Chapter 11: Banking Industry: Structure and Competition

The resulting loss of income advantages for banks relative to these innovations has resulted in a loss of market share and has led to the growth of the __________________, which has made use of these innovations to enable borrowers to bypass the traditional banking system.

shadow banking system

state banks

state-chartered banks

A change in the financial environment will

stimulate a search by financial institutions for innovations that are likely to be profitable.

A particularly important financial innovation that developed in the 2000s as a result of securitization and the shadow banking system was the ______

subprime mortgage

Allowing banks to conduct interstate banking through branching is especially important because many bankers feel _________

that economies of scale cannot be fully exploited through the bank holding company structure, but only through branching networks in which all of the bank's operations are fully coordinated.

Two concerns remain about the effects of bank consolidation:

that it may lead to a reduction in lending to small businesses and that banks rushing to expand into new geographic markets may take increased risks leading to bank failures. The jury is still out on these concerns, but most economists see the benefits of bank consolidation and nationwide banking as outweighing the costs.

Because it now became easier to assess the risk associated with a pool of subprime mortgages, it became possible to bundle them into a mortgage-backed security, providing a new source of funding for these mortgages. The result was an explosion of subprime mortgage lending, which, as we will see in Chapter 12, was a key factor _____

that led to the global financial crisis of 2007-2009

Information technology has also been increasing economies of scope which is?

the ability to use one resource to provide many different products and services. For example, details about the quality and creditworthiness of firms not only inform decisions about whether to make loans to them but also can be useful in determining at what price their shares should trade.

shadow banking system

bank lending has been replaced by lending via the securities markets, with the involvement of a number of different financial institutions.

dual banking system

banks chartered by the federal government and banks chartered by the states operate side by side.

national banks

federally chartered banks (called national banks)

However, because the financial industry is more heavily regulated than other industries_____________

government regulation is a much greater spur to innovation in this industry.

With the drop in the cost of telecommunications, banks have developed another financial innovation

homebanking

The process of financial innovation, as we have discussed it so far, is much like innovation in other areas of the economy: It occurs in

in response to changes in demand and supply conditions.

The most important source of the changes in supply conditions that stimulated financial innovation has been the improvement in computer and telecommunications technology. This technology, called _________, has had two effects:

information technology First, it has lowered the cost of processing financial transactions, making it profitable for financial institutions to create new financial products and services for the public. Second, it has made it easier for investors to acquire information, thereby making it easier for firms to issue securities.

The most significant change in the economic environment that altered the demand for financial products in recent years has been the dramatic increase in the volatility of _________

interest rates

Commercial paper

is a short-term debt security issued by large banks and corporations

Securitization, definition and what is it the fundamental building block of

is the process of bundling small and otherwise illiquid financial assets (such as residential mortgages, auto loans, and credit card receivables), which have typically been the bread and butter of banking institutions, into marketable capital market securities. the fundamental building block of the shadow banking system.

Schematically, the securitization process is described by the following sequence:

loan origination-> servicing -> bundling -> distribution

Given that information technology is increasing economies of scope,

mergers of banks with other financial service firms like that of Citicorp and Travelers have become increasingly common, and more mega-mergers are likely to be on the way. Banking institutions are becoming not only larger but also increasingly complex organizations, engaging in the full gamut of financial service activities.

adjustable-rate mortgages

mortgage loans on which the interest rate changes when a market interest rate (usually the Treasury bill rate) changes

Securitization, on the other hand, is a process of asset transformation that involves a _______

number of different financial institutions working together. These institutions comprise the shadow banking system. In other words, asset transformation accomplished through securitization and the shadow banking system is not done "under one roof," as is traditional banking.

Because the securitization process involves the origination of loans and then finally the distribution of securities, securitization is also characterized as an ____________

originate-to-distribute business model

Advocates of nationwide banking believe that consolidation will _______

produce more efficient banks and a healthier banking system that is less prone to bank failures

An important feature of the U.S. banking industry is that competition can be __________________

repressed by regulation but not completely quashed

Two sets of regulations have seriously restricted the ability of banks to make profits:

reserve requirements that force banks to keep a certain fraction of their deposits as reserves (vault cash and deposits in the Federal Reserve System) and restrictions on the interest rates that can be paid on deposits.

