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date: 24 February 2018

Banking an Overview

Abstract and Keywords

This article begins with a review of the radical changes in the business of banking in recent years. It goes on to discuss the meltdown in credit markets around the globe and the resulting high profile bank bailouts. It then looks back at the situation in early 2007, when banks in the US and Europe were posting record profits, major risks appeared to have abated, and banking systems had been deregulated, allowing for more competition and innovation. This is followed by a discussion of the transformation of the banking industry.

Keywords: banking business, banking industry, credit markets, bank bailouts

Introduction

111Banks play critical roles in every economy. They operate the payments system, are the major source of credit for large swathes of the economy, and (usually) act as a safe haven for depositors' funds. The banking system aids in allocating resources from those in surplus (depositors) to those in deficit (borrowers) by transforming relatively small liquid deposits into larger illiquid loans. This intermediation process helps match deposit and loan supply and provides liquidity to an economy. If intermediation is undertaken in an efficient manner, then deposit and credit demands can be met at low cost, benefiting the parties concerned as well as the economy overall. In addition to these on-balance sheet activities, banking organizations have long engaged in traditional off-balance sheet operations, providing loan commitments, letters of credit, and other guarantees that help counterparties plan for future investments, and in some cases gain access to alternative sources of external finance (p. 2) (e.g., commercial paper market). They also provide an expansive range of various derivative contracts that allow counterparties to hedge their market risks.2

In recent years, this simple conceptualization of banking business has radically changed. The largest banks in many countries have transformed themselves, typically via merger and acquisition (M&A), into multiproduct financial service conglomerates with offerings including: retail banking, asset management, brokerage, insurance, investment banking, and wealth management. These major developments on the product side have also been matched by the emergence of a diverse array of new funding sources. Driven by securitization, particularly of residential mortgages, banks have become less constrained by their deposit bases for lending. On-balance sheet assets have increasingly been bundled and sold into the market to release capital to finance expansion. Off-balance sheet vehicles (such as Structured Investment Vehicles (SIVs), SIV-lites, and conduits) have been created to enable banks to collateralize assets funded by the issue of short-term paper, not only generating trading profits, but also enabling them to raise resources to finance growing funding gaps (loans minus deposits). Small and medium-sized institutions have also actively participated in diversifying their product and funding features.

The phenomenal growth in structured credit products has been a major recent feature of modern banking business. The issuance of such products in the US and Europe grew from around $500 billion in 2000 to $2.6 trillion in 2007, while global issuance of collateralized debt obligations (CDOs) grew from about $150 billion in 2000 to about $1.2 trillion in 2007 (IMF 2008: 56). Banks actively created off-balance sheet vehicles that packaged various market and credit risks by pooling assets (such as bonds, loans, or mortgage-backed securities) and then divided the resulting cash flows into various tranches (according to their risk/credit rating) that were then sold to investors. The investors could choose to hold different tranches reflecting their risk-return preferences. Up until mid-2007, the demand for structured credit products boomed. Investors were attracted to these securities because they typically appeared to offer higher returns than equivalently rated company bonds. Banks were also attracted to the business as it allowed them to reduce their regulatory capital charges by transferring credit risk to other parties. In general, the view was that the new structured credit products were beneficial as they allowed greater risk to be shared across a broader spectrum of investors, or, to put this another way, banks no longer had to be the major holders of credit risk.

At the peak of the credit cycle in 2006, around one-fifth of US mortgage originations were of the subprime variety, and 75 percent of these were securitized of which around 80 percent were funded by AAA-rated paper (IMF, 2008: 59). (p. 3) When foreclosures and defaults on US subprime mortgages accelerated from late 2006 onwards, the value of the securities backed by such assets rapidly declined, particularly because the complex nature of the tranching and the lack of transparency of the bank's off-balance sheet vehicles made it nearly impossible to value such assets. Holders of investments backed by subprime mortgages did not know what they were worth, and banks became wary of lending to each other because they also did not know the extent of losses held in structured credit vehicles. In addition, real estate prices tumbled in the US adversely affecting prime and subprime borrowers alike who increasingly defaulted, further putting downward pressure on the value of securitized mortgage products and bank loan books (Foote, et al., 2008). All in all, this culminated in a liquidity freeze in interbank markets and the subsequent credit crunch (Crouhy, Jarrow, and Turnbull, 2008; and Hellwig, 2008).

As the meltdown in credit markets continued, banking sector traumas have been experienced around the globe. The first high-profile casualty surprisingly was not in the US but in the UK, Northern Rock, one of the country's largest mortgage lenders experienced a run on its deposits (the first since Victorian times) and had to be rescued (nationalized) by the government in September 2007. The main cause of failure was cited as a reckless business model, overdependence on short-term wholesale funds, as well as failings in regulatory oversight (HM Treasury, 2008). There then followed further bank collapses. On 16 March 2008, Bear Stearns became the largest casualty of the credit crunch to that date when the failing investment bank was purchased by J.P. Morgan Chase for a nominal amount ($2 per share or $236 million) following the provisions of earlier liquidity support (a revised offer of $10 per share was made on 24 March enabling J. P. Morgan Chase to acquire 39.5 percent of Bear Stearns). In addition, the Federal Reserve extended safety net arrangements to ensure that J.P. Morgan Chase would not suffer significant losses on loans extended to Bear Stearns. On 11 June 2008, the FDIC took over IndyMac Bank, a large alt-A mortgage lender that suffered large losses on these mortgages.3 The bank had $32 billion in assets, making it the second largest bank failure in US history. The estimated cost of the failure at the time of this writing is $8.9 billion. The takeover followed a slow run or ‘walk’ on the bank of $1.3 billion in deposits withdrawn between 27 June and 10 July. This followed a public warning about the bank from Senator Charles Schumer. At the same time, Fannie Mae and Freddie Mac, who hold or guarantee over $5 trillion in US mortgages (about half of the total), were having their own problems of a ‘walk’ on their outstanding stock and shares, both of which declined by more than 80 percent in value from a year earlier. On Sunday, 13 July 2008, Treasury Secretary Henry Paulson announced a plan to insure that both organizations would continue to support the housing market. This consisted of a proposal that the Treasury would (p. 4) temporarily increase its credit lines to the organizations, that they may borrow from the Federal Reserve under certain circumstances, and that the Treasury would get temporary authority to buy their shares should that be necessary. In early September 2008, Freddie Mac and Fannie Mae were placed into conservatorship of the Federal Housing Finance Agency (FHFA). September witnessed further turmoil by the demise of Lehman Brothers and the sale of Merrill Lynch to Bank of America. The two remaining large investment banks, Goldman Sachs and Morgan Stanley, converted to bank holding companies. AIG, the world's largest insurance company was rescued by the Federal Reserve courtesy of an $85 billion emergency loan and in exchange, the Federal government acquired a 79.9 percent equity stake. Washington Mutual (WaMu) was acquired by the US Office of Thrift Supervision (OTS) and the bulk of its untroubled assets sold to J.P. Morgan Chase. In addition to the aforementioned problems, various UK banks also were experiencing severe financing difficulties. HBOS agreed on 17 September 2008 to an emergency acquisition by its UK rival Lloyds TSB after a major fall in its stock price originating from growing fears about its exposure to British and American mortgage-backed securities (MBS). The UK government waived its competition rules making the deal possible. On 29 September, Bradford and Bingley Bank was nationalized. The government assumed control of the bank's £50 billion mortgage and loan portfolio, while its deposit and branch network was sold to Spain's Grupo Santander.

A major feature of the crisis or turmoil that has engulfed banks from September 2008 onwards has been growing market concerns about their capital strength, particularly in the US and Europe. This is despite the fact that many banks have sought to boost solvency by a variety of means. Table 1.1 highlights the amount of capital raised from July 2007 to December 2008 and level of write-downs that have occurred in major banks from the start of 2007 to December 2008. It can be seen that, overall, capital injections exceed write-downs by about $60 billion.

