1. Bank
Regulation 18

2. Background
As with so many other things, it takes a crisis to get action on Capitol Hill (e.g. terrorism, Katrina, etc.)
The Great Depression was a catalyst for all kinds of regulation, including that of
corporations (Securities Acts of 1933, 1934 and the SEC)
banking (Banking Act of 1933, deposit insurance, etc.) Bank failures in 1920s related to agriculture followed by massive failures in 1930s from the Great Depression finally prompted action by FDR and Congress
Bank failures of 1970s and 1980s again caused a slew of bank regulation

3. History of U.S. Bank Failures
# of banks failed 3 in 2007
30 in 2008
148 in 2009
157 in 2010
92 in in in so far in 2014
See FDIC website for details

4. History of Bank Failures

6. A Bank Run It’s a Wonderful Life Mary Poppins
Mary Poppins

7. Deposit Insurance - Background
March of 1933, panic of massive proportions across the country with runs on the bank everywhere
In response, FDR took several steps:
On March 6, FDR declared a four-day banking holiday
Adventist miracle
Baker Boyer Bank’s back door
On March 12, FDR held his first “fire-side chat”, a live nation-wide radio broadcast to reassure the nation
Fed issued new notes to increase $ supply and Bureau of Engraving went into 24 hr/day production of currency/coin
FDR pushed deposit insurance regulation

8. Deposit Insurance - Background
Congressman Steagall championed deposit insurance as a solution but he faced much resistance from Congress (Senator Glass), the executive branch and the banking industry
Those opposed to deposit insurance claimed that:
It removed penalties for bad judgment (moral hazard)
It was too expensive
It wouldn’t work as demonstrated by the collapse of state insurance funds who already tried it
It was an intrusion by gov’t into private affairs

9. Deposit Insurance - Background
Finally, the Banking Act of 1933, signed into law by FDR on June 16, 1933, approved national deposit insurance (Section 8 of the Act created the FDIC). The FDIC is run by a 5-member board chosen by the President
Martin Gruenberg
FDIC Chair since Nov/12

10. Deposit Insurance Ceilings
How Deposit Insurance Coverage Has Increased
1934: (Jan.) $2,500
1934: (July) $5,000
1950: $10,000
1966: $15,000
1969: $20,000
1974: $40,000
1980: $100,000
2008: $250,000 (temporary until 2010)
2010: $250,000 (made permanent)
What would inflation adjusted coverage in 2013 for 1980 coverage dollars?
Not one penny has been lost by depositors since inception

11. 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 – rate about .3% of deposits
Before 1991, the rate was the same for all banks, regardless of risk (under Basel Accord), causing moral hazard problem
In 1991, the Federal Deposit Insurance Act (FDICA) phased in risk-based insurance premiums

12. Regulation of Deposit Insurance
Covers bank accounts and IRAs/Keoghs but NOT securities or mutual funds
Coverage varies per type of ownership category: single (max $250k); joint (max. $250k per individual); self-directed retirement (max $250k); and trust (max. $250k).
Sole proprietorships (Sch. C) are considered owner’s single account.
Partnerships and corporations are separate legal entities ($250k max.)
Depositor
Type of Deposit
Amount Deposited
Abe & Barb
Zero-Interest Checking
$150,000 CD
$200,000
Passbook Savings
Abe's Restaurant (a sole proprietorship)
$260,000
Abe’s IRA Account
$275,000
Barb’s IRA Account
$300,000
TOTAL DEPOSITED
$1,385,000
INSURED AMOUNT? ??

13. Background of regulation
Banking industry has experienced tremendous change in recent years
Post-Depression legislation focused on safety and soundness of commercial banks
Since the 1980s, there’s been substantial deregulation of financial services industry
Today, intense competition/consolidation has occurred, as banks try to compete with services (one-stop-shop) and create economies of scale.

