The structure of banking in the United States is largely a result of regulatory restrictions on interstate banking. At the beginning of the twentieth century, most U.S. banks had a single branch from which they served customers. During the early part of the twentieth century, many of these banks expanded by opening more branches in order to serve their customers better. This ran into opposition from two quarters. First, small banks that still had only a single branch were concerned that they would lose market share. Second, large money center banks were concerned that the multibranch banks would be able to offer check-clearing and other payment services and erode the profits that they themselves made from offering these services. As a result, there was pressure to control the extent to which community banks could expand. Several states passed laws restricting the ability of banks to open more than one branch within a state.

      The McFadden Act was passed in 1927 and amended in 1933. This act had the effect of restricting all banks from opening branches in more than one state. This restriction applied to nationally chartered as well as to state-chartered banks. One way of getting round the McFadden Act was to establish a multibank holding company. This is a company that acquires more than one bank as a subsidiary. By 1956, there were 47 multibank holding companies. This led to the Douglas Amendment to the Bank Holding Company Act. This did not allow a multibank holding company to acquire a bank in a state that prohibited out-of-state acquisitions. However, acquisitions prior to 1956 were grandfathered (that is, multibank holding companies did not have to dispose of acquisitions made prior to 1956).

      Banks are creative in finding ways around regulations – particularly when it is profitable for them to do so. After 1956, one approach was to form a one-bank holding company. This is a holding company with just one bank as a subsidiary and a number of nonbank subsidiaries in different states from the bank. The nonbank subsidiaries offered financial services such as consumer finance, data processing, and leasing and were able to create a presence for the bank in other states.

      The 1970 Bank Holding Companies Act restricted the activities of one-bank holding companies. They were only allowed to engage in activities that were closely related to banking, and acquisitions by them were subject to approval by the Federal Reserve. They had to divest themselves of acquisitions that did not conform to the act.

      After 1970, the interstate banking restrictions started to disappear. Individual states passed laws allowing banks from other states to enter and acquire local banks. (Maine was the first to do so in 1978.) Some states allowed free entry of other banks. Some allowed banks from other states to enter only if there were reciprocal agreements. (This means that state A allowed banks from state B to enter only if state B allowed banks from state A to do so.) In some cases, groups of states developed regional banking pacts that allowed interstate banking.

      In 1994, the U.S. Congress passed the Riegel-Neal Interstate Banking and Branching Efficiency Act. This Act led to full interstate banking becoming a reality. It permitted bank holding companies to acquire branches in other states. It invalidated state laws that allowed interstate banking on a reciprocal or regional basis. Starting in 1997, bank holding companies were allowed to convert out-of-state subsidiary banks into branches of a single bank. Many people argued that this type of consolidation was necessary to enable U.S. banks to be large enough to compete internationally. The Riegel-Neal Act prepared the way for a wave of consolidation in the U.S. banking system (for example, the acquisition by JPMorgan of banks formerly named Chemical, Chase, Bear Stearns, and Washington Mutual).

      As a result of the credit crisis which started in 2007 and led to a number of bank failures, the Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law by President Obama on July 21, 2010. This created a host of new agencies designed to streamline the regulatory process in the United States. An important provision of Dodd–Frank is what is known as the Volcker rule which prevents proprietary trading by deposit-taking institutions. Banks can trade in order to satisfy the needs of their clients and trade to hedge their positions, but they cannot trade to take speculative positions. There are many other provisions of Dodd–Frank and these are summarized in Section 16.4. Banks in other countries are implementing rules that are somewhat similar to, but not exactly the same as, Dodd–Frank. There is a concern that, in the global banking environment of the 21st century, U.S. banks may find themselves at a competitive disadvantage if U.S regulations are more restrictive than those in other countries.

      2.2 THE CAPITAL REQUIREMENTS OF A SMALL COMMERCIAL BANK

To illustrate the role of capital in banking, we consider a hypothetical small community bank named Deposits and Loans Corporation (DLC). DLC is primarily engaged in the traditional banking activities of taking deposits and making loans. A summary balance sheet for DLC at the end of 2015 is shown in Table 2.2 and a summary income statement for 2015 is shown in Table 2.3.

TABLE 2.2 Summary Balance Sheet for DLC at End of 2015 ($ millions)

      Table 2.2 shows that the bank has $100 million of assets. Most of the assets (80 % of the total) are loans made by the bank to private individuals and small corporations. Cash and marketable securities account for a further 15 % of the assets. The remaining 5 % of the assets are fixed assets (i.e., buildings, equipment, etc.). A total of 90 % of the funding for the assets comes from deposits of one sort or another from the bank's customers. A further 5 % is financed by subordinated long-term debt. (These are bonds issued by the bank to investors that rank below deposits in the event of a liquidation.) The remaining 5 % is financed by the bank's shareholders in the form of equity capital. The equity capital consists of the original cash investment of the shareholders and earnings retained in the bank.

      Consider next the income statement for 2015 shown in Table 2.3. The first item on the income statement is net interest income. This is the excess of the interest earned over the interest paid and is 3 % of the total assets in our example. It is important for the bank to be managed so that net interest income remains roughly constant regardless of movements in interest rates of different maturities. We will discuss this in more detail in Chapter 9.

TABLE 2.3 Summary Income Statement for DLC in 2015 ($ millions)

      The next item is loan losses. This is 0.8 % of total assets for the year in question. Clearly it is very important for management to quantify credit risks and manage them carefully. But however carefully a bank assesses the financial health of its clients before making a loan, it is inevitable that some borrowers will default. This is what leads to loan losses. The percentage of loans that default will tend to fluctuate from year to year with

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