U.S. Banking Regulation

I. Objectives of Financial Regulation

Safety and Soundness To prevent disruptions in the payments

system and to avoid a system-wide collapse of financial intermediaries.

Safety and soundness is promoted via (1) monetary and fiscal policies aimed at stable

levels of economic growth and prices, (2) the development and maintenance of an

efficient clearing systems network to ensure a stable payments system, and

(3) supervision of depository intermediaries.

I. Objectives of Financial Regulation

Consumer and Investor Protection Modern financial instruments are complex

legal contracts whose risk-return trade-off can easily confuse the average consumer or investor. Regulation can be used to standardize and simplify these contracts.

It can also be used to protect consumers against information asymmetry problems and potentially fraudulent schemes. Examples:

Truth-in-lending and Insider trading laws

I. Objectives of Financial Regulation

Fairness While unimpeded financial markets are

efficient, they may not reflect societal values. Consequently, regulators intervene m markets to obtain a "fairer" allocation of resources. Examples:

The preferential tax treatment given mortgage borrowers and credit unions;

Laws opposed to discriminatory lending practices;

Anti-trust laws.

I. Objectives of Financial Regulation

Information Disclosure To ensure the disclosure of an adequate

amount of information so that investors can make educated decisions m their borrowing and lending.

Disclosure rules have two basic objectives: First, to inform investors, and, Second, to prevent fraud. Examples of information

disclosure regulation is evidenced in the GAAP accounting statements and Call Reports filed by depository intermediaries.

II. The Cost of Regulation

Regulation is very expensive to banks: Estimates of compliance costs in the banking

industry alone run in the billions of dollars. Compliance costs include expenses incurred in

preparing financial reports, personnel expenditures due to on-site examinations, and the expenses of training and supervision.

However, indirect compliance costs are the largest component of total compliance costs.

III. The Theory of Regulatory Dialectic

The Theory of Regulatory Dialectic: Regulations changes in response to market

demands, but in general lags behind. A set of regulations was imposed for the purpose

of correcting or preventing certain financial problems in the beginning.

They became burdens to financial institutions and financial institutions attempted to circumvent the regulations by innovations, which made regulations ineffective.

Regulations were changed to bring financial institutions back under control.

IV. Major Banking Legislations

1927 The McFadden Act Subjected branching of nationally

chartered banks to the same branching regulations as state-chartered banks.

Liberalizing national banks' securities underwriting activities, which previously had to be conducted through state-chartered affiliates.

IV. Major Banking Legislations

1933 The Banking Acts of 1933 (the Glass-Steagall Act) Generally prohibited commercial banks from

underwriting securities with four exceptions:a. Municipal general obligation bonds.b. U.S. government bonds.c. Private placements.d. Real estate loans.

Established the FDIC to insure bank deposits.

IV. Major Banking Legislations

1956 The Bank Holding Company Act Restricted the banking and nonbanking

acquisition activities of multibank holding companies.

Empowered the Federal Reserve to regulate multibank holding companies by

a. Determining permissible activities.b. Exercising supervisory authority.c. Exercising chartering authority.d. Conducting bank examinations.

IV. Major Banking Legislations

1970 Amendments to the Bank Holding company Act of 1956 Extended the BHC Act of 1956 to one-

bank holding companies. Restricted permissible BHC activities to

those "closely related to banking.

IV. Major Banking Legislations

1978 International Banking Act Regulated foreign bank branches and

agencies in the United States. Subjected foreign banks to the

McFadden and Glass-Steagall Acts. Gave foreign banks access to Fedwire,

the discount window, and deposit insurance.

IV. Major Banking Legislations

1980 Depository Institutions Deregulation and Monetary Control Act (DIDMCA) Set a six-year phaseout for Regulation Q interest

rate ceilings on small time and saving deposits. Authorized NOW accounts nationwide. Introduced uniform reserve requirements for state

and nationally chartered banks. Increase the ceiling on deposit insurance coverage

from $40,000 to $100,000. Allowed federally chartered thrifts to make consumer

and commercial loans (subject to size restrictions).

