CHAPTER
18
Bank
Regulation
Background


As with so many other things, it takes a crisis to get
action on Capitol Hill (e.g. terrorism, Katrina, etc.)
The Great Depression was a catalyst for all kinds of
regulation, including that of
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corporations (Securities Acts of 1933, 1934 and the SEC)
banking (Banking Act of 1933, deposit insurance, etc.)
Bank failures in 1920s related to agriculture followed by
massive failures in 1930s from the Great Depression
finally prompted action by FDR and Congress
Bank failures of 1970s and 1980s again caused a
slew of bank regulation
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History of U.S. Bank Failures
# of banks failed
3 in 2007
30 in 2008
148 in 2009
157 in 2010
92 in 2011
51 in 2012
24 in 2013
18 in 2014
7 in 2015
2 so far in 2016
See FDIC website for details http://www.fdic.gov/bank/individual/failed/banklist.html
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Trouble banks
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History of Bank Failures
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A Bank Run
It’s a Wonderful Life
http://www.youtube.com/watch?v=qu2uJWSZkck
Mary Poppins
http://www.youtube.com/watch?v=lfP8__wl-_4
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Deposit Insurance - Background


March of 1933, panic of massive proportions
across the country with runs on the bank
everywhere
In response, FDR took several steps:

On March 6, FDR declared a four-day banking
holiday
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Adventist miracle
Baker Boyer Bank’s back door
On March 12, FDR held his first “fire-side chat”, a
live nation-wide radio broadcast to reassure the
nation
http://www.youtube.com/watch?v=z9CBpbuV3ok
Fed issued new notes to increase $ supply and
Bureau of Engraving went into 24 hr/day
production of currency/coin
FDR pushed deposit insurance regulation
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Deposit Insurance - Background


Congressman Steagall championed deposit insurance
as a solution but he faced much resistance from
Congress (Senator Glass), the executive branch and
the banking industry
Those opposed to deposit insurance claimed that:
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It removed penalties for bad judgment (moral hazard)
It was too expensive
It wouldn’t work as demonstrated by the collapse of state
insurance funds who already tried it
It was an intrusion by gov’t into private affairs
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Deposit Insurance - Background
Finally, the Banking Act of 1933, signed into law by FDR on
June 16, 1933, approved national deposit insurance (Section 8
of the Act created the FDIC). The FDIC is run by a 5-member
board chosen by the President
Martin Gruenberg
FDIC Chair since Nov/12
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Deposit Insurance Ceilings
How Deposit Insurance Coverage Has Increased
 1934: (Jan.) $2,500
 1934: (July) $5,000
 1950: $10,000
 1966: $15,000
 1969: $20,000
 1974: $40,000
 1980: $100,000
 2008: $250,000 (temporary until 2010)
 2010: $250,000 (made permanent)
 What would inflation adjusted coverage in 2015 for 1980
coverage dollars? http://data.bls.gov/cgi-bin/cpicalc.pl
 Not one penny has been lost by depositors since inception
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Regulation of Deposit Insurance

The pool of funds used to cover insured depositors is
called the Bank Insurance Fund
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Supported by annual insurance premiums paid by
commercial banks – rate about .3% of deposits
Before 1991, the rate was the same for all banks,
regardless of risk (under Basel Accord), causing moral
hazard problem
In 1991, the Federal Deposit Insurance Act (FDICA)
phased in risk-based insurance premiums
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Regulation of Deposit Insurance

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Covers bank accounts and IRAs/Keoghs but NOT securities or mutual funds
Coverage varies per type of ownership category: single (max $250k); joint
(max. $250k per individual); self-directed retirement (max $250k); and trust
(max. $250k).
Sole proprietorships (Sch. C) are considered owner’s single account.
Partnerships and corporations are separate legal entities ($250k max.)
Type of
Deposit
Amount Deposited
Depositor
Abe & Barb
Zero-Interest Checking
$150,000
Abe & Barb
CD
$200,000
Abe & Barb
Passbook Savings
$200,000
Zero-Interest Checking
$260,000
Abe’s IRA Account
CD
$275,000
Barb’s IRA Account
CD
$300,000
Abe's Restaurant
(a sole proprietorship)
TOTAL DEPOSITED
INSURED AMOUNT?
$1,385,000
??
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Background of regulation

