financial industry structure

《financial industry structure》由会员上传分享，免费在线阅读，更多相关内容在工程资料-天天文库。

Chapter13FinancialIndustryStructureLearningObjectivesUnderstand . . .LO1BankingindustrystructureLO2NondepositoryinstitutionsCanada,anationof35millionpeople,has24domesticbanks.IftheUnitedStateshadthesameratioofbankstopopulation,itwouldhavesomethinglike215banks.Infact,asofthefirstquarterof2013,about6,000commercialbanksexistwithinU.S.borders,allvyingtoservesome315millionAmericans.WhiletheUnitedStatesandCanadaareextremes,mostcountries’bankingsystemsmorecloselyre-sembletheCanadianstructure.InJapan,forexample,127millionpeopledependon120banks;intheUnitedKingdom,63millionpeopleareservedby155domes-ticallyincorporatedbanks;andinChina,therearefewerthan200banksfor1.35billionpeople!Amazingly,theUnitedStatesoncehadevenmorebanksthanitdoestoday.AsFigure13.1shows,thenumberofcommercialbankspeakedatnearly15,000in1984andhasbeenfallingeversince.Thefigurealsoshowsanoddpatterninthestructureofbanks.Fordecades,mostU.S.bankswereunitbanks,orbankswithoutbranches.Throughoutthe1950sand1960s,morethantwo-thirdsofbankswereunitbanks.Overthelastquarterofthe20thcentury,however,thepatternchanged.Today,lessthanone-fourthofbanksintheUnitedStatesareunitbanks.Whatexplainsthischangeinstructure?ThedeclineinthetotalnumberofbanksandtheincreaseinthenumberofbankswithbranchesarenottheonlychangestheU.S.bankingindustryhasseeninrecentyears.InApril1998,theTraveler’sInsuranceCompany,togetherwithitsinvestmentbankingandbrokeragesubsidiarySalomonSmithBarney,mergedwithCitibank,thenthesecondlargestcommercialbankinthecountry,tobecomeCitigroup.Atthetimeofitscreation,Citigrouphad$700billioninassetsandmorethan100millioncustomersin100countries.Itwasalsoillegal.Butbytheendof1999,thelawthatforbadesuchcombinationshadbeenrepealed,andCitigroupbeganbuyingupevenmorefinancialfirms.Today,Citigroupandafewothermegabanksprovideabroadassortmentofproductsofferedbyalmostallotherfinancialinstitutions.Thesemayincludethefunctionsofaninsurancecompany,apensionfund,asecuritiesbroker,acollectionofmutualfunds,afinancecompanyand—ofcourse—acommercialbank,allrolledintoone.cec2174X_ch13_327-358.indd32725/11/135:41PM 328lChapter13FinancialIndustryStructureFigure13.1NumberofInsuredCommercialBanksintheUnitedStates,1935–201216,00014,00012,00010,0008,0006,0004,0002,00001935194019451950195519601965197019751980198519901995200020052010UnitBanksBankswithBranchesSOURCE:FDICHistoricalStatisticsonBanking,www2.fdic.gov/hsob/hsobRpt.asp.(FREDdatacode:USNUM).Thecrisisof2007–2009hastransformedtheU.S.financialindustry.Thefailureorforcedmergerofseverallargebanksandotherdepositoryinstitutionsacceleratedconcentration,boostingthedepositshareofthetopfourcommercialbanksbyabout7 percentagepoints,toaround40percentofthetotal.InJuly2008,theU.S.govern-mentplacedthetwomassivegovernment-sponsoredenterprises(GSEs,page 68)forhousingfinanceinconservatorship(wipingouttheirprivateshareholders,butallowingthemtooperatewhileinsolvent).InSeptember2008,theinvestmentbankingerathathadprevailedsincethe1930scametoanabruptendasthefourlargestindependentinvestmentbanksfailed,merged,orbecamebankholdingcompanies.Theensuingrunonmoney-marketmutualfunds(MMMFs)wasstoppedonlybyagovernmentguaran-teeofMMMFliabilities.AndthefederalgovernmentinvestedseveralhundredbilliondollarstorestorethecapitalofthelargestU.S.financialinstitutions,bailingouttheircreditorstostabilizethefinancialsystem.AsidefromtheGSEs,theseinstitutionshaverepaidthegovernment,but,asrecentlyas2012,afew“private”intermediariesstillhadtheU.S.governmentastheirlargestshareholder.Tounderstandthechangingstructureofthefinancialindustry,wewilldiscusstheservicesofferedbybothdepositoryandnondepositoryfinancialinstitutions.Together,theyprovideabroadmenuofservices:buyingandsellingsecurities;offeringloans,insurance,andpensions;andprovidingcheckingaccounts,creditcards,anddebitcards.Mostfinancialinstitutionsperformatleastafewofthesefunctions.Visitthewebsiteofanylargebank,forinstance,andyouwilldiscoverthatyoucangetnotonlycheckingandsavingsaccounts,loansandcreditcards,butinsuranceandstockbroker-ageservices.Thefirsthalfofthischapterwillconsidercurrenttrendsinthebankingindustry,includingthetendencytowardconsolidationwithnondepositoryinstitutions.Thesecondhalfofthechapterwillstudythefunctionsandcharacteristicsofnonde-positoryinstitutions.cec2174X_ch13_327-358.indd32825/11/135:41PM BankingIndustryStructureChapter13l329BankingIndustryStructureToday’sbankingsystembearslittleresemblancetotheoneAmericansknewin1960or1970.Thenpeopleusedtheirneighborhoodbanks.Notonlydidcustomerswalkintothebanktoconducttheirbusiness,buttheyknewthetellersandbankmanagerstheysawthere.Todaymostofusdon’tgobeyondtheATMinthelobby,andifwedo,weprobablydon’trecognizetheemployeesinside.SomeofusdoourbankingviamobilephoneorovertheInternetandneverseethebank’s“bricksandmortar.”Bankshavebeentransformedsothatlocationdoesn’tmatterthewayitoncedid.Thischangehasoccurredonboththenationalandtheinternationallevel.Thebestwaytounderstandthestructureoftoday’sbankingindustryistotraceitbacktoitsroots.Thatmeanslookingatthelegalhistoryofbanking.Inthissectionwe’lllearnthatbankinglegislationisthereasonwehavesomanybanksintheUnitedStates.We’lllookatthetrendtowardconsolidationthathasbeensteadilyreducingthenumberofbankssincethemid-1980s.Andwe’llbrieflyconsidertheeffectsofglobalization.AShortHistoryofU.S.BankingIfyouwanttostartabank,youcan’tjustrentaspace,putupasign,andopenthedoor.Youneedpermissionintheformofabankcharter.UntiltheCivilWar,allbankcharterswereissuedbystatebankingauthorities.BecausetheauthorsoftheU.S.Constitutionfearedastrongcentralgovernment,intheearlyyearsoftheRepub-licthefederalgovernmentwasweakandsometimesineffectual.Stategovernmentswereoftenmorepowerful.Until1863,infact,therewasnonationalcurrency.Instead,statebanksissuedbanknotesthatcirculatedinmuchthewaydollarbillsdotoday.Butwhilethestate-charteredbanksusuallypromisedtoredeemtheirbanknotesingold,theydidsoonlyifthebearerpresentedthematthebank.Asthebearertraveledfartherandfartherfromthebank,thevalueofthenotesfell.SoanoteissuedbyaNewYorkbankwasworthlessinPhiladelphiathanitwasinA$10banknoteissuedbytheCentralBankofTennesseein 1853.NewYork.Besidescurrencythatdidnotholditsvaluefromoneplacetoanother,theearlyAmericanfinancialsystemwasplaguedbyinsufficientcapitalandfraud.Banksreg-ularlyfailed,andwhentheydid,theirbanknotesbecameworthless.AswesawinChapter2,giventhelicensetoprintmoney,mostpeoplewillprinttoomuch.Withsomanydifferentbanknotescirculating,tellingthesoundmoneyfromtheunsoundbecameinordinatelyconfusingandinefficient.Thewholepointofprintingmoneyistoreduceinformationcostsandfacilitatetrade.Still,reasonablepeoplehesitatedtoacceptbanknotesissuedbybankstheyweren’tfamiliarwith,somoneywasnotwidelyaccepted.Intheend,thesystemjustdidn’twork.RadicalchangecameduringtheCivilWar,whenCongresspassedtheNationalBankingActof1863,initiatingagradualshiftinpowerawayfromthestates.Althoughthenewlawdidn’teliminatestate-charteredbanks,itdidimposea10percenttaxontheirissueofbanknotes.Atthesametime,theactcreatedasystemoffederallychar-teredbanks,ornationalbanks,whichwouldbesupervisedbytheOfficeoftheComp-trolleroftheCurrency,insidetheU.S.DepartmentoftheTreasury.Thesenewnationalcec2174X_ch13_327-358.indd32925/11/135:41PM 330lChapter13FinancialIndustryStructurebankscouldissuebanknotestax-free.Congress’sintentwastoputthestatebanksoutofbusinessbytakingawaytheirsourceoffunds.Whiletheactdidgetridofstate-issuedbanknotes,statebanksdevisedanotherwaytoraisefunds,bycreatingdemanddeposits.Thisexplainstheoriginofthedualbankingsystemwehavetoday,inwhichbankscanchoosewhethertogettheirchar-tersfromtheComptrolleroftheCurrencyattheU.S.Treasuryorfromstateofficials.Roughlythree-quartersofU.S.banksnowhaveastatecharterandtheresthaveafederalcharter.Thedecisionisrelatedtoabank’sprofitability.Statebankingauthori-tieshavebeenmorepermissivethanfederalauthoritiesinthetypesofoperationstheyallow.Becausegreaterflexibilityinabank’soperationsmeansabetterchanceofmak-ingaprofit,statechartershavebeentheoverwhelmingchoice.Furthermore,iftheComptrolleroftheCurrencywon’tallowabanktoengageinaparticularpractice,thebankcanalwayschangeitscharter.Thisabilitytoswitchbackandforthbetweenstateandfederalcharterscreatedwhatamountstoregulatorycompetition,whichhashastenedinnovationinthefinancialindustry.Inthe1990s,changesinbankinglawrequiredfederalandstateagenciestocoordinatetheiroversightoffi-nancialintermediaries.Buttheglobalizationofthefinancialsystem,togetherwithbanks’abilitytomovefundseasilyacrossinternationalboundaries,meansthattodayregulatorycompetitionexistsnotsomuchbetweenstateandfederalgovernmentregulatorsbutThefirstnationalbanknoteissuedin1863.betweenregulatorsofdifferentcountries.FollowingtheBankingActof1863,thenextmajoreventinU.S.bankinghistoryoccurredin1933,inthemidstoftheGreatDepression.From1929to1933,morethanathirdofallU.S.banksfailed;individualdepositorslost$1.5billion,orabout3 per-centoftotalbankdeposits.Millionsofsmallsaverslosttheirlifesavings.Toprotectdepositorsandmakebankssafer,CongressenactedtheGlass-SteagallActof1933,whichcreatedtheFederalDepositInsuranceCorporation(FDIC)andseverelylimitedtheactivitiesofcommercialbanks.TheFDICprovidedinsurancetoindividualdepositors,sotheywouldnotlosetheirsavingsintheeventthatabankfailed.Theactalsorestrictedbankassetstocertainapprovedformsofdebtandforbadebanksfromdealinginsecurities,providinginsurance,orengaginginanyoftheotheractivitiesundertakenbynondepositoryinstitutions.Byseparatingcommercialbanksfrominvestmentbanking,thelawlimitedtheabil-ityoffinancialinstitutionstotakeadvantageofeconomiesofscaleandscopethatmightexistinvariouslinesofbusiness.Nevertheless,thisrestrictiononbanks’activi-tiesremainedinplaceuntil1999,whentheGramm-Leach-BlileyFinancialServicesModernizationActrepealedtheGlass-SteagallAct.Wewillreturntothistopicshortly.TherepealoftheGlass-SteagallActin1999eliminatedtherestrictionsonbanks’activities,butitrenewedconcernsaboutpotentialmismanagementoflargefinancialholdingcompanies.Thefinancialcrisisof2007–2009underscoredtheseconcernsandledtothebiggestfinancialreformsincetheGreatDepression,theDodd-FrankWallStreetReformandConsumerProtectionActof2010.Dodd-Frankaimstopreventfinancialcrisesandnewgovernmentbailoutsoffinancialintermediaries.Inmorethan800pagesofcom-plexlegislation,itsetsoutnewrulesforfinancialinstitutionsandmarkets;requiresclosergovernmentoversightoverkeyestablishments,calledsystemicallyimportantfinancialinstitutions(SIFIs)regardlessoftheirlegalform;andsharplyaltersthecec2174X_ch13_327-358.indd33025/11/135:41PM BankingIndustryStructureChapter13l331authoritiesofthegovernmentagenciesthatgovernthefinancialsystem.LikeGlass-Steagall,theVolckerrule—apartofDodd-FranknamedaftertheformerFederalRe-servechairmanwhoadvocatedit—alsoforbidsinsureddepositoriesfromproprietarytrading,segmentingthisandotherbusinessactivitiessothatdepositinsurancecannotsubsidizebankrisk-taking.WewillexploretheDodd-FrankActanditsimplicationsinsomedepthinChap-ter 14.ButitisalreadyclearthatDodd-Frank—andthehundredsofrulesandproce-duresthatthegovernmentisstilldevelopingtoimplementit—willcontinuetochangethefinanciallandscapesignificantlyincomingyears,muchlikethereformsofthe1930sdidintheirtime.Whatremainsunclearishowsuccessfulitwillbeinpreventinganotherfinancialcrisis.CompetitionandConsolidationNoneofthehistoricaleventswehavediscussedexplainswhythereareroughly6,000commercialbanksintheUnitedStatesasofearly2013orwhythatnumberhasbeenshrinkingsincethemid-1980s.Tounravelthemystery,let’sreturntoFigure13.1.Noticethedivisionbetweenbankswithbranchesandbanksthatdon’thavebranches.Aswementionedintheintroduction,banksthatdonothavebranchesarecalledunitbanks.Thealternative,whichisfamiliartomostofustoday,isabankwithmanybranchesspreadoutoverawidegeographicarea.LargebanksliketheBigFour—BankofAmerica,Citibank,JPMorganChase,andWellsFargo—maintainbranchesinmanycitiesacrossmanystatesandforeigncountries.We’llreturntothesebanksinamoment.Fornow,noticefromthefigurethatin1935,thevastmajorityofbankshadnobranches;today,nearlythree-quartersofthemdo.Infact,ifwelookatthenumbers,weseethatin1935therewere14,125commercialbanksintheUnitedStates,withatotalof17,237offices;asofthefirstquarterof2013,therewereroughly6,000banks,buttheyhadawhopping90,000offices!Today’sbanksnotonlyhavebranches,theyhavelotsofthem.ThenumberofbanksandbankbranchesintheUnitedStatestellsonlypartofthestory;wealsoneedtolookatbanksize.Table13.1showsthattheU.S.bankingsystemiscomposedofalargenumberofverysmallbanksandasmallnumberofverylargeones.Roughly1percentofthebanksholdmorethan75percentofallbankassets.Infact,theBigFouraloneaccountforaround40percentofassetsanddepositsintheU.S.commercialbankingsystem.Table13.1NumberandAssetsofCommercialBanksintheUnitedStatesSizeofInstitution(Assets)NumberPercentofTotalAssetsLessthan$100million1,9150.8%$100millionto$1billion3,5967.9%$1billionto$10billion4478.6%$10billionormore9082.6%Total6,048100%($13.4trillion)SOURCE:FDICQuarterlyBankingProfile,FirstQuarter2013,TableIII-A.Percentagesdonotsumto100%duetorounding.cec2174X_ch13_327-358.indd33125/11/135:41PM 