PART 6. THE ROLES OF REGULATION,
DEPOSIT INSURANCE, AND ETHICS IN
SHAPING BANKING AND THE FINANCIALSERVICES INDUSTRY



Chapter 16. Theories, Objectives, and
Agencies of Bank Regulation
Chapter 17. Deposit Insurance, Bank
Failures, and the Savings-and-Loan
Mess
Chapter 18. Ethics in Banking and the
Financial-Services Industry
Chapter 16
1
Chapter 16. Theories, Objectives,
and Agencies of Bank Regulation

Learning Objectives: To understand …






1. Financial modernization and the Gramm-LeachBliley Act of 1999
The K in TRICK as the symbolic umbrella of bank
regulation
Bank regulation in the context of agency theory
(principal-agent model)
The layers of competition for regulatory services
Regulation as a tax and an on-going struggle
between regulators and regulatees
Good intentions and unintended evils of regulation
Chapter 16
2
CHAPTER THEME

Bank regulators try to serve the conflicting objectives
of safety and stability on the one hand and efficient
banking structure (competition) on the other hand.
The U.S. Congress, acting as agent for taxpayer
principals, monitors bank regulators (including
deposit insurers), who in turn monitor insured
depositories. Monitoring and bonding are costly
activities. Since regulation acts as a tax, bankers
attempt to pass the incidence of it onto their
customers. The struggle between regulators and
regulatees, which can be described as the "regulatory
dialectic", serves to stimulate financial innovation but
at the expense of wasting costly resources.
Chapter 16
3
An Industry View?

“We believe financial institutions should
be operated as if there were no
regulators for supervision, no discount
window for liquidity, and no deposit
insurance for bailouts.”



John G. Medlin, Jr.
Chief Executive Officer (retired)
Wachovia Corporation
Chapter 16
4
What Do Bank Regulators
and Deposit Insurers Do?

They supervise


They provide liquidity


What? Why?
How? When?
They bail out distressed banks

How? Why?
Chapter 16
5
FINANCIAL MODERNIZATION AND THE GRAMMLEACH-BLILEY (GLB) ACT OF 1999

Purpose of the GLB Act


To enhance competition in the financialservices
industry
by
providing
a
prudential framework for the affiliation of
banks,
securities
firms,
insurance
companies, and other financial service
providers, and for other purposes.
Table 16-1 (p .555) list the provisions of the
GLB Act
Chapter 16
6
GLB Act (1999)

Meyer [2001]describes the act as having two
broad kinds of provisions:


1. Specific and explicit standards for becoming a
financial holding company (FHC)
2. Less specific and less explicit standards, with
little or no guidance for implementation (e.g., the
reasonable holding period for merchant-banking
investments) This category involves issues that
were more technical and upon which a consensus
was more difficult to reach. As a result, as
Congress is prone to do, these issues were left to
the banking agencies to establish
Chapter 16
7
Principal-Agent Relations and
Regulatory Discipline





Principal (monitors =>)
Taxpayers
Lawmakers
Regulators
Insured banks
Chapter 16





Agent
Lawmakers
Regulators
Insured banks
Borrowers
8
Regulatory Versus Market
Discipline


Regulatory discipline works through
regulatory interference (e.g., the K in
TRICK – capital adequacy)
Market discipline works through
financial markets in terms of the costs
of financial distress and the cost of
funds (capital)
Chapter 16
9
The Objectives of Bank
Regulation


Safety (protection of “small depositors”)
Stability (of the banking/financial
system)


Structure (competition and efficiency)


Contagion and systemic risk
IO model
Do these objectives conflict?
Chapter 16
10
The Federal Safety Net and
Too-Big-To-Fail (TBTF)

Discuss the roles and effects of …






DIDMCA (1980)
Continental Illinois (1984)
FIRREA (1989)
FDICIA (1991)
LTCM (1998)
GLB (1999)
Chapter 16
11
Three Layers of FinancialServices Competition



Explicit price
User convenience
User confidence


Modeling the confidence function and the
role of government guarantees (an
unbooked intangible asset)
How does regulation shapes these
functions?
Chapter 16
12
The Regulatory Dialectic
(Struggle Model)




Thesis
Antithesis
Synthesis
Historical struggles



Interest-rate controls
Geographic restrictions
Product restrictions
Chapter 16
13
Regulation Discussion




As a tax
Good intentions and unintended evils
Jurisdictional tangle of federal regulation
The Federal Banking Troika




FDIC
OCC
Fed
Role of SEC
Chapter 16
14
Strength-in-Banking Equation



Strength = New powers + Firm supervision
New powers: Innovations driven by TRICK
and relaxation of antiquated restrictions
Firm supervision


Regulatory style: FDICIA’s PCA, RBC
requirements, compliance with CRA, adequate
capital to get new powers, bank examinations
Market style: Market cap, cost of funds, cost of
financial distress
Chapter 16
15
Large Complex Banking Organizations
(LCBOs) and Risk-Focused Supervision


Risk exposure => risk management =>
supervision by risk
Contrast and compare (Table 16-9, p. 583)


Traditional bank examination
Risk-focused supervision of LCBOs
Chapter 16
16
Lessons from the Derivatives
Debacles of the mid-1990s




What’s important for prudential supervision
(and risk management) is the underlying risk
characteristics of financial instruments
Risk must be measured on a portfolio basis
rather than instrument by instrument
Importance of internal risk controls (e.g.,
Bankers Trust and Barings)
Align financial incentives with managerial
objectives
Chapter 16
17
CHAPTER SUMMARY


Understanding the U.S. federal safety
net and how it operates captures the
roles of regulation and deposit
insurance in the FSI
Key concepts include the principal-agent
relations of regulatory discipline, the
regulatory dialectic, supervision by risk,
contagion (systemic risk), IO model
Chapter 16
18
Chapter 16
19