Abstract
A number of varied but mutually interactive forces are at work in the market-place that are fundamentally changing the nature and structure of the financial services business.1 These changes are occurring, at somewhat uneven rates, throughout the world. Commercial banks, which have traditionally been at the centre of the financial services business, are caught in a dilemma. On the one hand, the banks must respond to these market-driven forces of change, or otherwise they will be by-passed by their customers. On the other hand, being inherently conservative and supervised by even more conservative regulators, the banks are hesitant to respond, and in some cases prohibited from responding, to these markets forces, lest their actions endanger their safety and soundness.
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Notes and References
A number of the issues treated in this chapter are discussed at greater length in Thomas F. Huertas, Toward a New System of Financial Regulation (forthcoming).
The McFadden Act, a federal law, bars branching across state lines by banks, and the Bank Holding Company Act (Douglas Amendment), another federal law bars bank holding companies from establishing or acquiring banks outside its headquarters state, unless permitted to do so by the host state. However, within the last five years, the states themselves have overridden these two federal laws. As of April 1986 thirty-one of the fifty states had passed laws under the Douglas Amendment permitting some form of interstate banking (American Banker, 22 April 1986). However most of these state laws allowed only for the creation of limited service banks or for regional reciprocal banking.
For failed banks with assets in excess of $500 million the Garn St-Germain Act (1982), another federal law, provided a temporary override of the Douglas Amendment that permitted out-of-state bank-holding companies to acquire such failed banks. This provision was to have expired in 1985, but has been extended twice and may be further extended and liberalised.
In contrast to the US, no other major industrial country imposes geographic restrictions on its banks. Consequently many banks domiciled in Japan, Germany, France, the UK, Italy and Canada have hundreds and even thousands of branches throughout these countries.
The Banking Act of 1933, a federal law popularly known as Glass-Steagall, prohibits banks that are members of the Federal Reserve System from underwriting corporate securities, foreign government bonds and certain municipal revenue bonds. The Act also prohibits member banks from being affiliated with an entity that is principally engaged in underwriting such securities.
The Bank Holding Company Act prohibits bank-holding companies from engaging in activities that are not so ‘closely related to banking’ as to be ‘a proper incident thereto’. Such forbidden activities would include insurance underwriting (with certain exceptions) and commercial activities, such as retailing or manufacturing. However, bank-holding companies may perform certain commercial activities in export trading company subsidiaries and banks themselves may acquire a limited amount of equity in commercial enterprises through venture capital subsidiaries. For a summary of current restrictions on bank activities see Robert E. Litan, ‘Evaluating and Controlling the Risks of Financial Product Deregulation’, Yale Journal on Regulation, 3 (1985) 3–8.
For a comparison of the restrictions on bank-holding companies relative to other firms see Robert C. Clark, ‘The Regulation of Financial Holding Companies’, Harvard Law Review, 92 (1979) 787–863.
Until recently a number of states imposed usury ceilings on consumer loans, and until April 1986 Regulation Q imposed ceilings on the rates that banks could pay on time deposits. The Banking Act of 1933 prohibits banks from paying interest on demand deposits, and this prohibition remains in effect. For a discussion of usury ceilings see Richard L. Peterson, ‘Consumer Finance’, in George J. Benston (ed.) Financial Services: The Changing institutions and Government Policy (Englewood Cliffs, NJ: Prentice-Hall 1983) pp. 185–212;
Christopher C. De Muth, ‘The Case against Credit Card Interest Rate Regulation’, Yale Journal on Regulation, Vol. 3, no. 2, Spring 1986, pp. 201–42.
For a summary of these regulations see Carter H. Golembe and David S. Holland, Federal Regulation of Banking, 1983–1984 (Washington, D.C.: Golembe Associates, 1983);
Robert C. Clark, ‘The Soundness of Financial Intermediaries’, Yale Law Journal, 84 (1976) 1–102.
Thomas F. Huertas, ‘The Regulation of Financial Institutions: A Historical Perspective on Current Issues’, in Benston, Financial Services, pp. 18–22.
