‘Chapter 20 Banking Regulation ‘Asymmewie Information and Bank Regulation Govemient Safeyy Net DepestInsarance and the FDIC {Global Box: The Spread of Government Insurance Throngheat the World: Is This « Good Thing Restrictions on Asset Holdings and tank Capital Requirements Mini-Case Box: Basle 2 I Spinning Out of Control bank Supesvision: Chartering and Bxarnnatien: [Now Tech in Bank Supesvisson: Assessment of Risk Management Disclosure Reyuizemears Concaimes Prtcction Restrictions tm Competition E-Finance Blo: Electric Banking: New Challenges for Thaak Regulation Toernisionul Banking Regulation Probicms in Regulating Inernational Banking Summary ‘The 19806 US. Banking Criss Federal Deposit Insurance Coepotation Improvement Actof 1991 Banking Crises Tarouphout the Woeld Setalanavia Latin America Rusia and Eastern Europe Japan China Fast Asa Dija Ve All Over Again = Overview and Teaching Tips ‘This chapter restos an analytic way of thinking by conducting an analysis using the auese election and socal hazard concept to show olay eu regulatory systors as the for staloes and how i edo 2 ‘banking cess. The sapir hasan appendix available oa the websie hich provides a vase in Which the seat is asked w evaluate the FDICLA legislation to se if t Wall uahieve is ouls. Covering his case ia Glass san excellent way of getting the stadents to geview the matecal im dhe chapee, [Nove that Chuper 15 does net need tobe covered in ones tw teat this chapter, However, if Chapter 15 i ‘covered in class, Chapter 20 sa aise application of the analyse i that chapter. Indeed, the instructor ight waa o ston in class the counterparts in private Fianciad marksts to the methods bank regulators tke to cope With slverse selection an moral bazar™ Answers to End-of-Chapter Questions 1 There would be averse selection because people who might want to burn this propenty for some personal gain would actively wy toobtsin substantial fre insurance policies. Moral hazard cold alco tea problem because a perion With a fire insurance policy has less incentive to take meaaures to proventa fie CChartering bunks is the hank regulation that helps reduce the adverse seletion problem because it altempts to screen proposals for new banks to prevent rsk-prone enteeprenears and crooks fom ontraling them. Tewill not always work becatse rsk-prone enfreprenctts ind crooks have incentives hid ther true nature are thus may slip through the chartering proces, 3. Regulations that restrict banks fiom holding risky wscts directly decrease the moral hazard of tisk taking by the bunk. Requirement that ferce harks to have a avge amount of capita aso decrease tne hanks" incentives fer risk taking because banks now have more to lose if they ‘ail, Such regulations| ‘ill rot completely eliminate the moral hezard problem because bankers have incentives te hide their holdings er risky assets rom the egulators snd to overstate the amount of thei capital 4. The tenefits ofa too-big-to-fll poliey are that it makes bunk panes less likely, The eos ae that increases the incentives of meri hazard by big banks Who kris tat depositors don ve ncentives to monitor the bank's risk-aking activities. In adhiion, 1s an unfair poiey because discriminates aainst smal hanks, S. Because of-balance-shect activities do net eppear en bank balance sheets, they cannot be deal vith by simple bank capital requirements, which are bused on Bank assets, such ay lover Banking regulators have dealt with this problem by imposing an addtional isk-hase requirement that requires bans to set aside additonal bank capital fr different kinds oF of-halance- sheet activities, 6 Because with higher amounis of capital. hanks have move to lose if they take em too uch risk. Th capital requtements make it less likey that banks will take on excessive rs Bank supervision involves bank examinations in which bank eximiners assess six areas of the bank ropresented in the CAMELS rating (capital alequacy. assot quality, mznagemnt, comings, liquidity and sensitivity to market risk). A low score on the CAMELS rating allows the supervisors to declare ‘thank to bea “problem bunk,” making it more subject to Frequent examinations and to sanetions to edule the amount of isk taking 448 engaged in, Bank examines also check thatthe bank is following the rules and regulations and is not holding securities or loars that are too risky. All of these measures help ensure that banks are not taking on tco much risk, and thus promote a safer and sounder barking sjstem,‘The Bank Insurance Fund of the FDIC was recapitaized by allowing itt bortow more from the ‘Treasury and by raising insurance premiuuns. The bill educed the scape of deposit insurance by limiting brokered deposits and by limiting the too big1o-fal doctrine by forcing the FDIC to usc the Feast cost method of closing failed banks except under unusual circumstances, The bill has prompt ‘conective action provisions tht requires the FDIC to intervene earlice with stonger actions when hanks move into one of the weaker of the five classifications based on hank eapital, The limiting of {deposit insurance and prompt