Growing worries about the capital strength of banks led to a collapse in stock prices and widespread bailouts. The highest profile bank bailout being the November rescue of Citigroup. In a complex deal, the US government announced it was purchasing $20 billion of preferred stock in Citigroup and warrants on 4.5 percent of its common stock. The preferred stock carried an 8 percent dividend. This acquisition followed an earlier purchase of $25 billion of the same preferred stock using Troubled Asset Relief Program (TARP) Funds.4 Under the agreement, Citigroup and regulators will support up to $306 billion of largely residential and commercial real estate loans and certain other assets, which will remain on the bank's balance sheet. Citigroup will shoulder losses on the first $29 billion of that (p. 5) (p. 6) portfolio and any remaining losses will be split between Citigroup and the government, with the bank absorbing 10 percent and the government absorbing 90 percent. The Citigroup deal was in certain respects similar to an effort orchestrated by Swiss financial regulators for UBS, another large global bank. In October, the Swiss central bank and UBS reached an agreement to transfer as much as $60 billion of troubled securities and other assets from UBS's balance sheet to a (p. 7) separate entity. Other major European banks that have sought substantial government support include Royal Bank of Scotland (by late November, the Bank was nearly 60 percent government owned) and Lloyds TSB (that acquired HBOS—already 40 percent state owned).

Table 1.1. Bank write-downs and capital raised up to December 2008

Bank

Write-down and loss

Capital raised

Wachovia Corporation

96.5

11.0

Citigroup Inc.

67.2

113.8

Merrill Lynch and Co.

55.9

29.9

UBS AG

48.6

34.0

Washington Mutual Inc.

45.6

12.1

HSBC Holdings Plc

33.1

4.9

Bank of America Corp.

27.4

58.5

National City Corp.

26.2

8.9

Morgan Stanley

21.5

24.6

JPMorgan Chase & Co.

20.5

44.7

Lehman Brothers Holdings Inc.

16.2

13.9

Royal Bank of Scotland Group Plc

15.6

50.0

Wells Fargo and Company

14.6

41.8

Credit Suisse Group AG

14.5

12.2

Bayerische Landesbank

14.5

8.8

1KB Deutsche Industriebank AG

14.1

11.6

Deutsche Bank AG

12.7

6.0

ING Groep NV

10.2

18.1

HBOS Plc

9.5

23.6

Crédit Agricole SA

9.4

12.2

Fortis

9.0

22.0

Société Générale

8.2

11.3

Mizuho Financial Group Inc

7.4

6.6

Goldman Sachs Group Inc.

7.1

20.5

Canadian Imperial Bank of Commerce

7.0

2.5

Barclays Plc

6.7

28.0

BNP Paribas

5.8

3.5

Hypo Real Estate Holding AG

5.5

0

KBC Groep NV

5.0

4.8

Dresdner Bank AG

5.0

0

Indymac Bancorp

4.9

0

Natixis

4.7

7.9

Landesbank Baden-Wurttemberg

4.5

0

UniCredit SpA

4.3

10.3

Nomura Holdings Inc.

4.2

5.9

E*TRADE Financial Corp.

4.1

2.2

HSH Nordbank AG

4.0

1.7

Lloyds TSB Group Plc

3.8

13.4

Bank of China Ltd

3.7

0

Rabobank

3.3

0

WestLB AG

3.3

6.9

Bear Stearns Companies Inc.

3.2

0

Commerzbank AG

3.0

11.3

Royal Bank of Canada

2.8

0.3

Fifth Third Bancorp

2.7

6.0

DZ Bank AG

2.5

0

Landesbank Sachsen AG

2.4

0

Sovereign Bancorp Inc.

2.4

1.9

US Bancorp

2.2

6.6

ABN AMRO Holding NV

2

0

Mitsubishi UFJ Financial Group

1.8

10.5

Industrial and Commercial Bank of Chin

1.7

0

KeyCorp

1.6

4.2

Dexia SA

1.6

8.8

Bank Hapoalim B.M.

1.6

2.2

Marshall and llsley Corp.

1.5

1.7

Sumitomo Mitsui Financial Group

1.2

12.7

Bank of Montreal

1.1

0

Alliance and Leicester Plc

1.1

0

Groupe Caisse dʼEpargne

1.1

0

Bank of Novia Scotia

1.1

0.2

Sumitomo Trust and Banking Co.

1.0

2.0

Gulf International Bank

1

1

National Bank of Canada

0.7

1

DBS Group Holdings Limited

0.2

3.7

American Express

0.0

3.4

Other European Banks (not listed above)

8.5

4.0

Other Asian Banks (not listed above)

5.2

11.4

Other US Banks (not listed above)

3.6

23.0

Other Canadian Banks (not listed above)

0.5

1.4

Total

744.6

805.3

Notes: All the charges stem from the collapse of the US subprime mortgage market and reflect credit losses or write-downs of mortgage assets that are not subprime, as well as charges taken on leveraged-loan commitments since the beginning of 2007. They are net of financial hedges the firms used to mitigate losses and pre-tax figures unless the bank only provided after-tax numbers. Credit losses include the increase in the provisions for bad loans, impacted by the rising defaults in mortgage payments. Capital raised includes common stock, preferred shares, subordinated debt, and hybrid securities, which count as Tier 1 or Tier 2 capital, as well as equity stakes or subsidiaries, sold for capital strengthening. Capital data begins with funds raised in July 2007. All numbers are in billions of US dollars, converted at the October 2008 exchange rate if reported in another currency.

Source: Bloomberg.

As the above events clearly indicate, this has been a momentous time for banking and the global economy has not faced such serious financial turmoil since the 1930s. These recent events have shockingly reminded us that the new style of intermediation activity is not without its risks. Banks are among the most leveraged of any type of firm. In the course of business, they rely on scale and various risk management mechanisms to ensure that deposit withdrawals, loan supply, and off-balance sheet obligations can be met. They use their own internal systems and are obliged by regulators, as well as the market, to maintain sufficient levels of capital and liquidity in order to back their business. Regulators also provide safety nets, such as deposit insurance and emergency lending facilities, in order to bolster confidence in the system. History, of course, tells us that, irrespective of what checks and balances are put in place, any inkling of a lack of confidence in an individual bank, a number of banks, or the markets on which banks depend, can signal potential disaster.

By the beginning of 2009 (the time of this writing), concerns about the stability of the global banking system had continued to mount. Between the summer of 2007 and December 2008, the Federal Reserve, the European Central Bank, and the Bank of England all undertook major refinancing operations aimed at injecting liquidity into gridlocked interbank markets. The turmoil has also brought about a range of measures initiated by individual countries relating to the offer of bank guarantees and various rescue plans the most important of which are summarized below:

Bank deposit guarantees schemes have been strengthened. The governments of Austria, Denmark, Germany, Hungary, Ireland, Slovakia and Slovenia are among those that have announced unlimited guarantees. In addition, the European commission has proposed rules to increase the minimum deposit insurance from €50,000 to €100,000. The US also raised its deposit insurance caps from $100,000 to $250,000 for most accounts. (Financial Times, 21 Nov. 2008)

Bank and financial firm rescue plans have been enacted by several governments. In the US, the government bailed out Citigroup and AIG and provided support to Bear Stearns (in relation to the sale to J.P. Morgan Chase, which was conditional on the Federal Reserve lending Bear Stearns $29 billion on a nonrecourse basis). The Federal Reserve has also used the Term Auction Facility (TAF)5 to provide liquidity to banks and the monthly amount of these auctions increased throughout 2008 to (p. 8) $300 billion by November 2008 (compared with $20 billion when the TAF was introduced in December 2007). A total of $1.6 trillion in loans to banks were made for various types of collateral by November 2008. In October 2008, the Fed announced that it was to expand the collateral it will lend against to include commercial paper, to help address ongoing liquidity concerns. By November 2008, the Federal Reserve had acquired $271 billion of such paper, out of a program limit of $1.4 trillion. Also, in November, the Fed announced the $200 billion Term Asset-Backed Securities Loan Facility—a program supported the issuance of asset-backed securities (ABS) collateralized by loans related to autos, credit cards, education, and small businesses. In the same month, the Federal Reserve also announced a $600 billion program to purchase MBS of Government-Sponsored Enterprises (such as Freddie Mac and Fannie Mae) in a move aimed at reducing mortgage rates.

Countries around the globe have enacted similar measures. In the UK, by the end of November 2008, the government had injected over £37 billion into three banks (RBS, HBOS, and Lloyds TSB). The authorities have also agreed to guarantee £250 billion in bank borrowing. The Bank of England is to lend at least £200 billion to banks via auctions so as to inject liquidity into the system. In France, the state pledged up to €40 billion to recapitalize banks and up to €320 billion to guarantee bank lending. In Germany, the government has agreed to inject a maximum of up to €80 billion for bank recapitalization plus an additional €400 billion in interbank lending guarantees. (See also Chapter 32 and Goddard, Molyneux, and Wilson (forthcoming), for details of other European country bank rescue plans).

