Chapter - 18 New

Chapter 18
Bank Regulation
Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
1
Chapter Outline
 Background
 Regulatory structure
 Deregulation Act of 1980
 Garn-St Germain Act
 Regulation of deposit insurance
 Regulation of capital
 Regulation of operations
 Regulation of interstate expansion
 How regulators monitor banks
 The “too-big-to-fail” issue
 Global bank regulations
2
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
3
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.
4
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
5
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.
6
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
7
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
8
Garn-St Germain Act of 1982
 The Act:
 Permitteddepository 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
9
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
10
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
11
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
12
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
13
 Basel II Accord
 Createdin 2004
 Two major parts of the Accord are:
 Revise the measurement of credit risk
 Explicitly account for operational risk
14
 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
15
 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
16
 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
17
 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.
18
 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.
 Market risk is the exposure to movements in market
forcesuch as interest rates, stock prices, and exchange rates
 Capital requirements imposed are based on the bank’s own
assessment of risk when applying the VAR model
 VAR is the estimated potential loss from trading businesses
that could result from adverse movements in market prices
 Banks typically use a 99 percent confidence level
19
 Use of the value-at-risk method to determine
capital requirements (cont’d)
 Testing the validity of a bank’s VAR
 The validity is assessed with backtests in which the actual
daily trading gains or losses are compared to the estimated
VAR over a particular period
 If the VAR is estimated properly, only 1 percent of the actual
daily trading days should show results that are worse than
the estimated VAR
 Related stress tests
 Some banks supplement the VAR estimate with stress tests
using extreme events
20
Regulation of Operations
 Regulation of loans
 Regulators monitor highly leveraged transactions (HLTs) and a
bank’s exposure to debt of foreign countries
 Banks are restricted to a maximum loan amount of 15 percent of
their capital to any single borrower
 Banks are regulated to ensure that they attempt to accommodate
the credit needs of the communities in which they operate
through the Community Reinvestment Act (CRA) of 1977
 Regulation of investment in securities
 Banks are not allowed to use borrowed or deposited funds to
purchase common stock
 Banks can invest only in bond that are investment-grade quality
21
Regulation of Operations (cont’d)
 Regulation of securities services
 The Glass-Steagall Act of 1933:
 Separated banking and securities activities
 Prevented any firm that accepted deposits from
underwriting stocks and bonds of corporations
 Was intended to prevent potential conflicts of
interest
22
 Regulation of securities services (cont’d)
 Deregulation of underwriting services
 In 1989, the Fed approved debt underwriting
applications for banks based on the requirements
that:
 Banks had sufficient capital to support the subsidiary that
would perform the underwriting
 Banks had to be audited to ensure that their
management was capable of underwriting debt
 The Fed imposed a ceiling on revenues from
corporate debt underwriting
23
 The Financial Services Modernization Act of 1999:
 Essentially repealed the Glass-Steagall Act
 Made it easier for commercial banks to engage in securities
and insurance activities
 Increased the degree to which banks can offer securities
services
 Allowed securities firms and insurance companies to acquire
banks
 Resulted in more consolidation among banks, securities
firms, and insurance companies
24
 Deregulation of brokerage services
 Banks had been allowed to offer discount brokerage services
even before 1999
 In the late 1990s, some banks acquired financial services
firms that offered full-service brokerage services
 Deregulation of mutual fund services
 Since June 1986, brokerage subsidiaries of bank holding
companies could sell mutual funds
 Private label funds are mutual funds created by banks in
conjunction with financial service firms
25
 Regulation of insurance services
 Before the late 1990s, banks were involved in insurance in
limited ways:
 Banks that had participated in insurance before 1971 were allowed
to continue to do so
 Some banks leased space in their buildings to insurance companies
in exchange for a payment equal to a percentage of the insurance
company’s sales
 In 1995, the Supreme Court ruled that national banks could sell
annuities
 In 1998, regulators allowed the merger between Citicorp and
Traveler’s Insurance Group
 In 1999, the Financial Services Modernization Act confirmed that
banks and insurance companies could merge
26
 Regulation of off-balance sheet transactions
