FINANCIAL INDUSTRY
STRUCTURE
Chapter 9
Decline of Glass-Steagal Act
• In 1927, interstate banking eliminated.
• In 1933, Glass-Steagal act created FDIC and separated
banking business from securities business.
During 1990’s, these regulations were eliminated and US
banks had a wave of consolidation and concentration.
Concentration
% of US Banking Assets held by Banks larger than
$10Billion
90.00%
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
2014
2007
2000
1993
Bank Holding Companies
•
Bank holding companies have a corporate structure in
which a parent company owns many subsidiaries in
different financial industries.
1.
2.
3.
4.
Subsidiaries engage in banking, securities, real estate and
insurance business.
Subsidiaries are separate legal entities so the bankruptcy of
one does not mean losses for the other.
Losses at one subsidiary do result in losses for
shareholders of the holding company.
Banks mostly protected from risk of sister companies.
Advantages: Protects depositors & bank capital from market
risk. One stop shopping can help build relationships.
Disadvantages: Bank holding company bankruptcies may
force bankruptcy of commercial banking. Hard for senior
management to align practices.
Financial Innovation and The Decline of
Traditional Banking
• Banking is traditionally the business of accepting
short-term retail deposits and making long-term
loans.
• A number of financial innovations have led to
changes in the financial industry and financial
regulation.
• Due to reductions in information & transaction
costs, the banking industry in US, Japan, and
Europe faces competition for both deposits and
credit.
Shadow Banking System
• Over the last 30 years, competitors to banks in providing
traditional banking services. The competitors include
• Investment/Merchant Banks
• Mutual Funds
• Hedge Funds
• GSE’s
• Pension Funds/Insurance Companies
• Finance Companies
• The FSB defines shadow banking as “credit intermediation
involving entities and activities (fully or partially) outside the
regular banking system”. In the Global Shadow Banking
Monitoring Report 20121, the term “Other Financial
Intermediaries” (OFIs) which include NBFIs except insurance
companies, pension funds or public sector financial entities, was
used as a conservative proxy for the size of shadow banking.
IMF Global Financial Stability Report - Chapter 2: Global Shadow Banking
Decline in Advantage in Providing Liquidity
• New Competition: Money Market Mutual Funds – Mutual funds
that are redeemable at a fixed price by writing checks. Mutual
funds invest in money markets. These are essentially checking
accounts issued by non-financial institutions that pay interest.
Decline in Advantage in Providing Credit
• Another of banks comparative advantage is their
ability to provide loans quickly and provide credit
to small or new firms.
• New Competition
• Commercial Paper: Short-term corporate bonds.
Many firms that relied on banks for short-term loans
now issue commercial paper.
• Junk Bonds: Bonds issued by firms with noninvestment grade credit ratings. Many firms that relied
on banks for credit now issue junk bonds.
Jan, 1991
Aug, 1991
Mar, 1992
Oct, 1992
May, 1993
Dec, 1993
Jul, 1994
Feb, 1995
Sep, 1995
Apr, 1996
Nov, 1996
Jun, 1997
Jan, 1998
Aug, 1998
Mar, 1999
Oct, 1999
May, 2000
Dec, 2000
Jul, 2001
Feb, 2002
Sep, 2002
Apr, 2003
Nov, 2003
Jun, 2004
Jan, 2005
Aug, 2005
Mar, 2006
Oct, 2006
May, 2007
Dec, 2007
Jul, 2008
Feb, 2009
Sep, 2009
Apr, 2010
Nov, 2010
Jun, 2011
Jan, 2012
Aug, 2012
Mar, 2013
Oct, 2013
May, 2014
Millions US$
Commercial Paper Outstanding: sa: Total
2500000
2000000
1500000
1000000
500000
0
US Corporate Bond Issuance US$ Billions
1,600.0
1,400.0
1,200.0
1,000.0
800.0
600.0
400.0
200.0
0.0
1996
1997
1998
1999
2000
2001
2002
2003
2004
Investment Grade
2005
2006
High Yield
2007
2008
2009
2010
2011
2012
2013
Loan Commitments & Letters of Credit
Banks collect fees for additional off balance sheet
activities
1. Loan Commitment: A line of credit giving
company ability to borrow when desired.
2. Letter of Credit: Promise by a bank to make
good on customer’s credit from another party.
Commercial LOC: Customer buys goods on credit.
If they get LOC from bank, the bank promises to pay
trade bill if the customer does not.
B. Standby LOC: If issuers of commercial paper, get
LOC from bank, the bank promises to pay bond
investors if issuer defaults.
A.
