Historical Development of the Banking System

Bank of North America opened in 1782 in Philadelphia

Federalists (Alexander Hamilton) wanted to centralize control of banking and
chartering banks

Bank of United States in 1791 it had elements of both a private and

central bank a gov. institution that is responsible for the amount of
money and credit supplied in an economy
Agricultural and other interests were against centralized power, eventually
eliminated the Bank of US when charter wasnt renewed, in 1811
Because the state banks were failures and the need to raise funds for the war
of 1812, Congress created the Second Bank of the US in 1816,
The argument about a centralized bank went on for awhile, when Andrew
Jackson was elected in 1832 a large advocate for states rights he vetoed
the the rechartering which then lapsed in 1836
Until 1863, all commercial banks in US were chartered by commission of the
state, no national currency existed and banks obtained funds by
banknotes which could be redeemed for gold, regulations were lax and
many banks failed due to fraud or lack of capital
To eliminate abuses of State chartered banks the National bank act of 1863
created new banking system of federally chartered banks called national
banks supervised by comptroller of the currency, department of the US
treasury

intended to dry up funds to state banks by imposing tax on their

banknotes, while leaving fed. banks un taxed banknotes

State banks got around this by acquiring funds through deposits

So today US has dual banking system banks operated by state and

federal supervision operate side by side
Central banking didnt reappear until 1913 with the Federal Reserve System
FED, All national banks were required to become a member of the FED
with new regulations issued

state banks could choose to become members but most did not
because of high costs of membership stemming from the FEDs
regulations
During Great Depression 1930-33 9000 banks failed wiped out savings of
many depositors at commercial banks, The FDIC was created providing
federal insurance on bank deposits, members of the FED were required to
purchase insurance, other banks could choose (almost all bought
insurance) but imposed everyone to more regulations
Glass Steagall Act prohibited banks from underwriting or dealing in corporate
securities and limited to purchase of debt securities, also prohibited
investment banks from participating in commercial banking, allowing a
clear separation between the banks

This was repealled in 1999, but during it commercial banks were forced
to sell off their investment banking operations and vice versa. Most
banks discontinued their deposit business and moved towards
investment

 Multiple Regulatory Agencies

Commercial banking has multiple regulatory agencies that overlap each

other.

Office of the Comptroller of Currency primary supervision of

national banks that own more than half go the assets in
commercial banking

FED and state banking authorities have joint primary

responsibility for state banks that are members of the FED,
Fed also responsibility over companies that own one or more
banks called bank holding companies and secondary
responsibility for national banks

FDIC and state banking authorities jointly supervise state banks

that have FDIC insurance but not in FED, State authorities
have sole jurisdiction over banks not in FED or FDIC
Financial Innovationa nd the Growth of the Shadow Banking System
Traditional banking of making loans funded by deposits has been in decline,
some of this been replaced by shadow banking system where bank
lends via securities
A change in the financial environment will stimulate a search by financial
institutions for innovations that are likely to be profitable
In 1960s interest rates and inflation became hard to predict, computer
technology changed supply conditions, regulations increased, old ways of
banking were less profitable, banks created new financial instruments to
raise funds and increase profits through new financial instruments, called
financial engineering
Three main types of financial innovation

Responses to changes in demand conditions: (Interest Rate

Volatility)

the most significant change in economic environment for demand

has been volatility of interest rates

large fluctuation in interest rates lead to large capital gains or

losses and larger uncertainty about returns

The increase in risk should increase the demand for new financial
products such as the ones created in the 70s

Adjustable-Rate Mortgages: where the interest rate

changes as the market interest rate changes, with
lower risk often banks issue lower initial interest rates

Financial Derivatives: helps Hedge protect themselves

from risk, Futures Contracts seller agrees to provide
a certain commodity to the buyer on a future date at a
agreed on price had been around for awhile, Chicago
Board of Trade created futures contracts on financial
instruments called Financial Derivatives could be
used to hedge risk

