Learning Unit #19

Banking Industry and Regulation

Objectives of Learning Unit Historical Development of the Banking System Structure of U.S. Commercial Banking Industry

Bank Consolidation and Nationwide Banking Banking and Other Financial Service Industries

Evolution of Banking Industry Financial Innovation Decline of Traditional Banking

Asymmetric Information and Bank Regulation Banking Crisis

U.S. Banking Crisis in 1980s Banking Crisis throughout the World

Historical Development of U.S. Banking System

Banking systems in developed countries are very similar, but the U.S. banking system has several unique characteristics reflecting its historical development of banking system. Three unique characteristics of the U.S. banking system are Structure of Central Bank Dual Banking System Multiple Regulatory Agencies

Central Bank in the U.S.

The U.S. government has attempted to create a central bank like those in other developed countries (e.g. Bank of England, ) several times, but failed. Bank of the United States from 1791 to 1811 Second Bank of the united States from 1816

to 1836 Federal Reserve System since 1931

Many feared that a centralized banking power in one hand might have too much power and influence on the U.S. society.

Dual Banking System

Dual banking system: Banks are chartered and supervised by the federal government (Office of the Comptroller of The Treasury Department) and by the state governments (banking commissions). National banks are chartered by the federal

government. Since it is chartered by the federal government, it

can start its banking business anywhere in the U.S. and can expand its business through out the U.S.

State banks are chartered by the state governments. Since it is chartered by a state, it must operates its

banking business within the state.

Multiple Regulatory Agencies

Banks in the U.S. are regulated by multiple of government agencies. Regulatory agencies which charter banks also

supervise banking activities of those chartered. Examine routinely banking activities. Establish and enforce banking laws.

Banks are further regulated by the Fed and the FDIC The Federal Reserve sets banking rules to facilitate its

monetary policy and to act as bank for all other banks in the U.S.

The Federal Deposit Insurance Corporation sets own requirement for insuring deposits at banks.

Time Line of the Early History of Commercial Banking in the United StatesThe chart below shows several important historical events in the U.S. banking system.

Banking Systems Abroad

In most developed countries There is only one central bank entity usually located

in its capital. Only central government has authority to charter

banks. Only one government agency (e.g. Treasury

Department, Finance Department) is responsible for banking regulation, including establishing banking laws, enforcing them, chartering banks, and supervising them.

Banks can operate throughout their country, so foreign banks are very large relative to most U.S. banks.

Highly Regulated U.S. Banking Industry

Because of dual banking system and multiple regulatory agencies in the U.S. banking system, the U.S. banking system is one the most highly regulated industry in the U.S.

Each state has different banking regulation enforcing both state banks and national banks. The federal government sets another banking regulation, then the Federal Reserves and FDIC.

Many laws actually had tried to keep both national and state banks align in their operations (so one does not have any regulatory advantage over another). This also reduced competition among banks, resulted in so many inefficient small banks everywhere in the U.S.

Structure of Commercial Banking Industry in the U.S. There are about 6,500 commercial banks in the U.S. as

of 2011. Most of them are small in their assets holding and have

few or just one office. Top ten largest U.S. banks have about 50% of bank

assets in the industry.

Top Ten Largest Banks in the U.S.

Top ten largest banks are those well-know banks which operate throughout the U.S. or in largest metropolitan areas.

Note: FIA Card Service is a subsidiary of Bank of America since 2006

Interstate Banking Restriction

McFadden Act of 1927 prohibited national banks from branching across state lines and forces all national banks to conform to the branching regulations in the state of their location. The law was intended to put national banks

and state banks on an equal footing. Riegle-Neal Interstate Banking and Branching

Efficiency Act of 1994 repealed McFadden Act.

Bank Consolidation and Nationwide Banking

The U.S. had very large numbers of small banks as compared with other developed countries due to prohibition of the interstate banking. Smaller U.S. banks were inefficient and lacks

economies of scale and scope. Banks got around this restriction by forming

bank holding companies. Bank holding companies: corporation that

owns several different companies and banks.

Bank Holding Companies

Bank holding companies simply own stocks of other companies and banks and operate like a single companies with many regional or sector divisions.

Example:

Bank Holding Co.

