Financial Industry Structure
Chapter Thirteen
Learning Objectives
Students will establish an understanding of 1. Bank assets and liabilities.
2. Bank capital and profitability.
3. Bank risk and risk management.
Introduction
• The U.S. has about 14,000 depository institutions and credit unions.
• For many years, most U.S. banks were unit banks, or banks without branches.
– Today fewer than a quarter are.
• 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.
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.
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.
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.
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.
A Short History of U.S.
Banking
• 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.
A Short History of U.S.
Banking
• 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.
A Short History of U.S.
Banking
• 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.
A Short History of U.S.
Banking
• 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.
A Short History of U.S.
Banking
• The Great Depression lead to the Glass- Steagall Act of 1933, which
• 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.
A Short History of U.S.
Banking
• 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.
A Short History of U.S.
Banking
• The financial crisis of 2007-9 lead to the largest reform since the Great Depression, the Dodd-Frank Wall Street Reform and Consumer Protection Act and 2010.
– Requires closer government oversight over key establishments called systemically important financial institutions (SIFS) regardless of their legal form, and
– Sharply alters the authorities of the government agencies that govern the financial system.
– It also forbids depositories from proprietary trading.
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.
Number & Assets of
U.S. Commercial Banks
Competition and Consolidation
• 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.
Competition and Consolidation
• 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.
Competition and Consolidation
• 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.
Competition and Consolidation
• 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.
Competition and Consolidation
• 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.
Competition and Consolidation
• 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 by about one-half.
– The number of savings institutions has fallen even more.
Competition and Consolidation
• 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?
Banking Industry Structure:
Key Legislation
• 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.
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.
Globalization of Banking
• 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.
Globalization of Banking
• 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.
Globalization of Banking
• 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.
Globalization of Banking
• 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.
Globalization of Banking
• 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.
Globalization of Banking
• It was revealed in 2012 that the LIBOR had been widely manipulated by global banks.
– This has raised doubts about using it as a benchmark.
– Led to government intervention to reform the way LIBOR is determined.
• For decades LIBOR has served as the global benchmark for private interest rates.
• The British Bankers Association (BBA) published daily LIBOR rates for
– 15 maturities, ranging from over night to 10
years, for the US dollar and nine other currencies.
• However, LIBOR rates are not based on actual transactions as are rates on US Treasury bills, but on a daily survey of a panel of banks.
• The global dependence on LIBOR as a measure based on good-faith reporting, created incentives for BBA panel banks to manipulate it.
• In 2012, the UK and US governments
revealed the manipulation of LIBOR and
announced record fines for two panel banks for multiyear manipulations of LIBOR.
• Fixing LIBOR will be difficult and transition
to a better LIBOR will have to be carefully
managed.
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.
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.
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.
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.
Nondepository Institutions
• There are five major 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.
Relative Size of
U.S. Financial Intermediaries
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.
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.
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.
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.
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.
Two Types of Insurance
• 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.
Two Types of Insurance
• 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.
Two Types of Insurance
• Life insurance comes in two basic forms.
• Term life insurance provides a payment to 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
Two Types of Insurance
• 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.
Two Types of Insurance
• 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.
Two Types of Insurance
• 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.
Two Types of Insurance
• 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.
• 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.
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 accurately estimate the percentage of policyholders who will
file claims.
The Role of Insurance Companies
• 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.
The Role of Insurance Companies
• 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.
The Role of Insurance Companies
• 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.
The Role of Insurance Companies
• 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.
• 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.
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.
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.
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.
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.
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.
• 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?
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.
Securities Firms: Brokers, Mutual Funds, and Investment Banks
• 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).
Securities Firms: Brokers, Mutual Funds, and Investment Banks
• 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, is to pool the small savings of individuals in
diversified portfolios that are composed of a wide variety of financial instruments.
Securities Firms: Brokers, Mutual Funds, and Investment Banks
• 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.
Securities Firms: Brokers, Mutual Funds, and Investment Banks
• 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.
Securities Firms: Brokers, Mutual Funds, and Investment Banks
• 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.
Securities Firms: Brokers, Mutual Funds, and Investment Banks
• 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.
• 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.
• 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.
• 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.
• How will the government regulate banks to avoid creation of “too big to fail” institutions?
• There has been discussion of reinstating the Glass-Steagall act that would split investment and commercial banking.
– But some feel this would impose significant costs and inefficiencies on the banking industry.
• The challenge to policy makers is to limit systemic risk but keep the financial system efficient.
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.
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.
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.
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.
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.
Government-Sponsored Enterprises
• 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.
Government-Sponsored Enterprises
• 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.
Government-Sponsored Enterprises
• 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.
Government-Sponsored Enterprises
• 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.
Government-Sponsored Enterprises
• 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.
• 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.