 Off-balance sheet transactions, such as letters of credit, expose
the bank to risk
 Risk-based capital requirements are higher for banks that
conduct more off-balance sheet activities
 Regulation of the accounting process
 Publicly-traded banks are required to provide financial
statements that indicate their recent financial position and
performance
 The Sarbanes-Oxley Act was enacted in 2002 to make corporate
managers, board members, and auditors more accountable for
the accuracy of the financial statement that their respective firms
provided
27
Regulation of Interstate Expansion
 The McFadden Act of 1927 prevented banks
from establishing branches across state lines
 The Douglas Amendment to the Bank Holding
Company Act of 1956 prevented interstate
acquisitions of banks by bank holding
companies
 By 1994, most states had approved nationwide
interstate banking
28
Regulation of Interstate Expansion
(cont’d)
 Interstate Banking Act
 Until 1994, most interstate expansion was achieved
through bank acquisitions
 In September 1994, federal guidelines passed a
banking bill that removed interstate branching
restrictions
 Known as the Reigle-Neal Interstate Banking and Branching
Efficiency Act of 1994
 Eliminated most restrictions on interstate bank mergers and
allowed commercial banks to open branches nationwide
 Allows banks to grow and increase economies of scale
29
How Regulators Monitor Banks
 Bank regulators:
 Typically conduct an on-site examination of each commercial
bank at least once a year
 Assess the bank’s compliance with existing regulations and its
financial condition
 Periodically monitor commercial banks with computerized
monitoring systems
 Monitor banks to detect any serious deficiencies that might
develop so that they can correct the deficiencies before the bank
fails
 The FDIC rates banks on the basis of six characteristics
(CAMELS ratings)
30
(cont’d)
 Capital adequacy
 Regulators determine the capital ratio (capital divided by
assets)
 If banks hold more capital, they can more easily absorb potential
losses
 Asset quality
 The FDIC evaluates the quality of the bank’s assets, including its
loans and securities
 Management
 The FDIC specifically rates the bank’s management according to
administrative skills, ability to comply with existing regulations,
and ability to cope with a changing environment
 The FDIC also assesses the bank’s internal control systems
31
(cont’d)
 Earnings
 A commonly used profitability ratio to evaluate banks is return
on assets (ROA), defined as EAT divided by assets
 Earnings can also be compared to industry earnings
 Liquidity
 Regulators prefer that banks not consistently rely on outside
sources of funds such as the discount window
 Sensitivity
 Regulators assess the degree to which a bank might be exposed
to adverse financial market conditions
 Regulators place much emphasis on a bank’s sensitivity to
interest rate movements
32
(cont’d)
 Rating bank characteristics
 Each of the CAMELS ratings is rated on a 1-to-5
scale (1 = outstanding)
 A composite rating is determined as the mean rating
of the six characteristics
 Banks with a composite rating of 4.0 or higher are
considered to be problem banks and closely
monitored
 The number of problem banks increased in the 2001–2002
period
33
(cont’d)
 Rating bank characteristics (cont’d)
 Limitations of a rating system
 Regulators do not have the resources to monitor each bank
on a frequent basis
 Over time some problem banks improve while others
deteriorate
 Many problems go unnoticed and it may be too late by the
time they are discovered
 Any system used to detect financial problems may err in one
of two ways:
 It may classify a bank as safe when it is failing
 It may classify a bank as very risky when in fact it is safe
34
(cont’d)
 Corrective action by regulators
 Regulators thoroughly investigate “problem banks:”
 They may request that a bank boost its capital level
 They can require additional financial information
 They have the authority to remove particular officers and
directors if it enhances the bank’s performance
 Ifregulators reduce bank failures by imposing
regulations that reduce competition, bank efficiency
will be reduced
35
(cont’d)
 Funding the closure of failing banks
 The FDIC is responsible for the closure of failing
banks
 Must decide whether to liquidate the bank’s assets or to
facilitate the acquisition of that bank by another bank
 After reimbursing depositors of the failed bank, the FDIC
attempts to sell any marketable assets or the failed banks
 If the failing bank is acquired, the potential acquirer may be
interested if the bank is given sufficient funds by the FDIC
36
(cont’d)
 In 1991, the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) provided that:
 Regulators were required to act more quickly in forcing banks
with inadequate capital to correct the deficiencies
 Regulators were required to close troubled banks more quickly
 Deposits exceeding the insured limit are not to be covered when
a bank fails
 Deposit insurance premiums were to be based on the risk of
banks
 The FDIC was granted the right to borrow $30 billion from the
Treasury to cover bank failures and an additional $45 billion to
finance working capital needs
37
The “Too-Big-To-Fail” Issue
 Some troubled banks have received

