CHAPTER 3

THE ORGANIZATION AND STRUCTURE OF BANKING AND THE FINANCIAL SERVICES INDUSTRY

Goal of This Chapter: The goal of this chapter is to explore the different types of organizations used in the banking and financial services industry, to see how changing public mobility and changing demand for financial services, the rise of potent competition, and changing government rules have change the structure, size and the types of organizations in this industry.

Key Topics in this Chapter

The Organization and Structure of the Commercial Banking Industry Internal Organization of the Banking Firm: Smaller Community and Larger

Money-Center Banks The Array of Organizational Structures in Banking: Unit, Branch, Holding

Company and Electronic Banks Interstate Banking and The Riegle-Neal Act Two Alternative Types of Banking Organizations as the 21st Century Opened: The

Financial Holding Company and Bank Subsidiaries Model The Changing Organization and Structure of Banking’s Principal Competitors Efficiency and Size

Chapter Outline

I. Introduction: Organizational Forms and Function in BankingII. The Organization and Structure of the Commercial Bank Industry

A. Advancing Size and Concentration of AssetsB. Is a Counter Trend Underway?

III. Internal Organization of the Banking FirmA. Community Banks and Other Community-Oriented Financial FirmsB. Larger Banks-Money Center, Wholesale and RetailC. Trends in Organization

IV. The Array of Organizational Structures and Types In the Banking IndustryA. Unit Banking OrganizationsB. Branch Banking Organizations

1. Organizational Characteristics2. Branching's Expansion3. Reasons behind Branching’s Growth4. Advantages and Disadvantages of Branch Banking

C. Electronic Branching-Websites and Electronic Networks: An Alternative and a Supplement to Traditional Bank Branch Offices?

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D. Bank Holding Company Organizations1. Organizational Characteristics2. Why Holding Companies Have Grown3. One-Bank Holding Companies4. Multibank Holding Companies5. Advantages and Disadvantages of Holding-Company Banking

V. Interstate Banking and the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994A. Riegle-Neal Interstate Banking and Efficiency Act of 1994B. Research on Interstate Banking

VI. Two Alternative Types of Banking Organization Available as the 21st Century Opened Financial Holding Company Model and Bank SubsidiariesA. Gramm-Leach-Bliley ActB. Financial Holding CompaniesC. Bank Subsidiaries

VII. Mergers and Acquisitions Reshaping the Structure and Organization of the Financial-Services Sector

VIII. The Changing Organization and Structure of Banking’s Principal CompetitorsA. ConsolidationB. Convergence

IX. Efficiency and Size: Do Bigger Financial Firms Operate at Lower Cost?A. Efficiency in Producing Financial Services

1. Economies of Scale2. Economies of Scope3. X-Efficiency

X. Financial Firm Goals: Their Impact on Operating Cost, Efficiency, and PerformanceA. Expense-Preference BehaviorB. Agency TheoryC. Corporate Governance

XI. Summary of the Chapter

Concept Checks

3-1. How would you describe the size distribution of American banks and the concentration of industry assets inside the United States? What is happening in general to the size distribution and concentration of banks in the United States and in other industrialized nations and why?

Although the largest banks in the United States make up only 6% of all FDIC insured banks, they control almost 87% of all the industry’s assets. This development is a result of the strong trend towards consolidation and convergence in the industry not only in the United States, but also globally and can be explained by the increasing competitive pressures in the industry and the economies of scale that prevail in banking.

3-2. Describe the typical organization of a smaller, community bank and a larger, money-center bank? What does each major division or administrative unit within the organization do?

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Small banks generally have four basic departments or divisions centered on lending (the credit function), fund-raising, operations, and marketing (and, perhaps, trust services). Daily operations are usually monitored by a cashier and/or auditor and by the vice presidents in charge of each department and division. Overall, the small bank's organization chart is simple and uncomplicated. In contrast, the largest banks usually have many specialized departments and divisions, including separate departments for different kinds of loans, departments to manage security holdings and borrow in the money market, a division or department to manage international operations, a marketing division, and a planning unit along with other divisions.

3-3. What trends are affecting the way banks are organized today?

