Professor Vinh Nguyen Faculty of Business and Economics The University of Hong Kong Banking Regulation 1. Bank Panics and the Need for Deposit Insurance ─ Prior to FDIC insurance, bank failures meant depositors lost money. “Good ” banks needed to separate themselves from “bad ” banks. ─ The inability of depositors to assess the quality of a bank ’s assets can lead to panics. Banking Regulation 1. Bank Panics and the Need for Deposit Insurance ─ Bank panics did occur prior to the FDIC, with major panics in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930–1933. ─ With a safety net, depositors will not flee the banking system at the first sign of trouble. Indeed, between 1934 and 1981, fewer than 15 banks failed each year. Banking Regulation 1. Bank Panics and the Need for Deposit Insurance ─ The FDIC insurance creates moral hazard incen- tives for banks to take on greater risk.
─ The FDIC insurance creates adverse selection. Those who can take advantage of (abuse) the insurance are mostly likely to find banks attractive. Banking Regulation 1. Bank Panics and the Need for Deposit Insurance ─ Regulators are reluctant to let the largest banks fail because of the potential impact on the entire system. This is known as the “Too Big to Fail” doctrine. Banking Regulation 1. Bank Panics and the Need for Deposit Insurance ─ When Continental Illinois failed in 1984, all deposits were insured, as were bond holders. The FDIC infused $4.5 billion to rescue the bank. ─ Even creditors are not interested in a bank’s health! Banking Regulation 1. Bank Panics and the Need for Deposit Insurance ─ Consolidation has created many “large” banks, exasperating the too-big-to-fail problem. ─ Banks now engage in more than just banking, extending FDIC to such activities as underwriting. Banking Regulation 2. Restrictions on Asset Holdings ─ Regulations limit the types of assets banks may hold as assets.
For instance, banks may not hold common equity. ─ Even with regulations in place, the 2007–2009 global financial crisis still occurred. Perhaps, more regulation is needed? Banking Regulation 3. Bank Capital Requirements ─ Banks are also subject to capital requirements. Banks are required to hold a certain level of capital (book equity) that depends on the type of assets that the bank holds. Banking Regulation 3. Bank Capital Requirements ─ Details of bank capital requirements:
• Leverage ratio must exceed 5% to avoid restrictions • Capital must exceed 8% of the banks risk-weighted assets and off- balance sheet activities ( details follow) • New capital requirements are forthcoming to address problems (such as OBS items) with risk-weighted assets Calculating Capital Requirements F ir st Na ti ona l Ban k A ss e ts L ia biliti e s R e ser v e s $3 m Ch ec k a bl e d e posits $20 m Trea su ry s ec u riti e s $10 m N ont ra ns ac tions d e posits $60 m G ov er nm e nt a g e n c y sec u riti e s $7 m Bo rr o w ings $11 m Muni c ip a l bonds $10 m L o a n loss re ser v e s $2 m R e sid e nti a l mo rtg a g e s $10 m B a nk ca pit a l $7 m R ea l e st a te lo a ns $20 m C& I loans $35 m Fix e d as sets $5 m Calculating Capital Requirements • Leverage Ratio = Capital/Assets = $7m/$100m = 7% • Bank is well capitalized Calculating Risk – Adjusted Requirements 0 × $3 mi lli on (R e se rve s) +0 × $10 mi lli on (T rea s u ry s ecu riti e s) + .20 × $7 mi lli on (A gency se cur iti e s ) + .50 × $10 mi lli on (M un ic ip a l bond s) + .50 × $10 mi lli on (R e si den ti a l m or tgag es ) +1.00 × $20 mi lli on (R e al e st a te loan s) +1.00 × $35 mi lli on (C o mm er c ial lo a n s ) +1.00 × $5 mi lli on (Fi xed a sse ts) +1.00 × $20 mi lli on (L et te rs of c red it ) $91.4 mi lli on (To ta l ris k -ad ju st ed a ss e ts ) Calculating Risk-Adjusted Requirements Core Capital Requirement = 4% x risk-adjusted assets = 4% x $91.4m = $3.66m < $7m of core capital Total Capital Requirement = 8% x risk-adjusted assets = 8% x $91.4m = $7.31m < $9m of total capital = $7m of core + $2m of loan loss reserves Bank Regulation 3. Bank Capital Requirements Banks now engage in regulatory arbitrage , where for a given category, they seek assets that are the riskiest. Banking Regulation 4. Disclosure Requirements ─ Better information reduces both moral hazard and adverse selection problems ─ Sarbanes-Oxley increased requirements for accurate accounting statements, created the PCAOB, and put limits on conflicts of interest ─ Mark-to-market accounting may help, if asset values can be determined Banking Regulation 4. Disclosure Requirements The Case of Mark -to -market accounting • In theory, market prices provide the best basis for estimating the true value of assets, and hence capital, in the firm. • Mark -to -market accounting, however, is subject to a major flaw: the price of an asset during a time of financial distress does not reflect its fundamental value. Banking Regulation 4. Disclosure Requirements The Case of Mark -to -market accounting • If banks are required to show “market ” value in financial records, a bank may appear undercapitalized, even though prices are not accurate • The criticism was made only when asset values were falling (2007 – 2009), not when asset prices were booming, making banks ’ balance sheets look very good (early 2000s). Banking Regulation 5. Consumer Protection ─ Standardized interest rates (APR) ─ Prevent discrimination (e.g., CRA to help avoid redlining particular areas) ─ The 2007–2009 revealed further need for consumer protection (from themselves?) as consumers took out loans where they clearly did not understand the terms Banking Regulation 5. Consumer Protection During the housing boom, mortgage originators had little incentive to ensure that subprime borrowers had an ability to pay back their loans. A particular infamous mortgage was dubbed the NINJA loan because it was issued to borrowers with No Income, No Job, and No Assets. Banking Regulation 5. Consumer Protection The Federal Reserve did address some issues in July of 2008 for subprime loans: ─ Mortgage had to consider ability to repay ─ No-doc (NINJA-type) loans were banned ─ Ban on prepayment penalties ─ Escrow accounts required Further regulations were established for all mortgages. Banking Regulation 5. Consumer Protection • The backlash is no t over. Consumer Financial Protection Bureau (CFPB) was proposed by Senator Elizabeth Warren and established in 2011 . • The CFPB publicized and investigated complaints against financial institutions, and extracted nearly $12 billion for 29 million consumers in refunds and cancelled debts. • The CFPB faces the criticism by the Republicans. In 2018, English v. Trump lawsuit over the appointment of the new director, Mick Mulvaney . Banking Regulation 6. Restrictions on Competition ─ Branching restrictions, which reduced competition between banks ─ Separation of banking and securities industries:
Glass-Steagall. In other words, preventing nonbanks from competing with banks (repealed in 1999) ─ Can lead to higher fees and less innovation Banking Regulation 7 . Macro vs. micro -prudential regulation ─ Micro regulation focuses on individual banks ─ Macro regulation looks at the banking system as a whole ─ Financial crisis shows the micro regulation is not enough