Transcript Regulating Finance

Regulating Finance
• Lots of bases to cover
Cover one by regulation or deregulation
 Unintended Consequences
• Reactions to regulatory policies
 frustrate regulator intent
Regulate bank balance sheets  off-balance sheet activities
Emplace a safety net  bankers become skydivers
• Regulation spreads to cover innovations
 complexity  ineffectiveness
Win by gaming the system
Regulation thru the decades…
• Response to Crisis of 1907
– Federal Reserve Act, 1913
• Response to Great Depression
– FDIC
– Glass – Steagle: commercial bank/investment bank
– SEC
– Interest rate restraints
• Tweaks during era of financial stability, 1956
– Holding companies under Fed
– Douglas amendment: further limit interstate branching
Deregulation … Failures … Responses
• 1980: Depository Institution Deregulation & Monetary Control Act
– Response to disintermediation
• Phased out interest rate ceilings
• Loosened reins on thrifts
• 1982: Garn – St. Germain: Unleashed thrifts
• Also: Allowed depository institutions to offer Money Mkt Deposit Accts.
• 1989: Financial Inst. Reform Recovery & Enforcement Act
– Cleanup after S& L debacle
• 1994: Riegel-Neal Interstate Banking & Branching Efficiency Act
• 1999: Gramm-Leach-Biley Financial Services Modernization…
 CITIGroup financial supermarket
• 2002: Sarbanes-Oxley
– Response to Enron, WorldCom,…
• Tightened accounting standards
• CEO/CFO signoff on financial statements
Regulatory Responses to Subprime-Triggered Crisis???
• Constraints on mortgage brokers???
• Ban exotic derivatives: Subprime MBS???
• Regulate compensation – clawbacks???
• Increase capital requirements
• Deal with GSEs: fully privatize? nationalize?? downsize???
• Limit investment bank, insurance company risk-taking???
– Major investment banks now Fed regulated bank holding cos.
• Restrict rating agency conflicts of interest???
• Increase regulation of derivatives?
– Restrict over-the-counter trades
• Require current bankruptcy plans
– Make failure of “TBTFs” credible
Primary Supervisory Responsibility of Bank
Regulatory Agencies
• Comptroller of the Currency—national banks
chartered by Federal government since 1863
• Federal Reserve and state banking authorities—
state banks that are members of the Federal
Reserve System
• Fed – also regulates bank holding companies
• FDIC—insured state banks that are not Fed
members
• State banking authorities—state banks without FDIC
insurance
The U.S. regulatory regime
Sources: Financial Services Roundtable (2007), Milken Institute.
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Innovations: Response to Interest Rate Volatility
• Adjustable-rate mortgages  teaser rates
• Financial Derivatives  hedging…and gambling
Innovations: Response to Information Technology
• Bank credit and debit cards
• Electronic banking
– ATM/Home banking/ABM/Virtual banking
• Overrides branch restrictions
• “Junk” bonds…High-yield bonds building our megaresorts
• Commercial paper market – MMMF support
• Securitization
Innovations:Avoiding Regulation/Loophole Mining
• Sweep accounts … reserve requirements
• Money Market Mutual Funds … Regulation Q
Decline of Traditional Banking
Decline in cost advantages in acquiring funds (liabilities)
Rising inflation  rise in interest rates and disintermediation
Low-cost source of funds, checkable deposits, declined in importance
Decline in income advantages on uses of funds (assets)
IT less need for banks to finance short-term credit and issue loans
IT  lower transaction costs for other financial institutions
Bank Responses:
•Riskier Lending … Commercial real estate, leveraged buyouts, takeovers
•Off balance sheet activities
Size Distribution of Insured Commercial Banks, September 30, 2008 ????
3,046
4,039
486
86
7,640
39.9
52.9
6.1
1.1
1.3
9.7
10.0
79.0
Bank Consolidation
Skirting branch restrictions
Skirting branch
•ATMs, Bank Holding Cos.restrictions
Interstate Banking and
Branching Efficiency Act, 1994
 Geographic deregulation
Pre-Crisis Findings:
•ATMs, Bank
•Intrastate deregulation more
Holding Cos.
positive for all but big banks
•Raises ROA/ROE &reduces
risks for banks under $15b
•Non-interest expense
down for banks under $1b
•Increases big bank risks
•NIM up for all but biggest
•Interstate deregulation
• Benefits of bank consolidation
•Small bank risks down
•Mid-sized risks up
Increased competition  close inefficient banks
•Big bank risks mixed
Efficiencies from economies of scale and scope
•ROA/ROE generally down
Lower chance of failure -- diversified portfolios •State of economy
• Costs
•Stronger impact on bank
performance than
Fewer community banks  less lending to small
business
branching deregulation
Banks in new areas  increased risks/failures
Attempted solutions: Constrain banks from taking too much risk
• Promote diversification…but systemic crisis is systemic
• Prohibit holdings of common stock
• Set capital requirements … Capital as cushion
• Minimum leverage ratio
• Basel Accord: risk-based capital requirements
… but there’s regulatory arbitrage
Prompt corrective action: Close ‘em down when capital inadequate
• Monitor … CAMELS
– Capital adequacy
– Asset quality
– Management
– Earnings
– Liquidity
– Sensitivity to market risk
• Disclosure requirements
… mark-to-market issue
• Restrictions on competition … make banking boring
Failed Banks Update
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Year
Number
2000
2
2001
4
2002
11
2003
3
2004
4
2005/2006
0
2007
3
2008 QI+Q2
4
2008 Q3
10
2008 Q4
12
2009 Q1
21
2009 Q2
24
2009 Q3
50
2009 Q4
45
2010 Q1
40
2010 Q2
48
2010 Q3
42
2010 thru 10/15
5
2009 Total = 140
2010 Y-T-D = 135