Lecture 10 - Financial Regulation
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This document provides an overview of financial regulation and its economic rationale. It discusses how government safety nets like deposit insurance can create moral hazard issues but are still necessary to prevent bank runs. It also describes different types of financial regulation, including restrictions on asset holdings, capital requirements, disclosure requirements, consumer protection laws, and international coordination challenges. The goal of regulation is to reduce asymmetric information problems while not unduly limiting competition.
Lecture 10 - Financial Regulation
- 1. An Economic Analysis of Financial Regulation Ryan Herzog, Ph.D. Associate Professor Economics
- 2. Preview • This chapter develops an economic analysis of financial regulation. • Readings – Understanding Bank Capital
- 3. Learning Objectives • Identify the reasons for and forms of a government safety net in financial markets. • List and summarize the types of financial regulation and how each reduces asymmetric information problems.
- 4. Asymmetric Information as a Rationale for Financial Regulation • Bank panics and the need for deposit insurance: – FDIC: short circuits bank failures and contagion effect – Payoff method – Purchase and assumption method (typically more costly for the FDIC) • Other form of government safety net: – Lending from the central bank to troubled institutions (lender of last resort)
- 5. The Spread of Government Deposit Insurance Throughout the World • Has government deposit insurance helped improve the performance of the financial system and prevent banking crises? – Research at the World Bank seems to answer “no,” since on average, the adoption of explicit government deposit insurance is associated with less banking sector stability and a higher incidence of banking crises. Furthermore, on average, deposit insurance seems to retard financial development.
- 6. Drawbacks of the Government Safety Net • Moral Hazard – Depositors do not impose discipline of marketplace – Financial institutions have an incentive to take on greater risk • Adverse Selection – Risk-lovers find banking attractive – Depositors have little reason to monitor financial institutions
- 7. “Too Big to Fail” • Government provides guarantees of repayment to large uninsured creditors of the largest financial institutions even when they are not entitled to this guarantee. • Uses the purchase and assumption method • Increases moral hazard incentives for big banks
- 8. Financial Consolidation and the Government Safety Net • Larger and more complex financial organizations challenge regulation: – Increased “too big to fail” problem – Extends safety net to new activities, increasing incentives for risk-taking in these areas (as has occurred during the global financial crisis
- 9. Types of Financial Regulation: Restrictions on Asset Holdings • Attempts to restrict financial institutions from too much risk taking: – Bank regulations • Promote diversification • Prohibit holdings of common stock – Capital requirements • Minimum leverage ratio (for banks) • Basel Accord: risk-based capital requirements • Regulatory arbitrage
- 10. Types of Financial Regulation: Capital Requirements • Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions • There are two forms: – Based on the leverage ratio, the amount of capital divided by the bank’s total assets: to be classified as well capitalized, a bank’s leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank. – Risk-based capital requirements – Regulatory arbitrage problem
- 11. Capital Requirements • Tier 1 capital is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings) • Tier 2 capital represents “supplementary capital” such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt. • Banks must hold Tier 1 capital equal to 4% of their risk weighted assets (this is owner equity). 7/22/2020 GONZAGA UNIVERSITY 11
- 12. Evolution of Capital Requirements • International Lending Supervision Act of 1983. – Major U.S., European and Japanese banks, the 1988 Basel Committee on Banking Regulation and Supervisory Practices announced that, for internationally active commercial banks, adequate capital requirements would be raised from 5.5% to 8% of total assets. – It was followed by Basel II in 2004, which incorporated types of credit risk in the calculation of ratios. • In the 21st century a system of applying a risk weight to different types of assets allowed banks to hold less capital with total assets. – Traditional commercial loans were given a weight of 1. • The one weight meant that for every $1 of commercial loans held on a bank's balance sheet, they would be required to maintain eight cents of capital. – Standard residential mortgages were given a weight of 0.5 – Mortgage-backed securities (MBS) issued by Fannie Mae or Freddie Mac were given a weight of 0.2 – Short-term government securities were given a weight of 0 7/22/2020 GONZAGA UNIVERSITY 12
- 13. Basel Accord 1988 • Deals with risk based capital requirements based on riskiness of assets – Capital must be 8% of their risk weighted assets – Adopted by over 100 countries • 4 Categories – 0% - Reserves and government securities in the OECD – 20% - Claims on banks in OECD countries – 50% - Municipal bonds and mortgages – 100% - Consumer and commercial loans 7/22/2020 GONZAGA UNIVERSITY 13
- 14. Where Is the Basel Accord Heading After the Global Financial Crisis? • Starting in June 1999, the Basel Committee on Banking Supervision released several proposals to reform the original 1988 Basel Accord. These efforts have culminated in what bank supervisors refer to as Basel 2, which is based on three pillars.
