COMSATS Virtual Campus
Islamabad
Handouts No 11
Banking Industry: Structure and Competition
U.S. banking industry is very different from the rest of the world. In most countries (Canada,
Germany, France, Japan, UK, etc.) four or five major banks dominate the banking industry with
nationwide branches, (like other industries where a small group of large firms dominate the
market: auto industry, software industry, discount chain stores, office supply stores, etc.). In
contrast, U.S. has 8,100 commercial banks, 1200 S&Ls, and 12,000 credit unions! Compared to
the rest of the world, we have 1) many more banks in general, we have 2) many more small
banks and 3) many fewer large banks.
See page 252. 91% of US banks have less than $500m in assets, and 32% have less than $50m in
assets. The top ten largest banks have only 60% of total assets, compared to Canada or UK
where 4 or 5 banks dominate the industry and have close to 90% of the assets.
Why is U.S. banking system so unique compared to the rest of the world? Partly due to the
McFadden Act (1927) - federal law prohibited branch banking across state lines - which was
recently repealed (1994). Why did the U.S. prohibit branch banking when no other country has
done so? Why did the U.S. separate commercial and investment banking when other countries
allow banks to operate in both areas? Why did so many banks fail in the 1930s and 1980s/1990s
in U.S. when other countries have had very few bank failures? Does the fact that we have the
most regulated banking system in the world have anything to do with the fact that we have had
the most bank failures?
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POINT: To understand the uniqueness of the U.S. banking system, we need to view the entire
history of banking, going back to the beginning of the country, since the uniqueness can be
traced
to
banking
HISTORICAL
history
all
the
way
back
DEVELOPMENT OF THE
to
the
1700s.
U.S. BANKING
SYSTEM
1790 - First Administration. Washington (P), A_______(VP), ____________ (Sect of State), and
___________ (Sect of treasury)
J
H
states
rights
strict
constitution
limit Fed power
no
national
federal
rights
broad
interpretation
expand fed govt., centralize power at federal level
or
state control of banking
central
bank
national
bank
or
central
bank
federal control of banking
Feud over the First National Bank of the U.S. - chartered in 1791 with 20 year charter and
Jefferson resigned in 1793. First attempt at a central bank, although it had elements of both a
private bank and a central bank. Owned partly by the US government, held all deposits of Fed
government. Controlled the supply of money and supply of credit.
Agricultural interests were skeptical of concentrated power of any kind, suspicious of a National
Bank. Somewhat suspicious of concentrated financial power in large Eastern cities like DC and
NYC. Favored state charted banking system.
In 1811, the charter for the First National Bank was not renewed, defeated by Jeffersonians,
states rights, agricultural interests.
State chartered banking system developed, but because of some abuses and because of the need
to raise funds to finance the War of 1812 and because some felt that there was a need to have a
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central bank, a second attempt at a national/central bank was made by the creation of the Second
National Bank of the US in 1816.
Debate and controversy still continued about whether there should be a National Bank - wasn't
explicitly allowed for in the Constitution - and reflected the tension about centralized power at
the federal level vs. decentralized power at the state level. Andrew Jackson was elected in 1832,
and the 2nd Bank applied for a renewal of its charter 4 years early - expired in 1836. Jackson
was strong advocate of states rights. Called the Second Bank of the U.S. a monopoly enjoying
exclusive privileges - only bank chartered by the Fed govt. and the only bank the US fed govt.
did business with. Also supervised the transfer of funds. Jackson favored using many banks.
Supported the grievances of the state banks.
Charter renewal passed Congress, Jackson vetoed and the charter of the Second Bank was not
renewed.
Early history explains: 1) the "historic phobia toward large banks" (and central banking) which
carried over even into the 20th century, 2) our unique banking system of many small banks, 3)
why the McFadden Act (1927) prohibiting branch banking across state lines would eventually
pass and 4) why a strong state banking system developed in the U.S., instead of a more typical
national banking system regulated by the federal govt.
1836-1863 - Era of "free banking."
