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I. Financial Innovations and U.S. BankingNote: The following Section I notes are primarily based on Mishkin Chapter 12, but some related materials from Mishkin Chapter 11 are also incorporated.
I.A Inducements to Financial Innovation
Since the 1960s, many changes that have occurred in the U.S. economy have had significant implications for U.S. financial markets. Three of these key changes are as follows:
These changes have stimulated a search by financial institutions for new financial products and services likely to be profitable in the new environment -- a process called financial engineering.
For example, the increased volatility of interest rates has led to the development of adjustable-rate mortgages (ARMs) -- that is, mortgage loans on which the interest rate changes when some specified market rate changes. The rapid development of computer technology has led to the development of financial products specifically dependent on this technology, such as bank credit cards and electronic banking facilities.
Also, financial institutions making use of new computer technology have been increasingly successful in their efforts to get around regulations perceived to restrict their ability to exploit profit opportunities -- a process aptly referred to as loophole mining.
For example, under the Glass-Steagall Act of 1933, banks were prohibited in most states from paying interest on checking deposit accounts, and maximum limits were imposed on the interest that could be paid on time deposit accounts (regulation Q).
In 1970, however, a mutual savings bank in Massachusetts found a loophole in this legislation. Specifically, by calling a check a Negotiable Order of Withdrawal (NOW), any account on which NOWs were written was not legally a checking account and so was not subject to the Glass-Steagall Act prohibitions on interest.
NOW accounts rapidly spread throughout New England. Finally, in 1980, legislation was enacted (the Depository Institutions Deregulation and Monetary Control Act) that included among its many provisions the authorization of NOW accounts nationwide for savings and loans, mutual savings banks, and commercial banks, with similar types of accounts ("share draft accounts") authorized for credit unions as well.
As this example demonstrates, details matter when it comes to regulation and supervision of the banking industry (or any industry for that matter). Earnings-driven individuals are continually trying to think of new ways to generate profits. Thus, subtle differences in the details of a regulation may have large unintended consequences, such as permitting profit-seeking individuals to find legal means to evade the regulation altogether.
I.B Four Key Financial Innovations
In Chapter 12, Mishkin discusses four financial innovations that have played a particularly important role in the decline of traditional banking practices in the U.S.:
These four financial innovations are briefly described below.
I.C Effects on U.S. Banking
Traditional banking business in the U.S. -- that is, lending funded with deposits -- has declined in both size and profitability as a result of the competitive pressures introduced by these and other financial innovations. For example, as seen in Figure 2 (Mishkin, Chapter 12, page 287), commercial banks' share of total credit advanced declined from 1974 through the mid-1990s, and has been fairly stagnant in recent years; and the share of thrifts (S&Ls, mutual savings banks, and credit unions) in total credit advanced has fallen dramatically since about 1977 and is now well below 10 percent.
The response of banks to this decline in traditional banking services has been to seek out other sources of profit. One strategy has been to expand into new areas of lending, such as commercial real estate loans. A second strategy has been to expand into nontraditional off-balance-sheet activities, including loan sales, trading positions in futures and options, foreign exchange trades on behalf of customers, servicing of mortgage-backed securities, debt security guarantees, provision of credit line backup, and other specialized services to customers. Both of these strategies have generated concern from financial rgulatory agencies because of their perceived higher riskiness.
The decline in traditional banking that has occurred in the U.S. is now also occurring in many other countries of the world as well. Because of increased international integration of financial markets, banks everywhere are facing more difficult competitive environments. The next section focuses more carefully on the way in which U.S. banking has been restructured in recent years.
II. Current Restructuring of U.S. BankingNote: The following Section II notes blend materials from Mishkin Chapters 11 and 12.
As seen in previous notes, banking in the U.S. has been regulated almost since its inception, and it remains one of the most highly regulated industries in the U.S.
Banks have not been allowed to own businesses that are not closely related to banking. They have been effectively barred from any meaningful participation in the securities industry. And they have been further limited by frequently changing rules regarding exactly what kinds of investments they are permitted to make.
In 1994, however, President Clinton signed into law the Riegle-Neal Interstate Banking and Branching Efficiency Act that permits banking across state lines. This act represents a critical step in the restructuring of the U.S. financial system, a process that began back in the 1970s and continues today. Together with the Federal Reserve's liberal merger and acquisition policy, the Riegle-Neal act fueled a significant movement towards bank consolidation within the U.S. and increased political pressure for the further liberalization of the regulations that restricted banking activities.
