FRBSF Economic Letter
2001-09; April 6, 2001
What's Different about Banks—Still?
New financial instruments, new information technologies, and a new regulatory
environment have blurred the distinctions between commercial banks and
nonbank financial intermediaries in the U.S. in recent years. Furthermore,
just as many nonbank financial institutions have increased their use of
securitization, commercial banks also have shifted their emphasis from
on-balance sheet to off-balance sheet activities (Boyd and Gertler 1994).
With all these changes in the competitive landscape, it seems appropriate
to revisit a question posed by University of Chicago economist Eugene
Fama (1985): "What's different about banks?" That is, why don't
finance companies, for example, beat out banks for the same business,
since banks face regulatory costs and finance companies do not? Some economists
have addressed the question by examining how specialization in certain
business and consumer loans could allow banks and finance companies to
cater to different clienteles. This specialization results directly from
the different informational advantage each possesses regarding either
the borrower or the collateral backing the loan. The relative value of
this loan-specific information could determine how market shares for business
and consumer loans between banks and finance companies evolve in the future.
This Economic Letter examines Fama's question after looking at
the evolution of finance companies since the early 1960s and the extent
to which they have penetrated the commercial loan market in particular.
This market had traditionally been dominated by the commercial banking
industry and has been less affected than either the real estate or consumer
loan markets by the trend toward securitization.
Trends in finance company and commercial
bank lending
In 1960, finance companies tended to be relatively small—total accounts
receivable were just $25 billion, and their focus was generally on small
consumer (often cash) loans. In the early 1960s, commercial banks competed
aggressively for this business, and from 1960 to 1979, finance companies'
share of total consumer lending fell from 28% to 15%, while depository
institutions' share rose from 48% to 73%. (Nonfinancial businesses, including
retailers and gasoline companies, once dominant players in consumer lending,
have seen their share steadily erode to less than 10% today.) But finance
companies were not languishing. Instead, they were taking advantage of
the rapid growth in the commercial paper market in the late 1960s and
shifting their lending activities away from consumer loans and toward
business lending. By 1975, the volume of business lending by finance companies
exceeded their consumer lending for the first time.
This trend has continued unabated to the present. In 2000, total owned
and managed receivables in the industry surpassed the $1 trillion mark
versus approximately $3.8 trillion in total loans in the U.S. commercial
banking system. However, this activity is highly concentrated: according
to a survey conducted by the Federal Reserve and reported by August, et
al. (1997), of 1,250 finance companies identified, the largest 20 firms
accounted for three-quarters of the total accounts receivable in the industry.
This growth in business lending by finance companies outpaced the growth
in commercial and industrial (C&I) loans at commercial banks. While
the ratio of total assets in the banking system to GDP has held steady
since 1975 (after experiencing a dip in the early 1990s), the share of
total assets in domestically chartered U.S. banks that is allocated to
C&I loans has edged down from nearly 16% to 14.5% today. This decline
was due in part to the surge in commercial lending in foreign bank affiliates
during the 1980s (McCauley and Seth 1992). However, finance companies,
which once played a very minor role in business lending, have now captured
a very significant market share. Today, their volume of non-securitized
business loans is roughly equal to one-half that of domestically chartered
U.S. banks, and perhaps as much as one-third that of the banking industry,
once foreign bank affiliates are included in the count.
How are commercial banks different?
Fama offered the following observation on the uniqueness of banks' commercial
lending activities. Bank loans represent a short-maturity funding source
that requires frequent renewal. Therefore, banks are on the front line
of establishing and continually reevaluating the creditworthiness of firms.
A bank's willingness to lend to a firm is a valuable signal that is readily
observed by the capital markets and by other potential creditors to the
firm, as well as by the firm's clients and suppliers. Fama notes that
it is common practice for many firms to incur the cost of establishing
a line of credit with a bank, even though they may never intend to use
it, in order to ensure that this signal is being sent. Bank loans play
a similar role in establishing the creditworthiness of households. But
why are banks especially well positioned to perform this monitoring activity?
Several of the reasons below focus on the unique ability of a bank to
offer demand deposits.
Black (1975) has argued that a bank can monitor a borrower relatively
cheaply by observing the way the borrower manages its demand deposit accounts—traditionally,
maintaining such an account is common practice for the loan recipient.
In addition, a bank provides other financial services to a corporate client,
such as managing its accounts receivable or managing the risk of a portion
of its asset portfolio. The sum total of these activities, often referred
to as "relationship lending," gives the bank an informational
advantage over finance companies. Bolton and Friexas (2000) point out
that, if the borrower is in financial distress, the bank, as a "relationship
lender" which has superior knowledge of the borrower's future prospects,
may deem the current weakness to be transitory. In this case, the bank
would choose to refinance the firm's debt rather than force the liquidation
of the assets. This aspect of relationship lending is obviously of value
to the firm, and it applies equally well to households.
