Working Together to Support Our Economy: The Large and Small Bank Nexus

5 Apr 2019
Read Time 4 mins
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Value of Large Financial Institutions

The U.S. economy is large and highly diversified producing over $20 trillion in output each year.  Banks of all sizes – large and small – work within this large and diversified economic system to efficiently channel credit from savers to borrowers.  Importantly, large banks are key providers of a range of financial services and support important infrastructures that are necessary to ensure the smooth operation of smaller banks.  In this post, we outline just a few of the ways in which large banks support the operations of smaller banks and the overall economy.

Quite naturally, many people associate banks with loans.  It is of course quite true that making loans is the primary business of banks, but banks also hold other assets in addition to loans.  In particular, banks also hold a range of securities in addition to loans.  Banks hold securities as a store of value as they consider future lending opportunities.  Once a new lending opportunity is identified, some securities can be liquidated to fund the loan.  For smaller banks whose lending opportunities may be more tied to the local economy in which they operate, this motivation for holding securities may be relatively more important.  A smaller community bank may, for example, invest some deposits in high quality government or corporate securities while it waits for more profitable lending opportunities to arise in its local market.

Large banks are a primary provider of security market-making and underwriting services that make it possible for smaller banks to efficiently buy and sell these securities to meet their investment and lending needs.

The left-hand panel of Figure 1 shows the dollar amount of securities held by smaller banks with total assets less than $10 billion.  As shown in the chart, smaller banks have held between $500 billion and $650 billion in securities since 2010.  The right-hand panel of Figure 1 shows Forum member participation in underwriting debt and equity securities offerings.  As shown in the figure, Forum members underwrite roughly 75% of these securities in the primary market.  In addition, Forum members also support deep and liquid secondary markets for these securities that make it easier and less costly for smaller banks to use securities as a store of value.  All of this means that large banks provide an important financial service that helps smaller banks efficiently shift some securities holdings to make resources available for lending in their local communities.

Source: FDIC Call Report, available at https://cdr.ffiec.gov/public/, Federal Reserve FR Y-15, available at https://www.ffiec.gov/nicpubweb/nicweb/hcsgreaterthan10b.aspx

 

In addition to helping smaller banks manage their securities holdings, some small banks also issue equity and debt themselves in public markets to augment and strengthen their funding base.  Because Forum members support liquid and vibrant capital markets through their underwriting and market making activities, smaller banks that issue capital market instruments benefit.  In particular, smaller banks issuing debt and equity pay lower fees and can pay lower interest rates and dividend yields when their securities trade in a more liquid and vibrant capital market.  Ultimately, these lower costs translate, in part, into lower fees and costs on the loans they make to customers.

Banks, both large and small, are in the business of assuming and managing risk.  And banks use a variety of strategies to manage risk.  One important strategy involves the use of derivatives, otherwise known as a financial contract whose value is based on the value of a financial asset like a security or market index.  Derivatives are regularly used by small banks to manage interest rate and credit risks.  When used prudently, derivatives allow a bank to reduce its exposure to interest rate and credit risks that then allow it to engage in a higher volume of lending to businesses and households.  The left-hand panel of Figure 2 shows the notional amount of derivatives held by small banks over the past decade.  As can be seen from the chart, small bank derivative use has been rising steadily over the past decade.  Large banks, and Forum members in particular, are key derivative market intermediaries for smaller banks.  As shown in the right-hand panel of Figure 2, among U.S. banking organizations, Forum members account for 92% of total derivative activity among U.S. bank holding companies and provide smaller banks with access to deep and liquid derivative markets to hedge risk.  Accordingly, the liquid, two-way derivative markets maintained by large U.S. banks helps smaller banks manage their risk so they can engage in a greater volume of lending to businesses and households.

Source: FDIC Call Report, available at https://cdr.ffiec.gov/public/, Federal Reserve FR Y-9C, available at https://www.ffiec.gov/nicpubweb/nicweb/hcsgreaterthan10b.aspx

 

The U.S. banking industry is incredibly diverse with over 5,000 banks contributing to the U.S. economy.  Large and small banks successfully operate side by side in this system.  Moreover, while small and large banks certainly compete in some areas, large banks and small banks also work collectively to channel credit to our economy.  In this post, we have provided some specific examples illustrating how large banks, and Forum members in particular, support and maintain important market infrastructures that are important for smaller banks.  Working together as part of a collaborative and cohesive economic system, banks of all sizes contribute to a growing economy.

 

 

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