im15 - Chapter 15 Banking Regulation Crisis and Response...

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Chapter 15 Banking Regulation: Crisis and Response Overview This chapter reviews the history of twentieth-century banking regulation. It focuses on how regulation promotes the effectiveness of banks as intermediaries in the saving-investment process. Rather than viewing each wave of banking regulation as an independent event, the chapter provides a framework for understanding the cyclical nature of regulation. The chapter posits a four-part cycle in which financial crisis leads to new regulation, which in turn provides incentives for financial innovation and is then followed by regulatory response to the innovation. For instance, the failure of the Fed to carry out its role as lender of last resort in the early 1930s led Congress to set up the FDIC and enact restrictions on bank competition. Banks responded with several innovations including, standby letters of credit, negotiable certificates of deposit, and NOW accounts. Congress then responded to these innovations by passing the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St. Germain Act of 1982. The chapter also contains a thorough account of the difficulties experienced by savings-and-loan associations and commercial banks during the 1980s. The S&L crisis is seen as the result of the maturity mismatch that thrifts operated under as a result of the regulations that reformed the industry during the 1930s. Because of these regulations S&Ls held mostly long-term, fixed-rate mortgages and financed them with short-term deposits. Accordingly, they were vulnerable to interest rate risk; a vulnerability that became strikingly evident beginning in 1979. Contributing to the crisis was the moral hazard problem inherent in deposit insurance; the failure of depositors to monitor S&Ls was not made good by the regulatory authorities. Students often are surprised to learn that, although fraud and corruption played some role in the S&L crisis, structural problems inherent in the regulations under which the industry had operated since the 1930s were more important. The provisions of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, which brought the immediate crisis to an end, are discussed. The related difficulties of the commercial banking system in the 1980s and recent proposals for reform are set out and evaluated. Among these are risk-based pricing of deposit insurance, required under the Federal Deposit Insurance Corporation Improvement Act of 1991 (a worthwhile exercise might be to apply the chapter’s model to current developments in the aftermath of FDICIA). The process of regulatory change is ongoing. If a major piece of banking reform legislation is currently in the news, it might be worthwhile to focus the discussion of this chapter’s material on it.
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