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Chapter 20
Banking
Regulation
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-2
Chapter Preview
• The financial system is one of the
most heavily regulated industries in
our economy. In this chapter, we
develop an economic analysis of why
regulation of banking takes the form
that it does. We see further that
regulation doesn’t always work.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-3
Chapter Preview
• Finally, we offer an explanation for the world
banking crisis and reforms to prevent future
disasters. Topics include:
– Asymmetric Information and Bank Regulation
– International Banking Regulation
– The 1980s U.S. Banking Crisis
– Federal Deposit Insurance Corporation Improvement
Act of 1991
– Banking Crisis Throughout the World
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-4
Asymmetric Information
and Bank Regulation
• Our previous analysis of asymmetric
information, moral hazard, and adverse
selection provide an excellent backdrop for
understanding the current regulatory
environment in banking.
• There are eight basic categories of bank
regulation, which we will examine from an
asymmetric information perspective.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-5
Asymmetric Information
and Bank Regulation
1. Government Safety Net: Deposit Insurance and the FDIC
• Prior to FDIC insurance, bank failures meant depositors lost
money, and had to wait until the bank was liquidated to receive
anything. This meant that “good” banks needed to separate
themselves from “bad” banks, which was difficult for banks
to accomplish.
• The inability of depositors to assess the quality of a bank’s
assets can lead to panics. If depositors fear that some banks
may fail, their best policy is to withdraw all deposits, leading to a
bank run, even for “good” banks. Further, failure of one bank
can hasten failure of others (contagion effect).
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-6
Asymmetric Information
and Bank Regulation
1. Government Safety Net: Deposit Insurance and
the FDIC
• Bank panics did occur prior to the FDIC, with major
panics in 1819, 1837, 1857, 1873, 1884, 1893, 1907,
and 1930-1933.
• By providing a safety net, depositors will not flee the
banking system at the first sign of trouble. Indeed,
between 1934 and 1981, fewer than 15 banks failed
each year.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-7
Asymmetric Information
and Bank Regulation
1. Government Safety Net: Deposit Insurance and
the FDIC
• The FDIC handles failed banks in one of two ways:
the payoff method, where the banks is permitted to
fail, and the purchase and assumption method, where
the bank is folded into another banking organization.
• Implicit insurance is available in some countries
where no explicit insurance organization exists. But,
as the next slide shows, deposit insurance is
spreading throughout the world.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-8
Global: The Spread of Deposit
Insurance Throughout the World
• Up to the 1960s, only six countries had
deposit insurance. By the 1990s, the
number topped 70.
• Has this spread of insurance been a good
thing? Did it improve the performance of
the financial system and prevent crises?
• Oddly enough, the answer appears to be
no.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-9
Global: The Spread of Deposit
Insurance Throughout the World
• Explicit government insurance is
associated with less bank sector stability
and higher bank crises.
• Appears to retard financial development
• But this appears to be only for countries
with ineffective laws, regulation, and high
corruption. Indeed, for emerging markets,
deposit insurance may be the wrong
medicine!
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-10
Asymmetric Information
and Bank Regulation
1. Government Safety Net: Deposit Insurance and
the FDIC:
• The FDIC insurance creates moral hazard
incentives for banks to take on greater risk than they
otherwise would because of the lack of “market
discipline” on the part of depositors.
• The FDIC insurance creates adverse selection.
Those who can take advantage of (abuse) the
insurance are mostly likely to find banks attractive.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-11
Asymmetric Information
and Bank Regulation
1. Government Safety Net: Deposit
Insurance and the FDIC:
• Regulators are reluctant to let the largest
banks fail because of the potential impact on
the entire system. This is known as the “Too
Big to Fail” doctrine. This increases the
moral hazard problem for big banks and
reduces the incentive for large depositors to
monitor the bank.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-12
Asymmetric Information
and Bank Regulation
1. Government Safety Net: Deposit
Insurance and the FDIC
• Consolidation has created many “large”
banks, exasperating the too-big-to-fail
problem. Further, banks now engage in more
than just banking, which may inadvertently
extend FDIC to such activities as
underwriting.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-13
Asymmetric Information
and Bank Regulation
2. Restrictions on Asset Holdings
• Regulations limit the type of assets banks
may hold as assets. For instance, banks
may not hold common equity.
