CHAPTER

1818Bank

Regulation

© 2003 South-Western/Thomson Learning

Chapter ObjectivesChapter Objectives

Describe the key regulations imposed on commercial banks

Explain development of bank regulation over time

Evaluate the areas of bank regulation Describe the main provisions of the Financial

Services Modernization Act of 1999

BackgroundBackground

Banking industry has experienced tremendous change in recent years Post-Depression legislation focused on safety and

soundness of commercial banks Deregulation of financial services industry Intense competition/consolidation Expansion--economies of scale

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Why Banks Are Regulated?Why Banks Are Regulated?

Deposits are 70% of money supply Center of payments mechanism Primary transmitter of monetary policy Major liquidity provider to economy

Make loans Deposits are liquid assets of customers

Liabilities are major, low risk assets of consumers

Regulatory StructureRegulatory Structure

The regulatory structure of the banking system in the U.S. is unique Dual banking system: Federal and State Charter

State charter = state bank Regulated by state banking agency Federal charter = national bank Regulated by Comptroller of the Currency

Regulatory StructureRegulatory Structure

Banks that are members of the Federal Reserve are also regulated by the Fed

Banks that are insured by the Federal Deposit Insurance Corporation are also regulated by the FDIC

Regulatory overlap: FDIC Federal Reserve System State banking authorities Now Securities and Exchange Commission--stock

Regulatory StructureRegulatory Structure

Regulation of bank ownership Bank independently owned Bank owned by a holding company

Popularity stems from amendments to the Bank Holding Company Act in 1970

Allowed BHC’s more flexibility to participate in activities like leasing, mortgage banking, and data processing, and later,

Insurance, securities underwriting, etc.

Deregulation Act of 1980Deregulation Act of 1980

Initiated to reduce bank regulations and increase Fed monetary policy effectiveness

Also known as DIDMCA Phase out of deposit rate ceilings

Interest rate ceilings were previously enforced by Regulation Q. Phased out by 1986

The act allowed banks to make their own decisions on what interest rates to offer on deposits

Allowance of checkable deposits for all depository institutions NOW accounts

Deregulation Act of 1980Deregulation Act of 1980

New lending flexibility for depository institutions Allowed S&Ls to offer limited commercial and

consumer loans

Explicit pricing of Fed services Ensures the Fed only provides services, such as check

clearing, that it can provide efficiently

Impact of the DIDMCA Consumers shift to NOW accounts and CDs, so banks

now pay more for funds than before. Also, increased competition between depository institutions

Garn-St. Germain Act, 1982Garn-St. Germain Act, 1982

Came at a time when some depository institutions were experiencing severe financial problems

Permitted depository institutions to offer money market deposit accounts to compete with money market mutual funds

Also allowed depository institutions to acquire failing institutions across geographic boundaries

In general, consumers appear to have benefited from deregulation

Regulation of Deposit InsuranceRegulation of Deposit Insurance

Deposit insurance began in 1933 with creation of Federal Deposit Insurance Corporation in response to bank runs/failures in 1920s (agricultural) and early 1930’s (Depression) Between 1930-1932 20% of banks failed. Initial wave of failures resulted in runs on other

banks, some of which were healthy The amount of deposits insured per person has

increased from $2,500 in 1933 to $100,000 today

Regulation of Deposit InsuranceRegulation of Deposit Insurance

The pool of funds used to cover insured depositors is called the Bank Insurance Fund Supported by annual insurance premiums paid by

commercial banks Until 1991, the rate was the same for all banks,

regardless of risk, causing moral hazard problem Federal Deposit Insurance Act (FDICA) of 1991

phased in risk-based insurance premiums

Regulation of CapitalRegulation of Capital

Banks are required to maintain a minimum amount of capital as a percentage of total assets Banks prefer low capital ratios to boost ROE Regulators prefer higher levels to absorb operating

losses In the 1988 Basel Accord central bankers of 12

countries agreed to uniform, risk-based capital requirements

Regulation of CapitalRegulation of Capital

Use of the Value-at-Risk method to determine capital requirements In 1998, large banks with substantial trading

businesses began using their own internal measures of market risk to adjust their capital requirements.