II.A Seven Distinct Types of U.S. Banking Regulations
Mishkin (Chapter 11) identifies seven distinct types of banking regulations that have at one time or another been imposed on the U.S. banking industry:
In the following sections, each type of regulation is taken up in turn. For each case, a brief discussion is given of the most important forms this type of regulation has taken in the U.S., and the extent to which these regulations have been modified or even eliminated in recent years.
II.B U.S. Government Safety Net Provisions
The Fed stands ready to provide discount loans (or advances) to U.S. banks who are short on reserves. Since such borrowing is generally interpreted by the public and the Fed as a sign of distress or liquidity mismanagement, however, banks usually only resort to discount loans in times of emergency and for short periods of time. Consequently, the Fed essentially functions as a lender-of-last-resort for banks in distress.
Moreover, the 1933 Glass-Steagall Act established the Federal Deposit Insurance Corporation (FDIC) to oversee the federal provision of insurance on deposit accounts up to a certain size, currently set at $100,000.
II.C U.S. Restrictions on Asset Holdings and Capital Requirements
Bank regulations can restrict the extent to which banks can hold risky assets such as real estate and common stocks, thus directly limiting the extent to which bank managers can engage in high-risk activities.
Such restrictions were imposed on U.S. banks and thrifts until the early 1980s. As detailed above, the relaxation of these restrictions in legislation enacted in the early 1980s is thought to have contributed substantially to the subsequent U.S. financial crisis. Tighter control of risky asset holdings were reimposed on S&Ls under legislation (FIRREA) enacted in 1989.
In addition, bank regulations can discourage bank managers from engaging in high-risk lending by requiring each bank to maintain its net worth ("bank capital") at or above some specified minimum level, so that the bank has more to lose should the bank go bankrupt.
Throughout most of the 1980s, U.S. banks were simply required to maintain a specified minimum "(capital) leverage ratio", defined to be the total amount of bank's net worth divided by the total amount of the bank's assets. Increased regulatory restrictions were automatically triggered if a bank's net-worth-to-assets ratio declined toward the minimum level.
Since the late 1980s, however, additional capital requirements have been imposed on larger banks in proportion to the riskiness of their trading activities. In addition, under legislation passed in 1991 (FDICIA), a carrot-and-stick approach is now used to encourage banks to hold more bank capital. Well-capitalized banks receive valuable privileges, while less-well-capitalized banks are subject to increasingly onerous regulation.
In addition, by international agreement among industrialized nations (the June 1988 Basel Accord, or "Basel 1"), additional types of bank capital restrictions are now imposed on banks engaging in significant off-balance-sheet activities. See Mishkin (Chapter 11, Global box discussion of "Basel 2", p. 256) for a discussion of ongoing attempts to reform the original 1988 Basel Accord.
II.D U.S. Chartering and Bank Examination
As noted in previous discussion of the dual nature of the U.S. banking system, anyone wishing to establish a bank in the U.S. must first apply for and obtain a charter -- i.e., a license to operate -- either from the Federal Government (specifically, the Comptroller of the Currency) or from a state banking agency.
Whether at the federal or state level, the chartering agency evaluates the anticipated financial soundness of a bank applicant by examining factors such as the quality and experience of the applicant's intended management, the applicant's projected earnings prospects, the applicant's qualification for deposit insurance, and the amount of the applicant's initial capitalization.
Once chartered, a bank must file periodic financial statements with the chartering agency, and it must also submit to regular examinations by a bank regulatory agency to ensure it remains in compliance with all charter provisions.
Chartering thus restricts entry into the U.S. banking industry. While providing protection against unqualified entrants, chartering also reduces the intensity of competition. Consequently, chartering reduces the likelihood that inefficient banks will fail.
Since 1993, chartering restrictions in the U.S. have been significantly eased in some respects and tightened in others. For example, chartering agencies are now less concerned with the prevention of harm (competition) to already existing banks. On the other hand, chartering agencies now place much greater emphasis on risk management.
II.E U.S. Disclosure Requirements
As discussed above, legislation enacted subsequent to the U.S. financial crisis in the 1980s imposed far more stringent reporting requirements on banks and thrifts. In particular, traditional disclosure requirements regarding balance sheets and income statements were supplemented with additional disclosure requirements focusing on risk exposure and risk management practices.
II.F U.S. Consumer Protection Legislation
One form that consumer protection legislation has taken in the U.S. is truth in lending laws -- that is, laws designed to force lenders to disclose to potential borrowers the true total costs of their borrowing, including a standardized annual interest rate and total financial charges.
