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CHAPTER
1818Bank
Regulation
© 2003 South-Western/Thomson Learning
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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
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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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3
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
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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
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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
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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)
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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
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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
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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
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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
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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
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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