©2009, The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Thirteen Regulation of Commercial Banks

©2009, The McGraw-Hill Companies, All Rights Reserved 13-2 McGraw-Hill/Irwin Commercial Banks Commercial banks provide many unique services –information, liquidity, price-risk reduction, transaction cost, maturity intermediation, and payment services –money supply transmission, credit allocation, intergenerational wealth transfers, and denomination intermediation Failure to provide these services can be costly to both users and suppliers of funds Accordingly, commercial banks are regulated at the federal (and sometimes state) level Commercial banks provide many unique services –information, liquidity, price-risk reduction, transaction cost, maturity intermediation, and payment services –money supply transmission, credit allocation, intergenerational wealth transfers, and denomination intermediation Failure to provide these services can be costly to both users and suppliers of funds Accordingly, commercial banks are regulated at the federal (and sometimes state) level

©2009, The McGraw-Hill Companies, All Rights Reserved 13-3 McGraw-Hill/Irwin Commercial Bank Regulation Safety and soundness regulation –assets must be diversified: cannot make loans greater than 10% of their equity capital to any one borrower –must maintain adequate equity capital levels to protect against insolvency risk –provision of guarantee funds such as the Deposit Insurance Fund (DIF) protects depositors in the event of default and prevents bank runs –monitoring and surveillance: banks must submit (publicly accessible) quarterly reports and are subject to on-site examinations Safety and soundness regulation –assets must be diversified: cannot make loans greater than 10% of their equity capital to any one borrower –must maintain adequate equity capital levels to protect against insolvency risk –provision of guarantee funds such as the Deposit Insurance Fund (DIF) protects depositors in the event of default and prevents bank runs –monitoring and surveillance: banks must submit (publicly accessible) quarterly reports and are subject to on-site examinations

©2009, The McGraw-Hill Companies, All Rights Reserved 13-4 McGraw-Hill/Irwin Commercial Bank Regulation Monetary policy regulation –the Central Bank (the Federal Reserve) directly controls the quantity of notes and coin (i.e., outside money) in the economy –however, the bulk of the money supply is held as bank deposits, called inside money –regulators require cash reserves to be held at commercial banks Monetary policy regulation –the Central Bank (the Federal Reserve) directly controls the quantity of notes and coin (i.e., outside money) in the economy –however, the bulk of the money supply is held as bank deposits, called inside money –regulators require cash reserves to be held at commercial banks

©2009, The McGraw-Hill Companies, All Rights Reserved 13-5 McGraw-Hill/Irwin Commercial Bank Regulation Credit allocation regulation –regulators encourage (and often require) lending to socially important sectors of the economy (e.g., housing and farming) –usury laws cap interest rates that can be charged on loans Investor protection regulation –protects investors against insider trading, lack of disclosure, malfeasance, and breach of fiduciary responsibility Credit allocation regulation –regulators encourage (and often require) lending to socially important sectors of the economy (e.g., housing and farming) –usury laws cap interest rates that can be charged on loans Investor protection regulation –protects investors against insider trading, lack of disclosure, malfeasance, and breach of fiduciary responsibility

©2009, The McGraw-Hill Companies, All Rights Reserved 13-6 McGraw-Hill/Irwin Commercial Bank Regulation Entry and chartering regulation –the entry of commercial banks is regulated –the permissible activities of commercial banks are defined by regulators –the barriers to entry and the scope of permissible activities allowed affects the charter values of banks and the size of the net regulatory burden The net regulatory burden is the difference between the costs of regulations and the benefits for the producers of financial services Entry and chartering regulation –the entry of commercial banks is regulated –the permissible activities of commercial banks are defined by regulators –the barriers to entry and the scope of permissible activities allowed affects the charter values of banks and the size of the net regulatory burden The net regulatory burden is the difference between the costs of regulations and the benefits for the producers of financial services

©2009, The McGraw-Hill Companies, All Rights Reserved 13-7 McGraw-Hill/Irwin Commercial Bank Regulation Regulators –the Federal Deposit Insurance Corporation (FDIC) –the Office of the Comptroller of the Currency (OCC) –the Federal Reserve System (FRS) –state agencies The four facets of regulatory structure –regulation of product and geographic expansion –provision and regulation of deposit insurance –balance sheet regulation –off-balance-sheet regulation Regulators –the Federal Deposit Insurance Corporation (FDIC) –the Office of the Comptroller of the Currency (OCC) –the Federal Reserve System (FRS) –state agencies The four facets of regulatory structure –regulation of product and geographic expansion –provision and regulation of deposit insurance –balance sheet regulation –off-balance-sheet regulation

