Chapter 15

1. Chapter 15 The Regulation of Markets and Institutions

2. Key Ideas • Different methods of regulating financial markets • Dual banking system and the regulators who oversee it • Universal banking and its possible benefits and risks

3. Introduction • Financial system is one of most intensely regulated sectors in US economy • Objectives of the regulations are: • To promote competition • To protect individual consumers • To maintain stability of financial system • To facilitate monetary policy

4. Primary Market • Philosophy • Best protection is provide adequate information about securities and investments • Full disclosure broadens participation in financial markets

5. Primary Market Securities Act of 1933 • Requires disclosure of information for newly issued publicly traded securities • Privately held firms are not required to reveal financial information to the public at large, only to the lenders

6. Primary Market Securities Exchange Act of 1934 • Created the Securities and Exchange Commission (SEC) to administer provisions of 1933 Act • Publicly traded security must file registration statement and preliminary prospectus disclosing information about issue

7. Primary Market Securities Exchange Act of 1934 • The prospectus does not state • the interest rate on a bond issue or • price for equity issues • determined in the market when sold • If information is adequate, SEC approves the statement and sale • Approval by the SEC does not imply that it views the new issue as an attractive investment • Approval simply means disclosure of information is adequate

8. Regulation of Secondary Market Securities Exchange Act of 1934 • Extended 1933 Act • Periodic disclosure of relevant financial information • For firms trading in secondary market • 10K Report • Annual financial statement and • Information about a firm’s performance and activity

9. Secondary Market • Securities Exchange Act of 1934 • Prohibits Insider Trading • Prohibit insiders from trading on private information not previously disclosed to public • Corporate officers and major stockholders must report all their transactions of their own firm’s stock

10. Regulation of Commercial Banks Philosophy • Protect individual depositor • Foster a competitive banking system • Ensure safety and soundness of banking system

11. Commercial Banks • Dual banking system • Federal and State banks existing side-by-side • Legislation in 1860 established federally chartered banks • Created Comptroller of the Currency (US Treasury Department) to supervise chartered banks • Imposed a prohibitive tax on issuance of state banknotes • Intent was to drive existing state chartered banks out of business

12. Commercial Banks • Dual banking system • However, state banks survived • Stopped issuing banknotes • Started to accept of demand deposits • State chartered banks are supervised by regulators in their respective state • Federally chartered banks tend to be larger in size, but state banks are more in number

13. Commercial Banks Federal Reserve Act of 1913 • Required national banks to become members of the Fed • State chartered banks had option of being a nonmember • All state banks (including nonmember) currently fall under regulation of the Fed Reserve System

14. Commercial Banks Federal Deposit Insurance Corporation (FDIC) • All member banks of Fed are required to carry FDIC insurance • Members include, • All national and • Some state banks • A majority of state banks (including non members) have opted to participate in FDIC program

15. Commercial Banks Multiple Regulators at Federal level with Overlapping and Conflicting authority. • Federal Reserve System • Comptroller of Currency • FDIC • Some experts suggest that all regulation should be combined in a single agency • However, no legislation exists to unify the structure

16. Commercial Banks Philosophy • Protect Individual Depositors • Maintain Stability of Financial System Strategy of Regulation: • Disclosure is not enough • Physical examination of member banks • Bank examinations are often not public by design

17. Commercial Banks Primary Liabilities: Demand Deposit • Banks must maintain sufficient liquidity to meet demand deposits • It is costly to keep excess reserve or liquid assets • Fear of insolvency may cause a run on the bank causing a system-wide bank panic • Paid on a first-come/first-serve basis • Periodic examination of a bank by regulatory agencies to insure banks are solvent

18. Commercial Banks • Deposit Insurance • FDIC established by Banking Act of 1933 to insure deposits at commercial and mutual savings banks. • Created after a large number of bank failures in the early 1930’s • Objective is to protect small savers • Reduce the incentive for depositors to join a bank run

19. Commercial Banks • Deposit Insurance • Currently insure deposits up to $100,000 for single account • Coverage depends on procedure used by FDIC: • Payoff Method • Bank goes into receivership by FDCI • FDIC pays out funds up to $100,000 • Purchase and Assumption Method • FDIC merges failed bank with a healthy one • Deposits of failed bank are assumed by solvent bank

20. Commercial Banks • Moral Hazard and Deposit Insurance • Existence of FDIC eliminates large-scale bank failure and bank run. • However, it creates a classic moral hazard problem • With FDIC insurance, depositors have little or no incentive to monitor riskiness of their banks. • Without monitoring, bank managers finds it easy to engage in risk shifting

