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Banking Regulation. Recall that the financial sector provides the efficient transfer of savings towards investment projects. Gross Domestic Savings ($1.8T). Foreign Savings ($640B). Government Deficit ($400B). S + (Imports – Exports) = I + (G-T). Gross Private Investment ($2T). - PowerPoint PPT Presentation
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Banking RegulationBanking Regulation
Recall that the financial sector provides the efficient transfer of savings towards investment projects
S + (Imports – Exports) = I + (G-T)
Foreign Savings ($640B)
Gross Domestic Savings ($1.8T)
Gross Private Investment ($2T)
Government Deficit ($400B)
Gross Private Investment represents the purchase of new capital goods – one of the primary sources of growth in the economy
Loans62%
Bonds30%
Stocks2%
Other6%
A majority of external funds raised by non-financial businesses come from bank loans. In particular, small businesses rely entirely on banks for financing
LoansBankDepositors
There is a moral hazard problem/adverse selection problem between both the bank and its depositors as well as between the bank and its potential loan customers
A bank can deal with this problem with:
•Credit Scoring
•Collateral
•Optimal Debt Contracts
This problem must be dealt with through regulation
Depository Institutions are broadly defined as businesses that accept deposits and make loans
Depository Institutions
Commercial Banks
Savings & Loans
Savings Banks
Credit Unions
Non-Bank Thrifts
•Deal almost exclusively in short term deposits and mortgages
•Are generally mutual companies (depositors are the owners)
•Are allowed to hold corporate equities/bonds
All Depository Institutions in the US are chartered
Depository Institutions
Commercial Banks
Savings & Loans
Savings Banks
Credit Unions
National Banks Comptroller of the Currency
State Banks State Authority
Federal Associations Office of Thrift Supervision
State Associations State Authority
Federal Unions National Credit Union Administration
State Unions State Authority
Federal Reserve Membership (1913)Federal Reserve Membership (1913)
National Banks are Required to be members National Banks are Required to be members of the Federal Reserve System (Membership of the Federal Reserve System (Membership is optional for state banks)is optional for state banks) Federal Reserve members are required to Federal Reserve members are required to
purchase stock in the federal reserve system.purchase stock in the federal reserve system. Federal Reserve members provide input to the Federal Reserve members provide input to the
election of Federal Reserve Board Memberselection of Federal Reserve Board Members The Federal Reserve provides check clearing The Federal Reserve provides check clearing
servicesservices
National Banks 2001
State Banks (Non-Member)
935
State Banks (Non-Member)
4833
Of the 7,769 banks in 2003, a vast majority are non-member state banks
Federal Deposit Insurance (1934)Federal Deposit Insurance (1934)
Federal reserve members are required to Federal reserve members are required to purchase deposit insurance. Insurance is purchase deposit insurance. Insurance is optional for state banks (98% of all banks optional for state banks (98% of all banks have deposit insurance)have deposit insurance)FDIC insured banks are charged up to 27 FDIC insured banks are charged up to 27
cents per $100 of eligible depositscents per $100 of eligible depositsAll deposits up to $100,000 are insured by the All deposits up to $100,000 are insured by the
FDIC. FDIC.
A timeline of Banking Regulation
1863 1927
1933
1980
1956 1999
1994
Res
tric
tio
ns
on
ac
tivi
ties
Res
tric
tio
ns
on
C
om
pet
itio
n McFadden Act
Banking Act
Holding Company Act
Monetary Control Act
Riegle-Neal
Holding Company Act
Glass - Steagall
Graham - Leach - Bliley
Great Depression
YearYear Number of BanksNumber of Banks Total BranchesTotal Branches
19001900 12,50012,500 13,00013,000
20002000 78007800 68,00068,000
Until the mid 1900’s, we were a nation of unit banks
Main Office
Branch Offices
National Banks
Prohibited from interstate branching
Must comply with state branching rules
McFadden Act (1927)
State Banks
Unit Banking
Limited Branching
Statewide Branching
Following the great depression, the activities of commercial banks were severely restricted
The Glass-Steagall Act of 1934 was designed to put a wall between commercial banking and investment banking
Glass-Steagall (1934)
Commercial Banks are restricted from participating in equities markets
Interest rates on non- transaction deposits is restricted to be below 5.25%
No interest allowed on transaction deposits
Regulation Q
Branching Restrictions could be avoided by forming holding companies
Main Office
Branch Offices
Illegal under the McFadden Act
Holding Company
Subsidiaries
Legal under the McFadden Act
The Bank Holding Company act allowed holding companies with only one bank to provide limited non-bank financial services on an interstate basis. This created a loophole around Glass-Steagall!!
