Foundations of Depository Institution Regulation

1. Chapter 11 Foundations of Depository Institution Regulation Unit III Financial Institutions PowerPoint Presentation by Charlie CookThe University of West Alabama

2. Fundamental Issues • In what ways did laws adopted in the 1930s exert long-term effects on the U.S. banking industry? • How did deposit interest rate ceilings ultimately help to spur depository institution deregulation in the 1980s? • Why does the provision of federal deposit insurance help to justify federal regulation of depository institutions? • How has the federal government sought to reduce the FDIC’s exposure to losses? © 2006 Thomson Business and Professional Publishing. All rights reserved.

3. Fundamental Issues (cont’d) • How did the Financial Services Modernization Act of 1999 alter the structure of U.S. bank regulation and supervision? • Do national bank regulators coordinate their policies? © 2006 Thomson Business and Professional Publishing. All rights reserved.

4. The Evolution of U.S. Depository Institution Regulation • Traditional Rationales for Government Regulation of Depository Financial Institutions • Maintaining depository institution liquidity. Banks need sufficient cash to meet depositors needs. • Assuring bank solvency by limiting failures. When assets are less than liabilities, the bank is insolvent. • Promoting an efficient financial system. Try to provide services at the lowest possible cost. • Protecting consumers. Due to asymmetric information, consumers do not know which banks are safest, etc. © 2006 Thomson Business and Professional Publishing. All rights reserved.

5. Bank Examinations • Examiners develop the CAMELS rating for the bank. • C: Capital adequacy • A: Asset quality • M: Management • E: Earnings • L: Liquidity • S: Sensitivity to risk © 2006 Thomson Business and Professional Publishing. All rights reserved.

6. CAMELS • Each category gets a 1-5 rating, 1 being the best, 5 the worst, and then the ratings are combined to get an overall rating. • 1-2 considered healthy • 3: placed on the “watch list” • 4-5: serious trouble © 2006 Thomson Business and Professional Publishing. All rights reserved.

7. Federal Regulation: 1933–1970 • The McFadden Act of 1927 • Prohibited national banks from operating outside their home state. • Restricted nationally chartered banks to branching only according to state laws as far as intrastate banking. • This varied by state: some states allowed many intrastate branches, others a few, and some following unit banking, in which each bank could only have one office. Kansas was the last state to give up unit banking in 1986. © 2006 Thomson Business and Professional Publishing. All rights reserved.

8. The McFadden Act of 1927 • Why restrict branches? Go back to the goal of limiting bank failures: some people blamed bank failures on too much competition between banks. • This view gained some support during the depression beginning in 1929. • Of course, banks would look for ways around these geographic restrictions. © 2006 Thomson Business and Professional Publishing. All rights reserved.

9. Banks response to geographic restrictions • Create bank holding companies: a corporation that owns many banks but is not itself a bank. This basically means you operate many banks as branches of a single bank. • Non-bank banking: banks were defined as entities that held deposits and made loans: thus set up 2 different companies: one accepts deposits but does not make loans, the other makes loans but does not accept deposits. • Electronic banking: ATM machines: some states at first saw these as a form of a branch bank. • Various laws in recent decades have removed most of these geographic restrictions. © 2006 Thomson Business and Professional Publishing. All rights reserved.

10. Federal Regulation: 1933–1970 • The Banking Act of 1933 (Glass-Steagall Act): • Created the Federal Deposit Insurance Corporation (FDIC), a guaranteed deposit insurance system for commercial banks and savings institutions. (savings institutions and credit unions are actually insured by other agencies) • Separated commercial and investment banking. Banks could not sell stock or insurance, for example. © 2006 Thomson Business and Professional Publishing. All rights reserved.

11. Federal Regulation: 1933–1970 • Prohibited interest payments on demand deposits • Placed interest rate ceilings on bank savings and time deposits (regulation Q) • Glass-Steagall also amended the McFadden Act by strengthening the language on branch banking. © 2006 Thomson Business and Professional Publishing. All rights reserved.

