Developments in the US Banking Industry - Assignment Example

Q a) This trend indicates that since 1934 the number of branches has increased to 82547 from zero reflecting a great change in the number of branches opened by the banks during this period. This increase in number of branches can also be attributed to the evolution of the banking system within the country as with the passage of time; the number of branches has increased manifolds. This also means that the overall access of public to banking facilities has increased too with the passage of time. However, one critical aspect of this trend is still lacking from this data which must be taken into consideration to make a solid comment regarding the overall access of the public to the banking facilities. The increase in population of the US has not been taken into consideration because current population of US is well over 300 Million and as such for 3634 individuals there is one bank branch.1 As compared to 1998 when US population was 270.298M and number of Branches was 62651, the average is 1 Branch for 4314 individuals. This simple statistics therefore indicate that the access to banking facilities has increased. (b) As per the data given, there were 14146 in 1934 whereas in 2008 the number of banks was 7086 indicating that the no of banks have declined to almost half since 1934. This fact can be attributed to two most important inferences i.e. bank failure, and consolidation. Bank Failure Source: http://mjperry.blogspot.com/2008/01/history-of-us-bank-failures.html As this graph indicates, the number of bank failures peaked during 1990s and as such this phenomenon might have contributed towards the reduction in the number of banks in 2008 as compared to 1934. Another important fact that can be attributed to this will be the relative consolidation of the industry as banks started to provide universal services including insurance, security trading, mortgages etc. These two facts therefore can readily explain this trend in the number of banks over the period of time. c) The trends definitely indicate that there is an increase in the consolidation of the industry as smaller players seems to have been acquired by the larger firms. The relative consolidation of the industry that might take place in periods to come can also be indicated from the fact that the financial sector as a whole is facing extreme economic situation wherein the large banks are facing it difficult to cope with the financial meltdown. d) Banks are considered as more sensitive because the overall impact of the economic shocks affect banks in more sever manner. The recent financial meltdown indicates the intensity of the bank failure and its impact on the economy as a whole. It is because of this reason that banks are often heavily regulated and their performance is closely watched not only by the regulators but by the general public also. It is therefore important that the banks must be managed in a manner that allow them to bear the economic shocks not only to negotiate with the competition within the economy but also other general economic shocks that can disrupts their own existence. The process of consolidation therefore is considered as necessary because it allows banks to accumulate significant capital to buffer themselves against the economic shocks besides achieving the economic efficiency. It is believed that the smaller banks due to their low capital as well as high risk tend to falter easily with major swings in the economy. On the other hand, however, larger and stronger banks (in terms of their capital and assets) tend to develop ability to cushion themselves against losses. This therefore also means that the process of consolidation will actually strengthen the ability of the financial system as a whole to negotiate with the risk in more appropriate manner. Similarly, competition within the banks can be detrimental for the smaller banks whereas the risk profile of competitive banks becomes high owing to their ability to procure lending business to them. (Rosen,2004). Thus competition is a double sword which at one hand can kill smaller banks but can also expose the larger banks to higher risk due to their increased exposure in high risk assets. The failure of the large banks such as Citibank is a reflection of the same phenomenon wherein due to its strong competitive position; Citibank acquired heavy exposure in risky assets thus exposing itself to the subprime mortgage crisis which resulted into its downfall from the grace in very short period of time. Q#2(a) There were 1441 bank failures during the period of 1985 and 2009 indicating that the bank failure has greatly accelerated during this period. Similarly, during the period of 1985 to 2005, there were 1301 failures and as such total failures after 2005 are 140. This figure also indicates that the pace of bank failure accelerated after the period of 2005 when financial crisis started to hit the US economy. During this period, the subprime mortgage crisis was the main cause as to why the overall pace of bank failure increased as banks start to find it difficult for them to cope with the increased competitive pressures and reduced profitability. These figures also reflect that the increase in number of failed banks during this period shall also be attributed to the overall economic conditions that economy of US has faced during this period. The era of 1980s was the height of the cold war between US and USSR and as such economy faced stiff conditions owing to the fact that most resources were put into potentially non-productive use such as funding the war against the Russian occupation in Afghanistan. Further, the relaxation in the financial regulations as well as the financial innovation resulted into the failure of the smaller players who could not meet the increasing competitive pressures. b) Before discussing the history of bank failure in US during the period of 1985 to 2005, it is important that we must first illustrate the relevant evolution of the commercial banking in US and how different circumstances led to the promulgation of different regulations and other changes. It is argued that the history of commercial banking in America is a history of erratic regulations as some times the regulations that were enacted favored the banks while sometimes the regulations were made strict and worked against the banks and as a result banks suffered. The modern history of commercial banking in US therefore can be easily divided into three broader areas as far as the regulations are concerned. The three broader areas are: 1. Era before 1980s 2. From 1980 to 1999 3. Post 1999 era It is believed that the era before 1980s was an era during which the commercial banks remained profitable as there were strict restrictions that were placed on the banks. Such restrictions therefore prevented banks to remain within their limits and lending in risky areas was restricted also. The regulatory environment was supportive for the commercial banks and as such banks remained largely profitable during this period. However, era between 1980 to 1999 witnessed a great increase in the number of bank failure and the unique position of the banks started to erode owing to many important factors most importantly the regulations and administrative steps. During this era various courts in the country started to give verdicts which basically allowed the financial institutions to engage into financial innovation and non-banking financial institutions were allowed to enter into the market. Further, due to advances in the information technology, financial innovation and higher returns offered by the capital markets, customers started to by-pass the commercial banks and invested their deposits in capital markets. This phenomenon also resulted into more competition for the banks and increase in overall cost of doing the