2BackgroundAs 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 ofcorporations (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 CongressBank failures of 1970s and 1980s again caused a slew of bank regulation
3History of U.S. Bank Failures # of banks failed 3 in 200730 in 2008148 in 2009157 in 201092 in in in so far in 2014See FDIC website for details
6A Bank Run It’s a Wonderful Life Mary Poppins Mary Poppins
7Deposit Insurance - Background March of 1933, panic of massive proportions across the country with runs on the bank everywhereIn response, FDR took several steps:On March 6, FDR declared a four-day banking holidayAdventist miracleBaker Boyer Bank’s back doorOn March 12, FDR held his first “fire-side chat”, a live nation-wide radio broadcast to reassure the nationFed issued new notes to increase $ supply and Bureau of Engraving went into 24 hr/day production of currency/coinFDR pushed deposit insurance regulation
8Deposit 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 industryThose opposed to deposit insurance claimed that:It removed penalties for bad judgment (moral hazard)It was too expensiveIt wouldn’t work as demonstrated by the collapse of state insurance funds who already tried itIt was an intrusion by gov’t into private affairs
9Deposit 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 PresidentMartin GruenbergFDIC Chair since Nov/12
10Deposit Insurance Ceilings How Deposit Insurance Coverage Has Increased1934: (Jan.) $2,5001934: (July) $5,0001950: $10,0001966: $15,0001969: $20,0001974: $40,0001980: $100,0002008: $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
11Regulation of Deposit Insurance The pool of funds used to cover insured depositors is called the Bank Insurance FundSupported by annual insurance premiums paid by commercial banks – rate about .3% of depositsBefore 1991, the rate was the same for all banks, regardless of risk (under Basel Accord), causing moral hazard problemIn 1991, the Federal Deposit Insurance Act (FDICA) phased in risk-based insurance premiums
12Regulation of Deposit Insurance Covers bank accounts and IRAs/Keoghs but NOT securities or mutual fundsCoverage 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.)DepositorType of DepositAmount DepositedAbe & BarbZero-Interest Checking$150,000CD$200,000Passbook SavingsAbe's Restaurant (a sole proprietorship)$260,000Abe’s IRA Account$275,000Barb’s IRA Account$300,000TOTAL DEPOSITED$1,385,000INSURED AMOUNT???
13Background of regulation Banking industry has experienced tremendous change in recent yearsPost-Depression legislation focused on safety and soundness of commercial banksSince the 1980s, there’s been substantial deregulation of financial services industryToday, intense competition/consolidation has occurred, as banks try to compete with services (one-stop-shop) and create economies of scale.
14Why Banks Are Regulated? Deposits are 70% of money supplyCenter of payments mechanismPrimary transmitter of monetary policyMajor liquidity provider to economy1998 South-Western College Publishing3
15Regulatory StructureThe regulatory structure of the banking system in the U.S. is uniqueDual banking system: Federal or state charterState charter = state bankRegulated by state banking agency (e.g Washington Dept. of Financial Institutions )Federal charter = national bankRegulated by Comptroller of the CurrencyRequired to be member of the FedAll banks with FDIC insurance are also regulated by the FDIC
16Regulatory StructureMember banks of the Fed. Res. are regulated by the Fed35% of banks are members, constitutes 70% of depositsAll 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 FDICFDIC regulates all of its membersRegulatory overlap:National banks: FDIC, Comptroller, & Fed. ReserveState banks: state banking authorities, Fed (if member) & FDIC (if Fed member or if chooses FDIC)
17Regulatory 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.
18Deregulation Act of 1980 (DIDMCA) Initiated to reduce bank regulations and increase Fed monetary policy effectivenessPhase out of deposit rate ceilingsInterest rate ceilings were previously enforced by Regulation Q. Phased out by 1986.Phased out by 1986, after which banks could decide their own ratesAllowed checkable deposits for all depository institutionsNOW accounts (high min. balance, pays interest, limited check-writing ability)
20Deregulation Act of 1980New lending flexibility for depository institutionsAllowed S&Ls to offer limited commercial and consumer loansStandard pricing of Fed services, which would be made available to all depository institutionsEnsures the Fed only provides services, such as check clearing, that it can provide efficientlyRaised deposit insurance from $40k to $100kImpact of the DIDMCAConsumers shift to NOW accounts and CDs with higher rates, so banks pay more for funds. Also, increased competition between depository institutions
21Garn-St. Germain Act, 1982Came at a time when some depository institutions were experiencing severe financial problemsPermitted 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 boundariesIn general, consumers appear to have benefited from this deregulation
22Regulation of Balance Sheet Banks are required to maintain a minimum amount of capital as a percentage of total assetsBanks prefer low capital ratios to boost ROEBut regulators prefer high capital to absorb operating lossesIn 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 stockTier 2 = loan loss reserve (up to a certain level) and subordinated debt
23Regulation 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
24Regulation 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 onlyrequire 6% Tier 1 capital and 4.5% for common equitybased on credit risk (e.g. sufficient collateral and degree of past-due loans)Require higher liquidity ratios, with regular stress testsU.S. signed on to Basel III in Dec/11, to be phased in
25Regulation of Balance Sheet Use of the Value-at-Risk (VaR) method to determine capital requirementsIn 1998, large banks with trading busines (forex, interest rate derivatives, etc.) started using a VaR model to stress test their capitalVaR 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
