•McFadden Act (1927) and Douglas Amendment (1956) limit interstate branching
•Interstate Banking and Branching Efficiency Act (1994) deregulates branching
•Gramm-Leach-Biley Financial Services Modernization Act (1999) repeals
Glass-Steagall
Regulating Finance
• Lots of bases to cover
Cover one by regulation or deregulation
 Unintended Consequences
• Reactions to regulatory policies
 frustrate regulator intent
Regulate bank balance sheets  off-balance sheet activities
Emplace a safety net  bankers become skydivers
• Regulation spreads to cover innovations
 complexity  ineffectiveness
Win by gaming the system
Primary Supervisory Responsibility of Bank
Regulatory Agencies
• Comptroller of the Currency—national banks
chartered by Federal government since 1863
• Federal Reserve and state banking
authorities—state banks that are members of
the Federal Reserve System
• Fed also regulates bank holding companies
• FDIC—insured state banks that are not Fed
members
• State banking authorities—state banks without
FDIC insurance
Innovations: Response to Interest Rate Volatility
• Adjustable-rate mortgages
• Financial Derivatives
Innovations: Response to Information Technology
• Bank credit and debit cards
• Electronic banking
– ATM/Home banking/ABM/Virtual banking
• Junk bonds
• Commercial paper market … backed by banks
• Securitization
Innovations:Avoiding Regulation/Loophole Mining
• Sweep accounts … reserve requirements
• Money Market Mutual Funds … Regulation Q
Decline of Traditional Banking
Decline in cost advantages in acquiring funds (liabilities)
Rising inflation  rise in interest rates and disintermediation
Low-cost source of funds, checkable deposits, declined in importance
Decline in income advantages on uses of funds (assets)
Information technology  less need for banks to finance short-term credit
and issue loans
IT  lower transaction costs for other financial institutions
Bank Responses:
•Riskier Lending … Commercial real estate, leveraged buyouts, takeovers
•Off balance sheet activities
Size Distribution of Insured Commercial Banks, September 30, 2008 ????
3,046
4,039
486
86
7,640
39.9
52.9
6.1
1.1
1.3
9.7
10.0
79.0
Ten Largest Non – US Banks, December 30, 2008
Ten Largest Banks in the World, 2007 $ Revenues
1. ING Group, Netherlands
6. BNP Paribas, France
2. Fortis, Belgium/Netherlands
7. Credit Agricole, France
3. Citigroup, US
8. Deutsche Bank, Germany
4. Dexia Group, Belgium
9. Bank of America, US
5. HSBC Holdings, UK
10. UBS, Switzerland
Bank Consolidation
Skirting
Skirtingbranch
branchrestrictions
restrictions
•ATMs,
•ATMs,Bank
BankHolding
HoldingCos.
Cos.
Interstate Banking
and Branching
Efficiency Act, 1994
 Geographic deregulation
• Benefits of bank consolidation
Increased competition  close inefficient banks
Efficiencies from economies of scale and scope
Lower chance of failure -- diversified portfolios
• Costs
Fewer community banks  less lending to small
business
Banks in new areas  increased risks/failures
Pre-Crisis Findings:
•Net interest margin up
•ROA, ROE up for big
banks
•Intrastate deregulation
more positive for all but
big banks
•Interstate deregulation
helps big banks most
•Non-performing loans
down for biggest banks
but up for smaller banks
•State of economy has
stronger impact on bank
performance than
branching deregulation
The U.S. regulatory regime: In need of reform?
