MONEY AND BANKING (Eco 340)
Prof. Ranjit Dighe
Lecture notes to accompany Cecchetti's Chapters 13 ("Financial Industry Structure")
Last revised 23-February-2009.

I. U.S. BANKING INDUSTRY STRUCTURE, COMPETITION, AND CONSOLIDATION

A striking feature of the U.S. banking industry is the very large number of banks, about 8,000 in all.
Most of these banks are very small, which is also unusual for an industrialized country. 

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 company in the world and has $1.5 trillion in assets (as of 2006).  But even Citigroup is not large enough to tower over the rest of the U.S. banking system; total depository institutions are about six times larger than Citigroup's total assets.
-- 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, and fairly quickly, but it's a very recent development and the industry is still far less concentrated than those of other countries.
-- In all, the U.S. has about 7,700 commercial banks, plus some 12,000 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 depository institutions 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.  See Table 13.1 in Cecchetti's textbook for 2006 numbers and for a full breakdown by size of bank.)
---- Compared with other countries, this 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.  There is a very large number of very small banks.  Even the largest banks are not nearly large enough to be dominant.  The combined output or assets of the four largest firms (i.e., the four-firm concentration ratio, a standard measure of industry concentration) is too small to suggest a concentrated or oligopolistic industry (though it has grown quite a bit in recent years).  Despite all this, the general view  among economists is that in the case of U.S. banking, the very large number of firms actually suggests a lack of 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

--> IMPACT:
* 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.

---- Note:  This does not necessarily mean that all bank consolidation is good.  The banking crisis that began in 2007 has mostly been concentrated among the biggest banks.  There is such a thing as inefficiencies of scale, too, and the concept may apply to some of these big banks.  In addition, the concept of "too big to fail" may also apply:  if it is widely believed that the failure of a very large bank would have disastrous ripple effects elsewhere in the financial system and the larger economy, then the managers of those banks may feel empowered to take excessive but possibly hugely profitable risks, believing that the government will bail them out if they make the bank insolvent.  This is a big moral hazard problem.

Q: Why did all these branching regulations exist in the first place?
A: Politics. In particular:
(1) Local banks successfully pushed for protective laws to shield them from competition.  They were able to play on ...
(2) ... public hostility to large banks, which goes back a long way in our history.  We were originally a nation of farmers (and were still one as late as the mid-19th century), and farmers tend to distrust banks.  Big banks also incurred the public's distrust of big business, which was considerable in the late 19th and early 20th centuries.

[Not covered in class, but possibly of interest:  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 regulations on banks, the banking systems 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 a 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. There are only about half as many banks today as in 1985. Why?  [See Cecchetti's Figure 13.1, "Number of Insured Banks in the U.S., 1935 to 2006."]
-- 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 since 1992, we were back to the norm of almost no bank failures until about 2007.  In 2008, there were 25 bank failures, and almost two months into 2009 we are on a pace for over 100 bank failures.
-- primary reason: BANK CONSOLIDATION 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.  Consider:  while the number of banks has fallen nearly in half since 1935 (from 14,000 to 7,700), the number of bank branches has more than quadrupled, from 17,000 to 75,000.  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.  Moreover, there seem to be considerable economies of scale (falling average costs as output increases) in banking, so the growing size of banks promises to bring better interest rates for depositors and better returns for bank stockholders.

Technology has also made the banking industry more competitive, as the spread of online banking, automated payments (e.g., direct deposit of paychecks), ATMs, etc. makes it increasingly unnecessary for you and your bank to be in the same town.  Banks that are far apart now can and do compete for people's deposit and loan business.

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.
-- (A key part of the Glass-Steagall Act that has not been repealed -- thankfully, most people would say -- is federal deposit insurance Corporation, which guarantees people's bank deposits up to a certain level, thereby doing much to prevent banking panics.)

II.  THE DECLINE IN TRADITIONAL BANKING

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 total financial intermediary assets was nearly 60% in 1960 and has fallen to just half that (30% 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.  [This needs to be updated.  In the late 1990s and much of the 2000s, financial sector profits were as much as 30% or more of total corporate profits in the U.S.  That wouldn't mean 30% of GDP, since profits are a small share of GDP, but it probably would be well over 0.7% of GDP.]
-- 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.

The decline in traditional banking goes hand in hand with the growth of certain ...

III. NONBANK FINANCIAL INSTITUTIONS

As recently as the mid-1980s, nonbank financial institutions were fairly insignificant (as a share of financial intermediary assets), except for 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.
-- Pension funds have also 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.
-- The growth of mutual and pension funds has largely been at the expense of banks and other depository institutions.  Banks and thrifts' combined share of financial intermediary assets fell from 55-60% (in 1960-1980) to 45% in 1990 and to 30% 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 19% of total financial intermediary assets in 1980; that number was less than 5% in 2004.
---- Banks' share of financial intermediary assets also fell sharply, but less dramatically, from 36-39% (in 1960-1980) to 24% (in 1990 and 2004).

[Refer to Cecchetti's Table 13.3, "Relative Size of U.S. Financial Intermediaries, 1960-2006."  That information can be summarized as follows:]

Share of total financial intermediary assets (total amount is $42 trillion, about three times the size of GDP):
 

Type of financial intermediary	1960	1980	2006
Depository institutions (banks and thrifts)	58%	56%	30%
Insurance companies (life insurance, property & casualty insurance)	24%	15%	14%
Pension funds (private, state & local government)	10%	17%	22%
Finance companies	5%	5%	4%
Mutual funds (stock & bond funds, money market funds)	3%	3%	23%
Government-sponsored enterprises (handling mortgages, student loans, farm loans, etc.)	1%	4%	7%

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 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 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 special accounts into which the 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 [which one might want to do if the plan is earning poor returns] and because the annual fees charged by the insurance companies are often 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.  (Relatively few 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.

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, and many different ways to distinguish them.
-- Stock-and-bond mutual funds' share of financial-intermediary assets will generally rise when the stock market rises, and fall when the stock market falls.
-- 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.