Chapter Nine

1. Chapter Nine Government’s Role in Banking

2. Regulation of Banks • Banking is one of the most heavily regulated industries in the U.S • An efficient payments system and circulation of money are essential to economic growth • Like all regulation, bank regulation does not come without costs

3. Why Does the Government Regulate Banks? • To reduce the externalities caused by bank problems • To keep banks small • To prevent bank runs • To ensure that payments flow through the banking system efficiently • To stabilize the money supply

4. Achieving the Goals of Regulation The government • Supervises banks to reduce externalities • Restricts mergers and bank activities to keep banks small • Provides a federal safety net to prevent bank runs • Offers services to ensure efficient payments • Requires banks to hold reserves to control the money supply

5. Bank Supervision • Bank failures cause more problems than typical business failures as they harm a wider range of people • Any activity banks engage in is subject to government regulation, costing both time and resources • Approximately 13% of banks’ total cost of doing business is compliance with regulations

6. Restricting Mergers • Lawmakers attributed bank failures during the Great Depression to too much inter-bank competition • The Glass-Steagall Act (1933) prohibits banks from participating in the securities industry and owning commercial firms • Arguments of excessive monopoly power versus economies of scope • The Gramm-Leach-Bliley Act (1999) allows banks to invest, sell insurance, and own commercial firms, but only those related to banking, securities, and insurance

7. Providing a Federal Safety Net • Deposit insurance is provided through the Federal Deposit Insurance Corporation (FDIC) • The Fed serves as a lender of last resort, guaranteeing funds to member banks in need • Both policies result in asymmetric information problems, compensated for by supervision • The government will not allow some banks to go bankrupt under the too-big-to-fail policy

8. When Banks Close When a bank fails, the FDIC must decide what to do with the bank’s assets and how to pay off creditors & depositors. It may • Pay off (insured depositors, then creditors) • Purchase and assumption (sell the bank and its assets, and FDIC assumes debts) • Assistance (keep the bank open and loan funds to survive)

9. When Banks Close (cont’d) Except for a brief period during the 80s (due to the S&L crisis), bank failures have become very rare

10. Ensuring Efficient Payments • Payment clearing services provided by the Fed to commercial banks • The Fed allows daylight overdrafts, allowing banks more flexibility

11. Controlling the Money Supply • The government can effect flows of money though the banking system by requiring banks to hold a certain amount of reserves • Banks prefer to use these funds to make additional loans or investments, thus imposing a large opportunity cost

12. Supervisors & Supervision • The U.S. has a dual banking system, meaning banks can choose whether to be chartered at the federal or state level • National banks must be members of the Federal Reserve system and be FDIC insured, and so are subject to federal supervision • State banks are FDIC insured, but may choose not to be members of the Fed system. They are supervised only by the FDIC and their state banking department

13. Supervisors & Supervision(cont’d) Supervision differs between national and state banks

14. Rating Banks • Banking supervisors use the CAMELS rating system to assess a bank’s health • Components of the CAMELS system • Capital adequacy • Asset quality • Management • Earnings • Liquidity • Sensitivity to risk

15. Capital Adequacy • The only objective component of the CAMELS rating system • Supervisors want banks to have a lot of equity capital so they have a stronger stake in good performance • Total risk-adjusted assets (TRAA) are a measure of a bank’s exposure to risk, based on four categories of risk among the bank’s assets

16. Capital Adequacy (cont’d) • To determine adequate capital, two levels of capital must be considered • Tier 1 capital- stockholder equity capital • Tier 2 capital- the bank’s loan loss reserves + subordinated debt Total Capital = Tier 1 capital + Tier 2 capital • A bank is adequately capitalized when Tier 1 capital > 0.04 x TRAA and total capital > 0.08 x TRAA • A bank is well capitalized when Tier 1 capital > 0.08 x TRAA and total capital > 0.10 TRAA

17. Evaluating Bank Mergers • In evaluating bank mergers, lawmakers consider • The effect of the merger on competition • The adequacy of the financial and managerial resources of the new bank • The ability of the bank to meet the convenience and needs of the community • Whether the banks provided complete information about the transaction to banking authorities

18. Banking authorities use the Herfindahl-Hirschman index (HHI) The HHI measures the amount of competition in a banking market If HHI becomes >1,800 and/or the change in the HHI > 200 Mergers are also denied if the new bank would hold more than 10% of the nation’s deposits Evaluating Bank Mergers (cont’d)