Banks were regulated/chartered by the
banking commission in each state. Banks issued private bank notes as currency and there was no
national currency issued by the federal government. Bank notes could be exchanged for gold
since the economy operated under a gold based monetary system (gold standard) using
commodity based money. In some states banking regulations were very loose, many banks
failed due to fraud, mismanagement, lack of capital, etc. - their bank notes became worthless.
1863 - National Banking Act of 1863 was passed to create a new banking
system of federally-chartered banks that would eliminate abuses of state-chartered banks by
eliminating state banks. Office of the Comptroller of the Currency was created under the Dept.
of Treasury to supervise the intended new system of only nationally-chartered banks.
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Strategy was to eliminate state-chartered banks by imposing very high taxes on their bank notes
and not taxing bank notes of federally chartered banks, in an attempt to dry up the source of
funds for state banks. In other words, the federal banks were given such a huge competitive
advantage, that the intent was that they would drive state banks out of business. State banks
cleverly started accepting deposits and survived the legislation that was passed to put them out of
business.
Why not just pass a law abolishing state-charted banks?
Because the state-chartered banks survived the National Banking Act of 1863 and we now have
a DUAL BANKING SYSTEM, another unique feature of U.S. banking law that only exists
here.
Banks can either be chartered by the Federal govt. and be a national bank or by an individual
State and be a state-chartered bank, e.g. Michigan National Bank vs Montrose State Bank.
We currently have about 2500 national banks (about 30% of the banks with 50% of the assets)
and 5500 (about 70%) state banks. National banks tend to be much larger, state banks much
smaller in size.
1913 - Central banking reappears after almost a 100 year absence, as the Federal Reserve
System is established, to help promote an even safer banking system. Fed Reserve has two
roles: 1) regulatory role and 2) ____________________ . Establishing a central bank was first
proposed in 1907, took 6 years of debate to overcome lingering fears of concentrated central
power, skepticism toward central banking, etc. and only passed by including several comprise
features including establishing 12 Federal Reserve districts, each with their own district bank to
guarantee that all regions of the country would be represented. This adds yet another unique
feature of U.S. banking unheard of anywhere else: central banking system with district/regional
banks. We study the Fed system in more detail later.
1927 - McFadden Act - prohibited branch banking across state lines, repealed only recently
(1994). Forced all banks to be small and local. Why could that be a problem?
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McFadden Act was proposed to be pro-competitive and put small, state-chartered banks and
large, nationally-chartered banks on an equal footing by only allowing banks to operate in one
state, but the result has largely been anti-competitive. McFadden insulated small banks from
out-of-state competition, and inefficient, weak, small banks cannot be driven out of business by
competition from a more efficient bank from another state, or even the same state.
Branching restrictions varied from state to state. Some states had "unit branch banking" laws,
which permitted only one location, NO branches. In most cases, it was easier for a bank to open
a branch in a foreign country than to open a branch in another state, or even the same state.
Reflects the historic hostility toward large banks. Rent-seeking by small rural banks. Legacy of
19th century politics: heavy restrictions on branch banking, many small, local banks. Similar
result: Sherman Anti-trust Act of 1890.
1930-1933: 9000 bank failures during the Great Depression, about 1/3 of all U.S. banks versus
Canada where 0 banks failed! "Menace of the small bank" - they are tied to the local economy,
result of the McFadden Act.
As part of Depression era banking legislation, Banking Act of 1933/Glass-Steagall Act was
passed. Two main features: 1) established FDIC(deposit insurance) and 2) separated commercial
and investment banking.
FDIC: originally 8 cents / $100 deposits. Maximum account insured was $2500, now it is
$100,000.
All federally chartered banks, and all state banks that were part of the FRS were required to join
FDIC, most of the rest joined voluntarily because it was cheap insurance. Problem with FDIC
originally: flat fee based insurance, not risk-adjusted, led to the problem of moral hazard and
safe banks subsidize the risky banks. Contributed to the S&Ls failures of the 80s/90s. How do
depositors choose a bank when making a $100,000 deposit if all banks are insured?
