FUNDAMENTAL FORCES

OF CHANGE IN BANKING

Chapter 1
 What makes a bank ‘special?’
Why do we call Bank of America a ‘bank,’ Merrill
Lynch a ‘securities brokerage company’ and State
Farm an ‘insurance company?’
 The answer lies in our history; with the implementation of:
 The Glass-Steagall Act which created three separate industries:
commercial banking, investment banking, and insurance.
 The Bank Holding Act determined activities closely related to
banking and limited the scope of activities a company could
engage in if it owned a bank.
 The McFadden Act limited the geographic market of banking by
allowing individual states to determine the extent to which a bank
could branch intra- or inter-state.
 As a result of these acts, the United States developed a unique
banking system which had a large number of smaller banks; limited
in the scope of products and services offered; and limited in the
geographic areas covered by banks.
The banking industry is consolidating and
diversifying simultaneously.
 The traditional definition of a bank has been blurred by the
introduction of new products and a wave of mergers, which
have dramatically expanded the scope of activities that
banks engage in and where products and services are
offered.
 Formerly, a commercial bank was defined as a firm that both
accepted demand deposits and made commercial loans.
 Today, these two products are offered by many financial
services companies: including commercial banks, savings
banks, credit unions, insurance companies, investment banks,
finance companies, retailers, and pension funds.
 What constitutes a bank, today is not as important as what
products and services are offered and in what geographic
markets the financial services company competes in.
While competition has increased the number of
firms offering financial products and services,
… the removal of interstate branching restrictions in the
U.S. has dramatically reduced the number of banks but
increased the number of banking offices (primarily
branches).

 Consolidation, in turn, has increased the proportion of

banking assets controlled by the largest banks.
 Not surprisingly, the same trends appear globally.
 The United States currently has several banks that operate
in all 50 states and many
locales outside the U.S.
 The largest foreign banks have
significant operations in the U.S.
and throughout the world.
 Increased competition
… quickly changing the nature
of commercial banking.
 Competition also means geography no
longer limits a financial institution’s trade area or the markets in which it
competes.
 Individuals can open a checking account at:
 a traditional depository institution,

 a brokerage firm, or

 a nonbank firm, such as GE Capital, State Farm Insurance, and

AT&T.
 You can deposit money electronically, transfer funds from one
account to another, purchase stocks, bonds and mutual funds, or
even request and receive a loan from any of these firms.
 Most allow you to conduct this business by phone, mail, or over the
Internet.
Regulatory restrictions on products and
services offerings worked effectively in
promoting a safe banking system until the
later half of the twentieth century.

 Product innovations and technological advances of the

later half of the twentieth century allowed investment
banking firms to circumvent the regulations restricting
their banking activities.
 In the late 1970s Merrill Lynch
effectively created an
“interest bearing checking account,” something banks
had not been legally allowed to offer.
 Junk bonds became an alternative financing source for
small business and other companies began to
encroach upon the banks primary market.
 Banks were heavily regulated
…state banking agencies, the FDIC, the Federal Reserve
and the Office of Comptroller of the Currency
 Merrill Lynch was only regulated by the
Securities and Exchange Commission.
 This allow investment companies to move into the banks market,
circumventing Glass-Steagall and the Bank Holding Company Act
 Not until the late 1980s and early 1990s did banks find ways
around Glass-Steagall using a Section 20 affiliate which
allowed them to offer a limited amount of investment
banking products and services.
 During this same period, the rise in the U.S. stock market
increased the average person’s awareness of higher promised
returns from mutual funds and stock transactions.
 This lead to a greater acceptance of non-FDIC insured deposit
products (mutual funds and stocks)
 Banks, however, were generally restricted to offering CD’s and
savings accounts which increased the erosion of the banks share
of the consumer’s investment wallet.
 Branching restrictions were primarily
responsible for the structure of the
banking system.
 This created a system of many more but smaller banks as
compared to other countries.
 By the late 1990s, all branching restrictions were removed
from the banking system and the number of independent
banks was reduced by almost half, the number of branches
increased by almost 50 percent and the size of the largest U.S.
banks increased dramatically.
 In fact, by size rankings, U.S. banks did not reach the largest
10 banks in the world until the late 1990s and today, some of
the largest banks in the world are U.S. banks.
Branching restrictions were effective at
reducing competition among depository
institutions and promoting a safe banking
system until the later half of the twentieth
century.

