Chapter 18 Bank Regulation Financial Markets and Institutions

Chapter Outline n n n Background Regulatory structure Deregulation Act of 1980 Garn-St Germain Act Regulation of deposit insurance Regulation of capital Regulation of operations Regulation of interstate expansion How regulators monitor banks The “too-big-to-fail” issue Global bank regulations 2

Background n The banking industry has become more competitive due to deregulation ¨ Banks have more flexibility on the services they offer, the locations where they operate, and the rates they pay depositors ¨ Banks have recognized the potential benefits from economies of scale and scope n Bank regulation is needed to protect customers who supply funds to the banking system ¨ Regulators are shifting more of the burden of risk assessment to the individual banks themselves 3

Regulatory Structure n The U. S. has a dual banking system consisting of federal and state regulation ¨ Three federal and fifty state agencies supervise the banking system ¨ A federal or state charter is required to open a commercial bank n n National versus state banks Federal charters are issued by the Comptroller of the Currency State banks may decide to become members of the Fed 35 percent of all banks are members of the Fed, comprising 70 percent of deposits 4

Regulatory Structure (cont’d) n Regulatory overlap ¨ National banks are regulated by the Comptroller of the Currency, the Fed, and the FDIC ¨ State banks are regulated by the state agency, the Fed, and the FDIC ¨ Perhaps a single regulatory agency should be assigned the role of regulating all commercial banks and savings institutions 5

Regulatory Structure (cont’d) n Regulation of bank ownership ¨ Commercial banks can be either independently owned or owned by a bank holding company Most banks are owned by BHCs n BHCs have more potential for product diversification because of amendments to the Bank Holding Company Act of 1956 n 6

Deregulation Act of 1980 n n The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was enacted in 1980 DIDMCA has two categories of provisions: Those intended to deregulate the banking industry ¨ Those intended to improve monetary control ¨ n The main deregulatory provisions are: Phaseout of deposit rate ceilings ¨ Allowance of NOW accounts for all depository institutions ¨ New lending flexibility for depository institutions ¨ Explicit pricing of Fed services ¨ 7

Deregulation Act of 1980 (cont’d) n n DIDMCA also called for an increase in the maximum deposit insurance level from $40, 000 to $100, 000 per depositor Impact of DIDMCA ¨ There has been a shift from conventional demand deposits to NOW accounts ¨ Consumers have shifted funds from conventional passbook savings accounts to various types of CDs ¨ DIDMCA has increased competition between depository institutions 8

Garn-St Germain Act of 1982 n The Act: ¨ Permitted depository institutions to offer money market deposit accounts (MMDAs), which have no interest ceiling n n MMDAs are similar to money market mutual funds MMDAs allow depository institutions to compete against money market funds in attracting savers’ funds ¨ Permitted depository institutions to acquire failing institutions across geographic boundaries n Intended to reduce the number of failures that require liquidation 9

Regulation of Deposit Insurance n Federal deposit insurance has existed since the creation of the FDIC in 1933 as a response to bank runs ¨ About 5, 100 banks failed during the Great Depression ¨ Deposit insurance has increased from $2, 500 in 1933 to $100, 000 today ¨ Insured deposits make up 80 percent of all commercial bank balances ¨ The FDIC is managed by a board of five directors, who are appointed by the President 10

Regulation of Deposit Insurance (cont’d) n The FDIC’s Bank Insurance Fund is the pool of funds used to cover insured deposits The fund is supported with annual insurance premiums paid by commercial banks, ranging from 23 cents to 31 cents per $100 of deposit ¨ In 2003, three BIF-insured banks failed with total assets of $1. 1 billion ¨ As of 2004, the BIF balance was about $34 billion ¨ n In 1991, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) was passed ¨ Phased in risk-based deposit insurance premiums to counteract the moral hazard problem 11

Regulation of Capital n Capital requirements force banks to maintain a minimum amount of capital as a percentage of total assets ¨ Banks would prefer low capital to boost their ROE ¨ Regulators have argued that banks need sufficient capital to absorb potential operating losses 12

Regulation of Capital (cont’d) n Basel Accord of 1988 ¨ ¨ ¨ Central banks of 12 major countries agreed to uniform capital requirements The Accord was facilitated by the Bank for International Settlements (BIS) The key contribution of the Accord is that the requirements were based on the bank’s risk level, forcing riskier banks to maintain a higher level of capital In 1996, the Accord was amended so that bank’s capital level also account for its sensitivity to market conditions Very safe assets are assigned a zero weight, while very risky assets are assigned a 100 percent weight 13

