Banking Law Prof. E.

Posner
Spring Quarter 2011
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Banking Law
1. Banking History & Economics
1.1.Major Themes
1.1.1. Protecting banks against themselves
1.1.2. Financial Innovation & Regulations
1.1.3. Effect of History on the Banking System
1.2.What is a Bank?
1.2.1. Bank is a firm w/ two functions
Financial Intermediary
o Intermediary offers diversification, enables economies of scale, expertise and provide
liquidity
o Bank solves maturity mismatch b/w demand deposits and borrower
Provides Transaction Services
o Bank account is a loan to bank. Demand deposits always callable, high liquidity
means lower interest rates
o Banks rely on Law of Large Numbers to protect against runs
Most efficient way to provide the transaction services is to hold accounts. Once a
bank has accounts it becomes profitable to engage in intermediation
1.2.2. American banking system still reflects history in dual state/federal charters and
structure of banks
1.3.Demand Deposits
1.3.1. Transaction Accounts: accounts customer may withdraw money from to pay
others. Can be demand, interest-bearing or both (NOW account).
1.3.2. Fractional Reserves: Banks can't know how much of their debt will come due,
but only need/want enough money to pay off deposits likely to be withdrawn b/c can
make more money, benefiting customers w/ lower fees / more services. Regulators set
minimum for reserves to prevent contagion.
1.3.3. Leverage: Describes effect of financing firm w/ debt & equity. More debt relative
to equity, the more leveraged.
Increases potential profitability of equity & increases risk. Profit when return on
assets exceeds interest rate paid on debt b/c return on equity higher
Banks have really high leverage because:
o More predictable return on assets
o Can readily obtain short-term loans from other banks/Fed if need it
o FDIC helps banks raise cash by attracting deposits
Banks leverage leaves them vulnerable to large, expected loan losses & sharp
increases in interest rates
o Regulators require a minimum equity cushion and push banks to resolve any
problems quickly.
Bank Runs & Panics: Juxtaposes individual rationality w/ mass irrationality b/c in
no ones best interest but once begins each individual has interest in joining the
run
FDIC has made bank runs rare
Role of Banks in Money Supply: Fed. has two roles-regulating banks & monetary
policy
o Two rules conflict:
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Spring Quarter 2011
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Bank exams may conflict w/ countercyclical monetary policy
Two functions compete for time & energy, w/ bank regulation usually losing out
Conflicts of interest w/ one role's goals subverted to accomplish other role's goals
Fed. actions have money multiplier effect--each bank will loan out money from
Fed, less reserve requirement. Problem is don't know money multiplier effect
Interest Rate Risk: Banks fund long term, fixed rate mortgages w/ demand
deposits, so mismatch b/w durations of assets & liabilities
o Incentives misalignment means insolvent banks might mismatch assets/liabilities in
hope interest rates fall and get huge profits. If rates rise, will fail but no one punished
b/c of FDIC
1.4.Why Regulate Banks?
1.4.1. Arguments for Regulation:
Banks are vulnerable b/c of their structure & its inherent mismatch
Bank failures have externalities in a way failures in other industries don't
(Schaake v. Dolley concern)
o Concern is that one bank failure will lead to lots of banks failing--this occurs
because:
Bank runs/people are skittish about banks
Banks are all interlinked/have accounts w/ each other, so have to withdraw from
other banks to meet demand deposits, leaving them short
Banks key to execution of monetary policy, serve as safety net of credit &
liquidity for everyone, especially during times of stress (credit crisis)
Failure of banking industry interferes w/ transaction system entire economy uses
to pay for goods/services
1.4.2. Arguments Against Regulation:
Aspenwall: banks provide services that worried about, but non bank institutions
also provide them and aren't regulated and are doing just fine, so regulation on
banks isn't necessary either (Shadow Market--not a good point after financial
crisis)
o Removing regulations allow for improved financial services & strengthen financial
entities, remove incentives to game system / care about regulatory arbitrage
Scottish Laissez-Faire Banking system worked well when used it, had fewer bank
failures then regulated England, had stable money supply
1.4.3. American Regulatory System
Pros:
o Fragmented regulatory system may protect against excessive regulation b/c banks can
switch b/w regulators
o Turf battles among regulators functions like competition, promoting diligence &
competence
o Similar to interest group battles in that will produce better policy (but better for
whom?)
Cons:
o Lots of jurisdictional overlaps that produce excessive, duplicative or conflicting
regulation, distort economic behavior, increase transaction costs, foster delay, lower
accountability, unfairly favor some and perpetuate regulatory conflicts of interest
o Allows banks to shop for most lenient regulator
1.5.Financial Crisis of 2007-2008
1.5.1. Terms & Concepts:
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Securitization:
o Bank lends to homeowner, receives a mortgage which sells to issuer.
o Issuer collects mortgages, divides them up and sells to bond holders
o Loan Servicer (often original bank)--receives payments from home owner and gives
them to issuer. Has foreclosure responsibilities
o Mortgage backed securities seen as less risky then mortgages b/c of liquidity
Tranching:
o Bondholders have different appetites for risk--some, like banks, need safest type of
bonds to satisfy rules
o People figured out how to convert risky bonds into a batch of safe bonds and a batch
of risky bonds by giving the people w/ safe bonds the right to mortgage payments
before the people w/ the risky bonds
o Idea was would be safer since spread out parts of mortgages across country and
housing prices across country have to drop at once for problems
o Problems:
Removal of link b/w buyer & loaners, so couldn't inspect houses
Calculations based on historical data which didn't include enough data on
extremes, so had Fat Tail problem
Rating agencies making the same assumptions as everyone else
Investment banks taking same risks
High demand for mortgage backed securities meant started to expand into
non-traditional mortgages, subprime lending, balloon mortgages, etc. Since so
cut up and mixed in couldn't value them
Repo Market
o Banks hold onto bonds as collateral for a form of depository banking used by
institutional investors & non-financial firms
o EX: Investor deposits (loans) $$$ w/ I-Bank overnight for interest and gets
asset-backed securities as collateral. Investor gets 3% interest on money deposits,
while securities earn 6%. Investor can roll over as long as want. Allows Investor to
earn interest while providing easy access to money.
o As Repo Market increased, demand for collateral increased, leading to rise of
securitization to meet needs
o Haircuts: If investor demands more in collateral then provide in "deposit" to protect
against decrease in value collateral requires bank to raise money / functions as
withdrawal
o LIBOR Rate: interest rate banks charge each other. Normally Treasury Rate & Libor
Rate are the same <1% (TED Spread).
1.5.2. Phases of Crisis
Rise of Shadow Banking:
o Traditional banking system became unprofitable in 1980s b/c lost market share to
money markets (replaced demand deposits) & junk bonds (replaced lending),
meaning keeping loans on balance sheets not profitable so began using securitization
to sell loans
Securitization let banks exit regulatory structure, but still at risk
Securitization markets now fund traditional banking system
Phase 1 (Late 2006)
o Subprime lending companies start going bankrupt and 2 Bear Sterns hedge funds
collapse
o Panic occurs b/c distribution of risks unknown. Investors started demanding haircuts,
requiring I-Banks to raise money (essentially withdrawing from I-Banks) which
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required selling assets (highly rated bonds) in fire sales, leading to low returns and
eventually insolvency
o In 2007, TED Spread jumped to 5% showing banks think there is a substantial chance
if one bank lends to another bank, won't get paid back.
