Chitchamon
Trakarnbaenchai
Kiyota Hanashiro
Sojung Park
Tomoka Minoumi
Vanessa Arana
Asymmetric Information And
Banking Regulation

The asymmetric information problem leads to
two reasons why the banking system might not
function well:
 Bank Failure – in which bank is unable to
meet its obligations to pay its depositors and
other creditors and this meant that
depositors would have to wait to get their
deposit funds until the bank was liquidated.
 Depositors’ lack of information about the
quality of bank assets can lead to bank
panics.
Government safety net

The government safety net can short-circuit
runs on banks and bank panics and by
providing protection for the depositor.
 One form of safety net is deposit
insurance, a guarantee such as that
provided by the Federal Deposit Insurance
Corporation (FDIC).
• The depositors are paid off in full on the
first $100,000.
FDIC and its two primary
methods to handle a failed bank.


Payoff method- this allows the bank to fail
and pays off deposits up to the $100,000
insurance limit. After the bank has been
liquidated, the FDIC lines up with other
creditors of the bank and is paid its share of
the proceeds from the liquidated assets.
Purchase and assumption method- finding a
willing merger partner who assumes (takes
over) all of the failed bank’s deposits so that
no depositor loses a penny. FDIC may help
the partner by providing it with subsidized
loans or by buying some of the failed bank’s
weaker loans.
Moral Hazard/Adverse Selection
and the Government Safety Net.

Moral Hazard
 With the existence of insurance , this will
increase incentives for taking risks that
might result in an insurance payoff.

Adverse Selection
 People who are most likely to produce the
adverse outcome insured against are those
who most want to take advantage of the
insurance.
Too Big to Fail
The failure of a very large bank makes it
more likely that a major financial disruption
will occur e.g. Continental Illinois.
 Too big to fail – the government provides
a guarantees of repayment of large
uninsured creditors of the largest banks.
The FDIC would do this by using the
purchase and assumption method, giving
the insolvent bank a large infusion of
capital and then finding a willing merger
partner to take over the bank and its
deposits.

Financial Consolidation and the
Government Safety Net

Financial consolidations poses two challenges to
banking regulation because of the existence of the
government safety net:
 The increased in size of banks as a result of
financial consolidation increases the too-big-to fail
problem, because there will now be more large
institutions whose failure would expose the financial
system to systemic risk.
 Financial consolidation of banks with other financial
services firms means that the government safety net
may be extended to new activities such as securities
underwriting, insurance, or real estate activities,
thereby increasing incentives for greater risk taking
in these activities that can also weaken the fabric of
the financial system.
Restriction on Asset Holdings and
Bank Capital requirements


Bank regulations restrict banks from holding
risky assets in order to avoid too much risk.
Requirements that banks have sufficient bank
capital are another way to reduce the bank’s
incentives to take on risk.
Bank capital requirements take two forms:
• Leverage ratio- the amount of capital divided by
the bank’s total assets. A good leverage ratio
must exceed than 5%
• Basel Accord- required banks to hold capital at
least 8% of their risk weighted assets.
Bank Supervision: Chartering and
Examination


Bank supervision – overseeing who operates
banks and how they are operated. This will
allow regulators to monitor whether the bank is
complying with a capital requirements and
restrictions on asset holdings, also function to
limit moral hazard.
Bank examiners give banks a CAMELS rating.
This based on the 6 areas assessed: capital
adequacy, asset quality, management,
earnings, liquidity, and sensitivity to market
risk.
Assessment of Risk Management
1993 Federal Reserve System’s 1993 guidelines
1994
Trading Activities Manual (provided bank examiners with to
evaluate
risk management systems)
1995
Announcement of assessing risk management processes at
the banks by the Federal Reserve and the Comptroller of the
Currency
↓
CAMELS system
enables bank examiners to give a separate risk management rating
from 1 to 5 by four elements.
(1) the quality of oversight provided by the board of directors and
senior management
(2) the adequacy of policies and limits for all activities that present
significant risks
(3) the quality of the risk measurement and monitoring systems
(4) the adequacy of internal controls to prevent fraud or
unauthorized activities on the part of employees
Major Financial Legislation in the United States

Federal Reserve Act (1913)
-created the Federal Reserve System

McFadden Act of 1927
-Effectively prohibited banks from branching across state lines
-Put national and state banks on equal footing regarding branching