- 15. Pillar 1 • Links capital requirements for large, internationally active banks more closely to actual risk of three types: market risk, credit risk, and operational risk. – Credit Risk - The standard risk weight categories used under Basel I. Basel II introduced a new 150% weighting for borrowers with lower credit ratings. The minimum capital required remained at 8% of risk weighted assets, with Tier 1 capital making up not less than half of this amount. – Operational Risk – Market Risk
- 16. Pillar 2 • Pillar 2 focuses on strengthening the supervisory process, particularly in assessing the quality of risk management in banking institutions and evaluating whether these institutions have adequate procedures in place for determining how much capital they need. • CAMELS – C - Capital – A - Asset Quality – M - Management – E - Earnings – L - Liquidity – S - Sensitivity to Market Risk • CAMELS ratings are not made public. • They are used to make decisions about whether to take formal action against the bank or even to close it. • Current practice is for supervisors to act as consultants, advising banks how to get the highest return possible while keeping risk at an acceptable level. 7/22/2020 GONZAGA UNIVERSITY 16
- 17. Where Is the Basel Accord Heading After the Global Financial Crisis? • Pillar 3 focuses on improving market discipline through increased disclosure of details about a bank’s credit exposures, its amount of reserves and capital, the officials who control the bank, and the effectiveness of its internal rating system.
- 18. Dodd-Frank • Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. – Created to ensure that the largest U.S. banks maintain enough capital to withstand systematic shocks to the banking system. – Dodd-Frank (Collins Amendment) • Set the tier 1 risk-based capital ratio of 4% • Globally, the Basel Committee on Banking Supervision released Basel III, regulations which further tighter capital requirements on financial institutions worldwide. 7/22/2020 GONZAGA UNIVERSITY 18
- 19. Dodd-Frank • More stringent capital and liquidity requirements for LCFIs (large, complex financial institutions). • Tougher regulation of systemically important non-bank financial companies. • The breakup of LCFIs, if necessary. • Tougher restrictions on bailouts. • More transparency for asset-backed securities and other • “exotic" financial instruments. • Improved corporate governance rules designed to give shareholders more say over the structure of executive compensation. 7/22/2020 GONZAGA UNIVERSITY 19
- 20. Financial Supervision: Prompt Corrective Action • If the amount of a financial institution’s capital falls to low levels, serious problems result. • To prevent this, the Federal Deposit Insurance Corporation Improvement Act of 1991 adopted prompt corrective action provisions that require the FDIC to intervene earlier and more vigorously when a bank gets into trouble.
- 21. Assessment of Risk Management • Greater emphasis on evaluating soundness of management processes for controlling risk • Trading Activities Manual of 1994 for risk management rating based on: – Quality of oversight provided – Adequacy of policies and limits for all risky activities – Quality of the risk measurement and monitoring systems – Adequacy of internal controls • Interest-rate risk limits: – Internal policies and procedures – Internal management and monitoring – Implementation of stress testing and value-at risk (VaR)
- 22. Disclosure Requirements • Requirements to adhere to standard accounting principles and to disclose wide range of information • The Basel 2 accord and the SEC put a particular emphasis on disclosure requirements • The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board • Mark-to-market (fair-value) accounting
- 23. Consumer Protection • Consumer Protection Act of 1969 (Truth-in- lending Act) • Fair Credit Billing Act of 1974 • Equal Credit Opportunity Act of 1974, extended in 1976 • Community Reinvestment Act • The subprime mortgage crisis illustrated the need for greater consumer protection.
