Chapter 11

Banking
Industry:
Structure and
Competition
 Preview

• This chapter examines the historical trends

in the banking industry that help explain the
unique structure of the U.S. system.

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 Learning Objectives

• Recognize the key features of the banking

system and the historical context of the
implementation of these features.
• Explain how financial innovation led to the
growth of the shadow banking system.
• Identify the key structural changes in the
commercial banking industry.
• Summarize the factors that led to
consolidation in the commercial banking
industry.

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 Learning Objectives

• Assess the reasons for separating banking

from other financial services through
legislation.
• Summarize the distinctions between thrift
institutions and commercial banks.
• Identify the reasons for U.S. banks to
operate in foreign countries and for foreign
banks to operate in the United States.

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 Overview

• Chapter 9: Economic issues and tradeoffs

in meeting goals faced by banks
• Chapter 10: Economic issues and tradeoffs
in meeting goals faced by regulators
• Chapter 11: The banking industry that
emerges from purposeful actions by banks
and regulators
• Policy Question: What type of banking
industry do we want?:
large/concentrated vs. small/fragmented
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 Figure 1 Time Line of the Early History of
Commercial Banking in the United States

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 Primary Supervisory Responsibility of
Bank Regulatory Agencies

• Office of the Comptroller of the Currency (U.S.

Treasury): Most national banks
• Federal Reserve and state banking authorities: state
banks that are members of the Federal Reserve
System.
• Federal Reserve: also regulates bank holding
companies and secondary responsibility for national
banks
• FDIC and state banking authorities: insured state
banks that are not Fed members.
• State banking authorities: uninsured state banks

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 Financial Innovation and the Growth
of the “Shadow Banking System”
A Fundamental Tension
• Financial innovation is driven by the desire
to earn profits
• A change in the financial environment ….
– 1. Demand conditions
– 2. Supply conditions
– 3. Costly Regulations
• ….will stimulate a search by financial
institutions for innovations that are likely to
be profitable

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 1. Banks’ Responses to
Changes in Demand Conditions:
Interest Rate Volatility
• Adjustable-rate mortgages
– Meet household need: lower initial interest rates
make them attractive to home buyers
– Flexible interest rates keep profits high when
rates rise
• Financial Derivatives (1975, Chicago)
– Ability to hedge interest rate risk
– Payoffs are linked to previously issued (i.e.
derived from) securities
– Trading and issuing fees

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 2. Banks’ Responses to
Changes in Supply Conditions
IT Technology
• IT technology
– Reduces transaction costs
– Increases information flows
-------------------
• Bank credit and debit cards
• Electronic banking
– ATM, home banking, ABM and virtual banking
• Junk bonds
• Commercial paper market
• Securitization (next slide)

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 2. Banks’ Responses to
Changes in Supply Conditions:(cont’d)

• Securitization
– To transform otherwise illiquid financial assets
into marketable capital market securities
– Another example of asset transformation
– Securitization played an especially prominent role
in the development of the subprime mortgage
market in the mid 2000s
– Referring back to the financial plumbing diagram,
the distinction between financial markets and
financial intermediaries is blurred

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 3. Banks’ Responses to
Regulations: Loophole Mining

• Reserve requirements act as a tax

on deposits
• Restrictions on interest paid on deposits led
to disintermediation
• This led to “non-checkable, checkable”
deposits:
– Money market mutual funds
– Sweep accounts

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 Financial Innovation and the Decline
of Traditional Banking (cont’d)

• Decline in cost advantages in acquiring funds

(liabilities)
– Rising inflation led to rise in interest rates and
disintermediation (fixed nominal rate)
– Low-cost source of funds, checkable deposits, declined in
importance (per above)
• Decline in income advantages on uses of funds
(assets)
– Information technology has decreased need for banks to
finance short-term credit needs or to issue loans
– Information technology has lowered transaction costs for
other financial institutions, increasing competition
• Net interest rate margin,all US banks -- next slide

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 Financial Innovation and the Decline
of Traditional Banking
Fig. 2 Bank Share of Total Non-
financial Borrowing, 1960–2014

Source: Federal Reserve Bank of St. Louis, FRED data base:

http://research.stlouisfed.org/fred2/; https://www2.fdic.gov/hsob/index.asp.

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 Figure 3 Number of Insured Commercial
Banks in the United States, 1934–2014
(Third Quarter)

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

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 Banks’ Responses

• Try to maintain overall profitability; exploit

risk/return tradeoff

A. Expand into new & riskier areas of lending

– Commercial real estate loans
– Corporate takeovers and leveraged buyouts
B. Pursue new off-balance-sheet activities
– Non-interest income
– E.g., credit default swaps
– Concerns about risk in these new businesses
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 Impetus For Consolidation

• Restrictions on branching
– McFadden Act and state branching regulations.

• Response to branching restrictions

– Bank holding companies.
– Automated teller machines
– Electronic banking

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 Bank Consolidation and
Nationwide Banking
• The number of banks has declined over
the last 25 years
– Bank failures and consolidation.
– Deregulation: Riegle-Neal Interstate Banking
and Branching Efficiency Act of 1994.
– Economies of scale and scope from
information technology.
• Results may be not only a smaller number
of banks but a shift in assets to much
larger banks.

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 Table 1 Size Distribution of Insured
Commercial Banks, June 30, 2014

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 Table 2 Ten Largest U.S. Banks, June
30, 2014

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 Benefits and Costs of Bank
Consolidation
• Benefits
– Increased competition, driving inefficient banks out
of business
– Increased efficiency also from economies of scale and
scope.
– Better able to compete in international markets
– Lower probability of bank failure from diversification
– Become “too big to fail”
• Costs
– Elimination of community banks may lead to less lending to
small business
– Banks expanding into new areas may take increased risks
and higher probability of bank failure

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 Table 3 Ten Largest Banks in the
World, 2014

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 Additional Material in this
Chapter: Some interesting
institutional details

• Separation of the Banking and Other

Financial Service Industries
• Thrift Industry: Regulation and
Structure
• International Banking

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 What is the future of U.S.
banking?
• Policy Question: What type of banking
industry do we want?:
large/concentrated
vs.
small/fragmented

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 Table 2 Ten Largest U.S. Banks, June
30, 2014

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