Chapter 14 The Banking Industry

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Chapter 14The Banking Industry
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Origins

• Unique structure of US banking traces to
  Americas unique political culture, especially
  early on.
• America wasand remainsextremely decentralized,
  implying strong local control.
• Populism has also often been a strong political
  current.
• Result The US banking industry consisted of a
  great many independent banks until recently.

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A Brief History 1789-1836

• With the Bank of England as his model, Alexander
  Hamilton persuaded Congress to establish the
  First Bank of the United States in 1791.
• Congress allowed it to lapse in 1811.
• The drubbing taken in the War of 1812 convinced
  Congress and Madison to establish the Second Bank
  of the United States in 1816.
• Andrew Jackson killed it in the 1830s.

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Brief History Free Banking

• Legislatures chartered banks in most states until
  the 1830s.
• Some consequences
• Corruption
• Scarcity of banks and monopoly
• In reaction, free banking spread beginning in the
  late 1830s.
• Free banking meant virtually free entry of
  state-chartered banks.

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Brief History National Banking

• The need to service a large Civil-War debt led to
  the National Banking Act of 1863.
• It established a national banking system and
  eliminated the issue of banknotes by state banks.
• To avoid being driven from business, state banks
  invented checkable deposits, a close substitute
  for banknotes.
• National banks soon followed suit.

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Brief History Federal Reserve

• Banks were prone to failure because of
  fragmentation among thousands of independent
  banks.
• The failure of a few banks would turn into
  system-wide payments crises.
• After the severe payments crisis of 1907,
  Congress created the Federal Reserve System in
  1913.
• Its ostensible purpose was to serve as a lender
  of last resort (LOLR).
• But populism fragmented it into 12
  semi-autonomous Federal Reserve Banks, which
  failed to serve as a LOLR during the payments
  crises of 1930-1933.
• Congress responded by enacting deposit insurance.

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1. Chartering

• New banks must obtain charters.
• Who charters whom
• The Office of the Comptroller of the Currency
  (OCC) national banks
• State banking authorities state banks
• Chartering authorities require banks to have
  sufficient equity as well as managers who are
  competent and honest.
• With only that requirement from about 1840 to
  1929, gt 25,000 banks existed in 1929.

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2. Chartering

• Entry was almost eliminated between 1933 and the
  early 1960s.
• Would-be entrants had to show that they were
  needed, a requirement that few could meet.
• This regulation sought to increase bank
  profitability, a goal largely unmet in practice.
• Beginning in the 1960s and especially after 1980,
  entry became much easier.
• Chartering authorities require call reports,
  which report assets, liabilities, earnings, and
  activities.

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Examination

• Who examines and regulates whom
• OCC national banks
• The Fed member state banks
• FDIC insured nonmember state banks
• State banking authorities uninsured state banks
• How often examined
• Small and mid-sized national banks and state
  member banks at least once every 18 months
• Large national banks several times a year
• Mega national banks essentially continually
• Nonmember state banks at least once every three
  years
• The Fed also regulates all bank-holding
  companies, corporations that own banks.

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CAMELS Ratings

• Examiners make unexpected trips to banks to check
  whether they are complying with the regulations.
• They grade on a scale of 1 (best) to 5 (worst)
• C capital adequacy
• A asset quality
• M management competence and honesty
• E earnings
• L liquidity
• S sensitivity to market risk

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How Is CAMELS Used?

• Banks with middling overall ratings are
  encouraged to improve.
• Banks with bad ratings receive cease and desist
  orders and may be ordered to stop paying
  dividends, to raise more equity, etc.
• Banks with very bad ratings are taken over and
  their managements are fired or even jailed.
• Other bank-like institutions have their own
  chartering authorities, examiners, deposit
  insurers, and regulators.

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Why Is Banking Regulated?

• There are economic and non-economic reasons.
• The economic reasons stem from three key
  characteristics of banking
• Asymmetric information
• Interconnectedness of banks through the payments
  system
• The role of banks in operating the payments system

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Asymmetric Information

• Banks are not transparent to depositors.
• They make their loans using information that only
  they possess.
• Depositors cant be sure whether their bank is
  sound with NW gt 0 or unsound with NW lt 0
• So rumors that a specific bank is unsound may set
  off a run against it.
• Why keep money in Bank I if rumor says its
  unsound?

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Implications for US History

• This result of asymmetric info was greatly
  exacerbated before deposit insurance was enacted.
• Banks were often small and poorly diversified,
  making NW lt 0 much more likely than in other
  countries.
• Deposit insurance since 1934 hasnt eliminated
  asymmetric information but rather changed who
  must worry about it FDIC rather than depositors.
• A key reason for regulation is to protect
  taxpayers.

