Chapter 15
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Chapter 15. The Regulation of Markets and Institutions. Key Ideas. Different methods of regulating financial markets Dual banking system and the regulators who oversee it Universal banking and its possible benefits and risks. Introduction.

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Chapter 15

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Chapter 15

Chapter 15

The Regulation of Markets and Institutions


Key ideas

Key Ideas

  • Different methods of regulating financial markets

  • Dual banking system and the regulators who oversee it

  • Universal banking and its possible benefits and risks


Introduction

Introduction

  • Financial system is one of most intensely regulated sectors in US economy

  • Objectives of the regulations are:

    • To promote competition

    • To protect individual consumers

    • To maintain stability of financial system

    • To facilitate monetary policy


Primary market

Primary Market

  • Philosophy

    • Best protection is provide adequate information about securities and investments

    • Full disclosure broadens participation in financial markets


Primary market1

Primary Market

Securities Act of 1933

  • Requires disclosure of information for newly issued publicly traded securities

  • Privately held firms are not required to reveal financial information to the public at large, only to the lenders


Primary market2

Primary Market

Securities Exchange Act of 1934

  • Created the Securities and Exchange Commission (SEC) to administer provisions of 1933 Act

  • Publicly traded security must file registration statement and preliminary prospectus disclosing information about issue


Primary market3

Primary Market

Securities Exchange Act of 1934

  • The prospectus does not state

    • the interest rate on a bond issue or

    • price for equity issues

    • determined in the market when sold

  • If information is adequate, SEC approves the statement and sale

  • Approval by the SEC does not imply that it views the new issue as an attractive investment

  • Approval simply means disclosure of information is adequate


Regulation of secondary market

Regulation of Secondary Market

Securities Exchange Act of 1934

  • Extended 1933 Act

    • Periodic disclosure of relevant financial information

    • For firms trading in secondary market

  • 10K Report

    • Annual financial statement and

    • Information about a firm’s performance and activity


Secondary market

Secondary Market

  • Securities Exchange Act of 1934

    • Prohibits Insider Trading

      • Prohibit insiders from trading on private information not previously disclosed to public

      • Corporate officers and major stockholders must report all their transactions of their own firm’s stock


Regulation of commercial banks

Regulation of Commercial Banks

Philosophy

  • Protect individual depositor

  • Foster a competitive banking system

  • Ensure safety and soundness of banking system


Commercial banks

Commercial Banks

  • Dual banking system

    • Federal and State banks existing side-by-side

    • Legislation in 1860 established federally chartered banks

    • Created Comptroller of the Currency (US Treasury Department) to supervise chartered banks

    • Imposed a prohibitive tax on issuance of state banknotes

    • Intent was to drive existing state chartered banks out of business


Commercial banks1

Commercial Banks

  • Dual banking system

    • However, state banks survived

      • Stopped issuing banknotes

      • Started to accept of demand deposits

    • State chartered banks are supervised by regulators in their respective state

    • Federally chartered banks tend to be larger in size, but state banks are more in number


Commercial banks2

Commercial Banks

Federal Reserve Act of 1913

  • Required national banks to become members of the Fed

  • State chartered banks had option of being a nonmember

  • All state banks (including nonmember) currently fall under regulation of the Fed Reserve System


Commercial banks3

Commercial Banks

Federal Deposit Insurance Corporation (FDIC)

  • All member banks of Fed are required to carry FDIC insurance

  • Members include,

    • All national and

    • Some state banks

  • A majority of state banks (including non members) have opted to participate in FDIC program


Commercial banks4

Commercial Banks

Multiple Regulators at Federal level with Overlapping and Conflicting authority.

  • Federal Reserve System

  • Comptroller of Currency

  • FDIC

  • Some experts suggest that all regulation should be combined in a single agency

  • However, no legislation exists to unify the structure


  • Commercial banks5

    Commercial Banks

    Philosophy

    • Protect Individual Depositors

    • Maintain Stability of Financial System

      Strategy of Regulation:

      • Disclosure is not enough

      • Physical examination of member banks

    • Bank examinations are often not public by design


    Commercial banks6

    Commercial Banks

    Primary Liabilities: Demand Deposit

    • Banks must maintain sufficient liquidity to meet demand deposits

    • It is costly to keep excess reserve or liquid assets

    • Fear of insolvency may cause a run on the bank causing a system-wide bank panic

    • Paid on a first-come/first-serve basis

    • Periodic examination of a bank by regulatory agencies to insure banks are solvent


    Commercial banks7

    Commercial Banks

    • Deposit Insurance

      • FDIC established by Banking Act of 1933 to insure deposits at commercial and mutual savings banks.

      • Created after a large number of bank failures in the early 1930’s

      • Objective is to protect small savers

      • Reduce the incentive for depositors to join a bank run


    Commercial banks8

    Commercial Banks

    • Deposit Insurance

      • Currently insure deposits up to $100,000 for single account

      • Coverage depends on procedure used by FDIC:

        • Payoff Method

          • Bank goes into receivership by FDCI

          • FDIC pays out funds up to $100,000

        • Purchase and Assumption Method

          • FDIC merges failed bank with a healthy one

          • Deposits of failed bank are assumed by solvent bank


    Commercial banks9

    Commercial Banks

    • Moral Hazard and Deposit Insurance

      • Existence of FDIC eliminates large-scale bank failure and bank run.

      • However, it creates a classic moral hazard problem

      • With FDIC insurance, depositors have little or no incentive to monitor riskiness of their banks.