In general, banks are becoming larger and more complex organizations with more departments and services and greater specialization. Deregulation and service innovation have accelerated this trend as intense competition at home and abroad has encouraged banks to become larger organizations, serving broader and more diversified market areas. Even small banks are reorganizing to meet these challenges by being more efficient in meeting their broader-based customer needs.

3-4. What are unit banks?

Unit banks offer their full menu of services from only one office, though they may operate any number of drive-in windows, automated teller machines, and point-of-sale terminals. These organizations are very common today.

3-5. What advantages might a unit bank have over banks of other organizational types? What disadvantages?

Unit banks have the advantage of being less costly to operate because full-service branch offices are an expensive way to grow and, because unit banks tend to be relatively small, they seem to be able to offer personalized services better than larger institutions. One disadvantage is the heavy dependence of most unit institutions on a single market area which increases their risk of failure and, some authorities believe, unit institutions may not be able to afford technologically advanced service delivery systems.

3-6. What is a branch banking organization?

A branch banking organization sells its full menu of services through more than one office. Regardless of its number of offices it is one corporation with one board of directors. However, each office has its own management team with limited authority to make decisions on customer loan applications and other facets of daily operation

3-7. What trend in branch banking has been prominent in the United States in recent years?

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Branch banking has become increasingly important with the great majority of states now allowing statewide branching. Today, more states permit statewide branching and only a minority restrict branching in some way. There was an increase in the number of branches in the 60’s, 70’s and 80’s as the population fled cities to suburban areas. However, in recent years the growth in full-service branches has slowed because of the sky-rocketing costs of land and building office facilities. In addition, ATM’s and electronic networks have taken over much of the routine banking transactions. There is not as much need for full service branches as before.

3-8. Do branch banks seem to perform differently than unit banks? In what ways? Can you explain any differences?

Branch banking has a number of important advantages. With offices spread over different areas branch banks may achieve more stable earnings and revenue flows. They may be able to grow faster because the additional offices can bring in more debt capital (principally deposits) with which to grow. However, research evidence accumulated in recent years suggests that adding new branch offices can subject the bank to high fixed costs, due to large and rising construction costs, which means the bank must work harder simply to reach a break-even point. Moreover, branch offices that are poorly situated or that have the misfortune to be located in an area whose economy is deteriorating may generate higher costs than revenues and saddle the bank with persistent net earnings losses.

3-9. What is a bank holding company?

A bank holding company is a corporation that holds an ownership interest in at least one bank. It is also allowed to own nonbank businesses as long as they are related to banking.

3-10. When must a holding company register with the Federal Reserve Board?

If the company owns at least 25 percent of the outstanding stock of at least one bank or otherwise exerts a controlling influence over at least one bank, it must register with the Federal Reserve Board and seek the Fed's approval if it wishes to increase its share of ownership in those banks in which it already has an interest or wishes to acquire additional banks or nonbank businesses.

3-11. What nonbank businesses are bank holding companies permitted to acquire under the law?

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The Bank Holding Company Act (as amended) requires a registered bank holding company to acquire only those nonbank businesses that are "closely related to banking" and "in the public interest." Among the most popular of these nonbank businesses that have been approved for holding-company acquisition include finance companies, mortgage banking firms, leasing companies, insurance agencies, data processing firms, and several other businesses as well. Increasingly as the 1990s began, bank holding companies sought approval to acquire failing savings and loan associations which the Federal Reserve Board granted after a case-by-case review. These S&L acquisitions were sanctioned by the U.S. Congress when the Financial Institutions Reform, Recovery, and Enforcement Act was passed in 1989 and, with passage of the Federal Deposit Insurance Corporation Improvement Act in 1991, bank holding companies were granted permission to acquire even healthy savings and loan associations with Federal Reserve Board approval. Today, the Gramm-Leach-Bliley Act allows financial services companies to be affiliated with each other. This includes investment-banking activities which allow banks to underwrite securities.

3-12. Are there any significant advantages or disadvantages for holding companies or the public if these companies acquire banks and other nonbank business ventures?

