An Analysis of US Commercial Banking Sector of USAs Banking Industry - Essay Example

? An Analysis of US Commercial Banking Sector of USA’s Banking Industry Table of Contents S.NO HEADING Page No 3 2 Methodology 4 3 Introduction 4 4 Findings and Discussion -Commercial Banks in USA- An Analysis 5 5 Conclusion and Recommendations 15 6 References 17 Abstract As per Berger, Kashyap, & Scalise (1995), commencing from 1980s, a number of factors were responsible for the instability of commercial banking industry in USA. A chain of deregulations facilitated other modes of financial service business like credit unions, thrifts and insurance and security firms – to venture into provinces once predominantly kept for commercial banks. In the first quarter of 2011 alone, there is a sharp increase of deposits by 10% at US commercial banks, which is roughly about 200% increase per annum throughout the year 2010. Strong rumour is haunting the global banking industry that another banking crisis may spearhead in the wake of recent crisis in EU, and that may impact US banking industry also. This research essay will look into the robustness of commercial banking industry of USA , its future, whether it will witness another turmoil in the near future and recommendation to protect the commercial banking sector in USA. Methodology In this research, secondary data has been used especially data has been collected from FDIC website –Statistics at a Glance section which offers an excellent data on commercial banks in USA. The online statistics is being published by FDIC both historical and quarterly statistics. (Heckman 2010:93). Further I have used past empirical studies on the subject, industry reports, financial reports, journal articles, industry publications, website etc. The main intention to use secondary data in this research report is that as it is offering conceptual development and significant insights which is not available elsewhere. By coalescing the available research literature, secondary data assist to fill in or round out the setting in the yawning gaps between primary data and even imply topics for future research on the subject. (Connaway & Powell 2010: 249). Introduction Strong rumour is haunting the global banking industry that another banking crisis may spearhead in the wake of recent crisis in EU, and that may impact US banking industry also. In response to the scenario in Europe, the financial markets in US are demonstrating mounting signs of risk aversion and volatility. The outcome of the 2008 financial turmoil has prolonged to weigh on the recovery of economy; the credit rate downgrade and the recent debt ceiling fiasco have surmounted anxieties of financial volatility. Nonetheless, the US commercial banks as compared to their counterparts in Europe have more expanded portfolios and retain a much lesser share of government bonds. Moreover, US government backing and deposit insurance offer a vibrant backbone in the case of future bank failures as depositors prolong to have confidence in the capability of the US government to meet its commitments if there is a run -on -banks. This can be corroborated from the contemporary extreme low treasury yields. (Fraser 2011). Findings and Discussion -Commercial Banks in USA- An Analysis Commercial banking can be described as fiscal mediators with towering leverage, i.e. a comparatively higher ratio of short-term debt in the guise of deposits with a moderately little portion of equity. Large number of individual customers and business might have contributed the deposits to the bank. Thus, so pooled funds of commercial banks are accustomed to advance loans to individuals and businesses. (Iannotta 2010:2) In USA, commercial banks are institutions, which function as a financial mediator between borrowers and savers – thus, grouping the savings of many depositors and lending the same to eligible borrowers. Commercial banks thrive with a little margin as there will not much difference between the interest rate paid to the depositors and interest rate charged to the borrowers. To minimise the risk, commercial banks have established loan procedures so that only certain borrowers who have a track record of repayment will be eligible for loans. To increase the revenue, investments in new kinds of financial investment groups were established, which are known as “hedge funds” in USA and these are known as investment banks. In the 1980s and 1990s, risky investments were made by these hedge funds and reported unusual profits. In 2007 , when the total assets in the whole US banking system had assets about USD 10 trillion , the hedge funds had grown to $2 trillion thereby holding 20% of US capital assets. If this sector fails, then whole banking industry in US would face turmoil as what had happened in recent financial crisis where two hedge funds in the investment bank of Bear Sterns that caused the financial turmoil. (Betz 2011:234). Statistics on Commercial Banks in USA Amount in $ Billions Statistics on Commercial Banks in USA Third Quarter 2011 Third Quarter 2010 Total Assets 12560 12120 Total Loan 6582 6611 Domestic Deposits 7582 6838 Coverage Ratio % 65.54 66.29 Bank Net Income 32695 21661 Real Estate Loans % 1.37 7.69 Consumer Loans 1.9 5.29 Source: FDIC –Statistics at a Glance Source: FDIC –Statistics at a Glance Source: FDIC –Statistics at a Glance There are more than 6352 commercial banks in the year 2011 which is more than any of the nations in the globe, and it had peak 7631 banks in the year 2004. The number of commercial banks decreased to 6352 in 2011 from that of 14,384 banks in 1975. In USA , about 10 largest banks have just 36% of the assets in the banking industry whereas in UK or Canada , just 5 or 6 banks control the banking industry. In USA , about 66% of aggregate of public deposits are held by commercial banks whereas the balance is held by thrift institutions. ( Polski 2009:1). US Commercial Banks Products and Services Segmentation IBISWorld 2008:8). Prior to 1927, an