Chapter 13. Financial Industry Structure

1. Chapter 13. Financial Industry Structure • Bank Structure • Nondepository instituions • Insurance • Pensions • Finance companies • GSEs

2. Dual banking system banking at state level until Civil War • state charters, regulation • banknotes as local currency • failures, fraud were common

3. National Bank Act 1863 • federal charters for banks • Comptroller of the Currency • federal banknotes • tax on state banknotes • state banks survived by accepting deposits -- dual banking system

4. Decentralization and Consolidation • Why so many small banks in U.S.? • McFadden Act 1927 • restricted intra and interstate branching of national banks • meant to protect small banks & promote competition -- but protected inefficient banks -- limited economies of scale

5. loopholes -- bank holding companies -- owned several banks -- limited service banks -- deposits or loans, not both -- ATMs • repealed 1994 (Reigle-Neal) • Rising bank profitability

6. Consolidation • repeal of McFadden • 1994 Reigle-Neal • Over 14,000 banks in 1985 • less than 8,000 today

7. A good thing? • economies of scale • diversification • But • risks with expansion? • responsive to small customers? • Local job loss

8. Bank Failures of the Great Depression • 1930-33, 1/3 of all U.S. banks failed • Congress responded w/ legislation • FDIC • federal insurance for bank deposits • banks pay premiums

9. Glass-Steagall Act • separated permissible activities of commercial, investment banks • idea: limit risk for commercial banks • weakened over time • repealed 1999

10. Globalization • Foreign branches (IBF) • Edge Act corporations • Subsidiary just for international banking • Acquire interests in foreign banks

11. Eurodollars • US $ deposits in foreign banks • Interbank lending in eurodollars • LIBOR • A common swap floating rate

12. Banks of the future • Universal banks • A full range of financial and nonfinancial services • Not yet in U.S.

13. Financial holding companies • e.g. Citigroup • Economies of scale • Lower average cost from large number of same type of transactions • Economies of scope • Lower average cost from large number of related transactions

14. Nondepository Institutions:Insurance • insurers bear risk that others pay to avoid • underwrite risk • receive premiums • invest premiums • face contingent liabilities

15. Types of insurance • Life Insurance • term life insurance • cash value life insurance

16. term life insurance • policy period • death benefit if occurs w/in policy period • no cash value

17. cash value life insurance • whole life insurance • death benefit • cash value builds over life of policy • premiums cover -- cost of insurance -- investment capital

18. Universal life insurance • similar to whole life • buildup of cash value may be used to finance future premiums

19. variable life insurance • policy holders chooses how to invest premiums • benefits/value depend on investment returns

20. other issues • For a group, mortality rate is predictable • timing & amounts of claims are predictable • Focus on longer term investments

21. Property & Casualty • auto, home insurance • timing/size of claims unpredictable • separate industry

22. Big losses for P&C • 1992 Hurricane Andrew • $15.5 billion • today $30 billion • 9/11 WTC attack • $35 billion

23. Pension Funds • Defined benefit plans • Defined contribution plans • Federal law does not require pensions, but does regulate them

24. Defined benefit plans • employer promised employee monthly payments during retirement -- life contingent -- choice of survivor benefits

25. How is payment determined? • formula • salary -- average last several years -- average of best years • years of service with sponsor

26. Vesting • minimum years of service necessary to receive benefits • complex federal rules about vesting • 5-7 years max for full vesting

27. Advantages • (for employee) • limited investment risk • payments promised reguardless of portfolio return • but sponsor bankruptcy could affect payment size

28. no risk of outliving assets • payments life contingent, NOT lump sum

29. Disadvantages • lack of portability from job to job • largest benefits accrue after 20 years • DB plans encourage loyalty

30. lack of control • how pension funds are invested • is sponsor investing enough? -- is pension fully funded?

31. Defined Contribution Plans • employee/individual contributes funds • employer may match contributions • employee chooses among investment options • range of choice varies among sponsors

32. amount accumulated at retirement depends on investment performance • lump sum at retirement • decision about spending • possible purchase an annuity

33. types of DC plans • employer sponsored • 401(k), 403(b), 414(h), 457 • individual • IRA, Roth IRA

35. Advantages (employee) • portability • value accumulates steadily • balance rolled over to new plans • cash value build up • cash out (tax penalty) • borrow against • survivor benefits

36. Disadvantages • employee bears investment risk • retiree risks outliving assets

37. corporate defined contribution plans • hold over 25% of assets as own company stock -- Enron 60% -- Anheuser Bush, Coca Cola, McDonald’s over 74% • big lack of diversification -- but easier to match 401(k) contributions w/ stock than w/cash

38. GSEs • Government charter to create private firms to intermediate debt markets • Fannie Mae, Freddie Mac • Home mortgages • Sallie Mae • Student loans

39. All borrow short term • (commercial paper) • And lend long-term • Implicit gov’t guarantee • Highly leveraged: 30 to 1 • High default rate could bankrupt them