Lesson 10: The Banking Industry

Upon completion of this lesson, you should be able to do the following:

  • Identify the difference between national and state banks.
  • Describe the government agencies that regulates the banking sector.
  • Explain why the government heavily regulates the banking sector.
  • Describe how banks circumvented government regulations.


This lesson concentrates on the United States banking industry. The United States banking system is different when compared to other industrial countries. The United States has more banks per capita and the banks tend to be smaller in terms of asset size. The difference is caused by U.S. government regulations. Early in the United States history, the public feared big banks, so state and federal governments passed regulations that caused banks to be small and encouraged a large number of banks to be formed.

National and State Banks

The United States has a dual banking system. A bank may choose a charter from a state government or from the U.S. federal government. The charter is a document that legally establishes a financial institution to participate in banking activities. When a bank receives a charter from the federal government, the bank is called a national bank. If a bank receives a charter from a state government, then it is called a state bank.

Federal Regulating Agencies

If a bank receives a charter from the federal government, then that bank is subject to three regulatory agencies. The agencies are listed below:

  1. Comptroller of the Currency - this is an office in the U.S. Treasury Department and regulates and examines national banks. This is the office that grants charters from the U.S. federal government and also requires national banks to be members of the Federal Reserve and FDIC.

  2. Federal Deposit Insurance Corporation (FDIC) - this agency insures deposits at banks. If this agency insures, then it will also regulate.

  3. Federal Reserve System (Fed) - the central bank of the United States. The Fed is a lender of the last resort. When a bank is having financial difficulties and cannot receive a loan from another financial institution, then the Fed is the last institution to ask for a loan. The Fed also regulates banks.

A state-chartered bank has it easier. The state bank is regulated by a state government agency, and has the option of joining the Fed and/or FDIC. Therefore, a state bank may have one regulatory agency to deal with or up to a maximum of three regulatory agencies.

Savings institutions and credit unions also have their own regulatory agencies. These institutions can either have a charter from the federal government or a state government. The Federal Home Loan Bank System (FHLBS) is the U.S. government agency that is equivalent to the Federal Reserve. The FHLBS regulates the savings institutions. Also, the FDIC insures deposits at savings institutions. Most credit unions have charters from the federal government and the agency is called the National Credit Union Administration. This agency also insures the deposits at credit unions. Credit unions are not insured by FDIC.

Government Regulation

The U.S. banking system is heavily regulated for 5 reasons.

  1. The United States government wants to ensure a stable financial system. A wave of bank failures could cause the economy to enter a recession, because the money supply decreases.

  2. Regulating banks helps the central bank achieve national economic goals by controlling the money supply, such as low inflation and low unemployment.

  3. The U. S. government wants to promote efficiency in the financial intermediation process.

  4. The U.S. government wants to provide low-cost financing for home buyers.

  5. The U.S. government wants to protect consumers. The financial system, such as a bank can be an extremely complicated. Many depositors may not understand the financial instruments and therefore are not able to determine the soundness of the institution or make rational decisions. In a competitive market like TVs, VCRs, and computers, the consumers can easily evaluate and compare different products. There is a information problem with financial markets and instruments.

The United States government passed the Glass-Steagall Banking Act of 1933. This law created the Federal Deposit Insurance Corporation (FDIC). FDIC is a U.S. federal government agency that insures the deposits of each depositor in commercial banks up to $100,000. For example, if you have $60,000 in your checking account and $60,000 in certificates of deposits, FDIC only insures up to $100,000. If your bank fails, you are guaranteed that your will get at least $100,000 from FDIC, potentially losing $20,000. There is a some chance that you may get all your money. It depends how FDIC handles the bank failure.

The FDIC gets its money from insurance premiums by charging commercial banks. Each commercial bank that is a member of FDIC has to pay $2,000 per year. The FDIC has been very successful. Between 1934 and 1981, bank failures average 10 per year. Before FDIC was created, bank failures averaged 2,000 per year during the Great Depression.

The insurance premium is the same for all depository institutions. Each institution has different costs, different levels of risk of its asset portfolios, and different probabilities of failure. The FDIC does not adjust its premium to reflect differences among banks. The flaws with FDIC can cause some banks to invest in riskier loans and securities, because the banks know if they get into financial trouble, the depositors are protected by FDIC.

The FDIC was establish to lower the rate of bank failures by helping to stop bank runs. A bank run is when depositors find out their bank is having financial trouble. Everyone runs to the bank to withdraw their deposits. A bank holds only a fraction of the total deposits, so the bank will close its doors after all the cash is gone from the vault. The bank is on the verge of failing and many depositors will not be able to get their money back. A bank can be financial healthy, but a rumor that the bank is having trouble can still cause a bank run, eventually causing the bank to fail.

A bank run on one bank can lead to bank runs on other banks. This is known as a contagion. As depositors line up at one bank to withdraw their accounts, not all depositors will get their money back. The depositors will tell friends and family, and they will begin to question the health of their banks. For many people, it is hard to gauge the financial health of banks. The friends and family start going to their banks to withdraw their accounts, causing more bank runs. As the contagion spreads, it can cause a wave of severe bank runs called financial panics. Financial panics can cause the economy to enter into a recession.