Banks realize that no one knows the value of their mortgage backed securities
Fed responds by cutting discount rate (lowering cost of lending)--no effect
Fed opens term auction facility to lend money to commercial banks and accepts
worse collateral than normal
In March of 2007 start lending to investment banks (first time Fed had lent to
I-Banks since 1936)
Bear Sterns is sold to JP Morgan w/ the help of the Fed--JPMorgan didn't
want to buy b/c didn't know what Bear's assets were worth (all mortgage
backed securities)--Fed guaranteed up to $37 Billion
September of 2007--Gov't takes over Freddie & Frannie (now owns 50% of
mortgage market)
Phase 2: Panic & Regulatory Response (Sept. 2007)
o Lehman fails and gov't lets it (listen to Greenspan critique). Leads to huge spike in
LIBOR. Prime Money Market Fund stop letting full withdrawal, leading to money
market panic. Commercial Paper market fails bad
Fed & Treasury lend/guarantee billions
Phase 3: Legislative Response (Oct. 2007)
o Congress passes TARP. Theory was that were going to buy mortgage backed
securities and ride out terms of mortgages. Problem was that no one knew what they
were worth, so instead pumped equity into banks so became solvent again. LIBOR
drops, crisis ends around 2009.
1.5.3. Macroeconomic Theory
Real problem was the Fed's actions
Greenspan Fed cut interest rates at any time something bad might happen
Investors began to think that if there was a problem, Fed would come to the rescue and
lend a lot of money to cover the assets, so were willing to over investmoral hazard
2. Banking Powers
2.1.Forming a Bank
2.1.1. First have to decide if want a state or nat'l bank
State--apply to state agency
National--apply to Comptroller of OCC
o OCC tends to have more credibility w/ investors so easier to raise capital, and if
reject can try state agency
Historically, if chartered a state bank, had to stay in that state, w/ many states
limiting size as well (so really small banks)
Congress created nat'l banking system b/c wanted to create national currency and
couldn't do that through state banks.
o Nat'l banks still couldn't cross state lines (birth of sister bank exemption)
o Threat that state banks could join nat'l banks was always a threat that required state
regulators to improve
This declined by 1980s and federal & state law have eroded dual banking system
Lots of conflict b/w state and nat'l law
2.1.2. Strict Approval Process:
Gov't responsible for losses of failed bank, effect of failure on other banks / econ.
OCC looks @ biz plan, access to capital, likelihood of success (fragility/high
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external costs of failure) & honesty (b/c gatekeepers of payment system)
Charter makes regulations easier to apply since have to meet at start
Effect of higher costs on start up limits # of banks, which established banks like.
Incentives for regulators to approve more charters to offset, making less stringent
Congress has opportunity to respond if dont like / think too stringent
Limitations help avoid race to bottom in bank qualitycontagion
2.1.3. Step one is to set up organizing group (usually initial board),pre-filing meeting
w/ OCC, file application, file organization certificate and elect board and
receive approval from OCC.
Every nat'l bank must have "natl" in name, meet conservative naming standards
Banks that obtain state charters still need to follow process to get FDIC insurance,
which almost every state requires
2.2.Banks Enumerated Powers
2.2.1. Nat'l Banking Act authorizes nat'l banks to engage in banking
Powers: Receive deposits, discount & negotiate promissory notes and other debt,
make loans secured by personal & real property, invest in high quality debt
securities, broker securities for customers, act as insurance agents in small towns,
offer trust services, lease-finance personal property and make investments to
promote public welfare
Forbidden: Can't own real property (aside from foreclosures/own building), own
corporate stock, u/w corporate securities, insurance or charge interest above the
legal rate
Banks have incidental powers necessary to carry on biz of banking
2.2.2. Incidental Powers Clause-- 96(1)
Arnold Tours v. Camp (1st. Cir. 1972): Court held that serving as a travel agent
was not an incidental power b/c not convenient or useful in connection w/
established activities authorized by express powers and therefore not necessary to
carry on business of banking
M&M Leasing v. Seattle 1st Nat'l Bank (9th Cir. 1977): Court held that banks
could lease personal property when all relevant circumstances show the
transaction is only a loan secured by property leased and no other material
burdens/risks taken on by bank. Limits include opening car rental biz, using
market power to extract concessions/savings, providing operational services (no
short-term leases, but can dispose of property at end of lease) and leases that
impose more significant financial risks then a normal loan
NationsBank of NC v. Variable Annuity Life Insurance (1995): OCC said banks
could act as agent for sale of annuities under its implicit powers. SC held that
annuities similar enough to savings accounts to be an incidental power since main
difference way paid (periodically for annuities v. lump sum at end for CD).
o SC didn't adopt Arnold Tours, said OCC decision needs to be w/in reasonable bounds
o Courts have become more permissive due to Chevron deference and trend of
deregulation
OCC Interpretive Letter #875 (1999): Banks can provide internet services to
retail merchants that are similar to finder activities (host sites, register w/ search
engines, provide order/payment methods, store data), provide design software
(necessary to use web services) & provide payment processing function (data on
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site visits, transactions and calculate sales tax)
o Reasoning of OCC in allowing finder services different then Arnold Tours but meets
NationsBank reasonable bounds

2.3.Real Property & Securities
2.3.1. Real Property: Four Exceptions to prohibition on owning real property:
Real property acquired by foreclosing (can hold for up to 5 years)
Real property acquired in satisfaction of debts previously contracted in course of
dealings
Real property necessary for accommodation in transaction of its business--must
be reasonably related to current & anticipated biz needs and investment can't
exceed capital w/o regulatory approval
Real property pursuant to power to invest to promote public welfare
2.3.2. Union Nat'l Bank v. Matthews (1878): SC held that object of restrictions was 1) to
keep capital from banks flowing; 2) to deter from real estate speculating; 3) to prevent
banks accumulating lots of property
2.3.3. Murabha Financing-Bank buys property from seller, and then resells at higher
price to buyer w/ an installment contract.
OCC says that it is acceptable even though bank owning property so long as don't
exert any control over property, don't pay taxes on it, etc
Acceptable b/c bank not bearing risk of ownership since functionally the same as
a mortgage
Net Lease Financing is basically the same thing b/c doesn't act as owner and buy
clause so low that leaser will always buy (and therefore bears risk of value
changes)--similar to M&M Leasing idea
Securities: Glass-Steagal split investment & commercial banks--21
Banks banned from buying stock--16 of Glass-Steagal
Exceptions:
o Banks can u/w, deal in and invest in U.S. gov't securities and general obligations of
state/local gov't (has legal obligation to repay)
o Banks can buy investment securities (investment grade corporate debt securities, w/
two rating agencies giving a qualifying rating) up to 10% of the bank's capital
o Banks can buy stock in own subsidiaries engaged in banking activities
o Banks can invest up to 10% of capital in bank service companies which provide
services to depository institutions 1861-67
o Banks can invest up to 5% of capital in small biz investment companies. 682
Intuition is that stock is risky, but bonds/debt are not due to priority in payments /
bankruptcy
o Problems:
Junk bonds can be riskier then stock
Hybrids of stock & debt-EX: Debt instrument w/ fixed payment and option to
convert into equity (or equity that can be converted into debt)
Diversifying portfolio w/ stocks can be safer then holding debt in one company
SIA v. Comptroller of Currency (DDC 1983): Banks are allowed to set up
brokerages to buy/sell securities for customers b/c 16 limits only on bank buying
for own account.
o Providing investment advice is part of / incidental to biz of banking--OCC Letter
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#622
o If a bank provides brokerage services, it must register as a broker-dealer w/ SEC and
comply w/ SEC rules
Investment Company Institute v. Camp (1971)
o U/W means buying up stock in large quantities and selling in small quantities (acting
as a wholesaler)
o Most famous for dicta about why Congress split commercial & investment
banking--Risk to bank b/c of bank's own exposure to speculation in its securities
Conventional wisdom as to root cause of Great Depression
Spillover effect on public confidence in banks (don't want people to stay away
from banks)
Bank may give too easy credit to subsidiaries portfolio's companies
Bank will lend money to customers to get them to invest in funds
Bank will advise (not impartially) that customers invest in fund
Bank will push fund customers to buy fund to prop up solvency of debtor
corporation held by fund
o This case doesn't matter except for dicta b/c bank holding companies can now own
both an I-Bank & a commercial bank
SIA v. Federal Reserve (1984): SC held that banks can't u/w commercial paper
(buying all of it and reselling to investors in smaller amounts at a slightly higher
amount) but can broker (get investor & company together) or discount
commercial paper.
