Cecchetti 5e Chapter13

Chapter 13
Financial Industry Structure
© 2017 McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objectives
1. Explain the structure, current trends, and
future prospects of the banking industry.
2. Discuss the functions and characteristics of
nondepository institutions.
© 2017 McGraw-Hill Education. All Rights Reserved. 13-2

Number of Insured Commercial
Banks in the United States, 1935-2015
13-3
© 2017 McGraw-Hill Education. All Rights Reserved.
A Short History of U.S. Banking
• To start a bank, one needs permission in
the form of a bank charter.
• Until 1863,
– All bank charters were issued by state
banking authorities, and
– There was no national currency so banks
issued banknotes.
• These banknotes did not hold value from
one place to another and banks regularly
failed.
13-4
• During the Civil War, Congress passed the
National Banking Act of 1863.
– State banks were not eliminated, but did
impose a 10% tax on their banknotes.
– The act created a system of federally chartered
banks, or national banks.
– National banks could issue banknotes tax-free.
13-5
• State banks devised another way to make
money--demand deposits.
• This is how we got the dual-banking system
we have today.
– Banks can choose whether to get their charters
from the Comptroller of the Currency at the U.S
Treasury or from state officials.
13-6
• About 3/4 quarters have a state charter and
the rest a federal charter.
• Which charter a bank chooses depends on
its profitability.
– State banks have more operational flexibility,
which means a better chance of making a profit.
– If the Comptroller of the Currency won’t let a
bank do something, they can always just change
their charter.
13-7
• The Great Depression lead to the Glass-
Steagall Act of 1933, which
• Created the Federal Deposit Insurance Corporation
(FDIC)
• Severely limited the activities of commercial banks
• Provided insurance to individual depositors, so they
would not lose their savings in the event that a bank
failed
• Restricted bank assets to certain approved forms of
debt
13-8
• The law separated commercial banks from
investment banks.
– Separating these two types of banks limited
financial institutions from taking advantage of
economies of scale and scope that might exist.
• This changed in 1999 with the Gramm-Leach-
Bliley Financial Services Modernization Act
which repealed the Glass-Steagall Act.
13-9
• The financial crisis of 2007-2009 lead to the
largest reform since the Great Depression,
the Dodd-Frank Wall Street Reform and
Consumer Protection Act and 2010.
– Requires closer government oversight over key
establishments called systemically important
financial institutions (SIFS) regardless of their
legal form, and
– Sharply alters the authorities of the government
agencies that govern the financial system.
– It also forbids depositories from proprietary
trading.

Competition and Consolidation
• There are roughly 5,400 commercial banks in the
U.S. today, and that number has been shrinking.
• The number of banks with branches has changed
significantly as well.
– For many years, most U.S. banks were unit banks, or
banks without branches.
– Three-quarters of today’s banks not only have
branches, they have many of them.
• The U.S. banking system is composed of a large
number of very small banks and a small number
of very large ones.
13-11
Number & Assets of
U.S. Commercial Banks

