Mishkin Chapter 11 - Banking Industry: Structure and Competition

How do small banks compete?

In U.S. there are 10,000 commercial banks, 1500 S&L's, 13,000 credit unions. See page 268. 93% of US banks have less than $500m in assets. The top ten largest banks have only 36.6% of total assets, compared to Canada or UK where 4 or 5 banks dominate the industry and have closer to 80-90% of the assets.

Compare Table 2, page 268 to Table 3, page 284.

Why? McFadden Act (1927) - federal law prohibited branch banking across state lines. Why did the U.S. prohibit branch banking when no other country has done so?

Historical Development of the Banking System

1790 - First Administration. Washington, Adams(VP), Jefferson (Sect of State) and Alex Hamilton (sect of treasury), $10 bill.

Jefferson                              Hamilton
states rights                           federal rights
strict constitution                  broad interpretation
limit Fed power                    expand fed gov
no national bank                   national bank
state control of banking        federal control of banking
state charters                         federal charters

Feud over National Bank - chartered in 1791 with 20 year charter. Jefferson resigned in 1793. First attempt at a central bank, although it had elements of both a private bank and a central bank. Owned partly by the US government, held all deposits of Fed government. Controlled the supply of money and supply of credit.

Agricultural interests were skeptical of concentrated power of any kind, suspicious of a National Bank. Somewhat suspicious of concentrated financial power in large Eastern cities like DC and NYC. Favored state charted banking system.

In 1811, the charter for the First National Bank was not renewed, defeated by Jeffersonians, states rights interests.

State chartered banking system developed, but because of some abuses and because of the need to raise funds to finance the War of 1812 and because it was felt that there was a need to have a central bank, a second attempt at a national/central bank was made by the creation of the 2nd Bank of the US in 1816.

Debate and controversy still continued about whether there should be a National Bank - wasn't explicitly allowed for in the Constitution. Andrew Jackson was elected in 1832, and the 2nd Bank applied for a renewal of its charter 4 years early - expired in 1836. Jackson was strong advocate of states rights. Called the 2nd Bank a monopoly enjoying exclusive privileges - only bank chartered by the Fed gov and the only bank the US fed gov did business with. Also supervised the transfer of funds. Jackson favored using many banks. Supported the grievances of the state banks.

Charter renewal passed Congress, Jackson vetoed. Charter revoked.

Explains the "historic phobia toward large banks."

1. Small banks and the general public have a long history of animosity and hostility toward large banks.

2. Early financial centers in big cities on East coast.

3. People distrusted large fed gov - skeptical of National Bank.

4. Strong state banking system developed, legacy of small banks.

1836-1863 - Era of "free banking." Banks were regulated/chartered by the banking commission in each state. Banks issued banknotes as currency. No national currency. Banknotes could be exchanged for gold. Gold standard. Commodity backed currency.

In some states regulation was very loose, many banks failed due to fraud, mismanagement, lack of capital, etc. - their banknotes became worthless.

1863 - National Banking Act of 1863. Created new banking system of federally chartered banks. Office of the Comptroller of the Currency was created under the Dept of Treasury to supervise national banks.

Legislation was intended to eliminate state chartered banks by imposing very high taxes on their banknotes and not taxing banknotes of federally chartered banks, in an attempt to dry up the source of funds for state banks. State banks started accepting deposits and survived.

States banks survived the National Banking Act of 1863 and we now have a DUAL BANKING SYSTEM.

Banks can either be chartered by the federal gov (national bank) or by the state and be a state-chartered bank. Michigan National Bank vs Montrose State Bank

We have about 3000 national banks (30% of the banks with 50% of the assets) and 7500 (70%) state banks.

National banks are required to join FRS and must have FDIC. State banks are not required to join FRS, most don't (only 1000 out of 7000 join FRS). State banks are not required to be covered by FDIC, most are (95%).

We have a "crazy-quilt pattern of state and federal regulations." Dept of Treasury - Office of the Comptroller of the Currency, FRS, FDIC and state banking regulators all have oversight authority that have blocked a national banking system.

1. Office of the Comptroller has primary regulatory responsibility over the 3000 nationally chartered banks. FRS has secondary responsibility.

2. The FRS and state banking authorities have primary regulatory responsibility over the 1000 state banks that are part of the FRS.

3. The FRS has authority over bank holding companies - companies that own one or more banks.

4. The FDIC and state banking authorities jointly supervise the state banks that are in FDIC but not in FRS.

5. State banks are not required to have FDIC. Those that don't (500) are supervised by the state banking agencies.

1913 - FRS established. Proposed in 1907. Designed to help promote an even safer banking system.

