The Bank Regulatory Environment

1. The Bank Regulatory Environment • Outline • Why banks are regulated? • Why do banks fail? • Bank reforms of the 1930s • Bank reforms since 1980 • Banking and commerce arrangement in other countries • The dual banking system

2. Why are banks regulated? • Prevent disruption of the economy • Prudential regulation to ensure safety and soundness Prevent large scale failures that would affect economic activity. Reduce systemic risk wherein bank failures are potentially contagious. Such shocks could be domestic or international in scope. • Guard against deposit insurance losses Protect small depositors by providing government deposit insurance (FDIC) Moral hazard problem of deposit insurance causes banks to have incentives to take risks with potential losses borne by the government. • Achieve desired social goals Prevent discrimination in lending, support housing finance, community development, etc.

3. Why do banks fail? • Credit risk, interest rate risk, foreign exchange risk, bank runs, and fraud • The small capital base of banks makes them sensitive to negative earnings. Banks use loan loss reserves to absorb expected losses on loans and from other sources. However, unexpected losses must be charged against equity capital and can cause the bank to become insolvent and/or closed by regulators. • Financial repression by the government by means of excessive control of the banking sector can raise failure risk. • Bank runs occur when many depositors suddenly withdraw their funds from banks. While uninsured deposits are especially at risk, insured deposits may be withdrawn also. • Fraud includes theft as well as lending to customers favored by friendship or political interest rather than economic profit for the bank.

4. Bank reforms of the 1930s • Large scale failures prior to and during the Great Depression in the period 1921-1933 caused Congress to pass new legislation regulating banks: • The Banking Act of 1933 (Glass-Steagall Act) Separated banking from investment banking (underwriting securities) Established the FDIC Permitted the Federal Reserve to regulate time deposit rates and prohibited interest on demand deposits Increased the minimum capital requirements on national banks • The Banking Act of 1935 Federal Reserve given expanded reserve requirement, discount rate, and deposit rate powers. Office of the Comptroller of the Currency (OCC) given expanded powers over granting new national bank charters. New applicants for banks must show that it would be successful and not damage other banks.

5. Bank reforms since 1980 • The 1933 and 1935 banking acts restricted pricing, geography, products, and capital in banking. • After WWII the banking industry became progressively more competitive and innovative. • Regulation Q placed limits on deposit costs Deposit outflows to money market mutual funds in periods of inflation and high interest rates. • Geographic restrictions on interstate banking and branch banking Highly concentrated loan portfolios and difficult to service customer needs of large firms with operations throughout the country. • Product restrictions on securities powers Large firms seeking debt finance increasingly used the securities markets to raise funds and not banks.

6. Bank reforms since 1980 • Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 • Uniform reserve requirements for all depository institutions. • Federal Reserve services available to all depository institutions. • Regulation Q to be phased out by the Depository Institutions Deregulation Committee (DIDC). • Deposit insurance limit raised from $40,000 to $100,000 per account. • Negotiable order of withdrawal (NOW) accounts approved (interest-bearing checking accounts with fixed limit of 6% interest rate). • Savings and loans allowed to make more consumer loans and given trust powers.

7. Bank reforms since 1980 • Garn-St Germain Depository Institutions Act of 1982 • Money market deposit accounts (MMDAs) to compete with money market mutual funds (MMMFs). These accounts had no interest rate ceilings and limited check writing privileges like MMMFs. • FDIC/FSLIC assistance for troubled or failing institutions • Net worth certificates (or bank capital held by the government) was used by regulators to keep failing thrifts from being closed. • Asset powers of thrifts expanded in consumer and commercial lending to enable them to compete with banks. These powers increased risk-taking activities of thrifts beyond their traditional home lending activities.

8. Bank reforms since 1980 • Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 • Regulatory structure: FHLBB closed and OTS established under the U.S. Treasury. Also, FSLIC closed and SAIF under FDIC to insure thrifts’ deposits. BIF under FDIC to insure banks’ deposits. • Thrifts’ asset powers reduced by focusing more on home lending (i.e., qualified thrift lenders or QTLs with at least 70% of assets in home real-estate related assets). • “Cease-and-desist” powers of regulators. • Cross-bank guarantees in multibank holding companies.

