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The Regulation of Markets and Institutions

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1 The Regulation of Markets and Institutions
Chapter 15 The Regulation of Markets and Institutions

2 Key Ideas Different methods of regulating financial markets
Dual banking system and the regulators who oversee it Universal banking and its possible benefits and risks

3 Introduction Financial system is one of most intensely regulated sectors in US economy Objectives of the regulations are: To promote competition To protect individual consumers To maintain stability of financial system To facilitate monetary policy

4 Primary Market Philosophy
Best protection is provide adequate information about securities and investments Full disclosure broadens participation in financial markets

5 Primary Market Securities Act of 1933
Requires disclosure of information for newly issued publicly traded securities Privately held firms are not required to reveal financial information to the public at large, only to the lenders

6 Primary Market Securities Exchange Act of 1934
Created the Securities and Exchange Commission (SEC) to administer provisions of 1933 Act Publicly traded security must file registration statement and preliminary prospectus disclosing information about issue

7 Primary Market Securities Exchange Act of 1934
The prospectus does not state the interest rate on a bond issue or price for equity issues determined in the market when sold If information is adequate, SEC approves the statement and sale Approval by the SEC does not imply that it views the new issue as an attractive investment Approval simply means disclosure of information is adequate

8 Regulation of Secondary Market
Securities Exchange Act of 1934 Extended 1933 Act Periodic disclosure of relevant financial information For firms trading in secondary market 10K Report Annual financial statement and Information about a firm’s performance and activity

9 Secondary Market Securities Exchange Act of 1934
Prohibits Insider Trading Prohibit insiders from trading on private information not previously disclosed to public Corporate officers and major stockholders must report all their transactions of their own firm’s stock

10 Regulation of Commercial Banks
Philosophy Protect individual depositor Foster a competitive banking system Ensure safety and soundness of banking system

11 Commercial Banks Dual banking system
Federal and State banks existing side-by-side Legislation in 1860 established federally chartered banks Created Comptroller of the Currency (US Treasury Department) to supervise chartered banks Imposed a prohibitive tax on issuance of state banknotes Intent was to drive existing state chartered banks out of business

12 Commercial Banks Dual banking system However, state banks survived
Stopped issuing banknotes Started to accept of demand deposits State chartered banks are supervised by regulators in their respective state Federally chartered banks tend to be larger in size, but state banks are more in number

13 Commercial Banks Federal Reserve Act of 1913
Required national banks to become members of the Fed State chartered banks had option of being a nonmember All state banks (including nonmember) currently fall under regulation of the Fed Reserve System

14 Commercial Banks Federal Deposit Insurance Corporation (FDIC)
All member banks of Fed are required to carry FDIC insurance Members include, All national and Some state banks A majority of state banks (including non members) have opted to participate in FDIC program

15 Commercial Banks Multiple Regulators at Federal level with Overlapping and Conflicting authority. Federal Reserve System Comptroller of Currency FDIC Some experts suggest that all regulation should be combined in a single agency However, no legislation exists to unify the structure

16 Commercial Banks Philosophy Strategy of Regulation:
Protect Individual Depositors Maintain Stability of Financial System Strategy of Regulation: Disclosure is not enough Physical examination of member banks Bank examinations are often not public by design

17 Commercial Banks Primary Liabilities: Demand Deposit
Banks must maintain sufficient liquidity to meet demand deposits It is costly to keep excess reserve or liquid assets Fear of insolvency may cause a run on the bank causing a system-wide bank panic Paid on a first-come/first-serve basis Periodic examination of a bank by regulatory agencies to insure banks are solvent

18 Commercial Banks Deposit Insurance
FDIC established by Banking Act of 1933 to insure deposits at commercial and mutual savings banks. Created after a large number of bank failures in the early 1930’s Objective is to protect small savers Reduce the incentive for depositors to join a bank run

19 Commercial Banks Deposit Insurance
Currently insure deposits up to $100,000 for single account Coverage depends on procedure used by FDIC: Payoff Method Bank goes into receivership by FDCI FDIC pays out funds up to $100,000 Purchase and Assumption Method FDIC merges failed bank with a healthy one Deposits of failed bank are assumed by solvent bank

20 Commercial Banks Moral Hazard and Deposit Insurance
Existence of FDIC eliminates large-scale bank failure and bank run. However, it creates a classic moral hazard problem With FDIC insurance, depositors have little or no incentive to monitor riskiness of their banks. Without monitoring, bank managers finds it easy to engage in risk shifting

