The Economics of Money, Banking, and
Financial Markets
Thirteenth Edition
Global Edition
Chapter 11
Banking Industry: Structure
and Competition
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Preview
• This chapter examines the historical trends in the banking
industry that help explain the unique structure of the U.S.
system.
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Learning Objectives (1 of 2)
11.1 Recognize the key features of the banking system and
the historical context of the implementation of these
features.
11.2 Explain how financial innovation led to the growth of
the shadow banking system.
11.3 Identify the key structural changes in the commercial
banking industry.
11.4 Summarize the factors that led to consolidation in the
commercial banking industry.
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Learning Objectives (2 of 2)
11.5 Assess the reasons for separating banking from other
financial services through legislation.
11.6 Summarize the distinctions between thrift institutions
and commercial banks.
11.7 Identify the reasons for U.S. banks to operate in
foreign countries and for foreign banks to operate in the
United States.
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Historical Development of the Banking
System
• Bank of North America chartered in 1782
• Controversy over the chartering of banks
• National Bank Act of 1863 creates a new banking system
of federally chartered banks
– Office of the Comptroller of the Currency
– Dual banking system
• Federal Reserve System is created in 1913.
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Figure 1 Time Line of the Early History of
Commercial Banking in the United States
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Primary Supervisory Responsibility of
Bank Regulatory Agencies
• Federal Reserve and state banking authorities: state
banks that are members of the Federal Reserve System.
• Fed also regulates bank holding companies.
• FDIC: insured state banks that are not Fed members.
• State banking authorities: state banks without FDIC
insurance.
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Financial Innovation and the Growth of
the “Shadow Banking System”
• Financial innovation is driven by the desire to earn profits
• A change in the financial environment will stimulate a
search by financial institutions for innovations that are
likely to be profitable
– Financial engineering
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Responses to Changes in Demand
Conditions: Interest-Rate Volatility
• Adjustable-rate mortgages
– Flexible interest rates keep profits high when rates
rise
– Lower initial interest rates make them attractive to
home buyers
• Financial derivatives
– Ability to hedge interest rate risk
– Payoffs are linked to previously issued (i.e., derived
from) securities.
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Responses to Changes in Supply
Conditions: Information Technology
• Bank credit and debit cards
– Improved computer technology lowers transaction
costs
• Electronic banking
– ATM, home banking, ABM, and virtual banking
• Junk bonds
• Commercial paper market
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Securitization and the Shadow Banking
System
• Securitization
– To transform otherwise illiquid financial assets into
marketable capital market securities.
– Securitization played an especially prominent role in
the development of the subprime mortgage market in
the mid 2000s.
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Avoidance of Existing Regulations
• Loophole Mining:
– Reserve requirements act as a tax on deposits
– Restrictions on interest paid on deposits led to
disintermediation
– Money market mutual funds
– Sweep accounts
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Bruce Bent and the Money Market Mutual
Fund Panic of 2008
• Bruce Bent, one of the originators of money market
mutual funds, almost brought down the industry during
the global financial crisis in the fall of 2008.
• Not surprisingly, given the extension of a government
safety net to the money market mutual fund industry,
there are calls to regulate this industry more heavily.
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Financial Innovation and the Decline of
Traditional Banking (1 of 3)
• As a source of funds for borrowers, market share has
fallen.
• Commercial banks’ share of total financial intermediary
assets has fallen
• No decline in overall profitability
• Increase in income from off-balance-sheet activities
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Figure 2 Bank Share of Total Nonfinancial
Borrowing, 1960–2020
Source: Federal Reserve Bank of St. Louis, F RED data base: [Link] ;
[Link] .
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Financial Innovation and the Decline of
Traditional Banking (2 of 3)
• Decline in cost advantages in acquiring funds (liabilities)
– Rising inflation led to rise in interest rates and
disintermediation
– Low-cost source of funds, checkable deposits,
declined in importance
• Decline in income advantages on uses of funds (assets)
– Information technology has decreased need for banks
to finance short-term credit needs or to issue loans
– Information technology has lowered transaction costs
for other financial institutions, increasing competition
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Financial Innovation and the Decline of
Traditional Banking (3 of 3)
• Banks’ Responses
– Expand into new and riskier areas of lending
▪ Commercial real estate loans
▪ Corporate takeovers and leveraged buyouts
– Pursue off-balance-sheet activities
▪ Non interest income
▪ Concerns about risk
▪ Decline of Traditional Banking in Other Industrialized
Countries
• Decline of Traditional Banking in Other Industrialized Countries
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Structure of the U.S. Commercial
Banking Industry
• Restrictions on branching
– McFadden Act and state branching regulations
• Response to branching restrictions
– Bank holding companies
– Automated teller machines
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Table 1 Size Distribution of FDIC-Insured
Banks, March 31, 2020
Table 1 Size Distribution of F DIC Insured Banks, March 31, 2017
Number of Share of Share of Assets
Assets Banks Banks (%) Held (%)
Less than $100 million 1,124 22.0 0.5
$100 million–$1 billion 3,168 61.9 6.7
$1 billion–$10 billion 680 13.3 10.0
$10 billion–$250 billion 131 2.6 32.3
More than $250 billion 13 0.3 50.4
Total 5,116 100.00 100.00
Source: FDIC Quarterly Banking [Link]
Profile,
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Table 2 Ten Largest U.S. Banks, 2017
Bank Assets ($ billions) Share of All Commercial Bank
Assets (%)
1. J.P. Morgan Chase & Co. 2,420 14.4
2. Bank of America Corp. 2,150 12.8
3. Citigroup Inc. 1,770 10.5
4. Wells Fargo & Co. 1,750 10.4
5. U.S. Bankcorp 416 2.5
6. Bank of New York Mellon Corp. 377 2.2
7. PNC Financial Services Group 362 2.2
8. Capital One Financial Corp. 314 1.9
9. HSBC North America Holdings 292 1.7
10. TD Bank U.S. Holding Co. 253 1.5
Total 10,103 60.1
Source: From [Link] ––Compare mortgage, refinance, insurance, C D rates:
[Link] .
