Ch10 (8th edition) BANKING INDUSTRY: STRUCTURE & COMPETITION

--(Note:  In the 9th edition, this chapter became chapter 12—Mish9ed_c12…)

 

*READ ONLY THESE PAGES:

--pp.250-277

 

*YOU DO NOT NEED TO READ THESE PAGES for Exams

--Pp.247-49 Historical section on evolution of US banks before 1930s  (See notes below:  from Rock’s discussion in lecture class—summarizing evolution of regulation of U.S.A. banking from 1920s until, today, 2011)

 

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**NOTES ON THE KEY IDEAS IN THE CHAPTER YOU ARE RESPONSIBLE FOR.

(BUT YOU DO NOT NEED TO REMEMBER NAMES OF LAWS IN THE USA…ONLY should know THEPURPOSE OF THE LAWS and the general evolution:

--- From 1930s-1950s-1970s  STRONG REGULATION era up through

--- the period of great DEREGULATION  from 1980s-1999 )

Mishkin’s Big Idea for this Chapter:

“Financial Innovation and the Evolution of the Banking Industry”

=Basic idea is:  A change in the financial environment (changes in either technology orregulation or industry structure) will cause financial institutions to engage in more financial innovation:

----the concept of banks creating financial change is sometimes called “financial engineering”  to ensure more profits (or prevent profits decreasing), often through selling new services or products to customers.

------since this is an economics text it organize the kinds of changes created into the following categories:  ==1 Supply side responses-changes;  ==Demand side reponses-changes; and ==3Changes to avoid regulations—responses to regulatory conditions

=pp.251ff (Mish8ed)

 

==1: Responses to Changes in Demand Conditions: Interest Rate Volatility (increasing volatility in late 1970s and 1980s):

-Adjustable-rate mortgages

--Flexible interest rates keep profits high when rates rise

--Lower initial interest rates make them attractive to home buyers

-Financial Derivatives

--Ability to hedge interest rate risk (through securities that could bet against interest rate increases or decreases)

--Payoffs are linked to securities previously issued (i.e. derived from existing securities).

 

==2: Responses to Changes in Supply Conditions: Information Technology improves availability of information about borrowers

-Bank credit and debit cards

--Improved computer technology lowers transaction costs

--{Also avoids regulation restricting inter-state banking}

-Electronic banking

--ATM, home banking, ABM and virtual banking

--{Also avoids regulation restricting inter-state banking}

-Junk bonds  (debt issued by low-rated, risky, companies) 

-Commercial paper market (short term debt by companies) 

-Securitization

--These are debt instruments that are created by transforming otherwise illiquid financial assets into marketable capital market securities.

--Securitization played an especially prominent role in the development of the subprime mortgage market in the mid 2000s.

 

==3:  Avoidance of Regulations: Loophole Mining (and modified regulations)

-Reserve requirements act as a tax

on deposits  (so by borrowing [liability but not ‘deposit’] banks could avoid the reserves holding requirement and lend out [assets] greater proportion of available funds [on asset side] 

-Restrictions on interest paid on deposits led to disintermediation (meaning bigger share of market by non-bank financial companies, and investment [uninsured] ‘banks’ in USA)

-Money market mutual funds  (uninsured accounts of clients with non-bank companies that hold mostly short term assets like commercial paper from other companies) 

-Sweep accounts  (daily movement from checking accounts [no interest payment allowed to owners of accounts] into quasi-savings accounts [to earn interest] by banks to avoid regulation; daily return of funds into checking account as needed by account-owner/company)  

-Super-regional banks can operate in multiple states directly (inter-state agreements allow this to begin, especially in 1980s)

 

 

 

Financial Innovation and the Decline of Traditional Banking

-As a source of funds for borrowers, market share has fallen

-Commercial banks’ share of total financial intermediary assets has fallen

-No decline in overall profitability

-Increase in income from off-balance-sheet activities

-Decline in cost advantages in acquiring funds (liabilities)

--Rising inflation led to rise in interest rates and disintermediation

--Low-cost source of funds, checkable deposits, declined in importance

-Decline in income advantages on uses of funds (assets)

-Information technology has decreased need for banks to finance short-term credit needs or to issue loans

-Information technology has lowered transaction costs for other financial institutions, increasing competition

 

Banks’ Responses

-Expand into new and riskier areas of lending

--Commercial real estate loans

--Corporate takeovers and leveraged buyouts

-Pursue off-balance-sheet activities

--Non-interest income (earned by not by traditional bank activities)

--Concerns about risk (unregulated activities increase with unknown risks for the system as a whole)

 

Structure of the U.S. Commercial Banking Industry: Geographic Restrictions beginning in 1927 and then deregulation (no restrictions) by national 1994 law.

