Regulation of the Banking System and the Financial Services Industry1
CHAPTER 15
Regulation of the Banking System and the Financial Services Industry
Learning Objectives
- Why regulation is needed in the financial services industry
- Who regulates whom in the banking system
- Some of the major pieces of legislation important to the banking industry today
- Regulatory challenges facing Congress and the regulators
Chapter Outline
- The Role of Regulation
- The How and Why of Financial Services Regulation
- Depository Institutions Deregulation and Monetary Control Act of 1980 and Garn-St. Germain Act of 1982: Deregulation in the Early 1980s
- Basel Accord –The Introduction of International Capital Standards
- Financial Institutions Reform, Recovery, and Enforcement Act of 1989—Reregulation in Response to Financial Crisis (Bailing Out the Thrifts)
- Federal Deposit Insurance Corporation Improvement Act of 1991—Tightening Up Deposit Insurance
- Community Reinvestment Act—Outlawing Discriminatory Lending Practices
- Interstate Banking and Branching Efficiency Act of 1994—The Dawn of Nationwide Branching?
- The Gramm-Leach-Bliley Act (GLBA) of 1999—The Final Demise of Glass-Steagall
A.Major Provisions of GLBA
- Other Possible Areas of Reforms
Answers to Review Questions
- How is the failure of an FI different from the failure of a video rental store? What do these differences imply about the need for regulation?
The main difference between the failure of a video rental store and the failure of an FI is the number of people each failure affects. The failure of a video store most evidently just affects the owners and employees of that particular store. Although customers may be upset that the store failed, they are not substantially harmed by the failure since there are substitutes to video rentals. However, the failure of an FI has more consequences. It affects not only the owners and employees of that particular FI, but also the people who have money in that FI. The failure of an FI has rippling effects throughout the economy, and because of this FIs must be more closely regulated than a video store.
- Discuss the major provisions of the FIRREA and the FDICIA.
The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) was passed in response to the S&L crisis of the 1980s and was signed into law in August 1989. The provisions of this act include the following:
1)1) The Savings Association Insurance Fund (SAIF) was created to provide insurance for the deposits of S&Ls, and replaced the FSLIC.
2)2) The Office of Thrift Supervision (OTS) was established to oversee the S&L industry, and the Resolution Trust Corporation (RTC) was set up as a temporary agency to dispose of the properties of the thrifts that failed between January 1, 1989 and July 1, 1995.
3)3) Deposit insurance was made a full faith and credit obligation of the federal government.
4)4) New regulations restricted the investments of S&Ls by limiting commercial mortgage lending and by phasing out junk bond investments by 1994.
5)5) Capital requirements were imposed on S&Ls.
The Federal Deposit Insurance Corporation Improvement Act (FDICIA) was passed in 1991 and attempted to secure the safety and soundness of the banking and thrift industries and included the following provisions:
1)1) Insurance premiums were scaled to the risk exposure of the banks or thrifts. Higher-risk institutions are charged a higher deposit insurance premium.
2)2) Insurance coverage of regular accounts was limited to a maximum of $100,000; while retirement accounts were limited to $100,000 per depository institution.
3)3) The FDIC was required to use the least costly method to resolve any insolvency.
4)4) Weak banks were categorized as “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” The greater the degree of undercapitalization, the more severe the restrictions on the bank’s operations.
5)5) The ability of foreign banks to use certain categories of deposits in the U.S. was limited.
- What is redlining? How is the Community Reinvestment Act supposed to affect redlining? Discuss some of the difficulties with assessing compliance with the law. Could my bank be violating the law if it fails to lend to businesses located in the deteriorating downtown area?
Redlining refers to the practice of drawing a red line around a certain area on a map and restricting the number or dollar amount of loans made in that area regardless of the creditworthiness of potential borrowers. The Community Reinvestment Act (CRA) was passed to increase the availability of credit to economically disadvantaged areas and to correct the practice of redlining. The CRA did not initially get much attention because it provided no means of enforcement. However, after amendments in 1989 bank mergers can be challenged or prevented because of inadequate CRA performance. It is hard to assess compliance with the CRA because banks are required to practice nondiscriminatory lending while focusing on safety and soundness. If a bank does not lend to businesses located in a deteriorating downtown area, it could be violating the law—but the specifics must be carefully examined. It could be that the businesses were not financially sound enough to be granted the loans.
- What is the Basel Accord? Why is it desirable to have uniform international capital standards for banks?
