurance Car insurance is an example of property and casualty insurance. It is a combination of Property insurance on the car itself, and Casualty insurance on the driver, who is protected against liability for harm or injury to other people or their property. Holders of property and casualty insurance pay premiums in exchange for protection during the term of the policy.
Two Types of Insurance On the balance sheets of insurance companies, these promises to policyholders show up as liabilities. On the asset side, insurance companies hold a combination of stocks and bonds. Property and casualty companies profit from the fees they charge for administering the policies they write. Because assets are essentially reserves against sudden claims, they have to be liquid.
Two Types of Insurance Life insurance companies hold assets of longer maturity than property and casualty insurers. Because more life insurance payments will be made well into the future, this better matches the maturity of the companies’ assets and liabilities. As a result, life insurance companies hold mostly bonds.
Life insurance is to support people who need it if something happens to you. People with young children need it the most. The best approach is to buy term life insurance. You should consider a term policy worth six to eight times your annual income. 13-49
The Role of Insurance Companies Like life insurers, property and casualty insurers pool risks to generate predictable payouts. They reduce risk by spreading it across many policies. Although there is no way to know exactly which policies will require payment, the insurance company can estimate precisely the percentage of policyholders who will file claims.