Chapter Nine
Government’s
Role in Banking
Regulation of Banks
• Banking is one of the most heavily regulated
industries in the U.S
• An efficient payments system and circulation of
money are essential to economic growth
• Like all regulation, bank regulation does not
come without costs
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Why Does the Government
Regulate Banks?
•
•
•
•
•
To reduce the externalities caused by
bank problems
To keep banks small
To prevent bank runs
To ensure that payments flow through
the banking system efficiently
To stabilize the money supply
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Achieving the Goals of Regulation
The government
• Supervises banks to reduce externalities
•
Restricts mergers and bank activities to keep
banks small
•
Provides a federal safety net to prevent bank
runs
•
Offers services to ensure efficient payments
•
Requires banks to hold reserves to control the
money supply
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Bank Supervision
•
Bank failures cause more problems than typical
business failures as they harm a wider range of
people
•
Any activity banks engage in is subject to
government regulation, costing both time and
resources
•
Approximately 13% of banks’ total cost of doing
business is compliance with regulations
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Restricting Mergers
•
Lawmakers attributed bank failures during the
Great Depression to too much inter-bank
competition
•
The Glass-Steagall Act (1933) prohibits
banks from participating in the securities
industry and owning commercial firms
•
Arguments of excessive monopoly power
versus economies of scope
•
The Gramm-Leach-Bliley Act (1999) allows
banks to invest, sell insurance, and own
commercial firms, but only those related to
banking, securities, and insurance
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Providing a Federal Safety Net
• Deposit insurance is provided through the
Federal Deposit Insurance Corporation (FDIC)
• The Fed serves as a lender of last resort,
guaranteeing funds to member banks in need
• Both policies result in asymmetric information
problems, compensated for by supervision
• The government will not allow some banks to go
bankrupt under the too-big-to-fail policy
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When Banks Close
When a bank fails, the FDIC must decide what
to do with the bank’s assets and how to pay
off creditors & depositors. It may
1. Pay off (insured depositors, then creditors)
2. Purchase and assumption (sell the bank
and its assets, and FDIC assumes debts)
3. Assistance (keep the bank open and loan
funds to survive)
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When Banks Close (cont’d)
Except for a brief period during the 80s (due to the S&L
crisis), bank failures have become very rare
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Ensuring Efficient Payments
• Payment clearing
services provided by
the Fed to
commercial banks
• The Fed allows
daylight overdrafts,
allowing banks more
flexibility
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Controlling the Money Supply
• The government can effect flows of money
though the banking system by requiring
banks to hold a certain amount of reserves
• Banks prefer to use these funds to make
additional loans or investments, thus
imposing a large opportunity cost
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Supervisors & Supervision
• The U.S. has a dual banking system, meaning
banks can choose whether to be chartered at
the federal or state level
• National banks must be members of the Federal
Reserve system and be FDIC insured, and so
are subject to federal supervision
• State banks are FDIC insured, but may choose
not to be members of the Fed system. They are
supervised only by the FDIC and their state
banking department
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Supervisors & Supervision
(cont’d)
Supervision differs between national and
state banks
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Rating Banks
• Banking supervisors use the CAMELS
rating system to assess a bank’s health
• Components of the CAMELS system
– Capital adequacy
– Asset quality
– Management
– Earnings
– Liquidity
– Sensitivity to risk
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Capital Adequacy
• The only objective component of the CAMELS
rating system
• Supervisors want banks to have a lot of equity
capital so they have a stronger stake in good
performance
• Total risk-adjusted assets (TRAA) are a measure
of a bank’s exposure to risk, based on four
categories of risk among the bank’s assets
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Capital Adequacy (cont’d)
• To determine adequate capital, two levels of
capital must be considered
– Tier 1 capital- stockholder equity capital
– Tier 2 capital- the bank’s loan loss reserves +
subordinated debt
Total Capital = Tier 1 capital + Tier 2 capital
• A bank is adequately capitalized when Tier 1
capital > 0.04 x TRAA and total capital > 0.08 x
TRAA
• A bank is well capitalized when Tier 1 capital >
0.08 x TRAA and total capital > 0.10 TRAA
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Evaluating Bank Mergers
• In evaluating bank mergers, lawmakers
consider
– The effect of the merger on competition
– The adequacy of the financial and managerial resources
of the new bank
– The ability of the bank to meet the convenience and
needs of the community
– Whether the banks provided complete information about
the transaction to banking authorities
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Evaluating Bank Mergers (cont’d)
• Banking authorities use the HerfindahlHirschman index (HHI)
• The HHI measures the amount of competition
in a banking market
HHI  s  s  ...  s
2
1
2
2
2
N
• If HHI becomes >1,800 and/or the change in
the HHI > 200
• Mergers are also denied if the new bank
would hold more than 10% of the nation’s
deposits
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