Chapter Thirteen
Regulation of
Commercial Banks
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Specialness of Commercial Banks
• Commercial banks provide many unique services
– information, liquidity, price-risk reduction, transaction
cost, maturity intermediation, and payment services
– money supply transmission, credit allocation,
intergenerational wealth transfers, and denomination
intermediation
• Failure to provide these services can be costly to
both users and suppliers of funds
• Accordingly, commercial banks are regulated at
the federal (and sometimes state) level
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Types of CB Regulations
• Safety and soundness regulation
– assets must be diversified: cannot make loans greater
than 15% of their equity capital to any one borrower
– must maintain adequate equity capital levels to protect
against insolvency risk – TARP’s Capital Purchase
Program.
– provision of guarantee funds such as the Deposit
Insurance Fund (DIF) protects depositors in the event
of default and prevents bank runs
– monitoring and surveillance: banks must submit
(publicly accessible) quarterly reports and are subject
to on-site examinations
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Layers of Regulation
Regulate by Monitoring
& Surveillance
Diversify
Assets
Loans
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Investments
Hold Sufficient
Capital
Guarantee
Funds
Cash
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Wall Street Reform & Consumer
Protection Act, 2010
• Promote robust supervision and regulation of financial
firms
– Financial Services Oversight Council
– New authority to Fed to supervise all financial firms
(non-banks) posing a threat to financial stability
– Stronger capital and prudential standards
– National Bank Supervisor
– Elimination of loopholes; BHCs and thrifts not in
mortgages
– Registration of hedge funds and private pools
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Dodd–Frank Act
• Comprehensive supervision of financial markets
– Regulation of securitization markets;
transparency, credit rating agencies, financial
interest requirement of securitized loans
originators
– Regulation of OTC derivatives
– Authority to FED to oversee payment, clearing
and settlement systems.
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Dodd–Frank Act – cont.
• Protect consumers and investors
– Consumer Financial Protection Agency
– Transparency , fairness and appropriateness of
financial products
– Higher standards for providers of consumer
financial products
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Dodd–Frank Act – cont.
• Provide tools to manage financial crisis
– New regime to resolve crisis involving nonbanks
– Revision to FED’s emergency lending powers
to improve accountability
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Dodd–Frank Act – cont.
• Raise international regulatory standards
and improve cooperation
– Strengthening capital framework
– Oversight of financial markets
– Coordination supervision of internationally
active firms
– Enhancing crisis management tools
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Commercial Bank Regulation
• Monetary policy regulation
– the Central Bank (the Federal Reserve) directly
controls the quantity of notes and coin (i.e., outside
money) in the economy
– however, the bulk of the money supply is held as bank
deposits, called inside money
– regulators require cash reserves to be held against
deposits at commercial banks
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Commercial Bank Regulation
• Credit allocation regulation
– regulators encourage (and often require) lending to
socially important sectors of the economy (e.g.,
housing and farming)
– QLT requiremement, usury laws cap interest rates that
can be charged on loans
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Commercial Bank Regulation
• Consumer Protection Regulations
– Community reinvestment Act (CRA) -1977
• CRA ratings, demographic data & lending
patterns
• Credit approval and denial decisions
– Home Mortgage Disclosure Act (HMDA) –
1975
– Consumer Financial Protection Agency, 2010
– Credit card abuses – fees, rates, universal
default
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Commercial Bank Regulation
• Investor protection regulation
– protects investors against insider trading, lack
of disclosure, malfeasance, and breach of
fiduciary responsibility
– Securities Act, 1933 & 1934
– Investment Company’s Act, 1940.