The FDIC uses two methods, when dealing with a bank failure.

  1. Seizure of assets - the FDIC closes the bank and seizes the bank's assets. All the bank's assets are sold and the money is returned to the depositors. If FDIC does not receive enough money to pay all depositors from selling the bank's asset, then FDIC pays the difference from its own pocket. The FDIC does not use the first method often.

  2. Seizure of control - the FDIC purchases and assumes control of the failed bank. The FDIC keeps the bank open and looks for another bank that is interested in buying the failed bank. If the FDIC cannot find a buyer, then FDIC will give extra incentives, such as low-interest rate loans from the FDIC or the FDIC buys the problem loans from the failed bank's portfolio. The FDIC will even allow a bank located in another state to buy a failed bank. (Federal law prohibited banks from crossing state lines and opening banks in another state).

The Glass-Steagall Banking Act of 1933 divided the investment banking and commercial banking functions. An investment banker is really a marketing agent for selling new stocks and bonds. Politicians and the public thought that commercial banks should not underwrite new stock and bonds for corporations. They believed banks were underwriting "risky" securities and banks had enormous power to create monopolies. In practice, the Glass-Steagall Banking Act insulated investment banking from competition. As a result, borrowers would pay more for issuing new securities than they would if competition from banks were allowed.

Another federal law, the McFadden Act, prohibits any type of commercial bank from opening a branch in another state. This law was to put national and state banks on equal footing and foster competition. However it allowed small inefficient banks to remain in business and caused the U.S. to have the largest number of banks in the world (14,217 banks as of 1986).

Some states restricted banks to one geographic location, which is called unit banking. Unit banking is a system that permits each bank to have a single geographical location, such as in one city, and the bank cannot have any branches. Currently, no states enforce unit banking. The other form is called branch banking. The state government allows a bank to have two or more banking offices owned by a single banking corporation within a geographical area. The geographic area can be a city, county, or state wide. Currently, 45 states allow state-wide branch banking.

Circumventing Governmental Regulations

Regulations caused banks to invent new financial institutions, thus circumventing the law.

  1. Bank holding companies - a bank holding company is where one corporation obtains ownership or control of two or more independent banks. A bank holding company can do three things.

    1. The bank holding company can branch within states or across state lines. For example, a corporation buys enough common stock of two banks to be the majority shareholder. Usually majority shareholders elect the Board of Directors and vote on corporate policy. Therefore, the holding company can control several banks.

    2. The bank holding company can buy other non-bank companies and enter into other spheres of economic activity, such as data processing, investment advice, and insurance. Allowing banks to participate in nonfinancial activities is called universal banking.

    3. The bank holding company can easily raise nondeposit funds. For example, a bank holding company controls one bank, and this bank needs funds. The holding company issues commercial paper on itself and diverts these raised funds to the bank, getting around interest rate restrictions on bank deposits. Therefore bank holding companies circumvent laws on restrictive banking.

  2. Nonbank bank - the legal definition of a bank is an institution that accepts deposits and makes loans. What if a bank stops taking deposits? Legally it is no longer a bank, so it is not subjected to the extensive bank regulations.

  3. Money market mutual funds (MMMF) - pools of liquid money-market assets managed by investment companies. The investment companies sell shares to the public in small denominations. MMMF were very successful. In 1977, MMMF was $3.3 billion and it grew to $186.9 billion in 1981. The MMMFs hurt the banks, as people started to withdraw money from the banks and invest it into MMMFs. MMMFs tend to pay a higher interest rate and allowed check writing privileges. This put pressure on banks, which put pressure on the regulatory agencies, which put pressure on Congress (and the President) to change the laws. Since 1982, banks have been offering money market deposit accounts (MMDA). MMDA are exactly the same as MMMF. The only difference is the MMDA is consider a bank account and is insured by the FDIC. MMDAs have no reserve requirements and have grown rapidly as people started to invest in them. In 1995, MMDAs had balances of $685 billion.

  4. Automated teller machine (ATM) - modern computer technology allows bank customers to receive banking services through computer terminals located at banks, stores, and shopping malls. Customers can make deposits, withdrawals, and credit card transactions. Technically, ATMs are not bank branches, and are not subjected to branch banking restrictions. Therefore, ATMs can be located some distance away from the main bank. Many banks created networks, so customers have access to their accounts from any place within the United States.

The political climate is changing in the United States. Innovation, rising interest rates, and deregulation has eroded the regulatory structure set up in the 1930s. Banks are allowed to cross state lines, open branches in other states, offer investment advice and brokerage services. There will be two results. First, banks will start acquiring other banks, causing the number of banks in the United States to decrease. Second, as banks merge, they become bigger and the size of their assets will increase. U.S. banks will approach the size of Japanese and German banks.