1. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-1 Chapter Fourteen Regulation of Depository Institutions

2. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-2 Overview: Specialness in Services DIs are special because of the vital services they provide to various sectors of the economy: –Information –Liquidity –Price-risk reduction –Transaction cost reduction –Maturity intermediation –Money supply transmission –Credit allocation –Intergenerational wealth transfer –Payment services –Denomination intermediation DIs are special because of the vital services they provide to various sectors of the economy: –Information –Liquidity –Price-risk reduction –Transaction cost reduction –Maturity intermediation –Money supply transmission –Credit allocation –Intergenerational wealth transfer –Payment services –Denomination intermediation

3. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-3 DIs also are special in terms of their regulation, including: –Safety and Soundness Regulation –Monetary Policy Regulation –Credit Allocation Regulation –Consumer Protection Regulation –Investor Protection Regulation –Entry and Chartering Regulation DIs also are special in terms of their regulation, including: –Safety and Soundness Regulation –Monetary Policy Regulation –Credit Allocation Regulation –Consumer Protection Regulation –Investor Protection Regulation –Entry and Chartering Regulation Overview: Specialness in Regulation

4. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-4 Types of Regulations Safety and Soundness Regulation - layers of regulation have been imposed on FIs to protect depositors and borrowers against the risk of failure Monetary Policy Regulation - regulators control and implement monetary policy by requiring minimum levels of cash reserves to be held against depository institution deposits Credit Allocation Regulation - regulations support the FI’s lending to socially important sectors, such as housing and farming Safety and Soundness Regulation - layers of regulation have been imposed on FIs to protect depositors and borrowers against the risk of failure Monetary Policy Regulation - regulators control and implement monetary policy by requiring minimum levels of cash reserves to be held against depository institution deposits Credit Allocation Regulation - regulations support the FI’s lending to socially important sectors, such as housing and farming (continued)

5. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-5 Types of Regulations Consumer Protection Regulation - regulations are imposed to prevent the FI from discriminating unfairly in lending Investor Protection Regulation - laws protect investors who directly purchase securities and/or indirectly purchase securities by investing in mutual or pension funds Entry and Chartering Regulation - entry and activity regulations limit the number of FIs in any given financial services sector, thus impacting the charter values of FIs operating in that sector Consumer Protection Regulation - regulations are imposed to prevent the FI from discriminating unfairly in lending Investor Protection Regulation - laws protect investors who directly purchase securities and/or indirectly purchase securities by investing in mutual or pension funds Entry and Chartering Regulation - entry and activity regulations limit the number of FIs in any given financial services sector, thus impacting the charter values of FIs operating in that sector

6. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-6 The Regulators The key regulators of DIs are the FDIC, OCC, FRS, FTC, OTS, and NCUA The different facets of the regulatory structure include –regulation of product and geographic expansion –the provision and regulation of deposit insurance –balance sheet regulations (reserve requirements and capital regulations) –regulations pertaining to off-balance-sheet activities The key regulators of DIs are the FDIC, OCC, FRS, FTC, OTS, and NCUA The different facets of the regulatory structure include –regulation of product and geographic expansion –the provision and regulation of deposit insurance –balance sheet regulations (reserve requirements and capital regulations) –regulations pertaining to off-balance-sheet activities

7. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-7 Commercial and Investment Banking Activities Commercial banking - banking activity of deposit taking and lending Investment banking - banking activity of underwriting, issuing, and distributing securities Section 20 affiliate - a securities subsidiary of a bank holding company through which a banking organization can engage in investment banking activities Commercial banking - banking activity of deposit taking and lending Investment banking - banking activity of underwriting, issuing, and distributing securities Section 20 affiliate - a securities subsidiary of a bank holding company through which a banking organization can engage in investment banking activities

8. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-8 Breakdown of Glass-Steagall Act Glass-Steagall Act (1933 Banking Act) sought to impose a rigid separation between commercial banking and investment banking Federal Reserve Board began allowing commercial banks to establish Section 20 affiliates in 1987 Federal Reserve Board and OCC allowed commercial banks to acquire directly existing investment banks in 1997 Financial Services Modernization Act passed by Congress in 1999 which repealed Glass-Steagall Glass-Steagall Act (1933 Banking Act) sought to impose a rigid separation between commercial banking and investment banking Federal Reserve Board began allowing commercial banks to establish Section 20 affiliates in 1987 Federal Reserve Board and OCC allowed commercial banks to acquire directly existing investment banks in 1997 Financial Services Modernization Act passed by Congress in 1999 which repealed Glass-Steagall

9. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-9 Regulatory Factors Impacting Geographic Expansion Unit bank - a bank with a single office Multibank hold company - a parent banking organization that owns a number of individual bank subsidiaries Grandfathered subsidiaries - subsidiaries established prior to the passage of a restrictive law and not subject to that law One-bank holding company - a parent banking organization that owns one bank subsidiary and nonbank subsidiaries Unit bank - a bank with a single office Multibank hold company - a parent banking organization that owns a number of individual bank subsidiaries Grandfathered subsidiaries - subsidiaries established prior to the passage of a restrictive law and not subject to that law One-bank holding company - a parent banking organization that owns one bank subsidiary and nonbank subsidiaries

10. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-10 History of Bank and Savings Institution Guarantee Funds FDIC –created in 1933 in the wake of the banking panics of 1930-1933 to maintain the stability and public confidence in the system –numerous bank failures in the 1980’s drained the FDIC fund –Congress passed the FDIC Improvement Act (FDICIA) to restructure the bank insurance fund and prevent insolvency The Demise of the FSLIC –S&L failures in the 1980’s depleted and present value of its liabilities exceeded that of its assets –Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) and transferred management to the FDIC and was renamed SAIF FDIC –created in 1933 in the wake of the banking panics of 1930-1933 to maintain the stability and public confidence in the system –numerous bank failures in the 1980’s drained the FDIC fund –Congress passed the FDIC Improvement Act (FDICIA) to restructure the bank insurance fund and prevent insolvency The Demise of the FSLIC –S&L failures in the 1980’s depleted and present value of its liabilities exceeded that of its assets –Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) and transferred management to the FDIC and was renamed SAIF

11. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-11 Causes of the Depository Fund Insolvencies The financial environment –dramatic rise in interest rates during 1979-1982 –collapse in oil, real estate, and other commodity prices –increased financial service firm competition at home and abroad Moral hazard –Deposit insurance itself was at the heart of the crisis –Banks engaged in risky ventures with depositors fully insured –Implicit premiums - deposit insurance premiums or costs imposed on a bank through activity constraints rather than direct monetary changes - could have substituted for absence of depositor discipline The financial environment –dramatic rise in interest rates during 1979-1982 –collapse in oil, real estate, and other commodity prices –increased financial service firm competition at home and abroad Moral hazard –Deposit insurance itself was at the heart of the crisis –Banks engaged in risky ventures with depositors fully insured –Implicit premiums - deposit insurance premiums or costs imposed on a bank through activity constraints rather than direct monetary changes - could have substituted for absence of depositor discipline

12. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-12 Balance Sheet Regulations Capital-to-assets ratio - ratio of core capital to assets Prompt corrective action - mandatory action that regulators must take as bank’s capital ratio falls Basel Accord - agreement that requires imposition of risk- based capital ratios on banks in major industrialized countries Risk-adjusted assets - On- and off-balance-sheet assets whose value is adjusted for credit risk Total risk-based capital ratio - ratio of total capital to risk-adjusted assets Tier 1 (core) capital ratio - ratio of core capital to risk- adjusted assets Capital-to-assets ratio - ratio of core capital to assets Prompt corrective action - mandatory action that regulators must take as bank’s capital ratio falls Basel Accord - agreement that requires imposition of risk- based capital ratios on banks in major industrialized countries Risk-adjusted assets - On- and off-balance-sheet assets whose value is adjusted for credit risk Total risk-based capital ratio - ratio of total capital to risk-adjusted assets Tier 1 (core) capital ratio - ratio of core capital to risk- adjusted assets

13. McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. 14-13 Foreign versus Domestic Regulation Product Diversification Activities –Financial Services Modernization Act of 1999 allowed banks to participate in nonbank activities Regulation of U.S. Banks in foreign countries –Federal Reserve Regulation K allowed banks to engage in the foreign country’s permitted banking activities –NAFTA enabled U.S. banks to expand into Mexico Regulation of foreign banks in the U.S. –International Banking Act (IBA) and Foreign Bank Supervision and Enforcement (FBSEA) allow federal regulators to have increasing control Product Diversification Activities –Financial Services Modernization Act of 1999 allowed banks to participate in nonbank activities Regulation of U.S. Banks in foreign countries –Federal Reserve Regulation K allowed banks to engage in the foreign country’s permitted banking activities –NAFTA enabled U.S. banks to expand into Mexico Regulation of foreign banks in the U.S. –International Banking Act (IBA) and Foreign Bank Supervision and Enforcement (FBSEA) allow federal regulators to have increasing control