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Market Structure and Regulation in the U.S. Banking Industry
Professor Wayne Carroll
Department of Economics
University of Wisconsin-Eau Claire
Slides available at www.uwec.edu/carrolwd
Roles of Banks in the Economy
Facilitate borrowing and lending Facilitate payments Risk management
Issue financial assets that allow firms to share risks
Provide guarantees and lines of credit
Role of Banks in LendingSources of External Funding for Business
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
bank loans non-bank loans bonds new equity
USA
Germany
Japan
Source: Available online at http://www.wiwi.uni-frankfurt.de/schwerpunkte/finance/wp/550.pdf
Financial Intermediaries
“Banks” include: Commercial banks Savings and loan associations (S&L’s)
Also sometimes called “thrifts” or “thrift institutions”
Credit unions
Financial IntermediariesAssets at end of 2002 (in billions)
Credit Unions: $553
S & L's: $1,338
Banks: $7,161
Ownership of Banks
U.S. banks are privately owned – no banks are owned by the government.
In most cases a bank’s stock is held by a large number of investors, so a bank has many “owners.”
It is relatively easy to establish a new bank in the U.S.
Bank Market Structure
There are a large number of banking firms in the U.S., but the number is falling due to mergers between banks.
Thousands of U.S. banks are very small, each having only a single office.
Many banks today have multiple branches or offices.
A “bank holding company” is a firm that owns one or more banking firms.
Size Distribution of U.S. Banks
Commercial Banks
Number of
Deposits (millions)
Asset Size(as of June 30, 2006) Institutions Offices
Less than $25 Million 586 712 $7,661
$25 Million to $50 Million 1,098 1,701 $33,511
$50 Million to $100 Million 1,718 4,007 $105,754
$100 Million to $300 Million 2,427 10,338 $349,740
$300 Million to $500 Million 672 5,088 $211,495
$500 Million to $1 Billion 494 6,322 $265,540
$1 Billion to $3 Billion 275 6,856 $338,909
$3 Billion to $10 Billion 120 6,601 $427,340
Greater than $10 Billion 89 38,848 $3,580,817
TOTALS 7,479 80,473 $5,320,767
Source: www2.fdic.gov/sod/index.asp
Bank Market Structure: An Example
Wells Fargo & Company is a bank holding company based in South Dakota (with historic roots in Minnesota and California). It includes:28 chartered bank companiesa total of over 3,000 branches in 23
states
Some Wells Fargo branches
Wells Fargo’s Broad Scope
Community Banking
34%
Investments and Insurance
15%
Specialized Lending
15%
Consumer Finance
7%
Home Mortgage and Home Equity
20%
Wholesale Banking/
Commercial Real Estate
9%
Source: www.wellsfargo.com/about/today1
20 Largest U.S. Banks (as of June 30, 2006)
Rank Institution Name State
HeadquarteredNumber of
OfficesDeposits
(thousands)
1 Bank of America, NA North Carolina 5,781 $563,906,844
2 JPMorgan Chase Bank, NA Ohio 2,679 $434,752,000
3 Wachovia Bank, NA North Carolina 3,136 $306,348,000
4 Wells Fargo Bank, NA South Dakota 3,200 $298,672,000
5 Washington Mutual Bank Nevada 2,167 $209,927,984
6 Citibank, NA New York 267 $142,508,000
7 SunTrust Bank Georgia 1,758 $117,956,301
8 U.S. Bank, NA Ohio 2,525 $117,337,830
9 HSBC Bank USA, NA Delaware 436 $75,588,320
10 World Savings Bank, FSB California 286 $61,321,407
11 PNC Bank, NA Pennsylvania 831 $58,134,805
12 Keybank, NA Ohio 957 $57,327,323
13 Regions Bank Alabama 1,397 $57,231,022
14 Merrill Lynch Bank USA Utah 3 $52,331,967
15 Branch Banking and Trust Company North Carolina 918 $51,246,133
16 Countrywide Bank, NA Virginia 2 $50,657,812
17 ING Bank, fsb Delaware 1 $46,440,495
18 Comerica Bank Michigan 387 $43,081,270
19 Sovereign Bank Pennsylvania 661 $40,829,851
20 The Bank of New York New York 354 $40,014,000
Source: www2.fdic.gov/sod/index.asp
A Simple Bank Balance Sheet
Assetsreserves"loans"
securitiesbank loans
Liabilitiesdepositsborrowings
Bank capital (equity)
Detailed Balance Sheet for the Banking Industry
Source: Mishkin, Economics of Money, Banking, and Financial Markets, 7th edition
Two Important Ratios
Capital/asset ratio – bank capital as a percentage of bank assets. The average capital/asset ratio for U.S. banks
was about 9% at the end of 2002. Reserve ratio – bank reserves as a
percentage of checkable deposits.
