Chapter 15
The Regulation of Markets
and Institutions
Key Ideas
 Different methods of regulating
financial markets
 Dual banking system and the
regulators who oversee it
 Universal banking and its possible
benefits and risks
Introduction
 Financial system is one of most
intensely regulated sectors in US
economy
 Objectives of the regulations are:
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To
To
To
To
promote competition
protect individual consumers
maintain stability of financial system
facilitate monetary policy
Primary Market
 Philosophy
 Best protection is provide adequate
information about securities and
investments
 Full disclosure broadens participation in
financial markets
Primary Market
Securities Act of 1933
 Requires disclosure of information for
newly issued publicly traded securities
 Privately held firms are not required to
reveal financial information to the public
at large, only to the lenders
Primary Market
Securities Exchange Act of 1934
 Created the Securities and Exchange
Commission (SEC) to administer provisions
of 1933 Act
 Publicly traded security must file
registration statement and preliminary
prospectus disclosing information about
issue
Primary Market
Securities Exchange Act of 1934
 The prospectus does not state
 the interest rate on a bond issue or
 price for equity issues
 determined in the market when sold
 If information is adequate, SEC approves
the statement and sale
 Approval by the SEC does not imply that
it views the new issue as an attractive
investment
 Approval simply means disclosure of
information is adequate
Regulation of Secondary Market
Securities Exchange Act of 1934
 Extended 1933 Act
 Periodic disclosure of relevant financial
information
 For firms trading in secondary market
 10K Report
 Annual financial statement and
 Information about a firm’s performance and
activity
Secondary Market
 Securities Exchange Act of 1934
 Prohibits Insider Trading
 Prohibit insiders from trading on private
information not previously disclosed to
public
 Corporate officers and major stockholders
must report all their transactions of their
own firm’s stock
Regulation of Commercial Banks
Philosophy
 Protect individual depositor
 Foster a competitive banking system
 Ensure safety and soundness of banking
system
Commercial Banks
 Dual banking system
 Federal and State banks existing side-by-side
 Legislation in 1860 established federally
chartered banks
 Created Comptroller of the Currency (US
Treasury Department) to supervise chartered
banks
 Imposed a prohibitive tax on issuance of state
banknotes
 Intent was to drive existing state chartered
banks out of business
Commercial Banks
 Dual banking system
 However, state banks survived
 Stopped issuing banknotes
 Started to accept of demand deposits
 State chartered banks are supervised by
regulators in their respective state
 Federally chartered banks tend to be
larger in size, but state banks are more
in number
Commercial Banks
Federal Reserve Act of 1913
 Required national banks to become
members of the Fed
 State chartered banks had option of
being a nonmember
 All state banks (including
nonmember) currently fall under
regulation of the Fed Reserve
System
Commercial Banks
Federal Deposit Insurance Corporation
(FDIC)
 All member banks of Fed are required to
carry FDIC insurance
 Members include,
 All national and
 Some state banks
 A majority of state banks (including non
members) have opted to participate in FDIC
program
Commercial Banks
Multiple Regulators at Federal level
with Overlapping and Conflicting
authority.
 Federal Reserve System
 Comptroller of Currency
 FDIC
 Some experts suggest that all regulation
should be combined in a single agency
 However, no legislation exists to unify
the structure
Commercial Banks
Philosophy
 Protect Individual Depositors
 Maintain Stability of Financial System
Strategy of Regulation:
 Disclosure is not enough
 Physical examination of member banks
 Bank examinations are often not public by
design
Commercial Banks
Primary Liabilities: Demand Deposit
 Banks must maintain sufficient liquidity
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to meet demand deposits
It is costly to keep excess reserve or
liquid assets
Fear of insolvency may cause a run on the
bank causing a system-wide bank panic
Paid on a first-come/first-serve basis
Periodic examination of a bank by
regulatory agencies to insure banks are
solvent
Commercial Banks
 Deposit Insurance
 FDIC established by Banking Act of 1933 to
insure deposits at commercial and mutual
savings banks.
 Created after a large number of bank
failures in the early 1930’s
 Objective is to protect small savers
 Reduce the incentive for depositors to
join a bank run
Commercial Banks
 Deposit Insurance
 Currently insure deposits up to $100,000
for single account
 Coverage depends on procedure used by
FDIC:
 Payoff Method
 Bank goes into receivership by FDCI
 FDIC pays out funds up to $100,000
 Purchase and Assumption Method
 FDIC merges failed bank with a healthy one
 Deposits of failed bank are assumed by solvent bank
Commercial Banks
 Moral Hazard and Deposit Insurance
 Existence of FDIC eliminates large-scale
bank failure and bank run.
 However, it creates a classic moral hazard
problem
 With FDIC insurance, depositors have
little or no incentive to monitor
riskiness of their banks.