business. The development of the products such as money market deposit accounts allowed consumers to enjoy alternatives to the checking accounts and invest their funds into those areas where the probability of return was higher as compared to the bank accounts. The emergence of the pension funds also started to erode the long term bank accounts with the commercial banks because consumers were finding it more appropriate to place their funds into pension funds which were offering higher returns. It is also important to note that this phenomenon resulted into the change in the portfolio of assets hold by the households within the economy because consumers were preferring to have their funds invested into those assets that provide higher returns regardless of the risk involved in such assets. As a result of this phenomenon, banks started to lose their deposits to the non-banking institutions and deposit taking became more expensive for the banks. This therefore also forced the commercial banks to gain the market through extensive lending into the real estate and increased their riskiness due to concentration risk. This era therefore witnessed the bank failure due to high deposit cost, low deposits, significant losses arising out as a result of bad loans etc. The data on the bank failure indicate one important aspect of the phenomenon discussed above i.e. most of the banks that failed were those with low deposit and asset base. Low asset base therefore does not provide the direct cushion against the losses and recurring losses can therefore erode the equity of the bank and result into the failure. However, the data provided in the table does not directly provide important insights into the nature of such failure i.e. why the banks failed and what were the reasons. Another important aspect is the relative size of the bank’s balance sheets i.e. the quantum of deposits and assets. Though the data indicates that the banks that failed were mostly those banks having very low deposit and asset base however it is really unclear regarding the overall riskiness of those banks. Evaluating the riskiness of the failed banks can provide important insight into the lending practices of the banks and may also lead to the assessment of management practices in such banks. This is because of the fact that high default ratio can also be a direct result of poor lending decisions that smaller banks often make in order to remain competitive. During 1980s, top 20 Banks of that time suffered heavily as they were more instrumental in extending loans to the foreign governments such as Mexico etc. These loans were though given at high rates however, few countries failed to honor their commitments hence the leading banks faced strong liquidity shortage as well as decline in profitability. Though this trend is still in practice however banks make lending to the foreign governments in indirect manner by first lending to the bodies like World Bank thus reducing their direct exposure to the risks that they may not withstand themselves. Another important reason for the bank failure was the increased competition for the borrowers as introduction of the new institutions within the economy made it difficult for the banks to attract good quality customers as pension funds, mutual funds, and insurance companies attempted to attract new borrowers thus reducing the number of good quality customers available to the banks. This made it easier for the banks to make high risk lending and increase their risk profile thus adding to their own woes to become more risky in nature. From 1980 to 1990 the percentage of asset holding by the commercial banks declined to a great extent and banks started to lose business to their competitors and hence the frequent failure of the smaller banks started to happen at rapid pace. The era between 1999 to 2005 witnessed changes in the regulatory environment and as such banks were given more breathing space to compete with the other financial institutions. Though the pace of bank failure remained almost stagnant during this period however the sector seem to remain strong due to increasing demands for consumer finance. Consumer spending has increased during this period which allowed banks to remain afloat during this period of relatively low volatility. Post 2005 Post 2005 data indicate that the failure of the banks increased and the pace almost quickened after 2007 when the financial meltdown started to take its roots. The apparent reason for the failure of the banks during this era was the subprime mortgage crisis that started to emerge during 2007. This phenomenon occurred due to the fact that the banks and other financial institutions started to securitize their mortgage portfolio and on mass default of the subprime borrowers, these banks faced strong liquidity crunch thus forcing them to suffer losses and eventually failure. The post 2005 era can therefore considered as one of the most troubled era in the history of modern banking in US as the mass scale failure of the banks brought the financial system to virtual collapse besides creating a strong contagion effect on other sectors of the economy.(Ellis,2009). Most notable failures during this period include the failure of Lehman Brothers, Citibank etc. both these banks were considered as the giants of the industry however due to their excessive risk taking, both suffered heavily as Lehman Brothers filed for bankruptcy whereas Citibank declared heavy losses during this period. Apart from this, other firms such as General Motors as well as Ford Motors suffered heavily too due to lack of availability of consumer finance to the customers owing to the prevailing financial meltdown. Thus the post 2005 era was probably one of the toughest eras in the modern history of US banking affecting the whole economy. Regulatory Response The regulatory response to the bank failure between 2005 and 2009 was rather swift and more rapid in nature. Though the issue is still debatable as to whether the government shall intervene in markets or not however, the response from the government was relatively more intense and rapid in nature. US government injected funds into the system just to ensure that the system does not collapse and cripple the whole economy. Further, there was a systematic effort by the FED to apply different monetary policy tools to stimulate growth in the economy. This was achieved through lowering down the interest rates to low level in order to stimulate the consumer spending and manufacturing activity. The economic stimulus plan given by the Obama Administration approximately earmarked more than $700 billion for creating the necessary stimulus to help economy to recover out of the recession as well as allowing banks to remain solvent. (Leonhardt,2010). Apart from this there are still more steps to be taken which can basically restrict the banks from putting their hand into risky loans besides improving the corporate governance mechanism within financial sector. The regulatory response to the bank failures also included the rationalization of the executive compensation of the banks so as to reduce the relative risk involved. Finally it can be argued that the regulatory response was mostly directed at bringing economy back on track rather than initiating a serious effort to discipline the banks and financial institutions to make prudent lending decisions. References 1. David Ellis. (2009). Get ready for a wave of bank failures. Available: http://money.cnn.com/2009/02/20/news/companies/bank_failures/. [Last accessed 03 March 2010.] 2. DAVID LEONHARDT. (2010). Judging Stimulus by Job Data Reveals Success . Available: http://www.nytimes.com/2010/02/17/business/economy/17leonhardt.html. [Last accessed 04 March 2010.] 3. Richard J. Rosen. (2004). Real Effects of Bank Competition. Journal of Money, Credit & Banking. 36 (1), 15-23. Read More