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Chapter 20 Banking Regulation. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-2 Chapter Preview The financial system is one of the most.

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Presentation on theme: "Chapter 20 Banking Regulation. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-2 Chapter Preview The financial system is one of the most."— Presentation transcript:

1 Chapter 20 Banking Regulation

2 Copyright © 2009 Pearson Prentice Hall. All rights reserved Chapter Preview The financial system is one of the most heavily regulated industries in our economy. In this chapter, we develop an economic analysis of why regulation of banking takes the form that it does. We see further that regulation doesn’t always work.

3 Copyright © 2009 Pearson Prentice Hall. All rights reserved Chapter Preview Finally, we offer an explanation for the world banking crisis and reforms to prevent future disasters. Topics include: – Asymmetric Information and Bank Regulation – The 1980s U.S. Banking Crisis – Federal Deposit Insurance Corporation Improvement Act of 1991; Dodd-Frank Regulatory Act, and Basil III – International Banking Regulation – Banking Crisis Throughout the World

4 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation Our previous analysis of asymmetric information, moral hazard, and adverse selection provide an excellent backdrop for understanding the current regulatory environment in banking. There are eight basic categories of bank regulation, which we will examine from an asymmetric information perspective.

5 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 1.Government Safety Net: Deposit Insurance and the FDIC Prior to FDIC insurance, bank failures meant depositors lost money, and had to wait until the bank was liquidated to receive anything. This meant that “good” banks needed to separate themselves from “bad” banks, which was difficult for banks to accomplish. The inability of depositors to assess the quality of a bank’s assets can lead to panics. If depositors fear that some banks may fail, their best policy is to withdraw all deposits, leading to a bank run, even for “good” banks. Further, failure of one bank can hasten failure of others (contagion effect).

6 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 1.Government Safety Net: Deposit Insurance and the FDIC Bank panics did occur prior to the FDIC, with major panics in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and By providing a safety net, depositors will not flee the banking system at the first sign of trouble. Indeed, between 1934 and 1981, fewer than 15 banks failed each year.

7 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 1.Government Safety Net: Deposit Insurance and the FDIC The FDIC handles failed banks in one of two ways: the payoff method, where the banks is permitted to fail, and the purchase and assumption method, where the bank is folded into another banking organization. Implicit insurance is available in some countries where no explicit insurance organization exists. But, as the next slide shows, deposit insurance is spreading throughout the world.

8 Copyright © 2009 Pearson Prentice Hall. All rights reserved Global: The Spread of Deposit Insurance Throughout the World Up to the 1960s, only six countries had deposit insurance. By the 1990s, the number topped 70. Has this spread of insurance been a good thing? Did it improve the performance of the financial system and prevent crises? Oddly enough, the answer appears to be no.

9 Copyright © 2009 Pearson Prentice Hall. All rights reserved Global: The Spread of Deposit Insurance Throughout the World Explicit government insurance is associated with less bank sector stability and higher bank crises. Appears to retard financial development But this appears to be only for countries with ineffective laws, regulation, and high corruption. Indeed, for emerging markets, deposit insurance may be the wrong medicine!

10 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 1.Government Safety Net: Deposit Insurance and the FDIC: The FDIC insurance creates moral hazard incentives for banks to take on greater risk than they otherwise would because of the lack of “market discipline” on the part of depositors. The FDIC insurance creates adverse selection. Those who can take advantage of (abuse) the insurance are mostly likely to find banks attractive.

11 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 1.Government Safety Net: Deposit Insurance and the FDIC: Regulators are reluctant to let the largest banks fail because of the potential impact on the entire system. This is known as the “Too Big to Fail” doctrine. This increases the moral hazard problem for big banks and reduces the incentive for large depositors to monitor the bank.

12 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 1.Government Safety Net: Deposit Insurance and the FDIC Consolidation has created many “large” banks, exasperating the too-big-to-fail problem. Further, banks now engage in more than just banking, which may inadvertently extend FDIC to such activities as underwriting.

13 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 2.Restrictions on Asset Holdings Regulations limit the type of assets banks may hold as assets. For instance, banks may not hold common equity.

14 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 3.Bank Capital Requirements Banks are also subject to capital requirements. Banks are required to hold a certain level of capital (book equity) that depends on the type of assets that the bank holds.

15 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 3.Bank Capital Requirements Details of bank capital requirements: Leverage ratio must exceed 5% to avoid restrictions Capital must exceed 8% of the banks risk- weighted assets and off-balance sheet activities (details follow) New capital requirements are forthcoming to address problems with risk-weighted assets

16 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 3.Bank Capital Requirements The next four slides show how to calculate Bank Capital requirements for a fictitious bank.

