 Friday Talk: Financial crisis  Course in spring on financial crisis  Chapter 11 &12  Regulation & Industry Structure  Links:  Marginal Revolution ▪

 Safety and soundness regulation  Entry, branching, network, and mergers ▪ Chapter 12  Deposit insurance  Deposit interest ceilings  Portfolio restrictions, including reserve requirements  Capital requirements  Regulatory monitoring and supervision 1-2

Copyright © 2007 Pearson Addison-Wesley. All rights reserved.11-3

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11-5  A story of  Changing financial conditions ▪ See marginal revolution link  Deregulation  Reregulation

 Declining profitability of traditional business  High interest rate environment ▪ Cost of funds increase, but long term loans on books  Regulatory relief  Depository Institutions Deregulation and Monetary Control Act ▪ Rate ceilings abolished (both lending and deposit) ▪ Increased deposit insurance ▪ Entry to new businesses allowed Copyright © 2007 Pearson Addison-Wesley. All rights reserved.1-6

11-7  Managers did not have expertise in managing risk  Rapid growth in new lending, real estate in particular  Activities expanded in scope; regulators at FSLIC did not have expertise or resources  High interest rates and recession increased incentives for moral hazard

11-8  Regulatory forbearance by FSLIC  Insufficient funds to close insolvent S&Ls  Established to encourage growth  Did not want to admit agency was in trouble  Zombie S&Ls  taking on high risk projects  Attract business from healthy S&Ls  Losses amount to $150 billion

11-9  Regulatory apparatus restructured  Federal Home Loan Bank Board relegated to the OTS  FSLIC given to the FDIC  RTC established to manage and resolve insolvent thrifts  Re-restricted asset choices

 FDIC went broke  Federal Deposit Insurance Corporation Improvement Act of 1991  Recapitalize the Bank Insurance Fund ▪ Increase ability to borrow from the Treasury ▪ Higher deposit insurance premiums  Reform the deposit insurance and regulatory system to minimize taxpayer losses  Prompt corrective action provisions ▪ Classification scheme 1-5, category 3 must have corrective action plan ▪ Category 5 - weakest banks must be closed by FDIC ▪ equity< 2% of assets  receivership within 90 days  Risk-based insurance premiums ▪ Later led to CDS market

 Preserve independence of regulator by eliminating discretion  Discretion creates opportunities for corruption or capture  Eliminate ‘zombies’ with prolonged capital inadequacy  Zombies likely to create additional harms (by taking on more risky deals)  Either bank or regulator must add capital 10-11