Copyright © 2000 Addison Wesley Longman Slide #18-1 Chapter Eighteen BANKING REGULATION

Copyright © 2000 Addison Wesley Longman Slide #18-2 How Asymmetric Information Explains Banking Regulation 1.Govt. Safety Net and Deposit Insurance A. Prevents bank runs due to asymmetric info: depositors can't tell good from bad banks B. Creates moral hazard incentives for banks to take on too much risk C. Creates adverse selection problem of crooks and risk-takers wanting to control banks D. Too-Big-to-Fail increase moral hazard incentives for big banks and is unfair 2.Restrictions on Asset Holdings Reduces moral hazard of too much risk taking

Copyright © 2000 Addison Wesley Longman Slide #18-3 How Asymmetric Information Explains Banking Regulation 3.Bank Capital Requirements A. Reduces moral hazard: banks have more to lose when have higher capital B. Higher capital means more collateral for FDIC 4.Bank Supervision: Chartering and Examination A. Reduces adverse selection problem of risk takers or crooks owning banks B. Reduces moral hazard by preventing risky activities C. New trend: assessment of risk management 5.Disclosure Requirements Better info reduces asymmetric info problem

Copyright © 2000 Addison Wesley Longman Slide #18-4 How Asymmetric Information Explains Banking Regulation 6.Consumer Protection A. Standardized interest rates (APR) B. Prevent discrimination: e.g., CRA 7.Restrictions on Competition to Reduce Risk- Taking A. Branching restrictions B. Separation of banking and securities industries: Glass-Steagall International Banking Regulation 1. Bank regulation abroad similar to ours 2. Particular problem of regulating international banking E.g., BCCI scandal

Copyright © 2000 Addison Wesley Longman Slide #18-5 Major Banking Legislation in U.S.

Copyright © 2000 Addison Wesley Longman Slide #18-6 The 1980s Banking Crisis Why? 1. Decreasing profitability: banks take risk to keep profits up 2. Financial innovation creates more opportunities for risk taking 3. Innovation of brokered deposits enables circumvention of $100,000 insurance limit Result: Failures  and risky loans 

Copyright © 2000 Addison Wesley Longman Slide #18-7 Federal Deposit Insurance Corporation Improvement Act (FDICIA) of FDIC recapitalized with loans and higher premiums 2. Reduce scope of deposit insurance and too-big-to-fail 3. Prompt corrective action provisions 4. Risk-based premiums 5. Annual examinations and stricter reporting 6. Enhances Fed powers to regulate international banking

Copyright © 2000 Addison Wesley Longman Slide #18-8 Evaluating FDICIA and Other Reforms Limits on Scope of Deposit Insurance 1. Eliminate deposit insurance entirely 2. Lower limits on deposit insurance 3. Eliminate too-big-to-fail 4. Coinsurance Prompt Corrective Action 1. Critics believe too many loopholes 2. However: accountability increased by mandatory review of bank failure resolutions

Copyright © 2000 Addison Wesley Longman Slide #18-9 Risk-based Insurance Premiums Hard to implement Other Proposed Changes 1. Regulatory consolidation 2. Market-value accounting Evaluating FDICIA and Other Reforms

Copyright © 2000 Addison Wesley Longman Slide #18-10 Banking Crises Worldwide

Copyright © 2000 Addison Wesley Longman Slide #18-11 Cost of Banking Crises in Other Countries

Copyright © 2000 Addison Wesley Longman Slide #18-12 Calculating Capital Requirements First National Bank Assets Liabilities Reserves $ 3 m Checkable deposits $ 20 m Treasury Nontransactions securities $10 m deposits $ 60 m Government agency Borrowings $ 11 m securities $ 7 mLoan loss reserves $ 2 m Municipal bonds $10 m Bank capital $ 7 m Residential mortgages $10 m Real estate loans $20 m C&I loans $35 m Fixed assets $ 5 m

Copyright © 2000 Addison Wesley Longman Slide #18-13 Leverage Ratio = Capital/Assets = $7m/$100m = 7% Bank is well capitalized Calculating Capital Requirements

Copyright © 2000 Addison Wesley Longman Slide #18-14 Calculating Risk-Adjusted Requirements Risk Adjusted Assets = 0 x $ 3 million(Reserves) + 0 x $10 million(Treasury securities) +.20 x $ 7 million(Agency securities) +.50 x $10 million(Municipal bonds) +.50 x $10 million(Residential mortgages) x $20 million(Real estate loans) x $35 million(Commercial loans) x $ 5 million(Fixed assets) x $20 million(Letters of credit) $91.4 million(Total risk-adjusted assets)

Copyright © 2000 Addison Wesley Longman Slide #18-15 Core Capital Requirement = 4% x risk-adjusted assets = 4% x $91.4m = $3.66m < $7m of core capital Total Capital Requirement = 8% x risk-adjusted assets = 8% x $91.4m = $7.31m < $9m of total capital = $7m of core + $2m of loan loss reserves Calculating Risk-Adjusted Requirements