Chapter 1 1

Part 1:Banking and the Forces of

Change in the Financial-Services Industry

Chapter 1: Overview of Banking and the Financial-Services Industry

Chapter 2: Drivers of Change, Innovation, and Consolidation in the Financial-Services Industry

Chapter 3: Technology in Banking: E-Money, E-Banking, and E-Commerce

Chapter 1 2

CHAPTER 1

OVERVIEW OF BANKING AND THE FINANCIAL-SERVICES INDUSTRY

Chapter 1 3

LEARNING OBJECTIVES

The functions of a financial system and that “Banks do it”

How to judge the efficiency of a financial system and how it interacts with the real economy

Who the major players in the FSI are and how they are organized

The role of the federal safety net and the difference between regulatory discipline and market discipline

The dimensions of bank competition and how regulation shapes them

TO UNDERSTAND....

Chapter 1 4

THE FUNCTIONS OF A FINANCIAL SYSTEM: Do Banks Do It?

Clear and settle payments to facilitate trade and commerce

Aggregate and disaggregate wealth and flows of funds so that both large-scale and small-scale projects can be financed

Transfer economic resources over time, space, and industries

Accumulate, process, and disseminate information for decision-making purposes

Provide ways for managing uncertainty and controlling risk

Provide ways for dealing with incentive and asymmetric-information problems that arise in financial contracting

Chapter 1 5

JUDGING THE EFFICIENCY OF A FINANCIAL SYSTEM

Allocative Efficiency Operational or Cost Efficiency Informational or Price Efficiency

Chapter 1 6

HOW THE FINANCIAL SECTOR AFFECTS THE REAL SECTOR

Credit Screening Activities Credit Rationing Creating Liquidity Facilitate Trade and Investment

Activities Debt Restructurings Feedback Role

Chapter 1 7

PLAYERS IN THE FINANCIAL- SERVICES

INDUSTRY Financial Holding Companies

Ex: Citigroup, American Express, Capital One Financial Bank Holding Companies

Ex: Bank of America, Wells Fargo, SunTrust Community Banks Securities Firms

Ex: Merrill Lynch, MSDW, Charles Schwab Thrift Institutions

Ex: Washington Mutual, Charter One Financial, Dime Bancorp

Chapter 1 8

PLAYERS IN THE FINANCIAL SERVICES INDUSTRY

(Continued)

Insurance CompaniesEx: Aetna, AFLAC, Allstate

Pension Funds Finance Companies Investment Funds Nonfinancial Corporations Venture Capitalists

Chapter 1 9

THE “-IZATION” OF THE FSI

Institutionalization Securitization Globalization Privatization Modernization

Chapter 1 10

TYPES AND CLASSES OF COMMERCIAL BANKS

National Banks -- Charters are issued by the Office of the Comptroller of the Currency (OCC)

State Banks -- chartered by states and D.C. Fed-Member Bank -- Must be insured by the

Federal Deposit Insurance Corporation Bankers’ Banks Pawnshops (“shadow banks”)

Chapter 1 11

BANK HOLDING COMPANIES (BHCs)

Dominant Organizational Form in US is the BHC One-Bank Holding Company Multi-Bank Holding Company

Evolution to LCBOs and FHCs

Chapter 1 12

MARKET CAPITALIZATION OF LARGE BHCs

Citigroup = $285 Billion J.P. Morgan Chase Co = $96 Billion Bank of New York = $37 Billion These data are as of September 13, 2000 –

update them. Have they recovered from the financial aftermath of the “Attack on America”?

Chapter 1 13

THE FEDERAL SAFETY NET:

Two Basic Components Discount Window -- The lender of

last resort for banks that encounter liquidity crises

Deposit Insurance -- Provided by the FDIC, provides public confidence to the banking system

The TBTF policy is implemented through these two components

Moral Hazard -- refers to behavior that is altered by the existence of insurance

Chapter 1 14

HOW DOES THE SAFETY NET WORK?

When banks experience financial difficulty, they...

1.Borrow funds from the lender of last resort, the Fed

2.The FDIC has time, called “forbearance”, to arrange a permanent solution to the bank’s problems, usually a merger with another viable bank in a purchase-and-assumption transaction

3.FDICIA (1991), however, calls for “prompt corrective action” or PCA

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Principal-Agent Relations, Regulatory, Discipline, and Market Discipline The key players in regulatory discipline

are: Taxpayers as principals President/Congress as agents and then as

principals Regulators as agents and then as

principals Managers of insured depositories as

agents and then as principals See Figure 1-2 (p. 16) for additional details

Chapter 1 16

TECHNIQUES FOR MANAGING THE SAFETY

NET Monitoring the value of the

collateral Restricting the kinds of assets

acceptable as collateral, and Charging risk-based premiums

Chapter 1 17

THE “CAMEL” MODELC = Capital AdequacyA = Asset QualityM = ManagementE = EarningsL = Liquidity(S = systemic risk, CAMELS)

Chapter 1 18

Regulatory Dialectic or Struggle Model Thesis Antithesis Synthesis

Chapter 1 19

THE RISKS OF BANKING

Credit Risk Interest-Rate Risk Liquidity Risk Foreign-Exchange Risk

Chapter 1 20

Strength-in-Banking Equation Strength = New powers + Firm

supervision New powers: GLB Act of 1999

(Modernization) Firm supervision: Risk-based

capital requirements (regulatory discipline) and market discipline

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The Dimensions of FSI Competition Price User convenience/service Public confidence Both market forces and regulations

shape these dimensions

Chapter 1 22

Chapter Summary Banks do it when it comes to the

functions of a financial system We judge financial systems in terms of

their efficiency – allocative, operating (cost), and price

Banks are heavily regulated firms (e.g., risk-based capital requirements, CAMEL, etc.) and structured as holding companies – BHCs, LCBOs, and FHCs

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Summary (continued) Customers pick financial-services

providers based on price, convenience, and confidence as shaped by market forces and regulators

As banks gain new powers (GLB Act of 1999) firm supervision by markets and regulators is required to maintain strength in banking

Chapter 1 24

Summary (continued) Principal-agent relations play a key

role in understanding how regulatory and market disciplines work

The regulatory dialectic or struggle model captures the ongoing battle between regulated FSFs and their regulators – thesis, antithesis, and synthesis