-Restrictions on branching (not allowed across state lines)

--McFadden Act (1927 effectively prohibiting interstate banking; branching only allowed (in one state) to extent permitted by each state’s laws) and state branching regulations.

-Response to branching restrictions

--Bank holding companies.(banks allowed branching only in some states in only one state by 1956 law ; allowed nationally by 1994 repeal law)

--Automated teller machines.

 

Bank Consolidation and Nationwide Banking

-The number of banks has declined over the last 30 years (this is usually called Increased National Concentration (also, the largest banks have grown the most to become even more dominant nationally—to hold greater share of total assets in the entire banking industry = less competitive banking/financial sector…depending on how one measures competition, nationally (less), for investors (less), or for choices available to individual consumer (more)

--Bank failures and consolidation….…makes increased concentration

--Deregulation: Riegle-Neal Interstate Banking and Branching Efficiency Act f 1994---Branches allowed across state lines…makes it easier for increased concentration

--Economies of scale and scope from information technology…makes it easier for increased concentration (although more choices for individuals among more market participants in local markets)

-Results may be not only a smaller number of banks but a shift in assets to much larger banks…leads toincreased bank concentration if nationally measured

 

USA: Separation of the Banking and Other Financial Service Industries: 1933-1999

=SEGREGATION OF BANKING FROM SPECULATIVE ACTIVITIES gradually reduced in power (Erosion of Glass-Steagall Act of 1933 = the US law that prohibited banks from buying stocks or engaging in ‘non-traditional banking’ activities from 1933-1999)

--Prohibited commercial banks from underwriting corporate securities or engaging in brokerage activities

--Section 20 loophole was allowed by the Federal Reserve enabling affiliates of approved commercial banks to underwrite securities as long as the revenue did not exceed a specified amount

 

--U.S. Supreme Court validated the Fed’s action

in 1988

--British call this separation “ring-fencing banking”

=DEREGULATION LAW: (Gramm-Leach-Bliley Financial Services Modernization Act of) 1999

--Nationally END of SEGREGATION LAW (ends the Glass-Steagall Act)

--Regional/Local Regulators: States regulate insurance activities

--Government Regulator: SEC keeps oversight of securities activities

--Government Regulator: Office of the Comptroller of the Currency---regulates bank subsidiaries engaged in securities underwriting

--Federal Reserve oversees bank holding companies

 

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USA—HISTORICAL PATTERN OF BANKING REGULATION

**Before 1930s:  Mixed system of (a) Little National (Federal-level) Regulation & (b) Local (State-Level) Variety of Different Systems of Banking Laws, but mainly they involved Minimal Regulation

**CRISIS of 1929-1933:  Stock Market boom in 1920s, with Banks lending to Stock speculators and Banks themselves speculating in Stocks—then Collapse of Stock Market in Autumn of 1929 that never fully recovers during next 10 years.

Strong Regulation (1933—1990s)

**1933-for many decades:  Strong Regulations at both National and Local Levels including (a) National Deposit Insurance and (b) Strict Regulatory Oversight & Inspections; and (c) Segregation of Banking from Speculative Investing meaning that BANKS could take deposits and make loans

---(Different Kinds of Banks with Insured Deposits:  (i) Commercial banks for Business banking and loans; (ii) Savings & Loans (‘mutuals’ democratically and locally controlled) and ‘mutuals’ for mortgages and housing for consumers in local markets; (iii) Credit Unions (customer-owned and democratically controlled—one person=one member=one vote electing unpaid Boards) credit cooperatives mainly for consumer lending; (iv) Government subsidized agencies and banks for lending for farming/Agriculture & Rural communities’ economic developments.)

---(Other Uninsured & essentially Unregulated Financial Institutions:  (v) Investment ‘banks’ (the ones that collapsed from March-October 2008…leading to more general crisis in finance); (vi) brokerages and other miscellaneous ‘Wall Street firms’.)   NOTE:  These were not regulated as banks…. but they were regulated to keep them more honest—to prevent fraud and other unscrupulous activities that tried to exploit or take advantage of their customers-investors.

**1980s Gradual Deregulation of Banking until near complete Deregulation in 1999 (ending the 1933 changes but keeping deposit insurance;  and, keeping, in theory at least, oversight & inspections…but lightly or minimal enforcement as ‘free market in banking’ returned to a quasi-pre-1933 system).

