Chapter 12 Banking Industry: Structure and Competition.

Chapter 12

Banking Industry: Structure and Competition

Historical Development of the Banking System

The first paper money, chiao-tzu• issued in 10th century Szechwan, China (Lui, 1983)• a bank receipt for iron Chinese coins deposited in Szechwan banks. • it became the first fiat money when the Szechwan gov’t took it over in 1023

In 1500-1600 London, • Goldsmiths began charging fees for safely storing gold coins. • The receipts were redeemable to only the depositor unless ‘or bearer’ was

printed next to the bearer’s name. • The Bank of England began issuing paper pounds in 1694• Pounds circulated as money because they were redeemable in gold. • The pound became fiat money when the UK gold standard was abandoned in

1931


The modern U.S. bank is a financial intermediary• it accepts deposits from savers • it lends money to borrowers. • it evolved from 16th century London goldsmiths.

‒ Goldsmiths had a history of safely storing gold‒ Table (a) on the following slide shows a T-account for the first goldsmith‒ The value on the left is called reserves

o the goldsmith is reserving it for its depositors

‒ The value on the right is called demand deposits o depositors can demand their gold coin at any time


Storing gold is profitable • John’s employer pays him in gold coin• John is willing to pay to have it safely kept by the goldsmith

‒ Storing it in one’s home or carrying it on one's person is risky‒ Depositing it at the goldsmith isn’t too inconvenient

o it is located near his village’s ale house and shops.

• Table (b) shows what happens after word spreads of the goldsmith safely storing John’s gold. ‒ Others deposit their gold in the goldsmith’s safe‒ The Goldsmith’s assets and liabilities rise to £1000‒ As the proceeds from fees pile up,

o the goldsmith’s wealth growso storing gold becomes his primary business.


After observing the goldsmith’s growing affluence • James inquires about borrowing gold sitting idle in the goldsmith’s safe to turn

his alehouse into an inn• The goldsmith accommodates the request if

‒ he believes depositors will keep their coins in his safe for the desired length of the loan‒ the inn will be profitable‒ James is willing and able to pay back

‒ the principal, the borrowed gold coins‒ interest, compensation for accepting credit risk.

• Because the gold coins are the property of others, making loans using demand deposits could be viewed as unscrupulous. ‒ The goldsmith offers to pay depositors interest. ‒ If net interest margin

o is negative, the goldsmith does not make a profit. o is positive, the goldsmith hesitate because demand deposits can be withdrawn at any time. o is high enough to encourage depositors to store gold coins for the length of the loan, the

goldsmith safely securitizes the loan (time deposit, CDs)


After the goldsmith lends James gold (short with demand deposits)• James pays

‒ Jill £500 for building materialso Jill deposits her £500 at the goldsmith

‒ Bill £400 for his laboro Bill deposits his £400 at the goldsmith

‒ The goldsmith’s liabilities increase by £900‒ The goldsmith’s reserves increase from £100 to £1000

o Reserves ratio

200/200 = 100%

1000/1000 = 100%

100/1000 = 10%

1000/1900 = 52.6%

(a)

(b)

(c)

(d)


While making loans & storing gold coin deposits, the goldsmith• discovers a reserves ratio of 0.2 is, under normal economic conditions, enough

to balance‒ outflows (gold withdrawals and gold payments from new loans) ‒ inflows (new gold deposits and loan payoffs in gold) ‒ the goldsmith will make loans until

o demand deposits times the reserves ratio = quantity of gold coin presently held in reserve.o The self-imposed reserves ratio is called the desired reserves ratio.

• Gold coin deposits have pushed the goldsmith’s reserves from £1000 to £10,000

‒ With a desired reserves ratio of 0.2, the goldsmith is comfortable with reserves backing just 20% of demand deposits.

‒ This is why the goldsmith has made £40,000 in loans to villagers‒ The goldsmith discovers that the paper receipts he has issued are circulating as money‒ As long as the receipts can be redeemed in gold coin, villagers consider the receipts money

because they are as good as gold.‒ The paper money is increasingly preferred to gold because it can be folded up in one’s pocket,

and its use eliminates trips to the goldsmith.


The system described above is called fractional reserve banking because reserves are a fraction of demand deposits • Such a system is inherently risky

‒ bank profits increase as the reserves ratio falls. o the goldsmith works less and less as an artisan and increasingly more as a banker as her

banking operations expand. o Balancing his T-account and reviewing loan applications is time consuming, but is necessary

to ensure a desired reserves ratio of 0.2o If the economy over-performs for a long period, the goldsmith may lower the desired reserves

ratio to 0.1 o more profitable

£10,000 in gold are backing £100,000 in demand deposits. more interest-bearing loans (5%) are made (from £40,000 to £90,000) interest payments increases by 125%

o more riskier An unexpected event, like the Little Ice Age (1560-1850) A collapse in firm revenue slows inflows of new gold deposits More out-migration increases outflows of gold


The Fed sets the required reserves ratio of 0.1 on checkable demand deposits in the U.S.’s fractional reserve banking system • This makes banks’ T-accounts slightly different than

the goldsmith’s• Reserves and loans are still listed on the asset side• The bank’s outstanding loans of $40,000, is split:

government, consumers, and businesses. • This means the bank voluntarily lends out all but

$10,000 of the $50,000 in checkable demand deposits.

