Regulating the Banking Industry ECO 473 – Money & Banking – Dr. D. Foster

 Maintaining depository institution liquidity.  Assuring bank solvency by limiting failures.  Promoting an efficient financial system.  Protecting consumers.

 The Banking Act of 1933 (Glass-Steagall Act): ◦ Created the Federal Deposit Insurance Corporation (FDIC). ◦ Placed interest rate ceilings on checking deposits of commercial banks. ◦ Separated commercial and investment banking. ◦ Branching restrictions.

 Disintermediation in the 1970s.  Depository Institutions Deregulation and Monetary Control Act (DIDMCA): ◦ Six-year phaseout of interest rate ceilings. ◦ Permitted NOW accounts. ◦ Increased FDIC coverage to $100,000.

 The Garn–St. Germain Act of 1982: ◦ Authorized money market deposit accounts. ◦ Increase the DIDMCA limit on consumer loans and commercial paper. ◦ Authorized savings institutions to make commercial real estate loans. ◦ Gave these institutions the power to purchase “unsecured loans,” including low-rated, “junk” bonds. ◦ Gave the FDIC power to permit troubled financial institutions to merge with healthier partners.

 Financial Institutions Reform, Recovery & Enforcement Act (FIRREA)  Financial Institutions Reform, Recovery & Enforcement Act (FIRREA): ◦ Authorized taxpayer funds to cover cost of liquidating failed thrifts. --Insurance wasn’t enough! ◦ Abolished current thrift regulatory structure. --Created Office of Thrift Supervision. --Created the Resolution Trust Corp. to liquidate thrifts. ◦ Moved thrift insurance (FSLIC) into FDIC. ◦ Required insurance fund = 1.25% of insured deposits.

 The moral-hazard problem of deposit insurance  The moral-hazard problem of deposit insurance: ◦ S&L crisis.  Too-big-to-fail policy  Too-big-to-fail policy: ◦ Continental Illinois ◦ Continental Illinois. Continental Illinois Continental Illinois  The FDIC Improvement Act Of 1991  The FDIC Improvement Act Of Allowed for earlier intervention by the FDIC. -- Let FDIC set/change premiums to boost fund. -- Mandated risk-based premium structure.

Banking Failure: The Case of Continental Illinois

The Continental Illinois Story  Origins to the Civil War … -- The Commercial National Bank. -- Mergers in 1910 and in Name change in  $50 million loan to survive the Great Depression -- Reconstruction Finance Corp. (gov’t.)  One of two largest Chicago banks in 1900s.  Generally, a conservative bank … -- Until the 1970s and its focus on commercial lending.

The Continental Illinois Story  By 1981, CINB was 7th largest bank in the U.S. -- Total assets = $45 billion.  Largest provider of commercial loans. -- $14 billion. -- Citibank was next, at $12.5 billion.  Great average ROE from % (2nd highest among top 10 banks).  Stock price high and rising $13; $27; $42. 1/25/1982 Morgan Stanley - CINB stock is an “attractive” buy. Current price = $38.

-- Penn Square Bank fails in July, Large portfolio of speculative oil & gas loans. - CINB owns $1 billion in Penn participations. (About half Penn’s total; Penn had $500 mill. in assets). Problems: -- Loan/Assets = 69% in 1981 (58% in 1977) -- ROA falling to.51% in Rolling over loans at lower interest rates. -- Large corporate customers going bankrupt. - Nucorp, Int’l Harvester had $250 mill. in loans. -- Core deposits constant from Falling from 30% to 20% of total deposits. -- Expensive, long-term CDs double; up to 30% of dep. -- Stock price down to $16. The Continental Illinois Story

-- Major shareholders dump CINB - U.S. Steel & Carnegie pensions completely divest themselves. - Stock had been recovering was back down to $14. It gets worse: -- By early 1984, non-performing loans … $2.3 billion Over half from troubled Latin America -- In early May 1984, the bank run begins. “The only difference between Continental and the Titanic is that the Titanic had a band.” --A.F. Ehrbar, Fortune magazine, 2/7/1983 The Continental Illinois Story

-- FDIC promises to protect all deposits, even if over the $100,000 maximum! The bank run: -- By May 11, CINB borrows $3.6 bill. from Fed’l Reserve -- Correspondent banks withdraw deposits. -- CINB creates $5.4 billion loan package w/16 banks. -- FDIC provides $2 billion in assistance. -- A group of 24 banks puts together a $5.3 billion deal. -- In July, as $ continue to flow out, FDIC “buys” $4.5 billion in bad loans from CINB. -- By September, all of top management & board of directors are replaced and a permanent plan is in place. -- In 1994, merged into Bank of America. The Continental Illinois Story

 The moral-hazard problem of deposit insurance.  Too-big-to-fail policy.  Was their strategy bad, or was it something else?

Banking Failure: The Case of Continental Illinois

Resolution Depository Assets Failure Cost Institution ($ Billions) Date ($ Billions) First Republic Bank (Dallas)$33.5July 1988$3.9 MCorp (Dallas)15.7February Continental Illinois (Chicago)33.6May Texas American (Fort Worth)4.8July First City Bancorp (Houston)4.8April Bank of New England (Boston)21.8January Goldome FSB (Buffalo)8.7May New York Bank for Savings (NYC)3.4March st National Bank of Keystone (WV)1.1September Crossland Savings Bank (Brooklyn)7.3January Superior Bank (Illinois)2.3July

 Capital requirements  Capital requirements: ◦ Minimum equity capital standards.  Risk-based capital requirements  Risk-based capital requirements: ◦ Risk factors that distinguish different depository institutions. [Degree of capitalization.]  Risk-adjusted assets  Risk-adjusted assets: ◦ A weighted average of bank assets to account for risk differences across types of assets. [Type of capitalization.]

 Act removes Glass-Steagall restrictions and permits: ◦ Securities firms and insurance companies to own commercial banks. ◦ Banks to underwrite insurance and securities, including shares of stock.

Regulatory Issues  Off-balance-sheet banking: ◦ Loan commitment; credit default swaps.  Asset valuation: ◦ Historical cost vs. market value  Derivatives: ◦ Replacement cost exposure. ◦ Credit/market/operating risks.  New wave of regulation: ◦ SOX; Dodd-Frank

Regulating the Banking Industry ECO 473 – Money & Banking – Dr. D. Foster