©2009, The McGraw-Hill Companies, All Rights Reserved 13-8 McGraw-Hill/Irwin Product Segmentation Regulation Commercial banking vs. investment banking –commercial banking involves deposit taking and lending –investment banking involves underwriting, issuing, and distributing securities –the Glass-Steagall Act of 1933 imposed a rigid separation between commercial and investment banks –by 1987 commercial banks were allowed to engage in limited investment banking activity through Section 20 affiliates –the Financial Services Modernization Act (FSMA) of 1999 repealed Glass-Steagall Commercial banking vs. investment banking –commercial banking involves deposit taking and lending –investment banking involves underwriting, issuing, and distributing securities –the Glass-Steagall Act of 1933 imposed a rigid separation between commercial and investment banks –by 1987 commercial banks were allowed to engage in limited investment banking activity through Section 20 affiliates –the Financial Services Modernization Act (FSMA) of 1999 repealed Glass-Steagall

©2009, The McGraw-Hill Companies, All Rights Reserved 13-9 McGraw-Hill/Irwin Product Segmentation Regulation Commercial banking vs. insurance underwriting –the Bank Holding Company Act (BHCA) of 1956 restricted insurance companies from owning or being affiliated with commercial banks –the FSMA of 1999 now allows bank holding companies to open insurance underwriting affiliates and also allows insurance companies to open banks Commercial banks and commerce –the BHCA of 1956 restricts commercial firms from acquiring banks –the 1970 Amendment to the BHCA requires banks to divest nonbank related subsidiaries Commercial banking vs. insurance underwriting –the Bank Holding Company Act (BHCA) of 1956 restricted insurance companies from owning or being affiliated with commercial banks –the FSMA of 1999 now allows bank holding companies to open insurance underwriting affiliates and also allows insurance companies to open banks Commercial banks and commerce –the BHCA of 1956 restricts commercial firms from acquiring banks –the 1970 Amendment to the BHCA requires banks to divest nonbank related subsidiaries

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Geographic Expansion Regulation Restrictions on intrastate banking –most banks used to be unit banksi.e., banks with single offices –by 1997 only six states restricted intrastate branching Restrictions on interstate banking –the McFadden Act of 1927 (amended in 1933) restricted national banks from branching across state lines as a result, the largest banks were set up as multibank holding companies (MBHCs) an MBHC is a parent banking organization that owns a number of individual bank subsidiaries Restrictions on intrastate banking –most banks used to be unit banksi.e., banks with single offices –by 1997 only six states restricted intrastate branching Restrictions on interstate banking –the McFadden Act of 1927 (amended in 1933) restricted national banks from branching across state lines as a result, the largest banks were set up as multibank holding companies (MBHCs) an MBHC is a parent banking organization that owns a number of individual bank subsidiaries

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Geographic Expansion Regulation –the Douglas Amendment to the BHCA of 1956 let states regulate MBHC expansion subsidiaries established prior to the passage of the amendment were considered grandfathered and not subject to the law –the 1970 Amendment to the BHCA of 1956 restricted the nonbank activities that one bank holding companies (OBHCs) could engage in a OBHC is a parent banking organization that owns one bank subsidiary and nonbank subsidiaries –the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 allows consolidation of out-of-state bank subsidiaries into a branch network and allows interstate mergers and acquisitions –the Douglas Amendment to the BHCA of 1956 let states regulate MBHC expansion subsidiaries established prior to the passage of the amendment were considered grandfathered and not subject to the law –the 1970 Amendment to the BHCA of 1956 restricted the nonbank activities that one bank holding companies (OBHCs) could engage in a OBHC is a parent banking organization that owns one bank subsidiary and nonbank subsidiaries –the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 allows consolidation of out-of-state bank subsidiaries into a branch network and allows interstate mergers and acquisitions