Our discussion of the factors that drive financial innovation suggests that there are three basic types of financial innovation:

responses to changes in demand conditions, responses to changes in supply conditions, and avoidance of existing regulations.

The decline of banks' traditional business has driven the banking industry to ________

seek out new lines of business

Around the world, there are three basic frameworks for the banking and securities industries:

-Universal Banking -British-style universal banking system -type found in Japan

How has those financial innovations hurt the income advantages of banks?

-We have seen that improvements in information technology have made it easier for firms to issue securities directly to the public. This change means that instead of going to banks to finance short-term credit needs, many of the banks' best business customers now find it cheaper to go instead to the commercial paper market for funds. -The emergence of the junk bond market has also eaten into banks' loan business. Improvements in information technology have made it easier for corporations to sell their bonds to the public directly, thereby bypassing banks. -We have also seen that improvements in computer technology have led to the growth of the shadow banking system and securitization, whereby illiquid financial assets such as bank loans and mortgages are transformed into marketable securities. Computers can enable other financial institutions to originate loans, they lower transaction costs, and evaluate default risk

Most economists are skeptical of these criticisms of bank consolidation. why?

As we have seen, research indicates that even after bank consolidation is completed, the United States will still have plenty of banks. The banking industry will thus remain highly competitive, probably even more so than it is now, considering that banks that had been protected from competition from out-of-state banks now have to compete with them vigorously to stay in business. It also does not look as though community banks will disappear. Similarly, California, which has allowed unrestricted statewide branching for a long time, continues to have a thriving population of community banks

reasons for the development of the ATM:

As we saw earlier in this chapter, avoiding regulation was not the only reason for the development of the ATM. The advent of cheaper computer and telecommunications technology enabled banks to provide ATMs at low cost, making them a profitable innovation.

______________- explain the first phase of banking consolidation

Mergers and acquisitions

dual banking system

The banking system in place in the United States, in which banks supervised by the federal government and banks supervised by the states operate side by side.

Why has bank consolidation been taking place in recent years?

With the barriers to interstate banking breaking down in the early 1980s, banks recognized that they could gain the benefits of diversification because they would now be able to make loans in many states rather than just one. This gave them an advantage: If one state's economy was weak, another state in which they operated might have a strong economy, thus decreasing the likelihood that loans in different states would default at the same time. In addition, allowing banks to own banks in other states meant that they could increase their size through out-of-state acquisition of banks or by merging with banks in other states

Why did this sudden decline of commercial banks take place?

bank failures are only part of the story, and bank consolidation is the rest of the story

Regulations restricting branching have stimulated similar economic forces and have promoted the development of two financial innovations:

bank holding companies and automated teller machines.

What does it mean to service a loan?

collect the interest and principal payments

The success of bank credit cards led these institutions to come up with another financial innovation:

debit cards

Disintermediation

depositors withdrew funds from banks to put them into higher-yielding securities. This loss of deposits from the banking system restricted the amount of funds that banks could lend

Large fluctuations in interest rates lead to substantial capital gains or losses and greater uncertainty about returns on investments. Recall that the risk that is related to the uncertainty about interest-rate movements and returns is called ___________

interest rate risk. This would mean higher interest rate risk

hedge

protect themselves from

Further, even in countries where securities markets have not grown, banks have still lost loan business because

their best corporate customers have had increasing access to foreign and offshore capital markets,

Debit cards depend even more on low costs of processing transactions, because

their profits are generated entirely from the fees paid by merchants on debit card purchases at their stores

At each step of the securitization process, the loan originator, servicer, bundler, and distributor earn a fee. Each of these four institutions has specialized in a particular element of the financial intermediation process. The shadow banking system, which comprises all of the financial institutions involved in the securitization process, can thus be very profitable if

transaction costs and the costs of collecting information are low.

