Chapter 10
Bank Regulation
Course Instructor: Yuki Wang
Learning Objectives
The problem of bank runs
Deposit insurance and moral hazard
How new banks are created
Restrictions on bank balance sheets
Banking supervision
How insolvent banks are closed
Regulation and Bank Failures
Federal and state Regulation exists to prevent bank failures
Failures are costly to depositors, the government, and the overall
economy
Normally business failures increase efficiency by freeing resources for more
productive uses
Regulators are concerned about two causes of bank failures:
Bank runs – sudden, large withdrawals by depositors who lose confidence
in a bank
Bank runs can push a healthy bank into insolvency, creating needless
losses for its owners and depositors
Moral hazard – the misuse of funds given by depositors
How Bank Runs Happen
The risk of a bank run is an extreme form of liquidity risk
A surge in withdrawals exhausts a bank’s liquid assets, forcing sale of loans
at fire-sale prices and causing insolvency
Depositors run on a bank because of the first-come, first served nature
of withdrawal
Runs may occur because a bank is insolvent, or even the bank is initially
solvent before the run
https://www.youtube.com/watch?v=HAzv1-t0Bt8&t=1s
An Example of a Bank Run
Assume depositors lose confidence in an
otherwise healthy bank, causing a run
The bank first uses reserves and sells
securities to meet depositors’ demands for
funds
Forced to sell loans at the fire-sale price
of $0.50 per $1, the bank pays off half of
remaining deposits
The bank cannot pay off the remaining
deposits and has negative net worth, so
the remaining depositors and bank owners
both lose
Suspension of Payments
Suspension of payments is the refusal by a bank to allow withdrawals by depositors
Banks suspend payments trying to stop a run
Suspending payments may change the self-fulfilling psychology of a run
Suspension allows a bank to increase its liquid assets
U.S. banks suspended payments in the 19th and early 20th centuries to stop runs
Panic of 1837: Many banks suspended payments during this economic crisis to
prevent collapse
Panic of 1907: A banking crisis caused several banks to suspend payments. The
J.P. Morgan banking group and the U.S. government stepped in to stabilize the
situation
The Federal Reserve was created in 1913 to prevent future banking crises
Bank Panics
A bank panic involves simultaneous
runs at many individual banks
Bank panics result from a
contagious loss of confidence
The great depression and bank
runs: The 1929 stock market crash
triggered severe bank panics,
leading to widespread bank
failures.
This crisis resulted in the
creation of the FDIC (Federal
Deposit Insurance Corporation)
in 1933
Deposit Insurance
Deposit insurance is a government guarantee to compensate
depositors for their losses when a bank fails
The Federal Deposit Insurance Corporation (FDIC) is the
government agency that insures deposits at U.S. commercial
banks and savings institutions
Credit unions in the United States are typically insured by the
National Credit Union Share Insurance Fund (NCUSIF)
The FDIC provides insurance of $250,000 per depositor, per
bank for individual accounts
The FDIC charges banks premiums of about 1% of a bank’s
assets each year and holds U.S. government bonds
Runs are unlikely because depositors know they will get their
money even if their bank fails
Moral Hazard Again
Deposit insurance creates incentives to misuse funds, increasing moral
hazard
Bankers can take excessive risks which increase profits if successful but
create losses for depositors and shareholders if unsuccessful, the principalagent problem
Bankers can exploit depositors by stealing their money, known as looting
https://www.youtube.com/watch?v=ThWzLe0WMsE
Problems with Deposit Insurance
Deposit insurance exacerbates the moral hazard problem, eliminating
depositors’ incentive to monitor bank behavior
With deposit insurance, bank failures aren’t costly for depositors, but they
are costly for the insurance fund
Moral hazard and absence of monitoring may end up hurting taxpayers
Bank Charter
A bank charter is an official authorization
issued by a regulatory authority that
allows an individual, group, or institution
to operate as a bank
National banks obtain federal charters
from the Office of the Comptroller of the
Currency (OCC)
State banks obtain charters from state
regulatory agencies
Credit unions obtain national charters
from the National Credit Union
Administration, or from state agencies
The Separation of Banking and Commerce
The separation of banking and commerce means that banks cannot merge
with nonfinancial firms, a wall created by the 1956 Bank Holding Company
Act
Supporters of the separation cite dangers including potential conflicts of
interest, such as pressure to lend to the commercial company
Others feel that linking financial and commercial firms creates economies of
scope
Restrictions on Bank Balance Sheets
Various bank regulatory agencies impose restrictions on banks:
1.
Restrictions on the assets a bank can hold
2.
Minimum capital requirements
Regulations are intended to reduce moral hazard and the risk of insolvency
Who Sets Banking
Regulations?
