Ch. 11 Banking Regulation 

What are the types of government safety nets?

Lecture Dates: November 12th– 17th 

∙ 8 Categories of Banking Regulation 

o Deal with asymmetric information  

1. The government safety net

∙ Government Safety Net 

∙ To prevent bank panics and failure  

∙ Types of Government Safety Nets 

∙ FDIC (Federal Deposit Insurance Corporation)  

∙ Central Bank as lender of last resort  

∙ Government Funding (TARP)  

∙ Bank Panic or Run 

∙ Northern Rock Bank  

What are the four elements of risk management?

∙ 1st bank to be affected by mortgage crisis

∙ Bank run  

∙ Depositors begin to lose confidence in a bank when they question the  value of the bank’s (underlying assets)

∙ Causes a serious problem as it is usually followed by the  

contagion effect  We also discuss several other topics like Who wrote “an essay on the principle of population” (1798)?
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∙ It affects good banks with otherwise would not have any  

problems

∙ Bad Loans 

∙ Bank becomes insolvent  If you want to learn more check out What is the standard sop expression for segment d is?

∙ Bank run – large # banks in late 19th and early 20th century  

∙ Liquid (first come first serve)

What is fdic (1934)?

∙ Bank panic  

∙ Spread to other healthy banks

∙ Costly for economy as a whole  

∙ Prevention  

∙ FDIC (1934)

∙ Coverage of up to $250,000

∙ Not stocks, bonds, US Treasury bills, US Treasury bonds,  

or US Treasury notes

∙ Reduce the bank failure substantially

∙ 1930-1933 – 2,000 / year

∙ 1934 -1981 – 15 / year

∙ Methods to handle failed banks  

∙ Payoff

∙ Fails the bank and pays off the deposits  

∙ Smaller banks

∙ Limited coverage for depositors  

∙ Purchase and Assumption  

∙ Arranges the sale of the failed bank to willing  Don't forget about the age old question of What is the study of energy and its transformations?

purchaser who takes over all of the failed banks  

deposits  

∙ Side Effects of the Safety Nets 

∙ Existence of insurance provides increased incentives for risk taking  by banks  

∙ And depositors have little reason to monitor banks  

activities

∙ Increase moral hazard problem

∙ Depositors have little motivations to distinguish good banks from  bad banks  Don't forget about the age old question of What is a theory that places the sun as the center of the universe, and the planets orbiting around it?
We also discuss several other topics like The raf kinase activates what cascade?

∙ Increase adverse selection  

2. Restrictions on bank assets holdings  

a. Attempts to restrict banks from too much risk taking

i. Restricting on assets holdings  

1. Prohibit holdings of common stock

2. Promote diversification  

ii. Set Capital Requirements  

1. Minimum leverage ratio (5% assets as capital)  

2. Basel Accord: risk-based capital requirements(8% risk

weighted assets as capital)  

a. Caused regulator arbitrage  

3. Capital Requirements  

4. Chartering and bank examination  

a. Chartering – screening of proposals to open new banks

∙ Required license from gov  

o Deal with adverse selection problem  

b. Examination – scheduled and unscheduled on site exams

∙ Monitor capital requirements and restrictions on assets holding  o Deal with moral hazard problem  

▪ CAMELS ( Capital adequacy, Asset quality,  

Management, Earnings, Liquidity, Sensitivity to market  

risk)

∙ Bank Examiners

o OCC – national  

o Fed – member state

o FDIC – other banks

o State Government  

5. Assessment of risk management  

∙ Financial Innovation – exposed banks to new environment in which a  bank can be driven into a problem more rapidly

∙ Examiners place greater emphasis on evaluating soundness of  

management processes for controlling risks  

∙ 4 elements of Risk Management  

∙ Quality of (internal) overnight provided  

∙ Adequacy of polices and limits  

∙ Quality of the risk measurement and monitoring systems  

∙ Adequacy of internal controls  

∙ Interest-Rate Risk Limits 

∙ Internal policies and procedures

∙ Internal management and monitoring  

∙ Implementation of stress testing and Value-at risk (VAR)

o Expecting losses by predicting future crisis  

6. Disclosure requirements  

a. To help the market assess the quality of banks portfolio and the amount of  the banks exposure to risk

b. Requirements to adhere to standard accounting principles and to disclose  wide range of information  

c. Eurocurrency Standing Committee of the G-10 Central Banks also  recommends estimates of financial risk generated by the firms internal  monitoring system be adapted for public disclosure  

7. Consumer protection

∙ Provide consumer necessary info to protect themselves

i. Truth-in-lending mandated under the Consumer Protection Act of 1969 ii. Fair Credit Billing Act of 1974

iii. Equal Credit Billing Act of 1974 – extended in 1976

iv. Community Reinvestment Act to prevent “redlining”

∙ Can’t exclude residents in certain areas  

v. Set up “consumer financial protection bureau (CFPB) – Dodd-Frank Act  ∙ Wallstreet reform

8. Restrictions on competition  

∙ Increased Competition  

∙ Decline in profitability

∙ Increase moral hazard incentives for banks to take on greater risk ∙ Regulations to protect banks form competition