 These same branching restrictions, however,

prevented banks from geographically diversify
their product and credit risk and quite possibly
contributed the loss of several large Texas
banks during the late 1980s.
 The removal of branching restrictions during the
later half of the twentieth century allowed banks
to offer services anywhere in the country and lead
to the creation of the first coast-to-coast bank
…forever changing the banks
market from local to global.

 Merrill Lynch and

State Farm already operated
branches across the nation and in comparison there were
significantly fewer, but larger, investment and insurance
companies.
 In addition to relaxation of branching restrictions, technological
advances allowed banks to open electronic branches, first by
using the ATM network and later by using the Internet.
This structural change is frequently
attributed to deregulation of the
financial services industry.
 In fact, deregulation was a natural response to
increased competition between depository
institutions and nondepository financial firms,
and between the same type of competitors
across world markets.
 In fact, some regulations can be credited for
the development of new products to avoid
regulation—hence increased competition from
firms not regulated like a bank; i.e., investment
banks.
Five fundamental forces have
transformed the financial services
market
1. Deregulation/re-regulation
2. Financial innovation
3. Securitization
4. Globalization
5. Advances in technology.
The latter factors actually represent
responses to deregulation and
re-regulation.
Historically, commercial banks have
been the most heavily regulated
companies in the United States
 Regulations took many forms including :
 maximum interest rates that could be paid on
deposits or charged on loans,
 minimum capital-to-asset ratios,
 minimum legal reserve requirements,
 limited geographic markets for full-service
banking,
 constraints on the type of investments
permitted, and
 restrictions on the range of products and
services offered.
Banks and other market participants have
consistently restructured their operations
to circumvent regulation and meet
perceived customer need
 In response, regulators or lawmakers would
impose new restrictions, which market
participants circumvented again.
 This process of regulation and market
response (financial innovation) and
imposition of new regulations (re-regulation)
is the regulatory dialectic.
Today banks are accessing the formerly
forbidden areas of investment banking, by
the repeal of the Glass-Steagall Act via the
Financial Services Modernization Act
(Gramm-Leach-Bliley Act of 1999).

 The Gramm-Leach-Bliley Act effectively eliminates the

majority of the remaining restrictions that have
separated commercial banking, investment banking and
insurance industries for over
50 years.
 The Glass-Steagall Act shaped the
structure, products and business
models of the banking industry for
the later half of the 20th century.
Increased competition
 The McFadden Act of 1927 and the Glass-
Steagall Act of 1933 determined the framework
within which financial institutions operated for
the next 50 years.
 The McFadden Act saw to it that banks would
be sheltered from competition with other banks
by extending state restrictions on geographic
expansion to national banks.
 The Glass-Steagall Act forbade banks from
underwriting equities and other corporate
securities, thereby separating banking from
commerce.
The fundamental forces of change
… increased competition
 Competition for deposits
 Competition for loans
 Competition for payment services
 Competition for other financial services
Competition for deposits
 High inflation abruptly ended the
guaranteed spread between asset yields and
liability costs in the late 1970s.
 In 1973 several investment banks created
money market mutual funds (MMMFs).
 Without competing instruments, MMMFs
increased from $10.4 billion in 1978 to almost
$189 billion in 1981.
 Congress passed legislation enabling banks
and thrifts to offer similar accounts
including money market deposit accounts
(MMDAs) and Super NOWs.
Competition for loans
 Loan yields fell relative to borrowing costs,
as lending institutions competed for a
decreasing pool of quality credits.
 High loan growth also raises bank capital
requirements.
 Junk bonds, commercial paper, auto finance
companies, credit unions, and insurance
companies compete directly for the same
good quality customers.
Competition for loans (continued)
 As bank funding costs rose, competition for
loans put downward pressure on loan yields and
interest spreads.
 Prime corporate borrowers have always had the
option to issue commercial paper or long-term
bonds rather than borrow from banks.
 Because the Glass-Steagall Act prevented
commercial banks from underwriting commercial
paper, banks lost corporate borrowers, who now
bypassed them by issuing commercial paper at
lower cost.
Competition for loans (continued)
 The competition for loans comes in many forms:
 Commercial paper
 Captive automobile finance companies
 Other finance companies
 The development of the junk bond market extended
loan competition to medium-sized companies
representing lower-quality borrowers.
 The growth in junk bonds reduced the pool of
good-quality loans and lowered risk-adjusted yield
spreads over bank borrowing costs.
Today, different size banks generally
pursue different strategies.
 Small- to medium-size banks continue to
concentrate on loans but seek to strengthen
the customer relationship by offering
personal service.
 These same banks have generally
rediscovered the consumer loan.
 The largest banks, in contrast, are looking
to move assets off the balance sheet.
 Regulatory capital requirements and the new
corporate debt substitutes often make the
remaining loans too expensive and too risky.
 Loan concentrations:
Consumer and commercial credits
Credit Risk Diversification
Commercial borrowers
Consumer loans
80.0%
69%
70.0% 67% 65%
64% 62%
60% 58% 59% 60% 60% 59%
60.0% 57% 55% 55% 57% 57%
Percent of loans