Banking industry has experienced tremendous
change in recent years
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Post-Depression legislation focused on safety and
soundness of commercial banks
Since the 1980s, there’s been substantial
deregulation of financial services industry
Today, intense competition/consolidation has
occurred, as banks try to compete with services
(one-stop-shop) and create economies of scale.
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Why Banks Are Regulated?
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Deposits are 70% of money supply
Center of payments mechanism
Primary transmitter of monetary policy
Major liquidity provider to economy
Failure of banks obviously can cause a
nationwide crisis (e.g. Financial crisis).
©1998 South-Western College Publishing
3
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Regulatory Structure

The regulatory structure of the banking system
in the U.S. is unique

Dual banking system: Federal or state charter

State charter = state bank
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Federal charter = national bank
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Regulated by state banking agency (e.g. Washington Dept. of
Financial Institutions www.dfi.wa.gov )
Regulated by Comptroller of the Currency www.occ.treas.gov
Required to be member of the Fed
All banks with FDIC insurance are also regulated
by the FDIC
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Regulatory Structure

Member banks of the Fed. Res. are regulated by the Fed
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Federal Deposit Insurance Corporation (FDIC)
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35% of banks are members, constitutes 70% of deposits
All national banks must be members (optional for the rest)
Before 1980, non-member banks had less stringent reserve requirements,
so many were opting out of membership. Today, both members &
nonmembers can borrow from Fed and have same reserve requirements.
All Fed member banks must carry dep. insurance thru FDIC
FDIC regulates all of its members
Regulatory overlap:
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National banks: FDIC, Comptroller, & Fed. Reserve
State banks: state banking authorities, Fed (if member) & FDIC (if Fed
member or if chooses FDIC)
Fed and state regulators now attempt to rely on each others’ audits, if
possible.
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Regulatory Structure
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Regulation of bank ownership
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Banks can be independently owned (e.g. Banner Bank)
Banks can be owned by a holding company (e.g. Baker
Boyer National Bank)
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Bank Holding Company Act which allowed a BHC
more flexibility to participate in activities like leasing,
mortgage banking, and data processing, insurance,
securities underwriting, etc.
Most investment banks converted to commercial bank
holding status in 2008-2009 in order to gain access to
the Fed.
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Deregulation Act of 1980 (DIDMCA)
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Initiated to reduce bank regulations and increase
Fed monetary policy effectiveness
Phase out of deposit rate ceilings
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Interest rate ceilings were previously enforced by
Regulation Q. Phased out by 1986.
Phased out by 1986, after which banks could decide
their own rates
Allowed checkable deposits for all depository
institutions

NOW accounts (high min. balance, pays interest,
limited check-writing ability)
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DIDMCA & Regulation Q
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Deregulation Act of 1980
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New lending flexibility for depository
institutions
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Allowed S&Ls to offer limited commercial and
consumer loans
Standard pricing of Fed services, which would
be made available to all depository institutions
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Ensures the Fed only provides services, such as check
clearing, that it can provide efficiently
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Raised deposit insurance from $40k to $100k

Impact of the DIDMCA

Consumers shift to NOW accounts and CDs with higher
rates, so banks pay more for funds. Also, increased
competition between depository institutions
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Garn-St. Germain Act, 1982
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Came at a time when some depository institutions
were experiencing severe financial problems
Permitted depository institutions to offer money
market deposit accounts (MMDAs) to compete with
money market mutual funds (MMMFs)
Also allowed depository institutions to acquire
failing institutions across geographic boundaries
In general, consumers appear to have benefited from
this deregulation
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Regulation of Balance Sheet

Banks are required to maintain a minimum amount of capital
as a percentage of total assets
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Banks prefer low capital ratios to boost return on equity (ROE)
e.g. Bank LoCap: Assets = $100, Liaibilities=$90, Capital=$10
Bank HiCap: Assets = $100, Liaibilities=$50, Capital=$50
If net income (return) was $10 for the year, the ROE would be 100%
for LoCap and 20% for HiCap.
But regulators prefer high capital to absorb operating losses
In the 1988 Basel I Accord, central bankers of 12 countries
met in Basel, Switzerland, and agreed to uniform, risk-based
capital requirements, that required banks to have Tier 1 of 4%
and overall capital (Tier 1+2) of 8% of assets.
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Tier 1 = shareholder equity, retained earnings, and preferred stock
Tier 2 = loan loss reserve (up to a certain level) and subordinated debt
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Regulation of Balance Sheet