In addition to the above, during 2008, many governments have introduced fiscal stimulus packages aimed at boosting demand (for instance, the US government announced a $168 billion package in February) followed by similar announcements later in the year in the UK (£20 billion), Germany (€50 billion), Italy (€80 billion), and Spain (€40 billion). At the time of writing, ramifications of the the impact of the aforementioned bailouts and fiscal stimulus rumble on with a strong possibility that the global economy will experience a severe economic slowdown. The seriousness of the ongoing funding difficulties faced by banks and the potential for significant macroeconomic disruption cannot be understated as identified in the G20 meeting held in Washington, DC on 15 November.6 The current turmoil will have ramifications for the structure of the banking industry, the strategies which banks follow, how they perform, and how they are regulated and supervised (p. 9) (Baily, Elmendorf, and Litan, 2008; Buiter, 2008; Caprio, Demirgüç-Kunt, and Kane, 2008; Yellen, 2008; and Udell, 2009). Acharya and Richardson (2009) produce an edited collection of contributions by prominent academics that offers financial policy recommendations and actions to restore the global financial system.

Back to the future: Drivers of change

Now let us turn the clock back to the start of 2007—how things looked so different then! Banks in the US and Europe had been posting record profits, major risks appeared to have abated, and banking systems had been deregulated, allowing for more competition and innovation. The general operating environment over the preceding decade or so had favored banks: declining interest rates, the stock market bubble of 1991–2001, and relatively buoyant economic growth (fueled to a major extent by booming real estate values and the bank credit that funded this) provided the bedrock for the strong performance of banking systems.

In addition to the generally favorable economic climate, banking business has been transformed by deregulation that removed barriers to competition in traditional and new (non-banking) product areas as well as geographically. In the US, the Gramm-Leach-Bliley (GLB) Act of 1999 effectively repealed the Glass-Steagall Act (1933) and granted broad-based securities and insurance powers to commercial banking organizations. Also, the Interstate Banking and Branching Efficiency Act of 1994 reduced geographical barriers to competition by permitting almost nationwide branch banking as of 1997 (although there was a national deposit cap of 10 percent). In Europe, the European Union's Single Market Programme had legislated for the possibility of a universal banking based system and a single banking license in 1992, and the introduction of the euro in 1999 further removed barriers to cross-border trade in banking and financial services (Goddard, Molyneux, and Wilson 2001; and Goddard, et al., 2007). Likewise, in Japan, the ‘Big Bang’ reforms introduced between 1998 and 2001 established a universal banking model, also enabling greater access to foreign banks wishing to enter the domestic financial services sector.

Inextricably linked to the deregulation trend have been the moves toward the harmonizing of regulations—across countries and different financial service sectors. In general, there has been a strong policy move to create more uniform regulatory structures so that no jurisdiction or sector of the financial services industry has an unfair competitive advantage. This is best reflected in European Union harmonization of financial services regulation under the Single Market Program as well as capital adequacy regulation under the Bank for International Settlements Basel I (1988), and the more recent updated Basel II (2006), that (p. 10) establishes minimum capital adequacy guidelines for internationally active banks. Virtually all developed countries' banking systems, and most others, currently adhere to Basel capital standards. In the European Union, Basel II is to be incorporated into European Union law under the Capital Adequacy Directive 3 (CAD 3) and in the US transition to Basel II began in 2008. The Bank for International Settlements (BIS) has been instrumental in helping to establish minimum international standards in the regulation of banks (particularly in emerging and less-developed countries) via its guidance and oversight on the ‘Core Principles for Effective Banking Supervision’ (1997; 2006). Other noteworthy initiatives include the OECD's anti-money-laundering/anti-terrorist financing initiatives under the aegis of the Financial Action Task Force.

Technology has been another important element in transforming the banking industry. Banks are major users of IT and other financial technologies. Technological advances have revolutionized both back-office processing and analysis of financial data, as well as front-office delivery systems. Evidence suggests that the former has led to significant improvements in bank costs and lending capacity whereas the latter has improved the quality and variety of banking services available to customers (Berger, 2003). Possibly the most substantial impact of technology on the banking system has been on the payments system, where electronic payments technologies and funds transfers have replaced paper-based payments (cash and checks) and paper recordkeeping. The reduction in costs from such changes has been significant (Humphrey, et al., 2006).

Developments in financial technologies, including new tools of financial engineering and risk management, coupled with the growth of new and broader derivatives markets, were also believed (up until recently at least) to have improved banks' risk management capabilities.7 The wider use of interest rate swaps and other derivative products facilitated by advances in trading and risk management technologies meant that banks could manage interest rate risk and other market risks more effectively. During the 1990s, banks shifted more of their activity toward non-interest income as a source of revenue, including trading revenue. As such, they increasingly adopted new (e.g., value-at-risk or VAR) technologies to manage their market risk. Similar risk measurement financial technologies, which link capital requirements to credit risk have been incorporated into Basel II.

Advances in new technologies have been inextricably linked to financial innovation (Molyneux and Shamrouk, 1999; and Frame and White, 2004). The meteoric growth in asset securitization stands out as a key example. Here the financial innovation element relates to the creation of synthetic liquid, tradable securities (p. 11) created from pools of illiquid, non-tradeable assets (for instance, individual residential mortgages, credit card receivables, and so on) where usually the payoff features of the traded securities differ significantly from those of the underlying assets. Advances in technology enable the efficient monitoring and analysis of information related to the performance and operation of the asset pools. A key aspect of this process relates to advances in credit scoring technology. This enables banks to transform quantitative information about individual borrowers (such as income, employment history, past payment record, and so on) into a ‘single numerical credit score, which lenders can use when screening and approving loan applications; securitizers can use (this information) to group loans of similar risk into pools, and investors can also use this (together with other information) to evaluate the risk of the resulting asset-backed securities’ (DeYoung, 2007: 46).

In addition to asset securitization/structured products mentioned earlier, there has also been an explosion in the types of financial products and services available. The emergence of alternative assets including hedge funds, private equity, REITs (real estate investment trusts), commodities, and their respective indices means that both retail and professional investors now have access to an extensive range of investments that seek to hunt out absolute (alpha) returns. These are complemented by the rapid recent growth in index trackers—such as Exchange-Traded Funds (ETFs)—that provide beta returns tracking a myriad of indexes—either long or short. The latter are increasingly competing with actively managed mutual funds (Economist, 1 Mar. 2008). As banks have sought to diversify their revenues, many have sought to build substantial private banking/wealth management franchises offering such services.

It is widely recognized that factors including the buoyant economic environment, deregulation, and technological and financial innovation have transformed the banking landscape. However, less has been said about the changing strategic focus of banks. The aforementioned forces have resulted in generally more competitive banking systems and this also has meant that banks now have to compete more aggressively than ever before for their key resource—capital. It is uncertain as to why banks wish to maintain capital resources well in excess of their regulatory minimum. According to Berger, et al. (2008), this could be for a number of reasons—high earnings retention, the perceived advantages associated with high economic capital (e.g., protection of a valuable charter), acquisition plans, and/or external pressure from regulators or the financial markets. Some banking organizations may also hold excess capital in anticipation of a crisis in order to cover a significant portion of losses, and to allow more lending and off-balance sheet activities than would otherwise be the case under such conditions, gaining market share on their less-capitalized competitors (Berger and Bouwman, 2009b). Whatever the motives, it is a fact that many banks have held capital resources well in excess of their regulatory minimums and that higher capitalized banks also tend to be better performers. The motives noted above, of course, are not mutually exclusive and it has been primarily the strategic desire of banks to manage their (p. 12) most costly resource—economic and regulatory capital—more efficiently in order to boost value creation for their owners. This simply means that banks have increasingly focused on strategies that seek to generate risk-adjusted returns in excess of the opportunity cost of capital (Fiordelisi and Molyneux, 2006). Corporate restructuring practices commonplace in the non-financial sector have become widespread in the banking industry. Business process re-engineering, outsourcing, open architecture (providing third-party products and services), joint ventures with high tech firms, third-party processing, and the drive for mega-scale in key sectors (credit cards, global custody, treasury activities) have primarily been motivated by the desire to generate risk-adjusted returns (in excess of the cost of capital) in order to boost returns and value for shareholders. Markets are not only more important for the business that banks do, but also for gauging their performance, especially as they all seek to raise costly capital from an ever-widening group of investors. The desire to generate returns sufficient to obtain capital resources at the appropriate cost has encouraged banks into many new areas of business—particularly those areas where capital requirements are less onerous compared with traditional on-balance sheet credits. The securitization phenomenon has been a major (spiraling) outcome of this trend.

