Chapter 161 PART 6. THE ROLES OF REGULATION, DEPOSIT INSURANCE, AND ETHICS IN SHAPING BANKING AND THE FINANCIAL- SERVICES INDUSTRY Chapter 16. Theories, Objectives, and Agencies of Bank Regulation Chapter 17. Deposit Insurance, Bank Failures, and the Savings-and-Loan Mess Chapter 18. Ethics in Banking and the Financial-Services Industry

Chapter 162 Chapter 16. Theories, Objectives, and Agencies of Bank Regulation Learning Objectives: To understand … 1. Financial modernization and the Gramm-Leach- Bliley Act of 1999 The K in TRICK as the symbolic umbrella of bank regulation Bank regulation in the context of agency theory (principal-agent model) The layers of competition for regulatory services Regulation as a tax and an on-going struggle between regulators and regulatees Good intentions and unintended evils of regulation

Chapter 163 CHAPTER THEME Bank regulators try to serve the conflicting objectives of safety and stability on the one hand and efficient banking structure (competition) on the other hand. The U.S. Congress, acting as agent for taxpayer principals, monitors bank regulators (including deposit insurers), who in turn monitor insured depositories. Monitoring and bonding are costly activities. Since regulation acts as a tax, bankers attempt to pass the incidence of it onto their customers. The struggle between regulators and regulatees, which can be described as the "regulatory dialectic", serves to stimulate financial innovation but at the expense of wasting costly resources.

Chapter 164 An Industry View? “We believe financial institutions should be operated as if there were no regulators for supervision, no discount window for liquidity, and no deposit insurance for bailouts.” John G. Medlin, Jr. Chief Executive Officer (retired) Wachovia Corporation

Chapter 165 What Do Bank Regulators and Deposit Insurers Do? They supervise What? Why? They provide liquidity How? When? They bail out distressed banks How? Why?

Chapter 166 FINANCIAL MODERNIZATION AND THE GRAMM- LEACH-BLILEY (GLB) ACT OF 1999 Purpose of the GLB Act To enhance competition in the financial- services industry by providing a prudential framework for the affiliation of banks, securities firms, insurance companies, and other financial service providers, and for other purposes. Table 16-1 (p.555) list the provisions of the GLB Act

Chapter 167 GLB Act (1999) Meyer [2001]describes the act as having two broad kinds of provisions: 1. Specific and explicit standards for becoming a financial holding company (FHC) 2. Less specific and less explicit standards, with little or no guidance for implementation (e.g., the reasonable holding period for merchant-banking investments) This category involves issues that were more technical and upon which a consensus was more difficult to reach. As a result, as Congress is prone to do, these issues were left to the banking agencies to establish

Chapter 168 Principal-Agent Relations and Regulatory Discipline Principal (monitors =>) Taxpayers Lawmakers Regulators Insured banks Agent Lawmakers Regulators Insured banks Borrowers

Chapter 169 Regulatory Versus Market Discipline Regulatory discipline works through regulatory interference (e.g., the K in TRICK – capital adequacy) Market discipline works through financial markets in terms of the costs of financial distress and the cost of funds (capital)

Chapter 1610 The Objectives of Bank Regulation Safety (protection of “small depositors”) Stability (of the banking/financial system) Contagion and systemic risk Structure (competition and efficiency) IO model Do these objectives conflict?

Chapter 1611 The Federal Safety Net and Too-Big-To-Fail (TBTF) Discuss the roles and effects of … DIDMCA (1980) Continental Illinois (1984) FIRREA (1989) FDICIA (1991) LTCM (1998) GLB (1999)

Chapter 1612 Three Layers of Financial- Services Competition Explicit price User convenience User confidence Modeling the confidence function and the role of government guarantees (an unbooked intangible asset) How does regulation shapes these functions?

Chapter 1613 The Regulatory Dialectic (Struggle Model) Thesis Antithesis Synthesis Historical struggles Interest-rate controls Geographic restrictions Product restrictions

Chapter 1614 Regulation Discussion As a tax Good intentions and unintended evils Jurisdictional tangle of federal regulation The Federal Banking Troika FDIC OCC Fed Role of SEC

Chapter 1615 Strength-in-Banking Equation Strength = New powers + Firm supervision New powers: Innovations driven by TRICK and relaxation of antiquated restrictions Firm supervision Regulatory style: FDICIA’s PCA, RBC requirements, compliance with CRA, adequate capital to get new powers, bank examinations Market style: Market cap, cost of funds, cost of financial distress

Chapter 1616 Large Complex Banking Organizations (LCBOs) and Risk-Focused Supervision Risk exposure => risk management => supervision by risk Contrast and compare (Table 16-9, p. 583) Traditional bank examination Risk-focused supervision of LCBOs

Chapter 1617 Lessons from the Derivatives Debacles of the mid-1990s What’s important for prudential supervision (and risk management) is the underlying risk characteristics of financial instruments Risk must be measured on a portfolio basis rather than instrument by instrument Importance of internal risk controls (e.g., Bankers Trust and Barings) Align financial incentives with managerial objectives

Chapter 1618 CHAPTER SUMMARY Understanding the U.S. federal safety net and how it operates captures the roles of regulation and deposit insurance in the FSI Key concepts include the principal- agent relations of regulatory discipline, the regulatory dialectic, supervision by risk, contagion (systemic risk), IO model

Chapter 1619