Lecture #14

Chapter 14: Commerical Banking Structure, Regulation, and Performance.

1913 : Federal Reserve Act : The Creation of modern currency and central bank in US

a) created the FED and monetary authority in US

b) The System : State and National chartered banks (no real difference except for branch banking purposes and regulation regularity.

c) To be a FED Member or not? Use of FED as lender of last resort.

1) regulation more intense, more costly initially

a) At what price would you consider the use of the discount window?

2) 2/3 of banks state chartered, 1/3 nationally chartered

a) 40% of assets in state banks, 60% in nationally chartered

3) 40% of banks FED Members, 3/4 of assets.

d) FED Member not same as FDIC Member

1) If a FED Member, must be FDIC Member.

2) Only about 83.5% FDIC Memebers.

e) with Monetary Control Act of 1980, FED embership is not the same issue as it used to be.

1) The key importance is the discount window.

FDIC Insurance : Established in 1934, during a time after many bank failures.

a) $100,000 per account per person per bank.

b) Insures an account in case of bank failure or mismanagement of funds.

c) Deposit Assumption : When a bank fails, FDIC attempts to find a bank to "assume" the failing bank, and their debt.

1) B of A with Security Pacific in 1989.

Why is there a ceiling to the insurance?

1) Keeps banks failing, does not fully interfere with the invisible hand.

2) It does, however, interfere.

3) What if ceiling was 0?

a) If insurance was 0, no risk taken by bank managers in loans. Difficulty in getting a loan.

b) If insurance were ¥ , infinite risk-taking. FED would be broke in hours.

4) Many private firms getting into deposit insurance also. task is very large to believe, however, that deposit insurance will never lose its public good status.

Check Clearing : Used to be done at FED exclusively.

1) As technology advanced, and costs of monitoring checks fell, competition increased. Fees paid for this service.

What is the market structure of banking?

a) many claim competitive, meaning zero-profit in LR.

b) many others claim oligopoly, especially in loans.

c) As the connections between the banks increase, the rate of interest increases.

1) information restrictions also add to these problems.

2) restrictions to interstate branch-banking and mergers keep concentration down in theory.

d) In the last year, the largest mergers ever in US banking took place.

1) Wells Fargo and Norwest

2) BancOne and First Chicago

3) Bank of America and NationsBank

e) What is the answer?

There are intrinsic limits to the amount a bank can charge on a loan, and the lack of information the bank can engage in when loaning to you.

1) usury laws and truth-in-lending statements.

McFadden Act (1927): Limited banks to branching based on state law.

1. give Utah example.

IBBEA: Interstate Banking and Branching Efficiency Act, (1997)

1. Unlimited branch banking.

2. Still limited by states with market power in banking.

Bank Holding Company: the Evolution and Future of Banking.

1) A firm that owns several firms, one of which is a bank.

2) Many investment houses have purchased banks to facilitate their CMAs.

3) Also provides money and currency for international transactions.

4) Initially there were few functions that could be mixed.

a) very integrated now.

Offshore Banking :

1) External currency market for US

a) Eurodollar : deposits denominated in dollars in Europe

2) Tax Havens huge for this industry

a) as taxes increase in other places, funds flow to these havens.

b) offshore rates >> domestic rates

1) offering higher rates to attract funds.

Structure of International Banking :

1) U.S. Banks larger and more branches than any other country

a) Deposits larger per bank

b) competition in banking long-time concern in US

c) large international banks built up to compete internationally.

1) Manifest destiny concept : where else was it going to be?

d) Branches abroad same as domestic bank

1) same HQ, same regs.

e) Most international banks are subsidiaries to avoid the regulations.

2) Major Expansion of international banking in the 1960’s and 1970’s

a) US Expansion because

1) allowed for ease of foreign expansion of US firms

2) domestic limits on growth avoided by going int’l

a) these limits were mainly branch banking limits.

3) participation in offshore market key.

b) Foreign Expansion, especially Japan, into US during same time.

1) major investments taking place, serve ethnic markets.

2) as US became financial center, wanted to participate

3) domestic limits here also.

3) Branch vs. Subsidiary

a) Tax dilemmas if a branch (Bank must follow US taxes if branch)

b) Subsidiary its own entity from a regulatory standpoint.

The Mix of International Banking and Domestic Banking System:

1) US banks all regulated the same, regardless of headquarters.

a) loss of reciporcity, especially in tax havens

2) All foreign banks treated as US banks for regulatory reasons.

a) Bank must hold more than $1 billion in reserves.

b) helps monetary policy and monetary control if all banks the same.

3) In offshore accounts, no reserve requirements.

a) in many cases, these banks served as tax havens in dollars, without much conversion or other transaction costs.

b) movement of domestic funds offshore to take advantage of large return, due to low costs.

4) Most offshore branches are branches of large banks

a) small banks cannot afford to participate directly in this market.

b) less risk in loans.

c) solvency of branch same as head office, also back by FED if a FED Member.

5) US M policy weakened due to these accounts.

a) cannot directly control a great amount of dollars if offshore.

1) Asymmetric information is a problem that comes from loan and insurance markets mainly.

2) Two major problems exist.

a) Moral Hazard : Borrower may default the loan, insuree may drive recklessly after insured. An incentive problem.

1) risk of this loan higher, drives rate of interest up.

b) Adverse Selection : Screening process to select loanees or insurees is flawed, and cannot catch 100% of potential problems. A screening problem.

1) loanee fights this problem by trying to always look like a "good" person, regardless of the truth.

c) MH a principal problem, AS an agent problem.

3) Signaling helps this process immensely. Agents signal to principals they are good.

Credit rationing a way that banks control loans, and the money supply, as a result of these problems.

Link from loans to Asymmetric Information : Loan process a game of deception and misinformation.

1) Credit Rationing : Banks ration credit to weed out potential bad loans.

a) reject some loan apps

b) limit the size of some loans.

2) Obviously, Moral Hazard and Adverse Selection are huge here.

a) MH : If all good loanees were given loans, a bank would fall prey to bad loanees disguising themselves in information as good.

1) What will borrower do with funds? This is the incentive problem.

b) AS : lenders prefer to ration credit than raise the rate of interest on loans, as they may drive good loanees out of the market for loans as r increases.

1) In loan app process, loanee can signal to bank his or her good aspects.

c) Real-estate loans (mortgages) are huge in this sense : they are tax-deductible, which helps payback incentives.

1) Home-equity loans where the risk increases again.

2) Credit Rationing huge on home equity to help bank risk.