Banks with national charters must join the
Fed and are regulated by the OCC
State chartered banks that choose to join the
Fed are regulated by the Fed and their state
agency
State banks that do not join the Fed are
regulated by the FDIC and their state agency
Savings banks and credit unions are regulated
by a mix of federal and state agencies
Restrictions on Assets
Regulators restrict assets that banks can hold to reduce moral hazard
1. Banks may own government and highly-rated corporate bonds and
mortgage-back securities, but not stocks or junk bonds
2. At national banks, loans to one borrower cannot exceed 15% of a bank’s
capital. Loan limits at state banks vary by state
Commercial real estate loans are often capped at 80% of the property’s value
Residential real estate loans are often capped at 80% to 95% of the property's
value
The Dodd-Frank bill requires that mortgage lenders verify a borrower’s ability
to afford the loan
Capital Requirements
Banks have an incentive to hold lower levels of capital to increase the return
on equity (ROE)
Capital requirements: The minimum levels of capital that banks must hold
Basel Accord: A 1988 agreement that sets international standards for bank
capital requirements
Over 100 countries have adopted the Basel provisions
Current U.S. Capital Requirements
First, a simple rule sets a bank’s
minimum equity ratio (ER) at 5%
Second, the Basel Accord requires
capital is at least 8% of risk-adjusted
assets (or risk-weighted assets, RWA)
Higher weights for riskier assets
Asset Type
Risk Weight (%)
Reserves and Treasury
Bonds
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Loans to Other Banks
20
Municipal Bonds and
Home Mortgages
50
Most Other Loans
100
This requirement is also referred
to as the capital adequacy ratio
(CAR)
The bank should use the higher
capital requirement to ensure that it
is compliant with both regulations
An Example
A bank with $150 of assets must
have at least 5% capital, or $7.50
(= .05 × 150)
Applying the Basel weights to each
asset class obtains risk-adjusted
assets of $107, requiring capital of
at least $8.56 (= .08 × 107)
The mix of assets determines
which requirement is more
stringent
Supervision
Bank supervision is the monitoring of banks’ activities by government
regulators
Regulators check capital requirements and asset restrictions
Regulators assess insolvency risk
Supervision includes information gathering, bank ratings, and enforcement
actions
https://www.youtube.com/watch?v=psahnlcr-C0
Information Gathering
Call reports are quarterly financial statements, including a balance
sheet and income statement
Regulators study call reports for adequate capital, increased risky
assets, or rising loan delinquencies
A bank examination is a visit by regulators to a bank’s headquarters to
gather information on the bank’s activities
Visits may be scheduled or surprise, and examiners check with
customers to verify information provided by the bank
Stress Testing
Stress testing simulates adverse economic
conditions to assess a bank's ability to
perform under financial shocks
The test evaluates capital adequacy,
liquidity, and risk management
Purpose: It helps regulators determine if
banks have enough capital to withstand
crises and meet obligations
Outcome: Results guide banks to raise
more capital or make adjustments to
strengthen their financial position
CAMELS Ratings
CAMELS ratings are evaluations by regulators of a bank’s insolvency risk based
on its Capital, Asset quality, Management, Earnings, Liquidity, and Sensitivity
Ratings are given for each category plus an overall rating:
1.
A rating of 1 is the best, and 5 is the worst
2.
An overall rating of 1 means the bank is fundamentally sound, while 5
means “imminent risk of failure”
CAMELS Ratings
COMPONENT
DESCRIPTION
Capital Adequacy
Measures the bank's capital relative to its risk-weighted assets. Ensures the
bank can absorb losses
Asset Quality
Evaluates the quality of the bank's assets, focusing on non-performing loans
and credit risk
Management
Assesses the effectiveness, experience, and decision-making of the
management team
Earnings
Examines profitability and sustainability of earnings, ensuring positive
income growth
Liquidity
Evaluates the bank's ability to meet cash obligations and fund withdrawals
Sensitivity
Assesses sensitivity to interest rate and market risk
An Example
1 Tier I Capital = common stock + preferred stock + retain earnings
2 Tier II Capital = undisclosed reserves+ subordinate term debt + general provision, revaluation reserves
3 NPBT: Net Profit before Tax
Enforcement Actions
A CAMELS rating of 1 or 2 means a bank is left alone until the next examination
A rating of 3 or worse requires that a bank take action to reduce risk and
improve its score
Banks may be required to slow loan growth, cut dividends, or fire managers
Regulators may impose fines and turn cases of suspected fraud over to the FBI
Closing Insolvent Banks
Normally, the FDIC deals with insolvent banks, forcing them to close quickly
An insolvent bank may be able to continue to operate because most of its
deposits are insured
Continued operation is dangerous for two reasons:
1. The bank may continue bad practices, increasing its losses
2. Since the bank is insolvent, moral hazard is increased as the bank may
increase risky activities, hoping high profits restore its solvency:
gambling for resurrection
Forbearance
Forbearance is a regulator’s decision to allow an insolvent bank to remain open
Regulators bend rules when practicing forbearance, hoping that solvency can be
restored
An example of forbearance is not writing down bad loans, allowing a bank to
avoid reducing its assets and capital, giving it time to recover
Deciding on Closure
The 1991 FDIC Improvement Act established stringent rules for closing banks
Regulators can close a bank if capital falls below 2% of assets, before a
bank is insolvent, to prevent moral hazard
Regulators have a second option of allowing a bank to increase capital by
issuing stock over a 3-month period
Deciding on Closure
The chartering agency (OCC or state agency) decides to close a bank and informs the
FDIC, which becomes the receiver for the bank:
Under the payoff method, the FDIC pays insured depositors and sells assets to
cover part of the cost of the payoff
Under the purchase and assumption method, the FDIC sells the insolvent bank to
a healthy bank, usually accepting a negative price since the liabilities that are
sold exceed assets
The FDIC chooses the method that is least expensive to the insurance fund
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