o Commercial Paper: Company can issue commercial paper to investors in lieu of
getting a loan
Benefit is that much easier to find people to buy smaller notes then get 1 large
loan
Investors like it b/c tradable (liquidity) and so demand lower interest rate then
large loan
Similar to bonds except have much shorter maturity period (<100 days) so much
less risky
o Note: An IOU. Commercial paper is a type of note.
o Odd that Banks can't U/W commercial paper:
Liquidity of commercial paper makes it safer for banks
Banks are allowed to own bonds in their portfolio
Spillover reasoning (like mutual funds) is why prohibit--interferes w/ banks role
as impartial source of credit b/c act as promoter when resell
o SIA v. Fed Reserve (DC Cir. 1986): Court allows banks to U/W commercial paper for
private investor
2.4.Insurance
2.4.1. Rationale for Insurance
Allows for smoothing of income-makes long term planning easier
o Diminishing marginal value of dollar means that willing to give up some money so
that have same amount regardless of catastrophe
Hedges against risk that you can't bear
2.4.2. Insurance companies set premiums by using actuarial tables & law of large
numbers. Must also take into account risk that more occurrences will happen than
expected, and add in admin. expenses and profit.
Make money on premiums that are higher than expected liability and investing
premiums while waiting for people to need payouts
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2.4.3. Nat'l Bank Act 92: Any nat'l bank can act as an insurance agent if they are
located and doing business in an area w/ population under 5000, even if principle
office is located somewhere else.
2.4.4. Graham-Leach-Bliley Act: Prohibits courts from providing deference to the
federal agency when there is a conflict b/w state insurance regulators and federal
insurance regulators.
2.4.5. Independent Insurance Agents of America v. Ludwig (DC Cir. 1993): Court
upheld OCC ruling that 92 doesn't limit who banks can sell insurance to if have a
branch in a qualifying location.
2.4.6. IIAA v. Hawke (DC Cir. 2000): OCC ruled that banks could sell crop insurance
b/c similar to credit insurance & benefits farmers & banks risks similar to those of
credit insurance. Court overturned b/c would render 92 redundant and b/c no way to
differentiate crop insurance and other forms
GLB Act gave power to banks to sell insurance if met requirements.
2.4.7. American Land Title Ass'n v. Clark (2d Cir. 1992): Court held that 92 barred sale
of title insurance. GLB Act also generally prohibits selling title insurance unless state
banks are allowed to
2.4.8. Independent Bankers Ass'n of America v. Heimann (DC Cir. 1979): Court upheld
OCC ruling that banks can sell credit life insurance b/c limited to special type of
coverage written to protect loans.
2.4.9. Barnett Bank of Marion County v. Nelson (1996): SC overturned FL law
prohibiting banks w/ holding companies from selling insurance in towns of less than
5000 b/c would frustrate purpose of 92
2.4.10. Ass'n of Banks in Insurance v. Duryee (SD Ohio 1999): Court overturned statute
requiring banks selling insurance to derive more than half of income from
non-deposit /loan customers b/c burdened 92 rights, interfered w/ customers in target
market
2.4.11. Insurance Underwriting: Banks cannot u/w insurance generally. OCC can
authorize specific products, assuming courts dont overturn. Credit-Related insurance
most common. Title insurance & tax-deferred annuities are not allowed.
2.4.12. Blackfeet Nat'l Bank v. Nelson (11th Cir. 1999): Blackfeet offered Retirement
CD where customer made initial deposit, chose a maturity date when they could
withdraw 2/3 of deposit and then received periodic payments until died. Court upheld
FL ruling that bank was u/w CD which is not an implied power and b/c of
McCarran-Ferguson Act flipping preemption so that state insurance laws preempt
unless federal law is about insurance regulation and 24 was about banking
regulation.
SC Test for Insurance:
o Whether practice has effect of transferring or spreading policy holder's risk
o Whether practice integral part of policy relationship b/w insurer & insured
o Whether practice is limited to entities in insurance industry
2.4.13. Republic of Nat'l Bank Dallas v. NW Nat'l Bank of Ft. Worth (Tex. 1978): D
issued letter of credit to facilitate sale of cemetery. Court held was a commercial
letter of credit, b/c bank acted as principal in issuing and engaged own credit, so had a
primary obligation independent of underlying contract requiring only the presentation
of documents to be fulfilled.
Letter of Credit: Agreement by bank w/ one party to pay a 3rd party when the
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3rd party performs a contract
o Purpose is facilitate commerce b/c adds trust (seller trusts bank if doesn't trust buyer)
o Works b/c bank knows buyer & seller knows bank, so bank acts as information
intermediary
o Necessary b/c don't trust legal system / don't have access to legal system
o Basically just a loan, so w/in implied powers / authority of bank
Commercial Letter of Credit: Bank promises to pay beneficiary when see
documents showing met contractual obligations to account party
Standby Letter of Credit: Bank guarantees that account party will perform
obligations to beneficiary. Account party has primary liability, bank only has
secondary liability.
2.4.14. Wichita Eagle & Beacon Publishing v. Pacific Nat'l Bank (9th Cir. 1974): Bank
gave letter of credit saying would pay if builders didn't build a garage. Court held that
was an impermissible guaranty, not a letter of credit b/c had to do factual
investigation into whether bank actually owed
Guaranty v. LoCabout who determines if complete. Guaranty, bank has to
determine facts / if complete. LoC-parties determine. No bank fact finding.
The problem w/ a guaranty / standby letter of credit is that banks/regulators don't
know how to evaluate them, can't put them on balance sheets (end up as footnote /
"off balance sheet")
3. Capital Regulation
3.1.Leverage Limit
3.1.1. FDIC insured banks must have at least 4% ratio of capital to total assets
3.1.2. Leverage Ratio: 1) Calculate Tier 1 Capital by adding common shareholder
equity, noncumulative perpetual preferred shares and any minority share holdings in
consolidated subsidiaries; 2) Divide Tier 1 Capital by banks total assets
3.2.Basel 1 Calculations
3.2.1. Calculating Risk Weighted Assets
1. Convert off-balance sheet assets by multiplying face amount by credit conversion
factor to produce credit-equivalent amount
o 100% factor: direct credit substitutes such as financial guarantee type standby letters
of credit, assets sold w/ recourse, commitments to purchase assets at a specified
future date
o 50% factor: transaction related contingencies such as backing labor & material
contract & subcontractors / suppliers performance
o 20% factor: Commercial letters of credit
o 0% factor: Unused portions of lines of credit expiring w/in 1 year, unused portions of
credit lasting longer than 1 year if bank reviews regularly/can cancel at any time,
unused portion of retail credit card lines bank can cancel any time
2. Sort credit-equivalent amounts into appropriate risk-weighting categories
o Letters of Credit treated as loans
3. Sort rest of balance sheet into weighted categories:
o 0% (no credit risk): Cash, foreign currency, Fed. Gov't obligations, gold, Fed
balances
o 20% (less credit risk): State & local gov't obligations, obligations conditionally
guaranteed by fed. gov't, claims against U.S. banks, mortgage backed securities
guaranteed by Fannie/Freddie Mac
o 50% (more credit risk): 1st mortgages to 1-4 family residences, state & local revenue
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bonds
o 100% (most credit risk): Loans to private borrowers, bank's premises & equipment,
real property acquired by foreclosure/satisfaction of debt
4. Multiply dollar total for each category by risk percentage
5. Add dollar totals for each category to get risk-weighted assets
3.2.2. Calculate Capital
6. Sort into Tier 1 & Tier 2 Capital
o Tier 1: Common shareholders' equity, noncumulative perpetual preferred shares,
minority shareholders in consolidated subsidiaries
o Tier 2: All non-Tier 1 Capital
EX: All other preferred shares, hybrid capital instruments, term subordinated
debt, loan-loss reserves, all preferred shares
7. Add Tier 1 & Tier 2 Capital along following guidelines:
o Subordinated debt & intermediate term preferred shares only in combined amount up
to 50% of Tier 1 capital
o General loan-loss reserves-only in amount up to 1.25% of risk-weighted assets
General Loan-Loss Reserves: reserves over and above any losses expected on
specific loans
o Include only 45% of unrealized appreciation on equity securities for sale
Unrealized appreciation means fair value of securities exceeds historical cost
o Dont change Preferred Shares amount up to Tier 1 cap.
