Economic Analysis of Banking Regulation

1. Economic Analysisof Banking Regulation Chapter 11

2. Stuff • Review Sheet • Test chapters: 6, 8, 9, 10, 11, 12 • Wed, Ricketts 203, 7:00 • No homework due • Commercial Paper

3. 7 ways banks are regulated • FDIC • Regulators restrict assets • Minimum bank capital requirements • Chartered and Auditied • Disclosure Req’t • Consumer Protection • Restrictions on Competition

4. 1) FDIC Regulation • Bank panic ‘cycles’ every 20 years • 1920’s: 600 insolvencies/year • 1930-33: 2000 insolvencies/year • 1934-81: 15 insolvencies/year • FDIC closes insolvent banks (G-S, 1933) • Payoff method • Purchase and Assumption of bad debt method • Used to be the most popular

5. FDIC and Moral Hazard • Depositors: no incentive to monitor bank mgmt. loan decisions • Bankers: no worries about bad loan decisions causing savers to lose saving • “Too big to fail” policyTaxpayers pay • Glass-Steagall implications

6. 2) Regulators Restrict Assets • E.g. no common stock allowed • Limits on risky loans

7. 3) Minimum Bank Capital Req’t • Traditional measure: Leverage Ratio • Bank Capital/Assets (inverse of equity multiplier!!) • Greater than 5%: well capitalized • Less than 3%: Trouble! • Basel Accord (1988) - International • Hold 8% of ‘risk-adjusted’ assets • Zero-weight: gov. securities • 20% weight: claims on banks • 50% weight: residential mortgages and municipal bonds • 100% weight: loans to consumers and corporations • Regulatory Arbitrage • Fed in ‘96: 3 times max capital that could be lost in 10 days

8. 4) Banks chartered, audited • Criteria • Mgmt. adequacy • Likely earnings • Adequacy of capital • Effect on competition (pre-1980) • Examination: • Quarterly ‘call reports’ • Annual Exams • Assets Risky? Get rid of them! • Worthless Loans? Write them down! • Capital Inadequate? Figure out new strategy!

9. CAMEL Rating • Credit risk of bank assessed • Enough collateral? Enough L-T relationships? Enough screening? • Acronym • Capital Adequacy • Asset quality • Management (oversight of board, internal policies) • Earnings • Liquidity • Sensitivity • IR rate assessed (Gap and Duration analysis) • Stress testing, etc.

10. 5) Disclosure Requirements • Accounting standards • Annual reports • Risk level disclosure • Disclose information about riskiest assets • New Zealand: if full disclosure, then no examination necessary

11. 6) Consumer Protection • Truth in Lending Act (1969) • Standardization and disclosure of lending terms • Fair Credit Billing Act amendment (1974) • Extends to credit cards • Billing errors, mechanism for appeal • Equal Equal Credit Opportunity Act (1976) • Community Reinvestment Act (1977) • Invest in neighborhood in which you accept deposits

12. 7) Competition restriction • Branching • Banks can’t be in security industry • Security, insurance can’t be in banking

13. International Banking Regulation • Similar to U.S. • Country hopping, no overarching regulatory organization • BCCI collapse (1991) • 7th largets bank in world at peak • Value of 20m, when audited in ‘91, only 10m! • “Registered” in Luxembourg • Laundering, bribery, arms trafficking, nuclear technologies, etc. • Intentionally avoided detection: had its own shipping and trading company, intelligence agency, etc.

14. Savings and Loan Crisis • Largest banking crisis since the depression • $500 billion dollar bailout over 40 years: still paying for it! • Good example of: • Deregulation vs. regulation • Moral Hazard • Bank management

15. Early Causes • Innovations in the ‘60s and 70’s, had to be riskier • FSLIC: bank mgmt indifferent to taking risk • Deregulation • DIDMCA 1980 • Garn- St. Germain Act 1982 • Increased FSLIC insurance from 40K to 100K • Can put 40% in commercial real estate loans • 30% in consumer lending • 10% in junk bonds or direct investments

16. More early causes • Recession of ‘80, ‘81 • Brokered deposits • Large denomination CD sold to brokerage • Cut into smaller FSLIC covered deposits • Remove incentive for large depositors to monitor lending practices of bankers (covered through innovation!) • By 1982, 50% of S&L’s were insolvent!!!

17. Resulting Problems • Managers did not have experience with this expanded risk portfolio • Regulators didn’t have the breadth, capacity, or experience to regulate • Result • Moral hazard by managers • Conflict of interest by regulators • Principal/Agent problem by politicians • Asymmetric Information with public

18. Regulatory Forbearance by FHLB, FSLIC • Refrained from closing insolvent banks • Irregular accounting allowed (goodwill) • Why? Conflict of interest • Not enough money to close (payoff/assumption) • Don’t want to offend politicians • Protect reputation • FHLB established to encourage growth of S&L industry, not shut it down

19. Zombie S&L’s: The Living Dead • Bankrupt (negative bank capital) but still operating • Had nothing to lose, moral hazard • ‘Bad’ S&L’s gave high interest on deposits, taking business from ‘Good’ S&L’s • Negative feedback loop • ‘87 legislation • Provided only $11 billion to back up losses, but… • Directed FHLB to CONTINUE regulatory forbearance

20. Politician Principal Agent • Hide problems from taxpayers, hoping it will go away • Career oriented • Close relationships with industry insiders (conflict of interest) • The Keating Five • Charles Keating, owner of Lincoln S&L, insolvent • Purchases 600M in junk bond to try to escape • Big contributor to congressmen, tell regulators to leave him alone • ‘89 collapse, $2.6 billion loss payed by taxpayers • 3 senators not re-elected after reprimanded

21. FIRREA (1989) - The Bailout • Regulatory Structure Revised • FSLIC and FHLB abolished • Treasury Dept. takes over (Office of Thrift Supervision) • Resolution Trust Corporation • Seizes assets of 25% of S&L • Sells $450B of assets of failed S&L • Fed gov’t issues bonds for $150B deficit • S&L regulations imposed again • 70% must be housing, no junk bonds, leverage 8% • Regulators have power to remove bank mgrs., impose penalties, issue cease and desist legal action

22. FDICIA (1991) - Insurance • No more brokered deposits • Limited “to big to fail” policy • Another money infusion from Treasury to cover S&L losses • Corrective action provisions: FDIC MUST intervene early if a bank is getting into trouble

23. Future proposed reforms • Limit deposit insurance to 90% of deposits • Outlaw regulatory forbearance • Value bank capital at cost, not market (see today’s WSJ!) • Consolidate regulatory agencies • As of Dec. 2006, bank insurance fund and savings and loan insurance fund became deposit insurance fund

24. World Banking Crises • Scandinavia • Russia • Japan • China • East Asian ‘Tigers’ • Latin America • Argentina