Responses to changes in supply conditions: Information

Technology

Has lowered cost of processing financial transactions

Easier for investors to acquire information, therefore easier for
firms to issue securities
Bank Credit and Debit Cards: have been around for
awhile, income comes from loans made to credit card
holders, losses come from defaults, stolen cards,
etc.,
Late 60s technology lowered transaction costs, with
wide success debit cards were created, profits
made entirely from fees paid by merchants on
debit card purchases at their stores
Electronic Banking: lowering transaction costs by ebanking, ATM Automated Teller Machine, as well
as home banking conducting much of their banking
via computer ABM Automated Banking Machine,
The Virtual Bank, has no physical location,
Junk Bonds: Before computers it was difficult to get info on
financials of firms that want to sell securities, with little
info only est. corporations were able to sell bonds
Commercial Paper Market: short term debt security issued
by large banks and corporations, easier to screen out
bad investments, money market mutual funds has
also increased commercial paper as they have to
keep a certain amount of liquid investments
Securitization: transforms illiquid financial assets (ex.
residential mortgages) into marketable securities,
institutions bundle these loans and pay a the interest
to the investor while charging a fee to the third party
service
Avoidance of existing regulations
when economy changes and regulations provide large profits if
there is a loophole, loophole mining will occur, two
requirements have seriously limited banks ability to make
profits
Reserve Requirements
They act as a tax on deposits, opportunity cost of
holding them was the interest that a bank could
otherwise earn by lending the reserves out, For
each dollar requirements imposed a cost equal
to interest rate that could be earned times the
fraction required in reserves per dollar of
deposit
Restrictions on Interest Rates to Depositors
Banks in most states prohibited interest on account
deposits until 1980, Banks still arent able to
pay interest on corporate checking accounts

called Deposit rate ceilings

When market rates were higher than deposit rates,
withdrawals were made limiting banks profits
called disintermediation
These Restrictions led to:
Money Market Mutual Funds
These issue shares and are redeemable at a fixed price by
writing checks, since they arent legally deposits they
are not subject to reserve requirements or limits on
interest payments
Sweep Accounts
Balances abovee a certain amount in a corporations
checking account are swept out each day and
invested overnight, since they arent classified as
deposits they are not subject to reserve requirements,
or interest limits which is normally not allowed, they
were so popular they lowered reserve requirements to
make this practice less desirable

Financial Innovation and the Decline of Traditional Banking

Decline in Cost Advantages in Acquiring Funds (Liabilities)

Until 1980, deposit ceilings limited paying max interest rate, this
was advantageous until inflation rose and deposit interest
rates were less appealing called disintermediation, with
money market mutual funds you could even use checking
account like services

Decline in Income Advantages on Uses of Funds (Assets)

The financial innovations like commercial paper, securitization,

junk bonds has decreased advantages of banks forcing them
into the shadow banking system

Information has made it easier for firms to issue straight to public,

many banks customers now go to commercial paper market
instead of bank loans

Junk Bonds are now sold to public more easily with more
information

Computers are now able to evaulate and sell securitzed loans

that were once advantageous to banks

Banks Responses

To survive and maintain profit levels banks could

Maintain traditional lending activity but expand to riskier

areas of lending, this risk led to financial crises

Pursue new off balance sheet activities that are more

profitable, embrace shadow banking. more risky,
weakening of bank balance sheets

Decline of Traditional Banking in Other Industrialized Countries

Very similar to our problems

Some countries companies have used loans from outside of their
country in Eurobonds etc.
Structure of the US Commercial Banking Industry
Restrictions on Branching

So many commercial banks reflects past regulations restricting ability of

institutions to open branches, additional offices for the conduct of
banking operations, each state had regulations, McFadden act put
national banks and state banks on equal playing field making them
follow the same state rules, strong anticompetitive forces
Response to Branching Restrictions

Bank Holding Companies

Corporation that owns several different companies. Can own

controlling interest in several banks even if branching isnt
permitted, Today bank holding companies own almost all
large banks more than 90% of commercial deposits

Automated Teller Machines

ATM are not deemed a branch if not owned or rented

Bank Consolidation and Nationwide Banking
Reduction in the amount of banks hasnt been entirely bank failure but more
so, bank consolidation and mergers

Because mergers and acquisitions has reduced the effectiveness of

branching restrictions, many states realized it would be best
interest if they allowed banks across state lines

Banks saw diversification by making loans in multiple states

Looser interstate laws created super regional banks

With the web and more technology bank consolidation increased,

economies of scale increased, information increased economies of
scope, one resource to provide many products and services

Consolidation has had two consequences

Different types of financial intermediaries are encroaching on

each others territory

Led to development of large complex banking organizations

The Riegel Neal Interstate Banking and Branching Efficiency Act of 1994

expanded regional compacts to tentire nation, overturned prohibitions on

interstate banking restrictions, Texas was only state who opted out
of the law, created a true nationwide banking system
What will the Structure of US Banking Industry Look Like in the Future?

