Chapter Eighteen Banking Regulation

Slide 18–3 How Asymmetric Information Explains Banking Regulation 1.Government Safety Net and Deposit Insurance a.Prevents bank runs due to asymmetric info: depositors can't tell good from bad banks b.Creates moral hazard incentives for banks to take on too much risk c.Creates adverse selection problem of crooks and risk-takers wanting to control banks d.Too-Big-to-Fail increase moral hazard incentives for big banks and is unfair 2.Restrictions on Asset Holdings –Reduces moral hazard of too much risk taking

Slide 18–4 How Asymmetric Information Explains Banking Regulation 3.Bank Capital Requirements a.Reduces moral hazard: banks have more to lose when have higher capital b.Higher capital means more collateral for FDIC 4.Bank Supervision: Chartering and Examination a.Reduces adverse selection problem of risk takers or crooks owning banks b.Reduces moral hazard by preventing risky activities c.New trend: assessment of risk management

Slide 18–5 How Asymmetric Information Explains Banking Regulation 5.Disclosure Requirements –Better info reduces asymmetric info problem 6.Consumer Protection a.Standardized interest rates (APR) b.Prevent discrimination (e.g., CRA) 7.Restrictions on Competition to Reduce Risk-Taking a.Branching restrictions b.Separation of banking and securities industries: Glass- Steagall

Slide 18–6 How Asymmetric Information Explains Banking Regulation International Banking Regulation 1.Bank regulation abroad similar to ours 2.Particular problem of regulating international banking (e.g., BCCI scandal)

Major Banking Legislation in U.S. FDIC index of regulations on banking

Slide 18–8 The 1980s 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 

Slide 18–9 Federal Deposit Insurance Corporation Improvement Act (FDICIA) of FDIC recapitalized with loans and higher premiums 2.Reduce scope of deposit insurance and too-big-to-fail 3.Prompt corrective action provisions 4.Risk-based premiums 5.Annual examinations and stricter reporting 6.Enhances Fed powers to regulate international banking

Slide 18–10 Evaluating FDICIA and Other Reforms Limits on Scope of Deposit Insurance 1.Eliminate deposit insurance entirely 2.Lower limits on deposit insurance 3.Eliminate too-big-to-fail 4.Coinsurance Prompt Corrective Action 1.Critics believe too many loopholes 2.However: accountability increased by mandatory review of bank failure resolutions

Slide 18–11 Evaluating FDICIA and Other Reforms Risk-based Insurance Premiums –Hard to implement Other Proposed Changes 1.Regulatory consolidation 2.Market-value accounting

Figure 18-1: Banking Crises Throughout the World Since 1970

Slide 18–13 Cost of Banking Crises in Other Countries

Slide 18–14 Calculating Capital Requirements

Slide 18–15 Calculating Capital Requirements Leverage Ratio= Capital/Assets = $7m/$100m = 7% Bank is well capitalized

Slide 18–16 Calculating Risk-Adjusted Requirements

Slide 18–17 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