Chapter Thirteen Regulation of Commercial Banks McGraw-Hill /Irwin 14-1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline 1. Specialness in Regulation 2. Regulators McGraw-Hill /Irwin 14-2 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 1. Overview: Specialness in Services • CBs are special because of the vital services they provide to various sectors of the economy: – – – – – – – – – – Information Liquidity Price-risk reduction Transaction cost reduction Maturity intermediation Money supply transmission Credit allocation Intergenerational wealth transfer Payment services Denomination intermediation McGraw-Hill /Irwin 14-3 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-4 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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) McGraw-Hill /Irwin 14-5 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-6 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-7 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-8 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-9 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-10 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-11 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-12 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-13 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-14 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-15 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw-Hill /Irwin 14-16 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.