Introduction: Ozsoy and Sayfullin (2006) found from the WordNet that banking is defined as a financial institution that accept deposits and channels the money into lending activities. According to online Oxford dictionary, we found that banking is defined as the business conducted or services offered by a bank. Banking is organized in form of financial institution which offers several financial functions which mainly included depositing and safekeeping, lending financial sources and act as role of payment to each other.
In our assignment, we review the different traditional banking and modern banking. In the traditional banking, it has perform the basic function such as depository institutions, maintain deposits, make loans, and control the checkable deposits portion of the economy’s money. Traditional bank is the original banks which was the original financial intermediaries in offering checking accounts. It also plays an important role in the financial markets to manage the circular flow of the fund. However, there are some limitations on the traditional banking and thus lead to the innovation in modern banking. Traditional banking has a limited accessibility in which people only can conduct business at their brick-and-mortar locations. It makes customers inconvenience in doing their business. It also provides less efficient services to customers because customers can only do their transactions in the bank. Therefore, customers would need to spend more time to complete the transaction by heading to the banks.
In the comparison, modern banking has come out variety of services which fulfill the unsatisfactory in traditional banking. Nowadays, deposits have become an important source of funds for financial institution. Thus, the ways to attract depositing are important for the financial institution in getting funds. So, many strategies has implied such as adjust saving’s interest rate or providing different types of financial instruments to collect funds. In addition, with the technology development, modern banking has brought a great positive impact to the customers. With the development of Automatic Teller Machine (ATM), Credit and Debit Cards, Phone Banking and Online Banking, it able to reduce cost, save time for payment and also increase the competitive advantage in financial service industry.
In conclusion, traditional banking provides the basic functions to public. However, by further improvement, modern banking has brought much of benefits to public which is unreachable in traditional banking.
(A) The changing character of the financial service industry and the role of consolidation
The financial services industry is consolidating around the globe. Consolidation of banks or financial companies may obtain a greater purchasing power as well as reduce the number of competitors in the market, increase economies of scales by eliminating repetitive assets, reduce costs and increase revenues. Mergers and acquisitions (M&As) among financial institutions are occurring at a torrid pace in US, which may also occur at a rapid in the near future Europe and Asia. (Berger et al, 1999). In this case, the consolidation of financial service industry has affected by the factors on the fundamental forces of change. The fundamental forces of change have transformed the structure of financial markets and institution and reflect the intense competition among the financial firms today. The factors are included deregulation and reregulation, financial innovation, securitization, globalization and advanced in technology.
Deregulation and reregulation is one of the important components in the fundamental. The aim of this fundamental is to protect the public’s resources and confidence in the financial system. Deregulation is defined as the process of eliminating the existing regulations on banking activities. On the other hand, it always confused with the reregulation which is the process of implementing new restrictions or modifying existing restrictions on banking activities. Deregulation and reregulation perform the function in address pricing issues, allowable geographic market penetration, and the ability in offer new products and services. One of the examples provided is the pricing regulation. It focused on removing price controls, which include provide the highest possible interest rates to depositors and the rate charge to borrowers. In addition, an act called Gramm-Leach-Bliley Act (GLB) is implemented in year 1999 to remove the barriers among the bank companies.
Financial innovation has also act as catalyst in the evolution of financial service industry and changing the character of financial market. The innovation involve in the process changing of instruments, institution and operating policies. It also considers innovate in new securities and financial market, new products and services, new organizational form and new delivery system. The innovation done by financial institutions may aim to enter a new market, new product market, increase capital base or deliver service in cheaper cost. As an example, the innovation in delivery system in banks has efficiently in fund transfers. During year 1980s, banks have come out with ATMs and POS terminals in all outlets. Besides, the more recent innovation included the development of smart cards, debit cards and home banking network.
Loans have offer high gross yield and classify as a risky assets in a bank when it failed to pay by the borrower. This may affect the liquidity position in a bank. In order to cope with this problem, banks have involved in securitization. Securitization is the process that converting assets into marketable securities. The bank’s assets and loans are combined in pool with same feature and sell pass-through certificates which are secured by the interest and principle payments on the assets itself. The loan securitized included mortgage and credit card receivable. The objective of banks involve in securitization is to eliminate interest risk which associated with financing the underlying assets. Besides, the bank also generates fee income from servicing the loans.