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Deposit Guarantee Funds The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to maintain the stability of the U.S. banking system –worked well until 1979 –from October 1979 to October 1982 the Fed targeted bank reserves and let interest rates rise dramatically –led to disintermediationi.e., the withdrawal of deposits from depository institutions and their reinvestment elsewhere –problems were exacerbated by a policy of regulatory forbearancei.e., a policy of not closing economically insolvent depository institutions, but allowing their continued operation The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to maintain the stability of the U.S. banking system –worked well until 1979 –from October 1979 to October 1982 the Fed targeted bank reserves and let interest rates rise dramatically –led to disintermediationi.e., the withdrawal of deposits from depository institutions and their reinvestment elsewhere –problems were exacerbated by a policy of regulatory forbearancei.e., a policy of not closing economically insolvent depository institutions, but allowing their continued operation

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Deposit Guarantee Funds The FDIC Improvement Act (FDICIA) of 1991 restructured the Bank Insurance Fund (BIF) The demise of the Federal Savings and Loan Insurance Corporation (FSLIC) –the FSLIC insured savings institutions from 1934 to 1989 –savings institutions failures in the 1980s led to an insolvent FSLIC by 1989 The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 –dissolved the FSLIC and transferred its management to the FDIC –created the Savings Association Insurance Fund (SAIF) The FDIC Improvement Act (FDICIA) of 1991 restructured the Bank Insurance Fund (BIF) The demise of the Federal Savings and Loan Insurance Corporation (FSLIC) –the FSLIC insured savings institutions from 1934 to 1989 –savings institutions failures in the 1980s led to an insolvent FSLIC by 1989 The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 –dissolved the FSLIC and transferred its management to the FDIC –created the Savings Association Insurance Fund (SAIF)

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Deposit Guarantee Funds The FDIC introduced risk-based deposit insurance premiums in January of 1993 –by 1996 the safest institutions insured by the BIF paid no deposit insurance premiums –by 1997 the safest institutions insured by the SAIF paid no deposit insurance premiums –by the early 2000s over 90% of depository institutions were in the safe category that paid no deposit insurance premium In March 2005 the BIF and the SAIF were merged into one Deposit Insurance Fund (DIF) In January 2007 the FDIC began a more aggressive insurance system where all institutions pay into the fund The FDIC introduced risk-based deposit insurance premiums in January of 1993 –by 1996 the safest institutions insured by the BIF paid no deposit insurance premiums –by 1997 the safest institutions insured by the SAIF paid no deposit insurance premiums –by the early 2000s over 90% of depository institutions were in the safe category that paid no deposit insurance premium In March 2005 the BIF and the SAIF were merged into one Deposit Insurance Fund (DIF) In January 2007 the FDIC began a more aggressive insurance system where all institutions pay into the fund

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Balance Sheet Regulation Liquidity regulation –banks must hold minimum levels of reserves against net transaction accounts –ensures that banks can meet required payments on liability claims such as deposit withdrawals –see Appendix 13c for more details Capital adequacy regulation –since 1987 U.S. commercial banks have faced two different capital requirements Tier I capital risk-based ratio Total capital (Tier I + Tier II) risk-based ratio Liquidity regulation –banks must hold minimum levels of reserves against net transaction accounts –ensures that banks can meet required payments on liability claims such as deposit withdrawals –see Appendix 13c for more details Capital adequacy regulation –since 1987 U.S. commercial banks have faced two different capital requirements Tier I capital risk-based ratio Total capital (Tier I + Tier II) risk-based ratio

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Balance Sheet Regulation Capital adequacy regulation (continued) –Tier I capital is composed of the book value of common equity plus an amount of perpetual preferred stock plus minority equity interests held by the bank in subsidiaries minus goodwill –Tier II capital includes secondary capital resources such as loan loss reserves and convertible and subordinated debt –risk-adjusted assets include both on- and off-balance-sheet assets whose values are adjusted for approximate credit risk –the total risk-based capital ratio is equal to the sum of Tier I and Tier II capital divided by risk-adjusted assets –the Tier I (core) capital ratio is equal to Tier I capital divided by risk-adjusted assets Capital adequacy regulation (continued) –Tier I capital is composed of the book value of common equity plus an amount of perpetual preferred stock plus minority equity interests held by the bank in subsidiaries minus goodwill –Tier II capital includes secondary capital resources such as loan loss reserves and convertible and subordinated debt –risk-adjusted assets include both on- and off-balance-sheet assets whose values are adjusted for approximate credit risk –the total risk-based capital ratio is equal to the sum of Tier I and Tier II capital divided by risk-adjusted assets –the Tier I (core) capital ratio is equal to Tier I capital divided by risk-adjusted assets

