Economic Analysisof Banking Regulation

Economic Analysisof Banking Regulation

Chapter 11Chapter 11

StuffStuff

Review Sheet Test chapters: 6, 8, 9, 10, 11, 12 Wed, Ricketts 203, 7:00 No homework due Commercial Paper

Review Sheet Test chapters: 6, 8, 9, 10, 11, 12 Wed, Ricketts 203, 7:00 No homework due Commercial Paper

7 ways banks are regulated7 ways banks are regulated

FDIC Regulators restrict assets Minimum bank capital requirements Chartered and Auditied Disclosure Req’t Consumer Protection Restrictions on Competition

FDIC Regulators restrict assets Minimum bank capital requirements Chartered and Auditied Disclosure Req’t Consumer Protection Restrictions on Competition

1) FDIC Regulation1) FDIC Regulation

Bank panic ‘cycles’ every 20 years 1920’s: 600 insolvencies/year 1930-33: 2000 insolvencies/year 1934-81: 15 insolvencies/year

FDIC closes insolvent banks (G-S, 1933) Payoff method Purchase and Assumption of bad debt method

Used to be the most popular

Bank panic ‘cycles’ every 20 years 1920’s: 600 insolvencies/year 1930-33: 2000 insolvencies/year 1934-81: 15 insolvencies/year

FDIC closes insolvent banks (G-S, 1933) Payoff method Purchase and Assumption of bad debt method

Used to be the most popular

FDIC and Moral HazardFDIC and Moral Hazard

Depositors: no incentive to monitor bank mgmt. loan decisions

Bankers: no worries about bad loan decisions causing savers to lose saving

“Too big to fail” policyTaxpayers pay

Glass-Steagall implications

Depositors: no incentive to monitor bank mgmt. loan decisions

Bankers: no worries about bad loan decisions causing savers to lose saving

“Too big to fail” policyTaxpayers pay

Glass-Steagall implications

2) Regulators Restrict Assets2) Regulators Restrict Assets

E.g. no common stock allowed Limits on risky loans

E.g. no common stock allowed Limits on risky loans

3) Minimum Bank Capital Req’t3) Minimum Bank Capital Req’t Traditional measure: Leverage Ratio

Bank Capital/Assets (inverse of equity multiplier!!) Greater than 5%: well capitalized Less than 3%: Trouble!

Basel Accord (1988) - International Hold 8% of ‘risk-adjusted’ assets

Zero-weight: gov. securities 20% weight: claims on banks 50% weight: residential mortgages and municipal bonds 100% weight: loans to consumers and corporations

Regulatory Arbitrage Fed in ‘96: 3 times max capital that could be lost in 10 days

Traditional measure: Leverage Ratio Bank Capital/Assets (inverse of equity multiplier!!) Greater than 5%: well capitalized Less than 3%: Trouble!

Basel Accord (1988) - International Hold 8% of ‘risk-adjusted’ assets

Zero-weight: gov. securities 20% weight: claims on banks 50% weight: residential mortgages and municipal bonds 100% weight: loans to consumers and corporations

Regulatory Arbitrage Fed in ‘96: 3 times max capital that could be lost in 10 days

4) Banks chartered, audited4) Banks chartered, audited

Criteria Mgmt. adequacy Likely earnings Adequacy of capital Effect on competition (pre-1980)

Examination: Quarterly ‘call reports’ Annual Exams

Assets Risky? Get rid of them! Worthless Loans? Write them down! Capital Inadequate? Figure out new strategy!

Criteria Mgmt. adequacy Likely earnings Adequacy of capital Effect on competition (pre-1980)

Examination: Quarterly ‘call reports’ Annual Exams

Assets Risky? Get rid of them! Worthless Loans? Write them down! Capital Inadequate? Figure out new strategy!

CAMEL RatingCAMEL Rating Credit risk of bank assessed

Enough collateral? Enough L-T relationships? Enough screening?

Acronym Capital Adequacy Asset quality Management (oversight of board, internal policies) Earnings Liquidity Sensitivity

IR rate assessed (Gap and Duration analysis) Stress testing, etc.

Credit risk of bank assessed Enough collateral? Enough L-T relationships? Enough

screening? Acronym

Capital Adequacy Asset quality Management (oversight of board, internal policies) Earnings Liquidity Sensitivity

IR rate assessed (Gap and Duration analysis) Stress testing, etc.

