Chapter 11. Economic Analysis of Bank Regulation Asymmetric Information Banking Crisis of 1980s Asymmetric Information Banking Crisis of 1980s

In economics, people respond to incentives regulation needed to counteract sometimes, regulation creates the wrong incentives people respond to incentives regulation needed to counteract sometimes, regulation creates the wrong incentives

I. Asymmetric Information banks solve some asymmetric info problems but creates others regulation deals with asymmetric info problems but creates others banks solve some asymmetric info problems but creates others regulation deals with asymmetric info problems but creates others

A. Deposit Insurance FDIC established 1934 prevents depositors from panicking and withdrawing funds “run on the bank” FDIC established 1934 prevents depositors from panicking and withdrawing funds “run on the bank”

2 types of action payoff method FDIC closes down insolvent bank depositors paid up to $100,000 FDIC sells off assets often depositors with more than $100,000 often given full refund payoff method FDIC closes down insolvent bank depositors paid up to $100,000 FDIC sells off assets often depositors with more than $100,000 often given full refund

purchase & assumption method FDIC finds a healthy bank to buy failing bank -- FDIC offers incentives no depositor losses more common method purchase & assumption method FDIC finds a healthy bank to buy failing bank -- FDIC offers incentives no depositor losses more common method

before FDIC bank panics 1819, 1837, 1857, 1873, 1884, 1893, 1907, after FDIC no national bank panics before FDIC bank panics 1819, 1837, 1857, 1873, 1884, 1893, 1907, after FDIC no national bank panics

Problems w/ deposit insurance moral hazard insurance gives less incentive to be careful depositors less careful in selecting bank banks less careful with depositor money moral hazard insurance gives less incentive to be careful depositors less careful in selecting bank banks less careful with depositor money

adverse selection if depositors not policing banks, questionable people, knowing this, attracted to banking adverse selection if depositors not policing banks, questionable people, knowing this, attracted to banking

FDIC policies make problems worse “too big to fail” FDIC gives preferential treatment to larger bank failures -- covering deposits > $100, prevent large losses moral hazard/adverse selection worse for larger banks “too big to fail” FDIC gives preferential treatment to larger bank failures -- covering deposits > $100, prevent large losses moral hazard/adverse selection worse for larger banks

B. Capital Requirements capital as % assets counteract moral hazard problems capital is lost if failure capital reduces risk-taking well-capitalized banks less supervision lower deposit insurance premiums capital as % assets counteract moral hazard problems capital is lost if failure capital reduces risk-taking well-capitalized banks less supervision lower deposit insurance premiums

C. Bank Supervision limiting ownership bank examinations asset risk bank loans capital requirement managing risk limiting ownership bank examinations asset risk bank loans capital requirement managing risk

disclosure financial statements consumer protection terms of credit fee disclosure discrimination “redlining” disclosure financial statements consumer protection terms of credit fee disclosure discrimination “redlining”

competition restricted until 1990s -- McFadden Act -- Glass Steagall increases health of banks -- driving “bad” banks out -- increasing efficiency competition restricted until 1990s -- McFadden Act -- Glass Steagall increases health of banks -- driving “bad” banks out -- increasing efficiency

II. Banking Crisis of the 1980s less than 20 banks failure per year per year what happened? less than 20 banks failure per year per year what happened?

A. Origins declining profitability of traditional activities financial innovations rising short-term interest rates in 1970s banks borrow short & lend long especially hard on S&Ls declining profitability of traditional activities financial innovations rising short-term interest rates in 1970s banks borrow short & lend long especially hard on S&Ls

DeregulationDeregulation banks lobby for change to reverse declining profits 1980 DIDMCA 1982 Garn-St. Germain banks lobby for change to reverse declining profits 1980 DIDMCA 1982 Garn-St. Germain

repealed Regulation Q offer interest-bearing checking S&Ls allowed more asset choices lending, junk bonds, common stock increase deposit insurance ceilings repealed Regulation Q offer interest-bearing checking S&Ls allowed more asset choices lending, junk bonds, common stock increase deposit insurance ceilings

result?result? big increase in moral hazard great incentive/ability to take risk thrifts lacked skills to manage risk regulators lacked resources to police thrifts did not correct problem with short- term interest rates big increase in moral hazard great incentive/ability to take risk thrifts lacked skills to manage risk regulators lacked resources to police thrifts did not correct problem with short- term interest rates

economic events very high short-term interest rates in recession falling farm, energy prices in early 1980s higher loan defaults very high short-term interest rates in recession falling farm, energy prices in early 1980s higher loan defaults

by % of all S&Ls are insolvent

B. Failure of regulators by 1982, regulators SHOULD HAVE shut down failed S&Ls but, instead, regulatory forbearance allowed insolvent S&Ls to keep operating by 1982, regulators SHOULD HAVE shut down failed S&Ls but, instead, regulatory forbearance allowed insolvent S&Ls to keep operating

why?why? FSLIC lacked the funds for depositor payoff regulators too friendly w/ industry regulators would be admitting to failure FSLIC lacked the funds for depositor payoff regulators too friendly w/ industry regulators would be admitting to failure

zombie S&Ls insolvent S&Ls, still operating nothing to lose offer very high deposit rates offer very low loan rates taking business from healthy S&Ls insolvent S&Ls, still operating nothing to lose offer very high deposit rates offer very low loan rates taking business from healthy S&Ls

C. Politics of the crisis economics caused the problems politics made the crisis principal-agent problem agents act on behalf of principals agents have different incentives and do not act in best interest of principals economics caused the problems politics made the crisis principal-agent problem agents act on behalf of principals agents have different incentives and do not act in best interest of principals

principals: voters/taxpayers elect politicians that appoint regulators pay cost of bailout agents: politicians/regulators principals: voters/taxpayers elect politicians that appoint regulators pay cost of bailout agents: politicians/regulators

principals benefit from dealing w/ crisis early to minimize costs agents benefit from re-election, career politicians got huge campaign contributions from S&L industry regulators pressured to back off principals benefit from dealing w/ crisis early to minimize costs agents benefit from re-election, career politicians got huge campaign contributions from S&L industry regulators pressured to back off

D. Bailout: FIRREA 1989 federal bonds to fund closure of S&Ls change in S&L regulation FSLIC, FHLB gone OTC created, FDIC for insurance RTC to liquidate assets done in 1995 federal bonds to fund closure of S&Ls change in S&L regulation FSLIC, FHLB gone OTC created, FDIC for insurance RTC to liquidate assets done in 1995

re-restricted S&L activities raised deposit insurance premiums more power to regulators in closing banks re-restricted S&L activities raised deposit insurance premiums more power to regulators in closing banks

E. Reform: FDICIA 1991 deal with moral hazard problems with deposit insurance limited “too big to fail” risk-based premium increased capital requirements increased authority to FDIC additional funds to FDIC deal with moral hazard problems with deposit insurance limited “too big to fail” risk-based premium increased capital requirements increased authority to FDIC additional funds to FDIC

TodayToday fewer, stronger banks strong regulatory presence return to profitability managing risk nontraditional activities fewer, stronger banks strong regulatory presence return to profitability managing risk nontraditional activities