The ability of holding companies to acquire nonbank businesses has given them the capacity to cross state lines even where state law prohibited entry by out-of-state banking firms. It also allows a holding company to diversify across many different product lines to help stabilize the company's net earnings. However, launching nonbank businesses can stretch holding-company management too far and make it ineffective, resulting in damage to the performance of banks belonging to the same holding company. The public may gain if holding companies are less subject to failure than other types of financial service firms and are more efficient to operate. However, the public may lose if the concentration of services in bank holding companies causes the prices of those services to rise or if resources are drained away from local communities causing slower growth of those communities.

3-13. What did the Riegle-Neal Interstate Banking Act do? Why was it passed into law?

In 1994 the U.S. Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act which allows bank holding companies to acquire a banking firm in any of the 50 states beginning in the Fall of 1995. After June 1, 1997 banking firms were allowed to convert banks acquired across state lines to branch offices if the states involved did not elect to “opt out" of interstate banking. The interstate banking law reflects the need for banking firms to diversify into different geographic markets and the demands of the public for financial service providers that can follow businesses and individuals as they move across the landscape.

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3-14. Can you see any advantages to allowing interstate banking? What about potential disadvantages?

As far as problems are concerned, interstate banking threatens to increase the concentration of banking resources in the U.S., especially among larger banks in various regions of the nation. Increased concentration possibly could lead to higher prices and less service if the antitrust laws are not fully enforced. On the other hand, recent studies suggest that interstate mergers generate positive abnormal returns on bank stock. In addition, these banks are not tied to one local economic area and appear to be less subject to failure.

3-15. How is the structure of the nonbank financial services industry changing? How do the organizational and structural changes occurring today among nonbank financial service firms parallel those experienced by the banking industry?

Almost all of banking’s top competitors are experiencing much the same changes as banks. For example, consolidation and convergence are occurring at a rapid pace. Generally, nonbank firms have experienced the same dynamic structural and organizational revolution as banks and for many of the same reasons.

3-16. What relationship appears to exist between bank size, efficiency, and operating costs per unit of service produced and delivered? How about among nonbank financial-service providers?

For banks and nonbank financial service providers alike, economies of scale and scope if achieved can lead to significant savings in operating costs with increases in service output. Economies of scale mean that costs per unit decrease as more units of the same service are produced. Economies of scope mean that as more different services are provided the joint costs of producing those services decrease.

3-17. Why is it so difficult to measure output and economies of scale and scope in the financial services industry? How could this measurement problem affect any conclusion reached about firm size, efficiency and expense behavior?

We have to be cautious about the conclusion reached by cost studies because the financial service business is changing rapidly in form and content and the available statistical methodology have serious limitations in that they focus on a single point in time rather than attempting to capture the dynamics of the industry.

3-18. What is expense-preference behavior? How could it affect the performance of a financial firm?

Expense preference behavior describes an approach to management in which managers use the resources of the firm to provide them with personal benefits not needed to produce and sell the products. This behavior leads to increasing costs of production and declining returns to the firm’s owners.

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3-19. Of what benefit is agency theory in helping us understand the consequences of changing control of a financial services firm? How can control by management as opposed to control by stockholders affect the behavior and performance of a financial services provider?

Agency theory analyzes the relationship between a firm’s owner (shareholder) and its managers. It explores whether there is a mechanism to compel managers to act in the best interest of and maximize the welfare of the firm’s owners. Owners do not have access to all the information and cannot fully evaluate the performance of a manager.

3-20. What is corporate governance and how might it be improved for the benefit of the owners and customers of financial firms?

Corporate governance describes the relationships that exist among managers, the board of directors, the stockholders, and other stakeholders of a corporation. Corporate governance can be improved through larger boards of directors and a high proportion of outside directors. This will expose managers to greater monitoring and discipline.

Problems

3-1. Suppose you owned a bank holding company headquartered in California. According to the laws, what other states could you enter and acquire banks through your bank holding company?

As a result of passage of Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 bank holding companies will be able to acquire banking firms anywhere in the nation. Bank holding companies can acquire banks throughout the nation without having to have the state’s permission.

3-2. Of the business activities listed below, which activities can be conducted through U.S. regulated financial-service holding companies today?

