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Bank Regulation: Financial Markets and Institutions, 7e, Jeff Madura
Bank Regulation: Financial Markets and Institutions, 7e, Jeff Madura
Bank Regulation: Financial Markets and Institutions, 7e, Jeff Madura
Bank Regulation
1
Chapter Outline
Background
Regulatory structure
Deregulation Act of 1980
Garn-St Germain Act
Regulation of deposit insurance
Regulation of capital
Regulation of operations
Regulation of interstate expansion
How regulators monitor banks
The “too-big-to-fail” issue
Global bank regulations
2
Background
The banking industry has become more
competitive due to deregulation
Banks have more flexibility on the services they offer,
the locations where they operate, and the rates they
pay depositors
Banks have recognized the potential benefits from
economies of scale and scope
Bank regulation is needed to protect customers
who supply funds to the banking system
Regulators
are shifting more of the burden of risk
assessment to the individual banks themselves
3
Regulatory Structure
The U.S. has a dual banking system consisting
of federal and state regulation
Three federal and fifty state agencies supervise the
banking system
A federal or state charter is required to open a
commercial bank
National versus state banks
Federal charters are issued by the Comptroller of the
Currency
State banks may decide to become members of the Fed
35 percent of all banks are members of the Fed, comprising
70 percent of deposits
4
Regulatory Structure (cont’d)
Regulatory overlap
National banks are regulated by the
Comptroller of the Currency, the Fed, and the
FDIC
State banks are regulated by the state
agency, the Fed, and the FDIC
Perhaps a single regulatory agency should be
assigned the role of regulating all commercial
banks and savings institutions
5
Regulatory Structure (cont’d)
Regulation of bank ownership
Commercial banks can be either
independently owned or owned by a bank
holding company
Most banks are owned by BHCs
BHCs have more potential for product
diversification because of amendments to the Bank
Holding Company Act of 1956
6
Deregulation Act of 1980
The Depository Institutions Deregulation and Monetary
Control Act (DIDMCA) was enacted in 1980
DIDMCA has two categories of provisions:
Those intended to deregulate the banking industry
Those intended to improve monetary control
The main deregulatory provisions are:
Phaseout of deposit rate ceilings
Allowance of NOW accounts for all depository institutions
New lending flexibility for depository institutions
Explicit pricing of Fed services
7
Deregulation Act of 1980 (cont’d)
DIDMCA also called for an increase in the
maximum deposit insurance level from $40,000
to $100,000 per depositor
Impact of DIDMCA
There has been a shift from conventional demand
deposits to NOW accounts
Consumers have shifted funds from conventional
passbook savings accounts to various types of CDs
DIDMCA has increased competition between
depository institutions
8
Garn-St Germain Act of 1982
The Act:
Permitted depository institutions to offer money
market deposit accounts (MMDAs), which have no
interest ceiling
MMDAs are similar to money market mutual funds
MMDAs allow depository institutions to compete against
money market funds in attracting savers’ funds
Permitted depository institutions to acquire failing
institutions across geographic boundaries
Intended to reduce the number of failures that require
liquidation
9
Regulation of Deposit Insurance
Federal deposit insurance has existed since the
creation of the FDIC in 1933 as a response to
bank runs
About 5,100 banks failed during the Great Depression
Deposit insurance has increased from $2,500 in 1933
to $100,000 today
Insured deposits make up 80 percent of all
commercial bank balances
The FDIC is managed by a board of five directors,
who are appointed by the President
10
Regulation of Deposit Insurance
(cont’d)
The FDIC’s Bank Insurance Fund is the pool of funds
used to cover insured deposits
The fund is supported with annual insurance premiums paid by
commercial banks, ranging from 23 cents to 31 cents per $100 of
deposit
In 2003, three BIF-insured banks failed with total assets of $1.1
billion
As of 2004, the BIF balance was about $34 billion
In 1991, the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) was passed
Phased in risk-based deposit insurance premiums to counteract
the moral hazard problem
11
Regulation of Capital
Capital requirements force banks to
maintain a minimum amount of capital as
a percentage of total assets
Banks would prefer low capital to boost their
ROE
Regulators have argued that banks need
sufficient capital to absorb potential operating
losses
12
Regulation of Capital (cont’d)
Basel Accord of 1988
Central banks of 12 major countries agreed to uniform capital
requirements
The Accord was facilitated by the Bank for International
Settlements (BIS)
