The Transformation of the U.S. Banking Industry: What a Long, Strange Trip It’s Been

Many aspects of the U.S. banking industry have changed since 1979 (the authors write in 1995):

Over 1/3 of all independent banking organizations (top-tier bank holding companies and unaffiliated banks) disappeared from 1979-94, while the assets of the industry were growing

Banks have lost market power over large borrowers, who now have access to many alternative forms of finance

Banks now have to compete for deposit funds with other financial institutions

Automated teller machines and on-line banking have altered the way many consumers deal with their banks

Policy Concerns The changes in the industry raise policy concerns because banks are an

integral part of the U.S. economy

Banks pool and absorb risks for depositors and provide stable sources of investment and working capital for nonfinancial firms

Banks are an important part of the payments system

Much of monetary policy operates through the banks

Banks are an important source of funds for small, information-problematic borrowers who often have limited access to other sources of finance

Thus, changes that affect banks can affect many other firms and consumers as well as government decisions

The Goal

This paper summarizes and quantifies changes in the U.S. commercial banking industry

It emphasizes regulatory changes and technical and financial innovations as the driving forces behind change in the industry

Changes in the regulatory environment include the deregulation of deposit accounts, several major changes in capital requirements, reductions in reserve requirements, expansion of bank powers, and liberalization of geographic restrictions on intrastate and interstate banking

Important technical innovations include advances in information processing and telecommunications that facilitate low-cost, rapid transfers of information and funds

Financial innovations include the securitization of many traditional bank assets and the expansion of derivative activity

Method

To document and assess the effects of these forces, they examine the evolution of the balance sheets, off-balance sheet activities, and income statements of all insured U.S. commercial banks

Their sample begins in 1979 and ends in December 1994; the most turbulent period in banking since the Great Depression

Main Results

They claim the most novel aspect of their analysis derives from their estimation of the patterns of bank lending to borrowers of different sizes over time

Large banking organizations tend to lend to medium and large business, whereas small banking organizations tend to lend to small businesses

In the early 1990s, a reduction in banking commercial and industrial lending occurred; this reduction affected borrowers of different sizes in different ways

Based on a sample of over 1.6 million individual loans to domestic businesses by U.S. banks, they estimate there was a 34.8% real contraction in loans to borrowers with bank credit of less than $1 million during the first half of the 1990s

They also estimate a large reduction in lending to large borrowers, but lending to medium-size borrowers was not affected as much; they provide some possible explanations in the body of the paper (large borrowers could obtain capital elsewhere through bonds, etc.)

Main Results, cont. They note that some of the reductions in small business lending may represent

improvements in efficiency

Geographic restrictions on intrastate and interstate banking have created barriers to entry into local markets and may have reduced competition and allowed banks to exploit their market power in pricing deposit and loan services

These restrictions also may have reduced the effectiveness of the market for corporate control in banking by limiting the set of firms that could potentially take over a bank; takeover threats discipline managers

Limited market forces may have resulted in some negative net present value loans being made; reallocating these funds improves economic welfare

To the extent that consolidation has reduced positive net present value loans, those loans will likely be reissued in the long run because of the profit opportunities associated with them

Regulatory Changes from 1979 to 1994

Regulatory changes have had a mixed impact on the profitability and competitive position of U.S. commercial banks relative to other financial intermediaries

These changes can be divided into five areas:

1. Expansion of bank powers

2. Reduction in reserve requirements

3. Formalization and tightening of capital requirements

4. Deregulation of deposit accounts

5. Liberalization of the rules and policies regarding geographical diversification

Reserve Requirements and Bank Powers

In general, changes in reserve requirements and bank powers likely improved the competitive position of banks

Reserve requirements were reduced three times during the sample period; by 1994 the only requirement was a 10% requirement for transaction balances

Bank power also grew, as regulators allowed banking organizations to enter new product markets