Banking Acts of 1933 (Glass-Steagall) and 1935
-Created the FDIC
-Separated commercial banking from the securities industry
-Prohibited interest on checkable deposits and restricted such deposits to
commercial banks
-Put interest-rate ceilings on other deposits

Securities Act of 1933 and Securities Exchange Act of 1934
-Required that investors receive financial info. on securities offered for public
sale
-Prohibited misrepresentations and fraud in the sale of securities
-Created the Securities and Exchange Commission (SEC)
Major Financial Legislation in the United States
(cont’d)

Investment Company Act of 1940 and Investment Advisers Act of
1940
-Regulated investment companies, including mutual funds
-Regulated investment advisers

Bank Holding company Act and Douglas Amendment (1956)
-Clarified the status of bank holding companies (BHCs)
-Gave the Federal Reserve regulatory responsibility for BHCs

Depository Institutions Deregulation and Monetary Control Act
(DIDMCA) of 1980
-Gave thrift institutions wider latitude in activities
-Approved NOW and sweep accounts nationwide
-Phased out interest-rate ceilings on deposits
-Imposed uniform reserve requirements on depository institutions
-Eliminated usury ceilings on loans
-Increased deposit insurance to $100,000 per account
Major Financial Legislation in the United States (con’t)




Depository Institutions Act of 1982 (Garn-St. Germain)
-Gave the FDIC and the FSLIC emergency powers to merge banks and thrifts
across state lines
-Allowed depository institutions to offer money market deposit accounts
(MMDAs)
-Granted thrifts wider latitude in commercial and consumer lending
Competitive Equality in Banking Act (CEBA) of 1987
-Provided $10.8 billion to the FSLIC
-Made provisions for regulatory forbearance in depressed areas
Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of
1989
-Provided funds to resolve S&L failures
-Eliminated the FSLIC and the Federal Home Loan Bank Board
-Created the Office of Thrift Supervision to regulate thrifts
-Created the Resolution Trust Corporation to resolve insolvent thrifts
-Raised deposit insurance premiums
-Reimposed restrictions on S&L activities
Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991
-Recapitalized the FDIC
-Limited brokered deposits and the too-big-to-fail policy
-Set provisions for prompt corrective action
-Instructed the FDIC to establish risk-based premiums
-Increased examinations, capital requirements, and reporting requirements
-Included the Foreign Bank Supervision Enhancement Act (FBSEA), which
strengthened the Fed’s authority to supervise foreign banks
Major Financial Legislation in the United States (cont’d)
Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994
-Overturned prohibition of interstate banking
-Allowed branching across state lines
 Gramm-Leach-Bliley Financial Services Modernization Act of 1999
-Repealed Glass-Steagall and removed the separation of banking and
securities industries
 Sarbanes-Oxley Act of 2002
-Created Public Company Accounting Oversight Board (PCAOB)
-Prohibited certain conflicts of interest
-Required certification by CEO and CFO of financial statements and
independence of audit committee
 Federal Deposit Insurance Reform Act of 2005
-Merged the Bank Insurance Fund and the Savings Association
Insurance Fund
-Increased deposit insurance on individual retirement accounts to
$250,000 per account
-Authorized FDIC to revise its system of risk-based premiums

Disclosure Requirements



Disclosure requirements are a key element of
financial regulation
The Securities Act of 1933 and the Securities and
Exchange Commission of 1934, imposes
disclosure requirements that issues publicly traded
securities
They also require financial institutions to provide
additional disclosure regarding their off-balance
sheet positions and more information about how
they value their portfolios
Disclosure Requirements cont’d



Disclosure requirements is needed to limit
incentives to take on excessive risk and to improve
the quality of information in the marketplace so that
investors can make informed decisions
This improves the ability of financial markets to
allocate capital to its most productive uses
The Sarbanes Oxley Act of 2002 took disclosure of
information by increasing the incentives to produce
accurate audits of corporate income statements and
balance sheets which established the Public
Company Accounting Oversight Board to oversee
the audit industry, and to put in place regulations to
limit conflicts of interest in the financial services
industry
Consumer Protection


The Consumer Protection Act of 1969 requires all
lenders, not just banks , to provide information to
consumers about the cost of borrowing, including
a standardized interest rate and the total finance
charges on the loan.
The Fair Credit Billing Act of 1974 requires
creditors, especially credit card issuers, to provide
information on the method of assessing finance
charges and requires that billing complaints be
handled quickly.
Consumer Protection cont’d

