J. K. Dietrich - FBE 524 - Fall, 2005
Financial Institution Regulation
Week 4 – September 21, 2005
J. K. Dietrich - FBE 524 - Fall, 2005
Rationales for Regulation of Financial Services
Economic activity– Monetary policy (money creation)– Credit allocation (‘disadvantaged’ sectors)– Government financing
Competition (equal opportunity and fairness) Asymmetry between providers and users Uninsurable (system-wide) risks
– Safety and promoting public confidence
J. K. Dietrich - FBE 524 - Fall, 2005
Types of Financial Firm Regulation
Chartering, branching, and registration Ownership, mergers, acquisitions Pricing and product review Activity and asset restrictions Capital requirements Disclosure and examination
J. K. Dietrich - FBE 524 - Fall, 2005
Key U.S. Banking Laws
J. K. Dietrich - FBE 524 - Fall, 2005
Brief Historical Overview
Civil war and National Banking Act (1863, 1864) establish “dual banking” system
Nineteenth century crises yield Federal Reserve Act (1913) and FR System (Board and 12 FR banks)
Great Depression produced major legislative response affecting banks, thrifts, and securities firms
Inflation from 1960’s forces deregulation
J. K. Dietrich - FBE 524 - Fall, 2005
Regulation in Response to 1930’s
Banking Act of 1933– Deposit insurance (FDIC)– Separation of underwriting activities
Securities Act of 1933 and Securities Exchange Act of 1934
Home Owners Loan Act and thrifts Banking Act of 1935
– Federal Open Market Committee (FOMC)– Interest-rate regulation
J. K. Dietrich - FBE 524 - Fall, 2005
The Great American Inflation
Demand for deregulation as some rates reflected inflation and others did not– Disintermediation and thrifts– Market response: money market mutual funds,
Eurodollars, commercial paper, BHC, etc. Response: Deposit Institution Deregulation and
Monetary Control Act of 1980– Political compromises– Nature of changes
J. K. Dietrich - FBE 524 - Fall, 2005
Inflation since 1950
-10
-5
0
5
10
15
20
25
50 55 60 65 70 75 80 85 90 95 00
CPIINFL MACPIINFL
CPI and Moving Average CPI Inflation 1950 to 2004
J. K. Dietrich - FBE 524 - Fall, 2005
Inflation and Interest Rates
-4
0
4
8
12
16
20
50 55 60 65 70 75 80 85 90 95 00
FCM10 FTBS3 MACPIINFL
U.S. Inflation and Treasury Rates 1950 to 2004
J. K. Dietrich - FBE 524 - Fall, 2005
The Last 25 Years
J. K. Dietrich - FBE 524 - Fall, 2005
DIDAMCA (1980)
Monetary Control Act– All deposit-taking institutions subject to
reserves– Thrifts could offer checking accounts
Deregulation Act– Deregulation Committee and experience
Powers of Thrifts
J. K. Dietrich - FBE 524 - Fall, 2005
1980’s: Savings and Loan Crisis
Garn-St Germain Act of 1982– Expanded powers: corporate (junk) bonds,
commercial real estate, commercial loans– Rules on acquisitions
Financial Institution Reform, Recovery and Enhancement Act of 1989 (FIRREA)– Restructure thrift regulators, re-regulation
Federal Deposit Insurance Corporation Improvement Act (1991) and closures
J. K. Dietrich - FBE 524 - Fall, 2005
Bank Regulatory Establishment
J. K. Dietrich - FBE 524 - Fall, 2005
Thrift Regulatory Establishment
J. K. Dietrich - FBE 524 - Fall, 2005
Bank Capital Regulation Risk adjusted assets
– Basel Agreement I and negotiations over II– Banks, thrifts, and insurance companies– Risk weights, on- and off- balance sheet
Value-at-risk (VAR) capital requirements– Internal models, trading assets 10% or $1
billion, after January, 1998– 3 x 10-day 99th percentile risk and benchmarks
J. K. Dietrich - FBE 524 - Fall, 2005
Basel I -- Background Basel I grew out of collaboration between
U.S. Federal Reserve and the Bank of England on standardizing regulation
The Bank for International Settlements (dating from German reparations in the 1920’s) became forum for the Group of 7
Most OECD countries accept the Basel I standards
Global acceptance wide by 1990’s
J. K. Dietrich - FBE 524 - Fall, 2005
Basel I Standards Focus is on capital adequacy Capital viewed as a shock absorber to
prevent losses to liability holders (at first bank depositors but increasingly life insurance customers)
Bank capital regulation before Basel I differed greatly among OECD countries
1988 Standard simplified risk classification of assets into four classes, all commercial loans were in the same class
J. K. Dietrich - FBE 524 - Fall, 2005
Capital Adequacy
Capital bufferBuffer = Assets - Liabilities =>Liabilities = Assets - Capital =>
Liabilities = Assets - Capital Assessing capital adequacy over time (U.S.)
