Presentation on theme: "BANK ORGANIZATION AND REGULATION Chapter 2 Bank Management 5th edition. Timothy W. Koch and S. Scott MacDonald Bank Management, 5th edition. Timothy W."— Presentation transcript:
Government agencies that regulate commercial banks have had to balance the banking systems competitiveness with general safety and soundness concerns. Historically, regulation has limited who can: open or charter new banks and what products and services banks can offer. Imposing barriers to entry and restricting the types of activities banks can engage in clearly enhance safety and soundness, but also hinder competition.
Historical regulation, which limits the number of banks and types of activities, has three drawbacks 1. It assumed that the markets for bank products, largely bank loans and deposits, could be protected and that other firms could not encroach upon these markets. Not surprisingly, investment banks, hybrid financial companies, insurance firms, and others found ways to provide the same products as banks across different geographic markets. 2. It discriminated against U.S.-based firms versus foreign-based firms. For example, prior regulations prohibited U.S. banks from underwriting securities for firms in the U.S. In contrast, foreign banks are generally not restricted as to their domestic corporate structure and thus have long been able to circumvent U.S. restrictions on under-writing activities. Such restrictions place U.S. banks at a competitive disadvantage. 3. Historical regulation has penalized bank customers who do not have convenient access to the range of products they demand. In addition, such restrictions generally raise prices above those obtained in a purely competitive marketplace.
The U.S. operates using a dual banking system.dual banking system. Individual states as well as the federal government issue bank charters. The Office of the Comptroller of the Currency (OCC) charters national banksOffice of the Comptroller of the Currency (OCC) Individual state banking departments charter state banks and savings institutes. The Office of Thrift Supervision (OTS) charters federal savings banks and savings associations.Office of Thrift Supervision (OTS) The Federal Deposit Insurance Corporation (FDIC) insures the deposits of banks and savings associations up to $100,000 per account.Federal Deposit Insurance Corporation (FDIC)
Bank regulation and supervision …conducted by four federal agencies (OCC, OTS, FDIC, and the Federal Reserve) as well as fifty state agencies.Federal Reserve Although this is a complicated system, it allows for a separation of duties as well as competition among the various regulatory agencies to produce a safe and efficient banking system.
Credit unions represent another type of depository institution. Even though credit unions perform some of the same functions as a bank, they are cooperative nonprofit financial institutions that exist for the benefit of members. To join a credit union, one must share a common bond with other members. The definition of common bond, however, has expanded to incorporate a community and hence the differences between credit unions and banks are disappearing as well. Credit unions often operate in subsidized office space with subsidized labor and do not pay corporate or state income taxes. This tax-exempt status puts them at a competitive advantage over other banking institutions. Credit unions were first chartered at the state level in By 1934, the federal government began to charter credit unions under the Farm Credit Association, and created the National Credit Union Administration (NCUA) in National Credit Union Administration (NCUA) A dual credit union regulatory system exists as well today as both states and the NCUA charter credit unions today.
National versus a State bank charter Before issuing a new charter, the chartering agencies ensure that the (de novo) bank will have the necessary capital and management expertise to ensure soundness and allow the bank to meet the publics financial needs. The agency that charters the institution is the institutions primary regulator with primary responsibility to ensure safety and soundness of the banking system. All banks obtain FDIC deposit insurance coverage as part of the chartering process.
While national banks are regulated only by federal regulatory agencies, state-chartered banks also have a primary federal regulator. The Federal Reserve is the primary federal regulator of an FDIC-insured state bank, which is a member of the Federal Reserve System, while the primary regulator of state non-Fed member banks is the FDIC.Federal Reserve Charter Class by their Primary Federal Regulator (thousands of dollars): June 2001 FDIC-Supervised Savings Banks 520 4, ,542,336 FDIC OTS-Supervised Savings Associations ,723,852 OTS U.S. Branches of Foreign Banks 18 4,069,399 Total 9,757 86,073 4,326,327,230 * Includesdeposits in domestic offices (50 states and DC), Puerto Rico, and U.S. Territories
In contrast to federally regulated national banks, state-chartered banks have generally had broader powers. Many states allow securities underwriting and brokerage; real estate equity participation, development, and brokerage; and insurance underwriting and brokerage. Still, regulations for banks are more restrictive than those that apply to thrift institutions. While thrifts must maintain at least 65 percent of their assets in housing-related investments and cannot have more than 10 percent in loans to businesses, they have historically been allowed nationwide branching and full-service underwriting and brokerage activities in insurance, real estate, and corporate instruments.
