The Regulations of Markets and Institutions

Introduction Financial system is one of most intensely regulated sectors in the economy Financial system is one of most intensely regulated sectors in the economy Promote competition Promote competition Protect individual consumers Protect individual consumers Assure stability of financial system Assure stability of financial system Facilitate monetary policy Facilitate monetary policy

Regulation of Financial Markets Desire to protect individual investor Desire to protect individual investor Best protection is adequate information about securities Best protection is adequate information about securities Full disclosure broadens investor’s participation in financial markets Full disclosure broadens investor’s participation in financial markets

Regulation of the Primary Market Securities Act of 1933 Securities Act of 1933 Requires disclosure of information for newly issued publicly traded securities Requires disclosure of information for newly issued publicly traded securities Privately held firms are not required to reveal financial information to the public at large, only to the lenders Privately held firms are not required to reveal financial information to the public at large, only to the lenders Securities Exchange Act of 1934 Securities Exchange Act of 1934

Securities Exchange Act of 1934 Created the Securities and Exchange Commission (SEC) to administer provisions of 1933 Act Created the Securities and Exchange Commission (SEC) to administer provisions of 1933 Act Publicly traded security must file registration statement and preliminary prospectus disclosing information about issue Publicly traded security must file registration statement and preliminary prospectus disclosing information about issue If information is adequate, SEC approves the statement and sale If information is adequate, SEC approves the statement and sale Approval by the SEC does not imply that it views the new issue as an attractive investment—merely means disclosure of information is adequate Approval by the SEC does not imply that it views the new issue as an attractive investment—merely means disclosure of information is adequate

Securities Exchange Act of 1934 Extended 1933 Act to include periodic disclosure of relevant financial information for firms trading in secondary market Extended 1933 Act to include periodic disclosure of relevant financial information for firms trading in secondary market 10K Report—Annual financial statement and relevant information about a firm’s performance and activity 10K Report—Annual financial statement and relevant information about a firm’s performance and activity Insider Trading Laws Insider Trading Laws Prohibit insiders from trading on private information not previously disclosed to public Prohibit insiders from trading on private information not previously disclosed to public Corporate officers and major stockholders must report all their transactions of their own firm’s stock Corporate officers and major stockholders must report all their transactions of their own firm’s stock

Regulation of the Secondary Market SEC and other regulatory agencies SEC and other regulatory agencies Have authority to regulate securities exchanges, OTC trading, dealers, and brokers Have authority to regulate securities exchanges, OTC trading, dealers, and brokers Basically rely on self-regulation by markets and firms under their control Basically rely on self-regulation by markets and firms under their control Fed sets margin requirements on stocks—how much of purchase price an investor can borrow Fed sets margin requirements on stocks—how much of purchase price an investor can borrow

Regulation of Commercial Banks in the United States Protect individual depositor Protect individual depositor Foster a competitive banking system Foster a competitive banking system Ensure bank safety and soundness Ensure bank safety and soundness

U.S. Banking Regulatory Structure Dual Banking System Dual Banking System Federal Reserve Act of 1913 Federal Reserve Act of 1913 FDIC FDIC

Dual Banking System Federal and State banks existing side-by-side Federal and State banks existing side-by-side Legislation in 1860’s established federally chartered banks under supervision of Comptroller of the Currency (US Treasury Department) Legislation in 1860’s established federally chartered banks under supervision of Comptroller of the Currency (US Treasury Department) Intent was to drive existing state chartered banks out of business by imposing a prohibitive tax on issuance of state banknotes Intent was to drive existing state chartered banks out of business by imposing a prohibitive tax on issuance of state banknotes

Dual Banking System However, state banks survived due to acceptance of demand deposits in lieu of currency However, state banks survived due to acceptance of demand deposits in lieu of currency State chartered banks are supervised by regulators in their respective state State chartered banks are supervised by regulators in their respective state Federally chartered banks tend to be larger, but state banks are more numerous Federally chartered banks tend to be larger, but state banks are more numerous

