Economic Analysis
of Banking Regulation
Chapter 11
Stuff
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Review Sheet
Test chapters: 6, 8, 9, 10, 11, 12
Wed, Ricketts 203, 7:00
No homework due
Commercial Paper
7 ways banks are regulated
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FDIC
Regulators restrict assets
Minimum bank capital requirements
Chartered and Auditied
Disclosure Req’t
Consumer Protection
Restrictions on Competition
1) FDIC Regulation
 Bank panic ‘cycles’ every 20 years
 1920’s: 600 insolvencies/year
 1930-33: 2000 insolvencies/year
 1934-81: 15 insolvencies/year
 FDIC closes insolvent banks (G-S, 1933)
 Payoff method
 Purchase and Assumption of bad debt method
 Used to be the most popular
FDIC and Moral Hazard
 Depositors: no incentive to monitor bank
mgmt. loan decisions
 Bankers: no worries about bad loan
decisions causing savers to lose saving
 “Too big to fail” policy
Taxpayers pay
 Glass-Steagall implications
2) Regulators Restrict Assets
 E.g. no common stock allowed
 Limits on risky loans
3) Minimum Bank Capital Req’t
 Traditional measure: Leverage Ratio
 Bank Capital/Assets (inverse of equity multiplier!!)
 Greater than 5%: well capitalized
 Less than 3%: Trouble!
 Basel Accord (1988) - International
 Hold 8% of ‘risk-adjusted’ assets
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Zero-weight: gov. securities
20% weight: claims on banks
50% weight: residential mortgages and municipal bonds
100% weight: loans to consumers and corporations
 Regulatory Arbitrage
 Fed in ‘96: 3 times max capital that could be lost
in 10 days
4) Banks chartered, audited
 Criteria
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Mgmt. adequacy
Likely earnings
Adequacy of capital
Effect on competition (pre-1980)
 Examination:
 Quarterly ‘call reports’
 Annual Exams
 Assets Risky? Get rid of them!
 Worthless Loans? Write them down!
 Capital Inadequate? Figure out new strategy!
CAMEL Rating
 Credit risk of bank assessed
 Enough collateral? Enough L-T relationships? Enough
screening?
 Acronym
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Capital Adequacy
Asset quality
Management (oversight of board, internal policies)
Earnings
Liquidity
Sensitivity
 IR rate assessed (Gap and Duration analysis)
 Stress testing, etc.
5) Disclosure Requirements
 Accounting standards
 Annual reports
 Risk level disclosure
 Disclose information about riskiest assets
 New Zealand: if full disclosure, then no
examination necessary
6) Consumer Protection
 Truth in Lending Act (1969)
 Standardization and disclosure of lending terms
 Fair Credit Billing Act amendment (1974)
 Extends to credit cards
 Billing errors, mechanism for appeal
 Equal Equal Credit Opportunity Act (1976)
 Community Reinvestment Act (1977)
 Invest in neighborhood in which you accept deposits
7) Competition restriction
 Branching
 Banks can’t be in security industry
 Security, insurance can’t be in banking
International Banking Regulation
 Similar to U.S.
 Country hopping, no overarching regulatory
organization
 BCCI collapse (1991)
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7th largets bank in world at peak
Value of 20m, when audited in ‘91, only 10m!
“Registered” in Luxembourg
Laundering, bribery, arms trafficking, nuclear
technologies, etc.
 Intentionally avoided detection: had its own shipping
and trading company, intelligence agency, etc.
Savings and Loan Crisis
 Largest banking crisis since the depression
 $500 billion dollar bailout over 40 years:
still paying for it!
 Good example of:
 Deregulation vs. regulation
 Moral Hazard
 Bank management
Early Causes
 Innovations in the ‘60s and 70’s, had to be riskier
 FSLIC: bank mgmt indifferent to taking risk
 Deregulation
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DIDMCA 1980
Garn- St. Germain Act 1982
Increased FSLIC insurance from 40K to 100K
Can put 40% in commercial real estate loans
30% in consumer lending
10% in junk bonds or direct investments
More early causes
 Recession of ‘80, ‘81
 Brokered deposits
 Large denomination CD sold to brokerage
 Cut into smaller FSLIC covered deposits
 Remove incentive for large depositors to
monitor lending practices of bankers (covered
through innovation!)
 By 1982, 50% of S&L’s were insolvent!!!
Resulting Problems
 Managers did not have experience with this
expanded risk portfolio
 Regulators didn’t have the breadth, capacity, or
experience to regulate
 Result
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Moral hazard by managers
Conflict of interest by regulators
Principal/Agent problem by politicians
Asymmetric Information with public
Regulatory Forbearance by
FHLB, FSLIC
 Refrained from closing insolvent banks
 Irregular accounting allowed (goodwill)
 Why? Conflict of interest
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Not enough money to close (payoff/assumption)
Don’t want to offend politicians
Protect reputation
FHLB established to encourage growth of S&L
industry, not shut it down
Zombie S&L’s: The Living Dead
 Bankrupt (negative bank capital) but still
operating
 Had nothing to lose, moral hazard
 ‘Bad’ S&L’s gave high interest on deposits, taking
business from ‘Good’ S&L’s
 Negative feedback loop
 ‘87 legislation
 Provided only $11 billion to back up losses, but…
 Directed FHLB to CONTINUE regulatory forbearance
Politician Principal Agent
 Hide problems from taxpayers, hoping it will go
away
 Career oriented
 Close relationships with industry insiders (conflict
of interest)
 The Keating Five
 Charles Keating, owner of Lincoln S&L, insolvent
 Purchases 600M in junk bond to try to escape
 Big contributor to congressmen, tell regulators to leave him
alone
 ‘89 collapse, $2.6 billion loss payed by taxpayers
 3 senators not re-elected after reprimanded
FIRREA (1989) - The Bailout
 Regulatory Structure Revised
 FSLIC and FHLB abolished
 Treasury Dept. takes over (Office of Thrift Supervision)
 Resolution Trust Corporation
 Seizes assets of 25% of S&L
 Sells $450B of assets of failed S&L
 Fed gov’t issues bonds for $150B deficit
 S&L regulations imposed again
 70% must be housing, no junk bonds, leverage 8%
 Regulators have power to remove bank mgrs., impose
penalties, issue cease and desist legal action
FDICIA (1991) - Insurance
 No more brokered deposits
 Limited “to big to fail” policy
 Another money infusion from Treasury to
cover S&L losses
 Corrective action provisions: FDIC MUST
intervene early if a bank is getting into
trouble
Future proposed reforms
 Limit deposit insurance to 90% of deposits
 Outlaw regulatory forbearance
 Value bank capital at cost, not market (see
today’s WSJ!)
 Consolidate regulatory agencies
 As of Dec. 2006, bank insurance fund and
savings and loan insurance fund became deposit
insurance fund
World Banking Crises
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Scandinavia
Russia
Japan
China
East Asian ‘Tigers’
Latin America
 Argentina