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Chapter 12
Commercial Banking Industry
Structure
Preview
• This chapter examines the historical trends
in the banking industry that help explain the
unique structure of the U.S. system.
Overview
• US banking system very different from
rest of the world.
• Many small banks.
• U.S. has about 7,000 commercial banks
for a population of about 300 million.
This is down from 14,000 in the mid
1980’s.
• Canada has 21 banks for about 36
million.
• Norway has 4 banks for 4.5 million.
Why is the US Unique?
• Need to look at the history of banking in the
US.
Need to look back to the 1700’s
Jefferson
• States rights
• Limit federal power
• No national or central
bank
• State control of banking
Hamilton
• Federal rights
• Expand Government
and centralize power
• National or central bank
• Federal control of
banking
Figure 1 Time Line of the Early History of Commercial
Banking in the United States
Early History
• 1791 - Bank of the United States chartered for 20
years. First attempt at a central bank to controlled
money supply and credit.
• Agricultural interest very skeptical of
concentration of power in large eastern cities,
advocated state charters.
• 1811 - charter not renewed. Defeated by states
rights and agricultural interests.
Early History – 1800’s
• War of 1812 – need to raise funds, some felt
need for a national/central bank.
• 1816 - second attempt at central bank. Second
Bank of the United States chartered for 20
years (this was only 5 years later)
• 1832- Andrew Jackson elected. Congress votes
to re-charter, Jackson, a strong advocate of
states rights, vetoes.
Free Banking Era:1832- 1863
• Banks chartered and regulated only by the
states
• No national currency
• Banks issued private bank notes (that could
be redeemed for gold) to attract funds
• Think about going to Tennessee with a bank note
issued by a bank in Philadelphia. Money is supposed
to reduce information cost and facilitate trade – not the
case here!
• Poor regulation, many banks under
capitalized, many failed, bank notes became
worthless.
National Banking Act of 1863
• Created federally chartered banks under
supervision of the Office of the Comptroller
of the Currency.
• Tried to eliminate state banks by imposing a
10% tax on state bank notes.
• Tax did not eliminate state banks.
• Did eliminate state bank notes.
• State banks created demand deposits.
• Today we have a “dual banking system”
• 2,100 federally chartered banks with 50% of total bank assets.
Early History Summary
• Phobia against large banks and central banking
which carried into the 20th century.
• State banking system developed in the US
rather than the typical national banking system
in other countries.
• Federally chartered banks in 1863. We have a
dual banking system in the US
1900s
• 1913 - The Federal Reserve System
• 1927 - McFadden Act
- prohibited branch banking across lines
• 1930 - 1933, the Great Depression
- Banking Act of 1933/ Glass-Steagall Act
- Set up FDIC - deposit insurance.
- Separated commercial and investment
banking.
- Restricted checkable deposits to commercial banks
- Put interest rate ceilings on bank deposits (Regulation Q)
McFadden Act - 1927
• Proposed as being pro-competitive.
• Actually anti-competitive because small banks
insulated from out-of-state competition.
• Some states had “unit banking” – No
branches!
• Big Negative - banks tied to local economy as
a result of McFadden Act.
• From 1930-1933, 9000 banks failed in the
US(1/3), compared to 0 in Canada.
How to get around regulations prohibiting
branching across state lines
• Bank Holding Companies
- Allowed
purchase of banks outside state
• Automated Teller Machines
- Not
considered to be branch of bank
McFadden Act repealed in 1994 by Reigle-Neal Act
Key Legislation Affecting the U.S. Banking
Industry
• 1913 Federal Reserve Act
• 1927 McFadden Act: Outlawed interstate branching and
required national banks to abide by the laws of the state in
which they operated.
• 1933 Glass-Steagall Act: Established federal deposit
insurance and prohibited commercial banks from engaging in
the insurance and securities businesses.