5) Disclosure Requirements5) Disclosure Requirements

Accounting standards Annual reports Risk level disclosure

Disclose information about riskiest assets New Zealand: if full disclosure, then no

examination necessary

Accounting standards Annual reports Risk level disclosure

Disclose information about riskiest assets New Zealand: if full disclosure, then no

examination necessary

6) Consumer Protection6) Consumer Protection

Truth in Lending Act (1969) Standardization and disclosure of lending terms Fair Credit Billing Act amendment (1974)

Extends to credit cards Billing errors, mechanism for appeal

Equal Equal Credit Opportunity Act (1976) Community Reinvestment Act (1977)

Invest in neighborhood in which you accept deposits

Truth in Lending Act (1969) Standardization and disclosure of lending terms Fair Credit Billing Act amendment (1974)

Extends to credit cards Billing errors, mechanism for appeal

Equal Equal Credit Opportunity Act (1976) Community Reinvestment Act (1977)

Invest in neighborhood in which you accept deposits

7) Competition restriction7) Competition restriction

Branching Banks can’t be in security industry Security, insurance can’t be in banking

Branching Banks can’t be in security industry Security, insurance can’t be in banking

International Banking RegulationInternational Banking Regulation Similar to U.S. Country hopping, no overarching regulatory

organization BCCI collapse (1991)

7th largets bank in world at peak Value of 20m, when audited in ‘91, only 10m! “Registered” in Luxembourg Laundering, bribery, arms trafficking, nuclear technologies,

etc. Intentionally avoided detection: had its own shipping and

trading company, intelligence agency, etc.

Similar to U.S. Country hopping, no overarching regulatory

organization BCCI collapse (1991)

7th largets bank in world at peak Value of 20m, when audited in ‘91, only 10m! “Registered” in Luxembourg Laundering, bribery, arms trafficking, nuclear technologies,

etc. Intentionally avoided detection: had its own shipping and

trading company, intelligence agency, etc.

Savings and Loan CrisisSavings and Loan Crisis

Largest banking crisis since the depression $500 billion dollar bailout over 40 years:

still paying for it! Good example of:

Deregulation vs. regulation Moral Hazard Bank management

Largest banking crisis since the depression $500 billion dollar bailout over 40 years:

still paying for it! Good example of:

Deregulation vs. regulation Moral Hazard Bank management

Early CausesEarly Causes

Innovations in the ‘60s and 70’s, had to be riskier FSLIC: bank mgmt indifferent to taking risk Deregulation

DIDMCA 1980 Garn- St. Germain Act 1982 Increased FSLIC insurance from 40K to 100K Can put 40% in commercial real estate loans 30% in consumer lending 10% in junk bonds or direct investments

Innovations in the ‘60s and 70’s, had to be riskier FSLIC: bank mgmt indifferent to taking risk Deregulation

DIDMCA 1980 Garn- St. Germain Act 1982 Increased FSLIC insurance from 40K to 100K Can put 40% in commercial real estate loans 30% in consumer lending 10% in junk bonds or direct investments

More early causesMore early causes

Recession of ‘80, ‘81 Brokered deposits

Large denomination CD sold to brokerage Cut into smaller FSLIC covered deposits Remove incentive for large depositors to

monitor lending practices of bankers (covered through innovation!)

By 1982, 50% of S&L’s were insolvent!!!

Recession of ‘80, ‘81 Brokered deposits

Large denomination CD sold to brokerage Cut into smaller FSLIC covered deposits Remove incentive for large depositors to

monitor lending practices of bankers (covered through innovation!)

By 1982, 50% of S&L’s were insolvent!!!