With the decline in the price of personal computers and their increasing presence in the home, we have seen a further innovation in the home banking area, the creation of a new type of banking institution, __________, (what is it and it's defintion)

virtual bank, a bank that has no physical location but rather exists only in cyberspace

With the improvement in information technology in the 1970s, it became easier for investors to acquire financial information about corporations, making it easier to screen out bad from good credit risks. With easier screening, investors were more willing to buy long-term debt securities from less-well-known corporations with lower credit ratings. With this change in supply conditions, ____

we would expect that some smart individual would pioneer the concept of selling new public issues of junk bonds, not for fallen angels but for companies that had not yet achieved investment-grade status.

Another result of the loosening of restrictions on interstate branching is the development of a new class of banks, called superregional banks:

which are bank holding companies that have begun to rival the money center banks in size but whose headquarters are not in one of the money center cities (New York, Chicago, and San Francisco).

Futures contracts

which the seller agrees to provide a certain standardized commodity to the buyer on a specific future date at an agreed-on price, had been around for a long time.

Several commercial banks attempted to expand the credit card business to a wider market in the 1950s, but why did they fail early on and what actually helped them to succeed?

-the cost per transaction of running these programs was so high that their early attempts failed In the late 1960s, improved computer technology, which lowered the transaction costs for providing credit card services, made it more likely that bank credit card programs would be profitable

Improved computer technology that lowered transcations costs for providing credit cards led to what two successful credit card programs:

BankAmericard (Visa now) and MasterCharge (Mastercard now)

What is bank consolidation?

Banks have been merging to create larger entities or have been buying up other banks

How did ATMs help banks get around regulations about other branches?

Banks quickly realized that if they did not own or rent an ATM, but instead let it be owned by someone else and paid a fee for each transaction, the ATM would probably not be considered a branch of the bank and thus would not be subject to branching regulations

What happened to regulation Q on deposit rate ceilings?

Banks supported legislation that eliminated it

Why did bills to overturn Glass-Steagall appear in almost every session of Congress in the 1990s

Because restrictions on commercial banks' securities and insurance activities put American banks at a competitive disadvantage relative to foreign banks

deposit rate ceilings

Fed set maximum limits on the interest rate that could be paid on savings and time deposits

This consolidation has had two consequences:

First, different types of financial intermediaries are encroaching on each other's territory, making them more alike. Second, consolidation has led to the development of large, complex banking organizations

In an attempt to survive and maintain adequate profit levels, many U.S. banks faced two alternatives:

First, they could attempt to maintain their traditional lending activity by expanding into new and riskier areas of lending. For example, U.S. banks increased their risk taking by placing a greater percentage of their total funds in commercial real estate loans, traditionally a riskier type of loan. The second way in which banks have sought to maintain their former profit levels is by pursuing new off-balance-sheet activities that are more profitable and in effect embrace the shadow banking system. (much more risk tho)

Why was the deposit rate ceiling good for a while and then bad?

For a while, these restrictions worked to the banks' advantage because their major source of funds (in excess of 60%) was checkable deposits, and the zero interest cost on these deposits meant that the banks had a very low cost of funds. But then, the rise in inflation beginning in the late 1960s led to higher interest rates, which made investors more sensitive to yield differentials on different assets. The result was the disintermediation process, in which people began to take their money out of banks, with their low interest rates on both checkable, savings and time deposits, and began to seek out higher-yielding investments. At the same time, as we have seen, attempts to get around deposit rate ceilings and reserve requirements led to the financial innovation of money market mutual funds, which put the banks at an even further disadvantage because depositors could now obtain checking account-like services while earning high interest on their money market mutual fund accounts.

Why was reserve requirements a major force behind financial innovation?

For each dollar of deposits, reserve requirements therefore imposed a cost on the bank equal to the interest rate, i, that could be earned if the reserves could be lent out times the fraction of deposits required as reserves, r. The cost of i x r imposed on the bank was just like a tax on bank deposits of i x r per dollar of deposits. This "tax" on deposits rises as interest rates rise. It is a great tradition to avoid taxes if possible, and banks also play this game. just as taxpayers look for loopholes to lower their tax bills, banks seek to increase their profits by mining loopholes and by producing financial innovations that enable them to escape the tax on deposits imposed by reserve requirements.