50.0% 43% 45% 45% 43% 43%

40% 42% 41% 40% 40% 41%
40.0% 35% 36% 38%
31% 33%
30.0%

20.0%

10.0%

0.0%
88

93

95

97
86
87

89

0
91
92

94

96

98

9
00
01
9

9
19
19

19
19

19
19

19
19

19
19

19
19

20
20
19

19
Captive automobile finance companies

 The three largest U.S. automobile

manufacturers as well as most foreign
automobile manufactures are aggressively
expanding in the financial services industry
as part of their long-term strategic plans.
Competition for payment services
 In an American Banker article, Diogo
Teixeira comment that:

GE Capital has almost $300 billion of financial

assets. GMAC has $12 billion of financial
services revenue, more than Microsoft's total
corporate revenue. Microsoft has no leasing
subsidiary, takes no deposits, makes no loans,
and offers not a single financial product -- in an
age when everybody has financial products.
Yet Microsoft is viewed as the threat, not GE
Capital or GMAC.
Competition for payment services
…the impact of technology
 Once the exclusive domain of banks and other
depository institutions, the nations payment
system has become highly competitive.
 The real challenge for the Federal Reserve
System and the banking industry is in the
delivery of payment processing services.
 This competition is coming from emerging
electronic payment systems, such as:
 smart and stored-value cards
 automatic bill payment
 bill presentment processing
It's not just electronic payment systems that are
eroding the banks traditional markets
 Cash money can be acquired at any teller
machine all over the country.
 You can open a checking account, apply for
a loan and receive the answer and funds
electronically.
 Direct deposit of paychecks, credit cards,
electronic bill payment, and smart cards
means that competition for financial services
goes well beyond the traditional banking
services lines we think of from the recent
past!
 Although cash remains the dominate form
of payment, the average payment size of
cash is the smallest

