Banking in the U. Banking in the U. S.S.

ECO 473Dr. D. Foster

I. Asymmetric I. Asymmetric InformationInformation

II. StructureII. Structure

I. Problems I. Problems of of

Asymmetric Asymmetric InformationInformation

Direct & Indirect FinanceDirect & Indirect Finance

Most external financing is done through intermediaries.

Banks Reduce Transaction CostsBanks Reduce Transaction Costs

• Banks reduce the cost of acquiring assets.

• Many costs are fixed.

• Bank assets are highly liquid.

• Economies of scale.e.g., using standard loan contracts as legal fees are

averaged over many loans

• Transactions costs are very low for lines of credit.

Adverse SelectionAdverse Selection

• Those most eager to make a deal are the least desirable to the other party.Bad risks want loans.Firms with lots of risk want to sell bonds.

• Risk drives up interest rate & drives out low risk borrowers, if this problem persists.

Moral HazardMoral Hazard

• Post-contractual change in behavior that puts other party at increased risk.Will borrower really be prudent and repay?Will company really be prudent and max. profits?Does insurance reduce vigilance?

• Markets cannot form if this persists.

Principal-Agent ProblemsPrincipal-Agent Problems

• The action of the agent is contrary to the desires of the principal.Workers shirk at their jobs.Managers are also agents - they work for owners-

shareholders.Can bond-holders and stock-holders really monitor

the firm?

• Problems: Enron, Arthur Anderson

How do Banks Deal with Asymmetries?How do Banks Deal with Asymmetries?

• Screen borrowers.Avoids free rider problems with information.

• Requirements for collateral and net worth.Shifts risk to the borrower; avoids adverse selection.Also, mitigates moral hazard.

• Imposing covenants and monitoring.Reduces moral hazard.

• Variable interest rates and credit rationing.Some tolerance for risk.

Should the government get involved with asymmetries?

Investment Banks & AsymmetriesInvestment Banks & Asymmetries

• They provide research on firms.• They underwrite new securities.

• Advantages:They work to show firms are not lemons.Long-run reputation at stake.

• Disadvantages:Are they serving the firm or the client?

II. Banking II. Banking Structure in the Structure in the United StatesUnited States

Institutions . . .Institutions . . .

• Commercial Banks “Money Center” banks

Regional (& Super-) banks

Community Banks

• Savings Institutions Lost 50% of deposits 1989 - 2001

1980s - Congress relaxes lending rules

• Credit Unions 1934-strict member rules; relaxed since.

no fed’l tax - deposit rates & loan rates

Commercial Bank Commercial Bank Assets Assets

($ Billions), January ($ Billions), January 20092009

Commercial & industrial loans 1,601.1 13.6%Consumer loans 869.8 7.4%Real estate loans 3,805.0 32.2%Interbank loans 389.8 3.3%Other loans 915.6 7.7%Total loans 7,581.3 64.1%

U.S. government securities 1,273.0 10.8%Other securities 872.7 7.4%Total securities 2,145.7 18.2%

Cash assets 967.3 8.2%

Other assets 1,123.6 9.5%Total assets 11,817.9 100.0%

JuneJune20132013

1,546.8 11.4%1,136.5 8.4%3,542.2 26.1%

123.5 0.9%941.6 6.9%

7,302.8 53.9%

1,838.9 13.6%891.1 6.6%

2,730.0* 20.1%

2,144.4 15.8%

1,383.8 10.2%13,548.8 100.0%

* $1,357.4 bill. is in * $1,357.4 bill. is in mortgaged-backed mortgaged-backed

securities (MBS)securities (MBS)

Commercial Bank LiabilitiesCommercial Bank Liabilitiesand Equity Capital and Equity Capital

($ Billions), January 2010($ Billions), January 2010

Transactions deposits 810.3 Small time and savings deposits 4,974.3 Large time deposits 1,865.8 Total deposits 7,650.4

Borrowings from banks $ 261.1 Other borrowings 1,636.6 Total borrowings 1,887.7

Trading liabilities 261.2 Other liabilities 399.1

Equity capital 1,273.4 Total liabilities & equity 11,451.8

7.1%43.4%16.2%66.8%

2.2%14.3%16.5%

2.2%3.5%

11.1%100.0%

JuneJune20132013

--- ---7,882.1 58.2%1,546.3 11.4%9,428.4 69.6%

142.2 1.0%1,385.1 10.2%1,527.2* 11.3%

237.3 1.7%448.4 3.3%

1,511.8 11.2%13,548.8 100.0%

Commercial Bank Asset AllocationsCommercial Bank Asset Allocations

Commercial Bank LiabilitiesCommercial Bank Liabilitiesand Equity Capitaland Equity Capital

Misc. Data on Banks & Savings Institutions Misc. Data on Banks & Savings Institutions (FDIC)(FDIC)

Misc. Data on Credit Unions (FDIC)Misc. Data on Credit Unions (FDIC)

The Top Ten Banks* Based on The Top Ten Banks* Based on DepositsDeposits

in the United States (FRS)in the United States (FRS)

*Bank Holding CompaniesAs of March 31, 2014

Assets in thousands of dollars.

