1. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-1 Financial Regulation, Technology & Financial Innovation Chapter 3

2. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-2 Regulatory Environment Emphasis changing over time The 1930s The 1960s to 1980 1980 The rules of the game changed High and highly variable interest rates Severe disintermediation ◦ Interest-bearing checking accounts ◦ Money market mutual funds ◦ More open entry into banking

3. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-3 Regulatory Environment (continued) The 1980s Increasing flexibility to cope with disintermediation Attempts to stabilize depository institution failures The 1990s Continuing deregulation ◦ Reduction in geographical branching restrictions ◦ Reduction in limits on financial service offerings Stabilization of regulatory structure Early 2000s Issues of Ethics & Fraud

4. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-4 Regulation of Depository Institutions Regulators of commercial banks Comptroller of the Currency (OCC) Federal Reserve System (“The Fed”) Federal Deposit Insurance Corporation (FDIC) State Banking Departments Regulators of thrifts Office of Thrift Supervision (OTS) Savings Association Insurance Fund (SAIF) Regulator of credit unions – National Credit Union Administration (NCUA)

5. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-5 What is Regulated? Initial creation of depository institutions Initial licensing and chartering Location and number of physical branches, offices Initial board of directors and officers Minimum cash and capital requirements to open On-going operations Mergers and acquisitions Opening or closing of offices, branches Many operations procedures What financial services/products may be offered For depository institutions

6. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-6 What is Regulated? Assets Diversification of assets Quality of assets Liquidity of assets Level of cash reserves Liabilities & equity Types of liabilities created Distribution of financing of assets Quality of liability and equity accounts Minimum capital requirements For depository institutions

7. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-7 What is regulated? (continued) Community involvement Degree of market share in each market area Non-discriminatory operating policies Degree of risk created through the use of derivatives and other financial instruments For depository institutions

8. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-8 Regulatory Process Examinations Federal Financial Institutions Examination Council (FFIEC) Securities & Exchange Commission State Regulatory Departments Reports Multiple agencies Multiple areas Sometimes cause conflicts CAMELS Rating For depository institutions

9. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-9 CAMELS Rating Capital adequacy Asset Quality Management Quality Earnings – amount & stability Liquidity Sensitivity to market risk For depository institutions

10. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-10 One versus Multiple Regulators Multiple regulators Provide more ability to detect problems Provide cross-checks Are inefficient and costly to maintain One regulator More efficient and lower cost Too much power concentrated in one place Perhaps functional reorganization is better For depository institutions

11. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-11 Finance Company Regulation Regulated at the state not federal level Licensing restrictions State licenses Local business permits, zoning, etc. Consumer Protection Legislation Applies Consumer Credit Protection Act of 1968 (Truth-in- Lending) Equal Credit Opportunity Act of 1974

12. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-12 Insurance Company Regulation Regulated at state not federal level Licensing & solvency requirements Mutual insurance funds by state Rate regulation Product regulation Insurance industry modernization plan from National Association of Insurance Commissioners)

13. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-13 Insurance Regulatory Modernization Action Plan Consumer protection Market regulation Speed-to-market for insurance products Producer licensing Insurance company licensing Solvency regulation Change in insurance company control

14. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-14 Pension Fund Regulation Federal Regulation through the Employee Retirement Income Security Act (1974) or ERISA ERISA Attempts to ensure assets equal liabilities Most employees are fully vested after 15 years of service Gives fund managers fiduciary responsibility Pension Benefit Guaranty Corporation provides insurance at a federal level

15. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-15 Regulation of Investment Companies & Mutual Funds Federal Securities Laws Securities Act of 1933 Securities Exchange Act of 1934 Investment Company Act of 1940 Investment Advisers Act of 1940 New federal legislation will deal with After-hour trading allowed for some investors Mandating stronger oversight of mutual fund boards Stronger disclosure requirements

16. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-16 Securities Firms Regulation Federal securities laws Securities Investor Protection Act of 1970 Securities Acts Amendments of 1975 Insider Trading & Securities Fraud Enforcement Act of 1988 Sarbanes-Oxley Act of 2002 New legislation on Providing valid investment advice to public Adhering to equal disclosure principles

17. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-17 The Dialectic Process Initial set of arguments/rules – THESIS Conflicting set of arguments or responses – ANTITHESIS A new set of arguments/rules emerging from the interaction between 1 & 2 above – SYNTHESIS The SYNTHESIS becomes the new THESIS for the next on-going round of the process

18. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-18 The Regulatory Dialectic Regulators/legislators create rules – THESIS Companies seek loopholes to earn profits – ANTITHESIS Regulators modify rules – NEW THESIS Companies seek to earn profits around rules – ANTITHESIS Eventually SYNTHESIS occurs and obsolete rules are eliminated

19. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-19 Why Regulations Become Obsolete Financial innovation Technology and economic conditions Globalization of financial markets

20. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-20 Major Banking Laws 1863 - 1935 1863-4 National Banking & Currency Acts 1913 Federal Reserve Act 1927 McFadden-Pepper Act 1933 Glass-Steagall Act Home Owners' Loan Act Securities Act of 1933 1934 Securities Exchange Act National Housing Act National Credit Union Act 1935 Banking Act of 1935

21. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-21 Major Banking Laws 1935 - 1980 1956 Bank Holding Company Act and Amendments (1966, 1970) 1960 Bank Merger Act 1966 Interest Rate Adjustment Act 1968 Consumer Credit Protection Act (Truth-in-Lending) 1970 Amendments to Bank Holding Company Act 1970 Federal Credit Union Act Amended (NCUSIF) 1974 Equal Credit Opportunity Act 1977 Community Reinvestment Act 1978 International Banking Act

22. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-22 Major New Laws 1980 - 2000 1980 DIDMICA 1982 Garn – St. Germain Depository Institutions Act 1987 Competitive Equality Banking Act (CEBA) 1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) 1991 Federal deposit Insurance Corporation Improvement Act (FDICIA) 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act (IBBEA) 1999 Financial Services Modernization (Graham- Leach-Bliley (GLB)

23. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-23 Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) Monetary Control Act of 1980 Depository Institutions Deregulation Act of 1980 Consumer Checking Account Equity Act of 1980 Expanded Powers for Thrifts Preemption of State Interest Rate Ceilings Truth-in-Lending Simplification Amendments to the National Banking Laws Financial Regulation Simplification Act of 1980 Moratorium on foreign takeovers of U.S. Financial Institutions DIDMCA - 1980

24. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-24 Garn-St. Germain Act of 1982 The Deposit Insurance Flexibility Act The New Worth Certificate Act The Thrift Institution Restructuring Act Changed loan limit, exempted some banks from reserve requirements Credit Union Amendments Amendment to Bank Holding Company Act Allowed governments to have NOW accounts Alternative Mortgage Transaction Act of 1982

25. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-25 CEBA of 1987 Competitive Equality Banking Act of 1987 Financial Institutions Competitive Equality Act Moratorium on Certain Nonbanking Activities FSLIC Recapitalization Act Thrift Industry Recovery Act Financial Institutions Emergency Acquisitions Act Expedited Funds Availability Act Credit Union Amendments Loan Loss Amortization Reaffirmation of Federal Deposit Insurance to legal limit Government Check Cashing Required

26. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-26 FIRREA of 1989 Financial Institutions Reform, Recovery, and Enforcement Act of 1989 Strengthened thrift standards & supervision Made FDIC sole insurer for banks & thrifts Restricted thrifts junk bond & R.E. investments Created the Office of Thrift Supervision (OTS) Abolished FSLIC & FHLBB, other reforms Created the Resolution Trust Corporation, the Resolution Funding Corp, & Oversight Board Permitted BHOs to acquire healthy thrifts Increased penalties for fraud by managers Lowered tax benefits to acquirers of failed thrifts

27. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-27 FDICIA of 1991 Federal Deposit Insurance Corporation Improvement Act of 1991 Authorized FDIC to borrow up to $30 billion from the U.S. Treasury to be repaid from bank insurance premiums Authorized FDIC to borrow up to $45 billion from U.S. Treasury to be repaid by sale of assets of failed banks Ordered regulators to develop better capital adequacy measures, and to move more promptly when an institution's capital position weakens; at 2%, institution must be closed Increases frequency of bank examination Restricted FDIC from fully reimbursing uninsured and foreign depositors when a bank fails Restricted regulators in making long-term loans to banks in difficulty Required higher deposit insurance for riskier banks

28. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-28 Ownership Forms Privately owned firms Stock owned firms Subchapter S corporations Limited liability companies Mutual firms Not-for-profit organizations Franchising and chain banks

29. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-29 Holding Companies Bank Holding Companies (BHC) & Financial Holding Companies (FHC) One bank versus multi-bank Created to: Provide greater financial leverage Circumvent regulations & restrictions Take advantage of economies of scale Provide multiple services to customer base

30. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-30 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 Allows interstate branching unless a state specifically passes a law prohibiting it De facto removes many restrictions about bank size Encourages large banking conglomerates Puts no restrictions on capital movements within the (now very expanded) bank Does not restrict the options of states to regulate banking within their environs

31. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-31 Riegle Community Development and Regulatory Improvement Act of 1994 Reduces frequency of examination for small, well- managed banks Reduces reporting requirements Requires regulatory agencies to review and eliminate outdated regulations Establishes Community Development Financial Institutions Fund to provide funding and technical support to "banks and other community organizations" promote local economic development in depressed communities and neighborhoods

32. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-32 One-Bank Holding Companies Circumvent product restrictions for banks Glass-Steagall restrictions were eased in 1980s Virtual Financial Institutions as Loopholes Financial Services Modernization Act of 1999 or Graham-Leach-Bliley Act of 1999

33. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-33 Financial Services Modernization Act of 1999 or Graham-Leach-Bliley Act of 1999 Financial Holding Companies National Bank Operating Subsidiaries Facilitating affiliation among banks, securities firms, and insurance companies Functional regulation Insurance Unitary savings and loan holding companies Privacy Federal Hold Loan Bank System modernization More complete disclosure to the public

34. Copyright © 2004 by Thomson Southwestern All rights reserved. 3-34 Continuing Regulatory Concerns Measuring risks Control of risks due to technology Detecting and preventing fraud Operations Corporate governance Through partnerships/alliances Money laundering Controlling risk via market discipline