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Chapter 13. Financial Industry Structure. Bank Structure Nondepository instituions Insurance Pensions Finance companies GSEs. Dual banking system. banking at state level until Civil War state charters, regulation banknotes as local currency failures, fraud were common.

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chapter 13 financial industry structure
Chapter 13. Financial Industry Structure
  • Bank Structure
  • Nondepository instituions
    • Insurance
    • Pensions
    • Finance companies
    • GSEs
dual banking system
Dual banking system

banking at state level until Civil War

  • state charters, regulation
  • banknotes as local currency
  • failures, fraud were common
slide3
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

decentralization and consolidation
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

slide5
loopholes

-- bank holding companies

-- owned several banks

-- limited service banks

-- deposits or loans, not both

-- ATMs

  • repealed 1994 (Reigle-Neal)
    • Rising bank profitability
consolidation
Consolidation
  • repeal of McFadden
    • 1994 Reigle-Neal
  • Over 14,000 banks in 1985
    • less than 8,000 today
a good thing
A good thing?
  • economies of scale
  • diversification
  • But
    • risks with expansion?
    • responsive to small customers?
    • Local job loss
bank failures of the great depression
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
slide9
Glass-Steagall Act
    • separated permissible activities of commercial, investment banks
    • idea: limit risk for commercial banks
    • weakened over time
    • repealed 1999
globalization
Globalization
  • Foreign branches (IBF)
  • Edge Act corporations
    • Subsidiary just for international banking
  • Acquire interests in foreign banks
eurodollars
Eurodollars
  • US $ deposits in foreign banks
  • Interbank lending in eurodollars
    • LIBOR
      • A common swap floating rate
banks of the future
Banks of the future
  • Universal banks
    • A full range of financial and nonfinancial services
    • Not yet in U.S.
slide13
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
nondepository institutions insurance
Nondepository Institutions:Insurance
  • insurers bear risk that others pay to avoid
    • underwrite risk
    • receive premiums
    • invest premiums
    • face contingent liabilities
types of insurance
Types of insurance
  • Life Insurance
    • term life insurance
    • cash value life insurance
term life insurance
term life insurance
  • policy period
  • death benefit if occurs w/in policy period
  • no cash value
cash value life insurance
cash value life insurance
  • whole life insurance
    • death benefit
    • cash value builds over life of policy
    • premiums cover

-- cost of insurance

-- investment capital

slide18
Universal life insurance
    • similar to whole life
    • buildup of cash value may be used to finance future premiums
slide19
variable life insurance
    • policy holders chooses how to invest premiums
    • benefits/value depend on investment returns
other issues
other issues
  • For a group, mortality rate is predictable
  • timing & amounts of claims are predictable
    • Focus on longer term investments
property casualty
Property & Casualty
  • auto, home insurance
  • timing/size of claims unpredictable
  • separate industry
big losses for p c
Big losses for P&C
  • 1992 Hurricane Andrew
    • $15.5 billion
    • today $30 billion
  • 9/11 WTC attack
    • $35 billion
pension funds
Pension Funds
  • Defined benefit plans
  • Defined contribution plans
  • Federal law does not require pensions, but does regulate them
defined benefit plans
Defined benefit plans
  • employer promised employee monthly payments during retirement

-- life contingent

-- choice of survivor benefits

how is payment determined
How is payment determined?
  • formula
    • salary

-- average last several years

-- average of best years

    • years of service with sponsor
vesting
Vesting
  • minimum years of service necessary to receive benefits
    • complex federal rules about vesting
    • 5-7 years max for full vesting
advantages
Advantages
  • (for employee)
  • limited investment risk
    • payments promised reguardless of portfolio return
    • but sponsor bankruptcy could affect payment size
slide28
no risk of outliving assets
    • payments life contingent,

NOT lump sum

disadvantages
Disadvantages
  • lack of portability from job to job
    • largest benefits accrue after 20 years
    • DB plans encourage loyalty
slide30
lack of control
    • how pension funds are invested
    • is sponsor investing enough?

-- is pension fully funded?

defined contribution plans
Defined Contribution Plans
  • employee/individual contributes funds
    • employer may match contributions
  • employee chooses among investment options
    • range of choice varies among sponsors
slide32
amount accumulated at retirement depends on investment performance
  • lump sum at retirement
    • decision about spending
    • possible purchase an annuity
types of dc plans
types of DC plans
  • employer sponsored
    • 401(k), 403(b), 414(h), 457
  • individual
    • IRA, Roth IRA
advantages employee
Advantages (employee)
  • portability
    • value accumulates steadily
    • balance rolled over to new plans
  • cash value build up
    • cash out (tax penalty)
    • borrow against
    • survivor benefits
disadvantages36
Disadvantages
  • employee bears investment risk
  • retiree risks outliving assets
slide37
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

slide38
GSEs
  • Government charter to create private firms to intermediate debt markets
  • Fannie Mae, Freddie Mac
    • Home mortgages
  • Sallie Mae
    • Student loans
slide39
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