Lecture 9
BEEM119 Economics of Banking
Jan Auerbach
Department of Economics University of Exeter
Contents
1 Financial Institutions and Key Concepts
1 Institutions and Concepts.
2 Understanding Interest Rates.
3 The Risk and Term Structure of Interest Rates.
4 The Efficient Markets Hypothesis.
2 Money
1 What is Money?
2 The Money Supply Process.
3 Quantitative Theory, Inflation, and the Demand for Money.
3 Banking and Financial Intermediation
1 An Economic Analysis of Financial Structure.
2 Banking Industry: Structure and Competition.
4 Banking and Policy
1 Economic Analysis of Financial Regulation.
2 Financial Crises.
Banking Industry: Structure and Competition
(Mishkin, chapter 13)
Number of Insured Commercial Banks in the United States, 1934-2010
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Bank Consolidation and Nationwide Banking
In the US, the number of banks has declined over the last 25 years due to
• Bank failures and consolidation.
• Deregulation: Riegle-Neal Interstate Banking and Branching
Efficiency Act f 1994.
• Economies of scale and scope from information technology.
Results may be not only a smaller number of banks but a shift in assets to much larger banks.
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Benefits and Costs of Bank Consolidation
Benefits
• Driving inefficient banks out of business
• Increased efficiency also from economies of scale and scope
• Lower probability of bank failure from more diversified portfolios
Costs
• Elimination of small community banks may lead to less lending to small business
• Banks expanding into new areas may take increased risks and fail
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Big Banks and Too Big To Fail
Too Big To Fail: The Pros and Cons of Breaking Up Big Banks
David C. Wheelock (2012) in The Regional Economist, Federal Reserve Bank of St. Louis.
Are the biggest US banks too big? Many people think so.
Some economists and policymakers have called for breaking up the largest banks and strictly limiting how large banks can become.
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The changing size of US banks
The average inflation-adjusted total assets of U.S. commercial banks rose from $167 million in 1984 to $893 million in 2011.
During that time, the number of banks fell by more than 50 percent.
The share of total banking system assets held by the very largest banks has continued to rise.
In 2001, the five largest commercial banks held 30 percent of total U.S. banking system assets.
In 2011, the five largest banks held 48 percent of total system assets.
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The Structure of the Banking System
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Why are Large Banks a problem?
During the latest financial crisis and recession four of the 10 largest US depository institutions–Bank of America, Citibank, Wachovia Bank and Washington Mutual Bank–either failed or received government assistance to stay afloat.
Only about 6 percent of smaller banks failed.
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Systemic Risk and Too Big To Fail
Systemic Risk: is the potential for the collapse of a large bank to impose significant losses on other firms or seriously impede the functioning of the financial system.
The resulting risks to the broader economy, lead governments to be willing to often treat large banks as too big to fail (TBTF).
They committed public funds to ensure payment of a large bank’s debts when it would otherwise default.
This policy means unlimited protection to all of a bank’s creditors.
Although treating large banks as TBTF mitigates systemic risk, TBTF has a dark side, known as moral hazard.
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TBTF and Moral hazard
Moral hazard leads to the tendency for insurance to encourage risk-taking and, thereby, make an insurance payout more likely.
A government acting on TBTF arguments insures a bank’s creditors. By guaranteeing protection from losses, banks are enabled to
• borrow on more favorable terms (funding advantage) and
• operate with greater leverage (incentives to take on more risk).
These banks then have a greater chance of failing than they would without the government guarantee.
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TBTF and Moral Hazard
E.g., federal deposit insurance may encourage greater risk-taking.
That is why there are measures in place to discourage or prevent excessive risk-taking, e.g.,
• federal deposit insurance covers deposits only partially; • banks are charged risk based insurance premiums;
• there are minimum capital requirements;
• and there exist government supervision.
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Dodd-Frank Act of 2010
The Dodd-Frank Act of 2010 imposes new rules and oversight over banks and other financial firms in an effort to control risk-taking.
It aims to end TBTF by a new process for resolving failures of large financial firms that subjects the creditors of such firms to losses.
Critics hold that ending TBTF and the associated moral hazard problem requires enforcing strict limits on the size of individual financial institutions.
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But Size Limits Might Be Costly
Economies of scale may be affected.
A production process is characterized by economies of scale if the cost of producing one unit of output falls with an increase in the amount produced.
Most research published before 2000 found that banks exhaust scale economies at roughly 300−500 million of assets.