Financial market and institutions nowadays have on the trend of globalization. Globalization is the evolution of financial markets and institution where geographic boundaries do not restrict financial and competition. In other words means that, with the globalization, financial institutions able to conduct their business throughout the world without any restrictions. Globalization allows the flow of funds freely between countries. Thus, a country’s policies may affect the economies of other countries. So, it is important that financial institution need to implement policies in order to go global to prevent the negative impact on economy. For example, the establishment of the European Community (EC) in 1992 which involve six foundation members included Belgium, France, Italy, Luxembourg, Netherland and West Germany with the aim of economic integration.
Lastly, advances in technology also play an important role in changing the character of financial service industry. Technology is essential in financial institution because it brings a big impact on efficiency and productivity. Technology enables a person to handle more people and transactions in same time which indirectly reducing the cost of delivering products and services. With advances in technology, banks can also increase the scope of the global market place and competitive advantage. However, it will also increase the competition between financial institutions in the market due to the advances technology.
In conclusion, the five forces of the fundamental change have brought a large effect on the changing character in financial service industry. These have improved the function and operation of financial institution and bring many benefits to customers. However, the increase in the five forces also may lead to arise of competition.
(B) Merger for the financial service industry
Asian’s financial crisis started in 1997 when ASEAN countries opened up their market to attract the foreign investment. However, this flow cause the asset bubbles burst when their economies were not competitively overtime to sustain the high interest rates to support their fixed exchange rates (Andrew, 2010). United States was seemed to be the initiator for the Asian’s financial crisis (Andrew, 2010). This financial crisis had brought the negative effect to United States and the world. In 1998, a slowdown situation happens in the world economy, which started from South East Asia (Sutthirak and Gonjanar, 2012). Therefore, according to Nanto (1998), stated that The United States Congress is likely to consider the Asian financial crisis within the three major legislative backgrounds. The first is in the financing and scope of the activities of the International Monetary Fund (IMF). The second context is in the influence of the crisis on the United Stated economy and financial service industry. Also, the last context is the efforts for trade and investment liberalization in the world.
In late 1999, Gramm’Leach’Bliley Act (GLB Act) also known as the Financial Services Modernization Act was enacted by the United States Congress which deregulated the financial services industry by expanding the powers of financial institutions (Yeager et al. 2007). U.S. banking industry particularly concern on Merger and acquisition and consolidation of financial institutions. The structure of the U.S. banking industry has changed dramatically since 1980s causes the number of institutions has declined seriously over this period. These regulatory changes have had powerful effects on competition and structure. Due to the existence of Gramm’Leach’Bliley Act of 1999 had approved the formation of financial holding companies, which were allowed to take place in any activity that consists of nature of financial (Yeager et al. 2007). For instance, it allowed financial institution provide additional products and services such as insurance by entering other financial markets and this is the main advantage of the GLB Act. Hence, this has indirectly caused the increase in bank merger. Therefore we found that there are numbers of 226 merged banks with the value of $118 billion in 2004 increased to 242 merged banks with value $19.6 billion in 2005 and further increase to the number of 261 merged banks with value $77.7 billion in 2006.
During the subprime crisis on 2007, financial markets have undergone losses that cause by threat of massive defaults by borrowers in mortgage markets. As a result, many banking industry failed. The subprime lending crisis has been indicated as disturbance in financial markets as banks have experienced difficulty in selling loans and securitizing loans in the syndicated loan market. The supply of liquidity of banks goes up, as well as provision of liquidity in the interbank market. Many banks experienced substantial losses in capital. (Berger, 2013). Failures of bank will be resolved by Federal Deposit Insurance Corporation (FDIC) by merging failed bank with other banks. (Wheelock, 2011). Hundreds of banks failed in the late 1980s and early 1990s. Some of bank were merge through unassisted merger and motivated by the relaxation of legal restrictions in term of bank branching.
Further, evidence indicates that merged banks have lower costs than non-merged banks due to their efficiency. Merged bank are applying most efficient technology available as well as cost minimizing input mix which also known as technical efficiency and allocative efficiency. Mergers may allow the banking industry to take advantage of the opportunities created by improved technology. (Al-SharkasIn, 2008). In 2008, the subprime crisis continues to spilled over and became a broader global financial crisis causes financial markets forced to be merged together. Besides that, recent financial crisis and recession show a great impact which number of commercial banks and savings institution failed has rose up in United States. This causes a decline in the number of merger banks in 2007 onwards which we can see from the table. In 2007, the number of banks merged are 249 out of 1119 with the bank value of $67.9 billion, and it decrease gradually to 119 in 2008 and 101 in 2009 with value of $28.3 billion and $1.0 billion respectively. The rapid decrease in value of bank from $28.3 billion to $1.0 billion have showed that although the bank merged but banks still suffer a huge amount of losses. As in 2010, the slightly increased in the number of merged banks from 101 to 160 which also indicates a slightly rose of value of merged banks from $1.0 billion to $10.3 billion. The increased in number of merged bank causing the value of banks to rose up due to maybe the capital of banks have increased. This increase in the capital of markets will indirectly increase the bank assets.