o Include Tier 2 capital only to amount of Tier 1 capital
8. Divide Total Capital by Risk-Weighted Assets
o Leverage Ratio: Tier 1 Capital / Total Assets
o Total RBCR: Total Capital / Risk-Weighted Assets
o Tier 1 RBCR: Tier 1 Capital / Risk-Weighted Assets
o Core Tier 1 RBCR: Core Tier 1 Capital / Risk-Weighted Assets
3.2.3. Problems w/ Basel I
Huge incentives for regulatory arbitrage: New financial instruments invented b/c
hope of improper evaluation, w/ instrument being put into a lower category then
appropriate (30% risk appropriate, regulator puts in 20% category). If put in
higher category, just don't use instrument / adjust instrument risk profile.
o One of stories of Financial Crisis b/c treated mortgage backed securities like
mortgages when much riskier
Accounting uses book value, not mark to market. Different then SEC, but trade
off: Mark to Market is guess, book value doesn't take into account value changing
Where do values come from? How accurate?
3.3.Basel II
3.3.1. Regulators generally agree Basel I adequate for most banks, but not large banks
b/c doesn't differentiate enough b/w asset' risks, doesn't recognize risk-mitigation
techniques, doesn't address all risks and ratios inadequate b/c of financial innovation
Basel II uses credit agency ratings, banks allowed to use own formulas or analyze
risk for each loan individually
3.3.2. Three Pillars of Basel II:
Minimum Capital Requirements: Additional req. of 2% equity in Tier 1 Capital
Supervisory Review
o Want banks to have governing structures to prevent from being too risky
o Core Principles: Board has oversight over lower levels; bank understands how to
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assess risk, independent group to monitor/tell bank being too risky
Market Discipline through increased Disclosure
3.4.Basel III
3.4.1. Basel II seen as failure b/c didn't stop crisis. Basel III raises capital ratios to 4%
equity in Tier 1 Capital and Tier 1 Capital requirement to 6%
3.5.Prompt Correctional Action
3.5.1. FDIC Act Sec. 38: Enacted rules for prompt corrective action, requires action in
some cases. Classifies banks into five categories:
Capital Category Leverage Ratio Total Risk Based Capital Ratio
Well Capitalized >=5% >=10%
Adequately Capitalized >=4% >=8%
Undercapitalized <4% <8%
Significantly
Undercapitalized
<3% <6%
Critically Undercapitalized <2% N/A
FDIC & Too Big to Fail skews tradeoff b/w risk & return
Regulators face perverse incentives to forbear (collective action) & overextend
safety net (failed banks are messy)
Institution falling below minimums faces progressively more stringent
restrictions/ requirements w/ goal correcting problem gets too large / FDIC has to
pay
Capital Based Supervision
Well capitalized category allows for streamline review of regulatory applications
and authority to affiliate w/ any company
All Institutions
o Cant make a capital distribution or pay a management fee if would leave
undercapitalized
Undercapitalized Institutions
o Must submit acceptable capital restoration plan, comply w/ limits on asset
growth and obtain prior approval for acquisitions, branching and new lines of
business
o May face appointment of conservator or receiver if have no reasonable
prospect of becoming adequately capitalized, dont submit a
timely/acceptable plan or materially fail to implement a plan
Significantly Undercapitalized Institutions
Presumptive Safeguards
o Mandatory actions unless exempted
o Require institution to sell enough stock/subordinated debt to recapitalize or
undergo a merger/acquisition
o Restrict transactions w/ affiliated institutions by denying sister bank
exemption
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o Prohibit from paying more than prevailing regional rates of interest on
deposits
Discretionary Safeguards (Sec. 38)
o Agency may further restrict institutions transactions w/ affiliates, asset
growth, require reduction of total assets, restrict overly risky activities, require
institution elect a new board or out any director or senior exec or prohibit
accepting deposits from other institutions, require parent holding company
obtain Federal Reserves permission before making capital distribution or
require divestiture of any subsidiary/affiliate
o Can treat banks like are in lower category (bank value lagging indicator)

Critically Undercapitalized Institutions Actions
o Prohibit payments on subordinated debt
o Place bank in conservatorship, receivership
3.6.Prudential Lending
3.6.1. Focus on particular assets rather than overall balance sheet
3.6.2. Single Lender Limit: Reduces risk of one borrower bringing down bank
Nat'l Bank's loans to one borrower cannot exceed 15% of capital
Bank can loan up to 10% more to that borrower if fully secured
Problem is that restricts banks ability to make money from large, stable
borrowers, increases transaction costs for large loans
OCC has authority to determine when a loan to one person should be attributed to
another
o Direct Benefit--borrower transfers to another in a transaction not at arm's length &
used to acquire goods/property/services
o Common Enterprise: Four types of circumstances
Rely on same source of repayment
One borrower controls and financial interdependent
Borrowers are borrowing to acquire same biz and will own more than half of
voting shares
OCC determination based on totality of circumstances
Higher Limits apply to:
o Making secured loans
o Discounting installment commercial paper that is guaranteed
o Renewing a legally binding commitment to finance if originally w/in the limit
Lending Limits don't apply to:
o Loans to state/federal gov't
o Uncollected funds that are in normal process of collecting
o Renewing/Restricting a loan w/o advancing new money after trying to bring into
conformity
o Additional money to pay taxes/insurance/security to maintain value of real property
securing the loan
o Financing a sale of bank's own assets
o Extensions of credit to affiliates
Syndicated Loans: Bank goes to other banks to participate in loan
Nonconforming Loan: Loan that complied originally. Must make reasonable
effort or correct w/in 30 days if for following reasons:
o Bank's capital declined, Separate borrowers merged/formed common enterprise, bank
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merged, lending limit/capital rules have changed, value of collateral arises
Loan limits apply to insiders, inter-bank liabilities
Insider Lending:
o No preferential terms, prior board approval required, limitations on extensions to any
one insider to $500K/5% of capital and aggregate to 100% of capital and overdrafts
restricted
o Loans to insider's ventures count, insiders of affiliates count, can't knowingly receive
improper credit, no preferential lending to correspondent bank's insiders
3.7.Deposit Insurance
3.7.1. Federal Gov't only one big enough to provide-state & private insurance have
failed. Seems like could get private insurance big enough, but still a bail out risk.
