Tài chính doanh nghiệp - Chapter 18: Bank regulation

Chapter 18Bank RegulationFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineBackgroundRegulatory structureDeregulation Act of 1980Garn-St Germain ActRegulation of deposit insuranceRegulation of capitalRegulation of operationsRegulation of interstate expansionHow regulators monitor banksThe “too-big-to-fail” issueGlobal bank regulations2BackgroundThe banking industry has become more competitive due to deregulationBanks have more flexibility on the services they offer, the locations where they operate, and the rates they pay depositorsBanks have recognized the potential benefits from economies of scale and scopeBank regulation is needed to protect customers who supply funds to the banking systemRegulators are shifting more of the burden of risk assessment to the individual banks themselves3Regulatory StructureThe U.S. has a dual banking system consisting of federal and state regulationThree federal and fifty state agencies supervise the banking systemA federal or state charter is required to open a commercial bankNational versus state banksFederal charters are issued by the Comptroller of the CurrencyState banks may decide to become members of the Fed35 percent of all banks are members of the Fed, comprising 70 percent of deposits4Regulatory Structure (cont’d)Regulatory overlapNational banks are regulated by the Comptroller of the Currency, the Fed, and the FDICState banks are regulated by the state agency, the Fed, and the FDICPerhaps a single regulatory agency should be assigned the role of regulating all commercial banks and savings institutions5Regulatory Structure (cont’d)Regulation of bank ownershipCommercial banks can be either independently owned or owned by a bank holding companyMost banks are owned by BHCsBHCs have more potential for product diversification because of amendments to the Bank Holding Company Act of 19566Deregulation Act of 1980The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was enacted in 1980DIDMCA has two categories of provisions:Those intended to deregulate the banking industryThose intended to improve monetary controlThe main deregulatory provisions are:Phaseout of deposit rate ceilingsAllowance of NOW accounts for all depository institutionsNew lending flexibility for depository institutionsExplicit pricing of Fed services7Deregulation Act of 1980 (cont’d)DIDMCA also called for an increase in the maximum deposit insurance level from $40,000 to $100,000 per depositorImpact of DIDMCAThere has been a shift from conventional demand deposits to NOW accountsConsumers have shifted funds from conventional passbook savings accounts to various types of CDsDIDMCA has increased competition between depository institutions8Garn-St Germain Act of 1982The Act:Permitted depository institutions to offer money market deposit accounts (MMDAs), which have no interest ceilingMMDAs are similar to money market mutual fundsMMDAs allow depository institutions to compete against money market funds in attracting savers’ fundsPermitted depository institutions to acquire failing institutions across geographic boundariesIntended to reduce the number of failures that require liquidation9Regulation of Deposit InsuranceFederal deposit insurance has existed since the creation of the FDIC in 1933 as a response to bank runsAbout 5,100 banks failed during the Great DepressionDeposit insurance has increased from $2,500 in 1933 to $100,000 todayInsured deposits make up 80 percent of all commercial bank balancesThe FDIC is managed by a board of five directors, who are appointed by the President10Regulation of Deposit Insurance (cont’d)The FDIC’s Bank Insurance Fund is the pool of funds used to cover insured depositsThe fund is supported with annual insurance premiums paid by commercial banks, ranging from 23 cents to 31 cents per $100 of depositIn 2003, three BIF-insured banks failed with total assets of $1.1 billionAs of 2004, the BIF balance was about $34 billionIn 1991, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) was passedPhased in risk-based deposit insurance premiums to counteract the moral hazard problem11Regulation of CapitalCapital requirements force banks to maintain a minimum amount of capital as a percentage of total assetsBanks would prefer low capital to boost their ROERegulators have argued that banks need sufficient capital to absorb potential operating losses12Regulation of Capital (cont’d)Basel Accord of 1988Central banks of 12 major countries agreed to uniform capital requirementsThe Accord was facilitated by the Bank for International Settlements (BIS)The key contribution of the Accord is that the requirements were based on the bank’s risk level, forcing riskier banks to maintain a higher level of capitalIn 1996, the Accord was amended so that bank’s capital level also account for its sensitivity to market conditionsVery safe assets are assigned a zero weight, while very risky assets are assigned a 100 percent weight13Regulation of Capital (cont’d)Basel II AccordThe Basel Committee