Chapter 18

Bank Regulation

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline
 Background
 Regulatory structure
 Deregulation Act of 1980
 Garn-St Germain Act
 Regulation of deposit insurance
 Regulation of capital
 Regulation of operations
 Regulation of interstate expansion
 How regulators monitor banks
 The “too-big-to-fail” issue
 Global bank regulations
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Background
 The banking industry has become more
competitive due to deregulation
 Banks have more flexibility on the services they offer,
the locations where they operate, and the rates they
pay depositors
 Banks have recognized the potential benefits from
economies of scale and scope
 Bank regulation is needed to protect customers
who supply funds to the banking system
 Regulators
are shifting more of the burden of risk
assessment to the individual banks themselves

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Regulatory Structure
 The U.S. has a dual banking system consisting
of federal and state regulation
 Three federal and fifty state agencies supervise the
banking system
 A federal or state charter is required to open a
commercial bank
 National versus state banks
 Federal charters are issued by the Comptroller of the
Currency
 State banks may decide to become members of the Fed
 35 percent of all banks are members of the Fed, comprising
70 percent of deposits

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Regulatory Structure (cont’d)
 Regulatory overlap
 National banks are regulated by the
Comptroller of the Currency, the Fed, and the
FDIC
 State banks are regulated by the state
agency, the Fed, and the FDIC
 Perhaps a single regulatory agency should be
assigned the role of regulating all commercial
banks and savings institutions

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Regulatory Structure (cont’d)
 Regulation of bank ownership
 Commercial banks can be either
independently owned or owned by a bank
holding company
 Most banks are owned by BHCs
 BHCs have more potential for product
diversification because of amendments to the Bank
Holding Company Act of 1956

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Deregulation Act of 1980
 The Depository Institutions Deregulation and Monetary
Control Act (DIDMCA) was enacted in 1980
 DIDMCA has two categories of provisions:
 Those intended to deregulate the banking industry
 Those intended to improve monetary control
 The main deregulatory provisions are:
 Phaseout of deposit rate ceilings
 Allowance of NOW accounts for all depository institutions
 New lending flexibility for depository institutions
 Explicit pricing of Fed services

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Deregulation Act of 1980 (cont’d)
 DIDMCA also called for an increase in the
maximum deposit insurance level from $40,000
to $100,000 per depositor
 Impact of DIDMCA
 There has been a shift from conventional demand
deposits to NOW accounts
 Consumers have shifted funds from conventional
passbook savings accounts to various types of CDs
 DIDMCA has increased competition between
depository institutions

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Garn-St Germain Act of 1982
 The Act:
 Permitted depository institutions to offer money
market deposit accounts (MMDAs), which have no
interest ceiling
 MMDAs are similar to money market mutual funds
 MMDAs allow depository institutions to compete against
money market funds in attracting savers’ funds
 Permitted depository institutions to acquire failing
institutions across geographic boundaries
 Intended to reduce the number of failures that require
liquidation

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Regulation of Deposit Insurance
 Federal deposit insurance has existed since the
creation of the FDIC in 1933 as a response to
bank runs
 About 5,100 banks failed during the Great Depression
 Deposit insurance has increased from $2,500 in 1933
to $100,000 today
 Insured deposits make up 80 percent of all
commercial bank balances
 The FDIC is managed by a board of five directors,
who are appointed by the President

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Regulation of Deposit Insurance
(cont’d)
 The FDIC’s Bank Insurance Fund is the pool of funds
used to cover insured deposits
 The fund is supported with annual insurance premiums paid by
commercial banks, ranging from 23 cents to 31 cents per $100 of
deposit
 In 2003, three BIF-insured banks failed with total assets of $1.1
billion
 As of 2004, the BIF balance was about $34 billion
 In 1991, the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) was passed
 Phased in risk-based deposit insurance premiums to counteract
the moral hazard problem

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Regulation of Capital
 Capital requirements force banks to
maintain a minimum amount of capital as
a percentage of total assets
 Banks would prefer low capital to boost their
ROE
 Regulators have argued that banks need
sufficient capital to absorb potential operating
losses

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Regulation of Capital (cont’d)
 Basel Accord of 1988
 Central banks of 12 major countries agreed to uniform capital
requirements
 The Accord was facilitated by the Bank for International
Settlements (BIS)
 The key contribution of the Accord is that the requirements were
based on the bank’s risk level, forcing riskier banks to maintain a
higher level of capital
 In 1996, the Accord was amended so that bank’s capital level
also account for its sensitivity to market conditions
 Very safe assets are assigned a zero weight, while very risky
assets are assigned a 100 percent weight