9. Bank reforms since 1980 • Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 • Prompt corrective action (PCA) by regulators allowed to increasingly restrict the activities of undercapitalized institutions. If a bank falls below 6% total risk-adjusted capital, it is considered to be undercapitalized. If a bank is critically undercapitalized, it must be closed by the FDIC. • Restrictions of the ability of the FDIC to protect uninsured depositors in a large bank failure (i.e., lessened the “too big to fail” or TBTF problem). • Risk-based deposit insurance scheme implemented. • Raised deposit insurance fees to build up federal insurance reserves.

10. Bank reforms since 1980 • Omnibus Budget Reconciliation Act of 1993 • Provided that insured depositors of failed banks have a priority of claims over noninsured depositors/creditors claims. Increases “market discipline” and protects smaller depositors. • Riegle-Neal Interstate Banking and Branching Act of 1994 • Interstate banking allowed in 1995 through multibank holding companies. • Interstate branching allowed in 1997. • Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley Act) • Ended 1933 Glass-Steagall prohibitions on separation of banks from investment banking and 1956 Bank Holding Company Act’s prohibitions on insurance underwriting. • Banks, brokerage firms, and insurance companies can merge. • Financial holding companies allowed to engage in a wide variety of financial services (i.e., financial supermarkets). • Banking and commerce remain separate.

11. Banking and commerce arrangements in other countries • Germany • Universal banking with no holding company structure required to offer multiple financial services -- can use the bank itself and subsidiaries of the bank. Banks can own commercial firms. • United Kingdom • Clearing banks engage in commercial and investment banking. Subsidiaries can conduct merchant banking, insurance activities, and real estate activities. Bank of England must approve a firm taking more than a 15% or greater stake in a U.K. bank. Banking and commerce not formally separated but tradition encourages separation.

12. Banking and commerce arrangements in other countries • Japan • After WWII the banking system was modeled after the U.S. Commercial and investment banking separated at that time. Until 1987, banks could hold up to 10% of outstanding shares of any company. Limited insurance and other financial service powers of banks. Main banks in keiretsu (a conglomerate firm) are very powerful in close relationships with client firms. • In 1999 the Japanese government rearranged the financial system into 7 financial groups combining banks, securities firms, insurance companies, etc. These financial holding companies promise to be the largest in the world by year-end 2000. • European Economic Community (EEC) • Commercial and investment banking allowed but not insurance activities in banks. Commerce and banking allowed with some percentage limitations (e.g., 10% of a banks’ equity can be held in an individual commercial firm).

13. Banking and commerce arrangements in other countries • Harmonization • International banking regulators seek harmonization of prudential standards. Basle Committee on Banking Supervision implemented risk-based capital standards for credit risk in 1988 for banks, with amendments in 1998 for securities trading capital requirements. • European Union’s Second Banking Directive has sought to introduce uniform banking and financial services rules in the EU. EU’s Own Funds Directive and Solvency Ratio Directive are consistent with the Basle Committee. • International Monetary Fund (IMF) has played a role in regulation in banking crises in countries around the world.

14. The dual banking system • Bank charter type, BHCs, and overlapping regulation: • OCC charters national banks (N.A. or national association) -- about 2,500 of 8,900 banks in 2000. • States can issue state charters for banks. • Dual national and state banking system. • Bank holding companies are corporations that hold stock in one of more banks and other financial service firms. The Federal Reserve provides a list of allowable nonbanking activities that are closely related to banking. • Overlapping regulatory authorities of Federal Reserve, OCC, FDIC, OTS, and state banks. Securities Exchange Commission (SEC) also involved in securities regulation of banking organizations. • Regulators charter, regulate (set rules), supervise (influence safety and soundness), and examine (CAMELS and compliance with regulations) banking organizations. • Regulatory dialectic (Kane) between regulators to control bank risk taking and banks to circumvent regulations for profit.