Chapter 15

The Regulation of Markets and Institutions

Key Ideas

Different methods of regulating financial markets

Dual banking system and the regulators who oversee it

Universal banking and its possible benefits and risks

Introduction Financial system is one of most intensely regulated sectors in US economy

Objectives of the regulations are: To promote competition To protect individual consumers To maintain stability of financial system

To facilitate monetary policy

Primary Market

Philosophy Best protection is provide adequate information about securities and investments

Full disclosure broadens participation in financial markets

Primary Market

Securities Act of 1933 Requires disclosure of information for newly issued publicly traded securities

Privately held firms are not required to reveal financial information to the public at large, only to the lenders

Primary Market

Securities Exchange Act of 1934 Created the Securities and Exchange Commission (SEC) to administer provisions of 1933 Act

Publicly traded security must file registration statement and preliminary prospectus disclosing information about issue

Primary Market

Securities Exchange Act of 1934 The prospectus does not state

the interest rate on a bond issue or price for equity issues determined in the market when sold

If information is adequate, SEC approves the statement and sale

Approval by the SEC does not imply that it views the new issue as an attractive investment

Approval simply means disclosure of information is adequate

Regulation of Secondary Market

Securities Exchange Act of 1934 Extended 1933 Act

Periodic disclosure of relevant financial information

For firms trading in secondary market 10K Report

Annual financial statement and Information about a firm’s performance and activity

Secondary Market

Securities Exchange Act of 1934 Prohibits Insider Trading

Prohibit insiders from trading on private information not previously disclosed to public

Corporate officers and major stockholders must report all their transactions of their own firm’s stock

Regulation of Commercial Banks

Philosophy Protect individual depositor Foster a competitive banking system

Ensure safety and soundness of banking system

Commercial Banks

Dual banking system Federal and State banks existing side-by-side

Legislation in 1860 established federally chartered banks

Created Comptroller of the Currency (US Treasury Department) to supervise chartered banks

Imposed a prohibitive tax on issuance of state banknotes

Intent was to drive existing state chartered banks out of business

Commercial Banks

Dual banking system However, state banks survived

Stopped issuing banknotes Started to accept of demand deposits

State chartered banks are supervised by regulators in their respective state

Federally chartered banks tend to be larger in size, but state banks are more in number

Commercial Banks

Federal Reserve Act of 1913 Required national banks to become members of the Fed

State chartered banks had option of being a nonmember

All state banks (including nonmember) currently fall under regulation of the Fed Reserve System

Commercial Banks

Federal Deposit Insurance Corporation (FDIC) All member banks of Fed are required to carry FDIC insurance

Members include, All national and Some state banks

A majority of state banks (including non members) have opted to participate in FDIC program

Commercial Banks

Multiple Regulators at Federal level with Overlapping and Conflicting authority.

Federal Reserve System Comptroller of Currency FDIC

Some experts suggest that all regulation should be combined in a single agency

However, no legislation exists to unify the structure

Commercial Banks

Philosophy Protect Individual Depositors Maintain Stability of Financial System

Strategy of Regulation: Disclosure is not enough Physical examination of member banks Bank examinations are often not public by design

Commercial Banks

Primary Liabilities: Demand Deposit

Banks must maintain sufficient liquidity to meet demand deposits

It is costly to keep excess reserve or liquid assets

Fear of insolvency may cause a run on the bank causing a system-wide bank panic

Paid on a first-come/first-serve basis

Periodic examination of a bank by regulatory agencies to insure banks are solvent

Commercial Banks

Deposit Insurance FDIC established by Banking Act of 1933 to insure deposits at commercial and mutual savings banks.

Created after a large number of bank failures in the early 1930’s

Objective is to protect small savers

Reduce the incentive for depositors to join a bank run

Commercial Banks Deposit Insurance

Currently insure deposits up to $100,000 for single account

Coverage depends on procedure used by FDIC: Payoff Method

Bank goes into receivership by FDCI FDIC pays out funds up to $100,000

Purchase and Assumption Method FDIC merges failed bank with a healthy one Deposits of failed bank are assumed by solvent bank

Commercial Banks Moral Hazard and Deposit Insurance Existence of FDIC eliminates large-scale bank failure and bank run.

However, it creates a classic moral hazard problem

With FDIC insurance, depositors have little or no incentive to monitor riskiness of their banks.

