Deregulation, Consolidation, and Collusion in The American Banking Industry

Arman Oganisian

Readings & Research in Industrial Organization ECN 490-003 Dr. Alan Kessler

May 15, 2013

I.

Introduction

The American banking industry today is very consolidated and heavily regulated. This has not always been the case. Rather, the industry has weathered periods of decreased and increased regulation before becoming the oligopolistic industry it is today. Part two of this paper will briefly survey pre-depression banking before detailing how the Great Depression spurred an era of increased regulation in the form of interstate M&A bans, interest rate ceilings, and separation of investment and commercial banking services. Part three will discuss the deregulation of the 1980s. Specifically, it will analyze the disintegration of post-Depression usury laws and interstate banking regulations, while noting the increasingly lax interpretations of Glass-Steagall. Part four of this paper will detail the resulting consolidation, arguing that it was a byproduct of the new, deregulated environment which allowed firms to take advantage of the benefits of M&A. The section will display some descriptive metrics of this consolidation. The industry realized a significant increase in M&A activity, following elimination of M&A restrictions. Additionally, since the newly merged banks were getting larger, entry into the industry was limited as newcomers were unable to compete. The simultaneous effects of difficult entry and spike in mergers resulted in industry consolidation. Additionally, firms took advantage of liberal Glass-Steagall interpretations by expanding vertically, as illustrated by the landmark Citibank-Travelers merger. As an industry becomes more oligopolistic, the incentive and ease of collusion increase. Part five of this paper discusses the dangers of this incentive within the context of the recent LIBOR rate-fixing debacle.

II.

Pre-1980s Banking

American banking was largely unregulated before the Great Depression. U.S. banking organizations offered commercial banking services, such as offering interest on deposits and loaning out those deposits in return for a greater rate, capturing the spread as profit. These banks also offered investment solutions such as facilitating initial stock offerings in a primary market, maintaining an active secondary market for those securities, etc. While interest-rate ceilings have existed since American independence, those ceilings were pushed higher with the passing of the Uniform Small Loan Law (USLL) in 1916. Congress passed the law with the intent of helping small business compete with loan sharks, which, because they operated outside regulatory influence, were able to charge higher interest rates. The law allowed authorized lenders to charge rates far higher than most state usury ceilings, in exchange for conforming to strict transparency and regulatory guidelines. Allowing commercial banks to enter this market, regulators thought, would take away the loan sharks edge by introducing competition (Carruthers et al, 2009). The Great Depression was a key turning point in regulatory history, both because it produced a regulation-friendly atmosphere and concrete regulations. In 1933, Congress passed the Glass-Steagall Act, which placed a wall of separation between commercial and investment operations. It claimed that any banking organization which accepted deposits could not be engaged principally in investment banking activities (GlassSteagall, 1933).1

The actual activities it lists are: flotation, underwriting, public sale, or distribution at wholesale or retail or through syndicate participation of stocks, bonds, debentures, notes, or other securities. - Banking Act of 1933 20 (b)
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The law also created the Federal Deposit Insurance Corporation (FDIC) to insure deposits up to $100,000 2 in an effort to avoid future bank runs. Regulation Q, a particularly important portion of Glass-Steagall, enacted strict ceilings on interest rates which banking organizations could offer to depositors, undoing much of the effects of the USLL. Under Regulation Q, savings account rates were capped at 5.25%, time deposits (such as CDs or certain money market funds) were limited to 5.75%-7.75% depending on maturity (Sherman, 2009). The regulation did not stop with Glass-Steagall. The Bank Holding Act of 1956 applied the same distinction between commercial and investment banking to bank holding companies, firms which control one or more banks but do not actually engage in banking themselves. An amendment to The Bank Holding Act, known as The Douglas Amendment, effectively banned interstate banking acquisitions. Although a bank could get an exemption by seeking the approval of the target banks state, this exemption was seldom granted. In 1933, Congress passed the Securities Act, which required banking organizations to file all initial public offerings of bonds and equity with the government. In 1934, the Securities and Exchange Commission (SEC) was born and charged with overseeing security transactions in secondary markets. Thus, banking was not only divided between commercial and investment banks, but the investment banks were bound to strict primary and secondary market regulations.

