Banking Regulation
Recall that the financial sector provides the efficient
transfer of savings towards investment projects
Gross Domestic Savings ($1.8T)
Foreign Savings ($640B)
Government Deficit ($400B)
S + (Imports – Exports) = I + (G-T)
Gross Private Investment ($2T)
Gross Private Investment represents the purchase of new
capital goods – one of the primary sources of growth in the
economy
A majority of external funds raised by non-financial
businesses come from bank loans. In particular, small
businesses rely entirely on banks for financing
Stocks
2%
Other
6%
Bonds
30%
Loans
62%
There is a moral hazard problem/adverse selection
problem between both the bank and its depositors as well
as between the bank and its potential loan customers
Depositors
This problem must
be dealt with
through regulation
Loans
Bank
A bank can deal with this problem
with:
•Credit Scoring
•Collateral
•Optimal Debt Contracts
Depository Institutions are broadly defined as businesses that
accept deposits and make loans
Depository Institutions
Commercial
Banks
Savings &
Loans
Savings
Banks
Credit
Unions
Non-Bank Thrifts
•Deal almost exclusively in short term deposits and
mortgages
•Are generally mutual companies (depositors are the
owners)
•Are allowed to hold corporate equities/bonds
All Depository Institutions in the US are chartered
Depository Institutions
Commercial
Banks
National Banks
Comptroller of the
Currency
State Banks
State Authority
Savings &
Loans
Savings
Banks
Credit
Unions
Federal Associations
Office of Thrift
Supervision
Federal Unions
National Credit
Union Administration
State Associations
State Authority
State Unions
State Authority
Federal Reserve Membership (1913)

National Banks are Required to be members
of the Federal Reserve System (Membership
is optional for state banks)



Federal Reserve members are required to
purchase stock in the federal reserve system.
Federal Reserve members provide input to the
election of Federal Reserve Board Members
The Federal Reserve provides check clearing
services
Of the 7,769 banks
in 2003, a vast
majority are nonmember state
banks
National Banks
2001
State Banks
(Non-Member)
4833
State Banks
(Non-Member)
935
Federal Deposit Insurance (1934)

Federal reserve members are required to
purchase deposit insurance. Insurance is
optional for state banks (98% of all banks
have deposit insurance)
FDIC insured banks are charged up to 27
cents per $100 of eligible deposits
 All deposits up to $100,000 are insured by the
FDIC.

A timeline of Banking Regulation
Restrictions on
Competition
Banking Act
McFadden Act
Holding Company Act
Monetary Control Act
1933
1863
Restrictions on
activities
Riegle-Neal
Great Depression
1999
1956
1927
1980
1994
Graham - Leach - Bliley
Holding Company Act
Glass - Steagall
Until the mid 1900’s, we were a nation of unit banks
Year
Number of Banks
Total Branches
1900
12,500
13,000
2000
7800
68,000
McFadden Act (1927)
National Banks
State Banks
Prohibited from
interstate
branching
Unit Banking
Must comply
with state
branching rules
Main Office
Limited Branching
Statewide Branching
Branch Offices
Following the great depression, the activities of
commercial banks were severely restricted
The Glass-Steagall Act of 1934 was
designed to put a wall between
commercial banking and investment
banking
Glass-Steagall (1934)
Commercial Banks are restricted from
participating in equities markets
Interest rates on non- transaction deposits
is restricted to be below 5.25%
No interest allowed on transaction
deposits
Regulation Q
Branching Restrictions could be avoided by forming
holding companies
Main Office
Holding Company
Branch Offices
Subsidiaries
Illegal under the McFadden Act
Legal under the McFadden Act
The Bank Holding Company act allowed holding companies with only
one bank to provide limited non-bank financial services on an
interstate basis. This created a loophole around Glass-Steagall!!
Prior to Bank Holding Company Act
Holding Company
Bank
Bank
After Bank Holding Company Act
Holding Company
Bank
Non-Bank
Branches
Collects deposits,
but doesn’t make
loans
Non- Bank
Offices
Financial
Services
Makes loans, but
doesn’t collect
deposits
Deregulation of the Financial Services sector
began in the 1980’s.
The Monetary Control Act (1980)
Began the phase out of interest rate ceilings
at depository institutions
Imposed uniform reserve requirements on
Banks and Thrifts
Riegle-Neal Interstate Banking and Branching Efficiency Act (1994)
Allowed holding companies to acquire banks in any state
Allowed banks to branch across state lines
Financial Services Modernization Act (Graham Leach-Bliley) (1996)
Permitted financial holding companies offering banking,
insurance, securities and other services under one controlling
corporation (allowed Citicorp to buy Traveler’s Insurance)
Problems with Monitoring
The CAMELS System
Capital Adequacy
Asset Quality
Management
Earnings
Liquidity
Sensitivity to Interest Rate Risk
Off Balance Sheet Activities
Derivatives
Financial Guarantees (SLC)
Asset Securitization
Banks are monitored using the
camels system. However, It’s
not always easy to accurately
assess the risk a bank is taking
on
In 1995, Barings Bank went
bankrupt due to losses in the
Derivatives market. At the time, it
was holding $60B worth of
derivative contracts – a
staggering number when
compared to Baring’s reported
equity of $615M!!
Problems with Restricting Activities
Banks compete with other financial services companies
as well as other banks!!
During the late 1970’s, market interest rates rose well above 10%,
but banks were restricted by regulation Q to pay only 5.25% in
savings accounts and 0% on checking accounts
Banks
Checking Accounts (0%)
Financial Companies
Money Markey Mutual
Funds (10%)
As households pulled their money out of banks, mortgage and
small business lending was seriously curtailed!
Problems with Restricting Competition
(Branching)
Restricting entry gives banks limited monopoly power, they can
use this to increase profits at the customers expense!
Banking is a decreasing cost industry (i.e. large startup costs, but
small marginal costs). By forcing banks to remain small and local,
they are forced to operate at an inefficiently small scale!
By forcing banks to remain in a confined geographical location, you
are forcing them to take on idiosyncratic (area specific) risk!
Since the 1970’s,
there has been
tremendous growth
in international trade
6
5
4
3
World Trade (in
Trillions of $s)
2
1
0
1979
1986
1989
1992
1995
1998
Even more
impressive is the
growth in foreign
exchange
400
350
300
250
200
150
100
50
0
Currency
Transactions
(in Trillions of $s)
1979 1986 1989 1992 1995 1998
US Banks locate facilities abroad to aid in international trade as well as
to avoid regulation and taxes
US Banks Operating Abroad
Subsidiaries: Governed by Federal Reserve Regulation K – must
be involved in business “closely related to banking.
International Banking Facilities: Accepts time deposits and
makes loans to foreign households & firms. Exempt from
reserve requirements, but may not do business in the US.
Edge Act Corporations: Makes loans/accepts deposits. Can deal
with both US and foreign citizens , but is limited to international
trade transactions
Branches: Offer a full line of banking services,
but are subject to foreign laws
Likewise for Foreign Banks…
Foreign Banks Operating in the US
Agency Office: Can’t accept deposits from US citizens, but can
transfer funds from abroad and make loans in the US
Branches: Offers a full range of banking services
for US citizens
Subsidiaries: Treated as a US bank. Subject to all US
regulations. Subsidiaries may also set up edge act
corporations and international lending facilities
Important Dates in International Banking
Bank for International (BIS) Settlements
Created
International Banking Act
Basle Accords I
Foreign Bank Supervision Act
BCCI Scandal
1930
1978
1988
1991
United States
United Kingdom
Federal Reserve
Bank of England
Under whose jurisdiction do international
banks fall? (it’s a gray area )
Regulating International
Banking
International Banking Act (1978)
Brought foreign banks operating in the US
under federal regulation for the first time
Foreign banks, however, were not monitored
as closely as US banks
Foreign Bank Supervision Act (1991)
Passed shortly after the BCCI scandal
Gave the Federal Reserve and the Comptroller
of the Currency greater control over foreign
banks operating in the US
Bank For International Settlements (1930)

