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Chapter 11

The Economics Of Banking Regulation And

Deposit Insurance

©Thomson/South-Western 2006

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Key 20th Century Financial Legislation

Federal Reserve Act (1913) Banking Acts of 1933 (Glass-Steagall) and 1935 Depository Institutions Deregulation and Monetary

Control Act of 1980 (DIDMCA) Depository Institutions Act of 1982 (Garn-St.

Germain Act) Financial Institutions Reform, Recovery, and

Enforcement Act of 1989 (FIRREA) Federal Deposit Insurance Corporation Improvement

Act of 1991 (FDICIA) Gramm-Leach-Bliley Financial Services

Modernization Act of 1999

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Federal Reserve Act (1913)

Created the Federal Reserve System

Intended to help prevent macroeconomic disruptions through better bank oversight and provide a “lender of last resort.”

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Banking Acts of 1933 (Glass-Steagall) and 1935

Created the Federal Deposit Insurance Corporation (FDIC)

Restricted checkable deposits to commercial banks

Prohibited interest payments on checkable deposits

Placed interest rate ceilings on savings and time deposits

Separated commercial banking from the securities industry

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Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA)

Phased out deposit rate ceilings Authorized NOW and ATS accounts

nationwide for commercial banks and thrifts Broadened permissible activities of thrift

institutions Imposed uniform reserve requirements on all

depository institutions Increased FDIC deposit insurance from

$40,000 to $100,000 per account

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Depository Institutions Act of 1982 (Garn-St. Germain Act)

Further broadened the permissible range of activities of thrift institutions

Authorized depository institutions to issue money market deposit accounts

Granted FDIC and Federal Savings and Loan Insurance Corporations (FSLIC) emergency powers to merge troubled thrifts and banks

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

Abolished the FSLIC and Federal Home Loan Bank Board

Created the Office of Thrift Supervision (OTS) to regulate thrifts

Created the Resolution Trust Corporation (RTC) to resolve insolvent thrifts

Provided funds to resolve failures of thrift institutions Re-imposed restrictions on S&L activities Increased insurance premiums for depository

institutions

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Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)

Recapitalized the FDIC Established provisions for prompt resolution of

impaired depository institutions Increased capital requirements for banks and thrifts Limited brokered deposits Moderated “too-big-to-fail” policy Mandated that the FDIC establish risk-based deposit

insurance premiums Increased the Federal Reserve’s authority to

supervise foreign banks in the United States

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Gramm-Leach-Bliley Financial Services Modernization Act of 1999

Overturned Glass-Steagall; eliminated the separation of commercial banking

from investment banking and other activities

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Limiting The Consequences Of Asymmetric Information

Asymmetric information exists because banks have more information about their activities and the risks they are taking than do bank depositors, government officials, regulators, and others. The existence of asymmetric information leads to the problems of:

moral hazard the propensity of bank managers, in an effort to reap high rates of return, to

take on more risk than is socially optimal

adverse selection the tendency for free wheeling and even unscrupulous individuals to seek to

enter the banking industry

Negative externalities arise with bank failures. Bank failures can disrupt local economies and trigger runs on other

banks, which are adverse macroeconomic consequences.

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The Government Safety Net for Bank Depositors: FDIC Insurance and Other Measures

Banking panics: 1873, 1884, 1893, 1907, and 1929-1933

Panics have contagion effects, in which failure of one bank in a region might lead to a run on other banks in the area.

A central bank’s job is to serve as a “lender of last resort.”

The Federal Deposit Insurance Corporation was created for the purpose of insuring bank deposits. With deposit insurance, individuals have little reason to

withdraw cash from their bank accounts, even if they suspect that their bank might fail.

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Challenges Created by the Government Safety Net

The problems of moral hazard and adverse selection in the banking industry are likely to be exacerbated by the existence of the safety net.

Banking authorities face a special dilemma in the case of banks deemed “too big to fail,” which creates moral hazard problems by increasing incentives for large banks to take risks.

The problems with a “too big to fail” policy are magnified when regulations allow banks to extend size, scope, and complexity.

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Regulatory Measures Intended To Limit Bank Risk Taking

Restricting Types of Eligible Bank Assets, Requiring Diversification, and Mandating Bank Capital Requirements: not allowed to hold stocks or corporate bonds; face regulations that limit loans to any individual borrower; required to maintain a portion of their assets in highly liquid form, and required to maintain a level of owners’ equity (capital accounts).

