Economic Analysis of Banking Regulation Chapter 11 Economic Analysis of Banking Regulation

Depositors cannot tell the good from the bad. Bank Failure Any indication of insolvency can cause a run on banks which can push a healthy bank into insolvency creating losses for its owners and depositors Depositors cannot tell the good from the bad. problem of asymmetric information. “Contagion effect”

An Example of a Bank Run Assume depositors lose confidence in an otherwise healthy bank causing a run of the bank The bank first uses liquid reserves and sells securities to meet depositor demands to withdraw funds The bank is next forced to sell loans at the fire-sale price of $0.50 per $1, the bank pays off half of remaining deposits The bank cannot pay off the remaining deposits and has negative net worth, so the remaining depositors and bank owners both lose. The example shows how a bank run can make a healthy bank insolvent. 3

Run on a Bank - Example Liquidate at 100% Liquidate at 50% The table contains the specific example of how a run turns a healthy bank into an insolvent bank. Liquidate at 100% Liquidate at 50% Total = $40 + $40 = $80 4

Cyclical downturns are associated with bank panics (bank runs) The period prior to the Federal Reserve from 1871-1913 Eleven recessions Bank panics during 7 recessions No panics without recessions.

The Government Safety Net Lender of Last Resort (Federal Reserve 1913) Deposit Insurance (FDIC 1934)

Federal Reserve: Lender of Last Resort Safety Net Intent - Lend to solvent but illiquid banks Does this create a moral hazard? Does the “lender of last” resort encourage banks to take on too much risk?

FDIC Deposit Insurance Safety Net: Intent - stop run on bank Does this create a moral hazard? - Depositors lose incentive to monitor risk taken by the bank’s managers - Do banks have incentive to take on more risk? Before deposit insurance, ratio of assets to bank capital was 4 to 1 ( 25% capital ratio) After deposit insurance, ratio of assets to bank capital was 13 to 1 (7.7% capital ratio).

Government Safety Net: “Too Big to Fail” Government provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee Can increases moral hazard incentives for big banks

FDIC Created in 1934 Eliminate run on banks and prevent bank failure Deposits now insured up to $250,000. 1930 – 1933, 2000 failures per year. 1934 - 1981 fewer than 15 failures per year.

What does the FDIC do if bank fails? Payoff method. Purchase and assumption method. http://www.fdic.gov/news/news/press/2012/pr12120.html

How to reduce Moral Hazard in Banking 1. Place Restrictions on Asset Holdings Reduces moral hazard of too much risk taking. For example, Glass - Steagall Act, bank’s can’t hold common stock. Promote diversification - Limits on loans to particular borrower or industry. 2. Minimum Bank Capital Requirements Banks have more to lose when have higher capital. Also, higher capital means more collateral for FDIC to grab.

How to Structure Capital Requirement There are two forms: The first type is based on the leverage ratio, the amount of capital divided by the bank’s total assets. To be classified as well capitalized, a bank’s leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank The second type is risk-based capital requirements

Basel – I Risk Based Capital Requirement Asset Risk Weight Cash and equivalents (reserves) Government securities Interbank loans (Federal Funds) 0.2 Mortgage loans 0.5 Ordinary loans (Comm’l and Industrial) 1.0

Capital Requirements for Melvin’s Bank First National Bank The table illustrates the computation of the minimum equity ratio and Basel capital requirement. 15

Capital Requirements for Melvin’s Bank The table illustrates the computation of the minimum equity ratio and Basel capital requirement. 16

How to reduce Moral hazard (Con’t) 3. Bank Supervision: Chartering and Examination A. Chartering reduces adverse selection problem of risk takers or crooks owning banks Examination reduces moral hazard by preventing risky activities - Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk: Implementation of stress testing and Value-at risk (VAR)

Bank Failures in the United States, 1934–2010

(General Economic Context) 1982-1989: U.S. Bank Crisis (General Economic Context) • Worried about inflation in late 1970s, Fed sharply tightened the money supply starting in late 1979. • Result - in high interest rates (i) and sharp deep recession in 1981-1982. • As i increased, increased costs of funds for Savings and Loans (S&Ls), not matched by higher earnings on principal assets (residential mortgages) whose rates were fixed. • By some estimates, over half of S&Ls in U.S. were insolvent by end of 1982.

