Bank Regulation in the United States

Bank Regulation in the United States

A briefing paper for Northern California legislative aides at City College of San Francisco on the topic of bank regulation in the United States.

Mike P. McKeever

Economics Instructor

© Copyright, February 22, 2009; contact the author by email at for permission to reproduce in whole or part.

[URL: www.mkeever.com/bank_regulation_usa.doc]

50 Phelan Avenue, San Francisco, CA. 94112 (415)239-3000

SITUATION REPORT

The national security of the United States is affected adversely when the banking system fails to ensure free flowing credit markets. The situation at United States is difficult today. Several banks have failed and more are facing hard times.

United States banks today have the ability to perform several functions: take in deposits, make loans, make and sell investments and sell insurance. They do not have the ability to invest in or sell real estate.

Recent bank troubles have contributed to the current recession; and, some opinions are that these bank troubles have caused the current malaise. Its effects are wide reaching.

Dennis Blair, the new director of national intelligence, stated to the Senate Select Committee on Intelligence that a prolonged economic crisis could produce 'regime-threatening instability' with violence and extremism in some countries. [SFChron, editorial, 02.16.09]

United States banks have custody of much of the country's money supply and, as a result of this responsibility, receive oversight from several federal regulatory bodies.

President Obama considers the bank situation so critical that he is examining the option of bank nationalization as a partial solution to the crisis. [E J Dionne, Jr., SF Chron. 02.16.09]

Congress has allocated $700 billion to banks to encourage them to lend money, but the credit markets are still frozen.

Commercial banks are able to borrow money from the Federal Reserve Bank at virtually zero interest.

Alan Greenspan's opinion is that the precipitating cause of the current economic crisis was a failure of bank regulation.

It is the author's opinion that the current administration is doing everything in its power to ameliorate the present situation.

Other commentators have stated that there has been a multi-trillion dollar loss of wealth throughout the world and that this wealth loss will take some time to work its way through the economy.

POSSIBLE FUTURE SCENARIOS

For policy planning purposes, it is useful to predict what might happen in the future, even though one economist said: 'All predictions [models] are wrong, some are useful...'

It is likely that the loss of wealth is permanent and will not be reversed until global economic growth resumes. The Dow Jones did not recover from the Depression losses until after World War II.

It is also likely that capital and wealth will not grow as rapidly as it has in the past. This assumes we will see eventual renewed economic growth.

A further prediction is that world governments will move to redress the imbalance between wages and capital formation in the next few years. This will be part of an attempt to reduce the world wide over capacity to produce products.

OBJECTIVES OF BRIEFING REPORT

The primary objective of this briefing is to present recommendations for changing the structure and procedures of bank regulation so that the likelihood of future bank problems is reduced.

Additionally, there is likelihood that the TARP program will not reach its goals unless bank regulation is improved.

Going forward, the overarching goal of bank regulation is to enhance stability in financial markets and promote the free flow of credit to worthy borrowers.

The regulations suggested in this brief are offered without regard to whether they require legislation or simply an administrative change. Bank regulations can have critical effects and should be considered as a whole regardless of their origin.

Because of the complexity of the situation, it is recommended that any and all regulation changes be examined by a panel of investors who buy bank shares as well as by the industry and affected regulators.

FIRST RECOMMENDATION:

RESTORE SEPARATION OF COMMERCIAL AND INVESTMENT BANKS

The first recommendation is to restore the separation of banking rights and privileges to the situation as it was under the New Deal regulations adopted in the 1930's. These regulations gave us 50 years of bank stability, economic growth and stable or falling income inequality.

In essence this means that commercial banks are allowed only to take deposits and make loans; they may not make investments or sell insurance. Banks which make investments may not take deposits - they can sell shares under SEC regulations. Insurance companies may not undertake banking activities and should be regulated under a separate jurisdiction.

As background, the following is quoted with permission from the paper by David Moss, 'An Ounce of Prevention: The Power of Public Risk Management in Stabilizing the Financial System' (Harvard Business School Working Paper 09-087, copyright January 2009). [http://www.hbs.edu/research/pdf/09-087.pdf].

