Week 8 Financial Industry Structure PDF

Week 8 Financial industry structure BANK2011 Banking and the Financial System The University of Sydney Page 1  Learning Objectives 1. Explain the structure, current trends, and future prospects of the banking industry. 2. Discuss the functions and ch...

Week 8 Financial industry structure BANK2011 Banking and the Financial System The University of Sydney Page 1  Learning Objectives 1. Explain the structure, current trends, and future prospects of the banking industry. 2. Discuss the functions and characteristics of non-depository institutions. The University of Sydney Page 2  Number of Insured Commercial Banks in the United States, 1935-2017 The University of Sydney Page 3  Competition and Consolidation – There are roughly 4,700 commercial banks in the U.S. today, and that number has been shrinking. – The number of banks with branches has changed significantly as well. – For many years, most U.S. banks were unit banks, or banks without branches. – Today’s banks not only have branches, they have many of them. – The U.S. banking system is composed of a large number of very small banks and a small number of very large ones. The University of Sydney Page 4  Competition and Consolidation The University of Sydney Page 5  Competition and Consolidation – The primary reason for this structure is the McFadden Act of 1927. – This legislation required that nationally chartered banks meet the branching restrictions of the states in which they were located. – Some states have laws forbidding branch banking, resulting in a large number of small banks. – There was fear that large banks would drive small banks out of business, reducing the quality in smaller communities. The University of Sydney Page 6  Competition and Consolidation – The result was a fragmented banking system nearly devoid of large institutions. – The U.S. ended up with a network of small, geographically dispersed banks that faced little competition - the opposite of what the act wanted. – In many states, more efficient and modern banks were legally precluded from opening branches to compete with local banks. The University of Sydney Page 7  Competition and Consolidation – Some banks reacted to branching restrictions by creating bank holding companies. – These are corporations that own a group of other firms. – Can be thought of as a parent firm for a group of subsidiaries. – Initially these were created as a way to provide nonbank financial services in more than one state. The University of Sydney Page 8  Competition and Consolidation – In 1956, Congress passed the Bank Holding Company Act. – This allowed bank holding companies to provide various nonbank financial services. – Technology has eroded the value of the local banking monopoly. – In the 1970s and 1980s, states responded by loosening their branching restrictions. The University of Sydney Page 9  Competition and Consolidation – In 1994, Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act. – This legislation reversed restrictions from the McFadden Act. – Since 1997, banks have been able to acquire an unlimited number of branches nationwide. – The number of commercial banks has fallen by about one-half. – The number of savings institutions has fallen even more. The University of Sydney Page 10  Competition and Consolidation – Deregulation provided benefits for the economy. – Banks became more profitable. – Operation costs and loan losses fell. – Interest rates paid to depositors rose. – Interest rates charged to borrowers fell. – The financial crisis of 2007-2009 has focused attention on the costs of deregulation. – Do the benefits of deregulation outweigh the risks? The University of Sydney Page 11  Banking Industry Structure: Key Legislation The University of Sydney Page 12  The Future of Banks – In November of 1999, the Gramm-Leach-Bliley Financial Services Modernization Act went into effect. – This effectively repealed the Glass-Steagall Act of 1933. – It allowed a commercial bank, investment bank, and insurance company to merge and form a financial holding company. – To serve all their customers’ financial needs, bank holding companies are converting to financial holding companies. The University of Sydney Page 13  The Future of Banks – Financial holding companies are a limited form of universal banks. – These are firms that engage in nonfinancial as well as financial activities. – In the U.S., different financial activities must be undertaken in separate subsidiaries and financial holding companies are still prohibited from making equity investments in nonfinancial companies. The University of Sydney Page 14  The Future of Banks – Owners and managers of these financial firms cite three reasons to create them: – Their range of activities, if properly managed, permits them to be well diversified. – These firms are large enough to take advantage of economies of scale. – These companies hope to benefit from economies of scope. The University of Sydney Page 