Ranjit Dighe
Lecture notes to accompany Mishkin's Chapters 10 and 12 ("Banking Industry: Structure and Competition," "Nonbank Finance").
Revised Nov. 17, 2005.

In these notes:
I. Structure of the U.S. banking industry
II. The decline in traditional banking
III. Nonbank financial institutions


While the U.S. has a number of very large banks, most of them are small in comparison with the leading banks of other industrialized countries.  Granted, the largest U.S. bank, Citigroup (or Citibank), is the largest bank in the world and has $1.4 trillion in assets (as of Dec. 2003).  But even Citigroup is not large enough to tower over the rest of the U.S. banking system; Citigroup controls 28% of total U.S. bank assets, followed by JP Morgan Chase with 16% and Bank of America with 15%.
-- After Citigroup, the next nine largest banks in the world (as of 2003) are all from Japan or Europe.
-- In Canada, Japan, Britain, and most western industrialized countries, four or five large banks dominate the landscape, controlling the vast majority of bank assets.  The U.S. banking industry has lately been moving in that direction -- the ten largest banks control 74% of total U.S. bank assets (as of 2003) -- but it's a very recent development.
-- In all, the U.S. has about 7,500 commercial banks, plus some 11,000 thrifts (smaller depository institutions, mostly credit unions, also savings & loan associations and mutual savings banks.  Thrifts specialize in mortgage and consumer loans). Most of these banks are quite small; almost half have less than $100 million in assets, and almost 95% have less than $1 billion in assets. (All numbers are as of 2003.)
---- Compared with other countries, 7,500 is a huge number of banks.  Canada and most European countries have well under 1,000.  Japan has less than 100.

In examining the structure of any industry, a key question is, How competitive is this industry?  The usual definition of perfect competition is that each firm is too small relative to the industry to influence price, entry into and exit from the industry are unrestricted, and long-run profits are no greater than could be earned elsewhere.  The opposite of perfect competition is monopoly; a more common occurence is oligopoly (a few big firms control the industry).
-- On the surface, the U.S. banking industry looks competitive.  So many banks, none of which are large enough to be dominant.  A standard measure of industry competition is the four-firm concentration ratio (CR4), defined as the share of total industry output (or, in this case, assets) of the four largest firms. The CR4 for the U.S. banking industry was 39% as recently as 2002 (?), which would seem to make it a fairly competitive industry.  (The CR4 for banking has since risen to 68%, as of Dec. 2003.)  And, indeed, government restrictions on branch banking and interstate banking are largely designed to keep banks from getting too big, which would seem to be a sensible tool of antitrust, pro-competitive policy.  And yet most economists would agree with Mishkin's statement that "the large number of banks in the U.S. must be seen as an indication of a lack of competition, not the presence of vigorous competition."
-- Q: Why is this?
-- A: For the most part, it's because of government regulations, which have the effect of propping up many smaller, inefficient banks, by shielding them from competition from larger, more efficient banks.
-- Key regulation: McFadden Act (1927-1994): effectively prohibited banks from having branches in more than one state. Though repealed in 1994, its effects are still with us.
-- State-level restrictions on branching have been common, too

* Large banks have been prevented from growing to their optimal, most efficient size, i.e. from fully exploiting economies of scale. This is in contrast to their foreign counterparts, which, as a result, are much larger.
* Smaller banks have been shielded from competition. Inefficient small banks, not consumers, have been the main beneficiaries of these regulations.A great many of the smaller banks in the U.S. are local monopolies.
-- Illustration: Lately restrictions on branch banking and interstate banking have been relaxed, to some degree. Depositors in Oswego and other small towns have benefitted because the small local banks now must offer more competitive interest rates, lower fees, better hours, etc. in order to compete with new, larger competitors like branches of the Chase and HSBC banks.

Q: Why did all these branching regulations exist in the first place?
A: Politics. Public hostility to large banks goes back a long way in the U.S.  Farmers generally distrust banks, and we were largely a nation of farmers in the nineteenth century.  Also, many state and local banks sought legislation to protect them from competition.
-- Through 1863, individual banks were chartered by their respective state governments, not by the federal government -- national banks, or even a central bank like the Fed, were not viewed as a desirable thing. Since individual states varied greatly in their requirements and regulations on banks, the banking systems, too, varied greatly from state to state. The Federal Reserve System did not even come into existence until 1913, because many Americans were fearful of the idea of powerful central bank.

