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CHAPTER 18 Bank Regulation
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. History of U.S. Bank Failures # of banks failed 3 in in in in in in in so far in 2014 See FDIC website for details
Copyright© 2002 Thomson Publishing. All rights reserved. History of Bank Failures
Copyright© 2002 Thomson Publishing. All rights reserved.
A Bank Run Its a Wonderful Life Mary Poppins
Copyright© 2002 Thomson Publishing. All rights reserved. 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 Banks 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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 wouldnt work as demonstrated by the collapse of state insurance funds who already tried it It was an intrusion by govt into private affairs
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. Deposit Insurance Ceilings How Deposit Insurance Coverage Has Increased 1934: (Jan.) $2, : (July) $5, : $10, : $15, : $20, : $40, : $100, : $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
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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 owners single account. Partnerships and corporations are separate legal entities ($250k max.) Depositor Type of Deposit Amount Deposited Abe & BarbZero-Interest Checking$150,000 Abe & BarbCD$200,000 Abe & BarbPassbook Savings$200,000 Abe's Restaurant (a sole proprietorship) Zero-Interest Checking$260,000 Abes IRA AccountCD$275,000 Barbs IRA AccountCD$300,000 TOTAL DEPOSITED$1,385,000 INSURED AMOUNT???
Copyright© 2002 Thomson Publishing. All rights reserved. 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, theres 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.
Copyright© 2002 Thomson Publishing. All rights reserved. ©1998 South-Western College Publishing3 Why Banks Are Regulated? Deposits are 70% of money supply Center of payments mechanism Primary transmitter of monetary policy Major liquidity provider to economy
Copyright© 2002 Thomson Publishing. All rights reserved. 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 )www.dfi.wa.gov 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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)
Copyright© 2002 Thomson Publishing. All rights reserved. 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.
Copyright© 2002 Thomson Publishing. All rights reserved. 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 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)
Copyright© 2002 Thomson Publishing. All rights reserved. DIDMCA & Regulation Q
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. Regulation of Balance Sheet Govt 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 didnt 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 wasnt worth it
Copyright© 2002 Thomson Publishing. All rights reserved. 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 owners funds (not deposits or borrowed funds) Bond investments limited to investment-grade only Investment banking activity allowed only for state and municipal bonds
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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.
Copyright© 2002 Thomson Publishing. All rights reserved. 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.)
Copyright© 2002 Thomson Publishing. All rights reserved. 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)
Copyright© 2002 Thomson Publishing. All rights reserved. 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 conveniencepromotes competition Banks take advantage of economies of scale BUT banks also become too-big-to-fail!
Copyright© 2002 Thomson Publishing. All rights reserved. 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.
Copyright© 2002 Thomson Publishing. All rights reserved. 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) 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.linked here
Copyright© 2002 Thomson Publishing. All rights reserved. 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) Dodd-Frank Wall St. Reform & Consumer Protection Act of 2010
Copyright© 2002 Thomson Publishing. All rights reserved Title X - Consumer Financial Protection Act (regulate consumer financial products, controversial) 4.11 Title XI – Feds System Provisions (create vice chair, Congressional oversight of Feds 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) Dodd-Frank Wall St. Reform & Consumer Protection Act of 2010
Copyright© 2002 Thomson Publishing. All rights reserved. Dodd-Frank Status Report n 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. n 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 govt claims it was proprietary trading. A big issue with the Volcker Rule is defining exactly what is hedging and what is speculation.
Copyright© 2002 Thomson Publishing. All rights reserved. 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 Portfolios exposure to potential events
Copyright© 2002 Thomson Publishing. All rights reserved. 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)
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. Bank Failure
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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
Copyright© 2002 Thomson Publishing. All rights reserved. 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 Govt Rescues
Copyright© 2002 Thomson Publishing. All rights reserved. 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. Global Bank Regulations
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