CHAPTER 12 Commercial Banking Structure, Regulation, and Performance Learning Objectives Who regulates whom in the banking system and why What a bank holding company is and why virtually all large banks are now organized as holding companies What is a financial holding company The nature of and reasons for the recent wave of bank mergers The profitability of the banking system in recent years Chapter Outline I. The Biggest Intermediary in Town II. The Banking Regulatory Structure III. The Structure of the Commercial Banking System IV. Bank Holding Companies and Financial Holding Companies V. Ongoing Changes in the Structure of the Banking Industry VI. The Evolution of International Banking VII. Bank Management: Managing Risks and Profits VIII. Bank Performance Answers to Review Questions We have stressed that the goals of efficiency and competition may conflict with the goals of safety and soundness. Give an example of when this could occur. The more competitive a market is, the greater the risk of failure of an individual firm f rom the pressure of intense competition. A banking system characterized by many small banks has greater competition and efficiency. However, it also faces a greater degree of risk and thus less safety and soundness. What is meant by a dual banking system? A dual banking system is the system in which commercial banks are chartered and regulated by either the federal government or a state government. 65 66 Chapter 12 What is a bank holding company? Why have most large banks become bank holding companies? What is a financial holding company? What must a bank holding company do to become a financial holding company? A bank holding company is a corporation that owns several firms —at least one of which is a bank. If the holding company owns one bank, it is called a one-bank holding company. If it owns more than one, it is called a multi-bank holding company. Many banks organize themselves into bank holding companies because they expect this organizational form to be more profitable than the single bank form. Bank holdi ng companies allow banks to circumvent restrictions on branching and thus seek out sources and uses of funds in other geographical markets, and to diversify into other product areas. A financial holding company is a holding company that can engage in an e ven broader array of financial-related activities than bank holding companies. Under the Gramm -Leach-Bliley Act of 1999, bank holding companies, securities firms, insurance companies, and other financial institutions can affiliate under common ownership t o form financial holding companies. To become a financial holding company, bank holding companies that meet certain criteria must file a declaration with the Federal Reserve. The declaration must certify that all of the bank holding company’s depository institution subsidiaries are well capitalized and managed. What are the two major provisions of the McFadden Act? What was the motivation behind its passage? The McFadden Act of 1927 outlawed interstate branching and made national banks conform to the intrastate branching laws of the states in which they were located. State and federal restrictions on intrastate and interstate branching were initially motivated by a desire to prevent undue concentration and competition in banking. In short, it was an a ttempt to increase safety and soundness at the expense of competition and efficiency. What is the IBBEA? What was the motivation behind its passage? The IBBEA is the Interstate Banking and Branching Efficiency Act that was signed into law in September 1994. The IBBEA allowed unimpeded nationwide branching of banks beginning on June 1, 1997. The motivation behind passing this act was that the McFadden Act, passed initially to foster greater competition and efficiency in the banking industry, ultimately served to limit competition. The point of IBBEA is to increase competition and efficiency perhaps at the expense of safety and soundness. How did multibank holding companies “get around” the McFadden Act before the passage of the IBBEA? Defend the following statement: The IBBEA did nothing more than endorse what was happening in the marketplace. By organizing themselves into holding companies, banks could circumvent restrictions on branching and thus seek out sources and uses of funds in other geographi c markets. The IBBEA did nothing more than endorse what banks were already doing under the bank holding company umbrella. Critique the following statement: Since there are over 8,100 commercial banks in the United States, banking is obviously a highly competitive industry. The fact that there are many banks does not necessarily mean the industry is highly competitive. Many of the banks in the United States are owned by the same parent company, Commercial Banking Structure, Regulation, and Performance 67 and the top banks control most of the banking industry’s assets. Som e banking markets in large cities are very competitive. However, some rural and smaller city markets are characterized by a few or only a single bank and thus appear to lack competition. Also, the market is characterized by a small number of very large b anks and a large number of very small banks. It is doubtful how much competition the very large banks face from the more numerous small banks. What is interest rate risk? Explain several ways banks can reduce interest rate risk. Interest rate risk is the possibility that there will be a change in the interest rate that will affect the price of the bank’s long -term assets and decrease earnings. Banks can use financial futures, options, and swaps to manage interest sate risk. Variable -rate loans can also be used to hedge against interest rate risk. The rates on these loans will be adjusted up or down as the cost of funds rises or falls. What is liquidity risk? Discuss ways in which banks deal with this risk. Does the development of nondeposit liabilities increase or decrease liquidity risk? Liquidity risk is the risk that assets will not be able to be converted into cash without the loss of value. Banks deal with this risk by holding highly liquid assets and back -up lines of credit. Also, nondeposit liabilities such as use of Fed funds or repurchase agreements help decrease liquidity risk. Identify