PURPOSES OF REGULATION

1
FINANCIAL REGULATION AND SOUNDNESS OF THE
FINANCIAL SYSTEM
Lecture 9
2
BEGINNING TERMS

• BANK REGULATIONS
• BANK SOUNDNESS
• DEREGULATION
• DUAL BANKING SYSTEM
• BANK MERGERS
• BANK HOLDING COMPANIES
• BANK RUN

3
BEGINNING TERMS

• BANK PANIC
• LENDER OF LAST RESORT
• DISCOUNT WINDOW
• CAPITAL REQUIREMENTS
• CHARTERING PROCESS
• DEPOSIT INSURANCE
• MORAL HAZARD
• FAILURE RESOLUTION
• PAY-OFF METHOD
• PURCHASE AND ASSUMPTION METHOD

4
BEGINNING TERMS

• FIXED COSTS
• ECONOMIES OF SCALE
• ECONOMIES OF SCOPE

5
PURPOSES OF REGULATION

• GENERAL PURPOSE
• SOUNDNESS OF THE BANKING
• SYSTEM-- SAFETY OF DEPOSITORS
• FUNDS

6
PURPOSES OF REGULATION

• GENERAL PURPOSE
• SOUNDNESS OF THE BANKING
• SYSTEM-- SAFETY OF DEPOSITORS
• FUNDS

LIMIT EXCESSIVE COMPETITION
REDUCE THE THREAT OF MONOPOLY
LIMIT RISK- TAKING
7
BASIS FOR REGULATING BANKS

• 1. CONSTITUTIONAL BASISART.I , SEC 8
• 2. EPISODES OF FINANCIAL PANIC
• THROUGHOUT U.S. HISTORY
• 3. DISASTER OF THE GREAT
• DEPRESSION
• 4. DEREGULATION MOVEMENT OF THE
• 1970S / LOBBYING BY DEPOSITORY
• INSTITUTION -- DIDMCA,1980 AND
• GARN-ST GERMAIN ACT, 1982

8
History of Bank Regulation Check List

• First Bank the United States, 1791- 1812
• Second Bank of United States, 1816 -1836
• Free Banking Period, 1836 - 1864
• National Banking Act, 1864
• Federal Reserve Act, 1913
• Federal Deposit Insurance Act, 1933
• The Glass-Steagall Act, 1933
• The Bank Holding Company Act, 1956
• International Banking Act, 1978
• Depository Institutions Deregulation and Monetary
• Control Act, 1980
• 11. Depository Institutions Act, 1982

9
History of Bank Regulation Check List
12. Financial Institutions Reform, Recovery, and
Enforcement Act, 1989 13. Federal Deposit
Insurance Corporation Improvement Act,
1991 14. Riegle-Neal Interstate Banking and
Branching Efficiency Act, 1994
10
First Bank the United States, 1791- 1812
The First Bank of the United States was needed
because the government had a debt from the
Revolutionary War, and each state had a
different form of currency. The Bank began while
Philadelphia was still the nation's capital.
Alexander Hamilton conceived of the bank to
handle the colossal war debt -- and to create a
standard form of currency.The First Bank's
charter was drafted in 1791 by the Congress and
signed by George Washington. In 1811, Congress
voted to abandon the bank and its charter. From
1812-1816 the Federal government was not directly
involved in bank regulation.