The number of banks in the U.S., after falling dramatically in the early years of the Great Depression (when there were over 9,000 bank failures), held remarkably steady at about 14,000 in the half-century from 1935 to 1985. Since the mid-1980s, however, the number of banks has dropped dramatically.[See Mishkin's Chapter 10, Figure 3, "Number of Insured Commercial Banks in the U.S., 1934-2004."] There are only about half as many banks today as in 1985. Why?
-- secondary reason: bank failures rose dramatically in the late 1980s. After averaging fewer than 10 bank failures per year in 1945-80, the rate of bank failures rose to over 100 a year in 1985-92, and close to 200 in 1989 as well as in 1990. The late eighties were hard times for the banking industry, as volatile interest rates forced many banks into insolvency and deregulation and lax enforcement of existing regulations led many banks (and, especially, savings and loan associations) into excessive risk-taking.  But in the relatively healthy banking era after 1992, some 95% of the decrease in the number of banks is due to ...
-- ... BANK CONSOLIDATION (primary reason) through mergers and acquisitions. Many smaller banks have been acquired by large banks, and many banks of all sizes have chosen to merge with others. Deregulation has aided this consolidation.
---- The most important piece of deregulation, as far as affecting bank consolidation, has been the Riegel-Neal Interstate Banking and Branching Efficiency Act (1994), which effectively repealed the McFadden Act and allowed interstate banking. Since the Riegel-Neal Act is still fairly new, it will likely encourage still more bank consolidation and growth in the future.
------ The recent bank merger movement has made the industry more concentrated, but also seems to have made it more competitive.  The greater concentration is evident in the rise in these numbers:  the four largest banks' share of total bank assets (CR4) rose from 25% in the late 1990s to 39% in 2002 (?) to 68% in Dec. 2003; in the same years, the ten largest banks' share of total bank assets rose from 36% to 58% to 74%.  But if the big banks are taking advantage of their new opportunity to branch into small cities and towns and compete again local monopolies or oligopolies, then they are promoting competition, not lessening it.  And that does seem to be the case.

Another important banking regulation that was recently repealed in part is the Glass-Steagall Act (1933), which separated commercial banking from the securities industry. Investment banks could underwrite corporate securities and hold stock, but they could not hold individuals' deposits; likewise, commercial banks were barred from holding stock or engaging in brokerage activities. The impetus for the Glass-Steagall Act was the Great Depression, which had hit rock bottom by the time of the Glass-Steagall Act and in which much-publicized Congressional hearings portrayed widespread abuses by commercial banks in their investment activities.
-- The separation of the banking and securities industries was recently eliminated by the Gramm-Leach-Bliley Act (1999). The new act allows securities firms and insurance companies to purchase banks. It also allows banks to underwrite insurance policies and securities.
-- (The Glass-Steagall Act also created the Federal Deposit Insurance Corporation (FDIC), which guaranteed people's bank deposits up to a certain maximum, thereby doing much to prevent future banking panics. That part of Glass-Steagall has not been repealed.) 


For a number of reasons, traditional banking has been on the decline in recent decades, both in the U.S. and worldwide. What this means:
(1) Banks now account for a much smaller portion of total financial assets and liabilities than they once did.
-- Banks and thrifts' combined share of financial intermediary assets was 55-60% in 1960, 1970, and 1980, but fell to 45% in 1990, and to 35% in 2004.
(2) Accepting deposits and making loans account for a much smaller portion of bank activities than they once did.
---- Off-balance-sheet activities of banks (including loan sales, fees, derivatives trading) have grown dramatically in recent decades.
---- In all, non-interest income (most of which comes from off-balance-sheet activities) is about 30% of total bank income today, nearly double what it was in 1980.

The statement that traditional banking has declined in the past few decades does not mean that banking itself has become unprofitable (far from it). Banks' profit rates rose in the late 1990s, to about 0.7% of GDP, their highest level in the past 30 years.
-- On the other hand, traditional banking (accepting deposits and making loans) has become less profitable. Banks are now in competition with mutual funds, et al. for people's savings, so they have to offer much higher, more competitive interest rates to depositors than before. Likewise, there are many more avenues of corporate finance available to businesses, so banks have to offer lower, more competitive interest rates on their loans than before.