Transformation of the banking landscape

The banking industry has been transforming for decades now. A study by Berger, et al. (1995) documented significant changes in the US banking industry from 1979 (prior to major deregulation of the early 1980s) to 1994 (prior to the effects of the Interstate Banking and Branching Efficiency Act of 1994, which permitted almost nationwide branch banking). The authors found that virtually all aspects of the US banking industry had changed dramatically over these fifteen years. Over one-third of all independent banking organizations (top-tier bank holding companies or unaffiliated banks) disappeared over the 1979–94 period, even while the industry was growing.8 On the asset side of the balance sheet, the industry lost market power over many of its large borrowers, who were able to choose among many alternative sources of finance. On the liability side, the industry evolved from a position of protected monopsony in which banks purchased deposit funds at regulated, below-market interest rates toward a market setting in which banks paid closer to competitive prices to raise funds. With respect to individual consumers, electronic (p. 13) interfaces such as automated teller machines and online banking altered the way many customers interact with their banks.

Over the last decade or so since that study, the structural features of global banking systems have radically altered. Developed banking markets have all experienced significant declines in the number of banks and industry concentration has generally increased at both the national and regional levels. In the US, for example, the number of FDIC-insured commercial banks fell from 10,359 in 1994 to 7,283 by December of 2007. Substantial declines have also been witnessed in Europe (Goddard, et al., 2007) and Japan. The decline in the number of banks, particularly in developed countries, however, has not been matched by a fall in the number of branches, quite the opposite. For example, the number of bank branches in the US increased 27 percent between 1994 and 2006, although average branch size (measured by the number of employees) has fallen (Hannan and Hanweck, 2008). Evidence from Europe also illustrates the current trend to increased branch numbers: they grew by around 5 percent between 2002 and 2006 (European Central Bank, 2007a). Of course, within Europe there are substantial differences across countries: Germany and the UK experienced declines, while France, Italy, and Spain had substantial increases over the aforementioned period.

The decline in the number of banks has mainly been a consequence of the M&A trend. The US stands out in this respect, as between 1980 and 2005, 11,500 bank mergers took place amounting to 440 mergers annually (Mester, 2007). Europe has also experienced substantial consolidation both domestically and increasingly on a cross-border basis. The latter has been motivated by the attractions of Europe's single market as well as the limited growth prospects available in increasingly congested domestic banking systems. Western European banks have also been major acquirers in the transition economies of Eastern Europe, where their financial systems are now dominated by foreign institutions. Spanish banks have a major presence throughout Latin America. The larger US banks have focused on building substantial regional (if not national) franchises as well as acquiring banks particularly in Mexico and also in Latin America. Many large banking organizations have acquired wholly or partially a wide range of banks in Asia, with a particular focus on China, India, and, most recently, Vietnam.

While the consolidation trend has had the overall impact of reducing the number of banks operating in many large developed markets, this trend is not universal. In many countries there has been an increase in foreign institutions. For example, between 2002 and 2006, out of twenty-seven European Union member states, bank numbers increased in Denmark, Estonia, Greece, Latvia, Lithuania, Malta, and Slovakia. All of these countries, apart from Denmark and Greece, are new members to the European Union that experienced significant foreign bank entry (European Central Bank, 2007a). The increase in foreign bank presence in different parts of the world is determined by a number of factors. As noted by Berger (2007), the high proportion of foreign banks in Eastern Europe is mainly a result of state (p. 14) privatization and a lack of local banking experience, whereas in Latin America it is more a consequence of liberalization programs post-crisis. ‘It is also noteworthy that three significant present and future economic powerhouses in Asia—Japan, China, and India—have relatively low foreign bank penetration’ (Berger, 2007: 1969). Evidence suggests that foreign banks tend to have a larger presence in systems where entry barriers are low and typically where they tend to be more efficient compared to their domestic counterparts in developing/emerging markets (Claessens, et al., 2001). In contrast, foreign banks tend to be less efficient than their domestic competitors in developed countries (Berger, et al., 2000), and this is often forwarded as an explanation for the relatively modest (albeit increasing) foreign bank shares in many developed financial systems.

Another interesting recent development has been for banks and sovereign wealth funds from emerging economies to make acquisitions/or to acquire stakes in international banks (Paulson, 2009). In March 2008, for example, it was confirmed that China's biggest bank, the Industrial and Commercial Bank of China (ICBC), had acquired a 20 percent stake in South Africa's largest bank, Standard Bank. The second half of 2007 and early 2008 also witnessed unprecedented injections of capital by sovereign wealth funds into major banks so as to shore up their eroding capital bases. Major examples include: Barclays (China Development Bank and Temasek, Singapore), Citigroup (Abu Dhabi Investment Authority), Credit Suisse (Qatar Investment Authority), Morgan Stanley (Chinese Investment Corporation), Merrill Lynch (Temasek, Singapore), and UBS (Government of Singapore Investment Corporation). This trend reflected the strength of emerging markets and the desire of banks and investors from these countries to pursue international diversification strategies by gaining ownership presence in major international banks.

In the light of current market turmoil, the general consolidation trend and the growing presence of foreign banks is likely to continue—perhaps seeing an increasing number of major Western banks being acquired by emerging market institutions. What seems inevitable, however, is that banking systems in developed countries at least will continue to remain concentrated with a handful of banks dominating domestic systems. Projections about the future structure of US banking, for instance, envisage a system, ‘characterized by several thousand very small to medium-size community bank organizations, a less numerous group of midsize regional organizations, and a handful of extremely large multinational banking organizations. … the US banking industry is not likely to resemble the banking industries in countries such as Germany, which have only a handful of universal banks’ (Jones and Critchfield, 2005: 48). One should add, however, that a key difference between banking in the US and in other developed countries relates to the high level of new bank entrants. DeYoung (2007) notes that in the 1980s, 1990s, and early 2000s, around 3,000 new banking charters were granted by state and federal banking supervisory authorities—and there is evidence that many of these de novo banks were established in markets where established banks had been acquired (Berger, et al., 2004). As far as we are aware, no other developed banking system shows anywhere near this level of new entry. In part because of this (p. 15) entry and in part because of rigorous antitrust enforcement which requires divestiture in mergers with significant local market overlap, local banking markets in the US have not become more concentrated over time. From 1994 to 2006, the mean local commercial bank deposit Herfindahl-Hirschman Index (HHI) actually fell slightly from .1976 to .1785 in metropolitan markets and from 0.4208 to 0.3847 in rural markets. In Europe, out of twenty-seven European Union countries, the asset market share of the top five banks has slightly fallen in over half the member countries since 2002. However, national concentration levels remain high—the five bank asset concentration ratio for the monetary union (euro) countries averaged 53.7 percent in 2006, and for the EU27 at 58.9 percent (European Central Bank, 2007a). Levels of concentration are typically much higher for the new member states.

The dominance of a handful of banks in national or/and local banking systems raises questions about competition and market power. Much attention has been paid to the impact of consolidation on small business lending, suggesting that as small banks have an advantage in processing ‘soft’ information they are more able to build stronger relationships and thus are better placed to provide credit facilities. The argument goes that big banks rely on ‘hard’ information reflected in transactional banking which somehow cannot deal with informationally opaque customers. Put simply, consolidation would be expected to reduce relationship banking and boost transactional banking leading to a reduction in lending to small firms. To a certain extent, the literature finds that big banks behave differently from small banks. Berger, et al. (2005), for example, find that large banks tend to lend at a greater distance, interact more impersonally with their borrowers, have shorter and less-exclusive relationships, and typically do not alleviate credit constraints as effectively. While the stylized dichotomy between the role of small and large banks in small business lending is widely noted in the literature, in reality the market for small business credit (in the US at least) is much more complex, reflected in a broad array of different lending technologies with markets exhibiting contestable features (Berger and Udell, 2006; and Berger, Rosen, and Udell, 2007). Evidence from the US, in general, does not support the view that consolidation has reduced the quantity or increased the pricing of small business banking services, as other local banks tend to pick up small business credits that are discarded by consolidating banks (Berger, et al., 1998; and Avery and Samolyk, 2004), although there is more mixed evidence from Europe (Bonaccorsi di Patti and Gobbi, 2007) and Japan (Uchida, Udell, and Watanabe, 2007).