The Equal Credit Opportunity Act of 1974
forbid discrimination by lenders based on
race, gender, marital status, age, or natural
origin.
 The Community Reinvestment act of 1977
was enacted prevent “redlining”, a lender’s
refusal to lend in a particular area. This act
requires that banks show that they lend in all
areas in which they take deposits, and if
banks are found to be in noncompliance with
the act, regulators can reject their
applications for mergers, branching, or other
new activities.
Restrictions on Competition


Increased competition can increase moral hazard
incentives of financial institutions toward assuming
greater risk in an effort to maintain former profit
levels.
Two ways that the U.S. government protect financial
institutions from competition are:
 Restrictions on branching which reduced competition
between banks, but were eliminated in 1994
 Preventing nonbank institutions from competing with banks
by engaging in banking business, which was eliminated in
1999
Restrictions on Competition

One disadvantage with restrictions on
competition was that they led to higher
charges to consumers and decreased
the efficiency of banking institutions,
which did not have to compete as
vigorously
Mark-to-Market Accounting and
the Subprime Financial Crisis

• Mark-to-Market Accounting: market
prices provide the best basis for
estimating the true value of assets, and
hence capital, in the firm
• Traditional historical-cost: the value
of an asset was set at its initial price
 →fluctuations in the value and liabilities

Mark-to-Market Accounting and
the Subprime Financial Crisis
(cont’d)
•mark-to-market accounting: a major flaw
•an important factor driving the crises
The Subprime Mortgage Crisis and
Consumer Protection Regulation

Large fees form mortgage origination

“Liar loans” : no need producing
documentation regarding assets and
liabilities

NINJA loan: No Income, No Job, and No
Assets

Mortgage originators were not required to
disclose information
The Subprime Mortgage Crisis and
Consumer Protection Regulation
(cont’d)

Federal Reserve issue a final rule for subprime mortgage
loans:
1: a ban on lenders making loans without regard to
borrowers’ ability to repay the loan from income assets
other than the home’s value
2: a ban on no-doc loans
3: a ban on prepayment penalties if the interest payment can
change in the first 4 yrs of the loans
4:a requirement that lenders establish and escrow account
for property taxes and homeowner’s insurance to be paid
into on a monthly basis
The Subprime Mortgage Crisis and
Consumer Protection Regulation (cont’d)
New regulation for all mortgage loans
1: a prohibition on mortgage brokers coercing a real estate
appraiser to misstate a home’s value

2: a prohibition on putting one late fee on top of another and
a requirement to credit consumers’ loan payment as of the
date of receipt
3: a requirement for lenders to provide a good-faith estimate
of the loans costs within three days after a household
applies for a loan
4: a ban on a number for misleading advertising practices,
including representing that a rate or payment is “fixed”
when the payment can change
International Financial
Regulation
– Financial Regulation in other countries is
similar to that in the United States.
• Financial institutions are charted and
supervised by government regulators.
– Difficulties in international Financial
regulation
• occur when financial institution operates in
many countries.
• regulators do not have the knowledge or
ability to keep close watch on operation in
other countries.
– Collapse of the BCCI(Bank of credit and commerce
international)
• Major international bank registered in Luxembourg,
operated in 70 countries.
• Bank of England closed BCCI down when massive
fraud discovered.
→ Highlighted difficulties.
– Basel Committee
• Announced procedures like Basel accord to provide
recommendations on banking regulations.
Ex) Allowed regulators in other countries to restrict the
operations of a foreign bank.
The 1980s SAVING AND LOAN AND BANK CRISIS
Pre-1934 : Bank failures were common and depositors
frequently suffered losses.
From 1934-1980 : Bank failures were a rarity, averaging
fifteen per year for commercial banks and fewer than
five per year for savings and loan associations.
After 1981 : Failures in both commercial banks and
saving and loan climbed to levels more than ten times
greater than in earlier years.
Reason? The burst of financial innovation in the 1960s 1970s and
early 1980s.
• Financial innovation decreased the profitability of certain
traditional lines of business for commercial Banks.
• Banks now faced increased competition for their sources of
funds from new financial institutions, such as money market
mutual funds.
• This circumstance forced financial instruments to seek out new
and potentially risky business to keep their profits up.
As a result, commercial banks and saving and loans did take
excessive risks and began to suffer substantial losses.
• The bank failure rose to a level of 200 per year by the late 1980s.
• The banking industry was reregulated and bailout provided. The
cost of the bailout was $150 billion, 3% GDP.