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Commercial Bank Regulation
• Entry and chartering regulation
– the entry of commercial banks is regulated
– the permissible activities of commercial banks are
defined by regulators
– the barriers to entry and the scope of permissible
activities allowed affects the charter values of banks
and the size of the net regulatory burden
• The net regulatory burden is the difference
between the costs of regulations and the benefits
for the producers of financial services
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Commercial Bank Regulation
• Regulators
–
–
–
–
the Federal Deposit Insurance Corporation (FDIC)
the Office of the Comptroller of the Currency (OCC)
the Federal Reserve System (FRS)
state agencies
• The four facets of regulatory structure
–
–
–
–
regulation of product and geographic expansion
provision and regulation of deposit insurance
balance sheet regulation
off-balance-sheet regulation
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Product Segmentation Regulation
• Commercial banking vs. investment banking
– commercial banking involves deposit taking and
lending
– investment banking involves underwriting, issuing,
and distributing securities
– the Glass-Steagall Act of 1933 imposed a rigid
separation between commercial and investment banks
– by 1987 commercial banks were allowed to engage in
limited investment banking activity through Section 20
affiliates
– the Financial Services Modernization Act (FSMA)
of 1999 repealed Glass-Steagall
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Product Segmentation Regulation
• Commercial banking vs. insurance underwriting
– the Bank Holding Company Act (BHCA) of 1956
restricted insurance companies from owning or being
affiliated with commercial banks
– the FSMA of 1999 now allows bank holding
companies to open insurance underwriting affiliates
and also allows insurance companies to open banks
• Commercial banks and commerce
– the BHCA of 1956 restricts commercial firms from
acquiring banks
– the 1970 Amendment to the BHCA requires banks to
divest nonbank related subsidiaries
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Geographic Expansion Regulation
• Restrictions on intrastate banking
– most banks used to be unit banks—i.e., banks with
single offices
– by 1997 only six states restricted intrastate branching
• Restrictions on interstate banking
– the McFadden Act of 1927 (amended in 1933)
restricted national banks from branching across state
lines
• as a result, the largest banks were set up as multibank
holding companies (MBHCs)
• an MBHC is a parent banking organization that owns a
number of individual bank subsidiaries
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Geographic Expansion Regulation
– the Douglas Amendment to the BHCA of 1956
• let states regulate MBHC expansion
• subsidiaries established prior to the passage of the amendment
were considered grandfathered and not subject to the law
– the 1970 Amendment to the BHCA of 1956 restricted
the nonbank activities that one bank holding
companies (OBHCs) could engage in
• a OBHC is a parent banking organization that owns one bank
subsidiary and nonbank subsidiaries
– the Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994
• allows consolidation of out-of-state bank subsidiaries into a
branch network and allows interstate mergers and acquisitions
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Deposit Guarantee Funds
• The Federal Deposit Insurance Corporation (FDIC)
was created in 1933 to maintain the stability of the U.S.
banking system
– worked well until 1979
– from October 1979 to October 1982 the Fed targeted bank
reserves and let interest rates rise dramatically
– led to disintermediation—i.e., the withdrawal of deposits from
depository institutions and their reinvestment elsewhere
– problems were exacerbated by a policy of regulatory
forbearance—i.e., a policy of not closing economically insolvent
depository institutions, but allowing their continued operation
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Deposit Guarantee Funds
• The FDIC Improvement Act (FDICIA) of 1991
restructured the Bank Insurance Fund (BIF)
• The demise of the Federal Savings and Loan Insurance
Corporation (FSLIC)
– the FSLIC insured savings institutions from 1934 to 1989
– savings institutions failures in the 1980s led to an insolvent FSLIC
by 1989
• The Financial Institutions Reform, Recovery, and
Enforcement Act (FIRREA) of 1989
– dissolved the FSLIC and transferred its management to the FDIC
– created the Savings Association Insurance Fund (SAIF)
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Deposit Guarantee Funds
• The FDIC introduced risk-based deposit insurance
premiums in January of 1993
– by 1996 the safest institutions insured by the BIF paid no deposit
insurance premiums
– by 1997 the safest institutions insured by the SAIF paid no deposit
insurance premiums
– by the early 2000s over 90% of depository institutions were in the
“safe” category that paid no deposit insurance premium
• In March 2005 the BIF and the SAIF were merged into
one Deposit Insurance Fund (DIF)
• In January 2007 the FDIC began a more aggressive
insurance system where all institutions pay into the fund
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The FDIC Assessment Rate Schedule for the
quarter ending September 30, 2007
Risk Category
I – Minimum
I – Middle
I – Middle
I – Maximum
II
III
IV
McGraw-Hill/Irwin
Annual Rate in BP # Institutions
5
2,709
5.01-6.00
3,088
6.01-6.99
1,422
7
859
10
422
28
64
43
7
13-23
% Total
31.6%
36.0%
16.6%
10.0%
4.9%
0.7%
0.1%
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Balance Sheet Regulation
• Liquidity regulation
– banks must hold minimum levels of reserves against net
transaction accounts
– ensures that banks can meet required payments on liability claims
such as deposit withdrawals
– see Appendix 13c for more details
• Capital adequacy regulation
– since 1987 U.S. commercial banks have faced two different
capital requirements
• Tier I capital risk-based ratio
• Total capital (Tier I + Tier II) risk-based ratio
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Regulations on Commercial Bank Liquidity
The first $10.7 million of net transaction accounts carry a 0% reserve requirement,
amounts from $10.7 million to $55.2 million carry a 3% reserve requirement and
all amounts over $55.2 million require a 10% reserve requirement.
