Bank Regulation (US)

Major Duties: Chartering and Examination

Chartering -- Granting the bank permission to begin business.

-- National Banks -- State Banks Examination – Supervision of bank

activity, including periodic auditing of bank records.

Regulators: Commercial Banks

Comptroller of the Currency -- charterer and primary examiner of national banks

State Banking Authorities -- charterer and primary examiner of state banks

Federal Reserve -- secondary examiner of member banks

Federal Deposit Insurance Corporation (FDIC)

Secondary examiner to some banks

Insures bank deposits, guaranteed up to $250,000 per depositor (more for some types of accounts, such as consumer saving for retirement)

Deposit Insurance: Pros and Cons

Pros -- protects customers

-- greatly reduces bank runs Cons -- gives banks implicit

incentive to engage in bad

business practices

Moral Hazard and Adverse Selection

Moral Hazard -- Those who have insurance may use it as a “safety net,” a justification to take on greater risk.

Adverse Selection -- Insurance tends to attract people most likely to take advantage of it.

FDIC -- Resolving Situations With Problem Banks

Options: handling problem banksClose bank, pay off depositors (e.g.

Freedom National Bank of RI)Merge bank with a healthy bank

(e.g. Syracuse Savings Bank)Decisions unique to individual

cases (e.g. Bank of New England) - the “too big to fail” policy

Regulators -- Savings Banks and Savings and Loans

Deposit Insurance: FDICPrimary Examiners: Federal Reserve,

FDIC, and Comptroller of the CurrencyMost Savings and Loans: members of

Federal Home Loan Bank System (FHLBS)

Regulatory system -- overhauled several times since late 1980s

Credit Unions

Most are members of the National Credit Union Administration (NCUA).

Deposit Insurance: National Credit Union Share Insurance Fund (NCUSIF).

No major overhauls to regulatory system.

US Banking in the Postwar Period

A chronicle of US banking from the end of World War II until now.

Significant ups and downs in US Banking, along with key regulatory changes.

US Banking in the 1950s and 1960s – Fat City

Regulation Q – mandated ceilings on bank deposits (no more than 3% max), kept cost of funds down for banks

Low inflation, low interest rate environment (e.g. 6% fixed rate mortgages)

The “3-6-3” Rule of Banking

The 1970s -- Banking in a Weakened State

Disintermediation -- due to rising market interest rates with Regulation Q, along with the emergence of Money Market Mutual Funds.

Interest Rate Risk -- inability to pass on rising interest rates to existing loans

Another Problem: The Fed Losing Member Banks

Traditional Advantage to Membership -- Use of the Discount Window.

Traditional Disadvantage to Membership -- Fed gives higher reserve requirements.

The Early 1980s -- Regulatory Forbearance

Regulatory Forbearance -- Passing legislation to improve banks competitive position, to see if they could fix the problem themselves.

The Depository Institutions Deregulation and Monetary Control Act (DIDMCA)Created NOW and ATS Accounts.Phased out Regulation Q,

completed on 3/31/86.Allowed Savings Banks and

Savings and Loans to make restricted amounts of commercial loans (% of total assets).

More Provisions: DIDMCA

Liberalized capital requirements of Savings Banks and S&Ls.

Increased deposit insurance from $40,000 to $100,000.

Opened the Discount Window to all banks.

Imposed uniform reserve requirements for all banks.

More Legislation: The Garn-St. Germain Act (1982)

Granted Money Market Deposit Accounts (MMDAs) and Super NOW Accounts.

Increased percentage of allowable assets of Savings Banks and Savings and Loans held as commercial mortgages.

Mid and Late 1980s -- The Problem Worsens

Defaults on very risky loans (shopping malls in the desert).

Purchases of junk bonds.Fraud in the banking system

(Charles Keating)

Regulatory Forbearance: A Failure

Increased moral hazard -- The “Haymaker” strategy.

Increased adverse selection -- The size of the mess doesn’t matter, illegal profiteering.

“Zombie Savings and Loans”

Late 1980s and Early 1990s -- Handling the Crisis

The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 -- regulators stepping in and resolving Savings and Loan crisis (other banks as well)

Major Provisions: FIRREA

Abolished the regulatory structure at that time -- the Federal Home Loan Bank Board (FHLBB) and the Federal Savings and Loan Insurance Corporation (FSLIC)

FDIC -- insurer of Savings Banks and Savings and Loans

More Provisions: FIRREA

Created Resolution Trust Corporation (RTC) -- manage the bailout

Savings and Loans -- can no longer purchase junk bonds

Increased capital requirements of Savings Banks and Savings and Loans from 3% to 8% (with risk adjustment for loans).

Still More Provisions: FIRREA

Significantly decreased percentage of assets of Savings Banks and Savings and Loans held as Commercial Loans.

Refocused Savings and Loans to consumer mortgages.

Legislation to Change the FDIC’s Role: FDICIA

Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991

Gave more authority to FDIC in some areas, took authority away in other areas.

Major Provisions -- FDICIA

Increased FDIC’s ability to fund the Savings and Loan bailout.

Gave FDIC authority to intervene earlier for banks facing difficulties.

Gave FDIC larger role in serving as bank examiner.

Greater limitations on imposing “too big to fail” policy.

More Provisions -- FDICIA

Gave Federal Reserve supervisory responsibility for foreign banks operating in the US.

Risk-based deposit insurance: addressing moral hazard.

