Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
Chapter Thirteen
Financial Industry Structure
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Introduction
• The U.S. has about 6,800 commercial banks
and roughly 16,000 depository institutions.
• For many years, most U.S. banks were unit
banks, or banks without branches.
• The decline in the total number of banks and
the increase in the number of banks with
branches are not the only changes we have
seen.
13-2
Introduction
13-3
Introduction
• The crisis of 2007-2009 has transformed the
U.S. financial industry.
• The failure or forced merger of several large banks
and other depository institutions accelerated
concentration.
• In July 2008, the U.S. government placed the
two massive government-sponsored enterprises
(GSEs) for housing finance in conservatorship.
• In September 2008, the four largest
independent investment banks failed, merged,
or became bank holding companies.
13-4
Introduction
• To understand the changing structure of the
financial industry, we will discuss the services
provided by both depository and nondepository
financial institutions.
• They provide a broad menu or services
including:
• Building and selling securities;
• Offering loans, insurance, and pensions; and
• Providing checking accounts, credit cards, and debit
cards.
13-5
Banking Industry Structure
• To understand the structure of today’s banking
industry, we need to trace it back to its roots.
• In this section we will learn that banking
legislation is the reason we have so many
banks in the U.S.
• We will look at the trend toward consolidation
that has been steadily reducing the number of
banks since the mid-1980’s.
• We will also briefly consider the effects of
globalization.
13-6
A Short History of U.S. Banking
• To start a bank, one needs permission in the
form of a bank charter.
• Until 1863,
• All bank charters were issued by state banking
authorities, and
• There was no national currency so banks issued
banknotes.
• These banknotes did not hold value from one
place to another and banks regularly failed.
13-7
A Short History of U.S. Banking
• During the Civil War, Congress passed the
National Banking Act of 1863.
• State banks were not eliminated, but did impose a
10% tax on their banknotes.
• The act created a system of federally chartered
banks, or national banks.
• National banks could issue banknotes tax-free.
13-8
A Short History of U.S. Banking
• State banks devised another way to make
money--demand deposits.
• This is how we got the dual-banking system we
have today.
• Banks can choose whether to get their charters from
the Comptroller of the Currency at the U.S Treasury
or from state officials.
13-9
A Short History of U.S. Banking
• About 3/4 have a state charter and the rest a
federal charter.
• Which charter a bank chooses depends on its
profitability.
• State banks have more operational flexibility, which
means a better chance of making a profit.
• If the Comptroller of the Currency won’t let a bank
do something, they can always just change their
charter.
13-10
A Short History of U.S. Banking
• The ability for banks to go back and forth
between charters created what amounts to
regulatory competition.
• This has accelerated innovation in the financial
industry.
• Globalization, however, has increased
competition between national government
regulators.
13-11
A Short History of U.S. Banking
• The Great Depression lead to the GlassSteagall Act of 1933.
• This legislation
• Created the Federal Deposit Insurance
Corporation (FDIC),
• Severely limited the activities of commercial
banks,
• Provided insurance to individual depositors, so
they would not lose their savings in the event
that a bank failed, and
• Restricted bank assets to certain approved forms
of debt.
13-12
A Short History of U.S. Banking
• The law separated commercial banks from
investment banks.
• Separating these two types of banks limited
financial institutions from taking advantage of
economies of scale and scope that might exist.
• This changed in 1999 with the Gramm-LeachBliley Financial Services Modernization Act
which repealed the Glass-Steagall Act.
13-13
Competition and Consolidation
• There are roughly 6,800 commercial banks in
the U.S. today, and that number has been
shrinking.
• The number of banks with branches has
changed significantly as well.
• Today’s banks not only have branches, they have
many of them.
• The U.S. banking system is composed of a
large number of very small banks and a small
number of very large ones.
13-14
Number & Assets of
U.S. Commercial Banks
13-15
Competition and Consolidation
• The primary reason for this structure is the
McFadden Act of 1927.
• This legislation required that nationally chartered
banks meet the branching restrictions of the states
in which they were located.
• Some states have laws forbidding branch banking,
resulting in a large number of small banks.
• There was fear that large banks would drive small
banks out of business, reducing the quality in
smaller communities.
