Economic Analysis of Banking Regulation

Economic Analysis of Banking Regulation

Asymmetric Information and Bank Regulation

Economic models often assume that all parties have perfect information. If this were true, depositors would know when bank managers were engaging in risky behavior and they would withdraw funds from the bank and put them in a bank with less risky managers.

In practice, no one has perfect information. Bank managers have far more information about their own intentions than depositors have about the managers’ intentions. This is called asymmetric information. Depositors do not have the same sort of information that the managers do. While depositors might be able to purchase the information the cost would be prohibitive.

We saw in a previous chapter how banks handled their adverse selection problem (screening, specialization, etc.). But this sort of mechanism does not exist for depositors save at a very high cost.

This sort of asymmetric information causes two major problems for the banking industry – remember that banks take deposits and make loans. When borrowers spend the money this creates new income and jobs.

How might depositors react to news of a bank failure?

Before FDIC the news of a bank failure might cause a bank panic. Suppose that only 5% of the banks are bad – how does an individual depositor know whether his bank is one of the bad ones? With perfect information there would be know problem. With asymmetric information the bank’s managers know but depositors can’t. It may be rational for all depositors to withdraw funds from their bank. If this occurs then all banks, good and bad, will face a run on deposits that many may not be able to withstand. So good banks as well as bad ones may fail. FDIC eliminates this problem.

Note: bank panics occurred in 1819, 1837, 1857, 1873, 1884, 1893, 1907 and 1930—33. None have occurred since the creation of FDIC. Even though a large number of banks failed in the 1980s no bank panics occurred

How does the Fed deal with Bank Failures

• Payoff method. The Fed pays off depositors (up to the $100,000 limit) and then joins the line with other creditors to divide the banks assets. Depositors with accounts over $100,000 often get back 90 cents on the dollar but it may take several years
• Purchase and assumption method. The Fed finds some other bank that will take over the failed bank. The Fed may subsidize the takeover by buying out some of the failed banks poorer loans. Depositors lose nothing when this method is used.

Class 1

Moral hazard and the government safety net.

While the FDIC protects depositors in the case of a bank failure, it may also encourage bank managers to act in a risky manner. Insurance often provides incentives for greater risk because the consequences of bad behavior are reduced. The safety net of FDIC insurance also makes depositors indifferent to the behavior of the bank. Since depositors have no incentive to withdraw funds from a risky bank, the bank managers don’t have to worry about depositors’ behavior either. So the Fed will conduct periodic examinations of banks to try to detect improper activity.

Adverse selection and the government safety net.

Depositors don’t even have to worry about risk takers and outright criminals from owning or managing banks. The lack of oversight on the part of depositors may attract risk takers or even criminals to the banking industry (hence we have the chartering process to try to prevent this.)

Too big to fail

The Fed has acknowledged that it will not allow large banks to fail. Continental Illinois became insolvent in May 1984. The FDIC guaranteed deposits up to $100,000 (which they were required to do) but also guaranteed deposits in excess of $100,000 and prevented loses to the banks stockholders.

The Comptroller of the Currency testified before Congress that its policy was to guarantee the 11 largest banks in the country as “too big to fail.” This does not mean that the banks managers would not lose their jobs. This policy clearly increases the moral hazard incentives for banks to engage in risky behavior. Even large depositors won’t be concerned if the bank fails and has no incentive to monitor the activities of the bank.

The too big to fail policy was later restricted by Congress.

Financial consolidation and the government safety net

The Riegle--Neal Interstate Banking and Branching and Efficiency Act of 1994 (did away with branching restrictions) and the Gramm—Leach—Billey Financial Services Modernization Act (did away with Glass—Steagall) lead to a good deal of bank consolidation. This mean more large banks and hence more banks that will be too big to fail. This increases risky behavior for the industry as a whole.

The removal of Glass—Steagall means that banks will be conducting more activities and it may be necessary to extend the safety net to cover these activities.