332lChapter13FinancialIndustryStructureTheprimaryreasonforthisstructureistheMcFaddenActof1927,whichrequiredthatnationallycharteredbanksmeetthebranch-ingrestrictionsofthestatesinwhichtheywerelocated.1Becausesomestateshadlawsthatforbadebranchbanking,theresultwasalargenumberofverysmallbanks.2Advocatesoflegallimitsonbranchingarguedthattheypreventedconcentrationandmonopolyinbankinginthesamewaythatantitrustlawspreventedconcen-trationinmanufacturing.TheMcFaddenActproducedafragmentedbankingsystemnearlydevoidoflargeinstitu-tions.Theresultwasanetworkofsmall,geo-graphicallydispersedbanksthatfacedvirtuallynocompetition.Inmanystates,moreefficientSOURCE:1998©RobertMankoff/TheNewYorkerCollection/www.cartoonbank.com.andmodernbankswerelegallyprecludedfromopeningbranchestocompetewiththesmall,in-efficientonesthatwerealreadythere.Inthesestates,theresultwasanetworkofsmallcommunitybanksthatfacednocompetitivepressurestoinnovate.Notonlythat,butthesystemwaspronetofailure.Becausetheonlyloanapplica-tionstheselocalbanksreceivedwerefromresidentsoftheirowncommunities,theirloanportfolioswereinsufficientlydiversified.Inafarmingtown,thebank’sfortunesdependedontheweather,becauseitsloanportfoliowascomposedalmostentirelyofagriculturalloans.Awareoftheproblem,thebankmanagerwouldeventuallystopmakingloansbecausetheriskwassimplytoogreat.Whencreditceasedtoflowintothecommunity,farmerscurtailedtheiroperations.Intheend,thebank’sownersmadeahealthyprofitbecausethebankwasprotectedfromcompetition—buteveryoneelseintownsuffered.Somebanksreactedtobranchingrestrictionsbycreatingbankholdingcompanies.Aholdingcompanyisacorporationthatownsagroupofotherfirms.Insomecontexts,itmaybethoughtofastheparentfirmforagroupofsubsidiaries.Bankholdingcom-panieshavebeenaroundsincetheearly1900s.Initially,theywerecreatednotjustasawaytoevadebranchingrestrictionsbutasawaytoprovidenonbankfinancialservicesinmorethanonestate.In1956,theU.S.CongresspassedtheBankHoldingCompanyAct,whichbroadenedthescopeofwhatbankholdingcompaniescoulddo,allowingthemtoprovidevariousnonbankfinancialservices.Overtheyears,changesinlawsandregulationshaveaddedassetmanagement,investmentadvice,insurance,leasing,collections,andrealestateservicestothelistofallowableactivities.Beginningintheearly1970s,technologyenabledbankstoborrowandlendatadistance.ThecombinationoftheU.S.mail,telephoneservice,andfinallythe1The1956DouglasAmendmentappliedthesamerestrictionstobankholdingcompanies,requiringthatanyout-of-stateexpansionbeexpresslyapprovedbythehoststate.2Inthenation’searlyyears,thestateswerestarvedforrevenue;theycouldneitherissuetheirowncurrencynortaxinterstatetrade.Thefeesthestatesearnedforgrantingbankchartersandthetaxestheyleviedonbankprofitsbecameimportantsourcesofrevenueforstategovernment.Thefeesgavethestategovernmentsanincentivetocreatemanysmallbanks,whilethetaxesgavethemaninterestinprotectingbanksandensuringtheywouldbeprofitable.Theresultwasafragmentedbankingsystemwithlittlecompetition.SeeR.KrosznerandP.Strahan,“WhatDrivesDeregulation?EconomicsandPoliticsoftheRelaxationofBankBranchingRestrictions,”QuarterlyJournalofEconomics114(November1999),pp.1437–1467.cec2174X_ch13_327-358.indd33225/11/135:41PM BankingIndustryStructureChapter13l333YOURFINANCIALWORLDPawnshopsContrarytotheirportrayalinthemoviesandonTV,pawn-feethatcandriveuptheinterestratetoseveralhundredshopsarenotdisreputableestablishmentsfrequentedpercentperyear.Whilesuchanarrangementmayseemout-bycriminalswhoaresellingstolengoods.Theyarelegiti-rageous,itisbetterthanthepaydayloandescribedinChap-matebusinessesthatprovideausefulservice.Thinkofater 12.Becausepawnbrokers’loansarecollateralized,thepawnshopasaneighborhoodnondepositoryinstitutioninterestrateschargedaremorereasonablethantheonesonthatmakescollateralizedloansandsellsawidevarietyofpaydayloans.Soifyoueverfindyourselfindirestraits,withmerchandiseontheside.Thepawnshop’smainbusinessnoothersourceofcredit,youcangotoapawnshop.istoprovideverysmallloans—smallerthanabankwouldconsider—topeoplewholackaccesstotheconventionalfinancialsystem.Sayyouhavesomethingvaluable,likeapieceofjewelry,abicycle,oracamera.Youneedcash,soyoutakethevalu-ableitemtoapawnshop.Thepawnbrokerwillofferyoualoanontheconditionthatyouleavetheitemthereascollat-eral.Whenyourepaytheloanalongwithinterestandfees,thepawnbrokerwillreturnyourcollateral.Butifyoudon’trepaytheloanontime,thepawnbrokertakesthecollateralandsellsit.Themerchandisethat’sforsaleinthepawnshopwascollateralfordefaultedloans.Needlesstosay,thetermsoftheloanarefavorabletothepawnbroker,nottoyou.Theloanamountisusuallylessthanhalfthevalueofthecollateral,andtheinterestrateishigh:3to5percentpermonthisstandard.ThereisalsoaInternetdramaticallyreducedtheimportanceofphysicallocationinbanking.With-outtheneedtopersonallyvisitthebanktoconducttheirbusiness,peopleceasedtocarewhetherabankwascharteredinthestatewheretheylived.Today,ATMs,laptopcomputers,cellphones,anddebitandcreditcardsallowdepositorsaccesstomeansofpaymentevenwhentheyarefarfromhome.Creditcompaniescanevaluateanyindividualorfirm’screditworthiness,soabankcanmakealoanregardlessoftheborrower’slocation.Inchangingthewaypeopleusethefinancialsystem,technologyhaserodedthevalueofthelocalbankingmonopoly.Inthe1970sand1980s,statesrespondedbylooseningtheirbranchingrestrictions.3Thenin1994,CongresspassedtheRiegle-NealInterstateBankingandBranchingEfficiencyAct.Thislegislationreversedtherestrictionsputinplacealmost70yearsearlierbytheMcFaddenAct.Since1997,bankshavebeenabletoacquireanunlimitednumberofbranchesnationwide.Whilesomebankscouldn’thandlethenewcompetitionandwentoutofbusiness,thevastmajoritythatceasedindependentoperationsdisappearedthroughmergerswithotherbanks.Thenumberofcommercialbankshasthusfallenbyaboutone-halfoverthepast3Anumberofotherchangestookplaceaswell.Forexample,until1980,federallawrestrictedtheinterestratebankscouldpayondeposits.UnderRegulationQ,theywereprohibitedfrompayinginterestoncheckingaccounts,andwerelimitedtoamaximumrateofjustover5percentonsavingsdeposits.Asinflationandinterestratesroseinthelate1970s,theserestrictionsbecameprohibitive.Manydepositorswithdrewtheirfundsfrombanksandplacedtheminmoney-marketmutualfunds,whoseinterestrateswerenotrestrictedbylaw.cec2174X_ch13_327-358.indd33325/11/135:41PM 334lChapter13FinancialIndustryStructureTable13.2KeyLegislationAffectingtheU.S.BankingIndustry1927McFaddenActOutlawedinterstatebranchingandrequirednationalbankstoabidebythelawsofthestatesinwhichtheyoperated.1933Glass-SteagallActEstablishedfederaldepositinsuranceandprohibitedcommercialbanksfromengagingintheinsuranceandsecuritiesbusinesses.1994Riegle-NealActRepealedtheMcFaddenAct’sprohibitionofinterstatebranching.1999Gramm-Leach-BlileyActRepealedtheGlass-SteagallAct’sprohibitionofmergersbetweencommercialbanksandinsurancecompaniesorsecuritiesfirms.2010Dodd-FrankActAimstopreventfinancialcrisesandgovernmentbailoutsofintermediaries,partlythroughgovernmentoversightofsystemicallyimportantfinancialinstitutions(SIFIs).twodecades,andthenumberofsavingsinstitutions—savingsandloansplussavingsbanks—hasfallenevenmore.TheRiegle-NealActallowedbankstodiversifygeographically.Todayabankthatwantstoestablishoperationsinanewstatecanpurchaseabankalreadylocatedinthatstate.Indoingso,itacquiresthebank’scustomers,aswellasitsemployeesandtheirknowledgeofthestate’sbusinessandlegalenvironment.Theresultshavebeendramatic.Banksbecamemoreprofitable:theiroperatingcostsandloanlossesfell;theinterestratespaidtodepositorsrosewhiletheinterestrateschargedtoborrowersfell.Theonlypeoplewhosufferedweretheemployeesofinefficientbanks,whohadtoworkharderandwerepaidlessasaresultofthenewcompetition.So,thederegulationofbanksprovidedsizablebenefitsfortheeconomy.4Table13.2summarizesthekeyeventsintheevolutionoftheU.S.bankingindustryoverthelastcentury.Thefinancialcrisisof2007–2009hasfocusedattentiononthecostsofderegulation.Didthepoormanagementofsomemegabanksrevealthelimitstoexpandinginstitu-tionalscaleandscope?Havethebiggestbanksalreadyoutrunthoseeconomies?Hasderegulationencouragedbankstotakeontoomuchrisk?Hasderegulationmotivatedsomebankstobecome“toobigtofail”inordertosecureagovernmentbailoutintheeventofdistress?Addressingthesecomplexquestionsismostlyanissueforgovernmentsupervi-sion,whichisthesubjectofChapter14.However,scholarsandpolicymakersalsoarereviewingwhetherthebenefitsofderegulationnotedearlierwarranttheextrarisksassociatedwiththoselargeintermediariesthatbecameaburdenontaxpayersandtheeconomyduringthefinancialcrisis.Someanalystsarguethatthecrisis-inducedin-creaseinbankingconcentrationraisesboththelikelihoodandexpectedcostofafuturefinancialcrisis.54Onewaytotellthatderegulationimprovedgrowthistolookatwhathappenedindifferentstates.Separatingtheimpactofderegulationfromthatofavarietyofothereffectsongrowthcanbetricky.Thefactthatstatesderegulatedatdifferenttimesallowseconomiststodisentangletheeffects.SeeJ.JayarantheandP.Strahan,“TheFinance-GrowthNexus:EvidencefromBankBranchDeregulation,”QuarterlyJournalofEconomics111(1996),pp.639–670.5See,forexample,Chapter7oftheAnnualReportoftheBankforInternationalSettlements,2009.cec2174X_ch13_327-358.indd33425/11/135:41PM BankingIndustryStructureChapter13l335TheGlobalizationofBankingTowardtheendofthe20thcentury,U.S.bankingunderwentnotjustanationalbutaninternationaltransformation.Anexplosionininternationaltradehadincreasedtheneedforinternationalfinancialservices.Verysimply,everytimeaJapanesecompanypurchasedsoftwareproducedintheUnitedStatesoranAmericanboughtatelevi-sionsetmanufacturedinChina,paymentshadtobemadeacrossnationalboundaries.Today,theinternationalbankingsystemhasadjustedtotheneedsofaninterdepen-dent,globalizedworld.LargeU.S.bankslikeJPMorganChaseandCitibankhavestationedATMsonthestreetsofFrankfurt,BuenosAires,andothermajorcapitals.InNewYork,keenobserverscanspottheforeignofficesofBarclays,DeutscheBank,andTokyo-Mitsubishi.By2012,U.S.banks’claimsontheirownforeignofficeswerenearly$2 trillion,plustheyhadanother$1trillionofdirectclaimsonforeigners.Andmorethan300foreignbankswithassetstotalingmorethan$3 trillionhadestablishedapresenceintheUnitedStates.Thereareanumberofwaysbankscanoperateinforeigncountries,dependingonsuchfactorsasthelegalenvironment.Themoststraightforwardapproachistoopenaforeignbranchthatoffersthesameservicesasthoseinthehomecountry.CertainlegalstructuresalsoallowU.S.bankstoengageinoperationsoutsideofthecountry,openingwhatlookstothecasualobserverlikeabranch(butmayhaveadifferentlegalstatus).Forexample,abankcancreateaninternationalbankingfacility(IBF),whichallowsittoacceptdepositsfromandmakeloanstoforeignersoutsidethecountry.OrthebankcancreateasubsidiarycalledanEdgeActcorporation,whichisestablishedspecificallytoengageininternationalbankingtransactions.Alternatively,abankhold-ingcompanycanpurchaseacontrollinginterestinaforeignbank.Fromourpointofview,theclassificationoftheparticularenterpriseislessimportantthanthefactthatU.S.bankstakeadvantageofvariousmethodstooperateoutsidethecountry.Foreignbanks,ofcourse,cantakeadvantageofsimilaroptions.TheycanpurchaseaninterestinaU.S.bank,openbranchesonU.S.soil,createaU.S.subsidiary,oropenwhatiscalledanagencyoffice.Thesealternativesdifferinthespectrumoffinancialservicestheycanprovide.ThegrowthofinternationalbankinghashadaneconomicimpactsimilartothatofMARKETSderegulationintheUnitedStates.Today,aborrowerinFrance,Brazil,orSingaporecanshopforaloanvirtuallyanywhereintheworld,andadepositorseekingthehigh-estreturncandothesame.Allthiscompetitionhasmadebankingatougherbusiness.Profitsareharderforbankerstocomebytodaythantheywerein1970,whendeposi-torsandborrowerswerecaptivetosmalllocalbanks.Butwhilebankers’livesmaybemoredifficult,onbalancetheimprovedefficiencyofthefinancialsystemhasenhancedgrowtheverywhere.Oneofthemostimportantaspectsofinternationalbankingistheeurodollarmarket.Eurodollarsaredollar-denominateddepositsinforeignbanks.Forreasonswewillexplainshortly,abankinLondon,Zurich,ortheCaymanIslandsmightofferitsbestcustomerstheabilitytomaketheirdepositsindollars.Inresponse,FordMotorCorpo-rationmightconverta$1milliondepositinitsNewYorkbanktoaeurodollardepositinthebank’sCaymanIslandssubsidiary.Afterthe$1millionhasbeendepositedinFord’sCaymanIslandsaccount,itislentbacktotheNewYorkbank.So,theaccountcontinuestoprovideFordwithallthesamefunctionsofthedepositatthesametimethattheNewYorkbanknowhasaloanliabilityfromitsoff-shoresubsidiary.BothFordandtheNewYorkbankhaveanincentivetodothis.Forthebank,theCaymanIslandsdepositischeaper.ItisnotsubjecttoU.S.reserverequirements,norcec2174X_ch13_327-358.indd33525/11/135:41PM 336lChapter13FinancialIndustryStructureisthebankrequiredtopayadepositinsurancepremiumonthebalance.Moreover,regulatorysupervisionismorelaxinthemiddleoftheGulfofMexicothanitisintheUnitedStates,whichreducesthecostofcompliance.Finally,profitsfromtheoffshorebankmaybesubjecttoalowercorporateincometaxratethanprofitsoriginatinginsidetheUnitedStates.TheseadvantagesallowthebanktopayFordahigherinterestrateonthedeposit,andtheyincreasethebank’snetinterestmargin.Anumberofforcesconspiredtocreatetheeurodollarmarket.Originally,itwasaresponsetorestrictionsonthemovementofinternationalcapitalthatwereinsti-tutedattheendofWorldWarIIwiththecreationoftheBrettonWoodssystemofexchangeratemanagement.