Federal Reserve Act of 1913 Required national banks to become members of the Fed, while state banks had option. Required national banks to become members of the Fed, while state banks had option. All state banks currently fall under regulation of the Fed (member or not) All state banks currently fall under regulation of the Fed (member or not)

Federal Deposit Insurance Corporation (FDIC) All member banks of Fed (national and some state banks) are required to carry FDIC insurance All member banks of Fed (national and some state banks) are required to carry FDIC insurance A majority of state banks not members of the Fed have opted to participate in FDIC program A majority of state banks not members of the Fed have opted to participate in FDIC program

Protecting Individual Depositors and Financial System Stability Rather than relying on disclosure, thrust of bank regulation is on bank examinations and prompt corrective action when necessary Rather than relying on disclosure, thrust of bank regulation is on bank examinations and prompt corrective action when necessary The primary liabilities of a commercial bank are their demand deposits The primary liabilities of a commercial bank are their demand deposits

Demand Deposits Paid on a first-come/first-serve basis Paid on a first-come/first-serve basis Banks must maintain sufficient liquidity to meet demand deposits Banks must maintain sufficient liquidity to meet demand deposits Difficult and costly for banks to sell illiquid assets Difficult and costly for banks to sell illiquid assets Fear that a bank is insolvent will cause a run on the bank or a system-wide bank panic Fear that a bank is insolvent will cause a run on the bank or a system-wide bank panic Periodic examination of a bank by regulatory agencies to insure banks are solvent Periodic examination of a bank by regulatory agencies to insure banks are solvent

Deposit Insurance FDIC established by Banking Act of 1933 to insure deposits at commercial and mutual savings banks. FDIC established by Banking Act of 1933 to insure deposits at commercial and mutual savings banks. Federal Savings and Loan Insurance Corporation (FSLIC) insured deposits in S&Ls Federal Savings and Loan Insurance Corporation (FSLIC) insured deposits in S&Ls Resulted from large number of bank failures in the early 1930’s Resulted from large number of bank failures in the early 1930’s Intent is to protect small savers and reduce the incentive for insured depositors to join a bank run Intent is to protect small savers and reduce the incentive for insured depositors to join a bank run

Deposit Insurance Currently insure deposits up to $100,000, but actual coverage may be more. Currently insure deposits up to $100,000, but actual coverage may be more. Coverage depends on procedure used by FDIC: Coverage depends on procedure used by FDIC: Payoff method—Bank goes into receivership and FDIC pays out funds up to $100,000 Payoff method—Bank goes into receivership and FDIC pays out funds up to $100,000 Assumption method—FDIC merges failed bank with a healthy one and deposits of failed bank are assumed by solvent bank Assumption method—FDIC merges failed bank with a healthy one and deposits of failed bank are assumed by solvent bank “Too big to fail” Doctrine—FDIC may extend loans to very large banks in trouble to allow continued operations “Too big to fail” Doctrine—FDIC may extend loans to very large banks in trouble to allow continued operations

Moral Hazard and Deposit Insurance Existence of FDIC eliminates possibility of large-scale bank failure and “run on the banks” Existence of FDIC eliminates possibility of large-scale bank failure and “run on the banks” Moral Hazard Moral Hazard Depositors have little incentive to monitor riskiness of their banks Depositors have little incentive to monitor riskiness of their banks

Moral Hazard and Deposit Insurance Shareholders and directors of banks have incentive to make their banks riskier at the expense of the FDIC Shareholders and directors of banks have incentive to make their banks riskier at the expense of the FDIC However, several factors may reduce risk taking However, several factors may reduce risk taking Risk averse—banks are privately owned and directors are paid based on performance Risk averse—banks are privately owned and directors are paid based on performance Bank examination and other regulatory efforts Bank examination and other regulatory efforts

