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U.S. Financial Regulation

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  1. U.S. Financial Regulation Online Economic Seminars www.econseminars.com Last Update: October 7, 2009

  2. Part 1Depository Financial Institutions:Commercial Banks

  3.  Overview of Banking Regulation ¶Regulatory Goals and Tools “Reserve Requirements”To ensure sufficient liquidity to convert notes (now deposits) into Specie (now notes), thereby avoiding bank runs  ”Capital Requirements” To ensure sufficient capital to allow banks to survive declines in asset prices ”Interbank Relations Rules” To ensure competition among banks and between banks and other institutions • Rules on Mergers and New Bank Formation • Rules on Deposit Interest Rates ”Interindustry Relations Rules” to ensure that combinations between bank and non-bank companies do not weaken banks ”Asset Allocation Rules” To ensure diversification

  4.  Fractional Reserve Banking

  5.  First Bank of the United States (1791 – 1811) ¶Formation Private Bank Formed By Congress With 20 Year Term Advocated By Alexander Hamilton, First Treasury Secretary And Leading Federalist (Democrat) Under Washington Opposed By Jefferson, Madison And Most Republicans

  6.  First Bank of the United States (1791 – 1811) ¶Functions  Manage State War Debts Recently Assumed By New Federal Government  Establish The Public Credit Of The U.S.  Provide Strong Central Currency As Alternative To State Banks  Act As Federal Fiscal And Monetary Agent • Receive Federal Tax Deposits And Make Payments • Manage U.S. Mint’s Minting of Coin And Purchase/Sale of Specie  Act As Private Bank • Make Loans (Excluding Loans to Federal Government) • Issue Bank Notes Convertible Into Specie and Legal Tender For Federal Tax Payment

  7.  First Bank of the United States (1791 – 1811) ¶Financing The Bank $10 Million Capitalization • $2 Million From U.S. Treasury - 100% Borrowed From Bank • $8 Million From Private Sources - 25% ($2M) Payable In Specie - 75% ($6M) Payable In Treasury Bonds and Scrip ¶Revenue Sources  Investment And Loan Portfolio  Customs Excise Taxes Tax On Whiskey Sales

  8.  First Bank of the United States ¶ Opposition To First Bank, Primarily In The South  Agricultural States Viewed The Bank As • A Tool Of Northern Commercial Interests • A Source Of Weakened Southern Banks • A Source Of Tighter Farm Credit • An Infringement On States’ Rights  South Objected To The Excise Tax On Alcohol Used To Finance The Bank’s Interest Payments On States’ Debts • Whiskey Was “A Necessity of Southern Life” • Controversy Led To Shay’s Rebellion (“The Whiskey Rebellion”) in 1794 ¶Charter Allowed To Expire In 1811 (Under Madison)

  9.  Second Bank of the United States (1816 – 1836) ¶Formation Private Bank Formed By Congress With 20 Year Term Advocated By The Democrats (Federalists) With Madison, A Republican, As President ¶Functions  Manage War Of 1812 Debts  Provide Strong Central Currency As Alternative To State Banks Act As Federal Fiscal And Monetary Agent • Receive Federal Tax Deposits And Make Payments • Manage U.S. Mint’s Minting of Coin And Purchase/Sale of Specie  Act As Private Bank • Make Loans Including Loans to Federal Government • Issue Bank Notes Convertible Into Specie and Legal Tender For Federal Tax Payment

  10.  Second Bank of the United States ¶Opposition To Bank Was Primarily In The South  Agricultural States Viewed The Bank As • A Tool Of Northern Commercial Interests • A Source Of Weakened Southern Banks • A Source Of Tighter Farm Credit • An Infringement On States’ Rights  In Early Years Bank Was Haunted By Corruption • Loans To Political Supporters • Nicholas Biddle Became President In 1822 And Ended Corrupt Practices

  11.  Second Bank of the United States ¶Andrew Jackson Was Strong Opponent •  Objected To Elite Central Institution Not Responsible To “The • People” •  Attempted To End Bank In 1832 By Transferring Federal Deposits To State Banks; Congress Over-Ruled •  Bank Became Pawn In Jackson-Clay Presidential Campaign  Bank Charter Allowed To Expire n 1836

