Chapter Thirteen

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

Financial Industry Structure

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter Thirteen

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Introduction

• The U.S. has about 6,800 commercial banks and roughly 16,000 depository institutions.

• For many years, most U.S. banks were unit banks, or banks without branches.

• The decline in the total number of banks and the increase in the number of banks with branches are not the only changes we have seen.

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Introduction

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Introduction

• The crisis of 2007-2009 has transformed the U.S. financial industry.• The failure or forced merger of several large banks

and other depository institutions accelerated concentration.

• In July 2008, the U.S. government placed the two massive government-sponsored enterprises (GSEs) for housing finance in conservatorship.

• In September 2008, the four largest independent investment banks failed, merged, or became bank holding companies.

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Introduction

• To understand the changing structure of the financial industry, we will discuss the services provided by both depository and nondepository financial institutions.

• They provide a broad menu or services including:• Building and selling securities;

• Offering loans, insurance, and pensions; and

• Providing checking accounts, credit cards, and debit cards.

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Banking Industry Structure

• To understand the structure of today’s banking industry, we need to trace it back to its roots.

• In this section we will learn that banking legislation is the reason we have so many banks in the U.S.

• We will look at the trend toward consolidation that has been steadily reducing the number of banks since the mid-1980’s.

• We will also briefly consider the effects of globalization.

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A Short History of U.S. Banking

• To start a bank, one needs permission in the form of a bank charter.

• Until 1863,• All bank charters were issued by state banking

authorities, and

• There was no national currency so banks issued banknotes.

• These banknotes did not hold value from one place to another and banks regularly failed.

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• During the Civil War, Congress passed the National Banking Act of 1863.• State banks were not eliminated, but did impose a

10% tax on their banknotes.

• The act created a system of federally chartered banks, or national banks.

• National banks could issue banknotes tax-free.

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• State banks devised another way to make money--demand deposits.

• This is how we got the dual-banking system we have today.• Banks can choose whether to get their charters from

the Comptroller of the Currency at the U.S Treasury or from state officials.

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• About 3/4 have a state charter and the rest a federal charter.

• Which charter a bank chooses depends on its profitability.• State banks have more operational flexibility, which

means a better chance of making a profit.

• If the Comptroller of the Currency won’t let a bank do something, they can always just change their charter.

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• The ability for banks to go back and forth between charters created what amounts to regulatory competition.• This has accelerated innovation in the financial

industry.

• Globalization, however, has increased competition between national government regulators.

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• The Great Depression lead to the Glass-Steagall Act of 1933.• This legislation

• Created the Federal Deposit Insurance Corporation (FDIC),

• Severely limited the activities of commercial banks,

• Provided insurance to individual depositors, so they would not lose their savings in the event that a bank failed, and

• Restricted bank assets to certain approved forms of debt.

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• The law separated commercial banks from investment banks.• Separating these two types of banks limited

financial institutions from taking advantage of economies of scale and scope that might exist.

• This changed in 1999 with the Gramm-Leach-Bliley Financial Services Modernization Act which repealed the Glass-Steagall Act.

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Competition and Consolidation

• There are roughly 6,800 commercial banks in the U.S. today, and that number has been shrinking.

• The number of banks with branches has changed significantly as well.• Today’s banks not only have branches, they have

many of them.

• The U.S. banking system is composed of a large number of very small banks and a small number of very large ones.

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Number & Assets of U.S. Commercial Banks

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• The primary reason for this structure is the McFadden Act of 1927.• This legislation required that nationally chartered

banks meet the branching restrictions of the states in which they were located.

• Some states have laws forbidding branch banking, resulting in a large number of small banks.

• There was fear that large banks would drive small banks out of business, reducing the quality in smaller communities.

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• The result was a fragmented banking system nearly devoid of large institutions.

• We ended up with a network of small, geographically dispersed banks that faced little competition - the opposite of what the act wanted.

• In many states, more efficient and modern banks were legally precluded from opening branches to compete with local banks.

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• Small local banks were without competition.• This lead to loan portfolios that were insufficiently

diversified.

• At some points loans were not made because the bank had taken on too much risk.

• Lack of credit only hurt these communities.

• Bank managers did well, but the communities suffered.

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• Some banks reacted to branching restrictions by creating bank holding companies.• These are corporations that own a group of other

firms.

• Can be thought of as a parent firm for a group of subsidiaries.

• Initially these were created as a way to provide nonbank financial services in more than one state.