The Basel Accord in an agreement between the U.S. and 11 other countries that established uniform international capital standards for banks. The Accord specified the amount of capital that banks must hold relative to assets. Because of these uniform international capital standards, banks could be more closely compared on the same grounds.
- What is the intent of the 25 core principles for effective bank supervision?
The 25 core principles for effective banking supervision are intended to function as a reference guide for regulators to use when supervising banks in their countries. These principles are designed so that domestic and international regulators and the financial markets may readily verify them in order to promote and ensure financial stability.
- Some contend that the passage of the IBBEA will have little effect on the banking industry. What is the basis of their argument? On what date were banks allowed to branch across state lines by merging with a bank in a different state?
Banks are great financial innovators, and therefore were already circumventing regulations on interstate banking and branching through bank holding company structures. So, if banks were already getting around these regulations, the law saying that interstate banking and branching is acceptable may not have much effect on the banking industry. IBBEA eliminated most restrictions on interstate bank mergers as of June 1, 1997.
- Explain at least three suggestions for deposit insurance reform to deal with the moral hazard problem.
Moral hazard is a very real problem in the area of deposit insurance. There are many suggested reforms to deal with this problem. One suggested reform is to privatize deposit insurance. Another reform involves capping deposit insurance at an amount less than $100,000. This would increase market discipline by causing large depositors to monitor the activities of their banks more closely. The other suggested reform is to make deposit insurance optional for bank customers. With this reform, depositors and banks would get to choose their level of regulation or lack thereof.
- Would a wealthy individual with bank accounts greater than $100,000 prefer the FDIC to use the purchase and assumption method or the payoff method to liquidate failed banks? Why?
An individual with bank accounts greater than $100,000 would prefer the FDIC to use the “purchase and assumption” method to liquidate bank failures. Under the “payoff method” these wealthy individuals would receive only $100,000 of their money and lose the rest.
- What is core capital? How do risk-adjusted assets differ from total assets?
Core capital is by definition the historical value of outstanding stock plus retained earnings. Risk adjusted assets take into account only credit risk and not interest rate, liquidity, or exchange rate risks. The amount of core capital that must be held is based on two measures: one measure is based on risk-adjusted assets and the other on total assets. The method based on risk-adjusted assets assigns different weights to different types of assets according to their risks.
- Who regulates money markets? Who regulates capital markets?
There is no one clear regulator for the money markets. However, the regulatory structure will continue to change as the financial services industry evolves. The Securities and Exchange Commission regulates securities—stocks and bonds—that are part of the capital markets.
- What are the major provisions of the Depository Institutions Deregulation and Monetary Control Act of 1980? The Garn-St. Germain Depository Institutions Act of 1982? Which act expanded the powers of the Fed? How?
The major provisions of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 can be divided into two groups: deregulation and monetary control.
Deregulation
1)1) The remaining Regulation Q ceilings were phased out over a 6-year period that ended in 1986.
2)2) Asset and liability powers of banks and thrifts were expanded: S&Ls and savings banks were allowed to extend loans to businesses and offer more services to customers. All depository intermediaries were permitted to offer households NOW accounts.
Monetary Control
1)1) All depository institutions were subject to reserve requirements—universal reserve requirements.
2)2) Reserve requirements were to be the same on particular types of deposits across institutions—uniform reserve requirements. This provision was phased in over an 8-year period that ended in 1987.
By mandating universal and uniform reserve requirements, the (DIDMCA) strengthened the effectiveness of the regulatory process and expanded the powers of the Fed. The Fed had a more direct control over the money supply and the supply of loanable funds.
The Garn-St. Germain Depository Institutions Act of 1982 has many provisions. Chief among them was one that sped up the pace of deregulation by allowing depository institutions to offer two types of deposit accounts designed to compete directly with money market mutual funds: 1) money market deposit accounts, which have no rate ceilings and permit six third-party payment transactions per month, and 2) super NOW accounts, which also have no rate ceiling but are fully checkable.
- Explain the difference between risk-based capital standards and risk-based deposit insurance premiums.
Risk-based capital standards refer to the amount of capital the Basel Accord requires banks to hold based on risk-based assets. Risk-based insurance premium is the deposit insurance premium that needs to be paid on risk-based assets.
- What are the regulatory responsibilities of the Securities and Exchange Commission? What is insider trading? Who sets margin requirements?
The Securities and Exchange Commission (SEC) regulates financial options, mutual funds, stocks and bonds, security firms, and U.S. Government securities. Insider trading is the trading of securities by those who have access to information about the companies involved before it is made public. Insider trading is illegal and forbidden. The Fed is responsible for setting margin requirements.
