Chapter 10 4th Edition Chapter 11 3 rd Edition Economic Analysis of Banking Regulation

Commercial Bank Failure Bank run - many depositors want their money back Any indication of insolvency can cause a run which can push a healthy bank into insolvency –creating losses for its owners and depositors This happens when depositors cannot tell the good from the bad. –problem of asymmetric information. Bank Panic - depositors run on many banks at the same time - “Contagion effect”

Example of a Bank Run Assume depositors lose confidence in an otherwise healthy bank causing a run of the bank. –Deposits are withdrawn first come-first served. To meet the withdrawals, bank first uses liquid reserves and sells securities to meet depositor withdrawal The bank is next forced to sell loans at the fire-sale price sat $0.50 per $1 to pay deposits The bank cannot pay off the remaining deposits and has negative net worth, so the remaining depositors and bank owners both lose.

Run on a Bank - Example Liquidate at 100% Liquidate at 50% Total = $40 + $40 = $80

Cyclical downturns are related to bank panics (bank runs) The period prior to the Federal Reserve from – Eleven recessions – Bank panics during 7 recessions – No panics without recessions.

The Government Safety Net Lender of Last Resort – The Federal Reserve (1913) Deposit Insurance (FDIC 1934) Purpose - Financial Stability

Federal Reserve as a Lender of Last Resort - Safety Net Intent - Lend to solvent but illiquid banks and stop bank runs 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 Deposits insured to $250,000. Does this create a moral hazard? –Depositors lose incentive to monitor risk taken by the bank’s managers –Banks less careful with depositor money and 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 (>$250,000) of the largest financial institutions even when they are not entitled to this guarantee Increases moral hazard incentives for big banks

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

What does the FDIC do if bank fails? Two approaches (1) Payoff Method. –FDIC closes down insolvent bank –depositors paid up to $250,000 –FDIC sells off assets – possible depositors with more than $250,000 given full refund.

What does the FDIC do if bank fails? (2)Purchase and Assumption Method –FDIC finds a healthy bank to buy failing bank -- FDIC offers incentives –no depositor losses –more common method s/2015/pr15077.htmlhttps:// s/2015/pr15077.html 11-12

1.Place Restrictions on Assets Restrictions on types of assets. –For example, Glass - Steagall Act, banks can’t hold common stock. Promote diversification – Place limits on loans to particular borrower or industry. –Cannot make loans greater than 10% of their equity capital to any one borrower How to reduce Moral Hazard in Banking

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:– –capital divided by 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)0 Government securities0 Interbank loans (Federal Funds)0.2 Mortgage loans0.5 Ordinary loans (Comm’l and Industrial)1.0

Capital Requirements for Melvin’s Bank First National Bank

Capital Requirements for Melvin’s Bank

How to reduce Moral Hazard in Banking 3. Bank Supervision: Chartering and Examination A.Chartering reduces adverse selection problem of risk takers or crooks owning banks B.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

Banking Crisis of the 1980s less than 20 banks failure per year per year what happened? 11-21

: U.S. Bank Crisis (General Economic Context) Worried about inflation, Fed tightened the money supply starting in late 1979 resulted in high interest rates (i) and sharp deep recession in As i increased, costs of funds for Savings and Loans (S&Ls) increased, not matched by higher interest income on principal asset (residential mortgages) whose rates were fixed.

: U.S. Bank Crisis (General Economic Context) Banks borrow short and lend long, especially hard on S&Ls that made mortgage loans Borrow at variable rate and lend at fixed rate By some estimates, over half of S&Ls in U.S. were insolvent by end of 1982.

Banking Crisis (Early Stage: Financial Innovation and Increased Competition) 1.Banks and S&L’s lost “source of funds” to competition resulting from financial innovation and regulation - Regulation Q - Money Market Mutual Funds (intro. 1971) - as π  => i  => banks and S&L’s lost deposits and faced increased cost of funds 2.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 4. Lack of diversification No branch banking caused lack of geographic diversification Lack of industry diversification - Texas banks concentrated in energy loans 5. To maintain interest margin, banks got into risky loans. –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 loans.

DIDMCA(1980) Depository Institutions Deregulation and Monetary Control Act –S&Ls - allowed to hold up to 40% of loans in 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 and NOW accounts introduced

Banking Crisis Later Stages: Regulatory Forbearance (Regulatory Failure) By 1982 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 “walking dead” S&Ls. Had nothing to lose, their incentive was to “gamble for resurrection” The zombies became vampires. Hurt healthy S&Ls by attracting funds away by offering above market rates. Outcome: Huge losses

Politics of the crisis economics caused the problems politics made the crisis by not addressing the problem 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 Politics of the crisis

principals benefit from dealing with 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 Politics of the crisis

Turning Point: Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989 Created Resolution Trust Corporation (RTC) 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.

Cost of Banking Crises in Other Countries (a)

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

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.