Banks can perform most of the activities listed. It may be easier to talk about the activities they cannot do. They cannot sell office furniture. They cannot perform professional advertising services. They cannot form real estate development companies, although there is some discussion in the media of allowing this in the future. They can do just about everything else today.

3-3 You are currently serving as president and chief executive officer of a unit bank that has been operating out of its present location for five years. Due to the rapid growth of households and businesses in the market area served by the bank and the challenges posed to your share of this market by several aggressive competitors you want to become a branch bank by establishing satellite offices. Please answer the following questions:

a. What laws and regulations have a bearing on where you might be able to locate the new facilities and what services you may offer?

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b. Based on the content of this chapter, what advantages would your branch likely to have over the old unit bank? What disadvantages are likely to come with adding branch offices? Any ideas on how you might minimize these disadvantages?

c. Would it be a good idea to form a holding company at the same time or perhaps before or after setting up the new branches? Based on the material in this chapter what advantages could a holding company bring to your bank? Disadvantages?

In general, the bank would have to seek approval from their chief regulating agency for any major actions that the bank takes. National banks have get approval from the Comptroller of the Currency. State member banks have to get approval from the Federal Reserve and state banks with insurance who are not members of the Federal Reserve would have to seek approval from the FDIC. All other banks would have to have approval of the state banking commission. However, depending on the services offered, the Gramm-Leach Bliley Act may apply. The Gramm-Leach-Bliley Act allows banks to offer many different services either as subsidiaries of the parent bank or under the financial holding company structure. In this case, the Federal Reserve must approve of the services and the structure of the bank.

Branch banking has a number of important advantages. With offices spread over different areas branch banks may achieve more stable earnings and revenue flows. They may be able to grow faster because the additional offices can bring in more debt capital (principally deposits) with which to grow. However, research evidence accumulated in recent years suggests that adding new branch offices can subject the bank to high fixed costs, due to large and rising construction costs, which means the bank must work harder simply to reach a break-even point. Moreover, branch offices that are poorly situated or that have the misfortune to be located in an area whose economy is deteriorating may generate higher costs than revenues and saddle the bank with persistent net earnings losses.

Formation of a holding company has a number of potential advantages. It may help lower the taxes earned by the whole banking organization and open up the possibility of acquiring nonbank businesses that help to diversify the bank's operations and reduce the risk to its earnings and long-run viability. The problem with starting a holding company at the same time as the opening of new branches are the costs involved (including legal fees, the cost of registering with the Federal Reserve Board, and underwriting costs as new stock is issued).

3-4. Suppose you are managing a medium-size branch banking organization (holding about $25 billion in assets) with all of its branch offices located within the same state. The board of directors has asked you to look into the possibility of the bank offering limited security trading and investment banking services as well as insurance sales. What laws opens up the possibility of offering the foregoing services and under what circumstances may they be offered? What do you see as the principal benefits from and the principal stumbling blocks to successful pursuit of such a project?

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The Gramm-Leach-Bliley Act of 1999 allows banks to offer selected nonbank financial services. The bank could offer these services either as a financial holding company or through bank subsidiaries. The financial holding company form seems to have the advantage because of limits on how large subsidiaries can be and because each affiliated firm would have its own capital and its own profits and losses that are separate from the profits and losses of any other part of the firm. However, fewer than 500 firms have achieved financial holding company status suggesting that this may be an expensive proposition that would be difficult for medium sized banking firms to undertake.

3-5. First Security Trust National Bank of Boston is considering making aggressive entry into the People’s Republic of China, possibly filing the necessary documents with the government in Beijing to establish future physical and electronic service facilities. What advantages might such a move bring to the management and shareholders of First Security? What potential drawbacks should be considered by the management and board of directors of this bank?

China is a huge market and entering into the Chinese market now may give this bank an advantage over other banks that wait enter. They will already have the necessary contacts and understanding of the Chinese system when it becomes a more open economy in the future. However, there is considerable risk. It could be years before the economy becomes more open so profit opportunities might be slow to develop. In addition, the government could change its mind about allowing foreign banks ownership in China and seize any assets held by foreign banks. Finally, the system is dominated by large government owned banks and it may be difficult to compete with these banks. The Chinese government could give preferential treatment to these government banks at the expense of the private sector.

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