"Financial panics and crises are not new problems. For most of the nation’s history, they represented a regular and often debilitating feature of American life. Until the Great Depression, major crises struck about every fifteen to twenty years in 1792, 1797, 1819, 1837-1839, 1857, 1873, 1893-95, 1907, and 1929-33.

But then the crises stopped. In fact, the United States did not suffer another major banking crisis for just about 50 years, by far the longest such stretch in the nation’s history. Although there were no doubt many reasons for this, it is difficult to ignore the federal government’s active role in managing financial risk. This role began to take shape in 1933 with passage of Glass-Steagall, which introduced federal deposit insurance, significantly expanded federal bank supervision, and required the separation of commercial from investment banking. The New Deal approach to financial regulation did not begin to be dismantled until passage of the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Depository Institutions Act (Garn-St. Germain) of 1982, which commenced the drive for financial deregulation. The drive for financial deregulation may be said to have culminated in 1999 with the passage of Gramm-Leach-Bliley, which repealed an important piece of Glass-Steagall, allowing consolidation of banks, securities firms, and insurance companies.

Contrary to prevailing wisdom in many quarters, New Deal financial regulation worked. Indeed, it worked remarkably well. Banking crises essentially disappeared after 1933 (see Figure 1), and this extraordinary achievement was secured without any apparent reduction in economic growth. Not only was the period of 1933-1980 one of unusually strong growth, but the growth was broad based, associated with stable or falling income inequality, rather than rising inequality which took hold after 1980."

Also from David Moss paper with permission.

SECOND RECOMMENDATION:

ENHANCE EXISTING REGULATION - MORE MONEY, MORE PEOPLE, NEW AGENCY

Under the New Deal regulation system, banks were regulated by the Comptroller of the Currency, the Federal Reserve Bank and the Federal Deposit Insurance Corporation.

If the separation between commercial and investment banks is restored pursuant to the first recommendation above, then that regulation framework may be adequate.

A strong proviso here is that the disclosure requirements for banks and other financial institutions should be increased greatly; see the Fifth Recommendation below. The existing regulation can only continue with more disclosure.

But, each of those agencies requires additional funding, personnel and a new sense of direction to counter the previous administration's philosophy that no regulation is the goal.

However, it may also be appropriate to place all bank regulation activity under a banking Czar which would report directly to the Secretary of the Treasury.

THIRD RECOMMENDATION:

CONSIDER TEMPORARY NATIONALIZATION OF SELECTED BANKS

It has happened that commercial banks with more than adequate capital have failed to lend money to worthy borrowers. Perhaps the corporation's shareholders are better served by an acquisition or a dividend that by additional lending.

In those cases, the national interest of the United States may be served by nationalizing the bank temporarily and ensuring that the bank resumes its lending activities.

Any nationalization should be on a case by case basis and not a system wide basis. Also, such a move should be preceded by a thorough examination of the bank's financial position and management practices.

FOURTH RECOMMENDATION:

ALLOW LIMITED SUSPENSION OF MARK-TO-MARKET ACCOUNTING RULE FOR SELECTED BANKS AND ASSETS

As background, one of the accounting rules adopted after the Enron debacle is that firms must reduce assets on their balance sheets to the lower of cost or market each year. In a market where the value of assets - homes - is falling, banks which place loans on homes in their asset columns are forced to write-off large amounts of over valued assets. This effectively reduces their net worth and damages their ability to qualify for loans from other banks.

But, it can be argued that the current decline in home values is not under the banks' control, that it is an historically unique situation and is a failure of government, not a market failure.

Additionally, mortgage backed bonds were marketed as secure bonds by other banks. It is not possible to determine the value of these bonds today. Many banks hold these bonds as reserves or investments. Their holding of those bonds makes their balance sheets questionable, thus making it more difficult to borrow.

Arguably, the marketing of these bonds was a regulation failure and not a banking or market failure.

If those arguments are accepted, then banks should be allowed five years to write down questionable assets instead of taking the losses all at once.

This may well make it easier for banks to borrow funds.

