PART 6. THE ROLES OF REGULATION, DEPOSIT INSURANCE, AND ETHICS IN SHAPING BANKING AND THE FINANCIAL-SERVICES INDUSTRY

1. PART 6. THE ROLES OF REGULATION, DEPOSIT INSURANCE, AND ETHICS IN SHAPING BANKING AND THE FINANCIAL-SERVICES INDUSTRY • Chapter 16. Theories, Objectives, and Agencies of Bank Regulation • Chapter 17. Deposit Insurance, Bank Failures, and the Savings-and-Loan Mess • Chapter 18. Ethics in Banking and the Financial-Services Industry Chapter 16

2. Chapter 16. Theories, Objectives, and Agencies of Bank Regulation • Learning Objectives: To understand … • 1. Financial modernization and the Gramm-Leach-Bliley Act of 1999 • The K in TRICK as the symbolic umbrella of bank regulation • Bank regulation in the context of agency theory (principal-agent model) • The layers of competition for regulatory services • Regulation as a tax and an on-going struggle between regulators and regulatees • Good intentions and unintended evils of regulation Chapter 16

3. CHAPTER THEME • Bank regulators try to serve the conflicting objectives of safety and stability on the one hand and efficient banking structure (competition) on the other hand. The U.S. Congress, acting as agent for taxpayer principals, monitors bank regulators (including deposit insurers), who in turn monitor insured depositories. Monitoring and bonding are costly activities. Since regulation acts as a tax, bankers attempt to pass the incidence of it onto their customers. The struggle between regulators and regulatees, which can be described as the "regulatory dialectic", serves to stimulate financial innovation but at the expense of wasting costly resources. Chapter 16

4. An Industry View? • “We believe financial institutions should be operated as if there were no regulators for supervision, no discount window for liquidity, and no deposit insurance for bailouts.” • John G. Medlin, Jr. • Chief Executive Officer (retired) • Wachovia Corporation Chapter 16

5. What Do Bank Regulatorsand Deposit Insurers Do? • They supervise • What? Why? • They provide liquidity • How? When? • They bail out distressed banks • How? Why? Chapter 16

6. FINANCIAL MODERNIZATION AND THE GRAMM-LEACH-BLILEY (GLB) ACT OF 1999 • Purpose of the GLB Act • To enhance competition in the financial-services industry by providing a prudential framework for the affiliation of banks, securities firms, insurance companies, and other financial service providers, and for other purposes. • Table 16-1 (p .555) list the provisions of the GLB Act Chapter 16

7. GLB Act (1999) • Meyer [2001]describes the act as having two broad kinds of provisions: • 1. Specific and explicit standards for becoming a financial holding company (FHC) • 2. Less specific and less explicit standards, with little or no guidance for implementation (e.g., the reasonable holding period for merchant-banking investments) This category involves issues that were more technical and upon which a consensus was more difficult to reach. As a result, as Congress is prone to do, these issues were left to the banking agencies to establish Chapter 16

8. Principal (monitors =>) Taxpayers Lawmakers Regulators Insured banks Agent Lawmakers Regulators Insured banks Borrowers Principal-Agent Relations and Regulatory Discipline Chapter 16

9. Regulatory Versus Market Discipline • Regulatory discipline works through regulatory interference (e.g., the K in TRICK – capital adequacy) • Market discipline works through financial markets in terms of the costs of financial distress and the cost of funds (capital) Chapter 16

10. The Objectives of Bank Regulation • Safety (protection of “small depositors”) • Stability (of the banking/financial system) • Contagion and systemic risk • Structure (competition and efficiency) • IO model • Do these objectives conflict? Chapter 16

11. The Federal Safety Net and Too-Big-To-Fail (TBTF) • Discuss the roles and effects of … • DIDMCA (1980) • Continental Illinois (1984) • FIRREA (1989) • FDICIA (1991) • LTCM (1998) • GLB (1999) Chapter 16

12. Three Layers of Financial-Services Competition • Explicit price • User convenience • User confidence • Modeling the confidence function and the role of government guarantees (an unbooked intangible asset) • How does regulation shapes these functions? Chapter 16

13. The Regulatory Dialectic (Struggle Model) • Thesis • Antithesis • Synthesis • Historical struggles • Interest-rate controls • Geographic restrictions • Product restrictions Chapter 16

14. Regulation Discussion • As a tax • Good intentions and unintended evils • Jurisdictional tangle of federal regulation • The Federal Banking Troika • FDIC • OCC • Fed • Role of SEC Chapter 16

15. Strength-in-Banking Equation • Strength = New powers + Firm supervision • New powers: Innovations driven by TRICK and relaxation of antiquated restrictions • Firm supervision • Regulatory style: FDICIA’s PCA, RBC requirements, compliance with CRA, adequate capital to get new powers, bank examinations • Market style: Market cap, cost of funds, cost of financial distress Chapter 16

16. Large Complex Banking Organizations (LCBOs) and Risk-Focused Supervision • Risk exposure => risk management => supervision by risk • Contrast and compare (Table 16-9, p. 583) • Traditional bank examination • Risk-focused supervision of LCBOs Chapter 16

17. Lessons from the Derivatives Debacles of the mid-1990s • What’s important for prudential supervision (and risk management) is the underlying risk characteristics of financial instruments • Risk must be measured on a portfolio basis rather than instrument by instrument • Importance of internal risk controls (e.g., Bankers Trust and Barings) • Align financial incentives with managerial objectives Chapter 16

18. CHAPTER SUMMARY • Understanding the U.S. federal safety net and how it operates captures the roles of regulation and deposit insurance in the FSI • Key concepts include the principal-agent relations of regulatory discipline, the regulatory dialectic, supervision by risk, contagion (systemic risk), IO model Chapter 16

19. Chapter 16