13-16
Competition and Consolidation
• The result was a fragmented banking system
nearly devoid of large institutions.
• We ended up with a network of small,
geographically dispersed banks that faced little
competition - the opposite of what the act
wanted.
• In many states, more efficient and modern
banks were legally precluded from opening
branches to compete with local banks.
13-17
Competition and Consolidation
• Small local banks were without competition.
• This lead to loan portfolios that were insufficiently
diversified.
• At some points loans were not made because the
bank had taken on too much risk.
• Lack of credit only hurt these communities.
• Bank managers did well, but the communities
suffered.
13-18
Competition and Consolidation
• Some banks reacted to branching restrictions
by creating bank holding companies.
• These are corporations that own a group of other
firms.
• Can be thought of as a parent firm for a group of
subsidiaries.
• Initially these were created as a way to provide
nonbank financial services in more than one state.
13-19
Competition and Consolidation
• In 1956, Congress passed the Bank Holding
Company Act.
• This allowed bank holding companies to provide
various nonbank financial services.
• Technology has eroded the value of the local
banking monopoly.
• In the 1970s and 1980s, states responded by
loosening their branching restrictions.
13-20
Competition and Consolidation
• In 1994, Congress passed the Riegel-Neal
Interstate Banking and Branching Efficiency
Act.
• This legislation reversed restrictions from the
McFadden Act.
• Since 1977, banks have been able to acquire an
unlimited number of branches nationwide.
• The number of commercial banks has fallen nearly
in half.
13-21
Competition and Consolidation
• Deregulation provided benefits for the
economy.
•
•
•
•
Banks became more profitable.
Operation costs and loan losses fell.
Interest rates paid to depositors rose.
Interest rates charged to borrowers fell.
• The financial crisis of 2007-2009 has focused
attention on the costs of deregulation.
• Do the benefits of deregulation outweigh the risks?
13-22
Banking Industry Structure:
Key Legislation
13-23
• Pawnshops provide loans to people without
access to the traditional financial system.
• A person brings something of value to the
pawn shop in exchange for a short term loan.
• Because the loans are collateralized, the terms
are often reasonable – better than payday loans,
for example.
13-24
Globalization of Banking
• There are a number of ways banks can operate
in foreign countries, depending on factors such
as the legal environment.
• Open a foreign branch that offers the same services
as those in the home country.
• Banks can create an international banking facility
(IBF), which allows it to accept deposits from and
make loans to foreigners outside the country.
• The bank can create a subsidiary called an Edge Act
corporation, which is established specifically to
engage in international banking transactions.
13-25
Globalization of Banking
• Alternatively, a bank holding company can
purchase a controlling interest in a foreign
bank.
• Foreign banks can take advantage of similar
options.
• All the competition has made banking a
tougher business.
13-26
Globalization of Banking
• One of the most important aspects of
international banking is the eurodollar market.
• Eurodollars are dollar-denominated deposits in
foreign banks.
• Originally the euromarket was a response to
restrictions on the movement of international
capital that were instituted with the Bretton
Woods system of exchange rate management.
13-27
Globalization of Banking
• To ensure the pound would retain its value, the
British government imposed restrictions on the
ability of British banks to finance international
transactions.
• In an attempt to evade these restrictions,
London banks began to offer dollar deposits
and dollar-denominated loans to foreigners.
• The result was what we know today as the
eurodollar market.
13-28
Globalization of Banking
• The Cold War accelerated this when the Soviet
government, fearing that the U.S. government
might freeze or confiscate their deposits,
shifted them from New York to London.
• In 1960, U.S. tried to prevent dollars from
leaving the country by increasing costs for
foreigners to borrow dollars in the U.S.
• In the early 1970s, domestic interest rate
controls and high inflation made domestic
deposits less attractive than eurodollar deposits.
13-29
Globalization of Banking
• The eurodollar market in London is one of the biggest
and most important financial markets in the world.
• The interest rate at which banks lend each other
eurodollars is called the London Interbank Offered
Rate (LIBOR).
• This is the standard against which many private loan rates are
measured.
• The gap between the LIBOR and expected Fed policy
interest rate provides a key measure of the intensity and
persistence of the liquidity crisis.
