1. Chapter 11 Economic Analysis of Banking Regulation

2. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-2 Asymmetric Information and Bank Regulation Government safety net: Deposit insurance and the FDIC  Short circuits bank failures and contagion effect  Payoff method  Purchase and assumption method Moral Hazard  Depositors do not impose discipline of marketplace  Banks have an incentive to take on greater risk Adverse Selection  Risk-lovers find banking attractive  Depositors have little reason to monitor bank

3. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-3 Too Big to Fail Government provides guarantees of repayment to large uninsured creditors of the largest banks even when they are not entitled to this guarantee Uses the purchase and assumption method Increases moral hazard incentives for big banks

4. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-4 Financial Consolidation Larger and more complex banking organizations challenge regulation  Increased “too big to fail” problem  Extends safety net to new activities, increasing incentives for risk taking in these areas

5. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-5 Restrictions on Asset Holding and Bank Capital Requirements Attempts to restrict banks from too much risk taking  Promote diversification  Prohibit holdings of common stock  Set capital requirements Minimum leverage ratio Basel Accord: risk-based capital requirements Regulatory arbitrage

6. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-6 Bank (Prudential) Supervision: Chartering and Examination Chartering (screening of proposals to open new banks) to prevent adverse selection Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard  Capital adequacy  Asset quality  Management  Earnings  Liquidity  Sensitivity to market risk

7. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-7 Assessment of Risk Management Greater emphasis on evaluating soundness of management processes for controlling risk Trading Activities Manual of 1994 for risk management rating based on  Quality of oversight provided  Adequacy of policies and limits  Quality of the risk measurement and monitoring systems  Adequacy of internal controls Interest-rate risk limits  Internal policies and procedures  Internal management and monitoring  Implementation of stress testing and Value-at risk (VAR)

8. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-8 Consumer Protection Truth-in-lending mandated under the Consumer Protection Act of 1969 Fair Credit Billing Act of 1974 Equal Credit Opportunity Act of 1974, extended in 1976 Community Reinvestment Act

9. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-9 Consumer Protection Laws Regarding Debt Truth in Lending Act of 1968 The Truth in Lending Act protects consumers from being misled in situations involving credit. Most notably, it requires that all fees and costs be provided to the borrower clearly up front. This is so consumers can compare credit offers before committing to one. In a credit transaction, the lender must both disclose and define all of the following: APR, finance charges, grace period, credit line, minimum payments, all annual fees, and all other applicable fees. Additionally, this act provides consumers with a 3-day “cooling off” period after signing on to certain real estate loans, such as mortgages, during which an individual may change his or her mind without penalty. Source: DebtHelp.com

10. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-10 Fair Credit Billing Act of 1974 The Fair Credit Billing Act also amended the Truth in Lending Act. It protects consumers from liability for billing errors on credit accounts. Borrowers have the right to dispute mistakes that are out of their control, including payments made but not credited, unauthorized charges, and simple computational errors. The dispute must be made within 60 days of the error. Within two billing cycles of the dispute (and 90 days), the lender must resolve the dispute. In addition, the Fair Credit Billing Act gives individuals the right to deny payment for services or products that are unacceptable.

11. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-11 The Community Reinvestment Act The Community Reinvestment Act is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate- income neighborhoods, consistent with safe and sound banking operations. It was enacted by the Congress in 1977

12. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-12 Restrictions on Competition Justified by moral hazard incentives to take on more risk as competition decreases profitability  Branching restrictions (eliminated in 1994)  Glass-Steagall Act (repeated in 1999) Disadvantages  Higher consumer charges  Decreased efficiency

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15. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-15 International Banking Regulation Similar to U.S.  Chartered and supervised  Deposit insurance  Capital requirement Particular problems  Easy to shift operations from one country to another  Unclear jurisdiction lines

16. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-16 Regulation Applies to a moving target  Calls for resources and expertise Details are important Political pressures

17. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-17 Additional - Usury Laws Many state's laws provide that you cannot lend money at an interest rate in excess of a certain statutory maximum. For IOWA, the legal rate of interest is 10%. In general consumer transactions are governed at a maximum rate of 12%.

18. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-18 Very important to know The Prime Interest Rate is the interest rate charged by banks to their most creditworthy customers (usually the most prominent and stable business customers).

19. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-19 LIBOR : rate stands for "London Inter-Bank Offered Rate." It is based on rates that contributor banks in London offer each other for inter-bank deposits. LIBOR is a rate at which a fellow London bank can borrow money from other banks.

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21. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-21 1980s S&L and Banking Crisis Financial innovation and new financial instruments increasing risk taking Increased deposit insurance led to increased moral hazard Deregulation  Depository Institutions Deregulation and Monetary Control Act of 1980  Depository Institutions Act of 1982

22. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-22 1980s S&L and Banking Crisis (cont’d) Managers did not have expertise in managing risk Rapid growth in new lending, real estate in particular Activities expanded in scope; regulators at FSLIC did not have expertise or resources High interest rates and recession increased incentives for moral hazard

23. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-23 1980s S&L and Banking Crisis: Later Stages Regulatory forbearance by FSLIC  Insufficient funds to close insolvent S&Ls  Established to encourage growth  Did not want to admit agency was in trouble

24. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-24 Principal-Agent Problem for Regulators and Politicians Agents for voters-taxpayers Regulators  Wish to escape blame (bureaucratic gambling)  Want to protect careers  Passage of legislation to deregulate  Shortage of funds and staff Politicians  Lobbied by S&L interests  Necessity of campaign contributions for expensive political races

25. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-25 The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 Regulatory apparatus restructured  Federal Home Loan Bank Board relegated to the OTS  FSLIC given to the FDIC Cost of the bailout approximately $150 billion Re-restricted asset choices

26. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-26 Federal Deposit Insurance Corporation Improvement Act of 1991 Recapitalize the Bank Insurance Fund  Increase ability to borrow from the Treasury  Higher deposit insurance premiums until the loans could be paid back and reserves of 1.25% of insured deposits maintained Reform the deposit insurance and regulatory system to minimize taxpayer losses  Too-big-to-fail policy substantially limited  Prompt corrective action provisions  Risk-based insurance premiums

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30. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-30 Deja Vu It is the existence of a government safety net that increases moral hazard incentives for excessive risk taking on the part of banks

31. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-31 Note: The original material provided by the textbook has been extended to complement the concepts in the class.