Sources of Commercial Bank RevenuesSources of Commercial Bank Revenues

Commercial Bank Expenses

Equity as a Percentage of Bank Equity as a Percentage of Bank Assets in the United States, Assets in the United States,

1840–Present1840–Present

Evolution of theories of bank Evolution of theories of bank management & risk.management & risk.

• Real bills doctrineReal bills doctrine

• Shiftability theoryShiftability theory

• Anticipated incomeAnticipated income

• Conversion of fundsConversion of funds

• Gap managementGap management

• Duration gap managementDuration gap management

• Real bills doctrine – Real bills doctrine – managing liquidity riskmanaging liquidity risk

• Shiftability theory

• Anticipated income

• Conversion of funds

• Gap management

• Duration gap management

Make low-risk loans with high liquidity…Make low-risk loans with high liquidity… Lend to finance shipment of goods:Lend to finance shipment of goods:

-- paid off quickly to known buyer.-- earns low return.

Lend for production…Lend for production…-- “self-liquidating” loans; repaid as sold.-- relatively low risk.

• Real bills doctrine

• Shiftability theoryShiftability theory – – managing credit riskmanaging credit risk

• Anticipated income

• Conversion of funds

• Gap management

• Duration gap management

Return with longer-term loans…Return with longer-term loans…-- adds to the default risk.-- offset with purchases of gov’t. securities.

- “Secondary reserves” add liquidity.

Popular until the Crash of 1929:Popular until the Crash of 1929:-- falling prices means converting to cash involves a capital loss.-- exacerbated circumstances, as loans were going into default as well.

• Real bills doctrine

• Shiftability theory

• Anticipated income -Anticipated income - managing interest rate riskmanaging interest rate risk

• Conversion of funds

• Gap management

• Duration gap management

Initiation of the “installment loan”…Initiation of the “installment loan”…-- mitigates default risk through ongoing payments.-- gives the bank a highly predictable stream of income.-- has features that make it a “super-liquidating” loan.

• Real bills doctrine

• Shiftability theory

• Anticipated income

• Conversion of fundsConversion of funds - - managing interest rate managing interest rate riskrisk

• Gap management

• Duration gap management

Match asset & liability maturities…Match asset & liability maturities…-- long-term loans with CDs.-- short-term loans with deposits.

Events that change interest rates will Events that change interest rates will be neutralized.be neutralized.

• Real bills doctrine

• Shiftability theory

• Anticipated income

• Conversion of funds

• Gap Management – Gap Management – managing profitmanaging profit

Duration gap managementDuration gap management

Relate assets & liabilities by interest…Relate assets & liabilities by interest…-- manage the “gap” to bank’s advantage.-- if re is rising, then make gap positive.-- if re is falling, then make gap negative.

Measure ave. time for payments (in or out)…Measure ave. time for payments (in or out)…-- if positive and interest rates fall, bank profits rise.-- if negative and interest rates rise, profits rise.

Does Bank Size Matter?Does Bank Size Matter?

• Economies of scale-- Efficient structure theory.-- Cost savings seem minor; mgt. savings.

• Concentration will . . .

-- raise costs?

-- lower costs?

• Consolidation stats (1990 vs. 2007): Community bank % of total bank assets: 22% v. 11% Top 10 bank % of total bank assets: 17% v. 40%

Universal BankingUniversal Banking

• Banks own firms-- Better informed about financial condition.-- Conflict of interest?

• Firms own banks-- Does the FED regulate the firm as well?

• Banks do . . . Whatever (economies of scope):-- Insurance.-- Real estate.-- Stock brokers.

Banking in the U. Banking in the U. S.S.

ECO 473Dr. D. Foster

I. Asymmetric I. Asymmetric InformationInformation

II. StructureII. Structure

Case: Bank Branching in IllinoisCase: Bank Branching in Illinois

• Very restrictive branching laws.Very restrictive branching laws.

““Unit banking” only, as per 1870 state Unit banking” only, as per 1870 state constitution.constitution.

1967 - banks could build a “drive up” 1967 - banks could build a “drive up” facility within 1500 feet of the unit bank.facility within 1500 feet of the unit bank.

1985 - banks could have 5 offices; 2 could 1985 - banks could have 5 offices; 2 could be in other counties if within 10 miles.be in other counties if within 10 miles.

1993 – prohibitions on branching removed.1993 – prohibitions on branching removed.

• June, 2006 – 4,349 branch banking offices.June, 2006 – 4,349 branch banking offices.

•Why deregulate?Why deregulate?-- Tech. change.-- Tech. change.-- Failing banks.-- Failing banks.-- Profit potential.-- Profit potential.-- Legal environment.-- Legal environment.

Illinois U.S.1967 0.99 1.861994 2.22006 3.39 3.21

Offices per 10K

Banks per 10,000 Assets (m) per 10,000 Assets (m)1994 994 0.84 $296 0.6 $6712006 650 0.54 $545 0.43 $1,858

Nationwide (ex. Ill.)Illinois

Case: Bank Branching in IllinoisCase: Bank Branching in Illinois