Because FDIC insured bank deposits, Glass-Steagall separated commercial banks from
investment banks. Commercial banks were insured and could accept deposits, couldn't
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underwrite or own any stock. Restrictions were placed on the assets of the bank - only approved
safe securities and loans. Investment banks couldn't accept deposits, offer savings/checking
accounts, etc. Could offer brokerage services and underwriting.
Insured banks were separated into two main types: commercial banks and savings and loans
(thrifts). Commercial banks were restricted to offering checking accounts and making business
loans. Interest on checking was prohibited until 1980. S&Ls could accept savings accounts and
offer home mortgages. Regulation Q gave FRS the authority to fix interest rate ceilings on
savings deposits until 1986, when Reg Q was repealed. Starting in 1980, S&Ls were allowed to
offer checking accounts.
The separation of banking into a) commercial and b) investment banking is another unique
feature of U.S. banks.
Glass-Steagall was finally repealed in 1999, and there is now widespread competition since
commercial banks can offer brokerage services, and investment banks can offer traditional
banking
services,
like
checking.
SUMMARY:
1. U.S. history explains the "historic phobia towards large bank", the skepticism towards a large
central bank, and how a strong state banking system developed; resulting in a unique banking
system with thousands and thousands of small banks operating in one state only (McFadden
Act).
2. Under the "stress test" of a severe economic contraction in the 30s (Great Depression), 9000
banks failed, over 1/3 all U.S. banks. Main reason for bank failures: the lack of geographic
diversification tied small banks to the local economy. Banking regulations contributed to the
failures.
3. In an attempt to strengthen the banking system and prevent bail failures in the future,
Depression-era banking regulations were passed including FDIC, separation of commercial and
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investment banking with restrictions on bank activities, interest rate controls on checking (0%)
and savings accounts (max. set by FRS), etc., making the U.S. banking system a) one of the most
heavily regulated banking system in the world, and b) one of the most heavily regulated U.S.
industry.
4. The heavy restrictions on banking activities in U.S. led to diligent "loophole mining" as
banks found creative way to circumvent banking laws. "Competition can be repressed but not
completely quashed", page 253. The reason that taxes/regulation are distortionary is that
__________________.
5. The banking regulations of the 1930s laid the groundwork for the next wave of bank failures
during the S&L crisis of the 80s/90s due to: a) rising interest rates, b) duration mismatch, c)
downward
sloping
yield
curve,
d)
flat
fee
based
deposit
insurance,
etc.
WAYS THAT BANKS HAVE CIRCUMVENTED BANKING REGULATIONS:
1. In 1970, a mutual savings bank (offers mortgages and savings accounts, like an S&L, but
structured as a cooperative - depositors own the bank - mostly in NE states) in Mass. found a
way to get around two laws: no checking accounts at mutual savings banks and no interest on
checking.
Problem: interest rates were rising in the 60s, and short term money market rates were many
times higher than the allowable int. on savings by Regulation Q. Banks offer savings accounts
and CDs in competition with other safe short term securities: Tbills, muni bonds, etc. and banks
were losing deposits to higher paying securities. "Financial disintermediation."
The bank offered interest-bearing NOW accounts (negotiable order of withdrawal) and claimed
that they were not technically a checking account, therefore not subject to the legal restrictions
on checking.
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Litigation followed, the mutual savings banks prevailed, and they and S&Ls were allowed to
offer NOW accounts in Mass and N.H. Profits increased because they could compete and attract
deposits.
Commercial banks were upset, didn't like the increased competition. Protested, and in 1974
Congress limited NOW accounts to the NE states, preventing nationwide NOW accounts. In
1980, legislation was passed that allowed all banks to offer checking accounts (commercial, SL,
mutual savings, credit unions) and allowed banks to pay interest on checking.
2. ATS - automatic transfer from savings. Allowed banks to get around not being able to pay
interest on checking. Two accounts: non interest-bearing checking and interest-bearing savings.
