Banking1

G406, Regulation, ch. 10 Eric Rasmusen, erasmuse@indiana.edu

October 31, 2013

Some of the Older Bank Regulations

We will focus on the large number of regulations that attempt to prevent moral hazard, but there are lots of other bank regulations, including: The Truth in Savings Act of 1991: Explain loan terms clearly.Equal Credit Opportunity Act (ECOA) of 1974: Don’t discriminate by race, sex, marital status, being on public assistance. The Community Reinvestment Act of 1977: Make loans in poor neighborhoods.

See http://www.bankersonline.com/abcsoup/abcsoup.html

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A Bank Run3

Bank Runs

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Is this a Prisoner’s Dilemma?

Three Government Tools

1. Deposit insurance.

2. The Fed’s discount window--- serving as lender of last resort.

3. Bailouts, even if not authorized by law.

These solve the coordination externality problem. All of these necessitate supervision of banks because they create moral hazard.

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“Primary Regulators”

There’s backup regulation too. The FDIC can monitor national banks if they have deposit insurance. Office of the Comptroller of the Currency: national banks and federal savings associationsThe Federal Reserve Board: State banks that are member of the Federal Reserve systemThe Federal Deposit Insurance Corporation (FDIC): State banks not members of the Fed. National Credit Union Administration (for credit unions)Securities and Exchange Commission (for investment banks)

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Citizens Bank fails, will reopen as Heartland Bank

PRINCETON – Federal banking regulators designated Citizens First National Bank as a failed bank Friday afternoon, ending its business and selling its assets. Citizens Bank customers can access their money by writing checks or using ATM or debit cards. All checks drawn on the bank will be honored, the Federal Deposit Insurance Corp. said, and all loan customers should continue to make their payments as usual. … The bank branches will reopen today as branches of Heartland Bank and Trust Company of Bloomington, which has agreed to assume Citizens Bank’s assets, including about $870 million in total deposits, the FDIC said in a news release Friday evening. Customers of Citizens Bank are now customers of Heartland Bank.

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LEVERAGE RAISES PROFITS: Riskless Arbitrage

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Risky Arbitrage— paying back the loan

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Average return in Plan 3: 0.8(610) + .2 (-400) = 210%

Risky Arbitrage (corrected for bankruptcy)

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Plan 3 Return: .8(610%) + .2 (-100%) = 488%- 20%= 468%.

Risk Regulation

1. Capital requirements. There is no one set ratio required; it depends on the riskiness of the bank’s assets. Basel I, II, III are international standards for capitalization ratios– nonbinding advice to each country’s regulators.

2. Restrictions on risky investments. No common stock, limits on options trading, loans to a single borrower can’t be too big, etc.

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Assets 12

http://finapps.forbes.com/finapps/jsp/finance/compinfo/FinancialIndustrial.jsp?tkr=BAC&period=qtr

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If Apple wants to park $20 million dollars somewhere and be able to get it back quickly, what can it do? Apple could buy a repo, a repurchase agreement, from the Apex Hedge Fund. Apple pays Apex $20 million in cash. Apex gives Apple $20 million in securities and agrees to buy them back tomorrow for $20.1 million in cash. Then, Apex lends the money to someone else for .3 million in interest. In effect, Apple deposits $20 million with Apex. Apex is a shadow bank, paying interest on Apple’s deposits and using those deposits to make loans. An odd feature of this is that if the security income happens to arrive overnight, Apex gets it, not Apple.

Shadow Banks

Runs on Shadow Banks

Apex is uninsured, so it has to put up the $20 million in securities as collateral. But what if Apple thinks the Apex collateral securities are really worth only $16 million? Suppose one day Apple refuses to renew unless Apex gives it “face value” of $25 million in securities instead. Apex has to return the $20 million or come up with an extra $5 million in securities. Suppose Apex spent the $20 million on other securities, believing Apple would keep renewing the repo. Apex doesn’t have the $20 million cash on hand. If Apex can’t sell for $20 million the securities it bought, or borrow $5 million instantly, it defaults on the repo.

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Moral Hazard and Systemic Risk

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Systemic Risk: The risk of collapse of an entire financialsystem because of the troubles of a few firms. Essentially,the bank run problem. NOT the same as systemATic riskin the CAPM model. Bank A can’t pay Bank B. Can Bank B pay Bank C? If B can’t, will C be able to pay?

Moral hazard in banking: When banks make risky investmentsbecause they know someone will rescue them if the investments fail.

“Too big to fail”: A company with debts to so many othercompanies that if it collapses it creates systemic risk, e.g., AIG.

The 2008 Banking Crisis

We’ll look at this as an example of what happens with regulation in good times and in bad times.

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The Events of 200817

Already, in 2007, some mortgage lenders were failing and the subprime mortgage market was in trouble.

