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Banking 1 G406, Regulation, ch. 10 Eric Rasmusen, October 31, 2013.

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Presentation on theme: "Banking 1 G406, Regulation, ch. 10 Eric Rasmusen, October 31, 2013."— Presentation transcript:

1 Banking 1 G406, Regulation, ch. 10 Eric Rasmusen, October 31, 2013

2 Some of the Older Bank Regulations We will focus on the large number of regulations that attempt to prevent moral hazard, but there are lots of other bank regulations, including: The Truth in Savings Act of 1991: Explain loan terms clearly. Equal Credit Opportunity Act (ECOA) of 1974: Dont discriminate by race, sex, marital status, being on public assistance. The Community Reinvestment Act of 1977: Make loans in poor neighborhoods. See 2

3 A Bank Run 3

4 Bank Runs 4 Is this a Prisoners Dilemma?

5 Three Government Tools 1. Deposit insurance. 2. The Feds discount window--- serving as lender of last resort. 3. Bailouts, even if not authorized by law. These solve the coordination externality problem. All of these necessitate supervision of banks because they create moral hazard. 5

6 Primary Regulators Theres backup regulation too. The FDIC can monitor national banks if they have deposit insurance. Office of the Comptroller of the Currency: national banks and federal savings associations The Federal Reserve Board: State banks that are member of the Federal Reserve system The Federal Deposit Insurance Corporation (FDIC): State banks not members of the Fed. National Credit Union Administration (for credit unions) Securities and Exchange Commission (for investment banks) 6

7 Citizens Bank fails, will reopen as Heartland Bank PRINCETON – Federal banking regulators designated Citizens First National Bank as a failed bank Friday afternoon, ending its business and selling its assets. Citizens Bank customers can access their money by writing checks or using ATM or debit cards. All checks drawn on the bank will be honored, the Federal Deposit Insurance Corp. said, and all loan customers should continue to make their payments as usual. … The bank branches will reopen today as branches of Heartland Bank and Trust Company of Bloomington, which has agreed to assume Citizens Banks assets, including about $870 million in total deposits, the FDIC said in a news release Friday evening. Customers of Citizens Bank are now customers of Heartland Bank. 7

8 LEVERAGE RAISES PROFITS: Riskless Arbitrage 8

9 Risky Arbitrage paying back the loan 9 Average return in Plan 3: 0.8(610) +.2 (-400) = 210%

10 Risky Arbitrage (corrected for bankruptcy) 10 Plan 3 Return:.8(610%) +.2 (-100%) = 488%- 20%= 468%.

11 Risk Regulation 1. Capital requirements. There is no one set ratio required; it depends on the riskiness of the banks assets. Basel I, II, III are international standards for capitalization ratios– nonbinding advice to each countrys regulators. 2. Restrictions on risky investments. No common stock, limits on options trading, loans to a single borrower cant be too big, etc. 11

12 Assets 12 http://fina pps.forbe apps/jsp/ finance/c ompinfo/ Financial Industrial.jsp?tkr= BAC&per iod=qtr

13 13 If Apple wants to park $20 million dollars somewhere and be able to get it back quickly, what can it do? Apple could buy a repo, a repurchase agreement, from the Apex Hedge Fund. Apple pays Apex $20 million in cash. Apex gives Apple $20 million in securities and agrees to buy them back tomorrow for $20.1 million in cash. Then, Apex lends the money to someone else for.3 million in interest. In effect, Apple deposits $20 million with Apex. Apex is a shadow bank, paying interest on Apples deposits and using those deposits to make loans. An odd feature of this is that if the security income happens to arrive overnight, Apex gets it, not Apple. Shadow Banks

14 Runs on Shadow Banks Apex is uninsured, so it has to put up the $20 million in securities as collateral. But what if Apple thinks the Apex collateral securities are really worth only $16 million? Suppose one day Apple refuses to renew unless Apex gives it face value of $25 million in securities instead. Apex has to return the $20 million or come up with an extra $5 million in securities. Suppose Apex spent the $20 million on other securities, believing Apple would keep renewing the repo. Apex doesnt have the $20 million cash on hand. If Apex cant sell for $20 million the securities it bought, or borrow $5 million instantly, it defaults on the repo. 14

15 Moral Hazard and Systemic Risk 15 Systemic Risk: The risk of collapse of an entire financial system because of the troubles of a few firms. Essentially, the bank run problem. NOT the same as systemATic risk in the CAPM model. Bank A cant pay Bank B. Can Bank B pay Bank C? If B cant, will C be able to pay? Moral hazard in banking: When banks make risky investments because they know someone will rescue them if the investments fail. Too big to fail: A company with debts to so many other companies that if it collapses it creates systemic risk, e.g., AIG.