12. Interest rate regulation • Why no interest on demand deposits? Such interest, some argued, would lead banks to make riskier loans and thus expose the bank to more risk. Again, the goal was to limit “destructive competition.” • Interest Rate Adjustment Act of 1966 placed similar restrictions on savings institutions deposits. © 2006 Thomson Business and Professional Publishing. All rights reserved.

13. Interest rate regulation • Interest rate regulations led to occasional disintermediation • A situation in which customers of depository institutions withdraw funds from their deposit accounts and use these funds to purchase financial instruments directly. • If other interest rates not subject to bank restrictions rose, depositors would withdraw funds from banks and move them to other financial assets. • Thus banks had difficulty competing for funds due to these interest rate restrictions. © 2006 Thomson Business and Professional Publishing. All rights reserved.

14. Partial Deregulation:1971–1989 • Depository Institutions Deregulation and Monetary Control Act (DIDMCA): (1980) • Set up a six-year phaseout of interest rate ceilings. • Permitted negotiable-order-of-withdrawal (NOW) accounts (interest-bearing checking deposits). • Increased FDIC coverage to $100,000 per account. (previously had been$40,000) However, did NOT increase the insurance premiums paid by banks for this insurance. • (can actually insure more than $100,000: see box on page 231). © 2006 Thomson Business and Professional Publishing. All rights reserved.

15. DIDMCA • This law made for more competition between banks, savings institutions, and credit unions, by allowing them to make more types of loans and issue credit cards • All federally insured depository institutions (not just banks) had to meet reserve requirements of the Federal Reserve and to pay for check clearing and wire transfer services of the Fed. • Two major effects: deregulated depository institutions and increased the federal governments stake in these institutions by expanding insurance and the role of the Federal reserve. © 2006 Thomson Business and Professional Publishing. All rights reserved.

16. Partial Deregulation:1971–1989 • The Garn–St. Germain Act of 1982: • Authorized money market deposit accounts. (in part to help compete against money market mutual funds outside of banks.) • Increase the DIDMCA limit on consumer loans and commercial paper for savings institutions (which were in financial trouble throughout the 70’s.) • Authorized savings institutions to make commercial real estate loans and to purchase “unsecured loans,” including low-rated, “junk” bonds. • Gave the FDIC power to permit troubled financial institutions to merge with healthier partners. © 2006 Thomson Business and Professional Publishing. All rights reserved.

17. Deposit Insurance Complications • The moral-hazard problem of deposit insurance: • The existence of federal deposit insurance can lead depository institution managers to make riskier choices than they might otherwise. • DIDMCA, by expanding insurance, increased this moral hazard problem. • Hopefully, control is maintained through regulation and periodic examination of depository institutions © 2006 Thomson Business and Professional Publishing. All rights reserved.

18. Deposit Insurance Complications • Too-big-to-fail policy: • A regulatory policy that protects the largest depository institutions from failure solely because regulators believe that such failure could undermine the public’s confidence in the financial system. • Began with the Continental Bank problems in Chicago in the 1980’s. Even deposits not usually covered by insurance were protected by the FDIC. • Six of the largest banks now have on-site examiners doing constant surveillance. • In part, this regulation of banks is due to the major problems that S &L’s faced. © 2006 Thomson Business and Professional Publishing. All rights reserved.

19. Savings and loan crisis of the 1980’s • Over half of S &L’s failed or were closed in the 80’s and early 90’s. • Causes? Interest rate issues during the 70’s and 80’s, then coupled with deregulation of the 80’s. Declines in oil and land prices made for some bad loans. Also moral hazard and regulatory failure contributed. • S & L crisis led to the passing of the FIRREA in 1989. © 2006 Thomson Business and Professional Publishing. All rights reserved.

20. Reregulation in the Late 1980s and Early 1990s • Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) 1989: • Eliminated the Federal Home Loan Bank Board (FHLBB ) and Federal Savings and Loan Insurance Corporation (FSLIC) • Created the Office of Thrift Supervision (OTS) and the Federal Housing Finance Board. • OTS now serves as primary federal regulatory agency for the industry © 2006 Thomson Business and Professional Publishing. All rights reserved.