The amount was originally $40,000, but was later increased to $100,000 by President Carter in 1980 with the passing of Depository Institutions Deregulation and Monetary Control Act
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All of the above regulation (interest rate ceilings, ban on interstate M&A activity, and primary/secondary market regulation) was intended to restrain excessive risk and alleviate principle-agent problems. The separation of commercial and investment banks was intended to curtail excessive risk-taking with depositor funds. Furthermore, regulation of primary and secondary markets would go a long way to aligning the interests of clients and their brokers. Interest-rate ceilings were intended to insure that banks would not engage in rate wars and regulation against interstate M&A would insure that the banking sector stays largely competitive, maximizing social welfare. III. Deregulation of American Banking

The 1980s would see the wholesale dissolution of many regulations detailed in the previous section. State usury ceilings were largely eliminated after 1978. Moreover, branching and interstate banking were also deregulated at the state level. Figure 1 shows the number of states which first allowed intrastate M&A (expansion via acquisition of whole banks or individual branches within the same state) in blue. The number of states that allowed M&A activity increased throughout the 1980s, as did the number of states that allowed for unrestricted branching (expansion by other means, such as opening a new branch without buying), shown in red. The green series shows the number of states that first allowed interstate M&A or branching for each year in the series. This series also increased over the time period shown. The origin of this state-level deregulation is none other than Maine (Strahan, 2002). In 1978, Maine took advantage of the Douglas Amendments exemption policy and granted external bank holding companies the right to acquire Maine-based banks if the state of the acquiring bank afforded Maine the same right. New York and Alaska

responded by passing similar legislation in 1982. The cumulative series in Figure 2 shows that, by the end of the 1980s, 45 states had followed suit and allowed interstate banking as well as unrestricted intrastate branching3. M&A and branching deregulation aside, state usury laws were virtually dissolved following the Supreme Courts ruling on Marquette National Bank v. First Omaha Service Corporation4 in 1978. The case surfaced an important question: since different states had different interest-rate ceilings on deposits, which ceiling should be enforced concerning an interstate loan? The Supreme Court ruled that, among other things, banks can export the interest rate ceiling of their home state when making an interstate loan. This sparked the fuse of usury deregulation. States began eliminating their ceilings in order to make themselves more attractive to banks. Many states, including South Dakota and Delaware, completely overturned their usury laws. Former South Dakota Governor, Bill Janklow, recalled that the legislation to overturn the laws were introduced and passed on the same day (Sherman, 2009). Furthermore, in 1980, President Carter signed the Depository Institutions Deregulation and Monetary Control Act into law, which created an oversight committee charged with eliminating interest-rate ceilings over the next six years. In addition to the deregulation of intrastate/interstate banking and elimination of interest-rate ceilings, Glass-Steagalls limitations received increasingly lax interpretations. Banks argued that the law was antiquated and that its restrictions Both Figure 1 and Figure 2 were created using data from Strahan, 2002. The full case description and decision are accessible at http://caselaw.lp.findlaw.com/scripts/getcase.pl?navby=case&court=us&vol=439& page=299 .
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put U.S. banks at a disadvantage relative to foreign banks. The Fed, consequently, deemed that commercial banks could derive up to 5% of their profits from investment banking activities in 1986. Later, that number was revised upward to 10%. The Fed argued that since Glass-Steagall failed to define engaged principally, it could interpret the degree of engagement (Sherman, 2009). In 1987, the Fed allowed commercial banks to underwrite commercial paper, mortgage-backed securities (MBSs), and municipal bonds. In 1996, the Fed loosened Glass-Steagall restrictions further by lowering the 10% standard to 25%. The final blow came in 1999, when the passing of the Financial Modernization Act formally overturned Glass-Steagall. IV. Consolidation of the 1980s

The deregulation detailed in the previous section sparked a simultaneous wave of mergers within the American banking industry. Starting in the 1980s, the total number of annual mergers reached new heights. Not only did the total number of mergers increase, but the average size increased during the same period. Simultaneously, fewer and fewer new bank charters were granted. The result was a shrinking of the industry between 1980 and 1994, making the banking industry an oligopoly in which a few large banks dominate the market. Figure 3 shows that between 1980 and 1994, the number of annual mergers had increased from 190 to 446, a 135% increase. Simultaneously, there were fewer new entrants into the industry. During the same period that bank mergers increased 135%, new state and federal charter grants dropped 76%. Fewer firms were entering the market because of the relatively high fixed cost associated with starting a bank. The mergers

