Commercial Banks Regulation Fall-2011

8/3/2019 Commercial Banks Regulation Fall-2011

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Finance 326

Commercial Bank Regulation

Depository Institutions

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Copyright 2011 David Ely. All rights reserved

Regulators of depository institutions

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Comptroller of the Currency (1863) Absorbed Office of Thrift Supervision in 2011

Federally-chartered commercial banks

Savings and Loans and Savings Banks

Federal Reserve Board (1913)

Bank holding companies State-chartered member banks

Federal Deposit Insurance Corp (FDIC) (1933) Non-member state-chartered banks

National Credit Union Administration (1970) Federally insured credit unions

Product Regulation

Glass Steagall Act (1933)

Separation of commercial and investment

banking Federal Reserve order (1987)

Authorize individual BHCs (case-by-casebasis) to establish section 20 subs to engage inunderwriting and dealing in securities

5% gross revenue of subsidiary

Product Regulation

Bank Holding Company Act (BHCA) of 1956

Separated insurance from commercial banking

Restricted commercial firms from acquiringbanks

the 1970 Amendment to the BHCA requiresbanks to divest nonbank related subsidiaries


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Financial Services Modernization Act of

1999 Repeals restrictions on banks affiliating with securities

firms Allows for the creation of "financial holding companies"

which can engage in securities and insurance activities Prohibits FDIC assistance to non-bank affiliates of banks Restricts expansion of BHCs with less than satisfactory

More disclosure on ATM fees Public disclosure of CRA agreements Ensures that appropriate anti-trust review is conducted

for new financial combinations

Issues in repealing Glass-Steagall

Will a bank suffer (and the deposit-insurance funds)if a securities affiliate fails? Resources of the bank used to bail out affiliate

Dividend paid by bank to BHC Bank loans to affiliate

Can secure firewalls eliminate this risk

Ability of regulators to observe these abuses? Policy: Conflicts of interest Stuff unplaced securities in trust department accounts Encourage bank customers to issue bonds

(underwritten by securities affiliate) to pay off bankloans

Tying

Geographic Regulation

Banking Holding Company Act of 1956, DouglasAmendment BHC can not acquire a bank in another state unless the

latter's laws permit such entry International Banking Act of 1978 Branching, Permissible activities, Fed services BHC rules

Changes in State branching laws and regionalagreements in 1980s

Garn-St Germain Act of 1982 FDIC/FSLIC authority to allow out-of-state

institutions to acquire failing institutions

Geographic Regulation

Riegle-Neal Interstate Banking and BranchingEfficiency Act 1994

BHCs can acquire banks in other states (startingSept 1995)

BHCs can convert out-of-state subsidiary banksn o ranc es o a s ng e n ers a e an s ar ng

June 1997)

Reach by M&A 30% in a single state and 10%nationally


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Some major dealsBanks Yr announced

Chase Manhattan J.P. Morgan 2000

J.P. Morgan Chase Bank One 2004

Wachovia SouthTrust 2004

Wachovia Golden West 2006

Bank of New York Mellon Financial 2007

JP Morgan Bear Sterns 2008

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JP Morgan Washington Mutual 2008

Wells Fargo Wachovia 2008

PNC Financial National City Corp 2008

Bank of America Merrill Lynch 2008

Questions

Why restrict branching?

Market concentration

Need for local financial services

Why consolidation since the 1990s?

Technological progress New delivery methods: ATMs, on-line banking,

may offer greater economies of scale Back-office operations

Favorable economic conditions Excess ca acit in industr due to rowth of

alternatives Foreign banks, capital markets, mutual funds

Globalization Need for cross-border services

Incentives for consolidation

Creates value for shareholders

Increase market power

Will consumers get better prices even if FI's costsfall?

Improve efficiency and lower costs

-potential customers (for customers who want one-stop shopping for financial services?)

Efficient institutions take over the less efficient


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Impact on services to small customers?

Large organizations have a lower proportion ofassets in small business loans

Large banks tend to charge lower rates, requireless collateral on small business loans than small

banks - emphasize higher quality loans rathert an re at ons p oans ransact ons en ng

Fair lending practices and other

regulations

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Community Reinvestment Act 1977

Importance in merger activity

Financial Services Act of 1999. Requiresdisclosure of all CRA agreements

Mergers

Poss e ro e or Just ce Department

Patriot Act (2001)

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Implement a customer identification program(CIP) when accounts are opened.

