U.S. Banking Regulation

1. U.S. Banking Regulation

2. I. Objectives of Financial Regulation • Safety and Soundness • To prevent disruptions in the payments system and to avoid a system-wide collapse of financial intermediaries. • Safety and soundness is promoted via • (1) monetary and fiscal policies aimed at stable levels of economic growth and prices, • (2) the development and maintenance of an efficient clearing systems network to ensure a stable payments system, and • (3) supervision of depository intermediaries.

3. I. Objectives of Financial Regulation • Consumer and Investor Protection • Modern financial instruments are complex legal contracts whose risk-return trade-off can easily confuse the average consumer or investor. Regulation can be used to standardize and simplify these contracts. • It can also be used to protect consumers against information asymmetry problems and potentially fraudulent schemes. Examples: • Truth-in-lending and • Insider trading laws

4. I. Objectives of Financial Regulation • Fairness • While unimpeded financial markets are efficient, they may not reflect societal values. Consequently, regulators intervene m markets to obtain a "fairer" allocation of resources. Examples: • The preferential tax treatment given mortgage borrowers and credit unions; • Laws opposed to discriminatory lending practices; • Anti-trust laws.

5. I. Objectives of Financial Regulation • Information Disclosure • To ensure the disclosure of an adequate amount of information so that investors can make educated decisions m their borrowing and lending. • Disclosure rules have two basic objectives: • First, to inform investors, and, • Second, to prevent fraud. Examples of information disclosure regulation is evidenced in the GAAP accounting statements and Call Reports filed by depository intermediaries.

6. II.The Cost of Regulation • Regulation is very expensive to banks: • Estimates of compliance costs in the banking industry alone run in the billions of dollars. • Compliance costs include expenses incurred in preparing financial reports, personnel expenditures due to on-site examinations, and the expenses of training and supervision. • However, indirect compliance costs are the largest component of total compliance costs.

7. III.The Theory of Regulatory Dialectic • The Theory of Regulatory Dialectic: • Regulations changes in response to market demands, but in general lags behind. • A set of regulations was imposed for the purpose of correcting or preventing certain financial problems in the beginning. • They became burdens to financial institutions and financial institutions attempted to circumvent the regulations by innovations, which made regulations ineffective. • Regulations were changed to bring financial institutions back under control.

8. IV. Major Banking Legislations • 1927 The McFadden Act • Subjected branching of nationally chartered banks to the same branching regulations as state-chartered banks. • Liberalizing national banks' securities underwriting activities, which previously had to be conducted through state-chartered affiliates.

9. IV. Major Banking Legislations • 1933 The Banking Acts of 1933 (the Glass-Steagall Act) • Generally prohibited commercial banks from underwriting securities with four exceptions: • Municipal general obligation bonds. • U.S. government bonds. • Private placements. • Real estate loans. • Established the FDIC to insure bank deposits.

10. IV. Major Banking Legislations • 1956 The Bank Holding Company Act • Restricted the banking and nonbanking acquisition activities of multibank holding companies. • Empowered the Federal Reserve to regulate multibank holding companies by • Determining permissible activities. • Exercising supervisory authority. • Exercising chartering authority. • Conducting bank examinations.

11. IV. Major Banking Legislations • 1970 Amendments to the Bank Holding company Act of 1956 • Extended the BHC Act of 1956 to one-bank holding companies. • Restricted permissible BHC activities to those "closely related to banking.

12. IV. Major Banking Legislations • 1978 International Banking Act • Regulated foreign bank branches and agencies in the United States. • Subjected foreign banks to the McFadden and Glass-Steagall Acts. • Gave foreign banks access to Fedwire, the discount window, and deposit insurance.

13. IV. Major Banking Legislations • 1980 Depository Institutions Deregulation and Monetary Control Act (DIDMCA) • Set a six-year phaseout for Regulation Q interest rate ceilings on small time and saving deposits. • Authorized NOW accounts nationwide. • Introduced uniform reserve requirements for state and nationally chartered banks. • Increase the ceiling on deposit insurance coverage from $40,000 to $100,000. • Allowed federally chartered thrifts to make consumer and commercial loans (subject to size restrictions).

