Market structure and regulation in the u s banking industry

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Market Structure and Regulation in the U.S Banking Industry

Professor Wayne Carroll Department of Economics University of Wisconsin-Eau Claire

carrolwd@uwec.edu

Slides available at www.uwec.edu/carrolwd

Roles of Banks in the Economy

 Facilitate borrowing and lending

Role of Banks in Lending

Source: Available online at http://www.wiwi.uni-frankfurt.de/schwerpunkte/finance/wp/550.pdf

Financial Intermediaries

“Banks” include:

 Commercial banks

 Savings and loan associations (S&L’s)

 Also sometimes called “thrifts” or “thrift institutions”

 Credit unions

Financial Intermediaries

Assets at end of 2002 (in billions)

Ownership of Banks

 U.S banks are privately owned – no banks are owned by the government

 In most cases a bank’s stock is held by a

large number of investors, so a bank has

many “owners.”

 It is relatively easy to establish a new bank in the U.S

Bank Market Structure

 There are a large number of banking firms in the U.S., but the number is falling due to

mergers between banks

 Thousands of U.S banks are very small,

each having only a single office

 Many banks today have multiple branches or offices

 A “bank holding company” is a firm that owns one or more banking firms

Size Distribution of U.S Banks

Number of 

Deposits  (millions)

 Asset Size (as of June 30, 2006) Institutions  Offices 

TOTALS  7,479 80,473 $5,320,767

Source: www2.fdic.gov/sod/index.asp

Bank Market Structure: An Example

Wells Fargo & Company is a bank

holding company based in South Dakota (with historic roots in Minnesota and

California) It includes:

 28 chartered bank companies

 a total of over 3,000 branches in 23

states

Some Wells Fargo branches

Wells Fargo’s Broad Scope

Source: www.wellsfargo.com/about/today1

20 Largest U.S Banks

(as of June 30, 2006)

Rank Institution Name   Headquartered State  Number of  Offices (thousands) Deposits 

1 Bank of America, NA North Carolina 5,781 $563,906,844

2 JPMorgan Chase Bank, NA Ohio 2,679 $434,752,000

3 Wachovia Bank, NA North Carolina 3,136 $306,348,000

4 Wells Fargo Bank, NA South Dakota 3,200 $298,672,000

5 Washington Mutual Bank Nevada 2,167 $209,927,984

6 Citibank, NA New York 267 $142,508,000

7 SunTrust Bank Georgia 1,758 $117,956,301

8 U.S Bank, NA Ohio 2,525 $117,337,830

9 HSBC Bank USA, NA Delaware 436 $75,588,320

10 World Savings Bank, FSB California 286 $61,321,407

11 PNC Bank, NA Pennsylvania 831 $58,134,805

12 Keybank, NA Ohio 957 $57,327,323

13 Regions Bank Alabama 1,397 $57,231,022

14 Merrill Lynch Bank USA Utah 3 $52,331,967

15 Branch Banking and Trust Company North Carolina 918 $51,246,133

16 Countrywide Bank, NA Virginia 2 $50,657,812

17 ING Bank, fsb Delaware 1 $46,440,495

18 Comerica Bank Michigan 387 $43,081,270

19 Sovereign Bank Pennsylvania 661 $40,829,851

20 The Bank of New York New York 354 $40,014,000 Source: www2.fdic.gov/sod/index.asp

A Simple Bank Balance Sheet

Detailed Balance Sheet for the Banking Industry

Source: Mishkin, Economics of Money, Banking, and Financial Markets, 7 th edition

Two Important Ratios

 Capital/asset ratio – bank capital as a

percentage of bank assets

 The average capital/asset ratio for U.S banks was about 9% at the end of 2002.

 Reserve ratio – bank reserves as a

percentage of checkable deposits

Information on U.S Banks

 It is easy to get a lot of financial data on U.S banks

 A great source:

www2.fdic.gov/idasp/index.asp

An Example: Data on Wells Fargo

What Can Go Wrong?

 “Bank failure” – the bank goes out of

 Bank owners lose their capital.

 The bank suffers significant losses – the government might have to help

Reasons for Bank Regulation

Banks must be regulated because:

 a bank failure can be devastating to depositors

 there’s a risk of systemic failure: the failure of

one bank can make it more likely that other

banks will fail

 depositors can’t monitor how the bank invests

their funds, creating a moral hazard problem.

 government assistance to a bank can be very costly

Reasons for Bank Regulation

Banks are less stable than other businesses  because:

 bank liabilities tend to be short-term – many

depositors could withdraw their funds with little notice

 bank assets tend to be longer-term – reserves and other liquid assets are only a small share of the total

 the behavior of depositors depends on their

confidence that the bank is sound, and this

confidence can be easily shaken

A Closer Look at Bank Failure

Two reasons for bank failure:

 The value of bank assets falls, so

assets<liabilities

 Deposit outflow: A large number of depositors withdraw their funds from the bank,

exhausting the bank’s cash (reserves) and

other liquid assets

Therefore a bank is more likely to fail if it has

a low capital/asset ratio or a low reserve ratio

A Closer Look at Bank Failure

Tradeoff between higher income and a lower risk of failure:

 Holding other things constant, the bank’s net

income is higher if its capital/asset ratio and reserve ratio are lower, since then it holds

relatively more interest-earning assets

 If the bank’s capital/asset ratio and reserve

ratio are higher, it’s less likely that the bank

will fail (so it’s less likely that the stockholders will lose their capital.)