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Balance Sheet Regulation Capital adequacy regulation (continued) –since 1991 banks have also been assessed based on their capital- to-assets (i.e., leverage) ratio capital-to-assets ratio = core capital ÷ total assets does not account for market values, riskiness of assets, or off- balance-sheet activities –since December 1992 regulators must take Prompt Corrective Action (PCA) if and when a bank falls outside of the well capitalized zone –risk-based capital ratios were phased in by Bank for International Settlement (BIS) countries (the U.S. included) by 1993 under the Basel Accord Capital adequacy regulation (continued) –since 1991 banks have also been assessed based on their capital- to-assets (i.e., leverage) ratio capital-to-assets ratio = core capital ÷ total assets does not account for market values, riskiness of assets, or off- balance-sheet activities –since December 1992 regulators must take Prompt Corrective Action (PCA) if and when a bank falls outside of the well capitalized zone –risk-based capital ratios were phased in by Bank for International Settlement (BIS) countries (the U.S. included) by 1993 under the Basel Accord

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Off-Balance-Sheet Regulation Banks earn fee income with off-balance-sheet (OBS) activities By engaging in OBS activities, banks can avoid regulatory costs such as reserve requirements, deposit insurance premiums, and capital adequacy requirements Banks must report notional values of OBS activity on Schedule L OBS activity is incorporated into the total risk-based capital ratio and the Tier I capital ratio, but not the leverage ratio Banks earn fee income with off-balance-sheet (OBS) activities By engaging in OBS activities, banks can avoid regulatory costs such as reserve requirements, deposit insurance premiums, and capital adequacy requirements Banks must report notional values of OBS activity on Schedule L OBS activity is incorporated into the total risk-based capital ratio and the Tier I capital ratio, but not the leverage ratio

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Foreign vs. Domestic Regulation Regulation of U.S. banks in foreign countries –the Overseas Direct Investment Control Act of 1964 restricted U.S. banks ability to lend to U.S. corporations to make foreign investment –the North American Free Trade Agreement (NAFTA) of 1994 enabled U.S. banks to expand to Mexico and Canada –a 1997 agreement between 100 countries (under the World Trade Organization (WTO)) began dismantling barriers inhibiting foreign direct investment into emerging countries Regulation of U.S. banks in foreign countries –the Overseas Direct Investment Control Act of 1964 restricted U.S. banks ability to lend to U.S. corporations to make foreign investment –the North American Free Trade Agreement (NAFTA) of 1994 enabled U.S. banks to expand to Mexico and Canada –a 1997 agreement between 100 countries (under the World Trade Organization (WTO)) began dismantling barriers inhibiting foreign direct investment into emerging countries

©2009, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Foreign vs. Domestic Regulation Regulation of foreign banks in the U.S. –the International Banking Act (IBA) of 1978 declared foreign banks are to be regulated the same as national domestic banks foreign banks are subject to Federal Reserve examinations –the Foreign Bank Supervision Enhancement Act (FBSEA) of 1991 gave additional powers to the Federal Reserve Fed must approve new subsidiary, branch, agency, or representative offices of foreign banks in the U.S. Fed has the authority to close foreign banks operating in the U.S. only foreign banks with access to the FDIC can accept consumer deposits state-licensed foreign branches are regulated as national branches Regulation of foreign banks in the U.S. –the International Banking Act (IBA) of 1978 declared foreign banks are to be regulated the same as national domestic banks foreign banks are subject to Federal Reserve examinations –the Foreign Bank Supervision Enhancement Act (FBSEA) of 1991 gave additional powers to the Federal Reserve Fed must approve new subsidiary, branch, agency, or representative offices of foreign banks in the U.S. Fed has the authority to close foreign banks operating in the U.S. only foreign banks with access to the FDIC can accept consumer deposits state-licensed foreign branches are regulated as national branches