The consolidation trend has also spawned an extensive literature looking at a broad array of features (see DeYoung, et al., forthcoming, for a detailed review). A recent snapshot of the sort of related issues considered include:

  • Motives for mergers: Hughes, et al. (2003); Campa and Hernando (2006); DeLong and DeYoung (2007)

  • Features of acquisition targets: Focarelli, Panetta, and Salleo (2002); Hosono, Sakai, and Tsuru (2006); Valkanov and Kleimeier (2007)

  • (p. 16) Diversification benefits: Stiroh and Rumble (2006); Pozzolo and Focarelli (2007)

  • Impact of deregulation on M&A activity: Carletti, et al. (2007); Jeon and Miller (2007)

  • Multimarket competition effects of M&A activity: Hannan and Prager (2004); Berger and Dick (2007); Berger, et al. (2007)

  • Impact of mergers on deposit prices: Focarelli and Panetta (2003); Craig and Dinger (2007)

  • Monoline versus universal financial service providers: Yom (2005)

  • Exploiting safety net subsidies: Mishkin (2006); Brewer and Jagtiani (2007)

  • Impact of mergers on systemic risk: De Nicolo and Kwast (2002); Baele, De Jonghe, and Vander Vennet (2007)

  • Efficiency effects of mergers: Carbó and Humphrey (2004); Cornett, McNutt, and Tehranian (2006); Hannan and Pilloff (2006); De Guevara and Maudos (2007).

Clearly the structural landscape of banking in many countries has changed as a result of the consolidation trend as well as the increased presence of foreign institutions. The landscape will inevitably further change in the light of widespread bank bailout and rescue packages. This changing environment poses various challenges to shareholders and managers in the context of appropriate corporate governance structures, as well as to regulators who need to determine the appropriate way to supervise universal banking firms that have global reach (Caprio, Demirgüç-Kunt, and Kane, 2008).

Despite these major structural developments, up until mid-2007 there was a general consensus that the US and many other banking systems were sound, particularly because banks appeared to be holding historically high levels of capital bolstered by Basel I and (more recently) Basel II requirements (Berger, et al., 2008). There was also evidence that for large banks their strong capital positions complemented their liquidity creation, although for small banks capital strength and liquidity creation appear to move in opposite directions (Berger and Bouwman, 2004a). Having said this, however, in Europe there had been a gradual trend for banks to hold lower levels of capital but more liquidity on the balance sheet compared to US banks, and the level of liquid assets systematically declined (albeit from high levels) from the 1990s onwards. High capital levels were required to back the rapid credit expansion that occurred from the mid-1990s onwards. In the US and UK, credit growth far exceeded core deposit gathering, leaving significant funding gaps that had to be financed via the interbank market and from securitization activity. This new intermediation model worked extremely well with an increasing portion of retail lending by banks shifting from portfolio lending that generated interest income to securitized lending that earned non-interest revenue. As competition in traditional deposit and lending business squeezed interest margins, product market deregulation, such as the Gramm-Leach-Bliley Act of 1999 in the US and Japan's ‘Big-Bang’, enabled banking (p. 17) organizations to produce or sell a wider range of services including equity and debt underwriting, securities brokerage, and insurance products and consequently increase non-interest income. In developed banking systems, cost levels were generally flat (if not declining) and the increase in total revenues from traditional and (increasingly) non-traditional sources meant that by the mid-2000s, bank profitability was strong in many countries. By 2006, the banking systems of France, Italy, Spain, Sweden, and the UK were posting returns on equity around 20 percent (European Central Bank, 2007b), and in the US ‘return on assets edged up to match its highest annual level in recent decades’ (Carlson and Weinbach, 2007: A37).

By early 2007, the general consensus appeared to be that high-performing banking systems, supported by excess capital and state-of-the-art risk management capabilities, bolstered by appropriate market-based regulation, would continue to finance growth at recent historical levels. Things have now certainly changed!

At the time of writing, the prospects for the banking industry are almost diametrically opposed to the view held eighteen months earlier. Commercial and residential real estate values continue to fall, avenues for bank financing via the securitization business and interbank markets have dried up, and major banks have suffered large losses of capital. Consequently, many of the largest banking organizations have had to raise additional capital (as illustrated in Table 1.1). Banks' funding gaps (loans minus deposits) remain at historically high levels, with added concerns about the ability of the system to meet substantial off-balance sheet commitments that still may be drawn. Much of this has yet to feed through into the real economy.

This handbook aims to provide further insight into many of the aforementioned developments as well as indications of future prospects in the banking business.

Book structure and chapter summaries

The contents of this Handbook are subdivided into five Parts, as follows: Part I, The Theory of Banking; Part II, Regulatory and Policy Perspectives; Part III, Bank Performance; Part IV, Macroeconomic Perspectives in Banking; and Part V, International Differences in Banking Structures and Environments. This section provides brief summaries of the chapter contents.

The theory of banking

Part I of this Handbook comprises seven chapters and examines why banks exist, how they function, how they are managed, and their legal, organizational, and (p. 18) governance structures. Particular emphasis is placed on the evolution of banks within the wider financial system. It is noted that the scale, scope, and complexity of banking business have increased as banks have diversified across product and geographic lines. This has led to changes in the techniques used by banks to manage liquidity, credit, and other risks. New complex organizational structures have emerged, including large international financial conglomerates that pose new challenges for regulation and supervision.

In Chapter 2, Franklin Allen and Elena Carletti examine the roles of banks in ameliorating informational asymmetries that may arise between lenders and borrowers; providing intertemporal smoothing of risk; and contributing to economic growth in Europe, the US, and Asia. In general, euro area countries have small but rapidly developing stock markets. Bank lending relative to GDP is substantial, and bond markets play an important role in the financial system. The UK has a large stock market and a large banking sector, but the UK bond market is relatively small. The US banking sector is small in relation to the size of the US economy, but both the stock market and the bond market are relatively large. Japan has a relatively large banking sector and highly developed capital markets. The chapter compares the role of bank-based and market-based banking systems and discusses aspects relating to relationship banking and the finance and growth debate. An interesting finding is that market-based financial systems like the US tend to be more innovative than bank-based systems.

Competition among banks, and between banks and non-banking financial institutions and financial markets has intensified in recent years. This competition has led to the transformation of banks, and the growing complementarities between banks and capital markets. In Chapter 3, Arnoud Boot and Anjan Thakor examine how banks choose between relationship- and transactions-based lending, and more generally the role of debt versus equity instruments and the economic functions of banks. The arguments presented suggest that banks have a growing dependence on the capital market for sources of revenue, for raising equity capital and for risk management, while capital market participants rely increasingly on banks' skills in financial innovation and portfolio management. The increased integration of banks with financial markets raises domestic and cross-border financial stability concerns, which in turn has implications for the design of domestic and international financial system regulation.

Banks are exposed to market risk, interest rate risk, credit risk, liquidity risk, and operational risk. For any bank, the measurement and management of risk is of the utmost importance. In Chapter 4, Linda Allen and Anthony Saunders describe the widely used VAR method of risk measurement. Accurate risk measurement enables banks to develop a risk management strategy, using derivative instruments such as futures, forwards, options, and swaps. However, the recent subprime crisis demonstrates that the use of derivative instruments does not by itself mitigate the risks of banking.

(p. 19) One of the key functions of the banking sector is maintaining liquidity. Banks use short-term liquid deposits to finance longer-term illiquid lending, and provide liquidity off the balance sheet in the form of loan commitments and other claims on their liquid funds. In Chapter 5, Philip Strahan examines the role of banks in providing funding liquidity (the ability to raise cash on demand) and in maintaining market liquidity (the ability to trade assets at low cost), thereby enhancing the efficiency of financial markets. Banks dominate in the provision of funding liquidity because of the structure of their balance sheets as well as their access to government-guaranteed deposits and central bank liquidity. There is considerable functional overlap between commercial banks and other financial institutions in providing market liquidity through devices such as loan syndication and securitization.

