Banking Regulation

1. Banking Regulation

2. Recall that the financial sector provides the efficient transfer of savings towards investment projects Gross Domestic Savings ($1.8T) Foreign Savings ($640B) Government Deficit ($400B) S + (Imports – Exports) = I + (G-T) Gross Private Investment ($2T) Gross Private Investment represents the purchase of new capital goods – one of the primary sources of growth in the economy

3. A majority of external funds raised by non-financial businesses come from bank loans. In particular, small businesses rely entirely on banks for financing

4. There is a moral hazard problem/adverse selection problem between both the bank and its depositors as well as between the bank and its potential loan customers Depositors Loans Bank This problem must be dealt with through regulation • A bank can deal with this problem with: • Credit Scoring • Collateral • Optimal Debt Contracts

5. Depository Institutions are broadly defined as businesses that accept deposits and make loans Depository Institutions Commercial Banks Savings & Loans Savings Banks Credit Unions • Non-Bank Thrifts • Deal almost exclusively in short term deposits and mortgages • Are generally mutual companies (depositors are the owners) • Are allowed to hold corporate equities/bonds

6. All Depository Institutions in the US are chartered Depository Institutions Commercial Banks Savings & Loans Savings Banks Credit Unions National Banks Comptroller of the Currency State Banks State Authority Federal Associations Office of Thrift Supervision State Associations State Authority Federal Unions National Credit Union Administration State Unions State Authority

7. Federal Reserve Membership (1913) • National Banks are Required to be members of the Federal Reserve System (Membership is optional for state banks) • Federal Reserve members are required to purchase stock in the federal reserve system. • Federal Reserve members provide input to the election of Federal Reserve Board Members • The Federal Reserve provides check clearing services

8. Of the 7,769 banks in 2003, a vast majority are non-member state banks

9. Federal Deposit Insurance (1934) • Federal reserve members are required to purchase deposit insurance. Insurance is optional for state banks (98% of all banks have deposit insurance) • FDIC insured banks are charged up to 27 cents per $100 of eligible deposits • All deposits up to $100,000 are insured by the FDIC.

10. A timeline of Banking Regulation Banking Act Restrictions on Competition McFadden Act Holding Company Act Monetary Control Act Riegle-Neal Great Depression 1933 1999 1956 1863 1927 1980 1994 Graham - Leach - Bliley Restrictions on activities Holding Company Act Glass - Steagall

11. Until the mid 1900’s, we were a nation of unit banks McFadden Act (1927) • National Banks • Prohibited from interstate branching • Must comply with state branching rules • State Banks • Unit Banking • Limited Branching • Statewide Branching Main Office Branch Offices

12. Following the great depression, the activities of commercial banks were severely restricted The Glass-Steagall Act of 1934 was designed to put a wall between commercial banking and investment banking • Glass-Steagall (1934) • Commercial Banks are restricted from participating in equities markets • Interest rates on non- transaction deposits is restricted to be below 5.25% • No interest allowed on transaction deposits Regulation Q

13. Branching Restrictions could be avoided by forming holding companies Main Office Holding Company Branch Offices Subsidiaries Illegal under the McFadden Act Legal under the McFadden Act

14. The Bank Holding Company act allowed holding companies with only one bank to provide limited non-bank financial services on an interstate basis. This created a loophole around Glass-Steagall!! Prior to Bank Holding Company Act After Bank Holding Company Act Holding Company Holding Company Bank Bank Bank Non-Bank Branches Non- Bank Offices Financial Services Collects deposits, but doesn’t make loans Makes loans, but doesn’t collect deposits

15. Deregulation of the Financial Services sector began in the 1980’s. • The Monetary Control Act (1980) • Began the phase out of interest rate ceilings at depository institutions • Imposed uniform reserve requirements on Banks and Thrifts • Riegle-Neal Interstate Banking and Branching Efficiency Act (1994) • Allowed holding companies to acquire banks in any state • Allowed banks to branch across state lines • Financial Services Modernization Act (Graham Leach-Bliley) (1996) • Permitted financial holding companies offering banking, insurance, securities and other services under one controlling corporation (allowed Citicorp to buy Traveler’s Insurance)

16. Problems with Monitoring The CAMELS System Capital Adequacy Asset Quality Management Earnings Liquidity Sensitivity to Interest Rate Risk Banks are monitored using the camels system. However, It’s not always easy to accurately assess the risk a bank is taking on In 1995, Barings Bank went bankrupt due to losses in the Derivatives market. At the time, it was holding $60B worth of derivative contracts – a staggering number when compared to Baring’s reported equity of $615M!! • Off Balance Sheet Activities • Derivatives • Financial Guarantees (SLC) • Asset Securitization

17. Problems with Restricting Activities Banks compete with other financial services companies as well as other banks!! During the late 1970’s, market interest rates rose well above 10%, but banks were restricted by regulation Q to pay only 5.25% in savings accounts and 0% on checking accounts As households pulled their money out of banks, mortgage and small business lending was seriously curtailed!

