The Regulation of Markets and Institutions Chapter 15 The Regulation of Markets and Institutions

Key Ideas Different methods of regulating financial markets Dual banking system and the regulators who oversee it Universal banking and its possible benefits and risks

Introduction Financial system is one of most intensely regulated sectors in US economy Reasons: To promote competition To protect individual consumers To maintain stability of financial system To facilitate monetary policy

Regulation of the Primary Market Philosophy: Best protection is have adequate information about securities Full disclosure broadens participation in financial markets

Regulation of the Primary Market Securities Act of 1933 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 Securities Exchange Act of 1934 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

Regulation of the Primary Market Securities Exchange Act of 1934 (Cont.) The prospectus does not state the interest rate on a bond issue or price for equity issues—determined in the market when sold 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

Regulation of Secondary Market Securities Exchange Act of 1934 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 Insider Trading Laws 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

Regulation of Secondary Market Securities Exchange Act of 1934 (Cont.) SEC and other regulatory agencies Have authority to regulate securities exchanges, OTC trading, dealers, and brokers 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

Regulation of Commercial Banks Principle philosophy: Protect individual depositor Foster a competitive banking system Ensure bank safety and soundness

Regulation of Commercial Banks U.S. Banking Regulatory Structure Dual banking system 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) Intent was to drive existing state chartered banks out of business by imposing a prohibitive tax on issuance of state banknotes

Regulation of Commercial Banks Dual banking system (Cont.) However, state banks survived Stopped issuing banknotes Started to accept of demand deposits State chartered banks are supervised by regulators in their respective state Federally chartered banks tend to be larger, but state banks are more numerous

Regulation of Commercial Banks Federal Reserve Act of 1913 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) Federal Deposit Insurance Corporation (FDIC) 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

Regulation of Commercial Banks U.S. Banking Regulatory Structure Multiple and sometimes conflicting supervisory authority at Federal level Fed, Comptroller of Currency (Department of the Treasury), and FDIC frequently clash over interpretation of certain laws Suggestion that all regulation should be combined in a single agency, but no legislation exists to unify the structure

Regulation of Commercial Banks Protecting Individual Depositors and Financial System Stability Rather than relying on disclosure, focus of bank regulation is on bank examinations and prompt corrective action (PCA) when necessary

Regulation of Commercial Banks The primary liabilities of a commercial bank are their demand deposits Paid on a first-come/first-serve basis Banks must maintain sufficient liquidity to meet demand deposits Difficult and costly for banks to sell illiquid assets It is also costly to keep excess reserve 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

Regulation of Commercial Banks Deposit Insurance 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 Resulted from large number of bank failures in the early 1930’s Objective is to protect small savers Reduce the incentive for depositors to join a bank run

Regulation of Commercial Banks Deposit Insurance Currently insure deposits up to $100,000 for single account Coverage depends on procedure used by FDIC: 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 “Too big to fail” Doctrine—FDIC may extend loans to very large banks in trouble to allow continued operations

Regulation of Commercial Banks Moral Hazard and Deposit Insurance Existence of FDIC eliminates possibility of large-scale bank failure and bank run However, it creates a classic moral hazard problem Depositors have little or no incentive to monitor riskiness of their banks Bank managers finds it easy to engage in risky activities

Regulation of Commercial Banks Moral Hazard and Deposit Insurance 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 Risk averse—banks are privately owned and directors are paid based on performance Bank examination and other regulatory efforts “Too big to fail” doctrine may unintentionally exacerbate the moral hazard problem Recently bank failures have increased due to banking deregulation and commercial banking activities becoming riskier

Regulation of Commercial Banks Risk-Based Capital Requirements Bank capital provides a cushion against failure Banks are required to maintain a capital-asset ratio based on a measure of the riskiness of their total assets 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)

Regulation of Commercial Banks Prompt Corrective Action (PCA)—FDIC Improvement Act of 1991 Established procedures to handle troubled banks Designed to close banks/thrifts before FDIC is exposed to excessive losses Prevent regulatory forbearance—when regulators keep an insolvent institution operating in hopes of “turning it around” Banks are ranked according to their perceived risk and more restrictions placed on riskier banks FDIC established risk-based deposit insurance premium—charge insurance premium based on the perceived risk of the bank

Regulation of Nondepository Depends very much on the type of liabilities they issue Pension funds and life insurance companies Heavily regulated because their liabilities are purchased by small investors and need to protect small investors Employee Retirement Income Security Act (ERISA) Established the Pension Benefit Guaranty Corporation

Regulation of Nondepository Employee Retirement Income Security Act (ERISA) Guarantees defined benefits pension plans, subject to a maximum amount Establishes minimum reporting, disclosure and investment standards Life Insurance Companies Regulated at the state level Impose risk-based capital requirements Perform periodic audits Implicit and explicit restrictions on pricing of particular products

Regulation of Nondepository Finance companies raise funds by issuing debt and equity and have virtually no regulation beyond the securities laws governing publicly traded securities Mutual Funds Regulated by the SEC Also subject to state regulations Motivation is protection of individual investors through full disclosure

The Glass-Steagall Act Segregated the banking industry from the rest of the financial services industry Banks are barred from owning corporate stock and other activities deemed too risky The Genesis of Glass-Steagall Prior to 1933, investment banking and commercial banking were conducted under same roof Following the financial collapse of the 1930s, it was felt that investment banking activities were too risky for banks

The Glass-Steagall Act The Genesis of Glass-Steagall (Cont.) This combination represented a substantial threat to financial system stability Although there was little empirical evidence to support this contention, the legislation mandated separation of the two activities

The Glass-Steagall Act The Erosion of Glass-Steagall Commercial banks exerted pressure on the Federal Reserve and courts to reduce the barriers caused by Glass-Steagall Bank-holding Companies Permitted banks to conduct nonbanking activities through subsidiaries In 1970 Federal Reserve was given power to determine what activities were permissible Activities had to be closely related to traditional banking During the 1970s and 80s banks acquired more freedom to engage in nontraditional banking activities

The Glass-Steagall Act The Erosion of Glass-Steagall (Cont.) In 1989 the Federal Reserve granted five banks the power to underwrite corporate debt through a Section 20 affiliate Gradually the Federal Reserve granted more and more banks the right to underwrite corporate debt

The Glass-Steagall Act The Erosion of Glass-Steagall (Cont.) The Gramm-Leach-Bliley Act (1999) Allowed affiliates of financial holding companies to engage in various banking activities and insurance underwriting Overall responsibility for regulation lies with the Federal Reserve through its role as the “umbrella” regulator Federal Reserve has power to ensure capital adequacy of holding companies, safety and soundness of their activities Individual affiliates of holding companies are subject to regulation by functional supervisors such as the SEC This regulation framework blends the disclosure-based and inspection-based approaches to regulation

The Glass-Steagall Act The Risk of Universal Banking 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 Just because investment banking is riskier than commercial banking, this does not mean that the combination of the two will be riskier

Universal Banking The Risk of Universal Banking The portfolio theory of risk suggests that diversification may reduce risk when commercial banking combine with investment banking and life insurance activities Perhaps it is time to let the banks decide for themselves whether universal banking reduces risk