This figure refers to the cost of executing a million instructions per second on top-of-the-line IBM mainframe computers. Cf. ‘Sierra Adds Power to IBM’, New York Times, 13 Feb 1985, section D, p. 1.
The Investment Company Act (1940) regulated the operation of investment advisors and the terms on which they could offer shares to the public. The Revenue Act of 1942 made corporate contributions to employee pension funds deductible as a business expense and deferred taxation on such funds as income to employees until the employees actually received the pension benefits.
Federal Reserve Bulletin, various issues, table 1.21, ‘Money Stock, Liquid Assets and Debt Measures’.
To achieve the rate of return required to continue attracting capital from shareholders banks must earn a pre-tax rate of return on assets of approximately 200 to 250 basis points. In contrast the typical management fee for a money-market mutual funds is approximately 25 to 50 basis points pre-tax. Cf. James M. McCormick, ‘The Need to Transform Banks into Intermediate that Make More Efficient Use of Equity’, Testimony before Senate Committee on Banking, Housing and Urban Affairs, 22 May 1986.
Money-market mutual funds usually sell at net asset value without any sales charge or redemption fees. The price of shares in the fund is held constant at $1 per share and interest is paid in the form of additional shares. Investments of the fund are restricted to short-term money-market instruments whose market value closely approximates their book value. Customers may draw on their balances in the fund by writing an order to liquidate a certain number of shares in the fund. However, for all practical purposes, this order is treated and processed by banks as cheques.
Institutional Investor (Aug 1984) p. 115; Federal Reserve Bulletin, 70 (1984) 812.
Federal Reserve Board, Flow of Funds, various issues.
For a description of this process see Harold van B. Cleveland and Thomas F. Huertas, ‘Stagflation: How We Got Into It — How to Get Out’, Foreign Affairs, 58 (1979) 103–20.
For a description of the new instruments see Bank for International Settlements, Recent Innovations in International Banking (Basle: Bank for International Settlements, 1986).
Specifically, corporations began to raise an increasing proportion of their funds in the public markets, and institutions (many of them corporate pension funds) were the principal purchasers of such securities. For example, commercial paper securitises what was traditionally thought of as prime material for a bank loan. It is a short-term, unsecured obligation of the most creditworthy corporations — exactly the type of obligation thought to constitute the main lending business of major banks. From 1976 to February 1986 commercial paper issued by non-financial corporations rose from $12.3 billion to $86 billion, an increase of 700 per cent. Over that same period commercial and industrial loans at large weekly reporting member banks in the USA rose from $109.4 to $255.9 billion, an increase of only 230 per cent. And over the past year non-financial commercial paper rose $13.5 billion, while large banks’ commercial and industrial loans rose only $2.1 billion (Business Week [17 Mar 1986] p. 149). What once would have been a loan has now become a security. Recently a Euromarket in commercial paper has developed which allows firms from other countries (as well as US firms) to issue commercial paper. In response, many countries (e.g. UK, Sweden) have begun to relax their prohibitions against commercial paper.
Like corporations, consumers have also gone to the public markets as investors and issuers. They have entered the public market as investors largely through their purchases of shares in money-market mutual funds (see note 8, above). They have indirectly entered the public markets as issuers through securitisation of residential mortgages, consumer auto loan receivables (CARS) and consumer credit-card receivables (CARDS). As a result consumers are receiving greater returns on their savings and may be paying lower costs for credit.
