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Chapter Thirteen

Regulation of
Commercial Banks

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Commercial Banks
Commercial
Commercial banks
banks provide
provide many
many unique
unique services
services

information,
information,liquidity,
liquidity,price-risk
price-riskreduction,
reduction,transaction
transaction
cost,
cost,maturity
maturityintermediation,
intermediation,and
andpayment
paymentservices
services
money
moneysupply
supplytransmission,
transmission,credit
creditallocation,
allocation,
intergenerational
intergenerationalwealth
wealthtransfers,
transfers,and
anddenomination
denomination
intermediation
intermediation

Failure
Failure to
to provide
provide these
these services
services can
can be
becostly
costly to
to
both
both users
users and
and suppliers
suppliers of
of funds
funds
Accordingly,
Accordingly,commercial
commercial banks
banks are
are regulated
regulated at
at
the
the federal
federal (and
(and sometimes
sometimesstate)
state) level
level
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Commercial Bank Regulation


Safety
Safety and
and soundness
soundness regulation
regulation

assets
assetsmust
mustbe
bediversified:
diversified:cannot
cannotmake
makeloans
loansgreater
greater
than
than10%
10%of
oftheir
theirequity
equitycapital
capitalto
toany
anyone
oneborrower
borrower
must
mustmaintain
maintainadequate
adequateequity
equitycapital
capitallevels
levelsto
toprotect
protect
against
againstinsolvency
insolvencyrisk
risk
provision
provisionof
ofguarantee
guaranteefunds
fundssuch
suchas
asthe
theDeposit
Deposit
Insurance
InsuranceFund
Fund(DIF)
(DIF)protects
protectsdepositors
depositorsin
inthe
theevent
event
of
ofdefault
defaultand
andprevents
preventsbank
bankruns
runs
monitoring
monitoringand
andsurveillance:
surveillance:banks
banksmust
mustsubmit
submit
(publicly
(publiclyaccessible)
accessible)quarterly
quarterlyreports
reportsand
andare
aresubject
subject
to
toon-site
on-siteexaminations
examinations

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Commercial Bank Regulation


Monetary
Monetary policy
policy regulation
regulation

the
theCentral
CentralBank
Bank(the
(theFederal
FederalReserve)
Reserve)directly
directly
controls
controlsthe
thequantity
quantityof
ofnotes
notesand
andcoin
coin(i.e.,
(i.e.,outside
outside
money)
money)in
inthe
theeconomy
economy
however,
however,the
thebulk
bulkof
ofthe
themoney
moneysupply
supplyisisheld
heldas
asbank
bank
deposits,
deposits,called
calledinside
insidemoney
money
regulators
regulatorsrequire
requirecash
cashreserves
reservesto
tobe
beheld
heldatat
commercial
commercialbanks
banks

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Commercial Bank Regulation


Credit
Credit allocation
allocation regulation
regulation

regulators
regulatorsencourage
encourage(and
(andoften
oftenrequire)
require)lending
lendingto
to
socially
sociallyimportant
importantsectors
sectorsof
ofthe
theeconomy
economy(e.g.,
(e.g.,
housing
housingand
andfarming)
farming)
usury
usurylaws
lawscap
capinterest
interestrates
ratesthat
thatcan
canbe
becharged
chargedon
on
loans
loans

Investor
Investor protection
protection regulation
regulation

protects
protectsinvestors
investorsagainst
againstinsider
insidertrading,
trading,lack
lackof
of
disclosure,
disclosure,malfeasance,
malfeasance,and
andbreach
breachof
offiduciary
fiduciary
responsibility
responsibility

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Commercial Bank Regulation


Entry
Entry and
and chartering
chartering regulation
regulation

the
theentry
entryof
ofcommercial
commercialbanks
banksisisregulated
regulated
the
thepermissible
permissibleactivities
activitiesof
ofcommercial
commercialbanks
banksare
are
defined
definedby
byregulators
regulators
the
thebarriers
barriersto
toentry
entryand
andthe
thescope
scopeof
ofpermissible
permissible
activities
activitiesallowed
allowedaffects
affectsthe
thecharter
chartervalues
valuesof
ofbanks
banks
and
andthe
thesize
sizeof
ofthe
thenet
netregulatory
regulatoryburden
burden