Banks would sweep funds from checking over a certain limit, into the savings account to get
interest. As checks would clear, funds would be transferred from savings to checking to cover
the account. Interest was effectively paid on checking.
3. Int. rate ceilings led to offering "gifts" to depositors when market rates were above ceiling.
4. Investment banks started offering what were essentially checking accounts. To get around
banking legislation, certain restrictions would be put on the accounts to distinguish them from
regular checking accounts. Example: minimum check amount, maximum checks per month, etc.
Money market mutual funds, cash management accounts.
5. High interest rates of the 70s led banks to find ways around having assets tied up in non
interest-bearing reserves. Int. rate (%) x Reserves ($) = Tax (opp cost) on bank reserves.
Banks found two sources of funds NOT subject to reserve requirements, which only apply to
checking and savings deposits:
a. Eurodollars - deposits from banks outside the U.S.
b. Commercial paper, issued by bank holding companies.
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6. Banks organized as a "bank holding company" (corporation owning several companies,
several banks) to help get around regulations. 90% of all current bank deposits are in banks
owned by a bank holding company. Advantages of bank holding companies:
a. Allowed the holding company to circumvent branch banking restrictions, especially when
banks started failing in the 1980s and a bank holding company was allowed to buy an out-ofstate bank.
b. holding companies can issue commercial paper to raise funds, not subject to reserve
requirements.
c. holding companies can offer services that traditional commercial banks could not - credit card
services, loan servicing in other states, investment services, courier services, real estate appraisal,
etc.
7. ATM machines. Allowed banks to operate across state lines as long as they didn't own the
ATMs. Someone else owns the ATMs, and the banks pay a fee based on volume. Customer of a
Michigan bank could make a withdrawal from their bank while traveling out of state (or make a
deposit),
which
before
ATMs
was
not
possible.
NATIONWIDE BANKING AND BANK CONSOLIDATION
See page 255. After 50 years of stability, the number of commercial banks has been falling, from
14,000 to 8,000 over the last 15 years, a decline of 6,000 banks. Reasons:
1. Bank failures, see page 275. About 1200 banks failed, explaining 20% of the 6,000 bank
decline.
2. Consolidation and bank mergers explain the other 80% of the decline in the number of U.S.
banks. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 repealed the
McFadden Act, and established the basis for a true nationwide banking system, like almost all
other countries, and now allows banks to merge, consolidate, buy out-of-state banks, etc.
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Why do consolidation and mergers make sense for commercial banks and their customers?
FUTURE OF BANKING
1. Continued consolidation and bank mergers will probably result in the number of banks
going from 8,000 to 4,000, or maybe even only a few hundred, see page 257, Box 1. All
industrialized countries have far fewer than 1000 banks. Japan has fewer than 100 banks, about
1% of the U.S. total.
Using California as an example, there are 400 commercial banks, both large and small. US
banking will probably develop like CA - many large nationwide banks (Citicorp, Chase
Manhattan, First Union) and many small community banks. If the rest of the U.S. develops like
CA, there will eventually be 4,000 banks (estimated). Trade-off between ______________ of
large banks and _________________ of small banks.
2. Repeal of the Glass-Steagall Act with the Gramm-Leach-Bliley Financial Services
Modernization Act of 1999, after repeated failures in almost every session of Congress during
the 1990s. Who would object to deregulation of the financial services industry, allowing
commercial banks to offer brokerage, insurance, real estate activities?
With the repeal of Glass-Steagall, there will now be even more consolidation and merger
activity, as bank now merge across financial service activities, e.g. the Citicorp-Travelers merger
of a commercial bank (Citicorp) and an insurance company (Travelers) that owns an investment
banking firm (Salomon Bros.) into Citigroup, one of the largest financial service firms in the
world.
3. Universal Banking. Probable model of the future of banking in U.S. is universal banking,
like in Germany, Netherlands, Switzerland, where there is no separation at all between
investment and commercial banking. Banks can provide a full range of financial services within
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one legal entity: banking, securities, real estate, insurance, etc. The universal banking model
also exists to a lesser degree in UK, Canada, Australia, and Japan, with more restrictions than in
Germany, Netherlands, Switzerland. As deregulation continues, and as Depression-era laws are
repealed (see pages 290-291), the U.S. is moving closer to universal banking.
