Economic Analysis of Banking Regulation Chapter 11

Stuff  Review Sheet  Test chapters: 6, 8, 9, 10, 11, 12  Wed, Ricketts 203, 7:00  No homework due  Commercial Paper  Review Sheet  Test chapters: 6, 8, 9, 10, 11, 12  Wed, Ricketts 203, 7:00  No homework due  Commercial Paper

7 ways banks are regulated  FDIC  Regulators restrict assets  Minimum bank capital requirements  Chartered and Auditied  Disclosure Req’t  Consumer Protection  Restrictions on Competition  FDIC  Regulators restrict assets  Minimum bank capital requirements  Chartered and Auditied  Disclosure Req’t  Consumer Protection  Restrictions on Competition

1) FDIC Regulation  Bank panic ‘cycles’ every 20 years  1920’s: 600 insolvencies/year  : 2000 insolvencies/year  : 15 insolvencies/year  FDIC closes insolvent banks (G-S, 1933)  Payoff method  Purchase and Assumption of bad debt method  Used to be the most popular  Bank panic ‘cycles’ every 20 years  1920’s: 600 insolvencies/year  : 2000 insolvencies/year  : 15 insolvencies/year  FDIC closes insolvent banks (G-S, 1933)  Payoff method  Purchase and Assumption of bad debt method  Used to be the most popular

FDIC and Moral Hazard  Depositors: no incentive to monitor bank mgmt. loan decisions  Bankers: no worries about bad loan decisions causing savers to lose saving  “Too big to fail” policy Taxpayers pay  Glass-Steagall implications  Depositors: no incentive to monitor bank mgmt. loan decisions  Bankers: no worries about bad loan decisions causing savers to lose saving  “Too big to fail” policy Taxpayers pay  Glass-Steagall implications

2) Regulators Restrict Assets  E.g. no common stock allowed  Limits on risky loans  E.g. no common stock allowed  Limits on risky loans

3) Minimum Bank Capital Req’t  Traditional measure: Leverage Ratio  Bank Capital/Assets (inverse of equity multiplier!!)  Greater than 5%: well capitalized  Less than 3%: Trouble!  Basel Accord (1988) - International  Hold 8% of ‘risk-adjusted’ assets  Zero-weight: gov. securities  20% weight: claims on banks  50% weight: residential mortgages and municipal bonds  100% weight: loans to consumers and corporations  Regulatory Arbitrage  Fed in ‘96: 3 times max capital that could be lost in 10 days  Traditional measure: Leverage Ratio  Bank Capital/Assets (inverse of equity multiplier!!)  Greater than 5%: well capitalized  Less than 3%: Trouble!  Basel Accord (1988) - International  Hold 8% of ‘risk-adjusted’ assets  Zero-weight: gov. securities  20% weight: claims on banks  50% weight: residential mortgages and municipal bonds  100% weight: loans to consumers and corporations  Regulatory Arbitrage  Fed in ‘96: 3 times max capital that could be lost in 10 days

4) Banks chartered, audited  Criteria  Mgmt. adequacy  Likely earnings  Adequacy of capital  Effect on competition (pre-1980)  Examination:  Quarterly ‘call reports’  Annual Exams  Assets Risky? Get rid of them!  Worthless Loans? Write them down!  Capital Inadequate? Figure out new strategy!  Criteria  Mgmt. adequacy  Likely earnings  Adequacy of capital  Effect on competition (pre-1980)  Examination:  Quarterly ‘call reports’  Annual Exams  Assets Risky? Get rid of them!  Worthless Loans? Write them down!  Capital Inadequate? Figure out new strategy!

CAMEL Rating  Credit risk of bank assessed  Enough collateral? Enough L-T relationships? Enough screening?  Acronym  Capital Adequacy  Asset quality  Management (oversight of board, internal policies)  Earnings  Liquidity  Sensitivity  IR rate assessed (Gap and Duration analysis)  Stress testing, etc.  Credit risk of bank assessed  Enough collateral? Enough L-T relationships? Enough screening?  Acronym  Capital Adequacy  Asset quality  Management (oversight of board, internal policies)  Earnings  Liquidity  Sensitivity  IR rate assessed (Gap and Duration analysis)  Stress testing, etc.