For many years, commercial banks were viewed as a special type of financial organization. They were the only firms allowed to issue demand deposits and thus dominated the payments system Prior to 1980, interest-bearing checking accounts did not exist except at credit unions. Because of this status, authorities closely regulated bank operations to control deposit growth and to ensure the safety of customer deposits. Among other restrictions, government regulators required: cash reserves against deposits, specified maximum interest rates banks could pay on deposits, set minimum capital requirements, and placed limits on the size of loans to borrowers. In addition to regulatory constraints, federal banking law further limited bank operations to activities closely related to banking and, in conjunction with state laws, prohibited interstate branching.
Historically, banks, savings associations, and credit unions each served a different purpose and a different market. Commercial banks mostly specialize in short-term business credit, but also make consumer loans and mortgages, and have a broad range of financial powers. Banks accept deposits in a variety of different accounts and invest these funds into loans and other financial instruments. Their corporate charters and the powers granted to them under state and federal law determines the range of their activities.
Savings institutions, savings and loan associations and savings banks, have historically specialized in real estate lending; e.g., loans for single-family homes and other residential properties. Savings associations are generally referred to as thrifts because they originally offered only savings or time deposits They have acquired a wide range of financial powers over the past two decades, and now offer checking accounts, make business and consumer loans, mortgages, and offer virtually any other product a bank offers. Savings institutions must maintain 65% of their assets in housing-related or other qualified assets to maintain their savings institution status. This is called the qualified thrift lender (QTL) test.
The number of thrifts has declined dramatically during the last two decades. The savings and loan crisis of the 1980s forced many institutions to close or merge with others, at an extraordinary cost to the federal government. Due to liberalization of the QTL, however, there was a resurgence of interest in the thrift charter and many insurance companies, securities firms, as well as commercial firms acquired a unitary thrift holding company in order to own a depository institution and bypass prohibitions in the Glass Steagall Act and the Bank Holding Company Act. This resurgence of interest stopped with the passage of Gramm-Leach- Bliley, which eliminated the issuance of new unitary thrift charters.
Credit unions are nonprofit institutions with an original purpose to encourage savings and provide loans within a community at low cost to their members. A common bond defines their members, although this common bond can be loosely defined. The members pool their funds to form the institutions deposit base and the members own and control the institution. Credit unions accept deposits in a variety of forms. All credit unions offer savings accounts or time deposits, while the larger institutions also offer checking and money market accounts. Credit unions have similarly expanded the scope of products and activities they offer to include almost anything a bank or savings association offers, including making home loans, issuing credit cards, and even making some commercial loans. Credit unions are exempt from federal taxation and sometimes receive subsidies, in the form of free space or supplies, from their sponsoring organizations. Although credit unions tend to be much smaller than banks or savings associations, there are several very large credit unions.
The largest federal and state chartered banks: (thousands of dollars, 2001)
Largest savings institutions and credit unions (thousands of dollars, 2001)
Number and total assets of various depository institutions: 1970 – 2001.
Commercial banks play an important role in facilitating economic growth. On a macroeconomic level, they represent the primary conduit of Federal Reserve monetary policy. Bank deposits represent the most liquid form of money such that the Federal Reserve Systems efforts to control the nations money supply and level of aggregate economic activity is accomplished by changing the availability of credit at banks. On a microeconomic level, commercial banks represent the primary source of credit to most small businesses and many individuals. A communitys vitality typically reflects the strength of its major financial institutions and the innovative character of its business leaders.
There has been a fundamental shift in the structure of financial institutions over the past two decades. In particular, depository institutions share of U.S. financial assets has systematically declined relative to assets held by other financial intermediaries.