(WewilllearnmoreabouttheinternationalmonetarysystemandcapitalcontrolsinChapter 19.)Toensurethatthepoundwouldretainitsvalue,theBritishgovernmentimposedrestrictionsontheabilityofBritishbankstofinanceinternationaltransactions.Inanattempttoevadetheserestrictions,Londonbanksbegantoofferdollardepositsanddollar-denominatedloanstoforeigners.Theresultwaswhatweknowtodayastheeurodollarmarket.TheColdWaracceleratedthemarket’sdevelopmentwhentheSovietgovernment,fearfulthattheU.S.governmentmightfreezeorconfiscatethem,shifteditsdollardepositsfromNewYorktoLondon.IntheUnitedStates,acombinationoffactorspropelledtheeurodollarmarketforward.Inthe1960s,U.S.authoritiestriedtopreventdollarsfromleavingthecountryandmadeitcostlyforforeignerstoborrowdollarsintheUnitedStatesforuseelsewhereintheworld.Thenintheearly1970s,acombinationofdomesticinterest-ratecontrolsandhighinflationratesmadedomesticdepositsmuchlessattractivethaneurodollardeposits,whichpaidcomparativelyhighinterestrates.Today,theeurodollarmarketinLondonisoneofthebiggestandmostimportantfinancialmarketsintheworld.Andtheinterestrateatwhichbankslendeachothereurodollars,calledtheLondonInterbankOfferedRate(LIBOR),servesasthebenchmarkformorethan$300trillion(notionalprincipal)ofinterest-ratederivatives,makingittheleadingglobalinterest-rateindicator.Italsoisthestandardagainstwhichmanyprivateloanratesaremeasured.Forexample,someadjustable-ratehomemort-gagesintheUnitedStatescarryaninterestratethatispeggedtoLIBOR.LIBORfiguredprominentlyinthefinancialcrisisof2007–2009whentheinterbanklendingmarketdriedup:thegapbetweenLIBORandtheexpectedFederalReservepolicyinterestrateprovidedakeymeasureoftheintensityandpersistenceoftheliquiditycrisis(seeChapter 3,LessonsfromtheCrisis:InterbankLending).However,revelationsin2012thatLIBORhadbeenwidelymanipulatedbyglobalbanksraisedseriousdoubtsaboutitsfutureasaninterest-ratebenchmarkandledtogovernmentinterventiontoreformthewayLIBORisdetermined(seeApplyingtheConcept:TheLIBORScandal).TheFutureofBanksToday’sbanksarebigger,fewerinnumber,andmoreinternationalinreachthanthebanksofyesteryear;theyalsohavemoretoofferinthewayofservices.Atypicallargecommercialbanknowoffersinvestmentandinsuranceproductsaswellasthemoreconventionaldepositaccountsandloans.Thistrendbeganin1998withCitigroup’screation(seethechapterintroduction).InNovember1999,theGramm-Leach-BlileyFinancialServicesModernizationActeffectivelyrepealedtheGlass-SteagallActof1933,allowingacommercialbank,investmentbank,andinsurancecompanytomergeandformafinancialholdingcompany.Citigroup,whichalreadyincludedallthree,becamelegal.Sincethen,in-vestmentfirmslikeJ.P.Morgan,whichoncedealtonlyinsecurities,wereacquiredbycec2174X_ch13_327-358.indd33625/11/135:41PM BankingIndustryStructureChapter13l337APPLYINGTHECONCEPTBeginningin2012,theU.K.andU.S.governmentsre-vealedtheextentoftheLIBORscandal,announcingrecordTHELIBORSCANDALfinesfortwopanelbanks($450millionand$1.5billion,respectively)formultiyearmanipulationsofLIBOR.Mean-while,asinvestigationsofotherbankscontinued,prosecu-Fordecades,LIBOR—theLondonInterbankOfferedRate—torsbegantochargebankemployeeswithcriminalfraud,servedasthepremierglobalbenchmarkforprivateinter-andhugeprivatelawsuitsagainstLIBORpanelbanksestrates.TheBritishBankers’Association(BBA),agroupsoughttorecoverthelossesfromthemanipulation.ofthelargestLondonbanks,publisheddailyLIBORratesAccordingtogovernmentreports,evenbeforethefinan-for15maturities,rangingfromovernightto10years,forthecialcrisisof2007–2009,derivativestradershadencouragedU.S.dollarandfornineothercurrencies.Ideally,these150theirbankstosubmitmisleadingratestobenefittheirderiva-benchmarksrepresentedtheratesatwhichbanksofimpec-tivesholdings.Andwhenthefinancialcrisisbegan,somecablecreditstatuslenttoeachothereachday.bankslowballedtheirLIBORsubmissionstoavoidstandingHowever,unlikeotherinterest-ratebenchmarks,suchoutfromthecrowdandtoappearmoresoundthaninfactasU.S.Treasurybillratesorthefederalfundsrate,LIBORtheywere.Panelbanksfearedthatreportingtheirtrue(higher-rateswerenotbasedonactualtransactionsbutratheronathan-average)costoffundsmightworrytheirdepositorsanddailysurveyofapanelofbanks(18Londonbanksfordol-promptarun(seeChapter14formoreonbankruns).larLIBOR,fewerbanksforothercurrencies).EachpanelTorestorethecredibilityofLIBORandshiftittoatrans-bankvoluntarilysubmittedtotheBBAitsestimateoftherateactions-basedmeasure,U.K.regulatorsarrangedfortheatwhichit“couldborrowfunds,wereittodosobyaskingtransferofownershipandadministrationofLIBORasofforandthenacceptinginterbankoffersinreasonablemarket2014fromtheBBAtoanexchange(NYSEEuronext).Butsize,justpriorto11.00amLondontime.”*fixing“surveyLIBOR”willnotbeeasy.Atransactions-basedFromoneperspective,thissurveyapproachisafeatureLIBORwouldreducetheeaseofmanipulation,butonlyforratherthanaflaw.Atsomematuritiesandforsomecurren-thefewmaturitiesandcurrenciesthataretrulyliquid(andcies,thereislittleactivityonwhichtobaseatransactionseventhesecanbecomeilliquidinacrisis).Atthesametime,measureofinterestrates.Evenforthedollar,euro,andyen,thepotentiallegalexposureforthebanksiscausingsomeactivityisconcentratedintheshortestmaturitiesouttosixtowithdrawfromLIBOR-likesurveys.Yet,withhundredsmonthsatmost.Consequently,forilliquidinstruments,asur-oftrillionsofdollarsofderivativesandothercontractsstillveymightprovidemoreinformationthanthemarketitself.basedonLIBOR,governmentsfearthatthedisappearanceAsLIBOR—anditssisterratesinFrankfurt(EURIBOR)ofLIBOR—eventemporarily—wouldsparkanotherfinancialandTokyo(TIBOR)—becamebenchmarksfortrillionsofcrisis.So,anytransitiontoabetterLIBORwillhavetobedollars(oreurosoryen)ofderivativecontracts,evenatinycarefullymanaged.**one-basis-point(0.01percent)changeintheseratescouldresultinmillionsinprofitsandlossesoninterest-ratederiva-tives.Hence,LIBOR’sextraordinarysuccess,combinedwith*FormoredetailsonLIBOR,seewww.bbalibor.com/bbalibor-itsrelianceongood-faithreporting,alsoboostedincentivesexplained/faqs.forBBApanelbankstomanipulateit—bothforprofitand**FortheBritishgovernment’sproposedreforms,see“Thefortheircreditreputation—bysubmittingmisleadingratestoWheatleyReviewofLIBOR:finalreport”atwww.gov.uk/the BBA.government/publications/the-wheatley-review.commercialbanks(inthiscase,ChaseManhattan),whilecommercialbankslikeBankofAmericahavepurchasedlargesecuritiesdealersandretailbrokers(MerrillLynch).Toservealltheircustomers’financialneeds,bankholdingcompaniesareconvertingtofinancialholdingcompanies.Financialholdingcompaniesarealimitedformofuniversalbank,atypeoffirmthatengagesinawiderangeoffinancial(andpossiblynonfinancial)activities.Dependingonthecountry,suchanarrangementprovidesmoreorlessseparationamongthebanking,insurance,andsecuritiesindustries.ThemostextremeexampleisGermany,whereuniversalbanksdoeverythingunderoneroof,includingdirectinvestmentinthesharesofnonfinancialfirms.IntheUnitedStates,differentfinancialactivitiesmustbeundertakeninseparatesubsidiaries,andfinancialholdingcompaniesarestillprohibitedfrommakingequityinvestmentsinnonfinancialcompanies.Theownersandmanagersoftheselargefinancialfirmscitethreereasonstocreatethem.First,theirrangeofactivities,properlymanaged,permitsthemtobewellcec2174X_ch13_327-358.indd33725/11/135:41PM 338lChapter13FinancialIndustryStructurediversified,sotheirprofitabilitydoesnotrelyononeparticularlineofbusiness.Thisreducedriskshouldincreasethevalueofthefirm.6Second,thesefirmsarelargeenoughtotakeadvantageofeconomiesofscale.AfinancialholdingcompanyneedsonlyoneCEOandoneboardofdirectorsregardlessofitssize.Onlyoneaccountingsystemisrequiredtorunthecompany.Third,thesecompanieshopetobenefitfromeconomiesofscope.Inthesamewaythatasupermarketoffersallsortsoffoodandnonfooditemsunderoneroof,financialholdingcompaniesoffercustomersawidevarietyofservices,allunderthesamebrandname.This,too,shouldreducecosts—ormaybethepeoplewhorunthesefirmsarejusttryingtobuildempires.WhileCitigroupwascreatingthefirstofthesefull-servicefinancialfirmsintheUnitedStates,therestofthefinancialworldwasnotstandingstill.Individualfirmswereworkingtoprovidecustomerswiththesameservicestheycouldobtainfrommoretraditionalfinancialintermediaries.Money-marketmutualfundscompetedwithbanksinprovidingliquidityservicestocustomers.Mortgagebrokersgaveconsumersachoiceinhowtoborrowforthepurchaseofahomeandthensoldthemortgagesinthefinancialmarketplace.Today,peoplewhoneedanautoloanoranykindofinsurancecangetdozensofpricequotesinafewhoursjustbyloggingontotheIn-ternet.Thescreeningofloanapplicants,whichwasoncethejoboftheneighborhoodbanker,hasbeenstandardizedandnowcanbedonebyvirtuallyanyone.ThentherearediscountbrokeragefirmslikeCharlesSchwabandE-Trade,whichprovidelow-costaccesstothefinancialmarkets.Unlikethebanksofthepast,thesealternativefinancialintermediariesdon’thavebalancesheetsoftheirown.Instead,forafeetheyprovidetheircustomerswithaccesstofinancialmarkets.Infact,thankstorecenttechnologicaladvances,almosteveryservicetraditionallyprovidedbyfinancialintermediariescannowbeproducedindependently,withoutthehelpofalargeorganization.Loanbrokerscangivelargeborrowersaccesstothepooledfundsofmanysmallsavers.Avarietyoffinancialfirms,includingbrokeragefirmsandmutual-fundcompanies,providesconnectionstothepaymentssystem,aswellastheabilitytotransformassetsintomoneyquicklyandatlowcost.Oneofthesedays,eventheelectriccompanymaygetintotheact.Or,aswehaveseeninKenya’sM-Pesasystem,perhapsthecellphoneproviderwilldoso(seeChapter 2).Andmanyintermediaries,includingmutual-fundcompaniesandpensionfunds,helpcustomerstospread,share,andtransferrisk.Finally,theproductionofinformationtomitigatetheproblemsofadverseselectionandmoralhazardhasbecomeabusinessinandof itself.Aswesurveythefinancialindustry,then,weseetwotrendsrunninginoppositedirections.Ontheonehand,largefirmsareworkinghardtoprovideone-stopshop-pingforfinancialservices.Ontheotherhand,aswewillseeinChapter 14,pressuresaregrowingongovernmentstorestrainorevenbreakupthelargest,mostcomplexintermediariesthatmightneedgovernmentsupportinacrisis.Inaddition,theindustryissplinteringintoahostofsmallfirms,eachofwhichservesaveryspecificpurpose.Willthefuturebeoneofgeneralists,specialists,orboth?Wewillhavetowaitandsee.Inthemeantime,let’slookmorecloselyattheroleofnondepositoryfinancialinstitu-tions.Andaswedo,let’sthinkaboutwhethertheirproductscanbeprovidedmoreeasilyandcheaplyaloneortogetherwithotherfinancialservices.6Financialeconomistsdisagreeonwhetherthereducedriskwouldactuallyincreasethefirm’svalue.Somepeoplearguethatfirmsshouldnotdiversifythemselvesbutleavethechoicetotheirstockholders.Aninvestorcanalwayspurchasesharesintwocompaniesthatwouldotherwisemerge,inproportiontowhateverriskexposuretheinvestordesires.Therealsoisconcernthatafirmwithmanydifferentlinesofbusinessmaynotbeaswellmanagedasspecializedfirms.cec2174X_ch13_327-358.indd33825/11/135:41PM