- commercial paper and junk bonds Why a Banking Crisis in 1980s? Early Stage: Financial Innovation and Increased Competition Banks and S&L’s loss of “sources of funds” advantage to competition due to financial innovation - Money Market Mutual Funds (intro. 1971) - π =>i  => loss of deposits and increased cost of funds Loss of “uses of funds” to competition due to financial innovation in direct finance - commercial paper and junk bonds 3. Result - loss of revenues and loss of cost advantages => reduced profits

Why a Banking Crisis in 1980s? - Early Stage Also, lack of diversification No branch banking caused lack of geographic diversification Lack of industry diversification - Texas banks concentrated in energy loans Result: Risky loans and bank failures. Commercial banks got into real estate and corporate take over loans. S & L’s got into loans they knew nothing about such as commercial and industrial.

Why a Banking Crisis in 1980s? Later Stages: Regulatory Forbearance (Regulatory Failure) Insolvent banks should have been closed, but regulators allowed insolvent S&Ls to operate with lowered capital requirements (“zombie banks”) : Insufficient funds to pay depositors. Sweep problems under rug. Regulator ( FHLBB) cozy with S&Ls Huge increase in moral hazard for zombie “living dead” S&Ls. They have nothing to lose, their incentive is to “gamble for resurrection” The zombies became vampires. Hurt healthy S&Ls by attracting funds away by offering above market rates. Outcome: Huge losses

Political Economy of S&L Crisis Explanation: Principal-Agent Problem Politicians influenced by S&L lobbyists rather than public Deny funds to close S&Ls Passed legislation to relax restrictions on S&Ls. S&Ls allowed to expand into commercial real estate, credit cards, junk bonds and even common stock. S&Ls had no experience in these areas Regulators influenced by politicians and desire to avoid blame A. Loosened capital requirements B. Regulatory forbearance. Insolvent S&Ls and banks allowed to remain in operation.

Depository Institutions Deregulation and Monetary Control Act DIDMCA(1980) Depository Institutions Deregulation and Monetary Control Act S&Ls - allowed to hold up to 40% commercial real estate S&Ls - allowed to hold up to 30% consumer loans and 10% junk bonds and common stock. FDIC deposit insurance increased from $ 40,000 to $100,000 Phased out Regulation Q restrictions on interest rates. This allowed banks to issue large denomination insured CDs

Capital requirement for S&Ls increased from 3% to 8% Turning Point: Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989 Resolution Trust Corporation (RTC) created and given funds to close insolvent S&Ls cost of $150 billion, 3% of GDP 750 (25%) of S&Ls closed. Capital requirement for S&Ls increased from 3% to 8% Re-regulation: Re-impose pre-1980 asset restrictions on S&Ls

Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 Prompt Corrective Action An undercapitalized bank is more likely to fail and more likely to engage in risky activities. The FDIC Improvement Act of 1991 requires the FDIC to act quickly to avoid losses to the FDIC. “Undercapitalized banks” must submit a capital restoration plan, restrict asset growth, and seek regulatory approval to open new branches or develop new lines of business. http://www.fdic.gov/bank/individual/failed/

Cost of Banking Crises in Other Countries (a)

Cost of Banking Crises in Other Countries (b) © 2004 Pearson Addison-Wesley. All rights reserved

Déjà Vu All Over Again! Banking crises are just history repeating itself. Financial liberalization leads to moral hazard (and bad loans!). Government stands ready to bailout the system. That implicit guarantee is enough to exacerbate the moral hazard problem.