Consolidations, new charters and bank failures The number of failed banks increases sharply from 1980 through 1988 This period coincides with economic problems throughout various sectors of the U.S. economy ranging from agriculture to energy to real estate. As regional economies faltered, problem loans grew at banks and thrifts that were overextended and subsequent losses forced closings. New charters representing the start-up of a new banks operations declined from 1984 to 1994, increased through 1998, and then decreased through 2001.
The major force behind consolidation has been mergers and acquisitions in which existing banks combine operations in order to cut costs, improve profitability, and increase their competitive position. Bankers who either lose their jobs in a merger or choose not to work for a large banking organization often find investors to put up the capital needed to start a new bank. Both mergers and new charters slowed dramatically in late 1998 as a result of a 25 percent fall in stock values at the largest bank holding companies and in 2001 with the continuing market decline.
Structural changes among FDIC-insured commercial banks, 1980–2001 New Charters Mergers Failures
The Central Bank …Congress created the Federal Reserve System in 1913 to serve as the central bank of the United States and to provide the nation with a safe, flexible and more stable monetary and financial systemFederal Reserve System The Fed's role in banking and the economy has expanded over the years, but its primary focus has remained the same. The Feds three fundamental functions are: 1. conduct the nations monetary policy, 2. provide and maintain an effective and efficient payments system, and 3. supervise and regulate banking operations. All three roles have a similar purpose, that of maintaining monetary and economic stability and prosperity.
The Federal Reserve System (The Fed)Federal Reserve System A decentralized central bank, with 12 districts reserve banks and branches across the country, Coordinated by a Board of Governors in Washington, D.C. The Board of Governors are appointed by the president of the United States and confirmed by the Senate for staggered 14-year terms. The seven-members of the Board Governors are the main governing body of the Federal Reserve System. The Board is charged with overseeing the 12 District Reserve Banks and with helping implement national monetary policy.
Monetary Policy The Federal Reserve conducts monetary policy through actions designed to influence the supply of money and credit in order to promote price stability and long-term sustainable economic growth. monetary policy There are basically three distinct monetary policy tools: 1. open market operations, open market operations 2. changes in the discount rate, and 3. changes in the required reserve ratio.
Open market operations … are conducted by the Federal Reserve Bank of New York under the direction of the Federal Open Market Committee (FOMC).Federal Open Market Committee (FOMC). The sale or purchase of U.S. government securities in the open market or secondary market is the Federal Reserves most flexible means of carrying out its policy objectives. Through the purchase or sale of short-term government securities, the Fed can adjust the level of reserves in the banking system. Fed open market purchases increase liquidity, hence reserves in the banking system, by increasing a banks deposit balances at the Fed. Fed open market sales of securities decrease bank reserves and liquidity by lowering deposit balances at the Fed.
Changes in the discount rate …directly affect the cost of borrowing Banks can borrow deposit balances, or required reserves, directly from Federal Reserve Banks (in its role as lender of last resort). The discount rate is the interest rate that banks pay. When the Fed raises (decreases) the discount rate it discourages (encourages) borrowing by making it more (less) expensive. Many economists argue that the Fed changes the discount rate primarily to signal future policy toward monetary ease or tightness rather than to change bank borrowing activity. Changes in the discount rate are formally announced and trumpeted among the financial press so that market participants recognize that the Fed will likely be adding liquidity or taking liquidity out of the banking system.
Changes in reserve requirements …directly affect the amount of legal required reserves and thus change the amount of money a bank can lend out. For example, a required reserve ratio of 10 percent means that a bank with $100 in demand deposit liabilities outstanding must hold $10 in legal required reserves in support of the DDAs. The bank can thus lend only 90 percent of its DDAs. When the Fed increases (decreases) reserve requirements, it formally increases (decreases) the required reserve ratio that directly reduces (raises) the amount of money a bank can lend. Thus, lower reserve requirements increase bank liquidity and lending capacity while higher reserve requirements decrease bank liquidity and lending capacity.
Organizational form of the banking industry The organizational structure of banking has changed significantly over the past two decades but changed most dramatically in the later half of the 1990s due primarily to: the impact of interstate branching, the Federal Reserve Systems relaxation of securities powers restrictions using a clause in the Glass-Steagall Act and most recently with the Gramm-Leach-Bliley Act of Banks can now branch across state lines and acquire insurance and securities firms by forming a Financial Holding Company under the provisions of Gramm-Leach- Bliley.
