The Bank Regulatory Environment

1
The Bank Regulatory Environment

• Outline
• Why banks are regulated?
• Why do banks fail?
• Bank reforms of the 1930s
• Bank reforms since 1980
• Banking and commerce arrangement in other
  countries
• The dual banking system

2
Why are banks regulated?

• Prevent disruption of the economy
• Prudential regulation to ensure safety and
  soundness
• Prevent large scale failures that would affect
  economic activity.
• Reduce systemic risk wherein bank failures are
  potentially contagious. Such shocks could be
  domestic or international in scope.
• Guard against deposit insurance losses
• Protect small depositors by providing government
  deposit insurance (FDIC)
• Moral hazard problem of deposit insurance causes
  banks to have incentives to take risks with
  potential losses borne by the government.
• Achieve desired social goals
• Prevent discrimination in lending, support
  housing finance, community development, etc.

3
Why do banks fail?

• Credit risk, interest rate risk, foreign exchange
  risk, bank runs, and fraud
• The small capital base of banks makes them
  sensitive to negative earnings. Banks use loan
  loss reserves to absorb expected losses on loans
  and from other sources. However, unexpected
  losses must be charged against equity capital and
  can cause the bank to become insolvent and/or
  closed by regulators.
• Financial repression by the government by means
  of excessive control of the banking sector can
  raise failure risk.
• Bank runs occur when many depositors suddenly
  withdraw their funds from banks. While uninsured
  deposits are especially at risk, insured deposits
  may be withdrawn also.
• Fraud includes theft as well as lending to
  customers favored by friendship or political
  interest rather than economic profit for the bank.

4
Bank reforms of the 1930s

• Large scale failures prior to and during the
  Great Depression in the period 1921-1933 caused
  Congress to pass new legislation regulating
  banks
• The Banking Act of 1933 (Glass-Steagall Act)
• Separated banking from investment banking
  (underwriting securities)
• Established the FDIC
• Permitted the Federal Reserve to regulate time
  deposit rates and prohibited interest on demand
  deposits
• Increased the minimum capital requirements on
  national banks
• The Banking Act of 1935
• Federal Reserve given expanded reserve
  requirement, discount rate, and deposit rate
  powers.
• Office of the Comptroller of the Currency (OCC)
  given expanded powers over granting new national
  bank charters. New applicants for banks must
  show that it would be successful and not damage
  other banks.

5
Bank reforms since 1980

• The 1933 and 1935 banking acts restricted
  pricing, geography, products, and capital in
  banking.
• After WWII the banking industry became
  progressively more competitive and innovative.
• Regulation Q placed limits on deposit costs
• Deposit outflows to money market mutual funds in
  periods of inflation and high interest rates.
• Geographic restrictions on interstate banking and
  branch banking
• Highly concentrated loan portfolios and difficult
  to service customer needs of large firms with
  operations throughout the country.
• Product restrictions on securities powers
• Large firms seeking debt finance increasingly
  used the securities markets to raise funds and
  not banks.

6
Bank reforms since 1980

• Depository Institutions Deregulation and Monetary
  Control Act (DIDMCA) of 1980
• Uniform reserve requirements for all depository
  institutions.
• Federal Reserve services available to all
  depository institutions.
• Regulation Q to be phased out by the Depository
  Institutions Deregulation Committee (DIDC).
• Deposit insurance limit raised from 40,000 to
  100,000 per account.
• Negotiable order of withdrawal (NOW) accounts
  approved (interest-bearing checking accounts with
  fixed limit of 6 interest rate).
• Savings and loans allowed to make more consumer
  loans and given trust powers.

7
Bank reforms since 1980

• Garn-St Germain Depository Institutions Act of
  1982
• Money market deposit accounts (MMDAs) to compete
  with money market mutual funds (MMMFs). These
  accounts had no interest rate ceilings and
  limited check writing privileges like MMMFs.
• FDIC/FSLIC assistance for troubled or failing
  institutions
• Net worth certificates (or bank capital held by
  the government) was used by regulators to keep
  failing thrifts from being closed.
• Asset powers of thrifts expanded in consumer and
  commercial lending to enable them to compete with
  banks. These powers increased risk-taking
  activities of thrifts beyond their traditional
  home lending activities.

8
Bank reforms since 1980

• Financial Institutions Reform, Recovery, and
  Enforcement Act (FIRREA) of 1989
• Regulatory structure FHLBB closed and OTS
  established under the U.S. Treasury. Also,
  FSLIC closed and SAIF under FDIC to insure
  thrifts deposits. BIF under FDIC to insure
  banks deposits.
• Thrifts asset powers reduced by focusing more on
  home lending (i.e., qualified thrift lenders or
  QTLs with at least 70 of assets in home
  real-estate related assets).
• Cease-and-desist powers of regulators.
• Cross-bank guarantees in multibank holding
  companies.

