1

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry
Goal of This Chapter: The goal of this chapter is to explore the different types of
organizations used in the banking and financial services industry, to see how changing
public mobility and changing demand for financial services, the rise of potent
competition, and changing government roles have change the structure, size and the types
of organizations in this industry.

The Organization and Structure of the Commercial Banking Industry

In banking, organizational form follows function because banks usually are organized in such a
way as to carry out the tasks and supply the services demanded of them. The board of directors is
charged with setting policy and overseeing a bank's performance.

Advancing Size and Concentration of Assets

The size and concentration of the US commercial banks are shown in tables 1 and 2. This
is also shown in exhibit 3-1. Most commercial banks in the US are small by global
standards. As these tables show almost half (approximately 3200) of these banks held
total assets of less than $100 million each in 2007 but only held about 2% of total
industry assets. Hundreds of these banks failed during the 2007 – 2008 credit crisis
because of bad loans.
The American banking industry also contains some of the largest financial service
organization on the planet. Examples are the Bank of America, Citigroup, J.P. Morgan
etc. The largest 10 of these banks now control about half of the industry assets.

Table 1: Number of US FDIC insured banks (total 7,350 in 2007)

Size Total Percent of total
Smallest banks 3,197 43.5%
(Each bank’s asset ≤ $100 million)
Medium sized banks 3,649 49.6%
($100 million < Each Bank’s ≤ $1 billion)
Largest banks 504 6.9%
(Each bank’s asset > $1 billion)

Table 2: Asset held by US FDIC insured banks (total assets $10,414 in 2007)
Size Total (billion $) Percent of total
Smallest banks 170 1.6%
Medium sized banks 1049 10.0%
Largest banks 9195 88.3%

In summary, although the largest banks in the US make up only 6.9% of all FDIC insured
banks, they control 88.3% of all the industry’s assets. This development is a result of the
strong trends towards consolidation and convergence in the industry not only in the
United States, but also globally and can be explained by the increasing competitive
pressures in the industry and economies of scale that prevail in banking. It can be
observed that, smaller banks continue to disappear and the biggest banks are gobbling up
greater industry shares each year. But there are signs that this pattern of change might
 2

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry
slow down in future years. 100 large U.S. banking organizations hold more than three-
quarters of industry wide assets and also their market share has risen recently. The top
100 U.S. banks held only about half of all U.S. domestic banking assets in 1980, but by
2000 their proportion of the nation’s domestic banking assets had climbed to more than
70 percent.

Exhibit 3 – 1: The structure of the US commercial banking industry, June 30, 2007

Number of U.S. FDIC-insured Commercial Banks, 2007

7%

43% Small ≤ $100 Million

50% Medium $100 Million -

$1 Billion
Large > $1 Billion

Assets Held by U.S. FDIC-Insured Commercial Banks, 2007

2%

11%
Assets Held By Larg e
Ban ks
Assets Held By Med ium
Ban ks
Assets Held By Small Banks
87%
 3

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry

As, Exhibit 3-2 shows, both small and medium-size banks have lost substantial market
share to the largest banks.

Internal Organization of the Banking Firm

Community Banks and Other Community-Oriented Financial Firms

Community banks also known as retail banks, serving smaller cities and towns, are
heavily committed to attracting smaller locally based household deposits and to making
household and small business loans. A ‘typical’ community bank has $300
million in assets and is located in a smaller city in the Midwest of the
US.
These small banks generally have four basic departments or divisions centered on lending
(the credit function), fund-raising, operations, and marketing (and, perhaps, trust
services). Daily operations are usually monitored by a cashier and/or auditor and by the
vice presidents in charge of each department and division. Overall, the small bank's
organization chart (exhibit 3 – 3) is simple and uncomplicated.
Survival and profitability of these banks depend on the health and local businesses as
many of them tied to agriculture. When local sales are depressed, the bank itself often
experiences slowed growth and its earnings may fail. Unlike larger institutions,
community bankers usually know their customers well and are good at monitoring the
ever changing fortunes of households and small businesses. Many financial experts
believe that the customers such as households and business in smaller
cities and towns are most likely to be damaged by decreased
 4

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry
competition.

