Chapter 17 Regulation Of The Financial Institutions’ Sector

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.  Learning Objectives  To explore why financial institutions are one of the most regulated industries in the modern world. To discover the many types of regulation, and to understand how the financial institutions have been affected. To understand how regulation has influenced and shaped the structure of financial-services industries.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction Financial institutions are one of the most heavily regulated businesses in the world. Many economists, financial analysts, and financial institutions have argued that regulation has done more harm than good. Other observers, however, argue that government regulations have achieved some positive results for the financial institutions as well as for the public.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Reasons Behind the Regulation of Financial Institutions Concern for the safety of the public’s funds. To promote public confidence in the system. To ensure equal opportunities and fairness in the public’s access to financial services. To prevent excessive money creation, and hence excessive inflation. To aid “disadvantaged” economic sectors. To ensure that important financial services are provided reliably and at a reasonable cost.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Does Regulation Benefit or Harm Financial Institutions? -Regulations subsidize the growth of financial institutions and protect them from competition. -Regulations tend to increase public confidence. -Regulations spawn innovative escapes (regulatory dialectics) through loopholes in the regulations. Regulations can benefit financial institutions.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Does Regulation Benefit or Harm Financial Institutions? -Regulatory dialectics are not the most productive form of innovation. -The time and energy spent on regulatory compliance activities are costly. Regulations can harm financial institutions.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Regulation of Commercial Banks Due to their importance in the financial system, commercial banks are typically the most regulated of all financial institutions. Responsibility for regulating banks operating in the U.S. today is divided among three federal agencies – the Federal Reserve System, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation – and the state banking commissions of the 50 states.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Federal Reserve System Supervises and regularly examines all member banks operating in the U.S. Imposes reserve requirements on deposits held by all depository institutions and grants temporary loans of reserves through its discount window. Must approve all applications of member banks to merge, establish branches, or exercise trust powers.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Federal Reserve System Supervises international banking corporations organized by U.S. banks and foreign banks operating in the U.S. Regulates and examines all bank and financial holding companies in the U.S. Conducts monetary policy to control the growth of money and credit in the financial system.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Office of the Comptroller of the Currency Issues charters for new national banks. Regulates and regularly examines all national banks. Must approve all national banks’ applications for new branch offices, trust powers, mergers, and consolidations. Declares insolvent national banks closed.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Federal Deposit Insurance Corporation Insures deposits of savings institutions (thrifts) and banks conforming to its regulations up to $100,000, and acts as receiver for all national banks declared insolvent and for state banks if requested by a state banking commission. Must approve applications by insured banks to set up branches, merge or exercise trust powers Requires all insured banks to submit reports on their financial condition..

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. State Banking Commissions Issue charters for new state banks. Supervise and regularly examine all state-chartered banks. Approve applications by state banks to form a holding company, acquire subsidiaries, or establish branches. Declare insolvent state-chartered banks closed and appoint a receiver to liquidate or otherwise dispose of the assets of failed state banks.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Opening Competition Across Political Boundaries The new geographic markets that banks can enter have been tightly controlled. It was believed, until quite recently, that “too much competition” could lead to excess volatility in bank profits and introduce instability into the nation’s banking system, thereby endangering the savings of depositors.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Opening Competition Across Political Boundaries

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Opening Competition Across Political Boundaries

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Opening Competition Across Political Boundaries The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation of the Services Banks Can Offer Regulations controlling the services banks can offer have also been tight out of concern for bank safety and a desire to protect certain nonbank financial institutions from tough bank competition. -Glass-Steagall Act (Banking Act) (1933) -Financial Services Modernization (Gramm-Leach-Bliley) Act (1999)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Gramm-Leach-Bliley Act The Financial Services Modernization (Gramm-Leach-Bliley) Act permitted banks to affiliate with security underwriting firms, insurance companies, and selected other types of businesses, through financial holding companies (FHCs) or a subsidiary structure. This law opened up the United States for the first time in more than half a century to universal or multidimensional banking.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Rise of Disclosure Laws in Banking One rapidly expanding area of U.S. banking regulation today concerns disclosure rules. -Truth in Lending Act (1968) -Home Mortgage Disclosure Act (1975) -Community Reinvestment Act (1977) -Truth in Savings Act (1991) -FDIC Improvement Act (1991) -Financial Services Modernization (Gramm-Leach-Bliley) Act (1999)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Growing Importance of Capital Regulation in Banking Another major trend reshaping the regulation of banks and other financial institutions today centers upon their capital. -Basel I Agreement (1988) -FDIC Improvement Act (1991) -Basel II Agreement (2007 or 2008)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Growing Importance of Capital Regulation in Banking The Basel I Agreement stipulated that:

