The Efficiency in the Banking System of the US - Coursework Example

Introduction Efficiency of banking system is considered as one of the most important economic phenomenon which effectively ensures the solvency of abanking system. The overall riskiness of the banking system can impact the whole financial system of any country thus it is often argued that the monetary policy authorities shall ensure that the financial system remain stable and does not create spillover effects on other sectors of the economy. Historically, during last few decades of the previous century, de-regulation of the banking sector was advocated in order to achieve more efficiency. As a result of the de-regulation process, banking firms started to expand and took excessive risks which ultimately resulted into their downfall in current financial crisis. However, until Second World War, US banking sector was heavily regulated.(Rothbard,2002). During this period, market concentration in banking system of US greatly supported the booming manufacturing sector of the economy.(Mitchner & Wheelock,2010). The current financial crisis clearly indicates towards the assessment of the efficiency of the banking system of any country so that proper steps can be taken to make sure that the impact of future adverse events remains within control. The question therefore also arises as to how to measure the efficiency of a banking system and how to evaluate it to make an assessment of the overall riskiness of the system and its potential impacts on other sectors of the economy. This paper will attempt to study the efficiency in the banking system of US with special reference to understanding the industrial characteristics of the market, an evaluation of the key environmental factors that derive the market besides reviewing the existing empirical studies that have been conducted on bank efficiency and competition within US. Industrial Characteristics of US Banking System One of the important characteristics of the US Banking system is the fact that it is a fragmented market which is equally dominated by smaller as well as large banking institutions. (Keeton, 2009). Smaller banking institutions mostly work on the regional level whereas large banks such as Citibank have international presence too. Thus there are three types of banking institutions that are present within the system i.e. those banks which are established under the Federal law, banks established under the State Law and private institutions. This bifurcation of the banking industry makes it more fragmented in nature and allow it to compete on various competitive basis. This fragmentation of the market therefore never allowed any bank to become dominant player in the market and system as a whole was considered as efficient with no clear market leaders and market concentration. However, at regional level monopoly existed as large concentration was witnessed between large firms at regional level.(Heggestad & Mingo,1977). Current financial crisis and Bank Efficiency In order to discuss the bank efficiency, it is really critical that a review of the current financial crisis and bank failure shall be provided. The failure of the banking sector in developed world including UK and US indicate that the banking system may not be entirely viable and external shocks can effectively collapse the whole system. (Keller & Stocker,2008) The failure of the banks therefore leads to the logical question of whether the banking sector of US was efficient. If efficiency was there than why it failed to bear the brunt of the crisis that quickly engulfed it and other sectors of the economy? The efficiency of the banks therefore needs to be viewed from multi-dimensional perspective and as such there is a need to understand the broader environmental factors that are the underlying causes of the failure of the banking system and relative inefficiency of the banks to tackle the crisis. Subsequent sections of this paper will therefore ponder on this issue. Bank Failure in US The recent financial crisis has resulted into the closure of many smaller and larger banks in US including liquidation of JP Morgan- one of the largest banks in the world. Number of banks in US during 1934 was 14146 whereas it almost declined to half during 2008 as number of banks were only 7086. This decline in the number of banks in US can be attributed to two critical factors i.e. the consolidation in the industry as well as the bank failure. The history of bank failure in US will indicate that the number of bank failures greatly accelerated during 1990s when US economy was going through mild recession and was involved in war in gulf region. Apart from this, the pace of bank failure in country quickened after 2007 in the wake of current financial crisis. Source: http://mjperry.blogspot.com/2008/01/history-of-us-bank-failures.html Bank efficiency in US There are different factors that are taken into consideration while analyzing the efficiency of a banking system. Most importantly, the cost to income ratio as well as cost to asset ratio is one of the leading indicators of the efficiency with which a bank can manage itself. Capital adequacy is another important indicator of the overall riskiness of a bank and must be adequately assessed in order to measure the availability of buffer capital to secure the bank against the losses that may be incurred in due course of time. It is also critical to understand that the overall riskiness of the banking sector is considered as the most important indicators of the efficiency because high riskiness of a bank can lead to its failure despite achieving the relative efficiency in its operations.(Rosen,2004). It is critical to note that measuring the cost efficiency of a banking sector in US may be difficult to measure as many empirical studies indicates that the due to heterogeneity of the banking sector in the country, it is relatively difficult to employ techniques such as measuring cost efficiency as the sole criteria for judging the efficiency of banking system in US.(Mester,1996). The banking system of US is considered as the largest banking sector in the world followed by Japan and UK. The number of deposit taking institutions increased over the period of time with increase in the average size of the financial institutions witnessed before the financial crisis. The existing financial crisis has resulted into the collapse large banks such as JP Morgan, Citibank as well as numerous other smaller banks which were operating at regional level. Such high ratio of bank failure therefore indicates impact of the current financial crisis on the overall viability of the financial sector. Studies conducted by Feng (2008) indicated that the large banks with over 1 billion of asset size were relatively more inefficient as compared to the banks falling into the smaller to medium sized banks. This study comprised of the data taken from 1998 to 2005 and attempted to assess the cost efficiency of the banks using Fourier analysis techniques. This study further revealed that as the banks grow in their size they become less efficient due to increasing cost burden on them as well as the relative efficiency that creep into such organizations with the passage of time. As of 2008, the total short term liabilities of the banking sector in the country comprised of 15% of the GDP of the country which is relatively considered as smaller as compared to the overall size of the economy of the country. The leverage ratio which is again one of the leading indicators of the riskiness of the banking sector of the country is 12 for the US Banking industry.