DECLINE
OF
TRADITIONAL
BANKING:
FINANCIAL
INNOVATION
AND
FINANCIAL DISINTERMEDIATION
Four financial innovations in the 70s and 80s have contributed to a decline of "traditional
banking" since 1975, see page 271, from about 55% to 35% of total credit in the economy.
1. Money market mutual funds - competition for bank deposits (checking and savings) from
investment banks, in the form of a mutual fund that invests in money market securities (Tbills,
commercial paper, etc.). Market really exploded in the late 70s, when Regulation Q fixed int.
rates on savings accounts at 5.5% when money market rates were over 10%. Massive financial
disintermediation resulted as bank customers took billions of dollars of checking and saving
deposits out of commercial banks. You usually have some check writing privileges with money
market mutual funds and they yield at least, if not more, than saving accounts, these funds
attracted both checking and savings deposits from traditional banks. From 1977 to 1982, money
market mutual funds grew from $4B to $230B!
2. Junk Bonds - Bond market competes with commercial banks for corporate borrowing.
Before 1980s, the only bonds issued were "investment grade" bonds, issued to only the most
creditworthy, well-established, large, blue chip firms.
There were only four bond ratings
available for new issues (AAA, AA, A, BBB), all investment grade ratings. The other five bond
ratings (BB and below) were used when an investment grade company got in financial trouble,
and became "fallen angels", and got their bond rating downgraded to "junk status."
Reason: in the pre-computer era it was harder and more expensive to get information about the
financial position and creditworthiness of small, medium and lesser known corporations, so they
were unable to issue bonds. Therefore, the smaller, medium-sized, younger firms could not issue
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bonds, they had to go to a bank for a commercial loan. Once information costs were reduced,
high yield bond market opened up.
Michael Milken and Drexel-Burnham opened up the bond market by opening up trading in highyield bonds, not for "fallen angels" but for firms that had not reached investment grade status.
Most of the computer revolution was financed with "junk bonds." MCI, other well known
companies started with junk bonds.
Junk bonds are an alternative for long term bank loans for non-investment grade companies, and
as this market developed in the 1980s, financial disintermediation took place as thousands of
firms issued bonds instead of using bank loans for debt financing.
3. Commercial paper - junk bonds are alternatives to long-term bank loans, commercial paper is
an alternative to short-term bank credit. Also led to financial disintermediation as credit shifted
away from banks to the commercial paper market, and commercial banks got cut out.
Development of the commercial paper market was also made possible by information revolution,
made it easier to assess credit risk.
Pension funds and money market funds provide the supply of credit for commercial paper.
Commercial paper and money market mutual funds grew together. Money market funds started
getting lots of funds to invest, commercial paper provided the ideal short term money market
instrument - liquid, low risk, short term. Significant increases in both the supply of credit
(money market funds) and the demand for credit (corporations) created the commercial paper
market, it grew from a $33B to $1200B over the last several decades.
4. Securitization - transforming illiquid financial assets into standardized, liquid, marketable
securities. This financial innovation also resulted from information technology lowering
transaction costs and is another example of financial disintermediation, money/credit flowing
away from traditional banks. In this case the credit market for residential real estate loans shifted
away from commercial banks (especially S&Ls) toward mortgage companies using securitized
mortgages.
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Residential mortgage industry gradually became securitized starting in the 1970s. Now 2/3 of
home mortgages are securitized. Single mortgage - not very marketable. Why?
Banks
and
mortgage
companies
started
packaging
individual
mortgages
in
large
bundles/portfolios, selling ownership interests in the portfolios as securities in amounts of
$100,000 or more.
Example: Mortgage company has a $10m portfolio of mortgages and it sells 100 securities to
investors (pension funds, insurance companies, individuals, etc.) in the amount of $100,000 each,
backed by the mortgages in the portfolio. Like a mutual fund, except you are buying a share of a
portfolio of mortgages instead of a share of a portfolio of stocks.
