Money Matters

The Banking System: Part II

Columns | Richie Rich | May 2010

The U.S. government bailed out several major banks in the financial crisis and is now starting to move away from the driver’s seat, handing the wheel of fortune back to the CEOs of those same banks who caused the problem in the first place.

This is the second part of our special series on the banking system. In this episode we will be focusing on the U.S. banking system in the context of the Federal Reserve System, the Fed. In our previous episode [VR, March 2010] we highlighted the major duties of the Fed, highlighting clear boundaries within the U.S. Banking System. This time we would like to focus on the U.S. banking structure and how the Fed influences the financial sector overall.

Banks in their primary function are financial institutions that accept deposits and channel them back out into lending activities. Banks primarily provide financial services to customers, while enriching investors. Government restrictions on financial activities by banks vary over time and situation. Banks are important players in financial markets and offer services including investment funds and loans.

Banks’ activities can be divided into retail banking, dealing directly with individuals and small businesses; business banking, providing services to mid-market business; corporate banking, directed at large business entities; private banking, providing wealth management services to high net worth individuals and families; and investment banking, relating to activities on the financial markets. Most banks are private, profit-making enterprises. However, some are owned by government, or are non-profit organizations.

Central banks are normally government-owned and charged with quasi-regulatory responsibilities, such as supervising commercial banks, or controlling the cash interest rate. They generally provide liquidity to the banking system and act as the lender of last resort in the event of a crisis, as we have seen in the last two years. No matter the layout, however, banks are in the system to make profits. The financial crisis has shown us that banks are willing to take high risks for a good return, and have to be constantly controlled by the Fed.

Risks include liquidity (where many depositors may request withdrawals beyond available funds), credit risk (the chance that those who owe money to the bank will not repay it), and interest rate risk (the possibility that the bank will become unprofitable, if rising interest rates force it to pay relatively more on its deposits than it receives on its loans).

In the United States, the banking industry is a highly regulated industry with detailed and focused regulators. Each regulatory agency has its own set of rules and regulations to which banks and thrifts must adhere.

The level of government regulation of the banking industry varies widely. However the minimum requirements for the issue of a bank license typically include, minimum capital; a minimum capital ratio; ‘fit and proper’ requirements for the bank’s controllers, owners, directors, and/or senior officers; and approval of the bank’s business plan as prudent and plausible. This ‘prudent’ standard, for example, prohibits U.S. banks from owning non-financial companies.

There is often a fine line between regulation and restrictions. The regulators face an increased burden with increased workload and more banks per regulator. As banks struggle to keep up with the changes in the regulatory environment, regulators struggle to manage their workload and effectively regulate their banks. The result is that banks are receiving less hands-on assessment by the regulators, less time spent with each institution, and the potential for more problems slipping through the cracks – potentially resulting in an overall increase in bank failures across the United States.

The changing economic environment has a significant impact on banks and thrifts as they struggle to effectively manage their interest rate spread in the face of low rates on loans, rate competition for deposits and the general market changes, industry trends and economic fluctuations. It has been a challenge for banks to effectively set their growth strategies with the recent economic market.

The management of the banks’ asset portfolios also remains a challenge in today’s economic environment. Loans are a bank’s primary asset and when loan quality becomes suspect, the foundation of a bank is shaken to the core.

While always an issue for banks, declining asset quality has recently become a big problem for financial institutions. There are several reasons for this, one of which is the lax attitude some banks have adopted because of the years of "good times."

The potential for this is exacerbated by the reduction in the regulatory oversight of banks and in some cases depth of management. Problems are more likely to go undetected, resulting in a significant impact on the bank when they are recognized. In addition, banks, like any business, struggle to cut costs and have consequently eliminated certain expenses, such as adequate employee training programs.

So where is the balance? Banks have to be regulated and monitored by an "independent source," i.e. the Fed, while banks also need to make a profit and deliver strong shareholder returns in order to be attractive for investors. Not an easy negotiation if you are the Fed. But all said, it’s good to check on regulations while the vehicle is still in the garage; too many seem to find themselves under-informed and in the driver’s seat, while already accelerating to full speed. Not an enviable place to be.

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