1. Financial Intermediation

1. 1. Financial Intermediation • Financial institutions (including banks, credit unions, insurance companies, mutual funds, and other financial intermediaries) channel funds from those surplus funds to those with shortages • As of the end of 2000, U.S. financial institutions held over $14.75 trillion in assets • In contrast, the U.S. motor vehicle and parts industry held total assets of $0.71 trillion • The commercial banking industry alone has over $6 trillion in financial assets (compared with $4 trillion in the insurance industry) and 2.1 million employees (more than the motor vehicle, steel, and petroleum industries combined) • Our discussion will focus primarily on banks, but many of the issues apply for other FI’s as well

2. The Role of Financial Institutions • Most household savers view direct investment in corporate securities unattractive relative to holding cash • There are several costs associated with direct investment: • Monitoring costs: the cost of monitoring the managers of the firm • Liquidity costs: securities may not be easily turned into cash • Price risk: the price of the asset may fluctuate • FI’s economize on these costs by pooling funds and transforming assets • FI’s can diversify, achieve scale economies, issue financial claims that are more attractive to households than the claims issued directly by firms, and act as a delegated monitor of the firms’ activities

3. Risks of Financial Institutions FI’s are generally exposed to several risks, and risk management is an important research area: • Credit risk: they hold some assets that are potentially subject to default • Interest rate risk: they tend to mismatch the maturities of their balance sheet assets and liabilities • Liquidity risk: a sudden surge of liability withdrawls might require an FI to liquidate assets at low prices • Technology risk: technological investments may not produce the cost savings anticipated (all firms bear this risk) • Operating cost risk: internal processes, people, and systems may fail or be inadequate (all firms bear this risk)

4. Regulations • FI’s receive special regulatory attention because of their risks and their special role in society • There are substantial negative externalities associated with the failure or inappropriate behavior of FI’s • For example, bank failure may destroy household savings and restrict firms’ access to credit; the possibility of bank failure may discourage deposits and investments • Designing appropriate regulations and exploring the impacts of regulations on firm behavior is an important research area

5. Industry Dynamics Several forces have contributed to industry evolution: • Regulatory changes have been an important source of external or environmental change that have contributed to merger activity – the regulations have favored some types of firms over others • External technological changes (mainly IT) • Globalization

6. Trends in the U.S. • Consider the most substantial changes in the shares of total assets in the U.S. financial services industry since WWII • From 1948 to 2000, the share of commercial banks declined from 56% to 36%, the share of thrifts (savings banks, savings associations, and credit unions) rose from 12% in 1948 to 20% from 1960-1980, but fell to 10% by 2000, the share of insurance companies fell from 24% to 17% • From 1948 to 2000, the share of investment companies (mutual funds) rose from 1% to 17%, the share of pension funds rose from 3% to 11%, and the share of finance companies (who handle auto loans and other consumer loans, etc.) rose from 2% to 8% • Savers increasingly prefer diversified investments in securities rather than the traditional financial claims offered by banks and borrowers increasingly prefer borrowing from finance companies

7. Regulatory Responses • Recent regulatory changes in the U.S. are allowing FI’s to move across traditional product boundaries • This should level the playing field • For example, banks have been acquiring mutual funds and expanding their pension fund management businesses and security underwriting activities • Banking organizations such as bank holding companies are getting bigger via mergers • Nevertheless, due to technological advances the costs of direct access to financial markets by savers are also falling (Internet stock trading, for example)

8. Globalization • U.S. FI’s must now compete increasingly with foreign FI’s • As of 2000, only three of the top 10 banks worldwide as measured by total assets are U.S. banks: Citigroup, J.P. Morgan Chase, and Bank of America • The others come from several countries: Japan, Germany, France, U.K., and Switzerland) • Foreign Banks’ assets in the U.S. have gone from $509 billion in 1992 to $780 billion in 2000

9. 2. Banks and Other Depository Institutions • Depository institutions include commercial banks, savings institutions, and credit unions • In each case, a significant proportion of their funds comes from customer deposits • Commercial banks are the largest group in size • Banks perform functions similar to other depository institutions in that they accept deposits (liabilities) and make loans (assets) • Banks differ from the others in several respects

10. Banks • Banks differ from the others in that their composition of assets and liabilities are more varied • Bank liabilities include several nondeposit sources of funds and their loans are broader in range, including consumer, commercial, and real estate loans • Banks are regulated separately • Within the banking industry the structure and composition of assets and liabilities varies significantly by asset size • For example, small banks make proportionately fewer commercial loans and credit card loans and more real estate loans than large banks

11. Size, Structure, Composition • In 2000 the U.S. had 8,315 commercial banks • The number of banks has been falling over time: in 1985 there were 14,416 banks • Most of the decline is due to mergers and acquisitions • Before the 1980s, banks could not merge across state lines • Several regulatory changes have occurred since then • In 1994 the Reigle-Neal Act allowed branching by banks across state lines • In 1999 the Financial Services Modernization Act allowed banks full authority to enter the investment banking and insurance business