Bank holding companies (a firm that owns at least 25% of a bank or exercises control over it) can now have separately capitalized subsidiaries that offer investment advice, provide discount brokerage services, and underwrite various securities

Capital RequirementsTightening capital requirements was likely costly for many banks, particularly the

largest ones; banks held much more capital in 1994 than in 1979

At the end of the 1970s, capital regulation was relatively ad hoc and depended largely on the judgement and discretion of a bank’s supervisors, but starting in 1981, new regulations required banks to hold capital equal to a flat percentage of their balance sheet assets

Since banks were not required to hold capital against off-balance sheet items, and all on-balance sheet assets had the same capital requirements regardless of risk or return, these rules provided incentives for banks to reorganize their balance sheet activities and expand off-balance sheet activities

In 1990, risk-based capital standards associated with the Basle Accord corrected some of the problems with the flat rate by requiring banks to hold different amounts of capital, depending on the perceived credit risk of on and off balance sheet assets

The FDIC Improvement Act of 1991 provided for “prompt corrective action,” which meant that banks with capital ratios below thresholds were subject to various mandatory and discretionary actions

Deposit Account Liberalization

They argue that the effect of deposit account liberalization is more ambiguous

Before the 1980s, the interest rates banks could pay on deposits and the types of accounts they could offer were restricted, but banks had few competitors for deposit funds

The expansion of money market mutual funds in the late 1970s started to reduce the advantage of banks in acquiring deposit funds, but by 1986 bank deposit rates were completely deregulated

Without deregulation, banks would have held many fewer deposits, but the deposits they did acquire may have been less costly

The net effect of deregulation is not clear

Geographic Expansion

The effect of geographic expansion is also ambiguous because it affected different banks in different ways

Geographic expansion was favorable for organizations that wished to expand geographically and unfavorable for those whose markets were invaded

Some of the reforms:

1. Liberalization of intrastate branching (branching within states)

2. Liberalization of rules for affiliation with multibank holding companies (MBHCs, which are firms that own or control more than one bank)

3. MBHCs were allowed to own banks in more than one state, usually through regional compacts approved by the legislatures of nearby states

4. Considerable liberalization of antitrust policy as applied to banking organizations

Interstate Banking

As of the end of 1994, MBHCs still could not expand nationwide and all interstate branching remained prohibited by the McFadden Act of 1927 and stage regulations

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 expanded the existing regional compacts to the nation as a whole and overturned the McFadden Act’s prohibition on interstate branching

Under Riegle-Neal, bank holding companies are permitted to acquire banks in any other state

Antitrust Policy In 1985, the Justice Department and the Federal Reserve began allowing bank

mergers in highly concentrated markets that raised the Herfindahl index by as much as 200 points, rather than the 50 point limit applied to other industries

Their assumption was that banks face substantial competition from nonbank financial institutions

Other changes include using savings and loan data in computing the Herfindahl for banks, considering possible competition, and ruling out sheer size as a reason for denying a merger

Today, most bank mergers are approved

Parties may have to divest some offices in local markets with significant market overlap

The Justice Department and the bank regulatory agencies have issued information about the criteria they use to decide which mergers to investigate; firms can consider these guidelines before attempting a merger

Technical Innovations from 1979 to 1994

ATMs provide a convenient substitute for human tellers, particularly for cash acquisition

Advances in computing power and telecommunications have also changed back-office operations and made electronic payments significantly more efficient

The application of credit scoring software has greatly facilitated the efficiency and standardization of credit evaluation

Evidence suggests that computerized credit-scoring models may result in fewer loan losses than methods that rely on the judgment of loan officers

Financial Innovations from 1979 to 1994

Financial innovations have increased the number of products that banks can offer

The development of secondary markets for mortgages and credit card receivables has given banks greater flexibility in their operations

There has been tremendous growth in the use of derivative securities (contracts with payoffs derived from the prices of other securities or commodities)

Derivatives allow bank customers to hedge market risks without the banks having to take on significant market risks themselves

