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Chapter 13 – Financial Industry Structure

Chapter 13

Financial Industry Structure

Chapter Overview

The first half of this chapter considers current trends in the banking industry, including

the tendency toward consolidation with nondepository institutions. In the second half of

the chapter the functions and characteristics of nondepository institutions are examined.

Learning Objectives: Establish an understanding of:

1. Bank assets and liabilities

2. Bank capital and profitability

3. Bank risk and risk management

Important Points of the Chapter

For decades, most U.S. banks were unit banks, meaning banks without branches. Today,

only one-third of U.S. banks are unit banks. This change in structure is not the only

change in the industry; at the end of 1999 the law forbidding combinations of commercial

banks, investment banks, and insurance companies was repealed, and the result was an

organization like Citigroup, which has these and other services under its umbrella. To

understand the structure of the financial industry we need to put the services it provides

into a larger perspective.

Application of Core Principles

Principle #4: Markets. The growth of international banking has had an economic impact

similar to that of deregulation in the United States, increasing the competition in banking

markets.

Principle #2: Risk. The early practice of selling insurance on sea voyages became the

source of the term underwriter; anyone who wished to assume the risk associated with the

voyage could sign their names under the description of the voyage.

Principle #4: Time. Pension funds help people to develop the discipline of saving

regularly, getting them to start early and helping them to stick with it. The earlier a

person begins saving and the more disciplined he or she is, the better off that person will

be later in life.

Principle #3: Information. Information and reputation are central to the underwriting

business; underwriters collect information to determine the price of the new securities

and then put their reputations on the line when they go out to sell the issues.

Additionally, finance companies are largely concerned with reducing the transactions and

information costs that are associated with intermediated finance, and are particularly

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good at screening potential borrowers’ creditworthiness, monitoring their performance

during the term of the loan, and seizing collateral in the event of a default.

Teaching Tips/Student Stumbling Blocks

The biggest challenge in teaching the material in this chapter is that undergraduate

students may have very little knowledge of some of the types of institutions

mentioned and will likely not appreciate the importance of things like pension

plans and life insurance. You can draw on the fact that many of them probably

have car insurance and build from there.

Features in this Chapter

Your Financial World: Pawnshops

Pawnshops are legitimate businesses that provide a useful service. They make

collateralized small loans and sell the merchandise that is either unclaimed or which was

the collateral on a defaulted loan.

Applying the Concept: The LIBOR Scandal

For decades, LIBOR—the London interbank offered rate—served as the premier global

benchmark for private interest rates. LIBOR rates are not based on transactions, but

rather on a daily survey of a panel of banks. Each bank submits its estimate to the rate at

which it could borrow funds. Manipulating this rate by submitting misleading rates could

lead to profits. According to government reports, derivatives traders had encouraged

their banks to submit misleading rates to benefit their derivatives holdings. Some bank

lowballed their LIBOR submissions to appear more financially sound.

Your Financial World: How Much Life Insurance Do You Need?

The purpose of life insurance is to take care of the people you are supporting in the event

of your death; it is replacement income. People with young children are the ones who

need life insurance the most. If you decide you need insurance, the next decision is what

kind. The best approach is to buy term life because it is less expensive. How much

insurance you should buy depends on the income you are replacing; most advisors

recommend six to eight times your annual income.

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Applying the Concept: Reinsurance and “Cat Bonds”

Insurance companies may themselves purchase insurance when they have large,

undiversified risks. The firms that provide the policies are reinsurance companies, which

are enormous and operate all over the world. The fact that they can spread their risk

globally gives them the ability to withstand individual losses, even if the losses are

catastrophic. The rising cost of reinsurance has led to the emergence of catastrophic

bonds (cat bonds), which allow individual investors to share a very small portion of the

reinsurance risk. Insurance companies sell these through investment banks and invest the

proceeds in U.S. Treasury securities.

Applying the Concept: Public Pensions and the Social Security System

In the United States, the Social Security system will soon be unable to meet the

obligations currently on its books. The system is a “pay-as-you-go” plan that distributes

the revenues (from current worker contributions) to current retirees. This is a very

different arrangement from a private pension fund. To keep the system solvent the

government may have to raise taxes on workers, decrease the benefits of future retirees,

or convert the system into one that mirrors a private pension plan (with individual

accounts). Regardless of which measure is taken, it is clear that the Social Security

system will have to change and the faster the better. In evaluating the proposals to fix it,

keep two key questions in mind: who will pay the bills and who will shoulder the risks?

Tools of the Trade: Hedge Funds

Hedge funds are investment partnerships, sometimes called “nontraditional investment

funds” that bring together small groups of people who must meet certain wealth

requirements. They are run by a general partner, or manager, and are unregulated. The

secrecy (even from the fund’s investors) associated with their operations creates the very

real possibility of moral hazard. Despite the implications of the name, hedge funds are

not low-risk enterprises.