Business Week, 18 Apr 1986. The five firms are General Motors, General Electric, Sears, Ford and American Express. General Motors has long had a successful consumer finance subsidiary, General Motors Acceptance Corporation (GMAC), that financed purchase of GM cars. Recently, however, GMAC has entered other financial service businesses as a means of capitalising on its broad customer base, its credit-scoring capabilities and its processing prowess. It acquired two mortgage banking concerns, making it the largest servicer of mortgages in the USA and it has announced plans to offer home mortgages through these subsidiaries. Like GM, General Electric is developing its financial services strategy through its captive finance subsidiary, General Electric Credit Corporation. GE Credit started as a captive consumer finance company to finance consumer purchases of GE appliances, but GE Credit gradually branched out into lending and leasing to unaffiliated third parties. In 1981 GE Credit entered insurance through the acquisition of Employers Reinsurance from Texaco, and in 1986 GE Credit announced its intention to enter investment banking through the acquisition of Kidder, Peabody & Co., one of the leading underwriting houses on Wall Street. Sears has perhaps the broadest financial services strategy of any firm in the USA. It has a leading insurance company (Allstate Insurance), a thrift institution (Sears Savings in California), a full-service broker/investment bank (Dean Witter) and a real estate broker (Coldwell Banker), and it has combined these units into what it calls the Sears Financial Network to provide one-stop financial shopping to consumers. Ford Motor also has a captive finance company, and it has acquired a full-service thrift institution, First Nationwide Savings, that will give it the capacity to take deposits, make mortages and consumer loans and even make corporate loans, if it so chooses. Finally, there is American Express, the only purely financial services company in the group. The company also has a comprehensive financial services strategy in place. The backbone of the company is the American Express card — a consumer transactions vehicle far superior to a personal cheque. But American Express also owns a leading investment bank (Shearson Lehman), a leading manager of mutual funds (Investors Diversified Services), at least two banks (Boston Safe Deposit Co. and American Express International Bank) and the controlling interest in an insurance company (Fireman’s Fund).
Total bank loans to developing countries rose from $72.9 billion in 1977 to $304.1 billion in 1986. International Monetary Fund (IMF), World Economic Outlook, Apr 1985, p. 262.
Total cross-border claims of the world’s major commercial banks rose from $1.7 trillion at the end of 1982 to $2.3 trillion at the end of September 1985. Of the total increase in claims ($650 billion), claims on non-OPEC developing countries accounted for only $95 billion (15 per cent), while claims on industrial countries accounted for $420 billion (64 per cent). Bank for International Settlements, International Banking Developments: Third Quarter 1985 (Basle, Switzerland: Bank for International Settlements, Jan 1986), Statistical Annex, pp. 15–16.
For example, J. P. Morgan & Co. and Bankers Trust have indicated that they will specialise in merchant banking for large institutions and high net worth individuals.
Memorandum regarding February 1986 Senior Loan Officer Opinion Survey, Federal Reserve Board, 11 Apr 1986.
Ibid. pp. 9–10.
Michael C. Jensen and Clifford W. Smith, Jr, ‘Stockholder, Manager, and Creditor Interests: Applications of Agency Theory’, in Edward I. Altman and Marti G. Subrahmanyam (eds), Recent Advances in Corporate Finance (Homewood, Ill.: Irwin, 1985) p. 121.
Total deposits at US commercial banks and thrift institutions amounted at the end of 1985 to approximately $2.8 trillion (Federal Reserve Bulletin, May 1986).
The FDIC insures up to $100000 of domestic deposits per individual per bank at commercial banks and mutual savings banks. The Federal Savings and Loan Insurance Corporation (FSLIC) insures up to $100000 of domestic deposits per individual per thrift at thrifts other than mutual savings banks. The $100000 limit covers practically all consumer deposits.
Insured deposits account for over 90 per cent of total deposits at the 14000 small, community banks with deposits of less than $100 million. In addition, essentially all deposits at FSLIC-insured institutions are insured, as are practically all deposits at mutual savings banks insured by the FDIC.
Total uninsured deposits at US banks (including uninsured deposits at foreign branches of US banks) amounted to $755 billion in mid-1985, or about 38 per cent of all deposits at US commercial banks. The nine largest banks (deposits in excess of $20 billion) hold over 40 per cent of all uninsured deposits.
Following the rescue and de facto nationalisation of Continental Illinois Corporation, the Comptroller of the Currency, C. Todd Conover, testified to Congress that the federal regulators regarded some banks as too big to fail. Cf. Tim Carrington, ‘U.S. Won’t Let 11 Biggest Banks in Nation Fail’, Wall Street Journal, 20 Sep 1984.
However, there is no evidence that the markets believe Mr Conover. Uninsured depositors continue to monitor and discipline the banks in which they place their funds. Cf. Thomas F. Huertas and Rachel L. S. Strauber, ‘Deposit Insurance: Overhaul or Tune-Up?’, Issues in Bank Regulation, 9 (1986) 6–10.