two factors that have contributed to the growth of international banking. What factors contribute to reduced profit margins in this area? A striking increase in international borrowing and lending by domestic banks began in the 1970s. The OPEC oil price increases of the 1970s increased the flow of international oil earnings into U. S. banks. This was followed by an increase in lending to governments an d projects in developing countries. Secondly, in the 1990s, the banking system became truly international in scope. Advances in electronics and telecommunications allowed domestic and foreign banks to participate in worldwide transactions without leaving home. Deregulation has also made it possible for U.S. banks to open offices and enter foreign markets more easily than before. However, electronic funds transfer results in tremendous competition. Thus , will more international competition, profit margins narrow. What is adverse selection? What is moral hazard? How can a bank manager deal with these risks? Adverse selection occurs when the least desirable borrowers pursue a loan most diligently. If a bank funds these less-desirable borrowers there is an increased risk of default. A moral hazard problem occurs when a borrower has an incentive to use the proceeds of a loan for a more risky venture after the loan is funded. To manage these risks, most banks use an asset -liability committee that is responsible for shaping a bank’s basic borrowing and lending strategy. This team must effectively assess and manage risk. Discuss the factors that have contributed to the revolutionary changes in the structure of U.S. banking in recent years. Which factors are most important? Could regulators have prevented many of the changes? Increasing competition from other FIs and other nonfinancial corporations in a global environment has been the major reasons for the structural changes in the U.S. banking system in recent years. Financial innovations have also played a large role in the structural revolution. 68 Chapter 12 Because of these continuing innovations, regulators could not have prevented many of the structural changes that occurred in the U.S. banking system. Will the revolutionary changes in banking increase or decrease the competitiveness of the industry? Why? The revolutionary change in the banking industry will likely increase the competitiveness of the industry. With decreased regulation, increased financial innovation, and greater competition from nonbanks, banks will be forced to adapt to maintain profits. One way they will likely do this is by combining with other types of financial intermediaries, and moving into other formerly prohibited financial servi ces areas. Discuss the following statement: The breakdown of barriers to interstate and intrastate banking means that competition in banking is decreasing. If one looks at the number of banks at the national level, interstate banking and branching has reduced the total number of banks in the United States. Thus, competition appears to be decreasing nationally. However, when one looks at individual state or city markets, bank branching has increased the numbers of banks participating in many local markets making these local markets more competitive. What is the difference between a bank holding company and a financial holding company? A bank holding company is a corporation that owns several firms, at least one of which is a bank. Financial holding companies are holding companies that can engage in an even broader array of financial-related activities than bank holding companies. A financial holding company can offer its customers a complete range of financial services including: securities underwriting and dealing, insurance agency and underwriting activities, and merchant banking activities. What is merchant banking? Merchant banking is the making of direct equity investments by a bank in start -up or growing nonfinancial businesses. Answers to Analytical Questions On June 30, 2001, what percentage of bank assets did the smallest 99.9 percent of banks control? What percentage of bank assets did the largest 0.1 percent of banks control? The smallest 99.9 percent of banks control 69.8 percent of bank a ssets. The largest 0.1 percent of banks control 30.2 percent of bank assets. Thus, a few bank holding companies control the lion’s share of banking assets. Commercial Banking Structure, Regulation, and Performance 69 Explain whether each of the following situation involves asymmetric information, adverse selection, or moral hazard: a. I am financing a new car. In applying for a loan, I withhold information about my student loan, and the loan does not show up on my credit report. b. Just before quitting my job, I take out all the credit cards I can. I plan to run them up to the limit and declare bankruptcy. c. I take out a loan to manufacture a product. My costs end up being higher than expected, and there seems to be little market for my product. I am unable to repay the loan. a. Asymmetric information b. Moral hazard c. None of the above; this is credit risk. If I had used the loan to by stock in a friend’s brother’s company instead, and the company failed and I was unable to repay the loan, that would be a case of moral hazard. Use Exhibit 12-1 to calculate the following: Deposits (in Billions Assets (in Billions of (figures as of 3/31/01) Number of Banks of Dollars) Dollars) Total domestic banks 8,237 $5,764.57 $6,310.81 National charter 2,201 3,134.04 3,440.22 State charter 6,036 2,630.53 2,870.50 Fed member 980 1,540.25 1,666.83 Non-Fed member 5,056 1,090.28 1,203.76 a. What percentage of state banking offices with FDIC insurance are members of the Fed? b. What percentage of FDIC-insured banking offices are members of the Fed? What percentage of total deposits do they hold? c. What percentage of total deposits is in national banks? a. 16.29 percent of state banking offices with FDIC insurance are members of the Fed. b. 38.7 percent of FDIC-insured banking offices are members of the Fed. This includes state- chartered Fed member banks as well as all nationally chartered banks. Together they hold about 76.3 percent of all deposits. c. National banks hold 54.7 percent of total deposits.
Pages to are hidden for
"ch12"Please download to view full document