The Banking System: Non-Bank Financial Institutions
ByStephen D. Simpson, CFA
Savings and Loans
Savings and loan associations, also known as S&Ls or thrifts, resemble banks in many respects. Most consumers don't know the differences between commercial banks and S&Ls. By law, savings and loan companies must have 65% or more of their lending in residential mortgages, though other types of lending is allowed.
S&Ls started largely in response to the exclusivity of commercial banks. There was a time when banks would only accept deposits from people of relatively high wealth, with references, and would not lend to ordinary workers. Savings and loans typically offered lower borrowing rates than commercial banks and higher interest rates on deposits; the narrower profit margin was a byproduct of the fact that such S&Ls were privately or mutually owned.
Credit unions are another alternative to regular commercial banks. Credit unions are almost always organized as not-for-profit cooperatives. Like banks and S&Ls, credit unions can be chartered at the federal or state level. Like S&Ls, credit unions typically offer higher rates on deposits and charge lower rates on loans, in comparison to commercial banks.
In exchange for a little added freedom, there is one particular restriction on credit unions; membership is not open to the public, but rather restricted to a particular membership group. In the past, this has meant that employees of certain companies, members of certain churches, and so on, were the only ones allowed to join a credit union. In recent years, though, these restrictions have been eased considerably, very much over the objections of banks.
While there used to be a significant number of independent private banks operating in the United States, the independent dedicated private bank is all but extinct. Private banks are increasingly part of larger commercial banks and international financial institutions. Almost every nationally known bank and financial services firm has a division that caters to wealthy clients.
Private banks target high net-worth individuals and do not encourage, or in many cases accept, people of lesser means opening accounts. Private banks look to provide a host of services beyond simple checking and savings accounts. Wealthy individuals often spend considerable resources sheltering their incomes and assets from the tax collector; tax planning, as well as the creation and sale of tax-minimizing investment projects, is a major service of private banks.
Investment and Merchant Banks
While investment banks may be called "banks," their operations are far different than deposit-gathering commercial banks. Complicating matters further, many major commercial banks bought investment banks, and some investment banks have reorganized themselves as commercial banks, in many cases to make themselves eligible for government-funded bailouts.
Investment banks are principally involved in underwriting debt and equity offerings, trading securities, making markets and providing corporate advisory services. Investment banks are also active counterparties in a variety of derivative transactions. Confusing matters further, some investment banks, including those without true bank subsidiaries, will engage in bank-like activity. It is not uncommon for investment banks to provide bridge loans and stand-by financing commitments for mergers and acquisitions.
Generally speaking, investment banks are subject to less regulation than commercial banks. While investment banks operate under the supervision of regulatory bodies, like the Securities and Exchange Commission, FINRA, and the U.S. Treasury, there are typically fewer restrictions when it comes to maintaining capital ratios or introducing new products.
Merchant banking has changed more than perhaps any other category of banking. Merchant banks used to exist to finance international trade, providing financing, letters of introduction and credit, for ocean-going voyages. Merchant banks then evolved into something more like what private equity is today; very few institutions call themselves "merchant banks" today.
The housing bubble and subsequent credit crisis brought attention to what is commonly called "the shadow banking system." This is a collection of investment banks, hedge funds, insurers and other non-bank financial institutions that replicate some of the activities of regulated banks, but do not operate in the same regulatory environment.
The shadow banking system funneled a great deal of money into the U.S. residential mortgage market during the bubble. Insurance companies would buy mortgage bonds from investment banks, which would then use the proceeds to buy more mortgages, so that they could issue more mortgage bonds. The banks would use the money obtained from selling mortgages, to write still more mortgages.
Many estimates of the size of the shadow banking system suggest that it had grown to match the size of the traditional U.S. banking system by 2008.
Apart from the absence of regulation and reporting requirements, the nature of the operations within the shadow banking system created several problems. Specifically, many of these institutions "borrowed short" to "lend long." In other words, they financed long-term commitments with short-term debt. This left these institutions very vulnerable to increases in short-term rates and when those rates rose, it forced many institutions to rush to liquidate investments and make margin calls. Moreover, as these institutions were not part of the formal banking system, they did not have access to the same emergency funding facilities. (Learn more in The Rise And Fall Of The Shadow Banking System.)
Islamic banks exist to fill the need for financial services that are compliant with Islamic rules concerning interest. Sharia law forbids the charging, or acceptance, of interest or other fees related to borrowing money. In the place of interest, Islamic banks make use of profit sharing arrangements, "safekeeping" agreements, joint ventures, leasing and cost-plus accounting to extend credit in a way that is compliant with Sharia.
As an example, an Islamic bank would not loan money to someone who wished to borrow a house or car. Instead, the bank might buy the asset itself, agree to resell it to the would-be borrower at a higher price and take the payments in installments. In practice, then, it is almost identical to how a regular mortgage or equipment loan works, as most mortgage borrowers pay equal fixed amounts for the duration of the loan, but there is no formal interest involved.
Many Islamic countries have regular banks operating in their borders, but this is nevertheless a growth market. If nothing else, many of these businesses are creative in how they establish workable business models that comply with rules on interest, and so on. Not surprisingly, Iran, Saudi Arabia, Malaysia, and UAE are among the leading nations in terms of assets managed by Islamic financial institutions.
Industrial banks are a special category of financial institution that exists for very specific purposes. Industrial banks are financial institutions owned by non-financial institutions.
As they are able to lend money, industrial banks are often used by their parent companies to facilitate financing for customers. Not all of these banks engage in lending; sometimes companies create industrial banks, simply to improve payment settlement efficiency and to reduce the costs of managing working capital accounts.
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