Established to handle German WWI
reparations, the BIS has become a center
for international cooperation.
Played a central role in the Bretton Woods
Exchange Rate System
 Integral in the Establishment of the Euro


The BIS is like a central bank for central
banks.
The Basle Accords established uniform capital
requirements for banks around the world. Equity
capital was required to equal at least 4% of a bank’s
risk weighted assets.
Risk weighted assets
Asset
Cash and equivalents
Government securities
Risk Weight
0
0
Interbank loans
Mortgage loans
Ordinary loans
0.2
0.5
1.0
Standby letters of credit
1.0
US Banking Sector
Assets
Liabilities
$ 54B (Cash)
$ 800B (Checking)
$ 46B (Reserves)
$ 4,500B (Saving)
$ 2,000 (T-Bills)
Loans
Loans
$ 1B (Discount)
$ 2,701 (Mortgage)
$ 3,000 (Other)
Res. Req. = 5%
Risk Weighted
Assets
$1,000B (Equity)
(0)( $54B) = $0
(0)($46B) = $0
(0)($2,000B) = $0
(.5)($2,701B) = $1,350.5B
+ (1)($3,000B) = $3,000B
$4,350.5B
Required Equity = (.04)($4350.5B) = $174.2B
Top Ten World Banks
Bank
Assets
(Billions)
Citigroup (US)
$1,497
JP Morgan + Bank One (US)
$1,097
Mizuho Financial Group (Japan)
$1,080
Bank of America + First Union (US)
$851
UBS (Switzerland)
$851
Sumitomo Mitsui (Japan)
$844
DeutscheBank (Germany)
$795
Mitsubishi Tokyo (Japan)
$781
HSBC (UK)
$759
BNP Paribas (France)
$744
Problems with International
Regulation

The key issue is that the banking industry
in Japan and Europe is Fundamentally
different from the US.
European Banking
Unlike the US, European Banks are
allowed to engage in securities markets
(universal banking)
 In fact, in Europe, banks are generally
significant shareholders in European
companies.
 Banks rely much more on equity than
deposits.

Japanese Banking

Japanese industry is organized into industrial
groups (keiretsu)







Mitsubishi
Mitsui
Sumitomo
Fuyo
Daiichii
Kangyo
Sanwa
Japanese Banking

These “groups” are both vertically and
horizontally integrated and are comprised
of a very large number of companies:
Sumitomo has 15 divisions ranging from
electronics to mining to consumer goods.
 Sumitomo controls assets equal to $50T.

Japanese Banking

Each “group” has its own bank which
handles its finances. This “main” bank
Owns equity in member firms
 Monitors member firms
 Provides credit for member firms.
