1. REGULATION OF FINANCIAL INSTITUTIONS
CHAPTER 16
REGULATION OF FINANCIAL INSTITUTIONS

2. Financial Institutions are Regulated Because:
They provide essential financial services to the public.
Financial institutions have access to privileged information about their customers.
Two-thirds of the money supply are liabilities of depository institutions. Control over the money supply means regulating "money supply" institutions.

3. Financial Institutions are Regulated Because: (concluded)
The federal government has promised to make good on deposits of failed depository institutions and thus regulate to ensure safety and soundness.
A sufficient level of competition is necessary to provide an adequate level and reasonable price for financial services.

4. Bank Failures in the United States
Occur when a bank’s assets are worth less than its liabilities.
Deposit insurance was developed to reassure uninformed depositors that their deposits were safe even if their bank failed.

5. Number and Percentage of all Banks Failing (1890-1998)

6. Lessons From Past Bank Failures
In the 1930's, banks failed because the Federal Reserve System could not provide liquidity (lend) to banks during rapid deposit withdrawal.
Depositor panic caused many failures of sound banks. Deposit insurance and unlimited liquidity from the Federal Reserve Banks have prevented bank panics.
Regional or industry-wide depressions may cause widespread bank failures.
Fraud, embezzlement, and poor management are the most notable causes of U.S. bank failure.

7. Deposit Insurance
Deposit insurance was first enacted in 1933 for up to $2,500 per account.
Over time the limit increased to $100,000 per account.
Currently, deposits are insured up to $100,000 per depositor.

8. Pay Off of a failed institution
A purchase and assumption (P&A) of all the deposits of the failed institution by a healthy institution is a preferred alternative to a liquidation.
This policy implies 100% deposit insurance coverage and favors large banks that are less likely to be liquidated.
The too-big-to-fail policy followed by the FDIC during the 1980s explicitly favored large banks.
A payoff and liquidation occurs when there is little value to the bank as a going concern.

9. FDIC Payoff Policy

10. FDIC-Assisted Purchase and Assumption Transaction: Failed Bank Subsidiary of New Bank

11. Bank examinations are an important part of bank regulation
Bank examinations are intended to promote and maintain safe and sound bank operating practices.
The examination procedure includes:
bank financial information collected quarterly (call reports).
on-site bank examinations.
discussion of examination findings with bank management.

12. Bank examinations are an important part of bank regulation (continued)
Areas of the Bank Analyzed in the Examination Process
Capital adequacy.
Asset quality.
Management competency.
Risk Management.
Earnings of the bank.
Liquidity of the bank.

13. Bank examinations are an important part of bank regulation (concluded)
On-site examinations are more likely to uncover pertinent private information than the off-site information provided by the banks themselves.
The large number of bank and S&L failures in the late 1980s have been attributed, in part, to infrequent examinations during that period.

14. Deposit Insurance and Moral Hazard
With deposit insurance, depositors feel safe and cease their surveillance of their depository institutions.
Deposit insurance creates a moral hazard for bank managers because they can acquire more risky assets without having to pay more for deposits.
Regulatory agencies counter this lack of market surveillance with increased regulation.

15. Insurance Agencies as Police
Banks are examined regularly. The board of directors is held responsible for any violations of of regulations.
Banks with poor CAMEL ratings may be subjected to “cease and desist” orders.
Banks with inadequate capital may be forced to raise additional capital.

16. Other Deposit Insurance Issues
Unequal coverage for large and small banks.
Different premium rates among types of depositories encourages charter switching.
Historically, deposit insurance premiums were the same for all institutions regardless of their riskiness.

17. The FDIC Improvement Act of 1991 (FDICIA)
Required early corrective action for all banks, regardless of size.
Mandated higher premiums to cover expected losses.
Mandated a risk-based (asset) deposit premium structure.
In 1993 riskier banks began paying higher deposit insurance premiums.

18. Bank Safety Regulations Reduce Risk Taking and Provide Public Confidence
Mandatory Federal Deposit Insurance.
Entry, branching, and holding company restrictions.
Deposit Rate Ceilings (Regulation Q)--reduced price competition among banks. Phased out (1986) with the DIDMCA of 1980.
Bank examinations--an assessment of the financial condition and management's performance.

19. Bank Safety Regulations (concluded)
Balance sheet restrictions control risk-taking
Adequate capital to absorb losses.
Limit size of loan to one customer -- forces diversification.
Require investment-grade quality securities only.
Prohibit investment in equity securities.
Prohibit investment banking activities in risky securities, though recent legislation has added investment banking authority to banking organizations.

20. Consumer Protection Regulations
Usury laws -- loan rate ceilings.
Truth in Lending (1968) -- disclosure of standardized lending terms at the time of the loan.
Equal Credit Opportunity Act (1974 and 1976) -- Excluded sex, marital status, race, age, etc. information from the credit decision.
Fair Credit Billing Act (1974) gave consumers redress for computer errors and billing information.
Community Reinvestment Act (1978) requires banks to make credit available in their market area.

21. Bank Regulators Bank Insurance Fund (FDIC-1933) and (SAIF-1989)
Insures deposits to $100,000.
Examines state chartered, non-Fed member banks and S & L's.
Autonomous funding from deposit premiums.
Influences all banks by providing deposit insurance.

22. Bank Regulators (continued)
Federal Reserve System (1913)
Examines state chartered, member banks.
Autonomous funding--independent.
Monetary control authority.
Regulates bank holding companies.
Comptroller of the Currency (OCC) 1863
Charters national banks; closes failed national banks.
Examines national banks.

23. Bank Regulators (concluded)
State Banking Agencies
Charter state banks.
Examine state chartered banks.
Protect public.