has worked on an accord that would refine the risk measures and increase the transparency of a bank’s risk to its customersThe three parts of the Accord are:Revise the measurement of credit riskExplicitly account for operational riskRequire more disclosure for market participants14Regulation of Capital (cont’d)Basel II Accord (cont’d)Revised measures of credit riskThe risk categories are being refined to account for some possible differences in risk levels of loans within a categoryA bank’s loans that are past due will have a weight of 150% applied to their assetsBanks can use the internal ratings-based (IRB) approach to calculate credit risk, in which banks provide summary statistics about their loans to the Basel CommitteeThe Committee then applied pre-existing formulas to the statistics in order to determine the required capital level15Regulation of Capital (cont’d)Basel II Accord (cont’d)Accounting for operational riskOperational risk is the risk of losses from inadequate or failed internal processes or systemsIntended to encourage banks to improve their techniques for controlling operational risk to reduce bank failuresInitially, banks can use their own methods for assessing their exposure to operational riskThe Basel Committee suggests the average annual income generated over the last three years16Regulation of Capital (cont’d)Basel II Accord (cont’d)Public disclosure of risk indicatorsThe Basel Committee plans to require banks to provide more information to existing and prospective shareholders about their risk exposure to different types of riskThis would provide existing and prospective investors with additional information about a bank’s risk17Regulation of Capital (cont’d)Use of the value-at-risk method to determine capital requirementsUnder the 1996 amendment to the Basel Accord, capital requirements on large banks were adjusted to incorporate their own internal measurements of general market riskMarket risk is the exposure to movements in market forces such as interest rates, stock prices, and exchange ratesCapital requirements imposed are based on the bank’s own assessment of risk when applying the VAR modelVAR is the estimated potential loss from trading businesses that could result from adverse movements in market pricesBanks typically use a 99 percent confidence level18Regulation of Capital (cont’d)Use of the value-at-risk method to determine capital requirements (cont’d)Testing the validity of a bank’s VARThe validity is assessed with backtests in which the actual daily trading gains or losses are compared to the estimated VAR over a particular periodIf the VAR is estimated properly, only 1 percent of the actual daily trading days should show results that are worse than the estimated VARRelated stress testsSome banks supplement the VAR estimate with stress tests using extreme events19Regulation of OperationsRegulation of loansRegulators monitor highly leveraged transactions (HLTs) and a bank’s exposure to debt of foreign countriesBanks are restricted to a maximum loan amount of 15 percent of their capital to any single borrowerBanks are regulated to ensure that they attempt to accommodate the credit needs of the communities in which they operate through the Community Reinvestment Act (CRA) of 1977Regulation of investment in securitiesBanks are not allowed to use borrowed or deposited funds to purchase common stockBanks can invest only in bond that are investment-grade quality20Regulation of Operations (cont’d)Regulation of securities servicesThe Glass-Steagall Act of 1933:Separated banking and securities activitiesPrevented any firm that accepted deposits from underwriting stocks and bonds of corporationsWas intended to prevent potential conflicts of interest21Regulation of Operations (cont’d)Regulation of securities services (cont’d)Deregulation of underwriting servicesIn 1989, the Fed approved debt underwriting applications for banks based on the requirements that:Banks had sufficient capital to support the subsidiary that would perform the underwritingBanks had to be audited to ensure that their management was capable of underwriting debtThe Fed imposed a ceiling on revenues from corporate debt underwriting22Regulation of Operations (cont’d)Regulation of securities services (cont’d)The Financial Services Modernization Act of 1999:Essentially repealed the Glass-Steagall ActMade it easier for commercial banks to engage in securities and insurance activitiesIncreased the degree to which banks can offer securities servicesAllowed securities firms and insurance companies to acquire banksResulted in more consolidation among banks, securities firms, and insurance companies23Regulation of Operations (cont’d)Regulation of securities services (cont’d)Deregulation of brokerage servicesBanks had been allowed to offer discount brokerage services even before 1999In the late 1990s, some banks acquired financial services firms that offered full-service brokerage servicesDeregulation of mutual fund servicesSince June 1986, brokerage subsidiaries of bank holding