1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 15 The Regulation of Markets and Institutions

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-2 Learning Objectives Describe the different methods of regulating primary, secondary, and intermediated financial markets Understand the United Stated dual banking system and the array of regulators who oversee it Explain universal banking and its possible benefits and risks

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-3 Introduction Financial system is one of most intensely regulated sectors in US economy –Promote competition –Protect individual consumers –Assure stability of financial system –Facilitate monetary policy

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-4 Regulation of Financial Markets in the United States Desire to protect individual investor Best protection is adequate information about securities Full disclosure broadens investor’s participation in financial markets

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-5 Regulation of Financial Markets in the United States (Cont.) Regulation of the Primary Market –Securities Act of 1933 Requires disclosure of information for newly issued publicly traded securities Privately held firms are not required to reveal financial information to the public at large, only to the lenders –Securities Exchange Act of 1934 Created the Securities and Exchange Commission (SEC) to administer provisions of 1933 Act Publicly traded security must file registration statement and preliminary prospectus disclosing information about issue

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-6 Regulation of Financial Markets in the United States (Cont.) Regulation of the Primary Market (Cont.) –Securities Exchange Act of 1934 (Cont.) The prospectus does not state the interest rate on a bond issue or price for equity issues—determined in the market when sold If information is adequate, SEC approves the statement and sale Approval by the SEC does not imply that it views the new issue as an attractive investment—merely means disclosure of information is adequate

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-7 Regulation of Financial Markets in the United States (Cont.) Regulation of Secondary Market –Securities Exchange Act of 1934 Extended 1933 Act to include periodic disclosure of relevant financial information for firms trading in secondary market 10K Report—Annual financial statement and relevant information about a firm’s performance and activity Insider Trading Laws –Prohibit insiders from trading on private information not previously disclosed to public –Corporate officers and major stockholders must report all their transactions of their own firm’s stock

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-8 Regulation of Financial Markets in the United States (Cont.) Regulation of Secondary Market (Cont.) –Securities Exchange Act of 1934 (Cont.) SEC and other regulatory agencies –Have authority to regulate securities exchanges, OTC trading, dealers, and brokers –Basically rely on self-regulation by markets and firms under their control Fed sets margin requirements on stocks—how much of purchase price an investor can borrow

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-9 Regulation of Commercial Banks in the United States Protect individual depositor Foster a competitive banking system Ensure bank safety and soundness

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-10 Regulation of Commercial Banks in the United States (Cont.) U.S. Banking Regulatory Structure –Dual banking system Federal and State banks existing side-by-side Legislation in 1860’s established federally chartered banks under supervision of Comptroller of the Currency (US Treasury Department) Intent was to drive existing state chartered banks out of business by imposing a prohibitive tax on issuance of state banknotes

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-11 Regulation of Commercial Banks in the United States (Cont.) U.S. Banking Regulatory Structure (Cont.) –Dual banking system (Cont.) However, state banks survived due to acceptance of demand deposits in lieu of currency State chartered banks are supervised by regulators in their respective state Federally chartered banks tend to be larger, but state banks are more numerous

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-12 Regulation of Commercial Banks in the United States (Cont.) U.S. Banking Regulatory Structure (Cont.) –Federal Reserve Act of 1913 Required national banks to become members of the Fed, while state banks had option. All state banks currently fall under regulation of the Fed (member or not) –Federal Deposit Insurance Corporation (FDIC) All member banks of Fed (national and some state banks) are required to carry FDIC insurance A majority of state banks not members of the Fed have opted to participate in FDIC program

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-13 Regulation of Commercial Banks in the United States (Cont.) U.S. Banking Regulatory Structure (Cont.) –Multiple and sometimes conflicting supervisory authority at Federal level –Fed, Comptroller of Currency (Department of the Treasury), and FDIC frequently clash over interpretation of certain laws –Suggestion that all regulation should be combined in a single agency, but no legislation exists to unify the structure

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-14 Regulation of Commercial Banks in the United States (Cont.) Protecting Individual Depositors and Financial System Stability –Rather than relying on disclosure, thrust of bank regulation is on bank examinations and prompt corrective action when necessary –The primary liabilities of a commercial bank are their demand deposits Paid on a first-come/first-serve basis Banks must maintain sufficient liquidity to meet demand deposits

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-15 Regulation of Commercial Banks in the United States (Cont.) Protecting Individual Depositors and Financial System Stability (Cont.) –The primary liabilities of a commercial bank are their demand deposits (Cont.) Difficult and costly for banks to sell illiquid assets Fear that a bank is insolvent will cause a run on the bank or a system-wide bank panic (Figure 15.a1) Periodic examination of a bank by regulatory agencies to insure banks are solvent

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-16 Regulation of Commercial Banks in the United States (Cont.) Deposit Insurance –FDIC established by Banking Act of 1933 to insure deposits at commercial and mutual savings banks. –Federal Savings and Loan Insurance Corporation (FSLIC) insured deposits in S&Ls –Resulted from large number of bank failures in the early 1930’s –Intent is to protect small savers and reduce the incentive for insured depositors to join a bank run

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-17 Regulation of Commercial Banks in the United States (Cont.) Deposit Insurance (Cont.) –Currently insure deposits up to $100,000, but actual coverage may be more. – Coverage depends on procedure used by FDIC: Payoff method—Bank goes into receivership and FDIC pays out funds up to $100,000 Assumption method—FDIC merges failed bank with a healthy one and deposits of failed bank are assumed by solvent bank “Too big to fail” Doctrine—FDIC may extend loans to very large banks in trouble to allow continued operations

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-18 Regulation of Commercial Banks in the United States (Cont.) Moral Hazard and Deposit Insurance –Existence of FDIC eliminates possibility of large- scale bank failure and “run on the banks” –Moral Hazard Depositors have little incentive to monitor riskiness of their banks