1927 - McFadden Act - prohibited branch banking across state lines. Still in effect. Forces all banks to be small and local. Was proposed to be pro- competitive and put small, state-chartered banks and large, national-chartered banks on an equal footing, but the result has been anti-competitive. Has insulated small banks from competition. Cartel of small banks. Inefficient, weak, small banks cannot be driven out of business by competition from a more efficient bank from another state, or even the same state.

Branching restrictions varied from state to state. Some states had "unit branch banking" laws, which permitted only one location, NO branches. In most cases, it was easier for a bank to open a branch in a foreign country than to open a branch in another state, or even the same state.

Reflects the historic hostility toward large banks. Rent-seeking by small rural banks. Legacy of 19th century politics: heavy restrictions on branch banking, many small, local banks. Similar result: Sherman Anti-trust Act of 1890.

1930s - 9000 bank failures. "Menace of the small bank" - they are tied to the local economy. 0 banks failed in Canada.

As part of Depression era banking legislation, Banking Act of 1933/Glass-Steagall Act was passed. Two main features: 1) established FDIC(deposit insurance) and 2) separated commercial and investment banking.

FDIC: originally 8 cents/$100 deposits. Maximum account insured was $2500, now it is $100,000.

All federally chartered banks, and all state banks that were part of the FRS were required to join FDIC, most of the rest joined voluntarily. Cheap insurance. Problem with FDIC originally: flat fee based insurance, not risk adjusted. Moral hazard. How do depositors choose a bank? Safe banks subsidize the risky banks.

Because banks were now going to be insured, Glass-Steagall separated commercial banks from investment banks. Commercial banks were insured and could accept deposits, couldn't underwrite or own any stock. Restrictions were placed on the assets of the bank - only approved debt instruments. See page 227.

Investment banks couldn't accept deposits, offer savings/checking accounts, etc. Could offer brokerage services and underwriting.

Insured banks were separated into two main types: commercial banks and savings and loans (thrifts).

Commercial banks were restricted to offering checking accounts and making business loans. Int on checking was prohibited.

S&Ls could accept savings accounts and offer home mortgages. Regulation Q gave FRS the authority to fix interest rate ceilings on savings deposits. Repealed in 1986. Starting in 1980, S&L's were allowed to offer checking accounts.

The heavy restrictions on banking activities lead to "Diligent Loophole Mining"

"competition can be repressed but not completely quashed." page 269. The reason that taxes/regulation are distortionary is that they can be AVOIDED.

Ways to get around restrictions:

1. In 1970, a mutual savings bank (offers mortgages and savings accounts, like an S&L, but structured as a cooperative - depositors own the bank - mostly in NE states) in Mass found a way to get around two laws: no checking accounts at mutual savings banks and no interest on checking.

Problem: interest rate were rising in the 60s, and short term money market rates were many times higher than the allowable int on savings by Req Q. Bank offer savings accounts and CDs in competition with other safe short term securities: Tbills, muni bonds, etc. Banks were losing deposits to higher paying securities. "Financial disintermediation."

The bank offered interest-bearing NOW accounts (negotiable order of withdrawal) and claimed that they were not technically a checking account, therefore not subject to the legal restrictions on checking.

Litigation followed, the mutual savings banks prevailed, and they and S&Ls were allowed to offer NOW accounts in Mass and N.H. Profits increased because they could compete and attract deposits.

Commercial banks were upset, didn't like the increased competition. Protested, and in 1974 Congress limited NOW accounts to the NE states, preventing nationwide NOW accounts. In 1980, legislation was passed that allowed all banks to offer checking accounts (commercial, SL, mutual savings, credit unions) and allowed banks to pay interest on checking.

2. ATS - automatic transfer from savings. Allowed banks to get around not being able to pay interest on checking. Two accounts: non interest-bearing checking and interest-bearing savings. Banks would sweep funds from checking over a certain limit, into the savings account to get interest. As checks would clear, funds would be transferred from savings to checking to cover the account. Interest was effectively paid on checking.

3. Int rate ceilings led to offering "gifts" to depositors when market rates were above ceiling.

4. Investment banks started offering what were essentially checking accounts. To get around banking legislation, certain restrictions would be put on the accounts to distinguish them from regular checking accounts. Example: minimum check amount, maximum checks per month, etc. Money market mutual funds, cash management accounts.

5. High interest rates of the 70s led banks to find ways around having assets tied up in non interest-bearing reserves. int rate x reserves = tax on reserves.