  12.  The “Free Banking” Era (1836 – 1863) ¶ State Banking  All Banks Chartered And Supervised By States  State Supervision Focused On • Capital Requirements • Bank Note Reserve Requirements (Usually Specie Plus Eligible Paper) • ¶ Era Of Frequent Bank Failures  General Relaxation Of Capital And Reserve Requirements  Banks Chose To Charter In Easy States  Southern Agricultural Banks Most “At Risk” • Agricultural PricesVolatility and Weak Supervision

  13.  The National Banking Act Of 1863 (Dual Banking) ¶Established Federally-Chartered Banks Civil War Took Southern Opponents To “National” Banking Out Of Congress Office Of The Comptroller Was Created To Supervise National Banks  Federally-Chartered Banks Tended To Have Weak Capital Requirements But Strong Reserve Requirements To Maintain Convertibility •Reserve Requirements Could Be Satisfied By Holding Treasury Securities, Thereby Enhancing War Finance •National Banks Were Required To Accept Each Others ‘ Notes At Par

  14.  The National Banking Act Of 1863 ¶ Congress Actively Favored National Banks  Levied A 10% Tax On Notes Of State Banks, Effectively Driving State Bank Note Issuance Out Of Existence •State Banks Responded By Shifting Issuance From Notes • To Deposits •  The Act Prohibited Interstate Banking •State Banks Could No Longer Shop For Favorable Charters • •State Banks Declined Significantly In Importance

  15.  The National Banking Act Of 1863 • ¶ The Act Did Not Prevent Bank Failures  The Panic Of 1873 •Agricultural Prices Collapsed •“The Crime Of 1873” The Panics Of the 1890s •International Gold Flows • •The Silver Purchase Act Of 1890 • The Panic Of 1907

  16.  The Federal Reserve Act Of 1913 ¶ Background  Crop Cycles And The “Inelastic Currency” •During Harvest Season Demand For Money And Credit Increased But No Source Of Increased Supply •Severe Seasonal Credit Crunches Occurred • Only Moderating Factors Were Inflows Of Foreign Credit And Lending By Clearing Houses

  17.  The Federal Reserve Act Of 1913 ¶ Background  The Panic Of 1907 •Weakening Economy Coincided With Financial Scandal And Harvest Time •Trust Company Failures In NYC Led To Major Credit Lockup • Problem Spread To Interior Banks As NY Correspondents Failed •Resolved By J.P. Morgan And Intervention By Clearing Houses, Treasury, And Strong Banks/Trust Companies

  18.  The Federal Reserve Act Of 1913 ¶ Federal Reserve System Structure  Managed By 7-Member “Board Of Governors” In DC Created 12 “Branches,” Called Federal Reserve Districts  Federal Reserve Bank Of New York Was Major District Bank Federal Open Market Committee Formed In 1930s •Function Was To Conduct Monetary Policy •12 Members--7 BOG Members Plus 5 Regional Bank Presidents In Rotation

  19.  The Federal Reserve Act Of 1913 ¶ Federal Reserve System Functions  Lend To Member Banks At Discount Window •Loans Made On “Real Bills” At “Discount Rate” •Loans For “Need,” Not “Profit” Supervise Member Banks  Provide Services To Member Banks •Check Clearing •Coin Sorting  Establish Reserve Requirements For Member Banks

  20.  The Banking Act Of 1933 (Glass-Steagall Act) ¶ Main Features  Prohibited Commercial Bank Ownership Of Investment Banks And Insurance Companies •  Prohibited Payment Of Interest On Demand Deposits • Established The FDIC To Insure Bank Deposits • Authorized Fed To Supervise Member Banks • Establish Capital Requirements For Member Banks Authorized Fed To Issue Federal Reserve Notes, Limited To 4 times Gold Stock Held

  21.  The Banking Act Of 1933 (Glass-Steagall Act) ¶ Main Features Expanded Authority Of The Federal Reserve System •Fed Could Set Ceilings On Rates Paid On “Time And Saving Deposits” •Fed Could Set Limits On Margin Loans By Banks And Others

  22.  Federal Reserve System Responses To 1933 Act ¶ Subsequent Developments Implemented Authority To Restrict “Margin Loans” •Established Regulation “T” For Security Lending By Broker- Dealers (1934) • •Established Regulation “U” Controlling Security Lending • By Banks (1936) • • Established Regulation “G” Controlling Security Lending By • Non-Bank Domestic Lenders (1968) • •Established Regulation “X” Controlling Security Lending By • Foreign Lenders (1968)

  23.  Federal Reserve System Responses To 1933 Act ¶ Subsequent Developments • ImplementedRegulation “Q” Setting Ceilings On Interest • Rates Paid On Bank Time And Saving Deposits (1933) •  Implemented Regulation “D” Creating Uniform Reserve • Requirements For Member Bank Deposits