The Fruits of Deregulation?  2001-2008

**CRISES of 21st Century:  (1) Dot.Com Stock Bubble and Bursting of 1990s-2000; (2) Corporate Accounting Scandals of 2001, with Enron as the most famous liar-company; (3) Mortgage Securitization & Housing Bubble of 2002-2007 and then Collapse of Investment Banks and Spread of Crisis throughout the World beginning in 2008. 

The Future:   Will the Massive Financial Crisis of 2008-present lead to New Re-strengthened Regulation of Banks and Entire Financial Sector?

--We will have to see what happens.  Currently, the rules are such that another crisis can occur and the banks will need to be bailed out (the top banks have become even bigger and certainly they are still, even more, “Too Big To Fail”)

 

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ROW (rest of world): Separation of Banking and Other Financial Services Industries Throughout the World

=Universal banking

--No separation between banking and securities industries

--Germany, Netherlands, Switzerland, much of EU

=British-style universal (partial hybrid) banking

--May engage in security underwriting

--U.K., Canada, Australia, (& USA post-1999)

----Separate legal subsidiaries are common

----Bank equity holdings of commercial firms are less common (than in universal banking systems)

----Few combinations of banking and insurance firms

=Many countries (partial hybrid system): Some legal separation

--Allowed to hold substantial equity stakes in commercial firms but holding companies are illegal

 

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NOT-QUITE INVESTOR-CONTROLLED COMMERCIAL BANKING:

=USA additional features (many countries also have other banks with special laws that control their corporate governments;  NOT purely investor-owned)

 

USA:  Thrift Industry: Regulation and Structure

=Savings and Loan Associations (called ‘Mutuals’ or ‘Associations’ in ROW)

--Chartered by the federal government or by states

 

--Most are members of Federal Home Loan Bank

System (FHLBS)

--Deposit insurance provided by Savings Association Insurance Fund (SAIF), part of FDIC

--Regulated by the Office of Thrift Supervision

--Most disappeared and became for-profit banks with deregulation of 1979 after takeovers by investor-owners (lots of scandals and crimes)

=Mutual Savings Banks (called ‘MUTUALS’ in the ROW)

--Approximately half are chartered by states

--Regulated by state in which they are located

--Deposit insurance provided by FDIC or state insurance

=Credit Unions (called CREDIT COOPERATIVES in the ROW)

--Tax-exempt

--Chartered by federal government or by states

--Regulated by the National Credit Union Administration (NCUA)

--Deposit insurance provided by National Credit Union Share Insurance Fund (NCUSIF)

--Board of Directors elected by members (=depositors/borrowers) on the basis of One Person = One Vote

--Most ‘efficient’ for consumers (lowest costs for banking services for consumers of all financial institutions in the USA)

 

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International Banking

=Rapid growth

--Growth in international trade and multinational corporations

--Global investment banking is very profitable

--Ability to tap into the Eurodollar market

 

Eurodollar Market

=Dollar-denominated deposits held in banks outside of the U.S.

=Most widely used currency in international trade

=Offshore deposits not subject to regulations

=Important source of funds for U.S. banks

 

Structure of U.S. Banking Overseas

=Shell operation

=Edge Act corporation

=International banking facilities (IBFs)

--Not subject to regulation and taxes

--May not make loans to domestic residents

 

Foreign Banks in the U.S.

=Agency office of the foreign bank

--Can lend and transfer fund in the U.S.

--Cannot accept deposits from domestic residents

--Not subject to regulations

=Subsidiary U.S. bank

--Subject to U.S. regulations

--Owned by a foreign bank

=Branch of a foreign bank

--May open branches only in state designated as home state or in state that allow entry of out-of-state banks

--Limited-service may be allowed in any other state

=Subject to the International Banking Act of 1978

=Basel Accord (1988)

--Example of international coordination of bank regulation

--Sets minimum capital requirements for banks

 

Ch11 (8th edition) ECONOMIC ANALYSIS of BANKING REGULATION

--(Note:  In 9th edition, this chapter RETAINS THE SAME number—Mish9ed_c11_StGuide.)

 

-text material, pages 279-305

-Questions at end of chapter:  Page 306

 

This chapter stresses the economic way of thinking by conducting an economic analysis using the adverse selection and moral hazard concepts to explain why a regulatory system takes the form it does and how it led to a banking crisis in the 1980s.

It ends with a discussion of where financial regulation might be heading in the future.

Students can benefit--better understand adverse selection and moral hazard--by comparing how problems of trust and behavior are dealt with in private financial markets to the methods financial regulators (public agencies of the government) use to cope with both adverse selection and moral hazard.