Bank of NC Bank of SC Bank of GA

Insurance Investment Brokerage

Nationwide Banking

Through mergers and consolidation, banks extend its banking service areas way beyond their state lines and into regions or nationwide. JPMorgan Chase & Co. is a result of mergers of Chase

Manhattan Bank (NY), Chemical Bank (NY), Manufactures Hanover Bank (NY), J.P. Morgan (NY), First Chicago Bank (IL), National Bank of Detroit (MI), Bank One (IL), First Commerce Bank (LA).

Bank of American is a result of mergers of North Carolina National Bank (NC), Bankers Trust of SC (SC), C&S/Sovran (GA, VA), Maryland National Bank (MD), Barnett National Bank (FL), Boatmen’s Bancshares (MO, KS, OK, IA, AR, TX, NM), Bank of America (CA, OR, WA, AZ, NM, OK, ID, IL), FleetBoston (MA, RI, CT), LaSalle Bank (IL, MI, IN),

Wells Fargo Bank (CA) acquired Wachovia Bank (NC) in 2008, which merged with First Union Bank (NC) in 2001.

Nationwide Banking

Through mergers and consolidation, two types of mega-banks emerged in the U.S.: Money center banks: Large banks located in key

financial centers (New Your City, Chicago). Citibank, J.P. Morgan Chase

Super-regional banks: Bank holding companies whose main business areas are not in the money center cities (New York, Chicago).

Bank of America, SunTrust Bank, U.S. Bankcorp., Wells Fargo, BB&T

Both money center banks and super regional banks are almost as large as those large banks in other developed countries.

Number of Commercial Banks in the U.S.

As a result of mergers and consolidations, A number of commercial banks has been declining since

1985. Several money center banks and super regional banks hold

majority of assets in the U.S.

Separation of banking and Other Financial Service Industries The government attributed massive bank failures

during the Great Depression to the stock market crash of 1929 which caused huge losses to the brokerage division of banks (which operated both investment banking, commercial banking, and brokerage services at that time).

Glass-Steagall Act of 1933 separated banking business from other financial services by prohibiting banks from underwriting securities and from engaging in brokerage activities. Ex. J.P. Morgan Co. was split to Morgan Bank

(commercial banking) and Morgan Stanley Co. (Investment banking).

Consolidation across Financial Industries Mergers and consolidations are not limited among

banks, but across financial industries including investment banks, stock brokers and dealers, and insurance. Citigroup includes Citibank for banking services and Smith

Barney (combined with Salomon Brothers) for brokerage services.

Bank of America acquired MBNA in 2006 (Credit card service), Countrywide in 2008 (Mortgage lending), Merrill Lynch in 2009.

Consolidation across Financial Industries Financial consolidation across financial industries

became possible through Bank holding companies which not only hold banks but

also related financial business firms. Gramm-Leach-Bliley Financial Services Modernization Act

of 1999 which repealed Glass-Steagall Act and allows mergers across financial service industries.

However, this law still prohibits non-financial firms such as Wal-Mart to operate commercial banking and financial services.

Consolidation across Financial Industries: Cause and Effect Financial consolidation across financial industries

occurred and accelerated in 1980s and 1990s because Both banks and financial service firms pursuit more profits

by exploiting economies of scope and lowering transaction and information costs by extending their services beyond their industries.

Financial innovations eroded a difference between banking services and other financial services, resulting in competition among banks, insurance companies, brokerage firms.

Competition with universal banking firms in Europe Financial consolidation across financial industries also

created conflicts-of-interest problems.

Universal Banking

Universal banking is a financial service firm which provides banking services as well as other financial services. Universal banking firms may be organized in two different ways:

European style: Commercial banks provide a full range of banking, securities, real estate, and insurance services, all within a single legal entity. Europe (e.g. Deutsche Bank in Germany, UBS in

Switzerland). Bank holding company style: Bank holding

companies own and operate separate financial service firms, including banks, securities, and insurance. England, U.S., and Japan

Universal Banking

Universal banking is often called as “financial supermarket” (like Wal-Mart supercenter) because under one roof customers can get all types of financial services. It is more convenient and efficient for

customers who do not need to contact different financial institutions or to move funds among them.

It is more efficient and profitable for financial institutions which can share customer information and operation resources and earn multiple revenues from the same customers.

Evolution of Banking Industry

U.S. banking industry has seen significant changes in recent years. Consolidation among banks and across financial

industries Financial innovation Decline in traditional banking business Changes in banking regulations

Financial Innovation

A change in the financial environment and technology stimulates a search by financial institutions for innovations that are likely to be profitable. Recent interest rate volatility and other economic and

market conditions necessitate financial institutions to develop new products and engage in new activities.