In the 2004 Basel II Accord, central bankers
agreed to the following reforms:
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Require higher capital based on credit risk (e.g. sufficient
collateral and degree of past-due loans)
Require higher capital based on operating risk (e.g. risk of
internal systems failing, such as computers, internal
controls, etc.)
Basel II was voluntary and non-enforceable
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Regulation of Balance Sheet

In the 2010 Basel III Accord, central bankers
agreed to the following reforms:
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define Tier 1 as common equity and retained earnings only
require 6% Tier 1 capital and 4.5% for common equity
based on credit risk (e.g. sufficient collateral and degree of
past-due loans)
Require higher liquidity ratios, with regular stress tests
U.S. signed on to Basel III in Dec/11, to be
phased in 2013-2018
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Regulation of Balance Sheet

Use of the Value-at-Risk (VaR) method to determine
capital requirements
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In 1998, large banks with trading busines (forex, interest
rate derivatives, etc.) started using a VaR model to stress
test their capital
VaR is an internal system, usually with a 99 percent
confidence interval, which shocks the system for tolerance
to events which might cause capital to decrease. This is
known as asset/liability management or ALM
In 2008, many banks had losses far bigger than their VaR
models predicted
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Regulation of Balance Sheet


Gov’t required stress tests during credit crisis in 2008 with
troubling outcomes
The resulting Trouble Asset Relief Program (TARP) in 20082010 infused $300B by purchasing 5% preferred stock of banks,
even if they didn’t want it

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E.g. In Feb/09, the Treasury Dept. “owned” 36% of Citicorp, while
executives continued to use company jets, chauffeurs, country club
memberships, etc. Eventually, Obama put limits on executive pay
TARP officially ended in Dec/14 and made a $15.3 billion profit
for the US. Gov’t. And it restored confidence in the system;
Nevertheless, TARP is still very controversial, with many
thoughtful people claiming it was dangerous for the gov’t to get
involved.
Copyright© 2002 Thomson Publishing. All rights reserved.
Regulation of Balance Sheet
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Regulation of loans
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Loan quality (LTV ratio, D/I ratio, credit history)
Highly leveraged transactions (HLTs) >75 LTV
Loans to foreign countries
Loans to the community (CRA encourages loans to low income borrowers)
Adequacy of loan loss reserves
Loans to single borrower (max. loan amount of 15% of capital)
Regulation of investment securities
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Common stocks allowed only with owner’s funds (not deposits or borrowed
funds)
Bond investments limited to investment-grade only
Investment banking activity allowed only for state and municipal bonds
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Regulation of Operations
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Regulation of securities services
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Deregulation of debt underwriting services, 1989
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Banking Act of 1933 (Glass-Steagall) separated banking and
securities services
Intended to prevent conflicts of interest, insider trading, and
self-interest lending
Allowed commercial paper and corporate debt underwriting
Still no common stock underwriting
Deregulation of mutual funds services

The Fed ruled in 1986 to allow brokerage subsidiaries of
bank holding companies to sell mutual funds
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Regulation of Operations
The Financial Services Modernization Act, 1999 (also
known as Gramm-Leach-Bliley Act)
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Essentially repealed the Glass-Steagall Act
Enables commercial banks to more easily pursue stock
underwriting and insurance activities
Allows financial institutions to diversify
Allows customers a one-stop-shop
BUT encourages a too-big-to-fail trend
During 2008-2009, major security firms were either purchased by commercial
banks (Merrill Lynch by BofA, and Bear Stearns by JPMC) or applied to
become bank holding companies (e.g. Goldman Sachs, Morgan Stanley).
Thus these security firms are now subject to more stringent regulations.
Copyright© 2002 Thomson Publishing. All rights reserved.
Regulation of Operations
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Regulation of insurance services
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Previously, banks sometimes leased space to insurance or
served as agent, but not underwriting insurance
Banks able to underwrite annuities, 1995
The passage of the Financial Services Modernization Act
(1999) confirmed that banks and insurers could
consolidate their operations (Citigroup & Travelers)
Regulation of off-balance sheet transactions