(Norris,2008). Though this leverage ratio is considered as low however it is still considered as higher to warrant about the overall riskiness and efficiency of the banking system of the country. The impact of regulation on the bank efficiency was also significant as after 1980s when US systematically started to de-regulate its banking sector, profitability started to increase. However, this increase in profitability is now considered as a direct result of the short term approach adapted by the bank management to achieve short term profitability targets rather than ensuring the long term viability of the institutions. The de-regulation of the banking sector therefore also resulted into the systematic decline in the efficiency of the banks over the period of time.(Ramirez,2003). This systematic decline in the efficiency of the banks however can also be attributed to the environmental factors. Environmental Factors Some of the most important environmental factors that resulted into the systematic de-regulation of the banking sector of the country were political and technological factors. During 1980s drastic steps were undertaken to de-regulate the banking system to allow it to become more efficient. By reducing the role of government in governing the market, it was believed that financial markets are flexible enough to adjust themselves for external shocks without the explicit help of the government. The increasing de-regulation of the sector is also often attributed to the creation of financial elite which formed nexus with the politicians to draft the laws in their own favors so that short term profitability targets can be achieved at the cost of long term stability. The current stimulus plan for the banking sector is also skeptically viewed as a step to serve the interest of the elite who were basically behind the creation of financial crisis. The era during the de-regulation also allowed non-banking institutions to start conducting activities that exclusively fell into the ambit of banking sector in the past. Due to this gradual encroachment of non-banking institutions, banks also started to lose their efficiency due to competitive pressures. In order to maintain their profitability and ensure the sustainability, smaller banks started to take high cost deposits and made lending into the areas which were potentially risky. High cost deposit ultimately increased the cost to income ratio of most of the banks and hence banks started to compromise their efficiency in a bid to earn profit.(Ellis,2009). The improvements in the technological factors are another important factor that resulted into the drastic changes in the banking sector of the country. Technology also increased the reach and efficiency of the banking system as consumers were now offered more unique options to conduct the banking activities. Technological improvements also resulted into the free flow of funds across the borders in a bid to look for attractive opportunities across the border. However, due to imprudent lending decisions of the banks, most of the loans sanctioned to sovereign governments went bad and banks suffered mostly due to their inefficient assessment of the credit worthiness of these governments. Conclusion Banking system of US is dominated by the smaller as well as larger players as there are many banks which operate the regional level with no international presence. Various studies indicated that the larger banks were relatively more inefficient as compared to the smaller banks. This fragmentation of the industry however gradually resulted into the consolidation as institutions started to fail due to increasing competitive pressures. Regulations enacted during 1980s allowed non-banking financial institutions to undertake some of the banking activities which ultimately resulted into the increase in cost to income ratio of the banks thus decreasing their inefficiency. On the whole efficiency of the US banking system is not so impressive considering the current financial crisis and the inability of the banking sector to cope with the situation despite the fact that industry earned highest profits in its whole history before the crisis. References 1. Ellis., D (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. Feng, G & Serletis, A (2008) Efficiency and productivity of the US banking industry, 1998-2005: evidence from the Fourier cost function satisfying global regularity conditions. Journal of Applied Econometrics. 24 (1) 105 – 138 3. Heggestad, A & Mingo, J (1977) The Competitive Condition of U.S. Banking Markets and the Impact of Structural Reform. The Journal of Finance. 32 (3) 649-661 4. Keeton, W (2009) The Role of Community Banks in the U.S. Economy Federal Reserve Bank of Kansas City, Available: www.kc.frb.org/PUBLICAT/ECONREV/Pdf/2q03keet.pdf [Last accessed 18th March, 2010] 5. Keller, C., & Stocker, M. (2008, November 18). Executive Compensations Role in the Financial Crisis., Available The National Law Journal: http://www.law.com/jsp/cc/PubArticleCC.jsp?id=1202426091714 [Last accessed March 15, 2010] 6. Mester, L (1996) MEASURING EFFICIENCY AT U.S. BANKS: ACCOUNTING FOR HETEROGENEITY IS IMPORTANT Federal Reserve Bank of Philadelphia, Available: http://www.philadelphiafed.org/research-and-data/publications/working-papers/1996/wp96-11r.pdf [Last accessed 16th March, 2010[ 7. Mitchner, K, Wheelock, D (2010) Does the Structure of Banking Markets Affect Economic Growth? Evidence from U.S. State Banking Markets NBER, Available: http://www.nber.org/papers/w15710.pdf [Last accessed 17th March, 2010] 8. Norris, F (2008) The World’s Banks Could Prove Too Big to Fail — or to Rescue New York Times, Available: http://www.nytimes.com/2008/10/11/business/worldbusiness/11charts.html?_r=2&partner=rssnyt&emc=rss&referer=sphere_related_content&referer=sphere_related_content&oref=slogin [Last accessed 16th March, 2010] 9. Ramírez, C (2003) Did branch banking restrictions increase bank failures? Evidence from Virginia and West Virginia in the late 1920s. Journal of Economics and Business. 55 (4) 331-352 10. Rosen R. (2004). Real Effects of Bank Competition. Journal of Money, Credit & Banking. 36 (1), 15-23. 11. Rothbard, M (2002). A history of money and banking in the United States: the colonial era to World War II. Amesterdam: Ludwig von Mises Institute. Read More