– ABC– Leverage– Risk-based capital
J. K. Dietrich - FBE 524 - Fall, 2005
Basel I Capital Standard
J. K. Dietrich - FBE 524 - Fall, 2005
Types of Risk
Market or interest-rate and exchange-rate risk– How values of assets change with changes in
interest and exchange rates Operating risks
– Losses due to failure of systems, personnel, or fraud
Credit risks – Losses due to departures from loan or debt
contracts regarding payments of cash
J. K. Dietrich - FBE 524 - Fall, 2005
Basel I Risk-Adjusted Capital
Assets classified into four risk weight classes– Short-term domestic governments and cash (0%)– Guaranteed loans and foreign governments (20%)– Revenue bonds and residential loans (50%)– All other loans and investments (100%)
Weighted assets must be backed by capital– 4% equity capital (Tier 1 capital)– 8% by equity and long-term subordinated debt
(Tier 1 and Tier 2 capital)
J. K. Dietrich - FBE 524 - Fall, 2005
Basel II
BIS has become the global forum for discussion of bank risk assessment
Basel I standards too simple– All private lending classified as equally risky
(100% risk weight, 8% capital backing)– Sophisticated market and credit-risk models– Value at Risk (VAR) analysis and acceptance
in assessing capital requirements for trading portfolios
J. K. Dietrich - FBE 524 - Fall, 2005
Basel II Focus
Credit risk and operating risk Three ‘pillars’
– Minimum capital requirements– Supervisory review– Effective market discipline
Goal is not to raise average capital requirements
Same Tier 1 and Tier 2 capital concept
J. K. Dietrich - FBE 524 - Fall, 2005
Application of Capital Standards Basel II standards apply to bank holding
companies on a consolidated basis Banks implement in one of three ways
– Standardized approach– Foundation internal ratings based (IRB)
approach– Advanced IRB approach
Strong emphasis on asset securitizations and other off-balance sheet activities
J. K. Dietrich - FBE 524 - Fall, 2005
Bank Responses to Basel II
Large banks want to reduce capital requirements– Income of $10 and capital of $100 implies
return on equity of 10%– Income of $10 and capital of $50 implies return
on equity of 20% Use of advanced internal risk-based
standards promises reduced capital
J. K. Dietrich - FBE 524 - Fall, 2005
Internal Risk-Based Capital
Require data and models– Data must include details on loans (terms,
collateral and subordination, participations or sales, etc.)
– Must include payment history and details of defaults and workouts
– Models must be acceptable to regulators Major effort must be undertaken and is
already well under way in some banks (U.S., Europe, Australia)
J. K. Dietrich - FBE 524 - Fall, 2005
Risk “Culture” Return and earnings objectives set in terms
of risk-adjusted returns with a focus on economic value added (earning a higher than risk-adjusted return)
Determine a firm risk-adjusted return on capital (RAROC)
– Deals must have appropriate capital charge– Prices must yield RAROC
Risk management must have political authority within the organization
J. K. Dietrich - FBE 524 - Fall, 2005
Holding Company Regulation
Bank holding companies– Bank Holding Company Act of 1956– 1970 amendments– FIRREA changes
Non-bank holding companies– Thrifts– Insurance companies– Securities firms
J. K. Dietrich - FBE 524 - Fall, 2005
Holding Companies andGlass-Steagall Act (to 1999)
Securities FirmInsurance Company
Non-Bank HoldingCompany
Bank HoldingCompany
Commercial Bank
Securities Subsidiary(Section 20)
SEC, ExchangesSROs
State InsuranceAgencies
Federal ReserveBoard
OCC, FDIC, orFRB
J. K. Dietrich - FBE 524 - Fall, 2005
Securities Markets Regulation
Issuers and investors– Registration and disclosure
Investor behavior– Insider trading– Market manipulation– Speculation and margin requirements
Investors and brokers– NASD and exchanges
J. K. Dietrich - FBE 524 - Fall, 2005
Securities Regulators
Securities Exchange Commission (SEC) Commodity Futures Trading Commission
(CFTC), outgrowth of trading in agricultural contracts
Treasury Department for government trading Federal Reserve for margin requirements Bank regulators for some aspects of banks’
trading activities
J. K. Dietrich - FBE 524 - Fall, 2005
Legal Liabilities
Securities Regulation
MutualFunds
Exchanges and SROs
Brokers,Dealers, IBs
Investor Issuer
Investor
Investor
Issuer
Issuer
Disclosure and Reporting
Man
ipu
lati
on, I
nsi
der
Tra
din
g
SEC ReviewLegal Liabilities
J. K. Dietrich - FBE 524 - Fall, 2005
Securities Firm Regulation
Registration Reporting (FOCUS) Capital requirements
– Haircuts Self-regulatory organizations
– NYSE– NASD– Futures Merchants Association
Government
J. K. Dietrich - FBE 524 - Fall, 2005
Insurance Regulation
United States vs. Rest of the World– States and McCarran-Ferguson Act– National Association of Insurance Commissioners
(NAIC)– Ministries of Finance, etc., elsewhere
Domestic, foreign, alien insurance companies in United States
EEC and 1992 China
J. K. Dietrich - FBE 524 - Fall, 2005
Finale: Gramm-Leach-Bliley Act
Established Financial holding companies– Insurance
– Securities activities
– Maintained separate of banking and commerce in general
Federal Reserve in umbrella regulator, but legislation compromise relied mainly on functional regulation, state insurance commissioners, SEC, CFTC, to protect turf
J. K. Dietrich - FBE 524 - Fall, 2005
Banks with Glass-Steagall
Finance CompanyCommercial Bank
Bank HoldingCompany
Discount Broker
Securities Subsidiary(Section 20)
J. K. Dietrich - FBE 524 - Fall, 2005
Financial Holding Company
Investment BankCommercial Bank
Financial HoldingCompany
Insurance Company
Thrift InstitutionAsset Management
Company
J. K. Dietrich - FBE 524 - Fall, 2005
Next week: September 28
Read Chapter 5 through 6 of Money and Capital Markets
Read articles posted on website suggested by students and download any handouts before class
Bring a Wall Street Journal to class every Tuesday