Unit 2: BankingUnit 2: Banking

Bank RegulationBank Regulation10/19/201010/19/2010

Financial InstitutionsFinancial Institutions

Type of Intermediary Primary Liabilities Primary Assets

Depository Institutions (banks)Commercial Banks Deposits Business and consumer loans,

mortgages, US Govt securities and municipal bonds

Savings and Loans Institutions Deposits Mortgages

Mutual Savings Banks Deposits Mortgages

Credit Unions Deposits Consumer Loans

Financial InstitutionsFinancial InstitutionsType of Intermediary Primary Liabilities Primary Assets

Contractual Savings InstitutionsLife Insurance Companies Premium from Policies Corporate bonds and mortgages

Fire and Casualty Insurance Companies Premium from Policies Municipal bonds, corporate bonds and stocks, US Govt securities

Pension Funds, Government Retirement Funds Employee and Employer Contributions

Corporate bonds and stock

Investment IntermediariesFinance Companies Commercial paper, stock, bonds Consumer and business loans

Mutual Funds Shares Stocks and bonds

Money Market Mutual Funds Shares Money market instruments

Financial InstitutionsFinancial Institutions

Value of Assets (Billions of $)Type of Intermediary 1970 1980 1990 2007 2010Q1

Depository Institutions (banks)Commercial Banks 517 1481 3334 11809.5 14438

Savings and Loans Institutions and Mutual Savings Banks 250 792 1365 1815.0 1262.3

Credit Unions 18 67 215 758.7 892.4

Financial InstitutionsFinancial InstitutionsValue of Assets (Billions of $)

Type of Intermediary 1970 1980 1990 2007 2010Q1

Contractual Savings InstitutionsLife Insurance Companies 201 464 1367 4952.5 4919.0

Fire and Casualty Insurance Companies 50 182 533 1381.0 1386.1

Pension Funds (Private) 112 504 1629 6410.6 5726.7

State and local Government Retirement Funds 60 197 737 3198.8 2793.9

Investment IntermediariesFinance Companies 64 205 610 1911.2 1665.8

Mutual Funds 47 70 654 7829.0 7311.9

Money Market Mutual Funds 0 76 498 3033.1 2930.7

Financial InstitutionsFinancial InstitutionsPre-1970• commercial banks

o monopoly on checking accountso more diversified

• thriftso could pay higher interest rateso mostly mortgages

• investment bankso could invest in equity securities

Financial InstitutionsFinancial Institutionsthrift institutions (thrifts)thrift institutions (thrifts) –

savings and loan associations (S&Ls), mutual savings banks, and credit unions

credit unionscredit unions –cooperative lending institutions

organized around a particular group(e.g., union members, employees, etc.)

S&Ls and Savings Banks• assets: focused on mortgages• liabilities: focused on savings accounts• mutually owned (not shareholder owned)

o eliminates debt/equity distinctiono decreases moral hazard

• regulated separately from other banks

Financial InstitutionsFinancial Institutions

Financial InstitutionsFinancial InstitutionsCredit Unions• type of mutual

o 1 vote regardless of # of shares• volunteer management• usually small• qualify as non-profits• exempt from corporate income tax• regulated separately from other banks

Financial InstitutionsFinancial Institutions

The lines between thrifts and commercial banks have become blurred as regulations have changed opening up thrifts to more assets and liabilities, deposit insurance has been extended to thrifts, and S&Ls became stockholder owned rather than

mutual owned post-WWII.

Financial InstitutionsFinancial Institutionsclosed end investment companyclosed end investment company –

stock owned: issues fixed # of shares and has a secondary market

(e.g., stock on exchange)

open end investment companyopen end investment company –mutually owned: variable # of shares,

not saleable on secondary market, direct link between share/asset value

(e.g., mutual fund, hedge fund)

Regulatory AgenciesRegulatory AgenciesRegulatory Agency Subject of Regulation Nature of RegulationOffice of the Comptroller of the Currency Federally charted commercial banks Charters and examines the books of

federally chartered commercial banks and imposes restrictions on assets they can hold

National Credit Union Administration (NCUA)

Federally chartered credit unions Charters and examines the books of federally chartered credit unions and imposes restrictions on assets they can hold

State banking and Insurance Commissions

State chartered depository institutions Charters and examines the books of state chartered banks and insurance companies; imposes restrictions on assets they can hold and imposes restrictions on branching

Regulatory Agency Subject of Regulation Nature of RegulationSecurities and Exchange Commission (SEC)

Organized Exchanges and Financial Markets

Requires disclosure of information; restricts insider trading

Commodities Futures Trading Commission (CFTC)