21. Commercial Banks • Moral Hazard and Deposit Insurance • Shareholders and directors of banks have incentive to make their banks riskier at the expense of the FDIC • “Too big to fail” Doctrine • FDIC may extend loans to very large banks in trouble to allow continued operations • This doctrine may unintentionally exacerbate the moral hazard problem • Recently bank failures have increased due to banking deregulation and commercial banking activities have become riskier

22. Regulation of Commercial Banks Risk-Based Capital Requirements • Bank capital acts as a cushion against failure • Banks are required to maintain a capital to assetratio • This ratio measures of bank’s risk exposure • Risk-based capital requirements • Higher capital requirement for banks with risky assets. • With higher risk amount of risk-based asset will go up. • This will cause Capital to Asset ratio to go down. • These requirements are agreed upon by the United States and members of the Bank for International Settlements (BIS)

23. Regulation of Commercial Banks • Prompt Corrective Action (PCA) • Passed as a part of FDIC Improvement Act of 1991 • Established procedures to handle troubled banks • Designed to close banks before FDIC is exposed to excessive losses • Prevent regulatory forbearance • when regulators keep an insolvent institution operating in hopes of “turning it around” • Banks are ranked according to their perceived risk and more restrictions placed on riskier banks • Established a risk-based deposit insurance premium in FDIC • charge insurance premium based on the perceived risk of the bank

24. Regulation of Nondepository • Regulations are designed based on the type of liabilities they issue Pension funds and life insurance companies • Heavily regulated because their liabilities are purchased by small investors and need to protect small investors • Employee Retirement Income Security Act (ERISA)

25. Regulation of Nondepository Employee Retirement Income Security Act (ERISA) • Established the Pension Benefit Guaranty Corporation • Guarantees defined benefits pension plans, subject to a maximum amount • Establishes minimum reporting, disclosure and investment standards

26. Regulation of Nondepository Life Insurance Companies • Regulated at the state level • Impose risk-based capital requirements • Perform periodic audits • Implicit and explicit restrictions on pricing of particular products

27. Regulation of Nondepository Finance companies • Raise funds by issuing debt and equity • Have virtually no regulation beyond the securities laws governing publicly traded securities

28. Regulation of Nondepository Mutual Funds • Regulated by the SEC • Also subject to state regulations • Objective is to protection of individual investors through full disclosure

29. The Glass-Steagall Act • Segregated the banking industry from the rest of the financial services industry • Banks are barred from owning corporate stock and other activities deemed too risky • The Genesis of Glass-Steagall • Prior to 1933, investment banking and commercial banking were conducted under same roof • Following the financial collapse of the 1930s, it was felt that investment banking activities were too risky for banks

30. The Glass-Steagall Act • The Genesis of Glass-Steagall • This combination represented a substantial threat to financial system stability • Although there was little empirical evidence to support this contention, the legislation mandated separation of the two activities

31. The Glass-Steagall Act • The Erosion of Glass-Steagall • Commercial banks exerted pressure on the Federal Reserve and courts to reduce the barriers caused by Glass-Steagall • Bank-holding Companies • Permitted banks to conduct nonbanking activities through subsidiaries • In 1970 Federal Reserve was given power to determine what activities were permissible • Activities had to be closely related to traditional banking • During the 1970s and 80s banks acquired more freedom to engage in nontraditional banking activities

32. The Glass-Steagall Act • The Erosion of Glass-Steagall • In 1989 the Federal Reserve granted five banks the power to underwrite corporate debt through a Section 20 affiliate • Gradually the Federal Reserve granted more and more banks the right to underwrite corporate debt

33. The Glass-Steagall Act The Gramm-Leach-Bliley Act (1999) • Allowed affiliates of financial holding companies to engage in various banking activities and insurance underwriting • Overall responsibility for regulation lies with the Federal Reserve through its role as the “umbrella” regulator • Federal Reserve has power to ensure capital adequacy of holding companies, safety and soundness of their activities

34. The Glass-Steagall Act The Gramm-Leach-Bliley Act (1999) • Individual affiliates of holding companies are subject to regulation by functional supervisors such as the SEC • This regulation framework blends the disclosure-based and inspection-based approaches to regulation

35. The Glass-Steagall Act The Risk of Universal Banking • Risk inherent in securities activities, especially the underwriting business, may affect the stability of the banking system • Losses in securities activities lead to more bank failures and significant losses to FDIC

36. The Glass-Steagall Act The Risk of Universal Banking • Other view: Just because investment banking is riskier than commercial banking, this does not mean that the combination of the two will be riskier

37. Universal Banking The Risk of Universal Banking • The portfolio theory suggests that diversification may reduce risk when commercial banking is combined with investment banking and life insurance activities • Perhaps it is time to let the banks decide for themselves whether universal banking reduces risk