15  The Future of Banks – Thanks to recent technological advances, almost every service traditionally provided by financial intermediaries can now be produced independently, without the help of a large organisation. – As we survey the financial industry, we see the two trends running in opposite directions. The University of Sydney Page 16  Non-depository Institutions – There are five major categories of non-depository institutions: – Insurance companies – Pension funds – Securities firms, including brokers, mutual-fund companies, and investment banks – Finance companies – Government-sponsored enterprises – Non-depository institutions also include an assortment of alternative intermediaries The University of Sydney Page 17 The University of Sydney Page 18  Insurance Companies – Modern forms of insurance can be traced back to around 1400, when wool merchants insured their overland shipments from London to Italy for 12 to 15 percent of their value. – The first insurance codes were developed in Florence in 1523, specifying the standard provisions for a general insurance policy. – They also stipulated procedures for handling fraudulent claims in an attempt to reduce the moral hazard problem. The University of Sydney Page 19  Insurance Companies – In 1688, Lloyd’s of London was established and began to insure ships on trade routes. – To obtain insurance, a ship’s owner would: – Write the details of the proposed voyage – Add the amount he was willing to pay for the service – Circulate the paper among the patrons at Lloyd’s coffeehouse – Interested individuals would decide how much to risk and sign their names - the underwriters. Underwriting implied unlimited liability. The University of Sydney Page 20  Two Types of Insurance – In terms of the financial system as a whole, insurance companies specialise in three of the five functions performed by intermediaries. – They pool small premiums and make large investment with them – They diversify risks across a large population – They screen and monitor policyholders to mitigate the problem of asymmetric information The University of Sydney Page 21  Two Types of Insurance – Insurance companies offer two types of insurance: – Life insurance – Property and casualty insurance The University of Sydney Page 22  Two Types of Insurance – Life insurance comes in two basic forms. – Term life insurance provides a payment to the policy holder’s beneficiaries in the event of the insured’s death at any time during the policy’s term. Generally renewable every year as long as the policyholder is less than 65 years old. – Whole life insurance is a combination of term life insurance and a savings account. The policyholder pays a fixed premium over his/her lifetime in return for a fixed benefit when the policyholder dies. Tends to be an expensive way to save so its use as a savings vehicle has declined The University of Sydney Page 23  Two Types of Insurance – Car insurance is an example of property and casualty insurance. – It is a combination of Property insurance on the car itself Casualty insurance on the driver, who is protected against liability for harm or injury to other people or their property – Holders of property and casualty insurance pay premiums in exchange for protection during the term of the policy. The University of Sydney Page 24  Two Types of Insurance – On the balance sheets of insurance companies, these promises to policyholders show up as liabilities. – On the asset side, insurance companies hold a combination of stocks and bonds. – Property and casualty companies profit from the fees they charge for administering the policies they write. – Because assets are essentially reserves against sudden claims, they have to be liquid. – Life insurance companies hold assets of longer maturity than property and casualty insurers. The University of Sydney Page 25  The Role of Insurance Companies – Like life insurers, property and casualty insurers pool risks to generate predictable payouts. – They reduce risk by spreading it across many policies. – Although there is no way to know exactly which policies will require payment, the insurance company can accurately estimate the percentage of policyholders who will file claims. The University of Sydney Page 26  The Role of Insurance Companies – Adverse selection and moral hazard create significant problems in the insurance market. – A person with terminal cancer has an incentive to buy life insurance for the largest amount possible - that’s adverse selection. – Without fire insurance, people would have more fire extinguishers in their houses - that’s moral hazard. The University of Sydney Page 27  The Role of Insurance Companies – Insurance companies work hard to reduce both adverse selection and moral hazard. – A person wanting life insurance needs a physical exam. – People who want car insurance must provide their driving records. – Policies also include restrictive covenants that require the insured to engage or not to engage in certain