1. Chapter 18 Bank Regulation
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2. Chapter Outline Background Regulatory structure
Deregulation Act of 1980
Garn-St Germain Act
Regulation of deposit insurance
Regulation of capital
Regulation of operations
Regulation of interstate expansion
How regulators monitor banks
The “too-big-to-fail” issue
Global bank regulations

3. Background
The banking industry has become more competitive due to deregulation
Banks have more flexibility on the services they offer, the locations where they operate, and the rates they pay depositors
Banks have recognized the potential benefits from economies of scale and scope
Bank regulation is needed to protect customers who supply funds to the banking system
Regulators are shifting more of the burden of risk assessment to the individual banks themselves

4. Regulatory Structure
The U.S. has a dual banking system consisting of federal and state regulation
Three federal and fifty state agencies supervise the banking system
A federal or state charter is required to open a commercial bank
National versus state banks
Federal charters are issued by the Comptroller of the Currency
State banks may decide to become members of the Fed
35 percent of all banks are members of the Fed, comprising 70 percent of deposits

5. Regulatory Structure (cont’d)
Regulation of bank ownership
Commercial banks can be either independently owned or owned by a bank holding company
Most banks are owned by BHCs
BHCs have more potential for product diversification because of amendments to the Bank Holding Company Act of 1956

6. Deregulation Act of 1980
The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was enacted in 1980
DIDMCA has two categories of provisions:
Those intended to deregulate the banking industry
Those intended to improve monetary control
The main deregulatory provisions are:
Phaseout of deposit rate ceilings
Allowance of NOW accounts for all depository institutions
New lending flexibility for depository institutions
Explicit pricing of Fed services

7. Deregulation Act of 1980 (cont’d)
DIDMCA also called for an increase in the maximum deposit insurance level from $40,000 to $100,000 per depositor
Impact of DIDMCA
There has been a shift from conventional demand deposits to NOW accounts
Consumers have shifted funds from conventional passbook savings accounts to various types of CDs
DIDMCA has increased competition between depository institutions

8. Garn-St Germain Act of 1982 The Act:
Permitted depository institutions to offer money market deposit accounts (MMDAs), which have no interest ceiling
MMDAs are similar to money market mutual funds
MMDAs allow depository institutions to compete against money market funds in attracting savers’ funds
Permitted depository institutions to acquire failing institutions across geographic boundaries
Intended to reduce the number of failures that require liquidation

9. Regulation of Deposit Insurance
Federal deposit insurance has existed since the creation of the FDIC in 1933 as a response to bank runs
Deposit insurance has increased from $2,500 in 1933 to $100,000 today
Insured deposits make up 80 percent of all commercial bank balances

10. Regulation of Deposit Insurance (cont’d)
In 1991, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) was passed
Phased in risk-based deposit insurance premiums to counteract the moral hazard problem

11. Regulation of Capital
Capital requirements force banks to maintain a minimum amount of capital as a percentage of total assets
Banks would prefer low capital to boost their ROE
Regulators have argued that banks need sufficient capital to absorb potential operating losses

12. Regulation of Capital (cont’d)
Basel Accord of 1988
Central banks of 12 major countries agreed to uniform capital requirements
The Accord was facilitated by the Bank for International Settlements (BIS)
The key contribution of the Accord is that the requirements were based on the bank’s risk level, forcing riskier banks to maintain a higher level of capital
In 1996, the Accord was amended so that bank’s capital level also account for its sensitivity to market conditions
Very safe assets are assigned a zero weight, while very risky assets are assigned a 100 percent weight

13. Regulation of Capital (cont’d)
Basel II Accord
The Basel Committee has worked on an accord that would refine the risk measures and increase the transparency of a bank’s risk to its customers
The three parts of the Accord are:
Revise the measurement of credit risk
Explicitly account for operational risk
Require more disclosure for market participants

14. Regulation of Operations
Regulation of loans
Regulators monitor highly leveraged transactions (HLTs) and a bank’s exposure to debt of foreign countries
Banks are restricted to a maximum loan amount of 15 percent of their capital to any single borrower
Banks are regulated to ensure that they attempt to accommodate the credit needs of the communities in which they operate through the Community Reinvestment Act (CRA) of 1977
Regulation of investment in securities
Banks are not allowed to use borrowed or deposited funds to purchase common stock
Banks can invest only in bond that are investment-grade quality

15. Regulation of Operations (cont’d)
Regulation of securities services
The Glass-Steagall Act of 1933:
Separated banking and securities activities
Prevented any firm that accepted deposits from underwriting stocks and bonds of corporations
Was intended to prevent potential conflicts of interest

16. Regulation of Operations (cont’d)
Regulation of securities services (cont’d)
Deregulation of underwriting services
In 1989, the Fed approved debt underwriting applications for banks based on the requirements that:
Banks had sufficient capital to support the subsidiary that would perform the underwriting
Banks had to be audited to ensure that their management was capable of underwriting debt
The Fed imposed a ceiling on revenues from corporate debt underwriting

17. Regulation of Operations (cont’d)
Regulation of securities services (cont’d)
The Financial Services Modernization Act of 1999:
Essentially repealed the Glass-Steagall Act
Made it easier for commercial banks to engage in securities and insurance activities
Increased the degree to which banks can offer securities services
Allowed securities firms and insurance companies to acquire banks
Resulted in more consolidation among banks, securities firms, and insurance companies

18. Regulation of Operations (cont’d)
Regulation of securities services (cont’d)
Deregulation of brokerage services
Banks had been allowed to offer discount brokerage services even before 1999
In the late 1990s, some banks acquired financial services firms that offered full-service brokerage services
Deregulation of mutual fund services
Since June 1986, brokerage subsidiaries of bank holding companies could sell mutual funds
Private label funds are mutual funds created by banks in conjunction with financial service firms

19. Regulation of Operations (cont’d)
Regulation of insurance services
Before the late 1990s, banks were involved in insurance in limited ways:
Banks that had participated in insurance before 1971 were allowed to continue to do so
Some banks leased space in their buildings to insurance companies in exchange for a payment equal to a percentage of the insurance company’s sales
In 1995, the Supreme Court ruled that national banks could sell annuities
In 1998, regulators allowed the merger between Citicorp and Traveler’s Insurance Group
In 1999, the Financial Services Modernization Act confirmed that banks and insurance companies could merge

20. Regulation of Operations (cont’d)
Regulation of off-balance sheet transactions
Off-balance sheet transactions, such as letters of credit, expose the bank to risk
Risk-based capital requirements are higher for banks that conduct more off-balance sheet activities
Regulation of the accounting process
Publicly-traded banks are required to provide financial statements that indicate their recent financial position and performance
The Sarbanes-Oxley Act was enacted in 2002 to make corporate managers, board members, and auditors more accountable for the accuracy of the financial statement that their respective firms provided

21. Regulation of Interstate Expansion
The McFadden Act of 1927 prevented banks from establishing branches across state lines
The Douglas Amendment to the Bank Holding Company Act of 1956 prevented interstate acquisitions of banks by bank holding companies
By 1994, most states had approved nationwide interstate banking

22. Regulation of Interstate Expansion (cont’d)
Interstate Banking Act
Until 1994, most interstate expansion was achieved through bank acquisitions
In September 1994, federal guidelines passed a banking bill that removed interstate branching restrictions
Known as the Reigle-Neal Interstate Banking and Branching Efficiency Act of 1994
Eliminated most restrictions on interstate bank mergers and allowed commercial banks to open branches nationwide
Allows banks to grow and increase economies of scale