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Interconnectedness of Banks

• The payments system tightly interconnects banks
  because it leads them to owe large amounts to
  each other even though little is actually owed in
  net.
• As a result, failure of several banks or any very
  large bank strains the system.
• Example Bank A owes 50 B to Bank B, which owes
  50 B to Bank C, which owes 50 B to bank A.
• Failure of any one brings down all three.

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Historical Relevance

• Agricultural distress once led many small and
  poorly diversified rural banks to fail and
  induced runs on many others.
• Stock market crashes sometimes led to the failure
  of a large NYC bank, which then brought down many
  other banks.
• The interconnectedness of banks contributed to
  contagion, the tendency of depositors to run on
  banks if they perceived any to be unsound.

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Efficiency of the Payments System

• An efficient payments system and financial system
  more generally contributes to the well-being of
  the entire economy.
• System-wide bank runs impair the efficiency of
  the payments system.
• The economy can suffer recessions in the short
  run and reduced productivity in the long run.
• These effects can be very large.

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1. Local Bank Runs

• A run on a single sound bank creates no
  difficulties.
• The currency withdrawn from one bank (Bank I) is
  deposited in another bank (Bank II).
• Lending contracts at Bank I and expands at Bank
  II, and total lending is unchanged.

Bank II
A
L
Bank I
A
L
Loans 200 M
Loans -200M
Deposits -200 M
Deposits 200 M
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2. Local Bank Runs

• Local runs on unsound banks also cause only local
  problems.
• The bank simply fails, depositors lose some
  wealth, and life goes on.
• The failure of such a bank is no different in
  kind from the failure of any other business.
• And bailing it out makes no more sense than
  bailing out other failing businesses.

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System-Wide Liquidity Risk

• The banking system is always illiquid because it
  cant increase the currency available for
  depositors.
• This holds even when every bank is solvent (NW ?
  0).
• Also when depositors try to withdraw currency
  from the banking system, many banks may become
  insolvent (NW lt 0).

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Example Initially

• Suppose the banking system has deposits of 950B,
  loans of 1000B, and NW 50 B (solvent.)
• The public then withdraws 100B in currency from
  the banks.

A
L
Deposits 950 B NW 50
Loans 1000 B
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Example Result

• The only way for the banks to obtain currency is
  to call bank loans away from the public.
• Interest rates increase because the supply of
  loans is lower.
• The value of the banks remaining loans decreases
  to, say, 840 B. NW -10 B
• Depositors now have an excellent reason to run on
  the banks insolvency.

A
L
Deposits 850 B NW -10 B
Loans 840 B
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Example Lender of Last Resort

• A lender of last resort can make the banking
  system liquid.
• It just prints up 100 B in currency and lends it
  to the banks.
• Eventually, when panic subsides and the currency
  is redeposited, the banks can repay the 100 B in
  loans.

A
L
Loans 1000 B
Deposits 850 B Loan from Fed 100 B NW 50 B
A
L
Loans 1000 B
Deposits 950 B NW 50B
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Case Study 9/11 and Its Aftermath

• The Fed lent banks about
• 50 B on 9/11
• 110 B on 9/12
• 120 B on 9/13
• 110 B on 9/14
• 50 B on 9/17
• Thereafter, its lending returned to normal.
• Its decisive action headed off panic in the
  financial system.

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1. History of Deposit Insurance

• The Fed failed to serve as a lender of last
  resort in 1930-1933, allowing 10,000 of 25,000
  banks to fail.
• So Congress enacted deposit insurance to reduce
  the need for a lender of last resort.
• Deposit insurance was provided by
• Federal Deposit Insurance Corporation (FDIC) to
  commercial banks
• Federal Savings and Loan Insurance Corporation
  (FSLIC) to savings institutions

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2. History of Deposit Insurance

• Virtually all banks and savings institutions
  bought deposit insurance.
• With deposit insurance came increased regulation
  of what the banks could do and increased
  regulatory supervision.
• Deposit insurance seemed to work well through the
  1960s.
• In the 1980s, FSLIC collapsed and FDIC nearly
  collapsed because of the high interest rates of
  the 1970s and 1980s, the computer revolution, and
  relaxed regulation.

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3. History of Deposit Insurance

• Banks and especially savings and loans failed in
  large numbers and previously accumulated reserves
  were quickly exhausted.
• In the early 1990s, Congress appropriated about
  200 B to bail out the insurance funds.
• The Federal Deposit Insurance Corporation
  Improvement Act of 1991 (FDICIA) restructured the
  regulation.
• FDICIAs goal was to restrain moral hazard and
  the resulting excessive risk-taking by banks and
  savings institutions.