Commercial banks are classified either as unit banks, with all operations housed in a single office, or as branch banks with multiple offices. Prior to the enactment of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which allow of nationwide interstate branch banking, state law determined the extent to which commercial banks could branch. Any organization that owns controlling interest in one or more commercial banks is a bank holding company (BHC). Control is defined as ownership or indirect control via the power to vote more than 25 percent of the voting shares in a bank. Prior to the enactment of interstate branching, the primary motivation behind forming a bank holding company was to circumvent restrictions regarding branching and the products and services that banks can offer. Today, the primary motive is to broaden the scope of products the bank can offer.
Unit versus Branch banking …The current structure of the commercial banking system as well as the dramatic changes in the number of banks has been heavily influenced by historical regulations which prevent branching to one degree of another. One of the primary reasons the number of banks has declined almost 50 percent since the mid 1980s is the relaxation of branching restrictions provided by Riegle-Neal Interstate Banking and Branching Efficiency Act of Since the mid 1980s, the number of banks has fallen about 50 percent while the number of branches has increased by 50 percent.
Changes in the number of banks and bank branches, 1960 – 2001
The number of interstate branches increased dramatically after interstate branching became fully effective in 1997.
Unit banks each have their own board of directors, a complete staff of officers, and separate documents and technology for conducting business. Operating expenses are generally higher for the parent company that owns multiple independent banks as compared to branches of the lead bank. the relaxation in branching restrictions and economic efficiencies is a primary motivating factor for a bank to form a bank holding company. Risk in the banking industry is considered higher with restrictive branching because individual banks were less diversified and more prone to problems Not surprisingly, states with the highest bank failure rates historically restricted branching. Branching generally reduces the number of competitors, lowers expenses, allows greater asset diversification, and expands each banks consumer deposit base Each of these factors decreases the chances of failure, everything else being equal.
Organizational form Independent Banks The term independent bank normally refers to a bank that is not controlled by a multibank holding company or any other outside interest. Bank Holding Companies A bank holding company is essentially a shell organization that owns and manages subsidiary firms.
Bank holding companies Bank holding companies are firms that control at least one bank subsidiary. They typically also own several non-bank subsidiaries--leasing or data processing firms. They generate earnings from fees, interest income, and dividends from equity in subsidiaries. They pay interest on borrowings and have administrative expenses. Control is defined as ownership or indirect control via power to vote more than 25 percent of the voting shares in a bank. Prior to nationwide interstate branching, the primary motivation was to circumvent restrictions regarding branching and the products and services that banks can offer. Today, the primary motivation is to expand the scope of products the bank can offer.
Like commercial banks, bank holding companies are heavily regulated by states and the federal government. The Bank Holding Company Act stipulates that the Board of Governors of the Federal Reserve System must approve all holding company formations and acquisitions. One-bank holding companies (OBHCs) control only one bank and typically arise when the owners of an existing bank exchange their shares for stock in the holding company. Multibank holding companies (MBHCs) control at least two commercial banks.
The Gramm-Leach-Bliley Act of 1999 also gave regulatory responsibility over Financial Holding Companies to the Federal Reserve. The Glass-Steagall Act effectively separated commercial banking from investment banking but left open the possibility of banks engaging in investment banking activities through a Section 20 affiliate so long as the bank was not principally engaged in these activities. Commercial banks received permission (in 1987) from the Federal Reserve to underwrite and deal in securities through Section 20 subsidiaries. The Fed resolved the issue of principally engaged initially by allowing banks to earn only 5 percent of the revenue in their securities affiliates. This was raised to 10 percent in 1989 and to 25 percent in March of The Gramm-Leach-Bliley Act of 1999 repeals the restrictions on banks affiliating with securities firms The law creates a new financial holding company, authorized to engage in: underwriting and selling insurance and securities, conducting both commercial and merchant banking, investing in and developing real estate and other "complimentary activities."