14. Why Banks Are Regulated?
Deposits are 70% of money supply
Center of payments mechanism
Primary transmitter of monetary policy
Major liquidity provider to economy
1998 South-Western College Publishing 3

15. Regulatory Structure
The regulatory structure of the banking system in the U.S. is unique
Dual banking system: Federal or state charter
State charter = state bank
Regulated by state banking agency (e.g Washington Dept. of Financial Institutions )
Federal charter = national bank
Regulated by Comptroller of the Currency
Required to be member of the Fed
All banks with FDIC insurance are also regulated by the FDIC

16. Regulatory Structure
Member banks of the Fed. Res. are regulated by the Fed
35% of banks are members, constitutes 70% of deposits
All national banks must be members (optional for the rest)
Before 1980, non-member banks had less stringent reserve requirements, so many were opting out of membership. Today, both members & nonmembers can borrow from Fed and have same reserve requirements.
Federal Deposit Insurance Corporation (FDIC)
All Fed member banks must carry dep. insurance thru FDIC
FDIC regulates all of its members
Regulatory overlap:
National banks: FDIC, Comptroller, & Fed. Reserve
State banks: state banking authorities, Fed (if member) & FDIC (if Fed member or if chooses FDIC)

17. Regulatory Structure Regulation of bank ownership
Banks independently owned (e.g. Banner Bank)
Banks owned by a holding company (e.g. Baker Boyer Bank)
Stems from amendments to the Bank Holding Company Act which allowed a BHC more flexibility to participate in activities like leasing, mortgage banking, and data processing, insurance, securities underwriting, etc.

18. Deregulation Act of 1980 (DIDMCA)
Initiated to reduce bank regulations and increase Fed monetary policy effectiveness
Phase out of deposit rate ceilings
Interest rate ceilings were previously enforced by Regulation Q. Phased out by 1986.
Phased out by 1986, after which banks could decide their own rates
Allowed checkable deposits for all depository institutions
NOW accounts (high min. balance, pays interest, limited check-writing ability)

19. DIDMCA & Regulation Q

20. Deregulation Act of 1980
New lending flexibility for depository institutions
Allowed S&Ls to offer limited commercial and consumer loans
Standard pricing of Fed services, which would be made available to all depository institutions
Ensures the Fed only provides services, such as check clearing, that it can provide efficiently
Raised deposit insurance from $40k to $100k
Impact of the DIDMCA
Consumers shift to NOW accounts and CDs with higher rates, so banks pay more for funds. Also, increased competition between depository institutions

21. 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 (MMDAs) to compete with money market mutual funds (MMMFs)
Also allowed depository institutions to acquire failing institutions across geographic boundaries
In general, consumers appear to have benefited from this deregulation

22. Regulation of Balance Sheet
Banks are required to maintain a minimum amount of capital as a percentage of total assets
Banks prefer low capital ratios to boost ROE
But regulators prefer high capital to absorb operating losses
In the 1988 Basel I Accord, central bankers of 12 countries met in Basel, Switzerland, and agreed to uniform, risk-based capital requirements, that required banks to have Tier 1 of 4% and overall capital (Tier 1+2) of 8% of assets.
Tier 1 = shareholder equity, retained earnings, and preferred stock
Tier 2 = loan loss reserve (up to a certain level) and subordinated debt

23. Regulation of Balance Sheet
In the 2004 Basel II Accord, central bankers agreed to the following reforms:
Require higher capital based on credit risk (e.g. sufficient collateral and degree of past-due loans)
Require higher capital based on operating risk (e.g. risk of internal systems failing, such as computers, internal controls, etc.)
Basel II was voluntary and non-enforceable

24. Regulation of Balance Sheet
In the 2010 Basel III Accord, central bankers agreed to the following reforms:
define Tier 1 as common equity and retained earnings only
require 6% Tier 1 capital and 4.5% for common equity
based on credit risk (e.g. sufficient collateral and degree of past-due loans)
Require higher liquidity ratios, with regular stress tests
U.S. signed on to Basel III in Dec/11, to be phased in

25. Regulation of Balance Sheet
Use of the Value-at-Risk (VaR) method to determine capital requirements
In 1998, large banks with trading busines (forex, interest rate derivatives, etc.) started using a VaR model to stress test their capital
VaR is an internal system, usually with a 99 percent confidence interval, which shocks the system for tolerance to events which might cause capital to decrease.
In 2008, many banks had losses far bigger than their VaR models predicted

26. Regulation of Balance Sheet
Gov’t required stress tests during credit crisis in 2008 with troubling outcomes
The resulting Trouble Asset Relief Program (TARP) in infused $300B by purchasing 5% preferred stock of banks, even if they didn’t want it
E.g. In Feb/09, the Treasury Dept. “owned” 36% of Citicorp, while executives continued to use company jets, chauffeurs, country club memberships, etc. Eventually, Obama put limits on executive pay
TARP stopped injecting capital by Oct/10; today most of the funds have been repaid
TARP ended up losing very little money, and it restored confidence in the system; nevertheless, TARP is still very controversial, with many thoughtful people claiming it wasn’t’ worth it