  24.  The Bank Holding Company Act Of 1956 ¶ Prohibited Banks From Buying Or Being Owned By Non-Bank Non-Financial Entities (e.g., Industrial Corporations)  Concern That Industrial Companies Would Borrow From Banks At Advantageous Terms, Thereby Weakening Banks  Concern That BHCs Were Being Used To Circumvent Prohibition Of Interstate Branching via “Chain Banking”  Excluded One-Bank Holding Companies

  25.  Bank Holding Company Act Amendments Of 1970 ¶ Extended To One-Bank Holding Companies The BHCA Limitations On Mergers With Non-Banking Companies

  26.  The Community Reinvestment Act Of 1977 (CRA) ¶ Introduced Social Criteria Into Bank Lending  Initiated By Concerns About “Redlning”  FDIC-Insured anks Evaluated On Basis Of Lending Within Deposit-Generating Communities • Focuses On Limiting Deposit Drains To Outside Areas • CRA Does Not Require Making Loans With High Default Prospects  Federal Reserve System Was Charged With Evaluating CRA Compliance

  27.  The Community Reinvestment Act Of 1977 (CRA) ¶ Government Sponsored Entities (FNMA, FHLMC) Also Required To Meet Social Criteria  Monitored By HUD  HUD Introduced “Special Affordable Loan” Requirement • GSEs Must Have A Minimum Share Of New Loans To Borrowers With Incomes Below 60% Of Community Median • GSEs SAL Minimum Started at 12% of New Mortgages In 1996, Rose to 28% in 2008

  28.  The Depository Institutions Deregulation And Monetary Control Act of 1980 (DIDMCA) ¶ Initiated Removal Of Glass-Steagall Restrictions  Established Uniform Reserve Requirements For Banks and Thrift Institutions  Phased Out Requlation Q, Allowing Unlimited Interest Payments on Time And Saving Deposits  Allowed Interest Payments On Substitutes For Demand Deposits (NOW Accounts)

  29.  The Depository Institutions Deregulation And Monetary Control Act of 1980 (DIDMCA) ¶ Other Actions Liberalized Investment Authority of Thrift Institutions • S&Ls Could Invest Up To 20% In Non-Mortgage Assets •MSBs Coukd Invest Up To 5% In Non-Mortgage Increased FDIC Deposit Insurance To $100K from $40K Required Federal Reserve System To Price Its Services (Check Clearing, Coin Sorting, FedWire, ACH, etc.)

  30.  The Financial Industry Modernization Act of 1999 [Called Gramm-Leach-Bliley Act, Or GLB Act] ¶ Continued Dismantling Of Glass-Steagall Act  In 1994 CitiBank Bought Travelers Insurance And Salomon Brothers’ Smith-Barney Brokerage To Form CtiGroup • CitiGroup Formation Illegal Under Glass-Steagall • CitiBank Received Waiver To Allow Merger  GLB Act Formalized Approval Of CitiGroup By Allowing Any Commercial Bank To Undertake Cross-Industry Mergers • Chase Bank Buys JPMorgan to Create JPMorganChase  Cross-Industry Merger Approval Conditioned On “Satisfactory” CRA Rating In Most Recent Evaluation

  31. Part 1.2Bank Supervisory Agencies

  32.  Supervisory Agency Structure

  33.  Supervisory Agency Ratings ¶ The CAMELS System (1978) CAMELS Criteria •Capital Adequacy •Asset Quality •Management Ability •Earnings Performance •Liquidity •Sensitivity To Market Risk • The CAMELS Ratings • •Rating Based On Call Reports, Field Visits • -Scored From 1 (Poor) To 5 (Excellent) • -Results Are Not Public • •Rating Assigned By Lead Supervisory Agency

  34.  The Basle Accords ¶ Basle I (1988) Established International Standards For Bank Supervision  Defined “Capital” • •Tier 1 Capital = Common Equity Paid In • + Cumulative Retained Earnings • + Noncumulative Preferred Stock • •Tier 2 Capital = Hybrid Debt • + Subordinated Debt • + Loan Loss Reserves • + Contingency Reserves

  35.  The Basle Accords ¶ Basle I (1988) •  Established Capital Composition Standards • •At Least 50% Of Capital Had To Be Tier 1 • •No More Than 50% Of Tier 2 Capital In Subordinated Debt • Set “Risk-Based” Capital Requirements (Credit Risk Only)