Two solutions: Eurodeposits and issuing commercial paper, as alternatives to deposits. Reserve requirements only apply to deposits (savings and checking).

a. Eurodollars - deposits from banks outside the U.S., not subject to reserve requirements.

b. Bank holding company can issue commercial paper to attract funds, not subject to reserve requirements.

6. Banks have found several ways to get around restrictions on branch banking

a. bank holding companies - holding company owns several different banks.

Advantages:

i. Allows the holding company to circumvent branch banking restrictions.

Example: First Chicago and NBD.

ii. holding companies can issue commercial paper to raise funds, not subject to reserve requirements.

iii. holding companies can offer services that banks legally can't - credit card services, loan servicing in other states, investment services, courier services, real estate appraisal, etc.

Services that holding companies are currently trying to offer: real estate brokerage, underwriting securities, travel agencies, management consulting, etc. Certain restrictions apply, but holding companies are finding ways around regulation.

See page 293. Bank failures started to accelerate in the early 1980s. Starting in 1982, a solution to bank failures was to allow holding companies to buy failing banks in other states. McFadden Act was loosened to help bank failures. Result: holding companies could engage in interstate banking.

b. ATM machines. Essentially allowed banks to operate across state lines if they didn't own or rent the ATMs. Someone else owns the ATMs, the banks pay fees based on transaction volume. And even if a bank does own the ATM, essentially a mini "branch bank", the restrictions of McFadden don't usually apply the way they would to a full-service branch bank.

Because of the advantages and flexibility of operating under a bank holding company, 90% of commercial bank deposits are held in banks owned by holding companies.


NATIONWIDE BANKING AND BANK CONSOLIDATION

See page 271. After 50 years of stability, the number of banks has been falling. Reasons:

1. Bank failures play a role. See page 293. 1200 banks failed, out of about 3000 fewer banks.

2. Consolidation. Mergers. Large role. Efficiency gains. Economies of scale. Spreading fixed costs over more branches. Diversification - loans in several states protects the banks.

Regional compacts - certain states allowing mergers in neighboring states. First Chicago and NBD.

Superregional banks - holding companies that operate in more than one state, but are not at one of the major money center cities (NY, Chi, SF). Examples: NationsBank of Charlotte, NC and BankOne of Columbus OH.

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 -

Expands regional mergers to the entire country and repeals the McFadden Act's restrictions on interstate banking. Act:

1. Allows bank holding companies to buy banks in any other state, subject to that state's banking laws.

2. Allows bank holding companies to merge the banks they own into one banking system with branches in more than one state.

Example: First Chicago and NBD could consolidate all branches under one name.

Riegle-Neal Act establishes the basis for a true nationwide banking system. Interstate banking has been taking place through the bank holding company strategy, but until 1994, most states prohibited interstate branching. Even with bank holding companies, real nationwide branching hasn't yet emerged.

Bank holding companies don't fully integrate banking operations, therefore all efficiencies and economies of scale have not yet been fully exploited. Nationwide branch banking will allow banks to fully consolidate and integrate banking operations.

Example: Target and Wal-Mart merge, but have to maintain separate corporate headquarters, separate advertising, separate distribution, payroll, etc.

FUTURE OF BANKING

1. Consolidation and mergers will probably result in the number of banks going from 10,000 to 4,000 (estimated). Most countries have fewer than 1000. Japan has only 100, 1% of the U.S. Using California as an example, there are 400 commercial banks, both large and small. US banking will probably develop like CA - many large nationwide banks (Citicorp, Chase Manhattan, First Union) and many small community banks. Trade-off between efficiency of large banks and personal service of small banks. McFadden Act has basically been repealed/replaced. Nationwide branch banking is inevitable.

2. Repeal of Glass-Steagall Act is inevitable. Rep Jim Leach (R, IA) chair of House banking committee - committed to repealing Glass-Steagall. Sponsored bills in 1995 and 1996 to repeal, but didn't pass.

Who would object?

Investment banks have been allowed to offer products to compete with banks - cash mgmt accts, money market accts. - so banks would like to compete with investment banks - offer brokerage services, underwriting, etc.

Advantage: Increased competition would be good for consumers, lower transactions costs, brokerage fees, etc.

Example: underwriting spreads for investment-grade bonds have fallen since commercial banks have been allowed to offer underwriting services. Underwriter may pay $990 for the security and sell at $1000, making a $10 spread. Increased competition may result in an offer of to buy of $991 and a sale price of $999. The company is better off, they get a higher price/lower interest expense. Investors are better off, they get a lower price, higher yield.