• The primary reason for this structure is the
McFadden Act of 1927.
– This legislation required that nationally chartered
banks meet the branching restrictions of the
states in which they were located.
– Some states have laws forbidding branch banking,
resulting in a large number of small banks.
– There was fear that large banks would drive small
banks out of business, reducing the quality in
smaller communities.
13-13
• The result was a fragmented banking system
nearly devoid of large institutions.
• We ended up with a network of small,
geographically dispersed banks that faced
little competition - the opposite of what the
act wanted.
• In many states, more efficient and modern
banks were legally precluded from opening
branches to compete with local banks.
13-14
• Some banks reacted to branching restrictions
by creating bank holding companies.
– These are corporations that own a group of other
firms.
– Can be thought of as a parent firm for a group of
subsidiaries.
– Initially these were created as a way to provide
nonbank financial services in more than one state.
13-15
• In 1956, Congress passed the Bank Holding
Company Act.
– This allowed bank holding companies to provide
various nonbank financial services.
• Technology has eroded the value of the local
banking monopoly.
– In the 1970s and 1980s, states responded by
loosening their branching restrictions.
13-16
• In 1994, Congress passed the Riegel-Neal
Interstate Banking and Branching Efficiency Act.
– This legislation reversed restrictions from the
McFadden Act.
– Since 1977, banks have been able to acquire an
unlimited number of branches nationwide.
– The number of commercial banks has fallen by about
one-half.
– The number of savings institutions has fallen even
more.
13-17
• Deregulation provided benefits for the economy.
– Banks became more profitable.
– Operation costs and loan losses fell.
– Interest rates paid to depositors rose.
– Interest rates charged to borrowers fell.
• The financial crisis of 2007-2009 has focused
attention on the costs of deregulation.
– Do the benefits of deregulation outweigh the risks?
13-18
Banking Industry Structure:
Key Legislation
13-19
The Globalization of Banking
• There are a number of ways banks can operate in
foreign countries, depending on factors such as the
legal environment.
– Open a foreign branch that offers the same services as
those in the home country.
– Banks can create an international banking facility (IBF),
which allows it to accept deposits from and make loans to
foreigners outside the country.
– The bank can create a subsidiary called an Edge Act
corporation, which is established specifically to engage in
international banking transactions.
• Alternatively, a bank holding company can purchase a
controlling interest in a foreign bank.
13-20
• Eurodollars are dollar-denominated deposits in
foreign banks.
• Originally the euromarket was a response to
restrictions on the movement of international
capital that were instituted with the Bretton
Woods system of exchange rate management.
• To ensure the pound would retain its value, the British
government imposed restrictions on the ability of
British banks to finance international transactions.
• In an attempt to evade these restrictions, London
banks began to offer dollar deposits and dollar-
denominated loans to foreigners.
13-21
• The eurodollar market in London is one of the biggest and
most important financial markets in the world.
• The interest rate at which banks lend each other eurodollars
is called the London Interbank Offered Rate (LIBOR).
– Serves as the global benchmark for interest-rate derivatives, making
it the leading global interest-rate indicator
– This is the standard against which many private loan rates are
measured.
• The gap between the LIBOR and expected Fed policy interest
rate provides a key measure of the intensity and persistence
of the liquidity crisis.

• It was revealed in 2012 that the LIBOR had
been widely manipulated by global banks.
– This has raised doubts about using it as a
benchmark.
– Led to government intervention to reform the way
LIBOR is determined.

