1. Chapter 15 The Regulation of Markets and Institutions

2. 15-2 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

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

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

5. 15-5 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

6. 15-6 Regulation of the Primary Market  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. 15-7 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. 15-8 Regulation of Secondary Market  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. 15-9 Regulation of Commercial Banks  Principle philosophy:  Protect individual depositor  Foster a competitive banking system  Ensure bank safety and soundness

10. 15-10 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

11. 15-11 Regulation of Commercial Banks  Dual banking system (Cont.)  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, but state banks are more numerous

12. 15-12 Regulation of Commercial Banks  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. 15-13 Regulation of Commercial Banks  U.S. Banking Regulatory Structure  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. 15-14 Regulation of Commercial Banks Protecting Individual Depositors and Financial System Stability  Rather than relying on disclosure, focus of bank regulation is on bank examinations and prompt corrective action (PCA) when necessary

15. 15-15 Regulation of Commercial Banks 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  Difficult and costly for banks to sell illiquid assets  It is also costly to keep excess reserve  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

16. 15-16 Regulation of Commercial Banks  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  Objective is to protect small savers  Reduce the incentive for depositors to join a bank run

17. 15-17 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 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. 15-18 Regulation of Commercial Banks  Moral Hazard and Deposit Insurance  Existence of FDIC eliminates possibility of large-scale bank failure and bank run  However, it creates a classic moral hazard problem  Depositors have little or no incentive to monitor riskiness of their banks  Bank managers finds it easy to engage in risky activities

19. 15-19 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  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 may unintentionally exacerbate the moral hazard problem  Recently bank failures have increased due to banking deregulation and commercial banking activities becoming riskier

20. 15-20 Regulation of Commercial Banks  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. 15-21 Regulation of Commercial Banks  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. 15-22 Regulation of Nondepository  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. 15-23 Regulation of Nondepository  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. 15-24 Regulation of Nondepository  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. 15-25 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

26. 15-26 The Glass-Steagall Act  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. 15-27 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

28. 15-28 The Glass-Steagall Act  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. 15-29 The Glass-Steagall Act  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  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

30. 15-30 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

31. 15-31 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