16 The 2008 Banking Crisis Well look at this as an example of what happens with regulation in good times and in bad times. 16

17 The Events of 2008 17 Already, in 2007, some mortgage lenders were failing and the subprime mortgage market was in trouble. In 2008, the Bear Stearns brokerage firm failed. Fannie Mae and Freddie Mac were taken over by the Treasury because of insolvency. The Lehmann Brothers investment bank failed. The Fed bailed out AIG. Treasury asked Congress for the TARP program and got it. Things calmed down again--- but a recession started.

18 What Caused the Crisis? Well look at the housing market, securitization, and the regulatory response. 18

19 Housing Prices 1890-2010 19

20 Housing Prices 2000-2012 spusa-cashpidff--p-us---- 20

21 How Down Payments Restrict Leverage 21 Suppose you buy a $100,000 house by paying $20,000 in cash and taking out a mortgage for $80,000. You are highly leveraged. If the price of the house goes down to $90,000, you still have some capital (equity) left, because you only have to pay off $80,000 to keep it. If the house price falls to $60,000, you would do better to let the bank foreclose (though it would hurt your credit rating).

22 Loan/House-Value 22

23 Subprime and Other Loans 23

24 Negative-Equity Nonprime Loans 24

25 Percentage of Defaults over Time 25

26 Foreclosures 26

27 Free Rent---Defaulters 27

28 Borrowing and Foreclosure 28 What happens when Smith loses ownership of a house? --Somebody else gets to live there. There is an opportunity cost to having Smith live in the house at 2810 Linden Court: Jones cant live there. If Smith would only pay $1,500 per month to live there and Jones would pay $2,500, value is maximized by having Jones live there instead.

29 2011 Foreclosure Rates 29 See

30 Prices of Credit Default Swaps 30

31 The TED Spread 31

32 Reserves in Banks 32

33 Policies for Crises 33 1. The insolvent banks are liquidated, their assets sold o to new owners. 2. The government nationalizes the insolvent banks, possibly reselling them later. 3. The Fed lends money to banks as lender of last resort. 4. The Treasury or Fed buys preferred stock in banks or in some other way injects capital that is to be repaid. 5. The Treasury or Fed buys toxic assets ---the assets of the bank whose prices have collapsed.

34 2008 Policy Responses 34 1. The Fed served as lender of last resort. It also bought dubious assets ($600 billion+) and commercial paper ($350 billion). 2. TARP. The Treasury made loans and bought stock in banks and nonbanks. (Cost: $435 billion disbursed, $279 returned) 3. AIG insurance company bailout. The Fed and TARP helped it out to address the CDS problem. 4. Treasury took over Fannie Mae and Freddie Mac, paying their debts (cost: $145 billion so far, $3.7 trillion in liability exposure!)

35 Dodd-Frank Act Changes 35 Capital requirements for nonbank financial companies. The Fed to extend credit to more kinds of firms, but not to insolvent ones. The FDIC can take over a financial company to prevent systemic risk, even before it is insolvent.

36 More Dodd-Frank Changes 36 The Consumer Financial Protection Bureau. A ban on proprietary trading (the Volcker Rule). Increased regulation of swaps and other derivatives, and a ban on banks owning them except to hedge existing risk. Price controls on retailer debit fees. Regulation of credit rating agencies.

37 Why the Lax Regulation of 2005? 37 Barney Frank, the Chairman of the House Banking Committee, in 2003: I do think I do not want the same kind of focus on safety and soundness that we have in OCC and OTS. I want to roll the dice a little bit more in this situation towards subsidized housing.

38 Securitization Securitization means the bundling together of diverse cash flows into a single asset, pieces of which are then sold. Someone could approach various banks around the country and buy the rights to the cash flows from 500 mortgages. Then he could sell shares in that to 1000 other investors. That way, the risk from the mortgages is pooled, the bank gets cash instead of having to hold loans, and investors get to buy an asset with a high interest rate. Securitization has a direct effect of reducing risk and making banks safer. 38

39 Tranches: Creating Safe Assets Out Of Risky Ones 39

40 The Bond Rating Companies 40 The bond rating companies such as Moodys grossly overrated the safety of mortgage-backed securities. Why? 1. Conflict of interest in getting rating fees? 2. The same reason as the banks and investment companies inexperience and folly? 3. Lack of incentive to maintain their reputations? Would a government agency have rated them more accurately?

41 Government Failure: Republic Windows and Doors 41 In 2008, Bank of America cut off the line of credit of Chicagos Republic Windows and Doors. Republic laid off its workers. Under state law the company was supposed to give two months notice, with continued pay and benefits. Politicians jumped in. Bank of America surrendered and gave Republic $1.35 million in the form of a loan.

42 GM and Chrysler Bailouts 42 In 2009 the government and union medical fund bought a majority interest in Chrysler and in General Motors. Why was this more controversial than buying stock in AIG or Citigroup?

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