Federal Regulatory Agencies Federal Reserve Federal Reserve Federal Deposit Insurance Corporation (FDIC) Federal Deposit Insurance Corporation (FDIC) Office of the Comptroller of the Currency (OCC) Office of the Comptroller of the Currency (OCC) Securities and Exchange Commission (SEC) Securities and Exchange Commission (SEC) Department of Justice Department of Justice

Major Bank Laws 1913 The Federal Reserve Act 1913 The Federal Reserve Act Created the Federal Reserve System. Created the Federal Reserve System The McFadden Act 1927 The McFadden Act Subjected branching of nationally chartered banks to the same branching regulations as state-chartered banks. Subjected branching of nationally chartered banks to the same branching regulations as state-chartered banks. Prohibited interstate banking. Prohibited interstate banking.

1933 The Glass-Steagall Act Established the FDIC as a temporary agency. Established the FDIC as a temporary agency. Separated commercial and investment banking. Separated commercial and investment banking. Established Regulation Q interest rate ceilings. Established Regulation Q interest rate ceilings. Set the interest rate ceiling on demand deposits at 0 percent. Set the interest rate ceiling on demand deposits at 0 percent.

Glass-Steagall Branching Restrictions Interstate branching: Interstate branching: The operation of banking offices in more than one state was made illegal. The operation of banking offices in more than one state was made illegal. Intrastate branching: Intrastate branching: The operation of banking offices anywhere within a state was left to the discretion of the states. The operation of banking offices anywhere within a state was left to the discretion of the states.

1935 The Banking Act Established the FDIC as a permanent agency. Established the FDIC as a permanent agency.

1956 The Bank Holding Company Act Restricted the banking and non- banking acquisition activities of multi- bank holding companies. Restricted the banking and non- banking acquisition activities of multi- bank holding companies. Empowered the Federal Reserve to regulate multi-bank holding companies. Empowered the Federal Reserve to regulate multi-bank holding companies.

1970 Amendments to the Bank Holding Company Act of 1956 Extended the BHC Act to one-bank holding companies. Extended the BHC Act to one-bank holding companies. Restricted permissible BHC activities to those “closely related to banking.” Restricted permissible BHC activities to those “closely related to banking.”

1978 International Banking Act Regulated foreign bank branches and agencies in the United States. Regulated foreign bank branches and agencies in the United States. Subjected foreign banks to the McFadden and Glass-Steagall Acts. Subjected foreign banks to the McFadden and Glass-Steagall Acts. Gave foreign banks access to Fedwire, the discount window, and deposit insurance. Gave foreign banks access to Fedwire, the discount window, and deposit insurance.

Partial Deregulation:1971–1989 Disintermediation: Disintermediation: A situation in which customers of depository institutions withdraw funds from their deposit accounts and use these funds to purchase financial instruments directly. A situation in which customers of depository institutions withdraw funds from their deposit accounts and use these funds to purchase financial instruments directly.

1980 Depository Institutions Deregulation and Monetary Control Act (DIDMCA) Phase-out of Regulation Q interest rate ceilings on small time and savings deposits by Phase-out of Regulation Q interest rate ceilings on small time and savings deposits by Authorized NOW accounts nationwide. Authorized NOW accounts nationwide. Imposed reserve requirements on all state and nationally chartered banks. Imposed reserve requirements on all state and nationally chartered banks. Increased the ceiling on deposit insurance coverage from $40,000 to $100,000. Increased the ceiling on deposit insurance coverage from $40,000 to $100,000. Allowed federally chartered savings institutions to make consumer and commercial loans. Allowed federally chartered savings institutions to make consumer and commercial loans.

