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CHAPTER 16

REGULATION OF FINANCIAL INSTITUTIONS

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Financial Institutions are Regulated Because: They provide essential financial services to the

public. Financial institutions have access to privileged

information about their customers. Two-thirds of the money supply are liabilities of

depository institutions. Control over the money supply means regulating "money supply" institutions.

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Financial Institutions are Regulated Because: (concluded) The federal government has promised to make

good on deposits of failed depository institutions and thus regulate to ensure safety and soundness.

A sufficient level of competition is necessary to provide an adequate level and reasonable price for financial services.

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Bank Failures in the United States Occur when a bank’s assets are worth less than

its liabilities. Deposit insurance was developed to reassure

uninformed depositors that their deposits were safe even if their bank failed.

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Number and Percentage of all Banks Failing (1890-1998)

YEAR NUMBER

ANNUAL PERCENTAGE OF

ACTIVE BANKS

AVERAGE

PER YEAR

1890-1899 1,084 1.50 1081900-1920 1,789 0.34 851921-1929 5,712 2.30 6341930-1933 9,096 11.29 2,2741934-1942 487 0.35 541943-1952 42 0.03 41953-1962 46 0.03 51963-1972 60 0.05 61973-1977 45 0.03 91978-1982 68 0.09 141983-1987 595 0.80 1191988-1991 720 1.40 1801992-1994 176 0.06 591995-1998 14 0.04 4

Since World War II, bank regulations have generally been successful in stopping massive bank failures.However, after rate ceilings were removed, interest rates rose, and the economy encountered a severerecession in the early 1980s, bank failures increased sharply. After the 1991 FDICI Act was passed, bankfailures declined sharply.Source: FDIC, Annual Report, various issues, and bimonthly Regulatory Review.

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Lessons From Past Bank Failures In the 1930's, banks failed because the Federal

Reserve System could not provide liquidity (lend) to banks during rapid deposit withdrawal.

Depositor panic caused many failures of sound banks. Deposit insurance and unlimited liquidity from the Federal Reserve Banks have prevented bank panics.

Regional or industry-wide depressions may cause widespread bank failures.

Fraud, embezzlement, and poor management are the most notable causes of U.S. bank failure.

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Deposit Insurance

Deposit insurance was first enacted in 1933 for up to $2,500 per account.

Over time the limit increased to $100,000 per account.

Currently, deposits are insured up to $100,000 per depositor.

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Pay Off of a failed institution

A purchase and assumption (P&A) of all the deposits of the failed institution by a healthy institution is a preferred alternative to a liquidation. – This policy implies 100% deposit insurance

coverage and favors large banks that are less likely to be liquidated.

– The too-big-to-fail policy followed by the FDIC during the 1980s explicitly favored large banks.

A payoff and liquidation occurs when there is little value to the bank as a going concern.

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FDIC Payoff Policy

ASSETS LIABILITIES AND NET WORTH

Value realized from sale of assets =$75 million

Deposits under $100,000 =$50 millionUninsured liabilities and deposits over$100,000 = $100 millionNet worth = -$75 million

In a deposit payoff, the FDIC pays off the $50 million in insured deposits and, in turn, is owed $50 millionby the bank. The FDIC then takes possession of the failed bank’s assets and liquidates them. It uses theproceeds to pay off the $150 million deposits and other liabilities (including the $50 million that it is owedin return for paying off the insured deposits). After recovering $75 million from the asset liquidation, theFDIC can pay itself and uninsured liability and deposits holders 50 cents in payoff for each one dollar ($75million/$150 million) of the bank’s liabilities that they own. The owners of the bank receive zero dollarsback, because the bank is insolvent and has no positive net worth.

