Bank History and Regulation

Economics Adam Smith and the “Invisible hand”  As individuals pursue their self interest, they promote the well-being of everyone.  19 th century example: British making loans to build railroads in U.S. What problems might prevent the invisible hand from operating? (market failure) Role of Intermediaries Role of government

Adverse Selection: Akerlof (1970) Adverse Selection: poor quality products are attracted to markets Buyers are willing to pay  $15,000 for good used car  $ 7,500 for a “lemon” Many Sellers  50% good cars: willing to take $12,500  50% bad cars: willing to take $7,500

Adverse Selection Buyers have no information about car quality – 50/50 proposition  On average, expect to get a car worth 0.50(7,500)+0.50(15,000) = $11,250  Buyers will not pay more than $11,250 for any car. Good cars exit market All bad cars sold for $7,500 Good sellers can’t credibly claim to be “good” Market Failure

Adverse Selection Adverse Selection in Financial Markets  Firms needing capital Solution  Create more information Disclosure requirements (regulation)  Use financial intermediaries who can monitor Restrictions on entry Disclosure requirements

Moral Hazard Moral hazard: Incentives change after transaction takes place.  When insured, take more risks  Once financed, tendency to slack Example:  CEO buys corporate jet with stock issue  Banks invest depositor money in risky ventures

Moral Hazard Solution  financial markets Align incentives of CEO with shareholders  Use financial intermediaries who can monitor Regulation on assets and activities (regulation)

Other issues Financial intermediaries also promote the invisible hand by: Lowering transaction costs  Economies of scale Promoting risk sharing  Pooling capital  Hedging expertise

Ch 10 – History of Banks Crazy complex system of regulation  Comptroller of the currency  Federal Reserve  State Banking Authorities When faced with regulation, banks develop methods to avoid costs

History of Banks American’s have distrusted big banks 19 th Century: states issued charters to banks  Raised funds by issuing own currency  No regulation – often failed 1863 – National Bank Act  Established national banks chartered by federal gov  Heavy tax on bank notes issued by state banks  State banks survived by acquiring funds through deposits  Dual banking system

Central Banking 1913: Federal Reserve System Created  National Banks required to become members of the Federal Reserve System  Central Bank Established  State Banks allowed option to join Most did not

Structure of Banking Industry McFadden Act of 1927  No branching across state lines  National Banks had to conform to state regulations and could only branch in their home state Glass-Steagall Act of 1933  Separation of I-Banks from Commercial Banks

Glass-Steagall Act (1933) I-banking activities of commercial banks blamed for bank failures during Great Depression Investment bank:  Raises capital by “underwriting” securities  Advises on merger activities  Research and brokerage services  Security Dealers

Glass-Steagall Act (1933) Separation of I-Banks from Commercial Banks  Commercial Banks Prohibited from underwriting or dealing in securities Limited banks to debt securities approved by regulators  Investment Banks Prohibited from commercial banking activities

Erosion of Glass-Steagall Banks at a competitive disadvantage  Good economy – people invest in securities  Bad economy – people turn to traditional banks  Barriers to “economies of scope” Financial Innovation:  Brokerage firms develop money market mutual funds. Pressure from Federal Reserve  Used loopholes in system to allow commercial banks to engage in limited underwriting  Allowed Citicorp and Travelers to merge

Gramm-Leach Bliley (1999) Allows I-banks to purchase commercial banks Allows commercial banks to underwrite insurance and securities.

Erosion of McFadden Act Bank Holding Companies  Holding company can own banks across state lines ATM’s owned by someone other than the banks. Mcfadden repealed by Riegle-Neal act of 1994  Has led to consolidation trend

Decline of Traditional Banking Traditional Banking  Make long-term loans  Fund them by making short-term deposits Greater Competition for Deposits  Regulation Q Maximum interest paid on deposits about 5% Can’t pay interest on checking accounts  Rise in inflation in 1960’s: higher rates  Money Market Mutual Funds

Decline of Traditional Banking Greater Competition for Assets  Junk Bonds  Commercial paper  Securitization Bank’s responses:  Pursue riskier activities  Pursue off-balance sheet activities Loan sales Fee’s for services: fx trades, loan commitments, banker’s acceptances

Ch 11 – Bank Regulation Banks solve some asymmetric info problems  but create others – depositors need to monitor and evaluate banks Regulation deals with asymmetric info problems  But creates others – provide insurance and perform other activities that may promote moral hazard

Government Safety net Free rider problem faced by depositors Adverse selection and bank panics  1819, 1937, 1857, 1873, 1884, 1893, 1907, Deposit Insurance: FDIC insurance  Moral Hazard – depositors have no incentive to monitor  “Too Big to Fail”

Restrictions on Bank Asset Ownership Commercial Banks: High quality corporate bonds are allowed but subject to restrictions Common stock investment is allowed in subsidiaries of banks or bank holding companies that are legally separate entities  Gramm-Leach-Bliley (1999) Except in rare instances, banks restrict themselves to “investment-grade” securities (high rated bonds)  “prudent man” rule of law: The fiduciary is required to invest trust assets as a "prudent man" would invest his own property

Other Regulations Capital requirements  Basel Accord: banks must hold at least 8% of “risk- weighted” assets and off-balance sheet items. Bank Supervision Supervision of Risk Management Disclosure Requirements

How Good Are the Regulators? Burst of Financial innovation in 1960’s and 1970’s Banks have incentive to engage in riskier activities – further fueled by deposit insurance. New legislation in early 1980’s:  S&L’s and Mutual Savings allowed 40% of assets in commercial real estate loans 30% in consumer lending 10% in commercial loans and leases 10% in “direct investments”: junk bonds, common stock, etc.  FDIC up from $40k to $100k  Phased out Regulation Q

How Good Are the Regulators? S&L’s regulated by Federal Savings and Loan Incorporation (FSLIC) which lacked the expertise to monitor effectively. Rising rates further increased moral hazard.  S&L’s bread and butter was fixed-rate mortgages. Regulators refrained from closing insolvent S&L’s  Further increased moral hazard Bank Failures increased dramatically

How Good Are the Regulators? Financial Institutions Reform, Recovery, and Enforcement Act of 1989  Rearranged how banks are regulated  Infusion of capital to bailout insolvent institutions  New restrictions on asset holdings of S&L’s  Increased capital requirements FDIC Improvement Act of 1991  Increased FDIC’s ability to borrow from treasury  FDCI charge higher deposit insurance premiums