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Pearson Prentice Hall Financial Markets and Institutions 19 - 1
Multiple Regulatory Agencies
– Overlapping jurisdictions 1. Office 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 fixed rate mortgages
2. Financial Derivatives -‐ instruments with payoffs 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 specific 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 financial info
1. Bank Credit & Debit Cards -‐ charged accounts started by Sears, Macy’s Goldwater’s; income: payment’s 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 financial 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 financial 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
fixed price by writing checks; created by Bruce Bent & Henry Brown in 1970; boomed during the rapid rise of inflation 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 corporation’s 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 inflation made investors more sensitive to yield
differentials on different 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 financial 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 find 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 off-‐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: reflected 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
v Bank Failure: 100 per year from 1985 to 1992 v Number of banks declined: 3,000 from 1985 to 1992 &
3,800 from 1992 to 2007 v Bank consolidation: merging to create larger entities; loophole
mining undermining branching restrictions v 1975 Maine: 1st interstate banking legislation that allowed out-‐of-‐
state purchase of banks v 1982 Massachusetts: regional compact with other New England
states to allow interstate banking v 1990: almost all states allowed some form of interstate banking
Pearson Prentice Hall Financial Markets and Institutions 19 - 16
Bank Consolidation & Nationwide Banking
v Diversification: if one state’s economy was weak, another state might have a strong economy
v Superregional banks: bank holding companies that rival the money center banks in size but whose headquarters are not in one of the money center cities (New York, Chicago, and San Francisco). E.g. Bank of America of Charlotte, North Carolina, and Banc One of Columbus, Ohio
v Web & improved IT: economies of scale & scope Economies of scope: ability to use one resource to provide many different products and services; synergies
v Large, complex banking organizations (LCBOs)
Pearson Prentice Hall Financial Markets and Institutions 19 - 17
Bank Consolidation & Nationwide Banking
Riegle-‐Neal Interstate Banking & Branching Efficiency Act of 1994
v Established the basis for a true nationwide banking system v Expands regional compacts to the entire nation & overturns the
McFadden Act & Douglas Amendment (prohibition of interstate banking)
v Allow bank holding companies to acquire banks in any other state, merge banks they own into 1 bank with branches in different states
v 1998 Bank of America & NationsBank merger created the 1st bank with branches on both coasts; banking industry consolidation led to banking organizations with operations n almost all of the 50 states
Pearson Prentice Hall Financial Markets and Institutions 19 - 18
Bank Consolidation & Nationwide Banking
What Will the Structure of the U.S. Banking Industry Look Like in the Future?
v Surge of Mergers and Acquisitions v Decline in number: from several thousands to several hundred v Concentration of Assets: shift in assets from smaller banks to
larger banks v More efficient banks & healthier banking system less prone to
bank failures v Fear: eliminate small banks, referred to as community banks;
historically untrue – New York, California v Economies of scale & scope
Pearson Prentice Hall Financial Markets and Institutions 19 - 19
Separation of Banking & Other Financial Service Industries
Other Financial Service Industries: securities, insurance, & real estate Erosion of Glass-‐Steagall v Federal Reserve used a loophole in Section 20 of the Glass-‐Steagall
Act in 1987 to allow bank holding companies to underwrite previously prohibited classes of securities, banks began to enter this business.
v U.S. Supreme Court validated the Fed’s action in July 1988 v Fed allowed J. P. Morgan, to underwrite corporate debt securities
(Jan 1989) & to underwrite stocks (Sep 1990), with the privilege later extended to other bank holding companies
v Regulatory agencies also allowed banks to engage in some real estate & insurance activities
Pearson Prentice Hall Financial Markets and Institutions 19 - 20
Separation of Banking & Other Financial Service Industries
The Gramm-‐Leach-‐Bliley Financial Services Modernization Act of 1999: Repeal of Glass-‐Steagall
v allows securities firms & insurance companies to purchase banks, and allows banks to underwrite insurance & securities and engage in real estate activities
v State regulatory authority: insurance activities v Securities & Exchange Commission (SEC): oversight of
securities activities v Office of the Comptroller of the Currency: authority to regulate
bank subsidiaries engaged in securities underwriting v Federal Reserve: oversight of bank holding companies
Pearson Prentice Hall Financial Markets and Institutions 19 - 21
Separation of Banking & Other Financial Service Industries
Implications for Financial Consolidation v Demise of large, free-‐standing investment bank v 2008: (from Mar to Sep) 5 of the largest free-‐standing
investment banks ceased to exist in old form a. Bear Stearns sold to J.P. Morgan b. Lehman Brothers c. Merrill Lynch sold to Bank of America d. Goldman Sachs e. Morgan Stanley
Pearson Prentice Hall Financial Markets and Institutions 19 - 22
Separation of Banking & Other Financial Service Industries
Separation of Banking & Other Financial Services Industries Throughout the World
v 3 Basic Frameworks for Banking & Securities Industries: a. Universal Banking – (Germany, Netherlands, & Switzerland)
No separation at all between the banking & securities industries. In a universal banking system, commercial banks provide a full range of banking, securities, real estate, & insurance services, all within a single legal entity. Banks are allowed to own sizable equity shares in commercial firms, and often they do.