11
Second Bank of United States, 1816 -1836
The Second Bank of the United States was
chartered for many of the same reasons as the
First Bank of the United States. The War of
1812 had left a formidable debt. Inflation surged
ever upward due to the ever-increasing amount of
notes issued by private banks. Specie was
jealously hoarded. For these reasons President
Madison signed a bill authorizing the 2nd Bank in
1816 with a charter lasting 20 years. In the late
1820s a clash erupted between President Andrew
Jackson and the Banks President Nicholas Biddle.
A fierce political battle took place in 1832 when
the Bank was to be rechartered. The U.S. Senate
passed to rechartering bill, but Jackson vetoed
it. The Bank obtained a Pennsylvania state
charter but failed in the early 1840s.
12
Free Banking Period, 1836 - 1864
During this period state banks issue their own
currency. Each state had their own regulatory
structure, most were relatively weak and lacked
adequate enforcement.The free banking period was
also called the era of wildcat banking. There was
little control over the money supply and over and
under expansion of money led to violent
business cycle movements. The economy lack a
homogeneous currency and banking regulation was
not uniform across the different states.
13
National Banking Act, 1864
The National Bank Act established a uniform
currency in the form of the National Bank notes.
The act created The Office of the Comptroller of
the Currency to supervise national banks and
control note issues. This Act began the dual
banking system in the United States.
14
Federal Reserve Act, 1913
The evolution of the Fed didn't begin in 1913
rather, in the Banking Panic of 1907, the most
severe of four national banking panics that had
occurred in the previous 34 years. From the
preamble An Act To provide for the establishment
of Federal Reserve banks, to furrish an elastic
currency, to afford means of rediscounting
commercial paper, to establish a more effective
supervision of banking in the United States, and
for other purposes.
15
Federal Deposit Insurance Act, 1933
The Great Depression of the late 1920s and early
1930s caused financial chaos in America. More
than 9,000 banks closed between the stock market
crash of October 1929 and March of 1933, when
President Franklin Delano Roosevelt took office .
For all practical purposes, the nation's banking
system had shut down completely even before
President Roosevelt - less than 48 hours after
his inauguration declared a "banking holiday"
suspending all banking activities until
stability could be restored. Among the actions
taken by Congress to bring order to the system
was the creation of the FDIC in June 1933. The
intent was to provide a federal government
guarantee of deposits so that customers' funds ,
within certain limits, would be safe and
available to them on demand. Since the start of
FDIC insurance on January 1, 1934, not one
depositor has lost a cent of insured funds as a
result of a failure.
16
The Glass-Steagall Act, 1933
The Glass-Steagall Act erected a wall between
commercial banking and investment banking.
Section 16, as amended by the Banking Act of
1935, generally prohibits Federal Reserve member
banks from purchasing securities for their own
account. exceptions include U.S. Government
obligations, obligations issued by government
agencies, college and university dormitory bonds,
and the general obligations of states and
political subdivisions. The Glass-Steagall Act
was enacted to remedy the speculative abuses that
infected commercial banking prior to the collapse
of the stock market and the financial panic of
1929-1933. Many banks, especially national banks,
not only invested heavily in speculative
securities but entered the business of investment
banking in the traditional sense of the term by
buying original issues for public resale.
17
The Bank Holding Company Act, 1956
In 1956, the first comprehensive regulatory
statute dealing expressly with BHCs was passed to
(1) restrict MBHCs from engaging in non-financial
activities and to limit financial activities 2)
restrict MBHCs from acquiring banks in more than
one state unless explicitly permitted by the
states involved (the Douglas Amendment to the
Act). Because the BHC Act applied only to MBHCs,
many banks whose inroads into nonbanking
activities were being obstructed by the courts,
formed one-bank holding companies (OBHCs) to
allow them to engage in both interstate banking
and nonbanking activities. In 1970 OBHC were
bought under the Act.
18
International Banking Act, 1978
Brought foreign banks under the federal
regulatory framework applicable to
domestic banks. Required deposit insurance for
branches of foreign banks engaged in retail
deposit activities.
19
Depository Institutions Deregulation and
Monetary Control Act (DIDMCA), 1980
Established "NOW Accounts." Started the
phase-out of interest rate ceilings on deposits
(Reg. Q). Established the Depository Institutions
Deregulation Committee. Expanded the banking
powers of thrift institutions. Raised the
deposit insurance ceiling to 100,000
20
Depository Institutions Act (Garn-St Germain),
1982
Increased FDIC powers to assist troubled banks.
Set up the Net Worth Certificate program.
Expanded the banking powers of thrift
institutions.
21
Financial Institutions Reform, Recovery, and
Enforcement Act (FIRREA), 1989
Abolished the Federal Savings Loan Insurance
Corporation (FSLIC). Gave responsibility for
insuring the deposits of thrift institutions to
the FDIC. Abolished the Federal Home Loan Bank
Board. Created the Resolution Trust Corporation
(RTC) as a temporary agency of the government.
22
Federal Deposit Insurance Corporation
Improvement Act (FDICIA), 1991
Recapitalized the Bank Insurance Fund and allowed
the FDIC to strengthen the fund by borrowing from
the Treasury. Mandated a least-cost and prompt
resolution approach to problem and failing banks.
Ordered the creation of a risk-based deposit
insurance assessment scheme. Established new
supervisory and regulatory examination standards
and put forth new capital requirements for
banks.
23
Riegle-Neal Interstate Banking and Branching
Efficiency Act, 1994
Permits adequately capitalized and managed bank
holding companies to acquire banks in any state
one year after enactment. Beginning June 1, 1997
allows interstate mergers between adequately
capitalized and managed banks subject to state
laws and CRA evaluations. Extends the statute of
limitations to permit the FDIC and RTC to revive
lawsuits that had expired under state statutes
of limitations.
24
Gramm-Leach-Bliley Act, 1999
This Act breaks down barriers--some of which are
seven decades old--and allows full affiliation of
banking with underwriting and agency activities
in securities and insurance. The act goes
further by allowing affiliation between
commercial and merchant banking that includes
allowing banks to hold equity in firms for the
purpose of eventual resale. The act also gives
the Fed and the Treasury the authority to define
new activities that are financial in nature, or
incidental to financial activities. Regarding
banking and commerce, the act for the most part
keeps them separate. However, the Fed can
determine when some nonfinancial activities are
complementary to financial services.
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OVERVIEW OF BRANCH BANKING HISTORY AND
TERMINOLOGY
26
HISTORICAL PATTERNS BRANCH BANKING
STATEWIDE BRANCHING
LIMITED-AREA BRANCHING
UNIT BANKING
27
HISTORICAL PATTERNS BRANCH BANKING
STATEWIDE BRANCHING
LIMITED-AREA BRANCHING
UNIT BANKING
RECIPROCAL INTERSTATE BRANCHING
28
HISTORICAL PATTERNS BRANCH BANKING
INTERSTATE BANKING ACT OF 1994
29
Expansion Through Bank Mergers
BANK MERGERS
30
Definition of Mergers
A merger is a combination of two or more
companies In which all but one of the combining
companies legally cease to exist and the
surviving company continues operation under its
original name. A consolidation is A combination
in which all of the combining companies are
dissolved and a new firm is formed. The term
merger is generally used to describe both of
these transactions. A horizontal merger is
between two or more companies that compete
directly with one another. A vertical merger is
between companies that may have a buyer/seller
relationship. A conglomerate merger is between
unrelated companies.
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Why Banks Merger

