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IBA
1/12/2012 UROOJ MERAJ

BANKING INDUSTRY OF U.S.A


y SYNOPSIS

Banking industry of USA provides major financial service of depositing and lending money and generates income through high loan rates and low deposit rates. Other activities are trust, investment advisory services and cash management. Banking institution means an entity that has its own bank charter, an independent bank or an individual bank subsidiary of a bank holding company. Banks offers different types of deposit accounts: savings, demand deposit, money market deposit and certificates of deposit, each with different features such as rate and fee schedules, minimum balance requirements and with drawl restrictions. Bank deposits are federally insured. Bank provides various credit facilities too. Bank is a primary financial service provider to customers in USA with long-term customer relationship. There are particularly two types of banking: Retail banking and corporate banking. Retail banking offers services to household and small businesses. Geographic market for retail banking is local because customers demand bank near to their home or office and it becomes cheaper to banks to provide service locally. Extensive research has been done on retail banking. Corporate banking involves financial services to large businesses commercial deposit and loan products and financial services (e.g. foreign exchange). Geographic market for corporate banking is regional, national or international. Few studies have done on corporate banking. y HISTORY

US banking industry are mainly comprised of large number of small, local organizations because of federal and state legal restrictions such as branching and intestate banking. A bank that wanted to operate in an area of the state in which it was prohibited from branching needed to form a bank holding company and establish a separate bank subsidiary, with its own charter and head office. McFadden Act of 1927 gave national banks some expanded but limited branching rights. Douglas amendment to the Banking Holding Company Act of 1956 prohibited interstate acquisitions unless permitted by the state legislature of the target institutions home. Glass Steagall Act of 1933 restricted commercial banking and investment banking as separate activities. In 1975 Maines state legislature passed a law allowing banking holding companies headquarters in other states to make acquisitions in Maine. In 1984 8 states enabled legislation and by 1995 every state had passed legislation allowing interstate banking and relaxing branching restriction. In 1985, Thirty mile Rule allowed a national bank to relocate its head office anywhere within 30 miles. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 removed many of the remaining restrictions; bank holding companies could purchase banking institutions in any state, a banking institution in one state could merge with an institution in another state. Opportunity of merger was given for interstate branching on June1.

STRUCTURE

Number and size of very large banks has increased since 1990. Banking industry has consisted mainly of a large number of small, locally oriented organizations which changed the structure through extensive mergers and acquisitions. From1995 2005, 3800 bank mergers involving $3.6 trillion in acquired assets were done in US. The mergers in which the target had total assets of at least $1 billion accounted for about 7% of all deals but more than 85% of all acquired assets. The 59 deals with the target that had total assets of at least $10 billion involved nearly 70% of all acquired assets, the 13 acquisitions of banking organizations with total assets of at least $50billion accounted for roughly 39% of acquired assets. In 1998 13% of industry assets were acquired. The Travelers Group and Citicorp merged to form largest banking organization in the US. The common reason of anticipated gains from mergers is reduced cost resulting from economies of scale so larger banks would be able to earn greater profits either by lowering their prices or by increasing their profit margins or through some combination of two. Economies of scale can be achieved through technology advancement, specialization or advertisement. Mergers also result in great market power through strengthening its brand identity. Large banks have substantial resources or deep pockets allowing them more flexibility in pricing strategies. For e.g. a large bank may decide to set its prices above the competitive level in a market. Smaller banks might try to undercut those prices in turn large bank could retaliate by drastically lowering prices and exercise market powers by exerting price leadership. Mergers may benefit banks by reducing risk through diversification. Greater diversification may make larger banks to get benefit of emerging profit opportunities because resources can be transferred through them from less profitable to more profitable region. Failure and formation of banking institution have played a role in the structure of banking industry since 1990. There are 466 banking institutions with total assets of $81.5 billion that failed between 1990 and 2006. There were no bank failures in 2005 or 2006. Reason behind this decline is falling interest rates. There are certain barriers for startups. One of them is legal restrictions that limit the potential pool of parties allowed to open a banking institution. A lack of comprehensive knowledge and information of market conditions give rise to non statutory barrier. Evaluating credit risks can involve a great deal of uncertainty and making bad loans can result in large losses and failure so banker may be hesitant to begin operating in a market they are unfamiliar with. Another non statutory legal restriction is that motivating customers to change banks may be difficult. In US commercial banking industry between 1990 and 2006, the total number of firms decline by more than 30% from 9.221 to 6.271 with having large number of organizations. At year end 2006, 20 banks had at least $100 billion in total consolidated assets, including 7 with assets of more than $250 billion and 3 with assets greater than $1 trillion. In contrast, only a handful of banks had assets exceeding $100 million as recently as the mid-1990s. the growth of the largest