Pearson Prentice Hall Financial Markets and Institutions 19 - 23
Separation of Banking & Other Financial Service Industries
Separation of Banking & Other Financial Services Industries Throughout the World
v 3 Basic Frameworks for Banking & Securities Industries: b. British-‐style universal banking system – (UK, US, Canada,
& Australia) Bank engages in securities underwriting, but it differs from the German-‐style universal bank in 3 ways: a. Separate legal subsidiaries: more common b. Bank equity holdings of commercial firms: less common c. Combinations of banking & insurance firms: less common
Pearson Prentice Hall Financial Markets and Institutions 19 - 24
Separation of Banking & Other Financial Service Industries
Separation of Banking & Other Financial Services Industries Throughout the World
v 3 Basic Frameworks for Banking & Securities Industries: c. Japan-‐style banking system
Some legal separation of the banking & other financial services industries. Major differences: a. Substantial Bank equity holdings of commercial firms:
allowed b. Bank Holding Companies: illegal
Section 65 of the Japanese Securities Act allow commercial banks to engage in securities activities (British-‐style UKBs)
Pearson Prentice Hall Financial Markets and Institutions 19 - 25
Thrift Industry: Regulation & Structure
Savings & Loan Associations v Regulatory authority: chartered by federal government or by
the states
v Most S & L are members of the Federal Home Loan Bank System (FHLBS), styled like the Federal Reserve System
v Office of Thrift Supervision: supervises 12 District Federal Home Loan banks
v FDIC: Federal deposit insurance up to $250,000 per account for S&Ls; Office of the Comptroller of the Currency regulates federally insured S&Ls
v FHLBS discount loan program provides a subsidy to S & L
Pearson Prentice Hall Financial Markets and Institutions 19 - 26
Thrift Industry: Regulation & Structure
Mutual Savings Bank v 400: similar to S&Ls but are jointly owned by the depositors
v Chartered by states v FDIC: Federal deposit insurance up to $100,000 per account v mutual savings banks whose deposits are not insured by the
FDIC have their deposits insured by state insurance funds v branching regulations for mutual savings banks are determined
by the states; not particularly restrictive, there are few mutual savings banks with assets of less than $25 million
Pearson Prentice Hall Financial Markets and Institutions 19 - 27
Thrift Industry: Regulation & Structure
Credit Unions v Small cooperative lending institutions around particular group
of individuals, e.g. union members or employees
v only depository institutions that are tax-‐exempt & can be chartered either by the states or by the federal government
v National Credit Union Administration (NCUA): issues federal charters & regulates federally chartered credit unions by setting minimum capital requirements, requiring periodic reports, & examining the credit unions
v National Credit Union Share Insurance Fund (NCUSIF): (subsidiary of NCUA) deposit insurance $100,000-‐per-‐account
Pearson Prentice Hall Financial Markets and Institutions 19 - 28
Thrift Industry: Regulation & Structure
Credit Unions v typically quite small; most hold less than $10 million of assets
v lending is for consumer loans with short terms to maturity, these institutions did not suffer the financial difficulty of S&Ls and mutual savings banks
v their ties to a particular industry or company make them more likely to fail when large numbers of workers in that industry or company are laid off & have trouble making loan payments
v Navy Federal Credit Union whose shareholders are members of the U.S. Navy and Marine Corps branches throughout the world
Pearson Prentice Hall Financial Markets and Institutions 19 - 29
International Banking
v 1960: 8 US banks operated branches in foreign countries, total assets were less than $4 billion
v Current: 100 US banks operated branches in foreign countries, total assets were less than $1.5 trillion
v 3 Factors: a. rapid growth in international trade & multinational corps
b. US banks have been able to earn substantial profits by being very active in global investment banking: underwrite foreign securities, investment banking & insurance activities
c. US banks wanted to tap into dollar-‐denominated deposits in foreign countries known as Eurodollars
Pearson Prentice Hall Financial Markets and Institutions 19 - 30
International Banking
v 1960: 8 US banks operated branches in foreign countries, total assets were less than $4 billion
v Current: 100 US banks operated branches in foreign countries, total assets were less than $1.5 trillion
v 3 Factors: a. rapid growth in international trade & multinational corps
b. US banks have been able to earn substantial profits by being very active in global investment banking: underwrite foreign securities, investment banking & insurance activities
c. US banks wanted to tap into dollar-‐denominated deposits in foreign countries known as Eurodollars
Pearson Prentice Hall Financial Markets and Institutions 19 - 31
International Banking
Eurodollar Market v created when deposits in accounts in the US are transferred to a
bank outside the US & are kept in the form of dollars
v More than 90% are time deposits; more than half of them are certificates of deposit with maturities of 30 days or more
v Reasons for US$ denomination:
a. dollar is the most widely used currency in international transactions
b. Eurodollars are “offshore” deposits -‐ not subject them to regulations such as reserve requirements or capital controls
Pearson Prentice Hall Financial Markets and Institutions 19 - 32
International Banking
Eurodollar Market v Main center: London
v Eurodollars also held outside Europe in locations that provide offshore status to these deposits, like Singapore, Bahamas, and the Cayman Islands
v Minimum transaction: $1 million; 75% deposits held by banks
Pearson Prentice Hall Financial Markets and Institutions 19 - 33
International Banking
Structure of U.S. Banking Overseas v Most foreign branches of US banks: Latin America, Far East,
Caribbean, & London
v London: largest volume of assets because it is a major international financial center and the central location for the Eurodollar market.