Futures Markets Exchanges Regulates procedures for trading in futures markets

Federal Deposit Insurance Corporation (FDIC)

Commercial banks, mutual savings banks, savings and loans associations

Provides insurance for each depositor. Currently it is set to $250000 per depositor, until 12/31/2013, whereas it will revert back to the pre-crisis level of $100000 per depositor; examines the books of insured banks and imposes restrictions on assets they can hold

Office of Thrift Supervision Savings and Loans Associations Examines the books of savings and loans associations and imposes restrictions on assets they can hold

Federal Reserve System All depository institutions Examines the books of commercial banks that are members of the system; sets reserve requirements for all banks

Regulatory AgenciesRegulatory Agencies

Regulatory AgenciesRegulatory AgenciesOffice of Thrift Supervision (OTS)• analogous to Comptroller of the Currency• national charters and regulations for thrifts• created in 1989

o renamed Federal Home Loan Bank Board• abolished in 2010

o rolled into Comptroller of the Currency

Regulatory AgenciesRegulatory AgenciesFederal Savings & Loan Insurance Corporation(FSLIC)• analogous to FDIC• federal deposit insurer to S&Ls• created in 1934• abolished in 1989

o insolvent due to S&L crisiso S&L deposit insurance went to FDIC

Regulatory AgenciesRegulatory AgenciesFederal Home Loan Bank System (FHLBS)• analogous to Federal Reserve• lender of last resort to S&Ls• 12 regions• dual chartering (national/state)

o national S&Ls (OTS) must join FHLBSo state S&Ls may join FHLBSo 80% of S&Ls joined FHLBS

• created in 1932o Federal Home Loan Bank Act

Regulatory AgenciesRegulatory Agencies

S&Ls• FHLB Board (charter)• FHLBS (LOLR)• FSLIC (insurance)

banks• Comptroller of Currency (charter)• Federal Reserve (LOLR)• FDIC (insurance)

Pre-1989 division:

Regulatory AgenciesRegulatory Agencies

Thrifts have been all but eliminated by the Financial Stability Act of

2010. Thrift charters still exist, but thrifts are now regulated by the Comptroller of the Currency, the Federal Reserve, and the FDIC.

Narrative History (branching)Narrative History (branching)Restrictions on branch banking have been present since 1863. Some states allowed intrastate branching, so banks switched from national to state charters in those states. The McFadden Act put national

banks on equal footing allowing intrastate branching where state banks could. In

1994 both intrastate and interstate branching was allowed.

Financial Legislation (branching)Financial Legislation (branching)McFadden Act of 1927• prohibited interstate branch banking• put national and state banks on equal footing

o if state banks branch, national can too

Riegle-Neal Interstate Branking and Branching Efficiency Act of 1994• allowed interstate branch banking• allowed intrastate branch banking

Narrative History (the Fed)Narrative History (the Fed)The Federal Reserve was created

so the United States would have a central bank that could conduct

monetary policy and act as a LOLR. Bank holding companies were

unregulated, so the Bank Holding Company Act gave oversight to the

Federal Reserve in 1956.

Financial Legislation (the Fed)Financial Legislation (the Fed)

Federal Reserve Act of 1913• created the Federal Reserve

Bank Holding Company Act of 1956• clarified status of bank holding companies• Federal Reserve regulates bank holding companies

Narrative History (wall)Narrative History (wall)The Glass-Steagall Act was a response to the stock market crash of 1929. It imposed a wall between commercial

banks and investment banks: commercial banks could not invest in

equity securities (stocks). The Gramm-Leach-Bliley Act of 1999 repealed this restriction, but it was re-imposed by

the Financial Stability Act of 2010.

Financial Legislation (wall)Financial Legislation (wall)Banking Act of 1933 (Glass-Steagall Act) and 1935• created the FDIC• separated banking and securities industries• prohibited interest on checkable deposits• checkable deposits for commercial banks only• regulation Q: interest-rate ceilings on deposits

Gramm-Leach-Bliley Financial Services Modernization Act of 1999• removed separation of banking and securities

Narrative History (regulation Q)Narrative History (regulation Q)Regulation Q was imposed by the Glass-Steagall Act of 1933. In the

1970s banks were hurt by interest rate caps and disintermediation, so they

called for deregulation. Mutual savings banks created Negotiable Orders of Withdraw (NOW accounts) in 1972,

which behaved like checking accounts. Banks complained. The DIDMCA of

1980 repealed regulation Q.