3.7.2. S&L Crisis: inflation increase in 1970s led to lack of deposits b/c
inflation>interest and couldn't sell mortgages except at a loss, so had low equity
leading to really risky investments b/c of moral hazard
3.7.3. Debate on Deposit Insurance:
Too hard to enforce Capital Requirements so should change FDIC
Friedman fan of deposit insurance b/c stopped bank runs for decades
England tried 90% of deposit, had bank runs
Not realistic to assume normal depositors will discipline banks & counting on
big/institutional depositors leaves too big to fail problem
Regulatory Costs means fewer desirable loans, less economic growth
3.7.4. Fed also has power to be lender of last resort (Dodd-Frank changed)
3.7.5. FDIC covers $250K per depositor per bank in each category
Covered: Checking, saving, short term CDs, Money Markets
Not Covered: Stocks, bonds, annuities, life insurance policies, safety deposit box
3.7.6. FDIC v. Philadelphia Gear (1986): FDIC refused to insure contingent letter of
credit from bank to PG. SC upheld b/c did not represent hard assets surrendered to
bank and so would not further Congressional intent to protect assets held by bank
4. Consumer Protection
4.1.Usury
4.1.1. Started w/ religious prohibition on charging interest, now seen as a high rate.
Laws are state, not federal
4.1.2. Might protect banks by stopping dealing w/ risky people, but poor proxy
4.1.3. Negative effects are that can't get capital/loans if too risk. Basically a price
control, leading to people trying to get loans in other ways
4.1.4. Rationale for Price Controls on Credit:
Protect Banks
Social Safety Net
Limit danger to people from being excessively optimistic, ignorant of finance
since better disclosure doesn't seem to help
Concern about bubbles from being able to borrow too easily
4.1.5. Marquette Nat'l Bank of Mpls. v. First of Omaha (1978): Omaha providing credit
cards to MN customers at NE rates b/c located there. SC held that nat'l bank's location
for purpose of Sec. 85 is where it is chartered and can charge interest rate of that state
4.1.6. Smiley v. Citibank (1996): Citibank in SD charging SD allowed late fees to CA
customers. SC held that late fees included in definition of interest rate b/c any flat
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change can be changed to percentage charge easily so fall under Marquette rule.
4.1.7. Tiffany v. Nat'l Bank of MO (1874): SC held that nat'l bank got to use highest
interest rate in state allowed (most favored lender rule)
4.1.8. Fisher: SC held natl bank can charge interest rate of customer state resides in if
have a branch in that state & higher rate than state charter is in
4.2.Consumer Protection Laws
4.2.1. Four main things the gov't is worried about:
Anti-discrimination
o Community Reinvestment Act
o Equal Credit Opportunity Act
o Fair Housing Act
Disclosure
o Truth in Lending Act
Financial Privacy
o Graham-Leach-Bliley Act
o Right to Financial Privacy Act
Collection of Debts
o Fair Debt Collection Practices Act
4.2.2. Implicit policy judgment that people can't protect themselves
4.2.3. U.S. v. Chevy Chase Consent Decree
Gov't sued bank for discriminatory effect in loan practices
Isn't this just a business decision?
o Neighborhoods poorer, higher credit risk, unsafe
o Poor people tend to rent (fewer mortgages)
o Poor people tend to deposit less money
Would it make a difference if lots of banks in that area?
o Maybe don't want to compete in that area for too few profits
Thinking seems to be that impact enough based on history of race, only way to
make sure banks go in and make loans
Redlining: historical practice of not lending to people in a certain area
4.2.4. Community Reinvestment Act
Generally only applies when bank wants to merge and worried regulators will say
no b/c of lending record in minority, poor areas--no penalty for not complying
unless trying to expand
Three Tests:
o Lending Test: look at # of loans, geographic distribution, characteristics, income,
community development lending, innovative/flexible lending practices
o Service Test: look at branches, ATMs, loan offices, extent/innovation of community
development)
o Investment Test: look at investments that benefit assessment area, can't be same as
lending/serviceEX: letting minority owned bank used branch for free/cheap
Bank gets to set criteria in action plan for each tier
Each category has five tiers--outstanding, high satisfactory, low satisfactory,
needs to improve, substantial noncompliance
Overall Four tiers--outstanding, satisfactory, needs to improve, substantial
noncompliance.
First thing have to do is figure out assessment area
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Isn't compatible w/ worries about banks being fragile b/c makes take on risky
loans.
Puts bank in competitive disadvantage w/ other lending institutions that don't have
these requirements
Maybe easiest way to get businesses (or credit for retailers) into poor
neighborhoods? Much easier ways to do thistax credits, etc
Encourages banks to limit themselves (and therefore their assessment areas) to
wealth, white neighborhoods
4.3.Predatory Lending
4.3.1. Stems from change in structure of mortgage industry
Used to be that bank got money from home owner's payments & loan was on
balance sheet so had lots of incentives to be diligent
New system allowed bank to sell mortgages to issuers removing incentive to be
diligent and issuer who purchased the loan didn't care b/c would package it into
tranches and sell to investors (institutional).
o Investors didn't care b/c rating agencies gave good ratings & b/c highly diversified
Subprime market exploded b/c could make a lot of money, needed mortgages for
mortgage backed securities
o Subprime generally didn't understand loan structures
Resulting Subprime Practices--Dodd-Frank has changed a lot of rules
o Subprime set by Dodd-Frank as 6.5% or more above T-Bill
o Excessive Interest & Fees
Fees tended to be hidden in fine print, didn't know "real" interest rate
Truth in Lending Act--requires banks to translate some fees into "effective"
interest rates.
TILA doesn't cover contingent fees, like prepayment fees (if refinance). Too
complicated at this point b/c of all kinds of different contingent fees
Prepayment fee covers risk to bank caused by fact person w/ loan only one
that can refinance and interest how banks make money
o Flipping-constant refinancing. Includes fees, usually necessary for ARMs, teasers.
Problems include optimism bias, people bearing all the risk and didnt understand
them
o "Large" Prepayment Penalties: D-F puts some limits. Problem is optimism bias,
underestimating chance will move
o Balloon Payments: Loan starts at low teaser rate and then goes much higher or loan
structured so only making interest payments for first few years w/o paying off
principle payments
Makes sense if want to buy house can't really afford yet, but should be able to &
house keeps appreciating b/c can refinance/sell when balloon payment starts
Ruin into problem w/ optimism bias, underestimating risk
o Negative Amortization-Pay less then interest, so effectively borrowing
o Adjustable Rate Mortgages-start out low then fluctuate at market rate
Cheaper b/c bear interest rate & can refinance if goes up (but not necessarily
quick enough)
Makes sense if think are going to move in soon
Disclosure not a very good solution b/c hard to do since so many contingencies
o Single Premium Credit Insurance
People don't notice a small amount when paying a large amount
Sell 5 years of insurance when get house, but spread premium over 30 years of
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mortgage, so seems really small.
