银行管理学 01

Fundamental Forces of Change in Banking

Chapter Objectives

1. Examine how recent competitive trends affect the banking industry.

2. Demonstrate how the forces of change (deregulation and reregulation, financial innovation, securitization,

globalization, and technological advances) reflect increased competition and have lead to industry consolidation, increased diversification of products and services, higher capital requirements, and entry into banking by nonbank firms, such as, investment banks, insurance companies, finance companies, and others.

3. Describe the activities of non-bank financial institutions, such as investment banks and captive automobile finance companies.

4. Introduce the structure and activities of GE Capital Services as a non-bank financial conglomerate.

Key Concepts

1. Competition in banking is evidenced by five fundamental forces of change that transform the structure and operation

of

financial institutions and markets: a. deregulation and reregulation b. financial innovation c. securitization d. globalization

e. technological advances

2. Increased competition brought about by deregulation has induced banks to take on greater portfolio risks in search of acceptable returns. Many banks have moved to nontraditional banking services to earn fees that can offset the volatility in earnings from traditional loans and better help grow earnings. Increased competition has also induced traditional nonbank firms to enter traditional banking businesses.

3. Since the 1980s deregulation efforts have removed interest rate ceilings on allowable rates paid depositors and

charged on certain loans and also expanded the range of products and services that banks can offer. Interstate banking and branching restrictions have similarly been eliminated.

4. In response to regulation, financial institutions create new financial instruments and financial markets, and

restructure the means by which they deliver products to consumers. This financial innovation enables them to circumvent restrictions and continue growth.

5. Securitization is the process of converting assets into marketable securities. It enables banks to move assets off-balance sheet and increase fee income. It increases competition for the types of standardized products, such as mortgages and other credit-scored loans, and eventually lowers the prices paid by consumers by increasing the supply and liquidity of these products. Given the problems of Enron, and Citicorp’s and J.P. Morgan’s efforts to make Enron’s financial statements appear less risky, analysts now focus carefully on which parties bear risk in securitization agreements.

6. Financial markets and institutions are becoming increasingly global in scope. Firms must recognize that businesses in other countries as well as their own are competitors, and that international events affect domestic operations.

7. Banks' traditional loan operations have been seriously undermined by the development of the commercial paper and junk bond markets as alternatives to bank loans. Corporations that issue these securities view them as cheaper substitutes for bank credit. Generally, any loan that can be credit scored can potentially be securitized. Securitization allows nonbank firms to originate loans, package them into pools, and sell securities collateralized by securities in the pools. This increases the competition for the securitized asset and will eventually lead to lower rates.

8. Technological advances in banking are constantly changing the competitive environment. Many of these advances relate to payment services and how customers conduct banking business. Many bankers and bank analysts believe that the greatest growth in the delivery of banking services will be through debit and smart cards, telephone banking and the internet. Such electronic payments systems will transform how people conduct their banking business and how banking firms compete.

9. GE Capital represents a financial services company that is itself part of General Electric. In July 2002, Jeff Immelt, GE’s CEO, split GE Capital into four separate businesses: GE Commercial Finance, GE Consumer Finance, GE

Insurance, and GE Equipment Management. GE Capital had almost $460 billion in assets in mid-2002, which made it the largest non-bank finance company in the U.S. GE Capital can offer services in all areas and compete directly with banks, yet avoid regulation as a bank because it does not own or manage a commercial bank or savings and loan. In 2001, GE Capital accounted for 40% of GE’s total earnings and 46% of GE’s total revenue.

10. Many firms obtained unitary thrift charters during the 1990s to offer nationwide banking services, yet avoid

regulation as a commercial bank. Formally, a firm obtains a federal savings bank charter, which allows it to issue deposits and make loans without hindering the nonfinancial products and services that it might otherwise offer. The firm can operate in a wide range of businesses not allowed traditional commercial banks. Thus, many insurance companies, finance companies, investment banks, and firms like Ford, Archer Daniel Midland, and State Farm Insurance operate unitary thrifts.

Teaching Suggestions

This chapter represents an opportunity to link bank management topics to current events. As a semester project, students should be encouraged to keep a file or log of events from recent newspapers or magazines that demonstrate the existence and impact of deregulation/reregulation, financial innovation, securitization, globalization, and technological advances. Ask students to i) obtain a list of nonbank firms that have obtained unitary thrift charters , ii) identify the number of internet banks that offer traditional banking products/services only via the internet, iii) keep a record of banks that buy banking and other firms outside their home country, and iv) provide a list of recent financial innovations in banking. Regular reference to the Wall Street Journal and the American Banker contributes to student understanding and interest.