Copyright © 2009 Pearson Prentice Hall. All
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Asymmetric Information
and Bank Regulation
3. Bank Capital Requirements
• Banks are also subject to capital
requirements. Banks are required to hold a
certain level of capital (book equity) that
depends on the type of assets that the bank
holds.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-15
Asymmetric Information
and Bank Regulation
3. Bank Capital Requirements
• Details of bank capital requirements:
• Leverage ratio must exceed 5% to
avoid restrictions
• Capital must exceed 8% of the banks risk-
weighted assets and off-balance sheet
activities (details follow)
• New capital requirements are forthcoming to
address problems with risk-weighted assets
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-16
Asymmetric Information
and Bank Regulation
3. Bank Capital Requirements
The next four slides show how to
calculate Bank Capital requirements for
a fictitious bank.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-17
Calculating Capital Requirements
First National Bank
Assets Liabilities
Reserves $3 m Checkable deposits $20 m
Treasury securities $10 m Nontransactions
deposits
$60 m
Government agency
securities
$7 m Borrowings $11 m
Municipal bonds $10 m Loan loss reserves $2 m
Residential mortgages $10 m Bank capital $7 m
Real estate loans $20 m
C&I loans $35 m
Fixed assets $5 m
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-18
Calculating Capital Requirements
• Leverage Ratio = Capital/Assets
= $7m/$100m = 7%
• Bank is well capitalized
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-19
0 × $3 million (Reserves)
+0 × $10 million (Treasury securities)
+ .20 × $7 million (Agency securities)
+ .50 × $10 million (Municipal bonds)
+ .50 × $10 million (Residential mortgages)
+1.00 × $20 million (Real estate loans)
+1.00 × $35 million (Commercial loans)
+1.00 × $5 million (Fixed assets)
+1.00 × $20 million (Letters of credit)
$91.4 million (Total risk-adjusted assets)
Calculating Risk-Adjusted Requirements
Copyright © 2009 Pearson Prentice Hall. All
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Calculating Risk-Adjusted Requirements
• Core Capital Requirement
= 4% x risk-adjusted assets
= 4% x $91.4m = $3.66m
< $7m of core capital
• Total Capital Requirement
= 8% x risk-adjusted assets
= 8% x $91.4m = $7.31m
< $9m of total capital
= $7m of core + $2m of loan loss reserves
Copyright © 2009 Pearson Prentice Hall. All
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Asymmetric Information
and Bank Regulation
3. Bank Capital Requirements
Of course, the system isn’t perfect.
Banks now engage in regulatory
arbitrage, where for a given category,
they seek assets that are the riskiest.
Basel continued to work on the system.
Copyright © 2009 Pearson Prentice Hall. All
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Basel 2: How well will it work?
• In June 1999, the Basel Committee
proposed several reforms to the original
Basel Accord, with the following
components:
– Linking capital requirements to actual risk for
large, international banks
– Steps to strengthen the supervisory process
– Increased market discipline mechanisms
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-23
Basel 2: How well will it work?
• The new system appears to be quite
complex, and implementation has been
delayed by years.
• U.S. regulators met to determine how best
to protect the FDIC insurance fund based
on the new capital requirements.
• Only the largest U.S. banks will be subject
to Basel 2. Other U.S. banks will follow a
simplified standard.
Copyright © 2009 Pearson Prentice Hall. All
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How Asymmetric Information Explains
Banking Regulation
4. Bank Supervision: Chartering and Examination
• Reduces the adverse selection problem of risk-
takers or crooks owning banks to engage in highly
speculative activities. As Lincoln S&L shows, this
isn’t a perfect system.
• Examinations assign a CAMEL rating to a bank,
which can be used to justify cease and desist orders
for risky activities.
• Period reporting (call reports) and frequent
(sometimes unannounced) examinations allow
regulators to address risky / questionable practices
in a prompt fashion.
Copyright © 2009 Pearson Prentice Hall. All
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How Asymmetric Information Explains
Banking Regulation
5. Assessment of Risk Management
• Past examinations focused primarily on the quality
of assets. A new trend has been to focus on
whether the bank may take excessive risk in the
near future.
