Lecture on Bank Regulation AssignmentPoint

1. Lecture on Bank Regulation www.AssignmentPoint.com

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