REGULATION OF FINANCIAL INSTITUTIONS CHAPTER 15 REGULATION OF FINANCIAL INSTITUTIONS Copyright© 2012 John Wiley & Sons, Inc.

Financial institutions are heavily regulated because society heavily depends on them. Financial intermediation necessarily involves “asymmetric information”. Failures of financial institutions involve high social and economic costs. The power to allocate credit is a significant and valuable social and economic power. Copyright© 2012 John Wiley & Sons, Inc.

Asymmetric Information Most consumers and businesses cannot expertly gauge a financial institution’s safety or soundness. Regulation is a mechanism for trust without personal verification. Regulators impose uniform standards of safety and soundness. Reliance on regulatory standards replaces individual trust in institutions. Benefits of financial intermediation are institutionalized into society. Copyright© 2012 John Wiley & Sons, Inc.

Major Banking Laws, 1913-1977 (Exhibit 15.1) Copyright© 2012 John Wiley & Sons, Inc.

Major Banking Laws, 1980-1991 (Exhibit 15.1) Copyright© 2012 John Wiley & Sons, Inc.

Major Banking Laws, 1994-2003 (Exhibit 15.1) Copyright© 2012 John Wiley & Sons, Inc.

Major Banking Laws, 2005-2010 (Exhibit 15.1) Copyright© 2012 John Wiley & Sons, Inc.

Failures of financial institutions Involve high social and economic costs. “Fallout” is worse than that of other business failures. Abrupt shrinkage of credit disrupts commerce; economic uncertainty inhibits saving, investing, and social progress; total costs to society typically exceed value of the institution. Regulation is a mechanism for preventing failures, or confining their effects. Regulators monitor safety and soundness proactively; deposit insurance protects against panic; central banks maintain liquidity in system as “lenders of last resort.” Copyright© 2012 John Wiley & Sons, Inc.

Allocating Credit and Regulation The power to allocate credit is a significant and valuable social and economic power. So significant that government naturally seeks to share it. So valuable that financial institutions accept regulation as a condition of it. Copyright© 2012 John Wiley & Sons, Inc.

Preventing bank failures Much bank regulation is aimed at preventing bank failures. Generally, banks fail for either of 2 reasons: ILLIQUIDITY Inability to disburse cash as promised. INSOLVENCY Insufficiency of assets to cover liabilities. Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

ILLIQUDITY An institution may be profitable, but still become illiquid. Too many depositors may withdraw at once. Loan demand may exceed planned funding ability. Too many long-term assets may be funded with short-term liabilities. Failures caused by illiquidity are preventable. Regulators proactively monitor funding practices. Regulators can arrange for emergency funding (e.g., discount window). Copyright© 2012 John Wiley & Sons, Inc.

INSOLVENCY If investments lose value or if loans default, a bank’s capital can erode. Because banks are highly leveraged, insolvency can happen when asset values fall by a relatively small amount. Regulators emphasize adequate capitalization— Minimum capital standards in terms of risk-weighted assets. Severe sanctions for undercapitalization. Copyright© 2012 John Wiley & Sons, Inc.

Lessons of Past Bank Failures By guaranteeing depositors’ funds, the FDIC has effectively prevented runs on institutions it insures. Regional or industry-wide depressions are a major cause of bank failures. Fraud, embezzlement, malfeasance, and poor management are the most notable causes of bank failures. Poor diversification is often a cause of bank failures. Copyright© 2012 John Wiley & Sons, Inc.

The FDIC Deposit Insurance Fund (DIF) consolidates former BIF — Bank Insurance Fund SAIF — Savings Association Insurance Fund FDIC insurance is mandatory for commercial banks, savings banks & savings associations. Federal insurance is extended to credit unions through NCUSIF. Coverage is now indexed for inflation. Copyright© 2012 John Wiley & Sons, Inc.

Two ways the FDIC handles bank failures Payoff & Liquidation Purchase & Assumption Copyright© 2012 John Wiley & Sons, Inc.

Pay off insured depositors Take over institution & sell off assets Payoff & Liquidation Pay off insured depositors Take over institution & sell off assets Pay other claimants against institution in order of their priority Copyright© 2012 John Wiley & Sons, Inc.

4) Subordinated creditors 5) Shareholders Order of claims 1) Expenses of receiver 2) Depositors FDIC as successor to insured depositors already paid Partial settlement with uninsured depositors depending on proceeds of liquidation 3) General creditors 4) Subordinated creditors 5) Shareholders Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

Purchase & Assumption Take over and operate institution as going concern Find new ownership for institution and/or selected assets— “Clean Bank”—buyer can “put” troubled assets back to FDIC “Whole Bank”—buyer assumes entire balance sheet Guarantee deposits but don’t pay off depositors; hand them over to new management Copyright© 2012 John Wiley & Sons, Inc.

Copyright© 2012 John Wiley & Sons, Inc.

Deposit Insurance Issues Moral Hazard “Too Big to Fail” “Policing” Premiums Copyright© 2012 John Wiley & Sons, Inc.

Moral Hazard Reduces incentive of depositors to be careful Increases temptation of depository institutions to “gamble” on higher risks Coverage is limited or “capped” for this reason. Uninsured depositors may take losses. Copyright© 2012 John Wiley & Sons, Inc.

This creates a “two-tiered” banking industry. “Too Big to Fail” To protect the economy, the government implicitly promises full bailout of the largest institutions. This creates a “two-tiered” banking industry. This adds to the temptation of the largest institutions to “gamble”. Of course the government does not explicitly say which banks it would save. Copyright© 2012 John Wiley & Sons, Inc.

