mishkin ppt19

Pearson Prentice Hall Financial Markets and Institutions 19 - 1

Multiple Regulatory Agencies

Overlapping jurisdictions 1. Oce of the Comptroller of Currency - primary supervisory

responsibility for the 1,500 national banks that own > 50% of assets of the commercial banking system

2. Federal Reserve & State Banking Authorities - primary responsibility for the 858 Fed member state banks

3. Federal Reserve - primary responsibility for bank holding companies; secondary responsibility for the national banks.

4. FDIC & State Banking Authorities - jointly supervise the 4,500 Non-Fed state banks that have FDIC insurance

5. State Banking Authorities sole jurisdiction over the fewer than 500 state banks without FDIC insurance

Pearson Prentice Hall Financial Markets and Institutions 19 - 2

Financial Innovation & Growth of Shadow Banking System

Shadow Banking System bank lending replaced by lending via the securities market

Financial Innovation: A change in the +inancial environment will stimulate a search by +inancial institutions for innovations that are likely to be pro@itable.

Why Financial Innovation Occurs: 1. Responses to Changes in Demand Conditions: Interest Rate Volatility 2. Responses to Changes in Supply Conditions: Information Technology 3. Avoidance of Existing Regulation 4. Decline of Traditional Banking

Pearson Prentice Hall Financial Markets and Institutions 19 - 3

Financial Innovation & Growth of Shadow Banking System

Responses to Changes in Demand Conditions: Interest Rate Volatility

1. Adjustable-Rate Mortgages - lending institutions adjusts rate based on T-bill rate changes. Initial rate is lower than conventional xed rate mortgages

2. Financial Derivatives - instruments with payos that are linked to previously issued securities; Hedge: protection against risk

Futures contracts - seller agrees to provide a certain standardized commodity to the buyer on a specic future date at an agreed-on price.

Pearson Prentice Hall Financial Markets and Institutions 19 - 4

Financial Innovation & Growth of Shadow Banking System

Responses to Changes in Supply Conditions: Information Technology - Lowered transaction costs, made available nancial info

1. Bank Credit & Debit Cards - charged accounts started by Sears, Macys Goldwaters; income: payments from stores 5%; Visa & MasterCard

2. Electronic Banking - ATM (24/7), US:250,000; Phils: 14,530 (BSP, Sep 2013); home banking; ABM ATM + internet Website + telephone to customer service; Virtual Bank cyberspace only e.g. Security First Network Bank, Bank of America;

3. Electronic Payment bills payment online, auto-debits - Scandinavians & Finland ahead of Americans

Pearson Prentice Hall Financial Markets and Institutions 19 - 5

Financial Innovation & Growth of Shadow Banking System

Responses to Changes in Supply Conditions: Information Technology - Lowered transaction costs, made available nancial info

4. E-money - substitute for checks & money; stored-value card & smart cards; e-cash

Phils - Happy Plus, various rewards/loyalty cards

5. Junk bonds - fallen angels, below Baa, have not yet achieved investment-grade

6. Commercial Papers - ST debt securities (large banks & corps) 7. Securitization process of transforming illiquid nancial assets

into marketable capital market securities

Pearson Prentice Hall Financial Markets and Institutions 19 - 6

Financial Innovation & Growth of Shadow Banking System

Avoidance of Existing Regulation - Heavily regulated industry; loophole mining 2 Sets of Regulations have been Major Forces for Innovation:

1. Reserve Requirement - recognized as a tax on deposit 2. Deposit rate ceilings - restrictions on interest paid on deposits:

prohibition on paying interest on checking accounts deposits; Regulation Q: Fed sets limits on interest rates on time deposits

Reason: depositors withdrew funds from banks to put them into higher-yielding securities, if market interest rates rose above the maximum rates that banks paid. Loss of deposits restricted banks lending funds: disintermediation.