Banking Supervision and Examination and Disclosure Requirements Regular examinations Disclosure requirements

Granting of Bank Charters and Restrictions on Competition in Banking New banks must obtain charters from the Comptroller of the Currency

(national banks) or state banking authorities (state banks).

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Events Leading Up To The S&L Disaster Of The 1980s

Origins and Operations of the Savings and Loan Industry Federal Home Loan Bank Board (FHLBB) was created to regulate the

S&Ls, and Federal Savings and Loan Insurance Corporation (FSLIC) was created to

insure S&L deposits. The S&Ls issued short-term savings deposits and granted 20 and 30-year

fixed rate mortgages The Escalation of Inflation and Interest Rates in the 1970s

Rising inflation caused interest rates to rise above their statutory ceiling for S&Ls.

Regulators allowed S&Ls to issue money market certificates with rates to match yields on 6-month Treasury bills.

The increase in the cost of funds, payable to all depositors, could only be shifted onto new homebuyers.

The Squeeze on S&Ls' Profits: Cyclical and Structural Causes In 1981, the spread between the yield earned on assets and the cost of funds

for the entire S&L industry was negative 0.8 percent. The S&L industry experienced huge operating losses in 1981 and 1982.

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Figure 11-1

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GOVERNMENT RESPONSE TO THE S&L PROBLEMS OF THE EARLY 1980s

Deregulation Congress enacted the Depository Institutions Act of 1982, (Garn-

St.Germain) authorizing: S&Ls to issue money market deposit accounts with no interest ceilings,

and S&Ls to make loans to consumers, businesses, and the commercial real

estate sector. Forbearance, Deposit Insurance, and Risk-Taking

Instead of closing insolvent S&Ls, regulatory authorities decided to let these institutions keep operating in hopes of better economic times.

Congress raised federal deposit insurance from $40,000 to $100,000. Insolvent S&Ls were motivated to take additional risks to shoot for

higher returns to bail themselves out. Inadequate Funding for S&L Supervisors and the FSLIC:

The Reagan administration denied requests from the supervisory agencies for increased funding for S&L examiners and was too late in bolstering the FSLIC.

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FIRREA (1989)

The Financial Institutions Reform, Recovery, And Enforcement Act Abolished both the FHLBB and the FSLIC, and created

The Office of Thrift Supervision (OTS) The FDIC took over the regulatory functions formerly held

by the FSLIC. Created two new insurance funds:

Bank Insurance Fund (BIF) for commercial banks, and Savings Association Insurance Fund (SAIF) for thrift

institutions. Created the Resolution Trust Corporation (RTC), to

manage and resolve insolvent thrift institutions and liquidate assets of failed institutions, which: Closed 747 bankrupt or ailing S&Ls, and Recovered most of the $450 billion worth of thrift institution assets.

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Figure 11-2

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The Escalation Of Commercial Bank Failures In The 1980s

The Adverse Effect of Financial Innovations and Regulatory Actions Deregulation allowed:

interest payments by banks on demand deposits; ceiling-free interest rates on time deposits; increased competition through branch banking, and increased competition for commercial and corporate loans.

Economic Instability and Commercial Bank Financial Condition High inflation led to high interest rates, which increased the

cost of bank funds. Competition reduced the "spread" and reduced business demand for bank loans, which induced banks to take greater risks (including loans to LDCs).

Recessions in 1980 and 1982 increased defaults. Oil price declines negatively impacted loans in TX, LA, OK.

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Figure 11-3

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Federal Deposit Insurance

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The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA)

This act had two primary purposes: to recapitalize the nearly insolvent FDIC, and to redesign the federal deposit insurance system with the

intent of minimizing taxpayer exposure to future losses. FDICIA:

restricted access of certain banks to brokered deposits; limited the "too big to fail" principle; required the FDIC to step in quickly and vigorously when a

bank's capital falls below a certain (positive) threshold, and

Categorizes banks from “well-capitalized” to “undercapitalized.” limits what undercapitalized banks can do changes differential FDIC insurance rates

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Evaluation of FDICIA

FDICIA goes a long way to cure the ills of the system by: increasing the percentage of bank depositors who

have incentives to monitor their bank; employing strong incentives for banks to reduce

risk taking, and forcing extremely under-capitalized banks to

close.

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Other Proposed Reforms of Deposit Insurance

Elimination of Deposit Insurance

Reducing the Limits of Coverage

Coinsurance

Abolishing the Too-Big-To-Fail Policy

Go to Private Deposit Insurance