Remember the size of Banks!
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Size distribution of banks
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Economies of Scale
Some newer studies find potential scale economies for banks with $1 trillion of assets or more. Only few banks would be above that!
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Economies of Scale and IT
Advances in information processing and communications technologies have revolutionized banking.
New technologies reduced the costs of information production.
The advantage of close proximity for evaluating credit risks and monitoring borrowers vanished.
Small/medium-size banks face competition in small-business lending.
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Economies of Scale, really?
Regulation and the size of banks
Regulation generates cost advantage for larger vs smaller banks, e.g., • loosening of branching restrictions,
• fixed costs of complying with new consumer protection. TBTF and external funding
TBTF treatment may generate a funding advantage.
It lowers risk premiums demanded by creditors of larger banks.
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Evidence of economies of scale for credit unions
Economies of Scale and Continuing Consolidation of Credit Unions
James A. Wilcox (2005) in Economic Letter, Federal Reserve Bank of San Francisco.
Larger credit unions, on average, have decidedly lower average costs and higher net incomes, consistent with economies of scale.
Credit unions are mutually owned by their members rather than by outside shareholders, making their depositors also their owners.
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Evidence of economies of scale for credit unions
Conventional measure of the cost efficiency: noninterest expense. Other things equal, lower expenses signal greater efficiency.
Costs for larger credit unions are substantially lower.
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Evidence of economies of scale for credit unions
So, smaller unions have to charge borrowers higher and pay savers lower interest rates.
Return On Assets (net income % of assets) rises with credit union size. The average ROA at very large credit unions is
• about twice as large as that for medium-sized credit unions • and nearly 1% larger than that for very small credit unions.
On average, very small unions earned virtually no income in 2004.
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Evidence of economies of scale for credit unions
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Evidence of economies of scale for credit unions
Typically overlooked aspect of high cost efficiency:
Larger credit unions tend to operate with relatively low capital ratios. They have more borrowers and savers–are thus likely more diversified.
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Economies of scale and industry consolidation
2 credit unions with over $1 billion in assets → nearly 100.
Their share of total credit union assets grew from 2% to 33%.
Due to relaxation of regulatory restraints on • their products and services and
• on their ability to reach more members
as well as substantial cost advantages for larger credit unions.
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IT and Financial Innovation
Credit and Debit cards
ATMs, internet banking, and virtual banking
New Financial Instruments
Securitization
• transforms otherwise illiquid financial assets into marketable capital market securities.
• played an especially prominent role in the development of the subprime mortgage market in the mid 2000s.
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Mortgage-Backed Securities
Mortgage-Backed Securities: How Important Is “Skin in the Game?”
Christopher M. James (2010) in Economic Letter, Federal Reserve Bank of San Francisco.
Loan origination and funding process (originate-to-distribute):
• Securitization of residential mortgages may have fundamentally altered key players’ incentives.
• Mortgage originators and the sponsors of mortgage-backed securities (MBS) have too little “skin in the game.”
• Originators and sponsors pay too little attention to the riskiness of the mortgages they originate and place in pools they sell.
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MBS–Moral Hazard, again
Critics hold that
• moral hazard inherent in the originate-to-distribute securitization • fostered a decline in lending standards
• which directly resulted in the credit crisis that began in 2007.
Dodd-Frank Wall Street Reform and Consumer Protection Act:
• requires securitizers to retain at least 5% of the credit risk associated with the mortgages underlying residential MBS.
This reform puts securitizers “skin in the game.”
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Importance of skin in the game
Do MBS loss rates vary with originator loss exposure?
The originator is responsible for evaluating the potential borrower, underwriting the loan, and extending mortgage credit.
In a securitization, the originator typically sells the loan.
After a loan is sold to a special purpose vehicle, it pools it with other mortgages and issues securities.
The sponsor sets underwriting guidelines for mortgages in the pool based on such parameters as FICO scores, loan-to-value ratios, etc.
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Importance of skin in the game
Typically, the sponsor retains the most junior or residual securitization tranche–the sponsor has first loss exposure.
Originator and sponsor loss exposure differs depending on whether the originator
• is affiliated with the entity that sponsors the securitized pool • and/or services the mortgages in the pool.
If sponsor and originator are affiliated, the originator retains greater loss exposure.
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Importance of skin in the game
If skin in the game matters, one would expect loss rates to be lower for affiliated deals and higher for mixed or unaffiliated deals.
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