Financial holding companies (FHC) are distinct entities from bank holding companies (BHC). A company can form a BHC or a FHC or both. The primary advantages to a banking organization to forming a FHC is that they can engage in a wide range of financial activities not permitted in the bank or with in a BHC. Some of these activities include: insurance and securities underwriting and agency activities, merchant banking and insurance company portfolio investment activities. activities that are "complementary" to financial activities also are authorized. The primary disadvantage to forming a FHC or converting their BHC to a FHC is that the Federal Reserve may not permit a company to form a financial holding company if any of its insured depository institution subsidiaries are not well capitalized and well managed, or did not receive at least a satisfactory rating in their most recent CRA exam.
Nonbank activities permitted bank holding companies The Federal Reserve Board regulates allowable nonbank activities that are closely related to banking in which bank holding companies may acquire subsidiaries. Restrictions came about for three reasons. 1. It was feared that large financial conglomerates would control the financial system because they would have a competitive advantage. 2. There was concern that banks would require customers to buy nonbank services in order to obtain loans. 3. Some critics simply did not believe that bank holding companies should engage in businesses that were not allowed banks because these businesses were less regulated and thus relatively risky.
Organizational structure of financial services company Bank Holding Company Thrift Holding Company Securities Subsidiaries Insurance Subsidiaries Real Estate Subsidiary Nonbank Subsidiaries and Service Companies Financial Services Holding Company
Organizational structure of the OBHC The bottom four levels have the same organizational form as the independent bank. Each subsidiary has a president and line officers. One-Bank Holding Company
Organizational structure of the MBHC. MultiBank Holding Company
Citicorp's multibank holding company consolidated balance sheet for parent company only (millions $) Citicorp's Multibank Holding Company Consolidated Balance Sheet for Parent Company Only (millions $)
Citicorp's multibank holding company consolidated income statement for parent company only (millions $)
Large and small banks …When many of us think of banks, we think of the largest banks in the country such as Bank of America, Citibank, Chase Manhattan Bank, First Union National Bank, Morgan Guaranty Trust Company, Fleet National Bank, Wells Fargo Bank, and Bank One. Of the approximate 8,100 commercial banks operating in the United States, however, only about 80 are greater than $10 billion in assets. The vast majority of banks are small banks (about 5,000), under $100 million in assets with a legal lending limit of less than $1 million. In fact, almost 96% of all banks have total assets less than $1 billion. Still, the largest banks (over $10 billion) hold almost 70 percent of
Banking business models … The business models followed by the majority of banks (small banks) is generally different that that of largest banks. Historically, small banks have been called independent or community banks while large banks have been labeled large holding company banks, multibank holding companies, or even money center banks. Never the less, banks of the same size, however, often pursue substantially different strategies
Business model structure of commercial banking The organizational structure of commercial banks can be characterized as banks falling into one of the following categories based on the range of products and services offered and the different geographic markets served: Global banks Nationwide banks Super Regional banks Regional banks Specialty banks limited region limited product line
Organizational structure of an independent bank
Five fundamental objectives of bank regulationbank regulation Ensure the safety and soundness of banks and financial institutions The Federal Reserve System uses regulation to provide monetary stabilityFederal Reserve System To provide an efficient and competitive financial system Protect consumers from abuses by credit- granting institutions To maintain the integrity of the nations payments systems.
Three separate federal agencies along with each state's banking department issue and enforce regulations The Federal Reserve The Federal Deposit Insurance Corporation (FDIC) The Federal Deposit Insurance Corporation (FDIC) Office of the Comptroller of the Currency (OCC) Office of the Comptroller of the Currency (OCC)
Most regulations can be classified in one of three basic categories: 1. supervision, examination, deposit insurance, chartering activity, and product restrictions are associated with safety and soundness 2. branching, mergers and acquisitions, and pricing are related to an efficient and competitive financial system 3. consumer protection.
Depository institutions and their regulators
Supervision and Examination … Regulators periodically examine individual banks and provide supervisory directives The OCC and FDIC assess the overall quality of a bank's condition according to the CAMELS system: Capital adequacy Asset quality Management quality Earnings quality Liquidity Sensitivity Regulators assign ratings from 1 (best) to 5 (worst) for each category and an overall rating for all features combined.