The
The net
net regulatory
regulatoryburden
burden isis the
the difference
difference
between
between the
the costs
costs of
of regulations
regulations and
and the
the benefits
benefits
for
for the
the producers
producers of
of financial
financial services
services
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Commercial Bank Regulation


Regulators
Regulators

the
theFederal
FederalDeposit
DepositInsurance
InsuranceCorporation
Corporation(FDIC)
(FDIC)
the
theOffice
Officeof
ofthe
theComptroller
Comptrollerof
ofthe
theCurrency
Currency(OCC)
(OCC)
the
theFederal
FederalReserve
ReserveSystem
System(FRS)
(FRS)
state
stateagencies
agencies

The
The four
four facets
facets of
of regulatory
regulatory structure
structure

regulation
regulationof
ofproduct
productand
andgeographic
geographicexpansion
expansion
provision
provisionand
andregulation
regulationof
ofdeposit
depositinsurance
insurance
balance
balancesheet
sheetregulation
regulation
off-balance-sheet
off-balance-sheetregulation
regulation

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Product Segmentation Regulation


Commercial
Commercial banking
banking vs.
vs. investment
investment banking
banking

commercial
commercialbanking
bankinginvolves
involvesdeposit
deposittaking
takingand
and
lending
lending
investment
investmentbanking
bankinginvolves
involvesunderwriting,
underwriting,issuing,
issuing,
and
anddistributing
distributingsecurities
securities
the
theGlass-Steagall
Glass-SteagallAct
Actof
of1933
1933imposed
imposedaarigid
rigid
separation
separationbetween
betweencommercial
commercialand
andinvestment
investmentbanks
banks
by
by1987
1987commercial
commercialbanks
bankswere
wereallowed
allowedto
toengage
engagein
in
limited
limitedinvestment
investmentbanking
bankingactivity
activitythrough
through Section
Section20
20
affiliates
affiliates
the
theFinancial
FinancialServices
ServicesModernization
ModernizationAct
Act(FSMA)
(FSMA)of
of
1999
1999repealed
repealedGlass-Steagall
Glass-Steagall

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Product Segmentation Regulation


Commercial
Commercial banking
bankingvs.
vs.insurance
insuranceunderwriting
underwriting

the
theBank
BankHolding
HoldingCompany
CompanyAct
Act(BHCA)
(BHCA)of
of1956
1956
restricted
restrictedinsurance
insurancecompanies
companiesfrom
fromowning
owningor
orbeing
being
affiliated
affiliatedwith
withcommercial
commercialbanks
banks
the
theFSMA
FSMAof
of1999
1999now
nowallows
allowsbank
bankholding
holdingcompanies
companies
to
toopen
openinsurance
insuranceunderwriting
underwritingaffiliates
affiliatesand
andalso
also
allows
allowsinsurance
insurancecompanies
companiesto
toopen
openbanks
banks

Commercial
Commercial banks
banksand
andcommerce
commerce

the
theBHCA
BHCAof
of1956
1956restricts
restrictscommercial
commercialfirms
firmsfrom
from
acquiring
acquiringbanks
banks
the
the1970
1970Amendment
Amendmentto
tothe
theBHCA
BHCArequires
requiresbanks
banksto
to
divest
divestnonbank
nonbankrelated
relatedsubsidiaries
subsidiaries

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Geographic Expansion Regulation


Restrictions
Restrictions on
on intrastate
intrastate banking
banking

most
mostbanks
banksused
usedto
tobe
beunit
unitbanksi.e.,
banksi.e.,banks
bankswith
with
single
singleoffices
offices
by
by1997
1997only
onlysix
sixstates
statesrestricted
restrictedintrastate
intrastatebranching
branching

Restrictions
Restrictions on
on interstate
interstate banking
banking

the
theMcFadden
McFaddenAct
Actof
of1927
1927(amended
(amendedin
in1933)
1933)
restricted
restrictednational
nationalbanks
banksfrom
frombranching
branchingacross
acrossstate
state
lines
lines
as
asaaresult,
result,the
thelargest
largestbanks
bankswere
wereset
setup
upas
asmultibank
multibank
holding
companies
(MBHCs)
holding companies (MBHCs)
an
anMBHC
MBHCisisaaparent
parentbanking
bankingorganization
organizationthat
thatowns
ownsaa
number
numberof
ofindividual
individualbank
banksubsidiaries
subsidiaries