1982 Garn-St. Germain Depository Institutions Act (DIA) Authorized money market deposit accounts. Authorized money market deposit accounts. Increase the DIDMCA Depository Institutions Deregulation and Monetary Control Act. The 1980 federal legislation that ended the regulation of the banking industry on consumer loans and commercial paper. Increase the DIDMCA Depository Institutions Deregulation and Monetary Control Act. The 1980 federal legislation that ended the regulation of the banking industry on consumer loans and commercial paper. Authorized savings institutions to make commercial real estate loans. Authorized savings institutions to make commercial real estate loans. Gave these institutions the power to purchase “unsecured loans,” including low-rated, “junk” bonds. Gave these institutions the power to purchase “unsecured loans,” including low-rated, “junk” bonds. Gave the FDIC power to permit troubled financial institutions to merge with healthier partners. Gave the FDIC power to permit troubled financial institutions to merge with healthier partners.

1989 Financial Institutions Reform Recovery, and Enforcement Act (FIRREA) Authorized a taxpayer bailout of the S&L industry. Authorized a taxpayer bailout of the S&L industry. Brought deposit insurance for Thrifts under the FDIC. Brought deposit insurance for Thrifts under the FDIC. Equalized the capital requirements of savings institutions and banks. Equalized the capital requirements of savings institutions and banks. Created the Office of Thrift Supervision (OTS) to replace the Federal Home Loan Bank Board as the chartering agency of Thrifts. Created the Office of Thrift Supervision (OTS) to replace the Federal Home Loan Bank Board as the chartering agency of Thrifts. Created the Resolution Trust Corporation (RTC) as a temporary agency to resolve failed and failing savings institutions. Created the Resolution Trust Corporation (RTC) as a temporary agency to resolve failed and failing savings institutions.

1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA) Established higher standards for safety and soundness for financial institutions. Established higher standards for safety and soundness for financial institutions. Introduced prompt corrective action (PCA), requiring mandatory interventions by regulators whenever a bank’s capital falls. Introduced prompt corrective action (PCA), requiring mandatory interventions by regulators whenever a bank’s capital falls. Required the establishment of risk-based deposit insurance premiums beginning in Required the establishment of risk-based deposit insurance premiums beginning in Limited the use of “too big to fail” bailouts by federal regulators for large banks. Limited the use of “too big to fail” bailouts by federal regulators for large banks. Restricted activities of foreign banks and insured state banks. Restricted activities of foreign banks and insured state banks.

Capital Requirements of Commercial Banks Commercial banks are highly leveraged. Commercial banks are highly leveraged. Equity/Total Assets < 8% Equity/Total Assets < 8% Regulators from the U.S. and 12 other major countries came together to formulate uniform standards that would apply to all their banks. Regulators from the U.S. and 12 other major countries came together to formulate uniform standards that would apply to all their banks. Established under the auspices of the Bank for International Settlements (BIS), an international clearing bank for central banks. Established under the auspices of the Bank for International Settlements (BIS), an international clearing bank for central banks. Adopted in November Adopted in November 1988.

Risk-Based Capital Requirements Banks are required to maintain a capital-asset ratio based on a measure of the riskiness of their total assets Banks are required to maintain a capital-asset ratio based on a measure of the riskiness of their total assets Bank capital provides a cushion against failure Bank capital provides a cushion against failure Risk-based capital requirements—as a bank’s assets become riskier regulators will force banks to increase their capital Risk-based capital requirements—as a bank’s assets become riskier regulators will force banks to increase their capital These requirements are agreed upon by the United States and members of the Bank for International Settlements (BIS) These requirements are agreed upon by the United States and members of the Bank for International Settlements (BIS)

Definitions of Capital Core capital (Tier 1 capital) Core capital (Tier 1 capital) Shareholders’ equity plus retained earnings. Shareholders’ equity plus retained earnings. Supplementary capital (Tier 2 capital) Supplementary capital (Tier 2 capital) A measure that includes certain preferred stock and most subordinated debt. A measure that includes certain preferred stock and most subordinated debt. Total capital Total capital The sum of core capital and supplementary capital. The sum of core capital and supplementary capital.

Minimum standards Ratio of core capital to risk-adjusted assets > 4%. Ratio of core capital to risk-adjusted assets > 4%. Ratio of total capital to risk-adjusted assets > 8%. Ratio of total capital to risk-adjusted assets > 8%. Ratio of total capital to unadjusted total assets > 4%. Ratio of total capital to unadjusted total assets > 4%.