Information on U.S. Banks
It is easy to get a lot of financial data on U.S. banks.
A great source:www2.fdic.gov/idasp/index.asp
An Example: Data on Wells Fargo
What Can Go Wrong?
“Bank failure” – the bank goes out of business. Bank depositors might lose some of their
funds. Bank creditors might lose some of their
investment Bank owners lose their capital.
The bank suffers significant losses – the government might have to help.
Reasons for Bank Regulation
Banks must be regulated because: a bank failure can be devastating to depositors. there’s a risk of systemic failure: the failure of
one bank can make it more likely that other banks will fail.
depositors can’t monitor how the bank invests their funds, creating a moral hazard problem.
government assistance to a bank can be very costly.
Reasons for Bank Regulation
Banks are less stable than other businesses because:
bank liabilities tend to be short-term – many depositors could withdraw their funds with little notice.
bank assets tend to be longer-term – reserves and other liquid assets are only a small share of the total.
the behavior of depositors depends on their confidence that the bank is sound, and this confidence can be easily shaken.
A Closer Look at Bank Failure
Two reasons for bank failure: The value of bank assets falls, so
assets<liabilities. Deposit outflow: A large number of depositors
withdraw their funds from the bank, exhausting the bank’s cash (reserves) and other liquid assets.
Therefore a bank is more likely to fail if it has a low capital/asset ratio or a low reserve ratio.
A Closer Look at Bank Failure
Tradeoff between higher income and a lower risk of failure:
Holding other things constant, the bank’s net income is higher if its capital/asset ratio and reserve ratio are lower, since then it holds relatively more interest-earning assets.
If the bank’s capital/asset ratio and reserve ratio are higher, it’s less likely that the bank will fail (so it’s less likely that the stockholders will lose their capital.)
A Closer Look at Bank Failure
If there were no government regulation of banks:
each bank would choose a capital/asset ratio and a reserve ratio to maximize the value of the bank.
depositors would want to deposit their money in banks that are well managed, so banks would have an incentive to choose capital/asset ratios and reserve ratios that reduce the threat of bank failure.
“market discipline”
A Closer Look at Bank Failure
But if there were no government regulation of banks:
banks would choose capital/asset ratios and reserve ratios that are too low from society’s standpoint.
banks would take on too much risk, so there would be too many bank failures, and the government would have to spend too much money to assist troubled banks.
An Example: Continental Illinois Bank
Continental Illinois Bank failed in 1984. The federal government paid billions of
dollars to keep Continental Illinois from closing.
This was the biggest bank “resolution” in U.S. history.
An Example: Continental Illinois Bank
Before it failed, Continental Illinois Bank: was the largest bank in Chicago. was the seventh-largest bank in the U.S. had 57 offices in 14 states and 29 foreign
countries.
An Example: Continental Illinois Bank
Why did Continental Illinois fail? Starting in the late 1970s, the bank grew fast, with
lots of loans to businesses. Poor quality loans Too many loans to firms in the oil industry Too many loans to borrowers in Latin America “Continental Illinois is willing to do just about anything
to make a deal.” High cost of funds
Large share of funds borrowed from other banks Relatively small reliance on domestic deposits Heavy borrowing in foreign money markets
An Example: Continental Illinois Bank
The Bank’s Troubles By 1984 the bank’s nonperforming loans
(loans on which payments were late) rose to $5.2 billion (over 10% of total loans).
May 1984: an electronic “bank run” – depositors withdrew billions of dollars in deposits
The FDIC and the Federal Reserve System pledged their support for the bank and lent over $5 billion.
An Example: Continental Illinois Bank
Dangers Many smaller banks had deposits at
Continental Illinois, so the failure of Continental Illinois could have caused some of them to fail, too.
Other depositors (including many important corporations) could lose some of their funds
Foreign investors would lose confidence in U.S. banks
An Example: Continental Illinois Bank
Rescuing Continental Illinois Bank Continental Illinois Bank had $3 billion in
insured deposits and $30 billion in uninsured deposits. The FDIC promised to guarantee all deposits.
The FDIC assumed the Bank’s 3.5 billion debt to the Federal Reserve.
The FDIC bought $1 billion in Continental Illinois stock – the FDIC “owned” the bank.