only made entering the industry more difficult because incumbent banks were increasing in size. As the average acquiring bank size and average target bank size increased (Figure 4), the average size of the merged firms also increased, creating banking behemoths that new entrants could not compete against. The result of these trends was a smaller industry. As banks consolidated and fewer players entered the market, the amount of banking organizations declined from a total of 12,239 in 1980 to 7,906 in 1994, a 35% decline. During the same period, data shows that MSA banking markets were very concentrated, recording an average HHI of over 1800 (Rhoades, 1996). This, according to Department of Justice standards, qualifies the banking industry as highly concentrated5 The spark in mergers is not a result of banks suddenly desiring to merge. Rather, it is often profitable for firms to merge and they would have done so before if the regulations restricting such mergers did not exist. Banks may have an incentive to merge for several reasons. Merging is a method of horizontal integration, which diversifies risk geographically for acquiring and target firms. A bank may wish to acquire a firm that produces complementary products or services. In this way, the acquiring bank can realize the benefits associated with economies of scale and increased specialization. Furthermore, smaller banks stood to benefit from being acquired. The greater resources and credit rating of the acquiring bank aside, shareholders had much to gain from being acquired. Shareholders of acquired firms received a premium of about 16-25% over the pre-acquisition stock price during that time (Perloff et al, 2005).

An HHI less than 1800 and greater than 1000 indicates a moderately concentrated market.
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Firms also took great advantage of lenient Glass-Steagall interpretations (and eventual repeal) by expanding vertically. Perhaps the most potent example is the 1998 merger of Citibank and Travelers Insurance Group to form Citicorp. The merger, a record $70 billion deal, would form the worlds largest financial institution. Before this merger, Travelers had purchased Salomon Brother and Smith Barney to add to its brokerage arm (Martin, 1998). Consolidation was not only horizontal, but also vertical. For the first time in a long time, securities, insurance, lending, wealth management, and other operations could all be run under one roof. As shown in figure 56, 2009 data suggests that 4 banks control 50% of the banking market, characteristic of an oligopolistic market. This is the product of deregulation in the 1980s and the subsequent horizontal and vertical consolidation via increasing (both in frequency and size) mergers. The industry had consolidated as more banks merged and fewer banks entered the market. V. Banking Cartels and the LIBOR Scandal

Collusion is common in concentrated, oligopolistic markets. Department of Justice data suggests that in 76% of price-fixing cases the four-firm concentration ratio was over 50% (Perloff et al, 2005). In the banking industry, the four-firm concentration ratio is just over 51% (adding up the four largest percentages in figure 5). It should be unsurprising, then, that Barclays admitted to submitting artificially low LIBOR survey responses and paid a $450 million settlement to government authorities as a result (Alessi, 2013).

The charts in figures 3-5 were made using the data from Rhoades, 1996. 9

As an aside, the LIBOR rate is a key interest-rate which determines the price of interbank lending. The British Banking Association (BBA) sets LIBOR, or the London Interbank Offer Rate, daily by surveying a group of banks (for US dollar LIBOR, the BBA survey 18 banks) and asking them what interest they would charge for a loan to another bank over various maturities. The average of the submissions, with the lowest and highest removed, is the LIBOR rate for that particular maturity for that particular day. For example, if the LIBOR for the overnight maturity is set at 5% by the collective survey, on that day, a bank in need of borrowing $5,000,000 to meet its daily reserve requirement must pay LIBOR*5,000,000 to the lending bank. In addition to governing interbank lending, LIBOR prices interest rate swaps, among other swaps. The most common and simplest interest rate swap known as a plain vanilla swap. This is a contract, between two parties, in which a floating stream of future interest rate payments (based on LIBOR) is swapped for a fixed stream of future payments. The former stream is referred to as the floating leg of the swap, while the latter is referred to as the fixed leg. Investors own either one leg or the other of a swap. LIBOR, published in 10 different currencies, controls some $800 trillion in short term loans, credit derivatives, interest rate swaps, etc, making it the largest market yet to be rigged (The Scam Busters, 2013). There were several motivations behind forming a cartel to fix LIBOR. First, the banks had much to gain from a lower LIBOR. It would provide cheaper overnight loans (as is clear from the example above), which banks take out daily in order to meet reserve requirements before closing. It would also be profitable for the banks stakes in the floating arms of interest rate swaps, which are priced using LIBOR, as discussed above.