Without monitoring, bank managers finds it easy to engage in risk shifting

Commercial Banks

Moral Hazard and Deposit Insurance Shareholders and directors of banks have incentive to make their banks riskier at the expense of the FDIC

“Too big to fail” Doctrine FDIC may extend loans to very large banks in trouble to allow continued operations

This doctrine may unintentionally exacerbate the moral hazard problem

Recently bank failures have increased due to banking deregulation and commercial banking activities have become riskier

Regulation of Commercial Banks

Risk-Based Capital Requirements Bank capital acts as a cushion against failure

Banks are required to maintain a capital to asset ratio

This ratio measures of bank’s risk exposure

Risk-based capital requirements Higher capital requirement for banks with risky assets.

With higher risk amount of risk-based asset will go up.

This will cause Capital to Asset ratio to go down.

These requirements are agreed upon by the United States and members of the Bank for International Settlements (BIS)

Regulation of Commercial Banks

Prompt Corrective Action (PCA) Passed as a part of FDIC Improvement Act of 1991

Established procedures to handle troubled banks

Designed to close banks before FDIC is exposed to excessive losses

Prevent regulatory forbearance when regulators keep an insolvent institution operating in hopes of “turning it around”

Banks are ranked according to their perceived risk and more restrictions placed on riskier banks

Established a risk-based deposit insurance premium in FDIC charge insurance premium based on the perceived risk of the bank

Regulation of Nondepository

Regulations are designed based on the type of liabilities they issue

Pension funds and life insurance companies

Heavily regulated because their liabilities are purchased by small investors and need to protect small investors

Employee Retirement Income Security Act (ERISA)

Regulation of Nondepository

Employee Retirement Income Security Act (ERISA)

Established the Pension Benefit Guaranty Corporation

Guarantees defined benefits pension plans, subject to a maximum amount

Establishes minimum reporting, disclosure and investment standards

Regulation of Nondepository

Life Insurance Companies Regulated at the state level Impose risk-based capital requirements

Perform periodic audits Implicit and explicit restrictions on pricing of particular products

Regulation of Nondepository

Finance companies Raise funds by issuing debt and equity

Have virtually no regulation beyond the securities laws governing publicly traded securities

Regulation of Nondepository

Mutual Funds Regulated by the SEC Also subject to state regulations

Objective is to protection of individual investors through full disclosure

The Glass-Steagall Act

Segregated the banking industry from the rest of the financial services industry

Banks are barred from owning corporate stock and other activities deemed too risky

The Genesis of Glass-Steagall Prior to 1933, investment banking and commercial banking were conducted under same roof

Following the financial collapse of the 1930s, it was felt that investment banking activities were too risky for banks

The Glass-Steagall Act

The Genesis of Glass-Steagall This combination represented a substantial threat to financial system stability

Although there was little empirical evidence to support this contention, the legislation mandated separation of the two activities

The Glass-Steagall Act

The Erosion of Glass-Steagall Commercial banks exerted pressure on the Federal Reserve and courts to reduce the barriers caused by Glass-Steagall

Bank-holding Companies Permitted banks to conduct nonbanking activities through subsidiaries

In 1970 Federal Reserve was given power to determine what activities were permissible

Activities had to be closely related to traditional banking

During the 1970s and 80s banks acquired more freedom to engage in nontraditional banking activities

The Glass-Steagall Act

The Erosion of Glass-Steagall In 1989 the Federal Reserve granted five banks the power to underwrite corporate debt through a Section 20 affiliate

Gradually the Federal Reserve granted more and more banks the right to underwrite corporate debt

The Glass-Steagall Act

The Gramm-Leach-Bliley Act (1999) Allowed affiliates of financial holding companies to engage in various banking activities and insurance underwriting

Overall responsibility for regulation lies with the Federal Reserve through its role as the “umbrella” regulator

Federal Reserve has power to ensure capital adequacy of holding companies, safety and soundness of their activities

The Glass-Steagall Act

The Gramm-Leach-Bliley Act (1999) Individual affiliates of holding companies are subject to regulation by functional supervisors such as the SEC

This regulation framework blends the disclosure-based and inspection-based approaches to regulation

The Glass-Steagall Act

The Risk of Universal Banking Risk inherent in securities activities, especially the underwriting business, may affect the stability of the banking system

Losses in securities activities lead to more bank failures and significant losses to FDIC

The Glass-Steagall Act

The Risk of Universal Banking Other view: Just because investment banking is riskier than commercial banking, this does not mean that the combination of the two will be riskier

Universal Banking

The Risk of Universal Banking The portfolio theory suggests that diversification may reduce risk when commercial banking is combined with investment banking and life insurance activities

Perhaps it is time to let the banks decide for themselves whether universal banking reduces risk