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• In 1956, Congress passed the Bank Holding Company Act.• This allowed bank holding companies to provide

various nonbank financial services.

• Technology has eroded the value of the local banking monopoly.• In the 1970s and 1980s, states responded by

loosening their branching restrictions.

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• In 1994, Congress passed the Riegel-Neal Interstate Banking and Branching Efficiency Act.• This legislation reversed restrictions from the

McFadden Act.

• Since 1977, banks have been able to acquire an unlimited number of branches nationwide.

• The number of commercial banks has fallen nearly in half.

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• Deregulation provided benefits for the economy.• Banks became more profitable.

• Operation costs and loan losses fell.

• Interest rates paid to depositors rose.

• Interest rates charged to borrowers fell.

• The financial crisis of 2007-2009 has focused attention on the costs of deregulation.• Do the benefits of deregulation outweigh the risks?

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Banking Industry Structure:Key Legislation

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• Pawnshops provide loans to people without access to the traditional financial system.

• A person brings something of value to the pawn shop in exchange for a short term loan.

• Because the loans are collateralized, the terms are often reasonable – better than payday loans, for example.

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Globalization of Banking

• There are a number of ways banks can operate in foreign countries, depending on factors such as the legal environment.• Open a foreign branch that offers the same services

as those in the home country.

• Banks can create an international banking facility (IBF), which allows it to accept deposits from and make loans to foreigners outside the country.

• The bank can create a subsidiary called an Edge Act corporation, which is established specifically to engage in international banking transactions.

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• Alternatively, a bank holding company can purchase a controlling interest in a foreign bank.

• Foreign banks can take advantage of similar options.

• All the competition has made banking a tougher business.

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• One of the most important aspects of international banking is the eurodollar market.

• Eurodollars are dollar-denominated deposits in foreign banks.

• Originally the euromarket was a response to restrictions on the movement of international capital that were instituted with the Bretton Woods system of exchange rate management.

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• To ensure the pound would retain its value, the British government imposed restrictions on the ability of British banks to finance international transactions.

• In an attempt to evade these restrictions, London banks began to offer dollar deposits and dollar-denominated loans to foreigners.

• The result was what we know today as the eurodollar market.

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• The Cold War accelerated this when the Soviet government, fearing that the U.S. government might freeze or confiscate their deposits, shifted them from New York to London.

• In 1960, U.S. tried to prevent dollars from leaving the country by increasing costs for foreigners to borrow dollars in the U.S.

• In the early 1970s, domestic interest rate controls and high inflation made domestic deposits less attractive than eurodollar deposits.

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• The eurodollar market in London is one of the biggest and most important financial markets in the world.

• The interest rate at which banks lend each other eurodollars is called the London Interbank Offered Rate (LIBOR).• This is the standard against which many private loan rates are

measured.

• The gap between the LIBOR and expected Fed policy interest rate provides a key measure of the intensity and persistence of the liquidity crisis.

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The Future of Banks

• In November of 1999, the Gramm-Leach-Bliley Financial Services Modernization Act went into effect.• This effectively repealed the Glass-Steagall Act of

1933.

• It allowed a commercial bank, investment bank, and insurance company to merge and form a financial holding company.

• To serve all their customers’ financial needs, bank holding companies are converting to financial holding companies.

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The Future of Banks

• Financial holding companies are a limited form of universal banks.• These are firms that engage in nonfinancial as well

as financial activities.

• In the U.S., different financial activities must be undertaken in separate subsidiaries and financial holding companies are still prohibited from making equity investments in nonfinancial companies.

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The Future of Banks

• Owners and managers of these financial firms cite three reasons to create them:• Their range of activities, if properly managed,

permits them to be well diversified.

• These firms are large enough to take advantage of economies of scale.

• These companies hope to benefit from economies of scope.

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The Future of Banks

• Thanks to recent technological advances, almost every service traditionally provided by financial intermediaries can now be produced independently, without the help of a large organization.

• As we survey the financial industry, we see the two trends running in opposite directions.

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Nondepository Institutions

• There are five categories of nondepository institutions:• Insurance companies;• Pension funds;• Securities firms, including brokers, mutual-fund

companies, and investment banks;• Finance companies, and• Government-sponsored enterprises.

• Nondepository institutions also include an assortment of alternative intermediaries, such as pawnshops.