corrective action should reduce moral hazard risk-taking on the past of banks. The bill instructs the FDIC to come up with risk-based premiums which will increase the premium cost when the banks tke on more rsk, thus helping to reduce the moral hazard preblem. ‘The bill also mandates inereased reporting requirements and annual examinations to prevent the banks fiom taking on oo much tisk. It ako eshances regulation of Foreige banks in the US. 10 keep thea from operating in the U.S. if they are aking on too much risk With the advent of new financial instruments, a bank that is quite healthy ata particular point in time ccan be ¢riven nto insolvency extremely raprily from nsky irading in thes: insirummemts. "Thus, focus ‘on bank capital al point in time may net be effective in indicating whether a bank will be king on excessive risk in the near fiture, Therefore, wo make sure that banks are not taking on too much Fsk, nk supervisors now are focusing mareon whether the risk-management procedures in hanks kssp them from excessive risk taking thal might make a future bank failure mere likely Mere public information about the risk incurred by banks and the quality of their portfolio helps Stockholders, creditors and depositors o evaluate and monitor banks and pall thir funds out if the banks are taking on too much risk, Thus, inorder to prevent this from happening hanks are icelyto take on bese risk and this make bunk failures les likely. Eliminating o limiting the ameunt of deposi insurance would help reduce the moral hazard of excessive risk taking on the part of hanks. IC would, however, make kank failures and panies more i not be a very good idea, In general, yes. A national banking system will enable banks to diversity heir loan pontolios beter, thus decreasing the likelihood of bank falures, In addition it may make banks and hence the economy ‘more efficient and will help increase banks’ profitability which will make them healthier ‘The economy would enefitfrem reduced moral hazard; that is, banks would not want 1 take on too much risk because doing So would increase their deposi insurance premiums. The problem i, however, that itis difficult to monitor the degree of risk in bank asses because often only the bank ‘making the loans knows how risky they ae.14. Market-value accounting for bank capital would let the deposit insurance agency know quickly if a bank was falling below its capital requirement so that it could be closed down before it led to substantial losses forthe insurance agency, Also it would help keep banks from operating with negative capital when the moral hazard problem becomes especially severe and the bank takes on excessive risk, However, making accurate market-value calculations of hank capita isa complex task Since it would require some estimates and approximations, However, even if not fully accurate, if smarket-value accounting provides a more accurate assessment of bank capital than historical-cost accounting, it would lead to lower losses Irom the deposit insurance agency. = Quantitative Problems 1 Consider a failing bunk. A deposit of $150,000 is worth how much if the FDIC uses the payer ‘method? The purchase and assumprion meted? Which is more costly 10 1a AYES? olution: Under the puyot! method, large deposits pay better than $0,sollar. En this case, the 150,000 i wort heer than $150,000 x 0.90.= 813,000. Under the perchese and sorbed, and all accounts are worth thet fall «assumption policy, the hank is compte value, Lpfton, the second method! will have a lower cost to the insurance fund. However. if Aepositors fear loss under the payoff method, they are les ikely to maintain account balances in excess of $100,000 in single bank, 2. Consider a bank with te Ielowing bakince sheet Asses Liabilities Required Rewrves ‘BEmilfion | Checkable Deposits 6100 milion Excess Reserves ‘$3 million | Bank Capital This 45 million Mortgages $40 million Commercial Loans S10 million CCaleubite the hanks risk- weighted assets, Solution: Resesves and T-bills have a zero weight, So, 856 million has zero weight Mortgages cay a 50% weight. RW Assets = $40 milan x 0.50 = $20 millon Commercial DOE weight, RW Assets = 10 million Total sk weighted assets = $30 million, 3. Consider ahank withthe Fellowing balance sheet: Assets bilities Required Reserves ‘SEmillion | Checkable Deposits $100 milion Excess Reserves 83 million | Bank Capital 6 million Tills $45 million (Counmereial Loans '$50 million The bank commits to a Ioan agreement for $10 million a commercial customer. Calculate the bank's capital ratio before and alter the agreement. Calculate the bank's rsk-weighted assets before and after the agreement. Solution: Before the agreement, the capital ratio = 6/106 = 5.66%. Since the loan agreement has m0 accounting transaction, the capital ratio is the same alter. For risk-weighted assets: Reserves ani T-bills havea ze10 weight. So, $56 million has zer0 weight, ‘Commercial loans carry a 100% weight, RW Assets = $50 milion, ‘Total rsk-wei After the loan agreement, tisk-weighted assets: Reserves and T-bills have a zero weight. So $56 million has zero weight. ‘Commercial loans carry a 100% weight, RW Assets = $50 million, ‘Commercial loan commits are at 100%, RW Assets = $10 million ‘Total risk-weighted assets = $60 million.