Regulation of Commercial Banks

8-1McGraw-Hill/IrwinChapter ThirteenRegulation of Commercial Banks13-2McGraw-Hill/IrwinCommercial BanksCommercial banks provide many unique servicesinformation, liquidity, price-risk reduction, transaction cost, maturity intermediation, and payment servicesmoney supply transmission, credit allocation, intergenerational wealth transfers, and denomination intermediationFailure to provide these services can be costly to both users and suppliers of fundsAccordingly, commercial banks are regulated at the federal (and sometimes state) level13-3McGraw-Hill/IrwinCommercial Bank RegulationSafety and soundness regulationassets must be diversified: cannot make loans greater than 10% of their equity capital to any one borrowermust maintain adequate equity capital levels to protect against insolvency riskprovision of guarantee funds such as the Deposit Insurance Fund (DIF) protects depositors in the event of default and prevents bank runsmonitoring and surveillance: banks must submit (publicly accessible) quarterly reports and are subject to on-site examinations13-4McGraw-Hill/IrwinCommercial Bank RegulationMonetary policy regulationthe Central Bank (the Federal Reserve) directly controls the quantity of notes and coin (i.e., outside money) in the economyhowever, the bulk of the money supply is held as bank deposits, called inside moneyregulators require cash reserves to be held at commercial banks13-5McGraw-Hill/IrwinCommercial Bank RegulationCredit allocation regulationregulators encourage (and often require) lending to socially important sectors of the economy (e.g., housing and farming)usury laws cap interest rates that can be charged on loansInvestor protection regulationprotects investors against insider trading, lack of disclosure, malfeasance, and breach of fiduciary responsibility13-6McGraw-Hill/IrwinCommercial Bank RegulationEntry and chartering regulationthe entry of commercial banks is regulatedthe permissible activities of commercial banks are defined by regulatorsthe barriers to entry and the scope of permissible activities allowed affects the charter values of banks and the size of the net regulatory burdenThe net regulatory burden is the difference between the costs of regulations and the benefits for the producers of financial services13-7McGraw-Hill/IrwinCommercial Bank RegulationRegulatorsthe Federal Deposit Insurance Corporation (FDIC)the Office of the Comptroller of the Currency (OCC)the Federal Reserve System (FRS)state agenciesThe four facets of regulatory structureregulation of product and geographic expansionprovision and regulation of deposit insurancebalance sheet regulationoff-balance-sheet regulation13-8McGraw-Hill/IrwinProduct Segmentation RegulationCommercial banking vs. investment bankingcommercial banking involves deposit taking and lendinginvestment banking involves underwriting, issuing, and distributing securitiesthe Glass-Steagall Act of 1933 imposed a rigid separation between commercial and investment banksby 1987 commercial banks were allowed to engage in limited investment banking activity through Section 20 affiliatesthe Financial Services Modernization Act (FSMA) of 1999 repealed Glass-Steagall13-9McGraw-Hill/IrwinProduct Segmentation RegulationCommercial banking vs. insurance underwritingthe Bank Holding Company Act (BHCA) of 1956 restricted insurance companies from owning or being affiliated with commercial banksthe FSMA of 1999 now allows bank holding companies to open insurance underwriting affiliates and also allows insurance companies to open banksCommercial banks and commercethe BHCA of 1956 restricts commercial firms from acquiring banksthe 1970 Amendment to the BHCA requires banks to divest nonbank related subsidiaries13-10McGraw-Hill/IrwinGeographic Expansion RegulationRestrictions on intrastate bankingmost banks used to be unit banks—i.e., banks with single officesby 1997 only six states restricted intrastate branchingRestrictions on interstate bankingthe McFadden Act of 1927 (amended in 1933) restricted national banks from branching across state linesas a result, the largest banks were set up as multibank holding companies (MBHCs)an MBHC is a parent banking organization that owns a number of individual bank subsidiaries13-11McGraw-Hill/IrwinGeographic Expansion Regulationthe Douglas Amendment to the BHCA of 1956let states regulate MBHC expansionsubsidiaries established prior to the passage of the amendment were considered grandfathered and not subject to the lawthe 1970 Amendment to the BHCA of 1956 restricted the nonbank activities that one bank holding companies (OBHCs) could engage ina OBHC is a parent banking organization that owns one bank subsidiary and nonbank subsidiariesthe Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994allows consolidation of out-of-state bank subsidiaries into a branch network and allows interstate mergers and acquisitions13-12McGraw-Hill/IrwinDeposit Guarantee FundsThe Federal Deposit Insurance Corporation (FDIC) was