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A lower rate would decrease the floating rate payments owed to the investor on the other end of the swap. According to 2013 statistics from the Bank of International Settlements (BIS), interest-rate contracts constitute the second largest OTC derivatives market, right behind FX contracts.7 There are also several reasons why rate-fixing should be expected in this industry. First, the industry underwent decades of consolidation and is now heavily concentrated (as indicated by average HHI mentioned in section IV and the four-firm ratio). Second, the banks are in close physical proximity. Nine of the ten largest American investment banks are located in midtown Manhattan (ironically, not on Wall Street). Bankers are heavily concentrated in just three financial districts in New York City, Hong Kong, and London, making it fairly easy to meet. Third, the expected benefit of price-fixing is high relative to expected punishment. As mentioned, banks stand to profit from manipulating the cost of their short term loans and the second largest OTC derivative market. The cost of getting caught, however, is relatively low. Barclays $450 million settlement, for example, is a trivial amount relative to its $50 billion market capitalization. Last summer, JP Morgan incurred a $6 billion trading loss (13 times greater than $450 million) and still finished off the quarter with profits that beat Wall Street analysts expectations. Finally, monitoring the cartel members is relatively easy since LIBOR is recalculated daily. If the actual rate consistently does not equal the agreed-upon rate, all members will know. Furthermore, BIS publishes OTC settlements on a quarterly basis, making it more difficult for any one member to cheat without getting caught. BIS Quarterly Review, March 2013, Table 19: http://www.bis.org/statistics/otcder/dt1920a.pdf
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Thus, the banking industry, because of its oligopolistic nature, is much more prone to collusion than more competitive industries. The industry is consolidated, the incentives to cheat are far greater than the disincentives, the banks are physically close, and cheating is easily monitored. VI. Conclusion

Part two of this paper began by describing the initial state of deregulation at the turn of the 20th century. Attitudes changed after the Great Depression as state and federal governments began imposing strict M&A regulation, interest-rate ceilings, and separated investment and commercial banks. Part three of this paper goes on to describe the deregulation of the 1980s. State-level interest rate ceilings were effectively eliminated after Marquette v. First Omaha. M&A restrictions were deregulated after Maine took advantage of the Douglas Amendments exemption policy. The remaining states followed Maine in the proceeding years. Furthermore, Glass-Steagall restrictions were increasingly loosened as the Fed began defining the engaged principally clause. Part four details how this deregulation provided the necessary environment for an M&A boom in the 1980s. As annual M&A transactions increased over the decade and beyond, the number of new entrants diminished. Newcomers could not compete with the larger merged banks. As a result, the industry shrank as firms continued to expand horizontally. Additionally, as Glass-Steagall restrictions were loosened, banking organizations expanded vertically and began providing numerous services and products. The industry, over time, began to resemble an oligopoly. In part five, the paper illustrates, via the LIBOR rate scandal, how collusion and price-fixing are prevalent within oligopolies. The concentration, geographic locations, and large benefit relative to expected punishment all incentivized banks to cheat.

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VII. Bibliography
"The Scam Busters: How Antitrust Economists Are Getting Better at Spotting Cartels." The Economist. The Economist, 15 Dec. 2012. Web. 1 Apr. 2013. <http://www.economist.com/news/finance-and-economics/21568364-howantitrust-economists-are-getting-better-spotting-cartels-scam-busters>. Abrantes-Metz, Rosa M., and D. Daniel Sokol. "Lessons From LIBOR." Harvard Business Law Review (HBLR). N.p., n.d. Web. 01 Apr. 2013. <http://www.hblr.org/2012/10/the-lessons-from-libor-for-detection-anddeterrence-of-cartel-wrongdoing/>. Alessi, Christopher. "Understanding the LIBOR Scandal." Council on Foreign Relations. N.p., 6 Feb. 2013. Web. 01 Apr. 2013. Bruce G. Carruthers & Timothy W. Guinnane & Yoonseok Lee, 2009."Bringing Honest Capital to Poor Borrowers: The Passage of the Uniform Small Loan Law, 1907-1930,"Working Papers 971, Economic Growth Center, Yale University. Carlton, Dennis W., and Jeffrey M. Perloff. Modern Industrial Organization. Boston: Pearson/Addison Wesley, 2005. Print. Creditcards.com. "How a Supreme Court Ruling Killed Off Usury Laws for Credit Card Rates." Fox Business. Fox News, 12 Nov. 2010. Web. 30 Mar. 2013. Martin, Mitchell. "Citicorp and Travelers Plan to Merge in Record $70 Billion Deal: A New No. 1:Financial Giants Unite." The New York Times. N.p., 7 Apr. 1998. Web. Philip E. Strahan, 2002."The Real Effects of U.S. Banking Deregulation, "Center for Financial Institutions Working Papers 02-39, Wharton School Center for Financial Institutions, University of Pennsylvania. Sherman, M., 2009. A short history of financial deregulation in the United States, CEPR Report, July. Stephen A. Rhoades, 1996."Bank mergers and industrywide structure," Staff Studies 169, Board of Governors of the Federal Reserve System (U.S.). Van, Hoose David. The Industrial Organization of Banking Bank Behavior, Market Structure, and Regulation. Berlin: Springer, 2010. Print. Borio, Claudio. BIS Quarterly (2013): n. pag. A141 Http://www.bis.org/publ/qtrpdf/r_qt1303.pdf. Web. 1 Apr. 2013.

