Bank History and
Regulation
Economics

Adam Smith and the “Invisible hand”
 As
individuals pursue their self interest, they promote
the well-being of everyone.
 19th century example: British making loans to build
railroads in U.S.

What problems might prevent the invisible hand
from operating? (market failure)

Role of Intermediaries
Role of government

Adverse Selection: Akerlof (1970)

Adverse Selection: poor quality products are
attracted to markets

Buyers are willing to pay
 $15,000
for good used car
 $ 7,500 for a “lemon”

Many Sellers
 50%
good cars: willing to take $12,500
 50% bad cars: willing to take $7,500
Adverse Selection

Buyers have no information about car quality –
50/50 proposition
 On
average, expect to get a car worth
0.50(7,500)+0.50(15,000) = $11,250
 Buyers will not pay more than $11,250 for any car.




Good cars exit market
All bad cars sold for $7,500
Good sellers can’t credibly claim to be “good”
Market Failure
Adverse Selection

Adverse Selection in Financial Markets
 Firms

needing capital
Solution
 Create

more information
Disclosure requirements (regulation)
 Use
financial intermediaries who can monitor
Restrictions on entry
 Disclosure requirements

Moral Hazard

Moral hazard: Incentives change after
transaction takes place.
 When
insured, take more risks
 Once financed, tendency to slack

Example:
 CEO
buys corporate jet with stock issue
 Banks invest depositor money in risky ventures
Moral Hazard

Solution
 financial

Align incentives of CEO with shareholders
 Use

markets
financial intermediaries who can monitor
Regulation on assets and activities (regulation)
Other issues

Financial intermediaries also promote the
invisible hand by:

Lowering transaction costs
 Economies

of scale
Promoting risk sharing
 Pooling
capital
 Hedging expertise
Ch 10 – History of Banks

Crazy complex system of regulation
 Comptroller
of the currency
 Federal Reserve
 State Banking Authorities

When faced with regulation, banks
develop methods to avoid costs
History of Banks

American’s have distrusted big banks

19th Century: states issued charters to banks
 Raised
funds by issuing own currency
 No regulation – often failed

1863 – National Bank Act
 Established
national banks chartered by federal gov
 Heavy tax on bank notes issued by state banks
 State banks survived by acquiring funds through
deposits
 Dual banking system
Central Banking

1913: Federal Reserve System Created

National Banks required to become members of the
Federal Reserve System

Central Bank Established

State Banks allowed option to join

Most did not
Structure of Banking Industry

McFadden Act of 1927
 No
branching across state lines
 National Banks had to conform to state
regulations and could only branch in their
home state

Glass-Steagall Act of 1933
 Separation
of I-Banks from Commercial Banks
Glass-Steagall Act (1933)

I-banking activities of commercial banks blamed
for bank failures during Great Depression

Investment bank:
 Raises
capital by “underwriting” securities
 Advises on merger activities
 Research and brokerage services
 Security Dealers
Glass-Steagall Act (1933)

Separation of I-Banks from Commercial Banks
 Commercial
Banks
Prohibited from underwriting or dealing in securities
 Limited banks to debt securities approved by regulators

 Investment

Banks
Prohibited from commercial banking activities
Erosion of Glass-Steagall

Banks at a competitive disadvantage
 Good economy – people invest in securities
 Bad economy – people turn to traditional banks
 Barriers to “economies of scope”

Financial Innovation:
 Brokerage

firms develop money market mutual funds.
Pressure from Federal Reserve
 Used
loopholes in system to allow commercial banks to
engage in limited underwriting
 Allowed Citicorp and Travelers to merge
Gramm-Leach Bliley (1999)

Allows I-banks to purchase commercial banks

Allows commercial banks to underwrite
insurance and securities.
Erosion of McFadden Act

Bank Holding Companies
 Holding
company can own banks across state lines

ATM’s owned by someone other than the banks.

Mcfadden repealed by Riegle-Neal act of 1994
 Has
led to consolidation trend
Decline of Traditional Banking

Traditional Banking
 Make
long-term loans
 Fund them by making short-term deposits

Greater Competition for Deposits

Regulation Q




Maximum interest paid on deposits about 5%
Can’t pay interest on checking accounts
Rise in inflation in 1960’s: higher rates
Money Market Mutual Funds
Decline of Traditional Banking

Greater Competition for Assets




Junk Bonds
Commercial paper
Securitization
Bank’s responses:
 Pursue
riskier activities
 Pursue off-balance sheet activities


Loan sales
Fee’s for services: fx trades, loan commitments, banker’s
acceptances
Ch 11 – Bank Regulation

Banks solve some asymmetric info problems


but create others – depositors need to monitor and
evaluate banks
Regulation deals with asymmetric info problems

But creates others – provide insurance and perform
other activities that may promote moral hazard
Government Safety net


Free rider problem faced by depositors
Adverse selection and bank panics
 1819,

1937, 1857, 1873, 1884, 1893, 1907, 1930-1933
Deposit Insurance: FDIC insurance

Moral Hazard – depositors have no incentive to monitor
 “Too
Big to Fail”
Restrictions on Bank Asset
Ownership

Commercial Banks:

High quality corporate bonds are allowed but subject to
restrictions

Common stock investment is allowed in subsidiaries of
banks or bank holding companies that are legally separate
entities


Gramm-Leach-Bliley (1999)
Except in rare instances, banks restrict themselves to
“investment-grade” securities (high rated bonds)

“prudent man” rule of law: The fiduciary is required to invest trust
assets as a "prudent man" would invest his own property
Other Regulations

Capital requirements
 Basel Accord:
banks must hold at least 8% of “riskweighted” assets and off-balance sheet items.

Bank Supervision

Supervision of Risk Management

Disclosure Requirements
How Good Are the Regulators?



Burst of Financial innovation in 1960’s and
1970’s
Banks have incentive to engage in riskier
activities – further fueled by deposit insurance.
New legislation in early 1980’s:
 S&L’s




and Mutual Savings allowed
40% of assets in commercial real estate loans
30% in consumer lending
10% in commercial loans and leases
10% in “direct investments”: junk bonds, common stock, etc.
 FDIC
up from $40k to $100k
 Phased out Regulation Q
How Good Are the Regulators?

S&L’s regulated by Federal Savings and Loan
Incorporation (FSLIC) which lacked the expertise
to monitor effectively.

Rising rates further increased moral hazard.
 S&L’s

bread and butter was fixed-rate mortgages.
Regulators refrained from closing insolvent S&L’s
 Further

increased moral hazard
Bank Failures increased dramatically
How Good Are the Regulators?

Financial Institutions Reform, Recovery, and
Enforcement Act of 1989





Rearranged how banks are regulated
Infusion of capital to bailout insolvent institutions
New restrictions on asset holdings of S&L’s
Increased capital requirements
FDIC Improvement Act of 1991


Increased FDIC’s ability to borrow from treasury
FDCI charge higher deposit insurance premiums