Why that first decline has occurred: Financial innovation has opened up new sources of competition for the banks, both on the asset side and on the liability side. Banks' cost advantages in acquiring funds have eroded, as have their advantages in loaning out money.
-- Behind the decline in bank deposits (liabilities):
---- The dramatic rise in interest rates in the late 1970s and early 1980s, combined with then-existing government regulations that imposed interest-rate ceilings on deposits, put the banks at a major disadvantage in acquiring funds. With soaring interest rates on bonds and other alternative interest-bearing assets, banks had a harder and harder time attracting deposits. Banks were particularly hurt by the development of a new financial institution, money market mutual funds, in the 1970s. These funds held highly liquid money-market assets and, like other mutual funds, sold shares to individuals. Since they were mutual funds and not depository institutions, they were not subject to the usual interest-rate maximums. The money market funds, unlike stock mutual funds, typically fixed the share prices at $1 per share and allowed their shareholders to write checks on them, thereby making the money market funds function much like checking accounts with higher interest rates.
-- Behind the decline in bank loans (assets): Four factors stand out:
---- (1) growth of the commercial paper market, spurred by improvements in information technology that made it easier for individual investors to evaluate the creditworthiness of corporations and hence more willing to hold corporate IOU's. The new money-market funds were especially eager to hold commercial paper.
---- (2) growth of the junk bond market, again spurred by better information technology. Previously, bond issues were an option only for well-known corporations with very high credit ratings. The new information technology made it easier to make specific evaluations of lesser and newer corporations and opened up a whole new market in medium- and low-grade bonds. The pioneer of junk bonds was Michael Milken of Drexel Burnham. Milken was famously indicted for fraud in 1989, but the junk-bond market, which exceeded $200 billion at the time, has stayed active.
---- (3) securitization -- the process of transforming previously illiquid financial assets, like mortgages, into marketable capital-market securities. Many banks have sold off much of their loan portfolios to the Government National Mortgage Association (GNMA), which guarantees them and then sells them to mutual-fund houses and other financial institutions, who bundle a bunch of loans together and sell shares in those loan packages. Many prominent mutual-fund houses sell shares in GNMA ("Ginnie Mae") funds, for example. Currently, two-thirds of all residential mortgages, or $1 trillion in mortgages, are securitized, and thus banks now account for a much smaller portion of real-estate loans outstanding.
---- (4) growing foreign competition. The banking industry has become considerably more international, with U.S. banks greatly expanding their foreign operations (from $4 billion in assets abroad in 1960 to more than $500 billion today) and foreign banks greatly expanding their U.S. operations. Foreign banks now hold 9% of total U.S. bank assets and account for 16% of the lending to U.S. corporations.

Why that second decline (in the shares of loans and deposits in total bank activities) has occurred:
off-balance-sheet activities (sources of bank income that do not appear on bank balance sheets) have grown dramatically in recent years. Some important off-balance-sheet activities for banks:


As recently as the mid-1980s, nonbank financial institutions were fairly insignificant (in their share of financial intermediary assets), except for the stodgy subjects of insurance companies and pension funds.  Mutual funds barely registered a blip on the radar screen at the time.  However, since the mid-1980s, nonbank financial institutions are where most of the action has been, mutual funds have been hottest of all, and life-insurance companies and pension funds have done very well, emulating mutual funds in some key respects.
-- When the stock market was at its peak, in 1999-2000, mutual funds and pension funds controlled a bit more than half of all financial intermediary assets in this country, and pension funds alone accounted for about as much as banks and thrifts combined (30%).  Mutual funds and pension funds currently (2004) control some 43% of assets.
-- Much of that growth has been at the expense of depository institutions.  Banks and thrifts' combined share of financial intermediary assets fell from 55-60% (in 1960, 1970, and 1980) to 45% in 1990 and to 35% in 2004.
---- The dropoff was most severe for savings & loan associations (S&Ls).  The S&L scandal of the late 1980s, which led to massive S&L failures and a costly federal bailout of their depositors, seems to have permanently blackened the name of S&Ls.  S&Ls and mutual savings banks held 20% of total financial intermediary assets in 1980; that number was down to 5% in 2004.
---- Banks' share of financial intermediary assets fell less dramatically, from 37-39% (in 1960, 1970, and 1980) to 28% (in 1990 and 2004).

[Refer to Mishkin's Chapter 12, Table 1, "Relative shares of total financial intermediary assets, 1960-2004."  That information can be summarized as follows:]

Share of total financial intermediary assets (%):
Type of financial intermediary 1960 1980 2004
Insurance companies
(life insurance, property & casualty insurance)
24% 16% 17%
Pension funds
(private, state & local government)
Finance companies
Mutual funds
(stock & bond funds, money market funds)
3% 4% 23%
Depository institutions
(banks and thrifts)
59% 58% 35%

Some further information about the nonbank financial intermediaries listed above:

Insurance companies are contractual intermediaries, defined as financial instititutions that hold and invest individuals' savings over the long term.  (Pension funds are, too.)  Insurance companies lost much of their share of financial assets in the 1960s and 1970s, in large part because of the relatively weak investment returns on "whole life" insurance policies.
-- Life-insurance companies, and contractual intermediaries in general, have been able to increase their share of financial-intermediary assets a bit since 1980 by jumping on the mutual/pension-fund bandwagon. This is thanks to a key 1974 law that encouraged pension funds to turn over their management to life insurance companies. The line between insurance companies and pension funds has since become very blurry. Today, pension funds account for more than half of the assets managed by life insurance companies.
---- Another popular pension-like arrangement offered by life-insurance companies is annuity plans, which are IRA-like arrangements whereby a customer pays an annual premium in exchange for a future stream of annual payments from retirement age until death. The earnings of these annuities accumulate tax-free (though they can be bad investments because it's costly to get out of a plan (if, for example, the plan is earning poor returns) and because the annual fees charged by the insurance companies are rather high). Annuity plans are typically run jointly by the insurance company and a mutual-fund house, so again the line between insurance companies and other financial institutions has gotten blurrier.

Pension funds, like mutual funds, tend to be most heavily invested in stocks. In fact, they are the main vehicle through which Americans own stock. (Not many people directly own shares of individual stocks.)  Pension funds have grown greatly in recent decades, thanks to favorable tax treatment (their earnings are not taxed until retirement) as well as the strong performance of the stock market in the 1980s and 1990s, since that's where pension funds are most heavily invested.  The aging of the baby-boom generation also has much to do with that growth; as the baby boomers hit their peak earning age, more money flows into pension funds every week.
-- There are two main types of pension plans:
---- defined-contribution plan: the size of the pension benefits is determined by contributions and their returns.
---- defined-benefit plan: the size of the benefits is set in advance, so contributions and earnings must be enough to cover those benefits in order for the plan to be fully funded. If not, then the plan is underfunded.
------ The largest, and most famous, public pension plan in America is Social Security, which is closer to a defined-benefit plan than to a defined-contribution plan, though it doesn't quite fit either definition. Social Security pensions depend in part on the amount of one's contributions into the system (which are paid as payroll taxes by current workers), but the government sets a minimum benefit for everyone and regularly adjusts it for inflation. Social Security is fully funded as regards current retirees (whose benefits are partly paid out of current contributions, making the plan partly a "pay-as-you-go" system). However, the program's assets are projected to be insufficient to cover the needs of future retirees beginning around 2037, so some kind of adjustment to the system will have to be made in order to keep it going.

Finance companies are a type of investment institution (so are mutual funds), which means they sell securities and invest the proceeds.  (A finance company sells bonds and/or commercial paper; a mutual fund sells shares in the fund.)  Otherwise, they are similar to banks, in that they use people's savings to make loans to businesses and consumers.
-- The most familiar finance companies are sales finance companies (Sears, General Motors' GMAC).  There are also consumer finance companies and business finance companies.

Mutual funds are
financial intermediaries that pool the money of small savers (individuals), who buy shares in the fund, and invest in stocks, bonds, etc. They allow the individuals to diversify (avoid risk) and also avoid transactions costs associated with buying securities directly. There are thousands of mutual funds out there, and many different ways to distinguish them.
-- Fluctuations in the stock-and-bond mutual funds' share of financial-intermediary assets will be driven in part on fluctuations in the stock market.
-- The growth of money market funds (MMFs), which hold only short-term money market assets, has been much steadier because the money market is much less volatile.  A great deal of the decline in traditional banking is from people moving money out of savings and checking accounts and into MMFs.

[Not covered in this unit, but largely covered during the lectures on the stock market- ]
-- Mutual funds can be bought and sold as
---- open-end funds: people can buy and sell fund shares directly from the fund itself. The fund's share price equals the net asset value (NAV) of the securities the fund holds, i.e., it's a weighted average of the price of each security in the fund's portfolio. Open-end funds are far more common than closed-end funds.
---- closed-end funds: fund shares are traded on a stock exchange. Share prices are closely related to NAV, but are ultimately determined by supply and demand, just like other stock prices. The most famous closed-end mutual fund is Warren Buffett's Berkshire Hathaway fund.
-- Mutual funds also differ according to whether the fund charges you a fee when you buy or sell them:
---- load funds: a commission (or load) is charged upon purchase or liquidation of fund shares. Load funds can be either front-loaded (fee charged at time of purchase) or back-loaded (fee charged at time of liquidation). The load charge is typically about 4-5% of the amount of your purchase or sale.
---- no-load funds: no commission is charged. No-load funds are more common and on average deliver higher returns than load funds.
-- Mutual funds also have annual maintenance fees that provide some or all of the income for the fund's owners and managers. The typical "expense ratio" is about 1.35% of a fund's net asset value.