Innovations and Banks vs. NonBanks

The innovations may have helped financial institutions other than banks more than banks

For example, the decreases in the cost of direct access to financial markets has led some firms that previously would have borrowed from banks to issue bonds instead

Similarly, nonbanks have developed products like money market mutual funds with check writing capabilities

The Data

The authors examine detailed data on banks during the period 1979-1994 to assess the impact of deregulation and innovation

Most of their data comes from the Reports of Condition and Income (“Call Reports”) that all federally insured commercial banks file with regulators each quarter

All dollar figures are converted to 1994 dollars

Unit of ObservationThey treat each top-tier bank holding company as a single, integrated banking

organization (they combine the assets of all the banks directly controlled by a holding company, or indirectly controlled through the ownership of a lower-tier holding company, into a single firm)

There are good reasons for doing this:

1. Legislation requires that all banks within a holding company may be held liable for any deposit insurance funds that are used to assist any other banks within the holding company, and the holding company itself has to provide funds when any of its banks become distressed; thus, the top-tier holding company is made the risk management unit by regulation

2. Most MBHCs are managed at the top tier3. Holding company affiliates often exchange portfolio instruments. For example,

because of legal lending limits, the largest loans are likely to be booked by the largest bank in the holding company, even if they are issued to the customer of one of the smaller affiliates.

4. In most cases, this issue makes no difference because most bank holding companies have only a single bank. In 1994, among holding companies with more than $100 billion in assets, an average of 70% of assets were in the single largest bank.

Categorization

They group banks by five size classes defined in terms of total assets (1994 dollars):

1. Under $100 million

2. From $100 million to $1 billion

3. From $1 billion to $10 billion

4. From $10 billion to $100 billion

5. Over $100 billion

The refer to (1) as small banks, (2-4) as mid-sized banks, and (5) as megabanks

Results: Consolidation

1979 1994

Total number of banking organizations 12,463 7,926Small Banks 10,014 5,636

Real industry gross total assets (in trillions) 3.26 4.02Percent in Megabanks 9.4 18.8Percent in Small Banks 13.9 7.0

Consolidation was fueled by the relaxation of geographic restrictions, an easier merger approval process, and innovations in information processing and telecommunications

Almost the entire reduction in the number of banks is accounted for by the reduction in the number of small banks

It is worth noting that during this period, 3,111 new banks entered the market

The Role of Technical and Financial Innovations1979 1994

Number of automated teller machines 13,800 109,080Real cost of an electronic deposit ($) .0910 .0138Real cost of processing a paper check ($) .0199 .0253Megabanks:

Notional value of derivates/assets .823 11.45“Other noninterest income”/operating income (%) 7.0 20.9

Small banks:Notional value of derivates/assets .001 .002“Other noninterest income”/operating income (%) 3.5 8.3

Megabanks have greatly expanded their use of derivatives and increased their “other noninterest income,” which includes fees from issuing derivative instruments

Small banks followed similar trends, but at a much smaller scale

They think regulations are the main cause of consolidation, but innovations may have contributed (some scale economies, but not substantial ones)

The Role of Changes in Geographic RestrictionsAt the time of writing, most intrastate restrictions on branching and affiliation with

MBHCs were lifted several years ago; they focus on interstate regulations

Until 1982, except for grandfathering arrangements, no state permitted MBHCs from other states to own banks within its borders

By the end of 1989 all but six small states allowed some interstate activity, and by 1993 only Hawaii did not allow any interstate MBHCs

1979 1989 1994National assets legally accessible from the typical U.S. state (%) 6.5 29.0 69.4Typical state’s assets controlled by out-of-state multibank holding companies (%) 2.1 18.9 27.9

At the end of the sample, interstate branching was still not permitted; the changes in the table are due to what MBHCs were permitted to do

The actual spread of interstate banking lagged behind what could have been done

The Role of External Competition

The banking industry has grown but it has lost market share to other financial institutions