17 Copyright © 2009 Pearson Prentice Hall. All rights reserved Calculating Capital Requirements

18 Copyright © 2009 Pearson Prentice Hall. All rights reserved Calculating Capital Requirements Leverage Ratio=Capital/Assets =$7m/$100m = 7% Bank is well capitalized

19 Copyright © 2009 Pearson Prentice Hall. All rights reserved Calculating Risk-Adjusted Requirements

20 Copyright © 2009 Pearson Prentice Hall. All rights reserved Calculating Risk-Adjusted Requirements Core Capital Requirement = 4% x risk-adjusted assets = 4% x $91.4m = $3.66m < $7m of core capital Total Capital Requirement = 8% x risk-adjusted assets = 8% x $91.4m = $7.31m < $9m of total capital = $7m of core + $2m of loan loss reserves

21 Copyright © 2009 Pearson Prentice Hall. All rights reserved Asymmetric Information and Bank Regulation 3.Bank Capital Requirements Of course, the system isn’t perfect. Banks now engage in regulatory arbitrage, where for a given category, they seek assets that are the riskiest. Basel continued to work on the system.

22 Copyright © 2009 Pearson Prentice Hall. All rights reserved Basel 2: How well it works? In June 1999, the Basel Committee proposed several reforms to the original Basel Accord, with the following components: – Linking capital requirements to actual risk for large, international banks – Steps to strengthen the supervisory process – Increased market discipline mechanisms

23 Copyright © 2009 Pearson Prentice Hall. All rights reserved Basel 2: How well it works? The new system appears to be quite complex, and implementation has been delayed by years. U.S. regulators met to determine how best to protect the FDIC insurance fund based on the new capital requirements. Only the largest U.S. banks will be subject to Basel 2. Other U.S. banks will follow a simplified standard.

24 Copyright © 2009 Pearson Prentice Hall. All rights reserved How Asymmetric Information Explains Banking Regulation 4.Bank Supervision: Chartering and Examination Reduces the adverse selection problem of risk- takers or crooks owning banks to engage in highly speculative activities. As Lincoln S&L shows, this isn’t a perfect system. Examinations assign a CAMEL (capital adequacy, asset quality, management, earnings, liquidity) rating to a bank, which can be used to justify cease and desist orders for risky activities. Period reporting (call reports) and frequent (sometimes unannounced) examinations allow regulators to address risky / questionable practices in a prompt fashion.

25 Copyright © 2009 Pearson Prentice Hall. All rights reserved How Asymmetric Information Explains Banking Regulation 5.Assessment of Risk Management Past examinations focused primarily on the quality of assets. A new trend has been to focus on whether the bank may take excessive risk in the near future. Four elements of risk management and control: 1.Quality of board and senior management oversight 2.Adequacy of policies limiting risk activity 3.Quality of risk measurement and monitoring 4.Adequacy of internal controls to prevent fraud

26 Copyright © 2009 Pearson Prentice Hall. All rights reserved How Asymmetric Information Explains Banking Regulation 5.Assessment of Risk Management U.S. regulators have also adopted similar- minded guidelines for dealing with interest- rate risk. Particularly important is the implementation of stress testing, or VAR calculations, to measure potential losses.

27 Copyright © 2009 Pearson Prentice Hall. All rights reserved How Asymmetric Information Explains Banking Regulation 6.Disclosure Requirements Better information reduces both moral hazard and adverse selection problems 7.Consumer Protection Standardized interest rates (APR) Prevent discrimination (e.g., CRA to help avoid redlining particular areas)

28 Copyright © 2009 Pearson Prentice Hall. All rights reserved How Asymmetric Information Explains Banking Regulation 8.Restrictions on Competition Branching restrictions, which reduced competition between banks Separation of banking and securities industries: Glass-Steagall. In other words, preventing nonbanks from competing with banks.

29 Copyright © 2009 Pearson Prentice Hall. All rights reserved How Asymmetric Information Explains Banking Regulation Many laws have been passed in the U.S. to regulate banking. Table 1 provides a summary of the major legislation and key provisions.

30 FDIC index of regulations on banking ations/laws/index.html Major Banking Legislation in the United States

31 Copyright © 2009 Pearson Prentice Hall. All rights reserved FDIC index of regulations on banking Major Banking Legislation in U.S. (cont.)