An Example: Continental Illinois Bank
Lessons from Continental Illinois Bank Banks have an incentive to take on too much
risk, so they need closer supervision The failure of a very large bank could have
broader negative effects Rescuing a large bank can be expensive for
the government
Good sources: www.fdic.gov/bank/historical/managing/contents.pdf -- Part II, Chap. 4 http://www.fdic.gov/bank/historical/history/vol1.html -- Chap. 7
Bank Regulation: An Overview
In the U.S. the government regulates banks in many ways:
Federal deposit insurance Imposing capital requirements (minimum
capital/asset ratios) Imposing reserve requirements (minimum
reserve ratios) Restricting the types of assets that banks
may hold Performing bank examinations (periodic
auditing reviews)
Primary bank regulators in the U.S.: Office of the Comptroller of the Currency (OCC)
part of the U.S. Department of the Treasury Federal Reserve System – the U.S. central bank Federal Deposit Insurance Corporation (FDIC) State bank regulators
Bank Regulation: An Overview
Federal Deposit Insurance
The U.S. Congress created the Federal Deposit Insurance Corporation (FDIC) in 1933, after the bank failures in the Great Depression.
Today the FDIC guarantees each bank deposit up to a maximum of $100,000.
FDIC insurance is funded by a small fee paid by banks based on their deposits.
Bank Failures in the Great Depression
Annual Number of Bank Suspensions
0
500
1000
1500
2000
2500
3000
3500
4000
4500
Effects of Federal Deposit Insurance
Deposit insurance prevents bank runs Prevents losses by small depositors Reduces “systemic risk” in the banking
system
Deposit insurance gives banks incentives to:
hold riskier assets. hold less capital. manage the bank’s assets less carefully.
Incentive Effects of Deposit Insurance:A Closer Look
Deposit insurance increases the supply of deposits (within the insurance coverage limits). Therefore banks can attract deposits more easily and can pay lower interest rates on their deposits even if they pursue risky strategies that increase the risk of bank failure.As a result, deposit insurance reduces banks’ incentives to avoid risk.
Capital Requirements
When there’s deposit insurance, banks have an incentive to hold too little capital.
Therefore the government imposes capital requirements to ensure that banks hold sufficient capital.
Capital Requirements
A simple capital requirement would require that a bank’s capital/asset ratio be greater than or equal to a specified level.
Example: capital/asset ratio ≥ 0.05.
Problem: Not all assets are equally risky. A simple capital requirement gives a bank an incentive to hold more risky assets.
Risk-weighted Capital Requirements
At an international conference in Basel, Switzerland in 1988, bank regulators from the world’s affluent countries agreed to impose risk-weighted capital requirements:
Classes of assets are assigned risk weights between 0% and 100%.
Risk-free assets carry a weight of 0%, and more-risky assets carry higher weights.
Capital requirements then set a minimum for the ratio of capital to risk-weighted assets.
Risk-weighted Capital Requirements:An Example
Assets Amount Risk weight Weighted assets
Cash $10,000,000 0% $0
T-bills $190,000,000 0% $0
Municipal bonds
$50,000,000 20% $10,000,000
Mortgages $300,000,000 50% $150,000,000
Home equity loans
$40,000,000 100% $40,000,000
TOTALS $590,000,000 $200,000,000
In this example, if regulators require the bank to maintain its risk-weighted capital ratio at a level of at least 8%, then the bank’s capital must be at least $16,00,000 (or 8% of $200,000,000).
If the bank acquires another $1 million in capital, it could invest up to: $12.5 million more in home-equity loans $25 million more in home mortgages $62.5 million more in municipal bonds
So risk-weighted capital requirements give the bank an incentive to hold less-risky assets.
Risk-weighted Capital Requirements:An Example
Proposed Capital Requirement Reform: Basel 2
Problem: Assets within a risk class might expose banks to different amounts of risk.
Bank regulators have designed a new system of bank capital requirements – Basel 2 – that will provide better incentives for banks to manage their risks in a way that promotes bank stability.
Basel 2 will take effect in some countries in 2007.
http://www.bis.org/publ/bcbsca.htm
Reserve Requirements
The Federal Reserve System requires banks to hold reserves that are greater than or equal to a specified percentage of their checkable deposits: 3% for smaller banks 10% for larger banks
Reserve Requirements
But reserves are higher than they need to be to promote stability of the banking system.
Today reserve requirements are more important in macroeconomic policy – they tie bank reserves to deposits, so the central bank can try to control deposits by controlling reserves.
Restrictions on Asset Holdings
Bank regulations include the following: Banks cannot hold common stock. Banks cannot invest too large a share of their
deposits in a single loan or in loans to businesses in a single industry.
Banks cannot lend funds to bank directors, managers, or principal shareholders at below-market rates.
Bank Examinations
Banks are visited on a regular schedule by bank examiners from the OCC, the Federal Reserve System, the FDIC, or other agencies.
Bank examiners review the bank’s financial statements and its confidential accounts.
The results are summarized in a “CAMELS” rating given to the bank.
