Market Structure and Regulation in
the U.S. Banking Industry
Professor Wayne Carroll
Department of Economics
University of Wisconsin-Eau Claire
carrolwd@uwec.edu
Slides available at www.uwec.edu/carrolwd
Roles of Banks in the Economy
 Facilitate borrowing and lending
 Facilitate payments
 Risk management


Issue financial assets that allow firms to share
risks
Provide guarantees and lines of credit
Role of Banks in Lending
Sources of External Funding for Business
100%
90%
80%
70%
60%
USA
50%
Germany
Japan
40%
30%
20%
10%
0%
bank loans
non-bank loans
bonds
Source: Available online at http://www.wiwi.uni-frankfurt.de/schwerpunkte/finance/wp/550.pdf
new equity
Financial Intermediaries
“Banks” include:
 Commercial banks
 Savings and loan associations (S&L’s)

Also sometimes called “thrifts” or “thrift
institutions”
 Credit unions
Financial Intermediaries
Assets at end of 2002 (in billions)
Credit Unions:
$553
S & L's:
$1,338
Banks: $7,161
Ownership of Banks
 U.S. banks are privately owned – no banks
are owned by the government.
 In most cases a bank’s stock is held by a
large number of investors, so a bank has
many “owners.”
 It is relatively easy to establish a new bank in
the U.S.
Bank Market Structure
 There are a large number of banking firms in
the U.S., but the number is falling due to
mergers between banks.
 Thousands of U.S. banks are very small,
each having only a single office.
 Many banks today have multiple branches or
offices.
 A “bank holding company” is a firm that owns
one or more banking firms.
Size Distribution of U.S. Banks
Commercial Banks
Number of
Asset Size
(as of June 30, 2006)
Institutions
Offices
Deposits
(millions)
586
712
$7,661
$25 Million to $50 Million
1,098
1,701
$33,511
$50 Million to $100 Million
1,718
4,007
$105,754
$100 Million to $300 Million
2,427
10,338
$349,740
$300 Million to $500 Million
672
5,088
$211,495
$500 Million to $1 Billion
494
6,322
$265,540
$1 Billion to $3 Billion
275
6,856
$338,909
$3 Billion to $10 Billion
120
6,601
$427,340
Greater than $10 Billion
89
38,848
$3,580,817
7,479
80,473
$5,320,767
Less than $25 Million
TOTALS
Source: www2.fdic.gov/sod/index.asp
Bank Market Structure: An Example
Wells Fargo & Company is a bank
holding company based in South Dakota
(with historic roots in Minnesota and
California). It includes:
 28 chartered bank companies
 a total of over 3,000 branches in 23
states
Some Wells Fargo branches
Wells Fargo’s Broad Scope
Investments and
Insurance
15%
Specialized
Lending
15%
Wholesale
Banking/
Commercial Real
Estate
9%
Home Mortgage
and Home Equity
20%
Source: www.wellsfargo.com/about/today1
Community
Banking
34%
Consumer
Finance
7%
20 Largest U.S. Banks
(as of June 30, 2006)
Rank
Institution Name
State
Headquartered
Number of
Offices
Deposits
(thousands)
1
Bank of America, NA
North Carolina
5,781
$563,906,844
2
JPMorgan Chase Bank, NA
Ohio
2,679
$434,752,000
3
Wachovia Bank, NA
North Carolina
3,136
$306,348,000
4
Wells Fargo Bank, NA
South Dakota
3,200
$298,672,000
5
Washington Mutual Bank
Nevada
2,167
$209,927,984
6
Citibank, NA
New York
267
$142,508,000
7
SunTrust Bank
Georgia
1,758
$117,956,301
8
U.S. Bank, NA
Ohio
2,525
$117,337,830
9
HSBC Bank USA, NA
Delaware
436
$75,588,320
10
World Savings Bank, FSB
California
286
$61,321,407
11
PNC Bank, NA
Pennsylvania
831
$58,134,805
12
Keybank, NA
Ohio
957
$57,327,323
13
Regions Bank
Alabama
1,397
$57,231,022
14
Merrill Lynch Bank USA
Utah
3
$52,331,967
15
Branch Banking and Trust Company
North Carolina
918
$51,246,133
16
Countrywide Bank, NA
Virginia
2
$50,657,812
17
ING Bank, fsb
Delaware
1
$46,440,495
18
Comerica Bank
Michigan
387
$43,081,270
19
Sovereign Bank
Pennsylvania
661
$40,829,851
20
The Bank of New York
New York
354
$40,014,000
Source: www2.fdic.gov/sod/index.asp
A Simple Bank Balance Sheet
Assets
 reserves
 "loans"
 securities
 bank
loans
Liabilities
 deposits
 borrowings
Bank capital
(equity)
Detailed Balance Sheet for the Banking Industry
Source: Mishkin, Economics of Money, Banking, and Financial Markets, 7th edition
Two Important Ratios
 Capital/asset ratio – bank capital as a
percentage of bank assets.

