Commercial Banking Industry
Structure

Preview
• This chapter examines the historical trends in the banking industry that help explain the unique structure of the U.S. system.

Overview
•
US banking system very different from rest of the world.
•
Many small banks.
•
U.S. has about 7,000 commercial banks for a population of about 300 million.
This is down from 14,000 in the mid
1980’s.
•
Canada has 21 banks for about 36 million.
•
Norway has 4 banks for 4.5 million.

Why is the US Unique?
•
Need to look at the history of banking in the
US.

Need to look back to the 1700’s
•
•
Jefferson
States rights
Limit federal power
Hamilton
• Federal rights
•
Expand Government and centralize power
•
National or central bank • No national or central bank
•
State control of banking •
Federal control of banking

Figure 1 Time Line of the Early History of Commercial
Banking in the United States

Early History
•
1791 - Bank of the United States chartered for 20 years. First attempt at a central bank to controlled money supply and credit.
•
Agricultural interest very skeptical of concentration of power in large eastern cities, advocated state charters.
•
1811 - charter not renewed. Defeated by states rights and agricultural interests.

Early History – 1800’s
•
War of 1812 – need to raise funds, some felt need for a national/central bank.
•
1816 - second attempt at central bank. Second
Bank of the United States chartered for 20 years (this was only 5 years later)
•
1832- Andrew Jackson elected. Congress votes to re-charter, Jackson, a strong advocate of states rights, vetoes.

Free Banking Era:1832- 1863
•
Banks chartered and regulated only by the states
•
No national currency
•
Banks issued private bank notes (that could be redeemed for gold) to attract funds
•
Think about going to Tennessee with a bank note issued by a bank in Philadelphia. Money is supposed to reduce information cost and facilitate trade – not the case here!
•
Poor regulation, many banks under capitalized, many failed, bank notes became worthless.

National Banking Act of 1863
•
Created federally chartered banks under supervision of the Office of the Comptroller of the Currency.
•
Tried to eliminate state banks by imposing a
10% tax on state bank notes .
•
Tax did not eliminate state banks .
• Did eliminate state bank notes.
•
State banks created demand deposits.
• Today we have a “dual banking system”
•
2,100 federally chartered banks with 50% of total bank assets.

•
Phobia against large banks and central banking which carried into the 20 th century.
•
State banking system developed in the US rather than the typical national banking system in other countries.
•
Federally chartered banks in 1863. We have a dual banking system in the US

1900s
•
1913 - The Federal Reserve System
•
1927 - McFadden Act
- prohibited branch banking across lines
•
1930 - 1933, the Great Depression
- Banking Act of 1933/ Glass-Steagall Act
- Set up FDIC - deposit insurance.
- Separated commercial and investment banking.
- Restricted checkable deposits to commercial banks
Put interest rate ceilings on bank deposits ( Regulation Q )

McFadden Act - 1927
•
Proposed as being pro-competitive.
•
Actually anti-competitive because small banks insulated from out-of-state competition.
• Some states had “unit banking” – No branches!
•
Big Negative - banks tied to local economy as a result of McFadden Act.
• From 1930-1933, 9000 banks failed in the
US(1/3), compared to 0 in Canada.

How to get around regulations prohibiting branching across state lines
-
Allowed purchase of banks outside state
-
Not considered to be branch of bank
McFadden Act repealed in 1994 by Reigle-Neal Act

Key Legislation Affecting the U.S. Banking
Industry
•
1913 Federal Reserve Act
• 1927 McFadden Act: Outlawed interstate branching and required national banks to abide by the laws of the state in which they operated.
•
1933 Glass-Steagall Act: Established federal deposit insurance and prohibited commercial banks from engaging in the insurance and securities businesses.
•
1994 Reigle-Neal Act: Repealed the McFadden Act
• 1999 Gramm-Leach-Bliley Act: Repealed the Glass-Steagall
Act’s prohibition of mergers between commercial banks and insurance companies or securities firms.

Financial Innovation and the Decline of Traditional
Banking – Attack on the balance sheet
• Commercial bank importance as a source of funds to non-financial borrowers has fallen over time.
• Without a decline in overall profitability

Bank Share of Total Nonfinancial
Borrowing, 1960–2014
40%
20%
28%
5%
Source: Federal Reserve Bank of St. Louis, FRED data base: http://research.stlouisfed.org/fred2/; https://www2.fdic.gov/hsob/index.asp.

Financial Innovation, Increased Competition for Sources of Funds
• Prior to 1980s - Regulation Q
• 60% of bank funds were deposits (now 6%)
•
1970s - π↑ => i↑
( Fisher Equation)
• Major Financial Innovation
• Money Market Mutual Funds (MMMF)
• Disintermediation – banks lost deposits to MMMF.
• Regulation Q eliminated in 1980, but banks lost
Cost Advantages in Acquiring Funds

Financial innovations leading to increase in direct finance – Competition for Use of Funds
• Junk Bonds
• Commercial Paper
• GE Capital is an example of a commercial finance company. At one point the largest issuer of commercial paper in the US.
Loans to buyers of
GE products
Commercial paper

Financial Innovation: Junk Bonds
• Prior to 1980, bonds were never issued that had a junk rating.
• Only firms with Baa or better could direct finance in the bond market.
• The only junk debt was bonds that had fallen in credit rating (so-called fallen angels).
• With improvement in information technology in the 1970s it became easier for investors to screen out bad credit from good credit risks and willing to buy new issue debt rated < Baa.

Financial Innovation: Commercial Paper Market
• Commercial paper refers to unsecured debt issued by corporations (non-financial and financial) with a short maturity.
• Peaked at $2.2 trillion outstanding mid 2007.
• As with junk bonds, improvement in information technology in the 1970s made it easier for investors to screen out bad credit from good credit risks
• Also, the development of money market mutual funds in the 1970s contributed to growth by creating a market for commercial paper.

Commercial Paper Outstanding: 2001 - 2014
13-23

Commercial Paper and ABCP Outstanding:
2001 - 2014
13-24

Bank Response
• Loss of cost advantages in raising funds and income advantages in making loans caused reduction in profitability in traditional banking
• Two Responses:
• Expanded into new and riskier areas of lending
• Commercial real estate loans
• Corporate takeovers and leveraged buyouts
• Increased income from off-balance-sheet activities (noninterest income)
• Trading activities

Bank Consolidation and Nationwide Banking
• The number of banks has declined over the last 25 years
• Combination of bank failures and consolidation.
• Deregulation: Riegle-Neal Interstate
Banking and Branching Efficiency Act f
1994.
• Economies of scale and scope from information technology.
• Not only a smaller number of banks but a shift in assets to much larger banks.

Figure 3 Number of Insured Commercial Banks in the United States, 1934 –2014 (Third Quarter)
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

• Dollar-denominated deposits held in banks outside of the U.S.
• Most widely used currency in international trade
• Offshore deposits not subject to regulations
• Important source of funds for U.S. banks

Another Example of Avoiding Regulation
• Eurodollars
• Dollar denominated deposits in foreign banks or foreign branches of US banks.
• Sweep Accounts: Funds are “swept” out of checking accounts nightly and invested at overnight rates. Since they are no longer checkable deposits, reserve requirement is avoided.

New York Bank
Reserves= $100,000 DD= $1,000,000
Loans= $900,000
Loans=
New York Bank
$1,000,000
Borrow from
Cayman Branch=
$1,000,000
Cayman Branch of NY Bank
DD= $1,000,000