NondepositoryInstitutionsChapter13l339NondepositoryInstitutionsAsurveyofthefinancialindustryrevealsabroadarrayofintermediaries.Besidesdepos-itoryinstitutions,therearefivemajorcategoriesofnondepositoryinstitution:insurancecompanies;pensionfunds;securitiesfirms,includingbrokers,mutual-fundcompanies,andinvestmentbanks;financecompanies;andgovernment-sponsoredenterprises.Thisclassificationisneitherexhaustivenormeanttoimplythataninstitution’sactivitiesarerestrictedtoaparticularcategory.Nondepositoryinstitutionsalsoincludeanassortmentofalternativeintermediaries,suchaspawnshops(seeYourFinancialWorld,page 333),paydayloancenters(seeYourFinancialWorld,page 307),rent-to-owncenters,peer-to-peerlendingfirms(seeIntheNews,page 288),andevenloansharks.Table13.3showsthatdepositoryinstitutionsaccountedforlessthanone-thirdofthe$54.6trillioninassetsheldbyfinancialintermediariesin2012.Inthedecadesafter1970,theshareofintermediationhandledbybanksfellsteadilyuntilthecrisisof2007–2009temporarilydepressedtheassetsofmanynonbanks,buttherelativedeclineofdepositoriessubsequentlyresumed.Insurancecompaniessufferedasimilarfateastheirshareofintermediationfellfrom18.5percentin1970to12.8 percentin2012.Meanwhile,mutualfundshavebeenthebigwinners,growingfroma3.5percentsharein1970tonearly25 percentin2012.PensionfundsincreasedinimportanceasTable13.3RelativeSizeofU.S.FinancialIntermediaries,1970–2012AssetsPercentofallIntermediaryAssets($ billions)2012197019902012DepositoryInstitutionsCommercialbanks$13,07037.2%29.3%24.0%Savingsinstitutions1,15318.812.12.1Creditunions8981.31.91.6InsuranceCompaniesLifeinsurance5,56214.812.110.2Propertyandcasualty1,4363.74.72.6PensionFundsPrivatepensionfunds6,5998.114.412.1Governmentpensionfunds4,6394.46.58.5MutualFundsMoneymarketfunds2,5070.04.44.6Stockandbondfunds10,7833.55.719.8FinanceCompanies1,6004.75.42.9Government-SponsoredEnterprises6,3053.43.711.6TotalAssetsofAllU.S.FinancialInstitutionsin20125$54.6trillionNOTE:Asof2012,mutualfundsincludeclosed-endandexchange-tradedfunds.SOURCE:BoardofGovernorsoftheFederalReserveSystem,FlowofFundsoftheUnitedStates,December6,2012,TablesL.109toL.128;andFDIC,StatisticsonDepositoryInstitutions.cec2174X_ch13_327-358.indd33925/11/135:41PM 340lChapter13FinancialIndustryStructurewell,risingfrom12.5percentofallassetsin1970tomorethan20 percentoverthe42-year period.Ourgoalinthissectionistounderstandtheroleofeachofthesetypesofnondeposi-toryinstitutioninourfinancialsystem.Wewilldosobyfocusingonthefunctionsofeach.RecallfromChapter11thatthefunctionsoffinancialinstitutionscanbedividedintofivecategories:(1)poolingtheresourcesofsmallsavers;(2)providingsafekeep-ingandaccountingservices,whichallowpeopletomakepaymentsandtracktheiras-sets;(3)supplyingliquiditybyconvertingresourcesintomeansofpaymentwheneverneeded;(4)providingdiversificationservices;and(5)collectingandprocessinginfor-mationinordertoreduceinformationcosts.Wewillusethesamesystemtoclassifynondepositoryinstitutions.InsuranceCompaniesInsurancecompaniesbeganwithlongseavoyages.Centuriesago,distanttradeandexplorationwerefraughtwithrisk,andthatriskgeneratedademandforinsurance.Modernformsofinsurancecanbetracedbacktoaround1400,whenwoolmerchantsinsuredtheiroverlandshipmentsfromLondontoItalyfor12to15percentoftheirvalue.(Overseasshipmentswereevenmoreexpensivetoinsure.)ThefirstinsurancecodesweredevelopedinFlorencein1523.Theyspecifiedthestandardprovisionsforageneralinsurancepolicy,suchasthebeginningandendofthecoverageperiodandthetimeframeforreceiptofpaymentfollowingaloss.Theyalsostipulatedproceduresforhandlingfraudulentclaimsinanattempttoreducethemoralhazardproblem.In1688,Lloyd’sofLondonwasestablished.Today,Lloyd’sisfamousforinsuringsingers’voices,dancers’legs,evenfoodcritics’tastebuds,aswellasmoretradi-tionalassetslikeairplanesandships.Thebest-knowninsurancecompanyintheworld,Lloyd’sbeganinasmallLondoncoffeehousewhoseproprietor,EdwardLloyd,cateredtoretiredseacaptainswhohadprosperedintheEastIndiesspicetrade.Havingsailedmanyofthetraderoutesthemselves,thesecaptainspossessedspecialknowledgeofthehazardsofseavoyages.Theyusedtheirknowledgetoassesstherisksassociatedwithparticularroutesandtodabbleinmarineinsurance.Theriskswerenotinconsequen-tial.Inthe17thcentury,atypicalvoyagetotheSpiceIslands(partofIndonesia)andbacklastedthreeyears.Onlyoneinthreeshipsreturnedwiththeircargo,andasfewasoneineightsailorslivedtotelloftheadventure.Therewardsofasuccessfulvoy-agewerecovetedspiceslikenutmeg,asinglesackofwhichcouldmakeaseacaptainwealthyfortherestofhislife.Toobtaininsurance,aship’sownerwouldwritethedetailsoftheproposedvoyageRISKonapieceofpaper,togetherwiththeamounthewaswillingtopayfortheservice,andthencirculatethepaperamongthepatronsatEdwardLloyd’scoffeehouse.Interestedindividualswoulddecidehowmuchoftherisktoacceptandthensigntheirnamesunderthedescriptionofthevoyage.Thiscustomarywayofdoingbusinessbecamethesourceofthetermunderwriter.Underwritingwasopentoanyonewhowishedtoassumetheriskassociatedwithseavoyages.BecauseLloyd’spredatedbyseveralcen-turiestheconceptoflimitedliability,inwhichinvestors’losseswereconfinedtotheamountoftheirinvestment,underwritingimpliedunlimitedliability.Thesayingwasthatanunderwriterwasliabledowntohislastcufflink.TodayLloyd’sprovidesinsurancethroughthemoreconventionalstructureofalim-itedliabilitycompany.Thelossesofindividualinvestorsinasyndicatearelimitedtotheamountoftheirinitialinvestment,andnopersonisexposedtothepossibilityoffinancialruin.cec2174X_ch13_327-358.indd34025/11/135:41PM NondepositoryInstitutionsChapter13l341TwoTypesofInsuranceAttheirmostbasiclevel,allinsurancecompaniesoper-atelikeLloyd’sofLondon.Theyacceptpremiumsfrompolicyholdersinexchangeforthepromiseofcompensationifcertaineventsoccur.Ahomeownerpaysapremiuminreturnforthepromisethatifthehouseburnsdown,theinsurancecompanywillpaytorebuildit.Fortheindividualpolicyholder,then,insuranceisawaytotransferrisk.Intermsofthefinancialsystemasawhole,insurancecompaniesspecializeinthreeofthefivefunctionsperformedbyintermediaries:Theypoolsmallpremiumsandmakelargeinvestmentswiththem;theydiversifyrisksacrossalargepopulation;andtheyscreenandmonitorpolicyholderstomitigatetheproblemofasymmetricinformation.Insurancecompaniesoffertwotypesofinsurance:lifeinsuranceandpropertyandcasualtyinsurance.Lifeinsurers—companieslikePrudentialofAmerica,Metropoli-tanLife,andJohnHancockMutualLife—sellpoliciesthatprotecttheinsuredagainstthelossofearningsfromdisability,retirement,ordeath.Propertyandcasualtycompa-niessellpoliciesthatprotecthouseholdsandbusinessesfromlossesarisingfromacci-dent,fire,andnaturaldisaster.Bothtypesofintermediaryallowindividualstotransfertheirrisktoagroup.Whileasinglecompanymayprovidebothkindsofinsurance,thetwobusinessesoperateverydifferently.Lifeinsurancecomesintwobasicforms,calledtermandwholelifeinsurance,aswellasavarietyofhybrids.Termlifeinsuranceprovidesapaymenttothepolicy-holder’sbeneficiariesintheeventoftheinsured’sdeathatanytimeduringthepolicy’sterm.Thepremiumdependsontheverypredictableproportionofpeople(ofagivenage)whowilldie.Termpoliciesaregenerallyrenewableeveryyearsolongasthepolicyholderislessthan65yearsold.Manypeopleobtaintermlifeinsurancethroughtheiremployers,anarrangementcalledgrouplifeinsurance.Wholelifeinsuranceisacombinationoftermlifeinsuranceandasavingsaccount.Thepolicyholderpaysafixedpremiumoverhisorherlifetimeinreturnforafixedbenefitwhenthepolicyholderdies.Shouldthepolicyholderdecidetodiscontinuethepolicy,itscashvaluewillberefunded.Astimepassesandthepolicyholderages,theemphasisofthewholelifepolicyshiftsfrominsurancetosavings.Someonewholivestoaripeoldagewillhaveaccumulatedsubstantialsavingsinawholelifepolicy,whichcanbecashedinifthepolicyholderchooses.Wholelifeinsurancetendstobeanex-pensivewaytosave,though,soitsuseasasavingsvehiclehasdeclinedmarkedlyaspeoplehavediscoveredcheaperalternatives.Mostadultshaveexperiencewithpropertyandcasualtyinsurancebecausedrivingacarwithoutitisillegal.Autoinsuranceisacombinationofpropertyinsuranceonthecaritselfandcasualtyinsuranceonthedriver,whoisprotectedagainstliabilityforharmorinjurytootherpeopleortheirproperty.Holdersofpropertyandcasualtyinsur-ancepaypremiumsinexchangeforprotectionduringthetermofthepolicy.Onthebalancesheetsofinsurancecompanies,thesepromisestopolicyholdersshowupasliabilities.Whilesomeclaimsmayalreadybeinprocess,mostofthemarefutureclaims.Ontheassetside,insurancecompaniesholdacombinationofstocks,bonds,andotherassets.Propertyandcasualtycompaniesprofitfromthefeestheychargeforadministeringthepoliciestheywrite;theclaimsarecoveredbythepremiums.Becausetheassetsareessentiallyreservesagainstsuddenclaims,theyhavetobeliquid.Alookatthebalancesheetofapropertyandcasualtyinsurerwillshowapreponderanceofgovernmentandotherliquidsecuritiesandmoney-marketinstruments.Lifeinsurancecompaniesholdassetsoflongermaturitythanpropertyandcasualtyinsurers.Becausemostlifeinsurancepaymentswillbemadewellintothefuture,thisbettermatchesthematurityofthecompanies’assetsandliabilities.Furthermore,whilestocksmaycarryarelativelylowdegreeofriskwhenheldforperiodsof25yearsorcec2174X_ch13_327-358.indd34125/11/135:41PM 342lChapter13FinancialIndustryStructureYOURFINANCIALWORLDHowMuchLifeInsuranceDoYouNeed?WediscusseddisabilityinsuranceinChapter3andauto-Finally,howmuchlifeinsuranceshouldyoubuy?IfyoumobileinsuranceinChapter5.Whataboutlifeinsurance?aremarriedwithtwosmallchildren,mostadvisorsrecom-Howmuchshouldyoubuy?Thefirstquestioniswhethermendthatyoubuyatermpolicyworthsixtoeighttimesyoushouldbuyanyatall.Thepurposeoflifeinsuranceisyourannualincome.Whilethatmightcoveryourfamily’sliv-totakecareofthepeopleyouaresupportingshouldsome-ingexpensesuntilthechildrenaregrown,considercarefullythingunpleasanthappentoyou.Thinkofitasreplacementwhetheritwillbeenoughtosendthemtocollege.Ifyouandincomethatwillbetherewhenyou’renot.Peoplewithyoungyourspouseeachearn$35,000ayear,eachofyoumightchildrenaretheoneswhoneedlifeinsurancethemost.Ifaneed$400,000worthoflifeinsurance.Forsomeonewhoisparentdies,someonewillhavetoraisethosechildrenandbetween30and40yearsold,a$400,000policymightcostputthemthroughschool,andalifeinsurancepolicywillpayabout$500ayear,sooutofyourjointannualincomeofthebills.Lifeinsuranceisnotforasinglecollegestudent$70,000,youandyourspousewouldbespending$1,000withnoobligations,sodon’tletanyonesellittoyouifyouontermlifeinsurance.That’sexpensive,sodon’tbuymoredon’tneedit.thanyouneed.Ifyouthinkyouneedlifeinsurance,thenextstepistodecidewhatkind.Thebestapproachistobuytermlifeinsur-*Yourparentsandgrandparentsmayhavepurchasedwholelifeance,whichwillpayoffonlyifyoudie.Becauseotherkindsinsurancepoliciesfortworeasons.First,inthepast,individualsoflifeinsuranceincludeinvestmentcomponents,theyaredidnothaveaccesstoalltheinvestmentchoicesthatareavail-abletoday.Second,taxlawsweredifferent;forsomepeople,sav-morecostly.Andbecausethepeoplewhoneedlifeinsur-ingthroughawholelifeinsurancepolicyhadtaxadvantages.Butancemostareyoungfamilieswithlimitedincomesandbigwiththecreationoftax-deferredsavingsvehicleslikeindividualexpenses,themoreaffordablethepolicy,thebetter.Mak-retirementaccounts(IRAs),thosebenefitsdisappeared.Today,ingyourinsuranceandinvestmentdecisionsseparatelyisyouwouldlikelypayalifeinsurancecompanymuchmorethanalsoeasierthantryingtoachieveallyourgoalswithasinglethevalueofanytaxbenefitstoyoutoadministerawholelifevehicle.