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Relative Size of U.S. Financial Intermediaries

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Insurance Companies

• Modern forms of insurance can be traced back to around 1400, when wool merchants insured their overland shipments from London to Italy for 12 to 15 percent of their value.

• The first insurance codes were developed in Florence in 1523, specifying the standard provisions for a general insurance policy.• They also stipulated procedures for handling

fraudulent claims in an attempt to reduce the moral hazard problem.

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Insurance Companies

• In 1688, Lloyd’s of London was established and began to insure ships on trade routes.

• To obtain insurance, a ship’s owner would:• Write the details of the proposed voyage,

• Add the amount he was willing to pay for the service, and

• Circulate the paper among the patrons at Lloyd’s coffeehouse.

• Interested individuals would decide how much to risk and sign their names - the underwriters.

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Insurance Companies

• Underwriting implied unlimited liability.• To participate in this insurance market,

individuals known as names join together in groups called syndicates.• When a new contract is offered, several syndicates

sign up for a portion of the risk in return for a portion of the premiums.

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Insurance Companies

• Today Lloyd’s provides insurance through the more conventional structure of a limited liability company.• The losses of individual investors in a syndicate are

limited to an amount of their initial investment, and

• No person is exposed to the possibility of financial ruin.

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Two Types of Insurance

• At the most basic level, all insurance companies operate like Lloyd’s.• They accept premiums from policyholders in

exchange for the promise of compensation if certain events occur.

• For the individual policy holder, insurance is a way to transfer risk.

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• In terms of the financial system as a whole, insurance companies specialize in three of the five functions performed by intermediaries.• They pool small premiums and make large

investment with them;

• They diversify risks across a large population; and

• They screen and monitor policyholders to mitigate the problem of asymmetric information.

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• Insurance companies offer two types of insurance:• Life insurance.

• Property and casualty insurance.

• While a single company may provide both kinds of insurance, the two businesses operate very differently.

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• Life insurance comes in two basic forms.• Term life insurance provides a payment ot the

policy holder’s beneficiaries in the event of the insured’s death at any time during the policy’s term.

• Generally renewable every year as long as the policyholder is less than 65 years old.

• Whole life insurance is a combination of term life insurance and a savings account.

• The policyholder pays a fixed premium over his/her lifetime in return for a fixed benefit when the policyholder dies.

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• Most whole life policies can be cashed in at any time.

• Whole life insurance tends to be an expensive way to save, though, so its use as a savings vehicle has declined markedly as people have found cheaper alternatives.

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• Car insurance is an example of property and casualty insurance.• It is a combination of

• Property insurance on the car itself, and

• Casualty insurance on the driver, who is protected against liability for harm or injury to other people or their property.

• Holders of property and casualty insurance pay premiums in exchange for protection during the term of the policy.

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• On the balance sheets of insurance companies, these promises to policyholders show up as liabilities.

• On the asset side, insurance companies hold a combination of stocks and bonds.

• Property and casualty companies profit from the fees they charge for administering the policies they write.

• Because assets are essentially reserves against sudden claims, they have to be liquid.

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• Life insurance companies hold assets of longer maturity than property and casualty insurers.• Because more life insurance payments will be made

well into the future, this better matches the maturity of the companies’ assets and liabilities.

• As a result, life insurance companies hold mostly bonds.

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• Life insurance is to support people who need it if something happens to you.

• People with young children need it the most.• The best approach is to buy term life insurance.• You should consider a term policy worth six to

eight times your annual income.

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The Role of Insurance Companies

• Like life insurers, property and casualty insurers pool risks to generate predictable payouts.• They reduce risk by spreading it across many

policies.

• Although there is no way to know exactly which policies will require payment, the insurance company can estimate precisely the percentage of policyholders who will file claims.

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• Adverse selection and moral hazard create significant problems problems in the insurance market.• A person with terminal cancer has an incentive to

buy life insurance for the largest amount possible - that’s adverse selection.

• Without fire insurance, people would have more fire extinguishers in their houses - that’s moral hazard.

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• Insurance companies work hard to reduce both adverse selection and moral hazard.• A person wanting life insurance needs a physical

exam.

• People who want auto insurance must provide their driving records.

• Policies also include restrictive covenants that require the insured to engage or not to engage in certain activities.

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• Insurance companies might also require deductibles.• These require the insured to pay the initial cost of

repairing accidental damage, up to some maximum amount.

• Or they may require coinsurance.• This is where the insurance company shoulders a

percentage of the claim, usually 80 or 90 percent and the insured assumes the rest.