Deregulation and technological innovation have permitted banking organizations such as financial holding companies to capture an increasing share of their revenue stream from non-interest sources. The increase in non-interest income reflects in part diversification into investment banking, venture capital, insurance underwriting, and fee- and commission-paying services linked to traditional retail banking services. In Chapter 6, Kevin Stiroh examines the effects of diversification on the risk and return characteristics of financial institutions. In many cases, risk-adjusted returns have declined following diversification into non-interest earning activities. This phenomenon maybe due to a tendency to diversify revenue streams, rather than clients, with the effect that interest and non-interest income are increasingly exposed to the same shocks. Alternatively, managers may have been willing to sacrifice profits to achieve growth through diversification, or the adjustment costs associated with diversification may have been larger than anticipated.

Under a universal banking model, the services of both commercial and investment banks are provided under one roof. Universal banks provide traditional deposit taking, lending, and payments services, as well as asset management, brokerage, insurance, non-financial business (commerce), and securities underwriting services. In Chapter 7, Alan Morrison examines the evolution of universal banking across countries and over time. Universal banking has operated in Germany for many years, but was generally restricted in the US (via Section 20 subsidiaries) until Congress passed the 1999 Gramm-Leach-Bliley Act. Potential conflicts of interests, such as the cross-selling of inappropriate in-house insurance and investment services to bank customers, or the mispricing of internal capital transfers between different parts of financial service groups and so on, are key issues for the universal banking model, which present significant challenges for regulation and for the wider health of the financial system.

As commercial banks have diversified into investment banking, a number of large international conglomerates have emerged. In Chapter 8, Richard Herring and Jacopo Carmassi examine the phenomenon of the international financial conglomerate. Typically, conglomerates have complex organizational structures—in some cases comprising hundreds of majority-owned subsidiaries. A subsidiary-based (p. 20) model may help ease problems of asymmetric information among shareholders, creditors, and managers; mitigate conflicts of interest; insulate the rest of the group from risk emanating from individual subsidiaries; or reduce taxes. However, the very scale and complexity of the largest international financial conglomerates poses new threats to the stability of the global financial system.

Regulatory and policy perspectives

Part II of this Handbook comprises nine chapters and examines the various roles of central banks, regulatory and supervisory authorities, and other government agencies which impact directly on the banking industry. Central banks execute monetary policy, which operates to a large degree through the banking system; act as a lender of last resort; and perform various other functions such as operating parts of the payments system. Government agencies provide safety net protection—such as explicit or implicit deposit insurance, unconditional payment system guarantees, and takeovers of troubled institutions—to prevent widespread or systemic bank failure. In part to protect against systemic failure, and in part to offset some of the perverse incentive effects of government safety net protection, government authorities also engage in prudential regulation and supervision, and set policies concerning bank closure. Competition and antitrust policy aimed at preventing abuses of market power also impact directly on the banking industry. So too do explicit or implicit government policy concerning foreign entry into domestic markets and foreign ownership of domestic industry.

The historical evolution of central banks has been shaped by successive monetary and financial crises throughout the nineteenth and twentieth centuries. In Chapter 9, Michel Aglietta and Benoît Mojon examine issues related to central banking. Today, the four major tasks of the central bank are: the settlement of interbank payments; bank regulation and supervision; lender of last resort; and the execution of monetary policy. However, not all central banks perform all four tasks; in some countries one or more of these functions is delegated to separate government agencies. In the UK, for example, regulation and supervision is the responsibility of the Financial Services Authority (FSA). In the US, responsibility for regulation and supervision is divided among several agencies, including the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC), as well as the central bank (the Federal Reserve). Future challenges that will influence the further evolution of central banking include securitization, electronic payments, asset price volatility, and the increasing internationalization of the banking industry.

In Chapter 10, Joe Peek and Eric Rosengren examine the role of the central bank in executing monetary policy, and the broader role of the banking sector in monetary policy transmission. Monetary policy is believed to affect real expenditure (p. 21) through three channels: the traditional interest rate channel, whereby changes in interest rates affect the spending preferences of consumers; the broad credit channel, whereby interest rate changes influence investor behavior and the borrowing preferences of the corporate sector; and the bank lending channel, whereby monetary policy affects the supply of bank credit through its effect on depositor behavior, or changes in the value of bank assets and liabilities. The empirical research reviewed using aggregate data suggests that bank lending contracts when monetary policy becomes tighter. The research also suggests that the effects of monetary policy will be influenced by the characteristics of the banking industry. For example, banks' capital constraints may limit their ability to increase lending in response to expansionary monetary policy. Various forms of financial innovation (such as securitization) may reduce the future importance of the bank lending channel.

Central banks also play an important role as lender of last resort to banks experiencing liquidity problems. Lending of last resort provides insolvent banks with liquidity and allows them to escape market discipline. In Chapter 11, Xavier Freixas and Bruno Parigi examine this lender of last resort function, and its relationship with bank closure policy. The difficulties in distinguishing liquidity and solvency shocks are highlighted. The lender of last resort function is usually handled by the central bank, while scrutiny of bank closure is commonly the responsibility of a separate agency, often a deposit insurer. The current financial crisis highlights the complexity of the lender of last resort function, which encompasses issues relating to monetary policy, bank supervision and regulation, and the operation of the interbank market. The authors posit that the lender of last resort function should be an integral and interdependent part of an overall banking safety net, which encompasses a deposit insurance system, a system of capital regulation, and a set of legal procedures to bailout or liquidate troubled banks.

The design of regulatory arrangements for the banking industry can lead to conflicts of interest that have the potential to undermine the quality of supervision and enforcement. In Chapter 12, Ed Kane explains how in extreme cases, conflicts of interest, combined with intense competition and technological and financial innovation, can give rise to inappropriate behavior on the part of bankers, increasing the probability of a banking crisis. Kane notes that recent technological change and regulatory competition has encouraged banks to securitize their loans in ways that masked credit risks, while supervisors have outsourced much of their responsibility to credit rating agencies.

Deposit insurance is intended to prevent ‘runs’ on individual banks by depositors. It also limits losses to depositors in the event of bank failure, and reduces the risk that a run on one bank might undermine confidence in others through a contagion effect. However, a flawed deposit insurance system might cause more harm than good, if moral hazard results in excessive risk taking or recklessness on the part of banks. In Chapter 13, Robert Eisenbeis and George Kaufman show a (p. 22) well-functioning and efficient deposit insurance guarantee system which involved: closing promptly struggling banks when leverage ratios declines to an unacceptably low level; assigning credit losses to uninsured bank claimants promptly; and reopening closed institutions as soon as possible to allow insured depositors and pre-existing borrowers full access to their funds and credit lines. Such a system, the authors argue, can be designed as part of an efficient financial safety net system.

To reduce moral hazard and systemic risk, regulators require banks to hold capital in order to absorb unforeseen risks. Standards developed by the Basel Committee on Banking Supervision (via Basel I and Basel II) have gone some way to aligning such capital requirements with banks' risk profiles. In Chapter 14, Michael Gordy and Erik Heitfield examine the rationale for capital regulation, and describe the key features of Basel II. The authors focus on the theoretical and empirical underpinnings of Basel II, and the challenges in rating the riskiness of assets contained in bank portfolios. A key issue identified is the extent to which the bank risk rating systems are responsive to changes in borrower default risk over the business cycle. If this is indeed the case, capital requirements under the Internal-Ratings-Based (IRB) approach will increase as an economy moves into recession and decline as an economy moves an expansion. Basel II is likely to make it more difficult for policymakers to maintain macroeconomic stability if banks' lending is procyclical.

As banking business has become increasingly complex, the usefulness of the traditional tools of supervision in monitoring risk taking by banks has been called into question. However, the efficient markets hypothesis suggests that private investors might be able to identify the risks associated with investing in shares of banks and other complex financial institutions, and thus exert market discipline. In Chapter 15, Mark Flannery defines the concept of market discipline and explains the importance of its two main components: market monitoring of bank value and market influence over a bank's strategic choices. He contends that banks' ex ante strategic choices will reflect market conditions if investors can identify and react to the condition of banking firms in a timely and accurate manner. The evidence presented in the chapter suggests that forward-looking market-based information embodied in banks' equity prices, debt instruments, and ratings can act to inform bank supervision, and to indicate the need for supervisory corrective action sooner than might otherwise be the case.

Competition in banking is important, because any form of market failure or anti-competitive behavior on the part of banks has far-reaching implications for productive efficiency, consumer welfare, and economic growth. In Chapter 16, Astrid Dick and Timothy Hannan review the methodologies used by researchers and policymakers to assess the form and intensity of competition in the banking industry. Methods for the measurement of competition are based on the structure-conduct-performance paradigm, and non-structural approaches from the new empirical industrial organization literature. Recently, alternative techniques have been developed, based on structural simulation modelling. Finally, the (p. 23) authors examine how competition policy in the European and US banking industry has evolved. In recent times, policy in Europe has moved closer to that of the approach advocated by regulators in the US, in which regulators not only deal with the outcomes of potential mergers, but also more widely with the potential barriers to competition in the financial services industry.

