Limitations on the Business of Banking (RLE Banking & Finance)

An Analysis of Expanded Securities, Insurance and Real Estate Activities

R Pace

• Publisher: Routledge
• Year: 2012
• Print ISBN: 9780415539326
• eBook ISBN: 9781136265334
• Edition: 1
• Topic: Economics
• Subtopic: Business General
• Index: Economics

This book is a study of how expanded bank powers could affect the banking industry in the US. Using contemporaneous measures, expanded data, a finer classification of industries, risk-reducing behavior, and the legal and regulatory environment this volume provides a more complete picture than earlier studies.

CHAPTER I

Introduction to Limitations on the Business
of Banking: An Analysis of Expanded
Securities, Insurance, and Real Estate
Activities

MOTIVATION

Expansion of bank powers is currently an important and highly debated issue. Bankers, financial economists, regulators, and politicians argue that, for banks to survive and compete successfully today and in the future, banks must have greater insurance, securities, and real estate powers. Bank powers are governed primarily by laws conceived during, or having foundations in, the Great Depression. There is no doubt that the financial services industry is much different today than it was ten years ago, much less nearly sixty years ago.

Banks are increasingly product-oriented, which is a change from traditional relationship banking. This is due in large part to the re-regulation and deregulation occurring in the 1980s. The financial services industry is an industry where the product no longer identifies the producer. Until 1980, demand deposits, the primary transaction account, were available almost exclusively from local commercial banks. Today, demand deposits, or at least transaction account substitutes, are available from savings and loan institutions, mutual funds, out-of-state commercial banks, brokerage firms, and foreign commercial banks. Short-term commercial loans once the almost exclusive province of commercial banks, are available from insurance firms, foreign banks savings and loan institutions and direct capital market participation.

The ability of foreign banks, insurance firms, securities firms, and other financial service firms to invade traditional commercial bank markets particularly harms banks because they are not able to respond in kind. For example, insurance companies offer products that are similar to long-term certificates of deposit, and securities brokers offer products that are functionally interest-bearing checking accounts. Commercial banks, however, are barred from offering most insurance and securities products. Responding to these pressures, banks are lobbying and litigating for greater product powers, with the emphasis on increased insurance, securities, and real estate powers. Given the significant investment in hiring lobbyists and lawyers to change banking regulations, bankers must perceive profit potential.

Regulators are concerned with maintaining a safe and sound banking system, which necessarily includes the management of the deposit insurance fund. Therefore, given the current structure of deposit insurance, any activity that increases the risk of the banking industry is of concern, since an increase in risk is borne by the fund (and ultimately, the taxpayers), not the bank. The concern is for an absolute change in risk, not, as some researchers have implied, whether currently permissible activities are relatively more or less risky than prohibited activities. An increase in risk with an appropriate increase in return is also not acceptable from the regulators’ point of view, since any upside gain is captured by the bank while downside losses are absorbed by the depository insurance fund.

The following are sources of increased competition for banks. Specifically note the erosion of banks’ services and products.

Interstate Banking

Banks had, in the past, geographical protection—Georgia banks need not worry about New York banks invading their market. As regional and interstate banking became a reality, the competition within the banking industry increased. All else equal in the financial services industry, one would expect increased failures and consolidation as the interstate barriers disappeared. As banks’ home offices are further away from their markets, the public tends to discriminate on a product basis rather than a relationship basis. Therefore, interstate banking is a contributing factor to both the product orientation and increased competition of the banking industry.

Deregulation of the Savings and Loan Industry

Specifically, the deregulated savings and loan industry now offers many of the same types of products as the commercial banking industry. Not only did the savings and loan industry gain the ability to invade commercial banks’ sources of funds (functional substitutes for demand deposits) but also their uses of funds (the ability to make short-term loans).

Competition from the Insurance Industry

Insurance firms have moved from being a vehicle to protect against a loss to offering investment products. These investment products are in direct competition with bank products. Additionally, insurance firms act as lenders of funds.

Competition from the Securities Industry

The securities industry has products that compete for demand deposits as well as traditional certificates of deposit (for example, mutual funds with check privileges). The securities industry also benefits from securitization and increased firm usage of the capital markets.

Securitization

Securitization has probably led to the homogenization of bank products more than any other factor. Almost anything can be packaged and securitized, from credit card loans and auto loans to the well-known home mortgage. When banks do not hold loans in their own portfolio, the bank functions as a loan originator and servicer. The securitization process requires bank products to be similar. Securitization results in regional product similarity which, in turn, results in increased competition, particularly price competition.

Capital Markets

Capital markets are becoming more accessible and viable substitutes for bank products. As an example, the commercial paper market competes directly with commercial banks for short-term commercial loans. Since most credit-worthy firms are those with the most access to capital markets, banks are left with firms without capital market access (the less credit-worthy firms).

Globalization

As the economy moves toward a global orientation, the United States banking market looks beyond its borders for banking services. The increasing presence of Foreign banks in the United States clearly increases competition. Furthermore, when overseas foreign banks offer products not available in the United States banks, foreign banks gain business expertise in different fields. This expertise is useful to firms that wish universal banking services.