• Reserves split into required reserves & excess reserves

‒ Required reserves ratio = 10%‒ Excess reserves ratio = 10%‒ Desired reserves ratio = 20%


Bank of North America chartered in 1782

Controversy over the chartering of banks.

National Bank Act of 1863 creates a new banking system of federally chartered banks• Office of the Comptroller of the Currency• Dual banking system

Federal Reserve System is created in 1913. Government’s perspective

The Mises Institutes’ perspective

Free Banking (Lawrence White)

Free Banking (Lawrence White)

Free Banking

The Mises Institute’s perspective

http://www.youtube.com/watch?v=ULvS4uvCeKM

http://www.youtube.com/watch?v=w4eglbS3sbE

http://www.youtube.com/watch?v=cMn9pc-aTDQ

http://www.youtube.com/watch?v=toCGhZI87hw&feature=player_detailpage

http://www.youtube.com/watch?v=0PyS2NtW3xA

http://www.youtube.com/watch?v=pzWJQepX6CA

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can

design. – F.A. Hayek

Figure 1


Primary Supervisory Responsibility of Bank Regulatory Agencies

• Federal Reserve and state banking authorities: o state banks that are members of the Federal Reserve System.

• Fed also regulates bank holding companies.

• FDIC: insured state banks that are not Fed members.

• State banking authorities: state banks without FDIC insurance.

The Federal Reserve System

Financial innovation is driven by the desire to earn profits

A change in the financial environment will stimulate a search by financial institutions for innovations that are likely to be profitable• Financial engineering

Responses to Changes in Demand Conditions: Interest Rate Volatility• Adjustable-rate mortgages

o Flexible interest rates keep profits high when rates riseo Lower initial interest rates make them attractive to home buyers

• Financial Derivativeso Ability to hedge interest rate risk o Payoffs are linked to previously issued (i.e. derived from) securities.

Responses to Changes in Supply Conditions: • Information Technology

o Bank credit and debit cards improved computer technology lowers transaction costso Electronic bankingo ATM, home banking, ABM and virtual bankingo Junk bondso Commercial paper market

Financial Innovation


Responses to Changes in Supply Conditions: • Information Technology (continued)

o Securitization To transform 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.

Avoidance of Existing Regulations• Loophole Mining

o Reserve requirements act as a tax on depositso Restrictions on interest paid on deposits led to disintermediationo Money market mutual fundso Sweep accounts

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 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)

o Rising inflation led to rise in interest rates and disintermediationo Low-cost source of funds, checkable deposits, declined in importance

• Decline in income advantages on uses of funds (assets)o Information technology has decreased need for banks to finance short-term credit

needs or to issue loans o Information technology has lowered transaction costs for other financial institutions,

increasing competitionBank’s Response• Expand into new and riskier areas of lending

o Commercial real estate loanso Corporate takeovers and leveraged buyouts

• Pursue off-balance-sheet activitieso Non-interest incomeo Concerns about risk

Structure of the U.S. Commercial Banking Industry

Restrictions on branching

• McFadden Act and state branching regulations.

Response to ranching restrictions

• Bank holding companies.

• Automated teller machines.

Thrift Industry: Regulation and Structure • Savings and Loan Associations

─ 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

• Mutual Savings Banks─ Approximately half are chartered by states─ Regulated by state in which they are located─ Deposit insurance provided by FDIC or state insurance

• Credit Unions─ 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)


Bank Share of Total Nonfinancial Borrowing

Source: Federal Reserve Flow of Funds; www.federalreserve.gov/releases/z1/Current/z1.pdf. Flow of Funds Accounts; Federal Reserve Bulletin.

Figure 2


Table 1


Table 2

Bank Consolidation and Nationwide Banking

The number of banks has declined over the last 25 years• Bank failures and consolidation.• Deregulation: Riegle-Neal Interstate Banking and Branching Efficiency Act f

1994.• Economies of scale and scope from information technology.• Results may be not only a smaller number of banks but a shift in assets to much

larger banks.

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

Gramm-Leach-Bliley Financial Services Modernization Act of 1999• Abolishes Glass-Steagall

• States regulate insurance activities

• SEC keeps oversight of securities activities

• Office of the Comptroller of the Currency regulates bank subsidiaries engaged in securities underwriting

• Federal Reserve oversees bank holding companies


Erosion of Glass-Steagall Act• 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

Source: www2.fdic.gov/qbp/qbpSelect.asp?menuitem=STAT.

Figure 3 Number of Insured Commercial Banks in the United States

(Third Quarter)


Universal banking• No separation between banking and securities industries

British-style universal banking• May engage in security underwriting

─ Separate legal subsidiaries are common─ Bank equity holdings of commercial firms are less common─ Few combinations of banking and insurance firms

Some legal separation• Allowed to hold substantial equity stakes in commercial firms but holding companies

are illegal

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

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


Table 3


Chapter 12 Banking Industry: Structure and Competition.

Documents

Transcript of Chapter 12 Banking Industry: Structure and Competition.