Lecture 19: Evolution of banking industry in the U.S. Mishkin Ch 10 – part A page 247-261
Introduction • Features of banking industry in the U.S. • dual banking system • separation of investment banking and commercial banking • multiple regulatory agencies • decline of traditional banking • Explained by two forces in evolution of banks • Regulation • Financial Innovation
Regulation • Alternation of federal chartered banks and state chartered banks in history. • Today, the U.S. has a dual banking system in which banks supervised by the federal government and banks supervised by the state coexist.
Regulation • Glass-Steagall Act (Banking Act of 1933) is an important act: • created the Federal Deposit Insurance Corporation (FDIC) to provide federal insurance to deposits • restricted interest payments on checkable deposits and interest rate ceilings were imposed on time deposit accounts (regulation Q) • imposed separation between commercial banking and investment banking
Multiple regulatory agencies • Comptroller of the Currency national banks • The Fed and state banking authorities state banks that are members of the Fed • Fed bank holding companies • FDIC insured state banks that are not Fed members • State banking authorities state banks without FDIC insurance
Financial innovations • Changes since 1960s • inflation and interest rates are at higher levels and more volatile • computer technology makes information production simple • significant new legislation has been enacted • Financial innovation is driven by bank’s desire to earn profits. Change in the financial environment lead to financial innovations.
Responses to changes in demand conditions: interest rate volatility • Adjustable-rate mortgages • Adjustable when market interest rate (6 month T-bill rate) change • Low initial interest rates make them attractive to home buyers; but still flexible to keep banks’ profits high when rates rise. • Financial derivatives • To hedge interest-rate risk
Responses to changes in supply conditions: Information Technology improved computer technology leads to • lower transaction costs • easier for investors to acquire information, screening • bank credit and debit cards • electronic banking • junk bonds • commercial paper • securitization: e.g. mortgage-backed securities
Avoidance of regulations: loophole mining • Reserve requirements It is like a tax on deposits • interest-rate ceilings (regulation Q) As i disintermediation loophole mine to escape these regulations: • money market mutual funds • just like interest earning checking accounts for consumers • not subject to reserve requirements and interest rate ceilings
Decline of traditional banking • Traditional banking business: lending funded with deposits, traditional financial intermediation role of banking. • Information technology has lowered transaction costs for other financial institutions, increasing competition. • Decline in cost advantages in acquiring funds (liabilities): e.g. deposit rate ceiling savors switch to mutual market funds, disintermediation. • Decline in income advantages on uses of funds (assets): information technology easier screening decreased need for loans.
Banks’ responses • Banking industry and profitability not in decline. • Expand into new and riskier areas of lending • Commercial real estate loans • Leveraged buyouts and corporate takeovers • Pursue off-balance-sheet activities • In the past, 7% of total bank income now 44%!