Suppose that a bank has average daily gross transaction deposits of $1,650 million,
including $150 million in its own deposits elsewhere and in currency in the process
of collection (CIPC) so that net transaction accounts are $1,500 million. The
minimum average reserves the bank must hold is:
Net Transaction
Accounts
% Reserve
Daily Avg.
Required Amount Required
Less than
10.700
0%
10.700
0.000
10.700 to
55.200
3%
44.500
1.335
more than
55.200
10% 1444.800
Total: 1500.000
144.480
145.815
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Capital Adequacy Regulation
• Since 1987 U.S. commercial banks have faced two
different capital requirements
• Capital-to-Assets (i.e., leverage) ratio
– capital-to-assets ratio = core capital ÷ total assets
– does not account for market values, riskiness of assets, or
off-balance-sheet activities
• Risk weighted capital requirement
– Tier I capital risk-based ratio
– Total capital (Tier I + Tier II) risk-based ratio
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Balance Sheet Regulation
• Since December 1992 regulators must take Prompt
Corrective Action (PCA) if and when a bank falls
outside of the “well capitalized” zone
• Risk-based capital ratios were phased in by Bank for
International Settlement (BIS) countries (the U.S.
included) by 1993 under the Basel Accord
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Capital Adequacy Regulation
• Tier I capital is composed of the book value of common equity
plus an amount of perpetual preferred stock plus minority
equity interests held by the bank in subsidiaries minus goodwill
• Tier II capital includes secondary capital resources such as
loan loss reserves and convertible and subordinated debt
• risk-adjusted assets include both on- and off-balance-sheet
assets whose values are adjusted for approximate credit risk
• the total risk-based capital ratio is equal to the sum of Tier I
and Tier II capital divided by risk-adjusted assets
• the Tier I (core) capital ratio is equal to Tier I capital divided
by risk-adjusted assets
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Off-Balance-Sheet Regulation
• Banks earn fee income with off-balance-sheet (OBS)
activities
• By engaging in OBS activities, banks can avoid regulatory
costs such as reserve requirements, deposit insurance
premiums, and capital adequacy requirements
• Banks must report notional values of OBS activity on
Schedule L
• OBS activity is incorporated into the total risk-based
capital ratio and the Tier I capital ratio, but not the
leverage ratio
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Regulations on Capital Adequacy (Leverage)
The FDICIA requires banks and thrifts to meet identical risk based
capital requirements. FDICIA requires regulators to mandate
prompt corrective actions (PCA) if a bank falls below the well
capitalized criteria.
The 1989 Basle Accord did three things:
1. Defined what banks could count as capital.
2. Increased the amount of capital a bank is required to hold by
requiring stricter minimum capital/asset ratios.
3. Made the required capital levels reflect the risk of the
institution.
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Basle Accord I defined two types of capital:
Tier 1 (Core) capital: “No Contractual Obligated Payments”
• Common Equity, including Retained Earnings (Must be  4% of
Risk Weighted Assets (RWA). Subject to regulatory approval:
• Qualifying cumulative and noncumulative perpetual preferred
stock (and surplus) {No more than 25% of the sum of the other
Tier 1 elements}
Tier 2 or Supplemental Capital (major components)
• Allowance for loan and lease losses - Up to 1.25% of RWA
• Perpetual preferred stock not counted in Tier 1.