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Geographic Expansion Regulation


the
theDouglas
DouglasAmendment
Amendmentto
tothe
theBHCA
BHCAof
of1956
1956

let
letstates
statesregulate
regulateMBHC
MBHCexpansion
expansion
subsidiaries
subsidiariesestablished
establishedprior
priortotothe
thepassage
passageof
ofthe
theamendment
amendment
were
wereconsidered
consideredgrandfathered
grandfatheredand
andnot
notsubject
subjecttotothe
thelaw
law

the
the1970
1970Amendment
Amendmentto
tothe
theBHCA
BHCAof
of1956
1956restricted
restricted
the
thenonbank
nonbankactivities
activitiesthat
thatone
onebank
bankholding
holding
companies
companies(OBHCs)
(OBHCs)could
couldengage
engagein
in
aaOBHC
OBHCisisaaparent
parentbanking
bankingorganization
organizationthat
thatowns
ownsone
onebank
bank
subsidiary
and
nonbank
subsidiaries
subsidiary and nonbank subsidiaries

the
theRiegle-Neal
Riegle-NealInterstate
InterstateBanking
Bankingand
andBranching
Branching
Efficiency
EfficiencyAct
Actof
of1994
1994

allows
allowsconsolidation
consolidationof
ofout-of-state
out-of-statebank
banksubsidiaries
subsidiariesinto
intoaa
branch
branchnetwork
networkand
andallows
allowsinterstate
interstatemergers
mergersand
andacquisitions
acquisitions

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Deposit Guarantee Funds


The
TheFederal
FederalDeposit
DepositInsurance
InsuranceCorporation
Corporation(FDIC)
(FDIC)
was
wascreated
createdin
in1933
1933to
tomaintain
maintainthe
thestability
stabilityof
ofthe
theU.S.
U.S.
banking
bankingsystem
system

worked
workedwell
welluntil
until1979
1979
from
fromOctober
October1979
1979totoOctober
October1982
1982the
theFed
Fedtargeted
targetedbank
bank
reserves
reservesand
andlet
letinterest
interestrates
ratesrise
risedramatically
dramatically
led
ledtotodisintermediationi.e.,
disintermediationi.e.,the
thewithdrawal
withdrawalof
ofdeposits
depositsfrom
from
depository
depositoryinstitutions
institutionsand
andtheir
theirreinvestment
reinvestmentelsewhere
elsewhere
problems
problemswere
wereexacerbated
exacerbatedby
byaapolicy
policyof
ofregulatory
regulatory
forbearancei.e.,
forbearancei.e.,aapolicy
policyof
ofnot
notclosing
closingeconomically
economicallyinsolvent
insolvent
depository
depositoryinstitutions,
institutions,but
butallowing
allowingtheir
theircontinued
continuedoperation
operation

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Deposit Guarantee Funds


The
TheFDIC
FDICImprovement
ImprovementAct
Act(FDICIA)
(FDICIA)of
of1991
1991
restructured
restructuredthe
theBank
BankInsurance
InsuranceFund
Fund(BIF)
(BIF)
The
Thedemise
demiseof
ofthe
theFederal
FederalSavings
Savingsand
andLoan
LoanInsurance
Insurance
Corporation
Corporation(FSLIC)
(FSLIC)

the
theFSLIC
FSLICinsured
insuredsavings
savingsinstitutions
institutionsfrom
from1934
1934toto1989
1989
savings
savingsinstitutions
institutionsfailures
failuresininthe
the1980s
1980sled
ledtotoan
aninsolvent
insolvent
FSLIC
by
1989
FSLIC by 1989

The
TheFinancial
FinancialInstitutions
InstitutionsReform,
Reform,Recovery,
Recovery,and
and
Enforcement
EnforcementAct
Act(FIRREA)
(FIRREA)of
of1989
1989

dissolved
dissolvedthe
theFSLIC
FSLICand
andtransferred
transferredits
itsmanagement
managementtotothe
theFDIC
FDIC
created
createdthe
theSavings
SavingsAssociation
AssociationInsurance
InsuranceFund
Fund(SAIF)
(SAIF)