Restriction on assets holdings and bank capital requirements

One way to prevent bank from engaging in risky behavior is to restrict what sort of assets they can own. After the Great Depression they the have been restricted to owning government securities (very liquid with almost no default risk) and loans. Bank regulations have also been applied to loans. Bank were required to diversity their loan portfolio. Banks usually were not allowed to make very large loans to individuals or make certain types of loans.

Banks were also required to have a certain amount of capital. This is what the bank owners will lose if the bank fails. It is hoped this will encourage the bank owners to hire good managers.

A bank is considered to be well leveraged if the leverage ratio exceeds 5%. If the ratio falls below 3% this will trigger increased restriction on the bank.

Off balance sheet activities

Banks are generating more income from fees and financial instrument trading that do not show up on the banks balance sheet. These activities expose the banks to risk. This has lead to an additional capital requirement over and above the leverage ratio. The purpose of this requirement is to ensure that the owners will monitor the off balance sheet activities (This is an international requirement to ensure that banks from different countries can be competitive internationally –the Basel Accord).

Bank supervision

While individual depositors can’t afford to monitor a banks activity the government provides that service by bank supervision (also called prudential supervision). A bank would be a very useful tool for crooks (money laundering, financing of operations, etc). It could also provide a ready source of funding to individuals who would be willing to engage in very risky schemes. Chartering is one mechanism used to prevent this. Chartering deals with the adverse selection problem.

• On site bank examinations. Regulators monitor whether a bank is complying with capital requirements and restrictions on asset holdings. Examiners give a CAMELS (capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk.) If the CAMELS rating is sufficiently low the examiners can direct the bank to alter its behavior. The examinations are occasionally unannounced.

• Chartering. This is a process to determine if a particular group of investors should be given the right to form a bank. Charters are granted by the Comptroller of the Currency (federal banks) or from a state banking authority. The chartering authority will examine how the bank is to be operated, the proposed management, likely earnings, and initial capital adequacy.

• Assessment of Risk Management. The bank examination traditionally had focused on whether the bank was in compliance with bank regulations at the time of the examination (adequate reserves, adequate capital, restrictions on asset holdings). Recently more attention is being paid to how a bank is likely to be operating in the future. The Baring bank failure.showed how a bank could be sound at one time but quickly become insolvent. Bank examination now includes

• The quality of oversight provided by the board of directors and senior management
• The adequacy of policies and limits for all activities that present significant risk
• The quality of risk measurement and monitoring systems.
• The adequacy of internal controls.

• Disclosure requirements. Banks are required to follow standard accounting practices and report certain information regarding its asset portfolio and exposure to risk. This report is available to the banking public. This provides stockholders, depositors and creditors with a means of monitoring the bank.

• Consumer protection. “Truth in lending” provisions in loan contracts. The Fair Credit Billing Act requires credit card companies to explain finance charges and settle billing complaints. It also prevents discrimination.

• Restrictions on competition. Competition can increase moral hazard incentives for banks to take more risk. We have seen restrictions on branch banking and Regulation Q. Also there were restrictions preventing nonblank institutions from engaging in banking. Also Glass—Steagall prevented commercial banks from investment banking activities. These restrictions on competition are being eliminated.

The 1980’s U.S. Banking Crisis.

There were few banking failures from the Great Depression to the mid 1980s, but there were a large number of failures at that time.

There were a number of reasons for this crisis. Much of it was caused by increased competition among financial institutions. Money market mutual funds competed with banks for deposits. Banks created things like NOW accounts as a mean of retaining depositors, but this raised the banks cost of obtaining funds. Banks also faced competition from money market mutual funds, junk bond dealers, and commercial paper issues in terms of how they earned revenues. Banks were caught in a profit squeeze. Revenues tended to decrease and costs tended to increase.

Banks sought new and riskier business opportunities. They made more real estate loans and made loans to businesses to assist in corporate takeovers and leveraged buyouts (where most of the funds to make the buyout are obtained by borrowing).

Deposit insurance was in creased from $40,000 per account to $100,000 per account. Increases moral hazard incentive for banks to make risky loans.