• Subordinated debt and finite lived preferred stock maturing no
sooner than 5 years.{Maximum amount is 50% of Tier 1}
Total Capital (TC) or Allowable Capital = Tier 1 + Tier 2
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Summary of the Risk Weights for On Balance Sheet Items
Risk Weight
Category 1
0%
Category 2
20%
Category 3
50%
Category 4
100%
Category 5
150%
Asset
Cash; Securities backed by U.S. and OECD govt. and some U.S. govt. agencies
Reserves at Fed (central banks)
GNMA mortgage backed securities
Loans to sovereigns with an S&P rating of AA- or better
Mortgage backed non-govt. agency sponsored securities such as FNMA and FHLMC backed securities
Most securities issued by govt. agencies; GO municipals
U.S. and OECD interbank deposits and guaranteed claims
Repos collateralized by U.S.G.S.
Loans to sovereigns with an S&P rating of A+ to ALoans to banks and corporates with an S&P rating of AA- or better
Single or multi-family mortgages (fully secured, first liens); Revenue bonds
Loans to sovereigns with an S&P rating of BBB+ to BBBLoans to banks and corporates with an S&P rating of A+ to ALoans to sovereigns with an S&P rating of BB+ to BLoans to banks with an S&P rating of BBB+ to BLoans to corporates with an S&P rating of BBB+ to BBAll other loans to private entities and all consumer loans
Physical assets
Corporate Bonds and other unclassified investments
All other assets, including intangibles
Loans to sovereigns, banks and securities firms with an S&P rating below BLoans to corporates with an S&P rating below BB-
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XYZ Bank (Millions)
ASSETS
LIABILITIES & EQUITY
Cash & Reserves
$ 5 Deposits
Investments in Treasuries
$ 10 10 year Sub. Debt
Commercial loans BB+
$ 12 Perpetual Noncum. PS
Single family mortgages
$ 45 Common stock
Consumer loans
$ 35 Retained Earnings
Commercial loans CCC+
$ 25
Allowance for loan losses
($ 10 )
Physical assets
$ 15
Total Assets
$137
Total
$113
$ 16
$ 1
$ 2
$ 5
$137
Off Balance Sheet:
• Banker’s Acceptances $20 million to entities with an A+ rating.
• Three year fixed-for-floating interest rate swap with notional
value of $75 million and a replacement cost of $3 million.
• Three year forward contract to sell euros for $10 million. The
contract has a replacement cost of $1 million.
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XYZ Bank (Millions $)
ASSETS
Cash & Reserves
Investments in Treasuries
Commercial Loans BB+
Single family mortgages
Consumer loans
Commercial loans CCC+
Allowance for loan losses
Physical assets
Total Assets
$ 5
$ 10
$ 12
$ 45
$ 35
$ 25
($ 10)
$ 15
$137
Risk
RWA
Weight
0%
$0.0
0%
$0.0
100%
$12.0
50%
$22.5
100%
$35.0
150%
$37.50
N/A
100%
$ 122.0
LIABILITIES &
EQUITY
Deposits
10 year Sub. Debt
Perpetual Noncum. PS
Common stock
Retained Earnings
Total
Capital
$113
$ 16
$ 1
$ 2
$ 5
Tier 2
Tier 1
Tier 1
Tier 1
$137
The on balance sheet risk weighted asset total is calculated as the
sum of the amount of each asset times the risk weight. Total on
balance sheet risk weighted assets are thus $122 million. The
reserve for loan losses is ignored in this calculation.
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Total Risk Weighted Assets (RWA)
On Balance Sheet RWA
Off-Balance Sheet Assets
Banker’s Acceptances
Swap
Forward
Total RWA
$122,000,000
$ 2,000,000
$ 3,375,000
$ 1,500,000
$128,875,000
The risk weighted equivalent asset amounts for the off balance sheet
items are calculated as follows:
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Calculations for the risk weighted equivalent asset amounts for the off
balance sheet items:
• Banker’s Acceptance $20 million to entities with an A+ rating.
20% conversion factor; risk weight is 50%
$20 million  0.20  50% = $2 million.
