1. Regulating Finance Lots of bases to cover Cover one by regulation or deregulation Unintended Consequences Reactions to regulatory policies frustrate regulator intent Regulate bank balance sheets off-balance sheet activities Emplace a safety net bankers become skydivers Regulation spreads to cover innovations complexity ineffectiveness Win by gaming the system

2. Regulation thru the decades… Response to Crisis of 1907 – Federal Reserve Act, 1913 Response to Great Depression – FDIC – Glass – Steagle: commercial bank/investment bank – SEC – Interest rate restraints Tweaks during era of financial stability, 1956 – Holding companies under Fed – Douglas amendment: further limit interstate branching

3. Deregulation … Failures … Responses 1980: Depository Institution Deregulation & Monetary Control Act – Response to disintermediation Phased out interest rate ceilings Loosened reins on thrifts 1982: Garn – St. Germain: Unleashed thrifts Also: Allowed depository institutions to offer Money Mkt Deposit Accts. 1989: Financial Inst. Reform Recovery & Enforcement Act – Cleanup after S& L debacle 1994: Riegel-Neal Interstate Banking & Branching Efficiency Act 1999: Gramm-Leach-Biley Financial Services Modernization… CITIGroup financial supermarket 2002: Sarbanes-Oxley – Response to Enron, WorldCom,… Tightened accounting standards CEO/CFO signoff on financial statements

4. Regulatory Responses to Subprime-Triggered Crisis??? Constraints on mortgage brokers??? Ban exotic derivatives: Subprime MBS??? Regulate compensation – clawbacks??? Increase capital requirements Deal with GSEs: fully privatize? nationalize?? downsize??? Limit investment bank, insurance company risk-taking??? – Major investment banks now Fed regulated bank holding cos. Restrict rating agency conflicts of interest??? Increase regulation of derivatives? – Restrict over-the-counter trades Require current bankruptcy plans – Make failure of TBTFs credible

5. Primary Supervisory Responsibility of Bank Regulatory Agencies Comptroller of the Currencynational banks chartered by Federal government since 1863 Federal Reserve and state banking authorities state banks that are members of the Federal Reserve System Fed – also regulates bank holding companies FDICinsured state banks that are not Fed members State banking authoritiesstate banks without FDIC insurance

6. 6 The U.S. regulatory regime Sources: Financial Services Roundtable (2007), Milken Institute.

7. Innovations: Response to Interest Rate Volatility Adjustable-rate mortgages teaser rates Financial Derivatives hedging…and gambling Innovations: Response to Information Technology Bank credit and debit cards Electronic banking – ATM/Home banking/ABM/Virtual banking Overrides branch restrictions Junk bonds…High-yield bonds building our megaresorts Commercial paper market – MMMF support Securitization Innovations:Avoiding Regulation/Loophole Mining Sweep accounts … reserve requirements Money Market Mutual Funds … Regulation Q

8. Decline of Traditional Banking Decline in cost advantages in acquiring funds (liabilities) Rising inflation rise in interest rates and disintermediation Low-cost source of funds, checkable deposits, declined in importance Decline in income advantages on uses of funds (assets) IT less need for banks to finance short-term credit and issue loans IT lower transaction costs for other financial institutions Bank Responses: Riskier Lending … Commercial real estate, leveraged buyouts, takeovers Off balance sheet activities

9. Size Distribution of Insured Commercial Banks, September 30, 2008 ???? 3,046 4,039 486 86 7,640 39.9 52.9 6.1 1.1 1.3 9.7 10.0 79.0

10. Bank Consolidation Benefits of bank consolidation Increased competition close inefficient banks Efficiencies from economies of scale and scope Lower chance of failure -- diversified portfolios Costs Fewer community banks less lending to small business Banks in new areas increased risks/failures Skirting branch restrictions ATMs, Bank Holding Cos. Interstate Banking and Branching Efficiency Act, 1994 Pre-Crisis Findings: Intrastate deregulation more positive for all but big banks Raises ROA/ROE &reduces risks for banks under $15b Non-interest expense down for banks under $1b Increases big bank risks NIM up for all but biggest Interstate deregulation Small bank risks down Mid-sized risks up Big bank risks mixed ROA/ROE generally down State of economy Stronger impact on bank performance than branching deregulation Geographic deregulation Skirting branch restrictions ATMs, Bank Holding Cos.

11. Attempted solutions: Constrain banks from taking too much risk Promote diversification…but systemic crisis is systemic Prohibit holdings of common stock Set capital requirements … Capital as cushion Minimum leverage ratio Basel Accord: risk-based capital requirements … but theres regulatory arbitrage Prompt corrective action: Close em down when capital inadequate Monitor … CAMELS – Capital adequacy – Asset quality – Management – Earnings – Liquidity – Sensitivity to market risk Disclosure requirements … mark-to-market issue Restrictions on competition … make banking boring

13. Failed Banks Update Year Number 20002 20014 2002 11 20033 20044 2005/20060 20073 2008 QI+Q24 2008 Q3 10 2008 Q4 12 2009 Q1 21 2009 Q2 24 2009 Q3 50 2009 Q4 452009 Total = 140 2010 Q1 40 2010 Q2 48 2010 Q3 42 2010 thru 10/15 52010 Y-T-D = 135