• DEFINITION PROFIT MEASURE
• P ( L iL ) - ( D iD ) - FC
  PROFIT
• PROFIT INDEX RETURN ON EQUITY PROFIT
  / EQUITY CAPITAL ROE
• ( P / E ) ( L iL ) - ( D iD ) - FC
  / E
• PROFIT INDEX ROE

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THE MERGER OF TWO BANKS CAN EFFECT

• FIXED OR OVERHEAD COSTS
• RESERVES
• EQUITY
• CHANGES IN THESE ITEMS CAN EFFECT THE
  CONSOLIDATED BANKS ROE .

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SUPPOSE WE HAVE TWO IDENTICAL BANKS

• BANK A BANK B

Ck. DEPOSIT 100M EQUITY 6M
RESERVES 12M LOANS 94
RESERVES 12M LOANS 94M
Ck. DEPOSITS 100 M EQUITY 6M
ASSUME THAT iL 12
iD 10
FC .5M
34
INITIAL PROFIT

• P ( 94 .12 ) - ( 100 .10 ) - .5

35
INITIAL PROFIT

• P ( 94 .12 ) - ( 100 .10 ) - .5

BANK REVENUE
BANK FUNDING COSTS
BANK FIXED COST
36
INITIAL PROFIT

• P ( 94 .12 ) - ( 100 .10 ) - .5
• 11.28 - 10.00 - .5 .78M
• ROE (P / E) ( .78 M/ 6 M ) .13

BANK REVENUE
BANK FUNDING COSTS
BANK FIXED COST
37
SUPPOSE BANK A AND BANK B
MERGE

• BANK A BANK B

Ck. DEPOSIT 100M EQUITY 6M
RESERVES 12M LOANS 94M
RESERVES 12 LOANS 94
Ck. DEPOSITS 100 M EQUITY 6M

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TO BECOME MEGA BANK

• MEGA BANK

RESERVES 24M LOANS 188M
Ck. DEPOSITS 200M EQUITY 12M
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POSSIBLE IMPACTS OF MERGER ON FIXED COST

• -- ELIMINATION OF ONE COMPUTER
• OPERATION
• -- LAYOFF SYSTEM ANALYSTS
• -- REDUCE RESEARCH STAFF , LOAN
• CLERKS , ONE PRESIDENT , ETC.