14. IV. Major Banking Legislations • 1982 Garn-St. Germain Depository Institutions Act (DIA) • Introduced money market deposit accounts (MMDAs) and super NOW accounts as interest rate-bearing savings accounts with limited check-writing features. • Allowed federally chartered thrifts more extensive lending powers and demand deposit-taking powers. • Allowed sound commercial banks to acquire failed savings banks. • Reaffirmed limitations on banks' ability to underwrite and distribute insurance.

15. IV. Major Banking Legislations • 1987 Competitive Equality in Banking Act (CEBA) • Redefined the definition of bank to limit the growth of nonbank banks. • Sought to recapitalize the Federal Savings and Loan Insurance Corporation (FSLIC).

16. IV. Major Banking Legislations • 1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) • Limited savings banks' investments in nonresidential real estate, required divestiture of junk bond holdings (by 1994), and imposed a restrictive asset test to qualify as a savings bank (the qualified thrift lender test, or QTL). • Equalized the capital requirements of thrifts and banks. • Replaced FSLIC with FDIC-SAIF. • Replaced the Federal Home Loan Bank Board as the charterer of federal savings and loans with the Office of thrift Supervision (OTS), and agency of the Treasury. • Created the Resolution Trust Corporation (RTC) to resolve failed and failing savings banks.

17. IV. Major Banking Legislations • 1991 The Federal Deposit Insurance Corporation Improvement Act (The FDICIA Act) • Introduced prompt corrective action (PCA), requiring mandatory interventions by regulators whenever a bank's capital falls. • Introduced risk-based deposit insurance premiums beginning in 1993. • Limited the use of "too big to fail" bailouts by federal regulators for large banks. • Extended federal regulation over foreign bank branches and agencies in the Foreign Bank Supervision and Enhancement Act.

18. IV. Major Banking Legislations • 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act • Permitted bank holding companies to acquire banks in other states, starting September 1995. • Invalidated the laws of states that allow interstate banking only on a regional or reciprocal basis. • Beginning June 1997, permitted bank holding companies to convert out-of-state subsidiary banks into branches of a single interstate bank. • Also permitted newly chartered branches within a state if state law allows.

19. IV. Major Banking Legislations • 1999 Financial Services Modernization Act • Eliminated restrictions on banks, insurance companies, and securities firms entering into each others' areas of business. • Provided for state regulation of insurance. • Streamlines bank holding company supervision, with the Federal Reserve as the umbrella holding company supervisor. • Prohibited FDIC assistance to affiliates and subsidiaries of banks and thrifts. • Provided for national treatment of foreign banks engaging in activities authorized under the Act.

20. V. Bank Safety Regulation • 1. Federal Deposit Insurance • Had effectively stopped widespread bank failures caused by panic withdrawals of depositors. What are the problems on the system? • 2. Deposit Rate Ceilings: • Why ceilings on deposit rates were imposed? • Did excessively high interest rates on deposit accounts really cause bank failures? • DIDMCA of 1980 phased out the ceilings.

21. V. Bank Safety Regulation • 3. Bank Examinations • To determine the soundness and prudence of the bank management. But bank examinations also serve as a controlling device in checking banks' risk taking. •   4. Balance Sheet Restrictions: • Adequate capital requirements • Maximum amount of loan extended to one individual borrowers and to each type of loans • Investment in corporate or municipal securities of "investment grade quality" • Minimum reserve requirements

22. V. Bank Safety Regulation • 5. Prohibition on Owning Equity Securities • Owning equity securities is too risky and losses on them could precipitate bank failures • To prevent the potential conflicts arising from combing the ownership and creditor functions of banks.

23. V. Bank Safety Regulation • 6. Separation of Commercial Banking and Investment Banking • The 1933 Glass-Steagall Act imposed rigid separation between commercial banking and investment banking with three exemptions: • The underwriting of new issues of Treasury securities. • The underwriting of municipal general obligations bonds. • The private placements of corporate debt and equity securities. • Investment banking was considered to be inherently too risky for commercial banks. But is this true?