Loan Commitments
5,000,000,000
4,500,000,000
4,000,000,000
3,500,000,000
3,000,000,000
2,500,000,000
2,000,000,000
1,500,000,000
1,000,000,000
500,000,000
0
2014
2009
2004
Credit Card & Home Equity Line of Credit
1999
Loan Commitments
1994
Loan Securitization
• Banks make loans in a certain class, bundle the
loans into a portfolio, sell securities, and dedicate
the principal and interest payments on the loans to
making coupon and face value payments on the
securities.
• Banks profits come as fee for setting up loan back
securities.
• Banks reduce the maturity mismatch between
assets and liabilities by raising funds this way
instead of deposits reducing interest rate and
liquidity risk.
• Primarily mortgage loans are securitized but also
securitization of credit card receivables, auto loans and
even leasing payments by rental companies.
Securitization
Banks collect fees for
making loans and
collecting repayment
Borrower
Borrower
Borrower
Borrower
Borrower
Loans
Bank
Will bundle loans
And sell to 3rd party
Bundle
3rd Party
Securitization
Company
(typically GSE)
Bonds
Bond Market
Mortgage Debt by Owners
16000000
14000000
12000000
Millions US$
10000000
8000000
6000000
4000000
2000000
0
Axis Title
Mortgage Debt: Mortgage or Pool Trusts
Mortgage Debt: Federal & Related Agencies
Mortgage Debt: Major Financial Institutions
Individuals & Others
Other Tyes of Securitization, Billions USD
900.0
800.0
700.0
600.0
500.0
400.0
300.0
200.0
100.0
0.0
19851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010201120122013
Automobile
Credit Card
Equipment
Student Loans
Vanilla Mortgage Backed Security
• A bond that raises funds to buy a bundle of mortgages
and uses income to repay bondholders.
• Usually sold to or guaranteed by GSE (Govt. Natl
Mortgage Assoc., Fed. Natl Mortgage Association,
Federal Home Loan Mortgage Corp.)
Mortgages
MBS
Bondholders
Mortgages
Mortgages
Single Tranche
Collateralized Mortgage Obligations
• A special purpose vehicle that buys mortgages and
structures payments into tranches.
• Usually private label, SPV/SPE , in order to expand base
of allowable mortgages.
Special purpose vehicle/entity: Quasi-independent company set
up to manage asset.
Senior Tranche AAA
Mortgages
CMO
Mortgages
Mortgages
Junior Tranche
CMO: Collateralized Mortgage Obligations
Sample
• An SPV is set up to
purchase mortgages
and issue bonds which
pay out in tranches.
Tranches are
orderings of payments
in terms of seniority.
Each tranche is has itsM. Brunnermeier, Princeton U. Slides.
Commercial and Investment Banks
own credit rating.
often set up SPV
Special purpose vehicle: Quasiindependent company set up to
manage asset.
Structured Securities
• Securitized bonds w/o GSE guarantees are risky because
in a slump not all mortgage borrowers will repay their debts.
But income is highly diversified.
• CMO’s structure payments according to seniority. Most
senior tranches have first call on income, so only lose
money if a large fraction of borrowers fail to repay.
• CMO’s concentrate risk among most junior tranches,
synthetically creating safe senior securities.
Collateralized Debt Obligations
• A special purpose vehicle that buys quantities of debt
securities (often MBS or CMO tranches) that might be low
rated and turn it into tranches some of which might be
better rated.
Senior Tranche AAA
BBB Securities
SPV
Junior Tranche
BBB Securities
BBB Securities
AAA tranches may have paid
higher returns than typical
AAA securities. Attractive to
institutions restricted to AAA
Sub-prime Lenders
• An industry of financial intermediaries that specialized in
making mortgage loans pre-packaged for securitization
arose.
• Many of these specialized in the sub-prime market.
• Typically, these were sold to SPV’s rather than GSE’s.
• Investors in CMO’s and CDO’s financed their purchases
with short-term borrowing and issuing commercial paper
often sold to MMMF’s.
• Shadow banking reduced maturity mismatch in traditional
banking sector but only shifted it to investment banks and
mutual funds.
End of Housing Bubble
• In 2005, housing prices reached a peak.
• However, by reducing lending standards and increasing
reliance on sub-prime lending, mortgage lending
continued to grow.
• By 2007, housing prices began to fall.