21 Commercial Banks Moral Hazard and Deposit Insurance
Shareholders and directors of banks have incentive to make their banks riskier at the expense of the FDIC “Too big to fail” Doctrine FDIC may extend loans to very large banks in trouble to allow continued operations This doctrine may unintentionally exacerbate the moral hazard problem Recently bank failures have increased due to banking deregulation and commercial banking activities have become riskier

22 Regulation of Commercial Banks
Risk-Based Capital Requirements Bank capital acts as a cushion against failure Banks are required to maintain a capital to asset ratio This ratio measures of bank’s risk exposure Risk-based capital requirements Higher capital requirement for banks with risky assets. With higher risk amount of risk-based asset will go up. This will cause Capital to Asset ratio to go down. These requirements are agreed upon by the United States and members of the Bank for International Settlements (BIS)

23 Regulation of Commercial Banks
Prompt Corrective Action (PCA) Passed as a part of FDIC Improvement Act of 1991 Established procedures to handle troubled banks Designed to close banks before FDIC is exposed to excessive losses Prevent regulatory forbearance when regulators keep an insolvent institution operating in hopes of “turning it around” Banks are ranked according to their perceived risk and more restrictions placed on riskier banks Established a risk-based deposit insurance premium in FDIC charge insurance premium based on the perceived risk of the bank

24 Regulation of Nondepository
Regulations are designed based on the type of liabilities they issue Pension funds and life insurance companies Heavily regulated because their liabilities are purchased by small investors and need to protect small investors Employee Retirement Income Security Act (ERISA)

25 Regulation of Nondepository
Employee Retirement Income Security Act (ERISA) Established the Pension Benefit Guaranty Corporation Guarantees defined benefits pension plans, subject to a maximum amount Establishes minimum reporting, disclosure and investment standards

26 Regulation of Nondepository
Life Insurance Companies Regulated at the state level Impose risk-based capital requirements Perform periodic audits Implicit and explicit restrictions on pricing of particular products

27 Regulation of Nondepository
Finance companies Raise funds by issuing debt and equity Have virtually no regulation beyond the securities laws governing publicly traded securities

28 Regulation of Nondepository
Mutual Funds Regulated by the SEC Also subject to state regulations Objective is to protection of individual investors through full disclosure

29 The Glass-Steagall Act
Segregated the banking industry from the rest of the financial services industry Banks are barred from owning corporate stock and other activities deemed too risky The Genesis of Glass-Steagall Prior to 1933, investment banking and commercial banking were conducted under same roof Following the financial collapse of the 1930s, it was felt that investment banking activities were too risky for banks

30 The Glass-Steagall Act
The Genesis of Glass-Steagall This combination represented a substantial threat to financial system stability Although there was little empirical evidence to support this contention, the legislation mandated separation of the two activities

31 The Glass-Steagall Act
The Erosion of Glass-Steagall Commercial banks exerted pressure on the Federal Reserve and courts to reduce the barriers caused by Glass-Steagall Bank-holding Companies Permitted banks to conduct nonbanking activities through subsidiaries In 1970 Federal Reserve was given power to determine what activities were permissible Activities had to be closely related to traditional banking During the 1970s and 80s banks acquired more freedom to engage in nontraditional banking activities

32 The Glass-Steagall Act
The Erosion of Glass-Steagall In 1989 the Federal Reserve granted five banks the power to underwrite corporate debt through a Section 20 affiliate Gradually the Federal Reserve granted more and more banks the right to underwrite corporate debt

33 The Glass-Steagall Act
The Gramm-Leach-Bliley Act (1999) Allowed affiliates of financial holding companies to engage in various banking activities and insurance underwriting Overall responsibility for regulation lies with the Federal Reserve through its role as the “umbrella” regulator Federal Reserve has power to ensure capital adequacy of holding companies, safety and soundness of their activities

34 The Glass-Steagall Act
The Gramm-Leach-Bliley Act (1999) Individual affiliates of holding companies are subject to regulation by functional supervisors such as the SEC This regulation framework blends the disclosure-based and inspection-based approaches to regulation

35 The Glass-Steagall Act
The Risk of Universal Banking Risk inherent in securities activities, especially the underwriting business, may affect the stability of the banking system Losses in securities activities lead to more bank failures and significant losses to FDIC

36 The Glass-Steagall Act
The Risk of Universal Banking Other view: Just because investment banking is riskier than commercial banking, this does not mean that the combination of the two will be riskier

37 Universal Banking The Risk of Universal Banking
The portfolio theory suggests that diversification may reduce risk when commercial banking is combined with investment banking and life insurance activities Perhaps it is time to let the banks decide for themselves whether universal banking reduces risk

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