Money and Banking

1
Money and Banking

• Spring 2007
• Martin Andreas Wurm
• University of Wisconsin - Milwaukee

2
Banking Regulation

• Required Reading Mishkin, Chapter 11

3
Banking Regulation

• 1. Overview
• Our discussion so far has demonstrated that
  financial markets play an important macroeconomic
  role, but that they are also fairly incomplete
  markets
• The major cause for economic inefficiency in
  these markets is asymmetric information.

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Banking Regulation

• 1. Overview
• Asymmetric information describes any situation in
  which one party of a deal knows more than another
  party. Two problems can arise from this
• Adverse Selection Occurs before a contract is
  made (e.g. selection of bad borrowers)
• Moral Hazard Occurs after a contract is made
  (e.g. non-compliance such as risky investment of
  borrowed funds)

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Banking Regulation

• 1. Overview
• While banks partly help to overcome some of these
  asymmetric information problems between lenders
  and borrowers, asymmetric information also can
  exist between a banks creditors and the bank
• As seen before banks largely operate on funds
  which are obtained from depositors, stockholders
  and other borrowers.
• Hence, there exists an incentive for bankers to
  get engaged in risky investment activities, which
  promise high returns if successful, while at the
  same time potential losses are incurred by bank
  creditors.

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Banking Regulation

• 1. Overview
• This problem gets worsened through inherent
  problems with banks balance sheets
• Banks assets generally are less liquid than
  their liabilities as seen before.
• If a banks depositors are loosing confidence in
  their bank and quickly withdraw large amounts of
  deposits, a bank can run into liquidity problems,
  even if its investment behavior is not overly
  risky.

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Banking Regulation

• 1. Overview
• Such a quick withdrawal from a banks deposits
  which causes a bank to become illiquid is known
  as a bank run. While often times actual problems
  in bank behavior preceed bank runs they can also
  be triggered by depositors expectations alone
  (self-fulfilling prophecy).
• Again, this is a result of asymmetric
  information, since most depositors only have
  limited means or interest in monitoring their
  banks investment behavior.

8
Banking Regulation

• 1. Overview
• Crises at one bank often times can spill-over to
  other banks, as depositors may perceive their
  deposits exposed to the risk of another bank run.
• If a sufficient amount of bank runs occur
  simultaneously, system-wide bank panics can
  occur. On these occasions, regulators usually
  close banks for a while (bank holidays) until the
  panic has cooled down.

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Banking Regulation

• 1. Overview
• Since banking runs/ panics are often associated
  with the loss of deposits, loans, investment and
  a reduction in the money supply, policy makers in
  most countries regulate the banking sector in
  order to reduce the number of panics.
• In the U.S. eight categories of regulations are
  in place
• The government safety net, restrictions on banks
  asset holdings, capital requirements, chartering/
  bank examination, assessment of banks risk
  management, disclosure requirements, consumer
  protection and restriction of competition

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Banking Regulation

• 2. The government safety net
• The primary government policy tool in the U.S. is
  the Federal Deposit Insurance Corporation (FDIC)
• The FDIC is a deposit insurance scheme set up in
  1934
• It guarantees deposits of member banks up to a
  value of 100.000 per deposit.

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Banking Regulation

• 2. The government safety net
• The installment of the FDIC had a significant
  impact on banking panics in the U.S.
• Prior to 1934 bank runs were common (during the
  1920s about 600 a year, from 1930-33 about 2000 a
  year).
• Further, larger bank panics occurred about every
  20 years (1819, 1837, 1857, 1873, 1884, 1893,
  1907 and 1930-33)
• Between 1934 and the early 1980s the number of
  bank runs in the U.S. on the other hand was only
  about 15 per year.

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Banking Regulation

• 2. The government safety net
• The FDIC operates using two methods of
  guaranteeing deposits
• 1. Payoff method In this scenario the FDIC
  allows a bank to fail, pays off all deposits
  to a value of 100,000 from insurance premia
  received by other member banks (and/or
  taxes).
• After that the bank gets liquidated and the
  FDIC receives its share of the proceeds from
  
• the banks liquidated assets.
• Using this method, the FDIC on average was able
  to save about 90 cents per each deposited Dollar.