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Deposit Guarantee Funds


The
TheFDIC
FDICintroduced
introducedrisk-based
risk-baseddeposit
depositinsurance
insurance
premiums
premiumsin
inJanuary
Januaryof
of1993
1993

by
by1996
1996the
thesafest
safestinstitutions
institutionsinsured
insuredby
bythe
theBIF
BIFpaid
paidno
nodeposit
deposit
insurance
insurancepremiums
premiums
by
by1997
1997the
thesafest
safestinstitutions
institutionsinsured
insuredby
bythe
theSAIF
SAIFpaid
paidno
no
deposit
depositinsurance
insurancepremiums
premiums
by
bythe
theearly
early2000s
2000sover
over90%
90%of
ofdepository
depositoryinstitutions
institutionswere
wereininthe
the
safe
category
that
paid
no
deposit
insurance
premium
safe category that paid no deposit insurance premium

In
InMarch
March2005
2005the
theBIF
BIFand
andthe
theSAIF
SAIFwere
weremerged
mergedinto
into
one
oneDeposit
DepositInsurance
InsuranceFund
Fund(DIF)
(DIF)
In
InJanuary
January2007
2007the
theFDIC
FDICbegan
beganaamore
moreaggressive
aggressive
insurance
insurancesystem
systemwhere
whereall
allinstitutions
institutionspay
payinto
intothe
thefund
fund
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Balance Sheet Regulation


Liquidity
Liquidityregulation
regulation

banks
banksmust
musthold
holdminimum
minimumlevels
levelsof
ofreserves
reservesagainst
againstnet
net
transaction
transactionaccounts
accounts
ensures
ensuresthat
thatbanks
bankscan
canmeet
meetrequired
requiredpayments
paymentson
onliability
liabilityclaims
claims
such
suchas
asdeposit
depositwithdrawals
withdrawals
see
seeAppendix
Appendix13c
13cfor
formore
moredetails
details

Capital
Capitaladequacy
adequacyregulation
regulation

since
since1987
1987U.S.
U.S.commercial
commercialbanks
bankshave
havefaced
facedtwo
twodifferent
different
capital
capitalrequirements
requirements

McGraw-Hill/Irwin

Tier
TierIIcapital
capitalrisk-based
risk-basedratio
ratio
Total
Totalcapital
capital(Tier
(TierII++Tier
TierII)
II)risk-based
risk-basedratio
ratio

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Balance Sheet Regulation


Capital
Capitaladequacy
adequacyregulation
regulation(continued)
(continued)

Tier
TierIIcapital
capitalisiscomposed
composedof
ofthe
thebook
bookvalue
valueof
ofcommon
commonequity
equity
plus
plusan
anamount
amountof
ofperpetual
perpetualpreferred
preferredstock
stockplus
plusminority
minorityequity
equity
interests
interestsheld
heldby
bythe
thebank
bankininsubsidiaries
subsidiariesminus
minusgoodwill
goodwill
Tier
TierIIIIcapital
capitalincludes
includessecondary
secondarycapital
capitalresources
resourcessuch
suchas
asloan
loan
loss
lossreserves
reservesand
andconvertible
convertibleand
andsubordinated
subordinateddebt
debt
risk-adjusted
risk-adjustedassets
assetsinclude
includeboth
bothonon-and
andoff-balance-sheet
off-balance-sheet
assets
assetswhose
whosevalues
valuesare
areadjusted
adjustedfor
forapproximate
approximatecredit
creditrisk
risk
the
thetotal
totalrisk-based
risk-basedcapital
capitalratio
ratioisisequal
equaltotothe
thesum
sumof
ofTier
TierIIand
and
Tier
TierIIIIcapital
capitaldivided
dividedby
byrisk-adjusted
risk-adjustedassets
assets
the
theTier
TierII(core)
(core)capital
capitalratio
ratioisisequal
equaltotoTier
TierIIcapital
capitaldivided
dividedby
by
risk-adjusted
risk-adjustedassets
assets