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Regulation of Capital (cont’d)
 Basel II Accord
 The Basel Committee has worked on an
accord that would refine the risk measures
and increase the transparency of a bank’s risk
to its customers
 The three parts of the Accord are:
 Revise the measurement of credit risk
 Explicitly account for operational risk

 Require more disclosure for market participants

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Regulation of Capital (cont’d)
 Basel II Accord (cont’d)
 Revised measures of credit risk
 The risk categories are being refined to account for some
possible differences in risk levels of loans within a category
 A bank’s loans that are past due will have a weight of 150%
applied to their assets
 Banks can use the internal ratings-based (IRB) approach to
calculate credit risk, in which banks provide summary
statistics about their loans to the Basel Committee
 The Committee then applied pre-existing formulas to the
statistics in order to determine the required capital level

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Regulation of Capital (cont’d)
 Basel II Accord (cont’d)
 Accounting for operational risk
 Operational risk is the risk of losses from inadequate or failed
internal processes or systems
 Intended to encourage banks to improve their techniques for
controlling operational risk to reduce bank failures
 Initially, banks can use their own methods for assessing their
exposure to operational risk
 The Basel Committee suggests the average annual income
generated over the last three years

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Regulation of Capital (cont’d)
 Basel II Accord (cont’d)
 Public disclosure of risk indicators
 The Basel Committee plans to require banks to
provide more information to existing and
prospective shareholders about their risk exposure
to different types of risk
 This would provide existing and prospective
investors with additional information about a bank’s
risk

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Regulation of Capital (cont’d)
 Use of the value-at-risk method to determine
capital requirements
 Under the 1996 amendment to the Basel Accord,
capital requirements on large banks were adjusted to
incorporate their own internal measurements of
general market risk
 Market risk is the exposure to movements in market forces
such as interest rates, stock prices, and exchange rates
 Capital requirements imposed are based on the bank’s own
assessment of risk when applying the VAR model
 VAR is the estimated potential loss from trading businesses
that could result from adverse movements in market prices
 Banks typically use a 99 percent confidence level
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Regulation of Capital (cont’d)
 Use of the value-at-risk method to determine
capital requirements (cont’d)
 Testing the validity of a bank’s VAR
 The validity is assessed with backtests in which the actual
daily trading gains or losses are compared to the estimated
VAR over a particular period
 If the VAR is estimated properly, only 1 percent of the actual
daily trading days should show results that are worse than
the estimated VAR
 Related stress tests
 Some banks supplement the VAR estimate with stress tests
using extreme events

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Regulation of Operations
 Regulation of loans
 Regulators monitor highly leveraged transactions (HLTs) and a
bank’s exposure to debt of foreign countries
 Banks are restricted to a maximum loan amount of 15 percent of
their capital to any single borrower
 Banks are regulated to ensure that they attempt to accommodate
the credit needs of the communities in which they operate
through the Community Reinvestment Act (CRA) of 1977
 Regulation of investment in securities
 Banks are not allowed to use borrowed or deposited funds to
purchase common stock
 Banks can invest only in bond that are investment-grade quality

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Regulation of Operations (cont’d)
 Regulation of securities services
 The Glass-Steagall Act of 1933:
 Separated banking and securities activities
 Prevented any firm that accepted deposits from
underwriting stocks and bonds of corporations
 Was intended to prevent potential conflicts of
interest

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Regulation of Operations (cont’d)
 Regulation of securities services (cont’d)
 Deregulation of underwriting services
 In 1989, the Fed approved debt underwriting
applications for banks based on the requirements
that:
 Banks had sufficient capital to support the subsidiary that
would perform the underwriting
 Banks had to be audited to ensure that their
management was capable of underwriting debt
 The Fed imposed a ceiling on revenues from
corporate debt underwriting

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Regulation of Operations (cont’d)
 Regulation of securities services (cont’d)
 The Financial Services Modernization Act of 1999:
 Essentially repealed the Glass-Steagall Act
 Made it easier for commercial banks to engage in securities
and insurance activities
 Increased the degree to which banks can offer securities
services
 Allowed securities firms and insurance companies to acquire
banks
 Resulted in more consolidation among banks, securities
firms, and insurance companies

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Regulation of Operations (cont’d)
 Regulation of securities services (cont’d)
 Deregulation of brokerage services
 Banks had been allowed to offer discount brokerage services
even before 1999
 In the late 1990s, some banks acquired financial services
firms that offered full-service brokerage services
 Deregulation of mutual fund services
 Since June 1986, brokerage subsidiaries of bank holding
companies could sell mutual funds
 Private label funds are mutual funds created by banks in
conjunction with financial service firms