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Banking Regulation

• 2. The government safety net
• The FDIC operates using two methods of
  guaranteeing deposits
• 2.Purchase and assumption method In this
  scenario the FDIC
• reorganizes a failed bank (usually through a
  merger) and tries to save all deposits,
  sometimes by subsidizing or taking
  over bad loans.
• While this method saves all deposits, it may not
  be always feasible and has been applied less
  since 1990.

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Banking Regulation

• 2. The government safety net
• Other forms of policy tools further are
  considered part of the government safety net
• Central banks through their ability to create
  liquidity through the printing press can act as
  lender of last resort to banks
• Further, governments directly can bail out banks
  through tax funds
• Finally, the IMF has been effectively acting as
  international lender of last resort in some
  instances of national bank panics.

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Banking Regulation

• 2. The government safety net
• The government safety net, while being effective
  at reducing banking crises, is not
  uncontroversial among economists
• In particular the presence of asymmetric
  information gives depositors an incentive to
  monitor bank behavior.
• If deposits are guaranteed, this incentive is
  removed and as a result moral hazard and adverse
  selection problems may become worse.

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Banking Regulation

• 2. The government safety net
• The original design of the FDIC left some of
  these incentives intact
• By guaranteeing deposits only up to 100,000,
  larger depositors which often are better informed
  about their banks, still have an incentive to
  monitor their banks behavior.
• However, when in 1984 Continental Illinois, one
  of the countries, largest 10 banks at the time
  failed, the FDIC did not only guarantee deposits
  exceeding 100,000, but also covered
  bond-holders losses.

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Banking Regulation

• 2. The government safety net
• In this context the Comptroller of the Currency
  testified to Congress, that the 11 biggest banks
  at the time were considered too-big-to-fail,
  since their failure may cause system-wide
  financial crises.
• This policy since then has been extended to other
  banks and the financial consolidation of banks
  following financial deregulation in the 1990s has
  caused more banks to become too big to fail.
• Further banks have extended their activities to
  new areas such as e.g. securities underwriting,
  which are now effectively covered by the FDIC.

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Banking Regulation

• 2. The government safety net
• As a consequence depositors incentives to
  monitor their banks have been removed even for
  large scale depositors at large banks.
• Hence, bank behavior at these banks may become
  more risky once more, and there exists some
  empirical evidence to support this idea (for
  details see Mishkin)

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Banking Regulation

• 3. Restrictions on banks asset holdings and
  capital requirements
• Since bankers in a world even without deposit
  insurance tend to be more risk loving than some
  of their creditors, some basic regulatory
  measures aim directly at reducing this type of
  behavior
• Certain types of asset holdings such as risky
  common stock are simply prohibited, while further
  portfolio diversification is encouraged

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Banking Regulation

• 3. Restrictions on banks asset holdings and
  capital requirements
• On the capital side banks are required to bring
  in a certain amount of their own funds the idea
  being, that if their own funds are at stake,
  their risk behavior may be reduced
• In the U.S. through most of the 1980s banks had
  to have a leverage ratio (capital/total assets)
  of at least 5 to avoid regulatory sanctions.

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Banking Regulation

• 3. Restrictions on banks asset holdings and
  capital requirements
• After some international bank failures in the
  1970s and 1980s, international attempts of
  standardizing capital requirements created the
  Basel Accord, which requires banks to hold at
  least 8 of their risk weighted assets as capital
• The Basel Accord was worked out by the Basel
  Committee on Banking Supervision at the Bank for
  International Settlements (BIS) in Zurich,
  Switzerland, and more than 100 countries have
  ratified the accord

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Banking Regulation

• 3. Restrictions on banks asset holdings and
  capital requirements
• The accord differentiates banks assets into four
  risk categories
• 1. Zero weight Reserves, OECD Govt securities
• 2. 20 weight Claims on OECD banks
• 3. 50 weight Municipal bonds, residential
  mortgages
• 4. 100 weight Other loans to consumers/
  corporations
• Further, banks off-balance sheet activities
  (such as trading in securities are also included
  in the risk analysis)

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Banking Regulation

• 3. Restrictions on banks asset holdings and
  capital requirements
• The Basel accord has limitations, in particular
  banks have frequently been engaged in regulatory
  arbitrage, i.e. have tried to formally stay in
  the same risk categorization, but to pick more
  risky assets within each category.
• An amendment of the Basel accord, known as Basel
  II, is underway, but its completion currently
  seems doubtful (its original ratification year
  should have been 2004, but it already has been
  rescheduled twice).