32 Copyright © 2009 Pearson Prentice Hall. All rights reserved Case: The 1980s U.S. Banking Crisis and its impact on bank regulations Prior to the 1980s, the FDIC and bank regulation seemed to be going well. However, in the 80s, failures rose dramatically, as you can see in the following slide.

33 Copyright © 2009 Pearson Prentice Hall. All rights reserved U.S. Bank Failures

34 Copyright © 2009 Pearson Prentice Hall. All rights reserved The 1980s U.S. Banking Crisis Why? 1.Decreasing profitability: banks take risk to keep profits up 2.Financial innovation creates more opportunities for risk taking 3.Innovation of brokered deposits enables circumvention of $100,000 insurance limit Result: Failures  and risky loans 

35 Copyright © 2009 Pearson Prentice Hall. All rights reserved Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 Following the widespread failure of thrift institutions in the late 1980s, the Bush administration proposed a set of legislation to overhaul the supervision and insurance for the thrift industry. As part of this, the FSLIC was dissolved and the FDIC assumed responsibility for insuring thrift institutions. To address the new needs of the FDIC, the Improvement Act of 1991 was passed.

36 Copyright © 2009 Pearson Prentice Hall. All rights reserved Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 FDIC recapitalized with loans, ability to borrow from the Treasury, and higher premiums to member banks Reduce scope of deposit insurance and too-big- to-fail – Lower limits on deposit insurance – Eliminate too-big-to-fail – Coinsurance

37 Copyright © 2009 Pearson Prentice Hall. All rights reserved Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 Prompt corrective action provisions 1.Critics believe too many loopholes 2.However: accountability increased by mandatory review of bank failure resolutions Risk-based premiums Annual examinations and stricter reporting Enhances Fed powers to regulate international banking

38 Copyright © 2009 Pearson Prentice Hall. All rights reserved Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 FDICIA also instructed the FDIC to develop risk-based insurance premiums. However, it wasn’t very effective. The Federal Deposit Reform Act of 2005 attempts to remedy this. FDICIA was a good start. But there are still concerns with too-big-to-fail doctrines and effective insurance premiums.

39 Dodd–Frank Wall Street Reform and Consumer Protection Act Introduction A bill that aims to increase government oversight of trading in complex financial instruments such as derivatives. The Dodd-Frank Regulatory Reform Bill was named after Senator Christopher J. Dodd and U.S. Representative Barney Frank. The restrictions placed on the types of proprietary trading that financial institutions will be allowed to practice are intended to prevent the collapse of major financial institutions such as Lehman Brothers. 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.

40 Dodd–Frank Wall Street Reform and Consumer Protection Act Overview The Act is categorized into sixteen titles and by one law firm's count, it requires that regulators create 243 rules, conduct 67 studies, and issue 22 periodic reports. The Act changes the existing regulatory structure, such as creating a host of new agencies (while merging and removing others) in an effort to streamline the regulatory process, increasing oversight of specific institutions regarded as a systemic risk, amending the Federal Reserve Act, promoting transparency, and additional changes. The Act establishes rigorous standards and supervision to protect the economy and American consumers, investors and businesses, ends taxpayer funded bailouts of financial institutions, provides for an advanced warning system on the stability of the economy, creates rules on executive compensation and corporate governance, and eliminates the loopholes that led to the economic recession.

41 Dodd–Frank Wall Street Reform and Consumer Protection Act Provisions Title I - Financial Stability Title II - Orderly Liquidation Authority Title III - Transfer of Powers to the Comptroller, the FDIC, and the FED Title IV - Regulation of Advisers to Hedge Funds and Others Title V – Insurance Title VI - Improvements to Regulation Title VII - Wall Street Transparency and Accountability Title VIII - Payment, Clearing and Settlement Supervision Title IX - Investor Protections and Improvements to the Regulation of Securities Title X - Bureau of Consumer Financial Protection Title XI - Federal Reserve System Provisions Title XII - Improving Access to Mainstream Financial Institutions Title XIII - Pay It Back Act Title XIV - Mortgage Reform and Anti-Predatory Lending Act Title XV - Miscellaneous Provisions Title XVI - Section 1256 Contracts

42 Basel III BASEL III (sometimes "Basel 3") refers to a new update to the Basel Accords that is under development. The Bank for International Settlements (BIS) itself began referring to this new international regulatory framework for banks as "Basel III" in September The draft Basel III regulations include: – tighter definitions of Common Equity; banks must hold 4.5% by January 2015, then a further 2.5%, total 7% – the introduction of a leverage ratio, – a framework for counter-cyclical capital buffers, – measures to limit counterparty credit risk, – and short and medium-term quantitative liquidity ratios.