Larger Banks-Money Center, Wholesale and Retail

Large money center banks – located in a larger city with wholesale or wholesale plus
retail in focus – are owned and controlled by holding companies. A ‘typical’ money
center bank has about $30 billion in assets and is located in a large
city in the eastern US.
The largest banks (exhibit 3 – 4)usually have many specialized departments and
 5

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry

divisions, including separate departments for different kinds of loans, departments to

manage security holdings and borrow in the money market (in which short-term debt
instruments with maturity less than 1 year are traded) and capital market (in which long-
term debt instruments with maturity more than 1 year are traded), a division or
department to manage international operations, a marketing division, and a planning unit
along with other divisions (see exhibit 3 – 4).
The largest money-center banks (Citigroup, J.P. Morgan, Deutschebank etc) posses some
advantages over smaller community oriented banks. Because they serve many different
markets (domestic and international) with many different services (different product
lines), they are able to stand against the risk of economic fluctuations.

Trends in Organization
In general, banks are becoming larger and more complex organizations with more
departments and services and greater specialization. Deregulation and service innovation
have accelerated this trend as intense competition at home and abroad has encouraged
banks to become larger organizations, serving broader and more diversified market areas.
This phenomenon is known as convergence. Convergence is a phenomenon
when financial service providers offer a range of services including
banking, insurance and securities services. Even small banks are reorganizing
to meet these challenges by being more efficient in meeting their broader-based customer
needs.

Unit Banking Organizations

 6

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry
Unit banks, one of the oldest kind, offer their full menu of services from only one office,
although some services (such as taking deposits, cashing checks, or paying bills) may be
offered from limited-service facilities, such as drive-in windows and automated teller
machines that are linked to the bank’s computer system. These organizations are very
common today. Many new banks start out as unit organizations, in part because their
capital, management, and staff are severely limited until the financial firm can grow and
attract additional resources and professional staff.
Unit banks have the advantage of being less costly to operate because full-service branch
offices are an expensive way to grow and, because unit banks tend to be relatively small,
they seem to be able to offer personalized services better than larger institutions. One
disadvantage is the heavy dependence of most unit institutions on a single market area,
which increases their risk of failure. Some authorities believe, unit institutions may not be
able to afford technologically advanced service delivery systems.

Branching Organization
As a unit bank grows larger in size it usually decides at some point to establish a branch
banking organization. A branch banking (exhibit 3 – 6) organization sells its full menu of
services through several locations, including a head office and one or more full-service
branch offices. Regardless of its number of offices it is one corporation with one board of
directors. However, each office has its own management team with limited authority to
make decisions on customer loan applications and other facts of daily operation.

Branching’s Expansion
Branch banking has become increasingly important with the great majority of states now
allowing statewide branching. Today, more states permit statewide branching and only a
minority restrict branching in some way. There was an increase in the number of
 7

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry
branches in the 60’s, 70’s and 80’s as the population from cities to suburban areas.
However, in recent years the growth in full-service branches has slowed because of the
sky-rocketing costs of land and building office facilities. In addition, ATM’s and
electronic networks have taken over much of the routine banking transactions. There is
not as much need for full service branches as before.
What Trend in Branch Banking Has Been Prominent in the U.S. in Recent Years?

Year # of Bank Main # of Branch Offices Total of U.S. Ave # of

Offices Bank Offices Branches/U.S.
Bank

1934 14,146 2,985 17,131 0.21

1970 13,511 21,810 35,321 1.61
1982 14,451 39,784 54,235 1.75
2007 7,241 77,947 85,188 10.76

Reasons Behind Branching’s Growth

One factor has been the exodus of population from cities to suburban communities,
forcing many large downtown financial firms to either follow or lose their mobile
customers. The result has been the expansion of branch offices and automated tellers.
Bank failures also helped branching activity as the healthier banks have been allowed to
take over the sick ones and convert them into branch offices. Business growth also helped
branching because more funds (deposits) could be achieved from more branches.
However, in recent years the growth in full-service branches has slowed because of the
sky-rocketing costs of land and building office facilities. In addition, ATM’s and
electronic networks have taken over much of the routine banking transactions. There is
not as much need for full service branches as before.

Advantages and Disadvantages of Branch Banking

Branch banking has a number of important advantages. With offices spread over different
areas branch banks may achieve more stable earnings and revenue flows. They may be
able to grow faster because the additional offices can bring in more debt capital
(principally deposits) with which to grow. However, research evidence accumulated in
recent years suggests that adding new branch offices can subject the bank to high fixed
costs, due to large and rising construction costs, which means the bank must work harder
simply to reach a break-even point. Moreover, branch offices that are poorly situated or
that have the misfortune to be located in an area whose economy is deteriorating may
generate higher costs than revenues and saddle the bank with persistent net losses.