Internationalization of banking and other financial services has been promoted by financial deregulation, as well as the globalization trend. To assess the extent of market openness and the potential for cross-border provision of financial services, it is useful to examine the commitments to greater openness made by countries under the auspices of the World Trade Organization. In Chapter 17, James Barth, Juan Marchetti, Daniel Nolle, and Wanvimol Sawangngoenyuang present evidence of some significant and worrying divergences between WTO commitments freely entered into by national governments, and the practices of bankers and national regulators. As a whole, developed countries tend to be more open than developing countries, but developing countries are more likely to meet their WTO obligations than developed countries.

Bank performance

Part III of the book comprises seven chapters dealing with bank performance. A number of issues are assessed, including efficiency, technological change, globalization, and ability to deliver small business, consumer, and mortgage lending services.

In Chapter 18, Joseph Hughes and Loretta Mester outline the different approaches used to examine the efficiency and overall performance of banks. Here the authors outline various structural and non-structural approaches to efficiency measurement. The structural approach requires a choice of the underlying production features of banking (intermediation, production, value-added, or other) and the specification of cost, profit, or revenue functions, from which (using various optimization techniques) one can derive relative performance measures. The authors stress that the role of capital and risk is important in bank's production features and therefore should be included in structural evaluations of bank performance. Non-structural approaches simply relate to the use of accounting/ financial ratios to measure bank performance. The chapter highlights the growing interest in using structural approaches to examine corporate governance and ownership issues, whereas non-structural indicators (such as Tobin's Q ratio) are widely used as indicators of the value of a bank's investment opportunities (or charter values). The chapter ends with a brief discussion on how consolidation has impacted bank performance.

Technological advances and financial innovation have led to fundamental changes in the nature of banking over the last twenty-five years. In Chapter 19, Scott Frame and Lawrence White focus on innovations in banking products (subprime mortgages, (p. 24) retail services including the growth of debit cards, online banking, and the use of prepaid cards) and processes (automated clearing houses, small businesses credit scoring, asset securitization, and risk management). In addition, various new organizational forms, such as internet-only banks and the establishment of Section 20 securities subsidiaries are discussed. Financial and technological innovations have impacted on bank performance and the wider economy.

International mergers between banks are relatively recent phenomena. In Chapter 20, Claudia Buch and Gayle DeLong examine the causes and effects of international bank mergers. The authors examine the determinants of and barriers to cross-border bank mergers, and their impact on the efficiency, competitiveness, and riskiness of financial institutions and the financial systems. Bank mergers tend to take place mostly between institutions from large and developed countries; between banks based in countries in close regional proximity; and between banks from countries that share a common cultural background.

Banks are the single largest provider of external finance to small businesses. In lending to small business, banks use a number of different lending technologies to overcome a lack of publicly available financial information. In Chapter 21, Allen Berger discusses small business lending. In particular, he covers how some of the technologies used to make lending decisions to small business have evolved over time from relationship-based models relying on soft information to more sophisticated models based on different combinations of hard and soft information. He also examines the effects of banking industry consolidation and technological progress on the use of the lending technologies and their effects on small business credit. He finds that consolidation and technological progress and their interactions appear to have resulted in banks placing a greater reliance on quantitative information to make lending decisions. This, the author notes, is reflected in greater distances between banks and their small business clients.

Consumer lending is an area of banking activity that attracts substantial political interest. Recent years have seen a substantial growth in consumer lending. In Chapter 22, Thomas Durkin and Gregory Elliehausen examine the key features and risks inherent in consumer lending, highlighting approaches to evaluating credit supply default risk, and the inextricable influence of adverse selection and asymmetric information in the consumer credit process. An interesting discussion of the role of consumer credit scoring is provided, noting that this has helped lower the costs of the credit evaluation process, and in addition has the advantage of providing consistent application processing across all loan applicants, which simplifies the management of lending.

Mortgage lending is an important part of the banking industry. In Chapter 23, Andreas Lehnert notes that deregulation and process and product innovations have allowed banks to separate origination, funding, and servicing functions. This has allowed small scale financial institutions to originate mortgages, and sell them to other financial institutions. These financial institutions can package the mortgages (p. 25) and sell them to investors. Evidenced by the recent turmoil in the US subprime market, this unbundling process has introduced tensions among borrowers, mortgage funders, investors, and regulators.

Securitization and financial innovation have transformed the financial system. The role of banks has been changed from ‘originate and hold’ to ‘originate, repackage, and sell’. In Chapter 24, David Marqués Ibañez and Martin Scheicher examine the securitization process and highlight the main reasons as to why banks undertake such activity. Particular focus is placed on the main types of instruments (mortgage-backed securities, collateralized debt obligations, credit default swaps) and their valuation. The chapter also examines the impact of the securitization trend on bank credit and the transmission of monetary policy. They argue that banks' incentives and ability to lend are now much more linked to financial market conditions compared with when banks primarily funded their lending via deposits.

Macroeconomic perspectives in banking

Part IV of the book comprises six chapters discussing the interactions between banking firms and the macroeconomy. This part of the book includes a discussion of the determinants of bank failures and crises, and the impact on financial stability, institutional development, and economic growth.

In Chapter 25, Olivier DeBandt, Philipp Hartmann, and José Luis Peydró examine elements of systemic risk in banking. The notion of contagion in interbank markets is examined along with the interactions between banks and asset prices in crisis periods. Recent advances in the role of liquidity for banking system stability are also examined. The authors note that the practical identification of specific contagion cases continues to be a challenge for empirical research. Nevertheless, the ongoing credit crisis presents new opportunities for innovative research in this area.

In Chapter 26, Gerard Caprio and Patrick Honohon chart the frequency and severity of banking crises. They note that the early years of the new millennium saw a drop in the frequency of banking crises both in developing and high-income economies. A combination of factors were attributed to such a decline, including low real interest rates; sound macroeconomic policies; the expansion of deposit insurance schemes; accumulation of official foreign exchange reserves; well-capitalized banking systems; and the expansion of derivatives and securitization. However, the authors point out that the recent events in the US subprime mortgage markets illustrate information problems in the financial system, which lead to investors taking excessive risks on products they do not understand.

In Chapter 27, Charles Calomiris reviews the theory and historical evidence related to the prevalence of bank failure, panics, and contagion. He argues that banking system panics are neither random events nor inherent to the function of (p. 26) banks or the structure of bank balance sheets, but are caused by temporary confusion about the incidence of shocks within the banking system. Drawing on empirical evidence, the author argues that deposit insurance and other policies intended to prevent instability have become the single greatest source of banking instability.

In Chapter 28, David Humphrey and James McAndrews analyze the use of retail payments systems (cash, checks, debit cards, credit cards, automated clearing houses, giro networks) and wholesale payment systems (secure giro and wire transfer networks) across countries. The costs and benefits of different systems to the banking system are highlighted, and policy avenues are explored with respect to both retail (privacy issues, card interchange fees, etc.) and wholesale payment systems (integration of back-office systems and uses of large value payment systems, systemic risk, etc.).

A large body of theoretical and empirical research now suggests that financial institutions and markets aid long run economic growth. Market frictions in the form of information and transaction costs necessitate the need for financial markets and intermediaries to mobilize savings, allocate resources, exert corporate control, facilitate risk management, and ease the exchange of goods and services (Levine, 1997; and Levine, 2005). The level of financial development depends on a number of factors, including the degree of economic freedom, the protection of property rights, and the origin and quality of the legal system (La Porta, R., Lopez-De-Silanes, F., Shleifer, A., and Vishny, R. W., 1998). In Chapter 29, Asli Demirgüç-Kunt examines the links between financial development and economic growth. Particular focus is placed on the role that government can play in promoting access to financial services leading to higher levels of financial development that eventually encourage economic growth and prosperity. The empirical literature appears to suggest that well-developed financial systems play an independent and causal role in promoting long-run economic growth. Such effects are proportionately greater across poorer segments of the population.