Holding Company
Prior to Bank Holding Company Act
Bank Bank Bank
Holding Company
After Bank Holding Company Act
Non-Bank Branches
Non- Bank Offices
Collects deposits, but doesn’t make loans
Makes loans, but doesn’t collect deposits
Financial Services
Deregulation of the Financial Services sector began in the 1980’s.
The Monetary Control Act (1980)
Began the phase out of interest rate ceilings at depository institutions
Imposed uniform reserve requirements on Banks and Thrifts
Riegle-Neal Interstate Banking and Branching Efficiency Act (1994)
Allowed holding companies to acquire banks in any state
Allowed banks to branch across state lines
Financial Services Modernization Act (Graham Leach-Bliley) (1996)
Permitted financial holding companies offering banking, insurance, securities and other services under one controlling corporation (allowed Citicorp to buy Traveler’s Insurance)
Capital Adequacyapital AdequacyAsset Qualitysset QualityManagementanagementEarningsarningsLiquidityiquiditySensitivity to Interest Rate Riskensitivity to Interest Rate Risk
Problems with Monitoring
Banks are monitored using the camels system. However, It’s not always easy to accurately assess the risk a bank is taking on
Off Balance Sheet Activities
Derivatives
Financial Guarantees (SLC)
Asset Securitization
In 1995, Barings Bank went bankrupt due to losses in the Derivatives market. At the time, it was holding $60B worth of derivative contracts – a staggering number when compared to Baring’s reported equity of $615M!!
The CAMELS System
Problems with Restricting Activities
Banks compete with other financial services companies as well as other banks!!
During the late 1970’s, market interest rates rose well above 10%, but banks were restricted by regulation Q to pay only 5.25% in savings accounts and 0% on checking accounts
BanksBanks Financial CompaniesFinancial Companies
Checking Accounts (0%)Checking Accounts (0%) Money Markey Mutual Funds Money Markey Mutual Funds (10%)(10%)
As households pulled their money out of banks, mortgage and small business lending was seriously curtailed!
Problems with Restricting Competition (Branching)
Restricting entry gives banks limited monopoly power, they can use this to increase profits at the customers expense!
Banking is a decreasing cost industry (i.e. large startup costs, but small marginal costs). By forcing banks to remain small and local, they are forced to operate at an inefficiently small scale!
By forcing banks to remain in a confined geographical location, you are forcing them to take on idiosyncratic (area specific) risk!
0
1
2
3
4
5
6
1979 1986 1989 1992 1995 1998
Since the 1970’s, there has been tremendous growth in international trade
World Trade (in Trillions of $s)
0
50
100
150
200
250
300
350
400
1979 1986 1989 1992 1995 1998
Even more Even more impressive is the impressive is the growth in foreign growth in foreign exchangeexchange
Currency Transactions (in Trillions of $s)
US Banks Operating Abroad
Subsidiaries: Governed by Federal Reserve Regulation K – must be involved in business “closely related to banking.
International Banking Facilities: Accepts time deposits and makes loans to foreign households & firms. Exempt from reserve requirements, but may not do business in the US.