Electronic Branching
Electronic Branches include web sites offering internet banking services, ATMs and
ATMs networks dispensing cash and accepting deposits, Point-of-Sale (POS) terminals in
 8

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry
stores to facilitate for payment for goods and services, and PCs and telephone systems
connecting the customers to the bank. Customers using their PCs, cell phones etc., can set
up accounts, transfer money between accounts, pay bills, request loans and various other
services.
Virtual Banks provide their services exclusively through the web and can generate cost
savings over traditional brick-and-mortar banks. Despite significantly lower transaction
costs, virtual banking firms have not yet demonstrated they can be consistently profitable.

Holding Company Organizations

A bank holding company (BHC) is a corporation that holds an ownership interest in at
least one bank. It is also allowed to own nonbank businesses as long as they are related to
banking. The BHC permits de jure (legal) separation between banks and nonbank
businesses having greater risk, allowing these different firms to be owned by the same
group of stockholders.
If the company owns at 25% of the outstanding stock of at least one bank or otherwise
exerts a controlling influence over at least one bank, it must register with the Federal
Reserve Board and seek the Fed’s approval if it wishes to increase its share of ownership
in those banks in which it already has an interest or wishes to acquire additional banks or
nonbank businesses.
The Bank Holding Company Act (as amended) requires a registered bank holding
company to acquire only those nonbank businesses that are "closely related to banking"
and "in the public interest." Among the most popular of these nonbank businesses that
have been approved for holding-company acquisition include finance companies,
mortgage banking firms, leasing companies, insurance agencies, data processing firms,
and several other businesses as well.
Why Holding Companies have grown? It makes easier for BHCs to access in capital
markets in raising funds, their ability to use higher leverage (more debt capital relative to
equity capital) than nonaffiliated banks, tax benefits, and their ability to expand into
businesses outside banking.
One-Bank Holding Companies: One-bank holding companies frequently (most
common in the US) control stock of just one bank. However, these one-bank holding
companies frequently owned and operated one or more nonbank businesses as well.
Once a BHC registers with Federal Reserve Board, any nonbank business must offer
services “closely related to banking” that also yield “public benefits” such as improved
availability of financial services or lower service prices.
Multibank Holding Companies: Multibank holding companies (exhibit 3 – 8) control
stocks of more than one bank. The multibank holding companies to acquire nonbank
businesses has given them the capacity to cross state lines even where state law
prohibited entry by out-of-state banking firms.
 9

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry

Advantages and Disadvantages of Holding-Company Banking: The ability of holding

companies to acquire nonbank businesses has given them the capacity to cross state lines
even where state law prohibited entry by out-of-state banking firms. It also allows a
holding company to diversify across many different product lines to help stabilize the
company's net earnings. However, launching nonbank businesses can stretch holding-
company management too far and make it ineffective, resulting in damage to the
performance of banks belonging to the same holding company. In summary, supporters
of holding company claim greater efficiency, more service available to customers, lower
probability of failure, and higher and more stable profits.
Holding company banking has been blamed for reducing competition as it swallows up
formerly independent banks, for overcharging customers, for ignoring the credit needs of
smaller towns and cities, and for accepting too much risk. There is some evidence that
multibank holding companies have taken away local funds (scarce capital) from
communities to help the troubled lead bank and weakened smaller towns and rural areas;
less credit may be available for local community projects.

An Alternative Type of Banking Organization Available as the 21st

Century Opened: Financial Holding Companies (FHCs)
Financial holding companies (FHCs) are defined as a special type of holding company
that may offer the broadest range of financial services that may include banking,
insurance, investment banking, and travel agencies (exhibit 3 – 9). With the FHC
approach each affiliated financial firm (banking, insurance agencies etc.) has its own
capital and management and its own profits and losses separate from the profits and
losses of other facilities of the FHC. Thus, bank affiliates of an FHC have some
protection against companywide losses.
 10

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry

The Changing Organization and Structure of Banking’s Principal

Competitors
Almost all of banking’s top competitors are experiencing the same changes as banks. For
example, consolidation (larger, but fewer banks, each serving a wider geographic area)
and convergence (with all financial firms coming to look alike, especially in the menu of
services offered) are occurring at a rapid pace. Generally, nonbank firms have
experienced the same dynamic structural and organizational revolution as banks and for
many of the same reasons.

Efficiency and Size: Do Bigger Financial Firms Operate at Lower Cost?