A Closer Look at Bank Failure

If there were no government regulation of 

banks:

 each bank would choose a capital/asset ratio

and a reserve ratio to maximize the value of the bank

 depositors would want to deposit their money in banks that are well managed, so banks would have an incentive to choose capital/asset ratios and reserve ratios that reduce the threat of bank failure

 “market discipline”

A Closer Look at Bank Failure

But if there were no government regulation of  banks:

 banks would choose capital/asset ratios and

reserve ratios that are too low from society’s

standpoint

 banks would take on too much risk, so there

would be too many bank failures, and the

government would have to spend too much

money to assist troubled banks

An Example:

Continental Illinois Bank

 Continental Illinois Bank failed in 1984

 The federal government paid billions of

dollars to keep Continental Illinois from

closing

 This was the biggest bank “resolution” in U.S history

An Example:

Continental Illinois Bank

Before it failed, Continental Illinois Bank:

 was the largest bank in Chicago

 was the seventh-largest bank in the U.S

 had 57 offices in 14 states and 29 foreign countries

An Example:

Continental Illinois Bank

Why did Continental Illinois fail?

 Starting in the late 1970s, the bank grew fast, with lots of loans to businesses.

 Poor quality loans

 Too many loans to firms in the oil industry

 Too many loans to borrowers in Latin America

 “Continental Illinois is willing to do just about anything

to make a deal.”

 High cost of funds

 Large share of funds borrowed from other banks

 Relatively small reliance on domestic deposits

 Heavy borrowing in foreign money markets

An Example:

Continental Illinois Bank

The Bank’s Troubles

 By 1984 the bank’s nonperforming loans

(loans on which payments were late) rose to

$5.2 billion (over 10% of total loans)

 May 1984: an electronic “bank run” –

depositors withdrew billions of dollars in

deposits

 The FDIC and the Federal Reserve System pledged their support for the bank and lent over $5 billion

An Example:

Continental Illinois Bank

Dangers

 Many smaller banks had deposits at

Continental Illinois, so the failure of

Continental Illinois could have caused some

of them to fail, too

 Other depositors (including many important corporations) could lose some of their funds

 Foreign investors would lose confidence in U.S banks

An Example:

Continental Illinois Bank

Rescuing Continental Illinois Bank

 Continental Illinois Bank had $3 billion in

insured deposits and $30 billion in

uninsured deposits The FDIC promised to

guarantee all deposits

 The FDIC assumed the Bank’s 3.5 billion debt

to the Federal Reserve

 The FDIC bought $1 billion in Continental

Illinois stock – the FDIC “owned” the bank

An Example:

Continental Illinois Bank

Lessons from Continental Illinois Bank

 Banks have an incentive to take on too much risk, so they need closer supervision

 The failure of a very large bank could have broader negative effects

 Rescuing a large bank can be expensive for the government

 Good sources:

 www.fdic.gov/bank/historical/managing/contents.pdf Part II, Chap 4

 http://www.fdic.gov/bank/historical/history/vol1.html Chap 7

Bank Regulation: An Overview

In the U.S the government regulates banks in many ways:

 Federal deposit insurance

 Imposing capital requirements (minimum

Primary bank regulators in the U.S.:

 Office of the Comptroller of the Currency (OCC)

 part of the U.S Department of the Treasury

 Federal Reserve System – the U.S central bank

 Federal Deposit Insurance Corporation (FDIC)

 State bank regulators

Bank Regulation: An Overview

Federal Deposit Insurance

 The U.S Congress created the Federal

Deposit Insurance Corporation (FDIC) in

1933, after the bank failures in the Great

Depression

 Today the FDIC guarantees each bank

deposit up to a maximum of $100,000

 FDIC insurance is funded by a small fee paid

by banks based on their deposits

Bank Failures in the Great Depression

Deposit insurance prevents bank runs

 Prevents losses by small depositors

 Reduces “systemic risk” in the banking system

Deposit insurance gives banks 

incentives to:

 hold riskier assets

 hold less capital

 manage the bank’s assets less carefully.

their deposits even if they pursue risky

strategies that increase the risk of bank

failure.

As a result, deposit insurance reduces

banks’ incentives to avoid risk.

