1. Ch 18 Banking Regulation

2. 2 PREVIEW As we have seen in the previous chapters, the financial system is among the most heavily regulated sectors of the economy, and banks are among the most heavily regulated of financial institutions.As we have seen in the previous chapters, the financial system is among the most heavily regulated sectors of the economy, and banks are among the most heavily regulated of financial institutions. In this chapter, we develop an economic analysis of why regulation of banking takes the form it does.

3. 3 There are eight basic categories of banking regulation: 1.the government safety net, 2.restrictions on bank asset holdings, 3.capital requirements, 4.chartering and bank examination, 5.assessment of risk management, 6. disclosure requirements, 7.consumer protection, 8. restrictions on competition. How Asymmetric Information Explains Banking Regulation

4. 4 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 骗 子 and risk-takers wanting to control banks d. Too-Big-to-Fail increase moral hazard incentives for big banks and is unfair e. Financial consolidation 1. Government Safety Net and Deposit Insurance

5. 5 asymmetric information problem leads to two reasons why the banking system might not function well. First, a bank failure 银行破产 meant that depositors would have to wait to get their deposit funds until the bank was liquidated 清算 (until its assets had been turned into cash); at that time, they would be paid only a fraction of the value of their deposits. Second is that depositors ’ lack of information about the quality of bank assets can lead to bank panics 银行恐慌, which, as we saw in Chapter 8, can have serious harmful consequences for the economy. “ sequential service constraint ” 按序服务原则 contagion effect 传染效应

6. 6 A government safety net for depositors can short-circuit runs on banks and bank panics, and by providing protection for the depositor, it can overcome reluctance to put funds in the banking system. One form of the safety net is deposit insurance, a guarantee such as that provided by the Federal Deposit Insurance Corporation (FDIC) in the United States in which depositors are paid off in full on the first $100,000 they have deposited in the bank no matter what happens to the bank. the FDIC was established in 1934

7. 7 The FDIC uses two primary methods to handle a failed bank. In the first, called the payoff method 偿付法, the FDIC allows the bank to fail and pays off deposits up to the $100,000 insurance limit (with funds acquired from the insurance premiums paid by the banks who have bought FDIC insurance).

8. 8 In the second method, called the purchase and assumption method 收购与接管法, the FDIC reorganizes the bank, typically by finding a willing merger partner who assumes (takes over) all of the failed bank ’ s deposits so that no depositor loses a penny. The FDIC may help the merger partner by providing it with subsidized loans or by buying some of the failed bank ’ s weaker loans. The net effect of the purchase and assumption method is that the FDIC has guaranteed all deposits.

9. 9 Deposit insurance is not the only way in which governments provide a safety net for depositors. In other countries, governments have often stood ready to provide support to domestic banks when they face runs even in the absence of explicit deposit insurance. This support is sometimes provided by lending from the central bank to troubled institutions and is often referred to as the “ lender of last resort ” 最后贷款人 role of the central bank.

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11. 11 Moral Hazard and the Government Safety Net. The most serious drawback of the government safety net stems from moral hazard, the incentives of one party to a transaction to engage in activities detrimental to the other party. with a safety net depositors know that they will not suffer losses if a bank fails, they do not impose the discipline of the marketplace on banks by withdrawing deposits when they suspect that the bank is taking on too much risk. Consequently, banks with a government safety net have an incentive to take on greater risks than they otherwise would.

12. 12 Adverse Selection and the Government Safety Net. A further problem with a government safety net like deposit insurance arises because of adverse selection, the fact that the people who are most likely to produce the adverse outcome insured against (bank failure) are those who most want to take advantage of the insurance. Because depositors protected by a government safety net have little reason to impose discipline on the bank, risk-loving entrepreneurs might find the banking industry a particularly attractive one to enter — they know that they will be able to engage in highly risky activities. Even worse, because protected depositors have so little reason to monitor the bank ’ s activities, without government intervention outright crooks might also find banking an attractive industry for their activities because it is easy for them to get away with fraud and embezzlement.

13. 13 “ Too Big to Fail. ” the Comptroller of the Currency (the regulator of national banks) testified to Congress that the FDIC ’ s policy was to regard the 11 largest banks as “ too big to fail ”— in other words, the FDIC would bail them out so that no depositor or creditor would suffer a loss. One problem with the too-big-to-fail policy is that it increases the moral hazard incentives for big banks. The result of the too-big-to-fail policy is that big banks might take on even greater risks, thereby making bank failures more likely.

14. 14 Financial Consolidation and the Government Safety Net. Financial consolidation 金融并购 poses two challenges to banking regulation First, the increased size of banks as a result of financial consolidation increases the too-big-to fail problem. Second, financial consolidation of banks with other financial services firms means that the government safety net may be extended to new activities such as securities underwriting, insurance, or real estate activities, thereby increasing incentives for greater risk taking in these activities that can also weaken the fabric of the financial system.

15. 15 2. Restrictions on Asset Holdings and Bank Capital Requirements  Bank regulations that restrict asset holdings and bank capital requirements are directed at minimizing this moral hazard, which can cost the taxpayers dearly.  Bank regulations that restrict banks from holding risky assets such as common stock are a direct means of making banks avoid too much risk. Bank regulations also promote diversification, which reduces risk by limiting the amount of loans in particular categories or to individual borrowers. Requirements that banks have sufficient bank capital are another way to change the bank ’ s incentives to take on less risk.