The Effects of Capital Requirements A number of banks failed to meet the three ratio requirements. A number of banks failed to meet the three ratio requirements. Reduced issuance of loans in response to higher capital standards. Reduced issuance of loans in response to higher capital standards.

New Capital Requirements for 2000s Under 1989 requirement risk weights were arbitrary. Under 1989 requirement risk weights were arbitrary. Banks could be treated the same but have very different risks. Banks could be treated the same but have very different risks. By 2005, the Basel Committee plans to have modified risk weights in place that will include greater-than-100% risk weighting for low-quality loans. By 2005, the Basel Committee plans to have modified risk weights in place that will include greater-than-100% risk weighting for low-quality loans.

1994 Riegle-Neal Interstate Banking and Branching Efficiency Act Allowed virtually unimpeded interstate branching by adequately capitalized and managed banks. Allowed virtually unimpeded interstate branching by adequately capitalized and managed banks. Permitted bank holding companies to acquire banks in other states, starting September Permitted bank holding companies to acquire banks in other states, starting September Invalidated the laws of states that allow interstate banking only on a regional or reciprocal basis. Invalidated the laws of states that allow interstate banking only on a regional or reciprocal basis. Beginning June 1997, permitted bank holding companies to convert out-of-state subsidiary banks into branches of a single interstate bank. Beginning June 1997, permitted bank holding companies to convert out-of-state subsidiary banks into branches of a single interstate bank. Permitted newly chartered branches within a state if state law allows. Permitted newly chartered branches within a state if state law allows.

1999 The Gramm-Leach-Bliley Financial Services Modernization Act Banks are empowered to underwrite insurance and securities, including shares of stock. Banks are empowered to underwrite insurance and securities, including shares of stock. Securities firms and insurance companies are permitted to own commercial banks. Securities firms and insurance companies are permitted to own commercial banks. Repealed key provisions of the 1933 Glass-Steagall Act. Repealed key provisions of the 1933 Glass-Steagall Act.

The Risk of Universal Banking The issue of risk has become a key issue in the debate over Gramm-Leach-Bliley The issue of risk has become a key issue in the debate over Gramm-Leach-Bliley Some concern that the risk of securities activities, especially the underwriting business, may jeopardize the stability of the banking system Some concern that the risk of securities activities, especially the underwriting business, may jeopardize the stability of the banking system Would bank losses in securities activities lead to more bank failures and significant losses to FDIC Would bank losses in securities activities lead to more bank failures and significant losses to FDIC Just because investment banking is riskier than commercial banking, this does not mean that the combination of the two will be riskier Just because investment banking is riskier than commercial banking, this does not mean that the combination of the two will be riskier

How many types of regulations do banks face? Federal Reserve Bank of NY lists the Federal Reserve Regulations Federal Reserve Bank of NY lists the Federal Reserve Regulations

Regulatory Environment Dual Banking System Federal Level Federal Level State Level State Level

Bank Regulation in the U.S. CharterNationalStateStateState Fed Member RequiredYesNoNo FDIC Insurance RequiredYesYesNo Approval of branches & mergers OCCStateStateState ExaminationOCCFedFDICState

Federal Reserve Supervision Member commercial banks Member commercial banks Bank holding companies Bank holding companies Financial holding companies Financial holding companies U.S. banking activities of foreign banks U.S. banking activities of foreign banks

FDIC Supervisor of state-chartered non-member banks. Supervisor of state-chartered non-member banks. Insurer. Insurer. In charge of bank failure In charge of bank failure Administers the BIF and SAIF Administers the BIF and SAIF

Comptroller of the Currency Regulates national banks that are not bank holding companies. Regulates national banks that are not bank holding companies. Regulates federally chartered branches of foreign banks. Regulates federally chartered branches of foreign banks.

