A Brief History of U.S. banking
The history of banking in the U.S. is a muddle. U.S. banking is unique in the fact that most other countries only have 4 or 5 large banks. There were upward of 40,000 banks in the U.S. prior to the great depression. About
40% of these disappeared at that time.
A good deal of politics affected banking laws during the late 18 th century and during the 19 th century. The Democratic party favored states rights and agricultural interests. The Democrats were the major party in the south and in rural areas. The Federalists and later the Republican party favored a strong federal government and business interests. The Republican were the major party in the large cities in the north. Alright, so some things change.
1782. The Bank of North America chartered in Philadelphia. It issued bank notes -- a promise to pay to the bearer a stated amount of gold. The bank could issue more bank notes than it had gold. The bank hopes that it will have enough gold reserves on hand to be able to pay people who show up demanding the gold. This is called fractional reserve banking and is still used (the Feds reserve requirement). This was to be a central bank —a government entity responsible for managing the nations money supply. This was a private bank (though given monopoly status) whose chief purpose was to help finance the Revolutionary War.
1791. The Bank of the United States is chartered. The Federalists were in charge. This is a private bank that also served as a central bank.
1811 The charter of the Bank of the United States is allowed to lapse.
The Democrats are in charge. Banks now become state chartered and regulated. Bank notes issued by state chartered banks become the nation ’s currency. There are a large number of banks each issuing their own notes. Many of the notes are worthless.
Counterfeiting is rampant. It is difficult to tell is a note is good or not – particularly if it is a note from a different area.
1816 The Second Bank of the United States is chartered. The federal government decided a national bank would have been useful in financing the War of 1812.
1832 Andrew Jackson (Democrat from a southern state, Tennessee) vetoes re--chartering of the Second Bank. Now there are only state

banks. Many of these were not able to redeem the bank notes they had issued.
1863 National Bank Act of 1863. Created federally chartered banks
(national banks). Also allowed state chartered banks (dual banking system). However the government attempted to put state banks out of business by placing very heavy taxes on their bank notes.
This occurred during the civil war. The south (Democrats) was strongly states rights. The Union supporters (Republicans) were strongly for national banks. The state banks were able to survive by creating deposit banking and making loans rather than issuing bank notes.
1913 Creation of the Federal Reserve System
– reintroduction of central banking. All national banks were required to belong to the Fed.
State banks could join the Fed but were not required to. Many did not because of the high cost of joining.
1933 The Great Depression saw the failure of about 40% of the nations banks as well as about a 30% reduction in the nations money supply. As a result banking legislation created the Federal Deposit
Insurance Corporation (FDIC). The Glass —Steagall act separated investment and commercial banking.
Restrictions on branching
There are about 8500 commercial banks in the U.S. There are about 5 in
Canada and in the United Kingdom. This is a result partly of banking regulations that prohibited the formation of large banks in the U.S.
The McFadden Act (1927) prevented banks from having branches outside the state where the home banks was located. Many state prohibited branches outside the county where the home bank was located. The effect of these regulations was to keep many small banks in business.
Does the existence of so many banks mean that the regulations foster competition in the industry? Or does it mean that so many survive because they are protected from competition? Are inefficient banks kept in business by these regulations? If competition is beneficial why don’t the regulations allow banks to compete by crossing boundaries?

Response to branching restrictions (“loophole mining”)
 Bank Holding Companies A holding company is a company that owns other companies. A bank holding company is one that can own several banks in different locations thus avoiding the branching restriction.
Holding companies can also engage in financial activities not permitted to commercial banks. Holding companies own almost all large banks. Over
90% of commercial bank deposits are held in banks owned by holding companies.
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Nonbank Banks: Banks are institutions that take in deposits and make loans. An institution that takes in deposits but doesn’t make loans is not a bank. An institution that doesn’t take in deposits but makes loans is not a bank. The Competitive Equality Bank Act of 1987 placed a moratorium on
 new nonblank banks.
 Automated Teller Machines. ATM’s are not considered to be a branch if the bank does not own or rent the machine. They let other people own the machine and earn fees for transactions. This allows them to serve customers outside their customary area.
The number of banks remained stable from 1935 to the mid 80’s. The number of banks fell from about 14,000 to about 9000. Some of these were failures but most were consolidations.
Loophole mining reduced the effectiveness of branch regulations and states decided to allow branching across state lines. Banks found it in their interest to have branches in other states as a means of insulating against regional recessions. Further large banks get certain economies of scale by consolidation.
The Riegle —Neal Interstate Banking and Branching Efficiency Act of 1994.
Overturned the McFadden Act prohibiting interstate banking. Also invalidated state laws prohibiting interstate banking.