Volume of Transactions Value of Transactions

% of
Cashless Growth: % Growth: Average
% Total Payments 1995- Total 1995- Transaction
2000 2000 2000 2000 1995 2000 2000 2000 Size 2000
Cash 550,000 82.3% #N/A #N/A 2,200,000 0.3% $ 4.00
Cheques issued 69,000 10.3% 58.2% 1.8% 73,515,000 85,000,000 10.9% 2.9% $ 1,231.88
Electronic Transactions:
ACH 6,900 1.0% 5.8% 14.6% 12,231,500 20,300,000 2.6% 10.7% $ 2,942.03
ATM 13,200 2.0% 11.1% 6.4% 656,600 800,000 0.1% 4.0% $ 60.61
Credit Card 20,000 3.0% 16.9% 6.0% 879,000 1,400,000 0.2% 9.8% $ 70.00
Debit Card 9,275 1.4% 7.8% 42.1% 59,100 400,000 0.1% 46.6% $ 43.13
Total retail electronic 49,375 7.4% 41.7% 10.7% 13,826,200 22,900,000 2.9% 10.6% $ 463.80
Chips 58 0.0% 0.0% 2.6% 310,021,200 292,147,000 37.4% -1.2% $ 5,037,017
Fed Wire 108 0.0% 0.1% 7.3% 222,954,100 379,756,000 48.6% 11.2% $ 3,516,259
Total wholesale electronic 166 0.0% 0.1% 5.5% 532,975,300 671,903,000 85.9% 4.7% $ 4,047,608
Total Electronic 49,541 7.4% 41.8% 10.7% 546,801,500 694,803,000 88.8% 4.9% $ 14,025
Competition for other bank services
 Banks and their affiliates offer many
products and services in addition to
deposits and loans.
 Trust services
 Brokerage
 Data processing
 Securities underwriting
 Real estate appraisal
 Credit life insurance
 Personal financial consulting
“Non-bank” activities of banks
…the Gramm-Leach-Bliley Act.
 Since the Glass-Steagall and Bank Holding
Company acts, banks could not directly underwrite
securities domestically.
 Today, a bank can enter this line of business by
forming a financial holding company through
provisions of the Gramm-Leach-Bliley Act.
 A financial holding company owns a bank or bank
holding company as well as an investment
subsidiary.
 The investment subsidiary of a financial holding
company is not restricted in the amount or type of
investment underwriting engaged in.
 Investment banking
 Commercial banks consider
investment banking attractive
because most investment banks:
 already offer many banking services to prime
commercial customers and high net worth
individuals and
 sell a wide range of products not available
through banks.
 can compete in any geographic market without
the heavy regulation of the FRS, FDIC, and OCC.
 earn extraordinarily high fees for certain types of
transactions and can put their own capital at risk
in selected investments.
Investment banking
 Investment banking encompasses
three broad functions:
1. underwriting public offerings of new
securities
2. trading existing securities
3. advising and
financing mergers
and acquisitions
Deregulation and re-regulation
 Deregulation is the process of eliminating
regulations, such as the elimination of
Regulation Q (interest rate ceilings imposed
on time and demand deposits offered by
depository institutions.)
 Deregulation is often confused with
reregulation, which is the process of
implementing new restrictions or modifying
existing controls on individuals and
activities associated with banking.
Efforts at deregulation and re-
regulation generally address:
 Pricing issues
 removing price controls on the maximum
interest rates paid to depositors and the rate
charged to borrowers (usury ceilings).
 Allowable geographic market penetration
 The Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994 has eliminate
branching restrictions.
 New products and services
 Gramm-Leach-Bliley Act of 1999 has
dramatically expanded the banks’ product
choices; i.e., insurance, brokerage services,
and securities underwriting.
Financial innovation
 Financial innovation is the catalyst behind
the evolving financial services industry.
 Innovations take the form of new securities
and financial markets, new products and
services, new organizational forms, and new
delivery systems.
 Regulation Q brought about financial
innovation as depository institutions tried to
slow disintermediation.
Financial innovation (continued)
 Banks developed new vehicles to compete with
Treasury bills, money market mutual funds, and
cash management accounts.
 Regulators typically responded by imposing
marginal reserve requirements against the new
instrument, raising the interest rate ceiling, and
then authorizing a new deposit instrument.
 Recent innovations take the form of new futures,
options, options-on-futures, and the development
of markets for a wide
range of securitized assets.
Response of banks
 One competitive response to asset quality
problems and earnings pressure has been to
substitute fee income for interest income by
offering more fee-based services.
 Banks also lower their capital requirements
and reduce credit risk by selling assets and
servicing the payments between borrower
and lender rather than holding the same
assets to earn interest.
 This process of converting assets into
marketable securities is called securitization.
Securitization
 Securitization is the process of converting
assets into marketable securities.
 It enables banks to move assets off-balance
sheet and increase fee income.
 It increases competition for standardized
products such as:
 mortgages and other credit-scored loans
 Eventually lowers the prices paid by
consumers by increasing the supply and
liquidity of these products.
The objectives behind securitization
include the following:
 Free capital for other uses
 Improve ROE via servicing income
 Diversify credit risk
 Obtain new sources of liquidity
 Reduce interest rate risk
Generally, any loan that can be credit scored can
potentially be securitized.
Securitization allows nonbank firms to originate loans,
package them into pools, and sell securities
collateralized by securities in the pools.
This increases the competition for the securitized asset
and will eventually lead to lower rates.
Off-balance sheet activities,
asset sales and Enron
 Enron engaged in questionable activities including not
reporting losses from business activities that the firm
inappropriately moved off-balance sheet.
 Enron was thus able to hide losses on the business
activities and/or use its off-balance sheet activities to
artificially inflate reported earnings.
 Many banks also enter into agreements that do not have
a balance sheet reporting impact until a transaction is
effected.
 An example might be a long-term loan commitment to a
potential borrower.
 Until the customer actually borrows the funds, no loan is
reported on the bank’s assets.
 Obviously, off-balance sheet positions generate
noninterest income but also entail some risk as the bank
must perform under the contracts.
From 1999-2001, PNC moved out of certain
lending businesses by selling off $20 billion in
loans and reducing unfunded loan commitments
by $25 billion
 Jan. ‘02. , PNC took a $615 million charge as it wrote down loans
 PNC took a $424 million charge for moving loans to the “held for
sale” category
 Indicated it would sell about $3.1 billion in loans and $8.2 billion in
letters of credit and unfunded commitments.
 PNC’s stock price increased, the positive response echoed the
market’s sentiment that the sooner you recognize bad loans and
move them off the balance sheet, the better.
 Late Jan. ‘02, the FED and SEC questioned the special third-party
structure used to shift assets off the balance sheet.
 PNC’s shares dropped--the use of such off-balance sheet
accounting was reminiscent of the Enron fiasco.
 PNC reclassified its treatment of the problematic deals and lowered
its reported income for 2001 several times.
 Earnings were restated due to new risks of special purpose
vehicles.
Globalization
 The gradual evolution of markets and
institutions so that geographic boundaries
do not restrict financial transactions.
 Financial markets and institutions are
becoming increasingly global in scope.
 Firms must recognize that businesses in
other countries as well as their
own are competitors, and that
international events affect
domestic operations.
Increased consolidation
 The dominant trend regarding the structure of
financial institutions is that of consolidation.
 With the asset quality problems of Texas
banks in the 1980, regulators authorized
acquisitions by out-of-state banks.
 By 1998, effectively all interstate branching
restrictions had been eliminated
 this has lead to
consolidation frenzy
in which we have
almost half as many
banks as compared
to the 1980’s
The later half of the 1990s saw not only a
large number of bank mergers but also
several of the largest bank consolidations:

 Citicorp merges with Travelers

 Chase Manhattan acquires Chemical Banking
 Chase Manhattan acquires J.P. Morgan
 Mellon Bank acquires Dreyfus
 NationsBank acquires BankAmerica
 Bank of New York acquires Irving Bank Corp
 Fleet Financial Group acquires BankBoston
 Bank One acquires First USA
 Southern National acquires BB&T Financial
The removal of restrictive branching laws
as well as “merger mania” of the late 1990s
has dramatically reduced the number of
banks.
 The primary factor leading the reduction in
the number of banks from a high of 14,364
in 1979 to about 8,000 at the beginning of
2002 can be attributed to the removal of
branching restrictions provided by Riegle-
Neal Interstate Banking and Branching
Efficiency Act of 1994
GE Capital Services is the financial
subsidiary of General Electric
 GECS divides its operations into two segments, Financing and Specialty
Insurance. The operations of GECS Financing are divided into four areas:
 Consumer services provides products such as private-label and bank credit
card loans, personal loans, time sales and revolving credit and inventory
financing for retail merchants, auto leasing and inventory financing, mortgage
servicing, and consumer savings and insurance services .
 Equipment management provides leases, loans, sales, and asset management
services for commercial and transportation equipment.
 Mid-market financing provides loans and financing and operating leases for
middle-market customers for a variety of equipment.
 Specialized financing provides loans and financing leases for major capital
assets, commercial and residential real estate loans, and investments; and
loans to and investments in management buyouts and corporate
recapitalizations.
 Specialty insurance provides U.S. and international property and casualty
reinsurance; specialty insurance and life reinsurance; financial guaranty
insurance (principally on municipal bonds and structured finance issues);
private mortgage insurance; and creditor insurance covering international
customer loan repayments.
2001 GE Capital Services operating
companies and lines of business

Segment Data (12/31/2001) Sales (000s) Net Earnings

General Electric Co. 74,037,000 13,684,000
GECS 58,353,000 5,417,000
Consumer Services 23,574,000 2,319,000
Equipment Management 12,542,000 1,607,000
Mid-Market Financing 8,659,000 1,280,000
Specialized Financing 2,930,000 557,000
Specialty Insurance 11,064,000 522,000
All Other -416,000 -699,000
 Growth in GECS Revenues 1990 – 2001

70,000 66,177

58,353
60,000 55,749

48,694
50,000
Millions of Dollars

39,931
40,000
32,713

30,000 26,492

17,276 19,875
20,000
14,418
11,851 13,053
10,000

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Source: GE’s Annual Report, 2001 (http://www.ge.com/)

Most of the legal and regulatory
differences which have historically
separated various types of depository
institutions are gone.
 Banks now compete with:
 traditional depository institution
 local commercial bank, savings bank, or credit unions
 brokerage firms
 such as Charles Schwab or Merrill Lynch,
 nonbank firm
 such as GE Capital, State Farm Insurance, and AT&T.
 All of these firms compete for business, pay and charge
market interest rates, and are generally not limited in the
scope of products and services they offer or the
geographic regions where they offer these products.
Bank Management,
Management 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning

FUNDAMENTAL FORCES
OF CHANGE IN BANKING

Chapter 1