BANKING INDUSTRY STRUCTURE &

COMPETITION

Gál Zoltán, FULL PROFESSOR

 Preview
• This chapter examines the historical trends in the banking
industry
• Comparison of the European and US banking system
• Comparison of universal and specialized banking
• Explain the unique structure of the U.S. system.
• The banking network consolidation in the US
• International banking regulations
 Learning Objectives (1 of 2)

• Recognize the key features of the banking system and the

historical context of the implementation of these
features.
• Understand the evolution and structures of different
national banking system models
• Explain how financial innovation led to the growth of the
shadow banking system.
• Identify the key structural changes in the commercial
banking industry.
• Summarize the factors that led to consolidation (size &
network) in the commercial banking industry.
 Learning Objectives (2 of 2)

• Assess the reasons for separating banking from other

financial services through legislation.
• Summarize the distinctions between thrift institutions and
commercial banks.
• Identify the reasons for U.S. banks to operate in foreign
countries and for foreign banks to operate in the United
States.
FINANCIAL INTERMEDIATION AND INDIRECT FINANCE

Revise from the previous class

Function of Financial Markets : Direct and
Indirect finance

Flow of Funds Through the Financial System

2-6
 Financial Intermediation
and Banks (cont'd)
• Direct finance
– Individuals purchase bonds from
a business
• Indirect finance
– Individuals hold money in a bank
– The bank lends the money to a business

15-7
 Financial Intermediation
and Banks (cont'd)
• Financial Intermediation
– The process by which financial institutions accept
savings (deposits) from businesses, households, and
governments and lend the savings to other businesses,
households, and governments.

15-8
Figure 15-4 The Process of Financial
Intermediation

15-9
 Financial Intermediation and Banks
• Two-tier banking system
– Most nations have a banking
system that encompasses two types
of institutions.
1. One type consists of private
banking institutions.
2. The other type of institution is a
central bank.
• One-tier (mono) banking system: in centrally
planned socialist countries
15-10
DIFFERENT BANKING STRUCTURES
Types of banking

Retail Banking mainly focuses on a single

individual. In contrast, Wholesale Banking
focuses on the larger group of individuals
or organizations, or companies to serve
these cooperative clients.
 Banking Structures Throughout the World
• Universal Banking (European continental model)
– Universal banking is a system in which banks provide a
wide variety of financial services, including commercial
and investment banking services.
– A universal bank is a bank that combines the three main
services of banking under one roof. The three services are
wholesale banking, retail banking, and investment
banking. In other words, it is a retail bank, a wholesale
bank, and also an investment bank.
– A universal bank participates in many kinds of banking
activities and is both commercial bank and an investment
bank as well as providing other financial services such as
insurance.

15-13
Banking Structures Throughout the World
(cont'd)
Universal Banking (European continental model)
– Offers a full range of financial services and to own
shares of stock in corporations (German banks)
– These are also called full-service financial firms,
although there can also be full-service investment
banks which provide wealth and asset management,
trading, underwriting, researching as well as financial
advisory.
*Retail Banking mainly focuses on a single individual.

Wholesale Banking focuses on the larger group of individuals or

organizations, or companies to serve these cooperative clients.
• What is the difference between wholesale and investment
banking?

• Investment Banking is a 'markets business': raising capital,

long term funds, broking and advisory services.
• Wholesale Banking is core commercial banking
(lending,borrowing, payment etc.)that serves large
institutions.
 17
Investment banks
• Investment banks act as intermediaries between
investors (who have money to invest) and corporations
(who require capital to grow and run their businesses).
• $111.45 billion in 2021 at a compound annual growth rate (CAGR) of
8.4%.
• Investigation, Analysis and Research (Origination),
Underwriting (Public Cash offerings), M&A consultancy
and Distribution.

22/03/2022
 18
Balance Sheet - Investment Bank vs. Commercial Bank

22/03/2022
 Banking Structures Throughout the World
(cont'd)
• US model is specialized banking:
• The concept is most relevant in the UK and the USA,
where historically (from 1933) there was a distinction
drawn between pure investment banks and commercial
banks up to 1990s.(1999)
 Roots of different financial system models
Institutional development of Anglo-Saxon and European continental
system models – Different emphasis on direct and indirect financing
1. Anglo-Saxon capital market-oriented system (Direct finance is
more dominant)
A model based on its overall capital market dominance needs to be
created United States, Great Britain, Canada, and Australia.
2. Bank-oriented continental model in France and Germany (+Japan,
China).
• In the economic development of Eastern Europe, the intermediary role
of banks was stronger by 19-20. century
• Securing and reallocating economic growth factors and late-comers
development, first and foremost through banking system.
• Gradual disintegration of the single-branch local-regional
banking system (unit bank), the continuation of the
development of these national branch network banks
(branch banks)
FinTech evolúciója:Ipar 1.0 -tól az ipar 4.0
korszakáig
 22
Weight of indirect finance 2
Share of banking assets of the total financial assest, 2003,2005, (%)

90
80
70
60
50
48
50 42
37 36 35
40 34 34
31
30
18
20
10
0
EMU

Latin-America
Asia
EU

USA

Japan

Emerging markets

CEE
Middle East
World

2003

2005

2007

22/03/2022
 Emergence of universal banks (credit demand based concept)
• Late comers in the continantal Europe: increasing capital needs - The
Universal Banking Model Based on Gerschenkron's Credit Demand
(Alexander Gerschenkron (1904-1978), American economic historian)
• There is a correlation between the lack of capital due to late comer
industrialization (rel.economic backwardness) and the weight of bank
(indirect) financing.