What will happen to community banks?
Will the large banks drive all small (community) banks out of existence? Will the economies of scale be such that the small banks can’t compete? California has not had limits on branching in the state for some time and still has plenty small banks. Small banks may be more agile than big banks in many areas.
Glass —Steagall Act.
After World War I businesses began to finance more of their investment activities by issuing stocks or bonds rather than by borrowing from banks. The banks tried to halt this drift by offering investment banking services and engaging in brokerage activities (buying and selling stocks or bonds). Many people, politicians included, believed that this activity either created or deepened the
Great Depression. Most economists now believe that there is very little evidence to support this view, but it was prevalent in the 1930s. It led to the passage of the Glass —Steagall Act which required banks to decide whether to become solely commercial or solely investment banks.
Erosion of Glass
—Steagall
More loophole mining. Brokerage firms use money market mutual funds. They issue things that look like deposits and invest in short term securities. They differ from banks in that they don’t make loan. They also don’t have reserve requirements and cant borrow in the Federal Funds market or from the Fed.
The Fed also allows bank holding companies to underwrite securities.
Gramm
—Leach—Billey Financial Modernization Act of 1999:
Repealed Glass —Steagall. Glass—Steagall had created a competitive disadvantage for U.S. banks compared to foreign banks.

Savings and Loan Associations (S&Ls)
S&Ls also have dual regulation. They may be chartered by the Federal government or by a state government. Most are members of the Federal Home
Loan Bank System (FHLBS) which regulates them in a manner similar to the
Fed. Their deposits are insured by the Savings Association Insurance Fund which is a subsidiary of the FDIC.
Initially S&Ls took in deposits and issued home mortgages. Recall that this lead to a mismatch between the maturity dates of the S&Ls assets and liabilities.
Branching regulations were looser for S&Ls than for commercial banks. Most states allowed branches anywhere within the state. Federally chartered S&Ls now can operate across state lines.
FHLBS can make loans to S&Ls similar to Feds discount loans. These can be long term loans.
Credit Unions
Credit unions take deposits from members. The members must have some common bond such as having the same employer. The deposits are called shares and are treated like checkable deposits or savings accounts. The credit union makes loans to members. They may be chartered by either a state government or by the federal government. They are tax exempt. The deposits are insured by the federal government.
Credit unions usually make short term loans to member so they do not have the timing mismatch between assets and liabilities that the S&Ls once had.
However, because of the common membership bond, they can get in trouble if the industry or company starts laying off workers.
Credit unions can extend across states or countries. The military has branches throughout the world.
In 1960 eight U.S. banks had branches in foreign countries with assets of $4 billion
In 2001 100 banks had foreign branches with assets of $500 bill.

