Banking RegulationBanking Regulation

Recall that the financial sector provides the efficient transfer of savings towards investment projects

S + (Imports – Exports) = I + (G-T)

Foreign Savings ($640B)

Gross Domestic Savings ($1.8T)

Gross Private Investment ($2T)

Government Deficit ($400B)

Gross Private Investment represents the purchase of new capital goods – one of the primary sources of growth in the economy

Loans62%

Bonds30%

Stocks2%

Other6%

A majority of external funds raised by non-financial businesses come from bank loans. In particular, small businesses rely entirely on banks for financing

LoansBankDepositors

There is a moral hazard problem/adverse selection problem between both the bank and its depositors as well as between the bank and its potential loan customers

A bank can deal with this problem with:

•Credit Scoring

•Collateral

•Optimal Debt Contracts

This problem must be dealt with through regulation

Depository Institutions are broadly defined as businesses that accept deposits and make loans

Depository Institutions

Commercial Banks

Savings & Loans

Savings Banks

Credit Unions

Non-Bank Thrifts

•Deal almost exclusively in short term deposits and mortgages

•Are generally mutual companies (depositors are the owners)

•Are allowed to hold corporate equities/bonds

All Depository Institutions in the US are chartered

Depository Institutions

Commercial Banks

Savings & Loans

Savings Banks

Credit Unions

National Banks Comptroller of the Currency

State Banks State Authority

Federal Associations Office of Thrift Supervision

State Associations State Authority

Federal Unions National Credit Union Administration

State Unions State Authority

Federal Reserve Membership (1913)Federal Reserve Membership (1913)

National Banks are Required to be members National Banks are Required to be members of the Federal Reserve System (Membership of the Federal Reserve System (Membership is optional for state banks)is optional for state banks) Federal Reserve members are required to Federal Reserve members are required to

purchase stock in the federal reserve system.purchase stock in the federal reserve system. Federal Reserve members provide input to the Federal Reserve members provide input to the

election of Federal Reserve Board Memberselection of Federal Reserve Board Members The Federal Reserve provides check clearing The Federal Reserve provides check clearing

servicesservices

National Banks 2001

State Banks (Non-Member)

935

State Banks (Non-Member)

4833

Of the 7,769 banks in 2003, a vast majority are non-member state banks

Federal Deposit Insurance (1934)Federal Deposit Insurance (1934)

Federal reserve members are required to Federal reserve members are required to purchase deposit insurance. Insurance is purchase deposit insurance. Insurance is optional for state banks (98% of all banks optional for state banks (98% of all banks have deposit insurance)have deposit insurance)FDIC insured banks are charged up to 27 FDIC insured banks are charged up to 27

cents per $100 of eligible depositscents per $100 of eligible depositsAll deposits up to $100,000 are insured by the All deposits up to $100,000 are insured by the

FDIC. FDIC.

A timeline of Banking Regulation

1863 1927

1933

1980

1956 1999

1994

Res

tric

tio

ns

on

ac

tivi

ties

Res

tric

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ns

on

C

om

pet

itio

n McFadden Act

Banking Act

Holding Company Act

Monetary Control Act

Riegle-Neal

Holding Company Act

Glass - Steagall

Graham - Leach - Bliley

Great Depression

YearYear Number of BanksNumber of Banks Total BranchesTotal Branches

19001900 12,50012,500 13,00013,000

20002000 78007800 68,00068,000

Until the mid 1900’s, we were a nation of unit banks

Main Office

Branch Offices

National Banks

Prohibited from interstate branching

Must comply with state branching rules

McFadden Act (1927)

State Banks

Unit Banking

Limited Branching

Statewide Branching

Following the great depression, the activities of commercial banks were severely restricted

The Glass-Steagall Act of 1934 was designed to put a wall between commercial banking and investment banking

Glass-Steagall (1934)

Commercial Banks are restricted from participating in equities markets

Interest rates on non- transaction deposits is restricted to be below 5.25%

No interest allowed on transaction deposits

Regulation Q

Branching Restrictions could be avoided by forming holding companies

Main Office

Branch Offices

Illegal under the McFadden Act

Holding Company

Subsidiaries

Legal under the McFadden Act

The Bank Holding Company act allowed holding companies with only one bank to provide limited non-bank financial services on an interstate basis. This created a loophole around Glass-Steagall!!