IV. Major Banking Legislations

1982 Garn-St. Germain Depository Institutions Act (DIA) Introduced money market deposit accounts

(MMDAs) and super NOW accounts as interest rate-bearing savings accounts with limited check-writing features.

Allowed federally chartered thrifts more extensive lending powers and demand deposit-taking powers.

Allowed sound commercial banks to acquire failed savings banks.

Reaffirmed limitations on banks' ability to underwrite and distribute insurance.

IV. Major Banking Legislations

1987 Competitive Equality in Banking Act (CEBA) Redefined the definition of bank to limit

the growth of nonbank banks. Sought to recapitalize the Federal

Savings and Loan Insurance Corporation (FSLIC).

IV. Major Banking Legislations

1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA)

Limited savings banks' investments in nonresidential real estate, required divestiture of junk bond holdings (by 1994), and imposed a restrictive asset test to qualify as a savings bank (the qualified thrift lender test, or QTL).

Equalized the capital requirements of thrifts and banks. Replaced FSLIC with FDIC-SAIF. Replaced the Federal Home Loan Bank Board as the

charterer of federal savings and loans with the Office of thrift Supervision (OTS), and agency of the Treasury.

Created the Resolution Trust Corporation (RTC) to resolve failed and failing savings banks.

IV. Major Banking Legislations

1991 The Federal Deposit Insurance Corporation Improvement Act (The FDICIA Act)

Introduced prompt corrective action (PCA), requiring mandatory interventions by regulators whenever a bank's capital falls.

Introduced risk-based deposit insurance premiums beginning in 1993.

Limited the use of "too big to fail" bailouts by federal regulators for large banks.

Extended federal regulation over foreign bank branches and agencies in the Foreign Bank Supervision and Enhancement Act.

IV. Major Banking Legislations

1994 Riegle-Neal Interstate Banking and Branching Efficiency Act Permitted bank holding companies to acquire banks

in other states, starting September 1995. Invalidated the laws of states that allow interstate

banking only on a regional or reciprocal basis. Beginning June 1997, permitted bank holding

companies to convert out-of-state subsidiary banks into branches of a single interstate bank.

Also permitted newly chartered branches within a state if state law allows.

IV. Major Banking Legislations

1999 Financial Services Modernization Act Eliminated restrictions on banks, insurance

companies, and securities firms entering into each others' areas of business.

Provided for state regulation of insurance. Streamlines bank holding company supervision,

with the Federal Reserve as the umbrella holding company supervisor.

Prohibited FDIC assistance to affiliates and subsidiaries of banks and thrifts.

Provided for national treatment of foreign banks engaging in activities authorized under the Act.

V. Bank Safety Regulation 1. Federal Deposit Insurance

Had effectively stopped widespread bank failures caused by panic withdrawals of depositors. What are the problems on the system?

  2. Deposit Rate Ceilings:

Why ceilings on deposit rates were imposed? Did excessively high interest rates on deposit

accounts really cause bank failures? DIDMCA of 1980 phased out the ceilings.

V. Bank Safety Regulation 3. Bank Examinations

To determine the soundness and prudence of the bank management. But bank examinations also serve as a controlling device in checking banks' risk taking.

  4. Balance Sheet Restrictions: Adequate capital requirements Maximum amount of loan extended to one

individual borrowers and to each type of loans Investment in corporate or municipal securities

of "investment grade quality" Minimum reserve requirements

V. Bank Safety Regulation 5. Prohibition on Owning Equity

Securities Owning equity securities is too risky

and losses on them could precipitate bank failures

To prevent the potential conflicts arising from combing the ownership and creditor functions of banks.

 

V. Bank Safety Regulation 6. Separation of Commercial Banking

and Investment Banking The 1933 Glass-Steagall Act imposed rigid

separation between commercial banking and investment banking with three exemptions:

a. The underwriting of new issues of Treasury securities.b. The underwriting of municipal general obligations

bonds.c. The private placements of corporate debt and equity

securities. Investment banking was considered to be

inherently too risky for commercial banks. But is this true?