Also have to pay interest since are borrowing on top of mortgage
Dodd-Frank prohibits
o 100% or > Loans/Mortgages
Used to require 20% money down before bought a house
Now, would loan down payment secured by equity of first mortgage so wouldn't
have any equity in house
Not clear that is a problem for consumers. If default, can just walk away from
house (dont have any equity to lose)
Concern is that people wouldn't consider this properly. Dodd-Frank didn't ban,
but left open for regulators
o Mandatory Arbitration-banned by Dodd-Frank
Potential problem: D-F dries up sub-prime market that had set up via Community
Reinvestment Act b/c won't be able to protect against risk
5. Affiliates
5.1.Affiliates: entities that control, are controlled by or under common control w/ a bank
5.2.Basic policies reflect tension b/w giving banks more freedom and protecting against
exposure to excessive risk
5.2.1. Three basic policies: 1) Allowing affiliates; 2) Allowing banks to deal w/
affiliates; 3) Maintaining meaningful separation b/w banks and affiliates
5.2.2. Worry is that transactions w/ affiliates expose bank to risk & create opportunities
for favoring affiliates at banks expense
Fischel: No incentive for bank to subsidize troubled affiliate b/c just shifts profit
and no incentive for that b/c no cap on profits for banks
o Incentive to overpay if BHC owns more of affiliate then bank (might be liable
to minority shareholders though)
5.3.Nat'l Bank Act Sec. 23A: Places limits on covered transactions
5.3.1. Covered Transactions:
Extends credit to/for the benefit of an affiliate
Issues a guarantee/standby letter of credit for benefit of affiliate
Purchases assets from an affiliate
Accepts securities issued by affiliate to secure any loan
Invests in securities issued by an affiliate
5.3.2. Four Main Rules
1. Transactions w/ affiliate have to be less than 10% of total capital--worry about
lack of diversification
2. Aggregate Transactions w/ affiliates have to be less than 20% of total
capital--ensures don't only invest in affiliates, but risk is prevents banks from
making good investments in affiliates b/c of knowledge of affiliates
3. Extensions of Credit, Letters of Credit must be fully secured w/ qualifying
capital--Odd b/c banks make all kinds of unsecured loans (credit cards). Get
around worries about using junk to secure by increasing requirements as go from
reliable to less reliable
o Require 100% if collateral is Fed. Gov't securities or banker acceptances
o Require 110% if collateral is state/municipal securities
o Require 120% if collateral is debt instruments not w/in another category
o Require 130% if collateral is stock, leases or other real/personal property (mtg)
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o Securities of an affiliate/low quality assets not allowed
o Collateral Requirement doesn't apply to buying assets from an affiliate, investing in
securities issued by an affiliate or accepting securities issued by affiliate as collateral
for an extension of credit to a non-affiliate
4. Bank cannot purchase a low-quality asset from an affiliate.
o Prevents affiliates from dumping on bank. Worry is that bank will overpay b/c of
moral hazard problem
o Qualifies if:
Bank examiners classify as low quality
Affiliate cannot treat accrued interest as income
Payments on asset are more than 30 days due
Obligor renegotiated terms b/c financial condition deteriorated
Sister Bank Exemption-recognizes affiliated banks just branches of same bank
o Exempts transactions b/w FDIC depository institutions under at least 80% common
control from % of capital limits and collateral requirements
o Not worried about transactions b/c all banks heavily regulated
o Want banks to be bigger b/c of economies of scale
o Suspended if bank is significantly undercapitalized
Subsidiary Exemption
o Operating Subsidiaries: Subs engaged only in activities that nat'l bank can conduct
directly. Treated as part of parent bank for Sec. 23A purposes. Rules only apply to
transactions w/ affiliates of parent bank, not to transactions w/ parent bank
o Financial Subsidiary: Only rule that transactions w/ parent exempt from is 10%
capital limitation
Other Exemptions:
o Transactions secured by U.S. Govt Securitiescovers up to amount of
securities used as collateral (Ex: $10M loan, $8M TBills, $2M not exempt)
o Purchasing assets w/ readily identifiable, public market prices
o Repurchasing a loan sold to affiliate originated by bank
o Giving immediate credit to affiliated bank in regular course of business
o Making deposits in affiliated bank in regular course of correspondent banking
o Investing in bank service corporations
5.4.National Bank Act Sec. 23B
5.4.1. Four Main Rules:
1. Bank must deal w/ affiliates on market terms (@ arms length)
o Look at comparable transactions, otherwise good faith
o Applies to:
Covered transactions
Sales of securities/assets to affiliates
Payment of money/furnishing service to affiliates
Transaction where affiliate acts as agent/broker/receives a fee for services to
bank or anyone (anyone pays)
Transaction b/w bank & 3rd party if affiliate has financial interest in the 3rd party
2. Bank as fiduciary can't purchase securities/assets from affiliate except under
instrument creating fiduciary, court order or law of jurisdiction covering fiduciary
3. Bank cannot purchase securities when affiliate U/W
o Aim is to prevent bank propping up price
o Exemption if purchase approved before IPO
4. Bank/affiliate can't publish ad stating/suggesting bank might be liable for
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obligations of affiliates.
5.5.Bank Holding Companies
5.5.1. BHC is any company having control over a bank. 3 Circumstances:
Company owns/controls/has power to vote 25% of any class of bank's voting
securities
Company controls election of majority bank's directors
Fed determines after notice/opportunity for a hearing
Rebuttable presumption no control if vote less than 5% of shares
5.5.2. Bank: Any institution that accepts demand deposits & make commercial loans or
any FDIC insured bank
CEBA creates some exceptions to definition
5.5.3. Need Fed's approval to become a BHC; acquire control of an additional bank;
acquire more than 5% of bank's voting shares, substantially all of its assets or to
merge w/ another BHC
5.5.4. BHCA restricts activities of BHC to:
Banking/managing/controlling banks and other subsidiaries authorized under
BHCA or furnishing services to its subsidiaries
Activities Fed determined closely related to banking before enactment of GLB
Act--Two part Test:
o Closely Related Test-->Public Benefits Test (p443-444)
Nat'l Courier Ass'n v. Federal Reserve (DC Cir. 1975): Court upheld Fed ruling
that could operate courier services for internal operations, banking transactions,
banking/financial records but Fed wrong to allow unsolicited request for courier
of non-financial material b/c not incidental/related
Data Processing Services v. Federal Reserve (DC Cir. 1984): Court upheld Fed
allowing Citicorp engaging in data processing/transmission of banking,
financial/economic data also held "economic related" would have been too far
Further Regulations of BHC:
o Must give notice of activities & acquisitions
o Must make reports on financial conditions, transaction and systems for monitoring
o Must undergo examinations
o Must comply w/ capital requirements
o Are subject to admin enforcement actions
5.6.Financial Holding Companies
5.6.1. Created by GLB Act--may engage in financial activities and
incidental/complementary activities
5.6.2. As bank powers expanded, thought was benefit to affiliation b/w banks &
financial firms
5.6.3. To qualify as FHC, a BHC must meet 3 criteria:
All FDIC institutions must be well capitalized & well managed (satisfactory in
management & composite rating in CAMELs)
Each institution must have satisfactory rating under Community Reinvestment
Act
Must file w/ Fed a declaration of intent to become FHC
5.6.4. 12 Classes Allowed (p468) Fed's Test to determine if activity allowed:
Purposes of GLB & BHC Act (no stated declaration though)
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Changes/reasonably expected changes in market where FHC competes
Changes/reasonably expected changes in tech for delivering financial services
Whether Activity is necessary/appropriate to provide financial services to
compete effectively, efficiently deliver info & services and offer customers means
for using financial services
6. Examination & Enforcement
6.1.Monitoring
6.1.1. Reasons for Regulatory Failure in 1980s & 1990s
Tools bad @ assessing safety/soundness & predicting problems
Structural changes (Larger/more complex)
De-Emphasized on site exams (bank reports became less reliable)
Large/Growing case load of failing banks overwhelmed regulators
Relaxation of regulations w/o taking into account moral hazard
Regulators practiced forbearance
6.1.2. FIRREA made exams/enforcement more strict-increased sanctions, freed agencies
from budgets/salary constraints
6.1.3. Regulatory crack down imposed real costs
Bank supervision expensive, create credit crunch, might deter talent from banking
6.1.4. Supervisory System:
Banks must file call reports (quarterly reports)
Must be one full scope on site exam each year
6.1.5. CAMELS System: Rate each category & overall on scale of 1(best) to 5 (worst).
Table on p636
Capital Adequacy:
o Assess whether have enough capital for risks
o Assess management's ability to identify/measure/monitor & control risks
o Required capital levels are minimums, not norms
Asset Quality
o Denotes soundness of assets, off balance sheet transactions
o Look at risk affecting value/marketability, including risk of default,
lending/investment standards, internal controls and risk ID and loan admin practices
o Look at diversification/concentration of credit risk
Management: Look at whether provide clear guidance on acceptable risk and have
appropriate policies, active oversight
Earnings: focus on size, trend, sustainability, budget & forecasting
Liquidity: compare cash needs w/ ability to raise cash in a timely manner through
selling assets or borrowing. Are deposits fully insured / a flight risk?