• Four elements of risk management and control:
1. Quality of board and senior management oversight
2. Adequacy of policies limiting risk activity
3. Quality of risk measurement and monitoring
4. Adequacy of internal controls to prevent fraud
Copyright © 2009 Pearson Prentice Hall. All
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How Asymmetric Information Explains
Banking Regulation
5. Assessment of Risk Management
• U.S. regulators have also adopted similar-
minded guidelines for dealing with interest-
rate risk.
• Particularly important is the implementation
of stress testing, or VAR calculations, to
measure potential losses.
Copyright © 2009 Pearson Prentice Hall. All
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How Asymmetric Information Explains
Banking Regulation
6. Disclosure Requirements
• Better information reduces both moral
hazard and adverse selection problems
6. Consumer Protection
• Standardized interest rates (APR)
• Prevent discrimination (e.g., CRA to help
avoid redlining particular areas)
Copyright © 2009 Pearson Prentice Hall. All
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How Asymmetric Information Explains
Banking Regulation
8. Restrictions on Competition
• Branching restrictions, which reduced
competition between banks
• Separation of banking and securities
industries: Glass-Steagall. In other words,
preventing nonbanks from competing with
banks.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-29
How Asymmetric Information Explains
Banking Regulation
Many laws have been passed in the U.S.
to regulate banking. Table 1 provides a
summary of the major legislation and key
provisions.
FDIC index of
regulations on banking
http://www.fdic.gov/regulations/laws/index.html
Major Banking
Legislation in the
United States
Copyright © 2009 Pearson Prentice Hall. All
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FDIC index of regulations on banking
http://www.fdic.gov/regulations/laws/index.html
Major Banking Legislation
in U.S. (cont.)
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-32
International Bank Regulation
We now turn to international regulation.
Banks around the world face similar
problems as the U.S., and so are regulated
in a similar fashion. Charters, supervision,
and deposit insurance are common themes
throughout the world. And capital
requirements are being standardized.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-33
International Bank Regulation
Banks around the world face similar
problems as the U.S., and so are regulated
in a similar fashion. Charters, supervision,
and deposit insurance are common themes
throughout the world. And capital
requirements are being standardized.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-34
International Bank Regulation
Banks that engage in international banking
cause problems for regulators:
– They can shift assets between countries
– Not clear who should have primary regulatory
authority. A good example was the collapse of
the Bank of Credit and Commerce International
due to fraud. The Bank of England closed it,
but only after huge depositor and investor
losses.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-35
International Bank Regulation
Although the need for bank regulation and
supervision is clear, getting supervisors
and regulators to act properly is difficult:
– Institution actively seek to avoid regulations
– It’s often difficult to capture the detail needed
to assess risk
– Political pressure can always sidetrack
regulators from doing their job
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-36
E-Finance: Electronic Banking
and Regulation
• Electronic banking has created new issues
in regulation, particularly security and
privacy.
• An incident in Russia (1995) highlights this,
where a computer programmer moved
millions in assets from Citibank accounts to
person accounts.
Copyright © 2009 Pearson Prentice Hall. All
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E-Finance: Electronic Banking
and Regulation
• Electronic banking creates the need to
assess the technical skills of banks to
handle transaction securely and safely.
Electronic signatures also had to be
addressed by Congress.
• Privacy is also a problem. There are laws
protecting consumers from the sharing of
information, but this regulation is likely to
evolve over time.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-38
International Banking Regulation
• Bank regulation abroad is similar to that in
the United States.
• There is a particular problem of regulating
international banking and can readily shift
business from one country to another
(e.g., BCCI scandal) and requires
coordination of regulators in different
countries (a difficult task).
Copyright © 2009 Pearson Prentice Hall. All
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The 1980s U.S. Banking Crisis
• Prior to the 1980s, the FDIC and bank
regulation seemed to be going well.
However, in the 80s, failures rose
dramatically, as you can see in the
following slide.
Copyright © 2009 Pearson Prentice Hall. All
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U.S. Bank Failures
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The 1980s U.S. Banking Crisis
• Why?
1.Decreasing profitability: banks take risk to keep
profits up
2.Financial innovation creates more
opportunities for risk taking
3.Innovation of brokered deposits enables
circumvention of $100,000 insurance limit
• Result: Failures ↑ and risky loans ↑
Copyright © 2009 Pearson Prentice Hall. All
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Federal Deposit Insurance Corporation
Improvement Act (FDICIA) of 1991
Following the widespread failure of thrift
institutions in the late 1980s, the Bush
administration proposed a set of legislation to
overhaul the supervision and insurance for the
thrift industry. As part of this, the FSLIC was
dissolved and the FDIC assumed responsibility
for insuring thrift institutions. To address the new
needs of the FDIC, the Improvement Act of 1991
was passed.