- 24. Restrictions on Competition • Justified as increased competition can also increase moral hazard incentives to take on more risk. – Branching restrictions (eliminated in 1994) – Glass-Steagall Act (repeated in 1999) • Disadvantages: – Higher consumer charges – Decreased efficiency
- 25. International Financial Regulation • Particular problems in financial regulation occur when financial institutions operate in many countries and thus can shift their business readily from one country to another. Financial regulators closely examine the domestic operations of financial institutions in their own country, but they often do not have the knowledge or ability to keep a close watch on operations in other countries
- 26. Major Financial Legislation in the United States • Federal Reserve Act (1913) – Created the Federal Reserve System • McFadden Act of 1927 – Effectively prohibited banks from branching across state lines – Put national and state banks on equal footing regarding branching (prevented large banks for opening near small banks) • Banking Acts of 1933 (Glass-Steagall) and 1935 – Created the FDIC – Separated commercial banking from the securities industry – Prohibited interest on checkable deposits and restricted such deposits to commercial banks – Put interest-rate ceilings on other deposits • Securities Act of 1933 and Securities Exchange Act of 1934 – Required that investors receive financial information on securities offered for public sale – Prohibited misrepresentations and fraud in the sale of securities – Created the Securities and Exchange Commission (SEC) • Investment Company Act of 1940 and Investment Advisers Act of 1940 – Regulated investment companies, including mutual funds – Regulated investment advisers
- 27. Major Financial Legislation in the United States • Bank Holding Company Act and Douglas Amendment (1956) – Clarified the status of bank holding companies (BHCs) – Gave the Federal Reserve regulatory responsibility for BHCs • Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 – Gave thrift institutions wider latitude in activities – Approved NOW and sweep accounts nationwide • NOW – similar to checking but until Regulation Q were treated differently and could pay interest – Phased out interest-rate ceilings on deposits – Imposed uniform reserve requirements on depository institutions – Eliminated usury ceilings on loans – Increased deposit insurance to $100,000 per account • Depository Institutions Act of 1982 (Garn-St. Germain) – Gave the FDIC and the Federal Savings and Loan Insurance Corporation (FSLIC) emergency powers to merge banks and thrifts across state lines – Allowed depository institutions to offer money market deposit accounts (MMDAs) – Granted thrifts wider latitude in commercial and consumer lending
- 28. Major Financial Legislation in the United States • Competitive Equality in Banking Act (CEBA) of 1987 – Provided $10.8 billion to shore up the FSLIC – Made provisions for regulatory forbearance in depressed areas • Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 – Provided funds to resolve savings and loan (S&L) failures – Eliminated FSLIC and the Federal Home Loan Bank Board – Created the Office of Thrift Supervision to regulate thrifts – Created the Resolution Trust Corporation to resolve insolvent thrifts – Raised deposit insurance premiums – Reimposed restrictions on S&L activities
- 29. Major Financial Legislation in the United States • Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 – Recapitalized the FDIC – Limited brokered deposits and the too-big-to-fail policy – Set provisions for prompt corrective action – Instructed the FDIC to establish risk-based premiums – Increased examinations, capital requirements, and reporting requirements – Included the Foreign Bank Supervision Enhancement Act (FBSEA), which strengthened the Fed’s authority to supervise foreign banks • Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 – Overturned prohibition of interstate banking – Allowed branching across state lines • Gramm-Leach-Bliley Financial Services Modernization Act of 1999 – Repealed Glass-Steagall and removed the separation of banking and securities industries • Sarbanes-Oxley Act of 2002 – Created Public Company Accounting Oversight Board (PCAOB) – Prohibited certain conflicts of interest – Required certification by CEO and CFO of financial statements and independence of audit committee
- 30. Major Financial Legislation in the United States • Federal Deposit Insurance Reform Act of 2005 – Merged the Bank Insurance Fund and the Savings Association Insurance Fund – Increased deposit insurance on individual retirement accounts to $250,000 per account • Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 – Created Consumer Financial Protection Bureau to regulate mortgages and other financial products – Required routine derivatives to be cleared through central clearing houses and exchanges – Required annual bank stress tests – Limits Federal Reserve lending to individual firms – Authorized government takeovers of financial holding companies – Created Financial Stability Oversight Council to regulate systemically important financial institutions – Banned banks from proprietary trading and from owning large percentages of hedge funds