VI. Bank Structure Regulation

1. Limited Entry Charters from either the federal or the state

government Criteria for granting charter:

1. demonstrate a need for their services by the community

2. would not endanger the solvency of other banks in the area

3. earning prospects 4. banking experience and reputation of the

applicants

VI. Bank Structure Regulation

2. Restrictions on Branching To be classified as a branch, a banking office

must accept deposits as well as making loans. State laws govern the degree of branching

allowed. Three modes are followed: unit banking, limited branching, and statewide branching.

In deciding for branching, regulators consider whether:

(1). there is a need for a new banking office in the area (2). it will not impair local bank competition

VI. Bank Structure Regulation

2. Restrictions on Branching Issues involved in branching legislation:

1. would branching increase the degree of concentration?

2. Would branching reduce competition? 3. would branching shift out funds from local

community? 4. would branching improve price and availability of

banking services? 5. Would branching endanger the soundness of

banks?

VI. Bank Structure Regulation

3. Bank Mergers: The Bank Merger Act of 1960 gives federal regulators

authority power to approve bank mergers. The law requires the agencies to disprove mergers

they consider damaging to competition and that they believe do not serve the needs or convenience of the local community.

The U.S. Justice Department and the Supreme Court may challenge the mergers approved by the regulators.

The Garn St. Germain Act of 1982 allows for out-or-state banking firms to acquire failed or failing depository institutions.

VI. Bank Structure Regulation

4. Bank Holding Companies: A BHC may own several banks or just one bank.

Formation of a new BHC is subject to approval of the FR Board. They are subject to much the same regulations that are applied to branching and bank mergers.

Factors for the explosive growth of BHCs: Banks put themselves under BHCs in order to utilize the

latter's power to acquire loanable funds through issuing commercial paper.

The power that BHCs give to banks to expand into another line of commerce.

BHCs realize economies of scale and scope through centralizing management and services facilities.

As a way to circumvent state laws and regulations prohibiting or restricting branch banking.

VI. Bank Structure Regulation

4. Bank Holding Companies: Advantages of BHCs:

capable of portfolio and geographical diversification

advantage of attracting highly qualified management personnel resulting in more efficient operation

large concentration of financial services more prone to risk taking, increasing the

probability of failures.

VI. Bank Regulatory Structure

Regulators of Various Functions __________________________________________________________________________ Type of Bank State Insured Noninsured National Member State State __________________________________________________________________________ Chartering and Comptroller State Authority State Authority State

Authority Licensing   Intrastate Comptroller Fed. Reserve FDIC State

Authority branching and and State Authority State Authority   Intrastate mergers, Comptroller Fed. Reserve FDIC State Authority acquisitions, and consolidations

VI. Bank Regulatory Structure

Regulators of Various Functions __________________________________________________________________________ Type of Bank State Insured Noninsured National Member State State __________________________________________________________________________ Reserve Fed. Reserve Fed. Reserve Fed. Reserve Fed. Reserve Requirements   Access to the Fed. Reserve Fed. Reserve Fed. Reserve Fed. Reserve

discount window

Deposit insurance FDIC FDIC FDIC None or StateInsurance

Fund   Supervision and Comptroller Fed. Reserve FDIC State Authority examination and and State Authority State Authority

VI. Bank Regulatory Structure

Regulators of Various Functions __________________________________________________________________________ Type of Bank State Insured Noninsured National Member State State __________________________________________________________________________ Prudential limits: Comptroller Fed. Reserve FDIC State Authority safety and and and soundness State Authority State Authority   Rulemaking: Fed. Reserve Fed. Reserve Fed. Reserve Fed. Reserve Consumer and and protection State Authority State Authority   Enforcement: Comptroller Fed. Reserve FDIC State Authority Consumer protection __________________________________________________________________________