In addition, merger and consolidation of banks enables banks to perform well and sustain in a competitive banking industry. It assist bank to have more capital, meanwhile can also enhance bank assets and can have a wide variety of financial products and services. However, in 2011, the number of banks has decreased to 123 with the value of $6.8 billion. This slight decreased in number of merged bank has leads to a reduction in value due to some banks have insufficient capital to conduct daily business and decided to close up. The acquisitions of failed banks by in-market competitors during 2007-2010 did not substantially increase concentration in most local banking markets. However, such acquisitions had a substantial impact in a few, mostly rural banking markets.
Despite concerns about consolidation in the financial services industry as a result of the Act, insurance industry shows no changes in consolidation. National and state-chartered banks that are members of the Federal Reserve System was restricted by The Glass-Steagall Act of 1933 from underwriting securities, dealing in securities, and under certain circumstances, holding securities. The purpose of the Glass-Steagall Act was to separate the three financial sectors to reduce what was perceived as excessive risk-taking by financial institutions and, more importantly, to restore public confidence in the overall banking system (Neale, 2005). Although there have been a lot of mergers between large banks and insurance companies, but the evidence on wealth effect that performed by merger of banks and insurance companies are still ambiguous. However, there is some results to recommend that the returns from mergers of insurance are higher than those of banks, but in term of how the risk and return of bank holding company (BHC) been affected during the time expand insurance activities is still ambiguous.
On the other hand, market participants view the channel of the GLB Act as good news for the insurance industry as a whole and the accident and health insurers (A&H) and life sub-combinations specifically (Neale, 2005). In addition, the GLB Act also brings results in reductions in market risk to different types of industries (Neale, 2005). Moreover, the researchers who are Cummins and Xie (2008) had examined the productivity and efficiency effects of mergers and acquisitions (M&As) in the US insurance industry between the period of 1994’2003. Their analysis results show that the M&As transactions lead to a major revenue efficiency obtained for acquirers and allocate efficiency obtained for targets. Therefore, insurance M&As have been value-enhancing these important measures.
Based on the information, insurance companies involve four different segments which are life/health, property, brokers and agents and managed care. In 2004, the value of 313 merged insurance companies was $14.4 billion increase to the value of $49.9 billion under 315 merged insurance companies. The value enhancing may due to the impact of GLB Act. Besides, from the data given, number of merged insurance companies in 2007 is 405 which comprise the sum up for the four segments with a value of $33.7 billion. Due to existence of Glass-Steagall Act causes the increased in the merging of insurance companies in 2008 which is 436 and with value of $28.8 billion. However, in 2009, this number of merged show a great decline from 436 to 318 with the value of $10.7 billion. Due to this decline in value, more insurance companies to be merged up during 2010 and 2011 with the number of 385 and 455 respectively. This has indirectly leads to an increase in value of $32.6 billion and $51.4 billion respectively. This increased in the number of merger are enable to eject more capital and give confident to shareholder wealth. Consolidation by the same time also provides merger in term of profit efficiency and cost efficiency. If more efficient banks take over less efficient banks, it will create efficiency gains. Moreover, because of diseconomies of scale, the combined firms actually performed slightly worse on average after the mergers, although this effect was small and often not statistically significant.
Lastly, the dollar amount of asset that controlled by money market industry has increased. Results of consolidation bring changes in money market which allows them to handle regulation. Due to the consolidation, it allows bank to fully diversify their portfolio such as loan. If loan to be diversified, it can indirectly causes the bank profitability increase and as a result dollar amount of asset control will rose up. As a result, consolidation also improves bank productivity and at the same time improves bank efficiency.
(C) The trend of the dollar amount of assets
Looking into the pie chart consisting of the assets of financial services sector covering from year 2007-2011, we can see that there are changes in the amount among the 6 sectors, which are banking, securities, pensions, government related, insurance, and also others. We can also witness an equal distribution in terms of the changes, with 3 sectors experiencing an increase and another 3 sectors experiencing a decline. Firstly, we focus on the sectors which experience an increase in the dollar amount of assets they control. The banking sector, government related sector, and also the insurance sector have increase the dollar amount of assets. Among them, the banking sector increased the most dollar amount of assets they control throughout these five years. Having assets totaling to 12362.1bilion in 2007, the amount increased to 14635.3 billion in 2011, recording the highest increase.