The average capital/asset ratio for U.S. banks
was about 9% at the end of 2002.
 Reserve ratio – bank reserves as a
percentage of checkable deposits.
Information on U.S. Banks
 It is easy to get a lot of financial data on U.S.
banks.
 A great source:
www2.fdic.gov/idasp/index.asp
An Example: Data on Wells Fargo
What Can Go Wrong?
 “Bank failure” – the bank goes out of
business.



Bank depositors might lose some of their
funds.
Bank creditors might lose some of their
investment
Bank owners lose their capital.
 The bank suffers significant losses – the
government might have to help.
Reasons for Bank Regulation
Banks must be regulated because:
 a bank failure can be devastating to depositors.
 there’s a risk of systemic failure: the failure of
one bank can make it more likely that other
banks will fail.
 depositors can’t monitor how the bank invests
their funds, creating a moral hazard problem.
 government assistance to a bank can be very
costly.
Reasons for Bank Regulation
Banks are less stable than other businesses
because:
 bank liabilities tend to be short-term – many
depositors could withdraw their funds with little
notice.
 bank assets tend to be longer-term – reserves
and other liquid assets are only a small share of
the total.
 the behavior of depositors depends on their
confidence that the bank is sound, and this
confidence can be easily shaken.
A Closer Look at Bank Failure
Two reasons for bank failure:
 The value of bank assets falls, so
assets<liabilities.
 Deposit outflow: A large number of depositors
withdraw their funds from the bank,
exhausting the bank’s cash (reserves) and
other liquid assets.
Therefore a bank is more likely to fail if it has
a low capital/asset ratio or a low reserve ratio.
A Closer Look at Bank Failure
Tradeoff between higher income and a lower
risk of failure:
 Holding other things constant, the bank’s net
income is higher if its capital/asset ratio and
reserve ratio are lower, since then it holds
relatively more interest-earning assets.
 If the bank’s capital/asset ratio and reserve
ratio are higher, it’s less likely that the bank
will fail (so it’s less likely that the stockholders
will lose their capital.)
A Closer Look at Bank Failure
If there were no government regulation of
banks:
 each bank would choose a capital/asset ratio
and a reserve ratio to maximize the value of the
bank.
 depositors would want to deposit their money in
banks that are well managed, so banks would
have an incentive to choose capital/asset ratios
and reserve ratios that reduce the threat of bank
failure.
 “market discipline”
A Closer Look at Bank Failure
But if there were no government regulation
of banks:
 banks would choose capital/asset ratios and
reserve ratios that are too low from society’s
standpoint.
 banks would take on too much risk, so there
would be too many bank failures, and the
government would have to spend too much
money to assist troubled banks.
An Example:
Continental Illinois Bank
 Continental Illinois Bank failed in 1984.
 The federal government paid billions of
dollars to keep Continental Illinois from
closing.
 This was the biggest bank “resolution” in U.S.
history.
An Example:
Continental Illinois Bank
Before it failed, Continental Illinois Bank:
 was the largest bank in Chicago.
 was the seventh-largest bank in the U.S.
 had 57 offices in 14 states and 29 foreign
countries.
An Example:
Continental Illinois Bank
Why did Continental Illinois fail?
 Starting in the late 1970s, the bank grew fast, with
lots of loans to businesses.




