Banking Industry: Structure and Competition

Early Timeline:
- 1782: Bank of North America is chartered.
- 1791: Bank of the United States is chartered.
- 1811: Bank of the United States' charter lapses.
- 1816: Second Bank of the United States is chartered.
- 1832: Andrew Jackson vetoes the re-chartering of the Second Bank of the United States.
- 1836: Charter lapses for the Second Bank of the United States.
- 1863: National Bank Act establishes national banks and the Office of the Comptroller of the Currency.
- 1913: Federal Reserve Act creates the Federal Reserve System.
- 1933: Banking Act of 1933 (Glass-Steagall) creates the Federal Deposit Insurance Corporation (FDIC) and separates banking and securities industries.
Post-1933 Major Events:
- 1999: Glass-Steagall Act was repealed, allowing commercial banks to re-engage in securities activities after previously having to sell off investment banking arms.
Outcome: Multiple Regulatory Agencies
1. Federal Reserve
2. FDIC
3. Office of the Comptroller of the Currency
4. State Banking Authorities

The shadow banking system has replaced some bank lending with lending via the securities market.
Three Types of Changes (Innovations):
- Response to Changes in Demand Conditions
- Response to Changes in Supply Conditions
- Avoidance of Existing Regulation

Major change: Huge increase in interest-rate risk starting in the 1960s.
Adjustable-Rate Mortgages are an example of a response to interest-rate volatility.
Banks started using derivatives to hedge risk.
Intermediaries (like the CBOT) started developing extensive interest rate products.

Major change: Improvement in information technology.
1. Lowered the cost of processing financial transactions, making it profitable for financial institutions to create new financial products and services.
2. Made it easier for investors to acquire information, thereby making it easier for firms to issue securities.

Many store credit cards existed long before WWII.
Improved technology in the late 1960s reduced transaction costs, making nationwide credit card programs profitable.
The success of credit cards led to the development of debit cards for direct access to checkable funds.

Automatic Teller Machines (ATMs) were the first innovation. There are over 500,000 ATMs servicing the U.S. alone.
Automated Banking Machines combine ATMs, the internet, and telephone technology to provide “complete” service.
Virtual banks now exist where access is only possible via the internet.

The development of computer systems and the internet has made electronic payments of bills a cost-effective method over paper checks or money.
The U.S. is still far behind some European countries in the use of this technology.

Electronic money, or stored cash, only exists in electronic form. It is accessed via a stored-value card or a smart card.
E-cash refers to an account on the internet used to make purchases.

Prior to 1980, debt was never issued that had a junk rating. The only junk debt was bonds that had fallen in credit rating.
Michael Milken of Drexel Burnham assisted firms in issuing original-issue junk debt and almost single-handedly created the market.

Commercial paper refers to unsecured debt issued by corporations with a short original maturity.
Over $1 trillion$ is outstanding in the market (end of 2015).
The development of money market mutual funds assisted in the growth in this area.

Securitization refers to the transformation of illiquid assets into marketable capital market instruments.
Today, almost any type of private debt can be securitized. This includes home mortgages, credit card debt, student loans, car loans, etc.

Money Market Mutual Funds (MMMFs): allow investors similar access to their funds as bank savings accounts but offered higher rates, especially in the late 1970s.
Currently, MMMFs have assets around $2.6 trillion$ . In an odd irony, risks taken by MMMFs almost brought down the industry in 2008.
Sweep Accounts: Funds are “swept” out of checking accounts nightly and invested at overnight rates. Since they are no longer checkable deposits, reserve requirement taxes are avoided.

Decline in Cost Advantages in Acquiring Funds (Liabilities)
- Disintermediation because:
  1. Deposit rate ceilings and regulation Q
  2. Money market mutual funds
- Checkable deposits fell from 60% of bank liabilities to less than 10% today.
Decline in Income Advantages on Uses of Funds (Assets)
1. Easier to use securities markets to raise funds: commercial paper, junk bonds, securitization
2. Finance companies more important because easier for them to raise funds

Loss of cost advantages in raising funds and income advantages in making loans causes reduction in profitability in traditional banking.
1. Expand lending into riskier areas (e.g., real estate).
2. Expand into off-balance sheet activities.
Creates problems for the U.S. regulatory system.
Similar problems for banking industry in other countries.