•McFadden Act (1927) and Douglas Amendment (1956) limit interstate branching•Interstate Banking and Branching Efficiency Act (1994) deregulates branching•Gramm-Leach-Biley Financial Services Modernization Act (1999) repeals Glass-Steagall

Regulating Finance• Lots of bases to cover

Cover one by regulation or deregulation

Unintended Consequences

• Reactions to regulatory policies

frustrate regulator intentRegulate 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

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

Innovations: Response to Interest Rate Volatility• Adjustable-rate mortgages• Financial Derivatives

Innovations: Response to Information Technology• Bank credit and debit cards• Electronic banking

– ATM/Home banking/ABM/Virtual banking• Junk bonds• Commercial paper market … backed by banks• Securitization

Innovations:Avoiding Regulation/Loophole Mining• Sweep accounts … reserve requirements• Money Market Mutual Funds … Regulation Q

Decline of Traditional BankingDecline in cost advantages in acquiring funds (liabilities)

Rising inflation rise in interest rates and disintermediationLow-cost source of funds, checkable deposits, declined in importance

Decline in income advantages on uses of funds (assets)Information technology 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 ????

3,0464,039 486 867,640

39.952.9 6.1 1.1

1.3 9.710.079.0

Ten Largest Banks in the World, 2007 $ Revenues1. ING Group, Netherlands 6. BNP Paribas, France2. Fortis, Belgium/Netherlands 7. Credit Agricole, France3. Citigroup, US 8. Deutsche Bank, Germany4. Dexia Group, Belgium 9. Bank of America, US5. HSBC Holdings, UK 10. UBS, Switzerland

Ten Largest Non – US Banks, December 30, 2008

Bank Consolidation

• Benefits of bank consolidation

Increased competition close inefficient banks

Efficiencies from economies of scale and scope

Lower chance of failure -- diversified portfolios• Costs

Fewer community banks less lending to small business

Banks in new areas increased risks/failures

Skirting branch restrictions•ATMs, Bank Holding Cos.

Interstate Banking and BranchingEfficiency Act, 1994

Pre-Crisis Findings:•Net interest margin up•ROA, ROE up for big banks•Intrastate deregulation more positive for all but big banks•Interstate deregulation helps big banks most•Non-performing loans down for biggest banks but up for smaller banks•State of economy has stronger impact on bank performance than branching deregulation

Geographic deregulation

Skirting branch restrictions•ATMs, Bank Holding Cos.

10

The U.S. regulatory regime: In need of reform?

Sources: Financial Services Roundtable (2007), Milken Institute.

National banks State commercial and savings banks

Federal savings banks

Insurance companies

Securities brokers/dealers

Other financial companies, including mortgage

companies and brokers

• Fed• OTS

• OCC• FDIC

• State bank regulators• FDIC• Fed--state member commerical banks

• OTS• FDIC

• 50 State insurance regulators plus District of Columbia and Puerto Rico

• FINRA• SEC• CFTC• State securities regulators

• Fed• State licensing (if needed)• U.S. Treasury for some products

• OCC• Host county regulator

• Fed• Host county regulator

• OTS• Host county regulator

Federal branch

Foreign branch

Limited foreign branch

Fed is the umbrella or consolidated regulator

Primary/secondaryfunctionalregulator

Notes:Justice Department: Assesses effects of mergers and acquisitions on competitionFederal Courts: Ultimate decider of banking, securities, and insurance productsCFTC: Commodity Futures Trading CommissionFDIC: Federal Deposit Insurance CorporationFed: Federal ReserveFINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the CurrencyOTS: Office of Thrift SupervisionSEC: Securities and Exchange Commission

• Federal Housing Finance Agency

Fannie Mae, Freddie Mac, and Federal Home Loan Banks

Financial, bank and thrift holding companies

Justice Department• Assesses effects of mergers and acquisitions on competition

Federal courts• Ultimate decider of banking, securities, and insurance products

Asymmetric Information and Bank RegulationGovernment safety net• Deposit insurance and FDIC

– Short circuits bank failures and contagion effect• Payoff method• Purchase and assumption method

• Fed as lender of last resort: Too BIG to Fail• Financial consolidation Exacerbates Too Big to Fail• Safety net extended to non-bank financial institutions

Safety Net Moral Hazard Problems – Depositors don’t impose discipline of marketplace– Banks have an incentive to take on greater risk

Safety Net Adverse Selection Problems– Risk-lovers find banking attractive– Depositors have little reason to monitor bank

Attempted solutions: Constrain banks from taking too much risk• Promote diversification• Prohibit holdings of common stock• Set capital requirements … Capital as cushion

• Minimum leverage ratio• Basel Accord: risk-based capital requirements

… but there’s regulatory arbitragePrompt 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

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

1980s S&L and Banking Crisis

• Financial innovation increased risk taking

• Increased deposit insurance moral hazard

• Deregulation

• Lack of management expertise

• Rapid growth in new lending: real estate

– Activities expanded in scope

– Regulators at FSLIC lacked expertise

• High interest rates/recession

increased incentives for moral hazard

1980s S&L and Banking Crisis: • Regulatory forbearance by FSLIC

– Insufficient funds to close insolvent S&Ls– Established to encourage growth– Did not want to admit agency was in trouble

• Zombie S&Ls taking on high risk projects and attracting business from healthy S&Ls

• Politicians lobbied by S&L interests

• Competitive Equality in Banking Act of 1987– Inadequate funding– Continued forbearance

The Financial Institutions Reform, Recovery, and Enforcement Act of 1989

• Regulatory apparatus restructured– Federal Home Loan Bank Board relegated to the OTS– FSLIC given to the FDIC– RTC established to manage and resolve insolvent thrifts

• Cost of the bailout approximately $150 billion• Re-restricted asset choices

• Increased core-capital leverage requirements

• Imposed same risk-based capital standards as those on commercial banks

• Enhanced enforcement powers of regulators

• Did not resolve underlying moral hazard and adverse selection problems