Poor quality loans
Too many loans to firms in the oil industry
Too many loans to borrowers in Latin America
“Continental Illinois is willing to do just about anything
to make a deal.”
 High cost of funds
 Large share of funds borrowed from other banks
 Relatively small reliance on domestic deposits
 Heavy borrowing in foreign money markets
An Example:
Continental Illinois Bank
The Bank’s Troubles
 By 1984 the bank’s nonperforming loans
(loans on which payments were late) rose to
$5.2 billion (over 10% of total loans).
 May 1984: an electronic “bank run” –
depositors withdrew billions of dollars in
deposits
 The FDIC and the Federal Reserve System
pledged their support for the bank and lent
over $5 billion.
An Example:
Continental Illinois Bank
Dangers
 Many smaller banks had deposits at
Continental Illinois, so the failure of
Continental Illinois could have caused some
of them to fail, too.
 Other depositors (including many important
corporations) could lose some of their funds
 Foreign investors would lose confidence in
U.S. banks
An Example:
Continental Illinois Bank
Rescuing Continental Illinois Bank
 Continental Illinois Bank had $3 billion in
insured deposits and $30 billion in
uninsured deposits. The FDIC promised to
guarantee all deposits.
 The FDIC assumed the Bank’s 3.5 billion debt
to the Federal Reserve.
 The FDIC bought $1 billion in Continental
Illinois stock – the FDIC “owned” the bank.
An Example:
Continental Illinois Bank
Lessons from Continental Illinois Bank
 Banks have an incentive to take on too much
risk, so they need closer supervision
 The failure of a very large bank could have
broader negative effects
 Rescuing a large bank can be expensive for
the government
 Good sources:
 www.fdic.gov/bank/historical/managing/contents.pdf -- Part II, Chap. 4
 http://www.fdic.gov/bank/historical/history/vol1.html -- Chap. 7
Bank Regulation: An Overview
In the U.S. the government regulates banks in
many ways:
 Federal deposit insurance
 Imposing capital requirements (minimum
capital/asset ratios)
 Imposing reserve requirements (minimum
reserve ratios)
 Restricting the types of assets that banks
may hold
 Performing bank examinations (periodic
auditing reviews)
Bank Regulation: An Overview
Primary bank regulators in the U.S.:
 Office of the Comptroller of the Currency (OCC)

part of the U.S. Department of the Treasury
 Federal Reserve System – the U.S. central bank
 Federal Deposit Insurance Corporation (FDIC)
 State bank regulators
Federal Deposit Insurance
 The U.S. Congress created the Federal
Deposit Insurance Corporation (FDIC) in
1933, after the bank failures in the Great
Depression.
 Today the FDIC guarantees each bank
deposit up to a maximum of $100,000.
 FDIC insurance is funded by a small fee paid
by banks based on their deposits.
Bank Failures in the Great Depression
Annual Number of Bank Suspensions
4500
4000
3500
3000
2500
2000
1500
1000
500
0
2
19
1
2
19
2
2
19
3
2
19
4
2
19
5
2
19
6
2
19
7
2
19
8
2
19
9
3
19
0
3
19
1
3
19
2
3
19
3
3
19
4
3
19
5
3
19
6
3
19
7
3
19
8
3
19
9
4
19
0
Effects of Federal Deposit Insurance
Deposit insurance prevents bank runs
 Prevents losses by small depositors
 Reduces “systemic risk” in the banking
system
Deposit insurance gives banks
incentives to:
 hold riskier assets.
 hold less capital.
 manage the bank’s assets less carefully.
Incentive Effects of Deposit Insurance:
A Closer Look
Deposit insurance increases the supply of
deposits (within the insurance coverage
limits).
Therefore banks can attract deposits more
easily and can pay lower interest rates on
their deposits even if they pursue risky
strategies that increase the risk of bank
failure.
As a result, deposit insurance reduces banks’
incentives to avoid risk.
Capital Requirements
 When there’s deposit insurance, banks have
an incentive to hold too little capital.
 Therefore the government imposes capital
requirements to ensure that banks hold
sufficient capital.
Capital Requirements
 A simple capital requirement would require
that a bank’s capital/asset ratio be greater
than or equal to a specified level.
 Example: capital/asset ratio ≥ 0.05.
 Problem: Not all assets are equally risky. A
simple capital requirement gives a bank an
incentive to hold more risky assets.
Risk-weighted Capital
Requirements
At an international conference in Basel,
Switzerland in 1988, bank regulators from the
world’s affluent countries agreed to impose
risk-weighted capital requirements:
 Classes of assets are assigned risk weights
between 0% and 100%.
 Risk-free assets carry a weight of 0%, and
more-risky assets carry higher weights.
 Capital requirements then set a minimum for the
ratio of capital to risk-weighted assets.
Risk-weighted Capital Requirements:
An Example
Assets
Amount
Risk weight
Weighted
assets
Cash
$10,000,000
0%
$0
T-bills
$190,000,000
0%
$0
Municipal
bonds
$50,000,000
20%
$10,000,000
Mortgages
$300,000,000
50%
$150,000,000
$40,000,000
100%
$40,000,000
Home equity
loans
TOTALS
$590,000,000
$200,000,000
Risk-weighted Capital Requirements:
An Example
 In this example, if regulators require the bank to
maintain its risk-weighted capital ratio at a level
of at least 8%, then the bank’s capital must be
at least $16,00,000 (or 8% of $200,000,000).
 If the bank acquires another $1 million in
capital, it could invest up to:



$12.5 million more in home-equity loans
$25 million more in home mortgages
$62.5 million more in municipal bonds
 So risk-weighted capital requirements give the
bank an incentive to hold less-risky assets.
Proposed Capital Requirement Reform:
Basel 2
 Problem: Assets within a risk class might
expose banks to different amounts of risk.
 Bank regulators have designed a new system
of bank capital requirements – Basel 2 – that
will provide better incentives for banks to
manage their risks in a way that promotes
bank stability.
 Basel 2 will take effect in some countries in
2007.
 http://www.bis.org/publ/bcbsca.htm
Reserve Requirements
 The Federal Reserve System requires banks
to hold reserves that are greater than or
equal to a specified percentage of their
checkable deposits:


3% for smaller banks
10% for larger banks
Reserve Requirements
 But reserves are higher than they need to be to
promote stability of the banking system.
 Today reserve requirements are more
important in macroeconomic policy – they tie
bank reserves to deposits, so the central
bank can try to control deposits by controlling
reserves.
Restrictions on Asset Holdings
Bank regulations include the following:
 Banks cannot hold common stock.
 Banks cannot invest too large a share of their
deposits in a single loan or in loans to
businesses in a single industry.
 Banks cannot lend funds to bank directors,
managers, or principal shareholders at belowmarket rates.
Bank Examinations
 Banks are visited on a regular schedule by
bank examiners from the OCC, the Federal
Reserve System, the FDIC, or other
agencies.
 Bank examiners review the bank’s financial
statements and its confidential accounts.
 The results are summarized in a “CAMELS”
rating given to the bank.
Bank Examinations
 Capital adequacy
 Asset quality
 Management
 Earnings
 Liquidity
 Sensitivity to market risk
CAMELS ratings
1
2
3
4
5
Sound in every respect
Fundamentally sound, but with modest
weaknesses that can be corrected
Moderately severe to unsatisfactory
weaknesses; vulnerable if there’s a business
downturn
Many serious weaknesses that have not been
addressed; failure is possible but not imminent
High probability of failure in the short term
Bank Examinations
 CAMELS ratings are disclosed to bank management,
but not to the public.
 If the CAMELS rating for a bank is unfavorable,
regulators can take actions like these:
 Require banks to disclose unfavorable information
in their public financial statements
 Issue a “cease and desist” order requiring the
bank to stop doing things that cause financial
troubles and to correct problems.
 Impose fines (up to $1,000,000 per day).
Bank Examinations
Bank Examinations
 Good sources on bank examinations and the
FDIC:
www.fdic.gov/regulations/examinations/index.html
www.fdic.gov/bank/analytical/banking/1999oct/1_v12n2.pdf
The Banking Crisis of the 1980s
 Hundreds of savings and loan associations (S&L’s)
and banks failed in the 1980s and early 1990s.
 This episode illustrates:
 how changes in the market environment and a
loosening of regulations can lead to a bank crisis.
 how government regulators can handle
widespread bank failures.
 how regulations and supervisory standards can be
improved to address new problems.
Magnitude of the Crisis
 From 1980 through 1994, over 2,900 banks
and S&L’s failed.
 1,617 banks with total assets of $302.6
billion
 1,295 S&L’s with total assets of $621 billion
 On average, a bank or S&L failed every 15
days from 1980 to 1994.
 During this period, about one out of every six
banks or S&L’s (holding a total of over 20% of
the assets of the system) was closed or got
government assistance.
Magnitude of the Crisis:
Number of Bank Failures Per Year
Causes of the Banking Crisis
The banking crisis had many causes,
including:
 changes
in the market environment
 looser regulations that gave S&L’s more
competitive options
Causes of the Banking Crisis:
Changes in the Market Environment
As a result of financial innovations in the
1960s and 1970s:
 banks and S&L’s faced more competition
from other financial firms (such as mutual
funds).
 new kinds of financial assets (such as
futures and other derivatives) made it
possible for investors (including banks and
S&L’s) to take on more risk.
 the financial market environment was more
complicated and harder for regulators to
monitor.
Causes of the Banking Crisis:
Changes in Regulation
 The banking industry was partially
deregulated in the early 1980s:


