Notes on Mishkin Chapters 11 and 12: Part A
(U.S. Banking: Structure and Historical Development)
Econ 353: Money, Banking, and Financial Institutions
- Last Updated: 28 March 2015
- Latest Course Offering: Spring 2011
- Course Instructor:
Professor Leigh Tesfatsion
tesfatsi AT iastate.edu
- Econ 353 Home Page:
- Key Empirical Facts for U.S. Financial Institutions
- Historical Development of U.S. Financial Institutions and Key Legislation
- Basic Concepts and Key Issues from Mishkin Chapters 11/12: Part A
Key Empirical Facts for U.S. Financial Institutions
- As of 2008, the ten largest banks in the world were all foreign
[Mishkin, Chapter 12, Table 3, p. 303]. In foreign countries, the banking industry tends to be highly concentrated in the sense that the industry is dominated by a small number of banks, typically five or fewer.
- Banking in the U.S. is not as concentrated as in many of its major
trading partners. However, concentration is increasing. In 1999 the five largest banks in the U.S. held less than 30% of total U.S. commercial bank assets. By 2008, this percentage had increased
to about 45%, a big increase [Mishkin, Chapter 12, Table 2, p. 290].
Nevertheless, most industries in the U.S. are still much more
concentrated than the commercial banking industry.
- From 1985 through 2008 the number of (insured) commercial banks in the U.S. fell dramatically [Mishkin, Chapter 12, Figure 3, p. 292].
By 2008 there were approximately 7,000 commercial banks in the U.S.,
down from 8,500 in 1999.
Still, the U.S. has far more banks than any other country of the world. About 40 percent of these banks are relatively small, with less than $100 million in assets [Mishkin, Chapter 12, Table 1, p. 290].
- Bank failures played an important, but not predominant, role in the
sharp decline in the number of U.S. commercial banks during 1985-1992, and bank failures played an almost negligible role in the continuing decline up through 2007 [see Mishkin, Chapter 11, Figure 1, p. 266, and Mishkin, Chapter 12, Figure 3, p. 292]. The primary reason for the decline in the number of U.S. commercial banks from 1985 through 2007 was bank consolidation.
- However, during the subprime financial crisis 2007-2011 the primary reason for further declines in the number of U.S. banks was bank failures.
- In the U.S., financial market regulation in general, and commercial bank regulation in particular, has developed as a crazy-quilt system of multiple regulatory agencies with overlapping jurisdictions [Mishkin, Chapter 2, Table 5, p. 47].
- Until the passage of the Riegle-Neal Act in 1994, a key difference
between banking regulation in the U.S. and elsewhere in the world was that U.S. commercial banks were prohibited from branching across state lines. See below for further discussion of this point.
- Until the passage of the Gramm-Leach-Bliley Act in Fall 1999, another key difference between banking regulation in the U.S. and elsewhere in the world was that U.S. commercial banks were prohibited by the Glass-Steagall Act of 1933 from participating in securities activities such as investment banking (underwriting of corporate securities) and brokerage activities involving corporate securities. See below for further discussion of this point.
For U.S. depository institutions, including commercial banks, principal
oversight and regulation is supplied by the Federal Reserve System (Fed), the central banking system for the U.S. [A central bank is a government institution that has responsibility for the amount of money and credit supplied in an economy as a whole.]
As shown by Mishkin (Chapter 16, Figures 1-2, pp. 388-389), the Fed has a complicated check-and-balance structure that has evolved in response to the persistent hostility of the American public to centralized authority.
- In comparison with central banks in other parts of the worlds, the Fed is relatively "independent," i.e., relatively free from political pressures [Mishkin, Chapter 16, pp. 396-399]. The President of the U.S. designates the members of the Federal Reserve Board of Governors as well as appointing a new Chairman of the Board every four years. However, the members of the Board serve for 14-year nonrenewable terms. Moreover, the Fed has an independent and substantial source of revenue from its holdings of securities and, to a lesser extent, from its loans to banks.
- In the U.S., the general structure and regulation of the thrift industry -- i.e., savings and loan associations, mutual savings banks, and credit unions -- closely parallels the general structure and regulation of the U.S. commercial banking industry [see Mishkin, Chapter 12, pp. 298-300]
- The internationalization of banking, both by U.S. commercial banks going abroad and foreign commercial banks entering the U.S., has meant that financial markets throughout the world have become more integrated. As a result, there is a growing trend toward international coordination of bank regulation [see Mishkin, Chapter 12, pp. 300-303].
Historical Development of U.S. Financial Institutions and Key Legislation
NOTE: See Mishkin, Chapter 12, pp. 275-277, and Mishkin, Chapter 11, Table 1, pp. 264-265.
- 1782: Modern banking in the U.S. began with the chartering in 1782 of the Bank of North America in Philadelphia. Its success led to the opening of numerous other banks.
