ECONOMIC ANALYSIS OF FINANCIAL

REGULATION

Chitchamon Trakarnbaenchai Kiyota Hanashiro

Sojung Park Tomoka Minoumi

Vanessa Arana

Asymmetric Information And Banking Regulation

The asymmetric information problem leads to two reasons why the banking system might not function well: Bank Failure – in which bank is unable to

meet its obligations to pay its depositors and other creditors and this meant that depositors would have to wait to get their deposit funds until the bank was liquidated.

Depositors’ lack of information about the quality of bank assets can lead to bank panics.

Government safety net The government safety net can short-circuit

runs on banks and bank panics and by providing protection for the depositor.

One form of safety net is deposit insurance, a guarantee such as that provided by the Federal Deposit Insurance Corporation (FDIC). • The depositors are paid off in full on the

first $100,000.

FDIC and its two primary methods to handle a failed bank. Payoff method- this allows the bank to fail and

pays off deposits up to the $100,000 insurance limit. After the bank has been liquidated, the FDIC lines up with other creditors of the bank and is paid its share of the proceeds from the liquidated assets.

Purchase and assumption method- finding a willing merger partner who assumes (takes over) all of the failed bank’s deposits so that no depositor loses a penny. FDIC may help the partner by providing it with subsidized loans or by buying some of the failed bank’s weaker loans.

Moral Hazard/Adverse Selection and the Government Safety Net.

Moral Hazard With the existence of insurance , this will

increase incentives for taking risks that might result in an insurance payoff.

Adverse Selection People who are most likely to produce the

adverse outcome insured against are those who most want to take advantage of the insurance.

Too Big to Fail The failure of a very large bank makes it more

likely that a major financial disruption will occur e.g. Continental Illinois.

Too big to fail – the government provides a guarantees of repayment of large uninsured creditors of the largest banks. The FDIC would do this by using the purchase and assumption method, giving the insolvent bank a large infusion of capital and then finding a willing merger partner to take over the bank and its deposits.

Financial Consolidation and the Government Safety Net

Financial consolidations poses two challenges to banking regulation because of the existence of the government safety net: The increased in size of banks as a result of financial

consolidation increases the too-big-to fail problem, because there will now be more large institutions whose failure would expose the financial system to systemic risk.

Financial consolidation of banks with other financial services firms means that the government safety net may be extended to new activities such as securities underwriting, insurance, or real estate activities, thereby increasing incentives for greater risk taking in these activities that can also weaken the fabric of the financial system.

Restriction on Asset Holdings and Bank Capital requirements Bank regulations restrict banks from holding

risky assets in order to avoid too much risk. Requirements that banks have sufficient bank capital are another way to reduce the bank’s incentives to take on risk.

Bank capital requirements take two forms: • Leverage ratio- the amount of capital divided by

the bank’s total assets. A good leverage ratio must exceed than 5%

• Basel Accord- required banks to hold capital at least 8% of their risk weighted assets.

Bank Supervision: Chartering and Examination

Bank supervision – overseeing who operates banks and how they are operated. This will allow regulators to monitor whether the bank is complying with a capital requirements and restrictions on asset holdings, also function to limit moral hazard.

Bank examiners give banks a CAMELS rating. This based on the 6 areas assessed: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk.

Assessment of Risk Management

1993 Federal Reserve System’s 1993 guidelines

1994 Trading Activities Manual (provided bank examiners with to evaluate risk management systems)

1995 Announcement of assessing risk management processes at the banks by the Federal Reserve and the Comptroller of the Currency

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CAMELS system enables bank examiners to give a separate risk management rating from 1 to 5 by four elements.(1) the quality of oversight provided by the board of directors and senior management(2) the adequacy of policies and limits for all activities that present significant risks(3) the quality of the risk measurement and monitoring systems(4) the adequacy of internal controls to prevent fraud or unauthorized activities on the part of employees

Major Financial Legislation in the United States Federal Reserve Act (1913)

-created the Federal Reserve System

McFadden Act of 1927-Effectively prohibited banks from branching across state lines-Put national and state banks on equal footing regarding branching