Justice Department
• Assesses effects of
mergers and acquisitions on
competition
Financial, bank and thrift
holding companies
• Fed
• OTS
Fannie Mae, Freddie Mac, and
Federal courts
Federal Home Loan Banks • Ultimate decider of
• Federal Housing Finance
Agency
banking, securities, and
insurance products
Fed is the umbrella or consolidated regulator
National banks
• OCC
Primary/
secondary • FDIC
functional
regulator
Federal
branch
• OCC
• Host county
regulator
State commercial Federal savings Insurance
and savings banks
banks
companies
Securities
brokers/dealers
Other financial companies,
including mortgage
companies and brokers
• OTS
• FDIC
• FINRA
• SEC
• CFTC
• State securities
regulators
• Fed
• State licensing
(if needed)
• U.S. Treasury
for some products
• State bank
regulators
• FDIC
• Fed--state member
commerical banks
Foreign
branch
• Fed
• Host county
regulator
• 50 State insurance
regulators plus
District of Columbia
and Puerto Rico
Limited foreign
branch
• OTS
• Host county
regulator
Sources: Financial Services Roundtable (2007), Milken Institute.
Notes:
Justice Department: Assesses effects of mergers and acquisitions on competition
Federal Courts: Ultimate decider of banking, securities, and insurance products
CFTC: Commodity Futures Trading Commission
FDIC: Federal Deposit Insurance Corporation
Fed: Federal Reserve
FINRA: Financial Industry Regulatory Authority
GSEs: Government Sponsored Enterprises
OCC: Comptroller of the Currency
OTS: Office of Thrift Supervision
SEC: Securities and Exchange Commission
10
Asymmetric Information and Bank Regulation
Government safety net
• Deposit insurance and FDIC
– Short circuits bank failures and contagion effect
• Payoff method
• Purchase and assumption method
• Fed as lender of last resort: Too BIG to Fail
• Financial consolidation Exacerbates Too Big to Fail
• Safety net extended to non-bank financial institutions
Safety Net  Moral Hazard Problems
– Depositors don’t impose discipline of marketplace
– Banks have an incentive to take on greater risk
Safety Net Adverse Selection Problems
– Risk-lovers find banking attractive
– Depositors have little reason to monitor bank
Attempted solutions: Constrain banks from taking too much risk
• Promote diversification
• Prohibit holdings of common stock
• Set capital requirements … Capital as cushion
• Minimum leverage ratio
• Basel Accord: risk-based capital requirements
… but there’s regulatory arbitrage
Prompt corrective action: Close ‘em down when capital inadequate
• Monitor … CAMELS
– Capital adequacy
– Asset quality
– Management
– Earnings
– Liquidity
– Sensitivity to market risk
• Disclosure requirements
… mark-to-market issue
Failed Banks Update
Year
Number
•
•
•
•
•
•
•
•
•
•
•
•
•
2000
2001
2002
2003
2004
2005/2006
2007
2008 QI+Q2
2008 Q3
2008 Q4
2009 Q1
2009 Q2
2009 Q3
2
4
11
3
4
0
3
4
10
12
21
24
50
1980s S&L and Banking Crisis
• Financial innovation  increased risk taking
• Increased deposit insurance  moral hazard
• Deregulation
• Lack of management expertise
• Rapid growth in new lending: real estate
– Activities expanded in scope
– Regulators at FSLIC lacked expertise
• High interest rates/recession
increased incentives for moral hazard
1980s S&L and Banking Crisis:
• Regulatory forbearance by FSLIC
– Insufficient funds to close insolvent S&Ls
– Established to encourage growth
– Did not want to admit agency was in trouble
• Zombie S&Ls taking on high risk projects and
attracting business from healthy S&Ls
• Politicians lobbied by S&L interests
• Competitive Equality in Banking Act of 1987
– Inadequate funding
– Continued forbearance
The Financial Institutions Reform,
Recovery, and Enforcement Act of 1989
• Regulatory apparatus restructured
– Federal Home Loan Bank Board relegated to the OTS
– FSLIC given to the FDIC
– RTC established to manage and resolve insolvent thrifts
• Cost of the bailout approximately $150 billion
• Re-restricted asset choices
• Increased core-capital leverage requirements
• Imposed same risk-based capital standards as those
on commercial banks
• Enhanced enforcement powers of regulators
• Did not resolve underlying moral hazard and adverse
selection problems