Copyright © 2009 Pearson Prentice Hall. All
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Federal Deposit Insurance Corporation
Improvement Act (FDICIA) of 1991
• FDIC recapitalized with loans, ability to borrow
from the Treasury, and higher premiums to
member banks
• Reduce scope of deposit insurance and too-big-
to-fail
– Eliminate deposit insurance entirely
– Lower limits on deposit insurance
– Eliminate too-big-to-fail
– Coinsurance
Copyright © 2009 Pearson Prentice Hall. All
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Federal Deposit Insurance Corporation
Improvement Act (FDICIA) of 1991
• Prompt corrective action provisions
1.Critics believe too many loopholes
2.However: accountability increased by mandatory
review of bank failure resolutions
• Risk-based premiums
• Annual examinations and stricter reporting
• Enhances Fed powers to regulate
international banking
Copyright © 2009 Pearson Prentice Hall. All
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Federal Deposit Insurance Corporation
Improvement Act (FDICIA) of 1991
• FDICIA also instructed the FDIC to develop
risk-based insurance premiums. However,
it wasn’t very effective. The Federal
Deposit Reform Act of 2005 attempts to
remedy this.
• FDICIA was a good start. But there are still
concerns with too-big-to-fail doctrines and
effective insurance premiums.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-46
Banking Crisis Throughout the World
As the next two slides illustrates, banking
crisis have struck a large number of
countries throughout the world, and many
of them have been substantially worse
than ours.
20-47
Banking Crisis Throughout the World
Cost of Banking
Crises in Other
Countries
Copyright © 2009 Pearson Prentice Hall. All
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Banking Crisis Throughout the World
• Latin America
– Many banks were government owned with interest rate
restrictions similar to Regulation Q.
– Similar loan losses and bailout experience as the U.S.
in the late 1980s.
– Argentina ran into government confidence problem,
causing required rates on government debt to
exceed 25%, which caused severe problems for the
banking industry.
– Losses and bailouts as a percent of GDP are high
(20% - 50%) relative to that in the U.S. (around 3%).
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-50
Banking Crisis Throughout the World
• Russia and Eastern Europe
– Many banks were government owned prior to
the downfall of communism.
– Private banks had little experience screening
and monitoring loans.
– Substantial loan losses ensued.
– The bailout in Russia alone may exceed
$15 billion
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-51
Banking Crisis Throughout the World
• Japan
– Prior to the 1980s, Japan’s financial markets
were heavily regulated. Deregulation led to
excessive risk taking and high loan losses,
particularly in real estate loans.
– Several large bank failures were announced in
1995. Several failures followed in 1996
and 1997.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-52
Banking Crisis Throughout the World
• Japan
– Japan is experiencing similar regulator
forbearance policies as the U.S. in the
early 1980s.
– Even with positive steps, bad loans throughout
the banking system required a bailout of $500
billion in 1998.
– System is still a long way from being healthy.
Copyright © 2009 Pearson Prentice Hall. All
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Banking Crisis Throughout the World
• Japan
– Immediately after 1998, the gov’t closed two
big banks. Cleanup stalled as banks tried to
avoid gov’t involvement. Bad loans were
estimated near $1 trillion.
– Only recently have the number of bad loans
started to decline, and larger banks have paid
back the bail-out money. Profitability is near.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-54
Banking Crisis Throughout the World
• China
– Many banks were government owned.
– Investments in many state-owned enterprises,
which are notoriously inefficient.
– Current attempt at a bailout calls for partial
privatization of the biggest banks.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-55
Banking Crisis Throughout the World
• East Asia
– Lending boom in the aftermath of
liberalization led to substantial loan losses.
– Nonperforming loans and bailout costs
exceeding 20% of GDP are commonplace.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-56
Déjà Vu All Over Again!
• Banking crises are just history repeating
itself. Financial liberalization leads to
moral hazard (and bad loans!). Deposit
insurance is not big enough to cover
losses, but the gov’t does stand ready to
bailout the system. And that implicit
guarantee is enough to exacerbate the
moral hazard problem.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-57
Chapter Summary
• Asymmetric Information and Bank Regulation: the
problems of adverse selection and moral hazard
were reviewed. These ideas are the basis for
exploring the regulatory environment of the
banking industry.