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• Remember that insurance is meant to shift risk from individuals to groups, to shift the responsibility for events that are certain to happen.• With the decoding of the human genome, a battery

of tests might soon be available to determine each person’ probability of developing a terminal disease.

• If this information is revealed, many people may not be able to get life insurance.

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• Some risks are too big for insurance companies.

• Reinsurance companies insure insurance companies against really big risks.

• Catastrophic bonds allow investors to share some of this risk.

• Cat bonds:• If there is no catastrophe, they pay a high return.

• If a specific event (described in the bond) occurs, they pay nothing.

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Pension Funds

• A pension fund offers people the ability to make premium payments today in exchange for promised payments under certain future circumstances. • They provide an easy way to make sure that a

worker saves and has sufficient resources in old age.

• They help savers to diversify their risk.

• By pooling the savings of many small investors, pension funds spread the risk.

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Pension Funds

• People can use a variety of methods to save for retirement, including employer sponsored plans and individual savings plans.

• There are two basic types:• Defined-benefit (DB) pension plans and

• Defined-contribution (DC) pension plans.

• Many employer-sponsored plans require a person work for a certain number of years before qualifying for benefits, a process called vesting.

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Pension Funds

• Defined-benefit plans.• Participants receive a life-time retirement income

based on the number of years they worked at the company and their final salary.

• Defined-contribution plans.• These are replacing defined-benefit plans.

• Sometimes referred to as “401(k)” after their IRS code.

• The employer takes no responsibility for the size of the employee's retirement income.

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Pension Funds

• You can think of a pension plan as the opposite of life insurance.• One pays off if you live, the other if you don’t.

• The balance sheets of pension funds look a lot like those of life insurance companies.• Both hold long-term assets like corporate bonds and

stocks.

• The only difference is that life insurance companies hold only half the equities that pension funds do.

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Pension Funds

• The U.S. government provides insurance for private, defined-benefit pension systems.• If a company goes bankrupt, the Pension Benefit

Guaranty Corporation (PBGC) will take over the fund’s liabilities.

• Although there are limits, it still increases the incentive for a firm’s managers to engage in risky behavior.

• Regulators monitor pension funds regularly.

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• Pay-as-you-go: Transfers tax revenue to current retirees.

• Excess revenue is spent by the Treasury.

• Trust fund is in U.S. Treasury securities which would have to be repaid with future tax revenue.

• Problems:• Population is aging so ratio of workers to retirees is falling.

• People are living longer so they receive more in benefits.

• What is the future?

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Securities Firms: Brokers, Mutual Funds, and Investment Banks

• The broad class of securities firms includes:• Brokerages,

• Investment banks, and

• Mutual fund companies.

• In one way or another, these are all financial intermediaries.

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• The primary services of brokerage firms are:• Accounting (to keep track of customers’ investment

balances),

• Custody services (to make sure valuable records such as stock certificates are safe), and

• Access to secondary markets (in which customers can buy and sell financial instruments).

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• Brokers also provide loans to customers who wish to purchase stock on margin.• They provide liquidity, both by offering check-

writing privileges with their investment accounts and by allowing investors to sell assets quickly.

• Mutual-fund companies offer liquidity services as well.

• The primary function of mutual funds, however, is to pool the small savings of individuals in diversified portfolios that are composed of a wide variety of financial instruments.

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• All securities firms are very much in the business of producing information.• Information is at the heart of the investment

banking business.

• Investment banks are the conduits through which firms raise funds in the capital markets.

• Through their underwriting services, these investment banks issue new stocks and a variety of other debt instruments.

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• The underwriter guarantees the price of a new issue and then sells it to investors at a higher price.• This is a practice called placing the issue.

• The underwriter profits from the difference between the price guaranteed to the firm that issues the security and the price at which the bond or stock is sold to investors.

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• Since the price at which the investment bank sells the bonds or stocks in financial markets can turn out to be lower than the price guaranteed by the issuing company, there is some risk to underwriting.

• For large issues, investors will band together and spread the risk among themselves rather than one taking the risk alone.

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• Investment banks also provide advice to firms that want to merge with or acquire other firms.• Investment bankers do the research to identify

potential mergers and acquisitions and estimate the value of the new, combined company.

• In facilitating these combinations, investment banks perform a service to the economy.• Mergers and acquisitions help to ensure that the

people who manage firms do the best job possible.