Bank Examinations
Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk
CAMELS ratings
1 Sound in every respect
2 Fundamentally sound, but with modest weaknesses that can be corrected
3 Moderately severe to unsatisfactory weaknesses; vulnerable if there’s a business downturn
4 Many serious weaknesses that have not been addressed; failure is possible but not imminent
5 High probability of failure in the short term
Bank Examinations
CAMELS ratings are disclosed to bank management, but not to the public.
If the CAMELS rating for a bank is unfavorable, regulators can take actions like these: Require banks to disclose unfavorable information
in their public financial statements Issue a “cease and desist” order requiring the
bank to stop doing things that cause financial troubles and to correct problems.
Impose fines (up to $1,000,000 per day).
Bank Examinations
Bank Examinations
Good sources on bank examinations and the FDIC:www.fdic.gov/regulations/examinations/index.html
www.fdic.gov/bank/analytical/banking/1999oct/1_v12n2.pdf
The Banking Crisis of the 1980s
Hundreds of savings and loan associations (S&L’s) and banks failed in the 1980s and early 1990s.
This episode illustrates: how changes in the market environment and a
loosening of regulations can lead to a bank crisis. how government regulators can handle
widespread bank failures. how regulations and supervisory standards can be
improved to address new problems.
Magnitude of the Crisis
From 1980 through 1994, over 2,900 banks and S&L’s failed. 1,617 banks with total assets of $302.6 billion 1,295 S&L’s with total assets of $621 billion
On average, a bank or S&L failed every 15 days from 1980 to 1994.
During this period, about one out of every six banks or S&L’s (holding a total of over 20% of the assets of the system) was closed or got government assistance.
Magnitude of the Crisis:Number of Bank Failures Per Year
Causes of the Banking Crisis
The banking crisis had many causes, including: changes in the market environment looser regulations that gave S&L’s more
competitive options
Causes of the Banking Crisis:Changes in the Market Environment
As a result of financial innovations in the 1960s and 1970s: banks and S&L’s faced more competition
from other financial firms (such as mutual funds).
new kinds of financial assets (such as futures and other derivatives) made it possible for investors (including banks and S&L’s) to take on more risk.
the financial market environment was more complicated and harder for regulators to monitor.
Causes of the Banking Crisis:Changes in Regulation
The banking industry was partially deregulated in the early 1980s: S&L’s had mostly been restricted to home
mortgage lending before, but now they were allowed to invest in commercial real estate and consumer loans.
S&L’s were allowed to invest in junk bonds (low-quality, high-risk commercial bonds) and common stocks.
Causes of the Banking Crisis:Changes in Regulation
Source:www.fdic.gov/bank/historical/history/421_476.pdf
Causes of the Banking Crisis
As a result, S&L’s held more risky assets, resulting in huge loan losses.
S&L management had little expertise in managing risks from new kinds of assets.
Regulators had little experience in monitoring the new risks.
Since S&L deposits (up to $100,000) were protected by federal deposit insurance, depositors had little incentive to monitor S&L risks.
Regulatory Failures in the Crisis
Regulators of S&L’s did not close insolvent institutions and end the crisis quickly. The deposit insurance fund wasn’t large
enough to cover losses.(The S&L deposit insurance fund had a balance of -$75 billion in 1988.)
Regulators wanted to encourage the growth of the S&L industry, not close S&L’s.
Regulators hoped the crisis would pass without revealing their failures.
Managing the Crisis
In 1989 the government created the Resolution Trust Corporation (RTC) to handle S&L’s that were failing.
Functions of the RTC: Took over assets of failing S&L’s and sold
them to recover as much of their value as possible.
Issued bonds to fund the costs of covering S&L losses.
Who Paid the Cost?
Bank and S&L stockholders Some depositors who had large
deposits that exceeded the deposit insurance limits
Taxpayers, who ultimately will pay higher taxes to pay off bonds that were issued to fund the costs of the crisis.
Regulatory Reforms Following the Crisis Some regulatory agencies that had not been
effective were eliminated, and their powers were given to other agencies.
Earlier restrictions on assets holdings by S&L’s were reinstated.
S&L’s were required to raise their capital/asset ratios.
Now bank examiners visit banks more frequently than before.
Regulators were required to act more quickly when a bank or S&L is failing.
Regulatory Reforms Following the Crisis
Source:www.fdic.gov/bank/historical/history/421_476.pdf
Lessons from the Banking Crisis
The U.S. banking crisis in the 1980s was similar to bank crises in other countries:
Financial liberalization allowed banks to take more risks, but there was not yet adequate government regulation and supervision of those risks.
A government “safety net” created moral hazard problems and eliminated some market discipline.
The Banking Crisis of the 1980s
Two excellent sources: Managing the Crisis: The FDIC and RTC
Experience www.fdic.gov/bank/historical/managing/index.html
History of the Eighties - Lessons for the Future www.fdic.gov/bank/historical/history/index.html