9
Bank reforms since 1980

• Federal Deposit Insurance Corporation Improvement
  Act (FDICIA) of 1991
• Prompt corrective action (PCA) by regulators
  allowed to increasingly restrict the activities
  of undercapitalized institutions. If a bank
  falls below 6 total risk-adjusted capital, it is
  considered to be undercapitalized. If a bank is
  critically undercapitalized, it must be closed by
  the FDIC.
• Restrictions on the ability of the FDIC to
  protect uninsured depositors in a large bank
  failure (i.e., lessened the too big to fail or
  TBTF problem).
• Risk-based deposit insurance scheme implemented.
• Raised deposit insurance fees to build up federal
  insurance reserves.

10
Bank reforms since 1980

• Omnibus Budget Reconciliation Act of 1993
• Provided that insured depositors of failed banks
  have a priority of claims over noninsured
  depositors/creditors claims. Increases market
  discipline and protects smaller depositors.
• Riegle-Neal Interstate Banking and Branching Act
  of 1994
• Interstate banking allowed in 1995 through
  multibank holding companies.
• Interstate branching allowed in 1997.
• Financial Services Modernization Act of 1999
  (Gramm-Leach-Bliley Act)
• Ended 1933 Glass-Steagall prohibitions on
  separation of banks from investment banking and
  1956 Bank Holding Company Acts prohibitions on
  insurance underwriting.
• Banks, brokerage firms, and insurance companies
  can merge.
• Financial holding companies allowed to engage in
  a wide variety of financial services (i.e.,
  financial supermarkets).
• Banking and commerce remain separate.

11
Banking and commerce arrangements in other
countries

• Germany
• Universal banking with no holding company
  structure required to offer multiple financial
  services -- can use the bank itself and
  subsidiaries of the bank. Banks can own
  commercial firms.
• United Kingdom
• Clearing banks engage in commercial and
  investment banking. Subsidiaries can conduct
  merchant banking, insurance activities, and real
  estate activities. Bank of England must approve
  a firm taking more than a 15 or greater stake in
  a U.K. bank. Banking and commerce not formally
  separated but tradition encourages separation.

12
Banking and commerce arrangements in other
countries

• Japan
• After WWII the banking system was modeled after
  the U.S. Commercial and investment banking
  separated at that time. Until 1987, banks could
  hold up to 10 of outstanding shares of any
  company. Limited insurance and other financial
  service powers of banks. Main banks in keiretsu
  (a conglomerate firm) are very powerful in close
  relationships with client firms.
• In 1999 the Japanese government rearranged the
  financial system into 7 financial groups
  combining banks, securities firms, insurance
  companies, etc. These financial holding
  companies promise to be the largest in the world
  by year-end 2000.
• European Economic Community (EEC)
• Commercial and investment banking allowed but not
  insurance activities in banks. Commerce and
  banking allowed with some percentage limitations
  (e.g., 10 of a banks equity can be held in an
  individual commercial firm).

13
Banking and commerce arrangements in other
countries

• Harmonization
• International banking regulators seek
  harmonization of prudential standards. Basle
  Committee on Banking Supervision implemented
  risk-based capital standards for credit risk in
  1988 for banks, with amendments in 1998 for
  securities trading capital requirements.
• European Unions Second Banking Directive has
  sought to introduce uniform banking and financial
  services rules in the EU. EUs Own Funds
  Directive and Solvency Ratio Directive are
  consistent with the Basle Committee.
• International Monetary Fund (IMF) has played a
  role in regulation in banking crises in countries
  around the world.

14
The dual banking system

• Bank charter type, BHCs, and overlapping
  regulation
• OCC charters national banks (N.A. or national
  association) -- about 2,500 of 8,900 banks in
  2000.
• States can issue state charters for banks.
• Dual national and state banking system.
• Bank holding companies are corporations that hold
  stock in one of more banks and other financial
  service firms. The Federal Reserve provides a
  list of allowable nonbanking activities that are
  closely related to banking.
• Overlapping regulatory authorities of Federal
  Reserve, OCC, FDIC, OTS, and state banks.
  Securities Exchange Commission (SEC) also
  involved in securities regulation of banking
  organizations.
• Regulators charter, regulate (set rules),
  supervise (influence safety and soundness), and
  examine (CAMELS and compliance with regulations)
  banking organizations.
• Regulatory dialectic (Kane) between regulators to
  control bank risk taking and banks to circumvent
  regulations for profit.