In Chapter 30, Nicola Cetorelli continues by examining the links between financial development and real economic activity, focusing on the specific mechanisms, such as competition, which link bank activity to the real economy. Evidence suggests that bank concentration is inversely related to economic growth due to lower credit availability, although this effect varies across industries. For instance, concentration allows for the development of long-lasting lending relationships and this seems to enhance growth in industries where young firms are more dependent on external finance.

International differences in banking structures and environments

Part V of the handbook focuses on the features of banking systems in different parts of the world. Six chapters highlight the main structural and institutional features of (p. 27) various systems. The chapters cover banking in the US, the EU15 countries, Transition countries, Latin America, Japan, and the developing nations of Asia. The banking systems in each of these geographic areas have evolved and changed over time. These chapters note that even as the financial services industry has become more globalized, major differences exist within regions and across countries. For example, the US operates a dual banking system where there is competition from efficient capital markets. The European Union has a single bank license and monetary union covering most of the countries. Eastern European banking systems have undergone a transition from central planning to privatization and the domination of foreign banks, and many are now undergoing more change following accession to the European Union. Latin America has undergone post-crisis liberalization programs, leading to a reduced role of the state and high foreign ownership. Japan has seen the virtual collapse and restructuring of its banking system. The developing nations of Asia still have high state bank ownership (China, India, and Pakistan), limited foreign entry in some markets (China and India), and have had to cope with the aftermath of the East Asia financial crisis (Indonesia, Malaysia, Thailand, and others).

Having said this, similar trends are apparent in various systems—namely, a decline in the number of banks particularly in developed economies, consolidation and concentration, the increased role of foreign banks, the broadening of banks into other financial services areas, greater disintermediation, and the ongoing and omnipresent role of regulatory change. However, as we noted earlier, the heterogeneity of different banking systems can be highlighted, among other factors, by the strong performance of UK and US banks (up until the start of 2007) compared to the weak returns posted by Japanese banks; the variation in the role of foreign and state ownership across many emerging banking markets; differences in business activity restrictions imposed on banking activity in various countries; and so on.

The US banking system has undergone dramatic changes in recent years. Following the removal of restrictive regulations pertaining to branching, product, and price competition, there has been a systematic decline in the number of banks via both mergers and acquisitions and bank failures. This has been accompanied by a significant increase in the number of new banks being chartered. Changes in regulation (notably the Gramm-Leach-Bliley Act of 1999) have allowed US banking organizations to establish financial holding companies and engage in the full range of financial services. The move toward a universal banking model has led to changes in balance sheet composition, strategy, and performance. In Chapter 31, Robert DeYoung discusses in detail the evolution of the US banking industry over the past twenty-five years. He examines how deregulation, technological change, and financial innovation have affected industry structure and the strategies banks pursue. He presents persuasive evidence that suggests that small and large banks can coexist in long-run equilibrium by pursuing very different strategies. In such an equilibrium, large banks use advantages afforded by scale to pursue a (p. 28) transaction-based banking business model, which is reliant on technology and hard information, while small banks maintain a geographically focused strategy to build and maintain long-term lending relationships. Large banks can thus produce high-volume standardized products at low cost, while small banks can produce lower volumes of more tailored products at a higher price.

Banking in European Union 15 countries has experienced marked changes in recent years. In Chapter 32, John Goddard, Philip Molyneux, and John Wilson examine the evolving structural and regulatory features of the industry. The number of banks has fallen substantially as a result of a merger and acquisitions (M&As) wave, and over the last few years, within-country industry concentration has reached historically high levels. Banks have increasingly focused on generating revenues through non-interest sources of income and there has been widespread diversification into areas such as insurance, pensions, mutual funds, and various securities-related areas. The regulatory environment has constantly changed with the European Union, progressing with legislation aimed at removing barriers for the creation of a single European financial services marketplace as well as the implementation of the new Basel II capital adequacy rules (under CAD3). However, despite wide-scale financial integration, there remain substantial differences in the features and performance of banks in different countries.

In Chapter 33, John Bonin, Iftekhar Hasan, and Paul Wachtel examine banking in transition countries. They note that given the centralized planning systems adopted by Soviet Bloc countries, banking in the transition countries is a relatively recent phenomenon. Attempts were made to establish a banking industry amidst the economic chaos following the fall of Communism in the late 1980s and early 1990s. Unsurprisingly, things went wrong and banking crises occurred. In response, banks were privatized and regulations enacted. The authors argue that banking structures in transition countries are now for the most part populated by privately owned (mainly foreign), relatively well-capitalized banks overseen by a set of regulations and supervision.

Extensive deregulation has taken place in the banking systems of Latin America in recent years. In Chapter 34, Fernando Carvalho, Luiz de Paula, and Jonathan Williams assess the extent to which interest rate deregulation, bank privatization, and the removal of barriers to foreign banking led to banking crises in Brazil, Chile, Argentina, and Mexico. The authors note that banking crises have not led to reversals in the financial liberalization process. Instead, most countries in the area have invested in building regulatory and supervisory infrastructures to ensure the future stability of the banking system. In the long run, it is hoped that such investments will yield a lower cost of capital and wider access to finance leading to economic growth.

Japan has a financial system in which the banking system has traditionally played a more important role than the stock market. The banking system is also rather complex with a wide array of different types of private, cooperative, and public (p. 29) banks, all undertaking a range of banking business. The system has undergone dramatic changes over recent years, mainly as a result of the major financial crisis that started in the early 1990s and then culminated in 1997–8. This was caused to some extent by an asset price bubble in real estate which was amplified by excessive bank lending to the sector. This resulted in the failure of a number of banks and a massive build-up of non-performing loans in the banking system. The perilous state of the banking system in the late 1990s resulted in a wide range of reforms aimed at improving banking and financial sector soundness, as well as restructuring of the banking system. In Chapter 35, Hirofumi Uchida and Gregory Udell outline the segmented nature of the Japanese banking system and discuss many of the aforementioned issues. The authors note that the dependence on banking appears to have diminished in recent years.

In Chapter 36, Leora Klapper, Maria Soledad Martinez Peria, and Bilal Zia examine banking in the developing nations of Asia. The authors examine the significant reforms and structural changes that have taken place in the aftermath of the financial crisis in East Asia in 1997. Reforms have included privatization and allowing greater foreign participation in the banking industry. The authors highlight variations across countries based on the extent to which they have been aggressive in the reform agenda. They note that while countries such as Pakistan and Korea have made real progress in reform, India and China have proceeded more slowly. Overall, reform has been slower than in transition countries and Latin America.

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Notes:

(1) Thanks to Mark Flannery and Ed Kane for insightful comments on this chapter.

(2) Numerous theories have sought to explain why banking is necessary. These theories primarily relate to: delegated monitoring; information production; liquidity transformation; consumption smoothing; and the role of banks as commitment mechanisms. Notable contributions include: Leland and Pyle, 1977; Diamond and Dybvig, 1983; Diamond, 1984; Fama, 1985; Boyd and Prescott, 1986; Holmstrom and Tirole, 1998; Diamond and Rajan, 2001; and Kashyap, Rajan, and Stein, 2002.

(3) An Alt-A mortgage is a type of US mortgage that, for various reasons, is considered riskier than ‘prime’ and less risky than ‘subprime’, and often does not require income verification of the borrower.

(4) The TARP is a plan under which the US Treasury would acquire up to $700 billion worth of mortgage-backed securities. After various revisions the plan was introduced on 20 Sept. 2008 by US Treasury Secretary Hank Paulson. At the time of writing, about half of the TARP funds have been allocated, mostly to capital injections in US banks.

(5) The Term Auction Facility (TAF) is a temporary program managed by the Federal Reserve aimed to ‘address elevated pressures in short-term funding markets’. Under the TAF, the authorities auction collateralized loans with terms of 28 and 84 days to depository institutions that are ‘in generally sound financial condition’ and ‘are expected to remain so over the terms of TAF loans’. Eligible collateral includes a variety of financial assets. The program was introduced in December 2007.

(6) The G20 meeting identified the causes of the financial crises in a formal declaration stating: ‘During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policymakers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions’. See ‹http://www.whitehouse.gov/news/releases/2008/11/20081115-1.html›.

(7) The current turmoil in credit markets begs the question as to why so many practitioners, policymakers, and other commentators did not see the limitations of the risk management practices being implemented. Arguments relating to disaster myopia and the difficulty in pricing various risks (‘Knightian uncertainty’) are possible explanations.

(8) The number of FDIC insured commercial banks fell by 27% over the same period.