21. FIRREA • FDIC now has two parts: • 1. Bank Insurance Fund (BIF): • FDIC fund covering insured deposits of commercial banks. • 2. Savings Association Insurance Fund (SAIF): • FDIC fund covering insured deposits of savings institutions. • FIRREA also created the Resolution Trust Corporation (RTC) and Resolution Finance Corporation (RFC) to help finance and dispose of the property of the failed S&Ls. © 2006 Thomson Business and Professional Publishing. All rights reserved.

22. FIRREA • Some parts of FIRREA reversed the deregulation movement: for example, S & L’s were no longer allowed to purchase junk bonds. • Also FIRREA required the Treasury to consduct a study of the deposit insurance system and submit proposals for reform, which led to the passage of FDICIA in 1991. © 2006 Thomson Business and Professional Publishing. All rights reserved.

23. The FDIC Improvement Act Of 1991 (FDICIA): several provisions including • Established structured early intervention and resolution (SEIR): • A regulatory system that authorizes the FDIC to intervene quickly in the management of a depository institution that currently threatens to cause losses for the federal deposit insurance funds. © 2006 Thomson Business and Professional Publishing. All rights reserved.

24. The FDIC Improvement Act Of 1991 • Deposit insurance premium: • The price that depository institutions pay to the FDIC’s insurance fund in exchange for a guarantee of federal insurance of covered deposits that they issue. • Risk-based deposit insurance premiums: • Premiums that depository institutions pay the FDIC based on the varying degrees to which they are capitalized and on the differing risk factors that they exhibit. © 2006 Thomson Business and Professional Publishing. All rights reserved.

25. Few banks actually paying insurance premiums today??? • http://www.fdic.gov/about/strategic/report/98Annual/cond.html © 2006 Thomson Business and Professional Publishing. All rights reserved.

26. Capital requirements • Recall equity capital of banks, just another name for net worth, assets minus liabilities • Various measures of capital have been used to assess the health of banks. • However, just comparing capital can be misleading: two banks with the same net worth can have greatly different portfolios of loans and other assets. • The Basel Accord established risk based capital requirements. © 2006 Thomson Business and Professional Publishing. All rights reserved.

27. Basel Committee: Capital Requirements • 1988, 12 nations met in Basel Switzerland and announced a system of Capital requirements: • Minimum equity capital standards that regulators impose upon depository institutions. • Risk-based capital requirements: • Regulatory capital standards that account for risk factors that distinguish different depository institutions. • Risk-adjusted assets: • A weighted average of bank assets that regulators compute to account for risk differences across types of assets. © 2006 Thomson Business and Professional Publishing. All rights reserved.

28. Basel Committee: Capital Requirements • 4 different risk weight categories: zero weight for treasuries and government bonds, 20% for assets with slight chance of default like municipal bonds, 50% on residential mortgages, and 100% on other consumer and corporate loans. • Adding up the weighted dollar amounts gives a total risk adjusted asset figure, used as the denominator in the calculation. © 2006 Thomson Business and Professional Publishing. All rights reserved.

29. Basel Capital Standards • Two different numerator measures: • 1. Core capital: • Defined as shareholders’ equity plus retained earnings. • Total capital: • The sum of core capital and supplementary capital. • Supplementary capital: • A measure that includes certain preferred stock and most subordinated debt. © 2006 Thomson Business and Professional Publishing. All rights reserved.

30. Basel Capital Standards • Three ratios looked at: • 1. Core capital / risk adjusted assets • This ratio is supposed to exceed 4%. • 2. Total capital/risk adjusted assets • This ratio is supposed to exceed 8% • 3. Total capital / Unadjusted total assets • This ratio should exceed 4%. © 2006 Thomson Business and Professional Publishing. All rights reserved.

31. The Effects of Capital Requirements • A number of banks failed to meet the three ratio requirements. • Reduced issuance of loans in response to higher capital standards. • Equity positions of U.S. commercial banks improved for the first time in almost fifty years, the ratio of equity to assets rose, beginning in 1990 © 2006 Thomson Business and Professional Publishing. All rights reserved.

