1. Chapter 15 The Regulation of Markets and Institutions

2. Key Ideas  Different methods of regulating financial markets  Dual banking system and the regulators who oversee it  Universal banking and its possible benefits and risks 15-2

3. Introduction  Financial system is one of most intensely regulated sectors in US economy  Objectives of the regulations are:  To promote competition  To protect individual consumers  To maintain stability of financial system  To facilitate monetary policy 15-3

4. Regulation of the Primary Market  Philosophy:  Best protection is have adequate information about securities  Full disclosure broadens participation in financial markets 15-4

5. 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 15-5

6. Regulation of the Primary Market  Securities Exchange Act of 1934  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  Approval simply means disclosure of information is adequate 15-6

7. Regulation of Secondary Market  Securities Exchange Act of 1934  Extended 1933 Act  Periodic disclosure of relevant financial information  For firms trading in secondary market  10K Report  Annual financial statement and  Information about a firm’s performance and activity  Prohibits Insider Trading  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 15-7

8. Regulation of Commercial Banks  Principle philosophy:  Protect individual depositor  Foster a competitive banking system  Ensure bank safety and soundness 15-8

9. Regulation of Commercial Banks  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 15-9

10. Regulation of Commercial Banks  Dual banking system  However, state banks survived  Stopped issuing banknotes  Started to accept of demand deposits  State chartered banks are supervised by regulators in their respective state  Federally chartered banks tend to be larger in size, but state banks are bigger in number 15-10

11. Regulation of Commercial Banks  Federal Reserve Act of 1913  Required national banks to become members of the Fed,  State banks had option of being a nonmember  All state banks (including nonmember) currently fall under regulation of the Fed  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 (including non members) have opted to participate in FDIC program 15-11

12. Regulation of Commercial Banks U.S. Banking Regulatory Structure  Multiple and sometimes conflicting supervisory authority at Federal level  Federal Reserve System  Comptroller of Currency (Department of the Treasury), and  FDIC  Some experts suggest that all regulation should be combined in a single agency, but no legislation exists to unify the structure 15-12

13. Regulation of Commercial Banks Protecting Individual Depositors and Financial System Stability  Regulations do not relying upon disclosure  Focus of bank regulation is on:  Bank examinations  Prompt corrective action (PCA) whenever necessary 15-13

14. Regulation of Commercial Banks Primary Liabilities: Demand Deposit  Paid on a first-come/first-serve basis  Banks need to maintain sufficient liquidity to meet demand deposits  It is costly to keep excess reserve or liquid assets  Fear that a bank is insolvent will cause a run on the bank or a system-wide bank panic  Periodic examination of a bank by regulatory agencies to insure banks are solvent 15-14

15. Regulation of Commercial Banks  Deposit Insurance  FDIC established by Banking Act of 1933 to insure deposits at commercial and mutual savings banks.  Created after a large number of bank failures in the early 1930’s  Objective is to protect small savers  Reduce the incentive for depositors to join a bank run 15-15

16. Regulation of Commercial Banks  Deposit Insurance  Currently insure deposits up to $100,000 for single account  Coverage depends on procedure used by FDIC:  Payoff Method  Bank goes into receivership by FDCI  FDIC pays out funds up to $100,000  Purchase and Assumption Method  FDIC merges failed bank with a healthy one  Deposits of failed bank are assumed by solvent bank 15-16

17. Regulation of Commercial Banks  Moral Hazard and Deposit Insurance  Existence of FDIC eliminates large-scale bank failure and bank run.  However, it creates a classic moral hazard problem.  With FDIC insurance, depositors have little or no incentive to monitor riskiness of their banks.  Without monitoring, bank managers finds it easy to engage in risky activities. 15-17

18. Regulation of Commercial Banks  Moral Hazard and Deposit Insurance  Shareholders and directors of banks have incentive to make their banks riskier at the expense of the FDIC  “Too big to fail” Doctrine  FDIC may extend loans to very large banks in trouble to allow continued operations  This doctrine may unintentionally exacerbate the moral hazard problem  Recently bank failures have increased due to banking deregulation and commercial banking activities becoming riskier 15-18

19. Regulation of Commercial Banks Risk-Based Capital Requirements  Bank capital acts as a cushion against failure  Banks are required to maintain a capital to asset ratio  This ratio measures of bank’s risk exposure  Risk-based capital requirements  Higher capital requirement for banks with risky assets.  With higher risk amount of risk-based asset will go up.  This will cause Capital to Asset ratio to go down.  These requirements are agreed upon by the United States and members of the Bank for International Settlements (BIS) 15-19

20. Regulation of Commercial Banks  Prompt Corrective Action (PCA)  Passed as a part of FDIC Improvement Act of 1991  Established procedures to handle troubled banks  Designed to close banks 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  Established a risk-based deposit insurance premium in FDIC  charge insurance premium based on the perceived risk of the bank 15-20

21. Regulation of Nondepository  Regulations are designed based 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  Guarantees defined benefits pension plans, subject to a maximum amount  Establishes minimum reporting, disclosure and investment standards 15-21

22. Regulation of Nondepository  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 15-22

23. Regulation of Nondepository  Finance companies  Raise funds by issuing debt and equity  Have virtually no regulation beyond the securities laws governing publicly traded securities  Mutual Funds  Regulated by the SEC  Also subject to state regulations  Objective is to protection of individual investors through full disclosure 15-23

24. The Glass-Steagall Act  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 15-24

25. The Glass-Steagall Act  The Genesis of Glass-Steagall  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 15-25

26. The Glass-Steagall Act  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 15-26

27. The Glass-Steagall Act  The Erosion of Glass-Steagall  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 15-27

28. The Glass-Steagall Act  The Erosion of Glass-Steagall  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  Federal Reserve has power to ensure capital adequacy of holding companies, safety and soundness of their activities  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 15-28

29. The Glass-Steagall Act  The Risk of Universal Banking  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 15-29

30. Universal Banking  The Risk of Universal Banking  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 15-30