1979 1994

U.S. banking industry real gross total assets ($ trillions) 3.26 4.02

Total credit market debt of individuals, businesses,

and governments ($ trillions) 8.27 17.14

U.S. banks’ share (%) 25.8 17.0

U.S. banks’ share of total non-credit market debt of financial intermediaries and total nonfarm, nonfinancial corporate debt has also fallen

The Role of Deposit Rate Regulation

1979 1986 1994Interest expenses/assets (%) 5.17 5.13 2.73One-year Treasury bill rate 10.65 6.45 5.32(Interest expenses/assets) minus

One-year Treasury bill rate -5.48 -1.32 -2.59Noninterest expenses/assets (%) 2.39 3.03 3.55

minus one-year T-bill rate -3.09 1.71 0.96

Number of banking offices 50,136 58,063 65,610Number of ATMs 13,800 64,000 109,080Number of employees (thousands) 1,403 1,548 1,468

Interest expenses are what banks have to pay to depositors; these expenses rose relative to T-bill rates (a proxy for the open market interest rate)

Noninterest expenses from data processing costs and providing extra branches and services also rose; banking offices, ATMs, and employees all increased

External Competition and Profitability The data suggest that external competition encouraged banks to pay higher interest to

depositors and increase customer services

This affected profitability and contributed to a shakeout

1979 1986 1994Return on equity for:All banks 14.0 10.0 15.0Megabanks 14.3 6.9 14.2Small banks 14.0 4.8 11.0

At the beginning of the sample period there were typically fewer than ten failures per year, but by the end of the 1980s there were more than two hundred failures per year

Before 1988, only five banks with assets over $1 billion had been closed by regulators, but after 1988, 27 banks in this size category were closed

Many failures had both high costs and many problem loans, but it is not clear whether high costs led to risky loans or the reverse or whether poor management led to both

The Role of Capital Regulation Before 1981 capital regulation was ad hoc; standard practice required less

capital for large banks because of their presumed superior diversification of risks

The formal flat-rate capital standards implemented in the early 1980s forced large banks to hold more capital

These standards did not require any capital against off-balance-sheet activities, and therefore encouraged banks to expand these activities (use standby letters of credit and loan commitments that back up commercial paper instead of loans)

Technical and financial innovations contributed to the expansion of off-balance-sheet activities and may have been more important than capital requirements

Lending Patterns

They examine the distribution of lending across borrowers of different size categories

Declines in bank lending to large borrowers are not critical because large borrowers typically have alternative sources of low-cost external finance

However, if small borrowers lose their bank funding, they may not be able to raise funds elsewhere, at least in the short run

The empirical literature suggests that small borrowers pay progressively lower loan rates and face easier collateral requirements as their banking relationship matures

These relationship borrowers may find it costly to form new relationships if their banks deny them credit

Data They estimate the distribution of loans by U.S. banks to different size categories of

domestic commercial and industrial borrowers from 1979-1994

Such data have not been previously constructed; they use an unpublished survey to get their data: the Federal Reserve’s Survey of the Terms of Bank Lending to Businesses (STBL) (although fn. 39 suggests Call Reports after 1994 provide some of this info)

The survey records the characteristics of all domestic C&I loans made by a sample of banks on one or more days of the first week of the second month each quarter

Approx. 300 banks each quarter, including the 48 largest banks and a representative stratified sample from smaller size classes

On average, about 25,500 loans are reported per quarter; 1,631,614 loans over the entire period 1979-1994

Organizations with STBL held 73% of the U.S. gross total assets in 1994

Categorizing BorrowersThey proxy for the size of the borrower by recording the maximum of:

1. The size of the loan from the bank2. The total commitment (if any) under which the loan was drawn from the

bank3. The total size of the participation (if any) by all banks in a loan participation

This measure estimates the total credit available to the borrower from the bank or group of banks involved in the loan

