BANKING AND BANK
REGULATION
Economic Forces in American History
Why do banks exist?
To intermediate
– Between lenders and borrowers
• Pooling resources for large-scale projects
– Between maturities (long vs short)
• Borrow short-term, lend long-term
– Between risk-takers and the risk-averse
• Pooling allows diversification
– Between liquid and illiquid
• Cash vs real estate etc.
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TYPES OF BANKS
We will analyze four types of banks:
1.
Merchant Banks – e.g. The House of Rothschild.
2.
Commercial Banks – i.e. depository institutions
3.
Investment Banks, including hedge funds
4.
Central Banks – e.g. the U.S. Federal Reserve
System, which we will cover in the separate
Monetary Policy lecture.
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MERCHANT BANKS
Historically, merchant banks antedated the
other types of banks on our list.
They were primarily:
– Money changers
– Bill brokers
– Family affairs (Rothschilds, Medicis etc.)
– They are provide system of payments
– No large financing of anything (except govt
debt at times)
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Antebellum banks
State-chartered: investors come
together & petition for charter
Charter:
– Must pass state legislature
– Specifies capital paid in etc.
– Gives right to issue bank notes
– Delimits area of investment (if any)
– Specifies shareholder (voting) rights
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What banks did
They focused on stuff that’s banned
today:
– Print their own money (bank notes)
• These circulate and are used for payment
• Farther afield, they circulate at a discount
• See Thompson’s Bank Note Reporter
– Lend money to insiders
• Bank directors get preferential access
– Exploit charter-granted (local) monopolies
• Financing local turnpikes or canals, roads etc.
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More of what banks did
They solicit deposits from gullible suckers…
er, esteemed depositors
Little reporting to outsiders (incl. minority
investors)
Sometimes they overprint their own money
and skip town
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INVESTMENT BANKS
Investment banks, as we know them today, emerged
in the late 19th Century.
They are primarily involved in
– Underwriting and
– Trading on the stock exchange
Their trading activities have grown dramatically in
the last three decades. Today, this trading is often
conducted by hedge funds.
Because they do not take deposits, historically,
investment banks have not been as regulated as
commercial banks.
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COMMERCIAL BANKS
What do (commercial) banks do?
They provide financial intermediation.
They “create” money.
How do they perform these two functions?
By adjusting their “balance sheets.”
The bank balance sheet shows:
Assets- e.g. reserves and loans
Liabilities- e.g. deposits
Stockholder Equity- i.e. bank capital
Note that:
Capital = Assets-Liabilities
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The Balance Sheet
of a Commercial Bank
Assets
Cash Reserves
Loans
Real Estate
Liabilities &
Stockholders’ Equity
300
1,000
100
Savings Deposits
Checking Deposits
Total Liabilities
Bank Capital
Total Assets:
$1,400
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Liabilities &
Bank Capital:
200
1,000
$1,200
200
$1,400
Fractional reserve banking
FRB relies on the fact that depositors
will not come all at once to withdraw
deposits
Most of the time, a sound assumption:
This is what allows the intermediation:
• Cash < Deposits (liabilities)
• Assets less liquid than deposits
• Loans are longer-term than deposits
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The Balance Sheet
of a Commercial Bank
Assets
Cash Reserves
Loans
Real Estate
Liabilities &
Stockholders’ Equity
300
1,000
100
Savings Deposits
Checking Deposits
Total Liabilities
Bank Capital
Total Assets:
$1,400
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Liabilities &
Bank Capital:
200
1,000
$1,200
200
$1,400
The Balance Sheet
of a Commercial Bank
Assets
Cash Reserves
Loans
Real Estate
Total Assets:
Liabilities &
Stockholders’ Equity
300
500
100
$900
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Savings Deposits
Checking Deposits
Total Liabilities
200
1,000
$1,200
Bank Capital
-300
Liabilities &
Bank Capital:
$900
Fractional reserve banking
FRB relies on the fact that depositors
will not come all at once to withdraw
deposits
When they do, it’s a run:
– Depositors run for their money
– Bankers run for their lives
– (Swindlers run for the hills)
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Central banks
Historically central banks were essentially
the government’s bank.
–
–
–
–
It was where govt deposited its money
It invested and traded in govt debt
It provided payment system for govt
It could occasionally be directed to certain
politically sanctioned investment projects
Such is the story of BoE, Austrian
National Bank, Banque de France,
1BUSA & 2BUSA
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Central banks
Historically central banks were essentially
the government’s bank.
However, modern central banks perform
two main functions:
– They serve as “lenders of last resort” – i.e. they
provide liquidity to the banking system during a
crisis. In other words, they are the bankers’
bank.
– Through regulation of commercial bank reserves,
central banks control the money supply. The Fed
also audits commercial bank balance sheets.
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A few ideas from US bank
regulation history
State chartering (1789 - )
Free banking (post-1836)
Unit banking (19th – 20th centuries)
Establishing the Fed (1913)
FDIC (1933)
The Chinese wall (1933)
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Problems with banking regulation
Ongoing financial innovation
– New financial products (investment banks, trusts, holding
companies, mutual funds, investment on margin, hedge
funds, derivatives)
– Laws age fast & fight the last war; regulation gets
circumvented
Information asymmetry
– Insiders always know more
– Private sector pays better (i.e. gets better people)
Regulatory capture
– Regulators respond to incentives, too
– Familiarity breeds alliances
Too big to fail & moral hazard
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U.S. BANKING HISTORY
After the Revolution, states began chartering
commercial banks.
The first Bank of the United States was chartered
by Congress in 1791.
The second Bank of the United States was
chartered in 1816.
The second Bank’s charter expired after 1836;
and it was not renewed.
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LANDMARKS IN U.S. BANKING
HISTORY (CONT.)
National Bank Acts were passed in 1863,1864,
and 1865.
Major bank panics occurred in 1833, 1837, 1839,
1857, 1873, 1893, 1907, 1930-1933.
The Federal Reserve System was created in
1913.
The FDIC was created in 1933.
Economic Forces in American History