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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