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Growing Importance of Capital Regulation in Banking While Basel I was directed at measuring credit risk primarily, Basel II brings in refined estimates of market risk exposure and adds new capital requirements for operational risk. Banks that qualify for the Basel II approach will be allowed to develop their own internal models of risk assessment (the internal-ratings-based approach) and use those models to calculate their own risk exposure and capital requirements.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Unfinished Agenda for Banking Regulation Slowly, banking is experiencing an era of deregulation, as legal constraints are lifted on a variety of banking activities. Supervision of financial institutions in the future will rest primarily upon: -government examinations (of market data and the firms’ risk management systems) -capital requirements, and -market discipline.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Regulation of Thrift Institutions Credit Unions -Chartering: National Credit Union Administration (NCUA) / state -New branches: No approval required -Mergers & acquisitions: NCUA / state -Deposit insurance: NCUA Share Insurance Fund / state -Supervision: NCUA / state -Depository Institutions Deregulation and Monetary Control Act (1980)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Regulation of Thrift Institutions Savings and Loan Associations -Chartering: Office of Thrift Supervision (OTS) / state -New branches: OTS / FDIC / state -Mergers & acquisitions: OTS / FDIC / state -Deposit insurance: FDIC / state -Supervision: OTS / state -Financial Institutions Reform, Recovery and Enforcement Act (1989) -FDIC Improvement Act (1991)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Regulation of Thrift Institutions

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Regulation of Thrift Institutions Savings Banks -Chartering: Office of Thrift Supervision (OTS) / state -New branches: OTS / state -Mergers & acquisitions: OTS / FDIC / state -Deposit insurance: FDIC / state -Supervision: FDIC / state

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Regulation of Thrift Institutions Money Market Funds -Chartering: Securities and Exchange Commission (SEC) -New branches: No approval required -Mergers & acquisitions: No approval required -Deposit insurance: no government insurance -Supervision: SEC (selected activities)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Regulation of Insurance Companies While not quite as heavily regulated as commercial banks, insurance intermediaries face tough regulatory rules that are imposed primarily by state insurance commissions.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Regulation of Pension Funds Because pension funds have risen rapidly to hold the bulk of the retirement savings of workers, they are heavily regulated by the courts and government agencies today. -Employee Retirement Income Security Act (1974) -Pension Benefit Guaranty Corporation, or “Penny Benny” (a federal agency)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Regulation of Finance Companies The bulk of regulation of finance companies is at the state level and focuses principally upon the making of consumer loans.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Regulation of Investment Companies Investment companies or mutual funds are regulated predominantly by the federal government in the U.S. -Securities and Exchange Commission -Investment Company and Investment Advisers Acts (1940)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Trends in The Regulation of Financial Institutions Regulation seeks to promote the safety and stability of financial institutions in order to preserve the confidence of the public and avoid institutional failures. However, regulation can become a costly burden that significantly increases the operating costs of financial institutions and limits the cleansing effects of failure and competition.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Trends in The Regulation of Financial Institutions Increasingly, -market discipline is playing a bigger role, -regulators are cooperating more (because the distinctions between the financial institutions are blurring), -the focus of regulation is moving away from control over the services offered and geographic expansion to controlling risk taking, and -there is increasing attention to public disclosure.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Markets on the Net Bank for International Settlements at Canadian Department of Finance at Conference of State Bank Supervisors at European Union at Federal Deposit Insurance Corporation at

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Markets on the Net Federal Financial Institutions Examination Council at Federal Reserve System at Federal Trade Commission at National Credit Union Administration at

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Markets on the Net Office of the Comptroller of the Currency at Office of Thrift Supervision at Securities and Exchange Commission at

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Introduction to Financial Institutions’ Regulation The Reasons Behind the Regulation of Financial Institutions -Does Regulation Benefit or Harm Financial Institutions?

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review The Regulation of Commercial Banks -The Federal Reserve System -Office of the Comptroller of the Currency -Federal Deposit Insurance Corporation -State Banking Commissions -Opening Competition Across Political Boundaries -Regulation of the Services Banks Can Offer -The Gramm-Leach-Bliley Act

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review The Regulation of Commercial Banks … continued -The Rise of Disclosure Laws in Banking -The Growing Importance of Capital Regulation in Banking -The Unfinished Agenda for Banking Regulation

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review The Regulation of Thrift Institutions -Credit Unions -Savings and Loans -Savings Banks -Money Market Funds The Regulation of Insurance Companies The Regulation of Pension Funds

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review The Regulation of Finance Companies The Regulation of Investment Companies An Overview of Trends in the Regulation of Financial Institutions