activities. The University of Sydney Page 28  The Role of Insurance Companies – Insurance companies might also require deductibles. – These require the insured to pay the initial cost of repairing accidental damage, up to some maximum amount. – Or they may require coinsurance. – This is where the insurance company shoulders a percentage of the claim, usually 80 or 90 percent and the insured assumes the rest. The University of Sydney Page 29  Pension Funds – A pension fund offers people the ability to make premium payments today in exchange for promised payments under certain future circumstances. – Provides a way to make sure that a worker saves and has sufficient resources in retirement. – They help savers to diversify their risk. – By pooling the savings of many small investors, pension funds spread the risk. The University of Sydney Page 30  Pension Funds – People can use a variety of methods to save for retirement, including employer sponsored plans and individual savings plans. – There are two basic types: – Defined-benefit (DB) pension plans – Defined-contribution (DC) pension plans – Many employer-sponsored plans require a person work for a certain number of years before qualifying for benefits, a process called vesting. The University of Sydney Page 31  Pension Funds – Defined-benefit plans – Participants receive a life-time retirement income based on the number of years they worked at the company and their final salary. – Defined-contribution plans – These are replacing defined-benefit plans. – Sometimes referred to as “401(k)” after their IRS code. – The employer takes no responsibility for the size of the employee’s retirement income. The University of Sydney Page 32  Pension Funds – The balance sheets of pension funds look like those of life insurance companies. – Both hold long-term assets like corporate bonds and stocks. – The only difference is that life insurance companies hold only half the equities that pension funds do. The University of Sydney Page 33  Pension Funds – The U.S. government provides insurance for private, defined-benefit pension systems. – If a company goes bankrupt, the Pension Benefit Guaranty Corporation (PBGC) will take over the fund’s liabilities. – Increases the incentive for a firm’s managers to engage in risky behaviour. – Regulators monitor pension funds regularly. The University of Sydney Page 34  Securities Firms: Brokers, Mutual Funds, and Investment Banks – The primary services of brokerage firms are: – Accounting (to keep track of customers’ investment balances) – Custody services (to make sure valuable records such as stock certificates are safe) – Access to secondary markets (in which customers can buy and sell financial instruments) – Brokers also provide loans to customers who wish to purchase stock on margin. – They provide liquidity, both by offering cheque-writing privileges with their investment accounts and by allowing investors to sell assets quickly. The University of Sydney Page 35  Securities Firms: Brokers, Mutual Funds, and Investment Banks – Mutual-fund companies offer liquidity services as well. – The primary function of mutual funds, is to pool the small savings of individuals in diversified portfolios that are composed of a wide variety of financial instruments. The University of Sydney Page 36  Securities Firms: Brokers, Mutual Funds, and Investment Banks – Investment banks are the conduits through which firms raise funds in the capital markets. – Through their underwriting services, these investment banks issue new stocks and a variety of other debt instruments. – The underwriter guarantees the price of a new issue and then sells it to investors at a higher price. – This is a practice called placing the issue. The University of Sydney Page 37  Securities Firms: Brokers, Mutual Funds, and Investment Banks – The underwriter profits from the difference between the price guaranteed to the firm that issues the security and the price at which the bond or stock is sold to investors. – Since the price at which the investment bank sells the bonds or stocks in financial markets can turn out to be lower than the price guaranteed by the issuing company, there is some risk to underwriting. – For large issues, investors will band together and spread the risk among themselves rather than one taking the risk alone. The University of Sydney Page 38  Securities Firms: Brokers, Mutual Funds, and Investment Banks – Investment banks also provide advice to firms that want to merge with or acquire other firms. – Investment bankers do the research to identify potential mergers and acquisitions and estimate the value of the new, combined company. – In facilitating these combinations, investment banks perform a service to the economy. – Mergers and acquisitions help to ensure that the people who manage firms do the best job possible. The University of Sydney Page 39  Homework problems – CS chapter 13 – Problems 3, 6, 7, 9, 15, 17, 19, 20 The University of Sydney Page 40