How does government regulation lead to financial innovation?

Government regulation leads to financial innovation by creating incentives for firms to skirt regulations that restrict their ability to earn profits

This attractive feature of adjustable-rate mortgages has encouraged mortgage issuing institutions to issue adjustable-rate mortgages with lower initial interest rates than those on conventional fixed-rate mortgages, making them popular with many households. Why are both types of mortgages still widespread?

However, because the mortgage payment on a variable-rate mortgage can increase, many households continue to prefer fixed-rate mortgages.

Why was restrictions on interest paid on deposits a major force behind financial innovation?

If market interest rates rose above the maximum rates that banks paid on savings and time deposits under Regulation Q (deposit rate ceilings) , depositors withdrew funds from banks to put them into higher-yielding securities. Banks had an incentive to get around deposit rate ceilings, because by so doing, they could acquire more funds to make loans and earn higher profits.

The loss of banks' monopoly power over depositors has occurred outside the United States as well. Financial innovation and deregulation are occurring worldwide and have created attractive alternatives for both depositors and borrowers. For example:

In Japan, for example, deregulation opened a wide array of new financial instruments to the public, causing a disintermediation process similar to that in the United States. In European countries, innovations have steadily eroded the barriers that have traditionally protected banks from competition.

How does a sweep account work and how does it get around the restrictions?

In this arrangement, any balances above a certain amount in a corporation's checking account at the end of a business day are "swept out" of the account and invested in overnight securities that pay interest. Because the "swept out" funds are no longer classified as checkable deposits, they are not subject to reserve requirements and thus are not "taxed." They also have the advantage that they allow banks, in effect, to pay interest on these checking accounts, which otherwise is not allowed under existing regulations. Because sweep accounts have become so popular, they have lowered the amount of required reserves to the degree that most banking institutions do not find reserve requirements binding: In other words, they voluntarily hold more reserves than they are required to.

We can now look at how the desire to avoid restrictions on interest payments and the tax effect of reserve requirements led to two important financial innovations:

Money Market Mutual Funds and Sweep Accounts

This form of corporate ownership (holding companys) has important advantages for banks.

It has allowed them to circumvent restrictive branching regulations, because the holding company can own a controlling interest in several banks even if branching is not permitted. Furthermore, a bank holding company can engage in other activities related to banking, such as the provision of investment advice, data processing and transmission services, leasing, credit card services, and servicing of loans in other states.

Homebanking

It is now cost-effective for banks to set up an electronic banking facility in which the bank's customer is linked up with the bank's computer and allowed to carry out transactions by using a smartphone, tablet, or personal computer. Now a bank's customers can conduct many of their bank transactions without ever leaving the comfort of home.

How does a money market mutual fund work and how does it get around the restrictions?

Money market mutual funds issue shares that are redeemable at a fixed price (usually $1) by writing checks. For example, if you buy 5,000 shares for $5,000, the money market fund uses these funds to invest in short-term money market securities (Treasury bills, negotiable certificates of deposit, commercial paper) that provide you with interest payments. In addition, you are able to write checks up to the $5,000 held as shares in the money market fund. Although money market fund shares effectively function as checking account deposits that earn interest, they are not legally deposits and so are not subject to reserve requirements or prohibitions on interest payments. For this reason, they can pay higher interest rates than deposits at banks.

What forces have caused a decline in traditional banking in other countries?