Jan, 2000
Apr, 2000
Jul, 2000
Oct, 2000
Jan, 2001
Apr, 2001
Jul, 2001
Oct, 2001
Jan, 2002
Apr, 2002
Jul, 2002
Oct, 2002
Jan, 2003
Apr, 2003
Jul, 2003
Oct, 2003
Jan, 2004
Apr, 2004
Jul, 2004
Oct, 2004
Jan, 2005
Apr, 2005
Jul, 2005
Oct, 2005
Jan, 2006
Apr, 2006
Jul, 2006
Oct, 2006
Jan, 2007
Apr, 2007
Jul, 2007
Oct, 2007
Jan, 2008
Apr, 2008
Jul, 2008
Oct, 2008
Jan, 2009
Apr, 2009
Jul, 2009
Oct, 2009
Jan, 2010
Apr, 2010
Jul, 2010
Oct, 2010
Jan, 2011
Apr, 2011
Jul, 2011
Oct, 2011
House Price Index: FHFA: Purchase Only: US: Jan1991=100
235
225
215
205
195
185
175
165
155
145
135
10
8
1985Q1
1985Q3
1986Q1
1986Q3
1987Q1
1987Q3
1988Q1
1988Q3
1989Q1
1989Q3
1990Q1
1990Q3
1991Q1
1991Q3
1992Q1
1992Q3
1993Q1
1993Q3
1994Q1
1994Q3
1995Q1
1995Q3
1996Q1
1996Q3
1997Q1
1997Q3
1998Q1
1998Q3
1999Q1
1999Q3
2000Q1
2000Q3
2001Q1
2001Q3
2002Q1
2002Q3
2003Q1
2003Q3
2004Q1
2004Q3
2005Q1
2005Q3
2006Q1
2006Q3
2007Q1
2007Q3
2008Q1
2008Q3
2009Q1
2009Q3
2010Q1
2010Q3
2011Q1
2011Q3
2012Q1
2012Q3
2013Q1
2013Q3
2014Q1
12
Mortgage losses
estimated at
$1.4 trilion by
IMF
Credit
performance
worse at subprime lenders.
6
4
2
0
Delinquency rate on all loans; All commercial banks (Seasonally adjusted)
Delinquency rate on loans secured by real estate; All commercial banks (Seasonally adjusted)
Liquidity of CMO’s and CDO’s
• There is much uncertainty and asymmetric info in CMO’s.
Difficult for a potential investor to evaluate quality of the
mortgage loan bundle while bundler/seller may have
better idea.
• Increased risk has generated lemon’s problem.
• Wide bid/ask spreads makes it difficult to reasonably
implement M2M accounting.
Issues
• Capitalization: Banks and other holders of mortgage
backed securities are likely to take large losses on
defaults.
• Liquidity: MMMF are supposed to be safe investments;
once risk becomes known MMMF‘s pull out of commercial
paper market go into treasuries.
• Complexity: CDO’s and CMO’s are complicated
instruments; difficult to tell good from bad. In hard times,
adverse selection may make selling them w/o huge
discount problematic.
• Business cycle issue. Large contraction in consumption
and investment likely to make default rates rise.
Shadow Banking and Asia
• FSB uses OFI’s (non-bank financial institutions less
insurance, pension funds & public institutions) as indicator
of shadow banking (Unit Trusts/Mutual Funds, Finance
Companies, Credit Unions, Brokerage Companies,
Structured Finance).
• Shadow banking in Asia generally:
• Small relative to banking sector but growing
• Mostly not financed through financial markets.
• Mostly finances simple loans or vanilla securities.
FSB Shadow Banking in Asia
• IMF Global Financial Stability Report
Chinese Banking System
1.
2.
3.
4.
5.
6.
Major Commercial Bank (BoC, ICBC, CCB, ABC)
Joint-Stock Commercial Bank (CITIC Industrial Bank, Bank of
Communications, Everbright)
City Commercial Bank (Bank of Shanghai, Bank of Beijing, Bank of
Tianjian)
Credit Cooperatives (Collective Banks – Urban and Rural)
Policy Banks (Export Import Bank, China Development Bank)
Trust Companies
2014 Q1 China Banking Regulatory
Commission RMB Billion
Total
Other (NBFI & Public)
Rural FI
City
Joint Stock
Major Commercial
CBRC
0
20000
40000
60000
80000 100000 120000 140000 160000 180000
Chinese Trust Companies
• China has heavily
regulated deposit
rates.
• Rich people seek
higher yields. WMP
direct funds to trust
companies –
specialized lenders
that finance projects
that cannot access
traditional banks.
Increasing Share of Lending through nonstandard channels.
160000
• Entrusted Loan: Firm
140000
120000
100000
80000
60000
40000
20000
Non Financial Enterprise Equity Financing
Net Corporate Bond Financing
Banker's Acceptance Bill
Trust Loan
Entrusted Loan
Loan in Foreign Currency
Loan in Local Currency
01-Sep-15
01-Mar-14
01-Dec-14
01-Jun-13
01-Sep-12
01-Dec-11
01-Jun-10
01-Mar-11
01-Sep-09
01-Dec-08
01-Mar-08
01-Jun-07
01-Dec-05
01-Sep-06
01-Mar-05
01-Jun-04
01-Sep-03
01-Dec-02
0
to firm loans with
bank/trust company
intermediation.
• Trust loan: Loan from
trust company, less
likely to SOE’s.
