hapter 13: Financial Industry Structure
In this chapter we examine the history of the banking system, along with its structure and trends today. There are some key features of the U.S. banking system that distinguish it from the banking systems of other industrialized countries, including
- a mix of state and federal regulation of the banking system.
- a decentralized and competitive banking structure.
- restrictions on the activities of banks
Bank Industry Structure
A Brief History
A Dual Banking System
- The first banks in the United States date back to the late 1700s. Up until the Civil War all banking regulation took place at the state level, with banks issuing their own local currency (banknotes) backed by gold to raise funds. Regulations were spotty at best, and bank failures were common.
- The National Bank Act of 1863 established federally regulated banks, in part to help finance the Civil War on the Union side. State banks also survived by accepting deposits (since the law placed a heavy tax on state banknotes). The result today is a dual banking system with both federal regulation for national banks and state regulation for state banks.
- Because of the dual banking system there are multiple regulatory agencies: The Office of the Comptroller of the Currency (1863), the Federal Reserve (1913), the FDIC (1933) and state agencies. Which agency has primary control depends on whether a bank has a federal or state charter, is part of bank holding company that owns multiple banks, or is FDIC insured. And yes, it is quite confusing.
The United States experienced massive bank failures following the stock market crash of 1929. Between 1930-33, one third of all U.S. banks failed, and those depositors lost everything. Congress passed several pieces of legislation in an effort to increase the safety of banking system:
- The Federal Deposit Insurance Corporation (FDIC) was created to provide federal insurance for bank deposits. Banks pay premiums based on their deposits. Almost all banks in the U.S. hold this insurance today.
- The Glass-Steagall Act separated commercial banks and investment banks and insurance in terms of permissible activities. The idea was that underwriting and stock brokering was too risky. This act was repealed in 1999.
- Regulation Q prohibited interest payments on checking deposits and set ceilings on interest rates on savings and time deposits. Regulation Q was repealed in 1980.
Looking at the U.S. banking system, we find it to be more decentralized than the banking systems of other industrialized nations. This means that the U.S. has many small banks (over 8500), while other nations like Canada or Germany have fewer, larger banks. How did this happen? Concern over large national banks driving small state banks out of business prompted Congress to pass the McFadden Act of 1927 that severely restricted the ability of national banks to establish branches within a state and prohibited interstate branching. These restrictions were eliminated in 1994, but still affect the structure of the banking system today.
The idea behind this legislation was to protect small neighborhood state-chartered banks from being driven out of business by the national banks and to promote competition. However, this legislation basically protected inefficient banks from competition and limited the ability of banks to take advantage of economies of scale in the provision of banking services.
To get around this legislation, bank holding companies, a company that owns several different banks, were formed. The holding companies were often allowed to purchase banks in multiple states. Another alternative was for banks to open branches that service depositors, but do not make loans. Finally, ATMs owned by other companies also gave banks a presence in multiple states. Using all of these loopholes, banks effectively achieved some interstate branching.
In 1994, the McFadden Act was repealed with the Riegle-Neal Interstate Banking and Branching Efficiency act. As a result, we have seen a huge increase in bank merger and consolidation activity. It is expected that allowing unrestricted branching will cut the number of banks in the United States in half.
Is this consolidation a good thing? Economists believe these trends will increase efficiency by driving out inefficient bank and allowing banks to take advantage of economies of scale. Also, large banks will have a more diversified (and thus less risky) loan portfolio. However, the question remains whether larger banks will be responsive to small communities and whether banks, eager to expand, will take unwise risks in their lending.
In 1933 the Glass Steagall Act banned commercial banks from brokerage, insurance, real estate, and most underwriting activities. At the same time, investment banks and insurance companies could not act a commercial banks. Again, this separation distinguished U.S. banks from those in other countries.
The motivation behind Glass Steagall was the belief at the time (held to be untrue today) that the bank failures between 1930-33 were to be blamed on the risks taken by banks in the stock market. So this regulation had the intent of making the banking system safer. In reality, restricting bank activities results in
(1) less diversification in the bank balance sheet since banks have fewer asset and liability choices,
(2) lost opportunities for reaping the economies of scale involved in the provision of financial services, not just banking services, and
(3) a competitive disadvantage for U.S. banks, since foreign banks do not face the same restrictions.
As in the case with the branching restrictions, bank holding companies used several loopholes to get around some of the Glass-Steagall restrictions. These restrictions were gradually weakened over time and finally repealed in 1999 with the Gramm-Leach-Bliley Act. This repeal has also resulted in the consolidation not just of commercial banks, but of different financial institutions. Citigroup, for example, offer a range of banking, insurance, and investment services resulting from mergers/acquisitions of Citibank, Traveler's Insurance, and Salomon Smith Barney.
The Globalization of Banking
The growth of international banking is mainly the result of the growing globalization of the economy. As more firms operate in multiple countries, the need for multinational banking services also grows. Also, the regulatory environment for overseas banking is often more favorable for U.S. banks.