16. 16 lose if it fails and is thus more likely to pursue less risky activities. Bank capital requirements take two forms. The first type is based on the so-called leverage ratio 杠杆比 率, the amount of capital divided by the bank ’ s total assets.

17. 17 In the wake of the Continental Illinois and savings and loans bailouts, regulators in the United States and the rest of the world have become increasingly worried about banks ’ holdings of risky assets and about the increase in banks ’ off-balance-sheet activities, activities that involve trading financial instruments and generating income from fees, which do not appear on bank balance sheets but nevertheless expose banks to risk.

18. 18 Basel Committee on Banking Supervision 巴塞尔银行监管委员会 Basel Accord 巴塞尔协议 The Basel Accord, which required that banks hold as capital at least 8% of their risk- weighted assets, has been adopted by more than 100 countries, including the United States. Assets and off-balance-sheet activities were allocated into four categories, each with a different weight to reflect the degree of credit risk.

19. 19 The first category carries a zero weight and includes items that have little default risk, such as reserves and government securities in the OECD, Organization for Economic Cooperation and Development, (industrialized) countries. The second category has a 20% weight and includes claims on banks in OECD countries. The third category has a weight of 50% and includes municipal bonds and residential mortgages. The fourth category has the maximum weight of 100% and includes loans to consumers and corporations. Off-balance-sheet activities are treated in a similar manner by assigning a credit-equivalent percentage 信用风险转换系数 that converts them to on-balance- sheet items to which the appropriate risk weight applies.

20. 20 limitations of the Accord －－ Regulatory arbitrage 监管套利, in which banks keep on their books assets that have the same risk-based capital requirement but are relatively risky, such as a loan to a company with a very low credit rating, while taking off 剔除 their books low-risk assets, such as a loan to a company with a very high credit rating.

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22. 22 3. 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  Overseeing who operates banks and how they are operated, referred to as bank supervision 银行监管 or more generally as prudential supervision 谨慎监管, is an important method for reducing adverse selection and moral hazard in the banking business.

23. 23 Chartering banks is one method for preventing this adverse selection problem; through chartering, proposals for new banks are screened to prevent undesirable people from controlling them.

24. 24 Regular on-site bank examinations, which allow regulators to monitor whether the bank is complying with capital requirements and restrictions on asset holdings, also function to limit moral hazard. Bank examiners give banks a so-called CAMELS rating 骆驼评级 (the acronym is based on the six areas assessed: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk). 资本充足率 (Capital Adequacy) 、资产质量 (Asset Quality) 、经营管理水平 (Management) 、 盈利水平 (Earnings) 和流动性 (Liquidity)

25. 25 A commercial bank obtains a charter either from the Comptroller of the Currency (in the case of a national bank) or from a state banking authority (in the case of a state bank). Once a bank has been chartered, it is required to file periodic (usually quarterly) call reports that reveal the bank ’ s assets and liabilities, income and dividends, ownership, foreign exchange operations, and other details. Bank examinations are conducted by bank examiners, who sometimes make unannounced visits to the bank (so that nothing can be “ swept under the rug ” in anticipation of their examination).

26. 26 4.Assessment of Risk Management In late 1995, the Federal Reserve and the Comptroller of the Currency announced that they would be assessing risk management processes at the banks they supervise. Now bank examiners give a separate risk management rating from 1 to 5 that feeds into the overall management rating as part of the CAMELS system.

27. 27 5. Disclosure Requirements  Better info reduces asymmetric info problem

28. 28 6. Consumer Protection a. Standardized interest rates (APR) b. Prevent discrimination (e.g., CRA)

29. 29 7. Restrictions on Competition a. Branching restrictions b. Separation of banking and securities industries: Glass-Steagall

30. Major Banking Legislation in U.S. FDIC index of regulations on banking http://www.fdic.gov/regulations/laws/index.html

31. 31 International Banking Regulation 1. Bank regulation abroad similar to ours 2. Particular problem of regulating international banking (e.g., BCCI scandal) Bank of Credit and Commerce International (BCCI) 国际信贷商业银行

32. 32 Problem in regulating international Banking Bank regulators closely examine the domestic operations of banks in their country, but they often do not have the knowledge or ability to keep a close watch on bank operations in other countries, either by domestic banks ’ foreign affiliates or by foreign banks with domestic branches. In addition, when a bank operates in many countries, it is not always clear which national regulatory authority should have primary responsibility for keeping the bank from engaging in overly risky activities.

33. 33 Cooperation among regulators in different countries and standardization of regulatory requirements provide potential solutions to the problems of regulating international banking.

34. 34 Summary Getting bank regulators and supervisors to do their job properly is difficult for several reasons. 1. in their search for profits, financial institutions have strong incentives to avoid existing regulations by loophole mining. Thus regulation applies to a moving target: Regulators are continually playing cat-and-mouse with financial institutions — financial institutions think up clever ways to avoid regulations, which then causes regulators to modify their regulation activities. Regulators continually face new challenges in a dynamically changing financial system, and unless they can respond rapidly to change, they may not be able to keep financial institutions from taking on excessive risk.

35. 35 2.In the regulation and supervision game, the devil is in the details. Subtle differences in the details may have unintended consequences; unless regulators get the regulation and supervision just right, they may be unable to prevent excessive risk taking. 3. regulators and supervisors may be subject to political pressure to not do their jobs properly.

36. 36 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 

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38. 38 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

39. 39 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

40. 40 Evaluating FDICIA and Other Reforms Risk-based Insurance Premiums  Hard to implement Other Proposed Changes 1. Regulatory consolidation 2. Market-value accounting