Capital Requirements

 When there’s deposit insurance, banks have

an incentive to hold too little capital

 Therefore the government imposes capital requirements to ensure that banks hold

sufficient capital

Capital Requirements

 A simple capital requirement would require that a bank’s capital/asset ratio be greater than or equal to a specified level.

 Example: capital/asset ratio ≥ 0.05.

 Problem: Not all assets are equally risky A simple capital requirement gives a bank an incentive to hold more risky assets.

Risk-weighted Capital

Requirements

At an international conference in Basel,

Switzerland in 1988, bank regulators from the

world’s affluent countries agreed to impose

risk-weighted capital requirements:

 Classes of assets are assigned risk weights

between 0% and 100%

 Risk-free assets carry a weight of 0%, and

more-risky assets carry higher weights

 Capital requirements then set a minimum for the ratio of capital to risk-weighted assets

Risk-weighted Capital Requirements:

Home equity

loans $40,000,000 100% $40,000,000

TOTALS $590,000,000 $200,000,000

 In this example, if regulators require the bank to maintain its risk-weighted capital ratio at a level

of at least 8%, then the bank’s capital must be

at least $16,00,000 (or 8% of $200,000,000)

 If the bank acquires another $1 million in

capital, it could invest up to:

 $12.5 million more in home-equity loans

 $25 million more in home mortgages

 $62.5 million more in municipal bonds

 So risk-weighted capital requirements give the bank an incentive to hold less-risky assets

Risk-weighted Capital Requirements:

An Example

Proposed Capital Requirement Reform:

Basel 2

 Problem: Assets within a risk class might

expose banks to different amounts of risk

 Bank regulators have designed a new system

of bank capital requirements – Basel 2 – that will provide better incentives for banks to

manage their risks in a way that promotes

bank stability

 Basel 2 will take effect in some countries in 2007

 http://www.bis.org/publ/bcbsca.htm

Reserve Requirements

 The Federal Reserve System requires banks

to hold reserves that are greater than or equal

to a specified percentage of their checkable deposits:

 3% for smaller banks

 10% for larger banks

Reserve Requirements

 But reserves are higher than they need to be to promote stability of the banking system.

 Today reserve requirements are more

important in macroeconomic policy – they tie bank reserves to deposits, so the central

bank can try to control deposits by controlling reserves

Restrictions on Asset Holdings

Bank regulations include the following:

 Banks cannot hold common stock

 Banks cannot invest too large a share of their deposits in a single loan or in loans to

businesses in a single industry

 Banks cannot lend funds to bank directors, managers, or principal shareholders at below-market rates

Bank Examinations

 Banks are visited on a regular schedule by bank examiners from the OCC, the Federal Reserve System, the FDIC, or other

CAMELS ratings

1 Sound in every respect

2 Fundamentally sound, but with modest

weaknesses that can be corrected

3 Moderately severe to unsatisfactory

weaknesses; vulnerable if there’s a business

Bank Examinations

 CAMELS ratings are disclosed to bank management, but not to the public.

 If the CAMELS rating for a bank is unfavorable,

regulators can take actions like these:

 Require banks to disclose unfavorable information

in their public financial statements

 Issue a “cease and desist” order requiring the

bank to stop doing things that cause financial

troubles and to correct problems.

 Impose fines (up to $1,000,000 per day).

Bank Examinations

The Banking Crisis of the 1980s

 Hundreds of savings and loan associations (S&L’s) and banks failed in the 1980s and early 1990s.

 This episode illustrates:

 how changes in the market environment and a

loosening of regulations can lead to a bank crisis.

 how government regulators can handle

widespread bank failures.

 how regulations and supervisory standards can be improved to address new problems.

Magnitude of the Crisis

 From 1980 through 1994, over 2,900 banks and S&L’s failed

 1,617 banks with total assets of $302.6

billion

 1,295 S&L’s with total assets of $621 billion

 On average, a bank or S&L failed every 15

days from 1980 to 1994

 During this period, about one out of every six banks or S&L’s (holding a total of over 20% of the assets of the system) was closed or got government assistance

Magnitude of the Crisis:

Number of Bank Failures Per Year

Causes of the Banking Crisis

The banking crisis had many causes,

including:

 changes in the market environment

 looser regulations that gave S&L’s more competitive options

Causes of the Banking Crisis:

Changes in the Market Environment

As a result of financial innovations in the

1960s and 1970s:

 banks and S&L’s faced more competition from other financial firms (such as mutual funds)

 new kinds of financial assets (such as

futures and other derivatives) made it

possible for investors (including banks and S&L’s) to take on more risk

 the financial market environment was more complicated and harder for regulators to

monitor

Causes of the Banking Crisis:

Changes in Regulation

 The banking industry was partially

deregulated in the early 1980s:

 S&L’s had mostly been restricted to home

mortgage lending before, but now they were allowed to invest in commercial real estate and consumer loans.

 S&L’s were allowed to invest in junk bonds (low-quality, high-risk commercial bonds) and common stocks.