Another form that consumer protection legislation has taken in the U.S. is laws to prevent discrimination in credit markets on the basis of age, gender, marital status, age, or national origin.
More controversially, the Community Reinvestment Act (CRA) enacted in 1977 was intended to promote community involvement. The CRA imposes reporting requirements on banks to ensure that the banks are lending to certain members of the community from whom they are acquiring deposits -- specifically, to low income community residents and to small businesses in the community. If a bank is found to be in noncompliance with the CRA, regulators can reject the bank's application for a merger, a new branch, or other proposed new activities.
Moreover, under the Gramm-Leach-Bliley Act of 1999, a bank holding company (BHC) cannot become a financial holding company (FHC) -- and hence cannot engage in the various new financial activities permitted to FHCs under this act -- unless all of the BHC's insured depository institutions have a CRA rating of satisfactory or better. See "Notes on the 1999 Gramm-Leach-Bliley Act" for further details.
The strengthening and increased enforcement of CRA provisions leading up to the subprime mortgage crisis 2007-2009 have been the source of a good deal of controversy. Some have claimed that these CRA provisions are in part responsible for this crisis in that they put strong pressure on banks to issue residential mortgages to subprime borrowers.
II.G U.S. Restrictions on Competition
In the past, U.S. banking legislation has frequently included provisions designed to protect banks from competition on the grounds that increased competition can lead to increased risk-taking by bank managers and hence to increased danger of bank failures.
The downside of these protective provisions is that inefficient banks are subject to less pressure to improve, which can result in higher costs to bank customers, suboptimal lending arrangements, and lower economic growth and development.
For example, one key type of protective provision that has been included in past U.S. banking law is branching restrictions. Branching restrictions have led to extensive loophole mining by banks attempting to get around these restrictions, e.g., the formation and reliance on bank holding companies, nonbank banks, and automated teller machines. In effect, branching took place, but by indirect and inefficient means. Legislation enacted in 1994 (Riegle-Neal) finally overturned earlier legislation prohibiting interstate branching.
II.H U.S. Separation of Banking and Securities Activities
As briefly discussed in previous lecture notes on Mishkin (Chapters 11/12:Part A), one of the most contentious aspects of the many-faceted 1933 Glass-Steagall Act has been its provisions requiring the separation of commercial banking and securities activities.
In particular, although the Glass-Steagall Act permitted commercial banks to sell new offerings of government securities (thought to be safe), it expressly prohibited commercial banks from underwriting corporate securities, from selling insurance, or from engaging in brokerage activities. Conversely, investment banks were prohibited from engaging in commercial banking activities.
Advocates justify this separation on the grounds that it reduces risk-taking behavior by commercial bank managers and protects commercial banks from competition. In addition, they argue that this separation also protects the securities industry from unfair "subsidized" competition from commercial banks -- subsidized in the sense that commercial bank depositors receive low-cost federally-provided deposit insurance whereas other firms providing insurance to their customers must do so at market cost.
Critics argue that brokerage and other nonbank firms have been able to pursue banking activities through financial innovations such as money market mutual funds and cash management accounts. Therefore it is unfair to prevent commercial banks from engaging in brokerage and other securities activities. In any case, commercial banks do so indirectly already, through bank holding companies; so retaining these separation provisions simply imposes higher costs on commercial banks without achieving the desired separation outcome in any case.
The benefits and costs of repealing the separation provisions of the Glass-Steagall Act have been under active study in the U.S. Congress since 1995. Representative Jim Leach of Iowa, then-Chair of the House Banking Committee, was a key advocate for repeal of these separation provisions. In Fall 1999 the U.S. Congress finally enacted financial modernization legislation --- the Gramm-Leach-Bliley Act --- that significantly weakened the Glass-Steagall separation provisions.
The key features and effects to date of the Gramm-Leach-Bliley Act are discussed briefly by Mishkin (Chapter 12, p. 297) and at greater length in "Notes on the 1999 Gramm-Leach-Bliley Act". In a nutshell, regarding separation provisions, the Gramm-Leach-Bliley Act eases the way for banks and nonbanking firms to consolidate in some fashion to take advantage of the synergies and cost advantages perceived to result from the ability to jointly undertake commercial banking and securities activities.
Many commentators have pointed to this easing as a key factor in the financial crisis of 2007-2009. As explained in Part A of these notes on Mishkin Chapters 11/12, this weakening of the Glass-Steagall Act has now been partially overturned by the version of the Volker Rule included in the Dodd-Frank Act of 2010.
III. Basic Concepts and Key Issues from Mishkin Chapters 11 and 12: Part B