27. Regulation of Balance Sheet
Regulation of loans
Loan quality (LTV ratio, D/I ratio, credit history)
Highly leveraged transactions (HLTs) >75 LTV
Loans to foreign countries
Loans to the community (CRA encourages loans to low income borrowers)
Adequacy of loan loss reserves
Loans to single borrower (max. loan amount of 15% of capital)
Regulation of investment securities
Common stocks allowed only with owner’s funds (not deposits or borrowed funds)
Bond investments limited to investment-grade only
Investment banking activity allowed only for state and municipal bonds

28. Regulation of Operations
Regulation of securities services
Banking Act of 1933 (Glass-Steagall) separated banking and securities services
Intended to prevent conflicts of interest, insider trading, and self-interest lending
Deregulation of debt underwriting services, 1989
Allowed commercial paper and corporate debt underwriting
Still no common stock underwriting
Deregulation of mutual funds services
The Fed ruled in 1986 to allow brokerage subsidiaries of bank holding companies to sell mutual funds

29. Regulation of Operations
The Financial Services Modernization Act, 1999 (also known as Gramm-Leach-Bliley Act)
Essentially repealed the Glass-Steagall Act
Enables commercial banks to more easily pursue stock underwriting and insurance activities
Allows financial institutions to diversify
Allows customers a one-stop-shop
BUT encourages a too-big-to-fail trend
During , major security firms were either purchased by commercial banks (Merrill Lynch by BofA, and Bear Stearns by JPMC) or applied to become bank holding companies (e.g. Goldman Sachs, Morgan Stanley). Thus these security firms are not subject to more stringent regulation.

30. Regulation of Operations
Regulation of insurance services
Previously, 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 (Citigroup & Travelers)
Regulation of off-balance sheet transactions
Risk-based capital requirements are higher for banks with more off-balance sheet activities (letters of credit, interest-rate swaps, loan commitments, etc.)

31. Regulation of Interstate Expansion
The McFadden Act of 1927 prevented banks from establishing branches across state lines.
Interstate bank holding company mergers were prevented by Douglass Amendment (1956)
Intent was to prevent large bank market control, but it also limited competition to interstate banks only
Slowly changes in state banking law permitted interstate banking
U.S. different from most other countries which have a few, large, national banks (e.g. Canada)

32. Regulation of Interstate Expansion
Interstate Banking Act, 1994
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
Reduce costs to consumers and add convenience—promotes competition
Banks take advantage of economies of scale
BUT banks also become too-big-to-fail!

33. Dodd-Frank Wall St. Reform & Consumer Protection Act of 2010
Or simply the Financial Reform Act of Dodd-Frank Act The stated aim of the legislation is:
“To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”
Senator Chris Dodd, Democrat.
Congressman Barney Frank, Democrat.
Senator Richard Shelby, Republican.

34. Dodd-Frank Wall St. Reform & Consumer Protection Act of 2010
The Act is 2307 pages and 16 chapters long. Still trying to figure out what it says. One of the shortest, user-friendly summaries I could find is linked here. Students should be familiar with these summary provisions.
4.1 Title I - Financial Stability Act ( create Financial Stability Oversight Council and Office of Financial Research to monitor systemic risk)
4.2 Title II - Orderly Liquidation Authority (extends liquidation authority beyond banks to other financial institutions)
4.3 Title III - Transfer of Powers to the Comptroller, the FDIC, and the FED (Enhancing Financial Institution Safety and Soundness Act) (streamline overlapping regulatory agencies, make $250,000 insurance limit permanent)
4.4 Title IV - Regulation of Advisers to Hedge Funds and Others (Private Fund Investment Advisers Registration Act) (regulate hedge funds for the first time, increasing investor min. wealth to $1 million, excluding home)