Holding Company

Prior to Bank Holding Company Act

Bank Bank Bank

Holding Company

After Bank Holding Company Act

Non-Bank Branches

Non- Bank Offices

Collects deposits, but doesn’t make loans

Makes loans, but doesn’t collect deposits

Financial Services

Deregulation of the Financial Services sector began in the 1980’s.

The Monetary Control Act (1980)

Began the phase out of interest rate ceilings at depository institutions

Imposed uniform reserve requirements on Banks and Thrifts

Riegle-Neal Interstate Banking and Branching Efficiency Act (1994)

Allowed holding companies to acquire banks in any state

Allowed banks to branch across state lines

Financial Services Modernization Act (Graham Leach-Bliley) (1996)

Permitted financial holding companies offering banking, insurance, securities and other services under one controlling corporation (allowed Citicorp to buy Traveler’s Insurance)

Capital Adequacyapital AdequacyAsset Qualitysset QualityManagementanagementEarningsarningsLiquidityiquiditySensitivity to Interest Rate Riskensitivity to Interest Rate Risk

Problems with Monitoring

Banks are monitored using the camels system. However, It’s not always easy to accurately assess the risk a bank is taking on

Off Balance Sheet Activities

Derivatives

Financial Guarantees (SLC)

Asset Securitization

In 1995, Barings Bank went bankrupt due to losses in the Derivatives market. At the time, it was holding $60B worth of derivative contracts – a staggering number when compared to Baring’s reported equity of $615M!!

The CAMELS System

Problems with Restricting Activities

Banks compete with other financial services companies as well as other banks!!

During the late 1970’s, market interest rates rose well above 10%, but banks were restricted by regulation Q to pay only 5.25% in savings accounts and 0% on checking accounts

BanksBanks Financial CompaniesFinancial Companies

Checking Accounts (0%)Checking Accounts (0%) Money Markey Mutual Funds Money Markey Mutual Funds (10%)(10%)

As households pulled their money out of banks, mortgage and small business lending was seriously curtailed!

Problems with Restricting Competition (Branching)

Restricting entry gives banks limited monopoly power, they can use this to increase profits at the customers expense!

Banking is a decreasing cost industry (i.e. large startup costs, but small marginal costs). By forcing banks to remain small and local, they are forced to operate at an inefficiently small scale!

By forcing banks to remain in a confined geographical location, you are forcing them to take on idiosyncratic (area specific) risk!

0

1

2

3

4

5

6

1979 1986 1989 1992 1995 1998

Since the 1970’s, there has been tremendous growth in international trade

World Trade (in Trillions of $s)

0

50

100

150

200

250

300

350

400

1979 1986 1989 1992 1995 1998

Even more Even more impressive is the impressive is the growth in foreign growth in foreign exchangeexchange

Currency Transactions (in Trillions of $s)

US Banks Operating Abroad

Subsidiaries: Governed by Federal Reserve Regulation K – must be involved in business “closely related to banking.

International Banking Facilities: Accepts time deposits and makes loans to foreign households & firms. Exempt from reserve requirements, but may not do business in the US.

Edge Act Corporations: Makes loans/accepts deposits. Can deal with both US and foreign citizens , but is limited to international trade transactions

Branches: Offer a full line of banking services, but are subject to foreign laws

US Banks locate facilities abroad to aid in international trade as well as to avoid regulation and taxes

Foreign Banks Operating in the US

Agency Office: Can’t accept deposits from US citizens, but can transfer funds from abroad and make loans in the US

Subsidiaries: Treated as a US bank. Subject to all US regulations. Subsidiaries may also set up edge act corporations and international lending facilities

Branches: Offers a full range of banking services for US citizens

Likewise for Foreign Banks…

Important Dates in International Banking

1930 1978 1988 1991

Bank for International (BIS) Settlements Created

International Banking Act Basle Accords I

Foreign Bank Supervision Act

BCCI Scandal

Bank of EnglandFederal Reserve

United States

Under whose jurisdiction do international banks fall? (it’s a gray area )

