Chapter 11
Economic
Analysis of
Banking
Regulation
Asymmetric Information
and Bank Regulation
• Government safety net: Deposit insurance and
the FDIC
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Short circuits bank failures and contagion effect
Payoff method
Purchase and assumption method
• Moral Hazard
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Depositors do not impose discipline of marketplace
Banks have an incentive to take on greater risk
• Adverse Selection
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Risk-lovers find banking attractive
Depositors have little reason to monitor bank
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Too Big to Fail
• Government provides guarantees of
repayment to large uninsured creditors
of the largest banks even when they are
not entitled to this guarantee
• Uses the purchase and assumption
method
• Increases moral hazard incentives for
big banks
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Financial Consolidation
• Larger and more complex banking
organizations challenge regulation
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Increased “too big to fail” problem
Extends safety net to new activities,
increasing incentives for risk taking in
these areas
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Restrictions on Asset Holding
and Bank Capital Requirements
• Attempts to restrict banks from too much
risk taking
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Promote diversification
Prohibit holdings of common stock
Set capital requirements
• Minimum leverage ratio
• Basel Accord: risk-based capital requirements
• Regulatory arbitrage
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Bank (Prudential) Supervision:
Chartering and Examination
• Chartering (screening of proposals to open
new banks) to prevent adverse selection
• Examinations (scheduled and unscheduled) to
monitor capital requirements and restrictions
on asset holding to prevent moral hazard
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Capital adequacy
Asset quality
Management
Earnings
Liquidity
Sensitivity to market risk
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Assessment of Risk Management
• Greater emphasis on evaluating soundness of
management processes for controlling risk
• Trading Activities Manual of 1994 for risk management
rating based on
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Quality of oversight provided
Adequacy of policies and limits
Quality of the risk measurement and monitoring systems
Adequacy of internal controls
• Interest-rate risk limits
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Internal policies and procedures
Internal management and monitoring
Implementation of stress testing and Value-at risk (VAR)
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Consumer Protection
• Truth-in-lending mandated under the
Consumer Protection Act of 1969
• Fair Credit Billing Act of 1974
• Equal Credit Opportunity Act of 1974,
extended in 1976
• Community Reinvestment Act
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Consumer Protection Laws Regarding Debt
• Truth in Lending Act of 1968
The Truth in Lending Act protects consumers from being
misled in situations involving credit. Most notably, it
requires that all fees and costs be provided to the
borrower clearly up front. This is so consumers can
compare credit offers before committing to one.
In a credit transaction, the lender must both disclose and
define all of the following: APR, finance charges, grace
period, credit line, minimum payments, all annual fees,
and all other applicable fees.
Additionally, this act provides consumers with a 3-day
“cooling off” period after signing on to certain real estate
loans, such as mortgages, during which an individual
may change his or her mind without penalty.
Source: DebtHelp.com
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• Fair Credit Billing Act of 1974
The Fair Credit Billing Act also amended the Truth in
Lending Act. It protects consumers from liability for billing
errors on credit accounts. Borrowers have the right to
dispute mistakes that are out of their control, including
payments made but not credited, unauthorized charges,
and simple computational errors.
The dispute must be made within 60 days of the error.
Within two billing cycles of the dispute (and 90 days), the
lender must resolve the dispute.
In addition, the Fair Credit Billing Act gives individuals
the right to deny payment for services or products that
are unacceptable.
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The Community Reinvestment Act
The Community Reinvestment Act is
intended to encourage depository
institutions to help meet the credit needs
of the communities in which they
operate, including low- and moderateincome neighborhoods, consistent with
safe and sound banking operations. It
was enacted by the Congress in 1977
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Restrictions on Competition
• Justified by moral hazard incentives to
take on more risk as competition
decreases profitability
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Branching restrictions (eliminated in 1994)
Glass-Steagall Act (repeated in 1999)
• Disadvantages
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Higher consumer charges
Decreased efficiency
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International Banking Regulation
• Similar to U.S.
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Chartered and supervised
Deposit insurance
Capital requirement
• Particular problems
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Easy to shift operations from one country
to another
Unclear jurisdiction lines
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Regulation
• Applies to a moving target
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Calls for resources and expertise
• Details are important
• Political pressures
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Additional - Usury Laws
Many state's laws provide that you cannot
lend money at an interest rate in excess
of a certain statutory maximum.
For IOWA, the legal rate of interest is 10%.
In general consumer transactions are
governed at a maximum rate of 12%.
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Very important to know
The Prime Interest Rate is the interest
rate charged by banks to their most
creditworthy customers (usually the most
prominent and stable business
customers).
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LIBOR : rate stands for "London Inter-Bank
Offered Rate."
It is based on rates that contributor banks in
London offer each other for inter-bank
deposits.
LIBOR is a rate at which a fellow London
bank can borrow money from other
banks.
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1980s S&L and Banking Crisis
• Financial innovation and new financial
instruments increasing risk taking
• Increased deposit insurance led to
increased moral hazard
• Deregulation
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Depository Institutions Deregulation and
Monetary Control Act of 1980
Depository Institutions Act of 1982
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1980s S&L
and Banking Crisis (cont’d)
• Managers did not have expertise in
managing risk
• Rapid growth in new lending, real estate
in particular
• Activities expanded in scope; regulators at
FSLIC did not have expertise or resources
• High interest rates and recession increased
incentives for moral hazard
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1980s S&L and Banking Crisis:
Later Stages
• Regulatory forbearance by FSLIC
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Insufficient funds to close insolvent S&Ls
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Established to encourage growth
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Did not want to admit agency was in trouble
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Principal-Agent Problem
for Regulators and Politicians
• Agents for voters-taxpayers
• Regulators
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Wish to escape blame (bureaucratic gambling)
Want to protect careers
Passage of legislation to deregulate
Shortage of funds and staff
• Politicians
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Lobbied by S&L interests
Necessity of campaign contributions for expensive
political races
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The Financial Institutions Reform,
Recovery, and Enforcement Act of 1989
• Regulatory apparatus restructured
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Federal Home Loan Bank Board relegated
to the OTS
FSLIC given to the FDIC
• Cost of the bailout approximately $150
billion
• Re-restricted asset choices
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Federal Deposit Insurance
Corporation Improvement Act of 1991
• Recapitalize the Bank Insurance Fund
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Increase ability to borrow from the Treasury
Higher deposit insurance premiums until the loans
could be paid back and reserves of 1.25% of
insured deposits maintained
• Reform the deposit insurance and regulatory
system to minimize taxpayer losses
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Too-big-to-fail policy substantially limited
Prompt corrective action provisions
Risk-based insurance premiums
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Deja Vu
• It is the existence of a government safety
net that increases moral hazard
incentives for excessive risk taking on
the part of banks
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Note: The original material provided by the textbook has been
extended to complement the concepts in the class.
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