American bank could establish their branch in a foreign nation more swiftly than in other states in the USA. The McFadden –Pepper Act (1927) had thawrted American giant banks from starting branches in various states in USA. Both in the year 1980s and early 1990s , there had been bank failures, which activated consolidation among US banks. “The passage of Riegle –Neal Interstate Banking and Branching Efficiency Act (1994)” had, in fact, kindled the bank consolidation in USA. This legislation knocked down the McFadden Act which barred the interstate banking,and this Act had now facilitated commercial banks in USA to run their bank branches across all the 50 states all over the USA. Glass-Steagall Act (1933) barrred the commerial banking venturing into investment banking like insurance ,securities and real estate business. It also barred the insurance companies and investment banks from engaging in commercial banking activities. In 1997, there was relaxation by Federal Reserve, which permitted banks to venture into underwriting of stocks and securities. However , Fed had fixed a ceiling on the income earned from investment banking activities that it should not exceed 10% of the aggregate revenue of banks which was later raised to 25% later. Thus , the above restrictions placed the American banks at relatively disadvantage position as compared to foreign banks. “The Gramm-Leach –Bliley Financial Services Modernisation Act” which not only overuled the Glass –steagall Act but also permitted insurance companies and security firms to acquire banks and also allowed the banks to guarantee securities and insurance and also engross in real estate sectors. Just eight US banks had their operation in foreign nations in 1960s and their aggregate assets were estimated less than $4 billion. As of today, in excess of 100 US banks are functioning in foreign countries with the aggregate assets totalling over $500 billion. USA COMMERCIAL BANKS MARKET SEGMENTATION IBISWorld 2008:41). It is to be noted that there is no oversight by US government on the entire “shadow-banking industry” of hedge funds and also the derivative markets are also not regulated. There is strong opposition by the US Federal Reserve to regularise the derivative markets. During 1930s, there had been many failures of banks in the USA when depositors pulled out their savings, fearing the run-on-a –bank. To prevent such misshapenings, the Glass-Steagall Act of 1933 was enacted mainly to separate the commercial banking from investment banking. This Act demanded the commercial banks to be isolated from investment banks. However, the investment banks started to report heavy revenues than commercial banks and this made the commercial banks in US to lobby with the US government to repeal the Glass-Steagall Act of 1933, and this had been done through the Gramm-Leach-Bliley Act of 1999.(Betz 2011:234). Major Players of US Commercial Banks Sector IBISWorld 2008:29). As per Berger, Kashyap, & Scalise (1995), commencing from 1980s, a number of factors were responsible for the instability of commercial banking industry in USA. A chain of deregulations facilitated other modes of financial service business like credit unions, thrifts and insurance and security firms – to venture into provinces once predominantly kept for commercial banks. As per Gupta and Misra (1999), to compete with cut-throat competition, banks in US started to add features like engaging in risky commercial real estate development and commercial banking witnessed a dramatic mishap due to these changes. During these phases, many banks have failed and many banks witnessed acute financial distress. (Kim& Miner 2007:689). There appears as of now that there is no immediate liquidity crunch and hence, there won’t be any “fire sale” of assets by US banks. The present state of the US banking sector demonstrates little worry over a immediate liquidity crisis as US banks have plenty of liquidity on hand as per chart 1 and also retain massive reserves at the Fed and there is less chance either to dispose off their liquid assets or to employ market funding sources to cater for immediate liquidity demands. (Fraser 2011). Now, in USA, commercial banks have changed to use of deposit funding, moreover the past many quarters. In the first quarter of 2011 alone, there is a sharp increase of deposits by 10% at US commercial banks, which is roughly about 200% increase per annum throughout the year 2010 and there was a very high loan-to-deposit ratio. Moreover, LOIS and TED spreads stay exorbitantly low as contrasted to the recession point thereby demonstrating high liquidity in the US markets, and the credit risk has been perceived at a minimal ratio as depicted in the following chart 2. (Fraser 2011). Given the excess liquidity , the US banking system is not likely to witness another turmoil except if shadow banking had an enhanced exposure or new strains harshly punch the real estate sector once again as what had happened during the subprime mortgage crisis in 2008. As regards to 2008 financial crisis, there had been severe distraction in the unstructured shadow banking sector which triggered the subprime mortgage crisis. (Fraser 2011). However, real estate in US prolongs to be a source of susceptible, but the mortgage market is already burnt the shock that the probability for one more “toxic asset” setting is very feeble. Nonetheless, in a probable risk setting, where home prices decline by another ten percent, then there will be an increase in the charge-off on the real estate loans which would definitely create and increase more financial stress in the US commercial banking sector in the near future. Further, commercial banking sector may witness a turmoil if consumer spending declines and if the employments regress back to downbeat growth poignantly. However, this may not happen even though the US economic scenario remains feeble, it seems that credit levels in chief shadow banking groups are reverting to pre-recession scenarios as