*insurancepolicy.more(recallthediscussioninChapter8),insurancecompaniescannotriskthepossi-bilitythattheymaybeforcedtosellstockswhenpricesarelowinordertopaypolicy-holders’claims.Asaresult,lifeinsurancecompaniesholdmostlybonds.TheRoleofInsuranceCompaniesLikelifeinsurers,propertyandcasualtyinsurerspoolriskstogeneratepredictablepayouts.Thatis,theyreduceriskbyspread-ingitacrossmanypolicies.RecallfromChapter5thatagroupofinvestmentswithuncorrelatedreturnsislessriskythananyindividualinvestment.Thesameistrueofinsurancecontracts.Whilethereisnowaytoknowexactlywhichpolicieswillrequirepayment—whowillhaveanautomobileaccident,loseahousetofire,ordie—thein-surancecompanycanaccuratelyestimatethepercentageofpolicyholderswhowillfileclaims.Doingsoallowsmanagerstocompute,withlittleuncertainty,howmuchthefirmwillneedtopayoutinanygivenyear.Fromthepointofviewofpolicyholders,propertyandcasualtyinsuranceallowsthemtospreadtheriskofaccidentanddamageacrossalargegroupofindividuals.InChapter11,wediscussedtheproblemofasymmetricinformationinstockandbondfinance.Recallthatwhenalenderorinvestorcannottellagoodborrowerorinvestmentfromabadone,thetendencyisforonlytheworstopportunitiestopresentthemselves.Thisphenomenoniscalledadverseselection.Furthermore,onceborrow-ersorentrepreneurshavereceivedfinancing,theyhavelessincentivetoavoidriskthanthelenderorinvestor.Thatproblemiscalledmoralhazard.cec2174X_ch13_327-358.indd34225/11/135:41PM NondepositoryInstitutionsChapter13l343Whileadverseselectionandmoralhazardcreatesignificantproblemsinthestockandbondmarkets,theycreateworseproblemsintheinsurancemarket.Apersonwhohasterminalcancersurelyhasanincentivetobuylifeinsuranceforthelargestamountpossible—that’sadverseselection.Andwithoutfireinsurance,peoplewouldhavemorefireextinguishersintheirhouses.Fireinsurancecreatesmoralhazard,encour-aginghomeownerstobelesscarefulinprotectingtheirhomesthantheywouldoth-erwise.Insurancecompaniesworkhardtoreduceboththeseproblems.Byscreeningapplicants,theycanreduceadverseselection.Apersonwhowantstobuyalifeinsur-ancepolicyoftenmustundergoaphysicalevaluation:weight,bloodpressure,bloodtests,andhealthhistory.Onlythosewhopasstheexamareallowedtopurchasepoli-cies.Andpeoplewhowantautomobileinsurancemustprovidetheirdrivingrecords,includingtrafficcitationsandaccidenthistories.Whilebaddriversmaybeallowedtobuycarinsurance,theywillneedtopaymoreforit.Byscreeningdriversandadjustingtheirpremiumsaccordingly,then,insurancecompaniescanreducetheirlossesduetoadverseselection.Insurancecompanieshavewaystoreducemoralhazardaswell.Policiesusuallyincluderestrictivecovenantsthatrequiretheinsuredtoengageornottoengageincertainactivities.Toqual-ifyforfireinsurance,arestaurantownermightberequiredtohavethesprinklersystemexaminedperiodically;toob-taininsuranceagainstphysicalinjury,abaseballorbasketballplayermightbeprecludedfromridingamotorcycle.Beyondsuchcovenants,insurancepoli-ciesoftenincludedeductibles,whichre-quiretheinsuredtopaytheinitialcostofrepairingaccidentaldamage,uptosomemaximumamount.Ortheymayrequirecoinsurance,inwhichtheinsur-ancecompanyshouldersapercentageof“Wecannotwritealifepolicyforyourhusband,Mrs.Blaine,becauseheistheclaim,perhaps80or90percent,andalreadydead.Ininsuranceterms,thatisconsideredapreexistingcondition.”theinsuredassumestherestofthecost.ItisinterestingtospeculateabouttheSOURCE:1997©J.B.Handelsman/TheNewYorkerCollection/www.cartoonbank.com.futureofinsuranceinanageinwhichfirmscancollectmoreandmoreinformationatlowerandlowercost.Rememberthatinsuranceismeanttoshiftriskfromindividualstogroups,nottoshifttheresponsi-bilityforeventsthatarecertaintohappen.Forexample,nooneexpectsaninsurancecompanytoselllifeinsurancetoapersonwithaterminaldisease.Hereinliesapotentialproblem.If,withthedecodingofthehumangenome,testsbecomeavailablewherebyapersoncandeterminetheirprobabilityofdevelopingaterminaldisease,thentheymaybeabletousethisinformationtogetafairlygoodideaoftheirlifeexpectancyandrelativecostofhealthcare.Ifapplicantsforhealthinsuranceweretowithholdthisinformationfrominsurancecompanies,theadverseselectionproblemcouldbecomesevereenoughtocausetheindustrytocollapse.Bycontrast,ifapplicantschosetorevealthisinformation,theymightnotbeabletoobtaininsurance.Someonewhohasahighprobabilityofgettingheartdiseaseatayoungagewillstillbeabletogetautomobileinsurance,butgettinglifeorhealthinsurancewillcec2174X_ch13_327-358.indd34325/11/135:41PM 344lChapter13FinancialIndustryStructureAPPLYINGTHECONCEPTSobig,infact,thattheyhavebecomenearmonopolies,driv-ingupthepriceofreinsuranceintheprocess.REINSURANCEAND“CAT BONDS”Therisingcostofreinsurancehasspurredthecreationofasecondsolutiontotheproblemofinsuringcatastrophicrisk.Financialexpertshavedesignedcatastrophicbonds,Togetamortgageonahome,you’llneedinsurance.Re-orcatbonds,whichallowindividualinvestorstoshareagardlessofwhereyoulive,yourlenderwillrequireyouverysmallportionofthereinsurancerisk.Itworkslikethis.tohavefireinsurance,andinsomeplacesyoumayalsoThroughaninvestmentbank,aninsurancecompanywillsellneedinsuranceagainstnaturaldisasterslikefloods,earth-aquantityofcatbonds,immediatelyinvestingproceedsinquakes,orhurricanes.Withoutsuchinsuranceyouwon’tgetlow-riskfinancialinstrumentslikeU.S.Treasurybonds.Ifaamortgage,andwithoutamortgageyouwon’tbuyahouse.catastropheoccurs,theU.S.TreasurybondsaresoldandClearly,it’sineveryone’sinterestforinsurancecompaniestotheresultingfundsusedtopaytheclaimstheinsuranceprovidesuchinsuranceandspreadtherisk.Butsometimescompanyfaces.Butifnoearthquake,fire,orhurricanehitsthiskindofinsuranceisn’teasytoobtain.duringthepolicyperiod,thecatbondownersreceiveasub-Imaginethataninsureristhinkingofofferingearthquakestantialreturnthatcanbeashighas10percentagepointsinsuranceinCalifornia.Unlikeautomobileaccidents,whenanabovetheyieldonU.S.Treasurybondsofequalmaturity.*earthquakehits,alargenumberofpolicyholderswillallfileThishighlevelofcompensation,coupledwithaverylowcor-claimsatthesametime.Theresultfortheinsurancecompanyrelationwiththereturnonmostotherinvestments,meansisalarge,undiversifiedrisk.Toofferearthquakeinsuranceandthatcatbondscanbothimprovetheexpectedreturnandstayinbusiness,apropertyandcasualtyinsurancecompanylowertheriskofatypicalinvestor’sportfolio.Nevertheless,mustfindsomewaytoinsureitselfagainstcatastrophicrisks—thedemandforcatbondsremainslimited,withissuanceoflargenaturaldisastersthatgenerateasignificantnumberoflessthan$7billionin2012,justbelowthe2007peak.payoutssimultaneously.TheexistenceofreinsuranceandcatbondshasclearReinsurancecompaniesofferasolutiontothisprob-benefits.Thesemechanismsfortransferringandspread-lembyprovidinginsurancetoinsurancecompanies.Sayingtheriskofcatastrophicdisasterimprovetherisk–returntheCaliforniainsurerestimatesthatanearthquakewouldtradeoffforindividualinvestors,enableinsurancecompa-generatepaymentsof$15billion(theapproximatelossinniestooffermoreinsurancethantheycouldotherwise,andthe1994earthquakeinNorthridge,LosAngeles).Thecom-allowprospectivehomeownerstogettheinsurancetheypanymayhavetheresourcestocoveronlythefirst$1 bil-need—andthemortgagefinancingtheywant—topurchaselionofpolicyholders’claims.Towritethefull$15 billionworthahome.ofinsurance,thecompanywillneedtobuy$14 billionofreinsurance.Reinsurancecompaniesareenormous;theyoperate*Oneofthefirstcatbondstobeissuedwasa$400millionofferingallovertheworld.Theirgeographicspreadallowsthemtoin1997bytheUnitedServicesAutomobileAssociation(USAA),diversifytheirrisk,becauseearthquakesdon’thappenataninsurerofcurrentandpastmilitarypersonnelandtheirfamilies.thesametimeinbothCaliforniaandJapan.ThefactthatThebondagreementprovidedthatifUSAA’slossesfromahur-reinsurancecompaniescanspreadtheirriskgloballygivesricaneratedcategory3,4,or5exceeded$1billionoverthenextthemtheabilitytowithstandindividuallosses,eveniftheyyear,bondholderswouldpay80percentofthenext$500 millionarecatastrophic.Forthistowork,reinsurershavetobebig.inclaims.beverydifficult.Providingaffordableinsuranceforsuch“preexistingconditions”wasoneoftheleadingmotivationsfortheU.S.healthcarereformsthatbegantotakeeffectin2014.PensionFundsLikeaninsurancecompany,apensionfundofferspeopletheabilitytomakepremiumTIMEpaymentstodayinexchangeforpromisedpaymentsundercertainfuturecircum-stances.Alsolikeaninsurancecompany,pensionfundsdonotacceptdeposits.Theydohelppeopletodevelopthedisciplineofsavingregularly,gettingthemstartedearlyandhelpingthemtostickwithit.AswesawinChapter4,theearlierapersonbeginssavingandthemoredisciplinedheorsheis,thebetteroffthatpersonwillbelaterinlife.Savingfromanearlyagemeansenjoyingahigherincomeatretirement.Pensionplansnotonlyprovideaneasywaytomakesurethataworkersavesandhassufficientresourcesinoldage;theyhelpsaverstodiversifytheirrisk.Bypoolingthesavingsofcec2174X_ch13_327-358.indd34425/11/135:41PM NondepositoryInstitutionsChapter13l345manysmallinvestors,pensionfundsspreadtherisk,ensuringthatfundswillbeavail-abletoinvestorsintheiroldage.Peoplecanuseavarietyofmethodstosaveforretirement,includingemployer-sponsoredplansandindividualsavingsplans,bothofwhichallowworkerstodeferincometaxontheirsavingsuntiltheyretire.NearlyeveryonewhoworksforalargecorporationintheUnitedStateshasanemployer-administeredpensionplan.Therearetwobasictypes:defined-benefit(DB)pensionplansanddefined-contribution(DC)pensionplans.Regardlessofthetype,manyemployer-sponsoredplansrequireaper-sontoworkforacertainnumberofyearsbeforequalifyingforbenefits.Thisqualify-ingprocessiscalledvesting.Thinkofvestingasthepointatwhichthecontributionsyouremployerhasmadetothepensionplanonyourbehalfbelongtoyou.Changingjobsbeforeyourpensioncontributionshavebeenvestedcanbeverycostly.Let’stakealookathowthetwotypesofpensionplanwork.Defined-benefitplanswereoncemorecommonthantheyaretoday.ParticipantsinDBplansreceivealife-timeretirementincomebasedonthenumberofyearstheyworkedatthecompanyandtheirfinalsalary.Forexample,someonewhoworkedforthesamecompanyfor30 yearsandretiredatasalaryof$100,000mightreceive2percentofthatsalaryforeachyearofservice,or$60,000peryear.Thatmayseemgood,buttoreapsuchben-efits,mostpeoplewouldneedtoworkaverylongtimeforthesamefirm.Defined-contributionplansarereplacingdefined-benefitplans,andtheyareverydifferent.Theseplansaresometimesreferredtobynameslike“401(k)”aftertheirdes-ignationsintheInternalRevenueServicecode.Inadefined-contributionplan,theem-ployeeandemployerbothmakecontributionsintoaninvestmentaccountthatbelongstotheemployee.Unlikeadefined-benefitplan,inaDCplantheemployertakesnoresponsibilityforthesizeoftheemployee’sretirementincome.Instead,atretirementtheemployeereceivestheaccumulatedfundsintheaccountandmustdecidewhattodowiththem.Theoptionsincludeacceptingalumpsum,removingsmallamountsatatime,orconvertingthebalancetoafixedmonthlypaymentforlifebypurchasinganannuity(seeYourFinancialWorld:Annuities).Youcanthinkofapensionplanastheoppositeoflifeinsurance.Onepaysoffifyoulive,theotherifyoudon’t.Thetwovehiclesaresimilarenoughthatthesameinstitu-tionoftenoffersboth.Andnotsurprisingly,thebalancesheetsofpensionfundslookalotlikethoseoflifeinsurancecompanies;bothholdlong-termassetslikecorporatebondsandstocks.Theonlydifferenceisthatlifeinsurancecompaniesholdonlyhalftheequitiesthatpensionfundsdo.7Finally,itisworthnotingthattheU.S.governmentdoesprovideinsuranceforprivate,defined-benefitpensionsystems.Ifacompanygoesbankrupt,thePensionBenefitGuarantyCorporation(PBGC)willtakeoverthefund’sliabilities.ThePBGCcurrentlyguaranteesmorethan25,000pensionfundscovering43 millionworkersandretirees.WhilethePBGC’sinsuranceiscapped,sothathighlypaidemployeeslikeairlinepilotsarenotfullyprotected,itstillincreasestheincentiveforafirm’smanag-erstoengageinriskybehavior.Toguardagainstthispossibility,regulatorsmonitorpensionfundsclosely.Evenso,someexpertsbelievethatPBGCcouldendupowinghundredsofbillionsofdollarsinthenot-too-distantfuture.Indeed,thespateofpen-sionplanfailuresandinvestmentsetbacksinthefinancialcrisisof2007–2009doubledthePBGC’sdeficitto$22 billioninfiscal2009comparedwiththeprioryear;byfiscal2012,itwas$34 billion.7Theheavieremphasisonequitiesmakespensionfundsmorerisky.Thisisariskthatispotentiallybornebytheplans’participants.Butasmentionedlaterinthissection,defined-benefitpensionplansareinsuredbytheU.S.government,soinrealitythisisariskbornebroadlybyeveryone.cec2174X_ch13_327-358.indd34525/11/135:41PM 