CHAPTER
18
© 2003 South-Western/Thomson Learning
Bank
Regulation
Chapter Objectives
Describe the key regulations imposed on
commercial banks
 Explain development of bank regulation over
time
 Evaluate the areas of bank regulation
 Describe the main provisions of the Financial
Services Modernization Act of 1999

Background

Banking industry has experienced tremendous
change in recent years
Post-Depression legislation focused on safety and
soundness of commercial banks
 Deregulation of financial services industry
 Intense competition/consolidation
 Expansion--economies of scale

Why Banks Are Regulated?
Deposits are 70% of money supply
 Center of payments mechanism
 Primary transmitter of monetary policy
 Major liquidity provider to economy

Make loans
 Deposits are liquid assets of customers


Liabilities are major, low risk assets of
consumers
3
Regulatory Structure

The regulatory structure of the banking system
in the U.S. is unique
Dual banking system: Federal and State
 Charter

State
charter = state bank
Regulated by state banking agency
Federal charter = national bank
Regulated by Comptroller of the Currency
Regulatory Structure
Banks that are members of the Federal
Reserve are also regulated by the Fed
 Banks that are insured by the Federal Deposit
Insurance Corporation are also regulated by
the FDIC
 Regulatory overlap:

FDIC
 Federal Reserve System
 State banking authorities
 Now Securities and Exchange Commission--stock

Regulatory Structure

Regulation of bank ownership
Bank independently owned
 Bank owned by a holding company

Popularity
stems from amendments to the Bank Holding
Company Act in 1970
 Allowed BHC’s more flexibility to participate in
activities like leasing, mortgage banking, and data
processing, and later,
Insurance, securities underwriting, etc.
Deregulation Act of 1980
Initiated to reduce bank regulations and increase
Fed monetary policy effectiveness
 Also known as DIDMCA
 Phase out of deposit rate ceilings

Interest rate ceilings were previously enforced by
Regulation Q. Phased out by 1986
 The act allowed banks to make their own decisions
on what interest rates to offer on deposits


Allowance of checkable deposits for all
depository institutions

NOW accounts
Deregulation Act of 1980

New lending flexibility for depository
institutions


Explicit pricing of Fed services


Allowed S&Ls to offer limited commercial and
consumer loans
Ensures the Fed only provides services, such as check
clearing, that it can provide efficiently
Impact of the DIDMCA

Consumers shift to NOW accounts and CDs, so banks
now pay more for funds than before. Also, increased
competition between depository institutions
Garn-St. Germain Act, 1982




Came at a time when some depository institutions
were experiencing severe financial problems
Permitted depository institutions to offer money
market deposit accounts to compete with money
market mutual funds
Also allowed depository institutions to acquire
failing institutions across geographic boundaries
In general, consumers appear to have benefited from
deregulation
Regulation of Deposit Insurance

Deposit insurance began in 1933 with creation
of Federal Deposit Insurance Corporation in
response to bank runs/failures in 1920s
(agricultural) and early 1930’s (Depression)
Between 1930-1932 20% of banks failed.
 Initial wave of failures resulted in runs on other
banks, some of which were healthy
 The amount of deposits insured per person has
increased from $2,500 in 1933 to $100,000 today

Regulation of Deposit Insurance

The pool of funds used to cover insured
depositors is called the Bank Insurance Fund
Supported by annual insurance premiums paid by
commercial banks
 Until 1991, the rate was the same for all banks,
regardless of risk, causing moral hazard problem
 Federal Deposit Insurance Act (FDICA) of 1991
phased in risk-based insurance premiums

Regulation of Capital

Banks are required to maintain a minimum
amount of capital as a percentage of total
assets
Banks prefer low capital ratios to boost ROE
 Regulators prefer higher levels to absorb operating
losses
 In the 1988 Basel Accord central bankers of 12
countries agreed to uniform, risk-based capital
requirements

Regulation of Capital

Use of the Value-at-Risk method to determine
capital requirements
In 1998, large banks with substantial trading
businesses began using their own internal
measures of market risk to adjust their capital
requirements.
 Use a VAR (value-at-risk) model, usually with a
99 percent confidence interval


Precursor to 1991 risk-based capital
requirements
Regulation of Capital

Testing the validity of a bank’s VAR
Uses backtests with actual daily trading gains or
losses
 If the VAR is estimated properly, only 1 percent of
the actual trading days should show results worse
than the estimated VAR


Related stress tests

Bank identifies a possible extreme event to
estimate potential losses
Regulation of Operations