• With the emergence of new industries (Industry 2.0: electronics,

chemicals, automotives) in capital-scarce continental countries, the
universal bank has become a long-term financier of increasingly
capital-intensive industrial (and infrastructure) developments.
• Universal banks not only financed industrial companies but also took part
in corporate governance of these companies through shareholding
(Germany)
 Emergence of universal banks (credit demand based concept)

Institutionalization of the central bank,

1. Medium decentralization of the state organization; quasi-
decentralized banking systems (local, unit-banks) (Austria-
Hungary, Germany, Switzerland); dual banking system (local
vs.national)
2. Strong decentralization, segmented banking system: lack of
central bank till 1913 hinders the introduction of universal banking
system: USA (dominance of state centered local, regional banks)
3. Due to strong centralization (Great Britain, France, Belgium)
specialized banking system developed (eg. Large London based
banks with extensive nation-wide branch networks)
Emergence of universal banks: deposit (liabilities)-based concept

• Verdier's (2003) source (liabilities)-based universal banking

model
• Due to the dense network of local credit unions, large banks
can rely on their equity and profits from corporate financing
bcz they were excluded from the local deposit markets.
• They need a central bank because of their risky corporate
investments
• Existence of segmented local banking networks (cooperative
savings banks), greater room for maneuver for local
economic development and local finance.
http://www.youtube.com/watch?v=4VFN_26IeKw
The evolution of the modern financial system
Regional and bank-oriented
Associated with industrializa-
tion phase of economic devel-
opment
Banks main source of external
funds needed by private sector
firms
Industrial growth financed by
loans, risk capital and profits
Local-regional and national
banking system; local sources
of capital important
Source: Martin, 1994.
National and capital market- Transnational and securitized
oriented form
Characteristics of industrial ma- Associated with post-industrial
turity phase of economic devel- and transnational phase of eco-
opment nomic development
Capital markets main source of Bulk of funds obtained through
funds, using savings of private capital and credit markets, using
investors mainly resources of institutional
investors
Capital markets channel personal Separation of capital and money
and other savings into industry; markets from industry and
risk spread across shareholders commodification of money;
proliferation of monetary prod-
ucts
Concentration and centralisation Development of globally inte-
towards national banking and grated system of world financial
capital markets; loss of local- centres; loss of national financial
regional financial autonomy; autonomy to supranational
emergence of internationalization economy of stateless monies
 Evolution of banking: stages and spatial expansion
STAGES
1. PURE FINANCIAL
INTERMEDIATION
- Banks lend out savings
- payment in commodity money
- No bank multiplier
- Savings preceedes investment
2. BANK DEPOSITS USED
AS MONEY
- Convenient to use paper
money as means of payment
- Reduced drains on bank
reserves
- Bank credit creation with
fractional reserves
- Investment can now preceed
saving
3. INTER-BANK LENDING
- Credit creation still
constrained by reserves
- Risk of reserve loss offset by
inter-bank lending
- Multiplier process works more
quickly
- Multiplier larger bcz banks
can hold lower reserves
BANKS AND SPACE
- Serving local communities
- Private Wealth-based
- Provinding foundation for
future financial centers
- Market dependent ont he
extent of confidence held in
banker
- Local unit banks, narrow
geographical scope of
local/regional banking
- Banking system developes
at nationalm level
- Nationwide geographical
scope
- correspondent banks
CREDIT AND SPACE
Intermediation only
Credit creation focused on
local community
bcz total credit constrained by
repo (repurchase) ratio. Lender
lends for the bank on short –
term basis (Bill of exchange,
váltó)
A hitelteremtés a helyi
közösség bázisán alapszik, a
teljes hitelállomány a repo
(repurchase) arányában
korlátozott.
Redeposit constrains relaxed a
bit so banks can lend wider
afiled
27
 A pénzügyi rendszerek és piacok evolúciója: a
bankfejlődés szakaszai
STAGES BANKS AND SPACE CREDIT AND SPACE
4 LENDER OF LAST - Central bank oversees the Banks freeer to respond credit
RESORT national banking system but demand as reserve constrains
- Central bank percieves need to limited power to constrain not binding, , and they can
promote confidence in banking credit determe the volume and
system distribution of credit within
- Lender of last resort facility national economy.
provided if inter-bank lending
inadequate
- Reserves now respond to
demand
- Credit creation freed from
reserves constrains
5 LIABILITY Banks compete at national level Credit creation determined by
MANAGEMENTS with non-bank financial struggle over market share and
- Competition from non banking institutions opportunities in speculative
intermediaries; struggle for markets.
larger market share Total credit uncontrolled.
- Banks actively supply credit
and seek deposits
- Credit expansion diverges from
real economic activity
6 SECURITISATION Deregulation opens up Shift to liquidity by empahis
- Capital adequacy ratio international competition, beeing put on services rather
28
- Reserves now respond to
demand
- Credit creation freed from
reserves constrains
5 LIABILITY Banks compete at national level Credit creation determined by
MANAGEMENTS with non-bank financial struggle over market share and
- Competition from non banking institutions opportunities in speculative
intermediaries; struggle for markets.
larger market share Total credit uncontrolled.
- Banks actively supply credit
and seek deposits
- Credit expansion diverges from
real economic activity
6 SECURITISATION Deregulation opens up Shift to liquidity by empahis
- Capital adequacy ratio international competition, beeing put on services rather
introduced to curtail credit eventually causing than credit; Credit decisions
- Banks have an incresing share concentratiuon in international concentrated in financial
of bad loans bcz of financial centres (IFCs) centres; Total credit
overlending in stage 5 determined by the availability
- Securitisation of bank assets of capital i.e.by central capital
- Increase in off-balance sheet markets
activities
- Drive to liquidity
Evolution of Universal banking in Hungary: transition from unit
bankingto nation-wide branch banking, in 1910

30
DIFFERENT NATIONAL MODELS OF BANKING SYSTEMS
Financial Intermediaries (in the USA)

2-32
 USA banking system: Depository Institutions (Banks) are broadly
defined as businesses that accept deposits and make loans