Link
Growth in Debt
Aggregate Financing/GDP
200.00%
190.00%
180.00%
170.00%
160.00%
150.00%
140.00%
130.00%
120.00%
110.00%
100.00%
Banking System in 2002/2004:
(Source: Asian Wall Street Journal {2002}/ BusinessWeek {2004})
Big Four Banks
Official
NPL
Ratio
Industrial & Commercial Bank of 21.56%
China
Bank of China
18.07%/
5.46%
China Construction Bank
11.92%/
3.08%
Agricultural Bank of China
30.07%
Reasons that NPL’s fell so fast
• [AMC’s] Asset Management Companies
have purchased Yuan 1.4 Trillion worth of
bad loans from banks.
• Credit Management : Banks have
improved their lending practices.
• More Loans- Banks have gone on a
lending binge and fresh loans may not
have gone bad yet.
Currency Internationalization
• China creating an offshore Renminbi market by
allowing Hong Kong residents to keep quota of
RMB deposits .
MacCauley Renminbi internationalisation and China’s financial
Development BIS Quarterly Review, December 2011
http://www.bis.org/publ/qtrpdf/r_qt1112f.pdf
Dec, 1980
Oct, 1981
Aug, 1982
Jun, 1983
Apr, 1984
Feb, 1985
Dec, 1985
Oct, 1986
Aug, 1987
Jun, 1988
Apr, 1989
Feb, 1990
Dec, 1990
Oct, 1991
Aug, 1992
Jun, 1993
Apr, 1994
Feb, 1995
Dec, 1995
Oct, 1996
Aug, 1997
Jun, 1998
Apr, 1999
Feb, 2000
Dec, 2000
Oct, 2001
Aug, 2002
Jun, 2003
Apr, 2004
Feb, 2005
Dec, 2005
Oct, 2006
Aug, 2007
Jun, 2008
Apr, 2009
Feb, 2010
Dec, 2010
Oct, 2011
Aug, 2012
Jun, 2013
Apr, 2014
Hong Kong Deposits
Deposits: HK$
Deposits: US Dollar: Exclude Foreign$ Swap
Deposits: Renminbi: Total Outstandings
Other
12000000
10000000
8000000
6000000
4000000
2000000
0
Issuance of RMB denominated bonds by Chinese and
overseas issuers in “dim sum” market.
Link
Trade Settlement
Link
Offshore RMB FX Market
RMB Daily Turnover, April 2013
20
18
16
Billions US$
14
12
Delivarable Forward
10
Spot
8
6
4
2
0
Onshore
Hong Kong
Other Offshore
Shu, He, and Cheng, 2013
Advantages
• Chinese (and other!) companies can settle and invoice in
Renminbi.
• In 2010, 2% of China’s trade was settled in RMB. In 2011, nearly
7%
• Create more balanced international portfolio of assets.
• Questions: Can China have international currency without
capital account convertibility.
• Over the last decade,
rapid increase in
globalization of
banking.
• Retrenchment after
2008
1995-Q4
1996-Q3
1997-Q2
1998-Q1
1998-Q4
1999-Q3
2000-Q2
2001-Q1
2001-Q4
2002-Q3
2003-Q2
2004-Q1
2004-Q4
2005-Q3
2006-Q2
2007-Q1
2007-Q4
2008-Q3
2009-Q2
2010-Q1
2010-Q4
2011-Q3
2012-Q2
2013-Q1
2013-Q4
2014-Q3
2015-Q2
Cross border lending
Global Bank Lending by Recipient
25
20
15
10
5
0
B:Banks, total
N:Non-banks, total
Regional Lending Growth
• International banking
to the Asian region is
growing.
• Increasing regional
exposure.
Dec, 1980
Oct, 1981
Aug, 1982
Jun, 1983
Apr, 1984
Feb, 1985
Dec, 1985
Oct, 1986
Aug, 1987
Jun, 1988
Apr, 1989
Feb, 1990
Dec, 1990
Oct, 1991
Aug, 1992
Jun, 1993
Apr, 1994
Feb, 1995
Dec, 1995
Oct, 1996
Aug, 1997
Jun, 1998
Apr, 1999
Feb, 2000
Dec, 2000
Oct, 2001
Aug, 2002
Jun, 2003
Apr, 2004
Feb, 2005
Dec, 2005
Oct, 2006
Aug, 2007
Jun, 2008
Apr, 2009
Feb, 2010
Dec, 2010
Oct, 2011
Aug, 2012
Jun, 2013
Apr, 2014
Millions HK$
8000000
7000000
6000000
5000000
4000000
3000000
2000000
1000000
0
To Finance Imports to and Exports & Re-exports from HK
To Finance Merchandising Trade Not Touching HK
Other Loans for Use in HK
Other Loans for Use outside HK
Other Loans where the Place of Use is Not Known