Fundamental Forces of Change in Banking 2869

8/7/2019 Fundamental Forces of Change in Banking 2869

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FUNDAMENTAL FORCESOF CHANGE IN BANKING

Chapter 1



What makes a bank ‘special?’Why do we call Bank of America a ‘bank,’ Merrill

Lynch a ‘securities brokerage company’ and StateFarm an ‘insurance company?’

The answer lies in our history; with the implementation of:The Glass-Steagall Act which created three separate industries:commercial banking, investment banking, and insurance.The Bank Holding Act determined activities closely related tobanking and limited the scope of activities a company couldengage in if it owned a bank.The McFadden Act limited the geographic market of banking byallowing individual states to determine the extent to which a bankcould branch intra- or inter-state.

As a result of these acts, the United States developed a uniquebanking system which had a large number of smaller banks; limitedin the scope of products and services offered; and limited in thegeographic areas covered by banks.



The banking industry is consolidating anddiversifying simultaneously.

The traditional definition of a bank has been blurred by theintroduction of new products and a wave of mergers, whichhave dramatically expanded the scope of activities thatbanks engage in and where products and services areoffered.

Formerly, a commercial bank was defined as a firm that both

accepted demand deposits and made commercial loans .Today, these two products are offered by many financialservices companies: including commercial banks, savingsbanks, credit unions, insurance companies, investment banks,finance companies, retailers, and pension funds.

What constitutes a bank, today is not as important as whatproducts and services are offered and in what geographicmarkets the financial services company competes in.



While competition has increased the number of firms offering financial products and services,… the removal of interstate branching restrictions in theU.S. has dramatically reduced the number of banks but increased the number of banking offices (primarilybranches).

Consolidation, in turn, has increased the proportion of banking assets controlled by the largest banks.Not surprisingly, the same trends appear globally.The United States currently has several banks that operatein all 50 states and manylocales outside the U.S.The largest foreign banks havesignificant operations in the U.S.and throughout the world.



Increased competition… quickly changing the natureof commercial banking.

Competition also means geography nolonger limits a financial institution’s trade area or the markets in which itcompetes.

Individuals can open a checking account at:a traditional depository institution,a brokerage firm, or

a nonbank firm, such as GE Capital , State Farm Insurance , andAT&T. You can deposit money electronically, transfer funds from oneaccount to another, purchase stocks, bonds and mutual funds, or even request and receive a loan from any of these firms.

Most allow you to conduct this business by phone, mail, or over the

Internet.

http://www.ge.com/

http://www.statefarm.com/

http://www.att.com/

http://www.att.com/

http://www.statefarm.com/

http://www.ge.com/



Regulatory restrictions on products andservices offerings worked effectively inpromoting a safe banking system until the

later half of the twentieth century.

Product innovations and technological advances of thelater half of the twentieth century allowed investment

banking firms to circumvent the regulations restrictingtheir banking activities.In the late 1970s Merrill Lynch effectively created an“interest bearing checking account,” something banks

had not been legally allowed to offer.Junk bonds became an alternative financing source for small business and other companies began toencroach upon the banks primary market.

http://www.ml.com/

http://www.ml.com/



Banks were heavily regulated…state banking agencies, the FDIC, the Federal Reserveand the Office of Comptroller of the Currency

Merrill Lynch was only regulated by theSecurities and Exchange Commission .This allow investment companies to move into the banks market,circumventing Glass-Steagall and the Bank Holding Company Act

Not until the late 1980s and early 1990s did banks find waysaround Glass-Steagall using a Section 20 affiliate whichallowed them to offer a limited amount of investmentbanking products and services.

During this same period, the rise in the U.S. stock marketincreased the average person’s awareness of higher promisedreturns from mutual funds and stock transactions.This lead to a greater acceptance of non-FDIC insured depositproducts (mutual funds and stocks)Banks, however, were generally restricted to offering CD’s andsavings accounts which increased the erosion of the banks shareof the consumer’s investment wallet.

http://www.ml.com/

http://www.sec.gov/

http://www.sec.gov/

http://www.ml.com/



Branching restrictions were primarilyresponsible for the structure of the

banking system.This created a system of many more but smaller banks ascompared to other countries.

By the late 1990s, all branching restrictions were removedfrom the banking system and the number of independentbanks was reduced by almost half, the number of branchesincreased by almost 50 percent and the size of the largest U.S.banks increased dramatically.In fact, by size rankings, U.S. banks did not reach the largest10 banks in the world until the late 1990s and today, some of the largest banks in the world are U.S. banks.



Branching restrictions were effective atreducing competition among depositoryinstitutions and promoting a safe bankingsystem until the later half of the twentiethcentury.