346lChapter13FinancialIndustryStructureAPPLYINGTHECONCEPTPUBLICPENSIONSANDTHESOCIALSECURITYSYSTEMProvidingfortheelderlyisatremendouschallengeforanysociety.Traditionally,childrencaredfortheirparentswhentheybecameold.Butwiththeadventofmodernindustrialsocietiesandanassociatedincreaseingeographicmobility,manyelderlyparentsnolongerlivewiththeirchildren.Todaytheexpectationisthatpeoplewillsaveenoughwhiletheyareworkingtopaytheirownwaywhentheyretire.Iftheydon’t,thegeneralviewisthatinacivilizedsociety,govern-mentshouldcareforthepoor.investedforthelongtermandonlyaftermanyyearsareDuringthe20thcentury,thegovernmentsofmanycoun-paidouttoretirees.Notonlyisthesourceoffundsdiffer-triescreatedpensionsystemsthatprovidedaguaranteedentbuttheallocationofriskdifferstoo.InthecurrentSocialincometotheelderly.TheseprogramswerefinancedbytaxSecuritysystem,theresponsibilitytopayretireesbelongstorevenuespaidbytheyoung.Aslongasworkers’incomesyoungergenerations.Theyfootthebill;theyfacetherisk.Ifweregrowingquicklyenoughandthepopulationitselfwastheeconomydoespoorly,forexample,wagesoftheyounggrowing,thearrangementworkedwell.Around1970,how-whoareworkingwillfall,makingitmoreburdensometopayever,botheconomicgrowthandpopulationgrowthbegantothetaxesrequiredtohonorpromisestoretirees.Incontrast,slowinindustrializedcountries.Atthesametime,medicalinaprivatepensionsystem,individuals’ownsavingsprovidecarewasimproving,raisingtheprospectofalongerlifefortheirretirementincomesandtheythemselvesfacetheriskeveryone.Graduallytheratioofworkerstoretireesbeganthatthereturnontheirinvestmentsmaybelow.tofall,sofewerandfewerworkingpeopleweresupportingTheSocialSecuritysystem’sfinancesareinbadshape.moreandmoreretirees.Accordingtothegovernment’s2012estimates,by2033taxToday,toremainfinanciallyviable,thesesystemsmustincomewillbesufficienttofinanceonly75percentofprom-change.Onesolution—toraisetheageatwhichfullretire-isedbenefits.Thereareonlyafewwaystheproblemcanbementbenefitsarereceivedto70insteadof67—hassofarrepaired.Thegovernmentcanreducethebenefitspromisedbeenpoliticallyunpalatable.Failuretodealwiththeproblemtofutureretirees,raisethetaxratethatfutureworkerspay,hassetthestageforacrisis.IntheUnitedStates,theSo-orconvertthesystemintoonethatmirrorsaprivatepen-cialSecuritysystemwilleventuallybeunabletomeetthesionplan,withindividualaccounts.Mostproposalstofixtheobligationscurrentlyonitsbooks.systeminvolvesomecombinationofallthreeoftheseap-SocialSecurityisnotapensionsysteminthetraditionalproaches.Forexample,suggestionstoprivatizethesystemsenseoftheterm.AllU.S.workerspaySocialSecuritytaxinvolvereducingbenefitstothosewhoarecurrentlyworking,(seethelinelabeled“FICA”onyourpaystub);inreturn,theraisingtheirSocialSecuritytaxes,andplacingnewreve-governmentpromisestomakepaymentstothemwhentheynuesintoindividualaccountssimilartodefined-contributionretire.ButwiththeSocialSecuritytaxesitcollectsfrompensionfunds.Insuchasystem,thegovernmentwouldcon-workers,thegovernmentcandoonlyoneoftwothings:ittinuetoguaranteethatthepoordonotstarve,butthosewhocangiveittocurrentretireesorspenditongeneralpro-arewellenoughofftotakecareofthemselveswouldhavetograms.Assuch,SocialSecurityisa“pay-as-you-go”systemdoso.thattransfersrevenuesdirectlyfromcurrentworkerstocur-Atthispoint,allanyoneknowsisthattheSocialSecurityrentretirees.systemwillhavetochangeandthefasterthebetter.Inevalu-Thisisaverydifferentarrangementfromaprivateatingtheproposalstofixit,keepinmindtwokeyquestions:pensionfund,inwhichcontributionsaccumulateandareWhowillpaythebillsandwhowillshouldertherisks?SecuritiesFirms:Brokers,MutualFunds,andInvestmentBanksThebroadclassofsecuritiesfirmsincludesbrokerages,investmentbanks,andmutualfundcompanies.Inonewayoranother,theseareallfinancialintermediaries.Theprimaryservicesofbrokeragefirmsareaccounting(tokeeptrackofcustomers’invest-mentbalances),custodyservices(tomakesurevaluablerecordssuchasstockcertifi-catesaresafe),andaccesstosecondarymarkets(inwhichcustomerscanbuyandsellcec2174X_ch13_327-358.indd34625/11/135:41PM NondepositoryInstitutionsChapter13l347financialinstruments).Brokersalsoprovideloanstocustomerswhowishtopurchasestockonmargin.Andtheyprovideliquidity,bothbyofferingcheck-writingprivilegeswiththeirinvestmentaccountsandbyallowinginvestorstosellassetsquickly.Mutual-fundcompanieslikeVanguard,Fidelity,andDreyfusofferliquidityservicesaswell;theirmoney-marketmutualfundsareakeyexample.Buttheprimaryfunctionofmu-tualfundsistopoolthesmallsavingsofindividualsindiversifiedportfoliosthatarecomposedofawidevarietyoffinancialinstruments.Allsecuritiesfirmsareverymuchinthebusinessofproducinginformation.Butwhilebrokersandmutualfundsprovidesomeinvestmentadvicetotheirretailcus-tomers,informationisattheheartoftheinvestmentbankingbusiness.InvestmentbankslikeGoldmanSachs,MorganStanley,andJPMorganChase—allnowdivisionsofbankholdingcompanies—aretheconduitsthroughwhichfirmsraisefundsinthecapitalmarkets.Throughtheirunderwritingservices,theseinvestmentbanksissuenewstocksandavarietyofotherdebtinstruments.Mostcommonly,theunderwriterguaranteesthepriceofanewissueandthensellsittoinvestorsatahigherprice,apracticecalledplacingtheissue.Theunderwriterprofitsfromthedifferencebetweenthepriceguaranteedtothefirmthatissuesthesecurityandthepriceatwhichthebondorstockissoldtoinvestors.Butbecausethepriceatwhichtheinvestmentbanksellsthebondsorstocksinfinancialmarketscanturnouttobelowerthanthepriceguaran-teedtotheissuingcompany,thereissomerisktounderwriting.Formostlargeissues,agroupofinvestmentbankswillbandtogetherandspreadtheriskamongthemselvesratherthanoneofthemtakingtheriskalone.Informationandreputationarecentraltotheunderwritingbusiness.UnderwritersINFORMATIONcollectinformationtodeterminethepriceofthenewsecuritiesandthenputtheirreputationsonthelinewhentheygoouttoselltheissues.Alarge,well-establishedinvestmentbankwillnotunderwriteissuesindiscriminately.Todosowouldreducethevalueofthebank’sbrand,alongwiththefeesthebankcancharge.Inadditiontounderwriting,investmentbanksprovideadvicetofirmsthatwanttomergewithoracquireotherfirms.Investmentbankersdotheresearchtoidentifypotentialmergersandacquisitionsandestimatethevalueofthenew,combinedcompany.Theinformationtheycollectandtheadvicetheygivemustbevaluablebecausetheyarepaidhandsomelyforthem.Infacilitatingthesecombinations,in-vestmentbanksperformaservicetotheeconomy.Mergersandacquisitionshelptoensurethatthepeoplewhomanagefirmsdothebestjobpossible.Managerswhodon’tgetthemostoutoftheresourcesentrustedtothemriskhavingtheircom-panypurchasedbyexecutiveswhocandoabetterjob.Thisthreatofatakeover—sometimesdescribedasthemarketforcorporatecontrol—providesdisciplineinthemanagementofindividualcompaniesandimprovestheallocationofresourcesacrosstheeconomy.FinanceCompaniesFinancecompaniesareinthelendingbusiness.Theyraisefundsdirectlyinthefinan-cialmarketsbyissuingcommercialpaperandsecuritiesandthenusethemtomakeloanstoindividualsandcorporations.Becausethesecompaniesspecializeinmakingloans,theyareconcernedlargelywithreducingthetransactionsandinformationcoststhatareassociatedwithintermediatedfinance.Andbecauseoftheirnarrowfocus,fi-nancecompaniesareparticularlygoodatscreeningpotentialborrowers’creditworthi-ness,monitoringtheirperformanceduringthetermoftheloan,andseizingcollateralintheeventofadefault.cec2174X_ch13_327-358.indd34725/11/135:41PM 348lChapter13FinancialIndustryStructureTOOLSOFTHETRADEHedgeFundsHedgefundsarestrictlyformillionaires.Theseinvestmentgroups:companieswhosestockpriceshethoughtwouldfallpartnerships(sometimesreferredtoasnontraditionalin-andcompanieswhosestockpriceshethoughtwouldrise.vestmentfunds)bringtogethersmallgroupsofpeoplewhoHesoldthefirstgroupshortandusedtheproceedstobuymeetcertainwealthrequirements.Toavoidvariouslegalsharesinthesecondgroup.Thetermhedgeinthenameregulations,hedgefundscomeintwobasicsizes:theycanhedgefundcomesfromthefactthatwhenthemarketinhaveamaximumofeither99investors,eachofwhomhasgeneralwentupordown,movingallstocksinthesamedi-atleast$1millioninnetworth,or499investors,eachofrection,thefundwouldtakelossesononegroupofstockwhomhasatleast$5millioninnetworth.Thelargerhedgebutturnaprofitonthesecond.Itwashedgedagainstmove-fundscanalsoacceptfundsfrominstitutionalinvestorslikementsinthemarketasawhole.Jonesturnedaprofitwhenpensionfunds,mutualfunds,andinsurancecompaniessothestockshesoldshortwentdownrelativetothestockshelongastheirnetworthisatleast$25million.Theminimumpurchased.Andthoseprofitsweresubstantial.investmentinahedgefundisusually$100,000.ThesereallyTodaywewouldrefertoJones’sfundasa“long-shortaremillionaires’investmentclubs.hedgefund”becausehewaslongonsomestocksandshortHedgefundsarerunbyageneralpartner,ormanager,onothers.In2012,accordingtoresearchfirmPertrac,morewhoisinchargeofday-to-daydecisions.Managersareverythan12,000hedgefundsmanagedmorethan$2.3 trillion.wellpaid,receivinganannualfeeofatleast2percentofas-Thelong-shortapproachisonlyoneofthestrategiestheirsetsplus20percentofprofits.Inayearinwhichthefund’smanagersfollow.Macrofundmanagerstakeunhedgedpo-returnoninvestmentis10percent,themanagerofanaver-sitionsinthehopeofbenefitingfromshiftsininterestratesorage-sizefundof$500millionwillreceive$20millioninfees.nationalmarketconditions.GlobalfundmanagersengageBecausethesefundsareunregulated,findingoutwhatininternationalstockpicking.Andthemanagersofrelativetheirportfolioscontaincanbeachallengeevenforthevaluefundstrytoexploitsmall,transitorydifferencesinthefund’sinvestors:themanagerneednottellanyone.Thisse-pricesofrelatedsecurities,suchasU.S.Treasurybillsandcrecycreatestheveryrealpossibilityofmoralhazard.Ifabonds.Long-TermCapitalManagement,thehedgefundfundstartstoincurlosses,determiningthereasonforthethatcollapsedinSeptember1998(seeChapter9),wasfol-fallinvalueisoftenimpossible.Toensurethatthemanager’slowingthislaststrategy,tryingtotakeadvantageofpriceincentivesmatchthoseoftheinvestors,themanagerisre-differencesbetweenU.S.Treasurybondsofslightlydifferentquiredtokeepalargefractionofhisorherownwealthinthematurities.Playinggameswithinterestratesiswhatledthefund.Byandlarge,thisrequirementsolvestheproblemoffirmtoamass$1.25trillionininterest-rateswaps.*moralhazard;fraudulentbehaviorisextremelyrare.Regardlessofthestrategiestheyuse,hedgefundman-Thenamehedgefundmaysuggestthatthesefundsem-agerstypicallystrivetocreatereturnsthatroughlyequalploythediversificationtechniquesdiscussedinChapter5,thoseofthestockmarket(asmeasuredbyacomprehen-buttheydonot.HedgingreducesriskbygroupingtogethersiveindexliketheS&P500)butareuncorrelatedwithit.Soindividualinvestmentswhosereturnstendtomoveinoppo-whileindividualhedgefundsareveryrisky—somethinglikesitedirections,buthedgefundsarenotlow-riskenterprises.10percentofthemclosedowneveryyear—aportfoliothatBecausetheyareorganizedasprivatepartnerships,hedgeinvestsinalargenumberofthesefundscanexpectreturnsfundsarenotconstrainedintheirinvestmentstrategies;theyequaltothestockmarketaveragewithlessrisk.Thatiswhycantradeinderivativesandborrowtocreateleverage.peoplelikehedgefundsandwhysuccessfulhedgefundA.W.Jonesfoundedthefirsthedgefundin1949.Hismanagersaresowellpaid.fundcombinedleveragewithshortselling(thepracticeofborrowingastockorbondwhosepriceyoubelievewillfall,*Foraninsightfulhistoryandanalysisofhedgefunds,seesellingit,andthenbuyingitbackatalowerpricebeforere-SebastianMallaby,MoreMoneythanGod:HedgeFundsandthepayingthelender).Jonesdividedthefund’sequitiesintotwoMakingofaNewElite(NewYork:PenguinPress,2011).Mostfinancecompaniesspecializeinoneofthreeloantypes:consumerloans,busi-nessloans,andwhatarecalledsalesloans.Somealsoprovidecommercialandhomemortgages.Consumerfinancefirmsprovidesmallinstallmentloanstoindividualcon-sumers.Ifyouvisitanappliancestoretopurchaseanewrefrigerator,youmaybeofferedadealthatincludes“nomoneydownandnopaymentsforsixmonths.”Ifyouacceptthisloanoffer,you’llbeaskedtofilloutanapplicationandtowaitafewcec2174X_ch13_327-358.indd34825/11/135:41PM