Banking Acts of 1933 (Glass-Steagall) and 1935-Created the FDIC-Separated commercial banking from the securities industry-Prohibited interest on checkable deposits and restricted such deposits to commercial banks-Put interest-rate ceilings on other deposits

Securities Act of 1933 and Securities Exchange Act of 1934-Required that investors receive financial info. on securities offered for public sale-Prohibited misrepresentations and fraud in the sale of securities-Created the Securities and Exchange Commission (SEC)

Major Financial Legislation in the United States (cont’d)

Investment Company Act of 1940 and Investment Advisers Act of 1940-Regulated investment companies, including mutual funds-Regulated investment advisers

Bank Holding company Act and Douglas Amendment (1956)-Clarified the status of bank holding companies (BHCs)-Gave the Federal Reserve regulatory responsibility for BHCs

Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980-Gave thrift institutions wider latitude in activities-Approved NOW and sweep accounts nationwide-Phased out interest-rate ceilings on deposits-Imposed uniform reserve requirements on depository institutions-Eliminated usury ceilings on loans-Increased deposit insurance to $100,000 per account

Major Financial Legislation in the United States (con’t) Depository Institutions Act of 1982 (Garn-St. Germain)

-Gave the FDIC and the FSLIC emergency powers to merge banks and thrifts across state lines-Allowed depository institutions to offer money market deposit accounts (MMDAs)-Granted thrifts wider latitude in commercial and consumer lending

Competitive Equality in Banking Act (CEBA) of 1987-Provided $10.8 billion to the FSLIC-Made provisions for regulatory forbearance in depressed areas

Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989-Provided funds to resolve S&L failures-Eliminated the FSLIC and the Federal Home Loan Bank Board-Created the Office of Thrift Supervision to regulate thrifts-Created the Resolution Trust Corporation to resolve insolvent thrifts-Raised deposit insurance premiums-Reimposed restrictions on S&L activities

Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991-Recapitalized the FDIC-Limited brokered deposits and the too-big-to-fail policy-Set provisions for prompt corrective action-Instructed the FDIC to establish risk-based premiums-Increased examinations, capital requirements, and reporting requirements-Included the Foreign Bank Supervision Enhancement Act (FBSEA), which strengthened the Fed’s authority to supervise foreign banks

Major Financial Legislation in the United States (cont’d)

Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994-Overturned prohibition of interstate banking-Allowed branching across state lines

Gramm-Leach-Bliley Financial Services Modernization Act of 1999-Repealed Glass-Steagall and removed the separation of banking and securities industries

Sarbanes-Oxley Act of 2002-Created Public Company Accounting Oversight Board (PCAOB)-Prohibited certain conflicts of interest-Required certification by CEO and CFO of financial statements and independence of audit committee

Federal Deposit Insurance Reform Act of 2005-Merged the Bank Insurance Fund and the Savings Association Insurance Fund-Increased deposit insurance on individual retirement accounts to $250,000 per account-Authorized FDIC to revise its system of risk-based premiums

Disclosure Requirements Disclosure requirements are a key element of

financial regulation The Securities Act of 1933 and the Securities and

Exchange Commission of 1934, imposes disclosure requirements that issues publicly traded securities

They also require financial institutions to provide additional disclosure regarding their off-balance sheet positions and more information about how they value their portfolios

Disclosure Requirements cont’d

Disclosure requirements is needed to limit incentives to take on excessive risk and to improve the quality of information in the marketplace so that investors can make informed decisions

This improves the ability of financial markets to allocate capital to its most productive uses

The Sarbanes Oxley Act of 2002 took disclosure of information by increasing the incentives to produce accurate audits of corporate income statements and balance sheets which established the Public Company Accounting Oversight Board to oversee the audit industry, and to put in place regulations to limit conflicts of interest in the financial services industry

Consumer Protection The Consumer Protection Act of 1969 requires all

lenders, not just banks , to provide information to consumers about the cost of borrowing, including a standardized interest rate and the total finance charges on the loan.

The Fair Credit Billing Act of 1974 requires creditors, especially credit card issuers, to provide information on the method of assessing finance charges and requires that billing complaints be handled quickly.

Consumer Protection cont’d The Equal Credit Opportunity Act of 1974

forbid discrimination by lenders based on race, gender, marital status, age, or natural origin.