  36.  The Basle Accords ¶ Basle II (2004) Extended Types Of Risk Evaluated •Credit Risk •Operational Risk •Market Risk Credit Risk Requirements • •Standard Method—e.g. 8% of Average Risk-Adjusted • Assets • •Internal Risk-Based Analysis (Option For Large Banks) Market Risk • •Basle II Recommends “Value At Risk” (VaR)

  37.  Basle II: Measuring Market Risk By VaR

  38.  Problems With VaR ¶Non-Normality In Distribution Of Returns Above-Normal Probability Of Large Asset Price Declines • Fat Tails And •“Black Swans” ¶Use Of Historical Data • Historical Measurement Of Correlations Between Asset • Returns • Dramatic Changes In Correlations In Crisis Periodx • Failure To Incorporate Connections Between Markets

  39.  What Went Wrong With Commercial Banks In 2008? ¶Off Balance Sheet Investments Structured Investment Vehicles • Independent Entities Created By Banks -Sold To Investors (Hedge Funds, High-Wealth) -Investors Financed Purchase Wiyj Short-Term Loans (Commercial Paper) -Banks Had No Explicit Obligation To Redeem -Bank’s Did Provide Letters of Credit (Commitments To Replace Short-Term Loans If Normal Lenders Withdrew)

  40.  What Went Wrong With Commercial Banks In 2008? ¶Off Balance Sheet Investments  The Collapse Of SIVs •During Credit Freeze In Fall, Banks Forced To Make Loans To SIVs, Selling Assets And Restricting Bank Loans •Banks Faced Implicit Commitents To Repurchase SIV Assets (”Reputational Put)

  41.  What Went Wrong With Commercial Banks In 2008? ¶Changes In Supervisory Philosophy  The Shift To Internal Risk Assessment (Basle II) • Applied To Large Banks • Rested On Poor Assumptions - Quantitative Risk Management Methods (VaR) Were Suitable - Management Incentives Were Aligned With Shareholders

  42. Part 2Depository Financial Institutions:Thrift InstitutionsSavings And Loan Associations And Mutual Savings Banks

  43. Thrift Institutions ¶ Designed To Collect Savings Deposits And Invest In Residential Mortgages ¶ S&L Deposits Insured By Federal Savings And Loan Insurance Corporation (FSLIC)L Institutions; MSB Deposits Insured By State Insurance Funds

  44. Thrift Institutions ¶ Fatal Flaws  Borrowed Short-Term (Deposits) And Made Long-Term Loans (Mortgages) • Viability Required Upward-Sloping Yield Curve And Stable Interest Rates  Undiversified Assets--Entirely In Residential Mortgages

  45. Important Legislation ¶ Federal Home Loan Bank Act of 1932  Created FHLB System  Modeled After Federal Reserve System • Twelve Regional Banks • Authority To Lend To S&Ls On Mortgage Collateral  Allowed Federally Chartered S&Ls

  46. Important Legislation ¶ Federal Savings And Loan Insurance Act Of 1934 Created FSLIC • Modeled After FDIC • Supervised By FHLB Board • Insured S&L Deposits

  47. Important Legislation ¶ Formation Of Government Sponsored Entities Federal National Mortgage Association (1938) • Purchased FHA/VA-Insured Mortgages • Financed By Bonds And “Pass-Thru” Securities • “Privatized” In 1968 Government National Mortgage Association (1968) • Supervised By HUD • Purchased Conventional And FHA/VA Mortgages

  48. Important Legislation ¶ Formation Of Government Sponsored Entities  Federal Home Loan Mortgage Corp (1970) • Supervised By FHLB Board • Purchased Conventional Mortgages

  49. Important Legislation ¶ Interest Rate Control Act of 1966 Subjected S&L Deposits to Regulation Q Ceiling Plus +.25% Goals: • Protect Income Of Thrift Institutions • Allow Thrifts A Small Deposit Rate Advantage Over Commercial Banks

  50. Important Legislation ¶ DIDMCA of 1980 Liberalized Investment Authority of Thrift Institutions •S&Ls Could Invest Up To 20% In Non-Mortgage Assets •MSBs Could Invest Up To 5% In Non-Mortgage Assets Eliminated Interest Rate Ceilings On Deposits (Reg Q) Required Federal Reserve To Price Services To Banks (Check Clearing, Coin Sorting, Currency Replacement)