Risk-based capital requirements are higher for banks with
more off-balance sheet activities (letters of credit, interestrate swaps, loan commitments, etc.)
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Regulation of Interstate Expansion
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The McFadden Act of 1927 prevented banks from
establishing branches across state lines.
Interstate bank holding company mergers were
prevented by Douglass Amendment (1956)
Intent was to prevent large bank market control, but
it also limited competition to interstate banks only
Slowly changes in state banking law permitted
interstate banking
While thousands of banks still exist in the US, most
other countries have only a few, large, national banks
(e.g. Canada)
Copyright© 2002 Thomson Publishing. All rights reserved.
Regulation of Interstate Expansion
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Interstate Banking Act, 1994
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Reigle-Neal Interstate Banking and Branching
Efficiency Act of 1994
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Eliminated most restrictions on interstate bank mergers and
allowed commercial banks to open branches nationwide
Allowed interstate bank holding companies to consolidate into
one charter
Reduce costs to consumers and add convenience—promotes
competition
Banks take advantage of economies of scale
BUT banks also become too-big-to-fail!
Copyright© 2002 Thomson Publishing. All rights reserved.
Dodd-Frank Wall St. Reform &
Consumer Protection Act of 2010
Or simply the Financial Reform Act of Dodd-Frank Act
The stated aim of the legislation is:
“To promote the financial stability of the United States by improving accountability and
transparency in the financial system, to end "too big to fail", to protect the American
taxpayer by ending bailouts, to protect consumers from abusive financial services
practices, and for other purposes.”
Senator Chris Dodd,
Democrat.
Congressman Barney
Frank, Democrat.
Senator Richard Shelby,
Republican.
Copyright© 2002 Thomson Publishing. All rights reserved.
Dodd-Frank Wall St. Reform &
Consumer Protection Act of 2010
The Act is 2307 pages and 16 chapters long. Still trying to figure out what it
says. One of the shortest, user-friendly summaries I could find is linked
here. Students should be familiar with these summary provisions.
4.1 Title I - Financial Stability Act ( create Financial Stability Oversight
Council and Office of Financial Research to monitor systemic risk)
4.2 Title II - Orderly Liquidation Authority (extends liquidation authority
beyond banks to other financial institutions)
4.3 Title III - Transfer of Powers to the Comptroller, the FDIC, and the
FED (Enhancing Financial Institution Safety and Soundness Act)
(streamline overlapping regulatory agencies, make $250,000 insurance limit
permanent)
4.4 Title IV - Regulation of Advisers to Hedge Funds and Others (Private
Fund Investment Advisers Registration Act) (regulate hedge funds for the
first time, increasing investor min. wealth to $1 million, excluding home)
Copyright© 2002 Thomson Publishing. All rights reserved.
Dodd-Frank Wall St. Reform &
Consumer Protection Act of 2010
4.5 Title V – Insurance (Federal Insurance Office Act and Nonadmitted
and Reinsurance Reform Act) (monitor insurance, except health, LT care &
crop; previously, oversight of insurance was done strictly at the state level)
4.6 Title VI - Improvements to Regulation (Bank and Savings Association
Holding Company and Depository Institution Regulatory Improvements
Act) (limits speculative investments of banks to 3% of Tier 1 capital; prohibits
proprietary trading (speculation) with depositor funds (Volcker Rule).
4.7 Title VII - Wall Street Transparency and Accountability Act (regulate
OTC derivatives, such as credit default swaps)
4.8 Title VIII - Payment, Clearing and Settlement Supervision Act (gives
Fed powers to monitor and supervise liquidity risk within banking system)
4.9 Title IX - Investor Protections and Securities Reform Act (more
disclosure, whistleblower protection and rewards, credit rating agencies,
originators keep 5% investment in mortgage, shareholders approve executive
compensation)
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Dodd-Frank Wall St. Reform &
Consumer Protection Act of 2010
4.10 Title X - Consumer Financial Protection Act (regulate consumer
financial products, controversial)
4.11 Title XI – Fed’s System Provisions (create vice chair, Congressional
oversight of Fed’s lending)
4.12 Title XII - Improving Access to Mainstream Financial Institutions Act
(make banks give low income $2500 microloans, & financial counseling)
4.13 Title XIII - Pay It Back Act (unused TARP funds go to deficit reduction)
4.14 Title XIV - Mortgage Reform and Anti-Predatory Lending Act
(underwriting, origination, no prepayment penalties, regulation of interestonly/graduated payment & reverse mortgages, financial counseling, appraisers,
valuation models, loan modifications, foreclosures, Chinese drywall)
4.15 Title XV - Miscellaneous Provisions (e.g. Mine safety & off-shore drilling
safety)
4.16 Title XVI - Section 1256 Contracts (IRC Section 1256 on futures/options)
Copyright© 2002 Thomson Publishing. All rights reserved.
Dodd-Frank Status Report


