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Chapter 13 Financial Industry Structure Conceptual and Analytical Problems For many years you have been using your local, small-town bank. One day you hear that the bank is about to be purchased by Bank of America. From your vantage point as a retail bank customer, what are the costs and benefits of such a merger? Answer: The benefits are that you will have access to a larger network of ATMs and you will be able to use your bank for a larger scope of financial services. However, you will likely receive less personal service. Economies of scale mean that larger banks have lower per-unit costs; and economics of scope mean that banks with a broader array of services have lower costs as well, so the costs of the services you use are likely to fall. If there are no other local, competing banks, the larger bank could try to use its market power to charge higher fees. However, with many financial services available at low cost on the Internet, such local market power may be limited. Why have technological advances hindered the enforcement of legal restrictions on bank branching? Answer: Most people don’t go into a physical bank building to withdraw cash from their accounts or make a deposit; instead they go to an ATM. ATMs do not qualify as “branches” of a bank, so a bank can expand its customer base across a larger geographic area without violating branching regulations. The advent of the Internet, combined with electronic and mobile banking, has made the location of bank buildings even less relevant. How did the financial crisis of 2007-2009 affect the degree of concentration in the U.S. banking industry? Answer: The spate of bank failures along with mergers between large banks and other depository institutions as a result of the crisis has increased the level of concentration in the industry. The top four commercial banks now account for about 40 percent of deposits. Banks have been losing their advantage over other financial intermediaries in attracting customers’ funds. Why? Answer: Other financial firms now exist that provide individuals with services typically performed by banks. Money market mutual funds offer customers access to financial instruments that usually pay a higher rate of interest than bank deposits, yet are still very liquid and can easily be converted into a means of payment. Banks no longer have such a large advantage in screening loan applicants because of the ease with which individuals can transmit information, so a customer who needs a loan can go online to get price quotes instead of going to the local bank. Discount brokerage firms provide individuals with low-cost access to the financial markets. An industry with a large number of small firms is usually thought to be highly competitive. Is that supposition true of the banking industry? What are the costs and benefits to consumers of the current structure of the U.S. banking industry? Answer: When the banking industry consisted of a large number of small firms, the industry was less competitive than it is today. A bank in a small town or rural area may have had a monopoly within its geographic area. As large banks branch across the country and technology such as mobile banking brings additional access to banking services, consumers benefit by having access to a larger network of ATMs and by being able to engage in a wider range of financial activities through their banks. Costs to consumers have fallen as a result of increased competition, but the level of personal service that consumers receive has declined. What was the main rationale behind the separation of commercial and investment banking activities in the Glass-Steagall Act of 1933? Why was the Act repealed? Answer: The Glass-Steagall Act was enacted in the wake of widespread bank failures during the Great Depression. It was widely believed that many commercial banks took on excessive risk and suffered from conflicts of interest due to their securities-related activities. By separating commercial and investment banking activities and so restricting how commercial banks could use the funds they raised, the act sought to protect depositors from excessive risk taking by these banks. While the Act sought to protect depositors, it also limited the ability of financial institutions to take advantage of economies of scale and scope. The potential benefits were evidently believed to outweigh the risks to depositors in the financial environment of the late 1990’s and the act was repealed. Explain what the phrase “too big to fail” means in reference to financial institutions. How did the policy responses to the financial crisis of 2007-2009 affect the too-big-to-fail problem? Answer: The phrase “too big to fail” refers to firms that are so big relative to the financial system as a whole that investors and counterparties assume that if these firms got into trouble the Federal Government would have to bail out their creditors to save the system. The bailouts of systemically important financial institutions in the financial crisis confirmed that these institutions were indeed “too-big-to-fail” and