Ex. Adjustable-rate mortgages, financial derivatives Progress in information technology enables financial

institutions to develop new services and products. Ex. Debit cards, Online banking, securitization

To expand its business beyond its industry a financial institution needs to develop new products which can avoid existing regulations.

Ex. Money market mutual funds

Decline of Traditional Banking

The U.S. banking industry has recently seen a significant decline in its traditional banking business (deposits & loans): On lending side, there is a significant decline in

bank share of total non-financial borrowing. On deposit side, there is a significant fall of

bank share in total financial intermediary assets.

Bank Share of Total Non-financial BorrowingCommercial bank share of total non-financial borrowing declined from 40% in 1974 to 25% in 2011.

Relative Shares of Total Financial Intermediary AssetsBank share of total financial intermediary assets has fallen from 60% in 1970 to below 35% in 2010.

Causes of Decline of Banking

Many competitions come from direct finance (other financial service industries) through financial innovations.

Liabilities side: depositors seek higher returns Money market mutual funds

Assets side: borrowers seek lower cost of borrowing

Junk bonds Commercial papers Securitization

Banks’ Responses to Decline of Banking

Banks responded a decline in traditional banking business and increased their profits by Expanding the traditional lending activities into

new and riskier areas Ex. Sub-prime mortgage loans & loan sales

Pursuing new and more profitable off-balance-sheet activities Ex. Securitization, derivative trading

Consolidating with other financial service industries

Financial innovation

Share of Non-interest Income in Total Bank Income

Recent Increase in Bank Failures

There is a significant increase in bank failures in late 1980s to early 1990s.

Some of them resulted from decline of traditional banking business due to increased competition with non-banking financial institutions.

Other bank failures resulted from mismanagement, taking too much risk, and unfamiliar financial service business.

Bank Failures in the United States

Since the Great Depression in 1930s, bank failures had been rare. However, there was an increase in bank failures in late 1980s to early 1990s, and another rise in bank failure since 2008.

Banking Regulation

The government heavily regulates the banking and financial industries to increase the information available to investors and to ensure the soundness of the financial system. Eight basic categories of banking regulation are Government safety net Restrictions on bank asset holdings Capital requirements Chartering and bank examination Assessment of risk management Disclosure requirements Consumer protection Restrictions on competition

Government Safety Net

To prevent bank run an resulting bank failure, the government set up the FDIC in 1934.

Currently, the FDIC (Federal Deposit Insurance Company) insures deposits at member banks up to $100,000. Before 1934, when a bank failed, depositors

lost all of their deposits. This created misery to many citizens in the U.S. during the Great Depression.

Because deposits are insured, depositors feel safe, so they do not need to rush to a failing bank to withdraw their deposits.

Bank Run and Bank Panic

Bank run: A large number of depositors withdraw their deposits in fear that the bank might fail and they might loose their deposits. Bank run may occur when a bank becomes insolvency.

Bank panic: Many banks suffer bank runs at the same time.

Bank run during the Great Depression Bank run in 2008

FDIC

Although a membership of the FDIC prevents a bunk run, a bank may fail if its loss is too large to recover. Then, the FDIC will handle a failing bank in two different ways: Pay-off method: the FDIC lets a bank fail and pay off

deposits. NetBank of Atlanta failed in 2007 and FDIC paid up to

an insured amount to each depositor. Purchase-and-assumption method: the FDIC takes

over failing bank’s management, reorganizes the bank, and merges it with a sound bank.

Failed Continental Illinois National Bank and Trust in 1984 was operated by the FDIC until its acquisition by Bank of America in 1994.

FDIC Insurance Funds The FDIC collects the insurance premiums from insured

banks and uses the insurance funds to pay off insured deposits if a bank fails. As of 2008, the FDIC holds $52 billion of insurance funds

and insures $7 trillion of deposits. Many large banks have more than hundreds of million

dollar deposits. (e.g. Bank of America had more than $800 million of deposits as of 2007)

A failure of IndyMac Bank of CA in 2008 may cost the FDIC $4 to $8 billion.

Too big to fail policy It is too costly for FDIC to let a large bank fail. If a large bank fails, the FDIC may not have enough

insurance funds to pay off all insured deposits. The FDIC is more like to take the purchase-and-

assumption method when a large bank fails.

Asymmetric Information and Deposit InsuranceLike any other insurance companies, the FDIC faces the problems of adverse selection and moral hazard. Deposit insurance creates a moral hazard problem.

