Econ2035

10.18.11

Chapter 8: The Banking Industry

Securitization: process in which a financial institution buys a large

number of bank loans, then issues securities entitling the holders to

shares of payments on the loans.

Subprime lenders: companies that lend to people with weak
credit histories
I.

Types of Banks

Table 8.1 Types of Banks

Commercial Banks
Money-center banks
Regional and superregional banks
Community banks
Thrift Institutions
Savings institutions
Credit Unions
Finance Companies

Commercial Banks
Commercial banks: institution that accepts checking and
savings deposits and lends to individuals and firms
Money-Center Banks
Money-center bank: commercial bank located in a major
financial center that raises funds primarily by borrowing from

other banks or by issuing bonds

Regional and Superregional Banks
Regional bank: commercial bank with assets above $1 billion

that operates in one geographical region

Superregional bank: commercial bank with assets above $1

billion that operates across most of the United States

Community Banks

Community bank: commercial bank with less than $1 billion in

assets that operates in a small geographical area

Thrift Institutions
Thrift institutions (thrifts): saving institutions and credit
unions
o Savings institution: type of bank created to accept
savings deposits and make loans for home mortgages; also
known as savings banks or savings and loan association
(S&Ls)
o Credit union: not-for-profit bank owned by its depositor
members, who are drawn from a group of people with

something in common
Finance Companies
Finance companies: non-bank financial institution that makes
loans but does not accept deposit

II.
Dispersion and Consolidation
Why So Many Banks?
o McFadden Act (1927): forbade banks to operate in more
than one state.
o Riegle-Neal Act (1994): repealed the McFadden Acts
ban on interstate banking. Today, banks can expand
around the country.
o Bank Charter: government license to operate a bank
o The National Bank Act (1863): established a federal
agency, the Comptroller of the Currency, to charter banks
National bank: bank chartered by the federal
government
State bank: bank chartered by a state government
o The Glass-Steagall Act (1933): Commercial banks were
forbidden to engage in the businesses of securities firms.
They couldnt own stocks, and they couldnt serve as
underwriters. The goal was to keep banks out of the risky
businesses that could lead to failures.

o The Decline of Restrictions: After World War II, the tide

turned toward deregulation of banks.
Gram-Leach-Bliley Act: fully repealed the
separation of commercial banks and securities firms
o The Financial Crisis
The trend toward banking deregulation was arrested

by the financial crisis of 2007-2009.

The financial crisis led to the Dodd-Frank Act,
formally known as the Wall Street Reform and

Consumer Protection Act.

Consolidation in Commercial Banking
The Role of Mergers
o Motives for mergers:
Economies of Scale: If two banks merge, for
example, they can reduce costs by combining their

computer systems.
Diversification: Mergers widen the banks operating

area, reducing its sensitivity to local problems

Empire Building: Bank managers, may also have
personal motives for expansion. In banking, as in
most industries, executives receive higher salaries at
larger institutions. Consequently, they may push for

mergers even if the deals dont increase profits.

The Role of Bank Failures
o The most recent financial crisis accelerated the
consolidation of the banking industry. The impetus for
some mergers was fear that a bank could not survive on its

own.
Too Big to Fail?
o Too big to fail (TBTF): doctrine that large financial
institutions facing failure must be rescued to protect the

financial system
International Banking
Eurodollars: deposits of dollars outside the United States
Foreign Banks in the United States
Consolidation Across Businesses

The Rise of Financial Holding Companies

o Financial holding company (FHC): conglomerate that
owns a group of financial institutions
o Economies of scope: cost of reductions from combining
different activities

III.
Securitization
The Securitization Process
o Figure 8.2
Fannie Mae and Freddie Mac
o Mortgage-backed securities (MBSs): securities that
entitle an owner to a share of payments on a pool of
mortgage loans
o Government-sponsored enterprise (GSE): private

corporation with links to the government

Why Securitization Occurs?
o Securitization occurs because banks want to sell loans and
because securities backed by bank loans are attractive to
many institutions.
o Benefits for Banks:
Banks sell mortgages because the possibility of

default makes it risky to hold them.

Many banks both sell mortgage loans and buy

mortgage-backed securities.
o Demand for Mortgage-Backed Securities
o The Spread of Securitization
Investment banks have extended securitization in
two directions: subprime mortgages and

IV.

nonmortgage loans.
Securitization is sometimes called shadow banking.

Subprime Lenders

Figure 8.2 Subprime lenders

Type of Lender

How Lender Copes with

Finance Company
Payday lender

Default Risk
Credit scoring; high interest rates
Postdated checks; very high

Pawnshop
Illegal loan sharks

interest rates
Very high collateral
Very high interest rates; threats to

defaulters
Subprime Finance Companies
Payday lenders: company that provides cash in return for a
postdated check
o Usury law: legal limit on interest rates
o Predatory lending: unfair lending practices aimed at

poor and uninformed borrowers

Pawnshops: small lender that holds an item of value as

collateral
Loan sharks: lender that violates usury laws and collects debts
through illegal means

V.
Governments Role In Lending
Support for Housing
o Mortgage Agencies
o Loan Guarantees: government promise to pay off a loan

if the borrower defaults

o Tax Incentives
Small-Business Loans
Student Loans
Community Reinvestment Act (CRA): law from 1977 that

requires banks to lend in low-income areas

Government-Owned Banks