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VIII. Figures and Tables

Figure 1: Deregulated States Over Time

12 10 Number of States 8 6 4 2 0

Intrastate Banking Via M&A Unrestricted Intrastate Branching Permitted Interstate Banking Permitted

Figure 2: Deregulated States Over Time, Cumulative

50 45 40 Number of States 35 30 25 20 15 10 5 0 Intrastate Banking Via M&A Unrestricted Intrastate Branching Permitted Interstate Banking Permitted

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Figure 3: Mergers Increase as Charters Decline

700 600 500 400 300 200 100 0 190 350 446 Number of Mergers Number of New Charters Granted 649

Figure 4: Average Size of M&A Activity Increased

16,000 Acquiring Bank, Average Assets 1987 USD, Millions 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 400 Target Bank, Average Assets 1987 USD, Millions 350 300 250 200 150 100 50 0

Acquiring Banks

Target Banks

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Figure 5: Market Share, 2009

JPMorgan Chase Bank of America 31.54% 31.19% Citibank HSBC USA 8.47% 3.98% 3.61% 3.67% 5.05% 4.26% 4.84% 7.37% Wachovia Bank of New York Mellon Capital One TD Bank Goldman Sachs Other Banks

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Table of Values for Figure 1 Intrastate Unrestricte Banking d Intrastate Via M&A Branching Permitted <1970 11 11 1970 1 1 1971 0 0 1972 0 0 1973 0 0 1974 0 0 1975 1 1 1976 1 1 1977 1 0 1978 1 0 1979 1 0 1980 1 0 1981 2 1 1982 1 0 1983 1 0 1984 1 1 1985 4 2 1986 2 1 1987 5 3 1988 6 5 1989 1 2 1990 4 6 1991 2 2 1992 0 0 1993 1 1 1994 1 0 1995 0 0 1996 0 0 >1996 1 12

Interstate Banking Permitted 0 0 0 0 0 0 0 0 0 1 0 0 0 2 2 3 9 10 9 6 2 1 2 1 1 0 0 0 1

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Table of Values for Figure 2 Intrastate Unrestricted Interstate Banking Intrastate Banking Via M&A Branching Permitted Permitted <1970 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 >1996 11 12 12 12 12 12 13 14 15 16 17 18 20 21 22 23 27 29 34 40 41 45 47 47 48 49 49 49 50 11 12 12 12 12 12 13 14 14 14 14 14 15 15 15 16 18 19 22 27 29 35 37 37 38 38 38 38 50 0 0 0 0 0 0 0 0 0 1 1 1 1 3 5 8 17 27 36 42 44 45 47 48 49 49 49 49 50

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Table of Values for Figure 3 Number of Number Mergers Charters Year Approved Granted 190 205 1980 359 199 1981 420 317 1982 428 361 1983 441 391 1984 475 330 1985 573 257 1986 649 219 1987 468 229 1988 350 192 1989 366 165 1990 345 92 1991 401 72 1992 436 59 1993 446 49 1994 Table of Values for Figure 4 Target Acquiring Banks Banks 1980 75 2,431 1981 120 2,873 1982 116 3,072 1983 134 2,272 1984 174 3,408 1985 150 2,464 1986 170 3,997 1987 192 14,036 1988 180 5,733 1989 114 3,160 1990 106 3,380 1991 369 8,296 1992 341 8,644 1993 191 7,504 1994 199 6,534

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Table of Values for Figure 5 Bank JPMorgan Chase Bank of America Citibank HSBC USA Wachovia Bank of New York Mellon Capital One TD Bank Goldman Sachs Other Banks Market Share 31.19% 8.47% 7.37% 4.84% 4.26% 5.05% 3.67% 3.61% 3.98% 31.54%

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