1.  Finish Chapter 10  Capital adequacy (solvency) and returns to equity  FDIC this weekend  Resolves 9 banks  http://www.fdic.gov/index.html (bair) http://www.fdic.gov/index.html  Chapter 11  Regulation

2. Capital Adequacy Management: Preventing Bank Failure High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$90MBank Capital$10MLoans$90MBank Capital$4M High Bank CapitalLow Bank Capital AssetsLiabilitiesAssetsLiabilities Reserves$10MDeposits$90MReserves$10MDeposits$96M Loans$85MBank Capital$5MLoans$85MBank Capital-$1M

3. Capital Adequacy Management: Returns to Equity Holders

4.  Basic microeconomic principles on efficiency  If market is competitive regulation can only harm society  Conditions for competitive market  Homogeneous good  Free entry and exit  Participants have full information  Many buyers and sellers

5.  Exceptions: where regulations can help  Market failures ▪ Market power (monopoly) ▪ Pollution & environmental harms ▪ Lack of property rights (e.g. fishing) ▪ Asymmetric information (e.g. credit)  Caution ▪ Government failure is possible when trying to solve a market failure.  However there are have been successes ▪ e.g. clean air act estimate 22 trillion in benefits

6.  These boats are the same length  Regulation intended to cut fishing effort  Instead regulation limits boat length  Result: ▪ Short & tall boats ▪ Fishing effort up ▪ Resources wasted… 10-6

7.  A huge part of the company’s credit-default swap business was devised.. to allow banks to make their balance sheets look safer than they really were.  Under a misguided set of international rules that took hold toward the end of the 1990s, banks were allowed use their own internal risk measurements to set their capital requirements.  How did banks get their risk measures low? … they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G….which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more “risk-free” assets.  http://dealbook.blogs.nytimes.com/2009/03/02/propping-up-a-house-of-cards/ 10-7

8.  Safety and soundness regulation  Entry, branching, network, and mergers  Deposit insurance  Deposit interest ceilings  Portfolio restrictions, including reserve requirements  Capital requirements  Regulatory monitoring and supervision 1-8

9.  Canada: 60 banks, US: 8000 banks  1927 US Laws allows state to restrict interstate and intrastate competition  Too many inefficient banks  Bank holding companies are a way around the law ▪ Independent company purchases many banks in many states.  States relax laws (1972-1991)  What’s the impact? 10-9

10.  Impacts of increased competition  Operating costs decline (about 8%) ▪ Includes wage decline ▪ Down 12% for men & 3% for women ▪ Difference across gender: Evidence of discrimination in noncompetitive setting  Loan losses decline  Interest rates decline for borrowers

11.  What about economic growth?  In States deregulating ▪ economic growth increases by.51% to 1.19% ▪ Convinced? What is the counterfactual? ▪ States that don’t deregulate saw a decline in growth rate (.6%)  What is the mechanism? ▪ The quality of lending improved not just the quantity. 10-11

12.  Restrictions on interest paid on deposits  5.5% maximum (1934-1980) ▪ Difficult to generate deposits when interest rate are high e.g. late 1970’s ▪ Regulation interacts with new economic conditions, harming banks  Response ▪ Money market mutual funds ▪ Push for deregulation

13. 10-13  Decline in cost advantages in acquiring funds (liabilities)  Rising inflation led to 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)  Information technology has decreased need for banks to finance short-term credit needs or to issue loans  Information technology has lowered transaction costs for other financial institutions, increasing competition

14. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.11-14