v Far East & Latin America: important regions in U.S. trade v Caribbean (Bahamas and the Cayman Islands): tax haven; “shell
operations” because they function primarily as bookkeeping centers & do not provide normal banking services
Pearson Prentice Hall Financial Markets and Institutions 19 - 34
International Banking
Structure of U.S. Banking Overseas v Edge Act Corporation : special subsidiary engaged primarily in
international banking.
U.S. banks (through their holding companies) can also own a controlling interest in foreign banks and in foreign companies that provide financial services, such as finance companies.
The international activities of U.S. banking organizations are governed primarily by the Federal Reserve’s Regulation K.
Pearson Prentice Hall Financial Markets and Institutions 19 - 35
International Banking
Structure of U.S. Banking Overseas v International Banking Facilities (IBFs) -‐ can accept time deposits
from foreigners but are not subject to either reserve requirements or restrictions on interest payments.
IBFs are also allowed to make loans to foreigners, but they are not allowed to make loans to domestic residents.
States have encouraged the establishment of IBFs by exempting them from state & local taxes. The purpose of establishing IBFs is to encourage American & foreign banks to do more banking business in the United States rather than abroad.
Assets climbed to nearly $200 billion in the first 2 years, & were $1.3 trillion at the end of 2009.
Pearson Prentice Hall Financial Markets and Institutions 19 - 36
International Banking
Foreign Banks in the U.S. v Foreign banks encouraged to establish offices in the US – hold
more than 16% of total U.S. bank assets & 26% market share in lending Phil: 10.4% of total assets & 10.7% of TLP of Phil. Banking System
v Foreign banks engage in banking activities in the United States by operating an agency office of the foreign bank, a subsidiary U.S. bank, or a branch of the foreign bank.
An agency office can lend and transfer funds in the US, but cannot accept deposits from domestic residents.
Pearson Prentice Hall Financial Markets and Institutions 19 - 37
International Banking
Foreign Banks in the U.S. v Foreign banks encouraged to establish offices in the US – hold
more than 16% of total U.S. bank assets & 26% market share in lending Phil: 10.4% of total assets & 10.7% of TLP of Phil. Banking System
v Foreign banks engage in banking activities in the United States by operating an agency office of the foreign bank, a subsidiary U.S. bank, or a branch of the foreign bank.
Pearson Prentice Hall Financial Markets and Institutions 19 - 38
International Banking
Foreign Banks in the U.S. An agency office can lend and transfer funds in the US, but cannot accept deposits from domestic residents.
Advantage: not being subject to regulations that apply to full-‐service banking offices.
A subsidiary U.S. bank is just like any other U.S. bank (it may even have an American-‐sounding name) and is subject to the same regulations, but it is owned by the foreign bank.
A branch of a foreign bank bears the foreign bank’s name and is usually a full-‐service office. Foreign banks may also form Edge Act corporations and IBFs.
Pearson Prentice Hall Financial Markets and Institutions 19 - 39
International Banking
Foreign Banks in the U.S. v Result of internationalization of banking:
a. financial markets throughout the world have become more integrated;
b. growing trend toward international coordination of bank regulation, e.g. Basel Accord
c. bank consolidation abroad: creation of the 1st trillion dollar bank with the proposed merger of the Industrial Bank of Japan, Dai-‐Ichi Kangyo Bank, and Fuji Bank, announced in August 1999, but which took place in 2002
Pearson Prentice Hall Financial Markets and Institutions 19 - 41
Philippine Banking System
-‐ Moody’s: only banking system in Southeast Asia rated positive
-‐ S & P: positive, together with Singapore, Indonesia, & Thailand
-‐ Fitch: stable, along with Malaysia vs negative on China, India, Indonesia, Mongolia, Sri Lanka, Thailand & Vietnam
-‐ BSP is setting the downstage for foreign investment and competition as the country joins the ASEAN Economic Community by 2015 and stands ready to tap consequential opportunities from the ASEAN Banking Integration by 2020.
Pearson Prentice Hall Financial Markets and Institutions 19 - 42
Philippine Banking System
Philippine Banking System -‐ Universal & Commercial banks: 36 with 5,425 branches/other offices
-‐ Thrift banks: 71 with 1,757 branches/other offices -‐ Rural & Coop banks: 566 with 2,080 branches/other offices -‐ BSP is setting the downstage for foreign investment and competition as the country joins the ASEAN Economic Community by 2015 and stands ready to tap consequential opportunities from the ASEAN Banking Integration by 2020.