Regulating International Banking Hi, my name is Jessica and my topic is the Regulation of International Banking. Some believe the largely unregulated nature of global banking industry leaves the world financial system vulnerable to bank failure on a massive scale. We will look at the consequences of bank failure and the measures government has taken to reduce this risk. By: Jessica Heaston

The Problem of Bank Failure How do banks fail? A bank fails when it is unable to meet its obligations to depositors. Consumer Confidence Loss in confidence undermines the payments system on which the economy runs. One of the major targets of regulating the international banking industry is aimed at the problem of bank failure. A bank fails when it is unable to meet its obligations to depositors. Banks use depositor’s funds to make loans and purchase assets; however, some of those borrowers may be unable to repay their loans or those assets may decrease in value, as we have seen in the current recession with borrowers defaulting on home loans and the homes themselves declining in market value. In these circumstances, a bank can find itself unable to pay off its deposits. Consumer confidence also plays a role in a bank’s financial health. If depositors believe that a bank’s assets have significantly declined in value, they have an incentive to withdraw their funds and place them in a different bank. If an atmosphere of financial panic develops, bank failure may not be limited to banks that have mismanaged their assets, but can spread to those suspected of having lent to banks in trouble.

Consequences of Bank Failure Loss to individual depositors Harm to macroeconomic stability Loss of confidence Reduction in financial investment Reduction in aggregate demand Some of the consequences associated with the failure of a bank are… The financial losses to individual depositors of non-FDIC insured banks. Negative effects on the macroeconomic stability of the region or for a large economy with many bank failures, instability could extend to the entire world as we are seeing in the current financial crisis. A general loss in confidence, which can undermine the payments system on which the economy runs. Reduction in the banking system’s ability to finance investment, thus reducing aggregate demand and resulting in an economic slump. There is also evidence that the string of U.S. Bank closings in the early 1930’s helped start and worsen the Great Depression and we have seen bank failure play a large part in the current financial crisis.

U.S. Bank Regulations Deposit Insurance Reserve Requirements Capital Requirements & Asset Restrictions Bank Examination Lender of the Last Resort Some of the current U.S. Banking regulations and protections currently in place are… Due to the current financial crisis, according to the FDIC website, unlimited deposit insurance coverage is available through December 31, 2009, for non-interest bearing transaction accounts at institutions participating in FDIC’s Temporary Liquidity Guarantee Program. However, on January 1, 2010, the standard coverage limit will return to $100,000 for all deposit categories except IRAs and Certain Retirement Accounts, which will continue to be insured up to $250,000 per owner. Historical Values: 1935 - $5,000 1950 - $10,000 1966 - $15,000 1969 - $20,000 1974 - $40,000 1980 - $100,000 This deposit insurance discourages “runs” on banks, because depositors have no incentive to withdraw their funds since they are insured by the U.S. government. Next, we have the reserve requirements which require banks to hold a portion of their assets in liquid form, in order to meet sudden deposit outflows. Then, we have capital requirements and asset restrictions. A bank’s capital, or net worth, is the difference between a bank’s assets and its liabilities. It equals the portion of the banks assets NOT owed to depositors. U.S. bank regulators set a minimum required level of bank capital to reduce the system’s vulnerability to failure. This gives the bank an extra margin of safety in case some of its other assets go bad. Other rules prevent banks from holding assets that are considered “too risky” such as common stocks, whose prices tend to be volatile and rules against lending too large a fraction of their assets to a single customer or foreign government. Bank examination is the legal right of the Fed, FDIC, and the Office of the Comptroller of the Currency to examine a bank’s books to ensure compliance with the regulations I mentioned earlier. Banks may be forced to sell assets that are deemed “too risky” or write off loans that the examiner thinks are unlikely to be repaid. Finally, the Fed acts as a “lender of the last resort” allowing U.S. banks to borrow from the Fed’s discount window. Discounting can be used as a form of monetary policy or to prevent bank panics. Since the Fed has the ability to create currency, it can lend to banks facing massive deposit outflows as much as it needs to satisfy their depositors claims. However, the lender of the last resort facilities are conditional on sound management to prevent banks from taking excessive risks because they know they will be bailed out. All of these safeguards work interdependently. Laxity in one area can cause other safeguards to backfire, which is likely one of the problems contributing to the current financial crisis.

U.S. Savings & Loan Crisis Caused the1990-1991 Recession Fall in commercial real estate values Sharp rise in bank closures Depletion of the FDIC Insurance Fund As an example of said laxity I wanted to briefly look at the U.S. Savings and Loan crisis in the 1980’s. In the early 1980’s the U.S. deregulated the savings and loans industry. Before the deregulation, savings and loans banks had largely been restricted to home mortgage lending. Afterwards, they were allowed to make riskier loans, such as loans on commercial real estate. While this deregulation was happening, bank examination couldn’t keep up with the new situation and depositors. The resulting wave of savings and loan bank failures left the taxpayers responsible for all of the insured deposits. These failures resulted in the 1990-1991 recession, a sharp fall in commercial real estate values, a dramatic rise in bank closures, and the depletion of the FDIC insurance fund.

International Banking Unprotected Interbank Deposits No Reserve Requirements Bank Examination Difficulty Lender of the Last Resort Responsibility Unclear To understand international banking regulations, its easiest to compare them to the U.S. regulations I already mentioned. Deposit insurance is essentially absent in international banking. While there are national deposit insurance systems in many countries, the amount of insurance available is always too small to cover the size of deposits that are common in international banking. In particular, interbank deposits between countries are unprotected. Concerted international reserve requirements are blocked by the political and technical difficulties of agreeing on an internally uniform set of regulations and by the reluctance of some countries to lose banking business by having tighter regulations. Bank examination proves difficult in an international setting. Some banks are less strict in keeping track of their foreign subsidiaries, which can greatly affect the parent bank’s liquidity in the case of a failure. Banks often take advantage of this by shifting risky business that their domestic regulators would question for foreign branches. Also, it is unclear with group of regulators has responsibility for monitoring a bank’s assets. Take for example a London subsidiary of an Italian bank that deals in Eurodollars. Should those assets be monitored by the British, Italian, or Americans? Similarly, there is uncertainly over which central bank, if any, is responsible for providing lender of the last resort facilities.

World Regulatory Cooperation 80% Eurocurrency Deposits in Private Banks High level of interbank depositing Development of Basel Committee There have, however, been attempts at international regulatory cooperation. This cooperation is necessary, because of the huge eurocurrency market and high level of unprotected interbank depositing, which can create a highly contagious atmosphere and set of a bank panic in the case of large failures. In response to this threat, this led to the development of the Basel Committee.

Basel’s Affect: Emerging Markets Poorer, developing countries that have liberalized their financial systems Brazil, Mexico, Indonesia, Thailand Sources and destination for private capital flows Core Principles for Effective Banking Supervision Central bank heads from 11 industralized countries in 1974 set up a group called the Basel Committee, which was presented earlier. In 1975, the Basel committee reached an agreement, called the Concordat, which allocated responsibility for supervising multinational banking establishments between parent and host countries and called for the sharing of information about banks by parent and host regulators. A major change in international financial relations has been the rapidly growing importance of new emerging markets, such as Brazil, Mexico, Indonesia, and Thailand as sourced and destinations for private capital flows. In September 1997, the Basel Committee issued its “Core Principles for Effective Banking Supervision” which established the 25 principles describing the minimum necessary requirements for effective bank supervision, covering licensing of banks, supervision methods, reporting requirements for banks, and cross-border banking. The Basel Committee and the IMF are monitoring the implementation of these standards around the world. The Basel agreement remains major forum for international banking cooperation.