United Kingdom

Regulating International Banking

International Banking Act (1978)

Brought foreign banks operating in the US under federal regulation for the first time

Foreign banks, however, were not monitored as closely as US banks

Foreign Bank Supervision Act (1991)

Passed shortly after the BCCI scandal

Gave the Federal Reserve and the Comptroller of the Currency greater control over foreign banks operating in the US

Bank For International Settlements (1930)Bank For International Settlements (1930)

Established to handle German WWI Established to handle German WWI reparations, the BIS has become a center reparations, the BIS has become a center for international cooperation.for international cooperation.Played a central role in the Bretton Woods Played a central role in the Bretton Woods

Exchange Rate SystemExchange Rate System Integral in the Establishment of the EuroIntegral in the Establishment of the Euro

The BIS is like a central bank for central The BIS is like a central bank for central banks.banks.

Risk weighted assetsRisk weighted assets

Asset Risk Weight

Cash and equivalents 0

Government securities 0

Interbank loans 0.2

Mortgage loans 0.5

Ordinary loans 1.0

Standby letters of credit 1.0

The Basle Accords established uniform capital requirements for banks around the world. Equity capital was required to equal at least 4% of a bank’s risk weighted assets.

Risk Weighted Assets

Assets Liabilities

$ 2,000 (T-Bills)

$1,000B (Equity)

US Banking Sector

$ 3,000 (Other)

$ 54B (Cash)$ 46B (Reserves)

Res. Req. = 5%

$ 2,701 (Mortgage)

$ 800B (Checking)$ 4,500B (Saving)

$ 1B (Discount)

Loans Loans

(0)( $54B)

(0)($46B)

(0)($2,000B)

(.5)($2,701B)

(1)($3,000B)

= $0

= $0

= $3,000B

= $0

= $1,350.5B

$4,350.5B

Required Equity = (.04)($4350.5B) = $174.2B

+

Top Ten World BanksTop Ten World Banks

Bank Assets (Billions)

Citigroup (US) $1,497

JP Morgan + Bank One (US) $1,097

Mizuho Financial Group (Japan) $1,080

Bank of America + First Union (US) $851

UBS (Switzerland) $851

Sumitomo Mitsui (Japan) $844

DeutscheBank (Germany) $795

Mitsubishi Tokyo (Japan) $781

HSBC (UK) $759

BNP Paribas (France) $744

Problems with International Problems with International RegulationRegulation

The key issue is that the banking industry The key issue is that the banking industry in Japan and Europe is Fundamentally in Japan and Europe is Fundamentally different from the US.different from the US.

European BankingEuropean Banking

Unlike the US, European Banks are Unlike the US, European Banks are allowed to engage in securities markets allowed to engage in securities markets (universal banking)(universal banking)

In fact, in Europe, banks are generally In fact, in Europe, banks are generally significant shareholders in European significant shareholders in European companies. companies.

Banks rely much more on equity than Banks rely much more on equity than deposits.deposits.

Japanese BankingJapanese Banking

Japanese industry is organized into industrial Japanese industry is organized into industrial groups (keiretsu)groups (keiretsu) MitsubishiMitsubishi MitsuiMitsui SumitomoSumitomo FuyoFuyo DaiichiiDaiichii KangyoKangyo SanwaSanwa

Japanese BankingJapanese Banking

These “groups” are both vertically and These “groups” are both vertically and horizontally integrated and are comprised horizontally integrated and are comprised of a very large number of companies:of a very large number of companies:Sumitomo has 15 divisions ranging from Sumitomo has 15 divisions ranging from

electronics to mining to consumer goods.electronics to mining to consumer goods.Sumitomo controls assets equal to $50T.Sumitomo controls assets equal to $50T.

Japanese BankingJapanese Banking

Each “group” has its own bank which Each “group” has its own bank which handles its finances. This “main” bankhandles its finances. This “main” bankOwns equity in member firmsOwns equity in member firmsMonitors member firmsMonitors member firmsProvides credit for member firms.Provides credit for member firms.