12. The Aggregate Balance Sheet On December 31, 2000, total loans amount to $3,752 billion, or 60% of total bank assets: • Business and commercial or industrial ($1,048 billion) • Commercial and residential real estate ($1,670 billion) • Individual, such as consumer loans and credit card debt ($610 billion) • Other, such as less developed country loans ($368 billion) Investment securities amount to $1,662 billion, or 27% of total assets: • Treasury bonds ($710 billion) • Other securities, mainly municipal securities and investment grade corporate bonds, make up the rest • The remaining 13% of assets consists of cash and other assets

13. Liabilities Commercial banks have two major sources of funds other than the equity provided by the owners: • Deposits ($4,177 billion, or 67% of total liabilities and equity) • Borrowings and other liabilities ($1,532 billion, or 25%) • Commercial banks are highly leveraged and hold little equity relative to total assets: in 2000 banks had an average ratio of equity to assets of 8.5% • Regulators require banks to hold a minimum level of equity capital to act as a buffer against losses

14. Deposits Of the total stock of deposits: • Transaction accounts (checkable deposits that bear no interest or are interest-bearing) comprised 22% • Retail or household savings and time deposits, which are normally individual account holdings of less than $100,000, comprised 64% (these have been falling because of competition from money market mutual funds, which pay a competitive rate of interest based on wholesale and money market rates) • Large time deposits in excess of $100,000 comprised 14% (these are mainly negotiable certificates of deposit: interest-bearing deposits with fixed maturities of at least 14 days)

15. Off Balance Sheet Activities • Off Balance Sheet items move onto the asset or liability side of the balance sheet when a contingent event occurs • Letters of credit (future commitments to lend), and derivative transactions such as futures, forwards, options, and swaps are important off balance sheet activities • Reserve requirements and deposit insurance premiums are not levied on off balance sheet activities, so banks have an incentive to engage in these activities • By the end of 2000, the notional value of OBS activities was $46,530 billion compared to $6,239 billion for on balance sheet activities • The growth in derivative securities activities is due to increased interest rate risk, credit risk, and foreign exchange risk; the contracts allow banks to hedge these risks without making changes to the balance sheet

16. Regulators U.S. banks may be subject to the supervision and regulations of up to four regulators: • Federal Deposit Insurance Corporation (FDIC): insures deposits, levies insurance premiums, manages the deposit insurance fund, carries out bank examinations, acts as the liquidator when an insured bank closes • Office of the Comptroller of the Currency (OCC): The oldest bank regulator agency, established in 1863, it is a subagency of the U.S. Treasury; its primary function is to charter national banks and to close them, but it also examines national banks and approves or disapproves merger applications

17. Regulators 3. State bank regulatory agencies: Banks do not need to be national banks; they can be chartered by any of 50 state agencies. In December 2000 2,230 banks were nationally chartered and 6,085 were state chartered, with approximately 55% and 45% of commercial bank assets, respectively 4. Federal Reserve System: All of the nationally chartered banks and 991 state chartered banks (that have chosen to be) are members of the Federal Reserve System; the Fed regulates and examines bank holding companies as well

18. Strategic Behavior Many aspects of bank behavior are not restricted: • Prices and profit rates are not subject to review, approval, or other constraints • Service provision: how many tellers to provide, bank hours, drive-through windows, ATMs, etc. • Service differentiation: banks offer different interest rates, fees, minimum balances, overdraft protection, branch location, ATM availability, and so on • Cost-reducing investments in back-office technology • Entry and exit: each year from 1990 to 1999: There were around 400 bank mergers Between 50 and 200 new banks were chartered 1,700 to 2,700 new branch offices were opened 600 to 1,500 branch offices were closed

19. Data • Primarily because of extensive regulation, we have unusually detailed data about the banking industry • Detailed, high-quality balance sheet and income statement data in digital form is available for all 8,000-plus banks in the industry • The data are comparable across all banking firms and across time • Outputs are fairly homogeneous (federally insured checking and savings accounts, loans) • If we focus on retail banking (the provision of basic financial services to households and small businesses) this is essentially a local-market industry, so many different geographic markets exist containing multiple firms in the same industry; this permits cross-sectional analyses where many factors are naturally held constant

20. 3. Retail Banking • Retail banking focuses on very limited geographical areas; branch networks are an important aspect of competition • In a 1998 survey, 95.2% of households that use any financial institution identified a local institution as their primary institution • 65% of primary institutions were local commercial banks • 50% of households obtained checking, savings, and money market deposit accounts within three miles of their home or workplace • 75% obtained these services within fifteen miles • The majority of households also obtained credit within three to twenty miles of home or work