35. Dodd-Frank Wall St. Reform & Consumer Protection Act of 2010
4.5 Title V – Insurance (Federal Insurance Office Act and Nonadmitted and Reinsurance Reform Act) (monitor insurance, except health, LT care & crop; previously, oversight of insurance was done strictly at the state level)
4.6 Title VI - Improvements to Regulation (Bank and Savings Association Holding Company and Depository Institution Regulatory Improvements Act) (limits speculative investments of banks to 3% of Tier 1 capital; prohibits proprietary trading (speculation) with depositor funds (Volcker Rule). 4.7 Title VII - Wall Street Transparency and Accountability Act (regulate OTC derivatives, such as credit default swaps) 4.8 Title VIII - Payment, Clearing and Settlement Supervision Act (gives Fed powers to monitor and supervise liquidity risk within banking system) 4.9 Title IX - Investor Protections and Securities Reform Act (more disclosure, whistleblower protection and rewards, credit rating agencies, originators keep 5% investment in mortgage, shareholders approve executive compensation)

36. Dodd-Frank Wall St. Reform & Consumer Protection Act of 2010
4.10 Title X - Consumer Financial Protection Act (regulate consumer financial products, controversial)
4.11 Title XI – Fed’s System Provisions (create vice chair, Congressional oversight of Fed’s lending)
4.12 Title XII - Improving Access to Mainstream Financial Institutions Act (make banks give low income $2500 microloans, & financial counseling)
4.13 Title XIII - Pay It Back Act (unused TARP funds go to deficit reduction)
4.14 Title XIV - Mortgage Reform and Anti-Predatory Lending Act (underwriting, origination, no prepayment penalties, regulation of interest-only/graduated payment & reverse mortgages, financial counseling, appraisers, valuation models, loan modifications, foreclosures, Chinese drywall)
4.15 Title XV - Miscellaneous Provisions (e.g. Mine safety & off-shore drilling safety)
4.16 Title XVI - Section 1256 Contracts (IRC Section 1256 on futures/options)

37. Dodd-Frank Status Report
As of Feb., 2014, fewer than half the rules mandated by Dodd-Frank have been implemented by regulators. Among the measures awaiting completion are rules designed to increase transparency in derivatives markets, and rules to improve consumer protections for mortgage borrowers.
The Volcker Rule, named after former Fed Chair Paul Volcker, prohibits commercial banks from proprietary trading (speculation with depositor funds). In 2012, JPM Chase lost $6.2 billion from what it claimed was hedging with credit derivatives, but the gov’t claims it was proprietary trading. A big issue with the Volcker Rule is defining exactly what is hedging and what is speculation.

38. How Regulators Monitor Banks
Regulators examine commercial banks at least once per year in an examination (audit)
CAMELS ratings
Capital adequacy
Regulators determine “adequacy” of capital
More capital allows banks to absorb losses
Asset quality
Credit risk
Portfolio’s exposure to potential events

39. 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)

40. 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 (asset/liability managemenet, see BMCU report)
Rating bank characteristics
Each of the CAMEL characteristics is rated on a 1-to-5 scale, with 1 indicating outstanding, 2 good, 3 so-so, 4 red flag, 5 failure
Used to identify problem banks
Subjective opinion must be used to supplement objective measures

41. 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
Many banks are put on probation
Regulators have the authority to take legal action against a bank if they do not comply

42. Bank Failure

43. 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 (>$250,000) customers not protected

44. The “Too-Big-To-Fail” Issue
Argument for government rescue
Because many depositors exceeded deposit insurance limits, failure to protect them could have caused runs at other large banks. Financial problems at large banks can be cantagious
Argument against government rescue
Sends a message that large banks will be protected from failure
Incentive for banks to take added risks
Removes incentive to make operations more efficient

45. 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

46. Gov’t Rescues Spring of 2008, Bear Stearns
Bear Stearns had facilitated many transactions in financial markets, and its failure would have caused liquidity problems
The Fed provided short-term loans to Bear Stearns to ensure that it had adequate liquidity
Fall of 2008, Lehman Brothers and AIG
Lehman Brothers was allowed to go bankrupt even though American International Group was rescued by the Fed.
One important difference between AIG and LB was that AIG had various subsidiaries that were financially sound at the time, and the assets in these subsidiaries served as collateral for the loans extended by the government
The risk of taxpayer loss due to the AIG rescue was low, but was very high in LB

47. Global Bank Regulations
Each country has a system for monitoring and regulating commercial banks.
Most countries also maintain different guidelines for deposit insurance.
Differences in regulatory restrictions give some banks a competitive advantage in a global banking environment.