Regulation of Capital (cont’d) n Basel II Accord ¨ The Basel Committee has worked on an accord that would refine the risk measures and increase the transparency of a bank’s risk to its customers ¨ The three parts of the Accord are: Revise the measurement of credit risk n Explicitly account for operational risk n Require more disclosure for market participants n 14

Regulation of Capital (cont’d) n Basel II Accord (cont’d) ¨ Revised n n n measures of credit risk The risk categories are being refined to account for some possible differences in risk levels of loans within a category A bank’s loans that are past due will have a weight of 150% applied to their assets Banks can use the internal ratings-based (IRB) approach to calculate credit risk, in which banks provide summary statistics about their loans to the Basel Committee ¨ The Committee then applied pre-existing formulas to the statistics in order to determine the required capital level 15

Regulation of Capital (cont’d) n Basel II Accord (cont’d) ¨ Accounting n n n for operational risk Operational risk is the risk of losses from inadequate or failed internal processes or systems Intended to encourage banks to improve their techniques for controlling operational risk to reduce bank failures Initially, banks can use their own methods for assessing their exposure to operational risk ¨ The Basel Committee suggests the average annual income generated over the last three years 16

Regulation of Capital (cont’d) n Basel II Accord (cont’d) ¨ Public disclosure of risk indicators The Basel Committee plans to require banks to provide more information to existing and prospective shareholders about their risk exposure to different types of risk n This would provide existing and prospective investors with additional information about a bank’s risk n 17

Regulation of Capital (cont’d) n Use of the value-at-risk method to determine capital requirements ¨ Under the 1996 amendment to the Basel Accord, capital requirements on large banks were adjusted to incorporate their own internal measurements of general market risk n n n Market risk is the exposure to movements in market forces such as interest rates, stock prices, and exchange rates Capital requirements imposed are based on the bank’s own assessment of risk when applying the VAR model VAR is the estimated potential loss from trading businesses that could result from adverse movements in market prices ¨ Banks typically use a 99 percent confidence level 18

Regulation of Capital (cont’d) n Use of the value-at-risk method to determine capital requirements (cont’d) ¨ Testing the validity of a bank’s VAR n The validity is assessed with backtests in which the actual daily trading gains or losses are compared to the estimated VAR over a particular period n If the VAR is estimated properly, only 1 percent of the actual daily trading days should show results that are worse than the estimated VAR ¨ Related stress tests n Some banks supplement the VAR estimate with stress tests using extreme events 19

Regulation of Operations n Regulation of loans Regulators monitor highly leveraged transactions (HLTs) and a bank’s exposure to debt of foreign countries ¨ Banks are restricted to a maximum loan amount of 15 percent of their capital to any single borrower ¨ Banks are regulated to ensure that they attempt to accommodate the credit needs of the communities in which they operate through the Community Reinvestment Act (CRA) of 1977 ¨ n Regulation of investment in securities Banks are not allowed to use borrowed or deposited funds to purchase common stock ¨ Banks can invest only in bond that are investment-grade quality ¨ 20

Regulation of Operations (cont’d) n Regulation of securities services ¨ The Glass-Steagall Act of 1933: Separated banking and securities activities n Prevented any firm that accepted deposits from underwriting stocks and bonds of corporations n Was intended to prevent potential conflicts of interest n 21

Regulation of Operations (cont’d) n Regulation of securities services (cont’d) ¨ Deregulation of underwriting services n In 1989, the Fed approved debt underwriting applications for banks based on the requirements that: Banks had sufficient capital to support the subsidiary that would perform the underwriting ¨ Banks had to be audited to ensure that their management was capable of underwriting debt ¨ n The Fed imposed a ceiling on revenues from corporate debt underwriting 22

Regulation of Operations (cont’d) n Regulation of securities services (cont’d) ¨ The n n n Financial Services Modernization Act of 1999: Essentially repealed the Glass-Steagall Act Made it easier for commercial banks to engage in securities and insurance activities Increased the degree to which banks can offer securities services Allowed securities firms and insurance companies to acquire banks Resulted in more consolidation among banks, securities firms, and insurance companies 23