Answers to End-of-Chapter Questions

1. The fundamental competitive forces of change are deregulation/reregulation, financial innovation, securitization, globalization, and technological advances. Each increases competition by expanding the number and nature of

competitors in different products and services. Regulators respond to competitive pressures to ‘level the playing field’ by either imposing new restrictions on activities allowed certain participants or relaxing existing restrictions. Legislation often follows to formalize the new constraints or opportunities. Consider interest-bearing checking accounts. At one time, no firm could pay interest on checking accounts. Now everyone does in one form or another. In the interim, regulators and legislators slowly allowed different firms to offer interest-checking, often after investment banks circumvented restrictions against it. The same result occurred with the initial passage of Glass-Steagall legislation, which separated banking from commerce. For many years, commercial banks could not underwrite most securities while investment banks could not make commercial loans and accept transaction accounts. Prior to the passage of the Financial Modernization Act, Citigroup was formed and it offered full-scale commercial and investment banking services,

insurance services via its Travelers subsidiary, and effectively forced the U.S. Congress to pass the Act making all this legal.

2. Securitization generally reduces the overall quality of assets because the loans that can be best securitized are the highest quality, most marketable assets with standardized features are that readily understood and valued.

3. Banks that have strong senior management, a well-trained staff, large amounts of capital, and good market share are best positioned to benefit from increased competition. They can choose the lines of business to enter and exit, have access to capital, and can expand geographically where appropriate. Strong management is evidenced by a constant reevaluation of strategies necessary to compete and the ability to implement the strategies. A bank’s Board of Directors should play a key role in ensuring the viable operation of the firm and continual strategic planning.

4. Investment banks generally offer services in the areas of: 1) making a market in securities, 2) underwriting securities, and 3) assisting in mergers and acquisitions, and 4) asset management. Most of these are fee-based services, which are not subject to credit risk. Commercial banks have become increasingly interested in the last three because of the

possibility of earning fee income. Banks that underwrite securities help a firm or government unit place a debt or equity issue with the investing public. They do so either on a best efforts basis for a fee, or actually buy the securities from the original issuer before selling them to investors. When assisting in mergers and acquisitions, banks charge substantial fees for their efforts without taking much risk. Banks that manage assets for customers charge a fee for the service.

5. This situation confronts many managers of community banks. One of the critical decisions that senior management and the Board of Directors makes is to determine the appropriate strategic plan. Importantly, bank managers must identify the key markets and customers that the bank wants to serve. They should emphasize the bank’s strengths,

including the fact that deposits are federally insured and the bank’s employees are long-time employees who know and serve their customers with personal attention. Managers should target those individuals and businesses and

products/services where they have the greatest competitive advantage. Generally, the bank should have better physical locations for customers to conduct business, and should be better able to handle the deposit and loan needs of small business customers. While it will likely decide not to compete on price with the savings and loan that pays 0.50% more on deposits, it should try to retain customers by linking bank deposit services with other services, such as credit card, trust, car loans, etc. To compete with internet providers of banking services, it might align itself with a third-party

provider and at least offer basic access as some customers will want this service in the future. Management should decide whether it wants to compete with discount brokers, insurance companies and real estate brokerages. If it chooses not to offer these services directly, it should refer customers to appropriate vendors for insurance and investment needs. For example, a bank may choose to provide several mutual funds on a referral basis without having to manage the funds.

6. Securitization

a. Mortgages: few problems; securitization allows a reduction in interest rate risk to the loan originator who moves the loans off the books because it no longer holds the mortgages in portfolio. The bank can choose to service the loans so that customers are less concerned that the bank does not control the credit. Many investors buy mortgage-backed securities because mortgages are often government insured so that credit risk is minimal.

b. Credit card loans: credit cards are issued to a wide range of borrowers. While the terms may be standardized, different individuals have far different purchase and payment behavior. There is no government guarantee. Thus the

repayment terms are less predictable. It is more difficult than with mortgages to identify the loans to package for sale and set up the appropriate type of reserve fund to handle defaults and payments. Still, firms that originate credit card loans via credit-scoring models (See chapter 17) can readily securitize these loans because investors know the basic characteristics of the credit card borrowers.

c. Automobile loans: much like credit card loans, auto loans are made to a wide range of borrowers. Without standardized features and repayment/default patterns, the cash flow features are less predictable. There is also no

government guarantee such that credit risk exists. Thus it is more difficult to package loans and find an interested buyer. Still, auto loans that are credit scored are readily securitized.

d. Small business loans can be easily securitized if they are government-guaranteed and issued under SBA guidelines. Many small business loan originators now credit score these loans such that they can eventually securitize them. There are potentially large differences in the underlying borrowers that make it more difficult to value these securities.