Resulting ProblemsResulting Problems

Managers did not have experience with this expanded risk portfolio

Regulators didn’t have the breadth, capacity, or experience to regulate

Result Moral hazard by managers Conflict of interest by regulators Principal/Agent problem by politicians Asymmetric Information with public

Managers did not have experience with this expanded risk portfolio

Regulators didn’t have the breadth, capacity, or experience to regulate

Result Moral hazard by managers Conflict of interest by regulators Principal/Agent problem by politicians Asymmetric Information with public

Regulatory Forbearance by FHLB, FSLIC

Regulatory Forbearance by FHLB, FSLIC

Refrained from closing insolvent banks Irregular accounting allowed (goodwill) Why? Conflict of interest

Not enough money to close (payoff/assumption) Don’t want to offend politicians Protect reputation FHLB established to encourage growth of S&L

industry, not shut it down

Refrained from closing insolvent banks Irregular accounting allowed (goodwill) Why? Conflict of interest

Not enough money to close (payoff/assumption) Don’t want to offend politicians Protect reputation FHLB established to encourage growth of S&L

industry, not shut it down

Zombie S&L’s: The Living DeadZombie S&L’s: The Living Dead

Bankrupt (negative bank capital) but still operating Had nothing to lose, moral hazard ‘Bad’ S&L’s gave high interest on deposits, taking

business from ‘Good’ S&L’s Negative feedback loop

‘87 legislation Provided only $11 billion to back up losses, but… Directed FHLB to CONTINUE regulatory forbearance

Bankrupt (negative bank capital) but still operating Had nothing to lose, moral hazard ‘Bad’ S&L’s gave high interest on deposits, taking

business from ‘Good’ S&L’s Negative feedback loop

‘87 legislation Provided only $11 billion to back up losses, but… Directed FHLB to CONTINUE regulatory forbearance

Politician Principal AgentPolitician Principal Agent Hide problems from taxpayers, hoping it will go

away Career oriented Close relationships with industry insiders (conflict of

interest) The Keating Five

Charles Keating, owner of Lincoln S&L, insolvent Purchases 600M in junk bond to try to escape Big contributor to congressmen, tell regulators to leave him alone ‘89 collapse, $2.6 billion loss payed by taxpayers 3 senators not re-elected after reprimanded

Hide problems from taxpayers, hoping it will go away

Career oriented Close relationships with industry insiders (conflict of

interest) The Keating Five

Charles Keating, owner of Lincoln S&L, insolvent Purchases 600M in junk bond to try to escape Big contributor to congressmen, tell regulators to leave him alone ‘89 collapse, $2.6 billion loss payed by taxpayers 3 senators not re-elected after reprimanded

FIRREA (1989) - The BailoutFIRREA (1989) - The Bailout

Regulatory Structure Revised FSLIC and FHLB abolished Treasury Dept. takes over (Office of Thrift Supervision)

Resolution Trust Corporation Seizes assets of 25% of S&L Sells $450B of assets of failed S&L Fed gov’t issues bonds for $150B deficit

S&L regulations imposed again 70% must be housing, no junk bonds, leverage 8% Regulators have power to remove bank mgrs., impose

penalties, issue cease and desist legal action

Regulatory Structure Revised FSLIC and FHLB abolished Treasury Dept. takes over (Office of Thrift Supervision)

Resolution Trust Corporation Seizes assets of 25% of S&L Sells $450B of assets of failed S&L Fed gov’t issues bonds for $150B deficit

S&L regulations imposed again 70% must be housing, no junk bonds, leverage 8% Regulators have power to remove bank mgrs., impose

penalties, issue cease and desist legal action

FDICIA (1991) - InsuranceFDICIA (1991) - Insurance

No more brokered deposits Limited “to big to fail” policy Another money infusion from Treasury to

cover S&L losses Corrective action provisions: FDIC MUST

intervene early if a bank is getting into trouble

No more brokered deposits Limited “to big to fail” policy Another money infusion from Treasury to

cover S&L losses Corrective action provisions: FDIC MUST

intervene early if a bank is getting into trouble

Future proposed reformsFuture proposed reforms

Limit deposit insurance to 90% of deposits Outlaw regulatory forbearance Value bank capital at cost, not market (see

today’s WSJ!) Consolidate regulatory agencies

As of Dec. 2006, bank insurance fund and savings and loan insurance fund became deposit insurance fund

Limit deposit insurance to 90% of deposits Outlaw regulatory forbearance Value bank capital at cost, not market (see

today’s WSJ!) Consolidate regulatory agencies

As of Dec. 2006, bank insurance fund and savings and loan insurance fund became deposit insurance fund

World Banking CrisesWorld Banking Crises

Scandinavia Russia Japan China East Asian ‘Tigers’ Latin America

Argentina

Scandinavia Russia Japan China East Asian ‘Tigers’ Latin America

Argentina