13-30
The Future of Banks
• In November of 1999, the Gramm-LeachBliley Financial Services Modernization Act
went into effect.
• This effectively repealed the Glass-Steagall Act of
1933.
• It allowed a commercial bank, investment bank, and
insurance company to merge and form a financial
holding company.
• To serve all their customers’ financial needs, bank
holding companies are converting to financial
holding companies.
13-31
The Future of Banks
• Financial holding companies are a limited form
of universal banks.
• These are firms that engage in nonfinancial as well
as financial activities.
• In the U.S., different financial activities must
be undertaken in separate subsidiaries and
financial holding companies are still prohibited
from making equity investments in
nonfinancial companies.
13-32
The Future of Banks
• Owners and managers of these financial firms
cite three reasons to create them:
• Their range of activities, if properly managed,
permits them to be well diversified.
• These firms are large enough to take advantage of
economies of scale.
• These companies hope to benefit from economies of
scope.
13-33
The Future of Banks
• Thanks to recent technological advances,
almost every service traditionally provided by
financial intermediaries can now be produced
independently, without the help of a large
organization.
• As we survey the financial industry, we see the
two trends running in opposite directions.
13-34
Nondepository Institutions
• There are five categories of nondepository
institutions:
• Insurance companies;
• Pension funds;
• Securities firms, including brokers, mutual-fund
companies, and investment banks;
• Finance companies, and
• Government-sponsored enterprises.
• Nondepository institutions also include an
assortment of alternative intermediaries, such
as pawnshops.
13-35
Relative Size of
U.S. Financial Intermediaries
13-36
Insurance Companies
• Modern forms of insurance can be traced back
to around 1400, when wool merchants insured
their overland shipments from London to Italy
for 12 to 15 percent of their value.
• The first insurance codes were developed in
Florence in 1523, specifying the standard
provisions for a general insurance policy.
• They also stipulated procedures for handling
fraudulent claims in an attempt to reduce the moral
hazard problem.
13-37
Insurance Companies
• In 1688, Lloyd’s of London was established
and began to insure ships on trade routes.
• To obtain insurance, a ship’s owner would:
• Write the details of the proposed voyage,
• Add the amount he was willing to pay for the
service, and
• Circulate the paper among the patrons at Lloyd’s
coffeehouse.
• Interested individuals would decide how much to
risk and sign their names - the underwriters.
13-38
Insurance Companies
• Underwriting implied unlimited liability.
• To participate in this insurance market,
individuals known as names join together in
groups called syndicates.
• When a new contract is offered, several syndicates
sign up for a portion of the risk in return for a
portion of the premiums.
13-39
Insurance Companies
• Today Lloyd’s provides insurance through the
more conventional structure of a limited
liability company.
• The losses of individual investors in a syndicate are
limited to an amount of their initial investment, and
• No person is exposed to the possibility of financial
ruin.
13-40
Two Types of Insurance
• At the most basic level, all insurance
companies operate like Lloyd’s.
• They accept premiums from policyholders in
exchange for the promise of compensation if certain
events occur.
• For the individual policy holder, insurance is a
way to transfer risk.
13-41
Two Types of Insurance
• In terms of the financial system as a whole,
insurance companies specialize in three of the
five functions performed by intermediaries.
• They pool small premiums and make large
investment with them;
• They diversify risks across a large population; and
• They screen and monitor policyholders to mitigate
the problem of asymmetric information.
13-42
Two Types of Insurance
• Insurance companies offer two types of
insurance:
• Life insurance.
• Property and casualty insurance.
• While a single company may provide both
kinds of insurance, the two businesses operate
very differently.
13-43
Two Types of Insurance
• Life insurance comes in two basic forms.
• Term life insurance provides a payment ot the
policy holder’s beneficiaries in the event of the
insured’s death at any time during the policy’s term.
• Generally renewable every year as long as the
policyholder is less than 65 years old.
• Whole life insurance is a combination of term life
insurance and a savings account.
• The policyholder pays a fixed premium over
his/her lifetime in return for a fixed benefit when
the policyholder dies.