have focused attention on finding policy remedies. Discuss the problems life insurance companies will face as genetic information becomes more widely available. Answer: Insurance companies can’t predict when a particular person will die, but when they pool together a group of individuals with uncorrelated risks, they can predict fairly accurately the outcome for the group as a whole. However, if the companies have access to genetic information, they will be able to estimate with some accuracy when each individual is likely to die. Companies either won’t want to issue insurance or will charge very high premiums to individuals who will probably die soon. Individuals who are likely to remain healthy will buy less insurance, though they may still want coverage for accidental death. Overall coverage would probably fall. When the values of stocks and bonds fluctuate, they have an impact on the balance sheets of insurance companies. Why is that impact more likely to be a problem for life insurance companies than for property and casualty companies? Answer: Property and casualty insurance companies have a different investment horizon compared to life insurance companies. Because property and casualty insurance companies are likely to have to make a large number of payments in the near future, they invest primarily in short-term assets, like money market instruments. Payments from life insurance companies don’t occur until far into the future, so they invest in longer-term instruments, predominately stocks and bonds. Life insurance companies face the risk that they will have to sell stocks or bonds when prices are low in order to pay policyholders’ claims. Compare and contrast the structures of bank holding companies, financial holding companies and universal banks. Answer: Bank holding companies typically own several banks, while financial holding companies own banks and other financial intermediaries (such as investment banks and insurance companies). In both instances, there usually remain legal and regulatory separations among the subsidiaries. Universal banks own a variety of intermediaries (with fewer legal and regulatory separations compared to financial holding companies) as well as nonfinancial firms. Increased diversification from holding a portfolio of firms lowers the risk to firm owners. What are the benefits of collaboration between a large appliance retailer and a finance company? Answer: The appliance retailer has customers walk in the door who will need financing to make purchases. Meanwhile, the finance company has access to funds in financial markets. So, there are economies of scope that the two can exploit through collaboration. Why did government-sponsored enterprises (GSEs) such as Freddie Mac and Fannie Mae have substantially higher leverage ratios than the average U.S. bank in the years preceding the financial crisis of 2007-2009? Explain how this made the enterprises more vulnerable to the house-price declines that precipitated the crisis. Answer: High leverage ratios resulted from the implicit guarantee behind these enterprises. Although their debt was not guaranteed by the government, there was widespread belief that the government would support the GSEs should they get into difficulties and therefore they didn’t have the need to hold as much capital as other institutions. The fall in house prices increased the rate of mortgage defaults, reducing the value of the assets of the GSEs. With high leverage ratios, the GSEs had small capital cushions and so when the value of their assets fell, they encountered solvency problems. Consider two countries with the following characteristics. Country A has no restrictions on bank branching and banks in Country A are permitted to offer investment and insurance products along with traditional banking services. In Country B, there are strict limits on branch banking and on the geographical spread of a bank’s business. In addition, banks in Country B are not permitted to offer investment or insurance services. a. In which country do you think the banking system is more concentrated? b. In which country do you think the banking system is more competitive? c. In which country do you think, everything else being equal, banking products are cheaper? Explain each of your choices. Answer: Country A is likely to have a more concentrated banking system, as fewer banks could service the entire country. In Country B, branching restrictions are likely to give rise to a large number of smaller banks. The experience in the United States with the McFadden Act would suggest that the banking system would be more competitive in Country A. Although banking restrictions are often intended to prevent concentration and monopoly power in the banking system, the outcome in the United States was a range of small inefficient banks that faced little competition in the geographic area in which they operated. In Country A, banks can take better advantage of economies of scale and scope and so banking products are likely to be cheaper. You examine the balance sheet of an insurance company and note that its assets are made up mainly