Chapter 18

Bank Regulation

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 Background
• The banking industry has become more competitive
due to deregulation
– Banks have more flexibility on the services they offer, the
locations where they operate, and the rates they pay for
deposits.
– Banks have recognized the potential benefits from
economies of scale and scope
• Bank regulation is needed to protect customers who
supply funds to the banking system
– Regulators are shifting more of the burden of risk
assessment to the individual banks themselves

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 Regulatory Structure

• The U.S. has a dual banking system consisting of

federal and state regulation
– Three federal and fifty state agencies supervise the
banking system
– A federal or state charter is required to open a commercial
bank
• National versus state banks
• Federal charters are issued by the Comptroller of the Currency
• State banks may decide to become members of the Fed
• 35 percent of all banks are members of the Fed, comprising 70
percent of deposits
• Both members and non members can borrow from the fed and
both ar subject to fed reserve requirements.

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 Regulatory Structure (cont’d)
• Regulatory overlap
– National banks are regulated by the Comptroller
of the Currency, the Fed, and the FDIC
– State banks are regulated by the state agency, the
Fed, and the FDIC
– Perhaps a single regulatory agency should be
assigned the role of regulating all commercial
banks and savings institutions

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 Regulatory Structure (cont’d)
• Regulation of bank ownership
• Commercial banks can be either independently owned
or owned by a bank holding company
• One-bank holding companies are more common than
multibank holding company
• More banks are owned by BHC than are owned
independently.

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 Deregulation Act of 1980
• The Depository Institutions Deregulation and Monetary
Control Act (DIDMCA) was enacted in 1980
• DIDMCA has two categories of provisions:
– Those intended to deregulate the banking industry
– Those intended to improve monetary control
• The main deregulatory provisions are:
– Removed interest rate ceilings on deposits.
– Allowed bank to offer Negotiable Order of Withdraws NOW accounts.
– New lending flexibility for depository institutions

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 Deregulation Act of 1980 (cont’d)

• Impact of DIDMCA
– There has been a shift from conventional demand deposits
to NOW accounts
– Consumers have shifted funds from conventional passbook
savings accounts to various types of CDs
– DIDMCA has increased competition between depository
institutions

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 Garn-St Germain Act of 1982

• The Act:
– Permitted depository institutions to offer money market
deposit accounts (MMDAs), which have no minimum
maturity and interest ceiling
• MMDAs are similar to money market mutual funds
• MMDAs allow depository institutions to compete against money
market funds in attracting savers’ funds
– Permitted depository institutions to acquire failing
institutions across geographic boundaries
• Intended to reduce the number of failures that require liquidation

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 Regulation of Deposit Insurance

• Federal deposit insurance has existed since the

creation of the FDIC in 1933 as a response to bank
runs
– About 5,000 banks failed during the Great Depression in
1930-1932
– FDIC preserve public confidence in the U.S. financial
system by providing deposite.
– The FDIC is managed by a board of five directors, who are
appointed by the President

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 Regulation of Deposit Insurance (cont’d)

– Deposit insurance limit has increased from $100,000 to

250,000 for per person insured by the FDIC.
 Bank insured by FDIC must pay annual insurance premium
 Insured banks was taking more risk because their depositors
were protected which later created moral hazard problem in
1980-1990
 The balance in the FDIC insurance fund declined because they
had to reimburse depositors.
In 1991, the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) was passed to prevent this moral
hazard problem

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 Regulation of Capital

• Capital requirements force banks to maintain

a minimum amount of capital as a percentage
of total assets
– Banks would prefer low capital to boost their ROE
– Regulators have argued that banks need sufficient
capital to absorb potential operating losses

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 Regulation of Capital (cont’d)

• Basel l Accord of 1988

– The Central banks of 12 major countries agreed to uniform
capital requirements
– The key provision of the Accord is that the requirements
were based on the bank’s risk level, banks with greater risk
are required to maintain a higher level of capital.

– Very safe assets such as cash are assigned a zero weight,

while very risky assets are assigned a 100 percent weight

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 Regulation of Capital (cont’d)

• Basel II Accord
– Created in 2004
– Two major parts of the Accord are:
• Revise the measurement of credit risk
• Explicitly account for operational risk

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 Regulation of Capital (cont’d)

• Basel II Accord (cont’d)

– Revising measurement of credit risk
• The risk categories are being refined to account for some possible
differences in risk levels of loans within a category

• Banks can use the internal ratings-based (IRB) approach to

calculate credit risk, in which banks provide summary statistics
about their loans to the Basel Committee
– The Committee then applied pre-existing formulas to the statistics in
order to determine the required capital level

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 Regulation of Capital (cont’d)

• Basel II Accord (cont’d)

– Accounting for operational risk
• Operational risk is the risk of losses from inadequate or
failed internal processes or systems
• Intended to encourage banks to improve their
techniques for controlling operational risk to reduce
bank failures
• By imposing higher capital requirements on banks With
higher levels of operational risk, Basel II provided an
incentive for banks to reduce their operational risk

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 Regulation of Capital (cont’d)

• Basel II Accord (cont’d)

– Public disclosure of risk indicators
• The Basel Committee plans to require banks to provide
more information to existing and prospective
shareholders about their risk exposure to different
types of risk
• This would provide existing and prospective investors
with additional information about a bank’s risk

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 Regulation of Capital (cont’d)

• Basel III Accord

• In response to credit crisis ,Basel III is developed in 2011
• It recommends the bank maintain Tire 1 capital of at least 6 percent of
total risk- weighed assets.
• Also recommended that banks maintain this extra layer of Tire 1 capital
of at least 2.5 percent of risk weighted asset by 2016.
- banks that do not maintain this extra layer could be retricted for
making dividendpayments,repurchasing stock,or granting bonuses to
executives
• Basel III propose banks to maintain sufficient liquidity so that they can
easily cover their cash needs under adverse condition.

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 Regulation of Capital (cont’d)

• Use of the value-at-risk method to determine capital

requirements
– A bank defines the VaR as the estimated potential loss
from its trading business that could result from adverse
movement in market prices.

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