Sensitivity to Market Risk: Degree to which changes in interest/exchange rates,
commodity/equity prices can reduce earnings/market value net worth
Composite: Reflects qualitative evaluation of bank's overall managerial, operation
and financial performances
If receive rating of 3 or worse, agency will take enforcement action
Limitations on CAMELS Ratings:
o Not much better then public info @ predicting, despite confidentiality
o Don't necessarily capture situation
o Measure only current condition, do not take into account regional/local developments
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o Don't look at long term risk factors
6.2.Enforcement
6.2.1. Cease & Desist Orders-Must show that:
Engaging in unsafe/unsound practice (fluid-no real definition)
Or violating statute, regulation or agency condition/agreement
6.2.2. Three stages: Notice of charges, hearing, decision on issuing order & contents
Can do more than order to stop. Can order correction/remedy (limit growth, sell
loans/assists, rescind contracts, change officers/employees). Must be designed to
remedy harm
Can pierce veil and go after directors, then consultants, then lawyers 12 USC
1818
Can issue temporary cease & desist b/c formal process lengthy
In re Seidman (1994): Examiner ruled D failure to disclose interest in real estate
to loan committee when got guarantee was unsafe/unsound. Court held approval
not unsafe/unsound b/c only one action & no abnormal risk, but hindering activity
was unsafe/unsound. Imprudent action not necessarily unsafe/unsound
6.2.3. Suspension, Removal & Prohibition
Hard to predict if people risky & can make errors both ways
Can prohibit people from working in banking
To remove prohibit must show:
o Violating statute, regulation, agency condition/agreement
o Engaging/participating in unsafe/unsound practice
o Breaching a fiduciary duty
Then must show wrongful act had requisite effect:
o Actual/probable financial loss/damage to bank
o Actual/probable prejudice to interest of depositors
o Financial gain or other benefit to respondent
Finally, must show displayed culpability--involved dishonesty, demonstrated
willful/continuing disregard for safety/soundness
6.3.Bank Failures
6.3.1. Three Basic Steps for resolving a failed bank:
1. Appoint Receiver to take control
o FDIC takes role as receiver (and also insurer)
o Can do so w/o prior notice but can then be challenged / most have a post seizure
hearing--prior notice would create a run
o Franklin Savings v. OTS (10th Cir. 1991): Court held that review upon merits looks
at whether statutory grounds, not procedure/policy & depends on whether arbitrary,
capricious, an abuse of discretion or not in accordance w/ law
Problem here was brokered deposits--act different then local depositors b/c
highly sensitive to interest rates & used to grow really quickly despite lack of
ability to handle growth/infusion of cash
2. Receiver Marshals Assets
o Can collect on bank's loans and other assets
o Can sell loans w/o borrowers consent
o Can transfer deposits to another bank w/o consent
o Can terminate some contracts/leases w/o liability for liquidated damages/lost profits
Can end lease if lessee but not if lessor
Qualified Financial Contracts
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Includes swaps, securities, commodity contracts, forward contracts, repo agreements
Cannot pick/choose actions for QFCs--can terminate, or only transfer to financial
institution and must take same action for all of same type & all w/ same owner.
Holder of QFC also has right to terminate
o Can invalidate pre-receivership transfers made to defraud
o Can merge bank w/ another FDIC bank
o Cross-Guarantee Liability to FDIC: If bank failure causes loss to FDIC, can hold
affiliated banks liable
o Can pursue claims against directors/officers--usually paid by insurance
FDIC v. American Casualty (7th Cir. 1993): Former director/shareholder brought
derivative suit against directors. Court upheld Regulatory Agency Exception &
Insured v Insured exception.
Regulatory Agency Exception b/c shareholders paying and don't want it pay of
regulators
I v. I exception b/c worried about collusion/manipulation & self dealing
3. Receiver Determines Validity & Priority of Claims
o All creditors must file proof of claims and receiver decides if valid (w/ court review)
o Generally pay all allowed claims w/in a priority class before moving on to next class
o Right of Set Off: Generally allow failed bank's creditors to deduct what bank owes
them against what they owe bank. This is de facto priority over other creditors
o Order of Priority:
Secured Claims--from value of collateral
Creditor must perfect or treated as unsecured
Secured only up to value of collateral. If value less, rest is unsecured, if more, pays
off other claims
Unsecured Claims
Administrative Expenses
Deposits (insured/uninsured)
General liabilities (bonds, unpaid bills/wages)
Subordinated Debt
Cross-Guarantee Liability claim by FDIC
Ownership interest of shareholders
o Four Rules of Validity
Claims must arise from legal obligation that existed before receivership and
value must be known
If no assets remain, no need to determine
Can make payments on properly proved claims at any time up to announced
deadline (can be early)
Side agreement rule can invalidate claim that depends on an agreement w/ failed
bank if adverse to FDIC
o Must determine validity w/in 180 days
o Downriver CFCU v. Penn Square Bank (10th Cir. 1989): Court overturned ruling
that PSB had materially misled P to induce deposits / imposition of constructive trust
b/c shared substantially w/ all other depositors.
Constructive trusts arise only if can show bank's fraud caused a particular harm
not shared by all others
o Leach v. FDIC (5th Cir. 1989): Court held that when shareholders share loss, loss is
done to corporate body not individual shareholders, so don't meet conditions for
derivative suit
Rationale for Receivership:
o Minimize loss to FDIC b/c get repaid by assets
o Helps discourage runs b/c know will get paid
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o Prevents managers from gambling, self dealing, misappropriating when about to fail
o Can put into conservatorship, but then uninsured deposits flee and FDIC takes losses
o Don't have to liquidate completely, can shift corporate identity
o Dual role of FDIC allows to pay out deposits quickly while holding assets to avoid
flooding the market
Resolution Options:
o Deposit Payoff/Straight Liquidation
o Insured Deposit Transfer: Pay healthy bank to assume assets & liabilities
o Purchase of Assets & Assumption of Liabilities
o Bridge Bank: If wants to sell as going concern, can transfer assets/liabilities to bridge
and have it carry on till find buyer
Least Cost Resolution Requirement
o FDIC must use method least costly to fund. Means don't pay uninsured creditors
Need uninsured creditors to create market discipline
o Exception for Systematic Risk--3 Types:
Cascade: One of largest institution fails, triggering cascade of failures that it
owes money. Hard to happen, need to be critical, like clearing/settlement
Solve by giving money to banks b/c are insolvent. Do so by purchasing an equity
stake. Works well if banks well run
FDIC banks required to limit credit exposure to prevent cascades
Contagion: Run b/c of lack of info and don't know if assets safe
Solve through stress tests to determine which solvent/insolvent and then go from
there. Another option is increasing insurance limits
Asset Implosion: Sudden & sustained drop in asset values destroys balance sheets
(liquidity problem)
Solve via loans b/c prop up value of assets. Question is always whether liquidity
problem (low value wrong b/c of fire sales) or solvency (high value was a
bubble/don't know value). Use equity for solvency problem
7. International Banking
7.1.Rationale for Special International Banking Rules:
7.1.1. Problem for smaller countries b/c West would put lots of money into their banks
then pull out at first sign of trouble (effect of a bank run--see Asian Tigers)
7.1.2. Finance see like trade originally--capital will flow where it is in demand. Problem
is that much more instability when capital flees
7.1.3. Regulations like Basel an attempt to solve this problem
7.2.European Debt Crisis
7.2.1. Have to bail out Greeks b/c German banks heavily invested. Can't let them leave
Euro b/c would collapse German banks
7.2.2. Shows Difficulty of Int'l Banking. Three main options:
Don't Regulate at all--capital flight, risky banks in under regulated countries
Try to create an int'l gov't--problematic b/c can't control countries like a federal
gov't can control states (Greece/Ireland)
Hybrid--put pressure on countries like Greece to behave responsibly but bail out if
necessary
7.2.3. Comparison b/w countries & banks
Extra complicated b/c gov't controls banks in that country, so if don't trust gov't,
don't trust banks
Can't invest in Good Countries & let bad fail:
o Politics--Elites don't want Eurozone to fail. Afraid if Greece fails, they will leave
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Eurozone, leading to contagion problem b/c then expect other countries to leave and
will sell Euros b/c afraid of inflation to rescue countries
o Hope is that economic boom will save countries
7.3.International Banking Act of 1978
7.3.1. Three different means foreign banks can enter U.S. Market
Branches (deposits)
Agencies (loans, pay checks, no deposits)
Representative office (office that is not a branch/agency/subsidiary)
7.3.2. Not required to obtain FDIC insurance if operate on wholesale basis or only take
foreign deposits unless accept deposits of less than $100K
7.3.3. Must select home state (initial state if new)
7.3.4. Subject to BHC Act
Can avoid prohibition on non banking activity if get designation from Fed that are
qualified foreign business organization
o Need to have more than half of non U.S. business be banking and more than half of
all banking business is outside of U.S.