Banks will decrease but not to the extent of other countries likely to end
around several thousand rather than several hundred banks
Are Bank Consolidation and Nationwide Banking Good Things?

advocates say it will produce more efficient banks, less prone to failures,
some fear it will eliminate small banks or community banks and
make the banking industry less competitive

Economists dont feel this way they believe the banking industry will be
as competitive or more with less restriction on interstate banking,

as well as small banks will still have advantages in local markets

Benefits will drive inneficient banks out of business, increase in

efficiency through economies of scale and scope, increased
diversification protects from bank failures

Negatives, could lead to reduction in loans to small businesses, banks

rushing into new areas may take larger risks
Separation of the Banking and Other Financial Service Industries
Glass Steagall Act separated banking from other financial service industries in
1933, allowed commercial banks to sell new offerings of gov. securities
but prohibited from underwriting corporate securities or brokerage
activities, prevented banks from engaging in insurance and real estate
activities,
Erosion of Glass Steagall

Banks still attempted to encroach others territories, laws and financial

innovations changed allowing for special circumstances to mix
different methods of finance
The Gramm Leach Bliley Financial Services Modernization Act of 1999:
Repeal of Glass Steagall

Because of the Glass Steagall restrictions US banks were at a

disadvantage to foreign banks. This act allowed security firms to
purchase banks and banks to underwrite securities and engage in
real estate activities
Implications for Financial Consolidation

trend towards larger and more complex mega banks with full financial
service activities
Separation of Banking and Other Financial Services Industries
Throughout the World

three different frameworks for banking and securities industries around

the world

Universal Banking: German Netherlands, Switzerland, no

separation, little restrictions, banks can own in commercial
firms

British Syle Universal in UK countries, bank can securities

underwrite, separate legal subsidiaries more common, bank
holdings in equity rare, combination of banking and
insurance firms rare

Legal separation of the banking and other financial service

industries in Japan, in Japan are allowed to hold equity
unlike US,
Thrift Industry: Regulation and Structure
Savings and Loan Associations

S&Ls can be chartered by state or gov. The Federal Home Loan Bank
System FHLBS, similar to FED gives 250,000 FDIC, minimum
capital requirements, periodic reports,

Branching more liberal for S&Ls allowed to branch statewide and since
81 allowed to branch nationwide


FHLBS gives longer loans than the FED,
Mutual Savings Banks

Most are chartered by states, jointly owned by depositors, Branching

regulations determined by state in which they operate
Credit Unions

Small cooperative lending institutions around particular group of ind. like

union members or employees of a firm, only depository institutions
that are tax exempt, NCUA issues minimal requirements, periodic
reports and exams
International Banking
Growth in international banking can be explained by three things

Rapid growth in international trade and multinational corporations,

american firms operating abroad needed banks

American banks have been able to earn profits by being active in global
investment banking, underwrite foreign securities, insurance abroad

American banks tap into large pool of dollar denominated deposits in

foreign countries known s Eurodollars,

Eurodollar Market

deposits in US are transferred to outside the country and

kept in the form of dollars

Companies hold in dollars outside US, because they may

use them in international transactions or they are now
considered offshore status

Structure of US Banking Overseas

US has most foreign branches in Laten America, Far East,

Caribbean, London,

An alternative corporate structure for US banks that operate

overseas is the Edge Act Corportion special subsidiary
engaged primarily in international banking, US banks can
also hold controlling interest in foreign banks through holding
companies

81 FED approved International Banking Facilities IBFs within

the US that can accept time deposits from foreigners but
arent subject to reserve requirements or restrictions on
interest payments, can make loans to foreigners but not
americans, exempt from regulations and taxes,
Foreign Banks in the US

More banks have opened overseas and foreign banks in US,

An agency office can lend and transfer funds in US but cant accept
deposits from domestic residents, not subject to regulations

Subsidiary US bank is just like any US bank same regulations, owned

by a foreign bank

Branch of a foreign bank, full service office,

Foreign banks often use Edge Act corporations and IBFs