• International Banking Regulation: The challenges
of international regulation, particularly
international banks, was discussed.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-58
Chapter Summary (cont.)
• The 1980s U.S. Banking Crisis: We
examined the causes of the U.S. crisis.
Further, we explored problems caused by
the political environment in fixing the
problem promptly.
• Federal Deposit Insurance Corporation
Improvement Act of 1991: The provisions
of this act and its implications for the safety
of the banking system were explored.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 20-59
Chapter Summary (cont.)
• Banking Crisis Throughout the World: As
reviewed, evidence suggests that the U.S.
is not alone in its banking problems, as
other countries face similar issues as the
U.S. in the late 1980s.

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M21 mish1520 06_ppw_c20

  • 2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-2 Chapter Preview • The financial system is one of the most heavily regulated industries in our economy. In this chapter, we develop an economic analysis of why regulation of banking takes the form that it does. We see further that regulation doesn’t always work.
  • 3. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-3 Chapter Preview • Finally, we offer an explanation for the world banking crisis and reforms to prevent future disasters. Topics include: – Asymmetric Information and Bank Regulation – International Banking Regulation – The 1980s U.S. Banking Crisis – Federal Deposit Insurance Corporation Improvement Act of 1991 – Banking Crisis Throughout the World
  • 4. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-4 Asymmetric Information and Bank Regulation • Our previous analysis of asymmetric information, moral hazard, and adverse selection provide an excellent backdrop for understanding the current regulatory environment in banking. • There are eight basic categories of bank regulation, which we will examine from an asymmetric information perspective.
  • 5. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-5 Asymmetric Information and Bank Regulation 1. Government Safety Net: Deposit Insurance and the FDIC • Prior to FDIC insurance, bank failures meant depositors lost money, and had to wait until the bank was liquidated to receive anything. This meant that “good” banks needed to separate themselves from “bad” banks, which was difficult for banks to accomplish. • The inability of depositors to assess the quality of a bank’s assets can lead to panics. If depositors fear that some banks may fail, their best policy is to withdraw all deposits, leading to a bank run, even for “good” banks. Further, failure of one bank can hasten failure of others (contagion effect).
  • 6. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-6 Asymmetric Information and Bank Regulation 1. Government Safety Net: Deposit Insurance and the FDIC • Bank panics did occur prior to the FDIC, with major panics in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930-1933. • By providing a safety net, depositors will not flee the banking system at the first sign of trouble. Indeed, between 1934 and 1981, fewer than 15 banks failed each year.
  • 7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-7 Asymmetric Information and Bank Regulation 1. Government Safety Net: Deposit Insurance and the FDIC • The FDIC handles failed banks in one of two ways: the payoff method, where the banks is permitted to fail, and the purchase and assumption method, where the bank is folded into another banking organization. • Implicit insurance is available in some countries where no explicit insurance organization exists. But, as the next slide shows, deposit insurance is spreading throughout the world.
  • 8. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-8 Global: The Spread of Deposit Insurance Throughout the World • Up to the 1960s, only six countries had deposit insurance. By the 1990s, the number topped 70. • Has this spread of insurance been a good thing? Did it improve the performance of the financial system and prevent crises? • Oddly enough, the answer appears to be no.
  • 9. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-9 Global: The Spread of Deposit Insurance Throughout the World • Explicit government insurance is associated with less bank sector stability and higher bank crises. • Appears to retard financial development • But this appears to be only for countries with ineffective laws, regulation, and high corruption. Indeed, for emerging markets, deposit insurance may be the wrong medicine!
  • 10. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-10 Asymmetric Information and Bank Regulation 1. Government Safety Net: Deposit Insurance and the FDIC: • The FDIC insurance creates moral hazard incentives for banks to take on greater risk than they otherwise would because of the lack of “market discipline” on the part of depositors. • The FDIC insurance creates adverse selection. Those who can take advantage of (abuse) the insurance are mostly likely to find banks attractive.
  • 11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-11 Asymmetric Information and Bank Regulation 1. Government Safety Net: Deposit Insurance and the FDIC: • Regulators are reluctant to let the largest banks fail because of the potential impact on the entire system. This is known as the “Too Big to Fail” doctrine. This increases the moral hazard problem for big banks and reduces the incentive for large depositors to monitor the bank.