S&L’s had mostly been restricted to home
mortgage lending before, but now they were
allowed to invest in commercial real estate
and consumer loans.
S&L’s were allowed to invest in junk bonds
(low-quality, high-risk commercial bonds) and
common stocks.
Causes of the Banking Crisis:
Changes in Regulation
Source:www.fdic.gov/bank/historical/history/421_476.pdf
Causes of the Banking Crisis
 As a result, S&L’s held more risky assets,
resulting in huge loan losses.
 S&L management had little expertise in
managing risks from new kinds of assets.
 Regulators had little experience in monitoring
the new risks.
 Since S&L deposits (up to $100,000) were
protected by federal deposit insurance,
depositors had little incentive to monitor S&L
risks.
Regulatory Failures in the Crisis
Regulators of S&L’s did not close insolvent
institutions and end the crisis quickly.
 The deposit insurance fund wasn’t large
enough to cover losses.
(The S&L deposit insurance fund had a
balance of -$75 billion in 1988.)
 Regulators wanted to encourage the
growth of the S&L industry, not close
S&L’s.
 Regulators hoped the crisis would pass
without revealing their failures.
Managing the Crisis
In 1989 the government created the
Resolution Trust Corporation (RTC) to handle
S&L’s that were failing.
Functions of the RTC:
 Took over assets of failing S&L’s and sold
them to recover as much of their value as
possible.
 Issued bonds to fund the costs of covering
S&L losses.
Who Paid the Cost?
 Bank and S&L stockholders
 Some depositors who had large
deposits that exceeded the deposit
insurance limits
 Taxpayers, who ultimately will pay
higher taxes to pay off bonds that were
issued to fund the costs of the crisis.
Regulatory Reforms Following the
Crisis
 Some regulatory agencies that had not been




effective were eliminated, and their powers were
given to other agencies.
Earlier restrictions on assets holdings by S&L’s
were reinstated.
S&L’s were required to raise their capital/asset
ratios.
Now bank examiners visit banks more frequently
than before.
Regulators were required to act more quickly
when a bank or S&L is failing.
Regulatory Reforms Following the
Crisis
Source:www.fdic.gov/bank/historical/history/421_476.pdf
Lessons from the Banking
Crisis
The U.S. banking crisis in the 1980s was
similar to bank crises in other countries:
 Financial liberalization allowed banks to take
more risks, but there was not yet adequate
government regulation and supervision of
those risks.
 A government “safety net” created moral
hazard problems and eliminated some market
discipline.
The Banking Crisis of the 1980s
Two excellent sources:
 Managing the Crisis: The FDIC and RTC
Experience
www.fdic.gov/bank/historical/managing/index.html
 History of the Eighties - Lessons for the
Future
www.fdic.gov/bank/historical/history/index.html