FIFTH RECOMMENDATION:

REQUIRE EXTENSIVE DISCLOSURE

In a detailed study by James Barth, Gerard Caprio, Jr. and Ross Levine ['Regulating Banks: What Really Works" in the Milken Institute Review, Fourth Quarter 2005] the authors examined the bank regulation policies in more than 100 countries to determine which policy mix created stability and growth.

Their conclusion is that market regulation wherein investors vote with their share purchases is more effective than regulation wherein regulators examine bank balance sheets and practices to see whether the bank measures up to some standard.

The caveat in their conclusion is that investors require extensive data to make good judgments about the bank.

Ensuring that good data is provided to investors is the responsibility of bank regulators. If regulators fail in that job, then investors will make poor decisions and banks will fail.

Thus, the best regulation is regulation where bank regulators require that good data is provided to investors and that investors make decisions on that data.

Barth, et. al., found that while 68% of US bank assets was funded by deposits in 2005, only 35% of US bank assets was funded by insured deposits that year. This meant that bank investors and depositors who did not have deposit insurance accounted for more than half of all deposits in 2005. Since the insurance limit was raised after their study was written, the situation may have changed.

Bottom line: sophisticated investors have significant influence in bank management. Shown in Exhibit C at the end of the paper is a list of items which can benefit from additional disclosure or change in present practices in US banks.

BASEL ACCORDS

An alternative regulation practice has been recommended by the G10. Known as the Basel Accords, the regulations therein set forth specific balance sheet and other quantifiable targets and then regulate banks to ensure that each bank conforms to each target.

However, according to Bryan J. Balin of The Johns Hopkins School of Advanced Studies in Washington DC as set forth in the article 'Basel I, Basel II, and Emerging Markets: A Nontechnical Analysis' as approved May 10 2008,

this method of bank regulation has serious flaws.

First, the standards listed are intended to be minimum standards but in practice they become maximum standards. Second, although intended for developed economies, they have become endemic in developing countries for which they are not suited. Third, bank managers have become adept at gaming the targets and thus avoiding the regulations' intended effect. For example, some of the regulations call for a certain percentage of capital to be extremely sound; but, some banks used the very questionable mortgage derivative bonds as a substitute for more solid loan assets, thus circumventing the capital requirements.

Last, the existence of standards reinforces the implied moral hazard that any bank will be rescued by the government whether it adheres to the standards or not.

Perhaps the best use of the Basel Accords will be to require that the data will be publicly disclosed for all banks and that inaccurate disclosure by banks of the required data will be grounds for civil or criminal prosecution.

As an example, the Basel I Accord of 1988 established capitalization rules whereby a bank must maintain capital (known as either Tier 1 or Tier 2 capital depending on perceived risk) equal to at least 8% of its risk weighted assets. (Investopedia: A Forbes Digital Company, www.investopedia.com/terms/b/basel_1.asp) These rules were modified significantly in Basel Accord II. Clearly, any such regulatory regimen requires very sophisticated bank examiners to enforce.

SIXTH RECOMMENDATION:

GUARANTEE LOANS TO MEMBER BANKS MADE BY MEMBER BANKS

One of the impediments to economic recovery appears to be that banks are reluctant to lend to other banks. If so, then the Federal Reserve could act as guarantor for any such loan. This would have the effect of encouraging banks to lend to each other.

Such a loan default would also trigger an extensive bank examination of the defaulting bank as a possible precursor to a nationalization action.

SEVENTH RECOMMENDATION:

REQUIRE SEC APPROVAL FOR ALL ASSET SALES FROM BANKS

The SEC should regulate and approve the sale of any security by a bank or other organization. For example, if a loan to buy a house is sold on a secondary market, the selling party should receive SEC approval before the sale is complete. This procedure can be routinized to keep delays short. But, it should require under civil or criminal penalty that the selling entity vouch for the truthfulness of all statements.

Had it been in place, this procedure may have prevented the junk mortgage bond fiasco.

Any expansion of SEC jurisdiction will require additional funding and staff.

EXHIBIT A:

IMPORTANT TERMS

COMMERCIAL BANK - A private business which takes deposits and makes loans