Use a VAR (value-at-risk) model, usually with a 99 percent confidence interval

Precursor to 1991 risk-based capital requirements

Regulation of CapitalRegulation of Capital

Testing the validity of a bank’s VAR Uses backtests with actual daily trading gains or

losses If the VAR is estimated properly, only 1 percent

of the actual trading days should show results worse than the estimated VAR

Related stress tests Bank identifies a possible extreme event to

estimate potential losses

Regulation of OperationsRegulation of Operations

Regulation of loans Regulators monitor:

Loan quality Loan diversification geographically and by industry Adequacy of loan loss reserves Exposure to debt of foreign countries

Regulation of investment securities Non-equity, investment grade investments Provides income and liquidity to bank Investment banking activity only in state and

municipal bonds

Regulation of OperationsRegulation of Operations

Regulation of securities services Banking Act of 1933 (Glass-Steagall) separated

banking and securities services Intended to prevent conflicts of interest and self-

interest lending Deregulation of corporate debt underwriting

services, 1989 Commercial paper and corporate debt securities Still no common stock underwriting

Regulation of OperationsRegulation of Operations

The Financial Services Modernization Act, 1999

Essentially repealed the Glass-Steagall Act Enables commercial banks to more easily pursue stock

underwriting and insurance activities

Deregulation of brokerage services In the late 1990s some banks acquired financial

services firms. Citicorp and Traveler’s Insurance Group, which owned

Solomon Brothers and Smith Barney, merged

Regulation of OperationsRegulation of Operations

Deregulation of mutual funds services The Fed ruled in 1986 to allow brokerage subsidiaries of

bank holding companies to sell mutual funds

Regulation of OperationsRegulation of Operations

Regulation of insurance services Banks that already participated in insurance before 1971

were grandfathered Banks sometimes leased space to insurance or served as

agent, but not underwriting insurance Banks able to underwrite annuities, 1995 The passage of the Financial Services Modernization Act

(1999) confirmed that banks and insurers could consolidate their operations

Regulation of off-balance sheet transactions Risk-based capital requirements are higher for banks with

more off-balance sheet activities

Regulation of Interstate ExpansionRegulation of Interstate Expansion

The McFadden Act of 1927 prevented banks from establishing branches across state lines.

No interstate bank holding company mergers (1956)

Intent was to prevent large bank market control, but limited competition to intrastate banking

Slow changes in state banking law to permit interstate banking

Regulation of Interstate ExpansionRegulation of Interstate Expansion

Interstate Banking Act 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 Allowed interstate bank holding companies to consolidate into

one charter Reduces costs to consumers and adds convenience—promotes

competition Banks take advantage of economies of scale

How Regulators Monitor BanksHow Regulators Monitor Banks

Regulators examine commercial banks at least once per year

CAMELS ratings Capital adequacy

Regulators determine the “adequacy” of capital More capital allows banks to absorb losses

Asset quality Credit risk Portfolio’s composition and exposure to potential

events

How Regulators Monitor BanksHow Regulators Monitor Banks

Management Rates management according to administrative

skills, ability to comply with existing regulations, and ability to cope with a changing environment.

Very subjective Earnings

Banks fail when their earnings are consistently negative

Commonly used ratio: Return on Assets (ROA)

How Regulators Monitor BanksHow Regulators Monitor Banks

Liquidity Extent of reliance on outside sources for funds (discount

window, federal funds)

Sensitivity to interest rate changes and market conditions

Rating bank characteristics Each of the CAMEL characteristics is rated on a 1-to-5

scale, with 1 indicating outstanding Used to identify problem banks Subjective opinion must be used to supplement objective

measures

How Regulators Monitor BanksHow Regulators Monitor Banks

Corrective action by regulators When a problem bank is identified it is thoroughly

investigated (examined) by regulators They may require specific corrective action, such

as boosting capital or delay expansion Regulators have the authority to take legal action

against a bank if they do not comply

How Regulators Monitor BanksHow Regulators Monitor Banks

Funding the closure of failing banks FDIC is responsible for closing failing banks

Liquidating failed bank's assets Facilitating acquisition by another bank

Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991

Regulators required to act more quickly for undercapitalized banks

Risk-based deposit insurance premiums Close failing banks more quickly Large deposit (>$100,000) customers not protected

The “Too-Big-To-Fail” IssueThe “Too-Big-To-Fail” Issue

Some troubled banks have received preferential treatment from bank regulators Continental Illinois Bank

Rescued by the federal government, while other troubled banks were not

As one of the country’s largest banks, Continental’s failure could have reduced public confidence in the banking system

The “Too-Big-To-Fail” IssueThe “Too-Big-To-Fail” Issue

Argument for government rescue Because many Continental depositors exceeded

$100,000, failure to protect them could have caused runs at other large banks

Argument against government rescue Sends a message that large banks will be protected

from failure Incentive to take added risks Removes incentive to make operations more

efficient

The “Too-Big-To-Fail” IssueThe “Too-Big-To-Fail” Issue

Proposals for government rescue Ideal solution would prevent a run on deposits

while not rewarding poorly performing banks with a bailout

Regulators should play a greater role in assessing bank financial conditions over time