U.S. banks that operate overseas, or that serve foreign customers in the U.S. are allowed to operate under alternative corporate structures. Edge Act corporations are subsidiaries of U.S. or foreign banks for international banking. International banking facilities (IBFs) in the U.S. accept deposits and make loans to foreign, but not U.S., customers. They receive favorable regulatory and tax treatment and encourage banking business to remain in the U.S.
An important part of overseas banking is the Eurodollars market. Eurodollars are dollar-denominated deposits in foreign banks. Such deposits have many tax and regulatory advantages. The market for these deposits is centered in London, and interbank lending in Eurodollars takes place at the LIBOR. Like Treasury yields, the LIBOR serves as a benchmark interest rate.
Nondepository Institutions
Nondepository institutions perform many of the five basic functions of financial intermediaries. Because they do not accept deposits, they are less central to the payment system than banks and they are not quite as heavily regulated as banks.
Insurance Companies
Insurance companies "accept premiums from policyholders in exchange for the promise of compensation if certain [adverse] events occur." (333) In other words, insurance companies are paid to assume risk. The pool the premiums and make large investments, the diversify risks across locations and events, and they reduce information costs in screening and monitoring. Property and casualty insurance includes homeowners, fire, and auto insurance. Life insurance provides death benefit policies (term life insurance) and policies that combine both a death benefit and savings (whole life insurance).
Life insurance payouts are a bit more predictable than P&C payouts (disasters like hurricane Katrina are tough to forecast), and this is reflected in their investments. Life insurance companies invest heavily in long term bonds, while P&C companies must rely more heavily on liquid money market instruments.
Insurance companies, like banks, face risks due to adverse selection and moral hazard. In the case of adverse selection, the riskiest individuals are more likely to seek policies. The terminally ill will want large life insurance policies more than the healthy, bad drivers may want more auto insurance than careful drivers. In the case of moral hazard, insurance makes people less careful, because they are protected. Insurance companies control these problems through screening (a physical exam, driving history) and monitoring (requiring sprinklers, having deductibles).
Pension Funds
Pension funds may be privately-sponsored or government-sponsored, but in either case they provide retirement income in return for contributions from employees and employers during their working years. Like insurance companies, they pool savings and help small savers to diversify their risk.
Defined-benefit plans are sponsored by an employers and guarantee benefit payments in retirement based on years of service and final salary. Typically a worker must be at an employer for a long time to be full vested, i.e. qualify for large benefits. This type of plan is declining due to its expense to the employer and the increasing mobility of workers, making it difficult to become fully vested. The plan benefits are also insured by the federal government through the Pension Benefit Guarantee Corporation. Recently the PBGC has had to step in and take over the pension plans of several bankrupt airlines. If GM were to default on its pension obligations, PBGC would probably require a federal government (i.e. U.S. taxpayer) bailout.
Defined-contribution plans are replacing defined benefit plans. Here both employer and employee contribute to an employees retirement investment account (like a 401k, for example). The employee owns the funds and has some control over how they are invested. However, employees also bear the investment risk as the benefit is not guaranteed but instead depends on investment performance.
Securities Firms
This a broad class of firms further broken down into brokers, investment banks, and mutual funds. Brokers provide accounting services and access to secondary markets in trading securities for their clients. The provide liquidity through check writing privileges and by facilitating buying and selling in financial markets.
Mutual funds sell shares to individuals and use those funds to purchase and manage a diversified portfolio of stocks and/or bonds. The value of the shares fluctuates with the value of the underlying portfolio. Why not just buy stock directly? Because through mutual funds, investors can diversify with little initial capital, receive professional management of their investments, and save on transactions costs. These advantages explain why the number of mutual funds has grown from less than 500 in 1980 to over 6000 today. Mutual funds vary according to their investment objectives and the type of securities they hold. Some funds focus on a particular sector, like technology or health care, while some focus on U.S. government bonds or municipal bonds.
Investment banks help bring new debt and equity issues to the primary market through advisement, research and underwriting. As underwriters, they buy new issues of stocks or bonds and then resell them in financial markets. Their role is crucial in helping firms to raise needed funds.
Finance Companies
Finance Companies perform many of the same lending functions as banks, but they do not accept deposits. Instead they raise money direct from financial markets through commercial papers and the secondary loan market. The companies may specialize in consumer finance (for appliances, furniture, electronics), business finance (equipment leasing) and sales finance (such as GMAC and Ford Motor Credit which finance automobile purchases.)
Government-Sponsored Enterprises
These firms are created by Congress to ensure liquidity in various lending markets, including mortgages and student loans. GSEs issue short-term debt, sell bonds back by longer term debt, and buy or guarantee loans in the secondary market. While GSEs are not specifically backed by the federal government, they have a line of credit with the U.S. Treasury, and financial markets perceive these firms as too important for the federal government to allow them to fail.
Two GSEs in the mortgage market, Fannie Mae and Freddie Mac, have fallen under harsh criticism from both Congress and the Federal Reserve. These two firms own or guarantee half of all mortgages in the U.S. so that falling housing prices and/or significant defaults could drive this firms to bankruptcy. While banks are leverages by a 10-to-1 ratio, the leverage of both of these GSEs is more like 30-to-1.
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