The Future of Banking.ppt

THE FUTURE OF BANKING

FIN 828: Seminar in Financial Institutions

Yea-Mow ChenDepartment of Finance

San Francisco State University

I. Why Are Financial Intermediaries Special?

•The basic function of a financial system: to efficiently transfer loanable funds from lenders (surplus spending units) to borrowers (deficit spending units), as such a financial system benefits the economy in many ways.


•Methods of Financial Intermediation:

1. Direct Financing

2. Semi-direct Financing

3. Financial Intermediation

•Question: Why financial Intermediation exists with direct financing side by side?


Cash

Households Corporations

Equity & Debt

FI

(Brokers)

FI

(Asset Transformers)

Deposits/Insurance Policies

Cash


Information Production and Processing

The specialty of financial intermediaries is on information production and information processing for identifying the true value of financial assets.


Risk Reduction and Transfer

Financial markets allows risk-averse investors to shift risk to riskier investors who are willing to bear the consequences of uncertainties. It also provides a way for investors to reduce risks through diversification.


Increase Liquidity

Secondary markets make transfer from one asset into another asset possible. The existence of the second markets simply increases the demand for securities. Financial institutions would also be able to convert illiquid assets into debt through the securitization process.


Price Discovering

Financial marketplace provides a mechanism for assets or securities to be traded and thus the real market value of the asset or security can be discovered or verified.


Monitoring and Enforcing

Financial intermediaries collect and process information about the borrowers once a loan or a financial liability contract is issued to market sure that all the conditions and covenants are followed and the loan or debt is repaid.


Reducing Transaction Costs

Transaction costs are the costs for a financial contract to be traded. It could include the costs of search and information, contracting, monitoring, and enforcing. The reduction on transaction costs by financial intermediaries might be the results of all the advantages that financial institutions are providing.

II. Specialness and Regulation

Important features of regulatory policy:•Protect ultimate sources and users of savings.

»Including prevention of unfair practices such as redlining and other discriminatory actions.

•Ensure soundness of the system as a whole.Regulation is not costless

•Net regulatory burden.


Safety and soundness regulation:•Regulations to increase diversification•Minimum capital requirements•Guaranty funds:

»FDIC: Bank Insurance Fund (BIF), Savings Association Insurance Fund (SAIF)

»Securities Investors Protection Fund (SIPC)

•Monitoring and surveillance.


•Safety and Soundness Regulation–Regulation is not without costs for those regulated:

•Excess equity capital requirement;•Information requested by regulators.

–The difference between the private benefits to an FI from being related – such as insurance fund guarantees – and the private costs it faces from adhering to regulation – such as examination- is called the net regulatory burden.


•Monetary Policy Regulation–It has been argued that imposing reserve requirements makes the control of the money supply and its transmission more predictable.

–Fis often view required reserves as similar to a tax and as a positive cost of undertaking intermediation.


•Credit Allocation Regulation–Credit allocation regulation supports the FI’s lending to socially important sectors such as housing and farming.–These regulations may require an FI to hold a minimum amount of assets in one particular sector of the economy or, alternatively, to set maximum interest rates, prices, or fees to subsidize certain sector.–Such regulations can be harmful to FIs that have to bear the private costs.


•Consumer Protection Regulation–Congress passed the Community Reinvestment Act (CRA) and the Home Mortgage Disclosure Act (HMDA) to prevent discrimination in lending.–Many analysts believe that community and consumer protection laws are imposing a considerable net regulatory burden on Fis without providing offsetting social benefits that enhance equal access to mortgage and lending markets.


•Investor Protection Regulation–Various laws protect investors against abuses such as insider trading, lack of disclosure, outright malfeasance, and breach of fiduciary responsibilities.

–Securities Act of 1933 and 1934 and the Investment Company Act of 1940.


•Entry Regulation–Barriers to entry and regulations pertaining to the scope of permitted activities affect the charter value of an FI and the size of its net regulatory burden.

–Entry regulation:•High capital contribution;•Restricting individuals who can establish FI.


•Entry Regulation–Barriers to entry and regulations pertaining to the scope of permitted activities affect the charter value of an FI and the size of its net regulatory burden.

–Entry regulation:•High capital contribution;•Restricting individuals who can establish FI.