These same branching restrictions, however, prevented banks from geographically diversify their product and credit risk and quite possibly

contributed the loss of several large Texasbanks during the late 1980s.



The removal of branching restrictions during thelater half of the twentieth century allowed banksto offer services anywhere in the country and lead

to the creation of the first coast-to-coast bank … forever changing the banksmarket from local to global.

Merrill Lynch andState Farm already operatedbranches across the nation and in comparison there weresignificantly fewer, but larger, investment and insurancecompanies.

In addition to relaxation of branching restrictions, technologicaladvances allowed banks to open electronic branches, first byusing the ATM network and later by using the Internet.



This structural change is frequentlyattributed to deregulation of thefinancial services industry.

In fact, deregulation was a natural response toincreased competition between depositoryinstitutions and nondepository financial firms,and between the same type of competitorsacross world markets.In fact, some regulations can be credited for the development of new products to avoidregulation—hence increased competition fromfirms not regulated like a bank; i.e., investmentbanks.



Five fundamental forces havetransformed the financial services

market1. Deregulation/re-regulation2. Financial innovation3. Securitization4. Globalization5. Advances in technology.

The latter factors actually represent responses to deregulation and

re-regulation.



Historically, commercial banks havebeen the most heavily regulatedcompanies in the United States

Regulations took many forms including :maximum interest rates that could be paid ondeposits or charged on loans,minimum capital-to-asset ratios,minimum legal reserve requirements,limited geographic markets for full-servicebanking,constraints on the type of investmentspermitted, andrestrictions on the range of products andservices offered.



Banks and other market participants haveconsistently restructured their operationsto circumvent regulation and meetperceived customer need

In response, regulators or lawmakers wouldimpose new restrictions, which marketparticipants circumvented again.This process of regulation and marketresponse ( financial innovation ) and

imposition of new regulations (re-regulation)is the regulatory dialectic .



Today banks are accessing the formerlyforbidden areas of investment banking, bythe repeal of the Glass-Steagall Act via theFinancial Services Modernization Act(Gramm-Leach-Bliley Act of 1999).

The Gramm-Leach-Bliley Act effectively eliminates themajority of the remaining restrictions that haveseparated commercial banking, investment banking andinsurance industries for over 50 years.The Glass-Steagall Act shaped thestructure, products and businessmodels of the banking industry for the later half of the 20th century.



Increased competition

The McFadden Act of 1927 and the Glass-Steagall Act of 1933 determined the frameworkwithin which financial institutions operated for the next 50 years.

The McFadden Act saw to it that banks wouldbe sheltered from competition with other banksby extending state restrictions on geographicexpansion to national banks.

The Glass-Steagall Act forbade banks fromunderwriting equities and other corporatesecurities, thereby separating banking fromcommerce.



The fundamental forces of change… increased competition

Competition for depositsCompetition for loansCompetition for payment servicesCompetition for other financial services



Competition for deposits

High inflation abruptly ended theguaranteed spread between asset yields andliability costs in the late 1970s.In 1973 several investment banks created

money market mutual funds (MMMFs).Without competing instruments, MMMFsincreased from $10.4 billion in 1978 to almost$189 billion in 1981.

Congress passed legislation enabling banksand thrifts to offer similar accountsincluding money market deposit accounts(MMDAs) and Super NOWs.



Competition for loans

Loan yields fell relative to borrowing costs,as lending institutions competed for adecreasing pool of quality credits.High loan growth also raises bank capitalrequirements.Junk bonds, commercial paper, auto financecompanies, credit unions, and insurancecompanies compete directly for the samegood quality customers.



Competition for loans (continued)

As bank funding costs rose, competition for loans put downward pressure on loan yields andinterest spreads.Prime corporate borrowers have always had the

option to issue commercial paper or long-termbonds rather than borrow from banks.Because the Glass-Steagall Act preventedcommercial banks from underwriting commercial

paper, banks lost corporate borrowers, who nowbypassed them by issuing commercial paper atlower cost.



Competition for loans (continued)

The competition for loans comes in many forms:Commercial paper Captive automobile finance companiesOther finance companies

The development of the junk bond market extendedloan competition to medium-sized companiesrepresenting lower-quality borrowers.The growth in junk bonds reduced the pool of

good-quality loans and lowered risk-adjusted yieldspreads over bank borrowing costs.



Today, different size banks generallypursue different strategies.

Small- to medium-size banks continue toconcentrate on loans but seek to strengthenthe customer relationship by offeringpersonal service.These same banks have generallyrediscovered the consumer loan.The largest banks, in contrast, are lookingto move assets off the balance sheet.

Regulatory capital requirements and the newcorporate debt substitutes often make theremaining loans too expensive and too risky.

Fundamental Forces of Change in Banking 2869

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