Government regulationof financial activities

Problem: there will always be people who want to cheat or cut corners: theft, fraud, misrepresentation, etc.

Ex ante solutions Government: legislation, regulation Private: reputation, contracts, arbitration

Ex post solutions Gov’t: fines, imprisonment, injunctions Private: shunning, expulsion

Financial services

Broad classes of financial services Intermediation Brokerage Investment banking Many firms offer some or all of these

services

Financial intermediation

Match savers with borrowers (businesses and households)

Primary example: deposit banking Accept deposits from savers Loan money to businesses and

households Interest rate spread is the primary

income source

Deposit banking

Commercial banks are the primary providers of deposit banking

Also Savings and Loan (emphasize mortgage lending)

And Credit Unions (non-profit) Deposit forms

Demand deposits (checking accounts) Savings accounts Currently pay essentially zero interest

Deposit banking

Loan forms Households

Home mortgages Automobile loans Personal loans

Businesses General purpose loans Factoring – purchase of accounts

receivable

Deposit banking

Problems that can arise when loans go bad insolvency: liabilities exceed assets

a serious problem that can lead to closure illiquidity: not enough cash to meet

liabilities usually easy to remedy by borrowing from

other banks or from the Fed

Deposit banking Deposit banks are inherently illiquid

Only a small fraction of deposit liabilities are backed by reserves (currency and accounts at the Fed)

Most deposits can be withdrawn on demand

Most loans cannot be called on short notice

Possibility of a “bank run” if too many depositors want their money simultaneously

Deposit Insurance

Almost all banks carry deposit insurance Provided by the Federal Deposit Insurance

Corporation (FDIC) Banks pay insurance premium based on

risk – a small fraction of insured deposits FDIC typically arranges mergers of failed

banks FDIC has failed to maintain reserves equal

to 1.15% of insured deposits

Bank Subsidies and Protections

Deposit insurance may be under-priced Potential competitors are barred from the

marketplace (e.g., WalMart) Banks were bailed out during the 2008

financial crisis. “Too big to fail” Implicit bailout protection encourages

risky behavior (“moral hazard”)

Bank Regulation

Deposit banks are regulated by a confusing array of Federal and State agencies

Federal Reserve FDIC Comptroller of the Currency State bank regulatory agencies

Main requirements 10% reserves on deposit liabilities Minimum levels of shareholder capital

FDIC insurance engendersmoral hazard

Encourages bank managers to take more risk

Discourages depositors from paying attention to how banks manage their deposits

Leads people to believe that deposit risk has been eliminated when in fact it has been socialized

FDIC vs. Private Insurance FDIC is governed by politics, not the

marketplace Coverage limits set by Congress Premium rates limited by statutes

Private insurance companies manage moral hazard with risk assessment

Private insurance companies face competition and must engage in price discovery

Brokerage

Brokers match buyers with sellers Real estate brokers Stock brokers Insurance brokers Marriage brokers (?)

Income mostly from commissions Real estate: about 6% Stock brokers: very low commissions

Stock brokerage

Firms that traditionally or primarily engage in brokerage typically do other things as well:

Bank subsidiaries (e.g., Schwab Bank) Hold securities for their own account,

thereby acting as dealers

Insurance for brokerage customers

Provided by Securities Investor Protection Corporation (SIPC)

Created by legislation but operates as a private, non-profit, self-funded corporation

Customer assets must be segregated Provides insurance against certain kinds of

malfeasance such as misappropriation of funds or unauthorized trading

Does not insure against market declines

Problems and solutions

Voluntary solutions Reputation Arbitration Industry associations

New York Diamond Dealers, 47th St. NYC

All Hasidic Jews Disputes settled by private arbitration Anyone failing to abide by arbitrators’ decisions

is subject to shunning and adverse publicity

The “Public Choice” approach to analysis of government

Applies economic tools to the analysis of politicians, bureaucrats and voters

Contrasts with the “public interest” viewpoint which assumes selfless dedication to the public welfare

Politicians motivated by re-election Bureaucrats want to keep their jobs Voters exhibit rational ignorance

Regulatory capture

Regulated industries have huge incentives to influence the agencies that regulate them

The general public has little or no knowledge of the regulation

Industry people know their business better than regulators

Regulators with the best of intentions may find their mission subtly shifted

Limited resources; revolving door

Regulator agencies have limited staff and budget

Often cannot possibly exercise detailed supervision over many large firms

Regulatory staff often work a few years in a regulatory agency then take jobs in one of the industries they regulated

Turf wars

The domains of regulatory agencies often overlap, leading to inter-agency “turf wars.”

Example: who should regulate futures contracts on stocks?

CFTC said all futures were in its domain SEC said anything involving stocks was

in its domain Promotes a “race to the bottom” as in the

case of the late Office of Thrift Supervision

False confidence

Government regulation can lead the public to believe they shouldn’t worry

Example: some Madoff investors told themselves securities markets are heavily regulated – nothing could go wrong

Hummel’s law of failure: Perceived market failure always leads to

calls for more government Perceived government failure always

leads to calls for more government

Sarbanes-Oxley

The collapse of Enron Corp. was a major scandal in 2001. It concealed off-balance-sheet operations

Ken Lay died in prison Jeffrey Skilling still in prison Enron’s auditor, the venerable Arthur

Anderson, was disbanded Also MCI, which engaged in fraudulent

accounting

Sarbanes-Oxley Sarbanes-Oxley was a regulator reform bill

passed in response to Enron & MCI scandals

CEOs must personally certify the accuracy of financial information

New bureaucracy established to oversee independent auditors

Additional disclosures required in financial statements

Criminal penalties for some offenses

Sarbanes-Oxley Outcomes

May have increased accuracy and thoroughness of financial reports

Compliance costs hit small firms harder than larger firms

Some foreign firms dropped NYSE listings to avoid Sarbanes-Oxley

May have reduced IPOs

Dodd-Frank

Passed in response to the financial crisis of 2008

Bailouts of large financial institutions Bailouts of GM and Chrysler Stock market crash (since recovered) Massive deficits

Official titles always reflect hoped-for results: “The Wall Street Reform and Consumer Protection Act”

Dodd-Frank

No one person understands its 2300 pages. Contains many references to other laws.

Despite its length, it left a great deal of rule-writing to bureaucracies. Although it passed in 2010, many of the rules are incomplete. Uncertainty hinders business recovery.

Dodd-Frank and the Volcker Rule

Prohibits banks from buying and selling securities for their own account, supposedly to lessen the prospect of future bailouts.

Four federal agencies share the responsibility for writing rules that implement the Volker rule. Turf wars!

Interested parties have been hard at work trying to influence the rules

Dodd-Frank and the Volcker Rule

Proprietary trading turns out not to be so easy to define. So exemptions have been carved out

Trading on behalf of customers Hedging Underwriting and market-making. Trading of their own securities

Crony capitalism

Adam Smith: business people hate competition and are eager to use government to suppress it

Government intrusion into the economy opens the door for businesses to seek advantages

Lobbying Campaign contributions Personal friendships

Crony capitalism

Laws governing complex economic activities are necessarily vague and incomplete.

Interpretation is left to the bureaucracy The door is open to business lobbying

The “military-industrial complex” is the granddaddy of them all

Close ties among defense contractors, military officials, employees and their dependents

Hummel’s law of failure

Perceived market failures always lead to calls for more government

Perceived government policies always lead to calls for more government