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Balance Sheet Regulation


Capital
Capitaladequacy
adequacyregulation
regulation(continued)
(continued)

since
since1991
1991banks
bankshave
havealso
alsobeen
beenassessed
assessedbased
basedon
ontheir
theircapitalcapitalto-assets
to-assets(i.e.,
(i.e.,leverage)
leverage)ratio
ratio

capital-to-assets
capital-to-assetsratio
ratio==core
corecapital
capitaltotal
totalassets
assets
does
doesnot
notaccount
accountfor
formarket
marketvalues,
values,riskiness
riskinessofofassets,
assets,ororoffoffbalance-sheet
balance-sheetactivities
activities

since
sinceDecember
December1992
1992regulators
regulatorsmust
musttake
takePrompt
PromptCorrective
Corrective
Action
Action(PCA)
(PCA)ififand
andwhen
whenaabank
bankfalls
fallsoutside
outsideof
ofthe
thewell
well
capitalized
capitalizedzone
zone
risk-based
risk-basedcapital
capitalratios
ratioswere
werephased
phasedininby
byBank
Bankfor
for
International
InternationalSettlement
Settlement(BIS)
(BIS)countries
countries(the
(theU.S.
U.S.included)
included)by
by
1993
1993under
underthe
theBasel
BaselAccord
Accord
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Off-Balance-Sheet Regulation
Banks
Banksearn
earnfee
feeincome
incomewith
withoff-balance-sheet
off-balance-sheet(OBS)
(OBS)
activities
activities
By
Byengaging
engagingin
inOBS
OBSactivities,
activities,banks
bankscan
canavoid
avoidregulatory
regulatory
costs
costssuch
suchas
asreserve
reserverequirements,
requirements,deposit
depositinsurance
insurance
premiums,
premiums,and
andcapital
capitaladequacy
adequacyrequirements
requirements
Banks
Banksmust
mustreport
reportnotional
notionalvalues
valuesof
ofOBS
OBSactivity
activityon
on
Schedule
ScheduleLL
OBS
OBSactivity
activityisisincorporated
incorporatedinto
intothe
thetotal
totalrisk-based
risk-based
capital
capitalratio
ratioand
andthe
theTier
TierIIcapital
capitalratio,
ratio,but
butnot
notthe
the
leverage
leverageratio
ratio
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Foreign vs. Domestic Regulation


Regulation
Regulation of
of U.S.
U.S. banks
banks in
in foreign
foreign countries
countries

the
theOverseas
OverseasDirect
DirectInvestment
InvestmentControl
ControlAct
Actof
of1964
1964
restricted
restrictedU.S.
U.S.banks
banksability
abilityto
tolend
lendto
toU.S.
U.S.
corporations
corporationsto
tomake
makeforeign
foreigninvestment
investment
the
theNorth
NorthAmerican
AmericanFree
FreeTrade
TradeAgreement
Agreement
(NAFTA)
(NAFTA)of
of1994
1994enabled
enabledU.S.
U.S.banks
banksto
toexpand
expandto
to
Mexico
Mexicoand
andCanada
Canada
aa1997
1997agreement
agreementbetween
between100
100countries
countries(under
(underthe
the
World
WorldTrade
TradeOrganization
Organization(WTO))
(WTO))began
began
dismantling
dismantlingbarriers
barriersinhibiting
inhibitingforeign
foreigndirect
direct
investment
investmentinto
intoemerging
emergingcountries
countries

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Foreign vs. Domestic Regulation


Regulation
Regulationof
offoreign
foreignbanks
banksin
inthe
theU.S.
U.S.

the
theInternational
InternationalBanking
BankingAct
Act(IBA)
(IBA)of
of1978
1978declared
declaredforeign
foreign
banks
banksare
aretotobe
beregulated
regulatedthe
thesame
sameas
asnational
nationaldomestic
domesticbanks
banks
foreign
foreignbanks
banksare
aresubject
subjecttotoFederal
FederalReserve
Reserveexaminations
examinations

the
theForeign
ForeignBank
BankSupervision
SupervisionEnhancement
EnhancementAct
Act(FBSEA)
(FBSEA)of
of
1991
1991gave
gaveadditional
additionalpowers
powerstotothe
theFederal
FederalReserve
Reserve

Fed
Fedmust
mustapprove
approvenew
newsubsidiary,
subsidiary,branch,
branch,agency,
agency,or
orrepresentative
representative
offices
officesofofforeign
foreignbanks
banksininthe
theU.S.
U.S.
Fed
Fedhas
hasthe
theauthority
authoritytotoclose
closeforeign
foreignbanks
banksoperating
operatingininthe
theU.S.
U.S.
only
onlyforeign
foreignbanks
bankswith
withaccess
accesstotothe
theFDIC
FDICcan
canaccept
acceptconsumer
consumer
deposits
deposits
state-licensed
state-licensedforeign
foreignbranches
branchesare
areregulated
regulatedas
asnational
nationalbranches
branches

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