Same forces as America: -increased competition from the expansion of securities markets and the growth of the shadow banking system -Both financial deregulation and advances in information technology in other countries have improved the availability of information in securities markets -same forces that drove the securitization have undercut the profitability of traditional banking in these countries as well

Commercial bank regulatory agencies:

The Office of the Comptroller of the Currency has the primary supervisory responsibility for national banks that own more than half of the assets in the commercial banking system. The Federal Reserve and the state banking authorities have joint primary responsibility for state banks that are members of the Federal Reserve System. The Fed also has regulatory responsibility over companies that own one or more banks (called bank holding companies) and secondary responsibility for the national banks. The FDIC and the state banking authorities jointly supervise state banks that have FDIC insurance but are not members of the Federal Reserve System. The state banking authorities have sole jurisdiction over state banks without FDIC insurance. (Such banks hold less than 0.2% of the deposits in the commercial banking system.)

What does the distributor do in the securitization process?

The bundler goes to a distributor (typically an investment bank), which designs a security that divides the portfolio of loans into standardized amounts. The distributor then sells the claims to these interest and principal payments as securities, mostly to other financial intermediaries that are also part of the shadow banking system

financial engineering

To survive in the new economic environment, financial institutions had to research and develop new products and services that would meet customer needs and prove profitable

A holding company is _____________

a corporation that owns several different companies.

Central bank

a government institution that has responsibility for the amount of money and credit supplied in the economy as a whole

subprime mortgage

a new class of residential mortgages offered to borrowers with less-than-stellar credit records

The McFadden Act and state branching regulations constituted strong anticompetitive forces in the commercial banking industry, _______________

allowing many small banks to stay in existence because larger banks were prevented from opening branches nearby.

Despite the Glass-Steagall prohibitions, the pursuit of profits and financial innovation stimulated both banks and other financial institutions to bypass the intent of the Glass-Steagall Act and encroach on each other's traditional territory:

-underwrite previously prohibited classes of securities -a commercial bank holding company, to underwrite corporate debt securities (in January 1989) and to underwrite stocks (in September 1990), with the privilege later extended to other bank holding companies. -The regulatory agencies also allowed banks to engage in some real estate and insurance activities.

What led to the growth in the commercial paper market?

1. Improvements in information technology also help explain the rapid rise of the commercial paper market. We have seen that improvements in information technology made it easier for investors to screen out bad from good credit risks, thus making it easier for corporations to issue debt securities. Not only did this make it simpler for corporations to issue long-term debt securities, as in the junk bond market, but it also meant they could raise funds by issuing short-term debt securities, such as commercial paper, with greater ease. 2. The development of money market mutual funds has been another factor in the rapid growth of the commercial paper market. Because money market mutual funds need to hold liquid, high-quality, short-term assets such as commercial paper, the growth of assets in these funds to around $2.7 trillion has created a ready market in commercial paper. 3. The growth of pension and other large funds that invest in commercial paper has also stimulated the growth of this market

With great changes occurring in the structure of this industry, the question naturally arises: What will the industry look like in ten years?

One view is that the industry will become more like that in many other countries and we will end up with only a couple of hundred banks. A more extreme view is that the industry will look like that of Canada or the United Kingdom, with a few large banks dominating the industry. Most experts come up with a different answer: The structure of the U.S. banking industry will still be unique, but not to the degree it once was. The consolidation surge is likely to settle down as the U.S. banking industry approaches several thousand, rather than several hundred, banks. Banking consolidation will result not only in a smaller number of banks but also in a shift in assets from smaller banks to larger banks.

Economists see some important benefits from bank consolidation and nationwide banking:

The elimination of geographic restrictions on banking increases competition and drives inefficient banks out of business, increasing the efficiency of the banking sector. -The move to larger banking organizations also means that there is some increase in efficiency because these organizations can take advantage of economies of scale and scope. -The increased diversification of banks' loan portfolios may lower the probability of a banking crisis in the future. -Thus nationwide banking is seen as a major step toward creating a banking system that is less vulnerable to banking crises.

If competition is beneficial to society, why did regulations restricting branching arise in America?

The simplest explanation is that the American public has historically been hostile to large banks. States with the most restrictive branching regulations were typically ones in which populist antibank sentiment was strongest in the nineteenth century.

Banking consolidation was given further stimulus by the passage in 1994 of the Riegle- Neal Interstate Banking and Branching Efficiency Act. How?