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Regulation of Operations (cont’d)
 Regulation of insurance services
 Before the late 1990s, banks were involved in insurance in
limited ways:
 Banks that had participated in insurance before 1971 were allowed
to continue to do so
 Some banks leased space in their buildings to insurance companies
in exchange for a payment equal to a percentage of the insurance
company’s sales
 In 1995, the Supreme Court ruled that national banks could sell
annuities
 In 1998, regulators allowed the merger between Citicorp and
Traveler’s Insurance Group
 In 1999, the Financial Services Modernization Act confirmed that
banks and insurance companies could merge

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Regulation of Operations (cont’d)
 Regulation of off-balance sheet transactions
 Off-balance sheet transactions, such as letters of credit, expose
the bank to risk
 Risk-based capital requirements are higher for banks that
conduct more off-balance sheet activities
 Regulation of the accounting process
 Publicly-traded banks are required to provide financial
statements that indicate their recent financial position and
performance
 The Sarbanes-Oxley Act was enacted in 2002 to make corporate
managers, board members, and auditors more accountable for
the accuracy of the financial statement that their respective firms
provided

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Regulation of Interstate Expansion
 The McFadden Act of 1927 prevented banks
from establishing branches across state lines
 The Douglas Amendment to the Bank Holding
Company Act of 1956 prevented interstate
acquisitions of banks by bank holding
companies
 By 1994, most states had approved nationwide
interstate banking

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Regulation of Interstate Expansion
(cont’d)
 Interstate Banking Act
 Until 1994, most interstate expansion was achieved
through bank acquisitions
 In September 1994, federal guidelines passed a
banking bill that removed interstate branching
restrictions
 Known as the Reigle-Neal Interstate Banking and Branching
Efficiency Act of 1994
 Eliminated most restrictions on interstate bank mergers and
allowed commercial banks to open branches nationwide
 Allows banks to grow and increase economies of scale

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How Regulators Monitor Banks
 Bank regulators:
 Typically conduct an on-site examination of each commercial
bank at least once a year
 Assess the bank’s compliance with existing regulations and its
financial condition
 Periodically monitor commercial banks with computerized
monitoring systems
 Monitor banks to detect any serious deficiencies that might
develop so that they can correct the deficiencies before the bank
fails
 The FDIC rates banks on the basis of six characteristics
(CAMELS ratings)

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How Regulators Monitor Banks
(cont’d)
 Capital adequacy
 Regulators determine the capital ratio (capital divided by
assets)
 If banks hold more capital, they can more easily absorb potential
losses
 Asset quality
 The FDIC evaluates the quality of the bank’s assets, including its
loans and securities
 Management
 The FDIC specifically rates the bank’s management according to
administrative skills, ability to comply with existing regulations,
and ability to cope with a changing environment
 The FDIC also assesses the bank’s internal control systems

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How Regulators Monitor Banks
(cont’d)
 Earnings
 A commonly used profitability ratio to evaluate banks is return
on assets (ROA), defined as EAT divided by assets
 Earnings can also be compared to industry earnings
 Liquidity
 Regulators prefer that banks not consistently rely on outside
sources of funds such as the discount window
 Sensitivity
 Regulators assess the degree to which a bank might be exposed
to adverse financial market conditions
 Regulators place much emphasis on a bank’s sensitivity to
interest rate movements

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How Regulators Monitor Banks
(cont’d)
 Rating bank characteristics
 Each of the CAMELS ratings is rated on a 1-to-5
scale (1 = outstanding)
 A composite rating is determined as the mean rating
of the six characteristics
 Banks with a composite rating of 4.0 or higher are
considered to be problem banks and closely
monitored
 The number of problem banks increased in the 2001–2002
period

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How Regulators Monitor Banks
(cont’d)
 Rating bank characteristics (cont’d)
 Limitations of a rating system
 Regulators do not have the resources to monitor each bank
on a frequent basis
 Over time some problem banks improve while others
deteriorate
 Many problems go unnoticed and it may be too late by the
time they are discovered
 Any system used to detect financial problems may err in one
of two ways:
 It may classify a bank as safe when it is failing
 It may classify a bank as very risky when in fact it is safe

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How Regulators Monitor Banks
(cont’d)
 Corrective action by regulators
 Regulators thoroughly investigate “problem banks:”
 They may request that a bank boost its capital level
 They can require additional financial information
 They have the authority to remove particular officers and
directors if it enhances the bank’s performance
 Ifregulators reduce bank failures by imposing
regulations that reduce competition, bank efficiency
will be reduced