“Policing” Insurance Agencies as “Police”: Depositors aren’t worried. They have no incentive to withdraw funds from an institution even if it is taking many risks. Deposit insurance funds must thus have a “police” mentality—try to protect the public who no longer protect themselves. This is a major reason institutions must be regularly examined. Stockholders and Creditors as “Police”: No insurance for them. If a bank is very risky, buyers of its securities will demand a very high return. Thus the capital market imposes a risk premium for risky banks. Bank examinations are costly and infrequent, but investors will monitor bank risk-taking and bid prices of the bank’s securities up or down as appropriate. Copyright© 2012 John Wiley & Sons, Inc.

For many years all banks paid the same premium rate. Premiums For many years all banks paid the same premium rate. Now premiums increase or decrease depending on— capitalization; examiner ratings. Copyright© 2012 John Wiley & Sons, Inc.

Safety and Soundness Regulation Capital Adequacy Regulation: Basel I (Basel Accord) Basel II Basel III Two forms of capital: Tier 1 Capital (Core Capital) Tier 2 Capital (Supplemental Capital) Risk weighted assets is a measure of assets that weights high-risk assets more heavily than low-risk assets. Copyright© 2012 John Wiley & Sons, Inc.

Minimum Capital Requirements Require the following: The ratio of Tier 1 capital to total assets must be at least 3% (leverage ratio). The ratio of Tier 1 capital to risk-weighted assets must be at least 4%. The ratio of total capital to risk-weighted assets must be at least 8%. Copyright© 2012 John Wiley & Sons, Inc.

Risk Weights for Assets, Exhibit 15.6 Copyright© 2012 John Wiley & Sons, Inc.

Risk Weights for Assets, Exhibit 15.6, cont. Copyright© 2012 John Wiley & Sons, Inc.

Risk Weights for Off-Balance-Sheet Activities Copyright© 2012 John Wiley & Sons, Inc.

For nonmember state banks it is the FDIC and the state banking agency. Bank Examinations All U.S. depository institutions are regularly examined by at least one regulator. For national banks, it is the OCC—the Office of the Comptroller of the Currency. For state banks who are members of the Federal Reserve System, it is the Federal Reserve and the state banking agency. For nonmember state banks it is the FDIC and the state banking agency. Copyright© 2012 John Wiley & Sons, Inc.

Safety & Soundness Examinations Promote and maintain safe and sound bank operating practices Procedure includes: bank financial information collected quarterly (call reports) on-site bank examinations discussion of findings with management “CAMELS” rating Copyright© 2012 John Wiley & Sons, Inc.

1 (Best) to 5 (Worst) in each of 6 areas: Capital adequacy CAMELS Ratings 1 (Best) to 5 (Worst) in each of 6 areas: Capital adequacy Asset quality Management competency Earnings Liquidity Sensitivity to Market Risk Copyright© 2012 John Wiley & Sons, Inc.

CAMELS Rating System, Exhibit 15.8 Copyright© 2012 John Wiley & Sons, Inc.

CAMELS Rating System, Exhibit 15.8, cont. Copyright© 2012 John Wiley & Sons, Inc.

Community Reinvestment Act compliance Consumer compliance Other Examinations Community Reinvestment Act compliance Consumer compliance Trust Department examinations as applicable Copyright© 2012 John Wiley & Sons, Inc.

Structure & Competition Regulations Branching Deposit rate ceilings Commercial banking vs. Investment banking Financial Services Modernization Act Copyright© 2012 John Wiley & Sons, Inc.

Branching Limitations For years branching was tightly controlled and subject to conflicting state regulations as well as ambiguous federal regulations. Interstate branching required approval of all states involved. Bank holding companies evolved as a regulatory avoidance technique. Today, after the Interstate Banking and Branching Efficiency Act of 1994— All banks can freely branch across state lines as long as it is through acquisition of another bank or branch. If allowed by state law, a bank can create a new branch (“de novo” branching) across state lines. Copyright© 2012 John Wiley & Sons, Inc.

Ceilings are gone now, but “innovation around” them left us with— Deposit Rate Ceilings Until 1980 “Reg Q” rate ceilings kept institutions from competing directly. Ceilings are gone now, but “innovation around” them left us with— MMDAs MMMFs NOW Accounts Copyright© 2012 John Wiley & Sons, Inc.

Commercial Banking vs. Investment Banking Glass-Steagall restrictions were gradually relaxed in the 1980s and 1990s. Financial Services Modernization Act of 1999 repealed most restrictions, allowing U.S. commercial banks affiliated subsidiaries for— investment banking; insurance; other financial activities. Copyright© 2012 John Wiley & Sons, Inc.

Financial Services Modernization Act of 1999 Banks can have securities and insurance subsidiaries. A new organizational form, financial holding companies (FHCs), can have many different kinds of financial institutions as subsidiaries. Insurance companies and securities firms can acquire commercial banks and form FHCs with Federal Reserve approval. Institutions must obey new privacy rules about sharing customer information. Federal Reserve is “umbrella” supervisor over FHCs while bank and nonbank subsidiaries fall under other regulators (“functional regulation”). Copyright© 2012 John Wiley & Sons, Inc.

Consumer Protection Regulations Loan rate ceilings Truth in Lending (1969) Equal Credit Opportunity Act (1974; 1976) Fair Credit Billing Act (1974) Community Reinvestment Act (1977) Fair Credit Reporting Act of 1970/Fair &Accurate Credit Transactions Act of 2003 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 Copyright© 2012 John Wiley & Sons, Inc.

State banking agencies FDIC Federal Reserve Bank Regulators State banking agencies FDIC Federal Reserve Office of the Comptroller of the Currency Office of Thrift Supervision Copyright© 2012 John Wiley & Sons, Inc.

Division of Responsibilities among Bank Regulators Copyright© 2012 John Wiley & Sons, Inc.