Seven categories:1. Under $100,000 in credit2. From $100,000 to $250,000 (here down is “very small”)3. From $250,000 to $1 million (here down is “small”)4. From $1 million to $10 million (4 and 5 are “medium”)5. From $10 million to $25 million6. From $25 million to $100 million (here up is “large”)7. Over $100 million

Stylized FactsLarge banking organizations make very few C&I loans to small borrowers:In 1994 megabanks had 2.5% of their $92.2 billion in C&I loans devoted to small

borrowers, well under 1% to very small borrowersIn contrast, they issues $40.8 billion, or 44.3% to large borrowers

Small banking organizations make most of their loans to small borrowers:In 1994 small banks made 81.7% of their $21.9 billion in C&I loans to small borrowers,

and most of the lending was to very small borrowersIn contrast, they made almost now loans ($0.1 billion) to large borrowers

The lending slowdown in the 1989-1992 period was concentrated among small borrowers (35.8% reduction in loans for small borrowers from 1989 to 1992, 45.2% for very small) and lending to these borrowers did not recover by 1994

In contrast, loans to medium borrowers declined only 13.9% during 1989-1992 and recovered almost completely by 1994

Loans to large borrowers declined 25.8% during 1989-1992 and continued to decline until 1994 (total 1989-1994 drop of 35.4%); financial innovations are likely responsible for this (these firms used other means to obtain financing)

Small Bank Lending and the Impact of Consolidation

Legal lending limits usually restrict lending to a single borrower to no more than 15% of the bank’s equity capital

Because of this and the need to diversify, small banks are virtually restricted to lend only to small borrowers

Thus, consolidation might lead to fewer loans to small borrowers because it removes the restrictions that small banks face

When large banks to make loans to small borrowers, they tend to charge lower average prices (in terms of interest rates and collateral)

This pattern is consistent with the view that large banks issue loans only to high quality small borrowers that can be evaluated the same way as large borrowers; it may be difficult to maintain procedures for analyzing financial ratios for some borrowers and doing relationship lending (which requires knowing the borrower, the community, etc.) for others

Consolidation and Concentration Will the removal of interstate barriers eventually lead to a market where ten or so

megabanks provide all banking services within the U.S.?

The authors estimate a detailed model to forecast what will happen; they conclude that concentration will increase but that many banks will still survive

Past experience suggests that banks do not expand everywhere even when they can; most large banks responded quickly to the liberalization of interstate banking, but they stayed within their regions

Another check: consider California, the fifth largest economy in the world. California has allowed full statewide branching since 1909; presumably the size distribution of banks within California has had time to evolve towards a long-run equilibrium

At the end of 1994, there were gross domestic banking assets of $298 billion in California (which is 8.5% of the national total) and 342 banking organizations

Projecting to the U.S., 342/(.085) yields 4,024 banking organizations in the U.S. in a long run free mobility equilibrium

Regulations and Further Consolidation

One reason why small banks will likely persist is that the system has adapted to them

Federal deposit insurance means that small banks can offer depositors virtually the same safety for their funds as a nationally diversified bank

The premiums banks pay for deposit insurance vary in a narrow band that does not fully account for risk

Where small banks cannot exploit economies of scale, as in back-office payments processing and issuing large loans, the banking system and the Federal Reserve have evolved to pool these services and offer them to small banks

In addition, small banks have built up capital in terms of branch offices and relationships with customers, and may have advantages in relationship lending or character lending (information about the error term in a credit scoring model)

Conclusion

The banking industry was transformed during the 1979 to 1994 period:

1. Massive net exit2. Dramatic rise in off-balance-sheet activities3. Diffusion of ATMS4. Loss of monopsony power over depositors5. Increase in equity capital ratios6. Geographic expansion7. Reductions to small and large borrower lending

These features can be explained by regulatory changes and technical and financial innovations

Despite the upheaval, the industry grew at a moderate pace, although it lost market share to other financial institutions

Ongoing consolidation will not likely lead to the disappearance of small banks