∙ Branching restrictions – McFadden Act

∙ Glass-Steagall Act – Commercial & investment separated

∙ Disadvantages 

∙ High consumer and decreased efficiency charges  

International Banking Regulations 

∙ Similar to US  

∙ Chartered and supervised  

∙ Deposit insurance  

∙ Capital requirement

∙ Particular problems  

o Easy to shift operations from one country to another

o Unclear jurisdiction lines

▪ Collapse of BCCI  

o Regulation and supervision is more difficult  

∙ Regulators (Tom) cannot take preventative measures so they will never catch  banks (Jerry)  

S & L and Banking Crisis in the 1980’s 

∙ Financial Innovations  

o Increased competition in the source of funds and use the uses of funds  ▪ Decrease the profitability of banking business  

o New environment (not 3 (get) – 6 (change) – 3 (profit)  

▪ New financial instruments like derivatives  

▪ Expose banks to higher risks

∙ Deposit Insurance  

o Increase moral hazard problem

∙ Deregulations  

o Allowed banks to get involved more risky activities  

o Depository Institutions Deregulations and Monetary Control Act (DI DMCA) of  1980

o Depository Institutions Act of 1982

▪ Expanded power to engage in risky activities

▪ Increase deposit insurance from$40k to $100k per account  

▪ Increase Moral Hazard Problems  

∙ Consequences 

1. Many S&L managers were lack of require expertise in new businesses and  environment

2. A rapid growth of new lending especially in real estate sector led to excessive risk  taking  

3. Deficiency of regulatory resources

o Plus macroeconomic environment of high interest rates (cost decrease) and the subsequent recession in the early (default of barrowers increase)

o Losses for S & L mounted to $10 billion (1981-1982)  

o More than half of S&L got insolvent by 1982  

▪ Kept running business because no money to buy them out

o Regulatory Forbearance by FSLIC – reluctant to close the insolvent S&L’s ▪ Insufficient funds to close insolvent S&L’s

▪ Too close to the people they were supposed to regulate  

▪ Did not want to admit agency was in trouble 

o Response of the troubled S & L 

▪ “long bomb” strategy

∙ Further higher risks

∙ Zombie S&L attracted business from healthy S&L’s by offering  higher investment rates  

o Competitive Equality in Banking Act of 1987 

▪ Inadequate funding to solve the problem together with continued  forbearance in Texas  

∙ Losses of S&L reached $20B in 1989  

o Principle Agent Problem  

▪ Structure of Political system  

▪ Regulators & Politicians as agents while voters-taxpayer as principals  ∙ Do not have the same incentives as taxpayers  

∙ Taxpayers bear the cost of any losses by the deposit insurance ∙ Regulators  

o Wish to escape blame

o Want to protect careers by acceding to pressure from  

politician

∙ Politicians 

▪ Surrounding S&L Crisis 

∙ Made easier for S&L to take risky activities  

∙ S&L industry unwilling to allocate the necessary funds for the  S&L regulatory agencies  

∙ Regulatory agencies cut back examinations as they were short staffed  

∙ Inadequate funding to close down the insolvent S&L’s  

o Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989

▪ George H.W. Bush proposed adequate funding to close down insolvent  S&L’s  

▪ Restructured Regulatory Apparatus 

∙ Cost of bailout approximately $160.1 Billion

∙ More than 2-3% of GDP  

∙ Selling gov’t securities  

∙ Re-restricted assets choice  

∙ 747 S&L failed

o Banking Crisis Everywhere 

▪ Not unique to US

▪ Existence of government safety net increases moral hazard incentives for  excessive on the part of banks  

▪ Scandinavian Countries, Latin America, Russia and Eastern Europe  ▪ Japan 1990’s, China 2000-2001, East Asia in 1997

o Dynamics of past US Financial Crises  

▪ Stage 1 Initiation of Financial Crisis  

∙ Mismanagement of financial liberalization/ innovation  

∙ Asset price boom and bust  

∙ Spikes in interest rates

∙ Increase in uncertainty

▪ Stage 2 Banking Crisis  

▪ Stage 3 Debt Deflation  

o Subprime Financial Crisis 2007-2008 

▪ Financial Innovations emerge in the mortgage markets 

∙ Subprime and Alt-A mortgages  

∙ Mortgage-backed securities (MBS)

∙ Collateralized debt of obligations (CDOs)

▪ Housing price bubble forms  

∙ Global Savings Gluts Increase in liquidity from cash flows surging  to the US  

∙ Development of subprime mortgage market fueled housing  

demand and housing prices  

▪ Agency Problem Arise 

∙ “Originate to distribute” model is subject to principal (investor)  agent (mortgage broker) problem  

∙ Borrowers had little incentives to disclose information about their  ability to pay  

∙ Commercial and investment banks had weak incentives to assess  the quality of securities  

▪ Information problems surface

▪ Housing price bubble bursts  

▪ Crisis spreads globally  

▪ Banks balance sheet deteriorate  

∙ Write off bad loans  

∙ Sell of assets and credit restriction ▪ High profile firms fail

∙ Bear Stearns  

∙ Fannie Mae and Freddie Mac  

∙ Lehman Brothers, Merrill Lynch ect.