  • 12. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-12 Asymmetric Information and Bank Regulation 1. Government Safety Net: Deposit Insurance and the FDIC • Consolidation has created many “large” banks, exasperating the too-big-to-fail problem. Further, banks now engage in more than just banking, which may inadvertently extend FDIC to such activities as underwriting.
  • 13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-13 Asymmetric Information and Bank Regulation 2. Restrictions on Asset Holdings • Regulations limit the type of assets banks may hold as assets. For instance, banks may not hold common equity.
  • 14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-14 Asymmetric Information and Bank Regulation 3. Bank Capital Requirements • Banks are also subject to capital requirements. Banks are required to hold a certain level of capital (book equity) that depends on the type of assets that the bank holds.
  • 15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-15 Asymmetric Information and Bank Regulation 3. Bank Capital Requirements • Details of bank capital requirements: • Leverage ratio must exceed 5% to avoid restrictions • Capital must exceed 8% of the banks risk- weighted assets and off-balance sheet activities (details follow) • New capital requirements are forthcoming to address problems with risk-weighted assets
  • 16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-16 Asymmetric Information and Bank Regulation 3. Bank Capital Requirements The next four slides show how to calculate Bank Capital requirements for a fictitious bank.
  • 17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-17 Calculating Capital Requirements First National Bank Assets Liabilities Reserves $3 m Checkable deposits $20 m Treasury securities $10 m Nontransactions deposits $60 m Government agency securities $7 m Borrowings $11 m Municipal bonds $10 m Loan loss reserves $2 m Residential mortgages $10 m Bank capital $7 m Real estate loans $20 m C&I loans $35 m Fixed assets $5 m
  • 18. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-18 Calculating Capital Requirements • Leverage Ratio = Capital/Assets = $7m/$100m = 7% • Bank is well capitalized
  • 19. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-19 0 × $3 million (Reserves) +0 × $10 million (Treasury securities) + .20 × $7 million (Agency securities) + .50 × $10 million (Municipal bonds) + .50 × $10 million (Residential mortgages) +1.00 × $20 million (Real estate loans) +1.00 × $35 million (Commercial loans) +1.00 × $5 million (Fixed assets) +1.00 × $20 million (Letters of credit) $91.4 million (Total risk-adjusted assets) Calculating Risk-Adjusted Requirements
  • 20. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-20 Calculating Risk-Adjusted Requirements • Core Capital Requirement = 4% x risk-adjusted assets = 4% x $91.4m = $3.66m < $7m of core capital • Total Capital Requirement = 8% x risk-adjusted assets = 8% x $91.4m = $7.31m < $9m of total capital = $7m of core + $2m of loan loss reserves
  • 21. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-21 Asymmetric Information and Bank Regulation 3. Bank Capital Requirements Of course, the system isn’t perfect. Banks now engage in regulatory arbitrage, where for a given category, they seek assets that are the riskiest. Basel continued to work on the system.
  • 22. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-22 Basel 2: How well will it work? • In June 1999, the Basel Committee proposed several reforms to the original Basel Accord, with the following components: – Linking capital requirements to actual risk for large, international banks – Steps to strengthen the supervisory process – Increased market discipline mechanisms
  • 23. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-23 Basel 2: How well will it work? • The new system appears to be quite complex, and implementation has been delayed by years. • U.S. regulators met to determine how best to protect the FDIC insurance fund based on the new capital requirements. • Only the largest U.S. banks will be subject to Basel 2. Other U.S. banks will follow a simplified standard.
  • 24. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-24 How Asymmetric Information Explains Banking Regulation 4. Bank Supervision: Chartering and Examination • Reduces the adverse selection problem of risk- takers or crooks owning banks to engage in highly speculative activities. As Lincoln S&L shows, this isn’t a perfect system. • Examinations assign a CAMEL rating to a bank, which can be used to justify cease and desist orders for risky activities. • Period reporting (call reports) and frequent (sometimes unannounced) examinations allow regulators to address risky / questionable practices in a prompt fashion.