The key contribution of the Accord is that the requirements were
based on the bank’s risk level, forcing riskier banks to maintain a
higher level of capital
In 1996, the Accord was amended so that bank’s capital level
also account for its sensitivity to market conditions
Very safe assets are assigned a zero weight, while very risky
assets are assigned a 100 percent weight
13
Regulation of Capital (cont’d)
Basel II Accord
The Basel Committee has worked on an
accord that would refine the risk measures
and increase the transparency of a bank’s risk
to its customers
The three parts of the Accord are:
Revise the measurement of credit risk
Explicitly account for operational risk
14
Regulation of Capital (cont’d)
Basel II Accord (cont’d)
Revised measures of credit risk
The risk categories are being refined to account for some
possible differences in risk levels of loans within a category
A bank’s loans that are past due will have a weight of 150%
applied to their assets
Banks can use the internal ratings-based (IRB) approach to
calculate credit risk, in which banks provide summary
statistics about their loans to the Basel Committee
The Committee then applied pre-existing formulas to the
statistics in order to determine the required capital level
15
Regulation of Capital (cont’d)
Basel II Accord (cont’d)
Accounting for operational risk
Operational risk is the risk of losses from inadequate or failed
internal processes or systems
Intended to encourage banks to improve their techniques for
controlling operational risk to reduce bank failures
Initially, banks can use their own methods for assessing their
exposure to operational risk
The Basel Committee suggests the average annual income
generated over the last three years
16
Regulation of Capital (cont’d)
Basel II Accord (cont’d)
Public disclosure of risk indicators
The Basel Committee plans to require banks to
provide more information to existing and
prospective shareholders about their risk exposure
to different types of risk
This would provide existing and prospective
investors with additional information about a bank’s
risk
17
Regulation of Capital (cont’d)
Use of the value-at-risk method to determine
capital requirements
Under the 1996 amendment to the Basel Accord,
capital requirements on large banks were adjusted to
incorporate their own internal measurements of
general market risk
Market risk is the exposure to movements in market forces
such as interest rates, stock prices, and exchange rates
Capital requirements imposed are based on the bank’s own
assessment of risk when applying the VAR model
VAR is the estimated potential loss from trading businesses
that could result from adverse movements in market prices
Banks typically use a 99 percent confidence level
18
Regulation of Capital (cont’d)
Use of the value-at-risk method to determine
capital requirements (cont’d)
Testing the validity of a bank’s VAR
The validity is assessed with backtests in which the actual
daily trading gains or losses are compared to the estimated
VAR over a particular period
If the VAR is estimated properly, only 1 percent of the actual
daily trading days should show results that are worse than
the estimated VAR
Related stress tests
Some banks supplement the VAR estimate with stress tests
using extreme events
19
Regulation of Operations
Regulation of loans
Regulators monitor highly leveraged transactions (HLTs) and a
bank’s exposure to debt of foreign countries
Banks are restricted to a maximum loan amount of 15 percent of
their capital to any single borrower
Banks are regulated to ensure that they attempt to accommodate
the credit needs of the communities in which they operate
through the Community Reinvestment Act (CRA) of 1977
Regulation of investment in securities
Banks are not allowed to use borrowed or deposited funds to
purchase common stock
Banks can invest only in bond that are investment-grade quality
20
Regulation of Operations (cont’d)
Regulation of securities services
The Glass-Steagall Act of 1933:
Separated banking and securities activities
Prevented any firm that accepted deposits from
underwriting stocks and bonds of corporations
Was intended to prevent potential conflicts of
interest
21
Regulation of Operations (cont’d)
Regulation of securities services (cont’d)
Deregulation of underwriting services
In 1989, the Fed approved debt underwriting
applications for banks based on the requirements
that:
Banks had sufficient capital to support the subsidiary that
would perform the underwriting
Banks had to be audited to ensure that their
management was capable of underwriting debt
The Fed imposed a ceiling on revenues from
corporate debt underwriting
22
Regulation of Operations (cont’d)
Regulation of securities services (cont’d)
The Financial Services Modernization Act of 1999:
Essentially repealed the Glass-Steagall Act
Made it easier for commercial banks to engage in securities