preferential treatment from bank regulators
 Continental Illinois Bank in 1984 was rescued
 As one of the largest banks in the country,
Continental’s failure could have reduced public
confidence in the banking system
 The indirect costs (such as bank runs) would have
been too great to risk
38
(cont’d)
 Argument for government rescue
 If Continental had not been rescued:
 Depositors with more than $100,000 at other banks could
have become more concerned about their risk
 Other banks would have been likely candidates for runs on
their deposit accounts
 Argument against government rescue
 A government bailout can be expensive
 The government sends a message to the banking industry
that large banks will not be allowed to fail and large banks
may take excessive risks
 Government intervention could reduce efficiency
39
(cont’d)
 Proposals for government rescue
 An ideal solution would prevent a run on
deposits of other large banks, yet not reward
a poorly performing bank with a bailout
 The Fed and the FDIC could play a greater role in
assessing bank financial conditions over time to
recognize problems early
40
Global Bank Regulations
 Each country has a system for monitoring and regulating
commercial banks
 Most countries also have a system for deposit insurance
 Canadian banks tend to be subject to fewer banking
regulations than U.S. banks, such as interstate
branching
 European banks have had much more freedom than
U.S. banks in offering investment banking services such
as underwriting
 Japanese commercial banks have some flexibility to
provide investment banking services, but not as much as
European banks
41
Global Bank Regulations (cont’d)
 Uniform global regulations
 Three of the more significant regulations are:
 The International Banking Act
 Places U.S. and foreign banks operating in the U.S.
under the same set of rules
 The Single European Act
 Places all European banks operating in many European
countries under the same set of rules
 The uniform capital adequacy guidelines
 Forces banks of 12 industrialized nations to abide by the
same minimum capital constraints
42
 Uniform global regulations (cont’d)
 Uniform regulations for banks operating in the United
States
 The International Banking Act of 1978 was designed to
impose similar regulations across domestic and foreign
banks doing business in the U.S.
 Prior to the act, foreign banks had more flexibility to cross
state lines in the U.S. than U.S.-based banks had
 The IBA required foreign banks to identify one state as their
home state
43
 Uniform regulations across Europe
 The Single European Act of 1987 was phased in throughout
many European countries
 The main provisions are:
 Capital can flow freely throughout the participating countries
 Banks can offer a wide variety of lending, leasing, and
securities activities in the participating countries
 Regulations regarding competition, mergers, and taxes are
similar throughout these countries
 A bank established in any participating country has the right to
expand into any other participating country
44
 Uniform regulations across Europe (cont’d)
 As a result of the Single European Act:
 A common market has been established for participating
countries
 European banks have begun to consolidate across
countries
 Banks can enter Europe and receive the same banking
powers as other banks there
 Some European savings institutions have evolved into
full-service institutions
45
 Uniform capital adequacy guidelines around
the world
 Before 1988, capital standards imposed on banks
varied across countries
 Some banks had a comparative advantage over others
 The uniform capital adequacy guidelines imposed
the same minimum capital requirements on the 12
participating countries
46

Chapter - 18 New

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter - 18 New

Uploaded by

Copyright:

Available Formats

Chapter 18

Financial Markets and Institutions, 7e, Jeff Madura

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

 Some troubled banks have received

You might also like