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-19 Regulation of Commercial Banks in the United States (Cont.) Moral Hazard and Deposit Insurance (Cont.) –Moral Hazard (Cont.) Shareholders and directors of banks have incentive to make their banks riskier at the expense of the FDIC However, several factors may reduce risk taking –Risk averse—banks are privately owned and directors are paid based on performance –Bank examination and other regulatory efforts “Too big to fail” doctrine man unintentionally exacerbate the moral hazard problem Recently bank failures have increased due to banking deregulation and commercial banking activities becoming riskier

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-20 Regulation of Commercial Banks in the United States (Cont.) Risk-Based Capital Requirements –Bank capital provides a cushion against failure –Banks are required to maintain a capital-asset ratio based on a measure of the riskiness of their total assets –Risk-based capital requirements—as a bank’s assets become riskier regulators will force banks to increase their capital –These requirements are agreed upon by the United States and members of the Bank for International Settlements (BIS)

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-21 Regulation of Commercial Banks in the United States (Cont.) Prompt Corrective Action (PCA)—FDIC Improvement Act of 1991 –Established procedures to handle troubled banks –Designed to close banks/thrifts before FDIC is exposed to excessive losses –Prevent regulatory forbearance—when regulators keep an insolvent institution operating in hopes of “turning it around” –Banks are ranked according to their perceived risk and more restrictions placed on riskier banks –FDIC established risk-based deposit insurance premium— charge insurance premium based on the perceived risk of the bank

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-22 Regulation of Nondepository Financial Intermediaries Depends very much on the type of liabilities they issue Pension funds and life insurance companies –Heavily regulated because their liabilities are purchased by small investors and need to protect small investors –Employee Retirement Income Security Act (ERISA) Established the Pension Benefit Guaranty Corporation

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-23 Regulation of Nondepository Financial Intermediaries (Cont.) –Employee Retirement Income Security Act (ERISA) Guarantees defined benefits pension plans, subject to a maximum amount Establishes minimum reporting, disclosure and investment standards –Life Insurance Companies Regulated at the state level Impose risk-based capital requirements Perform periodic audits Implicit and explicit restrictions on pricing of particular products

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-24 Regulation of Nondepository Financial Intermediaries (Cont.) Finance companies raise funds by issuing debt and equity and have virtually no regulation beyond the securities laws governing publicly traded securities Mutual Funds –Regulated by the SEC –Also subject to state regulations –Motivation is protection of individual investors through full disclosure

25. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-25 The Glass-Steagall Act, A Collapsing Barrier Segregated the banking industry from the rest of the financial services industry Banks are barred from owning corporate stock and other activities deemed too risky The Genesis of Glass-Steagall –Prior to 1933, investment banking and commercial banking were conducted under same roof –Following the financial collapse of the 1930s, it was felt that investment banking activities were too risky for banks

26. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-26 The Glass-Steagall Act, A Collapsing Barrier (Cont.) The Genesis of Glass-Steagall (Cont.) –This combination represented a substantial threat to financial system stability –Although there was little empirical evidence to support this contention, the legislation mandated separation of the two activities

27. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-27 The Glass-Steagall Act, A Collapsing Barrier (Cont.) The Erosion of Glass-Steagall –Commercial banks exerted pressure on the Federal Reserve and courts to reduce the barriers caused by Glass-Steagall –Bank-holding Companies Permitted banks to conduct nonbanking activities through subsidiaries In 1970 Federal Reserve was given power to determine what activities were permissible Activities had to be closely related to traditional banking During the 1970s and 80s banks acquired more freedom to engage in nontraditional banking activities

28. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-28 The Glass-Steagall Act, A Collapsing Barrier (Cont.) The Erosion of Glass-Steagall (Cont.) –In 1989 the Federal Reserve granted five banks the power to underwrite corporate debt through a Section 20 affiliate –Gradually the Federal Reserve granted more and more banks the right to underwrite corporate debt

29. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-29 The Glass-Steagall Act, A Collapsing Barrier (Cont.) The Erosion of Glass-Steagall (Cont.) –The Gramm-Leach-Bliley Act (1999) Allowed affiliates of financial holding companies to engage in various banking activities and insurance underwriting Overall responsibility for regulation lies with the Federal Reserve through its role as the “umbrella” regulator Individual affiliates of holding companies are subject to regulation by functional supervisors such as the SEC This regulation framework blends the disclosure-based and inspection-based approaches to regulation Federal Reserve has power to ensure capital adequacy of holding companies and insure depository institutions are not threatened by other activities

30. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-30 The Glass-Steagall Act, A Collapsing Barrier (Cont.) The Risk of Universal Banking –The issue of risk has become a key issue in the debate over Gramm-Leach-Bliley –Some concern that the risk of securities activities, especially the underwriting business, may jeopardize the stability of the banking system –Would bank losses in securities activities lead to more bank failures and significant losses to FDIC –Just because investment banking is riskier than commercial banking, this does not mean that the combination of the two will be riskier

31. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-31 The Glass-Steagall Act, A Collapsing Barrier (Cont.) The Risk of Universal Banking (Cont.) –The portfolio theory of risk suggests that diversification may reduce risk when commercial banking combine with investment banking and life insurance activities –Perhaps it is time to let the banks decide for themselves whether universal banking reduces risk

32. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-32 TABLE 15.1 Principal Financial Regulators in the United States

33. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-33 TABLE 15.2 Status of Insured Commercial Banks, 2007 (dollars in billions)

34. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-34 TABLE 15.3 Capital Ratios—An Example

35. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-35 TABLE 15.4 Summary of Prompt Corrective Action* (any restrictions in one category apply to all lower categories as well)