Regulation of Operations (cont’d) n Regulation of securities services (cont’d) ¨ Deregulation n n Banks had been allowed to offer discount brokerage services even before 1999 In the late 1990 s, some banks acquired financial services firms that offered full-service brokerage services ¨ Deregulation n n of brokerage services of mutual fund services Since June 1986, brokerage subsidiaries of bank holding companies could sell mutual funds Private label funds are mutual funds created by banks in conjunction with financial service firms 24

Regulation of Operations (cont’d) n Regulation of insurance services ¨ Before the late 1990 s, banks were involved in insurance in limited ways: n n Banks that had participated in insurance before 1971 were allowed to continue to do so Some banks leased space in their buildings to insurance companies in exchange for a payment equal to a percentage of the insurance company’s sales In 1995, the Supreme Court ruled that national banks could sell annuities ¨ In 1998, regulators allowed the merger between Citicorp and Traveler’s Insurance Group ¨ In 1999, the Financial Services Modernization Act confirmed that banks and insurance companies could merge ¨ 25

Regulation of Operations (cont’d) n Regulation of off-balance sheet transactions Off-balance sheet transactions, such as letters of credit, expose the bank to risk ¨ Risk-based capital requirements are higher for banks that conduct more off-balance sheet activities ¨ n Regulation of the accounting process Publicly-traded banks are required to provide financial statements that indicate their recent financial position and performance ¨ The Sarbanes-Oxley Act was enacted in 2002 to make corporate managers, board members, and auditors more accountable for the accuracy of the financial statement that their respective firms provided ¨ 26

Regulation of Interstate Expansion n The Mc. Fadden Act of 1927 prevented banks from establishing branches across state lines The Douglas Amendment to the Bank Holding Company Act of 1956 prevented interstate acquisitions of banks by bank holding companies By 1994, most states had approved nationwide interstate banking 27

Regulation of Interstate Expansion (cont’d) n Interstate Banking Act ¨ Until 1994, most interstate expansion was achieved through bank acquisitions ¨ In September 1994, federal guidelines passed a banking bill that removed interstate branching restrictions n n n Known as the 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 Allows banks to grow and increase economies of scale 28

How Regulators Monitor Banks n Bank regulators: Typically conduct an on-site examination of each commercial bank at least once a year ¨ Assess the bank’s compliance with existing regulations and its financial condition ¨ Periodically monitor commercial banks with computerized monitoring systems ¨ Monitor banks to detect any serious deficiencies that might develop so that they can correct the deficiencies before the bank fails ¨ n The FDIC rates banks on the basis of six characteristics (CAMELS ratings) 29

How Regulators Monitor Banks (cont’d) n Capital adequacy Regulators determine the capital ratio (capital divided by assets) ¨ If banks hold more capital, they can more easily absorb potential losses ¨ n Asset quality ¨ n The FDIC evaluates the quality of the bank’s assets, including its loans and securities Management The FDIC specifically rates the bank’s management according to administrative skills, ability to comply with existing regulations, and ability to cope with a changing environment ¨ The FDIC also assesses the bank’s internal control systems ¨ 30

How Regulators Monitor Banks (cont’d) n Earnings A commonly used profitability ratio to evaluate banks is return on assets (ROA), defined as EAT divided by assets ¨ Earnings can also be compared to industry earnings ¨ n Liquidity ¨ n Regulators prefer that banks not consistently rely on outside sources of funds such as the discount window Sensitivity Regulators assess the degree to which a bank might be exposed to adverse financial market conditions ¨ Regulators place much emphasis on a bank’s sensitivity to interest rate movements ¨ 31

How Regulators Monitor Banks (cont’d) n Rating bank characteristics ¨ Each of the CAMELS ratings is rated on a 1 -to-5 scale (1 = outstanding) ¨ A composite rating is determined as the mean rating of the six characteristics ¨ Banks with a composite rating of 4. 0 or higher are considered to be problem banks and closely monitored n The number of problem banks increased in the 2001– 2002 period 32

How Regulators Monitor Banks (cont’d) n Rating bank characteristics (cont’d) ¨ Limitations of a rating system n Regulators do not have the resources to monitor each bank on a frequent basis n Over time some problem banks improve while others deteriorate n Many problems go unnoticed and it may be too late by the time they are discovered n Any system used to detect financial problems may err in one of two ways: ¨ ¨ It may classify a bank as safe when it is failing It may classify a bank as very risky when in fact it is safe 33

How Regulators Monitor Banks (cont’d) n Corrective action by regulators ¨ Regulators n n n thoroughly investigate “problem banks: ” They may request that a bank boost its capital level They can require additional financial information They have the authority to remove particular officers and directors if it enhances the bank’s performance ¨ If regulators reduce bank failures by imposing regulations that reduce competition, bank efficiency will be reduced 34