III. Recent Bank Performance







Bank Profitability Stabilized in the 90s ROA of Different Size Banks, 1990-97 All $0m- $100m $1b- $10b Year Banks $100m -$1b -$10b and above ____________________________________________________ 1990 0.49% 0.79% 0.78 0.76% 0.38% 1991 0.54 0.83 0.83 0.54 0.44 1992 0.95 1.08 1.05 0.95 0.92 1993 1.22 1.16 1.19 1.33 1.24 1994 1.17 1.16 1.22 1.19 1.17 1995 1.17 1.18 1.25 1.28 1.10 1996 1.19 1.23 1.29 1.31 1.10 1997 1.24 1.25 1.39 1.30 1.18 1998 1.19 1.14 1.31 1.52 1.08 1999 1.31 1.01 1.34 1.48 1.28 2000 1.19 1.01 1.28 1.29 1.16 ________________________________________________________




ROE of Different Size Banks, 1990-97 All $0m- $100m $1b- $10b Year Banks $100m -$1b -$10b and above ____________________________________________________ 1990 7.64% 9.02% 9.95 10.25% 6.68% 1991 8.05 9.40 10.51 7.50 7.35 1992 13.24 11.93 12.60 12.52 13.86 1993 15.67 12.29 13.61 14.02 16.81 1994 14.90 12.01 13.49 14.19 15.73 1995 14.68 11.37 13.48 15.04 15.60 1996 14.40 11.69 13.63 14.82 14.93 1997 14.71 11.57 14.50 14.30 15.32 1998 13.95 10.15 13.57 15.96 13.82 1999 15.34 9.07 14.24 16.02 15.97 2000 14.07 9.09 13.56 14.57 14.42 ________________________________________________________





IV. Recent Banking Trends 1. The Erosion of Market Share ______________________________________________________________________________________ Percentage of Total Assets ----------------------------------------------------------------------------------------------------- 1900 1948 1960 1970 1980 1990 2000 -------------------------------------------------------------------------------------------------------------------------------- Commercial Banks 62.9% 55.9% 38.2% 37.9% 34.8% 30.4% 35.6% Thrifts 18.2 12.3 19.7 20.4 21.4 14.3 10.0 Insurance Companies 13.8 24.3 23.8 18.9 16.1 17.3 16.8 Life Insurance 9.4 16.1 18.7 14.6 11.5 12.5 Others 2.8 3.8 4.2 3.6 4.5 4.9 Pension Funds 16.6 25.7 9.3 12.4 17.4 22.3 10.7 Private Funds 16.6 15.1 6.2 8.0 12.5 14.8 Public Funds 0 10.6 3.2 4.4 4.9 7.5 Investment Companies 0 0.9 2.9 3.5 3.6 10.0 17.0 Mutual Funds 0 0.0 2.7 3.4 1.5 5.5 Money Market Funds 0 0.0 0.0 0.2 1.9 4.5 Finance Companies 0 2.0 4.6 4.8 5.1 5.6 7.9 Total ________________________________________________________________________

IV. Recent Banking Trends The Erosion of Short-term Credit

Granted by Banks Market Shares of Short-Term Credits ------------------------------------------------------------------------------ 1950 1960 1970 1980 1990 1992 ------------------------------------------------------------------------------ Bank Loans 91% 87% 83% 71% 59% 59% Nonbank Financial 6 9 9 14 17 18 Commercial Paper 1 2 6 9 12 12 Foreign Loans - - - 1 9 8 Bankers' Acceptance 2 2 2 5 3 2 ------------------------------------------------------------------------------

IV. Recent Banking Trends

2. Bank Consolidation and Geographic Expansion

As a result of the rapid M&A activity, the number of banks and banking organizations both fell by about 40 percent between 1989 and 1999.

The number of banks in the United States is likely to slip to 7,500 by the year 2000; there were 11,300 banks in 1993 and 14,500 in 1983.

The share of total nationwide assets held by the largest eight banking organizations nearly doubled over the period, rising from 21.3% to 41.5%.

At the same time, the market share and profitability of very small and small banking organizations fell sharply.


Four Key Factors Contributed to the Fast Pace of M&A Activity:

1. Profitability and high stock prices in banking might have relaxed financing constraints on M&A activity;

2. Banks have been losing market share to competing financial institutions on both sides of the balance sheet since the end of the 1970s. Consolidation provides an efficient way to eliminate excess capacity.

