Chapter 18

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					Chapter 18
Commercial Banking Industry:
Structure and Competition
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   We begin by examining the banking system, both in
    the U.S. and abroad. We then examine the role of
    financial innovation and its impact on competition.
    Topics include:
    ◦ Financial Innovation and the Decline of Traditional
       Banking
    ◦ Bank Consolidation and Nationwide Banking
    ◦ Separation of Banking and Other Financial Service
       Industries
    ◦ International Banking
    ◦ Banking Sector in Turkey


                                                            18-2
Financial Innovation
 Innovation is a result of search for profits. A change in
  the financial environment will stimulate a search for
  new products and ideas that are likely to increase the
  profit.
 Financial institution found that many of the old ways of
  doing business were no longer profitable; the financial
  services and products they had been offering to the
  public were not selling.
 Many financial intermediaries found that they were no
  longer be able to acquire funds with their traditional
  financial instruments, and without these funds they
  would soon be out of business.

                                                         18-3
Financial Innovation
 Thus in order to survive in the new economic
  environment, financial institutions had to research and
  develop new products and services that would meet
  customer needs and provide profit, a process referred
  to as financial engineering.
 There are generally three types of changes we can
  examine:
  ◦ Response to Changes in Demand Conditions
  ◦ Response to Changes in Supply Conditions
  ◦ Avoidance of Regulation



                                                       18-4
     Financial Innovation
   Response to Changes in Demand Conditions
    ◦ Major change is huge increase in interest-rate risk
      starting in 1960s.
    ◦ The increase in the volatility of interest rates.
    ◦ Large fluctuations in interest rates lead to substantial
      capital gains and losses and greater uncertainty about
      returns on investments.
    ◦ Adjustable-Rate Mortgages are an example of the reply
      to interest-rate volatility.
    ◦ Banks also started using derivates to hedge risk, and
      intermediaries started developing extensive interest
      rate products.
                                                                 18-5
    Financial Innovation
   Response to Changes in Supply Conditions
    ◦ The most important source of the changes in supply
      conditions that stimulate financial innovation has been
      the improvement in computer and telecommunications
      technology, called information technology.
    ◦ It has two effects:
       It has lowered the cost of processing financial
         transactions, making it profitable for financial
         institutions to create new financial products and
         services for the public.
       It has made it easier for the investors to acquire
         information, thereby making it easier for firms to
         issue securities.
                                                           18-6
Financial Innovation:
Bank Credit and Debit Cards
    Many store credit cards existed long before
     WWII.
    Improved technology in the late 1960s reduced
     transaction costs making nationwide credit card
     programs profitable.
    The success of credit cards led to the
     development of debit cards for direct access to
     checkable funds.



                                                       18-7
Financial Innovation:
Electronic Banking
   Automatic Teller Machines (ATMs) were the first
    innovation on this front. Today, over 250,000 ATMs
    service the U.S. alone.
    ◦ Cheaper transaction for banks and more convenient
      for the customer.
   Home banking is an electronic banking facility in
    which the bank’s customer is linked up with the
    bank’s computer to carry out transactions by using
    either a telephone or a personal computer.



                                                      18-8
Financial Innovation: Electronic Payment and
E-Money
  Electronic Payment
   ◦ Automated payment schemes
      Banks cost decreases since instead of human
       beings computer arrangements makes the
       payments.
      Customers become more likely to open a bank
       account in the bank.
  E-Money
   ◦ Electronic money, or stored cash, only exists in
     electronic form. It is accessed via a stored-value
     card or a smart card.
   ◦ E-cash refers to an account on the internet used to
     make purchases.
                                                       18-9
Financial Innovation: Junk Bonds

     With the improvement in information
      technology in the 1970’s, it became easier for
      investors to acquire financial information about
      corporations, making it easier to screen out bad
      from good credit risks.
     With easier screening, investors were more
      willing to buy long-term debt securities from
      less well-known corporations with lower credit
      ratings.


