Market Structure and Regulation in the U.S. Banking Industry

1. Market Structure and Regulation in the U.S. Banking Industry Professor Wayne Carroll Department of Economics University of Wisconsin-Eau Claire carrolwd@uwec.edu Slides available at www.uwec.edu/carrolwd

2. Roles of Banks in the Economy • Facilitate borrowing and lending • Facilitate payments • Risk management • Issue financial assets that allow firms to share risks • Provide guarantees and lines of credit

3. Role of Banks in Lending

4. Financial Intermediaries “Banks” include: • Commercial banks • Savings and loan associations (S&L’s) • Also sometimes called “thrifts” or “thrift institutions” • Credit unions

5. Financial IntermediariesAssets at end of 2002 (in billions)

6. Ownership of Banks • U.S. banks are privately owned – no banks are owned by the government. • In most cases a bank’s stock is held by a large number of investors, so a bank has many “owners.” • It is relatively easy to establish a new bank in the U.S.

7. Bank Market Structure • There are a large number of banking firms in the U.S., but the number is falling due to mergers between banks. • Thousands of U.S. banks are very small, each having only a single office. • Many banks today have multiple branches or offices. • A “bank holding company” is a firm that owns one or more banking firms.

8. Size Distribution of U.S. Banks

9. Bank Market Structure: An Example Wells Fargo & Company is a bank holding company based in South Dakota (with historic roots in Minnesota and California). It includes: • 28 chartered bank companies • a total of over 3,000 branches in 23 states

10. Some Wells Fargo branches

11. Wells Fargo’s Broad Scope Source: www.wellsfargo.com/about/today1

12. 20 Largest U.S. Banks (as of June 30, 2006)

13. Assets reserves "loans" securities bank loans Liabilities deposits borrowings Bank capital (equity) A Simple Bank Balance Sheet

14. Detailed Balance Sheet for the Banking Industry Source: Mishkin, Economics of Money, Banking, and Financial Markets, 7th edition

15. Two Important Ratios • Capital/asset ratio – bank capital as a percentage of bank assets. • The average capital/asset ratio for U.S. banks was about 9% at the end of 2002. • Reserve ratio – bank reserves as a percentage of checkable deposits.

16. Information on U.S. Banks • It is easy to get a lot of financial data on U.S. banks. • A great source: www2.fdic.gov/idasp/index.asp

17. An Example: Data on Wells Fargo

18. What Can Go Wrong? • “Bank failure” – the bank goes out of business. • Bank depositors might lose some of their funds. • Bank creditors might lose some of their investment • Bank owners lose their capital. • The bank suffers significant losses – the government might have to help.

19. Reasons for Bank Regulation Banks must be regulated because: • a bank failure can be devastating to depositors. • there’s a risk of systemic failure: the failure of one bank can make it more likely that other banks will fail. • depositors can’t monitor how the bank invests their funds, creating a moral hazard problem. • government assistance to a bank can be very costly.

20. Reasons for Bank Regulation Banks are less stable than other businesses because: • bank liabilities tend to be short-term – many depositors could withdraw their funds with little notice. • bank assets tend to be longer-term – reserves and other liquid assets are only a small share of the total. • the behavior of depositors depends on their confidence that the bank is sound, and this confidence can be easily shaken.

21. A Closer Look at Bank Failure Two reasons for bank failure: • The value of bank assets falls, so assets<liabilities. • Deposit outflow: A large number of depositors withdraw their funds from the bank, exhausting the bank’s cash (reserves) and other liquid assets. Therefore a bank is more likely to fail if it has a low capital/asset ratio or a low reserve ratio.

22. A Closer Look at Bank Failure Tradeoff between higher income and a lower risk of failure: • Holding other things constant, the bank’s net income is higher if its capital/asset ratio and reserve ratio are lower, since then it holds relatively more interest-earning assets. • If the bank’s capital/asset ratio and reserve ratio are higher, it’s less likely that the bank will fail (so it’s less likely that the stockholders will lose their capital.)