- 1791: Alexander Hamilton established the Bank of the United States in Philadelphia, the first U.S. central bank. This move towards centralized banking was highly controversial.
- 1811: The charter for the Bank of the United States was allowed to lapse.
- 1816: Congress chartered the Second Bank of the United States in response to abuses by state banks and to difficulties encountered by the Federal government in attempting to finance the War of 1812.
- 1832: Andrew Jackson vetoed the rechartering of the Second Bank of the United States in the face of populist fears of "big city" banking interests. States were given the right to control banks within their borders. This was the commencement of the Free Banking Period, so called because there was very little federal government intervention in banking activities.
- The National Banking Act of 1863: This act established a new banking system of federally-chartered banks (national banks) and imposed a tax on the issuance of banknotes (paper money backed by gold) by state-chartered banks (state banks) in an attempt to eliminate them. State banks responded by setting up a demand deposit system that made currency issuance unnecessary. This resulted in a dual banking system consisting of banks chartered and supervised by the federal government operating side by side with banks chartered and supervised by state
- Federal Reserve Act of 1913: This act established the U.S. central banking system on a firm footing for the first time. The purpose of this central banking system -- referred to as the Federal Reserve System (Fed) -- was to be the promotion of stability in the banking industry. The Fed was given a monopoly power over the issuance of currency.
- All national banks were required to join the Federal Reserve
System, and were then to be subject to regulation.
- State banks were given the option to join or not.
Most chose not to join to avoid the high costs associated with
- Banking Act of 1933 (Glass-Steagall): This important act: (1) created the Federal Deposit Insurance Corporation (FDIC) to provide federal insurance on commercial bank deposits; (2) restricted interest payments by depository institutions; and (3) imposed separation between commercial banking and the securities industry. Under this act:
- Members of the Federal Reserve System were required to purchase
FDIC insurance for their depositors.
- Nonmembers were given the choice to purchase insurance or not.
Most chose to purchase insurance to stay competitive with
- Any bank insured by the FDIC was subject to regulation by
- Interest payments on checkable deposit accounts were
prohibited, and checkable deposit accounts were restricted
to commercial banks. Interest-rate ceilings were also imposed
on time deposit accounts (a restriction known as
- Commercial banks were prohibited from underwriting or dealing
in corporate securities and were limited to the purchase of
debt securities approved by bank regulatory agencies.
Investment banks were also prohibited from engaging in
commercial banking activities.
- Representative Jim Leach of Iowa, Chair of the House
Banking Committee, attempted unsuccessfully in 1995, and
again unsuccessfully in 1996, to push a bill through Congress
repealing that part of the Glass-Steagall Act requiring
separation of commercial banking from the securities industry.
Finally, in Fall 1999, the Gramm-Leach-Bliley Act
was enacted by the U.S. Congress which significantly weakened
these separation provisions. See below for further discussion
of this act.
- Branching Restrictions 1863--1985: Branching restrictions are geographic limitations on the ability of individual banks to open more than one office or branch.
- National Banking Act of 1863: This act gave states the authority to restrict branching within their borders.
- McFadden Act of 1927: This act prohibited national banks from opening branches outside their home state and forced all national banks to conform to the branching regulations in their home state.
- These two acts were meant to foster competition by preventing large banks from driving smaller banks out of business by opening a nearby branch. The actual result was lack of competition, however. Inefficient small banks were able to remain in business, even if they offered poor inadequate services, because their customers had nowhere else to go.
- The branching restrictions imposed by these acts account for the comparatively large number of commercial banks in the United States relative to other countries.
- These branching restrictions stimulated the development of
three financial innovations to get around them:
- Bank Holding Companies:
- Bank holding companies are companies that own one or more banks. Bank holding companies can own a controlling interest in several banks even if branching is not permitted. Many states permit bank holding companies in other states to own controlling interests in banks in their state.
- Nonbank Banks:
- Nonbank banks are limited service banks that fall outside the legal definition of a bank (as defined in the Bank Holding Act of 1956) as an institution that both accepts deposits and makes loans. Thus, nonbank banks are not subject to branching restrictions.
- Automated Teller Machines:
- Automated teller machines (ATMs) are small, widely distributed electronic machines that permit customers to make bank transactions by inserting plastic bank cards and typing in instructions. By not owning or renting an ATM, but instead letting it be owned by someone else and simply paying the owner a fee for each transaction, banks can effectively use ATMs as surrogate branches.
- 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act: This act essentially recognized a movement underway by states since 1985 to get around branching restrictions by various means. It overturned the McFadden Act's prohibition of interstate banking and established the basis for a true nationwide banking system. In doing so, it increased substantially the benefits of bank consolidation for the banking industry.