Verify the identity of any person seeking to openan account and maintaining records of thatinformation

ew an - aun er ng programs

Deposit Insurance

Federal Deposit Insurance Corporation (FDIC) 1933 Financial Institutions Reform, Recovery, and

Enforcement Act (FIRREA) of 1989 Created Saving Association Insurance Fund (SAIF) to

replace Federal Savings and Loan InsuranceCorporation (FSLIC) which became insolvent after

FDIC Improvement Act (FDICIA) of 1991 Introduced Prompt Corrective Action

Risk-based insurance premiums implemented in 1993


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FDIC insurance coverage recent

changes

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Merging the Bank Insurance Fund (BIF) and theSavings Association Insurance Fund (SAIF) intoDeposit Insurance Fund (DIF) EffectiveJanuary 2007

Increasing the coverage limit to $250,000 in200 . a e permanent n 2010

Deposit premium assessment rate schedule

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Supervisory Group

A B C

Well capitalized 12-16 bp 22 bp 32 bp

Adequatelycapitalized

22 bp 22 bp 32 bp

Source. FDIC Quarterly Banking Profile, v5(2), June, 2011

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Capital restrictions: Basel I (1987)

Capital to be based on risk-adjusted assets Only credit risk considered at first

Capital to be based on on- and off-balance-sheetassets

Requirements

Total capital: 8% Tier 1 (Core) 4%

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Problems with leverage ratios

Market value: may not be adequatelyreflected by leverage ratio

Asset risk: ratio fails to reflect differencesin credit and interest rate risks

- -requirements


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What qualifies for capital?

Tier I capital

Common equity

Perpetual preferred stock (w/ limits)

Minority equity interests held in subsidiaries

Tier II capital

Subordinated debt

Intermediate-term preferred stock

Loan loss reserves (w/ limits)

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FDICIA (1992)

Prompt corrective action: Leverage (Core Capital / Total Assets)

Capital categories for regulatory action Total capital / Risk-weighted assets Tier 1 capital / Risk-weighted assets Tier 1 capital / Total assets

Categories Well capitalized Adequately capitalized Undercapitalized Significantly undercapitalized Critically undercapitalized

Capital Category Distribution June 30, 201123

InstitutionsPercent

AssetsPercent Capital Category

Number of

of Total of Total

96.0% 99.2% Well Capitalized 7,211

1.7% 0.4% AdequatelyCapitalized 129

1.0% 0.2% Undercapitalized 74

0.9% 0.1%Significantly

Undercapitalized65

0.5% 0.1%Critically

Undercapitalized34

Source. Federal Deposit Insurance Corporation (2011). Quarterly Banking Profile, June 30, 2010

Basel II Capital Accord

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Key dates

Implementation: Europe (Jan 2007) US (2009)

Refines credit risk calculation and addsoperational risk (loss resulting from inadequateor failed internal processes, people and systems,or rom externa events)

Impact

High-risk banks will hold more capital

Low-risk banks will hold less capital


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Objectives of new accord

Flexibility

Shift away from a one-size-fits-all approach

More emphasis on banks internal models,supervisory review, and market discipline

Flexibility creates incentives for better riskmanagement

Capital calculations across banks must becomparable

First Pillar minimum capital requirement

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8% minimum Total capital / [Credit + Market + Operational

risk] Credit risk: Standardized approach

More risk weights: 0%, 20%, 50%, 100%, 150%

Refined to incor orate borrower t e and externalcredit rating agency assessments

Credit risk: Internal rating based (IRB) model Each borrowers creditworthiness is estimated and

then translated into estimates of potential futurelosses

Risk-adjusted assets an example

Amount Weight Amt x Wgt

Cash $20 0.0 $0

OECD interbank

deposit

$25 0.2 $5

Mortgage loans $70 0.5 $35

Commercial loans $70 1.0 $70

Risk-adj assets $110

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Capital requirement for credit risk

Two-step process for off-balance-sheet items

Derive credit equivalent amount for each item:assets face value multiplied by a conversion factorspecified by regulators

Multiply credit equivalent amounts by the


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Capital requirement for credit risk

Credit equivalent amount of OBS derivativesecurity items = Potential exposure + Currentexposure

Potential exposure: credit risk if counterpartydefaults in the future.

urren exposure: os o rep ac ng a er va vesecurities contract at todays prices. Positivereplacement costs raise capital requirements.

