Financial Markets and Institutions (2-downloads)

Commercial Banks

Thrifts

0

10

20

30

40

2000

1995

2010

2005

1990

1985

1980

1975

1970

1965

1960

F I G U R E   1 9 . 2

Bank Share of Total Nonfinancial Borrowing, 1960–2010

Source: Federal Reserve Flow of Funds Accounts; Federal Reserve Bulletin.

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Chapter 19 Banking Industry: Structure and Competition

471

of funds, checkable deposits, declined dramatically in importance for banks, falling

from more than 60% of bank liabilities to less than 5% today.

The growing difficulty for banks in raising funds led to their supporting legisla-

tion in the 1980s that eliminated Regulation Q ceilings on time deposit interest rates

and allowed checkable deposit accounts that paid interest. Although these changes

in regulation helped make banks more competitive in their quest for funds, it also

meant that their cost of acquiring funds had risen substantially, thereby reducing their

earlier cost advantage over other financial institutions.

Decline in Income Advantages on Uses of Funds (Assets)

The loss of cost advan-

tages on the liabilities side of the balance sheet for American banks is one reason that

they have become less competitive, but they have also been hit by a decline in income

advantages on the assets side from the financial innovations we discussed earlier—

junk bonds, securitization, and the rise of the commercial paper market. The result-

ing loss of income advantages for banks relative to these innovations has resulted

in a loss of market share and has led to the growth of the shadow banking system,

which has made use of these innovations to enable borrowers to bypass the tradi-

tional banking system.

We have seen that improvements in information technology have made it eas-

ier for firms to issue securities directly to the public. This has meant that instead

of going to banks to finance short-term credit needs, many of the banks’ best busi-

ness customers now find it cheaper to go instead to the commercial paper market for

funds. In addition, the commercial paper market has allowed finance companies,

which depend primarily on commercial paper to acquire funds, to expand their oper-

ations at the expense of banks. Finance companies, which lend to many of the same

businesses that borrow from banks, have maintained their market share relative to

banks (about 30% of commercial and industrial bank loans). The emergence of the

junk bond market has also eaten into banks’ loan business. Improvements in informa-

tion technology have made it easier for corporations to sell their bonds to the pub-

lic directly, thereby bypassing banks. Although Fortune 500 companies started taking

this route in the 1970s, now lower-quality corporate borrowers are using banks less

often because they have access to the junk bond market.

We have also seen that improvements in computer technology have led to secu-

ritization, whereby illiquid financial assets such as bank loans and mortgages are

transformed into marketable securities. Computers enable other financial institutions

to originate loans because they can now accurately evaluate credit risk with statis-

tical methods, while computers have lowered transaction costs, making it possible

to bundle these loans and sell them as securities. When default risk can be easily eval-

uated with computers, banks no longer have an advantage in making loans. Without

their former advantages, banks have lost loan business to other financial institu-

tions even though the banks themselves are involved in the process of securitiza-

tion. Securitization has been a particular problem for mortgage-issuing institutions

such as S&Ls, because most residential mortgages are now securitized.

Banks’ Responses

In any industry, a decline in profitability usually results in exit

from the industry (often due to widespread bankruptcies) and a shrinkage of mar-

ket share. This occurred in the banking industry in the United States during the 1980s

via consolidations and bank failures (discussed in the previous chapter).

In an attempt to survive and maintain adequate profit levels, many U.S. banks

face two alternatives. First, they can attempt to maintain their traditional lending

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Part 6 The Financial Institutions Industry

activity by expanding into new and riskier areas of lending. For example, U.S. banks

increased their risk taking by placing a greater percentage of their total funds in com-

mercial real estate loans, traditionally a riskier type of loan. In addition, they increased

lending for corporate takeovers and leveraged buyouts, which are highly leveraged

transaction loans. The decline in the profitability of banks’ traditional business may

thus have helped lead to the crisis in banking in the 1980s and early 1990s that we

discussed in the last chapter, as well as the global financial crisis that started in

2007 discussed in Chapter 8.

The second way banks have sought to maintain former profit levels is to pur-

sue new off-balance-sheet activities that are more profitable and in effect embrace

the shadow banking system. U.S. commercial banks did this starting in the early

1980s, more than doubling the share of their income coming from off-balance-sheet,

non-interest-income activities. This strategy, however, has generated concerns about

what activities are proper for banks and whether nontraditional activities might be

riskier and, therefore, result in excessive risk taking by banks.

The decline of banks’ traditional business has thus meant that the banking indus-

try has been driven to seek out new lines of business. This could be beneficial because

by so doing, banks can keep vibrant and healthy. Indeed, bank profitability was high

up until 2007, and nontraditional, off-balance-sheet activities played an important

role in high bank profits. However, the new directions in banking have led to increased

risk taking, and thus the decline in traditional banking has required regulators to be

more vigilant. It also poses new challenges for bank regulators, who, as we saw in

Chapter 18, must now be far more concerned about banks’ off-balance-sheet activities.

Decline of Traditional Banking in Other Industrialized Countries

Forces similar

to those in the United States have been leading to the decline of traditional bank-

ing in other industrialized countries. The loss of banks’ monopoly power over depos-

itors has occurred outside the United States as well. Financial innovation and

deregulation are occurring worldwide and have created attractive alternatives for

both depositors and borrowers. In Japan, for example, deregulation opened a wide

array of new financial instruments to the public, causing a disintermediation process

similar to that in the United States. In European countries, innovations have steadily

eroded the barriers that have traditionally protected banks from competition.

In other countries, banks also faced increased competition from the expansion

of securities markets and the growth of the shadow banking system. Both financial

deregulation and fundamental economic forces in other countries have improved the

availability of information in securities markets, making it easier and less costly for

firms to finance their activities by issuing securities rather than going to banks.

Further, even in countries where securities markets have not grown, banks have

still lost loan business because their best corporate customers have had increasing

access to foreign and offshore capital markets, such as the Eurobond market. In

smaller economies, like Australia, which still do not have as well-developed corpo-

rate bond or commercial paper markets, banks have lost loan business to interna-

tional securities markets. In addition, the same forces that drove the securitization

process in the United States have been at work in other countries and have under-

cut the profitability of traditional banking in these countries as well. The United States

has not been unique in seeing its banks face a more difficult competitive environment.

Thus, although the decline of traditional banking occurred earlier in the United States

than in other countries, the same forces have caused a decline in traditional bank-

ing abroad.

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Chapter 19 Banking Industry: Structure and Competition

473

Structure of the U.S. Commercial Banking Industry

There are currently approximately 7,000 commercial banks in the United States,

far more than in any other country in the world. As Table 19.2 indicates, we have

an extraordinary number of small banks. A remarkable 36.9% of the banks have less

than $100 million in assets. Far more typical is the size distribution in Canada or

the United Kingdom, where five or fewer banks dominate the industry. In contrast,

the 10 largest commercial banks in the United States (listed in Table 19.3) together

hold just 37% of the assets in their industry.

Most industries in the United States have far fewer firms than the commercial

banking industry; typically, large firms tend to dominate these industries to a greater

extent than in the commercial banking industry. (Consider the computer software

industry, which is dominated by Microsoft, or the automobile industry, which is dom-

inated by General Motors, Ford, Toyota, and Honda.) Does the large number of banks

in the commercial banking industry and the absence of a few dominant firms sug-

gest that commercial banking is more competitive than other industries?

TA B L E   1 9 . 2

Size Distribution of Insured Commercial Banks, March 31, 2010