• LIBOR rates are not based on actual transactions as are
rates on U.S. Treasury bills, but on a daily morning
survey of a panel of London banks.
• The global dependence on LIBOR as a measure based
on good-faith reporting, created incentives for British
Bankers’ Association (BBA) panel banks to manipulate
it.
• In 2012, the UK and US governments revealed the
manipulation of LIBOR and announced record fines for
two panel banks for multiyear manipulations of LIBOR.
• Eliminating LIBOR would lead to financial chaise and
replacing it would create extensive legal headaches.
• Officials have suggested changing the method for
computing LIBOR and switching from the average of
survey responses to the median response.
The Future of Banks
• In November of 1999, the Gramm-Leach-Bliley
Financial Services Modernization Act went into
effect.
– This effectively repealed the Glass-Steagall Act of
1933.
– It allowed a commercial bank, investment bank, and
insurance company to merge and form a financial
holding company.
– To serve all their customers’ financial needs, bank
holding companies are converting to financial holding
companies.
13-25
The Future of Banks
• Financial holding companies are a limited
form of universal banks.
– These are firms that engage in nonfinancial as well
as financial activities.
• In the U.S., different financial activities must
be undertaken in separate subsidiaries and
financial holding companies are still
prohibited from making equity investments in
nonfinancial companies.
13-26
The Future of Banks
• Owners and managers of these financial firms
cite three reasons to create them:
– Their range of activities, if properly managed,
permits them to be well diversified.
– These firms are large enough to take advantage of
economies of scale.
– These companies hope to benefit from economies
of scope.
13-27
The Future of Banks
• Thanks to recent technological advances,
almost every service traditionally provided by
financial intermediaries can now be produced
independently, without the help of a large
organization.
• As we survey the financial industry, we see the
two trends running in opposite directions.
13-28
Nondepository Institutions
• There are five major categories of
nondepository institutions:
– Insurance companies
– Pension funds
– Securities firms, including brokers, mutual-fund
companies, and investment banks
– Finance companies
– Government-sponsored enterprises
• Nondepository institutions also include an
assortment of alternative intermediaries
13-29
13-30
Insurance Companies
• Modern forms of insurance can be traced back
to around 1400, when wool merchants
insured their overland shipments from London
to Italy for 12 to 15 percent of their value.
• The first insurance codes were developed in
Florence in 1523, specifying the standard
provisions for a general insurance policy.
– They also stipulated procedures for handling
fraudulent claims in an attempt to reduce the
moral hazard problem.
13-31
Insurance Companies
• In 1688, Lloyd’s of London was established and
began to insure ships on trade routes.
• To obtain insurance, a ship’s owner would:
– Write the details of the proposed voyage
– Add the amount he was willing to pay for the
service
– Circulate the paper among the patrons at Lloyd’s
coffeehouse
– Interested individuals would decide how much to
risk and sign their names - the underwriters.
• Underwriting implied unlimited liability.
13-32
• In 2015 the U.S. Supreme court upheld the Affordable Care
Act
• Adverse selection problem for health insurance programs
- Can be addressed in one of two ways
1. Allow price discrimination
2. Make insurance mandatory
• Adverse selection was managed in the U.S. prior to the
mainly through participation in group insurance offered
through an employer
- 18 percent of the population was uninsured and
persons with “preexisting conditions” could not obtain
new coverage
• Advances in DNA testing is adding to the adverse selection
problem
13-33
Two Types of Insurance
• In terms of the financial system as a whole,
insurance companies specialize in three of the
five functions performed by intermediaries.
– They pool small premiums and make large
investment with them
– They diversify risks across a large population
– They screen and monitor policyholders to mitigate
the problem of asymmetric information
13-34
• Insurance companies offer two types of
insurance:
– Life insurance
• Property and casualty insurance
13-35
• Life insurance comes in two basic forms.
• Term life insurance provides a payment to the policy
holder’s beneficiaries in the event of the insured’s
death at any time during the policy’s term.
• Generally renewable every year as long as the policyholder is
less than 65 years old.
• Whole life insurance is a combination of term life
insurance and a savings account.
• The policyholder pays a fixed premium over his/her lifetime
in return for a fixed benefit when the policyholder dies.
• Tends to be an expensive way to save so its use as a savings
vehicle has declined
13-36
• Car insurance is an example of property and
casualty insurance.
– It is a combination of
• Property insurance on the car itself
• Casualty insurance on the driver, who is protected
against liability for harm or injury to other people or
their property
• Holders of property and casualty insurance
pay premiums in exchange for protection
during the term of the policy.
13-37
• On the balance sheets of insurance companies,
these promises to policyholders show up as
liabilities.
• On the asset side, insurance companies hold a
combination of stocks and bonds.
• Property and casualty companies profit from the
fees they charge for administering the policies
they write.
• Because assets are essentially reserves against
sudden claims, they have to be liquid.
• Life insurance companies hold assets of longer
maturity than property and casualty insurers.
13-38
• Life insurance is to support people who need
it if something happens to you.
• People with young children need it the most.
• The best approach is to buy term life
insurance.
• You should consider a term policy worth six to
eight times your annual income.
13-39
The Role of Insurance Companies
• Like life insurers, property and casualty
insurers pool risks to generate predictable
payouts.
– They reduce risk by spreading it across many
policies.
• Although there is no way to know exactly
which policies will require payment, the
insurance company can accurately estimate
the percentage of policyholders who will file
claims.
13-40
• Adverse selection and moral hazard create
significant problems in the insurance market.
– A person with terminal cancer has an incentive to
buy life insurance for the largest amount possible -
that’s adverse selection.
– Without fire insurance, people would have more
fire extinguishers in their houses - that’s moral
hazard.
13-41
• Insurance companies work hard to reduce
both adverse selection and moral hazard.
– A person wanting life insurance needs a physical
exam.
– People who want auto insurance must provide
their driving records.
– Policies also include restrictive covenants that
require the insured to engage or not to engage in
certain activities.
13-42
• Insurance companies might also require
deductibles.
– These require the insured to pay the initial cost of
repairing accidental damage, up to some
maximum amount.
• Or they may require coinsurance.
– This is where the insurance company shoulders a
percentage of the claim, usually 80 or 90 percent
and the insured assumes the rest.
13-43
• Some risks are too big for insurance companies.
• Reinsurance companies insure insurance
companies against really big risks.
• Catastrophic bonds allow investors to share some
of this risk.
• Cat bonds:
– If there is no catastrophe, they pay a high return.
– If a specific event (described in the bond) occurs, they pay
nothing.