Deposit insurance …The Federal Deposit Insurance Corporation (FDIC) insures the deposits of banks up to a maximum of $100,000 per account holder while almost all credit unions are insured by the National Credit Union Share Insurance Fund (NCUSIF), which is controlled by the NCUA.Federal Deposit Insurance Corporation (FDIC) The FDIC was created by the Banking Act of 1933, in response to the large number of bank failures that followed the stock market crash of Originally the FDIC insured deposits up to $5,000. Fundamentally, all newly chartered banks must obtain FDIC insurance. The FDIC also acts as the primary federal regulator of state- chartered banks that do not belong to the Federal Reserve System. State banks who are members of the Federal Reserve System have that agency for their primary federal regulator. The FDIC also has backup examination and regulatory authority over national and Fed-member banks. The FDIC is also the receiver of failed institutions. The FDIC declares banks and savings associations insolvent and handles failed institutions by either liquidating them or selling the institutions to redeem insured deposits.
Two insurance funds under the FDIC: The Bank Insurance Fund (BIF) for banks and the Savings Association Fund (SAIF). The BIF and SAIF funds are scheduled to be merged but this has not occurred as of mid The OCC and state banking authorities officially designate banks as insolvent, but the Federal Reserve and FDIC assist in closings. The Federal Reserve also serves as the federal government's lender of last resort. When a bank loses funding sources, the Federal Reserve may make a discount window loan to support operations until a solution appears.
Federal Reserve bank regulations
Interstate Branches as a Percentage of Total Offices for FDIC- The Riegle-Neal Interstate Banking and Branching Efficiency Act, 1994, mandates interstate branch banking, superseding state banking pacts
Nonbank banks …most large banking organizations have established nonbank affiliates Edge Act corporations Edge Act corporations provide a full range of banking services but, by law, deal only in international transactions There are two types of Edge corporations: banks and investment companies Loan production offices (LPOs) make commercial loans but do not accept deposits Consumer banks outside their home state Consumer banks accept deposits but make only consumer loans
Consumer Protection. State legislatures and the Federal Reserve have implemented numerous laws and regulations to protect the rights of individuals who try to borrow. Regs. AA, B, BB, C, E, M, S, Z, and DD apply specifically to consumer regulation. Equal credit opportunity (Reg. B), for example, makes it illegal for any lender to discriminate against a borrower on the basis of race sex, marital status, religion, age, or national origin. Community reinvestment prohibits redlining in which lenders as a matter of policy do not lend in certain geographic markets. Reg. Z requires disclosure of effective rates of interest, total interest paid, the total of all payments, as well as full disclosure as to why a customer was denied credit.
Trends in federal legislation and regulation The fundamental focus of federal banking legislation and regulation since 1970 has been to define and ultimately expand the product and geographic markets served by depository institutions, and to increase competition. Subsequent problems with failed savings and loans and commercial banks raised concerns that only a few large organizations would survive because all financial institutions would eventually have the same powers and large firms would drive small firms out of business.
Today, the banking and financial services industry is evolving into a new and exciting industry full of challenges and opportunities. Smaller banks appear to have opportunities in providing specialized products and services. Larger banks have expanded their product mix and have blurred the distinction between a bank and a securities firm.
Key legislative and regulatory changes have attempted to address three basic issues 1. What is a bank? 2. Where can banks conduct business? 3. What products can banks offer and what interest rates may be charged or paid?
Key Legislation: Depository Institutions Deregulation and Monetary Control Act of 1980 Garn-St. Germain Depository Institutions Act of 1982 The Tax Reform Act of 1986 Competitive Equality Banking Act of 1987 The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) The Federal Deposit Insurance Corporation Improvement Act of 1991 Market value accounting and FASB 115 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 The 1998 Credit Union Membership Access Act Financial Services Modernization Act (Gramm-Leach- Bliley Act of 1999) USA Patriot Act of 2001
Financial Services Modernization Act (Gramm-Leach-Bliley Act of 1999) The repeal of restrictions on banks affiliating with securities firms clearly tops the list of provisions of Gramm-Leach-Bliley. The Act, however, was more comprehensive and addressed new powers and products of banks and the financial services industry, functional regulation of the industry, insurance powers, the elimination of new charters for unitary savings and loan holding companies and even consumer privacy protection. In fact, it is the privacy section of the bill that has some of the most far reaching beyond banking.