21. Evidence that Retail Banking is Local According to a 1993 survey: • 96% of small businesses use a local institution as their primary financial institution • 84% use a local commercial bank • 50% of small businesses obtained 12 of 13 financial services studied within seven miles • The fact that banks continued to expand the number of branches even as the number of banks dropped (due to exit and mergers) suggests that banks believe that having a local presence is important 57,000 branches in 1985; 73,000 branches in 2000 14,268 banks in 1985; 8,239 banks in 2000

22. Concentration in Local Markets Many banking markets are highly concentrated 141 out of 318 (54%) metropolitan statistical area markets had a Herfindahl-Hirschman index greater than 1,800 in the year 2000 2,073 out of 2,266 rural markets had an HHI exceeding 1,800 In aggregate, the average HHI for MSAs is 1,921 and for rural markets is 4,019, with CR3s (measured using deposits) of 64% and 87% respectively

23. Recent Changes: Mergers Legislation by individual states in the 1980’s and 1990’s, along with recent federal legislation allowing full nationwide banking, have led to ongoing unprecedented merger activity From 1980 to 1998 over 7,900 banks were acquired involving $2.4 trillion in acquired assets The number of banks fell and the share of nationwide banking deposits held by the largest fifty banking firms rose from 37% to 62% However, the average CRs and HHIs over all local banking markets have remained roughly constant The mergers are a response to deregulation and the globalization of large-scale wholesale banking The recent trend involves adjustments away from an artificial, legally created industry structure made up of fifty separate banking structures – one in each state. More deposits are now held by banks based out-of-state.

24. Barriers to Entry Recent legislation allowing interstate banking has reduced legal barriers to entry into local retail banking markets. However, there are still other market-based barriers to entry A number of basic characteristics of retail banking appear to be sources of market imperfections that could create barriers to entry: The existence of relatively uninformed buyers Information and transaction costs for buyers and sellers A local market size that allows for only a small number of efficiently sized sellers The existence of sunk costs Frictions associated with entry and exit At least five barriers to entry can be attributed to these characteristics

25. Economies of Scale Relative to Market Size Economies of scale are particularly important in smaller markets where an entrant must obtain a large market share in order to operate at efficient scale An attempt to acquire such a share would provoke a response from incumbents Evidence suggests there is far less entry in small banking markets than in large markets There are many small banking markets; nearly 50% of the U.S. population lives in rural counties and small MSAs

26. Switching Costs If customers want to switch banks they incur search and transaction costs Switching costs make it difficult for new entrants to attract customers away from incumbents In retail banking, the wide range of fees and interest rates along with the small size of many transactions and many customers’ lack of ability to understand the implications of the terms offered by different competitors make search costs high Location is important; customers want a bank that is close Ending a relationship with one’s current bank is also costly; closing accounts, paying off loans, etc.

27. Strategic Barriers to Entry Major banks can establish exclusive contracts to place branches in the major grocery stores or other retail stores in the area Site preemption is another strategy; incumbents who have better knowledge about growth and local politics may be able to obtain the best locations Potential entrants know less about local market conditions Incumbents may be able to exploit their informational advantage by setting prices that mislead potential entrants about demand and cost conditions Incumbents can build up their brand name recognition to keep customers

28. Empirical Evidence on Barriers to Entry Evidence suggests that competition is imperfect and that entry and exit are not sufficient to drive all inefficient firms out of the market: Research in retail banking generally finds a significant positive relationship between profits or prices and measures of concentration Several studies find inefficiency not associated with size per se, but related to managerial skill; there are substantial cost differences between firms even within the same size category High local market deposit growth over three to four years is associated with relatively high profits; suggesting that incumbent expansion and entry is not sufficient to drive profits back down The adjustment of some rates paid by banks to retail depositors is asymmetric. Deposit rates (like interest on a savings account) adjust down faster than up, benefiting the banks. This asymmetry is more pronounced in more concentrated markets There is evidence switching costs are high. In markets where they are higher, deposit rates are lower

29. Electronic Technology Today, virtually all back-office and bank-to-bank operations are performed electronically If electronic banking spreads at the retail level, eventually a local presence may be less important ATMs are pervasive: The number of ATMs grew from 800 in 1972 to 18,500 in 1980, 61,117 in 1985, and 273,000 in 2000 The number of ATM transactions grew from 3.6 billion in 1985 to 13.2 billion in 2000; the dollar volume rose from $228 billion to over $700 billion ATMs are primarily cash dispensers; they are not a substitute for a branch The number of bricks and mortar banking offices also rose during this period along with the number of checks written (35 billion to 68 billion checks)

30. E-Banking Computers may have more potential than ATMs to replace branches Online banking software offers a range of services, including account histories, bill payment, stop payment, loan applications, etc. In the late 1990’s some pure online banks were established; these have not really taken off In mid 2000, fewer than 25 pure online banks existed and accounted for only 5% of the U.S. online banking market Growth in online banking comes primarily from the introduction of online Internet banking services by traditional banks (who view it as an additional service) Bank consumers tend to be conservative in their habits; changes take a long time to diffuse and often require infrastructure investments