Chapter 13. Financial Industry Structure

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Chapter 13. Financial Industry Structure

• Bank Structure
• Nondepository instituions
• Insurance
• Pensions
• Finance companies
• GSEs

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Dual banking system

• banking at state level until Civil War
• state charters, regulation
• banknotes as local currency
• failures, fraud were common

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• National Bank Act 1863
• federal charters for banks
• Comptroller of the Currency
• federal banknotes
• tax on state banknotes
• state banks survived by accepting deposits
• -- dual banking system

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Decentralization and Consolidation

• Why so many small banks in U.S.?
• McFadden Act 1927
• restricted intra and interstate branching of
  national banks
• meant to protect small banks promote
  competition
• -- but protected inefficient banks
• -- limited economies of scale

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• loopholes
• -- bank holding companies
• -- owned several banks
• -- limited service banks
• -- deposits or loans, not both
• -- ATMs
• repealed 1994 (Reigle-Neal)
• Rising bank profitability

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Consolidation

• repeal of McFadden
• 1994 Reigle-Neal
• Over 14,000 banks in 1985
• less than 8,000 today

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A good thing?

• economies of scale
• diversification
• But
• risks with expansion?
• responsive to small customers?
• Local job loss

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Bank Failures of the Great Depression

• 1930-33, 1/3 of all U.S. banks failed
• Congress responded w/ legislation
• FDIC
• federal insurance for bank deposits
• banks pay premiums

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• Glass-Steagall Act
• separated permissible activities of commercial,
  investment banks
• idea limit risk for commercial banks
• weakened over time
• repealed 1999

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Globalization

• Foreign branches (IBF)
• Edge Act corporations
• Subsidiary just for international banking
• Acquire interests in foreign banks

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Eurodollars

• US deposits in foreign banks
• Interbank lending in eurodollars
• LIBOR
• A common swap floating rate

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Banks of the future

• Universal banks
• A full range of financial and nonfinancial
  services
• Not yet in U.S.

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• Financial holding companies
• e.g. Citigroup
• Economies of scale
• Lower average cost from large number of same type
  of transactions
• Economies of scope
• Lower average cost from large number of related
  transactions

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Nondepository InstitutionsInsurance

• insurers bear risk that others pay to avoid
• underwrite risk
• receive premiums
• invest premiums
• face contingent liabilities

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Types of insurance

• Life Insurance
• term life insurance
• cash value life insurance

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term life insurance

• policy period
• death benefit if occurs w/in policy period
• no cash value

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cash value life insurance

• whole life insurance
• death benefit
• cash value builds over life of policy
• premiums cover
• -- cost of insurance
• -- investment capital

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• Universal life insurance
• similar to whole life
• buildup of cash value may be used to finance
  future premiums

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• variable life insurance
• policy holders chooses how to invest premiums
• benefits/value depend on investment returns

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other issues

• For a group, mortality rate is predictable
• timing amounts of claims are predictable
• Focus on longer term investments

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Property Casualty

• auto, home insurance
• timing/size of claims unpredictable
• separate industry

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Big losses for PC

• 1992 Hurricane Andrew
• 15.5 billion
• today 30 billion
• 9/11 WTC attack
• 35 billion

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Pension Funds

• Defined benefit plans
• Defined contribution plans
• Federal law does not require pensions, but does
  regulate them

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Defined benefit plans

• employer promised employee monthly payments
  during retirement
• -- life contingent
• -- choice of survivor benefits

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How is payment determined?

• formula
• salary
• -- average last several years
• -- average of best years
• years of service with sponsor

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Vesting

• minimum years of service necessary to receive
  benefits
• complex federal rules about vesting
• 5-7 years max for full vesting

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Advantages

• (for employee)
• limited investment risk
• payments promised reguardless of portfolio return
• but sponsor bankruptcy could affect payment size

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• no risk of outliving assets
• payments life contingent,
• NOT lump sum

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Disadvantages

• lack of portability from job to job
• largest benefits accrue after 20 years
• DB plans encourage loyalty

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• lack of control
• how pension funds are invested
• is sponsor investing enough?
• -- is pension fully funded?

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Defined Contribution Plans

• employee/individual contributes funds
• employer may match contributions
• employee chooses among investment options
• range of choice varies among sponsors

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• amount accumulated at retirement depends on
  investment performance
• lump sum at retirement
• decision about spending
• possible purchase an annuity

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types of DC plans

• employer sponsored
• 401(k), 403(b), 414(h), 457
• individual
• IRA, Roth IRA

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(No Transcript)
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Advantages (employee)

• portability
• value accumulates steadily
• balance rolled over to new plans
• cash value build up
• cash out (tax penalty)
• borrow against
• survivor benefits

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Disadvantages

• employee bears investment risk
• retiree risks outliving assets

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• corporate defined contribution plans
• hold over 25 of assets as own company stock
• -- Enron 60
• -- Anheuser Bush, Coca Cola,
• McDonalds over 74
• big lack of diversification
• -- but easier to match 401(k) contributions w/
  stock than w/cash

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GSEs

• Government charter to create private firms to
  intermediate debt markets
• Fannie Mae, Freddie Mac
• Home mortgages
• Sallie Mae
• Student loans

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• All borrow short term
• (commercial paper)
• And lend long-term
• Implicit govt guarantee
• Highly leveraged 30 to 1
• High default rate could bankrupt them