• 1994 Reigle-Neal Act: Repealed the McFadden Act
• 1999 Gramm-Leach-Bliley Act: Repealed the Glass-Steagall
Act’s prohibition of mergers between commercial banks and
insurance companies or securities firms.
Financial Innovation and the Decline of Traditional
Banking – Attack on the balance sheet
• Commercial bank importance as a source of
funds to non-financial borrowers has fallen over
time.
• Without a decline in overall profitability
Bank Share of Total Nonfinancial
Borrowing, 1960–2014
40%
28%
20%
5%
Source: Federal Reserve Bank of St. Louis, FRED data base:
http://research.stlouisfed.org/fred2/; https://www2.fdic.gov/hsob/index.asp.
Financial Innovation, Increased Competition for Sources
of Funds
• Prior to 1980s - Regulation Q
• 60% of bank funds were deposits (now 6%)
• 1970s - π↑ => i↑ (Fisher Equation)
• Major Financial Innovation
• Money Market Mutual Funds (MMMF)
• Disintermediation – banks lost deposits to MMMF.
• Regulation Q eliminated in 1980, but banks lost
Cost Advantages in Acquiring Funds
Financial innovations leading to increase in direct
finance – Competition for Use of Funds
• Junk Bonds
• Commercial Paper
• GE Capital is an example of a commercial
finance company. At one point the largest
issuer of commercial paper in the US.
Loans to
buyers of
GE products
Commercial
paper
Financial Innovation: Junk Bonds
• Prior to 1980, bonds were never issued
that had a junk rating.
• Only firms with Baa or better could direct finance in
the bond market.
• The only junk debt was bonds that had fallen in credit
rating (so-called fallen angels).
• With improvement in information technology in
the 1970s it became easier for investors to
screen out bad credit from good credit risks and
willing to buy new issue debt rated < Baa.
Financial Innovation: Commercial Paper Market
• Commercial paper refers to unsecured
debt issued by corporations (non-financial
and financial) with a short maturity.
• Peaked at $2.2 trillion outstanding mid 2007.
• As with junk bonds, improvement in information
technology in the 1970s made it easier for
investors to screen out bad credit from good
credit risks
• Also, the development of money market mutual
funds in the 1970s contributed to growth by
creating a market for commercial paper.
Commercial Paper Outstanding: 2001 - 2014
13-23
Commercial Paper and ABCP Outstanding:
2001 - 2014
13-24
Bank Response
• Loss of cost advantages in raising funds and
income advantages in making loans caused
reduction in profitability in traditional banking
• Two Responses:
• Expanded into new and riskier areas of lending
• Commercial real estate loans
• Corporate takeovers and leveraged buyouts
• Increased income from off-balance-sheet activities (noninterest income)
• Trading activities
Bank Consolidation and Nationwide Banking
• The number of banks has declined over the
last 25 years
• Combination of bank failures and
consolidation.
• Deregulation: Riegle-Neal Interstate
Banking and Branching Efficiency Act f
1994.
• Economies of scale and scope from
information technology.
• Not only a smaller number of banks but a shift
in assets to much larger banks.
Figure 3 Number of Insured Commercial Banks in
the United States, 1934–2014 (Third Quarter)
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.
Eurodollar Market
• Dollar-denominated deposits held in banks
outside of the U.S.
• Most widely used currency in international
trade
• Offshore deposits not subject to
regulations
• Important source of funds for U.S. banks
Another Example of Avoiding Regulation
• Eurodollars
• Dollar denominated deposits in foreign
banks or foreign branches of US banks.
• Sweep Accounts: Funds are “swept” out of
checking accounts nightly and invested at
overnight rates. Since they are no longer
checkable deposits, reserve requirement is
avoided.
Eurodollars
New York Bank
Reserves= $100,000
DD= $1,000,000
Loans= $900,000
New York Bank
Loans=
$1,000,000
Borrow from
Cayman Branch=
$1,000,000
Cayman Branch of NY Bank
DD= $1,000,000