The second pie chart consists of the assets if financial services sector from 2004-2008. However, the trend this time is different from the first pie chart. All the six sectors in the chart experience increase in their assets for these five years. Since all the sectors have posted an increase in their assets, we will straightly look into the sector that has generated the highest increase among them all. The banking sector has yet again produced the highest gain in assets among those six sectors. The banking sector recorded a total gain of 4880.5 billion USD in the five years. The difference is obtained from the total assets in 2008 and the total assets in 2004. The banking started with the total of 10864.2 billion USD in 2004 and it then increased to 15744.7 billion USD in2008. Meanwhile, other sectors have also recorded an increase, but with far lesser that what the banking sector had achieved.
The third pie chart is pretty much similar to the second one in terms of its trend and also its flow. All the six sectors have yet again projected an increase in their respective assets. The sector which has increased the largest still remains to the banking sector. The sector has increased by 3950.6 billion USD throughout the five years studied. The difference is obtained by comparing the total assets in 2004 (12318.8 billion USD) and total assets in 2008 (16269.4 billion USD). The other sectors also recorded increase, but the amount is lesser than the banking sector.
The last pie chart consists of the percentage of assets owned from year 2006 to 2010. This time there are five sectors experiencing an increase while the remaining one sector is facing a loss. The sector above refers to the ‘other’ sector. The banking sector continues to dominate the other sectors in terms of asset holdings, with a total of 3175.1 billion USD gain in its assets. The difference is derived by comparing the amount in 2006 (13317.1 billion USD) and also in 2010 (16492.2 billion USD). As a result of this, we are keen to study the reasons or factors behind the increase.
One of the main reasons behind this increase is due to the mergers and acquisitions between banks in the banking sector, or in other words consolidations of banks. During the Subprime Crisis that occurred in 2007, many parties have felt the impact, and of course banks are not excluded. Many banks, particularly small-sized banks faced difficulties in maintaining their operations and also their profits. Eventually, this has led to the failure of these banks. However, banks with large capital base seized the opportunity to acquire these banks and increase the size of their bank. Over the period of 2000-2010, U.S banking industry has consistently experience over 150 mergers annually (Adams, 2012). As a result of that, the dynamics of consolidation increase questions about the competition, output, efficiency and financial stability.
By undergoing the process of merge and acquire, this can actually benefit large-sized banks. The effects of it are clear-cut. (Berger et al. 1999) pointed the consequences of mergers and acquisitions, which may lead to changes in efficiency, market power, economies of scale and scope, availability of services to small customers and payments systems efficiency. In the archived tables, the banking sector is broken up into three different categories which are commercial banking, savings institutions and also credit unions. If we were to compare the stability of these three categories, then commercial banking would be the most stable of them all. The reason is because of its large increase compared to credit unions. The evidence can be found through the figures expressed in the table. The savings institutions have suffered losses in their asset earnings whereas the commercial banking and credit unions sector experience an increase in asset earnings every year from 2007-2011.
To understand the situation better, we analyze the table in detail. Starting in 2007, the savings institutions sector started off with 1815.0 billion USD, but the amount started to drop year by year, declining to 1523.5 billion USD in 2008, 1253.7 billion USD in 2009, and lastly dropping to 1244.1 billion USD in 2010, showing a constant decline or loss throughout the years. Next, we will examine in detail the sectors of who have shown a positive note on their asset earnings. Firstly, the credit unions sector has recorded a constant growth with a small margin, starting from 758.7 billion USD in 2007, slowly increasing to 872.4 billion USD in 2008, 882.7 billion USD in 2009 and finally 912.0 billion USD in 2010. After that, we move on to the sector which recorded the highest gain, which is the commercial banking sector. With the total amount of 11191.8 billion USD in 2007, the sector has increased its earnings to 13408.8 billion USD in 2008, 14133.0 billion USD in 2009 and lastly reaching 14336.1 billion USD in 2010.
The increase in the credit unions sector as well as commercial banking sector has caught our attention. Therefore, we are keen to explore the impacts of this increase. Consolidation may influence bank interest rates, competition and transmission mechanism of monetary policy. Besides that, consolidation of banks could also provide an expansion in size as well as the chance for reorganization of management (Saibu, n.d). Moreover the consolidation of banks could also help banks to achieve a higher efficiency due to a greater movement in the scale of activity. The consolidation might also yield a higher financial intermediation and reduce banks to a mere financial investment.
Looking back to the current graph, which is from year 2007-2011, the securities sector, pensions sector and ‘other’ sectors have declined in assets. This is probably due to the Subprime Financial Crisis that happened in 2007 that have badly affected these sectors. Hence, the number of dollar assets they hold decrease and their business is affected. In contrary, this situation has benefited the other three sectors which increased their assets. As an overall, we can see that the financial crisis has different effects on different sectors.
