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CHAPTER 16 REGULATION OF FINANCIAL INSTITUTIONS CHAPTER OBJECTIVES 1. This chapter explains how and why depository institutions are regulated, with particular emphasis on commercial banks as the basic model for other depository institutions. 2. The chapter summarizes major financial institutions legislation of the last 25 years. 3. The chapter surveys federal deposit insurance, with particular attention to prevention of bank failure and disposition of failed banks. Crucial public policy issues in government deposit insurance include moral hazard and the “Too Big to Fail” doctrine. 4. The chapter summarizes the bank examination process, a unique regulatory intervention with few parallels in other industries, and explains the “CAMELS” rating system. 5. The chapter identifies the principal regulators of banking and summarizes the seemingly convoluted relationships among them. While sufficient analysis does discern a logic in these relationships, students without a career interest in banking may just prefer to learn them by rote memorization. 6. The chapter discusses other regulatory agendas, including competition, structure, and consumer protection. CHANGES FROM THE LAST EDITION Tables, data, anecdotal references, and legislative developments have been updated. CHAPTER KEY POINTS 1. Depository institutions are heavily regulated because society heavily depends on them. Their deposit liabilities represent most of the money supply and their operations are critical to the payments system. Their power to allocate credit is a social and economic power so important that government inevitably seeks to share it. Unregulated banking is thus not an option in a developed country. Institutions accept regulation as a condition of their profitability and power, but try to “innovate around” regulation. This sets up a “regulatory dialectic” in which innovation prompts new regulation. 2. Most regulation focuses on safety and soundness, and particularly aims to prevent either of the main causes of bank failure: illiquidity or insolvency. Bank failures have less acceptable “fallout” than failures of other businesses: The social cost of a failure (damage to public confidence, disruption of credit) is assumed to exceed the value of the institution. Key safety and soundness measures include minimum risk-based capital standards, risk-based deposit insurance premiums, and the CAMELS rating system. Much of today’s regulatory system represents painful lessons learned in the 1980s and early 1990s. 3. The FDIC has evolved from a mere backer of deposits to a proactive “policeman”. Much of the banking legislation of the late 1980s and early 1990s was concerned with enlarging the FDIC and its powers. Deposit insurance entails some interesting public policy issues, including moral hazard and the “too big too fail” doctrine. When disposing of a failed bank, the FDIC prefers to maintain it as a going concern by turning its viable assets and liabilities over to a healthy institution. This avoids the
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This note was uploaded on 02/23/2011 for the course FINA 4090 taught by Professor S during the Spring '11 term at Toledo.

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