The Community Reinvestment act of 1977 was enacted prevent “redlining”, a lender’s refusal to lend in a particular area. This act requires that banks show that they lend in all areas in which they take deposits, and if banks are found to be in noncompliance with the act, regulators can reject their applications for mergers, branching, or other new activities.

Restrictions on Competition

Increased competition can increase moral hazard incentives of financial institutions toward assuming greater risk in an effort to maintain former profit levels.

Two ways that the U.S. government protect financial institutions from competition are: Restrictions on branching which reduced competition

between banks, but were eliminated in 1994 Preventing nonbank institutions from competing with banks

by engaging in banking business, which was eliminated in 1999

Restrictions on Competition

One disadvantage with restrictions on competition was that they led to higher charges to consumers and decreased the efficiency of banking institutions, which did not have to compete as vigorously

Mark-to-Market Accounting and the Subprime Financial Crisis

• Mark-to-Market Accounting: market prices provide the best basis for estimating the true value of assets, and hence capital, in the firm

• Traditional historical-cost: the value of an asset was set at its initial price

→fluctuations in the value and liabilities

Mark-to-Market Accounting and the Subprime Financial Crisis (cont’d)

•mark-to-market accounting: a major flaw

•an important factor driving the crises

The Subprime Mortgage Crisis and Consumer Protection

Regulation Large fees form mortgage origination

“Liar loans” : no need producing documentation regarding assets and liabilities

NINJA loan: No Income, No Job, and No Assets

Mortgage originators were not required to disclose information

The Subprime Mortgage Crisis and Consumer Protection Regulation (cont’d) Federal Reserve issue a final rule for subprime mortgage loans:

1: a ban on lenders making loans without regard to borrowers’ ability to repay the loan from income assets other than the home’s value

2: a ban on no-doc loans

3: a ban on prepayment penalties if the interest payment can change in the first 4 yrs of the loans

4:a requirement that lenders establish and escrow account for property taxes and homeowner’s insurance to be paid into on a monthly basis

The Subprime Mortgage Crisis and Consumer Protection Regulation (cont’d) New regulation for all mortgage loans

1: a prohibition on mortgage brokers coercing a real estate appraiser to misstate a home’s value

2: a prohibition on putting one late fee on top of another and a requirement to credit consumers’ loan payment as of the date of receipt

3: a requirement for lenders to provide a good-faith estimate of the loans costs within three days after a household applies for a loan

4: a ban on a number for misleading advertising practices, including representing that a rate or payment is “fixed” when the payment can change

International Financial Regulation – Financial Regulation in other countries is

similar to that in the United States.

• Financial institutions are charted and supervised by government regulators.

– Difficulties in international Financial regulation

• occur when financial institution operates in many countries.

• regulators do not have the knowledge or ability to keep close watch on operation in other countries.

– Collapse of the BCCI(Bank of credit and commerce international)

• Major international bank registered in Luxembourg, operated in 70 countries.

• Bank of England closed BCCI down when massive fraud discovered.

→ Highlighted difficulties.

– Basel Committee

• Announced procedures like Basel accord to provide recommendations on banking regulations.

Ex) Allowed regulators in other countries to restrict the operations of a foreign bank.

The 1980s SAVING AND LOAN AND BANK CRISIS

Pre-1934 : Bank failures were common and depositors frequently suffered losses.

From 1934-1980 : Bank failures were a rarity, averaging fifteen per year for commercial banks and fewer than five per year for savings and loan associations.

After 1981 : Failures in both commercial banks and saving and loan climbed to levels more than ten times greater than in earlier years.

Reason? The burst of financial innovation in the 1960s 1970s and

early 1980s. • Financial innovation decreased the profitability of certain

traditional lines of business for commercial Banks. • Banks now faced increased competition for their sources of

funds from new financial institutions, such as money market mutual funds.

• This circumstance forced financial instruments to seek out new and potentially risky business to keep their profits up.

As a result, commercial banks and saving and loans did take

excessive risks and began to suffer substantial losses. • The bank failure rose to a level of 200 per year by the late 1980s. • The banking industry was reregulated and bailout provided. The

cost of the bailout was $150 billion, 3% GDP.