Lesson 10: The Banking Industry
Upon completion of this lesson, you should be able to do the following:
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:
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.
The U.S. banking system is heavily regulated for 5 reasons.
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.
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.
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.