  • 25. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-25 How Asymmetric Information Explains Banking Regulation 5. Assessment of Risk Management • Past examinations focused primarily on the quality of assets. A new trend has been to focus on whether the bank may take excessive risk in the near future. • Four elements of risk management and control: 1. Quality of board and senior management oversight 2. Adequacy of policies limiting risk activity 3. Quality of risk measurement and monitoring 4. Adequacy of internal controls to prevent fraud
  • 26. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-26 How Asymmetric Information Explains Banking Regulation 5. Assessment of Risk Management • U.S. regulators have also adopted similar- minded guidelines for dealing with interest- rate risk. • Particularly important is the implementation of stress testing, or VAR calculations, to measure potential losses.
  • 27. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-27 How Asymmetric Information Explains Banking Regulation 6. Disclosure Requirements • Better information reduces both moral hazard and adverse selection problems 6. Consumer Protection • Standardized interest rates (APR) • Prevent discrimination (e.g., CRA to help avoid redlining particular areas)
  • 28. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-28 How Asymmetric Information Explains Banking Regulation 8. Restrictions on Competition • Branching restrictions, which reduced competition between banks • Separation of banking and securities industries: Glass-Steagall. In other words, preventing nonbanks from competing with banks.
  • 29. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-29 How Asymmetric Information Explains Banking Regulation Many laws have been passed in the U.S. to regulate banking. Table 1 provides a summary of the major legislation and key provisions.
  • 30. FDIC index of regulations on banking http://www.fdic.gov/regulations/laws/index.html Major Banking Legislation in the United States
  • 31. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-31 FDIC index of regulations on banking http://www.fdic.gov/regulations/laws/index.html Major Banking Legislation in U.S. (cont.)
  • 32. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-32 International Bank Regulation We now turn to international regulation. Banks around the world face similar problems as the U.S., and so are regulated in a similar fashion. Charters, supervision, and deposit insurance are common themes throughout the world. And capital requirements are being standardized.
  • 33. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-33 International Bank Regulation Banks around the world face similar problems as the U.S., and so are regulated in a similar fashion. Charters, supervision, and deposit insurance are common themes throughout the world. And capital requirements are being standardized.
  • 34. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-34 International Bank Regulation Banks that engage in international banking cause problems for regulators: – They can shift assets between countries – Not clear who should have primary regulatory authority. A good example was the collapse of the Bank of Credit and Commerce International due to fraud. The Bank of England closed it, but only after huge depositor and investor losses.
  • 35. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-35 International Bank Regulation Although the need for bank regulation and supervision is clear, getting supervisors and regulators to act properly is difficult: – Institution actively seek to avoid regulations – It’s often difficult to capture the detail needed to assess risk – Political pressure can always sidetrack regulators from doing their job
  • 36. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-36 E-Finance: Electronic Banking and Regulation • Electronic banking has created new issues in regulation, particularly security and privacy. • An incident in Russia (1995) highlights this, where a computer programmer moved millions in assets from Citibank accounts to person accounts.
  • 37. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-37 E-Finance: Electronic Banking and Regulation • Electronic banking creates the need to assess the technical skills of banks to handle transaction securely and safely. Electronic signatures also had to be addressed by Congress. • Privacy is also a problem. There are laws protecting consumers from the sharing of information, but this regulation is likely to evolve over time.
  • 38. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-38 International Banking Regulation • Bank regulation abroad is similar to that in the United States. • There is a particular problem of regulating international banking and can readily shift business from one country to another (e.g., BCCI scandal) and requires coordination of regulators in different countries (a difficult task).
  • 39. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-39 The 1980s U.S. Banking Crisis • Prior to the 1980s, the FDIC and bank regulation seemed to be going well. However, in the 80s, failures rose dramatically, as you can see in the following slide.
  • 40. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-40 U.S. Bank Failures
  • 41. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-41 The 1980s U.S. Banking Crisis • Why? 1.Decreasing profitability: banks take risk to keep profits up 2.Financial innovation creates more opportunities for risk taking 3.Innovation of brokered deposits enables circumvention of $100,000 insurance limit • Result: Failures ↑ and risky loans ↑
  • 42. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-42 Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 Following the widespread failure of thrift institutions in the late 1980s, the Bush administration proposed a set of legislation to overhaul the supervision and insurance for the thrift industry. As part of this, the FSLIC was dissolved and the FDIC assumed responsibility for insuring thrift institutions. To address the new needs of the FDIC, the Improvement Act of 1991 was passed.