Depository Institutions BANKS

Commercial Savings & Savings Credit

Banks Loans Banks Unions
Non-Bank Thrifts
• Raise finds by issuing checkable •Deal almost exclusively in short term
(demand), savings and time deposits.deposits and mortgages.
• Money multiplier (credit creation) •Are generally mutual companies (depositors
function. are the owners)
• Making different (commercial,
consumer, mortgage) loans. •Are allowed to hold corporate
• Diversified asset portfolios equities/bonds
 Depository Institutions (Banks)
• Commercial banks
– Raise funds primarily by issuing checkable, savings, and
time deposits which are used to make commercial,
consumer and mortgage loans
– Collectively, these banks comprise the largest financial
intermediary and have the most diversified asset
portfolios

Copyright © 2006
Pearson Addison-Wesley.
2-34
All rights reserved.
 Depository Institutions (Banks)
• S&Ls, Mutual Savings Banks and Credit Unions
– Raise funds primarily by issuing savings, time, and
checkable deposits which are most often used to make
mortgage and consumer loans, with commercial loans
also becoming more prevalent at S&Ls and Mutual
Savings Banks
– Mutual savings banks and credit unions issue deposits as
shares and are owned collectively by their depositors,
most of which at credit unions belong to a particular
group, e.g., a company’s workers

2-35
 Financial Intermediation and Banks (cont'd)
• Payment Intermediaries
– Institutions that facilitate transfers of funds
between depositors who hold transactions
deposits with those institutions
– Credit card companies (MC, Visa, American
Express)
– New FinTechs: TransferWise

15-36
 Credit cards; How a Debit-Card Transaction Clears

credit and debit the account

15-37
 The 3 pillars of German banking system

In terms of total assets, the four major German commercial banks (Deutsche Bank AG,
Commerzbank AG, UniCredit Bank AG and Deutsche Postbank AG) account for nearly
65 %. This reflects the particular importance of the major banks.
Key figures and business aims of German banks
 Co-operative banks tackle information asymmetry

Cooperative bank model:

counter information
19th Bank Costumer
asymmetry
century:
Information Banks are reluctant to lend as they do not
advantage possess sufficient information to price Costumer = Member
in favour of risk for certain marktes
customer Result:restricted supply lending to higher
rates & lower aggregate borrowing

21st Bank = Cooperative

Bank Costumer
century:
Information Banks (suppliers) have and advantage Cooperative model finds the balance
over costumers (buyers) due to advanced between the banks & costumers.
advantage
IT analytics, credit scoring Minimized information asymmetry.
in favour of
bank Result: Higher customer demand due to Coop represent both buyesr &
information asymmetry, higher prices & supplyers through member
take up. ownership..
Source: Burger-Gál, 2011, Wyman, 2009
Az ügyfélhez való földrajzi közelség; a tagsági tulajdon információs előnyeinek kiaknázása (pl. helyi kis- és középvállalatok finanszírozásában); a
szövetkezettel szembeni bizalom növekedése az informális, helyi kapcsolatokon keresztül; információs előny érvényesítése a versenytársakkal szemben
(országos hálózatú kereskedelmi bankok).
 Increasing members in the German
cooperative banks

No of
branches
(1000)

No. of coop banks

(1000, right)

Members
(million)
Balance sheet
per branch(100
million €, right)

1970 1980 1990, 2000 2010

Reunification
Forrás: BVR (2010),
CEPS (2010: 30)
 Performance at cooperative banks means achieving
stakeholder value creation in an efficient manner

Structural factors
Actual execution: maximising efficiency
„Dual bottom-line” institutions: stakeholder and relative growth
vs. shareholder banks; profit+ social
impact Owners (members) are users Efficiency:
(costumers) • Shows how scarce resources are used to
• Value-added is incorporated in achieve a goal
products • Cost-income-ratio is one main metric
• Profit expectation vs. profit • Includes efficient risk management
pressure • May be explicitly influenced by
• Goal is to maximise benefit/surplus institutional protection schemes
distributed to members
Relative growth and value creation:
high • Relative, compared to market
Bad coop. Ideal coop
• Measures the co-operative’s
attractiveness (social & economic and
Efficiency community values) to existing and new
Destroying Bad
credibility managers members
low • Includes profitability, profit growth,
low high number of new members and clients
42
Relative
growth Sources: CEPS(2010:4), Wyman (2008: 31)
 Top-25 global banking groups by Tier 1 capital
(Bn $), 2006

Bank of America
Citigroup
HSBS
CREDIT AGRICOLE
JP Morgan Chase
4th
Mitsubitsi Financial…
ICBC
Royal Bank Of…
Bank of China
Sandander Banco…
BNP Paribas
Barclays Bank
HBOS
China Construction…
Mizuho Financial
Wachovia
Unicerdit
Wells Fargo
RABOBANK
ING Bank
19th
Sumimoto Financial
UBS
Deutsche Bank
ANB Amro
CREDIT MUTUEL
25th
0 20 40 60 80 100
 Share of cooperative banking sector
• 37% of population in Germany and 40% in Austria are customers of
CBs
• 32% of SMEs were members of cooperative banks in EU-15 (2003)
• The Italian Banche Popolari is responsible for 75% of SME lending
• 90% of Frech farmers are customers of Credit Agricole

Cooperative Banks—Market Shares of Assets (In percent of total banking system assets)
1994 1997 2000 2003
Austria … 29.4 29.5 35.6
Finland 18.5 17.5 16.2 15.9
France 1/ 28.4 27.9 28.1 24.1
Germany 14.3 12.4 9.8 10.3
Greece … 0.2 0.3 0.6
Italy … 17.0 16.8 14.9
Netherlands … 21.2 29.0 26.7
Portugal … 3.5 3.4 3.5
Spain 3.0 3.5 3.7 3.9
1/ Including savings banks, before and after their conversion to cooperative banks in 2000
 The birth of cooperative bank models