Pearson Prentice Hall Financial Markets and Institutions 19 - 7

Financial Innovation & Growth of Shadow Banking System

Avoidance of Existing Regulation 2 Sets of Innovation: 1. Money Market Mutual Fund - issued shares, redeemable at a

xed price by writing checks; created by Bruce Bent & Henry Brown in 1970; boomed during the rapid rise of ination in 1978; not subject to reserve requirements, but came to regulation scrutiny as government safety came to the rescue in 2008 (Mini-case: Bruce Bent & the Money Market Mutual Fund Panic of 2008)

2. Sweep Accounts any balances above a certain amount in a corporations checking account at the end of a business day are swept out of the account and invested in overnight securities that pay interest

Pearson Prentice Hall Financial Markets and Institutions 19 - 8

Financial Innovation & Growth of Shadow Banking System

Decline of Traditional Banking

- Traditional banking: make LT loans, issue ST deposits; asset transformation, referred to as borrowing short, lending long

- US Banks as a source of fund, market share: a. Commercial banks - 1974: 40% down to 26% in 2009 b. Thrift banks - late 1970s: 20% down to 3% 2010 - US Banks asset size, market share: a. Commercial banks - 1960 to 1980: 40% down to 25% in 2009 b. Thrift banks - 1960 to 1980: 20% down to 3% 2010

- Phils: 81.3 % total assets of the Financial System (BSP, 2013)

Pearson Prentice Hall Financial Markets and Institutions 19 - 9

Financial Innovation & Growth of Shadow Banking System

Decline of Traditional Banking

Liabilities side: Decline in Cost Advantages in Acquiring Funds - 1960: rise in ination made investors more sensitive to yield

dierentials on dierent assets. People began to take their money out of banks, with their low interest rates on both checkable & time deposits, and began to seek out higher-yielding investments.

- Result: disintermediation - Legislative response: 1980s - elimination of Regulation Q ceilings

on time deposit interest rates & allowed checkable deposit accounts that paid interest

Pearson Prentice Hall Financial Markets and Institutions 19 - 10

Financial Innovation & Growth of Shadow Banking System

Decline of Traditional Banking

Asset side: Decline in Income Advantages on Uses of Funds - Loss of market share from nancial innovations: junk bonds,

securitization, & commercial paper (CP) market

- Result: shadow banking growth - Finance Companies: depend primarily on CP to acquire funds, to

expand their operations at the expense of banks. Many of the banks best business customers nd it cheaper to go instead to the CP market for funds.

- Securitization - due to IT: accurately evaluate credit risk with statistical methods & lower transaction costs

Pearson Prentice Hall Financial Markets and Institutions 19 - 11

Financial Innovation & Growth of Shadow Banking System

Decline of Traditional Banking

Banks Response to survive: Seek out new lines of business 1. Expanding into new and riskier areas of lending - increased

their risk taking by placing a greater % of their total funds in: a. commercial real estate loans b. lending for corporate takeovers & leveraged buyouts

2. Pursue new o-balance-sheet activities - embrace shadow banking: non-interest-income activities.

Result: Challenge to regulators

Pearson Prentice Hall Financial Markets and Institutions 19 - 12

Structure of the US Commercial Banking Industry

1. Physical: approximately 7,000 commercial banks

Philippines: As of end-December 2013, there were 9,935 operating banking units - 5,461 Universal & KBs, 1,828 TBs, 2,646 Rural & Coop

Pearson Prentice Hall Financial Markets and Institutions 19 - 13

Structure of the US Commercial Banking Industry

Pearson Prentice Hall Financial Markets and Institutions 19 - 14

Structure of the US Commercial Banking Industry

2. Restriction on Branching: reected hostility to large banks, protection of small banks. McFadden Act of 1927 prohibited banks from branching across state lines & forced all national banks to conform to the branching regulations of the state where their headquarters were located. Bank response: bank holding companies & ATMs

Bank Holding Companies own controlling interest in several banks even if branchings not permitted; can engage in other banking-related activities , such as the provision of investment advice, data processing & transmission services, leasing, credit card services, and servicing of loans in other states.

Pearson Prentice Hall Financial Markets and Institutions 19 - 15

Bank Consolidation & Nationwide Banking

vBank Failure: 100 per year from 1985 to 1992 vNumber of banks declined: 3,000 from 1985 to 1992 &

3,800 from 1992 to 2007 vBank consolidation: merging to create larger entities; lo