                                                    18-10
Financial Innovation: Commercial Paper Market

      Commercial paper refers to unsecured debt
       issued by corporations with a short
       original maturity.
      The improvements in the information
       technology not only make it easier for
       corporations to issue debt securities in the junk
       bond market, but it also helps less well-known
       firms to raise funds by issuing short-term debt
       securities more easily.


                                                      18-11
Financial Innovation: Securitization
   Securitization refers to the transformation of illiquid
    assets into marketable capital market instruments.
   Today, almost any type of private debt can be
    securitized. This includes home mortgages, credit
    card debt, student loans, car loans, etc.
   Improvements in the ability to acquire information
    have made it easier to sell marketable securities.
   Decreased transaction costs due to improvements
    in computer technology help banks to bundle
    together loan portfolios cheaply.
                                                          18-12
Financial Innovation: Avoidance of Existing
Regulations
   Regulations Behind Financial Innovation
    1.Reserve requirements
       Tax on deposits
  2.Deposit-rate ceilings (Reg Q)
     Fed set maximum limits on the interest rate that
      could be paid on time deposits.
 As market i , loophole mine to escape reserve
  requirement tax and deposit-rate ceilings
  ◦ The opportunity cost is increasing
  ◦ Customers withdraw their deposits and invest in the
    market instruments.
                                                     18-13
Financial Innovation: Avoidance of Existing
Regulations
   Money Market Mutual Funds: allowed investors similar
    access to their funds as a bank savings accounts, but
    offered higher rates, especially in the late 1970s.
    ◦ MMMFs issue shares that are redeemable at a fixed
      price by writing check.
    ◦ They provide you with interest payments
    ◦ You are able to write checks on this account.

   Sweep Accounts: Any balances above a certain amount in
    a corporation’s checking account at the end of a business
    day are “swept” out of checking accounts nightly and
    invested at overnight rates that pay interest. Since they
    are no longer checkable deposits, reserve requirement
    taxes are avoided.
                                                            18-14
Financial Innovation and the Decline in
Traditional Banking
 The traditional role of transforming short-term
  deposits into long-term loans has been greatly affected
  by financial innovation.
 Why?

    ◦   Decline in Cost Advantages in Acquiring Funds
        (Liabilities)
         π  i  then disintermediation because
          1. Deposit rate ceilings and regulation Q
          2. Cost of acquiring funds had risen substantially
             and reduced bank’s earlier cost advantage over
             other financial institutions
                                                           18-15
Financial Innovation and the Decline in
Traditional Banking




                                          18-
                                          16
Financial Innovation and the Decline in
Traditional Banking
◦ Decline in Income Advantages on Uses of Funds
  (Assets)
      Improvements in information technology have
       made it easier for firms to issue securities
       directly to the public. It becomes easier to use
       securities markets to raise funds by issuing
       commercial paper and junk bonds.
      Also, illiquid financial assets can be transformed
       into marketable securities (securitization).



                                                            18-17
Banks' Response

 Loss of cost advantages in raising funds and income
  advantages in making loans causes reduction in
  profitability in traditional banking
   1. Expand lending into riskier areas (e.g., real
      estate)
   2. Expand into off-balance sheet activities
  These new lines of business caused increase in
   risk taking




                                                   18-18
Decline in Traditional Banking in Other
Industrialized Countries
   Forces similar to those in the U.S. have
    led to a similar decline in other industrialized
    countries.
   For example, Australian banks have lost business
    to international securities markets
   In many countries, as securities markets
    develop, banks also face competition from the
    new products offered.



                                                  18-19
    Bank Consolidation and Nationwide Banking
 Banks have started to merge to create larger entities or
  have been buying up other banks.
 Reasons for bank consolidation:
 ◦ Decrease in the barriers to interstate banking
            Banks can merge with the ones in other states or buy
             them and diversify their asset and liabilities portfolios.
    ◦       Improved computer technology
            Economies of scale have increased, since large up-front
             investments are required to set up many information
             technology platforms for financial institutions.
       Consolidation is taking place not only to make financial
        institutions bigger, but also to increase the combination
        of products and sevices they can provide.