• Cooperative banks have long been an integral and well-established

part of the financial system in many European countries
• there is no single universal model
• Cooperative banks have evolved from their origins in the second
half of the 19th century, and many have evolved over time into
full-service universal banks
• Friedrich Wilhelm Raiffeisen (1818 – 1888) was a German, who
pioneered rural credit unions in 1864.
• Hermann Schulze-Delitzsch (1808-1883)who established the first
urban cooperatives (e.g. a shoemaker’s cooperative but also
savings and creditcooperatives) in the town of Delitzsch in 1852.
• They became widespear during cris times when the the credit
channels are not developed or disrupted.
Indian Financial system (mixed anglo saxon –
European continantal)
National systems of banking
 Banking Structures Throughout the World
• The ways that banks around the world differ
– Size
• United States has banks of various sizes
• Europe, China and Japan have few large banks
– Legal
• Limits on financial services such as insurance and bank
stock ownership (separate commercial and investment
bank operation) USA till 1990s
• Universal banking
– Importance in financial system
• Major importance (bank-oriented financial systems)
• Part of a varied (complex) financial system (United
States) 15-48
The World’s Largest Banks by Tier 1 capital,
1994-2010
The World’s Largest Banks, 2006

15-50
Top global banks by assets, 2020
Table 3 Ten Largest Banks in the World, 2020

Bank Assets (U.S. $ trillions)

1. Industrial and Commercial Bank of China, China 4.32

2. China Construction Bank Corp., China 3.82
3. Agricultural Bank of China, China 3.70
4. Bank of China, China 3.39
5. JPMorgan Chase, US 3.14
6. HSBC Holdings plc, United Kingdom 2.92
7. Mistubishi UFJ Financial Group, Japan 2.89
8. Bank of America, US 2.62
9. BNP Paribas 2.43
10. Credit Agricole Group, France 1.98

Source: From Bankrate.com––Compare mortgage, refinance, insurance, CD rates,

http://www.bankrate.com/finance/banking/largest-banks-in-the-world- .
1.aspx
Top global banks by market capitalization, 2019
Top global banks by Tier 1 capital, 2020

Tier 1 capital:
disclosed reserves—
that appears on the
bank's financial
statements—and
equity capital
HISTORICAL DEVELOPMENT OF THE BANKING
SYSTEM
(REGULATIONS & INNOVATIONS)
 Historical Development of the Banking System
• Bank of North America chartered in 1782
• Controversy over the chartering of banks
• National Bank Act of 1863 creates a new banking system of
federally chartered banks
– Office of the Comptroller of the Currency (Pénzügyi
Ellenőrzési Hivatal)
– Dual banking system (Federal & state level)
• Federal Reserve System (central bank functions) is created
in 1913.
Figure 1 Time Line of the Early History of
Commercial Banking in the United States
 Primary Supervisory Responsibility of Bank
Regulatory Agencies

• Federal Reserve and state banking authorities:

state banks that are members of the Federal
Reserve System.
• Comptroller of the Currency—national banks
• Fed also regulates bank holding companies.
• FDIC Dederal Deposit Insurance Corp): insured
state banks that are not Fed members.
• State banking authorities: state banks without
FDIC insurance.
 The Federal Reserve System
• The Fed
– The Federal Reserve System; the central bank of the United States
– The most important regulatory agency in the U.S. monetary system
– Established in 1913 by the Federal Reserve Act

– Federal Reserve Banks (12 Districts),25 branches

15-59
 U.S. Has a Dual Banking System
• State banks chartered by state governments
• National banks chartered by federal government beginning
in 1863

10-60
 Levels of financial regulations
There is a adverse selection problem/moral hazard problem
between both the bank and its depositors as well as
between the bank and its potential loan customers

Depositors Bank Loans

This problem must A bank can deal with this problem

be dealt with with:
through regulation
•Credit Scoring
FDIC (Revolut has
•Collateral
an issue in Hungary:
wahat is it? •Optimal Debt Contracts
 A timeline of Banking Regulation
Banking Act
Restrictions on

McFadden Act
Competition

Holding Company Act

Monetary Control Act

Great Depression Riegle-Neal

1933 1956 1999

1863 1927 1980 1994

Graham - Leach - Bliley

Restrictions on

Holding Company Act

activities

Glass - Steagall
 Federal Deposit Insurance (1934)
• Federal reserve members are required to purchase deposit
insurance. Insurance is optional for state banks (98% of all
banks have deposit insurance)
– FDIC insured banks are charged up to 27 cents per $100
of eligible deposits
– All deposits up to $100,000 are insured by the FDIC.
REGULATIONS AND INNOVATIONS

THE BIRTH OF SHADOW BANKING

 Regulations & innovations
• Questions: Which one is the more important?
• Financial innovation is driven by the desire
to earn profits
• Innovations often responds to regulations and
changing in the financial environment
– Recent outcome and framework: SHADOW BANKING

1. Responses to change in demand conditions

2. Responses to changes in supply conditions
3. Securitization of Shadow Banking System
4. Avoidance of regulations

10-65
 Financial Innovation and the Growth of the
“Shadow Banking System”
• A change in the financial environment will stimulate
a search by financial institutions for innovations that
are likely to be profitable
• A shadow banking system is the group of financial
intermediaries facilitating the creation of credit
across the global financial system but whose
members are not subject to regulatory oversight
(risk, liquidity, and capital restrictions) . E.g.hedge
funds, unlisted derivatives
• The shadow banking system also refers to
unregulated activities by regulated institutions (off
balance sheet, CDS).
 1 Responses to Changes in Demand Conditions:
Interest Rate Volatility
High fluctuation of interest rates (1960s: 1-3.5%; 1970s:
4-12%; 1980s: 5-15%, )
• Adjustable-rate mortgages
– Flexible interest rates keep profits high and lower
interest rate risk when rates rise for banks
– Lower initial interest rates make them attractive
to home buyers
• Financial Derivatives
(invented in 1870s but re-introduced in 1975)
– Ability to hedge interest rate risk (Futures)
– Payoffs are linked to previously
issued (derived) securities