23. A Closer Look at Bank Failure If there were no government regulation of banks: • each bank would choose a capital/asset ratio and a reserve ratio to maximize the value of the bank. • depositors would want to deposit their money in banks that are well managed, so banks would have an incentive to choose capital/asset ratios and reserve ratios that reduce the threat of bank failure.  “market discipline”

24. A Closer Look at Bank Failure But if there were no government regulation of banks: • banks would choose capital/asset ratios and reserve ratios that are too low from society’s standpoint. • banks would take on too much risk, so there would be too many bank failures, and the government would have to spend too much money to assist troubled banks.

25. An Example: Continental Illinois Bank • Continental Illinois Bank failed in 1984. • The federal government paid billions of dollars to keep Continental Illinois from closing. • This was the biggest bank “resolution” in U.S. history.

26. An Example: Continental Illinois Bank Before it failed, Continental Illinois Bank: • was the largest bank in Chicago. • was the seventh-largest bank in the U.S. • had 57 offices in 14 states and 29 foreign countries.

27. An Example: Continental Illinois Bank Why did Continental Illinois fail? • Starting in the late 1970s, the bank grew fast, with lots of loans to businesses. • Poor quality loans • Too many loans to firms in the oil industry • Too many loans to borrowers in Latin America • “Continental Illinois is willing to do just about anything to make a deal.” • High cost of funds • Large share of funds borrowed from other banks • Relatively small reliance on domestic deposits • Heavy borrowing in foreign money markets

28. An Example: Continental Illinois Bank The Bank’s Troubles • By 1984 the bank’s nonperforming loans (loans on which payments were late) rose to $5.2 billion (over 10% of total loans). • May 1984: an electronic “bank run” – depositors withdrew billions of dollars in deposits • The FDIC and the Federal Reserve System pledged their support for the bank and lent over $5 billion.

29. An Example: Continental Illinois Bank Dangers • Many smaller banks had deposits at Continental Illinois, so the failure of Continental Illinois could have caused some of them to fail, too. • Other depositors (including many important corporations) could lose some of their funds • Foreign investors would lose confidence in U.S. banks

30. An Example: Continental Illinois Bank Rescuing Continental Illinois Bank • Continental Illinois Bank had $3 billion in insured deposits and $30 billion in uninsured deposits. The FDIC promised to guarantee all deposits. • The FDIC assumed the Bank’s 3.5 billion debt to the Federal Reserve. • The FDIC bought $1 billion in Continental Illinois stock – the FDIC “owned” the bank.

31. An Example: Continental Illinois Bank Lessons from Continental Illinois Bank • Banks have an incentive to take on too much risk, so they need closer supervision • The failure of a very large bank could have broader negative effects • Rescuing a large bank can be expensive for the government • Good sources: • www.fdic.gov/bank/historical/managing/contents.pdf -- Part II, Chap. 4 • http://www.fdic.gov/bank/historical/history/vol1.html -- Chap. 7

32. Bank Regulation: An Overview In the U.S. the government regulates banks in many ways: • Federal deposit insurance • Imposing capital requirements (minimum capital/asset ratios) • Imposing reserve requirements (minimum reserve ratios) • Restricting the types of assets that banks may hold • Performing bank examinations (periodic auditing reviews)

33. Bank Regulation: An Overview Primary bank regulators in the U.S.: • Office of the Comptroller of the Currency (OCC) • part of the U.S. Department of the Treasury • Federal Reserve System – the U.S. central bank • Federal Deposit Insurance Corporation (FDIC) • State bank regulators

34. Federal Deposit Insurance • The U.S. Congress created the Federal Deposit Insurance Corporation (FDIC) in 1933, after the bank failures in the Great Depression. • Today the FDIC guarantees each bank deposit up to a maximum of $100,000. • FDIC insurance is funded by a small fee paid by banks based on their deposits.

35. Bank Failures in the Great Depression

36. Effects of Federal Deposit Insurance Deposit insurance prevents bank runs • Prevents losses by small depositors • Reduces “systemic risk” in the banking system Deposit insurance givesbanks incentives to: • hold riskier assets. • hold less capital. • manage the bank’s assets less carefully.