companies could sell mutual fundsPrivate label funds are mutual funds created by banks in conjunction with financial service firms24Regulation of Operations (cont’d)Regulation of insurance servicesBefore the late 1990s, banks were involved in insurance in limited ways:Banks that had participated in insurance before 1971 were allowed to continue to do soSome banks leased space in their buildings to insurance companies in exchange for a payment equal to a percentage of the insurance company’s salesIn 1995, the Supreme Court ruled that national banks could sell annuitiesIn 1998, regulators allowed the merger between Citicorp and Traveler’s Insurance GroupIn 1999, the Financial Services Modernization Act confirmed that banks and insurance companies could merge25Regulation of Operations (cont’d)Regulation of off-balance sheet transactionsOff-balance sheet transactions, such as letters of credit, expose the bank to riskRisk-based capital requirements are higher for banks that conduct more off-balance sheet activitiesRegulation of the accounting processPublicly-traded banks are required to provide financial statements that indicate their recent financial position and performanceThe Sarbanes-Oxley Act was enacted in 2002 to make corporate managers, board members, and auditors more accountable for the accuracy of the financial statement that their respective firms provided26Regulation of Interstate ExpansionThe McFadden Act of 1927 prevented banks from establishing branches across state linesThe Douglas Amendment to the Bank Holding Company Act of 1956 prevented interstate acquisitions of banks by bank holding companiesBy 1994, most states had approved nationwide interstate banking27Regulation of Interstate Expansion (cont’d)Interstate Banking ActUntil 1994, most interstate expansion was achieved through bank acquisitionsIn September 1994, federal guidelines passed a banking bill that removed interstate branching restrictionsKnown as the Reigle-Neal Interstate Banking and Branching Efficiency Act of 1994Eliminated most restrictions on interstate bank mergers and allowed commercial banks to open branches nationwideAllows banks to grow and increase economies of scale28How Regulators Monitor BanksBank regulators:Typically conduct an on-site examination of each commercial bank at least once a yearAssess the bank’s compliance with existing regulations and its financial conditionPeriodically monitor commercial banks with computerized monitoring systemsMonitor banks to detect any serious deficiencies that might develop so that they can correct the deficiencies before the bank failsThe FDIC rates banks on the basis of six characteristics (CAMELS ratings)29How Regulators Monitor Banks (cont’d)Capital adequacyRegulators determine the capital ratio (capital divided by assets)If banks hold more capital, they can more easily absorb potential lossesAsset qualityThe FDIC evaluates the quality of the bank’s assets, including its loans and securitiesManagementThe FDIC specifically rates the bank’s management according to administrative skills, ability to comply with existing regulations, and ability to cope with a changing environmentThe FDIC also assesses the bank’s internal control systems30How Regulators Monitor Banks (cont’d)EarningsA commonly used profitability ratio to evaluate banks is return on assets (ROA), defined as EAT divided by assetsEarnings can also be compared to industry earningsLiquidityRegulators prefer that banks not consistently rely on outside sources of funds such as the discount windowSensitivityRegulators assess the degree to which a bank might be exposed to adverse financial market conditionsRegulators place much emphasis on a bank’s sensitivity to interest rate movements31How Regulators Monitor Banks (cont’d)Rating bank characteristicsEach of the CAMELS ratings is rated on a 1-to-5 scale (1 = outstanding)A composite rating is determined as the mean rating of the six characteristicsBanks with a composite rating of 4.0 or higher are considered to be problem banks and closely monitoredThe number of problem banks increased in the 2001–2002 period32How Regulators Monitor Banks (cont’d)Rating bank characteristics (cont’d)Limitations of a rating systemRegulators do not have the resources to monitor each bank on a frequent basisOver time some problem banks improve while others deteriorateMany problems go unnoticed and it may be too late by the time they are discoveredAny system used to detect financial problems may err in one of two ways:It may classify a bank as safe when it is failingIt may classify a bank as very risky when in fact it is safe33How Regulators Monitor Banks (cont’d)Corrective action by regulatorsRegulators thoroughly investigate “problem banks:”They may request that a bank boost its capital levelThey can require additional financial informationThey have the authority to remove particular officers and directors if it enhances the bank’s performanceIf regulators reduce bank failures by imposing regulations that reduce competition, bank efficiency will