- Branching Abroad: In recent years, U.S. commercial banks have increasingly opened branches abroad. This internationalization of the U.S. commercial banking industry can be explained by three basic factors:
- First, the rapid growth in international trade and multinational corporations has required commercial banks to become increasingly global in their orientation.
- Second, by branching abroad, U.S. commercial banks have been able to pursue activities that have been prohibited in the U.S. under the Glass-Steagall Act, such as investment banking and insurance activities.
- Third, by branching abroad, U.S. commercial banks are able to
participate more directly and profitably in the Eurodollar market, i.e., the market for dollar-denominated deposits held in foreign countries. The Eurodollar market, initiated by actions of the Soviet Union in the 1950s (see Mishkin, Chapter 12, Box Discussion, page 301), is now one of the most important financial markets in the world. The main center of the Eurodollar market is in London.
- The Gramm-Leach-Bliley Financial Services Modernization Act of 1999:
The principal focus of the Gramm-Leach-Bliley (GLB) Act of Fall 1999 is the relaxation of the provisions of the Glass-Steagall Act of 1933 requiring separation of commercial banking and securities activities. Specifically, the GLB Act eases the way for banks and nonbanking firms to consolidate in some fashion to take advantage of the synergies and cost advantages perceived in such combinations.
- The GLB Act is 395 pages in length, hence it is difficult to do justice to the full scope of this important act in just a few paragraphs. The key features and effects to date of the GLB Act are discussed at some length in
"Notes on the 1999 Gramm-Leach-Bliley Act".
- Sarbanes-Oxley Act of 2002:
On July 30, 2002, President Bush signed into law the Sarbanes-Oxley (SOX) Act of 2002. The SOX Act was legislated in direct response to the
Enron scandal (2000-2001).
The SOX Act was meant to shore up accounting practices by closing loopholes subject to abuse. It imposes restrictions on publicly held companies and their audit firms. In particular, it applies to any Certified Public Accountant (CPA), large or small, who actively works as an auditor of (or for) a publicly traded company.
- Federal Deposit Insurance Reform Act of 2005:
Among other things, this act merged two different insurance funds for financial deposit institutions into one fund called the Depositor Insurance Fund (DIF), increased deposit insurance on individual retirement accounts (IRAs) to $250,000 per account and indexed the amount to inflation, and authorized the Federal Deposit Insurance Corporation (FDIC) to revise its system of risk-based premiums.
Dodd-Frank Wall Street Reform and Consumer Protection Act
The Dodd-Frank Act was legislated in direct response to the subprime financial crisis that started in 2007. It has been called "the most sweeping change to financial regulation in the U.S. since the Great Depression." It affects all Federal financial regulatory agencies and almost every aspect of the U.S. financial service industry. Some key provisions of this massive bill include:
- a consolidation of regulatory agencies;
- the establishment of a new oversight council to evaluate systemic risk;
- a more comprehensive regulation of financial markets, including markets for derivatives;
- additional protection reforms for consumers and investors;
- a weakened version of the Volker Rule proposed by Paul Volker (Fed Chair 1979-1987). NOTE: The original Volker Rule re-instated the prohibition against combining commercial banking and securities activities that had been included in the Glass-Steagall Act of 1933 and overturned by the GLB Act of 1999.
Basic Concepts and Key Issues from Mishkin Chapters 11 and 12: Part A
- Basic Concepts from Mishkin Chapters 11 and 12: Part A
- bank industry concentration
- central bank
- the Fed (Federal Reserve System)
- the thrift industry (S&Ls, mutual savings banks, and credit unions)
- dual banking system
- branching restrictions
- bank holding company
- nonbank bank
- automated teller machine
- eurodollar market
- Key Issues from Mishkin Chapters 11 and 12: Part A
- What are the key empirical facts characterizing U.S. banking today?
- What are the key ways in which U.S. banking differs from banking abroad?
- In what sense is the Fed more independent than central banks in many
other countries of the world?
- What key historical events led to a dual banking system in the U.S.?
- What are the key provisions of the Federal Reserve Act of 1913?
- What are the key provisions of the Banking Act of 1933 (Glass-Steagall)?
- What arguments have been given for and against the separation of
banking and securities activities in the U.S., as imposed by
the 1933 Glass-Steagall Act and significantly weakened by the
November 1999 Gramm-Leach-Bliley Act?
- Why are the advantages and disadvantages of bank branching restrictions?
- What kinds of branching restrictions were imposed on U.S. banks
- What are the key provisions of the 1994 Riegle-Neal Interstate Banking
and Branching Efficiency Act?
- What is the Sarbanes-Oxley Act of 2002 all about?
- What did the Federal Insurance Deposit Reform Act of 2005 attempt to accomplish?
- What was the motivation for the Dodd-Frank Act of 2010, and what are some of its key provisions?
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