10-67
 2 Responses to Changes in Supply Conditions:
Information Technology
• Bank credit and debit cards (which one was introduced earlier?)
– Improved computer technology lowers the transaction
costs
• Electronic banking
– ATM
– Home banking
– ABM (automated banking machines)
– Virtual banking
• Junk bonds (lower rated bonds from riskier corps)
• Commercial paper market (short term debt securities)

10-68
 3 Securitization and the Shadow Banking System
• Securitization
– To transform otherwise illiquid financial
assets into marketable capital market
securities involving different less reguated
financial institutions.
– Bundling illiquid assets of e.g.mortgage & auto
loans into markatable capital market securities

– Securitization played an especially prominent

role in the development of the subprime
mortgage market in the mid 2000s.
 Financial engineering and the „originate to distribute model”
in the shadow banking
• Financial engineering is the application of mathematical methods
to the solution of problems in finance in developing new
instruments to address the needs of investors and institutions in a
rapidly changing financial climate.
e.g. Financial mathematics, mathematical finance, financial physics and
computational finance
'Originate-to-hold' model to Originate & Distribute model
 Financial innovations before and after 2008 crisis

Financial mathematics models FinTech

(IT-driven models, distributed
ledger, cryptos, FinTech platforms)
 3 Securitization and the Shadow Banking System
(Cont.)
• These securities (along with many other securities
– private & Fannie Mae and Freddie Mac) were
used as collateral in the Shadow Banking System.

• Sale and Repurchase Market (“REPO”) – The

essence of “Shadow” Banking. Shadow Banks (1)
do not take deposits; (2) provide credit and
liquidity; (3) no access to central bank funding or
the FDIC.
 Subprime mortgage market operates with low transaction cost
Mortgage broker – loan originator
Servicer (takes interest and principal payments , sells mortgage to another institution
Bundler- takes interest and principal payments, passes to distributor
Distributor sells the claims to interest and principal payments as securities to other
financial intermediary (MMF, pension fund),
real estate mortgage investment conduit (REMIC)
74
 Subprime mortgage market

Average US Home prices Growth in subprime loans

75
Size of Sahadow banking
In China shadow banking is growing

https://www.cnbc.com/2013/09/12/risk-is-being-driven-
to-shadow-banks.html
Commercial banks' income sources
Sources of non-interest income, end-2007 (
Michael Brei)
 4 Avoidance of Existing Regulations
• Loophole Mining:
– Reserve requirements act as a tax on deposits
– Restrictions on interest paid on deposits led to
disintermediation
– Money market mutual funds
– Sweep accounts
 4 Avoidance of Existing Regulations (cont.)
Regulations Behind Financial Innovation
1. Reserve requirements
Tax on deposits = i  r
2. Deposit-rate ceilings (Reg Q till 1980, i was over 10%
while REG Q was 5.5% max.)
As i , loophole mine to escape reserve requirement tax
and deposit-rate ceilings
Regulation Q was repealed in 1986
3. Money market mutual funds (Bruce Bent, 1970)
4. Sweep accounts*

*A sweep account automatically transfers cash funds into a safe but

higher interest-earning investment option at the close of each business
day, e.g., into a money market fund.
10-81
 Problems with Restricting Activities

Banks compete with other financial services companies as

well as other banks!!

During the late 1970’s, market interest rates rose well above 10%,
but banks were restricted by regulation Q to pay only 5.25% in
savings accounts (time deposits) and 0% on checking accounts

Banks Financial Companies

Checking Accounts (0%) Money Markey Mutual
Funds (10%)

As households pulled their money out of banks, mortgage

and small business lending was seriously curtailed!
 4 Avoidance of Regulations: Loophole Mining
(cont.)
• Reserve requirements act as a tax
on deposits
– Sweep accounts (not subject to reserve requirement, so
non taxable checking account invested, swept out into
overnight securities, into MMF)
• Restrictions on interest paid on deposits led to
disintermediation of bank deposits to avoid interest rate
ceiling.
– Money market mutual funds (with higher returns,
invested into higher than 5.5% Regulation Q interest
rate ceiling)

10-83
 Bruce Bent and the Money Market Mutual Fund
Panic of 2008

• Bruce Bent, one of the originators of money market

mutual funds, almost brought down the industry during
the global financial crisis in the fall of 2008.

• Not surprisingly, given the extension of a government

safety net to the money market mutual fund industry,
there are calls to regulate this industry more heavily.
IMPACT OF INOVATION ON TRADITIONAL
BANKING
 Financial Innovation and the Decline of
Traditional Banking (1 of 3)
• As a source of funds for borrowers, market share
has fallen.
• Commercial banks’ share of total financial
intermediary assets has fallen
• No decline in overall profitability: Increase in
income from off-balance-sheet activities
Figure 3 Number of Commercial Banks in
the United States, 1934–2019

Source: Federal Reserve Bank of St. Louis, FRED database:

https://fred.stlouisfed.org/series/USN .
UM
10-88
 Financial Innovation and the Decline of
Traditional Banking (2 of 3)
• Decline in cost advantages in acquiring funds
(liabilities)
– Zero interest rate checkable deposits were
cheap source till 1970s
– Rising inflation led to rise in interest rates and
disintermediation
– Low-cost source of funds, checkable deposits
declined in importance (from 60% to 10% as
source of fund/liabilities between 1960s-2018)

10-89
 Financial Innovation and the Decline of
Traditional Banking (2 of 3)
• Decline in income advantages on uses of funds
(assets)
– Information technology has decreased need for banks to
finance short-term credit needs or to issue loans
– Information technology has lowered transaction costs
for other financial institutions, increasing competition
• Clients Bypassing banks and went directly to money
and capital markets (commercial paper, junk bonds)
• Increasing the role of shadow banking system
• Problems for S& L to securitize mortgage loans
 Decline in Traditional Banking