Mortgage company could service the loans for a fee, collect the interest and principal from the
borrowers (homeowners), and pass the payments on the owners of the securities. They could
also make a profit on the sale of the securities. Example: mortgage portfolio yields 8.5%,
mortgage company sells to investors to yield only 8.25%, generate $25,000 per year profit on the
$10m portfolio.
GNMA pass-through mortgage security - investor buys a certain percentage of a loan portfolio, a
pro rata direct ownership position (e.g. 1%), instead of a fixed dollar amount or a non-ownership
debt obligation.
CMOs - collateralized mortgage obligations. Developed in the 1980s as another financial
innovation. Solution to the unpredictability of mortgage payoff. CMOs were sold as different
classes (tranches) that determined the order of payoff. Class 1 got paid off first, like a short term
bond, and the other classes got paid next, etc. CMOs are like a combination of short, medium
and long term bonds. Can be sold to suit investors needs.
Securitization also developed in other areas: auto loans, credit cards, computer leases, etc.
SUMMARY:
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1. U.S. banking system is unique compared to other developed countries, due to unique historical
events in U.S. history going back to the 1700s that caused the development of the banking
industry in the U.S. to depart from banking systems in other countries.
a. The model that emerged in most countries (UK, Germany, Canada) was the system of
"universal banking" with nationwide banking, with fewer restrictions (compared to U.S.) on
banks assets, activities, products, financial services, geographical branching, etc. Result with
universal banking: a small number (4 or 5) dominant, large banks with nationwide banking,
offering both commercial banking services and investment banking services.
b. The model that emerged in the U.S. was a system of thousands of very small, state-chartered
banks operating in one state only (McFadden Act), which was a very fragile system that did not
allow banks to a) achieve economies of scale or b) achieve geographical diversification.
Consequently, 9000 banks failed during the Great Depression of the 1930s and over 1000 banks
failed during the "S&L crisis" of the 1980s and 1990s.
c. The U.S. banking system has been one of the most heavily regulated in the world, and has
been one of the most heavily regulated industry in the U.S. The U.S. has also had more bank
failures (more than 10,000 in the last 70 years) than any other country. Banking regulations also
led to "diligent loophole mining" by U.S. banks, as they found ways to circumvent banking laws,
in many cases to remain competitive and prevent financial disintermediation.
2. As a result of financial disintermediation, financial innovation, deregulation, etc., there has
been a decline of traditional banking in the last twenty years. Commercial banks and S&L's
share of total financial intermediary assets has gone from 58% in 1960 to 28% in 1999, see page
315.
a. Financial disintermediation in the form of money market mutual funds, junk bonds,
commercial paper and securitized mortgages all resulted in a flow of funds, credit and business
away from commercial banks and toward security markets, investment banks, bond markets,
direct finance, etc.
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b. Costly information and transaction costs are a barrier to trade in the credit markets, and gave
commercial banks an advantage when information costs were high. Advances in computer and
information
technology
lowered
information
costs,
which
contributed
to
financial
disintermediation, by allowing borrowers (corporations) and savers/investors to "cut out the
middleman" (i.e. the banks), and engage in direct finance instead of indirect finance.
Commercial paper was an alternative to short-term bank credit and junk bonds were an
alternative to long-term bank credit, and the development of both markets was facilitated by
information technology.
3. Banking regulations from the 1920s (McFadden Act) and 1930s (Glass-Steagall, Regulation
Q, zero interest on checking) have now been repealed, resulting in bank mergers and
consolidations, both across state lines and across financial service activities.
a. Banking deregulation is now moving the U.S. banking industry toward "universal banking"
system of Germany, Switzerland, Netherlands.
b. Banking consolidation is now moving the U.S. banking system toward the Canadian, British,
Japanese banking system (and toward other U.S. industries), where a small number of very large
banks (corporations) will dominate the industry, and compete against some surviving small
banks.
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