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POSSIBLE IMPACTS OF MERGER ON FIXED COST

• SUPPOSE THAT FC RISE TO 700,000 AFTER THE
  ELIMINATION OF DUPLICATE OPERATIONS i.e., FOR
  THE COMBINED ORGANIZATION.
• P ( 188 .12 ) - ( 200 .10 ) - .7M
• 22.56 - 20.00 - .7
• 1.86 or 1,860,000
• ROE P / E 1,860,000 / 12,000,000
• .155 or 15.5

41
DEFINITION

• ECONOMIES OF SCALE WHEN COSTS RISE LESS THAN
  PROPORTIONALLY WITH ASSETS , WE SAY ECONOMIES OF
  SCALE EXIST. IN OUR EXAMPLE , ASSETS DOUBLED FROM
  106M TO 212M AND FIXED COSTS (FC) ROSE FROM
  500,000 TO 700,000 .

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POSSIBLE IMPACT OF MERGER ON RESERVES

• SUPPOSE THAT RISK POOLING - DIVERSIFICATION -
  ALLOWS MEGA BANK TO REDUCE ITS RESERVE POSITION
  FROM 24M TO 23.4M. THIS MEANS THAT LOANS CAN BE
  INCREASED FROM 188M TO 188.6M .

43
RESULT OF THIS STRATEGY

• P ( 188.6 .12 ) - ( 200 .10 ) - .7
• 22.63 - 20.00 - .7
• 1.93 or 1,930,000
• ROE P / E 1,930,000 / 12,000,000
• .1608 or 16.08
• UP FROM THE 15.5 IN THE PREVIOUS EXAMPLE

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POSSIBLE IMPACT OF THE MERGE ON EQUITY

• SUPPOSE THAT MEGA BANK IS ABLE TO POOL RISK IN
  SUCH MANNER AS TO REDUCE ITS EQUITY CUSHION BY
  3M.
• MEGA BANK

RESERVES 23.4 LOANS 188.6
Ck. DEPOSITS 203 EQUITY 9
45
POSSIBLE IMPACT OF THE MERGE ON EQUITY

• P ( 188.6 .12 ) - ( 203 .10 ) - .7
• 22.63 - 20.30 - .7
• 1.63 or 1,630,000
• ROE P / E 1,630,000 / 9,000,000
• .1811 or 18.11

46
BANK HOLDING COMPANIES STRUCTURE AND REGULATION
47
Definition of a Holding Company
In a holding company transaction the acquiring
firm purchases all or a controlling interest in
another company. For a bank holding company
controlling interest means power to vote 25
percent or more of any class of voting
securities of a bank or company. In a holding
company transaction, the companies become
affiliated, and the acquiring company becomes
the holding company in a parent/subsidiary
relationship. For example, Mellon Bank Corp had
several subsidiaries Including Mellon Bank, The
Dreyfus Co.and the Boston Company. The latter two
companies are referred to as nonbank affiliates.
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BANK HOLDING COMPANY STRUCTURES AND SCOPE
ECONOMIES

• PARENT HOLDING COMPANY

PARENT COMPANY
49
BANK HOLDING COMPANY STRUCTURES AND SCOPE
ECONOMIES

• SINGLE BANK HOLDING COMPANY

PARENT COMPANY
ANCHOR BANK
50
BANK HOLDING COMPANY STRUCTURES AND SCOPE
ECONOMIES

• MULTIBANK HOLDING COMPANY

PARENT COMPANY
ANCHOR BANK
BANK 1
BANK 2
BANK 3
51
BANK FAILURES AND THE FDIC
52
TREND IN BANK FAILURES
1935
1990
53
BANK SAFETY AND SOUNDNESS

• SYSTEM ISSUES
• BANK RUN A SIMULTANEOUS WITHDRAWAL OF DEPOSITS
  BY A LARGE NUMBER OF DEPOSITORS -- A BANK
  PROBLEM.
• BANK PANIC A RUN ON MANY BANKS SIMULTANEOUS --
  A SYSTEM PROBLEM .