5) Disclosure Requirements  Accounting standards  Annual reports  Risk level disclosure  Disclose information about riskiest assets  New Zealand: if full disclosure, then no examination necessary  Accounting standards  Annual reports  Risk level disclosure  Disclose information about riskiest assets  New Zealand: if full disclosure, then no examination necessary

6) Consumer Protection  Truth in Lending Act (1969)  Standardization and disclosure of lending terms  Fair Credit Billing Act amendment (1974)  Extends to credit cards  Billing errors, mechanism for appeal  Equal Equal Credit Opportunity Act (1976)  Community Reinvestment Act (1977)  Invest in neighborhood in which you accept deposits  Truth in Lending Act (1969)  Standardization and disclosure of lending terms  Fair Credit Billing Act amendment (1974)  Extends to credit cards  Billing errors, mechanism for appeal  Equal Equal Credit Opportunity Act (1976)  Community Reinvestment Act (1977)  Invest in neighborhood in which you accept deposits

7) Competition restriction  Branching  Banks can’t be in security industry  Security, insurance can’t be in banking  Branching  Banks can’t be in security industry  Security, insurance can’t be in banking

International Banking Regulation  Similar to U.S.  Country hopping, no overarching regulatory organization  BCCI collapse (1991)  7th largets bank in world at peak  Value of 20m, when audited in ‘91, only 10m!  “Registered” in Luxembourg  Laundering, bribery, arms trafficking, nuclear technologies, etc.  Intentionally avoided detection: had its own shipping and trading company, intelligence agency, etc.  Similar to U.S.  Country hopping, no overarching regulatory organization  BCCI collapse (1991)  7th largets bank in world at peak  Value of 20m, when audited in ‘91, only 10m!  “Registered” in Luxembourg  Laundering, bribery, arms trafficking, nuclear technologies, etc.  Intentionally avoided detection: had its own shipping and trading company, intelligence agency, etc.

Savings and Loan Crisis  Largest banking crisis since the depression  $500 billion dollar bailout over 40 years: still paying for it!  Good example of:  Deregulation vs. regulation  Moral Hazard  Bank management  Largest banking crisis since the depression  $500 billion dollar bailout over 40 years: still paying for it!  Good example of:  Deregulation vs. regulation  Moral Hazard  Bank management

Early Causes  Innovations in the ‘60s and 70’s, had to be riskier  FSLIC: bank mgmt indifferent to taking risk  Deregulation  DIDMCA 1980  Garn- St. Germain Act 1982  Increased FSLIC insurance from 40K to 100K  Can put 40% in commercial real estate loans  30% in consumer lending  10% in junk bonds or direct investments  Innovations in the ‘60s and 70’s, had to be riskier  FSLIC: bank mgmt indifferent to taking risk  Deregulation  DIDMCA 1980  Garn- St. Germain Act 1982  Increased FSLIC insurance from 40K to 100K  Can put 40% in commercial real estate loans  30% in consumer lending  10% in junk bonds or direct investments

More early causes  Recession of ‘80, ‘81  Brokered deposits  Large denomination CD sold to brokerage  Cut into smaller FSLIC covered deposits  Remove incentive for large depositors to monitor lending practices of bankers (covered through innovation!)  By 1982, 50% of S&L’s were insolvent!!!  Recession of ‘80, ‘81  Brokered deposits  Large denomination CD sold to brokerage  Cut into smaller FSLIC covered deposits  Remove incentive for large depositors to monitor lending practices of bankers (covered through innovation!)  By 1982, 50% of S&L’s were insolvent!!!