banks has been constrained by the Riegle Neal Act of 1994 by placing a cap of 10% on the share of deposits that a banking organization can control as a result of an interstate acquisition. In fact one bank has approached the limit. Based on data from year-end 2006, Bank of America Corporation controls just fewer than 10 % of all US deposits. Between 1990 and 2006 the share of deposits under the control of the 10 largest banks has grown from 20% to 44.5%. The 25, 50 and 100 largest banks also increased the share of deposits under their control. Urban and rural local areas are analyzed separately for concentration. The threefirm concentration ratio (CR3) the aggregate share of deposits controlled by the three banks with the greatest individual market share- provides a measure of the prominence of the leading firms. The Herfindahl-Hirschman Index (HHI) takes into account the market shares of all banks in the market but gives larger banks a great influence. HHI is computed as the sum of the square market shares of every bank in the market. Its value ranges from 10000 for monopoly to 0 for competitors. Concentration measured by both measured is decline between 1990 and 2006 in rural and urban markets. The relevant geographic market in retail banking is the area within which banks can reasonably turn for customers and customers can reasonably turn for banks. Most customers still prefers that their bank should have a local physical presence; nonetheless, the increasing influence of technological advances on the retail banking industry suggests that the relevant geographic size of retail banking markets should be reassessed regularly. Commercial banks are the largest most prevalent most diversified group of depository institutions of US however thrift institutions and credit unions are also relevant. Thrifts held total assets of $1.7 trillion and credit unions had $710 billion at the end of 2006 while commercial banks had $ 10 trillion. Thrifts institutions raise funds primarily by collecting consumer deposits and invest funds principally in mortgage and other consumer loans. They were restricted from originating commercial loans before 1980 then restrictions were relaxed. The lack of full competition by thrifts in retail banking is recognized by antitrust authorities. Credit Unions are nonprofit, cooperative financial institutions that collect deposits from and make loans to members. For each credit union, members share a common bond, such as belonging to the same organization or being employed by the same company. Membership requirements and narrow set of products limit the competitive importance of credit unions. According to the Federal Deposit Insurance Corporation (FDIC), an Industrial loan company (ILC) is an FDIC supervised financial institution that can be owned by a commercial firm that is not regulated by a federal banking agency. Operating with less supervision, owners of ILCs may be more likely to experience several financial difficulties than highly regulated parents like bank holding companies. The specialized firms compete in certain but limited respect with commercial banks. Because non bank institutions offer a limited set of products and services, they are less likely to form the special type of customer relationships that banks form. For e.g. mortgage originators or consumer finance companies etc.