and insurance activities
Increased the degree to which banks can offer securities
services
Allowed securities firms and insurance companies to acquire
banks
Resulted in more consolidation among banks, securities
firms, and insurance companies
23
Regulation of Operations (cont’d)
Regulation of securities services (cont’d)
Deregulation of brokerage services
Banks had been allowed to offer discount brokerage services
even before 1999
In the late 1990s, some banks acquired financial services
firms that offered full-service brokerage services
Deregulation of mutual fund services
Since June 1986, brokerage subsidiaries of bank holding
companies could sell mutual funds
Private label funds are mutual funds created by banks in
conjunction with financial service firms
24
Regulation of Operations (cont’d)
Regulation of insurance services
Before the late 1990s, banks were involved in insurance in
limited ways:
Banks that had participated in insurance before 1971 were allowed
to continue to do so
Some banks leased space in their buildings to insurance companies
in exchange for a payment equal to a percentage of the insurance
company’s sales
In 1995, the Supreme Court ruled that national banks could sell
annuities
In 1998, regulators allowed the merger between Citicorp and
Traveler’s Insurance Group
In 1999, the Financial Services Modernization Act confirmed that
banks and insurance companies could merge
25
Regulation of Operations (cont’d)
Regulation of off-balance sheet transactions
Off-balance sheet transactions, such as letters of credit, expose
the bank to risk
Risk-based capital requirements are higher for banks that
conduct more off-balance sheet activities
Regulation of the accounting process
Publicly-traded banks are required to provide financial
statements that indicate their recent financial position and
performance
The Sarbanes-Oxley Act was enacted in 2002 to make corporate
managers, board members, and auditors more accountable for
the accuracy of the financial statement that their respective firms
provided
26
Regulation of Interstate Expansion
The McFadden Act of 1927 prevented banks
from establishing branches across state lines
The Douglas Amendment to the Bank Holding
Company Act of 1956 prevented interstate
acquisitions of banks by bank holding
companies
By 1994, most states had approved nationwide
interstate banking
27
Regulation of Interstate Expansion
(cont’d)
Interstate Banking Act
Until 1994, most interstate expansion was achieved
through bank acquisitions
In September 1994, federal guidelines passed a
banking bill that removed interstate branching
restrictions
Known as the Reigle-Neal Interstate Banking and Branching
Efficiency Act of 1994
Eliminated most restrictions on interstate bank mergers and
allowed commercial banks to open branches nationwide
Allows banks to grow and increase economies of scale
28
How Regulators Monitor Banks
Bank regulators:
Typically conduct an on-site examination of each commercial
bank at least once a year
Assess the bank’s compliance with existing regulations and its
financial condition
Periodically monitor commercial banks with computerized
monitoring systems
Monitor banks to detect any serious deficiencies that might
develop so that they can correct the deficiencies before the bank
fails
The FDIC rates banks on the basis of six characteristics
(CAMELS ratings)
29
How Regulators Monitor Banks
(cont’d)
Capital adequacy
Regulators determine the capital ratio (capital divided by
assets)
If banks hold more capital, they can more easily absorb potential
losses
Asset quality
The FDIC evaluates the quality of the bank’s assets, including its
loans and securities
Management
The FDIC specifically rates the bank’s management according to
administrative skills, ability to comply with existing regulations,
and ability to cope with a changing environment
The FDIC also assesses the bank’s internal control systems
30
How Regulators Monitor Banks
(cont’d)
Earnings
A commonly used profitability ratio to evaluate banks is return
on assets (ROA), defined as EAT divided by assets
Earnings can also be compared to industry earnings
Liquidity
Regulators prefer that banks not consistently rely on outside
sources of funds such as the discount window
Sensitivity
Regulators assess the degree to which a bank might be exposed
to adverse financial market conditions
Regulators place much emphasis on a bank’s sensitivity to
interest rate movements
31
How Regulators Monitor Banks
(cont’d)
Rating bank characteristics
Each of the CAMELS ratings is rated on a 1-to-5
scale (1 = outstanding)
A composite rating is determined as the mean rating
of the six characteristics
Banks with a composite rating of 4.0 or higher are
considered to be problem banks and closely
monitored
The number of problem banks increased in the 2001–2002
period
32
How Regulators Monitor Banks
(cont’d)
Rating bank characteristics (cont’d)