As of 2015, only about half of the rules mandated by Dodd-Frank have been
implemented by regulators. Among the measures awaiting completion are rules
designed to increase transparency in derivatives markets, and rules to improve
consumer protections for mortgage borrowers.
The Volcker Rule, named after former Fed Chair Paul Volcker, prohibits commercial
banks from proprietary trading (speculation with depositor funds). In 2012, JPM Chase
lost $6.2 billion from what it claimed was hedging with credit derivatives, but the gov’t
claims it was proprietary trading. A big issue with the Volcker Rule is defining exactly
what is hedging and what is speculation.
Copyright© 2002 Thomson Publishing. All rights reserved.
How Regulators Monitor Banks
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Regulators examine commercial
banks at least once per year in an
examination (audit)
CAMELS ratings
Capital adequacy
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Regulators determine
“adequacy” of capital
More capital allows
banks to absorb losses
Asset quality
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Credit risk
Portfolio’s exposure
to potential events
F
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a
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i
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C
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i
s
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How Regulators Monitor Banks

Management
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Rates management according to administrative
skills, ability to comply with existing regulations,
and ability to cope with a changing environment.
Very subjective
Earnings


Banks fail when their earnings are consistently
negative
Commonly used ratio: Return on Assets (ROA)
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How Regulators Monitor Banks

Liquidity

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Extent of reliance on outside sources for funds (discount
window, federal funds)
Sensitivity to interest rate changes and market
conditions (asset/liability managemenet, see BMCU
report)
Rating bank characteristics



Each of the CAMEL characteristics is rated on a 1-to-5
scale, with 1 indicating outstanding, 2 good, 3 so-so, 4 red
flag, 5 failure
Used to identify problem banks
Subjective opinion must be used to supplement objective
measures
Copyright© 2002 Thomson Publishing. All rights reserved.
How Regulators Monitor Banks

Corrective action by regulators
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When a problem bank is identified it is thoroughly
investigated (examined) by regulators
They may require specific corrective action, such
as boosting capital or delay expansion
Many banks are put on probation
Regulators have the authority to take legal action
against a bank if they do not comply
Copyright© 2002 Thomson Publishing. All rights reserved.
Bank Failure
Copyright© 2002 Thomson Publishing. All rights reserved.
How Regulators Monitor Banks

Funding the closure of failing banks

FDIC is responsible for closing failing banks

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Liquidating failed bank's assets
Facilitating acquisition by another bank
Federal Deposit Insurance Corporation Improvement
Act (FDICIA) of 1991
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Regulators required to act more quickly for
undercapitalized banks
Risk-based deposit insurance premiums
Close failing banks more quickly
Large deposit (>$250,000) customers not protected
Copyright© 2002 Thomson Publishing. All rights reserved.
The “Too-Big-To-Fail” Issue

Argument for government rescue


Because many depositors exceeded deposit
insurance limits, failure to protect them could have
caused runs at other large banks. Financial
problems at large banks can be cantagious
Argument against government rescue



Sends a message that large banks will be protected
from failure
Incentive for banks to take added risks
Removes incentive to make operations more
efficient
Copyright© 2002 Thomson Publishing. All rights reserved.
The “Too-Big-To-Fail” Issue

Proposals for government rescue


Ideal solution would prevent a run on deposits
while not rewarding poorly performing banks with
a bailout
Regulators should play a greater role in assessing
bank financial conditions over time
Copyright© 2002 Thomson Publishing. All rights reserved.
Gov’t Rescues
Spring of 2008, Bear Stearns
•
Bear Stearns had facilitated many transactions in financial markets, and its
failure would have caused liquidity problems
•
The Fed provided short-term loans to Bear Stearns to ensure that it had
adequate liquidity
Fall of 2008, Lehman Brothers and AIG
• Lehman Brothers was allowed to go bankrupt even though American
International Group was rescued by the Fed.
• One important difference between AIG and LB was that AIG had various
subsidiaries that were financially sound at the time, and the assets in these
subsidiaries served as collateral for the loans extended by the government
• The risk of taxpayer loss due to the AIG rescue was low, but was very high
in LB
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Global Bank Regulations
 Each country has a system for monitoring and regulating
commercial banks.
 Most countries also maintain different guidelines for deposit
insurance.
 Differences in regulatory restrictions give some banks a
competitive advantage in a global banking environment.
Copyright© 2002 Thomson Publishing. All rights reserved.