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Bank Regulation

Bank Regulation. 18. Chapter Objectives. Describe the key regulations imposed on commercial banks Explain development of bank regulation over time Evaluate the areas of bank regulation Describe the main provisions of the Financial Services Modernization Act of 1999. Background.

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Bank Regulation

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  1. Bank Regulation 18

  2. Chapter Objectives • Describe the key regulations imposed on commercial banks • Explain development of bank regulation over time • Evaluate the areas of bank regulation • Describe the main provisions of the Financial Services Modernization Act of 1999

  3. Background • Banking industry has experienced tremendous change in recent years • Post-Depression legislation focused on safety and soundness of commercial banks • Deregulation of financial services industry • Intense competition/consolidation • Expansion--economies of scale

  4. Why Banks Are Regulated? • Deposits are 70% of money supply • Center of payments mechanism • Primary transmitter of monetary policy • Major liquidity provider to economy • Make loans • Deposits are liquid assets of customers • Liabilities are major, low risk assets of consumers 3

  5. Regulatory Structure • The regulatory structure of the banking system in the U.S. is unique • Dual banking system: Federal and State • Charter • State charter = state bank • Regulated by state banking agency • Federal charter = national bank • Regulated by Comptroller of the Currency

  6. Regulatory Structure • Banks that are members of the Federal Reserve are also regulated by the Fed • Banks that are insured by the Federal Deposit Insurance Corporation are also regulated by the FDIC • Regulatory overlap: • FDIC • Federal Reserve System • State banking authorities • Now Securities and Exchange Commission--stock

  7. Regulatory Structure • Regulation of bank ownership • Bank independently owned • Bank owned by a holding company • Popularity stems from amendments to the Bank Holding Company Act in 1970 • Allowed BHC’s more flexibility to participate in activities like leasing, mortgage banking, and data processing, and later, • Insurance, securities underwriting, etc.

  8. Deregulation Act of 1980 • Initiated to reduce bank regulations and increase Fed monetary policy effectiveness • Also known as DIDMCA • Phase out of deposit rate ceilings • Interest rate ceilings were previously enforced by Regulation Q. Phased out by 1986 • The act allowed banks to make their own decisions on what interest rates to offer on deposits • Allowance of checkable deposits for all depository institutions • NOW accounts

  9. Deregulation Act of 1980 • New lending flexibility for depository institutions • Allowed S&Ls to offer limited commercial and consumer loans • Explicit pricing of Fed services • Ensures the Fed only provides services, such as check clearing, that it can provide efficiently • Impact of the DIDMCA • Consumers shift to NOW accounts and CDs, so banks now pay more for funds than before. Also, increased competition between depository institutions

  10. Garn-St. Germain Act, 1982 • Came at a time when some depository institutions were experiencing severe financial problems • Permitted depository institutions to offer money market deposit accounts to compete with money market mutual funds • Also allowed depository institutions to acquire failing institutions across geographic boundaries • In general, consumers appear to have benefited from deregulation

  11. Regulation of Deposit Insurance • Deposit insurance began in 1933 with creation of Federal Deposit Insurance Corporation in response to bank runs/failures in 1920s (agricultural) and early 1930’s (Depression) • Between 1930-1932 20% of banks failed. • Initial wave of failures resulted in runs on other banks, some of which were healthy • The amount of deposits insured per person has increased from $2,500 in 1933 to $100,000 today

  12. Regulation of Deposit Insurance • The pool of funds used to cover insured depositors is called the Bank Insurance Fund • Supported by annual insurance premiums paid by commercial banks • Until 1991, the rate was the same for all banks, regardless of risk, causing moral hazard problem • Federal Deposit Insurance Act (FDICA) of 1991 phased in risk-based insurance premiums

  13. Regulation of Capital • Banks are required to maintain a minimum amount of capital as a percentage of total assets • Banks prefer low capital ratios to boost ROE • Regulators prefer higher levels to absorb operating losses • In the 1988 Basel Accord central bankers of 12 countries agreed to uniform, risk-based capital requirements

  14. Regulation of Capital • Use of the Value-at-Risk method to determine capital requirements • In 1998, large banks with substantial trading businesses began using their own internal measures of market risk to adjust their capital requirements. • Use a VAR (value-at-risk) model, usually with a 99 percent confidence interval • Precursor to 1991 risk-based capital requirements

  15. Regulation of Capital • Testing the validity of a bank’s VAR • Uses backtests with actual daily trading gains or losses • If the VAR is estimated properly, only 1 percent of the actual trading days should show results worse than the estimated VAR • Related stress tests • Bank identifies a possible extreme event to estimate potential losses