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Banking Regulation

• 4. Bank Supervision Chartering and Examination
• Chartering and bank examination are two crucial
  methods to reduce asymmetric information
  problems
• Chartering deals with the adverse selection
  problem
• Individuals who want to open a bank are
  carefully screened.
• Examination deals with the moral hazard problem
• Compliance with capital requirements and
  restrictions on assets are monitored on a regular
  basis.

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Banking Regulation

• 4. Bank Supervision Chartering and Examination
• Charters to national banks are issued by the
  Comptroller of the Currency, state bank charters
  are issued by state banking authorities.
• Investors which are interested in opening a bank,
  must apply with a full business plan and are
  examined with respect to their management
  capabilities, potential future earnings and
  initial capital stock.

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Banking Regulation

• 4. Bank Supervision Chartering and Examination
• Once a charter is granted, banks are subjected to
  frequent (at least once a year) and unannounced
  examination. The criterion used to assess a
  banks situation is the CAMELS ration (for
  capital adequacy, asset quality, management,
  earnings, liquidity and sensitivity to market
  risk)
• Further, banks have to file periodic call reports
  on their assets, liabilities, income, dividends,
  ownership, foreign exchange transactions, etc.

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Banking Regulation

• 4. Bank Supervision Chartering and Examination
• If banks fail to comply, the examinating
  authority can issue cease and desist orders, mark
  banks as problem banks or close a bank
  entirely.
• The authorities which deal with chartering and
  examination are
• The Comptroller of the Currency for national
  banks
• The Federal District Banks for member banks of
  the FED
• The FDIC for non-member banks of the FED

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Banking Regulation

• 5. Assessment of banks risk management
• The dynamics of financial innovation over the
  past decades have lead to the insight on
  regulators behalf that simple examination of a
  banks current situation may not be sufficient
  with respect to the risks banks are facing today.
• As a consequence the CAMELS rating has been
  amended by a risk score, which tries to classify
  the quality of a banks risk management according
  to the quality of oversight through directors and
  senior management, policies against and limits to
  risky investment policies, the quality of risk
  measurement and monitoring and the internal fraud
  control within a bank.

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Banking Regulation

• 6. Disclosure requirements
• Since depositors and other bank creditors do not
  necessarily have the means and incentive to
  gather information about bank behavior by
  themselves, banks are forced to provide
  information to the public
• Banks are subject not only to regular disclosure,
  but also to specific accounting and balancing
  principles in addition to the existing standard
  regulations.

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Banking Regulation

• 7. Consumer protection
• Since often times smaller bank customers are more
  strongly imposed to moral hazard and adverse
  selection problems, legislation has been passed
  to protect banks customers
• The consumer protection act of 1964 aims at
  creating truth in lending, i.e. all lenders
  have to provide information about the cost of
  borrowing when a contract is made.

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Banking Regulation

• 7. Consumer protection
• Further,
• The fair credit billing act of 1974 forces
  creditors to provide information on assessment
  charges and to speed up the handling of billing
  complaints
• Both acts are administered by the FED under
  regulation Z

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Banking Regulation

• 7. Consumer protection
• Further,
• The equal credit opportunity act of 1974 / 1976
  prohibits discrimination by race, gender, age,
  etc. in bank lending
• The community reinvestment act of 1977 prohibits
  red-lining, i.e. banks must also lend in areas
  which they raise deposits from

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Banking Regulation

• 8. Restrictions on competition
• For a long time bank competition in this U.S. was
  restricted, since there was a common believe that
  competition incentived bankers to get engaged in
  more risky behavior
• Branch banking, non-bank activities or the
  payment of interest on deposits in the U.S. was
  prohibited under the Glass-Steagal act which was
  repealed in 10000 and Requlation Q.
• Limits to competition create the usual problems
  of monopolization in the banking sector, while
  the detrimental effects were strongly debated by
  many economists.