created in 1933 to maintain the stability of the U.S. banking systemworked well until 1979from October 1979 to October 1982 the Fed targeted bank reserves and let interest rates rise dramaticallyled to disintermediation—i.e., the withdrawal of deposits from depository institutions and their reinvestment elsewhereproblems were exacerbated by a policy of regulatory forbearance—i.e., a policy of not closing economically insolvent depository institutions, but allowing their continued operation13-13McGraw-Hill/IrwinDeposit Guarantee FundsThe FDIC Improvement Act (FDICIA) of 1991 restructured the Bank Insurance Fund (BIF)The demise of the Federal Savings and Loan Insurance Corporation (FSLIC)the FSLIC insured savings institutions from 1934 to 1989savings institutions failures in the 1980s led to an insolvent FSLIC by 1989The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989dissolved the FSLIC and transferred its management to the FDICcreated the Savings Association Insurance Fund (SAIF)13-14McGraw-Hill/IrwinDeposit Guarantee FundsThe FDIC introduced risk-based deposit insurance premiums in January of 1993by 1996 the safest institutions insured by the BIF paid no deposit insurance premiumsby 1997 the safest institutions insured by the SAIF paid no deposit insurance premiumsby the early 2000s over 90% of depository institutions were in the “safe” category that paid no deposit insurance premiumIn March 2005 the BIF and the SAIF were merged into one Deposit Insurance Fund (DIF)In January 2007 the FDIC began a more aggressive insurance system where all institutions pay into the fund13-15McGraw-Hill/IrwinBalance Sheet RegulationLiquidity regulationbanks must hold minimum levels of reserves against net transaction accountsensures that banks can meet required payments on liability claims such as deposit withdrawalssee Appendix 13c for more detailsCapital adequacy regulationsince 1987 U.S. commercial banks have faced two different capital requirementsTier I capital risk-based ratioTotal capital (Tier I + Tier II) risk-based ratio13-16McGraw-Hill/IrwinBalance Sheet RegulationCapital adequacy regulation (continued)Tier I capital is composed of the book value of common equity plus an amount of perpetual preferred stock plus minority equity interests held by the bank in subsidiaries minus goodwillTier II capital includes secondary capital resources such as loan loss reserves and convertible and subordinated debtrisk-adjusted assets include both on- and off-balance-sheet assets whose values are adjusted for approximate credit riskthe total risk-based capital ratio is equal to the sum of Tier I and Tier II capital divided by risk-adjusted assetsthe Tier I (core) capital ratio is equal to Tier I capital divided by risk-adjusted assets13-17McGraw-Hill/IrwinBalance Sheet RegulationCapital adequacy regulation (continued)since 1991 banks have also been assessed based on their capital-to-assets (i.e., leverage) ratiocapital-to-assets ratio = core capital ÷ total assetsdoes not account for market values, riskiness of assets, or off-balance-sheet activitiessince December 1992 regulators must take Prompt Corrective Action (PCA) if and when a bank falls outside of the “well capitalized” zonerisk-based capital ratios were phased in by Bank for International Settlement (BIS) countries (the U.S. included) by 1993 under the Basel Accord13-18McGraw-Hill/IrwinOff-Balance-Sheet RegulationBanks earn fee income with off-balance-sheet (OBS) activitiesBy engaging in OBS activities, banks can avoid regulatory costs such as reserve requirements, deposit insurance premiums, and capital adequacy requirementsBanks must report notional values of OBS activity on Schedule LOBS activity is incorporated into the total risk-based capital ratio and the Tier I capital ratio, but not the leverage ratio13-19McGraw-Hill/IrwinForeign vs. Domestic RegulationRegulation of U.S. banks in foreign countriesthe Overseas Direct Investment Control Act of 1964 restricted U.S. banks’ ability to lend to U.S. corporations to make foreign investmentthe North American Free Trade Agreement (NAFTA) of 1994 enabled U.S. banks to expand to Mexico and Canadaa 1997 agreement between 100 countries (under the World Trade Organization (WTO)) began dismantling barriers inhibiting foreign direct investment into emerging countries13-20McGraw-Hill/IrwinForeign vs. Domestic RegulationRegulation of foreign banks in the U.S.the International Banking Act (IBA) of 1978 declared foreign banks are to be regulated the same as national domestic banksforeign banks are subject to Federal Reserve examinationsthe Foreign Bank Supervision Enhancement Act (FBSEA) of 1991 gave additional powers to the Federal ReserveFed must approve new subsidiary, branch, agency, or representative offices of foreign banks in the U.S.Fed has the authority to close foreign banks operating in the U.S.only foreign banks with access to the FDIC can accept consumer depositsstate-licensed foreign branches are regulated as national branches