• Three year fixed for floating interest rate swap with notional value of $75
million and a replacement cost of $3 million.
Potential exposure:
Amount x conversion factor : $75 million  0.005 = $375,000
Current exposure: = replacement cost
= $3 million.
The total credit equivalent amount
= $3, 375,000
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• Three year forward contract to sell euros for $10 million; replacement cost of
$1 million.
Potential exposure:
$10 million  0.05 = $500,000
Current exposure:
The current exposure is the replacement cost of $1 million.
The total credit equivalent amount = $1,500,000
Risk weight = 100%
Equivalent on balance sheet risk weighted amount
=$1,500,000  1.00 = $1,500,000
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Tier 1 Capital = $8,000,000
Tier 2 Capital = $5,610,937 million = $4 million + $1,610,937
Tier 2 Capital is calculated as follows:
• Only $4 million in 10 year subordinated debt can be counted because this
category is limited to no more than 50% of Tier 1 Capital.
• Only part of the $10 million loan loss reserve can be counted; (maximum
amount of loan loss reserves that can be counted as capital is 1.25% of risk
weighted assets
or $1,610,937 = $128,875,000 * 0.0125 in this case.
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Minimum capital requirements per category are as follows:
•
Well Capitalized: (Zone 1)
TC/RWA  10%, AND Tier 1/RWA  6%, AND TC/TA  5%
•
Adequately Capitalized: (Zone 2)
TC/RWA  8%, AND Tier 1/RWA  4%, AND TC/TA  4%
•
Undercapitalized: (Zone 3)
TC/RWA < 8%, OR Tier 1/RWA < 4%, OR TC/TA < 4%
•
Significantly Undercapitalized: (Zone 4)
TC/RWA < 6%, OR Tier 1/RWA < 4%, OR TC/TA < 3%
•
Critically Undercapitalized:(Zone 5)
TC/RWA  2% OR Tier 1/RWA  2%, OR TC/TA  2%
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Is the bank “well capitalized”?
Total Capital or Allowable capital = Tier 1 + Tier 2 = $13,610,937
•Total Capital/ RWA= $13,610,937 / $128,875,000 = 10.56%
•Tier 1 Capital / RWA=
$8,000,000 / $128,875,000 = 6.21%
•Total Capital / Total Assets=$13,610,937 / $137,000,000 = 9.94%
This bank is well capitalized:
Well Capitalized: (Zone 1)
Total Capital /RWA  10%,
AND Tier 1 Capital /RWA  6%,
AND Total Capital/TA  5%
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Basel II has three main pillars to help ensure the safety and
soundness of the financial system:
Pillar 1:
Maintain and update regulatory capital requirements for
credit, market and operational risk. The addition of capital
requirements for operational risk is new.
Pillar 2:
Promote disclosure of the institution’s capital structure, risk
exposure and capital adequacy.{Much of this is new}.
Pillar 3:
Stress the continued importance of the regulatory evaluation
process in addition to capital requirements. In particular
ensuring that the bank has valid internal control procedures.
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Foreign vs. Domestic Regulation
• Regulation of U.S. banks in foreign countries
– the Overseas Direct Investment Control Act of 1964
restricted U.S. banks’ ability to lend to U.S.
corporations to make foreign investment
– the North American Free Trade Agreement
(NAFTA) of 1994 enabled U.S. banks to expand to
Mexico and Canada
– a 1997 agreement between 100 countries (under the
World Trade Organization (WTO)) began
dismantling barriers inhibiting foreign direct
investment into emerging countries
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Foreign vs. Domestic Regulation
• Regulation of foreign banks in the U.S.
– the International Banking Act (IBA) of 1978 declared foreign
banks are to be regulated the same as national domestic banks
• foreign banks are subject to Federal Reserve examinations
– the Foreign Bank Supervision Enhancement Act (FBSEA) of
1991 gave additional powers to the Federal Reserve
• Fed must approve new subsidiary, branch, agency, or representative
offices of foreign banks in the U.S.
• Fed has the authority to close foreign banks operating in the U.S.
• only foreign banks with access to the FDIC can accept consumer
deposits
• state-licensed foreign branches are regulated as national branches
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