Bank Regulation US

1
Bank Regulation (US)

• Major Duties Chartering and Examination
• Chartering -- Granting the bank permission to
  begin business.
• -- National Banks
• -- State Banks
• Examination Supervision of bank activity,
  including periodic auditing of bank records.

2
Regulators Commercial Banks

• Comptroller of the Currency -- charterer and
  primary examiner of national banks
• State Banking Authorities -- charterer and
  primary examiner of state banks
• Federal Reserve -- secondary examiner of member
  banks

3
Federal Deposit Insurance Corporation (FDIC)

• Secondary examiner to some banks
• Insures bank deposits guaranteed up to 100,000
  per depositor

4
Deposit Insurance Pros and Cons

• Pros -- protects customers
• -- greatly reduces bank runs
• Cons -- gives banks implicit
• incentive to engage in bad
• business practices

5
Moral Hazard and Adverse
Selection

• Moral Hazard -- Those who have insurance may use
  it as a safety net, a justification to take on
  greater risk.
• Adverse Selection -- Insurance tends to attract
  people most likely to take advantage of it.

6
FDIC -- Resolving Situations With Problem Banks

• Options handling problem banks
• Close bank, pay off depositors (e.g. Freedom
  National Bank of RI)
• Merge bank with a healthy bank (e.g. Syracuse
  Savings Bank)
• Decisions unique to individual cases (e.g. Bank
  of New England) - the too big to fail policy

7
Regulators -- Savings Banks and Savings and Loans

• Deposit Insurance FDIC
• Primary Examiner Office of Thrift Supervision
  (OTS)
• Most Savings and Loans members of Federal Home
  Loan Bank System (FHLBS)
• Regulatory system -- overhauled in past decade

8
Credit Unions

• Most are members of the National Credit Union
  Administration (NCUA).
• Deposit Insurance National Credit Union Share
  Insurance Fund (NCUSIF).
• No major overhauls to regulatory system.

9
The Savings and Loan Crisis (US) A Case Study

• Affected all of banking system, Savings and Loans
  the most dramatic.

10
US Banking in the 1950s and 1960s Fat City

• Regulation Q mandated ceilings on bank deposits
  (no more than 3 max), kept cost of funds down
  for banks
• Low inflation, low interest rate environment
  (e.g. 6 fixed rate mortgages)
• The 3-6-3 Rule of Banking

11
The 1970s -- Banking in a Weakened State

• Disintermediation -- due to rising market
  interest rates with Regulation Q, along with the
  emergence of Money Market Mutual Funds.
• Interest Rate Risk -- inability to pass on rising
  interest rates to existing loans

12
Another Problem The Fed Losing Member Banks

• Traditional Advantage to Membership -- Use of the
  Discount Window.
• Traditional Disadvantage to Membership -- Fed
  gives higher reserve requirements.

13
The Early 1980s -- Regulatory Forbearance

• Regulatory Forbearance -- Passing legislation to
  improve banks competitive position, to see if
  they could fix the problem themselves.

14
The Depository Institutions Deregulation and
Monetary Control Act (DIDMCA)

• Created NOW and ATS Accounts.
• Phased out Regulation Q, completed on 3/31/86.
• Allowed Savings Banks and Savings and Loans to
  make restricted amounts of commercial loans ( of
  total assets).

15
More Provisions DIDMCA

• Liberalized capital requirements of Savings Banks
  and SLs.
• Increased deposit insurance from 40,000 to
  100,000.
• Opened the Discount Window to all banks.
• Imposed uniform reserve requirements for all
  banks.

16
More Legislation The Garn-St. Germain Act
(1982)

• Granted Money Market Deposit Accounts (MMDAs) and
  Super NOW Accounts.
• Increased percentage of allowable assets of
  Savings Banks and Savings and Loans held as
  commercial mortgages.

17
Mid and Late 1980s -- The Problem Worsens

• Defaults on very risky loans (shopping malls in
  the desert).
• Purchases of junk bonds.
• Fraud in the banking system (Charles Keating)
• Brokering Deposits -- spreading out deposit
  insurance.