7. Commercial paper and junk bonds provide alternative financing to bank credit for business customers. The

commercial paper market came first and allowed low-risk businesses to access funds directly from investors on a short-term, unsecured basis. The junk bond market allows higher-risk businesses the same access. Firms with the best reputations and operating performance can readily access funds in this form. Thus bank loan portfolios have been directed less at the highest quality borrowers and those lower quality borrowers with access to the junk bond market. Many commercial loan portfolios are subsequently concentrated in real estate and middle-market business loans.

8. In the late 1970s and early 1980s, rising interest rates brought about disintermediation at banks and thrifts as

customers withdrew funds from low-rate savings in search of higher yields. The result was a liquidity crisis that forced banks to look for ways to retain their deposits. Since legislation was unlikely, bankers created new accounts that combined the features of savings accounts that paid market interest rates and checking accounts that provided

transactions services. The automatic transfers of savings (ATS) allowed banks to pay interest on checking accounts by forcing a zero balance at the close of each business day in the checking account portion of the ATS account. Legislators eventually realized that banks must be allowed to pay interest on checking accounts and NOW accounts were authorized. Today, investment banks, GE Capital Services, and virtually any group that offers a credit card pays interest on some acounts from which the holder can write checks. Most banks similarly offer sweep accounts that automatically force a zero balance in noninterest-bearing checking accounts.

9. Many banks have felt the competition from foreign banks operating in the U.S. Bank customers have more outlets for their funds and borrowers have more alternatives. Low-risk businesses can borrow domestically or via foreign institutions that have a competitive advantage if the business operated outside the U.S. Banks with U.S. operations only thus will find that the pool of available customers is shrinking while the number of competitors with a global perspective is increasing. Bankers often fear globalization because it represents the unknown. There are cultural and language barriers that managers must overcome in order to effectively compete. Nationwide financial services companies will be greatly affected because they compete in many geographic markets throughout the U.S. and many of their customers conduct business outside the U.S. while non-U.S. based customers also conduct considerable business in the U.S. Community banks will be less affected because they compete in limited geographic markets, but their customer base is changing with the changing U.S. demographics, such that they too will need to be aware of global issues, global payment systems, and the needs of customers from different cultures.

10. Captive automobile companies were created to make car and dealer inventory loans, but now they are expanding into other consumer loans, such as mortgages and appliance loans. These companies are not regulated as banks are, and thus can offer a wider range of products and compete nationwide.

11. Increased capital at a bank lowers risk. This potentially benefits depositors by reducing the likelihood of failure and deposit runs. Equity owners gain because their investment is safer, and recently the stock market has attached a premium to banks with substantial equity because they are perceived to be safer with greater expansion opportunities. Society generally benefits because safe banks are more likely to lend. Additional capital should be required as banks and other firms offer nontraditional products. It is not appropriate for the FDIC to insure other lines of business or products because firms should only offer them if they are willing to accept and able to manage the risk. Firms should be allowed to fail when they operate poorly. One way to require capital would be to estimate the riskiness of the line of business relative to other activities of the firm. The greater is perceived risk, the greater should be the capital requirements. Perhaps capital requirements should be linked to the volatility in returns of the line of business.

12. A small community bank cannot earn above-average returns on these low-margin products/services today because of competition. It must develop other loan products or services that can be offered at profitable margins. This might be some specialized form of lending tied to a specific type of loan or industry, it might be emphasizing originating loans and

selling them to long-term investors, while retaining servicing, or it might be offering non-credit products that competitors don’t successfully offer within their trade area. Management might also focus on how these services are delivered. Many start-up operations in today’s environment invest little in offices and branches and offer the bulk of their services over the internet, via telephone, or via banking representatives going to the customers’ places of businesses with their laptops. This potentially controls costs and allows greater room for competitive investments.