Reasons
 Natural growth in foreign trade and multinational corporations. U.S. companies will want to exchange foreign currency for dollars.
 U.S. banks earn profits from international investment banking. o Underwriting foreign securities o Selling insurance o Eurodollars
Eurodollar market
 Created when deposits in accounts in U.S. banks are transferred to a bank outside the U.S. and the deposit is kept in the form of dollars. The foreign bank actually keeps the deposits in a U.S. bank so the creation of Eurodollars does not cause deposits in U.S. to decline. These are often kept in CD’s to earn interest.
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Dollars are widely accepted in international trade. Suppose company X in some foreign country (F) sold a product in the U.S. and also wanted to buy goods from country G. One option is to trade dollars for F currency units (paying a fee) and then trading F currency units for G currency units (paying a fee). The other alternative is to have dollars and give them to the company in country G.
The Structure of U.S. Banking Overseas
 U.S. banks have most of their foreign branches in London, Latin
America, the Far East and the Caribbean
 London is the center of the Eurodollar market
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Large volume of trade in Latin America and the Far East
 Very limited regulation in the Caribbean.
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Edge Act Corporations
– this act allows U.S. bank holding companies to own foreign banks and companies that provide foreign financial services.
Governed by Fed’s Regulation K.
 International Banking Facilities (IBFs) – can accept time deposits from foreigners. These deposits are not subject to reserve requirements or restrictions on interest payments. IBFs can make loans to foreigners but not to U.S. citizens.. They are exempt from state and local taxes.

Foreign Banks in the U.S.
 The growth of international trade has encouraged foreign banks to have branches in the U.S. They can operate in a number of capacities
 Agency offices can lend and transfer funds in the U.S. but cannot accept deposits from U.S. residents. They are not subject to all the regulations that apply to full service banks (don’t need FDIC insurance for example).
 Subsidiaries of U.S. banks. Just like a U.S. bank. Subject to U.S. banking
 laws but owned by a bank in a foreign country.
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Branch of a foreign bank. Bears name of foreign banks and may be a full service bank. These branches were not subject to many U.S. banking regulations prior to 1978. After the International Banking Act of 1978 they were subject to more restrictions.
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Money Market Mutual funds. Owned by depositors who receive shares
(liabilities to the fund). The fund invests in short —term assets such as T bills, CDs, commercial paper, etc. ). Depositors can write checks on the shares. While the depositors can treat the shares just like a checkable deposit, the shares are not legally deposits (they aren’t in a commercial bank) and hence they are not subject to reserve requirements or prohibitions against interest payments. These funds have caused competition for banks particularly when regulation Q still existed and the interest earned on the money market far exceeded that allowed under regulation Q.
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Junk Bonds. Bonds from little known or new companies that have not yet established a good credit rating. It will be difficult for such companies to sell bonds unless they are willing to pay a high rate of interest unless some investment firm sells them for the companies. This provides an alternative to bank deposits.
Junk bonds refer to newly issued bonds with low credit ratings.
Fallen angels refer to previously issued bonds which have had their credit ratings fall below Baa.

 Commercial Paper Market. A short term debt security issued by large banks and corporations. When this provides corporations an alternative to bank loans for short term financing. Money market mutual funds are one source of purchasers of commercial paper.
 Securitization. Transforming otherwise illiquid assets (e.g. residential mortgages) into more liquid assets. Banks can bundle a number of mortgages and sell the entire packages in portions. The bank still collects the payments and then passes them through to the third party. Bundling provides diversification. GNMA (Gennie Mae) guarantees the interest and principle payments on the bundles. This makes it easy for banks to sell the bundles. It also make banks more willing to give mortgages.
Securitization also applies to bundles of automobile loans, credit card receivables, and commercial and computer leases. Note that this bundling activity required the existence of modern computers to keep track of everything.

The percentage of credit obtained from banks and thrifts has been declining.
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Bank profitability suffered in the 1980s and early 90s but appears to have recovered.

Traditional banking activities are becoming less profitable but non traditional activities are becoming more profitable. In particular banks are earning much more now from off balance sheet activities (securitization and fee income activities).
Reasons for the Decline of Traditional Banking
 Increase costs of acquiring funds (liabilities) o Elimination of Regulation Q meant banks had to pay more interest to attract time deposits. o Interest on deposits that function just like checkable deposits
(banks use NOW accounts but they must compete with money market mutual funds).
 Decrease in income advantages on asset side o Securitization (while banks use this activity other financial institutions do so as well and thus compete with banks). o , commercial paper o junk bonds (new companies may fund activities in this manner rather than a bank loan)
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Banks Responses to the Decline
Declines in profitability usually result in exits from the industry. The banking industry has seen failures and consolidation.

Banks have used more off balance sheet activities (loan sales and fee generating activity).