Bank History and Regulation

1. Bank History and Regulation

2. Economics • Adam Smith and the “Invisible hand” • As individuals pursue their self interest, they promote the well-being of everyone. • 19th century example: British making loans to build railroads in U.S. • What problems might prevent the invisible hand from operating? (market failure) • Role of Intermediaries • Role of government

3. Adverse Selection: Akerlof (1970) • Adverse Selection: poor quality products are attracted to markets • Buyers are willing to pay • $15,000 for good used car • $ 7,500 for a “lemon” • Many Sellers • 50% good cars: willing to take $12,500 • 50% bad cars: willing to take $7,500

4. Adverse Selection • Buyers have no information about car quality – 50/50 proposition • On average, expect to get a car worth 0.50(7,500)+0.50(15,000) = $11,250 • Buyers will not pay more than $11,250 for any car. • Good cars exit market • All bad cars sold for $7,500 • Good sellers can’t credibly claim to be “good” • Market Failure

5. Adverse Selection • Adverse Selection in Financial Markets • Firms needing capital • Solution • Create more information • Disclosure requirements (regulation) • Use financial intermediaries who can monitor • Restrictions on entry • Disclosure requirements

6. Moral Hazard • Moral hazard: Incentives change after transaction takes place. • When insured, take more risks • Once financed, tendency to slack • Example: • CEO buys corporate jet with stock issue • Banks invest depositor money in risky ventures

7. Moral Hazard • Solution • financial markets • Align incentives of CEO with shareholders • Use financial intermediaries who can monitor • Regulation on assets and activities (regulation)

8. Other issues • Financial intermediaries also promote the invisible hand by: • Lowering transaction costs • Economies of scale • Promoting risk sharing • Pooling capital • Hedging expertise

9. Ch 10 – History of Banks • Crazy complex system of regulation • Comptroller of the currency • Federal Reserve • State Banking Authorities • When faced with regulation, banks develop methods to avoid costs

10. History of Banks • American’s have distrusted big banks • 19th Century: states issued charters to banks • Raised funds by issuing own currency • No regulation – often failed • 1863 – National Bank Act • Established national banks chartered by federal gov • Heavy tax on bank notes issued by state banks • State banks survived by acquiring funds through deposits • Dual banking system

11. Central Banking • 1913: Federal Reserve System Created • National Banks required to become members of the Federal Reserve System • Central Bank Established • State Banks allowed option to join • Most did not

12. Structure of Banking Industry • McFadden Act of 1927 • No branching across state lines • National Banks had to conform to state regulations and could only branch in their home state • Glass-Steagall Act of 1933 • Separation of I-Banks from Commercial Banks

13. Glass-Steagall Act (1933) • I-banking activities of commercial banks blamed for bank failures during Great Depression • Investment bank: • Raises capital by “underwriting” securities • Advises on merger activities • Research and brokerage services • Security Dealers

14. Glass-Steagall Act (1933) • Separation of I-Banks from Commercial Banks • Commercial Banks • Prohibited from underwriting or dealing in securities • Limited banks to debt securities approved by regulators • Investment Banks • Prohibited from commercial banking activities

15. Erosion of Glass-Steagall • Banks at a competitive disadvantage • Good economy – people invest in securities • Bad economy – people turn to traditional banks • Barriers to “economies of scope” • Financial Innovation: • Brokerage firms develop money market mutual funds. • Pressure from Federal Reserve • Used loopholes in system to allow commercial banks to engage in limited underwriting • Allowed Citicorp and Travelers to merge

16. Gramm-Leach Bliley (1999) • Allows I-banks to purchase commercial banks • Allows commercial banks to underwrite insurance and securities.

17. Erosion of McFadden Act • Bank Holding Companies • Holding company can own banks across state lines • ATM’s owned by someone other than the banks. • Mcfadden repealed by Riegle-Neal act of 1994 • Has led to consolidation trend

18. Decline of Traditional Banking • Traditional Banking • Make long-term loans • Fund them by making short-term deposits • Greater Competition for Deposits • Regulation Q • Maximum interest paid on deposits about 5% • Can’t pay interest on checking accounts • Rise in inflation in 1960’s: higher rates • Money Market Mutual Funds

19. Decline of Traditional Banking • Greater Competition for Assets • Junk Bonds • Commercial paper • Securitization • Bank’s responses: • Pursue riskier activities • Pursue off-balance sheet activities • Loan sales • Fee’s for services: fx trades, loan commitments, banker’s acceptances

20. Ch 11 – Bank Regulation • Banks solve some asymmetric info problems • but create others – depositors need to monitor and evaluate banks • Regulation deals with asymmetric info problems • But creates others – provide insurance and perform other activities that may promote moral hazard

21. Government Safety net • Free rider problem faced by depositors • Adverse selection and bank panics • 1819, 1937, 1857, 1873, 1884, 1893, 1907, 1930-1933 • Deposit Insurance: FDIC insurance • Moral Hazard – depositors have no incentive to monitor • “Too Big to Fail”

22. Restrictions on Bank Asset Ownership • Commercial Banks: • High quality corporate bonds are allowed but subject to restrictions • Common stock investment is allowed in subsidiaries of banks or bank holding companies that are legally separate entities • Gramm-Leach-Bliley (1999) • Except in rare instances, banks restrict themselves to “investment-grade” securities (high rated bonds) • “prudent man” rule of law: The fiduciary is required to invest trust assets as a "prudent man" would invest his own property

23. Other Regulations • Capital requirements • Basel Accord: banks must hold at least 8% of “risk-weighted” assets and off-balance sheet items. • Bank Supervision • Supervision of Risk Management • Disclosure Requirements

24. How Good Are the Regulators? • Burst of Financial innovation in 1960’s and 1970’s • Banks have incentive to engage in riskier activities – further fueled by deposit insurance. • New legislation in early 1980’s: • S&L’s and Mutual Savings allowed • 40% of assets in commercial real estate loans • 30% in consumer lending • 10% in commercial loans and leases • 10% in “direct investments”: junk bonds, common stock, etc. • FDIC up from $40k to $100k • Phased out Regulation Q

25. How Good Are the Regulators? • S&L’s regulated by Federal Savings and Loan Incorporation (FSLIC) which lacked the expertise to monitor effectively. • Rising rates further increased moral hazard. • S&L’s bread and butter was fixed-rate mortgages. • Regulators refrained from closing insolvent S&L’s • Further increased moral hazard • Bank Failures increased dramatically

26. How Good Are the Regulators? • Financial Institutions Reform, Recovery, and Enforcement Act of 1989 • Rearranged how banks are regulated • Infusion of capital to bailout insolvent institutions • New restrictions on asset holdings of S&L’s • Increased capital requirements • FDIC Improvement Act of 1991 • Increased FDIC’s ability to borrow from treasury • FDCI charge higher deposit insurance premiums