Chapters 11 & 12 Banking Industry: Structure, Competition and Regulation

Chapters 11 & 12

Banking Industry: Structure, Competition and Regulation

10-2

Financial Innovation

Innovation is result of search for profitsResponse to Changes in Demand

Major change is huge increase in interest-rate risk starting in 1960sExample: Adjustable-rate mortgages

Financial Derivatives

Response to Change in SupplyMajor change is improvement in computer technology1. Increases ability to collect information2. Lowers transaction costsExamples:1. Bank credit and debit cards2. Electronic banking facilities3. Junk bonds4. Commercial paper market5. Securitization

© 2004 Pearson Addison-Wesley. All rights reserved 10-3

Avoidance of Existing Regulations

Regulations Behind Financial Innovation

1. Reserve requirements

Tax on deposits = i r

2. Deposit-rate ceilings (Reg Q till 1980)

As i , loophole mine to escape reserve requirement tax and deposit-rate ceilings

Examples

1. Money market mutual funds (Bruce Bent)

2. Sweep accounts


The Decline in Banks as a Source of Finance

10-5

Decline in Traditional Banking

Loss of Cost Advantages in Acquiring Funds (Liabilities) i then disintermediation because

1. Deposit rate ceilings and regulation Q2. Money market mutual funds3. Foreign banks have cheaper source of funds: Japanese banks

can tap large savings pool

Loss of Income Advantages on Uses of Funds (Assets)1. Easier to use securities markets to raise funds: commercial

paper, junk bonds, securitization2. Finance companies more important because easier for them to

raise funds


Banks’ Response

Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability in traditional banking

1. Expand lending into riskier areas: e.g., real estate

2. Expand into off-balance sheet activities

3. Creates problems for U.S. regulatory system

Similar problems for banking industry in other countries


Structure of the Commercial Banking Industry


Table 1 Size Distribution of Insured Commercial Banks, September 30, 2008


Ten Largest U.S. Banks


Branching Regulations

Branching Restrictions: McFadden Act and Douglas Amendment

Very anticompetitive

Response to Branching Restrictions

1. Bank Holding CompaniesA. Allowed purchases of banks outside state

B. BHCs allowed wider scope of activities by Fed

C. BHCs dominant form of corporate structure for banks

2. Automated Teller MachinesNot considered to be branch of bank, so networks allowed


Bank Consolidation and Number of Banks


Bank Consolidation and Nationwide Banking

• The number of banks has declined over the last 25 years– Bank failures and consolidation.

– Deregulation: Riegle-Neal Interstate Banking and Branching Efficiency Act f 1994.

– Economies of scale and scope from information technology.

• Results may be not only a smaller number of banks but a shift in assets to much larger banks.


Benefits and Costs of Bank Consolidation

• Benefits

– Increased competition, driving inefficient banks out of business

– Increased efficiency also from economies of scale and scope

– Lower probability of bank failure from more diversified portfolios

• Costs

– Elimination of community banks may lead to less lending to small business

– Banks expanding into new areas may take increased risks and fail

10-14

Separation of Banking andOther Financial Service IndustriesErosion of Glass-SteagallFed, OCC, FDIC, allow banks to engage in underwriting

activitiesGramm-Leach-Bliley Financial Modernisation Services Act

of 1999: Repeal of Glass-Steagall1. Allows securities firms and insurance companies to purchase banks2. Banks allowed to underwrite insurance and engage in real estate

activities3. OCC regulates bank subsidiaries engaged in securities underwriting4. Fed oversee bank holding companies under which all real estate,

insurance and large securities operations are housedImplications: Banking institutions become larger and more complex


How Asymmetric InformationExplains Banking Regulation

1. Government Safety Net and Deposit Insurance

A. Prevents bank runs due to asymmetric information: depositors can’t tell good from bad banks

B. Creates moral hazard incentives for banks to take on too much risk

C. Creates adverse selection problem of crooks and risk-takers wanting to control banks

D. Too-Big-to-Fail increases moral hazard incentives for big banks

2. Restrictions on Asset Holdings

A. Reduces moral hazard of too much risk taking


3. Bank Capital Requirements

A. Reduces moral hazard: banks have more to lose when have higher capital

B. Higher capital means more collateral for FDIC

4. Bank Supervision: Chartering and Examination

A. Reduces adverse selection problem of risk takers or crooks owning banks

B. Reduces moral hazard by preventing risky activities

5. New Trend: Assessment of Risk Management

6. Disclosure Requirements

A. Better information reduces asymmetric information problem



7. Consumer Protection

A. Standardized interest rates (APR)

B. Prevent discrimination: e.g., CRA

8. Restrictions on Competition to Reduce Risk-Taking

A. Branching restrictions

B. Separation of banking and securities industries in the past: Glass-Steagall

International Banking Regulation

1. Bank regulation abroad similar to ours

2. Particular problem of regulating international banking

e.g., BCCI scandal


Documents

Chapters 11 & 12 Banking Industry: Structure, Competition and Regulation