Chapter 12

Banking Industry:
Structure and
Competition
 Overview of banking industry
• The operations of individual banks (how they acquire, use, and manage funds to
make a profit) are roughly similar throughout the world.

• In all countries, banks are financial intermediaries in the business of earning profits.

• The structure and operation of the banking industry differs worldwide. In most
countries, four or five large banks typically dominate the banking industry, but in
the United States there are on the order of 8,000 commercial banks

• The chapter gives an overview shows how financial innovation has increased the
competitive environment for the banking industry

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 Financial Innovation in a changing environment
• The financial industry is in business to earn profits by
selling its products.
High and
• If a soap company perceives that there is a need in the High interest
unpredictable
rate
marketplace for a laundry detergent with fabric softener, inflation

it develops a product to fit the need.

• Similarly, to maximize their profits, financial institutions Financial
environment
develop new products to satisfy their own needs as well
as those of their customers.
• Financial innovation is driven by the Changes in
Advances in
information
desire to earn profits regulations
technology
• A change in the financial environment will stimulate a
search by financial institutions for innovations that are
likely to be profitable.
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 Financial Innovation in a changing environment

• Due to these changes in financial environment, Many financial intermediaries found

that they were no longer able to acquire funds with their traditional financial
instruments, and without these funds they would soon be out of business.
• financial engineering: the process in which financial institutions had to research and
develop new products and services that would meet customer needs and stay
profitable.

• Reasons behind financial innovation:

1. responses to changes in demand conditions,
2. responses to changes in supply conditions, and
3. avoidance of regulations

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 1. Responses to Changes in Demand Conditions:
Interest Rate Volatility
• The most significant change in the economic environment that altered the demand for
financial products in recent years has been the dramatic increase in the volatility (variance
or uncertainty) of interest rate.
• Interest rate risk: uncertainty about interest-rate movements and returns
• In the 1950s, the interest rate on three-month Treasury bills fluctuated between 1.0% and
3.5%
• In the 1970s, it fluctuated between 4.0% and 11.5%;
• In the 1980s, it ranged from 5% to over 15%.
• Large fluctuations in interest rates lead to substantial capital gains or losses and greater
uncertainty about returns on investments
• Thus, increase in interest-rate risk increases the demand for financial products and services
that could reduce that risk
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 1. Responses to Changes in Demand Conditions:
Interest Rate Volatility
Adjustable-rate mortgages:
• Banks would not want to make a mortgage loan at a 10% interest rate and two months
later find that they could obtain 12% in interest on the same mortgage.
• Adjustable-rate Mortgage : they are Mortgage loans on which the interest rate
changes when a market interest rate (usually the Treasury bill rate) changes.
➢ Lower initial interest rates make them attractive to home buyers
➢ Flexible interest rates keep profits high when rates rise

• However, because the mortgage payment on a variable-rate mortgage can increase, many
households continue to prefer fixed-rate mortgages

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 2. Responses to Changes in Supply Conditions:
Information Technology
• The most important source of the changes in supply conditions that stimulate financial
innovation has been the improvement in computer and telecommunications technology.
• Information technology lowered the cost of processing financial transactions, making it
profitable for financial institutions to create new financial products and services for the
public such as:
• Bank credit and debit cards
• credit cards, money is lent from the issuer (the bank) and it
is subject to credit limits set by the issuer.
➢ It must be used by the authorized person.
➢ The issuer owns the available funds in the card
• A firm issuing credit cards earns income from loans it makes to
credit card holders and from payments made by stores on credit
card purchases.
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 2. Responses to Changes in Supply Conditions:
Information Technology
• A credit card program’s costs arise from loan defaults, stolen
cards, and the expense involved in processing credit card
transactions.
• improved computer technology, which lowered the
transaction costs for providing credit card services, made it
more likely that bank credit card programs would be
profitable
Debit card: it enable consumers to purchase goods and
services by electronically transferring funds directly from their
bank accounts to a merchant’s account.
➢ It must be used by the authorized person.
➢ The cardholder owns the available funds in the card
➢ It may be issued on a current account or on a salary account.

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 2. Responses to Changes in Supply Conditions:
3- Evolution
Information Technology
of the Payments
System
• Electronic banking
The wonders of modern computer technology have also enabled banks to lower the cost of
bank transactions by having the customer interact with an electronic banking (e-banking)
facility rather than with a human being
1- automated teller machine (ATM), an electronic machine that allows customers to get
cash, make deposits, transfer funds from one account to another, and check balances.
2- home banking: cost-effective for banks to set up an electronic banking facility in which
the bank’s customer is linked up with the bank’s computer to carry out transactions by
using either a telephone or a personal computer.
3- virtual bank: bank that has no physical location but rather exists only in cyberspace
1995, Security First Network Bank, based in Atlanta but now owned by Royal Bank of
Canada, became the first virtual bank, planning to offer an array of banking services on the
Internet
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Faculty of Economics and Business Administration