NondepositoryInstitutionsChapter13l349minuteswhilesomeonechecksyourcredit.ThecreditisusuallysuppliednotbythestorebutbyafinancecompanylikeWellsFargo.Thiskindofconsumercreditallowspeoplewithoutsufficientsavingstopurchaseappliancessuchastelevisionsets,wash-ingmachines,andmicrowaveovens.Businessfinancecompaniesprovideloanstobusinesses.Ifyouwanttostartyourownairline,forexample,youwillneedtoacquiresomeairplanes.Thatisn’tasdif-ficultasitmaysound,becauseyoudon’tneedtoshellouttheentire$100millionpriceofanewplane.Airplanes,likeautomobiles,canbeleased.Thatis,abusinessfinancecompanybuystheplaneandthenleasesitbacktoyou,anapproachthatsignificantlyreducesthecostofstartingyournewenterprise.Whilethisexampleisextreme,financecompanieswillpurchasemanytypesofequipmentandleasethembacktofirms.Inadditiontoequipmentleasing,businessfinancecompaniesprovidebothinven-toryloansandaccountsreceivableloans.Inventoryloansenablefirmstokeeptheirshelvesstockedsothatwhenacustomerasksforaproduct,thefirmcanfilltheorder.Accountsreceivableloansprovidefirmswithimmediateresourcesinanticipationofreceiptofcustomers’payments.Thepurposeofboththeseloantypesistoprovideshort-termliquiditytofirms.Salesfinancecompaniesspecializeinlargerloansformajorpurchases,suchasautomobiles.Cardealerscustomarilyofferfinancingtopeoplewhoareshoppingforanewcar.Whenyoupurchaseacar,atacertainpointinthenegotiationsthesalespersonwillaskhowyouintendtopayforit.Unlessyouhavesizablesavingsorarebuyingaverycheapcar,youwillneedtoborrow.Thecarbusinessisorganizedsothatyoudon’tneedtoleavethedealershiptogetyourloan;someonetherewilltakecareofitforyou.Thefinancingisarrangedthroughafinancecompany,possiblyafinancedivisionofthemanufacturer,thatspecializesinmakingcarloans.Government-SponsoredEnterprisesYouwillnotbesurprisedtolearnthattheU.S.governmentisdirectlyinvolvedinthefinancialintermediationsystemandthattherisktakingofgovernment-relatedinter-mediariescontributedimportantlytothefinancialcrisisof2007–2009.Youmightbesurprisedthatintermediationbyavarietyofgovernmentagenciesgrewmarkedlyafterthecrisisandaccountedformostnewhomemortgages.Insomecases,thegovernmentprovidesloanguarantees;inothers,itchartersfinancialinstitutionstoprovidespecifictypesoffinancing,suchashome,farm,andstudentloans.In1968,whenCongresswantedtoexpanditssupportformort-gagelendingtolow-andmoderate-incomefamilies,itprivatizedtheDepression-eraFederalNationalMortgageAssociation(FannieMae)and,in1970,issuedasimilarcharterforacompetingentity,theFederalHomeLoanMortgageCorpora-tion(FreddieMac).Eachwasthuscharteredbythegovernmentasacorporationwithapublicpurpose,ahybridcorporateformknownasagovernment-sponsoredenterprise(GSE).WhilethedebtissuedbyFannieandFreddiewasnotguaranteedbythegovernment,marketparticipantsgenerallyassumedthatitwouldbeinacrisis.In1968,CongressalsoestablishedtheGovernmentNationalMortgageCorporation(GinnieMae)asaGSEthatiswhollyownedbythefederalgovernment.TheU.S.gov-ernmentexplicitlyguaranteesGinnieMaedebt.(Toprovidestudentloans,Congressin1974charteredtheStudentLoanMarketingAssociation—SallieMae—asaGSEbutby2004hadterminatedthecharter,makingSallieMaeawhollyprivate-sectorfirm).cec2174X_ch13_327-358.indd34925/11/135:41PM 350lChapter13FinancialIndustryStructureINTHENEWSFed’sTarulloSaysRevivingGlass-SteagallMay Be Costlyregulationsincethe1930s,andareorganizationoftheFed’sapproachtoinspectingbanksandensuringfinan-cialstability.HewasObama’sfirstappointeetotheFedandistheleadgovernorinchargeofbanksupervisionandByCraigTorresandJoshuaZumbrunregulation.December4,2012GovernmentSupportFederalReserveGovernorDanielTarullosaidenactingalawTheFedandlawmakersinrecentyearshavemitigatedsomesimilartotheGlass-SteagallActthatseparatesinvestmentofthe“toobigtofailproblem,”inwhichthecollapseofaandcommercialbankingcouldimpose“substantialcosts”byfirmthreatensthebroaderfinancialsystemandwouldre-curtailingtherangeofservicesofferedbyindividualbanks.quiregovernmentsupport,Tarullosaidinresponsetoaudi-Twootherproposals,toplaceacaponbanks’non-depositencequestions.financingortorequirefirmstomaintaincertainlevelsof“Iwouldcertainlynotsayit’sbeeneliminated,”Tarullolong-termdebt,maybetterreducetherisksthatledtothesaidoftheriskposedbytoo-big-to-failfirms.2008financialcrisisandbroughtdownfirmssuchasBearInexpressingskepticismaboutGlass-Steagall,TarulloStearnsCos.,LehmanBrothersHoldingsInc.,andAmericansaidmanyfirmsatthecenterofthefinancialcrisisin2008InternationalGroupInc.and2009wereeitherstand-alonebanksorinvestmentbanks,“ThereinstatementofGlass-SteagallwouldmeanthatsuchasLehmanBrothersandWashingtonMutualInc.bankclientscouldnolongerretainonefinancialfirmthatSuchfirmswouldn’tnecessarilybesubjecttoabreak-upwouldhavethecapacitytoofferthewholerangeoffinancingunderGlass-Steagall.options,”Tarullosaidtoday . . . .AnothercosttosucharuleCappingabank’snon-depositliabilitiesasafractionofcouldbedamagecausedtothemanysmallbanksthatprovideU.S.GDPhas“considerableconceptualappeal,”Tarullosomecapitalmarketservicestosmallbusinesses,hesaid.said.Suchanapproach“allowsrelativeflexibilitytothefirmTarullo,60,hasoverseentheimplementationoftheinmeetingthatconstraint”sincethefirmcouldshrinkitsDodd-FrankAct,themostsweepingoverhauloffinancialbalancesheetthroughsellinganyassetsitwished.Attheirfounding,theGSEshadsimilarfinancialcharacteristics.Theyissuedshort-termbondsandusedtheproceedstoprovideloansorguaranteesofoneformoran-other.Becauseoftheirexplicitorimplicitrelationshiptothegovernment,theypaidlessthanprivateborrowersfortheirliabilitiesandpassedonsomeofthesebenefitsintheformofsubsidizedmortgagesandloans.Asthecrisisof2007–2009highlighted,housingintermediationisbyfarthelarg-estofthesegovernment-sponsoredactivities.In2012,mortgageloansandmort-gageguaranteesissuedbyGSEsandotherfederalagenciesexceeded$6trillion,ormorethanhalfoftheresidentialmortgagemarketofnearly$11 trillion.Forcom-parison,outstandingTreasurysecurities—includingbills,notes,andbonds—totaled$11 trillion.Intheyearsprecedingthe2007–2009crisis,FannieandFreddiehadtakenadvan-tageoftheirimplicitgovernmentbackstopbyoperatingonaslimcapitalcushion.Eachhadaleverageratio(assetsdividedbycapital)thatwasaroundthreetimeshigherthanthatoftheaverageU.S.bank(recallthediscussioninChapter12).In2005,forcec2174X_ch13_327-358.indd35025/11/135:41PM NondepositoryInstitutionsChapter13l351CertainSize“Weneedtoadjusttheregulatoryrequirementsforfor-Ifresearchshowedeconomiesofscaleandscopeinbank-eignbanksinresponsetochangesinthenatureoftheiringwereunlikelytoberealizedbeyondacertainsize,thenactivitiesintheUnitedStates,therisksattendanttothosepolicymakerswould“haveapointofreferenceforsettingchanges,andinstructionsfromCongress,”Tarullosaid.thecap,”hesaid.SOURCE:Bloomberg.com,December4,2012.UsedwithpermissionofFurtheranalysisoftheproposalwouldbeneeded,TarulloBloombergL.P.Copyright©2012.Allrightsreserved.said,andmay“suggestalternativemeanstothesamepolicygoals.”Aproposaltorequirebankstoincreasetheuseoflong-LESSONSOFTHEARTICLEtermdebt“wouldnotseemtocarrysignificanthurdles,”heIn2010,CongressenactedtheDodd-Frankfi-said. . . .nancialreformstopreventfuturecrisesbutleftThecentralbankhasusedannualstresstestsofbanks’manyspecificstobedecidedbyregulatorslikecapitalstrengthtoboosttieronecommoncapitalto$803theFed.Theirchallengeistoreducesystemicbillionforthe19largestbanksfrom$420billioninthefirstriskwithoutrenderingthefinancialsystemin-quarterof2009.Theratioofcapitaltoassetsweightedforefficient.Tolimitthe“toobigtofail”problem,riskhasaboutdoubledto10.9percentfrom5.4percent. . . .policymakersaretryinganumberofremedies,Inthepasttwomonths,Tarullohasintroducedtwonewincludingcappingthesizeandleverageoftheideasforbankregulation.HesaidinanOct.10speechthatlargestfinancialfirmsandprohibitingcertainitwouldbe“appropriate”forCongresstolegislateanupperriskyactivities.Thearticlenotesthatsegment-boundaryforthelargestbanksthatareabletopreserveaingtheactivitiesofintermediariestoday(asdid“too-big-to-fail”quality.theGlass-SteagallActin1933)wouldincreaseTheFedgovernorsaidonNov.28attheYaleSchoolofcostswithouteliminatingsystemicrisk(seeManagementinNewHaven,Connecticut,thatthecentralChapter5,LessonsfromtheCrisis:SystemicbankisplanningtoughercapitalandleveragerulesforU.S.Risk).unitsofforeignbanks.example,theirfinancialstatementsshowedaleverageratioofabout30to1.Withsuchlowlevelsofcapital,thesetwomassiveGSEscouldnotwithstandthesurgeofdefaultswhenhomepricesbegantodeclinenationwidein2006.Despitenumerouspubliceffortstosavethem,arunonGSEdebtinthesummerof2008compelledtheU.S.TreasurytoplaceFannieandFreddieintoconservatorship—abankruptcyprocedurethatallowsthemtooperatedespiteinsolvency.Ayearlater,theCongressionalBudgetOfficeestimatedthatthegovernment’scommitmentstothoseGSEswouldaddnearly$300billiontothefederaldeficitin2009,mostofwhichre-flectedthevalueoftheirassetsandliabilitieswhenconservatorshipbegan.8Inthecrisis,FannieandFreddieprovedtobetoobigtofail—theirdemiseprob-ablywouldhavetoppledtheentirefinancialsystem.Thisdidnotcomeasasurprise.8SeeCongressionalBudgetOffice,“AnOverviewofFederalSupportforHousing,”EconomicandBudgetIssueBrief,November3,2009.cec2174X_ch13_327-358.indd35125/11/135:41PM 352lChapter13FinancialIndustryStructureYOURFINANCIALWORLDAnnuitiesMostcollegestudentsdon’thavetoworryaboutannuities,bond.Variableannuitiescanbeinvestedinavarietyofmu-atleastnotyet.Butitisverylikelythatwhenyouretire,youtualfundsofferedbytheinsurancecompany,andthegrowthwillturnyourretirementsavingsintoanannuity.And,inthedependsontheperformanceofthefunds.Variableannui-meantime,someonemaytrytosellyouone.Here’swhattiesarecomplicated,andinsurancecompanieswillcombineannuitiesareandhowtheywork.themwithlifeinsuranceproducts.AnannuityisafinancialinstrumentinwhichapersonGettingtherightportfolioofinsuranceandannuitiesis(calledthe“annuitant”)makesapaymentinexchangeforparticularlydifficult.Unlikethecaseforstocksandbonds,nothepromiseofaseriesoffuturepayments.Similartoasimpleriskmeasurescurrentlyexisttohelpinvestorsassessbond,annuitiesaretypicallysoldbyinsurancecompanies,specificinsuranceandannuityproducts.Economistshaveandtheycomeinmanyformsandhavemanynames.Thereproposedthatinsurersdiscloseastandardizedindexthatarefixed-periodversuslifetimeannuities.Afixed-periodan-quantifiesthebenefitsofeachproducttosomeonewhosenuitymakesfixedmonthlyorannualpaymentsforaspeci-healthispoor(comparedwithsomeonewhoishealthy),andfiedperiodlike10or15years.Bycontrast,alifetimeannuityaseparate“mortality”indicatorforthebenefitstotheirben-guaranteesperiodicpaymentsfortheremainderofthean-eficiariesiftheydie.Thesetwonumberswouldgoalongnuitant’slife(andpossibly,thatoftheperson’sspouseaswaytohelpcustomers(ortheirfinancialadvisors)findthewell).Anannuityisthereverseoflifeinsurance.Alifeinsur-mostappropriateproducts.*ancepolicyholderpaystheinsurancecompanyeachyearorWheredoesthisleaveustoday?Annuitiesareuseful,month,withthebeneficiariesreceivingalumpsumwhenhebutyoushouldprobablyholdoffbuyingoneuntilyouareorshedies.Anannuitantmakesalump-sumpaymentandreadytoretire.Investyourretirementsavingsinindexmutualthenreceivesastreamofpaymentsuntildeath.fundswithlowexpenseratios,andbuytermlifeinsurance.Thentherearedeferredversusimmediateannuities.AnWhenthetimecomestoretire,thencallaninsurancecom-immediateannuitystartsrightaway,whilewithadeferredpanyandbuyanannuity.That’sgoingtobethecheapest,annuity,contributionsaremadeandinvestmentreturnsac-easiest,andsimplestwaytogo.crueforpaymentatalaterdate.Formoreinformationonannuities,whattheyareandOnceyourealizethatannuitiesareatypeofinvestment,howtheywork,gotowww.iii.org/individuals/annuities.thingsgetevenmorecomplicated.Insurancecompanies*Fordetailsontheseindexes,see“BetterGuidanceonMattersofferfixedversusvariableannuities.Fixedannuitiesguar-ofLifeandDeath,”TheRegion,FederalReserveBankofMin-anteetheprincipalvalueplusaminimuminterestrate,likeaneapolis,June2012.Inearlieryears,manyeconomistsandpolicymakershadwarnedaboutthethreattothefinancialsystemposedbyFannieandFreddie.9In2011,aTreasuryreportproposedtoreducetheroleoftheGSEsbycompellingthemto(1) raisethefeesfortheirguarantees,(2) requiredownpaymentsofatleast10 percent,(3) reducethesizeofindividualmortgageseligibleforGSEguarantees,and(4) winddowntheirinvestmentportfoliosatapaceofatleast10percentannually.Thereportalsoidentifiedthreepotentiallong-runoptionsforGSEreform:(1)privatiz-ing,(2) privatizingbutwithagovernmentmechanismtoprovidecreditduringacrisis,and(3) privatizingwithgovernmentreinsuranceforcrisisepisodes.Thetwolatteroptionsstillwouldposealong-runrisktotaxpayers.Inthesummerof2013,PresidentObamaendorsedlegislativeeffortstowinddowntheGSEsovertime,whilemaintain-inga“limited”governmentroleinhousingfinanceoverthelongterm.Yet,asofmid-2013,theGSEs,togetherwithagenciessuchastheFederalHousingAdministration9TounderstandthevulnerabilityoftheGSEsthateconomistshighlighted,seeViralAcharyaetal.,GuaranteedtoFail(Princeton,NJ:PrincetonUniversityPress,2011).cec2174X_ch13_327-358.indd35225/11/135:41PM