of U.S. Treasury bills and commercial paper. Is this more likely to be the balance sheet of a property and casualty insurance company or a life insurance company? Explain your answer. Answer: This is more likely to be a property and casualty insurance company. This type of company tends to hold liquid assets such as the short-term instruments described in order to meet sudden claims. Life insurance companies hold assets of longer maturity, as most of their payments will be made well into the future. Statistically, teenage drivers are more likely to have an automobile accident than adult drivers. As a result, insurance companies charge higher insurance premiums for teenager drivers. Suppose one insurance company decided to charge teenagers and adults the same premium based on the average risk of an accident for all drivers. Using your knowledge of the problems associated with asymmetric information, explain whether you think this insurance company will be profitable. Answer: This insurance company is unlikely to be profitable because of the problem of adverse selection. The insurance premium based on the average risk of an accident in a pool of both teenagers and adults will be higher than the premium for the relatively low-risk adults alone and lower than the premium for teenagers alone. Therefore, adults will not choose to be insured by this company but teenagers will. The premium charged based on the average risk of teenagers and adults would not be sufficient to cover the claims of a teenage-only pool and so the company would not be profitable. Use your knowledge of the problems associated with asymmetric information to explain why insurance companies often include deductibles as part of their policies. Answer: The presence of deductibles helps to reduce moral hazard. In the case of car insurance, for example, the insured faces a cost associated with an accident and so will likely be more careful when driving. Suppose you have a defined-contribution pension plan. As you go through your working life, in what order would you choose to have the following portfolio allocations: (a) 100 percent bonds and money-market instruments, (b) 100 percent stocks, (c) 50 percent bonds and 50 percent stocks? Answer: You should choose (b), (c) and (a). Early in your working life, investing in stocks makes sense as they generally earn a relatively high rate of return and are relatively safe when held over the long term. As you approach retirement and the need to use your long-term savings, you should reduce the share of assets allocated to stocks, eventually focusing on fixed-income and liquid financial instruments. As an employee, would you prefer to participate in a defined-benefit pension plan or a defined-contribution pension plan? Explain your answer. Answer: If you are a risk-averse person and plan to stay in the same job for a significant portion of your working life, you may prefer a defined benefit plan. The longer you work for a company, the higher the pension benefits. In addition, your employer bears the risk associated with making future payments of a certain size to you. However, if you plan to change jobs regularly and are confident about making investment decisions about your retirement savings, you may prefer a defined-contribution plan. In the aftermath of the financial crisis of 2007-2009, there have been calls to re-instate the separation of commercial and investment banking activities that were removed with the repeal of the Glass-Steagall Act. Do you think this is a good way to reduce systemic risk? Answer: Separating commercial and investment banking activities into different institutions may remove some conflicts of interest for banks across their different activities and may protect against excessive risk taking with depositors’ funds. On the other hand, this type of separation may not mitigate the “too-big-to-fail” problem. It also limits the benefits from economies of scope. A more effective way to reduce systemic risk might be through capital and liquidity requirements. Suppose a well-known financial holding company agreed to be the underwriter for a new stock issue. After guaranteeing the price to the issuing company but before selling the stocks, a scandal surrounding the business practices of the holding company is revealed. How would you expect this scandal to affect (a) the financial holding company and (b) the issuing company? Answer: Because the financial holding company relies on its reputation to place the stock issue with investors, it is likely to find it much more difficult to sell the stock at the price it has planned upon. It will lose on the deal as it has already agreed a price with the issuing firm. The issuing firm will not be directly affected in that its funds from this issue are already guaranteed. It may, however, suffer indirect adverse consequences by association. Consider three possible health insurance programs with the following characteristics:
Program A: Participation in the program is voluntary and the policy premium charged varies with an individual’s health status, with those in relatively better health paying less.