3. Sophisticated financial technologies may be more efficiently produced by largest institutions;

4. Deregulation of restrictions on banks ability to expand geographically were relaxed in the 1980s and early 1990s.


Concentration, Ownership, and Number of Firms in the Commercial Banking Industry Number of Number of Number of Asset Share Asset

Share Asset Share U.S. Bank Banking offices in of Largest of Very Small of Small Charters Orga. Banks plus Eighth Banking Banking

Banking Thrifts organizations Orga. Orga. __________________________________________________________________________ 1989 12,728 9,620 84,391 21.3 3.3 12.3 1990 12,370 9,391 84,377 21.3 3.3 12.5 1991 11,950 9,167 83,485 23.7 3.2 12.8 1992 11,495 8,871 81,204 23.6 3.1 12.9 1993 11,001 8,445 80,759 24.8 2.8 12.4 1994 10,488 8,017 81,675 26.3 2.6 11.6 1995 9,983 7,680 81,929 30.0 2.3 11.1 1996 9,576 7,415 83,077 31.3 2.1 10.7 1997 9,216 7,225 84,199 35.2 1.8 10.0 1998 8,846 6,943 84,869 35.0 1.6 9.1 1999 8,698 6,852 N/A 41.5 1.6 9.0 __________________________________________________________________________


Growth of Banking Offices in U.S. Banking Average

# of Branch Number of Bank Number of Total pf All

Offices per Year Home Offices Branch Offices U.S. Bank Offices Bank

__________________________________________________________________________ 1934 14,146 2,985 17.131 0.21 1940 13,442 3,489 16,931 0.26 1952 13439 5,486 18,925 0.41 1964 13,493 14,703 28,196 1.09 1970 13,511 21,810 35.321 1.61 1982 14,451 39,784 54,235 2.75 1988 13,137 46,619 59,756 3.55 1993 11,212 53,049 64,261 4.73 1999 8,551 63,648 72,265 7.45 __________________________________________________________________________


The Increased Concentration in U.S. Banking ( trillions of 1999 dollars)

1990 1993 1996 1999 _________________________________________________________ Number of banks 12,370 11,001 9,576 8,698 Total assets $4.22 $4.23 $4.80 $5.47 % held by fifty largest BHCs 55.3 % 59.7 % 66.6 % 68.1% %held by ten largest BHCs 25.6 % 31.6 % 38.5 % 44.8 %

Total domestic deposits $2.93 $2.76 $2.85 $3.08 % held by fifty largest BHCs 48.0% 51.4% 56.9% 58.2% % held by ten largest BHCs 17.3 % 22.0 % 26.2 % 33.6 % _________________________________________________________ Source: Consolidated Reports of Condition and Income, 1990-99.


3. Rising Competition from other Financial Services Companies: Non-bank financial institutions especially

finance companies, foreign institutions, and the public capital markets, have increased their market share in commercial lending at the expense of domestic commercial banks.

Non-financial institutions, such as Sears, AT&T, and General Motors, have increased their market share in consumer lending at the expense of the banks.


4. Information Technology and Banking (1). New technology had made offering new

products available: Securitization would not be possible without the servicing

software that controls and monitors cash flows. Investors trade pools of credit card loans because

they can assess default risk without knowing the creditworthiness of each borrower.

Swaps, swaptions, collars and caps are feasible and easier to use because computer pricing models narrow the bounds of mispricing and other errors.


(2). Derivative products for risk management: Banks' risk management has been improved with the striking advances in information technology:

Artificial intelligence software can narrow the role of human judgment in the management of credit risk.

(3). Internet banking had reduced costs substantially;

(4). New technology had relaxed the geographical market and product constraints, which led to a greater market consolidation.


(5). But low-cost information is a double-edged sword: 1. If loans are more liquid, then banks' private

information about these loans and their role in monitoring the loans are both diminished.

2. If loans are securitized, any broker should be able to pool loans, issue traded claims against the pool, collecting interest and principal, and disbursing it to claim-holders.

3. If the bank's clients can manage interest risk with derivatives, why should they pay the bank for such protection?

V. CONSOLIDATION: THE EFFECTS OF THE GRAMM-LEACH-BLILEY ACT (GLBA) Expansion of Bank Powers Prior to Gramm-Leach-Bliley:

Date Description _________________________________________________________________ April 30, 1987 Federal Reserve authorizes limited underwriting

activity for Bankers Trust, JP Morgan, and Citicorp with a 5% revenue limit on ineligible activities.