Edge Act Corporations: Makes loans/accepts deposits. Can deal with both US and foreign citizens , but is limited to international trade transactions
Branches: Offer a full line of banking services, but are subject to foreign laws
US Banks locate facilities abroad to aid in international trade as well as to avoid regulation and taxes
Foreign Banks Operating in the US
Agency Office: Can’t accept deposits from US citizens, but can transfer funds from abroad and make loans in the US
Subsidiaries: Treated as a US bank. Subject to all US regulations. Subsidiaries may also set up edge act corporations and international lending facilities
Branches: Offers a full range of banking services for US citizens
Likewise for Foreign Banks…
Important Dates in International Banking
1930 1978 1988 1991
Bank for International (BIS) Settlements Created
International Banking Act Basle Accords I
Foreign Bank Supervision Act
BCCI Scandal
Bank of EnglandFederal Reserve
United States
Under whose jurisdiction do international banks fall? (it’s a gray area )
United Kingdom
Regulating International Banking
International Banking Act (1978)
Brought foreign banks operating in the US under federal regulation for the first time
Foreign banks, however, were not monitored as closely as US banks
Foreign Bank Supervision Act (1991)
Passed shortly after the BCCI scandal
Gave the Federal Reserve and the Comptroller of the Currency greater control over foreign banks operating in the US
Bank For International Settlements (1930)Bank For International Settlements (1930)
Established to handle German WWI Established to handle German WWI reparations, the BIS has become a center reparations, the BIS has become a center for international cooperation.for international cooperation.Played a central role in the Bretton Woods Played a central role in the Bretton Woods
Exchange Rate SystemExchange Rate System Integral in the Establishment of the EuroIntegral in the Establishment of the Euro
The BIS is like a central bank for central The BIS is like a central bank for central banks.banks.
Risk weighted assetsRisk weighted assets
Asset Risk Weight
Cash and equivalents 0
Government securities 0
Interbank loans 0.2
Mortgage loans 0.5
Ordinary loans 1.0
Standby letters of credit 1.0
The Basle Accords established uniform capital requirements for banks around the world. Equity capital was required to equal at least 4% of a bank’s risk weighted assets.
Risk Weighted Assets
Assets Liabilities
$ 2,000 (T-Bills)
$1,000B (Equity)
US Banking Sector
$ 3,000 (Other)
$ 54B (Cash)$ 46B (Reserves)
Res. Req. = 5%
$ 2,701 (Mortgage)
$ 800B (Checking)$ 4,500B (Saving)
$ 1B (Discount)
Loans Loans
(0)( $54B)
(0)($46B)
(0)($2,000B)
(.5)($2,701B)
(1)($3,000B)
= $0
= $0
= $3,000B
= $0
= $1,350.5B
$4,350.5B
Required Equity = (.04)($4350.5B) = $174.2B
+
Top Ten World BanksTop Ten World Banks
Bank Assets (Billions)
Citigroup (US) $1,497
JP Morgan + Bank One (US) $1,097
Mizuho Financial Group (Japan) $1,080
Bank of America + First Union (US) $851
UBS (Switzerland) $851
Sumitomo Mitsui (Japan) $844
DeutscheBank (Germany) $795
Mitsubishi Tokyo (Japan) $781
HSBC (UK) $759
BNP Paribas (France) $744
Problems with International Problems with International RegulationRegulation
The key issue is that the banking industry The key issue is that the banking industry in Japan and Europe is Fundamentally in Japan and Europe is Fundamentally different from the US.different from the US.
European BankingEuropean Banking
Unlike the US, European Banks are Unlike the US, European Banks are allowed to engage in securities markets allowed to engage in securities markets (universal banking)(universal banking)
In fact, in Europe, banks are generally In fact, in Europe, banks are generally significant shareholders in European significant shareholders in European companies. companies.
Banks rely much more on equity than Banks rely much more on equity than deposits.deposits.
Japanese BankingJapanese Banking
Japanese industry is organized into industrial Japanese industry is organized into industrial groups (keiretsu)groups (keiretsu) MitsubishiMitsubishi MitsuiMitsui SumitomoSumitomo FuyoFuyo DaiichiiDaiichii KangyoKangyo SanwaSanwa
Japanese BankingJapanese Banking
These “groups” are both vertically and These “groups” are both vertically and horizontally integrated and are comprised horizontally integrated and are comprised of a very large number of companies:of a very large number of companies:Sumitomo has 15 divisions ranging from Sumitomo has 15 divisions ranging from
electronics to mining to consumer goods.electronics to mining to consumer goods.Sumitomo controls assets equal to $50T.Sumitomo controls assets equal to $50T.
Japanese BankingJapanese Banking
Each “group” has its own bank which Each “group” has its own bank which handles its finances. This “main” bankhandles its finances. This “main” bankOwns equity in member firmsOwns equity in member firmsMonitors member firmsMonitors member firmsProvides credit for member firms.Provides credit for member firms.