Loss of Cost Advantages in Acquiring Funds

(Liabilities)
  i  then disintermediation because
1.Deposit rate ceilings and regulation Q (1933-
2010)
2.Money market mutual funds
3.Foreign banks have cheaper source of funds:
Japanese banks can tap large savings pool
Loss of 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
10-91
 Financial Innovation and the Decline of Traditional
Banking (3 of 3): Banks’ Responses
Loss of cost advantages in raising funds and income advantages in
making loans causes reduction in profitability in traditional banking
Banks’ Responses
1. Expand lending into riskier areas: e.g., real estate
• Commercial real estate loans
• Corporate takeovers and leveraged buyouts
2. Expand into off-balance sheet activities (non-interest rate but
fee generation)
• Non interest income
• Concerns about risk
• Decline of Traditional Banking in Other Industrialized Countries
3. Creates problems for U.S. regulatory system

• Similar problems for banking industry in other advanceds

countries (Eurobond markets, Australia)
FINANCIAL DISINTERMEDIATION
 Financial disintermediation
• The process by which financial sector players enter into
more and more business directly with each other,
bypassing banks.
• The main area of disintermediation is the DIRECT FINANCE via capital
market, which enables securitization to bypass traditional financial
intermediaries (banks) and to avoid bank commissions, thus
increasing investors' returns on credit and other transactions.
• One interpretation is that disintermediation means bypassing the
financial intermediary system. In this interpretation, direct
participation in the money and capital markets represents
disintermediation (direct financing)
• Also referred to as (banking) disintermediation is the phenomenon of
investors shifting their savings from bank deposits to institutional
investors.
 Stages of financial disintermediation
1. Investment banks vs commercial banks after 1933
2. Institutional investors (pension funds, insurance
companies, mutual funds) from 1950s
3. Non-Financial service providers (selling banking products,
e.g. Texaco petrol staions, Texco financial services)
4. Challenges of FinTech companies
 Financial disintermediation
• The former three actors saver ̶̶̶ bank ̶̶̶ borrower relationship is replaced by
the saver ̶̶̶ non-bank financial intermediary ̶̶̶ bank ̶̶̶ borrower - four-
actors mediation chain
– The emergence of non-bank players also in retail markets
previously dominated by banks (insurance and pension funds
investment products competing for deposits
• Institutional investors (pension funds, insurance companies,
mutual funds) have become the strongest competitors of
banks.
– Strong competition has pushed players towards cooperation
(eg bankassurance model).
– Competition of non-financial service providers (Tesco
Finance); alternative payment channels on the Internet and
mobile phones
– Competition from Fintech start-ups
 Rise of new challengers: Fintech companies
Banks reaction:
• Have become distributors of new investment and pension insurance
products,
• They have also developed riskier product segments through the
securitization of loans.
• Developing or merging with Fintech start-ups
 Table 1 Size Distribution of Insured Commercial
Banks, March 31, 2017

Table 1 Size Distribution of FDIC Insured Banks, March 31, 2017

Assets Number of Share of Share of Assets

Banks Banks (%) Held (%)
Less than $100 million 1,501 25.6 0.5
$100 million–$1 billion 3,605 61.6 6.9
$1 billion–$10 billion 632 10.8 10.4
$10 billion–$250 billion 109 1.9 31.6
More than $250 billion 9 0.2 50.6
Total 5,856 100.00 100.00

Source: FDIC Quarterly Banking Profile, https://www.fdic.gov/bank/analytical/qbp/index.html

 Table 2 Ten Largest U.S. Banks, 2017

Bank Assets ($ billions) Share of All Commercial Bank

Assets (%)
1. J.P. Morgan Chase & Co. 2,420 14.4
2. Bank of America Corp. 2,150 12.8
3. Citigroup Inc. 1,770 10.5
4. Wells Fargo & Co. 1,750 10.4
5. U.S. Bankcorp 416 2.5
6. Bank of New York Mellon Corp. 377 2.2
7. PNC Financial Services Group 362 2.2
8. Capital One Financial Corp. 314 1.9
9. HSBC North America Holdings 292 1.7
10. TD Bank U.S. Holding Co. 253 1.5
Total 10,103 60.1

Source: From Bankrate.com––Compare mortgage, refinance, insurance, CD rates:

http://www.bankrate .com/banking/americas-top-10-biggest-banks/#slide=1.
2017
NETWORK STRUCTURE OF BANKING
AND BRANCHING OUT IN THE USA
 Network structure of the U.S. Commercial
Banking Industry Branching
• McFadden Act (1927) and state branching
regulations prohibited branching across state lines
and forced all national banks to conform to the
branching regulations of the state in which they
were located.
• Bank holding companies (1956) 90% of total
banking assets
• Automated teller machines (ATMs, 1967) are
responses to these regulations

0-102
 Until the mid 1900’s, we were a nation of unit banks

Year Number of Banks Total Branches

1900 12,500 13,000
2000 7800 68,000

McFadden Act (1927)

National Banks State Banks Main Office

Prohibited from Unit Banking
interstate
Limited Branching
branching
Statewide Branching
Must comply
with state
branching rules
Branch Offices
 Branching Restrictions could be avoided by forming
holding companies

Main Office Holding Company

Branch Offices Subsidiaries

Illegal under the McFadden Act Legal under the McFadden Act
 A timeline of Banking Regulation
Banking Act
Restrictions on

McFadden Act
Competition

Holding Company Act

Monetary Control Act

Great Depression Riegle-Neal

1933 1956 1999

1863 1927 1980 1994

Graham - Leach - Bliley

Restrictions on

Holding Company Act

activities

Glass - Steagall
 The Bank Holding Company act allowed holding companies with only
one bank to provide limited non-bank financial services on an
interstate basis. This created a loophole around Glass-Steagall!!