Financial Legislation (regulation Q)Financial Legislation (regulation Q)Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980• gave thrifts wider latitude in activities (deposits)• approved NOW and sweep accounts• phased out interest-rate ceilings on deposits• imposed uniform reserve requirements• eliminated usury ceilings on loans• increased deposit insurance to $100,000

Financial Legislation (misc)Financial Legislation (misc)Depository Institutions Act of 1982 (Garn-St. Germain Act)• emergency powers for FDIC and FSLIC• depository institutions can offer MMDAs• granted thrifts wider latitude in lending (assets)

Competitive Equality in Banking Act (CEBA) of 1987• provided $10.8 billion to the FSLIC• regulatory forbearance in depressed areas

Narrative History (S&Ls)Narrative History (S&Ls)Savings & Loans were deregulated with other thrifts in the early 80’s. Deposit

insurance created a moral hazard problem (fixed premiums irrespective of risk)

leading to risky investments. S&Ls had higher interest rate risk and a lower equity

cushion. When insolvent they would gamble even more to get even again

(zombie S&Ls).

Narrative History (S&Ls)Narrative History (S&Ls)In the late 1980’s many S&Ls failed. The

Federal Savings and Loan Insurance Corporation (FSLIC) did not have enough

money to pay out deposit insurance claims. When it went bankrupt the federal

government passed FIRREA: bailed out S&Ls, re-imposed restrictions on S&L

activities, and put S&Ls under the FDIC for future deposit insurance.

Financial Legislation (S&Ls)Financial Legislation (S&Ls)Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989• funds to resolve S&L failures• eliminated FSLIC and FHLB Board• created Office of Thrift Supervision• created Resolution Trust Corporation• raised deposit insurance premiums• re-imposed restrictions on S&L activities

Narrative History (FDIC)Narrative History (FDIC)The FDIC created moral hazard in part

because its premiums were unrelated to the riskiness of assets. This was partly

fixed by imposing risk-based premiums. In addition banks were monitored closer to

identify solvency problems earlier. Congress stopped the “too big to fail”

policy, but it left a loophole in the Federal Reserve legislation that Bernake exploited.

Financial Legislation (FDIC)Financial Legislation (FDIC)

Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991• recapitalized the FDIC• limited “too big to fail” policy• established risk-based premiums for FDIC• increased examinations, capital & reporting reqs.• Federal Reserve supervision of foreign banks

Financial Legislation (FDIC)Financial Legislation (FDIC)

Federal Deposit Insurance Corporation Reform Act of 2005• merged Bank Insurance Fund & Savings Ass. Fund• increased deposit insurance on IRAs to $250k• revised risk-based premiums for FDIC

Narrative History (stocks)Narrative History (stocks)The SEC was created in 1934 to

regulate stock trades. The stock crash of 1929 precipitated this legislation. Accounting shenanigans by the Enron

Corporation in 2001 led to the Sarbanes-Oxley Act of 2002, which imposed accounting regulations on

publicly traded companies.

Financial Legislation (stocks)Financial Legislation (stocks)Securities Act of 1933 / Securities Exchange Act of 1934• required financial reports for investors• prohibited securities misrepresentations and fraud• created Securities and Exchange Commission (SEC)

Sarbanes-Oxley Act of 2002• Public Company Accounting Oversight Board (PCAOB)• prohibits certain conflicts of interest• requires CEO/CFO certification of financial statements

Financial Legislation (brokers)Financial Legislation (brokers)

Investment Company Act of 1940• regulated investment companies

Investment Advisers Act of 1940• regulated investment advisers

Narrative History (2010)Narrative History (2010)In response to the Great Recession

(the sub-prime crisis) Congress enacted a comprehensive financial

reform bill in July of 2010. It undoes a lot of past deregulation and

imposes many new regulations. The unintended consequences of this

legislation are not yet clear.

Financial Legislation (2010)Financial Legislation (2010)Financial Stability Act of 2010 (Dodd-Frank Wall Street Reform and Consumer Protection Act)• consolidates regulatory agencies• eliminates thrift charter• creates Financial Stability Oversight Council• creates Bureau of Consumer Financial Protection• Volcker rule• regulates derivatives• regulates hedge funds

Financial Legislation (2010)Financial Legislation (2010)Volcker Rule• prohibits banks from proprietary trading

o trading own money instead of client money• prohibits banks from investing in hedge funds• limits liabilities banks can hold

Financial Stability Oversight CouncilFinancial Stability Oversight Council• Secretary of the Treasury (chair)• Chair of the Federal Reserve• Comptroller of the Currency• Director of the Bureau of Consumer Financial Protection• Chair of the SEC• Chair of the FDIC• Chair of the CFTC• Director of the Federal Housing Finance Agency• Chair of the National Credit Union Administration Board• independent member (with insurance expertise)