37. Incentive Effects of Deposit Insurance:A Closer Look Deposit insurance increases the supply of deposits (within the insurance coverage limits). Therefore banks can attract deposits more easily and can pay lower interest rates on their deposits even if they pursue risky strategies that increase the risk of bank failure. As a result, deposit insurance reduces banks’ incentives to avoid risk.

38. Capital Requirements • When there’s deposit insurance, banks have an incentive to hold too little capital. • Therefore the government imposes capital requirements to ensure that banks hold sufficient capital.

39. Capital Requirements • A simple capital requirement would require that a bank’s capital/asset ratio be greater than or equal to a specified level. • Example: capital/asset ratio ≥ 0.05. • Problem: Not all assets are equally risky. A simple capital requirement gives a bank an incentive to hold more risky assets.

40. Risk-weighted Capital Requirements At an international conference in Basel, Switzerland in 1988, bank regulators from the world’s affluent countries agreed to impose risk-weighted capital requirements: • Classes of assets are assigned risk weights between 0% and 100%. • Risk-free assets carry a weight of 0%, and more-risky assets carry higher weights. • Capital requirements then set a minimum for the ratio of capital to risk-weighted assets.

41. Risk-weighted Capital Requirements:An Example

42. Risk-weighted Capital Requirements:An Example • In this example, if regulators require the bank to maintain its risk-weighted capital ratio at a level of at least 8%, then the bank’s capital must be at least $16,00,000 (or 8% of $200,000,000). • If the bank acquires another $1 million in capital, it could invest up to: • $12.5 million more in home-equity loans • $25 million more in home mortgages • $62.5 million more in municipal bonds • So risk-weighted capital requirements give the bank an incentive to hold less-risky assets.

43. Proposed Capital Requirement Reform: Basel 2 • Problem: Assets within a risk class might expose banks to different amounts of risk. • Bank regulators have designed a new system of bank capital requirements – Basel 2 – that will provide better incentives for banks to manage their risks in a way that promotes bank stability. • Basel 2 will take effect in some countries in 2007. • http://www.bis.org/publ/bcbsca.htm

44. Reserve Requirements • The Federal Reserve System requires banks to hold reserves that are greater than or equal to a specified percentage of their checkable deposits: • 3% for smaller banks • 10% for larger banks

45. Reserve Requirements • But reserves are higher than they need to be to promote stability of the banking system. • Today reserve requirements are more important in macroeconomic policy – they tie bank reserves to deposits, so the central bank can try to control deposits by controlling reserves.

46. Restrictions on Asset Holdings Bank regulations include the following: • Banks cannot hold common stock. • Banks cannot invest too large a share of their deposits in a single loan or in loans to businesses in a single industry. • Banks cannot lend funds to bank directors, managers, or principal shareholders at below-market rates.

47. Bank Examinations • Banks are visited on a regular schedule by bank examiners from the OCC, the Federal Reserve System, the FDIC, or other agencies. • Bank examiners review the bank’s financial statements and its confidential accounts. • The results are summarized in a “CAMELS” rating given to the bank.

48. Bank Examinations • Capital adequacy • Asset quality • Management • Earnings • Liquidity • Sensitivity to market risk

49. CAMELS ratings 1 Sound in every respect 2 Fundamentally sound, but with modest weaknesses that can be corrected 3 Moderately severe to unsatisfactory weaknesses; vulnerable if there’s a business downturn 4 Many serious weaknesses that have not been addressed; failure is possible but not imminent 5 High probability of failure in the short term

50. Bank Examinations • CAMELS ratings are disclosed to bank management, but not to the public. • If the CAMELS rating for a bank is unfavorable, regulators can take actions like these: • Require banks to disclose unfavorable information in their public financial statements • Issue a “cease and desist” order requiring the bank to stop doing things that cause financial troubles and to correct problems. • Impose fines (up to $1,000,000 per day).