Regulation of loans

Regulators monitor:
Loan
quality
Loan diversification geographically and by industry
Adequacy of loan loss reserves
Exposure to debt of foreign countries

Regulation of investment securities
Non-equity, investment grade investments
 Provides income and liquidity to bank
 Investment banking activity only in state and
municipal bonds

Regulation of Operations

Regulation of securities services
Banking Act of 1933 (Glass-Steagall) separated
banking and securities services
 Intended to prevent conflicts of interest and selfinterest lending


Deregulation of corporate debt underwriting
services, 1989
Commercial paper and corporate debt securities
 Still no common stock underwriting

Regulation of Operations

The Financial Services Modernization Act,
1999
Essentially
repealed the Glass-Steagall Act
Enables commercial banks to more easily pursue stock
underwriting and insurance activities

Deregulation of brokerage services
In
the late 1990s some banks acquired financial
services firms.
 Citicorp and Traveler’s Insurance Group, which owned
Solomon Brothers and Smith Barney, merged
Regulation of Operations

Deregulation of mutual funds services
The
Fed ruled in 1986 to allow brokerage subsidiaries of
bank holding companies to sell mutual funds
Regulation of Operations

Regulation of insurance services





Banks that already participated in insurance before 1971
were grandfathered
Banks sometimes leased space to insurance or served as
agent, but not underwriting insurance
Banks able to underwrite annuities, 1995
The passage of the Financial Services Modernization Act
(1999) confirmed that banks and insurers could
consolidate their operations
Regulation of off-balance sheet transactions

Risk-based capital requirements are higher for banks with
more off-balance sheet activities
Regulation of Interstate Expansion
The McFadden Act of 1927 prevented banks
from establishing branches across state lines.
 No interstate bank holding company mergers
(1956)
 Intent was to prevent large bank market
control, but limited competition to intrastate
banking
 Slow changes in state banking law to permit
interstate banking

Regulation of Interstate Expansion

Interstate Banking Act

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
 Allowed interstate bank holding companies to consolidate into
one charter
 Reduces costs to consumers and adds convenience—promotes
competition
 Banks take advantage of economies of scale
How Regulators Monitor Banks
Regulators examine commercial banks at least
once per year
 CAMELS ratings
 Capital adequacy

Regulators determine the “adequacy” of capital
 More capital allows banks to absorb losses


Asset quality
Credit risk
 Portfolio’s composition and exposure to potential
events

How Regulators Monitor Banks

Management
Rates management according to administrative
skills, ability to comply with existing regulations,
and ability to cope with a changing environment.
 Very subjective


Earnings
Banks fail when their earnings are consistently
negative
 Commonly used ratio: Return on Assets (ROA)

How Regulators Monitor Banks

Liquidity



Extent of reliance on outside sources for funds (discount
window, federal funds)
Sensitivity to interest rate changes and market
conditions
Rating bank characteristics



Each of the CAMEL characteristics is rated on a 1-to-5
scale, with 1 indicating outstanding
Used to identify problem banks
Subjective opinion must be used to supplement objective
measures
How Regulators Monitor Banks

Corrective action by regulators
When a problem bank is identified it is thoroughly
investigated (examined) by regulators
 They may require specific corrective action, such
as boosting capital or delay expansion
 Regulators have the authority to take legal action
against a bank if they do not comply

How Regulators Monitor Banks

Funding the closure of failing banks

FDIC is responsible for closing failing banks
Liquidating
failed bank's assets
Facilitating acquisition by another bank

Federal Deposit Insurance Corporation Improvement
Act (FDICIA) of 1991
Regulators
required to act more quickly for
undercapitalized banks
Risk-based deposit insurance premiums
Close failing banks more quickly
 Large deposit (>$100,000) customers not protected
The “Too-Big-To-Fail” Issue

Some troubled banks have received
preferential treatment from bank regulators

Continental Illinois Bank
Rescued
by the federal government, while other
troubled banks were not
As one of the country’s largest banks, Continental’s
failure could have reduced public confidence in the
banking system
The “Too-Big-To-Fail” Issue

Argument for government rescue


Because many Continental depositors exceeded
$100,000, failure to protect them could have
caused runs at other large banks
Argument against government rescue
Sends a message that large banks will be protected
from failure
 Incentive to take added risks
 Removes incentive to make operations more
efficient

The “Too-Big-To-Fail” Issue

Proposals for government rescue
Ideal solution would prevent a run on deposits
while not rewarding poorly performing banks with
a bailout
 Regulators should play a greater role in assessing
bank financial conditions over time