‘The actual risk-weighted assets forthe loin commitment may vary depending onthe terms ‘of the commitnent and othcr factors, However, under the idea of fisk-weighted assets, the $10 million woukd be correct. (Oldhat Financial started its first day of operations with $9 milion in carital. $130 million in ‘checkable deposits are eceived. The bank issues a $25 millior commercial loan and another $50 million in meetgages, with the following terms: ‘+ mortgages: 200 standard 3 $250,000, te with a nominal annual rate of 5.25% each for -year, fined Joan: 3-year lean, simple interest paid monthly at 0.75¢é/month required rocerves are 86, what des the bank balance sheets loak like? Tena reserves. How well capitalized isthe bank" y fan bose Solution: Assets T Tiabitiies Required Reserves, $104 million | Checkable Deposits $130 million Excess Reserves $53.6 million | Bank Capital $9 million Loans $75 nillion ‘The bank is well capiuilized, at 9/139 = 647% Calculate the risk-weighted assets and risk-weighted capital ratio of Outhat’s first day Solution: Reserves have a nero weight. So. $64 million has zero weight Residestial mortgages carry a 50% weight, RW Assets (Ceimmercial loans camry 100% weight. RW Assets = $25 mn “The capital tatio = 9/50 = 18% ‘The nextday. terrible news hits the mortgage markets, an merigage rates jump (© 13%, What is the market value oF Outhat’s mortgages? Wha is Outhat's “market value” capital ratio? Solution: When issued, the required payment is PV ~ $250,000, I~ 5.25/12, N ~ 360, PV-0 (Compute PMT. PMT = $1,380.51 ‘Alter the rate inerease, the mortgages are worth: PMP =S1,280.51, T= 13/12, N= 360, FV=0 Compute PV. PV = $124,797.56, or loss of about 50% of value. ‘The new “market valuo" balance shect is: Assets iabilities Required Reserves $10.4 million | Checkable Deposits $130 million, Excess Reserves $53.6 million Bank Capital =$16 million Loans $50 million However, the loss would nat be immediately recognized. No actual accounting transaction ‘would lake place. 1. Bank regulators force Outhat to sell its mortgages to recognize the fair market value, What is the accounting transaction? How does this affect its capital position? Solution: The sale of each mortgage would be recorded as: Debit Cre ‘ah $124,798 Mortgages $250,000 Loss $125,202 Aer the fact, the actual balance sheet is Assets T Liabilities Required Reserves. $10.4 million | Checkable Deposits $130 million ExcessReserves $78.6 million | Bank Capital -$16 million Loans $25 million Now. the true state of the bank's positicn is realized,& Congress allowed Outhat t amortize the loss over the remaining life ofthe mortgage. If this technique was used in the sale, how would the tanssetion have been reconied What would be the annual adjustmen'? What does Oldhat's balance sheet look like? What isthe capital ratio? Solution; ‘The sale of each merteage would be recorded as Debit Credit csr Morea Copitalized Loss 8 ‘Thon, cach year for the next 30 years the loss would be written of Debit Credit Loss (Expense) S417340__| Capitalized Loss SAITO Aller the fact, the actual balance sheet is now: Asels Tabilities Required Reserves $10.4 million | Chectable Deposits $130 million Excess Reserves $78.6 milbn | Bank Capital $9 million Capitalized Loss $25 million Loans. $25 million ‘The bank is again well capitalized, a 9/139 = 6.47% 9. Oldhat decides to invest the 78.6 million in excess reserves in commercial loans, What will be the ‘impact on is capital ratio? lis rsk-weighted capital ratio? Solution: With the commercial loan, the balance sheet is now’ ‘Assets iabilities Required Reserves $104 million | Checkable Deposits $130 million Excess Reserves, SO million Bank Capital 59 million Capitalized Loss $25 million Loans. $108.6 million ‘The bank is stil well capitalized, at 9/13 47%For tisk-weighted Reserves have a zeia weight, 0, $104 mi iow has zer0 weight. ‘The remaining balance sheet is at 100%, or $128.6 millon, ‘The risk-weighted capi ratio = 0/1286 = % 10, The had news about the mortgages is featured inthe local newspaper, causing a minor bank run, $6 mi Solution: The balance sheet isnow: Asseis Required Reserves Excess Reserves Capitalized Loss Loans ‘The bank is stil well capitalized, at 9/133 jon is deposits are withdrawn, Examine the bank's condition, Liabilities S44 million ‘S12 millicn 80 million Bank Capital $9 million 25 million $103.6 million 6.768% However, the requited reserve ratio is 8%, 0189.92 millon. The bank is roughly $5.5 ‘million shor. " Dlathat horrows $85.5 million inthe overnight fl funds market. What is the new halanee shect for Oldhat? How well capitalized i the hank? Solution: The balance sheet is now: Aseis Required Reserves Excess Reserves Capitalized Loss Loans ‘The bank is stil well capitalized, at 9/138. ilities 399 million | Checkable Deposits $124 million 0 million Fed findstorrowed $3.5 million 825 million Bank Capital $9 million $103.6 million 65%