McFadden Act (1927) and Douglas Amendment (1956) limit interstate branching

1. McFadden Act (1927) and Douglas Amendment (1956) limit interstate branching • Interstate Banking and Branching Efficiency Act (1994) deregulates branching • Gramm-Leach-Biley Financial Services Modernization Act (1999) repeals • Glass-Steagall

2. Regulating Finance • Lots of bases to cover Cover one by regulation or deregulation  Unintended Consequences • Reactions to regulatory policies  frustrate regulator intent Regulate bank balance sheets  off-balance sheet activities Emplace a safety net  bankers become skydivers • Regulation spreads to cover innovations  complexity  ineffectiveness Win by gaming the system

3. Primary Supervisory Responsibility of Bank Regulatory Agencies • Comptroller of the Currency—national banks chartered by Federal government since 1863 • Federal Reserve and state banking authorities—state banks that are members of the Federal Reserve System • Fed also regulates bank holding companies • FDIC—insured state banks that are not Fed members • State banking authorities—state banks without FDIC insurance

4. Innovations: Response to Interest Rate Volatility • Adjustable-rate mortgages • Financial Derivatives Innovations: Response to Information Technology • Bank credit and debit cards • Electronic banking • ATM/Home banking/ABM/Virtual banking • Junk bonds • Commercial paper market … backed by banks • Securitization Innovations:Avoiding Regulation/Loophole Mining • Sweep accounts … reserve requirements • Money Market Mutual Funds … Regulation Q

5. Decline of Traditional Banking • Decline in cost advantages in acquiring funds (liabilities) • Rising inflation  rise in interest rates and disintermediation • Low-cost source of funds, checkable deposits, declined in importance • Decline in income advantages on uses of funds (assets) • Information technology  less need for banks to finance short-term credit • and issue loans • IT  lower transaction costs for other financial institutions • Bank Responses: • Riskier Lending … Commercial real estate, leveraged buyouts, takeovers • Off balance sheet activities

6. Size Distribution of Insured Commercial Banks, September 30, 2008 ???? 3,046 4,039 486 86 7,640 39.9 52.9 6.1 1.1 1.3 9.7 10.0 79.0

8. Ten Largest Non – US Banks, December 30, 2008 • Ten Largest Banks in the World, 2007 $ Revenues • ING Group, Netherlands 6. BNP Paribas, France • Fortis, Belgium/Netherlands 7. Credit Agricole, France • Citigroup, US 8. Deutsche Bank, Germany • Dexia Group, Belgium 9. Bank of America, US • HSBC Holdings, UK 10. UBS, Switzerland

9. Bank Consolidation Interstate Banking and Branching Efficiency Act, 1994 • Skirting branch restrictions • ATMs, Bank Holding Cos. • Skirting branch restrictions • ATMs, Bank Holding Cos.  Geographic deregulation • Pre-Crisis Findings: • Net interest margin up • ROA, ROE up for big • banks • Intrastate deregulation • more positive for all but • big banks • Interstate deregulation • helps big banks most • Non-performing loans • down for biggest banks • but up for smaller banks • State of economy has • stronger impact on bank • performance than • branching deregulation • Benefits of bank consolidation • Increased competition  close inefficient banks • Efficiencies from economies of scale and scope • Lower chance of failure -- diversified portfolios • Costs • Fewer community banks  less lending to small business • Banks in new areas  increased risks/failures

10. The U.S. regulatory regime: In need of reform? Sources: Financial Services Roundtable (2007), Milken Institute.

11. Asymmetric Information and Bank Regulation Government safety net • Deposit insurance and FDIC • Short circuits bank failures and contagion effect • Payoff method • Purchase and assumption method • Fed as lender of last resort: Too BIG to Fail • Financial consolidation Exacerbates Too Big to Fail • Safety net extended to non-bank financial institutions Safety Net  Moral Hazard Problems • Depositors don’t impose discipline of marketplace • Banks have an incentive to take on greater risk Safety Net Adverse Selection Problems • Risk-lovers find banking attractive • Depositors have little reason to monitor bank

12. Attempted solutions: Constrain banks from taking too much risk • Promote diversification • Prohibit holdings of common stock • Set capital requirements … Capital as cushion • Minimum leverage ratio • Basel Accord: risk-based capital requirements … but there’s regulatory arbitrage Prompt corrective action: Close ‘em down when capital inadequate • Monitor … CAMELS • Capital adequacy • Asset quality • Management • Earnings • Liquidity • Sensitivity to market risk • Disclosure requirements … mark-to-market issue • Restrictions on competition … make banking boring

14. Failed Banks Update Year Number • 2000 2 • 2001 4 • 2002 11 • 2003 3 • 2004 4 • 2005/2006 0 • 2007 3 • 2008 QI+Q2 4 • 2008 Q3 10 • 2008 Q4 12 • 2009 Q1 21 • 2009 Q2 24 • 2009 Q3 50

16. 1980s S&L and Banking Crisis • Financial innovation  increased risk taking • Increased deposit insurance  moral hazard • Deregulation • Lack of management expertise • Rapid growth in new lending: real estate • Activities expanded in scope • Regulators at FSLIC lacked expertise • High interest rates/recession increased incentives for moral hazard

17. 1980s S&L and Banking Crisis: • Regulatory forbearance by FSLIC • Insufficient funds to close insolvent S&Ls • Established to encourage growth • Did not want to admit agency was in trouble • Zombie S&Ls taking on high risk projects and attracting business from healthy S&Ls • Politicians lobbied by S&L interests • Competitive Equality in Banking Act of 1987 • Inadequate funding • Continued forbearance

18. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 • Regulatory apparatus restructured • Federal Home Loan Bank Board relegated to the OTS • FSLIC given to the FDIC • RTC established to manage and resolve insolvent thrifts • Cost of the bailout approximately $150 billion • Re-restricted asset choices • Increased core-capital leverage requirements • Imposed same risk-based capital standards as those on commercial banks • Enhanced enforcement powers of regulators • Did not resolve underlying moral hazard and adverse selection problems