Limitations of a rating system
Regulators do not have the resources to monitor each bank
on a frequent basis
Over time some problem banks improve while others
deteriorate
Many problems go unnoticed and it may be too late by the
time they are discovered
Any system used to detect financial problems may err in one
of two ways:
It may classify a bank as safe when it is failing
It may classify a bank as very risky when in fact it is safe
33
How Regulators Monitor Banks
(cont’d)
Corrective action by regulators
Regulators thoroughly investigate “problem banks:”
They may request that a bank boost its capital level
They can require additional financial information
They have the authority to remove particular officers and
directors if it enhances the bank’s performance
Ifregulators reduce bank failures by imposing
regulations that reduce competition, bank efficiency
will be reduced
34
How Regulators Monitor Banks
(cont’d)
Funding the closure of failing banks
The FDIC is responsible for the closure of failing
banks
Must decide whether to liquidate the bank’s assets or to
facilitate the acquisition of that bank by another bank
After reimbursing depositors of the failed bank, the FDIC
attempts to sell any marketable assets or the failed banks
If the failing bank is acquired, the potential acquirer may be
interested if the bank is given sufficient funds by the FDIC
35
How Regulators Monitor Banks
(cont’d)
In 1991, the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) provided that:
Regulators were required to act more quickly in forcing banks
with inadequate capital to correct the deficiencies
Regulators were required to close troubled banks more quickly
Deposits exceeding the insured limit are not to be covered when
a bank fails
Deposit insurance premiums were to be based on the risk of
banks
The FDIC was granted the right to borrow $30 billion from the
Treasury to cover bank failures and an additional $45 billion to
finance working capital needs
36
The “Too-Big-To-Fail” Issue
37
The “Too-Big-To-Fail” Issue (cont’d)
38
The “Too-Big-To-Fail” Issue (cont’d)
39
Global Bank Regulations
Each country has a system for monitoring and regulating
commercial banks
Most countries also have a system for deposit insurance
Canadian banks tend to be subject to fewer banking
regulations than U.S. banks, such as interstate
branching
European banks have had much more freedom than
U.S. banks in offering investment banking services such
as underwriting
Japanese commercial banks have some flexibility to
provide investment banking services, but not as much as
European banks
40
Global Bank Regulations (cont’d)
Uniform global regulations
Three of the more significant regulations are:
The International Banking Act
Places U.S. and foreign banks operating in the U.S.
under the same set of rules
The Single European Act
Places all European banks operating in many European
countries under the same set of rules
The uniform capital adequacy guidelines
Forces banks of 12 industrialized nations to abide by the
same minimum capital constraints
41
Global Bank Regulations (cont’d)
Uniform global regulations (cont’d)
Uniform regulations for banks operating in the United
States
The International Banking Act of 1978 was designed to
impose similar regulations across domestic and foreign
banks doing business in the U.S.
Prior to the act, foreign banks had more flexibility to cross
state lines in the U.S. than U.S.-based banks had
The IBA required foreign banks to identify one state as their
home state
42
Global Bank Regulations (cont’d)
Uniform global regulations (cont’d)
Uniform regulations across Europe
The Single European Act of 1987 was phased in throughout
many European countries
The main provisions are:
Capital can flow freely throughout the participating countries
Banks can offer a wide variety of lending, leasing, and
securities activities in the participating countries
Regulations regarding competition, mergers, and taxes are
similar throughout these countries
A bank established in any participating country has the right to
expand into any other participating country
43
Global Bank Regulations (cont’d)
Uniform global regulations (cont’d)
Uniform regulations across Europe (cont’d)
As a result of the Single European Act:
A common market has been established for participating
countries
European banks have begun to consolidate across
countries
Banks can enter Europe and receive the same banking
powers as other banks there
Some European savings institutions have evolved into
full-service institutions
44
Global Bank Regulations (cont’d)
Uniform global regulations (cont’d)
Uniform capital adequacy guidelines around
the world
Before 1988, capital standards imposed on banks
varied across countries
Some banks had a comparative advantage over others
The uniform capital adequacy guidelines imposed
the same minimum capital requirements on the 12
participating countries
45