In 2008, the Bear Stearns brokerage firm failed. Fannie Mae and Freddie Mac were taken over by the Treasury because of insolvency. The Lehmann Brothers investment bank failed. The Fed bailed out AIG. Treasury asked Congress for the TARP program and got it. Things calmed down again--- but a recession started.

What Caused the Crisis?

We’ll look at the housing market, securitization, and the regulatory response.

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Housing Prices 1890-201019

Housing Prices 2000-2012

http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----

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How Down Payments Restrict Leverage

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Suppose you buy a $100,000 house by paying $20,000in cash and taking out a mortgage for $80,000.

You are highly leveraged. If the price of the house goesdown to $90,000, you still have some capital (equity) left,because you only have to pay off $80,000 to keep it.

If the house price falls to $60,000, you would do betterto let the bank foreclose (though it would hurt your creditrating).

Loan/House-Value22

Subprime and Other Loans23

Negative-Equity Nonprime Loans

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Percentage of Defaults over Time

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Foreclosures26

Free Rent---Defaulters27

Borrowing and Foreclosure28

What happens when Smith loses ownership of a house?--Somebody else gets to live there.

There is an opportunity cost to having Smith live in the house at 2810 Linden Court: Jones can’t live there.

If Smith would only pay $1,500 per month to live thereand Jones would pay $2,500, value is maximized by having Jones live there instead.

2011 Foreclosure Rates 29

See http://www.realtytrac.com/trendcenter/

Prices of Credit Default Swaps30

The TED Spread31

Reserves in Banks32

Policies for Crises33

1. The insolvent banks are liquidated, their assets sold o to new owners.2. The government nationalizes the insolvent banks, possibly reselling them later.3. The Fed lends money to banks as lender of last resort.4. The Treasury or Fed buys preferred stock in banks or in some other way injects capital that is to be repaid.5. The Treasury or Fed buys toxic assets ---the assets of the bank whose prices have collapsed.

2008 Policy Responses 34

1. The Fed served as lender of last resort. It also boughtdubious assets ($600 billion+) and commercial paper ($350billion).2. TARP. The Treasury made loans and bought stock inbanks and nonbanks. (Cost: $435 billion disbursed, $279returned)3. AIG insurance company bailout. The Fed and TARPhelped it out to address the CDS problem.4. Treasury took over Fannie Mae and Freddie Mac, payingtheir debts (cost: $145 billion so far, $3.7 trillion inliability exposure!)

Dodd-Frank Act Changes 35

Capital requirements for nonbank financial companies.

The Fed to extend credit to more kinds of firms, but not to insolvent ones.

The FDIC can take over a financial company to preventsystemic risk, even before it is insolvent.

More Dodd-Frank Changes36

The Consumer Financial Protection Bureau.

A ban on proprietary trading (the Volcker Rule).

Increased regulation of swaps and other derivatives, anda ban on banks owning them except to hedge existingrisk.

Price controls on retailer debit fees. Regulation of credit rating agencies.

Why the Lax Regulation of 2005?

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Barney Frank, the Chairman of the House Banking Committee,in 2003:

“I do think I do not want the same kind of focuson safety and soundness that we have in OCC andOTS. I want to roll the dice a little bit more in thissituation towards subsidized housing.”

Securitization

Securitization means the bundling together of diverse cash flows into a single asset, pieces of which are then sold.

Someone could approach various banks around the country and buy the rights to the cash flows from 500 mortgages. Then he could sell shares in that to 1000 other investors. That way, the risk from the mortgages is pooled, the bank gets cash instead of having to hold loans, and investors get to buy an asset with a high interest rate. Securitization has a direct effect of reducing risk and making banks safer.

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Tranches: Creating Safe Assets Out Of Risky Ones

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The Bond Rating Companies40

The bond rating companies such as Moody’s grossly overratedthe safety of mortgage-backed securities. Why?

1. Conflict of interest in getting rating fees?2. The same reason as the banks and investment companies—inexperience and folly?3. Lack of incentive to maintain their reputations?

Would a government agency have rated them more accurately?

Government Failure: Republic Windows and

Doors

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In 2008, Bank of America cut off the line of credit ofChicago’s Republic Windows and Doors. Republic laid offits workers. Under state law the company was supposed togive two months notice, with continued pay and benefits.

Politicians jumped in.

Bank of America surrendered and gave Republic $1.35million in the form of a “loan”.

GM and Chrysler Bailouts42

http://rasmusen.org/g406/2012-oped-NOL-tax.pdf http://rasmusen.org/papers/gm-ramseyer-rasmusen.doc

In 2009 the government and union medical fund boughta majority interest in Chrysler and in General Motors.

Why was this more controversial than buying stock in AIGor Citigroup?