NondepositoryInstitutionsChapter13l353andtheDepartmentofVeteransAffairs,stillfinancetheoverwhelmingshareofnewresidentialmortgages.Concernedaboutsupportingtherecoveryofthehousingmar-ket,thegovernmenthasbeenreluctanttothrottletheGSEs.You’llhavetowatchthefinancialnewstoseehowgovernmentinvolvementinhousingfinanceevolves.Table13.4summarizesthecharacteristicsandrolesoffinancialintermediaries.Table13.4SummaryofFinancialIndustryStructureFinancialPrimarySourcesofPrimaryUsesofIntermediaryFunds(Liabilities)Funds(Assets)ServicesProvidedDepositoryCheckabledepositsCash•PoolingofsmallsavingstoprovidelargeloansInstitutionSavingsandtimeLoans•Diversified,liquiddepositaccounts(Bank)depositsSecurities•AccesstopaymentssystemBorrowingfrom•ScreeningandmonitoringofborrowersotherbanksInsuranceExpectedclaimsCorporatebonds•PoolingofriskCompanyGovernmentbonds•ScreeningandmonitoringofpolicyholdersStocksMortgagesSecuritiesShort-termloansCommercialpaper•ManagementofassetpoolsFirmBonds•ClearingandsettlingtradesStocksInvestment•ImmediatesaleofassetsBank•Accesstospectrumofassets,allowingdiversification•Evaluationoffirmswishingtoissuesecurities•ResearchandadviceforinvestorsMutual-FundSharessoldtoCommercialpaper•PoolingofsmallsavingstoprovideaccesstoCompanycustomersBondslarge,diversifiedportfolios,whichcanbeliquid(includingMortgagesexchange-tradedfunds,StocksETFs)RealestateFinanceBondsMortgages•ScreeningandmonitoringofborrowersCompanyBankloansConsumerloansCommercialpaperBusinessloansPensionFundPolicybenefitstoStocks•Poolingofemployees’andemployers’bepaidouttofutureGovernmentbondscontributionsretirees•Diversificationoflong-terminvestmentstoensureCorporatebondsfutureincomeforretireesCommercialpaperGovernment-BondsMortgages•LargestshareofhousingfinanceSponsoredLoanguaranteesFarmloansEnterprise•AccesstofinancingforborrowerswhocannotGuaranteepaymentsobtainitelsewherecec2174X_ch13_327-358.indd35325/11/135:41PM 354lChapter13FinancialIndustryStructureTermsbankcharter,329LondonInterbankOfferedRatebankholdingcompany,332(LIBOR),336defined-benefitpensionplan,345propertyandcasualtyinsurance,341defined-contributionpensionplan,345systemicallyimportantfinancialinstitutions(SIFIs),330dualbankingsystem,330termlifeinsurance,341economiesofscale,338underwriting,347economiesofscope,338unitbank,327eurodollars,335universalbank,337FannieMae,349vesting,345financialholdingcompany,336wholelifeinsurance,341hedgefund,348UsingFRED:CodesforDataThisChapterDataSeriesFREDDataCodeCommercialbanksUSNUMBankswithtotalassetsover$20billionFREQ5BankfailuresBKFTTLA641NReturnonequityUSROEEquitytoassetsratioEQTACreditmarketassetsheldbydomesticfinancialsectorsTCMAHDFSwww.mhhe.com/moneyandbanking4eHeldbycommercialbanksCBUSCCBTCMAHDFSHeldbyprivatepensionfundsPPFTCMAHDFSHeldbybrokersanddealersBDTCMAHDFSHeldbypropertyandcasualtyinsurersPCICTCMAHDFSHeldbylifeinsurersLICTCMAHDFSHeldbymoneymarketmutualfundsMMMFTCMAHDFSHeldbymutualfundsMFTCMAHDFSHeldbygovernment-sponsoredenterprisesGSETCMAHDFS3-monthU.S.dollarLIBORUSD3MTD156NChapterLessons1.TheUnitedStateshasacomparativelylargebutdecliningnumberofbanks.a.ThelargenumberofbanksintheUnitedStatesisexplainedbyrestrictionsonbranching,bothwithinandacrossstatelines,thatwereimposedbythefederalgovernmentin1927.cec2174X_ch13_327-358.indd35425/11/135:41PM ChapterLessonsChapter13l355b.ThelargenumberofbanksintheUnitedStatesisasignofananticompetitivelegalenvironment.c.Since1997,bankshavebeenpermittedtooperateinmorethanonestate.Thischangehasincreasedcompetitionanddrivenmanysmall,inefficientbanksoutofbusiness.d.Between1933and1999,bankswereprohibitedfromengaginginthesecuritiesandinsurancebusinesses.e.Bankinghasbeenexpandingnotjustacrossstateboundariesbutacrossinterna-tionalboundaries.i.ManyU.S.banksoperateabroad,andalargenumberofforeignbanksdobusinessintheUnitedStates.ii.Eurodollars—dollardepositsinforeignbanks—playanimportantpartintheinternationalfinancialsystem.f.Thefinancialindustryisconstantlyevolving.Withchangesinregulations,finan-cialservicescannowbeprovidedintwoways:i.throughalargeuniversalbank,whichprovidesalltheservicesanyonecouldpossiblyneed.ii.throughsmallspecializedfirms,whichsupplyalimitednumberofservicesatalowprice.2.Nondepositoryinstitutionsareplayinganincreasinglyimportantroleinthefinan-cialsystem.Fivetypesoffinancialintermediarymaybeclassifiedasnondepositoryinstitutions.a.Insurancecompanies.i.Lifeinsurancecompaniesinsurepolicyholdersagainstdeaththroughtermlifeinsuranceandprovideavehicleforsavingthroughwholelifeinsurance.ii.Propertyandcasualtycompaniesinsureindividualsandbusinessesagainstlossesarisingfromspecificevents,likeaccidentsandfires.iii.Thetwoprimaryfunctionsofinsurancecompaniesareto:•allowpolicyholderstotransferrisk.www.mhhe.com/moneyandbanking4e•screenandmonitorpolicyholderstoreduceadverseselectionandmoralhazard.b.Pensionfundsperformtwobasicservices.i.Theyallowemployeesandemployerstomakepaymentstodaysothatem-ployeeswillreceiveanincomeafterretirement.ii.Theyspreadriskbyensuringthatthoseemployeeswholivelongerthanoth-erswillcontinuetoreceiveanincome.Forthisreason,pensionfundsmaybethoughtofastheoppositeoflifeinsurance.c.Securitiesfirmsincludethreebasictypesoffinancialintermediary:brokers,mutual-fundcompanies,andinvestmentbanks.i.Brokersgivecustomersaccesstothefinancialmarkets,allowingthemtobuyandsellsecurities.ii.Mutual-fundcompaniesprovidesaverswithsmall-denominationsharesinlarge,diversifiedinvestmentpools.iii.Investmentbanksscreenandmonitorfirmsbeforeissuingtheirsecurities.d.Financecompaniesspecializeinmakingloanstoconsumersandbusinessesforthepurchaseorleaseofspecificproducts,suchascarsandbusinessequipment.e.Government-sponsoredenterprisessupplydirectfinancingandprovideloanguaranteesforlow-interestmortgages,studentloans,andagriculturalloans.cec2174X_ch13_327-358.indd35525/11/135:41PM 356lChapter13FinancialIndustryStructureConceptualandAnalyticalProblems1.Formanyyearsyouhaveusedyourlocal,small-townbank.OnedayyouhearthatthebankisabouttobepurchasedbyBankofAmerica.Fromyourvantagepointasaretailbankcustomer,whatarethecostsandbenefitsofsuchamerger?(LO1)2.Whyhavetechnologicaladvanceshinderedtheenforcementoflegalrestrictionsonbankbranching?(LO1)3.Howdidthefinancialcrisisof2007–2009affectthedegreeofconcentrationintheU.S.bankingindustry?(LO1)4.Bankshavebeenlosingtheiradvantageoverotherfinancialintermediariesinat-tractingcustomers’funds.Why?(LO2)5.Anindustrywithalargenumberofsmallfirmsisusuallythoughttobehighlycom-petitive.Isthatsuppositiontrueofthebankingindustry?WhatarethecostsandbenefitstoconsumersofthecurrentstructureoftheU.S.bankingindustry?(LO1)6.*WhatwasthemainrationalebehindtheseparationofcommercialandinvestmentbankingactivitiesintheGlass-SteagallActof1933?Whywastheactrepealed?(LO1)7.Explainwhatthephrase“too-big-to-fail”meansinreferencetofinancialinstitu-tions.Howdidthepolicyresponsestothefinancialcrisisof2007–2009affectthetoo-big-to-failproblem?(LO1)8.Discusstheproblemslifeinsurancecompanieswillfaceasgeneticinformationbecomesmorewidelyavailable.(LO2)9.Whenthevaluesofstocksandbondsfluctuate,theyhaveanimpactonthebalancesheetsofinsurancecompanies.Whyisthatimpactmorelikelytobeaproblemforlifeinsurancecompaniesthanforpropertyandcasualtycompanies?(LO2)10.*Compareandcontrastthestructuresofbankholdingcompanies,financialhold-www.mhhe.com/moneyandbanking4eingcompanies,anduniversalbanks.(LO1)11.Whatarethebenefitsofcollaborationbetweenalargeapplianceretailerandafinancecompany?(LO2)12.Whydidgovernment-sponsoredenterprises(GSEs)suchasFreddieMacandFannieMaehavesubstantiallyhigherleverageratiosthantheaverageU.S.bankintheyearsprecedingthefinancialcrisisof2007–2009?Explainhowthismadetheenterprisesmorevulnerabletothehouse-pricedeclinesthatprecipitatedthecrisis.(LO2)13.Considertwocountrieswiththefollowingcharacteristics.CountryAhasnore-strictionsonbankbranchingandbanksinCountryAarepermittedtoofferinvest-mentandinsuranceproductsalongwithtraditionalbankingservices.InCountryB,therearestrictlimitsonbranchbankingandonthegeographicalspreadofabank’sbusiness.Inaddition,banksinCountryBarenotpermittedtoofferinvest-mentorinsuranceservices.Explaineachofyourchoicesforthefollowing.(LO1)a.Inwhichcountrydoyouthinkthebankingsystemismoreconcentrated?b.Inwhichcountrydoyouthinkthebankingsystemismorecompetitive?c.Inwhichcountrydoyouthink,everythingelsebeingequal,bankingproductsarecheaper?*Indicatesmoredifficultproblemscec2174X_ch13_327-358.indd35625/11/135:41PM DataExplorationChapter13l35714.YouexaminethebalancesheetofaninsurancecompanyandnotethatitsassetsaremadeupmainlyofU.S.Treasurybillsandcommercialpaper.Isthismorelikelytobethebalancesheetofapropertyandcasualtyinsurancecompanyoralifeinsurancecompany?Explainyouranswer.(LO2)15.*Statistically,teenagedriversaremorelikelytohaveanautomobileaccidentthanadultdrivers.Asaresult,insurancecompanieschargehigherinsurancepremi-umsforteenagedrivers.Supposeoneinsurancecompanydecidedtochargeteen-agersandadultsthesamepremiumbasedontheaverageriskofanaccidentforalldrivers.Usingyourknowledgeoftheproblemsassociatedwithasymmetricinformation,explainwhetheryouthinkthisinsurancecompanywillbeprofit-able.(LO2)16.Useyourknowledgeoftheproblemsassociatedwithasymmetricinformationtoexplainwhyinsurancecompaniesoftenincludedeductiblesaspartoftheirpolicies.(LO2)17.Supposeyouhaveadefined-contributionpensionplan.Asyougothroughyourworkinglife,inwhatorderwouldyouchoosetohavethefollowingportfolioal-locations:(a)100percentbondsandmoney-marketinstruments,(b)100percentstocks,(c)50percentbondsand50percentstocks?(LO2)18.Asanemployee,wouldyouprefertoparticipateinadefined-benefitpensionplanoradefined-contributionpensionplan?Explainyouranswer.(LO2)19.Intheaftermathofthefinancialcrisisof2007–2009,therehavebeencallstoreinstatetheseparationofcommercialandinvestmentbankingactivitiesthatwasremovedwiththerepealoftheGlass-SteagallAct.Doyouthinkthisisagoodwaytoreducesystemicrisk?(LO1)20.Supposeawell-knownfinancialholdingcompanyagreedtobetheunderwriterforanewstockissue.Afterguaranteeingthepricetotheissuingcompanybutbe-foresellingthestocks,ascandalsurroundingthebusinesspracticesofthehold-ingcompanyisrevealed.Howwouldyouexpectthisscandaltoaffect(a) thewww.mhhe.com/moneyandbanking4efinancialholdingcompanyand(b) theissuingcompany?(LO1)DataExplorationForgeneralinformationonusingFederalReserveEconomicData(FRED)online,visitwww.mhhe.com/moneyandbanking4eandclickonStudentEdition,thenFREDResources.1.Oneaspectofthe2007–2009financialcrisiswasarunonsomemoneymarketmu-tualfunds(MMMFs).Plotweeklydatafor2008oninstitutionalMMMFdepositsScanhereforquickaccesstotheresources(FREDcode:WIMFSL),andidentifythetimingoftherunvisually.Next,downloadfortheseproblems.Needthedataandreportthesizeofthedepositoutflowintheweekthattherunpeaked.abarcodereader?TryWhydidthisrunend?(LO1)(Hint:Turnofftherecessionbars.)ScanLife,availableinyourappstore.2.Whendidthefinancialcrisisof2007–2009peakandwhy?Plotweeklydatafor2006–2010for1-weekU.S.dollarLIBOR(FREDcode:USD1WKD156N)andtheeffectivefederalfundsrate(FREDcode:DFF).Explainthepattern.(LO1)(Hint:Forconsistency,plotbothseriesonthesamefrequencybyspecifying“Weekly,end-ingWednesday.”)cec2174X_ch13_327-358.indd35725/11/135:41PM 358lChapter13FinancialIndustryStructure3.Howdidcompetitionfrommoneymarketmutualfundsaffecttraditionalsavingsinstitutionsthatprovidedmortgagesatfixedinterestrates?Beginningwith1981,plottheratioofretailmoneymarketmutualfunds(FREDcode:WRMFSL)tothesumofsavingsandsmalltimedepositsatsavingsinstitutions(FREDcodes:SVGTIandSTDTI).Whatfavoredmoneyfundsinthe1980sand1990s?Whydidtheratioshrinkinthefirsthalfofthe2000s?(LO1)4.Howhavethemarketsharesofbanksandtraditionalsavingsinstitutionsevolvedovertime?Plotthefraction(inpercent)ofcreditmarketassetsheldbytheentiredomesticfinancialsector(TCMAHDFS)thatisheldbycommercialbanks(FREDcode:CBUSCCBTCMAHDFS).Plotasimilarmarketsharefortheassetsheldbysavingsinstitutions(FREDcode:SITCMAHDFS).Explainthelong-termtrendsthatyouobserve.(LO2)FurtherDataExploration:TheFDIC’swebsite(www.fdic.gov/bank/statistical)providesseveraldatabasesthatallowforfurtherexplorationoftheU.S.bankingsystem.Forexample,thesummarytables(attheFDICwebsite,select“SummaryofDeposits”andthen“SummaryTables.”)providedetailsofbankdepositsbyclassofbankcharter,assetsize,depositsize,andregion.“StatisticsonBanking”tables(www2.fdic.gov/SDI/SOB)detailassetsandliabilities(andothercharacteristics)ofbanksbytypeandsize,bothnationallyandatthestatelevel.Finally,the“HistoricalStatisticsonBanking”section(www2.fdic.gov/hsob/index.asp)providesdataontheevolutionoftheinsuredbankingsystemsincetheFDIC’soriginin1934.www.mhhe.com/moneyandbanking4ecec2174X_ch13_327-358.indd35825/11/135:41PM