depicted in Chart 3. (Fraser 2011). As of now, the recession in US has come to an end; Fed policies have been aimed towards barring maturity mismatch and excessive leverage as both these factors may destabilize the financial strength. Moreover, there is a commitment by Fed to keep the interest rates without volatility till mid-2013, which will restrict volatility of interest rates and assist to maintain the shadow banking system in control for a short-run at least. (Fraser 2011). There has been escalating fears that engulfing the US fiscal scenarios, may place the US commercial banks to have run on deposits once again due to the EU zone crisis. At times of financial turbulence, banks run- on -deposits generally happen when bank customers predict that loan beneficiaries of US commercial banks may default the further installement which may make US commercial banks to feel difficulty in repayment of deposits to them. As of now, in US, there exists no guise of insurance to safeguard the substitute guises of deposits though the deposit insurance which was introduced in the 1930s mainly to safeguard the customary bank runs. (Fraser 2011). As Consumer and C&I asset quality are just back to normal levels, there is no imminent risk is anticipated to other major areas of vulnerability for the US commercial banks as of now as depicted in Chart 4. As the problematic and weak institutions failed already, the other chief areas of vulnerability for the US commercial banking system do not offer an immediate peril as depicted in chart 5. Hence, at present, US banking sector is focusing on deposits as their vital funding sources instead of other perilous guises of funding as shown in Chart 6. Commercial Banking Industry Performance During the five- year period ending 2008, the commercial banking industry witnessed a relatively topsy-turvy. From the year 2004 onwards, commercial banking sector in USA started to slide before witnessing 3 good years of development. In the year 2008, the subprime mortgage crisis hit the banking industry in US and hence there was a plummet in the industry performance, and severe losses were reported. Commercial banking sector revenue soared at the rate of 5.7% per annum over the five -year period to 2008, increased to $799 billion in 2008 from $606 billion at the close of 2003. However, banking industry profit slide to just $59 billion in the year 2008 from $119 billion at the end of 2003. This also witnessed a decline in the profit margin to 7.4% from that of 19.6% as the banking industry was largely affected by increasing loan loss provisions. Further, there had been also a declined in the enterprise number of 1.5% chiefly due to acquisitions and mergers. Despite the fact, the decline in the establishment number in the 5 years to 2008, there had been a growth in the employment rate, aggregating a growth of 0.8%, to 1.86 million people on an annual basis. Wages also increased in the banking sector to $136 million in 2008 from that $125 million in 2003. (IBISWorld 2008:41). Conclusion and Recommendations Commercial banking sector may witness turmoil if consumer spending declines and if the employments regress back to downbeat growth poignantly and hence Federal Reserve should take appropriate steps to avoid this. As of now, in US, there exists no guise of insurance to safeguard the substitute guises of deposits though the deposit insurance which was introduced in the 1930s mainly to safeguard the customary bank runs. US government should address this issue. Since, in the US commercial banking sector in the 5 years to 2008, there had been a growth in the employment rate, aggregating a growth of 0.8%, to 1.86 million people on an annual basis. Wages also increased in the banking sector to $136 million in 2008 from that $125 million in 2003. Hence, US government should offer more incentives and protection mechanism to commercial banking sector which offers not only sizeable employment but also tax revenues to US government. As compared to the foreign banking sector, the US banking sector seems to be steady and stays comparatively vibrant in terms of composition of its portfolio. Europe, especially, has been wrestling with concerns of solvency, funding and reserve features emanating from the sovereign debt debacle which the US has just successfully evaded. If any sign of weakness is felt by the depositors and regulators in US in the near future , it may create more sensitive even though US banking sector’s panorama may still better than Europe. Concerns of another Lehman Brothers- kind of tragedy is haunting the US financial markets and however , given the present condition of the shadow banking system of USA , one another financial crisis in US may not have the same impact of the subprime mortgage crisis that happened in 2008. US commercial banks have adequate muscle to withstand the risk of a steep fall in consumer spending and the peril of negative job growth that may happen in the near future that may impact growth of the banking industry in USA. (Fraser 2011). References Betz, F. (2011) Societal Dynamics: Understanding Social Knowledge and Wisdom. New York: Springer. Connaway, LS & Powell, RR. (2010) Basic Research Methods for Libraries. New York: ABC-CLIO. FDIC. (2012) Historical Statistics on Banking-FDIC [online] available from [ accessed 25 January 2012] Fraser, K. (2011) Banking Watch- USA [online]available from [accessed 25 January 2012] Heckman, L. (2010). How to Find Business Information: A Guide for Business People, Investors. New York: ABC-CLIO Iannotta G. (2010). Investment Banking: A Guide to understanding and Advisory Services. New York: Springer IBIS World Industry Report. (2008). Commercial Banking in the US. [online] available from [accessed 25 January 2012] Kim, J & Miner, AS. (2007) Vicarious Learning from Failures of the US Commercial Banking. Academy of Management Journal, Vol 50 (2), 687-714 Polski, MM. (2009). The Invisible Hands of U.S Commercial Banking Reform. New York: Springer. Read More