Prior to Bank Holding Company Act After Bank Holding Company Act
(1956)

Holding Company Holding Company

Bank Bank Bank Non-Bank Non- Bank Financial

Branches Offices Services

Collects deposits, Makes loans, but

but doesn’t make doesn’t collect
loans deposits
 Branching Regulations
Branching Restrictions: McFadden Act (1927) and Douglas
Amendment (1956)
Very anticompetitive
Response to Branching Restrictions
1. Bank Holding Companies
A. Allowed purchases of banks outside state
B. BHCs allowed wider scope of activities by Fed
C. BHCs dominant form of corporate structure for banks
2. Automated Teller Machines (1967 Barclays)
Not considered to be branch of bank, so networks
allowed

10-107
 Bank Consolidation and Nationwide Banking
• The number of banks has declined dramatically over the
last 30 years.
– Bank failures and consolidation (S&L)
– Deregulation: Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994
– Economies of scale and scope from information
technology
• Results may be not only a smaller number of
banks but a shift in assets to much larger banks.
 Figure 3 Number of Commercial Banks in the United States,
1934–2019

Source: Federal Reserve Bank of St. Louis, FRED database:

https://fred.stlouisfed.org/series/USN .
UM
 What Will the Structure of the U.S. Banking
Industry Look Like in the Future?

• Although the United States retains a unique banking

structure in possessing a large number of banks, its
structure is converging with systems in Europe and Japan.
• How far the convergence between banking systems will
extend is the subject of ongoing academic debate
 ‚Clicks’ or ‚bricks’ in the Banking Industry?
• Early internet based banks wre not successful, and profitable
(First e (Dublin), Wingspan (Bank One)
1. Depositors trust in institutions with longer track record.
2. Customers worry about securities of their online
transactions
3. Customers may prefer service provided of physical
branches and to buy long term products face to face (40%
of US costumers)
4. Technical problems may occur in online transactions
5. COVID
• Coextistence of „clicks and bricks”
• Decline of physical branches in the future
• https://www.cbsnews.com/news/banking-100000-jobs-wells-fargo-analysts-
automation/
• https://www.pymnts.com/news/retail/2020/ebay-repurposes-la-gas-station-for-
 Are Bank Consolidation and Nationwide Banking
Good Things? (1 of 2)
• Benefits
– Increased competition, driving inefficient banks out of
business
– Also, increased efficiency from economies of scale and
scope
– Lower probability of bank failure from more diversified
portfolios
 Are Bank Consolidation and Nationwide Banking
Good Things? (2 of 2)
• Costs
– Elimination of community banks may lead to less
lending to small business
– Banks expanding into new areas may take increased
risks and fail
DE-REGULATION OF USA BANKING
SYSTEM IN THE 1990S
 Following the great depression, the activities of
commercial banks were severely restricted

The Glass-Steagall Act of 1934 was

designed to put a wall between
commercial banking and investment
banking

Examples of separation: J.P Morgan

(CB) vs Morgan Stanley (IB)
Glass-Steagall (1934)
Commercial Banks are restricted from
participating in equities markets
Interest rates on non- transaction deposits
is restricted to be below 5.25%
Regulation Q
No interest allowed on
transaction/checkable deposits
 Separation of the Banking and Other Financial
Service Industries (1 of 2)
• Erosion of Glass-Steagall Act (1933)
– Prohibited commercial banks from underwriting
corporate securities or engaging in brokerage
activities
– Section 20 loophole was allowed by the Federal
Reserve (1980s) enabling affiliates of approved
commercial banks to underwrite securities as
long as the revenue did not exceed a specified
amount (10 then later 25% of total revenue)
– U.S. Supreme Court validated the Fed’s action
in 1988
 Separation of Banking and Other Financial Service
Industries (1 of 2)
Gramm-Leach-Bliley Financial Modernisation Services Act
(1999)
1. Repeal of Glass-Steagall: allow banks to engage in
underwriting activities
2. States regulate insurance activities (Bank-surrance)
– Allows securities firms and insurance companies to
purchase banks
– Banks allowed to underwrite insurance and engage in real
estate activities
3. SEC keeps oversight of securities activities
4. OCC (Office of the Comptroller of the Currency)
regulates bank subsidiaries engaged in
securities underwriting
5. Fed oversee bank holding companies under which all real
estate, insurance and large securities are housed
Stimulated consolidation of the banking industry; Banking
institutions become larger and more complex
10-120
 Emergence of universal banking in the USA
• 1999-es Gramm-Leach-Bliley Financial Services Modernization
Act (repeal of Glass –Steagall, 1933):
– Provision of capital market services by US commercial
banks.
– Commercial banks can purchase or merge with brokerage
firms, insurance companies, pension funds, and hedge
funds in a single holding company (financial conglomerates)
• Integration of different financial market activities within an
institution and the strengthening of specialization.
• Continuous expansion
– of cross-sectoral (banksurance, structured securities)
– and cross-border (international) activities, which deepens
the global integration of the financial system.
 Table 1 Size Distribution of Insured Commercial
Banks, March 31, 2017

Table 1 Size Distribution of FDIC Insured Banks, March 31, 2017

Assets Number of Share of Share of Assets

Banks Banks (%) Held (%)
Less than $100 million 1,501 25.6 0.5
$100 million–$1 billion 3,605 61.6 6.9
$1 billion–$10 billion 632 10.8 10.4
$10 billion–$250 billion 109 1.9 31.6
More than $250 billion 9 0.2 50.6
Total 5,856 100.00 100.00

Source: FDIC Quarterly Banking Profile, https://www.fdic.gov/bank/analytical/qbp/index.html

 The Global Financial Crisis and the Demise of
Large, Free-Standing Investment Banks
• Although the move toward bringing financial service
activities into larger, more complex banking organizations
was inevitable after the demise of Glass-Steagall,
• no one expected it to occur as rapidly as it did in 2008.
Over a six-month period from March to September 2008,
all five of the largest, free-standing investment banks
ceased to exist in their old form.
 Separation of Banking and Other Financial
Services Industries Throughout the World