Banks have grown from small unit (branches) into much larger corporate entities with
many branches, reaching across countries and continents with growing menu of services.
Question is: Do larger financial firms enjoy a cost advantage over smaller firms? In
other words: Are bigger financial institutions simply more efficient than smaller ones?
There are two possible sources of cost saving due to growth: (1) Economies of scale, if
they exist, mean that doubling of output of any service or package of services will result
in less than doubling production cost because of greater efficiencies in using the firm’s
resources to produce multiple units of the same service package. In other words,
economies of scale mean that costs per unit (or average cost) decrease as more units of
the same service are produced. (2) Economies of scope, mean that employing the same
management, staff, and facilities to offer multiple products or services, thereby helping to
reduce the per unit cost of production and delivery of goods and services. In other words,
economies of scope mean that as more different services are provided the joint costs of
producing those services decrease.
Recent research suggests that average cost curve in the banking industry – the
relationship between bank size (measured by total assets) and the cost of production per
unit of service output – is roughly U-shaped as shown in exhibit 3 – 10, but appears to
have a fairly flat middle portion. This implies that a fairly wide range of banking firms lie
 11

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry
close to being at maximally efficient size. However, smaller banks tend to produce a
different menu of services than do larger banks. Some studies suggest that the smaller
and medium-size banks tend to reach their optimal size (lowest production cost)
somewhere between $100 and $500 million or $1 billion in aggregate assets. Larger
banks tend to achieve optimal (lowest-cost) size at somewhere between $2 and as high as
$10 to $25 billion in assets.

Thus, there is evidence for at least moderate economies of scale in banking, though most
studies find only weak evidence or none at all for economies of scope. However, we have
to be cautious about the conclusion reached by cost studies because the financial service
business is changing rapidly in form and content and the available statistical methodology
have serious limitations in that they focus on a single point in time rather than attempting
to capture the dynamics of the industry.
Is a financial-service firm, regardless its size, operating as efficiently as it possibly can?
This is known as x-efficiency; that is, it raises question if a firm operating on its cost-
efficient-frontier, with little or no waste. Research evidence shows that most banks do not
operate at their minimum possible cost.

Financial Firm Goals: Their Impact on Operating Cost, Efficiency, and

Performance
There is a conflict between the goals (maximize the profit of the owners or shareholders
of the firm) of the firm and the interest of the management of the financial firms which
can be summarized in two forms:
 12

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry
1. Expense – preference Behavior
2. Agency theory

Expense – preference Behavior

Expense preference behavior describes an approach to management in which managers
use the resources of the firm to provide them with personal benefits not needed to
produce and sell the products. This behavior leads to increasing costs of production and
declining returns to the firm’s owners. Such expense-preference behavior may show up in
the form of staffs larger than required to maximize profits or excessively rapid growth,
which causes expenses to get out of control. In short, managers have more opportunity to
enjoy a lavish lifestyle at the shareholders’ expense.

Agency theory
The concept of expense preference behavior is part of a much larger view of agency
theory. Agency theory analyzes the relationship between a firm’s owner (shareholder)
and its managers. It explores whether there is a mechanism to compel managers to act in
the best interest and maximize the welfare of the firm’s owners. Owners do not have
access to all the information and cannot fully evaluate the performance of a manager.
One way to reduce costs from agency problems is to develop better systems for
monitoring the behavior of managers and put in place stronger incentives for managers to
follow the wishes of owners.
Many experts believe that lower agency costs and better company performance depend
upon the effectiveness of corporate governance. Corporate governance describes the
relationships that exist among managers, the board of directors, the stockholders, and
other stakeholders of a corporation. Corporate governance can be improved through
larger boards of directors and a high proportion of outside directors. This will expose
managers to greater monitoring and discipline.

1. Which of the following is a reason for the rapid growth in branch

banks?
A) Exodus of population from cities to suburban areas*
B) Bank convergence
C) Business failures
D) Decreased costs of brick and mortar
E) All of the above

2. When financial service providers offer a range of services

including banking, insurance and securities services it is known
as:
A) Consolidation
B) Convergence*
C) Economies of scale
D) E-Efficiencies
E) None of the above
 13

FIN 323

CH3: The Organization and Structure of Banking and the Financial Services Industry

3. The gradual evolution of markets and institutions such that geographic boundaries
do not restrict financial transactions is known as:
A) Deregulation
B) Integration
C) Re-regulation
D) Globalization*
E) Moral suasion

4. Which of the following is considered an advantage of branch banking?

A) Increased availability and convenience of services
B) Decreased chance of failure
C) Reduced transaction costs
D) B and C above
E) All of the above *

5. Bank holding company organizations have several advantages over other types of
banking organizations. Among the advantages mentioned in this chapter is:
A) Greater ease of access to capital markets
B) Tax advantage
C) Product-line diversification
D) All of the above.*
E) None of the above.