Resulting Problems  Managers did not have experience with this expanded risk portfolio  Regulators didn’t have the breadth, capacity, or experience to regulate  Result  Moral hazard by managers  Conflict of interest by regulators  Principal/Agent problem by politicians  Asymmetric Information with public  Managers did not have experience with this expanded risk portfolio  Regulators didn’t have the breadth, capacity, or experience to regulate  Result  Moral hazard by managers  Conflict of interest by regulators  Principal/Agent problem by politicians  Asymmetric Information with public

Regulatory Forbearance by FHLB, FSLIC  Refrained from closing insolvent banks  Irregular accounting allowed (goodwill)  Why? Conflict of interest  Not enough money to close (payoff/assumption)  Don’t want to offend politicians  Protect reputation  FHLB established to encourage growth of S&L industry, not shut it down  Refrained from closing insolvent banks  Irregular accounting allowed (goodwill)  Why? Conflict of interest  Not enough money to close (payoff/assumption)  Don’t want to offend politicians  Protect reputation  FHLB established to encourage growth of S&L industry, not shut it down

Zombie S&L’s: The Living Dead  Bankrupt (negative bank capital) but still operating  Had nothing to lose, moral hazard  ‘Bad’ S&L’s gave high interest on deposits, taking business from ‘Good’ S&L’s  Negative feedback loop  ‘87 legislation  Provided only $11 billion to back up losses, but…  Directed FHLB to CONTINUE regulatory forbearance  Bankrupt (negative bank capital) but still operating  Had nothing to lose, moral hazard  ‘Bad’ S&L’s gave high interest on deposits, taking business from ‘Good’ S&L’s  Negative feedback loop  ‘87 legislation  Provided only $11 billion to back up losses, but…  Directed FHLB to CONTINUE regulatory forbearance

Politician Principal Agent  Hide problems from taxpayers, hoping it will go away  Career oriented  Close relationships with industry insiders (conflict of interest)  The Keating Five  Charles Keating, owner of Lincoln S&L, insolvent  Purchases 600M in junk bond to try to escape  Big contributor to congressmen, tell regulators to leave him alone  ‘89 collapse, $2.6 billion loss payed by taxpayers  3 senators not re-elected after reprimanded  Hide problems from taxpayers, hoping it will go away  Career oriented  Close relationships with industry insiders (conflict of interest)  The Keating Five  Charles Keating, owner of Lincoln S&L, insolvent  Purchases 600M in junk bond to try to escape  Big contributor to congressmen, tell regulators to leave him alone  ‘89 collapse, $2.6 billion loss payed by taxpayers  3 senators not re-elected after reprimanded

FIRREA (1989) - The Bailout  Regulatory Structure Revised  FSLIC and FHLB abolished  Treasury Dept. takes over (Office of Thrift Supervision)  Resolution Trust Corporation  Seizes assets of 25% of S&L  Sells $450B of assets of failed S&L  Fed gov’t issues bonds for $150B deficit  S&L regulations imposed again  70% must be housing, no junk bonds, leverage 8%  Regulators have power to remove bank mgrs., impose penalties, issue cease and desist legal action  Regulatory Structure Revised  FSLIC and FHLB abolished  Treasury Dept. takes over (Office of Thrift Supervision)  Resolution Trust Corporation  Seizes assets of 25% of S&L  Sells $450B of assets of failed S&L  Fed gov’t issues bonds for $150B deficit  S&L regulations imposed again  70% must be housing, no junk bonds, leverage 8%  Regulators have power to remove bank mgrs., impose penalties, issue cease and desist legal action

FDICIA (1991) - Insurance  No more brokered deposits  Limited “to big to fail” policy  Another money infusion from Treasury to cover S&L losses  Corrective action provisions: FDIC MUST intervene early if a bank is getting into trouble  No more brokered deposits  Limited “to big to fail” policy  Another money infusion from Treasury to cover S&L losses  Corrective action provisions: FDIC MUST intervene early if a bank is getting into trouble

Future proposed reforms  Limit deposit insurance to 90% of deposits  Outlaw regulatory forbearance  Value bank capital at cost, not market (see today’s WSJ!)  Consolidate regulatory agencies  As of Dec. 2006, bank insurance fund and savings and loan insurance fund became deposit insurance fund  Limit deposit insurance to 90% of deposits  Outlaw regulatory forbearance  Value bank capital at cost, not market (see today’s WSJ!)  Consolidate regulatory agencies  As of Dec. 2006, bank insurance fund and savings and loan insurance fund became deposit insurance fund

World Banking Crises  Scandinavia  Russia  Japan  China  East Asian ‘Tigers’  Latin America  Argentina  Scandinavia  Russia  Japan  China  East Asian ‘Tigers’  Latin America  Argentina