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FDIC-Assisted Purchase and Assumption Transaction: Failed Bank Subsidiary of New Bank

ASSETS LIABILITIES AND NET WORTH

$75 million, value of old bank’s goodassets acquired by new bank

$100 million in deposits and otherliabilities of old bank assumed bynew bank

$20 million in financial assistanceprovided by FDIC in exchange for somebad assets$5 million purchase premium paid bynew bank’s owners in the form ofassumed liabilities$5 million in new cash injected by newbank’s owners to buy capital

$5 million in new capital in new bank

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Bank examinations are an important part of bank regulation Bank examinations are intended to promote and

maintain safe and sound bank operating practices.

The examination procedure includes:– bank financial information collected quarterly (call

reports).– on-site bank examinations.– discussion of examination findings with bank

management.

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Bank examinations are an important part of bank regulation (continued) Areas of the Bank Analyzed in the Examination

Process– Capital adequacy.– Asset quality.– Management competency.– Risk Management.– Earnings of the bank.– Liquidity of the bank.

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Bank examinations are an important part of bank regulation (concluded)

On-site examinations are more likely to uncover pertinent private information than the off-site information provided by the banks themselves.

The large number of bank and S&L failures in the late 1980s have been attributed, in part, to infrequent examinations during that period.

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Deposit Insurance and Moral Hazard With deposit insurance, depositors feel safe and

cease their surveillance of their depository institutions.

Deposit insurance creates a moral hazard for bank managers because they can acquire more risky assets without having to pay more for deposits.

Regulatory agencies counter this lack of market surveillance with increased regulation.

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Insurance Agencies as Police

Banks are examined regularly. The board of directors is held responsible for any violations of of regulations.

Banks with poor CAMEL ratings may be subjected to “cease and desist” orders.

Banks with inadequate capital may be forced to raise additional capital.

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Other Deposit Insurance Issues

Unequal coverage for large and small banks. Different premium rates among types of

depositories encourages charter switching. Historically, deposit insurance premiums were

the same for all institutions regardless of their riskiness.

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The FDIC Improvement Act of 1991 (FDICIA) Required early corrective action for all banks,

regardless of size. Mandated higher premiums to cover expected

losses. Mandated a risk-based (asset) deposit premium

structure. In 1993 riskier banks began paying higher

deposit insurance premiums.

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Bank Safety Regulations Reduce Risk Taking and Provide Public Confidence Mandatory Federal Deposit Insurance. Entry, branching, and holding company

restrictions. Deposit Rate Ceilings (Regulation Q)--reduced

price competition among banks. Phased out (1986) with the DIDMCA of 1980.

Bank examinations--an assessment of the financial condition and management's performance.

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Bank Safety Regulations (concluded)

Balance sheet restrictions control risk-taking– Adequate capital to absorb losses.– Limit size of loan to one customer -- forces

diversification.– Require investment-grade quality securities only.– Prohibit investment in equity securities.– Prohibit investment banking activities in risky

securities, though recent legislation has added investment banking authority to banking organizations.

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Consumer Protection Regulations

– Usury laws -- loan rate ceilings.– Truth in Lending (1968) -- disclosure of

standardized lending terms at the time of the loan.– Equal Credit Opportunity Act (1974 and 1976) --

Excluded sex, marital status, race, age, etc. information from the credit decision.

– Fair Credit Billing Act (1974) gave consumers redress for computer errors and billing information.

– Community Reinvestment Act (1978) requires banks to make credit available in their market area.

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Bank Regulators

Bank Insurance Fund (FDIC-1933) and (SAIF-1989) – Insures deposits to $100,000.– Examines state chartered, non-Fed member

banks and S & L's.– Autonomous funding from deposit premiums.– Influences all banks by providing deposit

insurance.

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Bank Regulators (continued)

Federal Reserve System (1913)– Examines state chartered, member banks.– Autonomous funding--independent.– Monetary control authority.– Regulates bank holding companies.

Comptroller of the Currency (OCC) 1863– Charters national banks; closes failed national

banks.– Examines national banks.– Autonomous funding--independent.

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Bank Regulators (concluded)

State Banking Agencies– Charter state banks.– Examine state chartered banks.– Protect public.