Pension Funds
• A pension fund offers people the ability to
make premium payments today in exchange
for promised payments under certain future
circumstances.
– Provides a way to make sure that a worker saves
and has sufficient resources in old age.
– They help savers to diversify their risk.
• By pooling the savings of many small
investors, pension funds spread the risk.
13-45
Pension Funds
• People can use a variety of methods to save for
retirement, including employer sponsored plans
and individual savings plans.
• There are two basic types:
– Defined-benefit (DB) pension plans
– Defined-contribution (DC) pension plans
• Many employer-sponsored plans require a person
work for a certain number of years before
qualifying for benefits, a process called vesting.
13-46
Pension Funds
• Defined-benefit plans
– Participants receive a life-time retirement income
based on the number of years they worked at the
company and their final salary.
• Defined-contribution plans
– These are replacing defined-benefit plans.
– Sometimes referred to as “401(k)” after their IRS
code.
– The employer takes no responsibility for the size of
the employee's retirement income.
13-47
Pension Funds
• The balance sheets of pension funds look like
those of life insurance companies.
– Both hold long-term assets like corporate bonds
and stocks.
• The only difference is that life insurance
companies hold only half the equities that
pension funds do.

Pension Funds
• The U.S. government provides insurance for
private, defined-benefit pension systems.
– If a company goes bankrupt, the Pension Benefit
Guaranty Corporation (PBGC) will take over the
fund’s liabilities.
– Increases the incentive for a firm’s managers to
engage in risky behavior.
– Regulators monitor pension funds regularly.
13-49
• Pay-as-you-go:
Transfers tax revenue to current retirees.
• Excess revenue is spent by the Treasury.
• Trust fund is in U.S. Treasury securities which
would have to be repaid with future tax revenue.
• Problems:
– Population is aging so ratio of workers to retirees is falling.
– People are living longer so they receive more in benefits.