13-44
Two Types of Insurance
• Most whole life policies can be cashed in at
any time.
• Whole life insurance tends to be an expensive
way to save, though, so its use as a savings
vehicle has declined markedly as people have
found cheaper alternatives.
13-45
Two Types of Insurance
• Car insurance is an example of property and
casualty insurance.
• It is a combination of
• Property insurance on the car itself, and
• Casualty insurance on the driver, who is
protected against liability for harm or injury to
other people or their property.
• Holders of property and casualty insurance pay
premiums in exchange for protection during the
term of the policy.
13-46
Two Types of Insurance
• On the balance sheets of insurance companies,
these promises to policyholders show up as
liabilities.
• On the asset side, insurance companies hold a
combination of stocks and bonds.
• Property and casualty companies profit from
the fees they charge for administering the
policies they write.
• Because assets are essentially reserves against
sudden claims, they have to be liquid.
13-47
Two Types of Insurance
• Life insurance companies hold assets of longer
maturity than property and casualty insurers.
• Because more life insurance payments will be made
well into the future, this better matches the maturity
of the companies’ assets and liabilities.
• As a result, life insurance companies hold mostly
bonds.
13-48
• Life insurance is to support people who need it
if something happens to you.
• People with young children need it the most.
• The best approach is to buy term life insurance.
• You should consider a term policy worth six to
eight times your annual income.
13-49
The Role of Insurance Companies
• Like life insurers, property and casualty
insurers pool risks to generate predictable
payouts.
• They reduce risk by spreading it across many
policies.
• Although there is no way to know exactly
which policies will require payment, the
insurance company can estimate precisely the
percentage of policyholders who will file
claims.
13-50
The Role of Insurance Companies
• Adverse selection and moral hazard create
significant problems problems in the insurance
market.
• A person with terminal cancer has an incentive to
buy life insurance for the largest amount possible that’s adverse selection.
• Without fire insurance, people would have more
fire extinguishers in their houses - that’s moral
hazard.
13-51
The Role of Insurance Companies
• Insurance companies work hard to reduce both
adverse selection and moral hazard.
• A person wanting life insurance needs a physical
exam.
• People who want auto insurance must provide their
driving records.
• Policies also include restrictive covenants that
require the insured to engage or not to engage in
certain activities.
13-52
The Role of Insurance Companies
• Insurance companies might also require
deductibles.
• These require the insured to pay the initial cost of
repairing accidental damage, up to some maximum
amount.
• Or they may require coinsurance.
• This is where the insurance company shoulders a
percentage of the claim, usually 80 or 90 percent
and the insured assumes the rest.
13-53
The Role of Insurance Companies
• Remember that insurance is meant to shift risk
from individuals to groups, to shift the
responsibility for events that are certain to
happen.
• With the decoding of the human genome, a battery
of tests might soon be available to determine each
person’ probability of developing a terminal
disease.
• If this information is revealed, many people may
not be able to get life insurance.
13-54
• Some risks are too big for insurance companies.
• Reinsurance companies insure insurance companies
against really big risks.
• Catastrophic bonds allow investors to share some of
this risk.
• Cat bonds:
• If there is no catastrophe, they pay a high return.
• If a specific event (described in the bond) occurs, they pay
nothing.
13-55
Pension Funds
• A pension fund offers people the ability to
make premium payments today in exchange for
promised payments under certain future
circumstances.
• They provide an easy way to make sure that a
worker saves and has sufficient resources in old
age.
• They help savers to diversify their risk.
• By pooling the savings of many small
investors, pension funds spread the risk.
13-56
Pension Funds
• People can use a variety of methods to save for
retirement, including employer sponsored plans
and individual savings plans.
• There are two basic types:
• Defined-benefit (DB) pension plans and
• Defined-contribution (DC) pension plans.
• Many employer-sponsored plans require a
person work for a certain number of years
before qualifying for benefits, a process called
vesting.
13-57
Pension Funds
• Defined-benefit plans.
• Participants receive a life-time retirement income
based on the number of years they worked at the
company and their final salary.
• Defined-contribution plans.
• These are replacing defined-benefit plans.
• Sometimes referred to as “401(k)” after their IRS
code.