Banks may take excessive risk since its deposits are insured (e.g. Who care if I fails my bank?).

Depositors do not care about riskiness of bank’s operation since their deposits are insured (e.g. Should I concern my bank’s financial condition? Not really!).

Deposit insurance creates an adverse selection. Risk-taking entrepreneurs want to start banking since

depositors may not check carefully about bank management but only concern with interest rates (e.g. Con men offer extremely high interest rates to gather funds from greedy depositors).

Restrictions on Bank Asset Holdings

The government restricts banks to hold types of assets and amount of each asset. Banks are not allowed to hold corporate stocks and junk

bonds. Banks are discouraged to hold too much risky loans.

Banks are encouraged to hold a certain amount of liquid assets.

The government restriction of bank asset holdings is intended to reduce moral hazard of taking too much risk. Without restriction, a risk-prone bank CEO may take

excessive risk to make more profits (and more compensations for him).

Capital Requirements

Risk-based capital requirement: The government requires the minimum amount of capital relative to bank’s assets and its risk. If a bank holds a large amount of assets, it will be required

to hold more capital in case of default of large loans. If a bank holds risky assets, it will be required to hold

more capital in case of many defaults together. The capital requirement is intended to reduce the moral

hazard problem of taking too much leverage. With higher capital, a bank has more to lose when it fails. Higher capital means more collateral for FDIC in case of

bank failure.

Chartering and Bank Examination A bank must be chartered and regularly examined by the

government. The regulatory agency evaluates each application of new bank

(e.g. soundness of business plan and background of bank executives).

The charter agency regularly examines bank’s financial reports and performs on-site evaluation (e.g. Is a bank complying to its requirement? Is a bank operating soundly?).

A bank chartering is intended to reduce the adverse selection problem and prevent crooks from opening a bank or risk-taking person from starting an unsound bank.

A bank examination is intended to reduce the moral hazard problem of engaging in risky activities. If examiners find any irregularity on bank’s financial statements or

not complying to its requirement, the regulatory agency can make a directional order or close the bank.

Assessment of Risk Management CAMELS rating system: a bank rating system that a bank

supervisory agency uses to evaluate riskiness of bank according to six factors. Capital adequacy Asset quality Management quality Earnings Liquidity Sensitivity to market risk

During regular examination the supervisory agency evaluates a bank’s operation in the CAMELS rating system and use to identify banks that are in need of attention.

Implementation of Risk Management Assessment After the financial crisis of 2008, the federal government

implemented various measures to evaluate the risk of banking.

Stress test: Evaluate losses and net worth of bank under dire scenarios and used to recommend adequate levels of capital.

Value-at-risk (VaR): Measure the size of the loss on a trading portfolio in very unlikely situation (e.g. probability to occur such situation is less than 1%).

Mark-to-market accounting: Assets held by banks are periodically evaluated at current market prices rather than historical book values.

Disclosure Requirements The government requires each bank to disclose its

financial statement regularly. Disclosure requirements are intended to reduce the

asymmetric information problem by providing more and better information about a bank.

With more information, shareholders, creditors, and depositors can monitor and evaluate banks. If a banks has an unsound operation, its shareholders may

ask its management team to change its operation. If a bank is operating unsoundly, no other banks or

corporations will be willing to lend funds to the bank. If a bank is insolvent, depositors may avoid the bank or

move any amount over insured amount from their accounts to another bank.

Consumer Protection Both depositors and borrowers must be given enough

information to protect themselves. “Truth in lending” under Consumer Protection Act: Banks

should not confuse or trick consumers Standardized interest rates (APR) Disclosure of total financial charge

Prevent or reduce lending discrimination CRA (Community Reinvestment Act) requires banks to make

loans in all areas where they get deposits. It promotes more lending in poor neighborhood, where banks are reluctant to lend due to high risk.

Prohibit predatory lending Some lenders take an advantage of poor credit borrowers

and charge extraordinary high interest rates (e.g. Payday lenders who often charge over 500% interest rate).

Restrictions on Competition Glass-Steagall Act of 1933 was intended to make

banks safer, but by prohibiting financial institutions in other financial industries from engaging in banking business it restricted competition in the banking industry.

McFadden Act of 1927 was intended to give equal standing between national and state banks, but by restricting national banks to cross state lines it restricted competition in local banking markets.

These anti-competitive restrictions in the banking industry have been repealed to foster more competition in the banking industry. Competition is believed to promote more efficient

operation and enforce sound banking system.