  16. Regulation of Operations • Regulation of loans • Regulators monitor: • Loan quality • Loan diversification geographically and by industry • Adequacy of loan loss reserves • Exposure to debt of foreign countries • Regulation of investment securities • Non-equity, investment grade investments • Provides income and liquidity to bank • Investment banking activity only in state and municipal bonds

  17. Regulation of Operations • Regulation of securities services • Banking Act of 1933 (Glass-Steagall) separated banking and securities services • Intended to prevent conflicts of interest and self-interest lending • Deregulation of corporate debt underwriting services, 1989 • Commercial paper and corporate debt securities • Still no common stock underwriting

  18. Regulation of Operations • The Financial Services Modernization Act, 1999 • Essentially repealed the Glass-Steagall Act • Enables commercial banks to more easily pursue stock underwriting and insurance activities • Deregulation of brokerage services • In the late 1990s some banks acquired financial services firms. • Citicorp and Traveler’s Insurance Group, which owned Solomon Brothers and Smith Barney, merged

  19. Regulation of Operations • Deregulation of mutual funds services • The Fed ruled in 1986 to allow brokerage subsidiaries of bank holding companies to sell mutual funds

  20. Regulation of Operations • Regulation of insurance services • Banks that already participated in insurance before 1971 were grandfathered • Banks sometimes leased space to insurance or served as agent, but not underwriting insurance • Banks able to underwrite annuities, 1995 • The passage of the Financial Services Modernization Act (1999) confirmed that banks and insurers could consolidate their operations • Regulation of off-balance sheet transactions • Risk-based capital requirements are higher for banks with more off-balance sheet activities

  21. Regulation of Interstate Expansion • The McFadden Act of 1927 prevented banks from establishing branches across state lines. • No interstate bank holding company mergers (1956) • Intent was to prevent large bank market control, but limited competition to intrastate banking • Slow changes in state banking law to permit interstate banking

  22. Regulation of Interstate Expansion • Interstate Banking Act • Reigle-Neal Interstate Banking and Branching Efficiency Act of 1994 • Eliminated most restrictions on interstate bank mergers and allowed commercial banks to open branches nationwide • Allowed interstate bank holding companies to consolidate into one charter • Reduces costs to consumers and adds convenience—promotes competition • Banks take advantage of economies of scale

  23. How Regulators Monitor Banks • Regulators examine commercial banks at least once per year • CAMELS ratings • Capital adequacy • Regulators determine the “adequacy” of capital • More capital allows banks to absorb losses • Asset quality • Credit risk • Portfolio’s composition and exposure to potential events

  24. How Regulators Monitor Banks • Management • Rates management according to administrative skills, ability to comply with existing regulations, and ability to cope with a changing environment. • Very subjective • Earnings • Banks fail when their earnings are consistently negative • Commonly used ratio: Return on Assets (ROA)

  25. How Regulators Monitor Banks • Liquidity • Extent of reliance on outside sources for funds (discount window, federal funds) • Sensitivity to interest rate changes and market conditions • Rating bank characteristics • Each of the CAMEL characteristics is rated on a 1-to-5 scale, with 1 indicating outstanding • Used to identify problem banks • Subjective opinion must be used to supplement objective measures

  26. How Regulators Monitor Banks • Corrective action by regulators • When a problem bank is identified it is thoroughly investigated (examined) by regulators • They may require specific corrective action, such as boosting capital or delay expansion • Regulators have the authority to take legal action against a bank if they do not comply

  27. How Regulators Monitor Banks • Funding the closure of failing banks • FDIC is responsible for closing failing banks • Liquidating failed bank's assets • Facilitating acquisition by another bank • Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 • Regulators required to act more quickly for undercapitalized banks • Risk-based deposit insurance premiums • Close failing banks more quickly • Large deposit (>$100,000) customers not protected

  28. The “Too-Big-To-Fail” Issue • Some troubled banks have received preferential treatment from bank regulators • Continental Illinois Bank • Rescued by the federal government, while other troubled banks were not • As one of the country’s largest banks, Continental’s failure could have reduced public confidence in the banking system

  29. The “Too-Big-To-Fail” Issue • Argument for government rescue • Because many Continental depositors exceeded $100,000, failure to protect them could have caused runs at other large banks • Argument against government rescue • Sends a message that large banks will be protected from failure • Incentive to take added risks • Removes incentive to make operations more efficient

  30. The “Too-Big-To-Fail” Issue • Proposals for government rescue • Ideal solution would prevent a run on deposits while not rewarding poorly performing banks with a bailout • Regulators should play a greater role in assessing bank financial conditions over time

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