CONDUCT

Bank conduct is defined as the ways in which banks compete with each other and the intensity of that competition. Banks engage in price competition. This competition is not straight forward as other industries because of varying interest rates and fees which are difficult to evaluate for the customers. Commercial banking is marked by customers maintaining a multi period relationship and meaningful price for retail banking is composite price. The location of branch offices and ATMs, customer services (length of operating hours, waiting time for tellers, loan officers, customer service rep, access to senior personnel etc), delivery channels (internet, telephone), variability in the set of offered products, brand recognition (advertising, socializing and sponsoring of a local event) are important forms of non price competition. Banks compete in developing customer relationships to enhance their prospects for cross selling (selling additional products and services to existing bank customers). It is more advantageous than media advertising, mailing and telephone solicitations because the customer becomes more responsive due to regular interactions. In this way bank can possess information regarding customer and use it for the formulation of required products. Thirdly trust develops and customer places more confidence in a bank. Bank conduct can be influenced by the barriers like customer switching costs, lack of clear information about market conditions, and legal restrictions. An important development that may influence conduct is the mere presence of large banks in a market that may affect competition indirectly by influencing the behavior of smaller rivals. Large banks may also have a negative influence on competition as a result of multimarket contact (when two or more banks compete with each other in several geographic areas or markets). Large banks with a small share of a local market may increase competition because they can easily draw on out-ofmarket resources to exploit profitable opportunities. Very large banks may also benefit from being considered too big to fail.

PERFORMANCE

The structure-conduct-performance paradigm asserts that market structure influences bank conduct, which in turn affects performance. (i) Market structure is related to bank prices in a way that suggests that the exercise of market power increases with concentration. (ii) Empirical analysis indicates that a bank efficiency is negative related to concentration. (iii) Because greater market concentration is associated with higher prices may lead to a greater net interest margin and a corresponding rise in banks profitability. Research indicates that as concentration increases, efficiency drops that lead to a decline in bank profitability. (iv) Greater size may enable large banks to operate more efficiently and more profitably than their smaller rivals. (v) Data for commercial banks of various sizes indicate that small banks are, on average, less profitable and less efficient than larger banks. Large banks appear to perform better than their smaller rivals. Large banks charge higher fees but they also charge lower rates on loans and the inability of large banks to grow their share of deposits in local markets is consistent with large

banks not having sizable competitive advantages over smaller rivals that enable them to attract and retain customers. (vi) If large banks have some unique influence on competition, the large bank may affect the performance of smaller.

PUBLIC POLICY

A well functioning banking system can potentially increase economic performance if it helps improve the allocation of resources to the more productive channel. After geographic deregulation many bank were legally able to acquire less efficient and less profitable banks therefore many mergers took place. Large diversified banks may be able to maintain credit flows during difficult times to affected geographic areas because they can draw on resources from other areas and a large bank may not be harmed severely by a local or regional down turn and able to maintain the flow of credit to an economically suffering area. Research confirms that measures of economic stability increased following deregulation. High local levels of concentration are associated with higher prices, higher profits, and lower efficiency. Prohibiting transactions by antitrust policy appears to be an effective way of maintaining markets so the customer would have adequate choices and banks cannot sustain high prices. The important issue to be considered is the dichotomy between the largest organizations in the industry and the many community banks is increasing. Another issue is the size of the relevant banking market that should be used when assessing concentration. Substantial media, consumer, regulatory and legislative attention has been paid recently to the issue of subprime lending, which has been defined by Edward Gramlich of the Board of Governors of the Federal Reserve System as the extension of credit to higher risk borrowers who do not qualify for traditional prime credit. Subprime credit is often predatory which is made to inappropriate borrowers who become unable to make schedule payments and subject to hefty penalties ultimately lose their home, car or other personal property. Government resources have been allocated to protecting those borrowers, for e.g. Truth in Lending Act, Fair Credit Reporting Act, the Truth in Savings Act and the Community Reinvestment Act. Illegal tying is an issue that has increased in importance since 1999 by removal of many restrictions through Gramm-Leach-Bliley Act which increased opportunities for banks to strong arm customers into buying unwanted products in order to obtain necessary one. One dislike source of bank revenue by the customer is ATM surcharge fee. It was introduced in 1996 while public response was vehement and some areas attempt to ban banks from imposing. ATM surcharge fee also raises antitrust issues. Large banks can through large networks of branches and ATM can influence customer of other banks.

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