Bank History and Regulation

Economics

Adam Smith and the “Invisible hand” As individuals pursue their self interest, they promote

the well-being of everyone. 19th century example: British making loans to build

railroads in U.S.

What problems might prevent the invisible hand from operating? (market failure)

Role of Intermediaries Role of government

Adverse Selection: Akerlof (1970)

Adverse Selection: poor quality products are attracted to markets

Buyers are willing to pay $15,000 for good used car $ 7,500 for a “lemon”

Many Sellers 50% good cars: willing to take $12,500 50% bad cars: willing to take $7,500

Adverse Selection Buyers have no information about car quality –

50/50 proposition On average, expect to get a car worth

0.50(7,500)+0.50(15,000) = $11,250 Buyers will not pay more than $11,250 for any car.

Good cars exit market All bad cars sold for $7,500 Good sellers can’t credibly claim to be “good” Market Failure

Adverse Selection Adverse Selection in Financial Markets

Firms needing capital

SolutionCreate more information

Disclosure requirements (regulation)

Use financial intermediaries who can monitor Restrictions on entry Disclosure requirements

Moral Hazard Moral hazard: Incentives change after

transaction takes place.When insured, take more risksOnce financed, tendency to slack

Example: CEO buys corporate jet with stock issueBanks invest depositor money in risky ventures

Moral Hazard

Solution financial markets

Align incentives of CEO with shareholders

Use financial intermediaries who can monitor Regulation on assets and activities (regulation)

Other issues

Financial intermediaries also promote the invisible hand by:

Lowering transaction costs Economies of scale

Promoting risk sharing Pooling capital Hedging expertise

Ch 10 – History of Banks

Crazy complex system of regulationComptroller of the currencyFederal ReserveState Banking Authorities

When faced with regulation, banks develop methods to avoid costs

History of Banks

American’s have distrusted big banks

19th Century: states issued charters to banks Raised funds by issuing own currency No regulation – often failed

1863 – National Bank Act Established national banks chartered by federal gov Heavy tax on bank notes issued by state banks State banks survived by acquiring funds through

deposits Dual banking system

Central Banking

1913: Federal Reserve System Created

National Banks required to become members of the Federal Reserve System

Central Bank Established

State Banks allowed option to join

Most did not

Structure of Banking Industry

McFadden Act of 1927No branching across state linesNational Banks had to conform to state

regulations and could only branch in their home state

Glass-Steagall Act of 1933Separation of I-Banks from Commercial Banks

Glass-Steagall Act (1933)

I-banking activities of commercial banks blamed for bank failures during Great Depression

Investment bank: Raises capital by “underwriting” securities Advises on merger activities Research and brokerage services Security Dealers

Glass-Steagall Act (1933)

Separation of I-Banks from Commercial BanksCommercial Banks

Prohibited from underwriting or dealing in securities Limited banks to debt securities approved by regulators

Investment Banks Prohibited from commercial banking activities

Erosion of Glass-Steagall Banks at a competitive disadvantage

Good economy – people invest in securities Bad economy – people turn to traditional banks Barriers to “economies of scope”

Financial Innovation: Brokerage firms develop money market mutual funds.

Pressure from Federal Reserve Used loopholes in system to allow commercial banks to

engage in limited underwriting Allowed Citicorp and Travelers to merge

Gramm-Leach Bliley (1999) Allows I-banks to purchase commercial banks

Allows commercial banks to underwrite insurance and securities.

Erosion of McFadden Act

Bank Holding Companies Holding company can own banks across state lines

ATM’s owned by someone other than the banks.

Mcfadden repealed by Riegle-Neal act of 1994 Has led to consolidation trend

Decline of Traditional Banking

Traditional Banking Make long-term loans Fund them by making short-term deposits

Greater Competition for Deposits Regulation Q

Maximum interest paid on deposits about 5% Can’t pay interest on checking accounts

Rise in inflation in 1960’s: higher rates Money Market Mutual Funds

Decline of Traditional Banking

Greater Competition for Assets Junk Bonds Commercial paper Securitization

Bank’s responses: Pursue riskier activities Pursue off-balance sheet activities

Loan sales Fee’s for services: fx trades, loan commitments, banker’s

acceptances

Ch 11 – Bank Regulation

Banks solve some asymmetric info problems but create others – depositors need to monitor and

evaluate banks

Regulation deals with asymmetric info problems But creates others – provide insurance and perform

other activities that may promote moral hazard

Government Safety net

Free rider problem faced by depositors

Adverse selection and bank panics 1819, 1937, 1857, 1873, 1884, 1893, 1907, 1930-1933

Deposit Insurance: FDIC insurance Moral Hazard – depositors have no incentive to monitor

“Too Big to Fail”

Restrictions on Bank Asset Ownership Commercial Banks:

High quality corporate bonds are allowed but subject to restrictions

Common stock investment is allowed in subsidiaries of banks or bank holding companies that are legally separate entities Gramm-Leach-Bliley (1999)

Except in rare instances, banks restrict themselves to “investment-grade” securities (high rated bonds) “prudent man” rule of law: The fiduciary is required to invest trust

assets as a "prudent man" would invest his own property

Other Regulations

Capital requirements Basel Accord: banks must hold at least 8% of “risk-

weighted” assets and off-balance sheet items.

Bank Supervision

Supervision of Risk Management

Disclosure Requirements

How Good Are the Regulators? Burst of Financial innovation in 1960’s and

1970’s Banks have incentive to engage in riskier

activities – further fueled by deposit insurance. New legislation in early 1980’s:

S&L’s and Mutual Savings allowed 40% of assets in commercial real estate loans 30% in consumer lending 10% in commercial loans and leases 10% in “direct investments”: junk bonds, common stock, etc.

FDIC up from $40k to $100k Phased out Regulation Q

How Good Are the Regulators?

S&L’s regulated by Federal Savings and Loan Incorporation (FSLIC) which lacked the expertise to monitor effectively.

Rising rates further increased moral hazard. S&L’s bread and butter was fixed-rate mortgages.

Regulators refrained from closing insolvent S&L’s Further increased moral hazard

Bank Failures increased dramatically

How Good Are the Regulators?

Financial Institutions Reform, Recovery, and Enforcement Act of 1989 Rearranged how banks are regulated Infusion of capital to bailout insolvent institutions New restrictions on asset holdings of S&L’s Increased capital requirements

FDIC Improvement Act of 1991 Increased FDIC’s ability to borrow from treasury FDCI charge higher deposit insurance premiums