 Without monitoring, bank managers finds it
easy to engage in risk shifting
Commercial Banks
 Moral Hazard and Deposit Insurance
 Shareholders and directors of banks have
incentive to make their banks riskier at the
expense of the FDIC
 “Too big to fail” Doctrine
 FDIC may extend loans to very large banks in trouble to
allow continued operations
 This doctrine may unintentionally exacerbate the moral
hazard problem
 Recently bank failures have increased due to
banking deregulation and commercial banking
activities have become riskier
Regulation of Commercial Banks
Risk-Based Capital Requirements
 Bank capital acts as a cushion against failure
 Banks are required to maintain a capital to asset
ratio
 This ratio measures of bank’s risk exposure
 Risk-based capital requirements
 Higher capital requirement for banks with risky assets.
 With higher risk amount of risk-based asset will go up.
 This will cause Capital to Asset ratio to go down.
 These requirements are agreed upon by the United
States and members of the Bank for International
Settlements (BIS)
Regulation of Commercial Banks
 Prompt Corrective Action (PCA)
 Passed as a part of FDIC Improvement Act of 1991
 Established procedures to handle troubled banks
 Designed to close banks before FDIC is exposed to
excessive losses
 Prevent regulatory forbearance
 when regulators keep an insolvent institution operating
in hopes of “turning it around”
 Banks are ranked according to their perceived
risk and more restrictions placed on riskier
banks
 Established a risk-based deposit insurance
premium in FDIC
 charge insurance premium based on the perceived risk of
the bank
Regulation of Nondepository
 Regulations are designed based on the type
of liabilities they issue
Pension funds and life insurance companies
 Heavily regulated because their
liabilities are purchased by small
investors and need to protect small
investors
 Employee Retirement Income Security
Act (ERISA)
Regulation of Nondepository
Employee Retirement Income Security Act
(ERISA)
 Established the Pension Benefit Guaranty
Corporation
 Guarantees defined benefits pension
plans, subject to a maximum amount
 Establishes minimum reporting, disclosure
and investment standards
Regulation of Nondepository
Life Insurance Companies
 Regulated at the state level
 Impose risk-based capital
requirements
 Perform periodic audits
 Implicit and explicit restrictions
on pricing of particular products
Regulation of Nondepository
Finance companies
 Raise funds by issuing debt and
equity
 Have virtually no regulation beyond
the securities laws governing
publicly traded securities
Regulation of Nondepository
Mutual Funds
 Regulated by the SEC
 Also subject to state regulations
 Objective is to protection of
individual investors through full
disclosure
The Glass-Steagall Act
 Segregated the banking industry from the
rest of the financial services industry
 Banks are barred from owning corporate
stock and other activities deemed too risky
 The Genesis of Glass-Steagall
 Prior to 1933, investment banking and
commercial banking were conducted under same
roof
 Following the financial collapse of the 1930s,
it was felt that investment banking activities
were too risky for banks
The Glass-Steagall Act
 The Genesis of Glass-Steagall
 This combination represented a
substantial threat to financial system
stability
 Although there was little empirical
evidence to support this contention, the
legislation mandated separation of the
two activities
The Glass-Steagall Act
 The Erosion of Glass-Steagall
 Commercial banks exerted pressure on the
Federal Reserve and courts to reduce the
barriers caused by Glass-Steagall
 Bank-holding Companies
 Permitted banks to conduct nonbanking activities
through subsidiaries
 In 1970 Federal Reserve was given power to determine
what activities were permissible
 Activities had to be closely related to traditional
banking
 During the 1970s and 80s banks acquired more freedom
to engage in nontraditional banking activities
The Glass-Steagall Act
 The Erosion of Glass-Steagall
 In 1989 the Federal Reserve granted five
banks the power to underwrite corporate
debt through a Section 20 affiliate
 Gradually the Federal Reserve granted
more and more banks the right to
underwrite corporate debt
The Glass-Steagall Act
The Gramm-Leach-Bliley Act (1999)
 Allowed affiliates of financial holding
companies to engage in various banking
activities and insurance underwriting
 Overall responsibility for regulation
lies with the Federal Reserve through its
role as the “umbrella” regulator
 Federal Reserve has power to ensure
capital adequacy of holding companies,
safety and soundness of their activities
The Glass-Steagall Act
The Gramm-Leach-Bliley Act (1999)
 Individual affiliates of holding
companies are subject to regulation by
functional supervisors such as the SEC
 This regulation framework blends the
disclosure-based and inspection-based
approaches to regulation
The Glass-Steagall Act
The Risk of Universal Banking
 Risk inherent in securities activities,
especially the underwriting business,
may affect the stability of the banking
system
 Losses in securities activities lead to
more bank failures and significant
losses to FDIC
The Glass-Steagall Act
The Risk of Universal Banking
 Other view: Just because investment
banking is riskier than commercial
banking, this does not mean that the
combination of the two will be riskier
Universal Banking
The Risk of Universal Banking
 The portfolio theory suggests that
diversification may reduce risk when
commercial banking is combined with
investment banking and life insurance
activities
 Perhaps it is time to let the banks
decide for themselves whether universal
banking reduces risk