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How Regulators Monitor Banks
(cont’d)
 Funding the closure of failing banks
 The FDIC is responsible for the closure of failing
banks
 Must decide whether to liquidate the bank’s assets or to
facilitate the acquisition of that bank by another bank
 After reimbursing depositors of the failed bank, the FDIC
attempts to sell any marketable assets or the failed banks
 If the failing bank is acquired, the potential acquirer may be
interested if the bank is given sufficient funds by the FDIC

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How Regulators Monitor Banks
(cont’d)
 In 1991, the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) provided that:
 Regulators were required to act more quickly in forcing banks
with inadequate capital to correct the deficiencies
 Regulators were required to close troubled banks more quickly
 Deposits exceeding the insured limit are not to be covered when
a bank fails
 Deposit insurance premiums were to be based on the risk of
banks
 The FDIC was granted the right to borrow $30 billion from the
Treasury to cover bank failures and an additional $45 billion to
finance working capital needs

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The “Too-Big-To-Fail” Issue

 Some troubled banks have received

preferential treatment from bank regulators
 Continental Illinois Bank in 1984 was rescued
 As one of the largest banks in the country,
Continental’s failure could have reduced public
confidence in the banking system
 The indirect costs (such as bank runs) would have
been too great to risk

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The “Too-Big-To-Fail” Issue (cont’d)

 Argument for government rescue

 If Continental had not been rescued:
 Depositors with more than $100,000 at other banks could
have become more concerned about their risk
 Other banks would have been likely candidates for runs on
their deposit accounts
 Argument against government rescue
 A government bailout can be expensive
 The government sends a message to the banking industry
that large banks will not be allowed to fail and large banks
may take excessive risks
 Government intervention could reduce efficiency

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The “Too-Big-To-Fail” Issue (cont’d)

 Proposals for government rescue

 An ideal solution would prevent a run on
deposits of other large banks, yet not reward
a poorly performing bank with a bailout
 The Fed and the FDIC could play a greater role in
assessing bank financial conditions over time to
recognize problems early

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Global Bank Regulations
 Each country has a system for monitoring and regulating
commercial banks
 Most countries also have a system for deposit insurance
 Canadian banks tend to be subject to fewer banking
regulations than U.S. banks, such as interstate
branching
 European banks have had much more freedom than
U.S. banks in offering investment banking services such
as underwriting
 Japanese commercial banks have some flexibility to
provide investment banking services, but not as much as
European banks

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Global Bank Regulations (cont’d)
 Uniform global regulations
 Three of the more significant regulations are:
 The International Banking Act
 Places U.S. and foreign banks operating in the U.S.
under the same set of rules
 The Single European Act
 Places all European banks operating in many European
countries under the same set of rules
 The uniform capital adequacy guidelines
 Forces banks of 12 industrialized nations to abide by the
same minimum capital constraints

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Global Bank Regulations (cont’d)
 Uniform global regulations (cont’d)
 Uniform regulations for banks operating in the United
States
 The International Banking Act of 1978 was designed to
impose similar regulations across domestic and foreign
banks doing business in the U.S.
 Prior to the act, foreign banks had more flexibility to cross
state lines in the U.S. than U.S.-based banks had
 The IBA required foreign banks to identify one state as their
home state

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Global Bank Regulations (cont’d)
 Uniform global regulations (cont’d)
 Uniform regulations across Europe
 The Single European Act of 1987 was phased in throughout
many European countries
 The main provisions are:
 Capital can flow freely throughout the participating countries
 Banks can offer a wide variety of lending, leasing, and
securities activities in the participating countries
 Regulations regarding competition, mergers, and taxes are
similar throughout these countries
 A bank established in any participating country has the right to
expand into any other participating country

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Global Bank Regulations (cont’d)
 Uniform global regulations (cont’d)
 Uniform regulations across Europe (cont’d)
 As a result of the Single European Act:
 A common market has been established for participating
countries
 European banks have begun to consolidate across
countries
 Banks can enter Europe and receive the same banking
powers as other banks there
 Some European savings institutions have evolved into
full-service institutions

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Global Bank Regulations (cont’d)
 Uniform global regulations (cont’d)
 Uniform capital adequacy guidelines around
the world
 Before 1988, capital standards imposed on banks
varied across countries
 Some banks had a comparative advantage over others
 The uniform capital adequacy guidelines imposed
the same minimum capital requirements on the 12
participating countries

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