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Bank Consolidation and Nationwide
Banking
• The number of banks has declined dramatically over the
last 30 years.
– Bank failures and consolidation
– Deregulation: Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994
– Economies of scale and scope from information
technology
• Results may be not only a smaller number of banks but a
shift in assets to much larger banks.
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Figure 3 Number of Commercial Banks in
the United States, 1934–2019
Source: Federal Reserve Bank of St. Louis, F RED database:
[Link] .
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What Will the Structure of the U.S. Banking
Industry Look Like in the Future?
• Although the United States retains a unique banking
structure in possessing a large number of banks, its
structure is converging with systems in Europe and
Japan.
• How far the convergence between banking systems will
extend is the subject of ongoing academic debate
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Are Bank Consolidation and Nationwide
Banking Good Things? (1 of 2)
• Benefits
– Increased competition, driving inefficient banks out of
business
– Also, increased efficiency from economies of scale
and scope
– Lower probability of bank failure from more diversified
portfolios
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Are Bank Consolidation and Nationwide
Banking Good Things? (2 of 2)
• Costs
– Elimination of community banks may lead to less
lending to small business
– Banks expanding into new areas may take increased
risks and fail
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Separation of the Banking and Other
Financial Service Industries (1 of 2)
• Erosion of Glass-Steagall
– Prohibited commercial banks from underwriting
corporate securities or engaging in brokerage
activities
– Section 20 loophole was allowed by the Federal
Reserve enabling affiliates of approved commercial
banks to underwrite securities as long as the revenue
did not exceed a specified amount
– U.S. Supreme Court validated the Fed’s action in
1988
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Separation of the Banking and Other
Financial Service Industries (2 of 2)
• Gramm-Leach-Bliley Financial Services
Modernization Act of 1999
– Abolishes Glass-Steagall
– States regulate insurance activities
– SEC keeps oversight of securities activities
– Office of the Comptroller of the Currency regulates
bank subsidiaries engaged in securities underwriting
– Federal Reserve oversees bank holding companies
– Stimulated consolidation of the banking industry
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Separation of Banking and Other Financial
Services Industries Throughout the World
– No separation between banking and securities
industries in Germany, Holland and Switzerland
– Universal banking in Great Britain
▪ May engage in security underwriting
▪ Separate legal subsidiaries are common
▪ Bank equity holdings of commercial firms are less
common
▪ Few combinations of banking and insurance firms
– Japanese style system
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The Global Financial Crisis and the Demise
of Large, Free-Standing Investment Banks
• Although the move toward bringing financial service
activities into larger, more complex banking organizations
was inevitable after the demise of Glass-Steagall, no one
expected it to occur as rapidly as it did in 2008. Over a
six-month period from March to September 2008, all five
of the largest, free-standing investment banks ceased to
exist in their old form.
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Thrift Industry: Regulation and
Structure (1 of 3)
• Savings and loan associations
– Chartered by the federal government or by states
– Most are members of Federal Home Loan Bank
System (FHLBS)
– Deposit insurance provided by Savings Association
Insurance Fund (SAIF), part of FDIC
– Regulated by the Office of Thrift Supervision
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Thrift Industry: Regulation and
Structure (2 of 3)
• Mutual savings banks
– Approximately half are chartered by states
– Regulated by state in which they are located
– Deposit insurance provided by FDIC or state
insurance
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Thrift Industry: Regulation and
Structure (3 of 3)
• Credit unions
– Tax-exempt
– Chartered by federal government or by states
– Regulated by the National Credit Union Administration
(NCUA)
– Deposit insurance provided by National Credit Union
Share Insurance Fund (NCUSIF)
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International Banking
• Rapid growth
– Growth in international trade and multinational
corporations
– Global investment banking is very profitable
– Ability to tap into the Eurodollar market
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Eurodollar Market
• Dollar-denominated deposits held in banks outside of the
United States
• Ironic birth in Communist period
• Most widely used currency in international trade
• Offshore deposits not subject to regulations
• Important source of funds for U.S. banks
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Structure of U.S. Banking Overseas
• Shell operation
• Edge Act corporation
• International banking facilities (IBFs)
– Not subject to regulation and taxes
– May not make loans to domestic residents
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Foreign Banks in the United States (1 of 2)
• Agency office of the foreign bank
– Can lend and transfer fund in the United States
– Cannot accept deposits from domestic residents
– Not subject to regulations
• Subsidiary U.S. bank
– Subject to U.S. regulations
– Owned by a foreign bank
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Foreign Banks in the United States (2 of 2)
• Branch of a foreign bank
– May open branches only in state designated as home
state or in state that allow entry of out-of-state banks
– Limited service may be allowed in any other state
• Subject to the International Banking Act of 1978
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Table 3 Ten Largest Banks in the World, 2020
Bank Assets (U.S. $ trillions)
1. Industrial and Commercial Bank of China, China 4.32
2. China Construction Bank Corp., China 3.82
3. Agricultural Bank of China, China 3.70
4. Bank of China, China 3.39
5. JPMorgan Chase, U S 3.14
6. HSBC Holdings plc, United Kingdom 2.92
7. Mistubishi UFJ Financial Group, Japan 2.89
8. Bank of America, U S 2.62
9. BNP Paribas 2.43
10. Credit Agricole Group, France 1.98
Source: From [Link]––Compare mortgage, refinance, insurance, C D
rates,
[Link] .
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