This legislation expanded the regional compacts to the entire nation and overturned the McFadden Act and Douglas Amendment's prohibition of interstate banking. Not only did this act allow bank holding companies to acquire banks in any other state, notwithstanding any state laws to the contrary, but bank holding companies could also merge the banks they owned into one bank with branches in different states.

One important form of an e-banking facility is the automated teller machine (ATM), which is?

an electronic machine that allows customers to get cash, make deposits, transfer funds from one account to another, and check balances

We would expect the increase in interest-rate risk to increase the demand for financial products and services that could reduce that risk. This change in the economic environment would thus stimulate a search by financial institutions for profitable innovations that meet this new demand and would spur the creation of new financial instruments that help lower interest-rate risk. Two financial innovations that were developed in the 1970s confirm this prediction:

adjustable-rate mortgages and financial derivatives

This legislation, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999:

allows securities firms and insurance companies to purchase banks, and allows banks to underwrite insurance and securities and engage in real estate activities. Under this legislation, states retain regulatory authority over insurance activities, while the Securities and Exchange Commission continues to have oversight of securities activities. The Office of the Comptroller of the Currency has the authority to regulate bank subsidiaries engaged in securities underwriting, but the Federal Reserve continues to have the authority to oversee the bank holding companies under which all real estate and insurance activities and large securities operations will be housed.

Because of their low cost, ATMs can be put at locations other than a bank or its _____

branches (offices for the conduct of bank operations)

Glass-Steagall of 1933 allowed

commercial banks to sell new offerings of government securities but prohibited them from underwriting corporate securities or from engaging in brokerage activities. It also prevented banks from engaging in insurance and real estate activities. In turn, it prevented investment banks and insurance companies from engaging in commercial banking activities and thus protected banks from competition.

bank holding companies

companies that own one or more banks

Consumers have benefited because ____________

credit cards are more widely accepted than checks as a method of paying for purchases (particularly abroad), and they allow consumers to take out loans more easily.

The financial innovations of sweep accounts and money market mutual funds are particularly interesting because they were stimulated by:

desire to avoid a costly regulation but also by a change in supply conditions—in this case, information technology.

However, critics of bank consolidation

fear that it will eliminate small banks, referred to as community banks, and that this will result in less lending to small businesses. In addition, they worry that a few banks will come to dominate the industry, making the banking business less competitive.

Why has traditional banking been on a decline?

financial innovations described earlier have caused banks to suffer declines in their cost advantages in acquiring funds—that is, on the liabilities side of their balance sheet—while at the same time losing income advantages on the assets side of their balance sheet. The simultaneous decline of cost and income advantages has resulted in reduced profitability of traditional banking and an effort by banks to leave this business and engage in new and more profitable activities.

The result is that consolidation is taking place not only to make ___________________

financial institutions bigger but also to increase the combination of products and services they can provide

Financial derivatives and why were they used?

futures contracts in financial instruments Officials at the Chicago Board of Trade realized that if they created financial derivatives because their payoffs are linked to (i.e., derived from) previously issued securities, they could be used to hedge risk.

Economies of scale have increased because large, upfront investments are required to set up information technology platforms for financial institutions. To take advantage of these economies of scale, banks ________

have needed to get bigger, and this development has led to additional consolidation.

Some firms that had fallen on bad times, known as fallen angels, had previously issued long-term corporate bonds with ratings that had now fallen below Baa, bonds that were pejoratively dubbed ______

junk bonds

American banks have also been hit by a decline in income advantages on the assets side from the financial innovations of/such as:

junk bonds, securitization, and the rise of the commercial paper market.

A firm issuing credit cards earns income from _______________________________. A credit card program's costs arise from __________________.

loans it makes to credit card holders and from payments made by stores on credit card purchases (a percentage of the purchase price, say, 3%). loan defaults, stolen cards, and the expense involved in processing credit card transactions.

The wonders of modern computer technology have also enabled banks to lower the cost of bank transactions by having the customer interact

with an electronic banking (e-banking) facility rather than with a human being