Chapter 18

Commercial Banking Industry: Structure and Competition

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Answers to End-of-Chapter Questions

1. Agricultural and other interests in the U.S. were quite suspicious of centralized power and thus opposed the creation of a central bank. 2. a. b. c. d. Office of the Controller of the Currency; the Federal Reserve; state banking authorities and the FDIC; the Federal Reserve.

3. False. Although there are many more banks in the United States than in Canada, this does not mean that the American banking system is more competitive. The reason for the large number of U.S. banks is anticompetitive regulations such as restrictions on banking. 4. New technologies such as electronic banking facilities are frequently shared by several banks, so these facilities are not classified as branches. Thus they can be used by banks to escape limitations to offering services in other states and, in effect, to escape limitations from restrictions on branching. 5. Because becoming a bank holding company allows a bank to: a. circumvent branching restrictions since it can own a controlling interest in several banks even if branching is not permitted, and b. engage in other activities related to banking that can be highly profitable. 6. International banking has been encouraged by giving special tax treatment and relaxed branching regulations to Edge Act corporations and to international banking facilities (IBFs); this was done to make American banks more competitive with foreign banks. The hope is that it will create more banking jobs in the United States. 7. IBFs encourage American and foreign banks to do more banking business in the United States, thus shifting employment from Europe to the United States. 8. No, because the Saudi-owned bank is subject to the same regulations as the American-owned bank. 9. The elimination of reserve requirements would decrease the size of money market mutual funds because banks could then offer higher interest rates on their deposits; funds would flow out of money market mutual funds into banks.

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Mishkin/Eakins Financial Markets and Institutions, Sixth Edition

10. The rise of inflation and the resulting higher interest rates on alternatives to checkable deposits meant that banks had a big shrinkage in this low-cost way of raising funds. The innovation of money market mutual funds also meant that the banks lost checking account business. The abolishment of Regulation Q and the appearance of NOW accounts did help decrease disintermediation but raised the cost of funds for American banks, which now had to pay higher interest rates on checkable and other deposits. Foreign banks were also able to tap a large pool of domestic savings, thereby lowering their cost of funds relative to American banks. 11. True. Higher inflation helped raise interest rates which caused the disintermediation process to occur and which helped create money market mutual funds. As a result banks lost cost advantages on the liabilities side of their balance sheets and this has led to a less healthy banking industry. However, improved information technology would still have eroded the banks income advantages on the assets side of their balance sheet, so the decline in the banking industry would still have occurred. 12. The growth of the commercial paper market and the development of the junk bond market meant that corporations were now able to issue securities rather than borrow from banks, thus eroding the competitive advantage of banks on the lending side. Securitization has enable other financial institutions to originate loans, again taking away some of the banks loan business. 13. Uncertain. The invention of the computer did help lower transaction costs and the costs of collecting information, both of which have made other financial institutions more competitive with banks and have allowed corporations to bypass banks and borrow directly from securities markets. Therefore, computers were an important factor in the decline of traditional banking. However, another source of the decline in the traditional banking industry was the loss of cost advantages for the banks in acquiring funds, and this loss was due to factors unrelated to the invention of the computer, such as the rise in inflation and its interaction with regulations which produced disintermediation. 14. Brokerage firms began to engage in the traditional banking business of issuing deposit instruments, while foreign bank activities in the United States further eroded the competitive position of U.S. banks. This led to the Federal Reserves allowing bank holding companies to enter the underwriting business through a loophole in Glass-Steagall in order to keep them competitive. Finally, legislation in 1999 was passed to repeal Glass-Steagall. 15. The Gramm-Leach-Bliley Act now opens the door to consolidation, not only in terms of the number of banking institutions, but also across financial service activities. Banking institutions will become larger and increasingly complex organizations, engaging in the full gamut of financial services activities.