Technology

Technology affects the competitive environment of commercial banks several ways. Technology contributes to the speed of information transfer making national and international banking possible. It also enables other financial service institutions to engage in information production, one of commercial banks’ fortes. Technology is a major factor in moving the economy toward a cashless economy, in which banks may have a smaller role.

A QUESTION OF IMPORTANCE

Banks are experiencing more competition and lower profits. Expanded bank powers may be an answer to some of the banking industry's problems. The question of how banks would respond to expanded powers at first seems unimportant. Simply grant banks expanded powers, and let the smart and strong survive. This course would be exceedingly ill-advised since banks play a special role in the economy. When banks fail, the failure can do more than simply hurt bank shareholders and employees. Bank failures can and do affect the real economy. The economy must have a safe and sound banking industry to function efficiently.

Deposit insurance adds another dimension to the problem. Given the nature of deposit insurance, increases in bank risk can be passed on to the deposit fund and ultimately to the taxpayers.

The problem of how expanded bank powers affects the risk of the banking industry warrants considerable study. A consequence of an incorrect policy decision could bankrupt the Federal Deposit Insurance Corporation (FDIC). While it is often predicted that the FDIC will go the way of the Federal Savings and Loan Insurance Corporation if no policy changes occur, this prediction hinges on the continued poor performance of banks.

Expanding bank powers may improve the health of banks. The arguments for bank power expansion generally fall into one of three categories:

1. Diversification benefits allow banks to reduce risk, increase profits, or both.
2. There is a need to level the playing field between banks and other financial service firms.
3. Economies of scale and/or scope will increase bank profitability and reduce risk.

This study's empirical analysis focuses on the potential of diversification benefits due to bank power expansion. A simulation model is employed to explore the potential risk and return of expanded bank powers.

SIMULATING THE RISKS AND RETURNS OF EXPANDED BANK POWERS

To determine how the banking industry's risk could change if granted expanded bank powers, Bank Holding Companies (BHCs) are hypothetically merged with insurance, security, and real estate firms. Risk and return is measured by the variance of accounting earnings, cash flows, and market returns. The hypothetically merged firm is compared to the original BHC to determine if the merger is beneficial. Each BHC is hypothetically merged with each and every insurance, security, and real estate firm in the data set. Previous hypothetical merger studies either randomly merge firms or construct average firms in each industry.

The simulation includes measures of cash flow. Contemporary studies focus on variation in accounting earnings or market returns. In addition to accounting earnings and market returns, this study uses three measures of cash flow. One purpose of using cash flow measures is as a compromise between market returns and accounting earnings. This is important because previous studies have mixed results concerning the change in risk of BHCs as they expand into new fields. Studies using market data find negligible or only minor diversification benefits, while studies using accounting data generally find some benefit to diversification.

CONTRIBUTIONS

The study adds to the knowledge of how expanded bank powers could potentially affect the banking industry by using more and new measures, employing an expanded data set, utilizing a superior classification of industries, capturing risk-reducing behavior, and incorporating the legal environment.

More and New Measures

Previous work uses either market returns or accounting earnings. Each has known strengths and weaknesses. This study employs, in addition to accounting earnings and market returns, three measures of cash flow.

Expanded Data

This study utilizes a greater number of firms over a greater time period than previous studies. Past studies do not include the late 1980s, noted as years of poor bank performance. Additionally, this study avoids a survivorship bias by including failed firms in the data. Finally, this is the only study to systematically examine each and every possible two-firm merger in the available data.

Superior Classification of Industries

Industries are subjected to a much finer classification than in previous studies. This study analyzes both state and national BHCs. Securities firms are classified into two industries, insurance firms into three industries, and real estate firms into five industries.

Risk-reducing Behavior

An acknowledged weakness of previous simulation studies is that random mergers ignore any risk-reducing behavior by BHC managers. The choice of random mergers assumes that no risk-reducing behavior by managers takes place in the selection of potential merger candidates. This is of particular concern since it has been empirically shown that BHCs with relatively more nonbank activities are less risky than BHCs with relatively less nonbank activities. This study simulates the potential risk-reducing behavior of BHC managers or bank regulators.

Legal Environment

Economics does not occur in a vacuum. Previous studies have given scant attention to the complex regulatory structure governing bank powers. This study describes the complex nature of bank power regulation and documents the movement toward expanding bank powers.

FORMAT

The study proceeds as follows: Chapter II, The Regulatory Boundaries of Bank Activities, focuses on the regulatory environment. Chapter III, Hypothetical Merger Simulation Using Earnings, conducts a mean-variance simulation using accounting earnings to determine the potential profitability and risk of bank power expansion. Chapter IV, Evidence Using Cash flow Variables, conducts the simulation model from Chapter III using three measures of cash flow. Chapter V, Summary of Limitations on the Business of Ban...

Table of contents

• Front Cover
• Half Title
• Title Page
• Copyright
• Title Page
• Copyright
• Dedication
• Contents
• Tables
• Acknowledgements
• Abbreviations
• Half Title
• CHAPTER I Introduction
• CHAPTER II The Regulatory Boundaries of Bank Activities
• CHAPTER III Hypothetical Merger Simulation Using Earnings
• CHAPTER IV Evidence Using Cash Flow Variables
• CHAPTER V Summary
• APPENDIX A Simulation Run Example
• APPENDIX B A Holding Period Return Extension
• REFERENCES
• INDEX