18. Problems with Restricting Competition (Branching) Restricting entry gives banks limited monopoly power, they can use this to increase profits at the customers expense! Banking is a decreasing cost industry (i.e. large startup costs, but small marginal costs). By forcing banks to remain small and local, they are forced to operate at an inefficiently small scale! By forcing banks to remain in a confined geographical location, you are forcing them to take on idiosyncratic (area specific) risk!

19. Globalization - the Final Frontier Since the 1970’s, there has been tremendous growth in international trade World Trade (in Trillions of $s)

20. Globalization - the Final Frontier Even more impressive is the growth in foreign exchange Currency Transactions (in Trillions of $s)

21. US Banks locate facilities abroad to aid in international trade as well as to avoid regulation and taxes US Banks Operating Abroad Subsidiaries: Governed by Federal Reserve Regulation K – must be involved in business “closely related to banking. International Banking Facilities: Accepts time deposits and makes loans to foreign households & firms. Exempt from reserve requirements, but may not do business in the US. Edge Act Corporations: Makes loans/accepts deposits. Can deal with both US and foreign citizens , but is limited to international trade transactions Branches: Offer a full line of banking services, but are subject to foreign laws

22. Likewise for Foreign Banks… Foreign Banks Operating in the US Agency Office: Can’t accept deposits from US citizens, but can transfer funds from abroad and make loans in the US Branches: Offers a full range of banking services for US citizens Subsidiaries: Treated as a US bank. Subject to all US regulations. Subsidiaries may also set up edge act corporations and international lending facilities

23. Important Dates in International Banking Bank for International (BIS) Settlements Created International Banking Act Basle Accords I Foreign Bank Supervision Act BCCI Scandal 1930 1978 1988 1991

24. United Kingdom United States Federal Reserve Bank of England Under whose jurisdiction do international banks fall? (it’s a gray area )

25. Regulating International Banking • International Banking Act (1978) • Brought foreign banks operating in the US under federal regulation for the first time • Foreign banks, however, were not monitored as closely as US banks • Foreign Bank Supervision Act (1991) • Passed shortly after the BCCI scandal • Gave the Federal Reserve and the Comptroller of the Currency greater control over foreign banks operating in the US

26. Bank For International Settlements (1930) • Established to handle German WWI reparations, the BIS has become a center for international cooperation. • Played a central role in the Bretton Woods Exchange Rate System • Integral in the Establishment of the Euro • The BIS is like a central bank for central banks.

27. Asset Risk Weight Cash and equivalents 0 Government securities 0 Interbank loans 0.2 Mortgage loans 0.5 Ordinary loans 1.0 Standby letters of credit 1.0 Risk weighted assets The Basle Accords established uniform capital requirements for banks around the world. Equity capital was required to equal at least 4% of a bank’s risk weighted assets.

28. US Banking Sector Risk Weighted Assets Assets Liabilities $ 54B (Cash) $ 800B (Checking) (0)( $54B) = $0 $ 46B (Reserves) $ 4,500B (Saving) (0)($46B) = $0 $ 2,000 (T-Bills) Loans (0)($2,000B) = $0 Loans $ 1B (Discount) $ 2,701 (Mortgage) (.5)($2,701B) = $1,350.5B $ 3,000 (Other) + (1)($3,000B) = $3,000B Res. Req. = 5% $1,000B (Equity) $4,350.5B Required Equity = (.04)($4350.5B) = $174.2B

29. Top Ten World Banks

30. Problems with International Regulation • The key issue is that the banking industry in Japan and Europe is Fundamentally different from the US.

31. European Banking • Unlike the US, European Banks are allowed to engage in securities markets (universal banking) • In fact, in Europe, banks are generally significant shareholders in European companies. • Banks rely much more on equity than deposits.

32. Japanese Banking • Japanese industry is organized into industrial groups (keiretsu) • Mitsubishi • Mitsui • Sumitomo • Fuyo • Daiichii • Kangyo • Sanwa

33. Japanese Banking • These “groups” are both vertically and horizontally integrated and are comprised of a very large number of companies: • Sumitomo has 15 divisions ranging from electronics to mining to consumer goods. • Sumitomo controls assets equal to $50T.

34. Japanese Banking • Each “group” has its own bank which handles its finances. This “main” bank • Owns equity in member firms • Monitors member firms • Provides credit for member firms.