Repeal of Regulation Q (raises cost of obtaining funds).

S&Ls and mutual saving banks were allowed to make commercial and real estate loans (rather than home mortgages. More competition for banks. S&Ls also made a number of questionable loans partly because of inadequate supervision by S&L regulators.

The S&L loans were made at normal interest rates at the time. But interest rates in the 1980s increased greatly. S&Ls and banks had to raise interest rates to depositors to keep deposits, but the interest rates on long term loans were fixed. So the cost of attracting funds was increasing but the return on many assets was fixed.

Interest rates rose because the Fed fought inflation. Nominal interest rates rose because of inflation as predicted by the Fisher equation. The Fed decided to fight inflation by reducing the growth of the money supply which increased interest rates (in the short term) even further.

Also there were regional recessions in the oil producing areas of the country and in the agricultural producing areas.

Regulatory forbearance

Regulators did not close insolvent S&Ls (Zombie S&L’s) . They lowered capital requirements by allowing “goodwill” to be used as capital.

Congress had not appropriated enough money to examine the S&Ls.

S&Ls had contributed to political campaigns.

There were insufficient funds in the FSLIC to cover deposits.

Regulators may have been too chummy with the S&Ls they were supposed to be regulating.

Regulators were reluctant to admit that they had made mistakes.

S&Ls in trouble took huge risks to try to get out of trouble. Most of these failed making the problem worse. They also offered very high interest rates taking depositors away from sound S&Ls. They also attracted funds away from banks.

The Competitive Equality in Banking Act of 1987

This act was supposed to clean up the S&L mess. Insolvent S&Ls were to be shut down and depositors paid off.

The FSLIC did not have sufficient funds to pay off depositors. Congress did not authorize enough the FSLIC to borrow enough additional funds. FSLIC took over houses where borrowers had defaulted.

The political economy of the S&L crisis

The principle agent problem for regulators and politicians.

The agents (politicians and regulators) do not have the same economic interest as the principles (taxpayers). The taxpayers would like the agents to act to reduce the cost of deposit insurance (which will be paid by the taxpayer in the last resort). High capital requirements will reduce the likelihood that the finance companies will engage in risky behavior. Likewise tight restriction on the type of assets a company might have will do the same.

Forbearance delays the problem and makes it worse. During the S&L crises regulators loosened rather than tightened capital requirements. They also loosened the requirements on assets. Failed S&Ls indicate a failure on the part of the regulatory agency. There is a temptation to cover up the problem in hopes it goes away. Quite frequently this just makes the problem much worse later on.

Politicians may receive campaign contributions from banks and S&Ls. Politicians do not like to see banks fail and close in their district. Politicians often pressure regulators for special treatment for banks in their district.

The S&L bailout.

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

Provided funding to pay depositors and shut down insolvent S&Ls. Eliminated the FSLIC and gave its powers to FDIC. The Resolution Trust Corporation took over insolvent thrifts and sold their assets. The total cost to the taxpayers of the bailout was about $150 billion.

FIRREA also imposed new restrictions on S&Ls. They cannot own junk bonds. Commercial real estate loans can’t exceed four times capital. S&Ls must hold at least 70% of their assets in housing related items.

The FDIC Improvement Act of 1991 (FDICIA)

• To recapitilize FDIC. Allowed FDIC to borrow up to $30 Billion from Treasury if it ran out of funds. This was to be a short term loan to be paid back when the FDIC sold a failed institutions. assets. It also required the FDIC to charge higher premiums.
• To reform FDIC.
• The “too big to fail” doctrine was limited
• Required FDIC to intervene earlier when banks get in trouble. Undercapitalized banks are not allowed to pay higher than average interest rates on deposits. Banks without adequate capital are required to submit capital restoration plans, restrict asset growth and seek approval to open new branches. In extreme cases the bank can be closed.
• Also instructed the FDIC to charge risk based insurance premiums.
• Restricted brokered deposits