Industry Chapters10&11
Banking and Regulation
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EvolutionoftheBankingIndustry
Financial innovation is driven by the desire to earn profits A change in the financial environment stimulates a search for innovations that are likely to be profitable
Responses to change in demand conditions Responses to changes in supply conditions Avoidance of regulations
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DualBankingSystem
State banks chartered by state governments
National banks chartered by federal government beginning in 1863
After the Riegle-Neal Act, the differences are mostly unimportant
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PrimarySupervisoryResponsibility ofBankRegulatoryAgencies
Comptroller of the Currency national banks Federal Reserve and state banking authoritiesstate banks that are members of the Federal Reserve System
Fed also regulates bank holding companies
FDICinsured state banks that are not Fed members State banking authorities state banks without FDIC insurance
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ResponsestoChangesinDemand Conditions:InterestRateVolatility
Adjustable-Rate Mortgages
Flexible interest rates keep profits high when rates rise Lower initial interest rates make them attractive to home buyers
Financial Derivatives
Ability to hedge interest rate risk Payoffs are linked to previously issued securities
Explosion of Securitization / OTD lending practices
Excessively easy money (low interest rates) in early 2000s led to profitable and robust market for MBS
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ResponsestoChangesinSupply Conditions:InformationTechnology
Bank credit and debit cards Improved computer technology lowers the transaction costs Electronic banking ATM Home banking ABM Virtual banking Junk bonds Commercial paper market Securitization (whoops)
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AvoidanceofRegulations: LoopholeMining
Reserve requirements act as a tax on deposits
Sweep accounts transform reservable liabilities into non-reservables
Restrictions on interest paid on deposits led to disintermediation
Mutual funds, esp. money market mutual funds
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DeclineofTraditionalBanking
As a source of funds for borrowers, market share has fallen Share of total financial intermediary assets has fallen
Also a result of increased popularity elsewhere
No decline in overall profitability
Saw drop in NIM
Increase in income from off-balance-sheet activities
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Whatcanthisdeclinebeattributedto?
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DeclineofTraditionalBanking
Decline in cost advantages in acquiring funds (liabilities)
Rising inflation led to rise in interest rates and disintermediation Low-cost source of funds, checkable deposits, declined in importance
Decline in income advantages on uses of funds (assets)
Information technology has decreased need for banks to finance short-term credit needs or to issue loans Information technology has lowered transaction costs for other financial institutions, increasing competition
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BanksResponses
Expand into new and riskier areas of lending
Commercial real estate loans Leveraged buyouts Corporate takeovers
Pursue off-balance-sheet activities
Non-interest income Concerns about risk
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Branching
McFadden Act and state branching regulations prohibited branching across state lines
Forced national banks to conform to the branching regulations of the state in which they were located Result?
Bank holding companies and automated teller machines are responses to these regulations
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BankConsolidation
The number of banks has declined over the last 25 years
Bank failures Consolidation DeregulationRiegle-Neal Interstate Banking and Branching Efficiency Act of 1994 Economies of scale and scope from information technology
Results may be not only a smaller number of banks but a shift in assets to much larger banks
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BenefitsandCostsofBank Consolidation
Benefits Increased competition, driving inefficient banks out of business Increased efficiency also from economies of scale and scope Lower probability of bank failure from more diversified portfolios Costs Elimination of community banks may lead to less lending to small business Banks expanding into new areas may take increased risks and fail
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SeparationofBankingandOther FinancialServices
Glass-Steagall Act of 1933
Prohibited commercial banks from underwriting corporate securities or engaging in brokerage activities Section 20 loophole was allowed by the Federal Reserve enabling affiliates of approved commercial banks to underwrite securities to a limited extent U.S. Supreme Court validated the Feds action in 1988
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SeparationofBankingandOther FinancialServices(contd)
Gramm-Leach-Bliley Financial Services Modernization Act of 1999
Abolishes Glass-Steagall States regulate insurance activities SEC keeps oversight of securities activities Office of the Comptroller of the Currency regulates bank subsidiaries engaged in securities underwriting Federal Reserve oversees bank holding companies
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ThriftIndustry: RegulationandStructure
Savings and Loan Associations
Chartered by the federal government or by states Most are members of Federal Home Loan Bank System (FHLBS) Deposit insurance provided by Savings Association Insurance Fund (SAIF), part of FDIC Regulated by the Office of Thrift Supervision Approximately half are chartered by states Regulated by state in which they located are Deposit insurance provided by FDIC or state insurance
Mutual Banks
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ThriftIndustry: RegulationandStructure(contd)
Credit Unions
Tax-exempt Chartered by federal government or by states Regulated by the National Credit Union Administration (NCUA) Deposit insurance provided by National Credit Union Share Insurance Fund (NCUSIF)
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AsymmetricInformationandBank 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
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TooBigtoFail
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
Taken another step recently (LTCM, BSC)
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RestrictionsonAssetHolding andBankCapitalRequirements
Attempts to restrict banks from too much risk taking
Promote diversification
All things in moderation?
Prohibit holdings of common stock Set capital requirements
Minimum leverage ratio Basel Accord: risk-based capital requirements
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Bank(Prudential)Supervision: CharteringandExamination
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 Filing periodic call reports
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ConsumerProtection
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
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RestrictionsonCompetition
Justified by moral hazard incentives to take on more risk as competition decreases profitability
Branching restrictions (eliminated in 1994) Glass-Steagall Act (repealed in 1999)
Disadvantages
Higher consumer charges Decreased efficiency
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MajorBankingLegislation
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MajorBankingLegislation
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MajorBankingLegislation
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InternationalBankingRegulation
Similar to U.S.
Chartered and supervised Deposit insurance Capital requirement Easy to shift operations from one country to another Unclear jurisdiction lines
Particular problems
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Regulation
Applies to a moving target
Calls for resources and expertise Plugging holes strategy?
Details are important Political pressures
Top recipients of campaign contributsion from FNM/FRE
Christopher Dodd Barack Obama John Kerry
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Numberofbankfailuressince GD
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1980sS&LandBankingCrisis
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
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1980sS&LandBankingCrisis (contd)
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
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1980sS&LandBankingCrisis: LaterStages
Regulatory forbearance by FSLIC
Insufficient funds to close insolvent S&Ls Established to encourage growth Did not want to admit agency was in trouble
Zombie S&Ls taking on high risk projects and attracting business from healthy S&Ls Competitive Equality in Banking Act of 1987
Inadequate funding Continued forbearance
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PrincipalAgentProblem forRegulatorsandPoliticians
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 Lobbied by S&L interests Necessity of campaign contributions for expensive political races
Politicians
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TheFinancialInstitutionsReform, Recovery,andEnforcementActof1989
Regulatory apparatus restructured
Federal Home Loan Bank Board relegated to the OTS FSLIC given to the FDIC RTC established to manage and resolve insolvent thrifts
Cost of the bailout approximately $150 billion Re-restricted asset choices
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FederalDepositInsuranceCorporation ImprovementActof1991
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
0.15% (1990); -0.25% (1991); 1.01% (2008)
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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US Current?
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DejaVu
It is the existence of a government safety net that increases moral hazard incentives for excessive risk taking on the part of banks
Notice how this has been part of Money & Banking Texts for years.
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