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4. History of Deposit Insurance

• Following FDICIA, regulators first emphasized
  capital adequacy.
• Capital adequacy by itself does not restrain
  risk-taking because banks can also decide how
  risky their assets are.
• Regulators must therefore monitor how risky bank
  assets are.
• Later under the BASEL I Agreement, regulators
  here and abroad began requiring more equity, the
  riskier a banks assets are.

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FDIC and Bank Failures

• If a bank becomes insolvent (NW lt 0), FDIC deals
  with its failure in one of two ways
• Liquidation close it, fire its managers, pay
  off its insured depositors, sell its assets, use
  the bankruptcy courts
• Purchase and assumption buy it for any
  remaining NW, arrange its merger with another
  bank, sweeten the deal if necessary

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Pros and Cons of Liquidation

• Pros
• Costs FDIC less
• Reduces moral hazard because uninsured liability
  holders know they can lose and managers know that
  they can be fired or even jailed
• Cons
• May disrupt the financial system
• May cause bank runs among uninsured liability
  holders if contagion is possible

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FDIC Behavior

• It usually liquidates small and mid-sized banks.
• It always does so if managers behaved
  inappropriately.
• It always uses purchase and assumption for large
  banks to prevent contagion.
• So large banks are said to be too big to fail.
• In effect, the uninsured liability holders of big
  banks are fully insured.

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FDIC and Mega Banks

• Moral hazard is a severe problem for large banks
  because they are too big to fail.
• With mega banks, even purchase and assumption is
  impractical since they are much too complex for
  outsiders to understand.
• It is likely that the Fed and FDIC would be stuck
  bailing them out while retaining most of the
  existing management intact.

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Basel II

• The Basel II Agreement regulates mega banks by
  requiring the soundness of their governance and
  internal controls on exposure to risk.
• For example, the Fed and OCC require mega banks
  to provide the computer code used to manage
  trading and loan assessment.
• The staffs of the Fed and OCC then evaluate the
  code and require changes if it controls
  risk-taking inadequately.

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More on Basel II

• The Fed and OCC evaluate the exposure to risk
  using VaR (value at risk).
• Each mega bank is required to simulate the
  outcomes from a wide range of scenarios.
• If very few of the scenarios wipe out the banks
  net worth, it is considered to be well run.
• If not, the regulators take action against it.

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Basel IIs Contributionto the Financial Crisis

• Basel II required commercial banks to mark
  mortgage-backed securities to market i.e. value
  them at their current market price.
• When their holdings of securities backed by
  subprime mortgages became very illiquid, they had
  to mark down these securities to much less than
  their fundamental values.
• The resulting fall in their equity put pressure
  on them to sell assets, further fueling the
  crisis.

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Contribution of the SEC

• The Securities and Exchange Commission required
  corporations to also mark their marketable
  securities to market.
• Investment banks therefore found themselves in
  the same bind as commercial banks.
• American Insurance General was also driven to the
  verge of bankruptcy by mark-to-market.

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Branching Restrictions

• Until about 1980, virtually all banks were unit
  banks because most states forbade branching.
• Some states allowed limited branching, and a few
  like California permitted state-wide branching.
• The McFadden Act of 1927 also prohibited
  bank-holding companies from owning banks in more
  than one state.
• Since 1980, most branching restrictions have been
  swept away.
• The Riegel-Neal Interstate Banking and Branching
  Efficiency Act of 1994 completed this process.

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Scope of Banking Activities

• The Glass-Steagall Act forbade banks to engage in
  many activities that had been widespread before
  1933.
• Large banks had often been both commercial and
  investment banks e.g. J. P. Morgan Company.
• Glass-Steagall was a reaction to the go-go 1920s
  and the Great Depression that followed.
• Glass-Steagall was long realized to have been a
  mistake.
• The Gramm-Leach-Bliley Financial Services
  Modernization Act of 1999 repealed it, thereby
  enhancing the efficiency of the financial system.

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Universal Banking

• Many other countries lack extensive financial
  markets. In such countries, banks are central.
• Some of these countries (e.g. Germany) have
  universal banks, which take large equity
  positions in firms and often put representatives
  on boards of directors. (US banks also did so
  before 1933 e.g. J P Morgan.)
• So universal banks have tight links with
  businesses.
• The banks in many other countries also have tight
  links with businesses e.g., Japan, South Korea
  and China
• These links may reduce information costs and
  increase the efficiency of the financial system.

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Crony Capitalism

• Tight bank-business links have, however, a dark
  side crony capitalism.
• Without well-functioning financial markets, such
  links can become not only tight but also
  incestuous and corrupt.
• Under crony capitalism, banks channel funds to
  their favored borrowers, leaving others with too
  little funding.
• Crony capitalism has been a serious problem in
  Thailand, Malaysia, South Korea, Indonesia, China
  and to some extent Japan.