January 18, 1989 Federal Reserve expands Section 20 underwriting permissibility to corporate debt and equity

securities, subject to revenue limit. September 13, 1989 Federal Reserve raises limit on revenue from

Section 20 ineligible activities from 5% to 10%. July 16, 1993 Court ruling in Independent Insurance Agents of

America v. Ludwig allows national banks to sell insurance from small towns.

January 18, 1995 Court ruling in Nationsbank v. VALIC allows banks to sell annuities.

March 26, 1996 Court ruling in Barnett Bank v. Nelson

overturns states restrictions on banks’ insurance sales.

October 30, 1996 Federal Reserve announces the elimination of many firewalls between bank and non-bank subsidiaries within BHCs.

December 20, 1996 Federal Reserve raises limit on revenue from Section 20 ineligible securities activities from 10% to 25%.

August 22, 1997 Federal Reserve eliminates many of the remaining firewalls between bank and non-

bank subsidiaries within BHCs April 6, 1998 Citicorp and Travelers Group announce

merger initiating a new round of debate on financial reform.

_________________________________________________________________

V. CONSOLIDATION: THE EFFECTS OF THE GRAMM-LEACH-BLILEY ACT (GLBA)

Expansion of Bank Powers Prior to the GLBA: Insurance and Annuity Sales by Banks

Planning on Marketing Currently within 2 within 1 Total Current Marketing Years Year Market Share __________________________________________________________________________ Variable Annuities 28.3% 15.2% 8.6% 52.1% ~15% Fixed Annuities 28.3 14.5 8.8 51.6 Life Insurance: <1% Term Life 27.8 20.7 11.8 60.3 Whole Life 23.1 21.4 11.3 55.8 Universal Life 21.1 21.1 11.5 53.7 Variable Life 17.4 21.1 11.1 49.6 Personal P&C <2% Homeowners 18.7 21.9 12.0 52.6 Auto 17.7 21.9 12.0 51.6 Commercial P&C 16.7 19.4 9.6 45.7 <2% __________________________________________________________________________


Market Reaction to the GLMA: October 22, 1999 Number of Single-Day Excess Obs. Return Return ____________________________________________________________ Sample 558 0.021 0.007

Top Financial Advisors 12 0.079 0.065 Bank Holding Companies: 290 0.011 -0.003 With Section 20 Subsidiaries 25 0.033 0.019 Top Financial Advisors 5 0.049 0.035 Top 20 by Assets 20 0.037 0.023

Securities Companies: 76 0.048 0.034 Top Financial Advisors 7 0.100 0.086 Top 20 by Assets 20 0.090 0.076

Insurance Companies: 156 0.029 0.015 Health Insurance Companies 27 0.008 -0.006 Life Insurance Companies 26 0.063 0.049 Property/Casualty Companies 74 0.027 0.013

Top 20 by Assets 20 0.068 0.054 Insurance Brokers/Agents 36 0.019 0.005 Market Return Measurements Dow Industrials: 0.017 S&P 500: 0.014 S&P Bank Index: 0.041 _________________________________________________________________


Market Reaction to the GLBA: October 22, 1999: 1. The most notable performers were

“financial advisers”; 2. BHCs with Section 20 subsidiaries also

experienced significant excess returns; 3. Insurance company shareholders also

reacted favorably to the compromise, in particular for life insurance shareholders.

V. CONSOLIDATION: THE EFFECTS OF THE GRAMM-LEACH-BLILEY ACT (GLBA) DATA: Number and Size of Sample Financial Firms, 1984-1998 Number Assets ($million) Industry of Firms Median Smallest Largest Mean _________________________________________________________ Bank Holding Company 462 2,169 1.00 617,679 10,175 Securities 57 261 0.45 317,590 14,421 Life Insurance 48 2,463 6.42 105,107 7,320 Property/Casualty 101 1,243 0.15 194,398 7,159 Insurance Insurance Agent/ 45 54 0.31 19,736 821 Broker Real Estate 23 26 0.18 1,151 80

Development Other Real Estate 9 37 2.34 800 85 Investment Advice 26 98 0.33 3,480 324 _______________________________________________________________