(D) Trend of the percentage of shares based on the volume of assets
In term of market shares based on the firm volume of assets held, there are few sectors that may have effect on the market shares like banking, securities, pensions, government related insurance and other sectors. We study the most recent time period information given in the website (2007-2011) to look at the percentage of which sectors had the most increase or decrease in the number of shares within this period. Based on the pie chart, the sector that increase the most in percentage of market shares are the banking sectors which had increased by 4%.
In year 2007, there was a subprime crisis in US which leads many of them panic and worried about the coming year financial situation and this subprime actually was the major cause of the 2008 financial crisis that lead the most severe recession. The most important factors that cause this subprime happen because of the greed and fraudulent, excessive borrowing and defective financial modeling which based on the assumption of the prices of home will rise. Therefore, subprime crisis lead to a consolidation of many banks because they afraid of the financial crisis that would happened in 2008 will seriously negative affected their bank flow especially those small banks. Many of the small banks tried to scrape together their profit earned during this period of poor loan demand and interest rates so they are willing to be acquired by the large banks. After the merger, there are positive effects on the formation of new business operation due to the integration of large acquisition in the financial local market. According to Francis, Hasan and Haizhi (2007), bank consolidations initiated by large in-market acquires have a significantly positive effect on new business formation in the long-run. Due to the growth of consolidation, it thereby creating a larger bank and this lead the percentage of the banking sector in term of market share based on the volume of assets increase the most in 2007 to 2011.
The sector that decrease the most in the period of 2007-2011 are other sectors which consist of finance companies, real estate investment trusts, asset-backed securities issuers and funding corporations. The reason of this great decrease around 3% in other sectors is mainly due to risk averse. Companies in this other sectors probably are those risk-averse companies so they are unwilling to accept a bargain with high risk although high returns are expected. However, they will choose to invest in a safer place by receiving a lower expected return. Investors in these sectors will then figure out which companies have more positive news and which are facing the more negative news.
Besides, market shares in securities sector like mutual and close-end funds based on the volume of assets held had also decreased by 2% in the period of 2007 to 2011. The decrease in the percentage of market shares in securities sector may probably due to the risk-averse factor too. They dislike risk so they will avoid taking those high risk securities into their portfolio even though those high risk securities may help them earned back a higher rate of return. Therefore, they will probably go for those lower return but safer investment with guaranteed interest rate like government bonds, index funds or bank. Securities sector shares go down may also due to the subprime crisis 2007 because bank or companies will afraid of the securities price will boost up or down unstably due to the market volatility. Investor may lack of confidence to invest in securities sector due to the housing bubble problems that occur when subprime crisis in 2007.
For insurance sector, there are slightly increase of 1% in term of market shares based on the volume of assets in 2007 to 2011. This shows that more and more people would like to buy insurance in life insurance companies or other insurers because they would like to protect themselves from unexpected risk. Many of them believed that insurance will lessen the risk of exposure to specific business impact such as loss or damage of assets, fluctuation or pressure in cash flow and business interruption.
For government-related and pensions sector, there are no changes in the percentages of market shares based on the volume of assets in the period of 2007-2011. This may be due to the government-related and pension sectors are more stable. Therefore, they are hardly affected by the unstable market economic like financial crisis because government will safeguard the financial situation. When 2008 financial crisis happened in US, most of the financial services sectors are affected however for government-related and pensions sector, they still able to maintain their market shares percentage because they are supported by the government.
Based on the other time period of the assets of financial services sectors, banking sector still indicate the higher increase in percentage which are 3% increase in 2004-2008 and 2005-2009, while 2006-2010 a 4% increase in the percentage of market shares. For securities sectors, there are no changes in the period of 2004-2008 and 2005-2009, however, there is a slightly decrease of 1% in the year of 2009 to 2010. For pensions sector, except the comparison from year 2007-2011, the percentage of market shares in others comparison time period 2004-2008, 2005-2009 and 2006-2010 had decreased by 4%, 2% and 1% accordingly. For government-related sector, there are no changes in the period of 2004-2008 but there is a slightly increase of 1% while comparing in the period of 2005-2009 and 2006-2010. For the insurance sector, there is a 1% decrease of market shares in 2004-2008 and 2005-2010 however no changes in the period of 2006-2010. For other sectors, an increase of 2% in 2004-2008 but this shows a decrease of 1% in market shares on the volume of assets when comparing in the period of 2005-2009 and 2006-2010.
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