• The employer takes no responsibility for the size of
the employee's retirement income.
13-58
Pension Funds
• You can think of a pension plan as the opposite
of life insurance.
• One pays off if you live, the other if you don’t.
• The balance sheets of pension funds look a lot
like those of life insurance companies.
• Both hold long-term assets like corporate bonds and
stocks.
• The only difference is that life insurance
companies hold only half the equities that
pension funds do.
13-59
Pension Funds
• The U.S. government provides insurance for
private, defined-benefit pension systems.
• If a company goes bankrupt, the Pension Benefit
Guaranty Corporation (PBGC) will take over the
fund’s liabilities.
• Although there are limits, it still increases the
incentive for a firm’s managers to engage in risky
behavior.
• Regulators monitor pension funds regularly.
13-60
• Pay-as-you-go:
Transfers tax revenue to current retirees.
• Excess revenue is spent by the Treasury.
• Trust fund is in U.S. Treasury securities which would
have to be repaid with future tax revenue.
• Problems:
• Population is aging so ratio of workers to retirees is falling.
• People are living longer so they receive more in benefits.
• What is the future?
13-61
Securities Firms: Brokers, Mutual
Funds, and Investment Banks
• The broad class of securities firms includes:
• Brokerages,
• Investment banks, and
• Mutual fund companies.
• In one way or another, these are all financial
intermediaries.
13-62
Securities Firms: Brokers, Mutual
Funds, and Investment Banks
• The primary services of brokerage firms are:
• Accounting (to keep track of customers’ investment
balances),
• Custody services (to make sure valuable records
such as stock certificates are safe), and
• Access to secondary markets (in which customers
can buy and sell financial instruments).
13-63
Securities Firms: Brokers, Mutual
Funds, and Investment Banks
• Brokers also provide loans to customers who
wish to purchase stock on margin.
• They provide liquidity, both by offering checkwriting privileges with their investment accounts
and by allowing investors to sell assets quickly.
• Mutual-fund companies offer liquidity services
as well.
• The primary function of mutual funds,
however, is to pool the small savings of
individuals in diversified portfolios that are
composed of a wide variety of financial
instruments.
13-64
Securities Firms: Brokers, Mutual
Funds, and Investment Banks
• All securities firms are very much in the
business of producing information.
• Information is at the heart of the investment
banking business.
• Investment banks are the conduits through
which firms raise funds in the capital markets.
• Through their underwriting services, these
investment banks issue new stocks and a
variety of other debt instruments.
13-65
Securities Firms: Brokers, Mutual
Funds, and Investment Banks
• The underwriter guarantees the price of a new
issue and then sells it to investors at a higher
price.
• This is a practice called placing the issue.
• The underwriter profits from the difference
between the price guaranteed to the firm that
issues the security and the price at which the
bond or stock is sold to investors.
13-66
Securities Firms: Brokers, Mutual
Funds, and Investment Banks
• Since the price at which the investment bank
sells the bonds or stocks in financial markets
can turn out to be lower than the price
guaranteed by the issuing company, there is
some risk to underwriting.
• For large issues, investors will band together
and spread the risk among themselves rather
than one taking the risk alone.
13-67
Securities Firms: Brokers, Mutual
Funds, and Investment Banks
• Investment banks also provide advice to firms
that want to merge with or acquire other firms.
• Investment bankers do the research to identify
potential mergers and acquisitions and estimate the
value of the new, combined company.
• In facilitating these combinations, investment
banks perform a service to the economy.
• Mergers and acquisitions help to ensure that the
people who manage firms do the best job possible.
13-68
• Hedge funds are strictly for millionaires.
• These investment partnerships bring together
small groups of people who meet certain
wealth requirements.
• Hedge funds come in two basic sizes:
• Maximum of 99 investors, each with at least $1
million in net worth, or
• Maximum of 499 investors, each with at least $5
million in net worth.
13-69
• Hedge funds are run by a well-paid general
partner, or manager, who is in charge of dayto-day operations.
• Managers are required to keep a large portion of
their own money in the fund to solve the problem of
moral hazard.
• Hedge funds are not low risk enterprises.
• Because they are set up as private partnerships, they
are not constrained in their investment strategies.