 

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*Asymmetric Information and Bank Regulation: Government Safety Net

-Bank panics and the need for deposit insurance:

--FDIC (deposit insurance fund): short circuits bank failures and contagion effect.

--Payoff method (letting an insolvent bank fail and then FDIC pays any depositor up to the maximum amount by law for losses at the bank but FDIC does not pay off any of the uninsured liabilities)

--Purchase and assumption method (typically more costly for the FDIC)…(FDIC gets another bank to take over a bankrupt bank and also  the FDIC takes over all the bad assets of the failed bank and also pays off any uncovered deposit liabilities)

-Other form of government safety net:

--Lending from the central bank to troubled institutions (lender of last resort)

 

*Government Safety Net—Effects of Government ‘insurance’ in dealing with Asymmetric Information problems (‘theory of free market failures’ and how government may even worsen them in the future though preventing bankruptcies in the present)

-Moral Hazard

--Depositors do not impose discipline of marketplace.

--Financial institutions have an incentive to take on greater risk.

-Adverse Selection

--Risk-lovers find banking attractive.

--Depositors have little reason to monitor financial institutions.

 

*Government Safety Net: Too Big to Fail

-Government provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee

-Uses the purchase and assumption method

-Increases moral hazard incentives for big banks, now and in future (implicit guarantee is perceived by investors and depositors and lenders to big banks)

 

*Government Safety Net: May even promote more Financial Consolidation

-Larger and more complex financial organizations challenge regulation

--Increased “too big to fail” problem

--Extends safety net to new activities, increasing incentives for risk taking in these areas (as has occurred during the subprime financial crisis in 2007-2008).

 

*Restrictions on Asset Holdings

-Attempts to restrict financial institutions from too much risk taking

--Bank regulations

----Promote diversification

----Prohibit holdings of common stock

--Capital requirements

----Minimum leverage ratio (for banks) {=capital/assets)

----Basel Accord: risk-based capital requirements

----Regulatory arbitrage (banks manipulate their holdings of assets in each risk-category and avoid the intent of the Basel risk-based capital requirement)

 

*Financial Supervision: Chartering and Examination

-Chartering (screening of proposals to open new financial institutions) to prevent adverse selection

-Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard {These are the so-called ‘Camels’ ratings applied by banking inspectors:  C.A.M.E.L.S.}

--Capital adequacy

--Asset quality

--Management

--Earnings

--Liquidity

--Sensitivity to market risk

-Filing periodic ‘call reports’

 

*Assessment of Risk Management: REGULATORS New Oversight Foci:

-Greater emphasis on evaluating soundness of management processes for controlling risk

-Trading Activities Manual of 1994 for risk management rating based on

--(1) Quality of oversight provided

--(2) Adequacy of policies and limits for all risky activities

--(3) Quality of the risk measurement and monitoring systems

--(4) Adequacy of internal controls

-Interest-rate risk limits

--Internal policies and procedures

--Internal management and monitoring

--Implementation of stress testing and Value-at risk (VAR)

 

*Disclosure Requirements

-Requirements to adhere to standard accounting principles and to disclose wide range of information

-The Basel 2 agreement (began 1999, in effect 2008) for internationally active banks (risk-weighted capital adequacy)

-In the USA, the SEC put a particular emphasis on disclosure requirements

----also, in USA, the Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board to ensure more truthfulness about risks and transparency in reporting

-Mark-to-market (fair-value) accounting (Assets may only be valued at their current market price)

 

*Consumer Protections: Laws (stronger protective ‘regulations’) that prevent consumers from being so easily fooled or intentionally confused by financial jargon and presentation of financial information:

-Consumer Protection Act of 1969 (Truth-in-lending Act).

-Fair Credit Billing Act of 1974.

-Equal Credit Opportunity Act of 1974, extended in 1976.

-Community Reinvestment Act.

-The subprime mortgage crisis (2002-2008) illustrated the need for greater consumer protection.

 

*Restrictions on Competition: Increasing (or increasing then Decreasing?):

-Removing restrictions were justified as increasing competition; BUT it can also increase moral hazard incentives to take on more risk.

--Branching restrictions (eliminated in 1994)

--Glass-Steagall Act (repealed in 1999)

-Disadvantages of restrictions on competition

--Higher consumer charges

--Decreased efficiency

            -{Disadvantages of removing restricted competition:  May allow bigger banks to get even bigger, and ultimately be counter-productive, leading to even higher prices paid by consumers due to Oligopolistic control of entire financial services sectors.}

 

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*Bank Failures in USA

            -Failures of Banks: Constant recurrence in entire history of US markets