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• Hedge funds are strictly for millionaires.• These investment partnerships bring together

small groups of people who meet certain wealth requirements.

• Hedge funds come in two basic sizes:• Maximum of 99 investors, each with at least $1

million in net worth, or

• Maximum of 499 investors, each with at least $5 million in net worth.

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• Hedge funds are run by a well-paid general partner, or manager, who is in charge of day-to-day operations.• Managers are required to keep a large portion of

their own money in the fund to solve the problem of moral hazard.

• Hedge funds are not low risk enterprises.• Because they are set up as private partnerships, they

are not constrained in their investment strategies.

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• Hedge fund managers typically strive to create returns that roughly equal those of the stock market.

• While individual hedge funds are very risky, a portfolio that invests in a large number of these funds can expect returns equal to the stock market average with less risk.

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Finance Companies

• Finance companies are in the lending business.• They raise funds directly in the financial

markets by issuing commercial paper and securities and then use them to make loans to individuals and corporations.

• They are concerned largely with reducing the transactions and information costs that are associated with intermediated finance.

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Finance Companies

• Because of their narrow focus, finance companies are particularly good at:• Screening potential borrowers’ creditworthiness,

• Monitoring their performance during the term of the loan, and

• Seizing collateral in the event of a default.

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Finance Companies

• Most finance companies specialize in one of three loan types:• Consumer loans,

• Business loans, and

• What are called sales loans.

• Some also provide commercial and home mortgages.

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Finance Companies

• Consumer finance firms provide small installment loans to individual consumers.

• Business finance companies provide loans to businesses.• Business finance companies also provide both

inventory loans and accounts receivable loans.

• Sales finance companies specialize in larger loans for major purchases, such as automobiles.

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• Following the financial crisis of 2007-2009, policymakers focused on how to prevent future crises.

• Proposed remedies included:• Breaking up the largest financial firms,

• Prohibiting certain risky activities, and

• Charging a fee for risk-taking.

• This article highlights the debate among policymakers about how to proceed.

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Government-Sponsored Enterprises

• The U.S. government is directly involved in the financial intermediation system.

• The risk-taking of government-related intermediaries contributed importantly to the financial crisis of 2007-2009.

• A hybrid corporate form known as a government-sponsored enterprise (GSE) is chartered by the government as a corporation with a public purpose.

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• The privatized Depression-era Federal National Mortgage Association (Fannie Mae) and a similarly government chartered competing entity, the Federal Home Loan Mortgage Corporation (Freddie Mac) are examples.

• While the debt issued by Fannie and Freddie was not guaranteed by the government, market participants generally assumed that it would be in a crisis.

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• In 1968, Congress also established the Government National Mortgage Corporation (Ginnie Mae) as a GSE that is wholly owned by the federal government.• The U.S. government explicitly guarantees Ginnie

Mae debt.

• Congress also chartered the Student Loan Marketing Association (Sallie Mae) as a GSE, but by 2004 had terminated the charter, making Sallie Mae a wholly private-sector firm.

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• At their founding, the financial GSEs had similar financial character:• They issued short term bonds and used the proceeds

to provide loans or guarantees of one form or another.

• Because of their implicit relationship to the government, they paid less than private borrowers for their liabilities and passed on some of these benefits in the form of subsidized mortgages and loans.

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• In the years preceding the 2007-2009 crisis, Fannie and Freddie had taken advantage of their implicit government backstop by operating on a slim capital cushion.

• Each had a leverage ratio that was around three times higher than that of the average U.S. bank.

• These two massive GSEs could not withstand the surge of defaults when home prices began to decline nationwide in 2006.

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• Despite numerous efforts to save them, a run on GSE debt in the summer of 2008 compelled the U.S. Treasury to place Fannie and Freddie into conservatorship.• This is a bankruptcy procedure that allows them to

operate despite insolvency.

• As of early 2010, it remains unclear what the U.S government will do with Fannie and Freddie.

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• An annuity is a financial instrument in which a person (the “annuitant”) makes a payment in exchange for the promise of a series of future payments.

• There are fixed-period and lifetime annuities.• And there are deferred versus immediate

annuities.• Finally, insurance companies offer fixed versus

variable annuities.

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

Financial Industry Structure

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

End ofChapter Thirteen

Chapter Thirteen

Documents

national banks

large banks

unit banks

chartered banks

commercial banks

bankingstate banks

total number of banks

short history of