18
Regulatory Forbearance A Failure

• Increased moral hazard -- The Haymaker
  strategy.
• Increased adverse selection -- The size of the
  mess doesnt matter, illegal profiteering.
• Zombie Savings and Loans

19
Late 1980s and Early 1990s -- Handling the
Crisis

• The Financial Institutions Reform, Recovery, and
  Enforcement Act (FIRREA) of 1989 -- regulators
  stepping in and resolving Savings and Loan crisis
  (other banks as well)

20
Major Provisions FIRREA

• Abolished the regulatory structure at that time
  -- the Federal Home Loan Bank Board (FHLBB) and
  the Federal Savings and Loan Insurance
  Corporation (FSLIC)
• FDIC -- insurer of Savings Banks and Savings and
  Loans
• Created Office of Thrift Supervision (OTS)

21
More Provisions FIRREA

• Created Resolution Trust Corporation (RTC) --
  manage the bailout
• Savings and Loans -- can no longer purchase junk
  bonds
• Increased capital requirements of Savings Banks
  and Savings and Loans from 3 to 8 (with risk
  adjustment for loans).
• Basle Agreement uniform 8 capital requirements
  for G-10 countries

22
Still More Provisions FIRREA

• Significantly decreased percentage of assets of
  Savings Banks and Savings and Loans held as
  Commercial Loans.
• Refocused Savings and Loans to consumer mortgages.

23
Legislation to Change the FDICs Role FDICIA

• Federal Deposit Insurance Corporation Improvement
  Act (FDICIA) of 1991
• Gave more authority to FDIC in some areas, took
  authority away in other areas.

24
Major Provisions -- FDICIA

• Increased FDICs ability to fund the Savings and
  Loan bailout.
• Gave FDIC authority to intervene earlier for
  banks facing difficulties.
• Gave FDIC larger role in serving as bank
  examiner.
• Greater limitations on imposing too big to fail
  policy.

25
More Provisions -- FDICIA

• Gave Federal Reserve supervisory responsibility
  for foreign banks operating in the US.
• Brokered deposits only insured under pension
  plans at well-capitalized banks.
• Risk-based deposit insurance addressing moral
  hazard.

26
Other Proposed Reforms Deposit Insurance

• Eliminate it, or restrict to very narrow banks.
• Lower limits.
• Have private deposit insurance by private
  insurers.
• Institute co-insurance (fully covered
  deductible plus of rest).

27
The 1992-2005 Healthy But Shrinking

• Savings and Loan bailout -- completed
  effectively.
• Disintermediation legislation -- it worked!
• Beneficial interest rate risk -- due to decreases
  in interest rates.
• A series of beneficial financial innovations.

28
Financial Innovations -- Banking

• The Individual Retirement Account (IRA) -- tax
  advantages for long-term saving (Classic IRA vs
  Roth IRA)
• Shorter-term mortgages (15 year, even 10 year).
• Adjustable Rate Mortgages (ARMs) -- sharing of
  interest rate risk
• Mortgage Securitization (Mortgage Backed
  Securities) enabled bank to sell money-losing
  mortgage.

29
More Financial Innovations in Banking

• Sweep Accounts -- balances in a checking account
  above a forecasted necessary minimum are
  automatically swept into RP, Eurodollars, MMMF,
  or MMDA (lowers required reserves).
• Automatic Teller Machines (ATMs)
• Debit cards and credit cards makes checking
  accounts more attractive, increases bank
  offerings.

30
Hedging Interest Rate Risk Futures and Options

• Large Banks in particular -- use with CDs,
  stabilizing cost of funds.
• Financial Futures Market -- Market to sell
  specified amounts of bonds at a specified bond
  price (and interest rate), at a specified future
  date.

31

• Options Market -- Market to buy (call option) or
  sell (put option) a security at a given price
  over a fixed time interval (up to a maximum
  amount
• Other Financial Derivatives

32
Compression of the Banking Industry

• The McFadden Act (1927) -- Prohibited interstate
  bank branching in the US
• Protecting the small bank versus limiting
  competition.