Program B: Participation in the program is voluntary and the policy premium is the same for everyone, based on the nation’s average cost of health care per person
Program C: Participation in the program is mandatory and the policy premium is the same for everyone, based on the nation’s average cost of health care per person
Which of the three programs is least likely to be viable? Explain your answer. Answer: Program B is the least likely to be viable due to adverse selection. If you can purchase health insurance at the same price regardless of your health status, in the case of voluntary participation, relatively healthy people would be less likely to participate than those in poorer health. This would result in relatively higher insurance payouts, which is not likely to remain viable. The mandatory element of Program C that would ensure participation by relatively healthy people makes it more viable, while the ability to price discriminate on the basis of health status makes Program A less likely to fail. Suppose a U.S. bank is considering providing its services abroad. List one possible advantage and one possible disadvantage of expanding via the acquisition of a controlling interest in a foreign bank versus the establishment of an international banking facility (IBF)? Answer: Once possible advantage of acquiring a controlling interest in a foreign bank relates to information costs. By retaining existing local staff and records of existing customers, the U.S. bank could reduce information costs relative to the alternative. One possible disadvantage of that approach would be giving up economies of scale in terms of being able to employ management and administrative systems already used by the U.S. bank. Data Exploration One aspect of the 2007-2009 financial panic was a run on some money market mutual funds (MMMFs). Plot weekly data (without recession bars) for 2008 on institutional MMMF deposits (FRED code: WIMFSL) and identify the timing of the run visually. Next, download the data and report the size of the deposit outflow in the week that the run peaked. Why did this run end? Answer: The run on MMMFs occurred in September, 2008; the data plot is below. Data for several weeks before and after the run are listed below the graph, showing that nearly $100 billion fled money funds in the week ending September 22, 2008. The Federal Reserve guaranteed the liabilities of these funds on September 19 (the middle of the reporting week), so the deposit outflow earlier in the week may have been larger. Soon after the intervention, fund deposits began to rise again. Institutional Money Funds (WIMFSL), Billions of Dollars, Weekly, Seasonally Adjusted
2008-07-14 2333.1
2008-07-21 2327.2
2008-07-28 2323.6
2008-08-04 2339.5
2008-08-11 2352.2
2008-08-18 2358.2
2008-08-25 2342.0
2008-09-01 2350.3
2008-09-08 2376.8
2008-09-15 2352.5
2008-09-22 2259.3
2008-09-29 2247.5
2008-10-06 2254.3
2008-10-13 2267.2
2008-10-20 2314.5
2008-10-27 2326.1
When did the financial crisis of 2007-2009 peak and why? Plot weekly data for 2006–2010 for the one-week LIBOR rate (FRED code: USD1WKD156N) and the effective federal funds rate (FRED code: FF). (For consistency, plot both series on the same basis by specifying “Weekly, ending Wednesday” in the “Modify Frequency” dropdown box.) Explain the pattern. Answer: The data plot is below. The gap between the one-week LIBOR rate and the federal funds rate primarily reflects liquidity concerns, because both involve uncollateralized loans to counterparty banks. The spread spiked following the failure of Lehman Brothers in September 2008, until the Federal Reserve responded with a massive increase in the supply of liquidity. ICE Benchmark Administration Limited (IBA), 1-Week London Interbank Offered Rate (LIBOR), based on U.S. Dollar© [USD1WKD156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USD1WKD156N. How did competition from money market mutual funds affect traditional savings institutions that provided mortgages at fixed interest rates? Beginning in 1981, plot the ratio of retail money market mutual funds (FRED code: WRMFSL) to the sum of savings and time deposits at savings institutions (FRED codes: SVGTI and STDTI). What favored money funds in the 1980s and 1990s? Why did the ratio shrink in the first half of the 2000s? Answer: The data plot is below. When interest rates rose in the 1980s, revenues from the fixed-rate mortgages did not. Yet, facing competition from money market funds, savings institutions had to pay higher rates on deposits, squeezing their profits and leading many to fail. By investing in short-term financial instruments, money market mutual funds were able to pay higher rates to their investors, so funds flowed from savings institutions to these mutual funds. In the first half of the 2000s, short-term interest rates fell to very low levels, so interest-sensitive investors in the money market mutual funds shifted their savings to higher-yielding assets.
Mutual funds allow small savers to pool their resources and purchase diversified portfolios of assets with low transaction costs. To see whether savers have taken advantage of these (and other) benefits, plot since 1980 mutual fund holdings (FRED code: MFTCMAHDFS) as a percentage of GDP (FRED code: GDP). Explain the pattern. Answer: The plot below shows that mutual funds have become increasingly important. The combination of diversification at low cost and tax protection offered by various retirement savings approaches strongly encouraged wealth accumulation through mutual fund holdings. The initial surge may reflect in part the introduction of traditional Individual Retirement Accounts or IRAs). The subsequent proliferation of another popular retirement saving instrument, 401(k) accounts offered by many employers, helped sustain the rising trend, as have more recent variations on the original IRA. indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