V. CONSOLIDATION: THE EFFECTS OF THE GRAMM-LEACH-BLILEY ACT (GLBA) Profitability and Risk Measure by Industry

Profitability Median 1984-98 1992-98 1971-

84 _________________________________________________________ Bank Holding Company 12.98% 13.28% 13.12% Securities 12.98% 16.45% 16.52% Life Insurance 10.58% 11.23% 12.82% Property/Casualty Insurance 11.17% 11.73% 13.44% Insurance Agent/Broker7.80% 14.75% 19.98% Real Estate Development 2.29% 8.94% 10.03% Other Real Estate 2.82% 5.12% 0.65% Investment Advice 20.13% 18.59%

_____________________________________


Findings on Profitability: Investment advice firms were the

most profitable over the 1984-98 period, followed by BHCs and securities firms. Insurance companies follow, while the least profitable firms were those engaged in real estate.


Median Risk S Z S Z S Z 1994-98 1992-98 1971-84

_________________________________________________________________ Bank Holding Company 0.0271 33.87 0.0173 53.93 0.0245 43.36 Securities 0.1049 10.44 0.0781 14.50 0.0909 13.33 Life Insurance 0.0453 19.09 0.0245 31.58 0.0261 36.79 Property/Casualty Insurance 0.069114.82 0.0449 20.04 0.0467 24.56 Insurance Agent/Broker 0.1468 8.49 0.0699 13.56 0.0554 15.97 Real Estate Development 0.2892 3.47 0.1408 7.36 0.1382 8.66 Other Real Estate 0.3642 2.31 0.3899 2.14 0.0925 12.98 Investment Advice 0.1655 9.48 0.1106 11.37 _________________________________________________________________


Findings on Risk: BHCs are the least risky, followed by

life insurance and property and casualty insurance firms. Securities and investment advice are in the middle of the group, and real estate firms are the most risky.


Combining the ten largest BHCs and the ten largest firms in each of the other industries: Number and Size of Sample Financial Firms, 1992-1998

Assets ($million) Industry Median Smallest Largest Mean _________________________________________________________ Top 10 BHCs 147,522 40,776 617,679

171,706 Top 10 Securities Firms 92,085 2,111 317,590 103,269 Top 10 Life Insurance Cos. 21,805 5,067 105,107 29,744 Top 10 Property/Casualty Firms 41,912 13,252 194,398 54,915 _________________________________________________________


Pro-forma Mergers: Profitability Measures If a Bank Holding Company Could Have Merged with One Nonbank Financial Firms:

____________________________________________________ Median Median*

Industry R R ____________________________________________________ Top 10 Bank Holding Company 16.77% 13.12% BHC-Securities Firm 16.90% 14.06% BHC-Life Insurance 16.26% 12.95% BHC-Property/Casualty Company 15.17 12.97% Top 10 Securities Firm 18.48% 16.52% Top 10 Life Insurance Company 13.29% 12.82% Top 10 Property/Casualty Company 11.84% 13.44% ____________________________________________________


Pro-forma Merger Findings: 1. Mergers between BHCs and life insurance

firms lower the risk of both firms. The top ten BHCs have a medium standard

deviation of 0.0212, while that of the life insurance firms is 0.0220. The median of the merged firms is 0.0176.

The Z-score also rises with these mergers, indicating that the barely lower profitability (16.26 profitability for the merged firms, compared with 16.77 for the BHCs) is offset by the benefits of the lower risk.


2. Mergers with securities firms and property and casualty firms barely change BHC risk, from 0.0212 to 0.0222 and to 0.0221, respectively, although the profitability of bankruptcy as indicated b the Z-score is higher for mergers with property and casualty firms.


Risk Measures If a Bank Holding Company Could Have Merged with One Nonbank Financial Firm

Median Median* Industry S Z S Z ________________________________________________________ Top 10 Bank Holding Co. 0.0212 52.08 0.0245 43.36 BHC-Securities Firm 0.0222 48.41 0.0480 24.93 BHC-Life Insurance 0.0176 56.83 0.0201 49.30 BHC-Property/Casualty Co. 0.0221 41.18 0.0432 25.28 Top 10 Securities Firm 0.0471 17.57 0.0909 13.33 Top 10 Life Insurance Co. 0.0220 36.66 0.0261 36.79 Top 10 Property/Casualty Co. 0.0304 24.34 0.0467 24.56 ____________________________________________________

The Future of Banking.ppt

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