be reduced34How Regulators Monitor Banks (cont’d)Funding the closure of failing banksThe FDIC is responsible for the closure of failing banksMust decide whether to liquidate the bank’s assets or to facilitate the acquisition of that bank by another bankAfter reimbursing depositors of the failed bank, the FDIC attempts to sell any marketable assets or the failed banksIf the failing bank is acquired, the potential acquirer may be interested if the bank is given sufficient funds by the FDIC35How Regulators Monitor Banks (cont’d)In 1991, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) provided that:Regulators were required to act more quickly in forcing banks with inadequate capital to correct the deficienciesRegulators were required to close troubled banks more quicklyDeposits exceeding the insured limit are not to be covered when a bank failsDeposit insurance premiums were to be based on the risk of banksThe FDIC was granted the right to borrow $30 billion from the Treasury to cover bank failures and an additional $45 billion to finance working capital needs36The “Too-Big-To-Fail” IssueSome troubled banks have received preferential treatment from bank regulatorsContinental Illinois Bank in 1984 was rescuedAs one of the largest banks in the country, Continental’s failure could have reduced public confidence in the banking systemThe indirect costs (such as bank runs) would have been too great to risk37The “Too-Big-To-Fail” Issue (cont’d)Argument for government rescueIf Continental had not been rescued:Depositors with more than $100,000 at other banks could have become more concerned about their riskOther banks would have been likely candidates for runs on their deposit accountsArgument against government rescueA government bailout can be expensiveThe government sends a message to the banking industry that large banks will not be allowed to fail and large banks may take excessive risksGovernment intervention could reduce efficiency38The “Too-Big-To-Fail” Issue (cont’d)Proposals for government rescueAn ideal solution would prevent a run on deposits of other large banks, yet not reward a poorly performing bank with a bailoutThe Fed and the FDIC could play a greater role in assessing bank financial conditions over time to recognize problems early39Global Bank RegulationsEach country has a system for monitoring and regulating commercial banksMost countries also have a system for deposit insuranceCanadian banks tend to be subject to fewer banking regulations than U.S. banks, such as interstate branchingEuropean banks have had much more freedom than U.S. banks in offering investment banking services such as underwritingJapanese commercial banks have some flexibility to provide investment banking services, but not as much as European banks40Global Bank Regulations (cont’d)Uniform global regulationsThree of the more significant regulations are:The International Banking ActPlaces U.S. and foreign banks operating in the U.S. under the same set of rulesThe Single European ActPlaces all European banks operating in many European countries under the same set of rulesThe uniform capital adequacy guidelinesForces banks of 12 industrialized nations to abide by the same minimum capital constraints41Global Bank Regulations (cont’d)Uniform global regulations (cont’d)Uniform regulations for banks operating in the United StatesThe International Banking Act of 1978 was designed to impose similar regulations across domestic and foreign banks doing business in the U.S.Prior to the act, foreign banks had more flexibility to cross state lines in the U.S. than U.S.-based banks hadThe IBA required foreign banks to identify one state as their home state42Global Bank Regulations (cont’d)Uniform global regulations (cont’d)Uniform regulations across EuropeThe Single European Act of 1987 was phased in throughout many European countriesThe main provisions are:Capital can flow freely throughout the participating countriesBanks can offer a wide variety of lending, leasing, and securities activities in the participating countriesRegulations regarding competition, mergers, and taxes are similar throughout these countriesA bank established in any participating country has the right to expand into any other participating country43Global Bank Regulations (cont’d)Uniform global regulations (cont’d)Uniform regulations across Europe (cont’d)As a result of the Single European Act:A common market has been established for participating countriesEuropean banks have begun to consolidate across countriesBanks can enter Europe and receive the same banking powers as other banks thereSome European savings institutions have evolved into full-service institutions44Global Bank Regulations (cont’d)Uniform global regulations (cont’d)Uniform capital adequacy guidelines around the worldBefore 1988, capital standards imposed on banks varied across countriesSome banks had a comparative advantage over othersThe uniform capital adequacy guidelines imposed the same minimum capital requirements on the 12 participating countries45