                                                                          18-20
Bank Consolidation and Nationwide Banking
   Are Bank Consolidation and Nationwide Banking a
    Good Thing?
    ◦ Cons
       1. Fear of decline of small banks and small business
          lending
       2. Since a few banks will dominate the industry, the
          sector may be less competitive.
       3. Rush to consolidation may increase risk taking
    ◦ Pros
        1. Community banks will survive
        2. Increase competition and efficiency
        3. Increased diversification of bank loan portfolios:
           lessens likelihood of failures
                                                                18-21
International Banking
   Factors of the growth of international banking
    1.Rapid growth of international trade
       Firms operate abroad need banking services in
        foreign countries to operate abroad.
    2.Banks abroad can pursue activities not allowed in
      home country
       The US banks can underwrite foreign securities
        and sell insurance
    3.Tap into Eurodollar market



                                                     18-22
International Banking
   The Eurodollar market represents U.S. dollars
    deposited in banks outside the U.S. Many
    companies want these dollars:
    ◦ The dollar is widely used in international trade
    ◦ Dollars held outside the U.S. are not subject to
      U.S. regulations
   London is the center for Eurodollars
   To capture the profits from Eurodollar
    transactions, U.S. banks opened abroad and
    attract these deposits.


                                                         18-23
Banking Sector in Turkey

   The Development of Banking Sector in Turkey
    ◦ The Ottoman Empire
    ◦ Development of national banks (1923-1932)
    ◦ Foundation of state-owned banks for special
      purposes (1933-1944)
    ◦ Development of private-owned banks (1945-
      1959)
    ◦ Planned period (1960-1980)
    ◦ Liberalization of the banking sector (1980-)


                                                     18-24
Banking Sector in Turkey

   The Ottoman Empire
    ◦ Banking sector started to develop at the end of
      19th century.
    ◦ They were mainly founded to meet the increasing
      debt demand of the treasury.
    ◦ The first banks were set up by foreign investors
       İstanbul Bank and Osmanli Bank
    ◦ During 1856-1923 periods the sector was
      controlled by the foreign-owned banks
       Make profits from the debts of the Ottoman
        Empire and the exchange rate movements
                                                    18-25
Banking Sector in Turkey

    ◦ Ziraat Bankasi, the first national bank, was
      founded in 1863.
    ◦ At the beginning of 1900s private-owned
      national banks were founded to give credit to
      Turkish investors.
   Development of National Banks
    ◦ The government emphasized the importance of
      national banking for the economy.
    ◦ The credits for the agriculture sector were
      rreoroganized and the new banks were set up to
      develop the industry and trade.
                                                      18-26
Banking Sector in Turkey

   Foundation of State-owned Banks
    ◦ The economic growth was accelerated by the
      help of state economic enterprises.
    ◦ In addition to extend credits and support the
      growth in different sectors state-owned banks
      were founded.
       Sumerbank-extend credits to the industrial
        sector
       Etibank-encourage investment in mining and
        energy sectors
       Denizbank-to finance maritime line enterprises
                                                     18-27
Banking Sector in Turkey

   Development of Private-owned Banks
    ◦ The growth of private sector, the increase in the
      capital accumulation, closer relations with the
      European countries both economically and
      politically, and more liberalized economy policies
      were the main characteristics of the period.
    ◦ Thus new banks were founded by the support of
      the government.




                                                       18-28
Banking Sector in Turkey

   Planned Period
    ◦ The specialized banks, development and
      investment banks and the group banking were
      developed.
    ◦ The “channelling funds to the investors problem”
      was emphasized. The distribution of the excess
      funds to some sectors as credits was not
      efficient.




                                                     18-29
Banking Sector in Turkey
   Liberalization of the Banking Sector
    ◦ The liberalization of interest rates, exchange rates
    ◦ Easy establishment of new banks
    ◦ The change in the portfolios of the banking sector
       The increase in FX credits
       Interbank operations
       Repos
       GDI
    ◦ Increase in competition


                                                        18-30

				
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