– Universal banking: No separation between banking and

securities industries in Germany, Holland and Switzerland
– Universal banking in Great Britain
• May engage in security underwriting
• Separate legal subsidiaries are common
• Bank equity holdings of commercial firms are less common
• Few combinations of banking and insurance firms
– Japanese style system:
• Some legal separation: Allowed to hold substantial
equity stakes in commercial firms but
• holding companies are illegal;
• Despite banking & securities are separated but
commercial banks increasingly active in securitization
SAVINGS AND LOAN INDUSTRY
 Thrift Industry: Regulation and Structure (1 of 3)

• Savings and loan associations

– Chartered by the federal government or by states
– Most are members of Federal Home Loan Bank
System (FHLBS)
– Deposit insurance provided by Savings Association
Insurance Fund (SAIF), part of FDIC
– Regulated by the Office of Thrift Supervision
 Thrift Industry: Regulation and Structure (2 of 3)

• Mutual savings banks

– Approximately half are chartered by states
– Regulated by state in which they are located
– Deposit insurance provided by FDIC or state insurance
 Thrift Industry: Regulation and Structure (3 of 3)

• Credit unions
– Tax-exempt
– Chartered by federal government or by states
– Regulated by the National Credit Union Administration
(NCUA)
– Deposit insurance provided by National Credit Union
Share Insurance Fund (NCUSIF)
INTERNATIONAL BANKING STRUCTURE
 Financial Intermediation and Banks (cont'd)
• International Financial Intermediation/
International banking
– Financing investment projects in more than
one country; Cross border operation
• Capital Controls
– Legal restrictions on the ability of a nation’s
residents to hold and trade assets denominated
in foreign currencies
• Liberalization & Derugalarisation
• Internal derelularisation(interest rate)
• External derelularisation (exchange rate)
15
 International Banking
• Rapid growth
– Growth in international trade and multinational
corporations
– Global investment banking is very profitable
– Ability to tap into the Eurodollar market

10-131
 Eurodollar Market
• Eurodollars (foreign currencies deposited outside the
home country)
• US Dollar-denominated deposits held in banks outside of
the United States
– Ironic birth in Communist period (1950 MKB, 1979 CIB,)
• USD is the most widely used currency in international
trade
• Offshore deposits not subject to regulations
– Important source of funds for U.S. banks
• Eurobonds (issued in a currency other than that of the country’s
currency in which it is sold e.g. USD denominated bonds sold in
London)
• Foreign bonds (sold in foreign country denominated in the
currency of that foreign country)
 Offshore banking (shell operation)
• An offshore bank is a bank regulated under international banking
license (often called offshore license), which usually prohibits the
bank from establishing any business activities in the jurisdiction
of establishment.
• Due to less regulation, minimal or zero taxation and transparency,
accounts with offshore banks were often used to hide undeclared
income.
• Since the 1980s, jurisdictions that provide financial services to
nonresidents on a big scale, can be referred to as Offshore Financial
Centres.
• OFCs often also levy little or no corporation tax and/or personal
income and high direct taxes such as duty, making the cost of living
high.
 Rise of offshore centres

Off-shore market clusters

134
Flying money: Outflows to the Offsore centres,
1990-2010

The 20 largest supplier countries, Bn USD: Total Offshore wealth:22 Trillion

USD, 2010

135
 Structure of U.S. Banking Overseas ( ½)
• Shell operation (offshore booking office/terminal)
• Edge Act corporation (1919. amendment of 1913
FED Act) allows national banks to open
subsidiaries abroad) first Citibank branch in
Buenos Aires, 1914
• International banking facilities (IBFs) from 1981
(NYC)
– Not subject to regulation and taxes
– Offshore status
– May not make loans to domestic residents

10-136
 US Banks locate facilities abroad to aid in international
trade as well as to avoid regulation and taxes

US Banks Operating Abroad

Subsidiaries: Governed by Federal Reserve Regulation K – must be

involved in business “closely related to banking.

International Banking Facilities: Accepts time deposits and

makes loans to foreign households & firms. Exempt from
reserve requirements, but may not do business in the US.

Edge Act Corporations: Makes loans/accepts deposits. Can deal

with both US and foreign citizens , but is limited to international
trade transactions

Branches: Offer a full line of banking services,

but are subject to foreign laws
 Foreign Banks in the United States (1 of 2)

• Agency office of the foreign bank

– Can lend and transfer fund in the United States
– Cannot accept deposits from domestic residents
– Not subject to regulations
• Subsidiary U.S. bank
– Subject to U.S. regulations
– Owned by a foreign bank
 Foreign Banks in the United States (2 of 2)

• Branch of a foreign bank

– May open branches only in state designated as home
state or in state that allow entry of out-of-state banks
– Limited service may be allowed in any other state
• Subject to the International Banking Act of 1978
• Basel Accord (1988)
– Example of international coordination of
bank regulation
– Sets minimum capital requirements for banks
 Likewise for Foreign Banks…

Foreign Banks Operating in the US

Agency Office: Can’t accept deposits from US citizens, but can

transfer funds from abroad and make loans in the US

Branches: Offers a full range of banking services

for US citizens

Subsidiaries: Treated as a US bank. Subject to all US regulations.

Subsidiaries may also set up edge act corporations and
international lending facilities
 Important Dates in International Banking

Bank for International (BIS) Settlements

Created

International Banking Act Basle Accords I

Foreign Bank Supervision Act

BCCI Scandal

1930 1978 1988 1991

The Bank of Credit and Commerce International (BCCI)
was an international bank founded in 1972 by Agha Abedi
Bankruptcy in 1998.
 United Kingdom
United States

Federal Reserve Bank of England

Under whose jurisdiction do international

banks fall? (it’s a grey area )
Regulating International Banking

International Banking Act (1978)

Brought foreign banks operating in the US
under federal regulation for the first time
Foreign banks, however, were not monitored
as closely as US banks

Foreign Bank Supervision Act (1991)

Passed shortly after the BCCI scandal
Gave the Federal Reserve and the Comptroller
of the Currency greater control over foreign
banks operating in the US