1 Chapter 18 Bank Regulation Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2 Chapter Outline 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

3 Background 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 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

4 Regulatory Structure 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 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

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

6 Deregulation Act of 1980 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 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) 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 The Act:  Permitted depository institutions to offer money market deposit accounts (MMDAs), which have no interest ceiling 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 Intended to reduce the number of failures that require liquidation

9 Regulation of Deposit Insurance Federal deposit insurance has existed since the creation of the FDIC in 1933 as a response to bank runs  Deposit insurance has increased from $2,500 in 1933 to $100,000 today  Insured deposits make up 80 percent of all commercial bank balances

10 Regulation of Deposit Insurance (cont’d) 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 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) 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) 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 Explicitly account for operational risk Require more disclosure for market participants

14 Regulation of Operations 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 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

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

16 Regulation of Operations (cont’d) Regulation of securities services (cont’d)  Deregulation of underwriting services 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 The Fed imposed a ceiling on revenues from corporate debt underwriting

17 Regulation of Operations (cont’d) Regulation of securities services (cont’d)  The 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

18 Regulation of Operations (cont’d) Regulation of securities services (cont’d)  Deregulation of brokerage services Banks had been allowed to offer discount brokerage services even before 1999 In the late 1990s, some banks acquired financial services firms that offered full-service brokerage services  Deregulation 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

19 Regulation of Operations (cont’d) Regulation of insurance services  Before the late 1990s, banks were involved in insurance in limited ways: 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

20 Regulation of Operations (cont’d) 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 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

21 Regulation of Interstate Expansion The McFadden 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

22 Regulation of Interstate Expansion (cont’d) 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 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