24. VI. Bank Structure Regulation • 1. Limited Entry • Charters from either the federal or the state government • Criteria for granting charter: • 1. demonstrate a need for their services by the community • 2. would not endanger the solvency of other banks in the area • 3. earning prospects • 4. banking experience and reputation of the applicants

25. VI. Bank Structure Regulation • 2. Restrictions on Branching • To be classified as a branch, a banking office must accept deposits as well as making loans. • State laws govern the degree of branching allowed. Three modes are followed: unit banking, limited branching, and statewide branching. • In deciding for branching, regulators consider whether: • (1). there is a need for a new banking office in the area • (2). it will not impair local bank competition

26. VI. Bank Structure Regulation • 2. Restrictions on Branching • Issues involved in branching legislation: • 1. would branching increase the degree of concentration? • 2. Would branching reduce competition? • 3. would branching shift out funds from local community? • 4. would branching improve price and availability of banking services? • 5. Would branching endanger the soundness of banks?

27. VI. Bank Structure Regulation • 3. Bank Mergers: • The Bank Merger Act of 1960 gives federal regulators authority power to approve bank mergers. • The law requires the agencies to disprove mergers they consider damaging to competition and that they believe do not serve the needs or convenience of the local community. • The U.S. Justice Department and the Supreme Court may challenge the mergers approved by the regulators. • The Garn St. Germain Act of 1982 allows for out-or-state banking firms to acquire failed or failing depository institutions.

28. VI. Bank Structure Regulation • 4. Bank Holding Companies: • A BHC may own several banks or just one bank. Formation of a new BHC is subject to approval of the FR Board. They are subject to much the same regulations that are applied to branching and bank mergers. • Factors for the explosive growth of BHCs: • Banks put themselves under BHCs in order to utilize the latter's power to acquire loanable funds through issuing commercial paper. • The power that BHCs give to banks to expand into another line of commerce. • BHCs realize economies of scale and scope through centralizing management and services facilities. • As a way to circumvent state laws and regulations prohibiting or restricting branch banking.

29. VI. Bank Structure Regulation • 4. Bank Holding Companies: • Advantages of BHCs: • capable of portfolio and geographical diversification • advantage of attracting highly qualified management personnel resulting in more efficient operation • large concentration of financial services • more prone to risk taking, increasing the probability of failures.

30. VI. Bank Regulatory Structure • Regulators of Various Functions • __________________________________________________________________________ • Type of Bank • State Insured Noninsured • National Member State State • __________________________________________________________________________ • Chartering and Comptroller State Authority State Authority State Authority • Licensing • Intrastate Comptroller Fed. Reserve FDIC State Authority • branching and and • State Authority State Authority • Intrastate mergers, Comptroller Fed. Reserve FDIC State Authority • acquisitions, and • consolidations

31. VI. Bank Regulatory Structure • Regulators of Various Functions • __________________________________________________________________________ • Type of Bank • State Insured Noninsured • National Member State State • __________________________________________________________________________ • Reserve Fed. Reserve Fed. Reserve Fed. Reserve Fed. Reserve • Requirements • Access to the Fed. Reserve Fed. Reserve Fed. Reserve Fed. Reserve discount window • Deposit insurance FDIC FDIC FDIC None or State Insurance Fund • Supervision and Comptroller Fed. Reserve FDIC State Authority • examination and and • State Authority State Authority

32. VI. Bank Regulatory Structure • Regulators of Various Functions • __________________________________________________________________________ • Type of Bank • State Insured Noninsured • National Member State State • __________________________________________________________________________ • Prudential limits: Comptroller Fed. Reserve FDIC State Authority • safety and and and • soundness State Authority State Authority • Rulemaking: Fed. Reserve Fed. Reserve Fed. Reserve Fed. Reserve • Consumer and and • protection State Authority State Authority • Enforcement: Comptroller Fed. Reserve FDIC State Authority • Consumer • protection • __________________________________________________________________________