Securities Firms: Brokers, Mutual Funds,
and Investment Banks
• The primary services of brokerage firms are:
– Accounting (to keep track of customers’
investment balances)
– Custody services (to make sure valuable records
such as stock certificates are safe)
– Access to secondary markets (in which customers
can buy and sell financial instruments)
• Brokers also provide loans to customers who
wish to purchase stock on margin.
– They provide liquidity, both by offering check-
writing privileges with their investment accounts
and by allowing investors to sell assets quickly.
13-51
• Mutual-fund companies offer liquidity services
as well.
• The primary function of mutual funds, is to
pool the small savings of individuals in
diversified portfolios that are composed of a
wide variety of financial instruments.
13-52
• Investment banks are the conduits through
which firms raise funds in the capital markets.
• Through their underwriting services, these
investment banks issue new stocks and a
variety of other debt instruments.
• The underwriter guarantees the price of a new
issue and then sells it to investors at a higher
price.
– This is a practice called placing the issue.
13-53
• The underwriter profits from the difference
between the price guaranteed to the firm that
issues the security and the price at which the
bond or stock is sold to investors.
• Since the price at which the investment bank sells
the bonds or stocks in financial markets can turn
out to be lower than the price guaranteed by the
issuing company, there is some risk to
underwriting.
• For large issues, investors will band together and
spread the risk among themselves rather than
one taking the risk alone.
13-54
• Investment banks also provide advice to firms
that want to merge with or acquire other firms.
– Investment bankers do the research to identify
potential mergers and acquisitions and estimate the
value of the new, combined company.
• In facilitating these combinations, investment
banks perform a service to the economy.
– Mergers and acquisitions help to ensure that the
people who manage firms do the best job possible.
13-55
Finance Companies
• Finance companies raise funds directly in the
financial markets by issuing commercial paper
and securities and then use them to make
loans to individuals and corporations.
• They are concerned largely with reducing the
transactions and information costs that are
associated with intermediated finance.
13-56
Finance Companies
• Because of their narrow focus, finance
companies are particularly good at:
– Screening potential borrowers’ creditworthiness
– Monitoring their performance during the term of
the loan
– Seizing collateral in the event of a default
13-57
Finance Companies
• Most finance companies specialize in one of
three loan types:
– Consumer loans
– Business loans
– Sales loans
– Some also provide commercial and home
mortgages.
13-58
Finance Companies
• Consumer finance firms provide small
installment loans to individual consumers.
• Business finance companies provide loans to
businesses.
– Business finance companies also provide both
inventory loans and accounts receivable loans.
• Sales finance companies specialize in larger
loans for major purchases, such as
automobiles.
13-59
• Hedge funds are strictly for millionaires.
• Hedge funds come in two basic sizes:
– Maximum of 99 investors, each with at least $1 million
in net worth
– Maximum of 499 investors, each with at least $5
million in net worth
• Hedge funds are run by a general partner, or
manager, who is in charge of day-to-day
decisions.
– Managers are required to keep a large portion of their
own money in the fund to solve the problem of moral
hazard.
13-60
• Hedge funds are not low risk enterprises.
– Because they are set up as private partnerships, they
are not constrained in their investment strategies.
• Hedge fund managers typically strive to create
returns that roughly equal those of the stock
market.
• While individual hedge funds are very risky, a
portfolio that invests in a large number of these
funds can expect returns equal to the stock
market average with less risk.

Government-Sponsored Enterprises
• The U.S. government is directly involved in the
financial intermediation system.
• The risk-taking of government-related
intermediaries contributed importantly to the
financial crisis of 2007-2009.
• A hybrid corporate form known as a
government-sponsored enterprise (GSE) is
chartered by the government as a corporation
with a public purpose.
13-62
• The privatized Depression-era Federal National

Mortgage Association (Fannie Mae) and a
similarly government chartered competing entity,
the Federal Home Loan Mortgage Corporation
(Freddie Mac) are examples.
• While the debt issued by Fannie and Freddie was
not guaranteed by the government, market
participants generally assumed that it would be in
a crisis.
13-63
• In 1968, Congress also established the
Government National Mortgage Corporation
(Ginnie Mae) as a GSE that is wholly owned by
the federal government.
– The U.S. government explicitly guarantees Ginnie Mae
debt.
• Congress also chartered the Student Loan
Marketing Association (Sallie Mae) as a GSE, but
by 2004 had terminated the charter, making Sallie
Mae a wholly private-sector firm.
13-64
• At their founding, the financial GSEs had
similar financial character:
– They issued short term bonds and used the
proceeds to provide loans or guarantees of one
form or another.
– Because of their implicit relationship to the
government, they paid less than private borrowers
for their liabilities and passed on some of these
benefits in the form of subsidized mortgages and
loans.
13-65
• U.S. governments role in mortgage finance has become
so large that a rapid exit is not an option
• In September 2008, amidst the financial crisis, investors
shunned the debt of Fannie Mae and Freddie Mac so
the U.S. Treasury put these GSEs into federal
conservatorship
• GSEs assets exceed their equity by more than 40
times
• GSEs are profitable again, reducing the pressure on
Congress to act on reforms
- Many people benefit from the system, but the rate of
U.S. ownership has been dropping
13-66
• An annuity is a financial instrument in which a
person (the “annuitant”) makes a payment in
exchange for the promise of a series of future
payments.
• There are fixed-period and lifetime annuities.
• And there are deferred versus immediate
annuities.
• Finally, insurance companies offer fixed versus
variable annuities.
13-67

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Chapter 13

Financial Industry Structure

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• The privatized Depression-era Federal National

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