8. Dodd-Frank Act
8.1.Two Main Goals: 1) Limit risk of contemporary finance (shadow banking) and; 2) Limit
damage caused by failure of large financial institutions
8.1.1. Enacted as response to the financial crisis. Reverses banking regulations
momentum, which was deregulatory starting in 1980s b/c of thoughts that regulations
too strict, putting American banks at disadvantage, leading to soporific credit market
8.1.2. D-F doesn't actually create a lot of new rules--tells agencies to create
8.2.Objectives of Effective Insolvency Laws:
8.2.1. Must be initiated in timely fashion
8.2.2. Limit damaging effect of financial distress on 3rd parties
8.2.3. Shareholders/Creditors shouldn't be paid in full to encourage limiting risks/ensure
monitoring
8.2.4. Bail outs should only be used when illiquid, not when insolvent
Regulators have incentives to bail out b/c failure messy/hard
Postpones needed restructuring if insolvent
Really should only use in case of systematic risk of counter-party contagion
(failure will cause creditors to fail)
8.3.Dodd Frank's Main Reforms:
8.3.1. Creation of FSOC--Focus Regulators on Systematic Risk
10 members-heads of various financial regulatory agencies
Ex Ante Job is to identify systematically important firms
o Criteria: BHC w/ more than $50B in assets, financial institutions deemed by FSOC as
"systematically important"
o "Systematically Important" have higher capital requirements (problematic), more
regulations, but cheaper access to credit b/c of expectations of bail out (Moral
Hazard!)
o Skeel thinks is corporatist b/c gives advantage to institution & provides gov't w/ new
policy levers in exchange
FSOC got Fed's Bailout authority
o Worry that Fed is playing favorites. Now has to make credit available generally
instead of to specific institutions. Can still game the rules though.
Banking Law Prof. E. Posner
Spring Quarter 2011
24

Effect on Financial Crisis:
o Still rely on Fed b/c only agency that can pay to get quality staff
o Will remove some uncertainty about which banks are systematically important/will
get bailed out, but still lots of discretion due to ability to add new institutions to the
systematically important list quickly
o Decentralization of authority can lead to uncertainty in responses (which regulator
should market listen too)
o Unclear as to which firms might be bailed out beyond ex ante systematic (problem of
drawing proper line as to which ones are systemically important)
8.3.2. Strengthen Resolution Authority of FDIC
Can get involved w/ financial non-banks now to prevent freeze from bankruptcy
(Lehman)
No real way for firms to challenge takeover.
Hard penalties required: Must liquidate, replace management, wipe out
shareholders and only pay creditors whose claims are not assumed
Potential Problems:
o Incentives for forbearance so will look for other ways
Fed can guarantee debt, come up w/ other programs
Can force other institutions to step in
o No reason for banks to fix problems in timely manner b/c of harsh penalties, so want
to make messy to get a bail out instead of resolution
o Timely intervention unlikely due to banks/regulators wanting to avoid
o FDIC not really set up to handle complicated liquidation-probably won't get most out
of assets
8.3.3. Improve Derivatives Market
Requires derivatives to use clearinghouses & trade on exchanges
Can't ban b/c too valuable
Clearinghouse: Members all provide pool of capital. Whenever member dealer
enters into contract w/ another member dealer, seller has to post collateral w/
clearinghouse. If default, seller pays. If seller defaults, collateral (and potentially
pool money) goes to buyer.
o Supposed to make credit risk less severe
o Shifts bail outs from tax payers to clearinghouses
o Problem w/ 1-2 big clearinghouses, back where we started w/ bailing out clearing
house--same moral hazard problems for clearing houses (will inadequately regulate
their members)
o Problem w/ many clearinghouses is that will have race to bottom in attempt to attract
biz, like w/ credit rating agencies. Harder to operate (less likely to happen) b/c of
smaller economy of scale (can't offset losses w/ gains as easily)
Exchanges: Requires standardization of derivative contracts. Limits value b/c can
tailor to individual situations
8.3.4. Enhance Regulations of banks/financial institutions
Volhker Rule: BHC can't engage in proprietary trading in securities except
subsidiary can up to 3% of Tier 1 capital
o Proprietary trading hard to define. Regulators will constantly be behind
Already created two exceptions:
Market Making: Bringing creditor and borrower together. Traditional bank
activity. Does buying commercial paper w/ expectation of selling count as
Banking Law Prof. E. Posner
Spring Quarter 2011
25

proprietary trading?
Hedging: Incredibly important for banks b/c of interest rate risk. Derivative
market used to protect against risk (ex: interest rate swaps). How do you
differentiate b/w hedging and gambling?
o Doesn't really deal w/ problems that cause financial crisis--banks speculating, but not
in stock market, this doesn't seem to apply to mortgage backed securities
Capital Requirements (going to become stricter in future)
8.3.5. Consumer Financial Protection Bureau
Responds to concern that consumers didn't understand loans
Goes beyond financial crisis--consumer advocates had wanted for a while but
banks had prevented politically and weren't able to stop after crisis--analogy to
Patriot Act & 9/11
Unusual agency--probably most independent b/c in Fed (independent) and w/
guaranteed funding stream. Not sure what it's going to do yet
o Can't effect usury rates
o Could decide that adjustable rate mortgages not allowed, or balloon payments, or
tighten U/W standards for mortgages.
8.3.6. Corporate Governance Reform-probably too limited to do anything
8.3.7. Credit Rating Industry Reform--regulators studying
8.3.8. Hedge Fund Registration & Disclosure--reg. people wanted for awhile
8.3.9. Allows for Contingent Capital
Gives banks capital infusion if in trouble by converting debt to equity
Removes run on bank by creditors
Who will buy this? Basically forces creditors to bail out bank
o Going to be better then subordinated debt b/c have same claim but w/o trouble of
converting it via bankruptcy/receivership
o Similar enough to equity that same people will buy
If distress is bad enough, won't do enough to stop collapse-marginal effect
Hard to set so doesn't convert too quickly / not quickly enough
8.4. D-F Conclusion
8.4.1. Still a lot of D-F to implement. Will depend on next President.
8.4.2. Don't know yet who winners/losers are
8.4.3. Live in Administrative State. This is b/c regulators have to move quick to prevent
institutions from gaming system / taking on too much risk
8.4.4. Corporatism--idea that gov't recognizing institutions as too big to fail.
Alternative is to have small institutions. Wouldn't have too many banks that are too
big to fail, but would lose efficiencies, economies of scale