At the nine largest banks (deposits in excess of $20 billion) uninsured deposits accounted for over 70 per cent of total deposits.
The General Accounting Office reports that as of 1982 individuals owned 128 interstate bank chains controlling 430 banks. Cf. Interstate Chain Banking, Majority Staff Report to the Subcommittee on Financial Institutions Supervision, Regulation and Insurance, Committee on Banking, Finance and Urban Affairs, 20 May 1985.
Cf. Charles T. Doyle, President, Independent Bankers Association of America, Testimony on the Financial Institutions Emergency Acquisitions Amendments of 1986 before the Subcommittee on Financial Institutions, House Committee on Banking, Finance and Urban Affairs, 1 May 1986.
The average return on assets for the 4200 national banks with assets of less than $300 million declined in 1985 for the sixty consecutive year…. In 1980 the average ROA for these banks was 1.13 per cent. In 1985 it was 0.53 per cent. Even the median ROA fell for this group, indicating the scope of the earnings pressure.’ Robert C. Clark, the Comptroller of the Currency, Remarks before the Conference: The Challenge of Increased Regulatory Supervision’, Morin Center for Banking Law Studies, Boston University, 2 May 1986, p. 4.
The total volume of assets under management by commercial banks for the account of others amounted to $585 billion at the end of 1984, or 23 per cent of the total assets managed by institutions for the account of others. Money Market Directory of Pension Funds and Their Investment Managers (Charlottesville, Va: Money Market Directories Inc., 1986) p. xx.
For example AMBAC insures municipal bonds against default, and invests the premiums received in federal government and corporate securities, rather than municipal securities.
For example, in an interest-rate swap, the bank provides one party with insurance against a rise in rates and the other with insurance against a fall in rates.
For example, banks provide standby letters of credit that back issues of commercial paper by corporations or short-term notes by municipalities. They also offer interest-rate and exchange-rate protection through various swaps, futures and hedging techniques. Finally, they are investors in financial guarantee insurance companies such as the Municipal Bond Insurance Association (MBIA), the Financial Guarantee Insurance Corporation (FGIC) or the American Municipal Bond Assurance Corporation (AMBAC). At Citicorp such debt products, liquidity insurance, financial guarantees and asset intermediation accounted for $238 million in profits in 1985, or $35 million more than the profits derived from core lending (Citicorp, Annual Report, 1985, p.24).
It should be noted, however, that non-bank firms are providing increasing competition in the asset-servicing business. For example, the largest servicer of mortgages in the country is GMAC, followed by Lomas & Nettleton, an independent mortgage banker. Over the past three years banks have lost a significant amount of market share to other mortgage-servicing companies. Cf. ‘GMAC’s Infant Affiliate is No. 1 in Mortgage Servicing- For Now’, American Banker, 5 May 1986.
As of 1980, cheques accounted for 14 per cent of total payments activity in terms of value, while electronic funds transfers (FedWire, CHIPS) accounted for 86 per cent of total payments. Cf. Association of Reserve City Bankers, Report on the Payments System (Washington, D.C., 1982) p. 12.
Although American Express has succeeded in making its charge card acceptable as a means of payment for consumer purchases throughout the US and in many other parts of the world, there are few other non-bank companies that have been able to accomplish this. Most other charge cards are only accepted by the merchant which issues them. (For example, a Bloomingdale’s charge card is only accepted at Blooming-dale’s.) Sears is trying to launch a generally accepted credit card called Discover, but it remains to be seen how successful this will be. For non-consumer payments, however, payment through the banking system (via cheque or though the electronic fund transfer systems operated by banks) remains practically the exclusive form of payment.
Evidence of this trend is the development of bilateral credit caps and net debit sender caps on the CHIPS system to limit the exposure of members to the failure of another bank. These limits have since been adopted by the Federal Reserve to limit intraday overdrafts on FedWire.
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Angermueller, H.H. (1988). The Evolution of Banking Strategies and Services: The Dilemma facing Today’s Bankers. In: Mikdashi, Z. (eds) International Banking. Palgrave Macmillan, London. https://doi.org/10.1007/978-1-349-09706-7_4
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