Chapter Thirteen
Regulation of Commercial
Banks
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Chapter Outline
1. Specialness in Regulation
2. Regulators
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1. Overview: Specialness in Services
• CBs are special because of the vital services they
provide to various sectors of the economy:
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Information
Liquidity
Price-risk reduction
Transaction cost reduction
Maturity intermediation
Money supply transmission
Credit allocation
Intergenerational wealth transfer
Payment services
Denomination intermediation
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Overview: Specialness in Regulation
• CBs also are special in terms of their
regulation, including:
– Safety and Soundness Regulation
– Monetary Policy Regulation
– Credit Allocation Regulation
– Consumer Protection Regulation
– Investor Protection Regulation
– Entry and Chartering Regulation
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Types of Regulations
• Safety and Soundness Regulation - layers of
regulation have been imposed on FIs to protect
depositors and borrowers against the risk of failure
• Monetary Policy Regulation - regulators control and
implement monetary policy by requiring minimum
levels of cash reserves to be held against depository
institution deposits
• Credit Allocation Regulation - regulations support the
FI’s lending to socially important sectors, such as
housing and farming
(continued)
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Types of Regulations
• Consumer Protection Regulation - regulations are
imposed to prevent the FI from discriminating unfairly
in lending
• Investor Protection Regulation - laws protect
investors who directly purchase securities and/or
indirectly purchase securities by investing in mutual or
pension funds
• Entry and Chartering Regulation - entry and
activity regulations limit the number of FIs in any
given financial services sector, thus impacting the
charter values of FIs operating in that sector
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2. The Regulators
• The key regulators are the FDIC, OCC, FRS, and
the FTC
• The different facets of the regulatory structure
include
– regulation of product and geographic expansion
– the provision and regulation of deposit insurance
– balance sheet regulations (reserve requirements and
capital regulations)
– regulations pertaining to off-balance-sheet activities
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2.1 Commercial and Investment Banking
Activities
• Commercial banking - banking activity of
deposit taking and lending
• Investment banking - banking activity of
underwriting, issuing, and distributing securities
• Section 20 affiliate - a securities subsidiary of a
bank holding company through which a banking
organization can engage in investment banking
activities
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Breakdown of Glass-Steagall Act
• Glass-Steagall Act (1933 Banking Act) sought to
impose a rigid separation between commercial banking
and investment banking
• Federal Reserve Board began allowing commercial
banks to establish Section 20 affiliates in 1987
• Federal Reserve Board and OCC allowed commercial
banks to acquire directly existing investment banks in
1997
• Financial Services Modernization Act passed by
Congress in 1999 which repealed Glass-Steagall
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Regulation of Product and Geographic
Expansion
• Product segmentation in U.S. Commercial
Banks
– Regulatory barriers and restrictions often inhibit
ability operate in some areas
• Universal FI
– An FI that can engage in a broad range of financial
service activities
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Regulatory Factors Impacting Geographic
Expansion
• Unit bank - a bank with a single office
• Multibank hold company - a parent banking
organization that owns a number of individual bank
subsidiaries
• Grandfathered subsidiaries - subsidiaries established
prior to the passage of a restrictive law and not subject
to that law
• One-bank holding company - a parent banking
organization that owns one bank subsidiary and
nonbank subsidiaries
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2.2 History of Bank and Savings Institution
Guarantee Funds
• FDIC
– created in 1933 in the wake of the banking panics of 1930-1933
to maintain the stability and public confidence in the system
– numerous bank failures in the 1980’s drained the FDIC fund
– Congress passed the FDIC Improvement Act (FDICIA) to
restructure the bank insurance fund and prevent insolvency
• The Demise of the FSLIC
– S&L failures in the 1980’s depleted and present value of its
liabilities exceeded that of its assets
– Congress passed the Financial Institutions Reform, Recovery,
and Enforcement Act (FIRREA) and transferred management to
the FDIC and was renamed SAIF
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Causes of the Depository Fund Insolvencies
• The financial environment
– dramatic rise in interest rates during 1979-1982
– collapse in oil, real estate, and other commodity prices
– increased financial service firm competition at home and
abroad
• Moral hazard
– Deposit insurance itself was at the heart of the crisis
– Banks engaged in risky ventures with depositors fully insured
– Implicit premiums - deposit insurance premiums or costs
imposed on a bank through activity constraints rather than
direct monetary changes - could have substituted for absence
of depositor discipline
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Reform of Deposit Insurance
• Insurance premiums based on CAMEL rating
• FDIC proposed merger of BIF and SAIF
• FDIC proposed deposit insurance be indexed to
inflation to maintain real value
• FDIC proposed that current fixed designated
minimum reserve ratio of 1.25% be changed to a
ratio ranging from 1.00 to 1.50%
• FDIC proposed charging premium for risk
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2.3 Balance Sheet Regulations
• Capital-to-assets ratio - ratio of core capital to assets
• Prompt corrective action - mandatory action that
regulators must take as bank’s capital ratio falls
• Basel Accord - agreement that requires imposition of riskbased capital ratios on banks in major industrialized
countries
• Risk-adjusted assets - On- and off-balance-sheet assets
whose value is adjusted for credit risk
• Total risk-based capital ratio - ratio of total capital to
risk-adjusted assets
• Tier 1 (core) capital ratio - ratio of core capital to riskadjusted assets
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2.4 Foreign versus Domestic Regulation
• Product Diversification Activities
– Financial Services Modernization Act of 1999 allowed banks
to participate in nonbank activities
• Regulation of U.S. Banks in foreign countries
– Federal Reserve Regulation K allowed banks to engage in the
foreign country’s permitted banking activities
– NAFTA enabled U.S. banks to expand into Mexico
• Regulation of foreign banks in the U.S.
– International Banking Act (IBA) and Foreign Bank
Supervision and Enforcement (FBSEA) allow federal
regulators to have increasing control
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