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First Pillar minimum capital requirement

Operational risk

Basic Indicator: 17-20% of sum of net interestincome and net non-interest income

Standardized: indicators for different businesslines

vance easuremen pproac es: u zeinternal loss data

Market risk

No change

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Second Pillar Supervisory review

Ensure banks have sound internal processes inplace

Regulators to be responsible for assessing theperformance of internal risk models

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Third Pillar market discipline

Greater public disclosure

Way bank calculate capital adequacy and riskassessment methods

Greater disclosure requirements for banksemploying internal risk assessment methods


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Calculation for on balance sheetitems

Face value Risk adj amt

Category 1

Category 2

Category 3

551,200

2,933,400

112,900

0

586,680

56,450

Category 4 6,651,500 6,651,500

Total 10,249,000 7,294,630

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OBS item Conversion Face valueUS DI counterparty (category 2)Loan commitments, BBB+

< 1 year> year

2050

1,0003,000

Standby LC, AA- ratedPerformance relatedOther

Commercial LC, BBB+

5010020

20056,400

400

Adj value Weighted

Loan commitments, BBB+

< year> year

Standby LC, AA- ratedPerformance relatedOther

Commercial LC, BBB+Total

1500

10056,400

80$58,280

1500

2011,280

80$13,080

Calculation for off balance sheet

items

equivalent value Risk adj amt

Category 1

Category 2

Category 3

770

58,280

67,750

0

13,080

33,875

Category 4 2,676,632 3,736,201

Total 2,803,432 3,783,156

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Ch 13. Problems 30-33

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Total risk-adjusted assets = $11,077,786

Tier I capital requirement = $443,111

Total capital requirement = $886,223

Leverage ratio: 5% of $ 10,249,000

= $512,450


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Ch 13. Problems 30-33

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Capital

Equity $225,000

Surplus value of equity $200,000

Qualifying perpetual preferred $ 50,000

$475,000

Basel III

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Agreement across 27 member countries reachedin 2010

Goals: Safer financial system; resilient to stress

More and higher quality capital

New standards phased in slowly

Basel III

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Raise quality of capital

Common equity must make up a higher percent ofcapital

Quantity of capital

Minimum common equity requirement raised to4.5 rom 2 n ase

Tier I minimum requirement increased to 6%(from 4%)

Capital conservation buffer of 2.5% to withstandperiods of stress (0% now)

Basel III

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Counter-cyclical capital buffer

0 2.5%

Capital to be built up during periods of rapidcredit aggregate growth

Capital released during downturns

ap ta eyon t e common stan ar s orsystemically important financial institutions


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Basel III More Details

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Bank for International Settlement (2010). The BaselCommittees response to the financial crisis: reportto the G20, October, Available:http://www.bis.org/publ/bcbs179.pdf

Caruana , Jaime (2010). Basel III: towards a safer

, ,General Manager of the BIS, at the 3rd SantanderInternational Banking Conference, Madrid, 15September 2010, Available:http://www.bis.org/speeches/sp100921.htm

CAMEL ratings used by regulators of

depositories

C apital adequacy

A ssets quality

M anagement

E arningsL iquidity

S ensitivity to market risk

Ratings from 1 (best) to 5 (worst)

Financial Crisis Causes

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Housing bubble

Sub-prime mortgages

Sub-prime mortgages transformed into securitiesthan were perceived to be of high quality

Highly leveraged financial institutions and

Fannie Mae and Freddie Mac contributed to housingbubble

Federal Reserve held interest rates too low

Financial Crisis: Major Events

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March 2008: JP Morgan acquires Bear Sternswith support from Fed

Sept 2008: Fannie Mae and Freddie Mac placed

in conservatorship Sept 2008: Lehman Brothers files for bankru tc rotection

Sept 2008: Fed takes various steps to provideliquidity to finance markets

Sept 2008: Washington Mutual and Wachovaclosed


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Financial Crisis

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October 2008: Emergency EconomicStabilization Act of 2008 becomes law(establishes $700 billion TARP)

Nov-Dec 2008: Treasury purchases preferredstock in commercial banks

Nov 2008: BofA ac uires Merrill L nch Dec 2008: Fed Funds rate target lowered to 0 to

0.25% Dec 2008: Loans to auto companies authorized

(TARP funds)

Financial Crisis

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May 2009: Stress tests of 19 largest US bankholding companies completed. 10 will need morecapital

June 2009: 10 largest financial institutions metrequirements for repayment of TARP funds

July 2010: Dodd-Frank Wall Street Reform andConsumer Protection Act signed into law

Documents

Commercial Banks Regulation Fall-2011