Chapter 10 Banking Industry: Structure and Competition

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Chapter 10 Banking Industry Structure and
Competition

• Historical Evolution of US Banking Industry
• Financial Innovation
• Branching and Bank Consolidation
• Several Important Acts to Know
• - McFadden Act of 1927 vs Riegle-Neal Act of
  1994 interstate banking and branching
• - Glass-Steagall Act of 1933 vs
  Gramm-Leach-Bliey Act of 1999 separation of
  banking and other financial services

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Overlapped Supervisory Responsibility of Banking

• Comptroller of the Currencynational banks
• Fed and state banking authoritiesstate banks
  that are members of the Federal Reserve System
• Fed also regulates bank holding companies
• FDICinsured state banks that are not Fed
  members
• State banking authoritiesstate banks without
  FDIC insurance

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Financial innovation

• Financial innovation has transformed the entire
  financial system
• A change in the financial environment will
  stimulate a search by financial institutions for
  innovations that are likely to be profitable
• Financial engineering
• Necessity was the mother of innovation
• Decline of traditional banking

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Responses to Changes in Demand Conditions
Interest Rate Volatility

• Adjustable-rate Mortgages
• -Reduce interest rate risk for financial
  institutions
• -In 1975 savings and loans in California began to
  issue adjustable-rate mortgages because of the
  high interest rate volatility in 1970s
• Financial Derivatives futures, options, swaps
• -Able to hedge interest rate risk
• -Payoffs are linked to other financial
  instruments such as stocks, bonds, or foreign
  exchanges.

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Responses to Changes in Supply Conditions
Information Technology

• Reduce Transaction Costs
• - Credit and debit cards
• - Electronic banking such as ATM, online
  banking
• Reduce Asymmetrical Information Problem
• - Junk bonds
• - Commercial paper market
• Securitization
• - transforms otherwise illiquid financial
  assets into marketable capital market securities
• - examples mortgage-backed securities,
  negotiable CDs, etc..

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Avoidance of RegulationsLoophole Mining

• This reason arises from the feature of banking
  industry heavy regulation
• Reserve requirements
• -act as a tax on deposits and the opportunity
  cost is the interest of potential loans.
• - ways to avoid tax sweep accounts
• Restrictions on interest paid on deposits,
  particularly checking accounts (Regulation Q)
• - disintermediation withdraw deposits and
  invest in high-yielding securities
• - ways to get around Regulation Q money
  market mutual funds

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Decline of Traditional Banking

• 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

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Banks Responses

• Decline in profitability of traditional baking
  results in bank failures and consolidations
  during 1980s
• How to survive?
• -expand into new and riskier areas of
  lending real estate loans, lending for takeovers
  leveraged buyouts, etc.
• -pursue off-balance-sheet activities loan
  sales, fee income, etc.
• Concerns about increased risk taking
• New Challenges for bank regulators

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Larger are better vs Smaller are better
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Branching

• McFadden Act of 1927 prohibited branching across
  state lines and forced all national banks to
  conform to the branching regulations of the state
  in which they were located
• Responses bank holding companies and ATM
• Deregulation Riegle-Neal Interstate Banking and
  Branching Efficiency Act of 1994

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The number of banks has declined over the last 25
years

• Bank failures
• Consolidation
• DeregulationRiegle-Neal Act of 1994
• Economies of scale and scope from information
  technology

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Benefits and Costs of Bank Consolidation

• Benefits
• Increased competition, driving inefficient banks
  out of business
• Increased efficiency also from economies of scale
  and scope
• Lower probability of bank failure from more
  diversified portfolios
• Costs
• Elimination of community banks may lead to less
  lending to small business
• Banks expanding into new areas may take increased
  risks and fail

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Separation of Banking and Other Financial
Services Glass-Steagall Act of 1933

• Reason Great Depression
• Allowed commercial banks from to sell new
  offering of government securities, but prohibited
  them from underwriting corporate securities or
  engaging in brokerage activities
• Example JP Morgan and First Boston
• Repeal of Glass-Steagall Gramm-Leach-Bliey Act
  of 1999

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Separation of Banking in the World

• Universal Banking Germany, Netherlands,
  Switzerland
• -No separation between banking and
  securities industries
• British-Style Universal System UK, Canada,
  Australia, US
• -May engage in security underwriting.
  Differ from Universal in three ways.
• Separate legal subsidiaries are common
• Bank equity holdings of commercial firms are less
  common
• Few combinations of banking and insurance firms
• Some legal separation Japan
• -Allowed to hold substantial equity stakes
  in commercial firms but holding companies are
  illegal