      • Without monitoring, bank managers finds it easy to engage in risk shifting


    Commercial banks10

    Commercial Banks

    • Moral Hazard and Deposit Insurance

      • Shareholders and directors of banks have incentive to make their banks riskier at the expense of the FDIC

      • “Too big to fail” Doctrine

        • FDIC may extend loans to very large banks in trouble to allow continued operations

        • This doctrine may unintentionally exacerbate the moral hazard problem

      • Recently bank failures have increased due to banking deregulation and commercial banking activities have become riskier


    Regulation of commercial banks1

    Regulation of Commercial Banks

    Risk-Based Capital Requirements

    • Bank capital acts as a cushion against failure

    • Banks are required to maintain a capital to assetratio

    • This ratio measures of bank’s risk exposure

    • Risk-based capital requirements

      • Higher capital requirement for banks with risky assets.

      • With higher risk amount of risk-based asset will go up.

      • This will cause Capital to Asset ratio to go down.

    • These requirements are agreed upon by the United States and members of the Bank for International Settlements (BIS)


    Regulation of commercial banks2

    Regulation of Commercial Banks

    • Prompt Corrective Action (PCA)

      • Passed as a part of FDIC Improvement Act of 1991

      • Established procedures to handle troubled banks

      • Designed to close banks before FDIC is exposed to excessive losses

      • Prevent regulatory forbearance

        • when regulators keep an insolvent institution operating in hopes of “turning it around”

      • Banks are ranked according to their perceived risk and more restrictions placed on riskier banks

      • Established a risk-based deposit insurance premium in FDIC

        • charge insurance premium based on the perceived risk of the bank


    Regulation of nondepository

    Regulation of Nondepository

    • Regulations are designed based on the type of liabilities they issue

      Pension funds and life insurance companies

    • Heavily regulated because their liabilities are purchased by small investors and need to protect small investors

    • Employee Retirement Income Security Act (ERISA)


    Regulation of nondepository1

    Regulation of Nondepository

    Employee Retirement Income Security Act (ERISA)

    • Established the Pension Benefit Guaranty Corporation

    • Guarantees defined benefits pension plans, subject to a maximum amount

    • Establishes minimum reporting, disclosure and investment standards


    Regulation of nondepository2

    Regulation of Nondepository

    Life Insurance Companies

    • Regulated at the state level

    • Impose risk-based capital requirements

    • Perform periodic audits

    • Implicit and explicit restrictions on pricing of particular products


    Regulation of nondepository3

    Regulation of Nondepository

    Finance companies

    • Raise funds by issuing debt and equity

    • Have virtually no regulation beyond the securities laws governing publicly traded securities


    Regulation of nondepository4

    Regulation of Nondepository

    Mutual Funds

    • Regulated by the SEC

    • Also subject to state regulations

    • Objective is to protection of individual investors through full disclosure


    The glass steagall act

    The Glass-Steagall Act

    • Segregated the banking industry from the rest of the financial services industry

    • Banks are barred from owning corporate stock and other activities deemed too risky

    • The Genesis of Glass-Steagall

      • Prior to 1933, investment banking and commercial banking were conducted under same roof

      • Following the financial collapse of the 1930s, it was felt that investment banking activities were too risky for banks


    The glass steagall act1

    The Glass-Steagall Act

    • The Genesis of Glass-Steagall

      • This combination represented a substantial threat to financial system stability

      • Although there was little empirical evidence to support this contention, the legislation mandated separation of the two activities


    The glass steagall act2

    The Glass-Steagall Act

    • The Erosion of Glass-Steagall

      • Commercial banks exerted pressure on the Federal Reserve and courts to reduce the barriers caused by Glass-Steagall

      • Bank-holding Companies

        • Permitted banks to conduct nonbanking activities through subsidiaries

        • In 1970 Federal Reserve was given power to determine what activities were permissible

        • Activities had to be closely related to traditional banking

        • During the 1970s and 80s banks acquired more freedom to engage in nontraditional banking activities


    The glass steagall act3

    The Glass-Steagall Act

    • The Erosion of Glass-Steagall

      • In 1989 the Federal Reserve granted five banks the power to underwrite corporate debt through a Section 20 affiliate

      • Gradually the Federal Reserve granted more and more banks the right to underwrite corporate debt


    The glass steagall act4

    The Glass-Steagall Act

    The Gramm-Leach-Bliley Act (1999)

    • Allowed affiliates of financial holding companies to engage in various banking activities and insurance underwriting

    • Overall responsibility for regulation lies with the Federal Reserve through its role as the “umbrella” regulator

    • Federal Reserve has power to ensure capital adequacy of holding companies, safety and soundness of their activities


    The glass steagall act5

    The Glass-Steagall Act

    The Gramm-Leach-Bliley Act (1999)

    • Individual affiliates of holding companies are subject to regulation by functional supervisors such as the SEC

    • This regulation framework blends the disclosure-based and inspection-based approaches to regulation


    The glass steagall act6

    The Glass-Steagall Act

    The Risk of Universal Banking

    • Risk inherent in securities activities, especially the underwriting business, may affect the stability of the banking system

    • Losses in securities activities lead to more bank failures and significant losses to FDIC


    The glass steagall act7

    The Glass-Steagall Act

    The Risk of Universal Banking

    • Other view: Just because investment banking is riskier than commercial banking, this does not mean that the combination of the two will be riskier


    Universal banking

    Universal Banking

    The Risk of Universal Banking

    • The portfolio theory suggests that diversification may reduce risk when commercial banking is combined with investment banking and life insurance activities

    • Perhaps it is time to let the banks decide for themselves whether universal banking reduces risk


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