Chapter 12

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

• No national or central bank

• State control of banking

Hamilton• Federal rights• Expand Government

and centralize power• National or central bank

• 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.

Early History Summary

• Phobia against large banks and central banking which carried into the 20th 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

• Bank Holding Companies- Allowed purchase of banks outside state

• Automated Teller Machines- 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

Source: Federal Reserve Bank of St. Louis, FRED data base: http://research.stlouisfed.org/fred2/; https://www2.fdic.gov/hsob/index.asp.

40%

20%

28%

5%

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.

Commercial paper

Loans to buyers of GE products

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.

13-23

Commercial Paper Outstanding: 2001 - 2014

13-24

Commercial Paper and ABCP Outstanding: 2001 - 2014

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 (non-interest 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/.

Eurodollar Market

• 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.

Eurodollars

New York Bank Cayman Branch of NY Bank

DD= $1,000,000Reserves= $100,000

Loans= $900,000

DD= $1,000,000

Borrow from Cayman Branch=

$1,000,000Loans=

$1,000,000

New York Bank