Structure and Competition in the Banking Industry Essay

Introduction

The banking industry is universal, and the operations of individual banks are similar throughout the world. Banks act as financial intermediaries between different parties to make profits. However, the banking industry in the United States is different from the economy having a large number of financial institutions, which increases the level of competition in the industry. The banking structure is uniform across all countries with minimal differences. This paper will look at the historical development of the banking system, the effect of many banks in an economy, the reason for a large number of financial institutions in America and forces leading to the growth of international banking.

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

Save 25%

History of Banking Systems

The commercial banking system in the US began in 1782 with the chartering of the North American bank in Philadelphia (Mishkin, 2014). The success of this bank introduced other banks into the economy, but there was an issue of whether the states or federal government should charter the banks. Alexander Hamilton advocated for centralized control of banks and bank chartering which led to the creation of the Bank of the United States in 1791. This bank had the elements of a central and private bank, and it was responsible for the credit and money in the entire United States economy. Its charter expired in 18110and congress created a second United States bank, which operated until 1836. In 1863 the National Banking Act was passed, and all banks were chartered. Later the banking industry introduced insurance to secure bank deposits in 1933 (Mishkin, 2014). These activities saw the introduction and development of the banking industry in the US.

Innovation and Change of Banking Strategies

The banking activity of offering loans using deposits began reducing and was replaced by shadow banking which is a technique where banks do lending through securities markets involving different financial institutions. The change was influenced by the need for new products and profit maximization for the financial institutions. The economic environment of the 1960s was characterized by rapid changes in technology, an increase in interest rates and high rates of inflation (Mishkin, 2014). Financial engineering was invented as a means to develop new banking products and strategies to ensure that the business was profitable in the tough economic environment. These conditions led to significant changes and innovations in the banking industry.

Factors Affecting Financial Innovation

Responses to Changes in Demand

The demand for financial products determines the level of innovation. Interest rates in the industry determine whether the demand for financial products increase or decreases. Interest rates led to the innovation of financial derivatives and adjustable-rate mortgages in the 1970s (Mishkin, 2014). The adjustable rates in mortgages were introduced to allow a change in the rates at any point of a mortgage. This innovation aimed at ensuring bank profitability at all levels. Financial derivatives were introduced in1975 as an instrument to protect financial against risks caused by factors such as a decrease in the interest rates.

Response to Supply Changes

Technology is the major influencing factor of the major changes in the supply of financial institutions. Technology has reduced the cost of handling financial transactions, which increased profits and gave banks an opportunity to create new products. It also allowed investors to easily access information making it easier for the issuance of securities by firms. Bank debit and credit cards is a major technological innovation that made work easier for customers and increased the lending amounts for these firms. Electronic banking was the second innovation to increase the supply of banking services. This service allowed customers to interact with electronic banking instead of individuals. Automated teller machines were the major innovation in electronic banking (Mishkin, 2014). It made it easier for customers to access their money without having to queue for over the counter withdrawals

Technology also allowed for the securitization exercise in banking. This activity involves grouping small, illiquid financial assets such as credit card receivables and auto loans. This process enables the trading of these assets on the capital securities. Technology also allowed for the issuance of commercial paper as a short-term loan by financial institutions. Subprime mortgages were then introducing shifting the focus of mortgages only on the prime borrowers to include other lower borrowers with a good credit record.

Avoiding existing regulations

The government heavily regulates the financial industry with some of these regulations reducing the profits of these institutions. The regulation leads to financial innovations directed at avoiding some procedures to maximize the profits of these firms. The major restrictions that led to innovations are reserve requirements and restrictions on interests for deposits (Mishkin, 2014). Banks resorted to reducing their quotations are a way to lower the taxes on deposits and reserve requirements. Banks then introduced money markets mutual funds to increase the scope of operation and deal with the reserve requirement restrictions. Banks created sweep accounts to avoid taxes from reserve restrictions. This service involves overnight trading of balances above the checking account at the end of a day on the securities, which reduces the amounts of checkable deposits. These innovations allowed banks to avoid special taxes on restrictions thus increasing their profits.

Competition Due to Financial Innovation

Financial innovation has transformed the banking industry from using short-term deposits to fund long-term loans to trading on the capital securities market. Over the years, fund provision by banks has decreased from 40% to around 27% in 2014 (Mishkin, 2014). The decrease is due to increased competition in the banking industry. The competition informed some innovations for the banks to retain their influential aspect in the market. Banks had an advantage from the interest ceiling on deposits. They were not allowed to pay interests on deposits, which increased their profit margin from lending these deposits. The introduction of interest on deposits caused more competition among banks, Saccos, and other financial institutions. The competition led to various innovations, which increased the effectiveness and efficiency of the banking industry. Banks had to come up with other products to retain their profits as depositors started taking their money out of banks and taking it to investors who offered better rates. Securitization was a strategy to earn more profits above other investment companies.

To cover up for this competition and maintain their initial profit levels banks were forced to maintain their traditional lending and get into riskier lending such as corporate takeovers and real estate funding. They were also forced to get into shadow banking. Through shadow banking, these firms were able to trade on securities and foreign exchange, which are riskier ventures but helped maintain the profit levels.

US Commercial Banking Industry Structure

The US economy has an approximate 5700 commercial banks with 30% of these banks having assets less than 100 million dollars (Mishkin, 2014). Unlike other industries in the United States, large commercial banks do not dominate the industry. The small banks have a significant influence on the industry. Therefore, the banking industry has the largest number of firms in the market with no dominant firms thus the industry is the most competitive in the economy. The large number of these institutions led to branching restrictions. These rules provided guidelines on the kind and number of branches a bank was allowed to open in particular states. The restrictions reduced the number of branches and at times prohibited the opening of branches.

Branching restrictions in the US led to some financial innovations to maintain competitiveness and increase profits. Banks resorted to automated teller machines and bank holding firms (Mishkin, 2014). A holding company can act on behalf of different banks and offer a variety of banking activities. These companies can operate in areas where branching is restricted. ATMs can be used to access customers in states where branching is not allowed.

Conclusion

The banking industry is universal with common operations internationally. Banking in the US began with the chartering of the Bank of North America in 1782, which was followed by other banks. The industry has the largest number of firms in the US. These numbers have led to high competition, which has also triggered various innovations, which have made the industry the most effective and efficient. The innovations have also be caused by various restrictions such as the reserve requirements by the Central bank. Technology and branching have also affected the number of innovations in the industry with banks coming up with different financial innovations to avoid restrictions and maintain their profit levels. The competitiveness increase in global trade and the need for more profits are primary reasons for the growth of international banking activities.

References

Mishkin, S. F. (2014). The Economics of Money, Banking, and Financial Markets. London: Pearson.