- Identify three self-regulating agencies and explain which industries they regulate. Speculate as to why an industry would self-regulate.
Securities firms are self-regulated by the National Association of Securities Dealers. The financial futures market is self-regulated by the National Futures Association. The financial options industry is self-regulated by the Options Clearing Corporation. Industries that self-regulate can be more accommodating to their needs and change the regulatory structure more quickly when they see a problem. Self-regulation also plays a role in preventing a government regulator from more strictly limiting the activities of an industry.
- Explain the function of each of the following:
a.National Credit Union Share Insurance Fund
b.Pension Benefit Guaranty Corporation
c.Securities Investor Protection Corporation
d.FDIC
a.The National Credit Union Share Insurance Fund insures deposits in credit unions up to $100,000. Credit unions do not pay an insurance premium, but rather put up capital equal to 1 percent of their insured deposits with the insurance fund. If this reserve is ever depleted because of losses, credit unions are required to replenish it out of capital.
b.The Pension Benefit Guaranty Corporation provides insurance in the event that a pension plan is unable to pay the benefits defined in the pension agreement. This corporation will pay the benefits according to the contract and make up any payment deficiencies up to a limit if a plan cannot pay its benefits.
c.The Securities Investor Protection Corporation insures retail customers of securities brokerage firms for up to $500,000 of their portfolios in the event the brokerage firm becomes insolvent.
d)d.The FDIC insures bank deposits up the $100,000.
- Explain the difference between the purchase and assumption method and the payoff method of resolving a bank insolvency. What does “too big to fail” mean?
The payoff method is the method of resolving a bank insolvency by which the FDIC pays off the depositors up to the $100,000 limit and closes the institution. Creditors, stockholders, and uninsured depositors all lose with the payoff method.
“Too big to fail” means that the regulators will not allow a “big” bank to fail, but rather will use the purchase and assumption method to resolve and insolvency. With this method, a healthy institution is found to take over the assets and liabilities of the failed bank. The insurer, usually the FDIC, pays the takeover institution the difference between the assets and the liabilities of the failed institution. Neither the takeover bank, nor the uninsured depositors, nor the creditors lose.
- What are the major provisions of the GLBA? What is a FHC? How does a bank holding company become a FHC? What conditions must be met to become a FHC?
The Gramm-Leach-Bliley Act (GLBA) was passed in November 1999, and became effective on March 11, 2000. This act allows bank holding companies meeting certain criteria to be certified as financial holding companies (FHCs). FHCs may engage in a broad array of financial and nonfinancial activities. To become a FHC, a bank holding company must file a declaration with the Fed certifying that all of its depository institutions are well capitalized and well managed and have a “satisfactory” or better rating under the CRA. The GLBA also authorized banks to underwrite and market municipal bonds and to own or control a “financial subsidiary.”
- Was investment banking effectively separated from commercial banking prior to the passage of GLBA? Explain.
Investment banking was somewhat separated from commercial banking prior to the passage of GLBA. However, even before the GLBA was passed, banks had made substantial inroads into investment banking by the late 1990s because regulatory barriers have been relaxed. In 1986, the Fed allowed bank holding companies to obtain 10 percent of their revenues from securities that were previously barred. In February 1996, the Fed raised the limit to 25 percent—causing most large bank holding companies to scramble to get into the securities market. GLBA effectively underwrote what the regulators and markets had already accomplished through innovation.
Answers to Analytical Questions
- Assume that a bank has core capital of $1 million and total capital of $2 million. Its total risk-adjusted assets are $25 million and total assets are $30 million. According to the Basel Accord, does the bank have adequate capital?
Core capital must be equal to at least 4 percent of risk-adjusted assets and total capital must be equal to at least 8 percent of risk-adjusted assets. Also a bank must have core capital equal to at least 3 percent of total assets.
Core capital = $1 million
Total Capital = $2 million
Risk-adjusted assets = $25 million
Total assets = $30 million
This bank meets all the necessary provisions of the Basel Accord; therefore it has adequate capital.
- Assume that a bank has the following:
Stock issued$15 million
Retained earnings$2.75 million
Loan-loss reserves$2.6 million
Subordinated debt$5 million
What is its core capital? What is its total capital?
Core capital = outstanding stock + retained earnings
Core capital = $15 million + $2.75 million = $17.75 million
Total Capital = core capital + loan loss reserves + subordinated debt
Total Capital = $17.75 million + $2.6 million + $5 million = $25.35 million