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Chapter 14 The Banking Industry Overview This chapter provides an overview of the structure of the banking industry in the United States. It focuses on the regulatory authorities that are responsible for monitoring the activities of banks and on explaining why regulation of the banking system has been necessary. The chapter gives a brief history of banking in the United States (which might be supplemented in courses that emphasize banking) and provides an overview of the development of bank regulation. The modern U.S. banking system dates from the passage of the National Banking Act of 1863, which authorized regulation of federally chartered banks by the Office of the Comptroller of the Currency in the U.S. Treasury Department. Three important regulatory interventions after 1863 helped shape the U.S. banking system: creation of the Federal Reserve System in 1913, creation of a system of federal deposit insurance in 1934, and enactment of various restrictions on bank branching. The explanation presented for why banks are regulated focuses on liquidity risk—the problems arising from the illiquidity of bank loans relative to deposits. Chief among the problems associated with liquidity risk are bank runs. A rather sophisticated explanation of bank runs is given: Banks have private information concerning the health of their loan portfolios, savers without access to this information may start a run even against a financially healthy bank. The main ways of dealing with bank runs are by setting up a lender of last resort (the Fed in the United States) or a system of deposit insurance (which the United States turned to after the Fed failed to end the banking panics of the early 1930s).
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75 Hubbard • Money, the Financial System, and the Economy, Sixth Edition The mechanics of how the FDIC deals with bank failures are described. Also discussed is the important idea that the establishment of deposit insurance introduced a significant moral hazard problem into the banking industry by greatly reducing the incentive of depositors to monitor banks. The Federal Deposit Insurance Corporation Improvement Act of 1991 clarified the FDIC’s role as monitor of the supervision of federal and state bank examiners. In addition, banking laws and regulations that require banks to maintain a minimum level of net worth are intended to reduce the costs of moral hazard. The chapter also discusses restrictions on banking industry competition. Geographic branching restrictions appear to be rapidly falling to competitive forces in the banking system, while restrictions on permissible activities of banks, although eroding, are still significant. (Changes in the law and administrative decisions in this area are ongoing and the discussion in the text may need to be supplemented with a discussion of recent developments.) The most important of these latter restrictions was the Glass-Steagall Act, which prohibited commercial banks from participating in underwriting corporate securities and from engaging in broker-dealer activities. The risk-sharing, liquidity, and information framework helps predict who the
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