In the News: Fed’s Tarullo Says Reviving Glass-Steagall May Be Costly

The Glass-Steagall Act separated investment and commercial banking. Reinstating that

law could impose significant costs by curtailing the range of services offered by

individual banks and damage many small banks that provide capital market services to

small businesses. Two other proposals, one to place a cap on banks’ non-deposit

financing and the other to require firms to maintain certain levels of long-term debt, may

better reduce the risks that led to the 2008 financial crisis. Under a Glass-Steagall like

law, “too-big-to-fail” institutions might not have been prevented in the 2008 financial

crisis. However, if economies of scale and scope would not be realized beyond a certain

size, then policy makers could have a reference point for limiting size.

Lessons from the Article: In 2010, Congress enacted the Dodd‐Frank financial reforms

to prevent future crises but left many specifics to be decided by regulators like the Fed.

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Their challenge is to reduce systemic risk without rendering the financial system

inefficient. To limit the “too big to fail” problem, policymakers are trying a range of

remedies, from capping the size and leverage of the largest financial firms, to

prohibiting certain risky activities. The article notes that segmenting the activities of

intermediaries today (as did the Glass‐Steagall Act in 1933) would increase costs

without eliminating systemic risk (see Chapter 5, Lessons from the Crisis: Systemic

Risk).

Your Financial World: Annuities

An annuity if a financial instrument in which a person makes a payment in exchange for

the promise of a series of future payments. It’s similar to a bond. Annuities are sold by

insurance companies and they come in many forms and have many names. Here are

some important distinctions:

Fixed versus lifetime annuities: fixed period annuities make payment for a

specified period, while lifetime annuities guarantee payments for the remainder of

the purchaser’s life (and possibly for the life of a spouse too).

Deferred versus immediate annuities: immediate annuities start right away; with

deferred annuities contributions are made and investment returns accrue for

payment at a later date.

Fixed versus variable annuities: fixed annuities guarantee the principal value plus

a minimum interest rate (like a bond). Variable annuities can be invested in a

variety of mutual funds, and the growth depends on the portfolio.

Annuities are useful but you probably should not buy one until you are really ready to

retire.

Additional Teaching Tools

In October, 2009, Bloomburg’s Businessweek reports that the European Union is

planning to break up Royal Bank of Scotland, Lloyds and Northern Rock. “Government

sources said ministers were “determined” to see more competition in the market,

following the £1.2 trillion bailout of the sector which resulted in the loss of three

independent banks and several building societies.”

(http://www.businessweek.com/globalbiz/content/oct2009/gb20091028_358093.htm).

Northern Rock would be split into two separate units, one profitable bank with no debt

and a “bad” bank, with the bad bank remaining in state hands. The purpose of the

breakups would be to increase competition in a sector some contend is too concentrated

in the hands of four large firms.

A video at WSJ.com describes the effect of the Volcker Rule on banks.

http://live.wsj.com/video/volcker-rule-sets-new-hurdles-for-banks/6F25E9BE-A073-473

A-8EE1-0EB7DEB7BA07.html?KEYWORDS=family+banks#!

6F25E9BE-A073-473A-8EE1-0EB7DEB7BA07

Virtual Tools

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Find out how many branches a bank has by searching the web. For example, this site

from Citibank allows you to find its 1,400 branches and 3,800 ATMs in 46 countries!

http://www.citibank.com/locations/

Learn more about Lloyd’s of London on its web site at:

http://www.lloyds.com/

Visit the government-sponsored agencies on the web:

For Fannie Mae, go to http://fanniemae.com/portal/index.html

For Ginnie Mae, go to http://www.ginniemae.gov/pages/default.aspx

For Freddie Mac, go to http://www.freddiemac.com/

For More Discussion

Take a field trip, either in person or using the imagination, and list all the banks and other

financial institutions that are convenient to your students’ homes or the college or

university. Have students obtain materials from different institutions to compare the

services offered and the prices of those services.

Is the U.S. Postal Service missing out on an opportunity? We in the United States do not

think of the USPS as offering financial services, but it does sell money orders. In other

countries people can also have savings accounts (sometimes called “giro”) at their post

offices. Is this something that the USPS should consider?

Chapter Outline

I. Banking Industry Structure

A. A Short History of U.S. Banking

1. Someone seeking to open a bank must obtain a charter, which until the Civil

War, were issued by state banking authorities.

2. Until 1863 there was no national currency; instead, state banks issued

banknotes that were redeemed in gold if the holder presented them at the

bank.

3. Banks regularly failed and their notes became worthless; with so many notes

in circulation it was difficult to tell the sound money from the unsound money.