1992-2005: Healthy But Shrinking

Savings and Loan bailout -- completed effectively.

Disintermediation legislation -- it worked!

Beneficial interest rate risk -- due to decreases in interest rates.

A series of beneficial financial innovations.

Financial Innovations -- Banking

The Individual Retirement Account (IRA) -- tax advantages for long-term saving (Classic IRA vs Roth IRA)

Shorter-term mortgages (15 year, even 10 year).Adjustable Rate Mortgages (ARMs) -- “sharing”

of interest rate riskMortgage Securitization (Mortgage Backed

Securities) – enabled banks to sell money-losing mortgage, decreases interest rate risk.

More Financial Innovations in Banking

Sweep Accounts -- balances in a checking account above a forecasted “necessary minimum” are automatically “swept” into RP, Eurodollars, MMMF, or MMDA (lowers required reserves).

Automatic Teller Machines (ATMs)Debit cards and credit cards – makes

checking accounts more attractive, increases bank offerings.

Hedging Interest Rate Risk: Futures and Options

Large Banks in particular -- use with CDs, stabilizing cost of funds.

Financial Futures Market -- Market to sell specified amounts of bonds at a specified bond price (and interest rate), at a specified future date.

Options Market -- Market to buy (call option) or sell (put option) a security at a given price over a fixed time interval (up to a maximum amount

Other Financial Derivatives

Compression of the Banking Industry

The McFadden Act (1927) -- Prohibited interstate bank branching in the US

Protecting the small bank versus limiting competition.

Circumventing the McFadden Act

Emergence of Bank Holding

Companies, corporations that house banks.

Shared electronic banking facilities.

Banks striking deals with the FDIC.

The Final Action: The Riegle-Neal Act

The Riegle-Neal Act (1994) -- Repealed the McFadden Act, permitted interstate branching in the US.

A flurry of bank mergers, for reasons different from the 1970s and 1980s.

2006- Subprime Mortgages and the Credit Crunch

Subprime Mortgages -- mortgages given to people with substandard credit qualifications.

Higher default risk than standard mortgages.Exist as securitized mortgages (MBS) –

“originate and distribute” banking.MBS done in “tranches” – splitting up

bundles according to default risk.

Deceptiveness With Mortgage Backed Securities

Collateralized Debt Obligations (CDO) – MBS reconstituted (split into tranches) and then resold).

Structured Investment Vehicles (SIV) – off-the-balance sheet nonbanks created by banks to hold CDO, exempt from Basel I capital requirements.

Conduits – similar to SIV but backed and owned by banks. Also buyers of CDO.

SIV, Conduits, financed through Asset-Backed Commercial Paper issued by banks

Subprime Mortgages, MBS, and the Credit CrunchDefault risk not valued properly by holders of

securitized mortgages (rating agencies paid by issuers of MBS).

Many MBS based upon subprime mortgages on ARMs – interest rate rises after adjustment period, increased defaults.

Falling house prices, bank and MBS holders can’t recoup full value of defaulted loan.

Falling home prices exacerbated by many foreclosures at once.

Major defaults on MBS, affects portfolios of holders beyond banks and the US.

The Federal Reserve: Banking and the Credit Crunch

Extended Discount Window loaning to banks, including establishing a Term Auction Facility (anonymous borrowing).

Purchased Asset-Backed Commercial PaperMajor infusion of liquidity into banking

system via open market operations.Kept Fannie Mae and Freddie Mac afloatHelped to administer the Troubled Asset

Relief Program (TARP): bailout funds for large banks facing financial difficulties.

The FDIC: Banking and the Credit Crunch

Extended deposit insurance protection to $250,000 (from $100,000).

With the Federal Reserve, helped to arrange some mergers between banks (e.g. Wachovia and Wells Fargo).

The Federal Government: Banking and the Credit Crunch

Passed the Dodd-Frank Act (2010) – increased regulation for banks. created Bureau of Consumer Financial

Protection increased regulation on predatory lending modification of regulatory structure in banking some supervision of Federal Reserve by

Federal Government A number of provisions, but not considered

tough enough by many

Underlying Issues: The Credit Crisis and Regulation

How and how much should the Federal Reserve, and FDIC, and Federal Government help holders of MBS, banks, and borrowers with subprime mortgages?

Assistance to avoid crisis versus increasing moral hazard/adverse selection

How to address which problem – liquidity versus loan defaults

The Federal Reserve as stabilizer versus the Federal Reserve as enabler

How to restore the confidence of banks

Issues in International Banking

Traditional Issue -- US banks (operating in the US or abroad) at a comparative disadvantage relative to foreign banks (operating in the US or abroad).

Applicable regulation comes from country of origin.

US banking, more heavily regulated.

Related Legislation

International Banking Act of 1978 -- Foreign banks operating in the US have to follow US banking regulations.

Provision of FDICIA -- Gave Federal Reserve supervisory responsibility over foreign banks operating in the US.

Repeal of McFadden Act?

International Banking and the Credit Crunch

Recognized as global financial problemA series of coordinated infusions of

liquidity (by open market operations) among a number of central banks worldwide

Increased Global Coordination of Banking Regulations?

US – traditionally reluctant in this area.

Basel Agreements – attempts to establish uniform global banking regulations across nations. Capital requirements (equity-asset ratios) Accounting of off-the-balance-sheet items Other regulatory requirements on

banks regarding loans and liquidity