Others have stressed the importance of the lender having superior knowledge
of the "second best" use of the collateral backing the loans,
which the bank would have to liquidate if early termination of the loan
were required. There are two issues here. First, borrowers know that lenders
who do not have full knowledge of the "second-best" use of the
collateral will be very reluctant to foreclose on a loan. Consequently,
a borrower in difficulty may be able to renegotiate the loan with more
favorable terms than were warranted by the level of default risk when
the loan was originated. To avoid such a renegotiation, banks need a "commitment
mechanism." One commitment mechanism, discussed by Diamond and Rajan
(2001), is the demand deposit contract; it requires the bank to meet withdrawals
on demand. If these withdrawal demands are sufficiently high, the borrower
realizes that the bank must liquidate the assets and sell off the collateral.
This commitment mechanism may be somewhat less credible for finance companies,
since they are unable to issue demand deposits, although a large share
of their funding is from short-term commercial paper.
Second, knowledge of the second-best use of the collateral allows room
for finance companies to compete with banks in commercial lending. As
described below, finance companies may specialize in certain categories
of loans for which they have more information than banks would about the
value of a loan's collateral. This informational advantage could outweigh
the information value of being a relationship lender, thus enabling banks
and finance companies to coexist. The importance of relationship lending
and collateral-specific knowledge also applies to the origination and
monitoring of consumer loans.
How are finance companies different?
Finance companies raise funds primarily by issuing debt instruments in
the credit markets consisting of commercial paper and bonds, with small
percentages raised from bank borrowings and equity. These funds are used
principally to finance consumer loans and business loans and, to a lesser
extent, real estate loans. The focus here is on the on-balance sheet non-securitized
consumer and business loans, which constitute approximately 85% of the
finance companies' aggregate accounts receivable. In recent years, finance
companies have securitized various pools of their assets, thus taking
them off balance sheet.
An examination of the accounts receivable of finance companies reveals
that, indeed, collateral-specific knowledge appears to be an important
determinant of the kind of lending they do. For example, consumer lending
by finance companies is dominated by auto loans and leases, many of which
are originated by finance companies that are captive businesses of the
large auto makers. Similarly, a significant portion of their business
lending is for auto loans and leases, some of which is dealer inventory
financing. However, the majority of business lending is for equipment
loans and leases for which specialized monitoring by finance companies
is feasible. For example, many large firms, such as Caterpillar, operate
their own captive finance company through which business loans are extended
for the purchase or lease of equipment produced by the parent company.
This type of specialization provides expertise in assessing the true market
value of the equipment and thereby reduces the cost to the finance company
of liquidating the assets in the event of default.
The information advantage that accrues from specialized monitoring, which
is often accompanied by collateral-specific knowledge, means that finance
companies can extend higher risk loans than banks can. Consequently, the
overall level of risk inherent in the typical business loan portfolio
of large finance companies exceeds the risk inherent in the business loan
portfolios of large commercial banks (Carey, et al. 1996).
Conclusions
In the early 1960s, finance companies in the United States were predominantly
small firms that specialized in small consumer loans. Since then, these
financial intermediaries have evolved into a $1 trillion industry. Today,
the volume of consumer lending by finance companies amounts to about a
fourth of that by depository institutions; their business lending amounts
to about half of that by domestically chartered U.S banks and perhaps
as much as a third of that by the banking industry, inclusive of foreign
bank affiliates. How these market shares change in the future will depend
largely on whether financial innovation, technological advances in information
processing, and consolidation in the banking industry in the presence
of deregulation reward or mitigate the informational advantages that have
enabled these firms to compete successfully through specialization.
Milton Marquis
Senior Economist, FRBSF, and
Professor of Economics, Florida State University
References
August, James D., Michael R. Grupe, Charles Lucket, and Samuel M. Slowinsky.
1997. "Survey of Finance Companies, 1996." Federal Reserve
Bulletin (July), pp. 543-556.
Black, Fischer. 1975. "Bank Funds Management in an Efficient Market."
Journal of Financial Economics 2, pp. 323-339.
Bolton, Patrick, and Xavier Friexas. 2000. "Equity, Bonds, and Bank
Debt: Capital Structure and Financial Market Equilibrium under Asymmetric
Information." Journal of Political Economy 108, pp. 324-351.
Boyd, John H., and Mark Gertler. 1994. "Are Banks Dead, or are Reports
Greatly Exaggerated?" In The (Declining?) Role of Banking,
Federal Reserve Bank of Chicago, pp. 85-117.
Carey, Mark, Mitch Post, and Steven A. Sharpe. 1998. "Does Corporate
Lending by Banks and Finance Companies Differ? Evidence on Specialization
in Private Debt Contracting." Journal of Finance 53, pp. 845-877.
Diamond, Douglas W., and Raghuram G. Rajan. 2001. "Liquidity Risk,
Liquidity Creation and Financial Fragility: A Theory of Banking."
Journal of Political Economy (forthcoming).
Fama, Eugene. 1985. "What's Different about Banks?" Journal
of Monetary Economics 15, pp. 29-39.
McCauley, Robert N., and Rama Seth. 1992. "Foreign Bank Credit to
U.S. Corporations: The Implications of Offshore Loans." Federal Reserve
Bank of New York Quarterly Review 17 (Spring) pp. 52-65.
Opinions expressed in this newsletter do not necessarily reflect
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or of the Board of Governors of the Federal Reserve System. Editorial
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