33
Circumventing the McFadden Act

• Emergence of Bank Holding
• Companies, corporations that house banks.
• Shared electronic banking facilities.
• Banks striking deals with the FDIC.

34
The Final Action The Riegle-Neal
Act

• The Riegle-Neal Act (1994) -- Repealed the
  McFadden Act, permitted interstate branching in
  the US.
• A flurry of bank mergers, for reasons different
  from the 1970s and 1980s.

35
2006- Subprime Mortgages and the Credit Crunch

• Subprime Mortgages -- mortgages given to people
  with substandard credit qualifications.
• Higher default risk than standard mortgages.
• Exist as securitized mortgages (MBS) originate
  and distribute banking.
• MBS done in tranches splitting up bundles
  according to default risk.

36
Deceptiveness With Mortgage Backed Securities

• Collateralized Debt Obligations (CDO) MBS
  reconstituted (split into tranches) and then
  resold).
• Structured Investment Vehicles (SIV)
  off-the-balance sheet nonbanks created by banks
  to hold CDO, exempt from Basel I capital
  requirements.
• Conduits similar to SIV but backed and owned by
  banks. Also buyers of CDO.
• SIV, Conduits, financed through Asset-Backed
  Commercial Paper

37
Subprime Mortgages, MBS, and the Credit Crunch

• Default risk not valued properly by holders of
  securitized mortgages (rating agencies paid by
  issuers of MBS).
• Many MBS based upon subprime mortgages on ARMs
  interest rate rises after adjustment period,
  increased defaults.
• Falling house prices, bank and MBS holders cant
  recoup full value of defaulted loan.
• Falling home prices exacerbated by many
  foreclosures at once.
• Major defaults on MBS, affects portfolios of
  holders beyond banks and the US.

38
Major Federal Reserve Actions Banking and the
Credit Crunch

• Extended Discount Window loaning to banks,
  including establishing a Term Auction Facility
  (anonymous borrowing).
• Purchased Asset-Backed Commercial Paper
• Major infusion of liquidity into banking system
  via open market operations.
• Kept Fannie Mae and Freddie Mac afloat
• Extended deposit insurance protection
• Helped arrange some bank mergers (e.g. Wachovia
  and Citigroup)
• The bailout bill and the bailout funds?

39
The Credit Crisis, Banking and the Federal Reserve

• How and how much should the Fed help holders of
  MBS, banks and borrowers with subprime mortgages?
• Assistance versus increasing moral hazard/adverse
  selection
• How to address which problem liquidity versus
  loan defaults
• The Federal Reserve as stabilizer versus the
  Federal Reserve as enabler
• How to restore confidence of banks

40
Issues in International Banking

• Traditional Issue -- US banks (operating in the
  US or abroad) at a comparative disadvantage
  relative to foreign banks (operating in the US or
  abroad).
• Applicable regulation comes from country of
  origin.
• US banking, more heavily regulated.

41
Reducing Comparative Disadvantage of US Banks

• Edge Act Corporations -- subsidiary of US bank
  which operates overseas.
• International Banking Facilities (IBFs) --
  Institutions in the US that can accept time
  deposits from foreigners and make loans to
  foriegners (not subject to reserve requirements).

42
Related Legislation

• International Banking Act of 1978 (1927) --
  Foreign banks operating in the US have to follow
  US banking regulations.
• Provision of FDICIA -- Gave Federal Reserve
  supervisory responsibility over foreign banks
  operating in the US.
• Repeal of McFadden Act?

43
International Banking and the Credit Crunch

• Recognition as global financial problem
• Coordinated infusions of liquidity (by open
  market operations) among a number of central
  banks worldwide
• Increased global coordination of banking
  regulations?
• Basel II treats off-balance sheet items as
  regular entities in computing capital
  requirements. Implemented in Europe in 2007, not
  in effect in US.