Economic Analysis of Banking Regulation

1. Chapter 11 Economic Analysis of Banking Regulation

2. Bank Failure Any indication of insolvency can cause a run on banks causing a healthy bank into insolvency. creating losses for its owners and depositors Depositors cannot tell the good from the bad. problem of asymmetric information. �Contagion effect�

3. An Example of a Bank Run Assume depositors lose confidence in an otherwise healthy bank causing a run of the bank The bank first uses liquid reserves and sells securities to meet depositor demands to withdraw funds The bank is next forced to sell loans at the fire-sale price of $0.50 per $1, the bank pays off half of remaining deposits The bank cannot pay off the remaining deposits and has negative net worth, so the remaining depositors and bank owners both lose. The example shows how a bank run can make a healthy bank insolvent.The example shows how a bank run can make a healthy bank insolvent.

4. Run on a Bank - Example The table contains the specific example of how a run turns a healthy bank into an insolvent bank.The table contains the specific example of how a run turns a healthy bank into an insolvent bank.

5. Cyclical downturns are associated with bank panics (bank runs) The period prior to the Federal Reserve, 1871-1913 Eleven recessions Bank panics during 7 recessions No panics without recessions.

6. The Government Safety Net Lender of Last Resort (Federal Reserve) Deposit Insurance (FDIC)

7. Government Safety Net: Lender of Last Resort Lend to solvent but illiquid banks Does this create a moral hazard? Does the �lender of last� resort encourage banks to take on too much risk?

8. Government Safety Net: Deposit Insurance Does this create a moral hazard? Depositors lose incentive to monitor risk taken by the bank�s managers Do banks have incentive to take on more risk? Before deposit insurance, ratio of assets to bank capital was 4 to 1. After deposit insurance, ratio of assets to bank capital was 13 to 1.

9. FDIC Created in 1934 Eliminate run on banks and prevent bank failure Deposits insured up to $100,000 � now $250,000 through 12/31/2013. 1930 � 1933, 2000 failures per year. 1934 - 1981 fewer than 15 failures per year.

10. What does the FDIC do if bank fails? Payoff method. Purchase and assumption method.

11. 1. Restrictions on Asset Holdings Reduces moral hazard of too much risk taking. For example, Glass - Steagall Act, bank�s can�t hold common stock. Limits on loans to particular borrower or industry. 2. Minimum Bank Capital Requirements Reduces moral hazard: banks have more to lose when have higher capital. Must be >5% to avoid regulatory restrictions. Basel Accord: 8% of risk-weighted assets. Also, higher capital means more collateral for FDIC to grab. How to reduce Moral hazard

12. Minimum Capital Requirement:Basel � I Capital Requirements

13. Capital Requirements for Melvin�s Bank The table illustrates the computation of the minimum equity ratio and Basel capital requirement.The table illustrates the computation of the minimum equity ratio and Basel capital requirement.

14. Capital Requirements for Melvin�s Bank The table illustrates the computation of the minimum equity ratio and Basel capital requirement.The table illustrates the computation of the minimum equity ratio and Basel capital requirement.

15. How to reduce Moral hazard 3. Bank Supervision: Chartering and Examination A. Chartering reduces adverse selection problem of risk takers or crooks owning banks Examination reduces moral hazard by preventing risky activities - Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk

16. Bank Failures in the United States, 1934�2008 Source: www.fdic.gov/bank/historical/bank/index.html.

17. Why a Banking Crisis in 1980s? - Early Stage Loss of �sources of funds� to competition due to financial innovation - Money Market Mutual Funds 2. Loss of �uses of funds� to competition - Commercial Paper and junk bonds (financial innovation in direct finance) 3. Loss of revenues, loss of cost advantages => reduced profits Lack of diversification - no branch banking (geographic) Texas banks concentrated in energy loans (industry) p? =>i ? => cost of funds ? Incentives for greater risk taking - Real estate, corporate takeover Result: Risky loans and bank Failures

18. Why a Banking Crisis in 1980s? Later Stages: Regulatory Forbearance (Regulatory Failure) Insolvent banks should have been closed, but regulators allowed insolvent S&Ls to operate with lowered capital requirements because: Insufficient funds to pay depositors. Sweep problems under rug. Regulator ( FHLBB) cozy with S&Ls Huge increase in moral hazard for zombie �living dead� S&Ls. They have nothing to lose, their incentive is to �gamble for resurrection� Zombies became vampires. Hurt healthy S&Ls by attracting funds away by offering above market rates. Outcome: Huge losses

19. Political Economy of S&L Crisis Explanation: Principal-Agent Problem Politicians influenced by S&L lobbyists rather than public Deny funds to close S&Ls Passed legislation to relax restrictions on S&Ls. S&Ls allowed to expand into commercial real estate, credit cards and even junk bonds and common stock. S&Ls had no experience in these areas � DIDMCA Regulators influenced by politicians and desire to avoid blame A. Loosened capital requirements B. Regulatory forbearance. Insolvent S&Ls and banks allowed to remain in operation.

20. DIDMCA Depository Institutions Deregulation and Monetary Control Act S&L- up to 40% commercial real estate S&L- up to 30% consumer loans and 10% junk bonds and common stock. FDIC deposit insurance increased from $ 40,000 to $100,000 Phased out Regulation Q restrictions on interest rates. This allowed banks to issue large denomination insured CDs 11-20

21. Turning Point: Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989 Resolution Trust Corporation (RTC) created and given funds to close insolvent S&Ls cost of $150 billion, 3% of GDP 25% (750) of S&Ls closed. Capital requirement ? from 3% to 8% Re-regulation: Re-impose pre-1980 asset restrictions

22. Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991

23. Cost of Banking Crises in Other Countries (a)

24. � 2004 Pearson Addison-Wesley. All rights reserved 11-24 Cost of Banking Crises in Other Countries (b)

25. D�j� Vu All Over Again! Banking crises are just history repeating itself. Financial liberalization leads to moral hazard (and bad loans!). Government stands ready to bailout the system. That implicit guarantee is enough to exacerbate the moral hazard problem.