States Regulate state-chartered, non-FDIC insured banks. Regulate state-chartered, non-FDIC insured banks.

Regulations to Protect Individual Depositors Deposit Insurance (1930) Deposit Insurance (1930) Insure up to $2,500 ($100,000 today) Insure up to $2,500 ($100,000 today) Moral Hazard Moral Hazard Deposit insurance provides insured banks incentives to take excessive risks. Deposit insurance provides insured banks incentives to take excessive risks. Risk-Based Capital Requirements Risk-Based Capital Requirements Prompt Corrective Action Prompt Corrective Action Risk-Based Deposit Insurance Premiums Risk-Based Deposit Insurance Premiums

As to guaranteeing bank deposits, the minute the government starts to do that… the government runs into a probably loss. As to guaranteeing bank deposits, the minute the government starts to do that… the government runs into a probably loss. President Franklin D. Roosevelt (1933) President Franklin D. Roosevelt (1933)

Deposit Insurance Reform In 1990, officials at the Federal Reserve Bank of Minneapolis proposed a reform of the deposit insurance system that included the following provisions: In 1990, officials at the Federal Reserve Bank of Minneapolis proposed a reform of the deposit insurance system that included the following provisions: Only one fully insured account per person Only one fully insured account per person Full insurance on only $10,000 Full insurance on only $10, percent insurance on all other deposits. 90 percent insurance on all other deposits. From the perspectives of reducing moral hazard and promoting economic stability, what are the advantages and disadvantages of such a plan? From the perspectives of reducing moral hazard and promoting economic stability, what are the advantages and disadvantages of such a plan?

Regulatory Forbearance Regulatory agencies often allowed insolvent S&Ls, banks, and other depository institutions to keep their doors open and permitted them to pay higher and higher interest rates. Regulatory agencies often allowed insolvent S&Ls, banks, and other depository institutions to keep their doors open and permitted them to pay higher and higher interest rates. Drove up deposit costs for all depository institutions. Drove up deposit costs for all depository institutions. FDICIA put a stop to regulatory forbearance. FDICIA put a stop to regulatory forbearance. A bank or thrift could be closed if its ratio of tangible equity capital to total assets fell below 2 percent for more than 90 days. A bank or thrift could be closed if its ratio of tangible equity capital to total assets fell below 2 percent for more than 90 days. A bank or thrift must be closed or sold if the condition lasts more than 270 days. A bank or thrift must be closed or sold if the condition lasts more than 270 days.

1982 Penn Square High proportion of energy-related loans. High proportion of energy-related loans. Poorly diversified. Poorly diversified. Credit-granting standards were extremely low. Credit-granting standards were extremely low. Many loans in default. Many loans in default. More than half of deposit accounts exceeded the insurance limit. More than half of deposit accounts exceeded the insurance limit. FDIC gave notice that it did not intend to guarantee them. FDIC gave notice that it did not intend to guarantee them.

Too-Big-To-Fail Doctrine September 1984, the Comptroller of the Currency declared that the 11 largest banks would not be allowed to fail. September 1984, the Comptroller of the Currency declared that the 11 largest banks would not be allowed to fail. Double standard. Double standard.

“Too-big-to-fail” 1984 Continental Illinois 1984 Continental Illinois All creditors were notified that FDIC guarantees were completely in force regardless of the size or nature of the liability. All creditors were notified that FDIC guarantees were completely in force regardless of the size or nature of the liability First Republic Bank Corporation 1988 First Republic Bank Corporation Interim financial assistance package of $1 billion Interim financial assistance package of $1 billion Provided assurances of protection to all bank depositors and creditors. Provided assurances of protection to all bank depositors and creditors.

Regulation of Nondepository Financial Intermediaries Depends on type Depends on type Pension Funds Pension Funds Employee Retirement Income Security Act (ERISA) Employee Retirement Income Security Act (ERISA) Mutual Funds Mutual Funds SEC SEC Life Insurance Companies Life Insurance Companies State State