1. chapter 11 Economic Analysis of Banking Regulation

2. Copyright © 2001 Addison Wesley Longman TM 11- 2 How Asymmetric Information Explains Banking Regulation 1.Government Safety Net and Deposit Insurance A.Prevents bank runs due to asymmetric information: 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 increases moral hazard incentives for big banks 2.Restrictions on Asset Holdings A.Reduces moral hazard of too much risk taking

3. Copyright © 2001 Addison Wesley Longman TM 11- 3 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 A.Better information reduces asymmetric information problem How Asymmetric Information Explains Banking Regulation

4. Copyright © 2001 Addison Wesley Longman TM 11- 4 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 in the past: Glass-Steagall International Banking Regulation 1.Bank regulation abroad similar to ours 2.Particular problem of regulating international banking e.g., BCCI scandal How Asymmetric Information Explains Banking Regulation

5. Copyright © 2001 Addison Wesley Longman TM 11- 5 Major Banking Legislation in U.S.

6. Copyright © 2001 Addison Wesley Longman TM 11- 6 Major Banking Legislation in U.S.

7. Copyright © 2001 Addison Wesley Longman TM 11- 7 Why a Banking Crisis in 1980s? Early Stages 1.Decreasing profitability: banks take risk to keep profits up 2.Deregulation in 1980 and 1982, more opportunities for risk taking 3.Innovation of brokered deposits enabled circumvention of $100,000 insurance limit 4.   i , net worth of S&Ls  A.Insolvencies  B.Incentives for risk taking  Result: Failures  and risky loans  Later Stages: Regulatory Forbearance 1.Regulators allow insolvent S&Ls to operate because A.Insufficient funds B.Sweep problems under rug C.FHLBB cozy with S&Ls 2.Huge increase in moral hazard for zombie S&Ls: now have incentive to “bet the bank” 3.Zombies hurt healthy S&Ls A.Raise cost of funds B.Lower loan rates 4.Outcome: Huge losses

8. Copyright © 2001 Addison Wesley Longman TM 11- 8 Political Economy of S&L Crisis Explanation: Principal-Agent Problem 1.Politicians influenced by S&L lobbyists rather than public A.Deny funds to close S&Ls B.Legislation to relax restrictions on S&Ls C.Competitive Bank Equality Act (CEBA) of 1987 had inadequate amount for bailout 2.Regulators influenced by politicians and desire to avoid blame A.Loosened capital requirements B.Regulatory forbearance C.Example: Keating and Lincoln Savings and Loan

9. Copyright © 2001 Addison Wesley Longman TM 11- 9 Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989 1.New regulatory structure: Office of Thrift Supervision as new regulator, FDIC takes over FSLIC fund 2.Resolution Trust Corporation (RTC) created and given funds to close insolvent S&Ls: cost of $100- $200 billion 3.Core capital requirement  from 3% to 8% 4.Reregulation: Asset restrictions like before 1982

10. Copyright © 2001 Addison Wesley Longman TM 11- 10 Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 1.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

11. Copyright © 2001 Addison Wesley Longman TM 11- 11 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 Risk-based Insurance Premiums 1.Hard to implement Other Proposed Changes 1.Regulatory consolidation 2.Market-value accounting

12. Copyright © 2001 Addison Wesley Longman TM 11- 12 Banking Crises Worldwide

13. Copyright © 2001 Addison Wesley Longman TM 11- 13 Cost of Banking Crises in Other Countries