4. In 1863 Congress passed the National Banking Act, which imposed a tax on

the issue of banknotes and created a system of federally chartered “national

banks,” to be supervised by the Office of the Comptroller of the Currency

(part of the U.S. Department of the Treasury). This initiated a gradual shift in

power away from the states.

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5. State banks devised another way to raise funds, which was the creation of

demand deposits.

6. The dual banking system still persists today, in which banks can choose

whether to get a charter from the federal government or from state officials.

7. State charters account for about two-thirds of U.S. banks, because the greater

permissiveness of state authorities (in terms of the types of operations they

allow) has meant a better chance of making a profit.

8. Banks can switch back and forth between federal and state charters, creating

what amounts to regulatory competition.

9. In 1933, Congress passed the Glass-Steagall Act, which created the Federal

Deposit Insurance Corporation (FDIC) and severely limited the activities of

commercial banks, separating banks from the securities industry in order to

avoid conflicts of interest.

10. This restriction on commercial bank activities remained in place until 1999,

when the passage of the Gramm-Leach-Bliley Financial Services

Modernization Act repealed Glass-Steagall, and opened up the possibilities for

banks to take advantage of economies of scale and scope.

11. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

sets new rules for financial institutions and markets, requires closer

government oversight of systematically important financial institutions, and

altered the authorities of the government agencies that govern the financial

system.

B. Competition and Consolidation

1. The U.S. banking structure is composed of a large number of very small banks

and a small number of very large ones.

2. The primary reason for this structure is the McFadden Act of 1927, which

required that nationally chartered banks meet the branching restrictions of the

states in which they were located. Since some states had laws that forbade

branching, the result was a large number of very small banks.

3. Some banks reacted to branching restrictions by creating bank holding

companies, corporations that own a group of other firms (like a parent firm for

a group of subsidiaries).

4. In 1956, Congress passed the Bank Holding Company Act, which broadened

the scope of what bank holding companies could do, allowing them to provide

various nonbank financial services.

5. Beginning in the 1970s, technology reduced the importance of physical

location in banking and eroded the value of the local banking monopoly.

Today, the majority of small businesses use various forms of internet banking,

making the physical location of the bank even less important.

6. In 1994 Congress passed the Reigle-Neal Interstate Banking and Branching

Efficiency Act, which reversed the restrictions put in place by the McFadden

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Act and allowed banks to acquire an unlimited number of branches

nationwide.

7. Since 1997, the number of banks has fallen nearly in half, and the number of

savings institutions has fallen even more.

8. While some of the decrease is due to failures, the vast majority disappeared

through mergers with other banks.

9. The Reigle-Neal Interstate Banking and Branching Efficiency Act allowed

banks to diversify themselves geographically, and as a result banks became

more profitable.

10. Overall, the deregulation of banks was good for the economy: interest rates

paid to depositors have increased, rates charged to borrowers have decreased,

and bank operating costs and loan losses have decreased.

C. The Globalization of Banking

1. Toward the end of the 20th century, U.S. banking underwent not just a national

but an international transformation as an explosion in international trade

increased the need for international financial services.

2. Foreign banks operate in the United States, and U.S. banks operate abroad.

3. Banks can operate in other countries by opening a foreign branch, creating an

International Banking Facility (IBF), creating an Edge Act subsidiary, or

purchasing a controlling interest in a foreign bank.

4. Foreign banks can take advantage of similar options.

5. The growth of international banking has had an economic impact similar to

that of deregulation in the United States, increasing the competition in and

efficiency of banking markets.

6. One of the most important aspects of international banking is the eurodollar

market, in which dollar-denominated deposits in foreign banks are exchanged.

7. The eurodollar market was created in response to restrictions on the

movement of international capital imposed at the end of World War II.

8. Today, the eurodollar market in London is one of the biggest and most

important financial markets in the world, and the interest rate at which banks

lend each other eurodollars (the London Interbank Offered Rate or LIBOR) is

the standard against which many private loan rates are measured.

D. The Future of Banks

1. Today’s banks are bigger, fewer in number and more international than those

of the past, and they offer more services.

2. Financial holding companies are a limited form of universal banks, firms that

engage in nonfinancial as well as financial activities.

3. The owners and managers of these financial firms cite three reasons to create

them: they are well diversified, they are large enough to take advantage of

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economies of scale, and they hope to benefit from economies of scope

(offering many products under the same “brand” name can also reduce costs).

4. 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.

5. Moreover, the production of information to mitigate the problems of adverse

selection and moral hazard has become a business in and of itself.

6. As we survey the financial industry we can discern two opposite trends: large

firms are working hard to provide one-stop shopping for financial services and

the industry is splintering into a host of small firms, each of which serves a

very specific purpose.

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