54
WAYS TO PROVIDE LIQUIDITY TO INDIVIDUAL BANKS AND
THE SYSTEM AS A WHOLE

• MUTUAL AID AND CLEARINGHOUSE -- J.P. MORGAN AND
  THE PANIC OF 1907 -- A PRIVATE SECTOR RESPONSE.
• LENDER OF LAST RESORT-- THE CENTRAL BANK AS A
  POOL OF LIQUIDITY-- DISCOUNT WINDOW / DISCOUNT
  RATE.

55
WAYS TO PROVIDE A MORE STABLE BANKING
ENVIRONMENT

• CHARTERING PROCESS
• CAPITAL REQUIREMENTS ON INDIVIDUAL BANKS
• DEPOSIT INSURANCE -- FDIC
• MORAL HAZARD AND ADVERSE SELECTION
• COINSURANCE

56
FDIC BANK FAILURE RESOLUTION POLICIES

• PAYOFF METHOD
• PURCHASE AND ASSUMPTION
• --- WITHOUT A BRIDGE BANK
• --- WITH A BRIDGE BANK
• TOO- BIG-TO- FAIL DOCTRINE
• EQUITY vs. STABILITY

57
PRODUCT-LINE RESTRICTIONS ISSUES

• GLASS-STEAGALL ACT OF 1933
• Case for the separation of commercial banking and
  investment banking
• Case against the separation of commercial banking
  and investment banking
• SCOPE ECONOMIES Savings resulting from the fact
  that different products are produced or different
  activities are pursued under one roof, in close
  proximity or within one organization. Costs less
  for a single firm to produce two (or more)
  products together, rather than two (or more)
  firms specializing and producing each product
  separately.

58
Regulatory Environment
Dual Banking System

• Federal Level
• State Level

59
Federal Regulatory Agencies
Federal Reserve (FRS) Federal Deposit
Insurance Corporation (FDIC) Office of the
Comptroller of the Currency (OCC) Securities
and Exchange Commission (SEC) Department of
Justice
60
Federal Reserve Monetary Policy and
Supervisory Duties

• Bank supervision
• Monetary policy
• Banking services
• Fiscal Agent

61
Federal Reserve Supervision

• Member commercial banks
• Bank holding companies
• Edge Act banks
• U.S. banking activities of foreign
• banks
• Foreign activities of U.S. member
• banks

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FDIC Duties

• Supervisor of state-charterednon-member banks
• Insurer
• In charge of bank failure

63
Insurance Function

• Administers the BAIF and SAIF
• FDICA of 1991 mandates risk-based
• Deposit insurance premiums

64
OCC Objectives

• To ensure the safety and soundness of the
  national banking system.
• To foster competition by allowing banks to offer
  new products and services.
• To improve the efficiency and effectiveness of
  OCC supervision, including reducing regulatory
  burden.
• To ensure fair and equal access to financial
  services for all people.

65
OCC Duties

• Examine the banks.
• Approve or deny applications for new charters,
  branches, capital, or other changes in corporate
  or banking structure.
• Take supervisory actions against banks that do
  not comply with laws and regulations or that
  otherwise engage in unsound banking practices.
  The agency can remove officers and directors,
  negotiate agreements to change banking practices,
  and issue cease and desist orders as well as
  civil money penalties.
• Issue rules and regulations governing bank
  investments, lending, and other practices.

66
SEC Duties

• Disclosure regulation for public companies,
  including quarterly and annual report filings.
• Registration of securities to be sold to the
  public.

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Justice Department Duties

• Prosecutes serious and willful violations of the
  antitrust laws.
• Criminal
• Civil
• Preserve competition for the benefit of
  businesses and consumers without impose
  unnecessary costs on society

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REGULATORY ISSUES

• DUAL BANKING SYSTEM
• -- CHARTERING
• -- EXAMINATION
• MULTIPLE REGULATORY AGENCIES
• -- OVERLAPPING JURISDICTION
• -- ADVANTAGES
• -- DISADVANTAGE