  • 43. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-43 Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 • FDIC recapitalized with loans, ability to borrow from the Treasury, and higher premiums to member banks • Reduce scope of deposit insurance and too-big- to-fail – Eliminate deposit insurance entirely – Lower limits on deposit insurance – Eliminate too-big-to-fail – Coinsurance
  • 44. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-44 Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 • Prompt corrective action provisions 1.Critics believe too many loopholes 2.However: accountability increased by mandatory review of bank failure resolutions • Risk-based premiums • Annual examinations and stricter reporting • Enhances Fed powers to regulate international banking
  • 45. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-45 Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 • FDICIA also instructed the FDIC to develop risk-based insurance premiums. However, it wasn’t very effective. The Federal Deposit Reform Act of 2005 attempts to remedy this. • FDICIA was a good start. But there are still concerns with too-big-to-fail doctrines and effective insurance premiums.
  • 46. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-46 Banking Crisis Throughout the World As the next two slides illustrates, banking crisis have struck a large number of countries throughout the world, and many of them have been substantially worse than ours.
  • 48. Cost of Banking Crises in Other Countries
  • 49. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-49 Banking Crisis Throughout the World • Latin America – Many banks were government owned with interest rate restrictions similar to Regulation Q. – Similar loan losses and bailout experience as the U.S. in the late 1980s. – Argentina ran into government confidence problem, causing required rates on government debt to exceed 25%, which caused severe problems for the banking industry. – Losses and bailouts as a percent of GDP are high (20% - 50%) relative to that in the U.S. (around 3%).
  • 50. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-50 Banking Crisis Throughout the World • Russia and Eastern Europe – Many banks were government owned prior to the downfall of communism. – Private banks had little experience screening and monitoring loans. – Substantial loan losses ensued. – The bailout in Russia alone may exceed $15 billion
  • 51. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-51 Banking Crisis Throughout the World • Japan – Prior to the 1980s, Japan’s financial markets were heavily regulated. Deregulation led to excessive risk taking and high loan losses, particularly in real estate loans. – Several large bank failures were announced in 1995. Several failures followed in 1996 and 1997.
  • 52. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-52 Banking Crisis Throughout the World • Japan – Japan is experiencing similar regulator forbearance policies as the U.S. in the early 1980s. – Even with positive steps, bad loans throughout the banking system required a bailout of $500 billion in 1998. – System is still a long way from being healthy.
  • 53. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-53 Banking Crisis Throughout the World • Japan – Immediately after 1998, the gov’t closed two big banks. Cleanup stalled as banks tried to avoid gov’t involvement. Bad loans were estimated near $1 trillion. – Only recently have the number of bad loans started to decline, and larger banks have paid back the bail-out money. Profitability is near.
  • 54. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-54 Banking Crisis Throughout the World • China – Many banks were government owned. – Investments in many state-owned enterprises, which are notoriously inefficient. – Current attempt at a bailout calls for partial privatization of the biggest banks.
  • 55. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-55 Banking Crisis Throughout the World • East Asia – Lending boom in the aftermath of liberalization led to substantial loan losses. – Nonperforming loans and bailout costs exceeding 20% of GDP are commonplace.
  • 56. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-56 Déjà Vu All Over Again! • Banking crises are just history repeating itself. Financial liberalization leads to moral hazard (and bad loans!). Deposit insurance is not big enough to cover losses, but the gov’t does stand ready to bailout the system. And that implicit guarantee is enough to exacerbate the moral hazard problem.
  • 57. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-57 Chapter Summary • Asymmetric Information and Bank Regulation: the problems of adverse selection and moral hazard were reviewed. These ideas are the basis for exploring the regulatory environment of the banking industry. • International Banking Regulation: The challenges of international regulation, particularly international banks, was discussed.
  • 58. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-58 Chapter Summary (cont.) • The 1980s U.S. Banking Crisis: We examined the causes of the U.S. crisis. Further, we explored problems caused by the political environment in fixing the problem promptly. • Federal Deposit Insurance Corporation Improvement Act of 1991: The provisions of this act and its implications for the safety of the banking system were explored.
  • 59. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 20-59 Chapter Summary (cont.) • Banking Crisis Throughout the World: As reviewed, evidence suggests that the U.S. is not alone in its banking problems, as other countries face similar issues as the U.S. in the late 1980s.