43 Basel III Too-big-to-fail institutions that took on too much risk – a large part of these risks being driven by new innovations that took advantage of regulatory and tax arbitrage with no effective constraints on leverage. Insolvency resulting from contagion and counterparty risk, driven mainly by the capital market (as opposed to traditional credit market) activities of banks, and giving rise to the need for massive taxpayer support and guarantees. Banks simply did not have enough capital. The lack of regulatory and supervisory integration, which allowed promises in the financial system to be transformed with derivatives and passed out to the less regulated and capitalised industries outside of banking – such as insurance and re- insurance. The same promises in the financial system were not treated equally. The lack of efficient resolution regimes to remove insolvent firms from the system. This issue, of course, is not independent of the structure of firms which might be too-big-to- fail. Switzerland, for example, might have great difficulty resolving a UBS or a Credit Suisse – given their size relative to the economy. They may have less trouble resolving a failed legally separated subsidiary.

44 Copyright © 2009 Pearson Prentice Hall. All rights reserved International Bank Regulation We now turn to international regulation. Banks around the world face similar problems as the U.S., and so are regulated in a similar fashion. Charters, supervision, and deposit insurance are common themes throughout the world. And capital requirements are being standardized.

45 Copyright © 2009 Pearson Prentice Hall. All rights reserved Banking Crisis Throughout the World As the next two slides illustrates, banking crisis have struck a large number of countries throughout the world, and many of them have been substantially worse than ours.

46 20-46 Banking Crisis Throughout the World

47 Cost of Banking Crises in Other Countries

48 Copyright © 2009 Pearson Prentice Hall. All rights reserved Banking Crisis Throughout the World Latin America – Many banks were government owned with interest rate restrictions similar to Regulation Q. – Similar loan losses and bailout experience as the U.S. in the late 1980s. – Argentina ran into government confidence problem, causing required rates on government debt to exceed 25%, which caused severe problems for the banking industry. – Losses and bailouts as a percent of GDP are high (20% - 50%) relative to that in the U.S. (around 3%).

49 Copyright © 2009 Pearson Prentice Hall. All rights reserved Banking Crisis Throughout the World Russia and Eastern Europe – Many banks were government owned prior to the downfall of communism. – Private banks had little experience screening and monitoring loans. – Substantial loan losses ensued. – The bailout in Russia alone may exceed $15 billion

50 Copyright © 2009 Pearson Prentice Hall. All rights reserved Banking Crisis Throughout the World Japan – Prior to the 1980s, Japan’s financial markets were heavily regulated. Deregulation led to excessive risk taking and high loan losses, particularly in real estate loans. – Several large bank failures were announced in Several failures followed in 1996 and 1997.

51 Copyright © 2009 Pearson Prentice Hall. All rights reserved Banking Crisis Throughout the World Japan – Japan is experiencing similar regulator forbearance policies as the U.S. in the early 1980s. – Even with positive steps, bad loans throughout the banking system required a bailout of $500 billion in – System is still a long way from being healthy.

52 Copyright © 2009 Pearson Prentice Hall. All rights reserved Banking Crisis Throughout the World Japan – Immediately after 1998, the gov’t closed two big banks. Cleanup stalled as banks tried to avoid gov’t involvement. Bad loans were estimated near $1 trillion. – Only recently have the number of bad loans started to decline, and larger banks have paid back the bail-out money. Profitability is near zero.

53 Copyright © 2009 Pearson Prentice Hall. All rights reserved Banking Crisis Throughout the World China – Many banks were government owned. – Investments in many state-owned enterprises, which are notoriously inefficient. – Attempt at a bailout called for partial privatization of the biggest banks.

54 Copyright © 2009 Pearson Prentice Hall. All rights reserved Banking Crisis Throughout the World East Asia – Lending boom in the aftermath of liberalization led to substantial loan losses. – Nonperforming loans and bailout costs exceeding 20% of GDP are commonplace.

55 Copyright © 2009 Pearson Prentice Hall. All rights reserved Déjà Vu All Over Again! Banking crises are just history repeating itself. Financial liberalization leads to moral hazard (and bad loans!). Deposit insurance is not big enough to cover losses, but the gov’t does stand ready to bailout the system. And that implicit guarantee is enough to exacerbate the moral hazard problem.


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