26Regulation of Balance Sheet Gov’t required stress tests during credit crisis in 2008 with troubling outcomesThe resulting Trouble Asset Relief Program (TARP) in infused $300B by purchasing 5% preferred stock of banks, even if they didn’t want itE.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 payTARP stopped injecting capital by Oct/10; today most of the funds have been repaidTARP 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
27Regulation of Balance Sheet Regulation of loansLoan quality (LTV ratio, D/I ratio, credit history)Highly leveraged transactions (HLTs) >75 LTVLoans to foreign countriesLoans to the community (CRA encourages loans to low income borrowers)Adequacy of loan loss reservesLoans to single borrower (max. loan amount of 15% of capital)Regulation of investment securitiesCommon stocks allowed only with owner’s funds (not deposits or borrowed funds)Bond investments limited to investment-grade onlyInvestment banking activity allowed only for state and municipal bonds
28Regulation of Operations Regulation of securities servicesBanking Act of 1933 (Glass-Steagall) separated banking and securities servicesIntended to prevent conflicts of interest, insider trading, and self-interest lendingDeregulation of debt underwriting services, 1989Allowed commercial paper and corporate debt underwritingStill no common stock underwritingDeregulation of mutual funds servicesThe Fed ruled in 1986 to allow brokerage subsidiaries of bank holding companies to sell mutual funds
29Regulation of Operations The Financial Services Modernization Act, 1999 (also known as Gramm-Leach-Bliley Act)Essentially repealed the Glass-Steagall ActEnables commercial banks to more easily pursue stock underwriting and insurance activitiesAllows financial institutions to diversifyAllows customers a one-stop-shopBUT encourages a too-big-to-fail trendDuring , 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.
30Regulation of Operations Regulation of insurance servicesPreviously, banks sometimes leased space to insurance or served as agent, but not underwriting insuranceBanks able to underwrite annuities, 1995The passage of the Financial Services Modernization Act (1999) confirmed that banks and insurers could consolidate their operations (Citigroup & Travelers)Regulation of off-balance sheet transactionsRisk-based capital requirements are higher for banks with more off-balance sheet activities (letters of credit, interest-rate swaps, loan commitments, etc.)
31Regulation 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 onlySlowly changes in state banking law permitted interstate bankingU.S. different from most other countries which have a few, large, national banks (e.g. Canada)
32Regulation of Interstate Expansion Interstate Banking Act, 1994Reigle-Neal Interstate Banking and Branching Efficiency Act of 1994Eliminated most restrictions on interstate bank mergers and allowed commercial banks to open branches nationwideAllowed interstate bank holding companies to consolidate into one charterReduce costs to consumers and add convenience—promotes competitionBanks take advantage of economies of scaleBUT banks also become too-big-to-fail!
33Dodd-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.
34Dodd-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)
35Dodd-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)
36Dodd-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)
37Dodd-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.
38How Regulators Monitor Banks Regulators examine commercial banks at least once per year in an examination (audit)CAMELS ratingsCapital adequacyRegulators determine “adequacy” of capitalMore capital allows banks to absorb lossesAsset qualityCredit riskPortfolio’s exposure to potential events
39How Regulators Monitor Banks ManagementRates management according to administrative skills, ability to comply with existing regulations, and ability to cope with a changing environment.Very subjectiveEarningsBanks fail when their earnings are consistently negativeCommonly used ratio: Return on Assets (ROA)
40How Regulators Monitor Banks LiquidityExtent 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 characteristicsEach 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 failureUsed to identify problem banksSubjective opinion must be used to supplement objective measures
41How Regulators Monitor Banks Corrective action by regulatorsWhen a problem bank is identified it is thoroughly investigated (examined) by regulatorsThey may require specific corrective action, such as boosting capital or delay expansionMany banks are put on probationRegulators have the authority to take legal action against a bank if they do not comply
43How Regulators Monitor Banks Funding the closure of failing banksFDIC is responsible for closing failing banksLiquidating failed bank's assetsFacilitating acquisition by another bankFederal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991Regulators required to act more quickly for undercapitalized banksRisk-based deposit insurance premiumsClose failing banks more quicklyLarge deposit (>$250,000) customers not protected
44The “Too-Big-To-Fail” Issue Argument for government rescueBecause 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 cantagiousArgument against government rescueSends a message that large banks will be protected from failureIncentive for banks to take added risksRemoves incentive to make operations more efficient
45The “Too-Big-To-Fail” Issue Proposals for government rescueIdeal solution would prevent a run on deposits while not rewarding poorly performing banks with a bailoutRegulators should play a greater role in assessing bank financial conditions over time
46Gov’t Rescues Spring of 2008, Bear Stearns Bear Stearns had facilitated many transactions in financial markets, and its failure would have caused liquidity problemsThe Fed provided short-term loans to Bear Stearns to ensure that it had adequate liquidityFall of 2008, Lehman Brothers and AIGLehman 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 governmentThe risk of taxpayer loss due to the AIG rescue was low, but was very high in LB
47Global 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.