bond market.Despitepredictions of the demise of the junkBefore1980,twoU.S.banks,Citicorp and BankAmericabond market after the Michael Milken embarrassment, it isCorporation,werethelargest banks in theworld.Intheclear that the junk bond market is here to stay. Although1990s,neither ofthese banksranks amongthetop twenty.sales of new junk bonds slid to $2.9 billion by 1990, theyAlthough some of this loss in market share may be due toreboundedtoS16.9billionin1991,S42billionin1992,the depreciation of the dollar, most of it is not.and $60 billion in 1993.Similarforces are working to undermine the tradiThe ability to securitize assets has made nonbanktional role of banks in other countries. The U.S. banks arefinancial institutions evenmoreformidable competitors fornot alone in losing their monopoly power over depositors.banks. Advances in information and data processing tech-Financial innovation and deregulation are occurring world-nology have enabled nonbank competitors to originatewideand have created attractive alternatives forboth deposloans,transformtheseintomarketablesecurities,and sellitors and borrowers.In Japan,for example, deregulation hasthem to obtain more funding with which to make moreopened a wide array of new financial instruments to theloans.Computer technology has eroded the competitivepublic, causing a disintermediation process similar to theone that has taken place in the United States.In Europeancountries, innovations have steadily eroded the barriers thathave traditionally protected banks from competition.U.S. banks are not alone in losing theirInothercountries,bankshavealsofacedincreasedmonopoly power over depositors. Financialcompetition from the expansion of securities markets.Both financial deregulation and fundamental economicinnovation and deregulation are occurringforces abroad have improved the availability of informationworldwide.in securities markets,making it easier and less costly forbusiness firms to finance their activities by issuing securi-ties rather than going to banks. Further, even in countriesadvantage of banks by lowering transactions costs andwhere securities markets have not grown, banks have stillenabling nonbank financial institutions to evaluate creditlost loan business because their best corporate customersrisk efficiently throughthe use of statistical methodshave had increasing access to foreign and offshore capitalWhen credit risk can be evaluated using statistical tech-markets such as the Eurobond market.In smaller econo-niques, as in the case of consumer and mortgage lending,mies, such as Australia, which still do not have well-banks no longer have an advantage in making loans.4 Andeveloped corporate bond or commercial paper markets.effort is being made in the United States to develop a mar-banks have lost loan business to international securitiesket for securitized small business loans as well.markets.In addition,the sameforces that drove the securi-U.S. banks have also been beset by increased for-tization process in the United States are at work in othereigncompetition,particularlyfromJapaneseandEuropeancountriesand will undercuttheprofitabilityof traditionalbanks.The success of the Japanese economy and Japan'sbanking there. Thus, although the decline of traditionalhigh savings rate gave Japanese banks access to cheaperbanking has occurred earlier in the United States than infundsthan wereavailableto American banks.This costother countries,we can expect a diminishedrolefor tradi-advantagepermitted Japanese banks to seek out loan busi-tional banking in these countries as well.ness in the United States more aggressively, eroding U.S.banksmarket share. In addition, banks from all majorHOWHAVEBANKSRESPONDED?countries followed their corporate customers to the UnitedIn any industry, a decline in profitability usually results inStates and often enjoyed a competitive advantage becauseexit from the industry (often by widespread bankruptcies)and a shrinkage of market share. This occurred in theof less burdensome regulation in their own countries.32FRBNYECONOMIC POLICY REVIEW/JULY1995
32 FRBNY ECONOMIC POLICY REVIEW / JULY 1995 bond market. Despite predictions of the demise of the junk bond market after the Michael Milken embarrassment, it is clear that the junk bond market is here to stay. Although sales of new junk bonds slid to $2.9 billion by 1990, they rebounded to $16.9 billion in 1991, $42 billion in 1992, and $60 billion in 1993. The ability to securitize assets has made nonbank financial institutions even more formidable competitors for banks. Advances in information and data processing technology have enabled nonbank competitors to originate loans, transform these into marketable securities, and sell them to obtain more funding with which to make more loans. Computer technology has eroded the competitive advantage of banks by lowering transactions costs and enabling nonbank financial institutions to evaluate credit risk efficiently through the use of statistical methods. When credit risk can be evaluated using statistical techniques, as in the case of consumer and mortgage lending, banks no longer have an advantage in making loans.4 An effort is being made in the United States to develop a market for securitized small business loans as well. U.S. banks have also been beset by increased foreign competition, particularly from Japanese and European banks. The success of the Japanese economy and Japan’s high savings rate gave Japanese banks access to cheaper funds than were available to American banks. This cost advantage permitted Japanese banks to seek out loan business in the United States more aggressively, eroding U.S. banks’ market share. In addition, banks from all major countries followed their corporate customers to the United States and often enjoyed a competitive advantage because of less burdensome regulation in their own countries. Before 1980, two U.S. banks, Citicorp and BankAmerica Corporation, were the largest banks in the world. In the 1990s, neither of these banks ranks among the top twenty. Although some of this loss in market share may be due to the depreciation