32. Equity as a Percentage of Bank Assets in the United States, 1840–Present SOURCE: SOURCES: Allen N.Berger, Richard J.Herring, and Giorgio P.Szego, “The Role of Capital in Financial Institutions,” Journal of Banking and Finance 19 (June 1995); and Federal Deposit Insurance Corporation. © 2006 Thomson Business and Professional Publishing. All rights reserved. Figure 11–1

33. Basel Capital Standards • Problems with these standards: • 1. No difference between say US gov’t bonds and those of say Turkey or an emerging nation. • 2. All corporate bonds got a 100% weight whether it was a high grade bond or a junk bond. • 3. No credit to banks that reduced risk by diversification of loans. © 2006 Thomson Business and Professional Publishing. All rights reserved.

34. New Capital Requirements for the 2000s? • Basel II regulatory system 2004 • Pillar 1: Modified risk-based capital requirements. For example, a 150 percent weight for junk bonds • Pillar 2: Greater supervisory discretion: supervisors can raise capital requirements at their own discretion. • Pillar 3: Increased disclosure of information to the public and markets. • U.S. regulators have chosen to apply all three pillars of the Basel II system to only a handful of the nation’s largest banks. © 2006 Thomson Business and Professional Publishing. All rights reserved.

35. Basel II regulatory system 2004 • Note that the Basel accords are not law, but a set of recommendations. Some major banks is the US have chosen to voluntarily comply. © 2006 Thomson Business and Professional Publishing. All rights reserved.

36. The Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley Act--GLBA) • Act removes Glass-Steagall restrictions and permits: • Securities firms and insurance companies to own commercial banks. • Banks to underwrite insurance and securities, including shares of stock. • This is done by forming Financial Holding Companies, such as Citigroup. © 2006 Thomson Business and Professional Publishing. All rights reserved.

37. GLBA • Review of bank regulatory structure: • OCC, Office of the Comptroller of the Currency, regulated the national banks • Federal Reserve regulated the state banks that were members of the Fed • FDIC regulated state banks that were not members of the Fed. • This system has existed since the 1930’s. • Under GLBA, the Fed also regulates bank holding companies, which makes it probably the most important of the 3 regulatory bodies. © 2006 Thomson Business and Professional Publishing. All rights reserved.

38. Regulation and Supervision of Savings Institutions. • Under FIRREA, noted earlier, OTS is still the main regulator of federal savings institutions. • States regulate the state chartered savings institutions. • Nearly all however must satisfy FDIC regulations as well. © 2006 Thomson Business and Professional Publishing. All rights reserved.

39. Regulation and Supervision of Credit Unions • National Credit Union Administration (NCUA) • Federal regulatory agency • Charter and regulate federally chartered credit unions and state member institutions • Administers the National Credit Union Share Insurance Fund, (NCUSIF) and most state-chartered credit unions contribute to and are covered by this insurance fund. © 2006 Thomson Business and Professional Publishing. All rights reserved.

40. International Dimensions of Bank Regulation • The Global Epidemic of Bank Failures • The US has certainly not been alone in dealing with bank troubles. • Bank troubles in the west, Scandinavia, Bulgaria, Mexico, and others • and major banking problems in the east, South Korea and Japan. • A big world with relatively few healthy banks • 133 out of 181 members of the IMF have had significant bank troubles since 1980. © 2006 Thomson Business and Professional Publishing. All rights reserved.

41. Why so many problems? • Two views: • 1. Banking is very unstable and risky, thus constantly in need of government regulation, insurance, etc. • 2. Government has made the industry worse, by insuring deposits and thus encouraging the moral hazard problem of making riskier loans. © 2006 Thomson Business and Professional Publishing. All rights reserved.

42. International Linkages and Bank Regulation • Regulatory arbitrage: • The act of trying to avoid regulations imposed by banking authorities in one’s home country by moving offices and funds to countries with less constraining regulations. • Limitations of international coordination • Basel Accord on risk-based capital standards • Failed because interpretation and national enforcement of the standards has varied so widely that “coordination” has never been achieved. © 2006 Thomson Business and Professional Publishing. All rights reserved.