Financial innovation, loophole mining, and the pursuit of profits have eroded the separation of banking and brokerage. Brokers are becoming more like bankers and vice-versa. In addition, finance companies have entered the banking industry - GM Credit, Ford Credit, GE Credit, etc. Commercial banks' credit market share has been falling - see page 289. "Decline of Traditional Banking."

Probable future of Banking in U.S.: Universal Banking - Germany, Netherlands, Switzerland. No separation at all between investment and commercial banking. Complete repeal of Glass-Steagall. Banks offer a complete range of financial services - commercial banking, investment banking, underwriting, insurance, real estate brokerage, etc. Banks are allowed to own common stocks.


DECLINE OF TRADITIONAL BANKING: FINANCIAL INNOVATION AND FINANCIAL DISINTERMEDIATION

1. Money market mutual funds - competition for bank deposits from investment banks. Market really exploded in the late 70s. Req Q fixed int rates on savings accounts at 5.5% when market rates were over 10%. Massive financial disintermediation.

2. Junk Bonds - Bond market competes with commercial banks for corporate borrowing. Before 1980, only investment grade bonds were issued. Investment grade requirements are very strict. Only blue-chip, well-established companies had access to the bond market. Small, medium, lesser known, younger firms could not issue bonds, they had to go to a bank for a commercial loan.

Investment grade bonds that were downgraded below (Baa) investment grade, were classified as "junk bonds", companies were "fallen angels."

Possible reason for no, non-investment grade bond market : (Mishkin) Information was too costly. Once information costs were reduced, high yield bond market opened up.

Michael Milken and Drexel-Burnham opened up the bond market by opening up trading in high-yield bonds, not for "fallen angels" but for firms that had not reached investment grade status. Most of the computer revolution was financed with "junk bonds." MCI, other well known companies started with junk bonds.

The equity of the firm that was holding "junk bonds" was always riskier than the debt. No one calls it "junk equity." Even DJI stocks probably are riskier than the average junk bonds.

Junk bonds: alternative for long term bank loans.

3. Commercial paper - alternative to short-term bank credit. Another form of financial disintermediation. Made possible by information revolution - easier to assess credit risk.

Pension funds and money market funds provide the supply of credit for commercial paper. Commercial paper and money market mutual funds grew together. Money market funds started getting lots of funds to invest, commercial paper provided the ideal short term money market instrument - liquid, low risk, short term.

4. Securitization - transforming illiquid financial assets into standardized, liquid, marketable securities. Financial innovation resulting from information technology lowering transaction cost. Another example of financial disintermediation.

Residential mortgage industry gradually became securitized starting in the 1970s. Now 2/3 of home mortgages are securitized. Single mortgage - not very marketable. Why?

Banks and mortgage companies started packaging mortgage loans in large bundles/portfolios, selling ownership interests in the portfolios as securities in amounts of $100,000. Mortgage-backed security. Example, NBD Bank has a $10m portfolio of mortgages - sell 100 $100,000 mortgage-backed securities to investors: individuals, pension funds, insurance companies, etc. NBD would service the loans for a fee, collect the interest and principal, and pass the payments on the owners of the securities. They would also make a profit on the sale of the securities. Example: loan portfolio yields 8.5%, banks sells to investors to yield 8%, get more than 100% of portfolio value.

GNMA pass-through mortgage security - investor buys a certain percentage of a loan portfolio, a pro rata direct ownership position, instead of a fixed dollar amount or a non-ownership debt obligation.

CMOs - collateralized mortgage obligations. Developed in the 1980s as another financial innovation. Solution to the unpredictability of payoff data. CMOs were sold as different classes (tranches) that determined the order of payoff. Class 1 got paid off first, like a short term bond, and the other classes got paid next, etc. CMOs are like a combination of short, medium and long term bonds. Can be sold to suit investors needs.

Securitization also developed in other areas: auto loans, credit cards, computer leases, etc.

SUMMARY:

1. As a result of financial disintermediation, financial innovation, deregulation, etc. there has been a decline of traditional banking. See page 334. Commercial banks and S&L's share of total financial intermediary assets has gone from 58% in 1960 to 32% in 1996.

2. Financial innovation and loophole mining lead to circumventing regulation.

3. Information technology has changed banking by facilitating innovation.

4. Costly information and transaction costs are a barrier to trade. Lower information costs leads to economic efficiency.

5. Information technology has decentralized power, and has made regulation obsolete.

6. Regulation protects the status quo.