of the dollar, most of it is not. Similar forces are working to undermine the traditional role of banks in other countries. The U.S. banks are not alone in losing their monopoly power over depositors. Financial innovation and deregulation are occurring worldwide and have created attractive alternatives for both depositors and borrowers. In Japan, for example, deregulation has opened a wide array of new financial instruments to the public, causing a disintermediation process similar to the one that has taken place in the United States. In European countries, innovations have steadily eroded the barriers that have traditionally protected banks from competition. In other countries, banks have also faced increased competition from the expansion of securities markets. Both financial deregulation and fundamental economic forces abroad have improved the availability of information in securities markets, making it easier and less costly for business firms to finance their activities by issuing securities rather than going to banks. Further, even in countries where securities markets have not grown, banks have still lost loan business because their best corporate customers have had increasing access to foreign and offshore capital markets such as the Eurobond market. In smaller economies, such as Australia, which still do not have welldeveloped corporate bond or commercial paper markets, banks have lost loan business to international securities markets. In addition, the same forces that drove the securitization process in the United States are at work in other countries and will undercut the profitability of traditional banking there. Thus, although the decline of traditional banking has occurred earlier in the United States than in other countries, we can expect a diminished role for traditional banking in these countries as well. HOW HAVE BANKS RESPONDED? In any industry, a decline in profitability usually results in exit from the industry (often by widespread bankruptcies) and a shrinkage of market share. This occurred in the U.S. banks are not alone in losing their monopoly power over depositors. Financial innovation and deregulation are occurring worldwide
banking industry in the United States during the 1980sChart8through consolidations and bank failures.From 1960 toCommercial Real Estate Loans as a Percentage of TotalCommercialBankAssets1980, bank failures in the United States averaged less than1960-94Percent12To survive and maintain adequate profit levels10many U.s. banks are facing two alternatives.8First, they can attempt to maintain their6traditional lending activity by expanding intonew, riskier areas of lending. .. [Second, theycan pursue new,off-balance-sheet activitiesn2 657075808590941960that are more profitable.Sources: Board of Governors of the Federal Reserve System, Federal ReerveBulletin and Flow of Funds Accounts.ten per year, but during the 1980s, bank failures soared, ris-estate loans, traditionally a riskier type of loan (Chart 8).Ining to more than 200 a year in the late 1980s (Chart 7).addition, they have increased lending for corporate take-To survive and maintain adequate profit levels,oversandleveragedbuyouts,whicharehighlyleveragedmany U.S. banks are facing two alternatives. First, they cantransactions.Thereisevidencethat bankshaveinfactattempt to maintain their traditional lending activity byincreased their lending to less creditworthy borrowers.expanding into new,riskier areas of lending.For example,During the 1980s, banks loan loss provisions relative toU.S. banks have increased their risk taking by placing aassets climbed substantially, reaching a peak of 1.25 per-greater percentage of their total funds in commercial realChart9Chart 7Loan Loss Provisions Relative to AssetsBankFailuresforCommercialBanks1960-941960-94NumberPercent2501.52001.01501000.5500 LOL1196065707580S949019608707580859094Sources: Federal Deposit Insurance Corporation, 1993 Ammual Report andSources: Federal Deposit Insurance Corporation, Statistics on Banking andQuarterly Banking ProfileQuarterly Banking Profile33FRBNYECONOMICPOLICYREVIEW/JULY1995
FRBNY ECONOMIC POLICY REVIEW / JULY 1995 33 banking industry in the United States during the l980s through consolidations and bank failures. From 1960 to 1980, bank failures in the United States averaged less than ten per year, but during the l980s, bank failures soared, rising to more than 200 a year in the late l980s (Chart 7). To survive and maintain adequate profit levels, many U.S. banks are facing two alternatives. First, they can attempt to maintain their traditional lending activity by expanding into new, riskier areas of lending. For example, U.S. banks have increased their risk taking by placing a greater percentage of their total funds in commercial real estate loans, traditionally a riskier type of loan (Chart 8). In addition, they have increased lending for corporate takeovers and leveraged buyouts, which are highly leveraged transactions. There is evidence that banks have in fact increased their lending to less creditworthy borrowers. During the l980s, banks’ loan loss provisions relative to assets climbed substantially, reaching a peak of 1.25 perTo survive and maintain adequate profit levels, many U.S. banks are facing two alternatives. First, they can attempt to maintain their traditional lending activity by expanding into new, riskier areas of lending. . . . [Second, they can] pursue new, off-balance-sheet activities that are more profitable. Chart 7 Number 1960 65 70 75 80 85 90 94 0 50 100 150 200 250 Bank Failures 1960-94 Sources: Federal Deposit Insurance Corporation, 1993 Annual Report and Quarterly Banking Profile. Chart 8 Percent Sources: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin and Flow of Funds Accounts. Commercial Real Estate Loans as a Percentage of Total Commercial Bank Assets 1960-94 1960 65 70 75 80 85 90 94 2 4 6 8 10 12 Chart 9 Percent 1960 65 70 75 80 85 90 94 0 0.5 1.0 1.5 Loan Loss Provisions Relative to Assets for Commercial Banks 1960-94 Sources: Federal Deposit Insurance Corporation, Statistics on Banking and Quarterly Banking Profile