1 The Economics of Financial Regulation Chapter 11

Chapter 11 Learning Objectives List the three layers of regulation for nationally chartered banks Explain the purpose of the McFadden Act and of the Glass-Steagall Act Describe the market failures that regulation attempts to solve Discuss loophole mining, lobbying and regulatory capture Discuss the pros and cons of deposit insurance List the two ways the FDIC can deal with a failed bank Discuss the three pillars of bank regulation 2

FIGURE 1 Time Line of the Early History of Commercial Banking in the United States 3

4 Bank Supervision Three layers of supervision for nationally chartered bank: 1863 Comptroller of Currency 1913 Federal Reserve 1933 FDIC

5 Restrictions on Competition McFadden Act Glass Steagall Goldman Sachs decision to become a bank holding company.

Market Failure Adverse selection (the lemons problem) Negative externalities 6

Downside of regulation Loophole mining and lobbying Regulators not acting in the public interest 7

Regulatory Capture Regulators are overly influenced by those they are supposed to regulate. 8

Blue Sky Laws Strict laws about what securities could be sold to the public Believed to be veiled attempts by bankers to protect their turf 9

Government Safety Net Emergency legislation March Bank failures : 2000/year : 15/year When bank fails, two things can happen … PAY OFF or PURCHASE & ASSUMPTION “ Too Big to Fail ” (relate to consolidation) 10

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Regulation Q Ceiling on interest rates that can be paid on deposits. Led to disintermediation in the inflationary 1970’s 12

13 FDIC Improvement Act (1991) Prompt corrective action Limited brokered deposits Renounced too-big-to-fail Supervision of foreign banks in U.S Risk based premiums

Three Pillars of Bank Regulation Capital Supervisory Review Market Discipline 14

15 Capital Requirements Leverage ratio = capital/assets > 5% Basel III: capital = 10-13% of risk adjusted assets (assets are weighted by risk factor) Regulatory arbitrage

16 CAMELS Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk

17 2. Restrictions on Assets No securities related activities except … Treasurys, municipals, government agency securities Foreign exchange Derivatives Commercial paper underwriting