Systemic Risk Systemic risk is the risk of collapse of an entire financial

system or entire market, as opposed to risk associated with any one individual entity, group or component of a system.

During the financial crisis of 2008, the global financial system was about collapse – causing many large global financial institutions to fail simultaneously.

All financial institutions have similar assets and liabilities, so adverse economic events affect assets or liabilities of most financial institutions together. Fire sales of assets by one institution to save itself may

cause distress to other financial; institutions. Due to complex financial ties (e.g. derivatives), a fall of one

institution can spread to many other institutions. Ex. AIG and Citi, JPMorgan Chase, Bank of America through

CDSs

Major Banking Legislation in the U.S.

Pre-Depression and post-Depression banking registrations to ensure safety of financial system.

Major Banking Legislation in the U.S.

S&L Crisis-period legislations: Deregulation and Re-regulation of banks.

Major Banking Legislation in the U.S.

Post-S&L crisis legislations: Strengthening and improving safety of Banks

Major Banking Legislation in the U.S.

Financial Globalization period legislations: Deregulation of financial industry

Major Banking Legislation in the U.S.

Post financial crisis of 2008: Re-regulation of financial industry

Banking Crises in the U.S.

The U.S. economy has experienced several banking and financial crises in this and last centuries. Panic of 1907 The Great Depression 1929-1939, including

Bank holiday in 1933 Savings & Loan Associations Crisis in 1980s Sub-prime mortgage loan crisis in 2007-

ongoing

Oversea Banking Crisis

Banking crisis is not limited in the U.S. Almost every economy in the world has

experienced banking and financial crises. Developed countries such as the U.S. and

Western European countries have experienced occasional banking crises.

Developing countries and newly industrialized countries, such as China, central and South American countries, Eastern Asian countries, and former socialist countries, have experienced chronic banking and financial crises.

Banking Crises Everywhere

Banking Crisis History in the World

Banking crises are often very costly to economies.

On-going banking crisis in China has cost 47% of its annual GDP already, while Japan has lost 24%.

During Asian financial crisis in 1997 through 2002, Indonesia lost 55% of its GDP, while Thailand lost 35% and Korea lost 28%.

Even though S&Ls crisis was costly for taxpayers, but its effect on the U.S. economy was relatively limited, only 3% of annual GDP of the U.S.

Banking Crisis in History in the World

Banking crises in 2008 have been very costly to world economy, in particular Europe.

These crises lead to recessions in many European countries since 2008.

Dodd-Frank Bill of 2010

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 overhauled the out-dated financial regulation.

Financial innovations, deregulation, and globalization in 1990s and 2000s made the existing regulation ineffective. Unregulated derivatives (e.g. CDSs) Unregulated shadow banking system (e.g.

hedge funds) Regulatory holes among multiple regulatory

agencies Disclosure & conflict of interest problems

Dodd-Frank Bill of 2010

Intended to prevent another financial crisis byConsumer Protection: Create the Consumer Financial Protection Bureau within the Fed (but independent from the Fed) to enforce regulations against predatory lending and miss-information of financial services.Resolution Authority: Enable the FDIC, the Fed, SEC, and newly created FIO (Federal Insurance Office) to orderly liquidation of non-bank financial institutions.Systematic Risk Regulation: Create a Financial Stability Oversight Council to monitor the systemic risk.Volcker Rule: Ban on proprietary trading by commercial banks, whereby deposits are used to trade on the bank's own accounts for own profits.Derivatives: Require more derivatives to be traded on exchange and cleared through clearinghouses.

Future Regulation after Dodd-Frank Act

Dodd-Frank Act left out some important regulatory issues which need to be addressed:Capital Requirement: Banks and other financial institutions must hold adequate capital relative to riskiness of assets held. Question is how much?Compensation: Failed institutions’ executive earned tremendous compensations in short period by taking too much risk, but were not held financially liable after institution’s failures. How to make them more accountable?Government-Sponsored Enterprises (GSEs): What to do with almost-failed Fannie Mae and Freddie Mac?Credit-Rating Agencies: How to mitigate the regulatory reliance of inaccurate ratings?Overregulation: Too little regulation caused the financial crisis, but too much regulation creates inefficiency.

Disclaimer

Please do not copy, modify, or distribute this presentation without author’s consent.

This presentation was created and owned byDr. Ryoichi Sakano

North Carolina A&T State University