13-70
• Hedge fund managers typically strive to create
returns that roughly equal those of the stock
market.
• While individual hedge funds are very risky, a
portfolio that invests in a large number of these
funds can expect returns equal to the stock
market average with less risk.
13-71
Finance Companies
• Finance companies are in the lending business.
• They raise funds directly in the financial
markets by issuing commercial paper and
securities and then use them to make loans to
individuals and corporations.
• They are concerned largely with reducing the
transactions and information costs that are
associated with intermediated finance.
13-72
Finance Companies
• Because of their narrow focus, finance
companies are particularly good at:
• Screening potential borrowers’ creditworthiness,
• Monitoring their performance during the term of the
loan, and
• Seizing collateral in the event of a default.
13-73
Finance Companies
• Most finance companies specialize in one of
three loan types:
•
•
•
•
Consumer loans,
Business loans, and
What are called sales loans.
Some also provide commercial and home
mortgages.
13-74
Finance Companies
• Consumer finance firms provide small
installment loans to individual consumers.
• Business finance companies provide loans to
businesses.
• Business finance companies also provide both
inventory loans and accounts receivable loans.
• Sales finance companies specialize in larger
loans for major purchases, such as automobiles.
13-75
• Following the financial crisis of 2007-2009,
policymakers focused on how to prevent future
crises.
• Proposed remedies included:
• Breaking up the largest financial firms,
• Prohibiting certain risky activities, and
• Charging a fee for risk-taking.
• This article highlights the debate among
policymakers about how to proceed.
13-76
Government-Sponsored Enterprises
• The U.S. government is directly involved in the
financial intermediation system.
• The risk-taking of government-related
intermediaries contributed importantly to the
financial crisis of 2007-2009.
• A hybrid corporate form known as a
government-sponsored enterprise (GSE) is
chartered by the government as a corporation
with a public purpose.
13-77
Government-Sponsored Enterprises
• The privatized Depression-era Federal National
Mortgage Association (Fannie Mae) and a
similarly government chartered competing
entity, the Federal Home Loan Mortgage
Corporation (Freddie Mac) are examples.
• While the debt issued by Fannie and Freddie
was not guaranteed by the government, market
participants generally assumed that it would be
in a crisis.
13-78
Government-Sponsored Enterprises
• In 1968, Congress also established the
Government National Mortgage Corporation
(Ginnie Mae) as a GSE that is wholly owned
by the federal government.
• The U.S. government explicitly guarantees Ginnie
Mae debt.
• Congress also chartered the Student Loan
Marketing Association (Sallie Mae) as a GSE,
but by 2004 had terminated the charter, making
Sallie Mae a wholly private-sector firm.
13-79
Government-Sponsored Enterprises
• At their founding, the financial GSEs had
similar financial character:
• They issued short term bonds and used the proceeds
to provide loans or guarantees of one form or
another.
• Because of their implicit relationship to the
government, they paid less than private borrowers
for their liabilities and passed on some of these
benefits in the form of subsidized mortgages and
loans.
13-80
Government-Sponsored Enterprises
• In the years preceding the 2007-2009 crisis,
Fannie and Freddie had taken advantage of
their implicit government backstop by
operating on a slim capital cushion.
• Each had a leverage ratio that was around three
times higher than that of the average U.S. bank.
• These two massive GSEs could not withstand
the surge of defaults when home prices began
to decline nationwide in 2006.
13-81
Government-Sponsored Enterprises
• Despite numerous efforts to save them, a run
on GSE debt in the summer of 2008 compelled
the U.S. Treasury to place Fannie and Freddie
into conservatorship.
• This is a bankruptcy procedure that allows them to
operate despite insolvency.
• As of early 2010, it remains unclear what the
U.S government will do with Fannie and
Freddie.
13-82
• An annuity is a financial instrument in which a
person (the “annuitant”) makes a payment in
exchange for the promise of a series of future
payments.
• There are fixed-period and lifetime annuities.
• And there are deferred versus immediate
annuities.
• Finally, insurance companies offer fixed versus
variable annuities.
13-83
Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
End of
Chapter Thirteen
Financial Industry Structure
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.