How Regulators Monitor Banks (cont’d) n Funding the closure of failing banks ¨ The FDIC is responsible for the closure of failing banks n n n Must decide whether to liquidate the bank’s assets or to facilitate the acquisition of that bank by another bank After reimbursing depositors of the failed bank, the FDIC attempts to sell any marketable assets or the failed banks If the failing bank is acquired, the potential acquirer may be interested if the bank is given sufficient funds by the FDIC 35

How Regulators Monitor Banks (cont’d) n In 1991, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) provided that: ¨ ¨ ¨ Regulators were required to act more quickly in forcing banks with inadequate capital to correct the deficiencies Regulators were required to close troubled banks more quickly Deposits exceeding the insured limit are not to be covered when a bank fails Deposit insurance premiums were to be based on the risk of banks The FDIC was granted the right to borrow $30 billion from the Treasury to cover bank failures and an additional $45 billion to finance working capital needs 36

The “Too-Big-To-Fail” Issue n Some troubled banks have received preferential treatment from bank regulators ¨ Continental Illinois Bank in 1984 was rescued As one of the largest banks in the country, Continental’s failure could have reduced public confidence in the banking system n The indirect costs (such as bank runs) would have been too great to risk n 37

The “Too-Big-To-Fail” Issue (cont’d) n Argument for government rescue ¨ If Continental had not been rescued: n n Depositors with more than $100, 000 at other banks could have become more concerned about their risk Other banks would have been likely candidates for runs on their deposit accounts ¨ Argument against government rescue n A government bailout can be expensive n The government sends a message to the banking industry that large banks will not be allowed to fail and large banks may take excessive risks n Government intervention could reduce efficiency 38

The “Too-Big-To-Fail” Issue (cont’d) n Proposals for government rescue ¨ An ideal solution would prevent a run on deposits of other large banks, yet not reward a poorly performing bank with a bailout n The Fed and the FDIC could play a greater role in assessing bank financial conditions over time to recognize problems early 39

Global Bank Regulations n n n Each country has a system for monitoring and regulating commercial banks Most countries also have a system for deposit insurance Canadian banks tend to be subject to fewer banking regulations than U. S. banks, such as interstate branching European banks have had much more freedom than U. S. banks in offering investment banking services such as underwriting Japanese commercial banks have some flexibility to provide investment banking services, but not as much as European banks 40

Global Bank Regulations (cont’d) n Uniform global regulations ¨ Three of the more significant n The International Banking Act ¨ n Places U. S. and foreign banks operating in the U. S. under the same set of rules The Single European Act ¨ n regulations are: Places all European banks operating in many European countries under the same set of rules The uniform capital adequacy guidelines ¨ Forces banks of 12 industrialized nations to abide by the same minimum capital constraints 41

Global Bank Regulations (cont’d) n Uniform global regulations (cont’d) ¨ Uniform regulations for banks operating in the United States n n n The International Banking Act of 1978 was designed to impose similar regulations across domestic and foreign banks doing business in the U. S. Prior to the act, foreign banks had more flexibility to cross state lines in the U. S. than U. S. -based banks had The IBA required foreign banks to identify one state as their home state 42

Global Bank Regulations (cont’d) n Uniform global regulations (cont’d) ¨ Uniform n n regulations across Europe The Single European Act of 1987 was phased in throughout many European countries The main provisions are: ¨ ¨ Capital can flow freely throughout the participating countries Banks can offer a wide variety of lending, leasing, and securities activities in the participating countries Regulations regarding competition, mergers, and taxes are similar throughout these countries A bank established in any participating country has the right to expand into any other participating country 43

Global Bank Regulations (cont’d) n Uniform global regulations (cont’d) ¨ Uniform n regulations across Europe (cont’d) As a result of the Single European Act: A common market has been established for participating countries ¨ European banks have begun to consolidate across countries ¨ Banks can enter Europe and receive the same banking powers as other banks there ¨ Some European savings institutions have evolved into full-service institutions ¨ 44

Global Bank Regulations (cont’d) n Uniform global regulations (cont’d) ¨ Uniform capital adequacy guidelines around the world n Before 1988, capital standards imposed on banks varied across countries ¨ n Some banks had a comparative advantage over others The uniform capital adequacy guidelines imposed the same minimum capital requirements on the 12 participating countries 45