Chapter 9 Government's Role in Banking

GOVERNMENT’S
ROLE IN BANKING
Chapter Nine
1
Regulation of Banks
 Banking is one of the most heavily regulated
industries in the U.S.
 An efficient payments system and circulation of

money are essential to economic growth.
 Like all regulation, bank regulation does not come

without costs.
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2
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Why Does the Government
Regulate Banks?
 To reduce the externalities caused by bank problems
 To keep banks small
 To prevent bank runs
 To ensure that payments flow through the banking system efficiently
 To stabilize the money supply
3
Why Does the Government
Regulate Banks? (cont’d)
 Bank run is a situation in which many depositors
go to a bank at the same time to withdraw their
money.
 Contagion is the spread of a bank run from one
bank to another.
 Government supervises the payments system—the
mechanisms by which cash, checks, and electronic
payments flow from buyers to sellers—to ensure
payments are carried out efficiently.
4
Policy Insider: How Today’s Banking
System Reflects Yesterday’s
Regulations
 The setup of banks today reflects the regulations in
the past.
 The Interstate Banking and Branching Efficiency
Act allowed nationwide branching.
 Nationwide branching promoted competition.
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Achieving the Goals of
Regulation
The government
 Supervises banks to reduce externalities
 Restricts mergers and bank activities to keep banks

small
 Provides a federal safety net to prevent bank runs
 Offers services to ensure efficient payments
 Requires banks to hold reserves to control the money
supply
6
Bank Supervision
 Bank failures cause more problems than typical
business failures as they harm a wider range of
people.
 Any activity banks engage in is subject to government

regulation, costing both time and resources.
 Approximately 13% of banks’ total cost of doing

business is compliance with regulations.
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Restricting Mergers
■ Lawmakers attributed bank failures during the Great
Depression to too much interbank competition.
■ The Glass-Steagall Act (1933) prohibits banks from
participating in the securities industry and owning
commercial firms.
■ Arguments of excessive monopoly power versus
economies of scope.
■ The Gramm-Leach-Bliley Act (1999) allows banks to

invest, sell insurance, and own commercial firms, but
only those related to banking, securities, and insurance.
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Providing a Federal Safety Net
■ Deposit insurance is provided through the Federal Deposit
Insurance Corporation (FDIC).
■ The Fed serves as a lender of last resort, guaranteeing

funds to member banks in need.
■ Both policies result in asymmetric-information problems,

compensated for by supervision.
■ The government will not allow some banks to go bankrupt

under the too-big-to-fail policy.
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When Banks Close
When a bank fails, the FDIC must decide what
to do with the bank’s assets and how to pay off
creditors & depositors. It may.
1. Pay off (insured depositors, then creditors)
2. Purchase and assumption (sell the bank and its assets, and FDIC
assumes debts)
3. Assistance (keep the bank open and loan funds to survive)
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When Banks Close (cont’d)
Figure 9.1 Failures of Commercial Banks and
Thrifts
Except for a brief period during the 80s (due to the S&L crisis),
bank failures have become very rare.
11
Ensuring Efficient Payments
■ Payment clearing services provided by the Fed

to commercial banks.
■ Provides lower costs, efficiency, and

centralization.
12
Controlling the Money Supply
■ The government can affect flows of money though
the banking system by requiring banks to hold a
certain amount of reserves and by modifying the
interest rate paid on reserves.
■ Banks prefer to use these funds to make additional

loans or investments, thus imposing a large
opportunity cost.
13
Dodd-Frank Wall Street Reform and
Consumer Protection Act, 2010
■ Greater regulatory oversight of mortgage industry
■ Financial Stability Oversight Council to keep large firms from
behaving recklessly
■ Consumer Financial Protection Bureau (CFPB) that enforces
consumer financial protection laws, educates about abusive
financial practices, and engages in research about consumer
finances
■ Increased capital and liquidity requirements for institutions
that pose a large risk to the economy; keep banks from
engaging in risky investment activities
■ Oversight and regulation of derivative securities
14
Supervisors & Supervision
 The U.S. has a dual banking system, meaning banks
can choose whether to be chartered at the federal or
state level.
 National banks must be members of the Federal

Reserve system and be FDIC insured, and so are
subject to federal supervision.
 State banks are FDIC insured, but may choose not to

be members of the Fed system. They are supervised
only by the FDIC and their state banking department.
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Figure 9.2 Banking Supervisors
Supervision differs between national and state banks

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Deposit Insurance
■ Risk-based deposit insurance premiums requires
riskier banks to pay large amounts into the deposit
insurance fund than safer banks.
■ After the financial crisis of 2008, FDIC increased
assessments on banks.
17
Rating Banks
■ Banking supervisors use the CAMELS rating
system to assess a bank’s health.
■ Components of the CAMELS system

– C apital adequacy
– A sset quality
– M anagement
– E arnings
– L iquidity
– S ensitivity to risk
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Capital Adequacy
 It is the only objective component of the CAMELS
rating system.
 Supervisors want banks to have a lot of equity capital

so they have a stronger stake in good performance.
 Basel Accord is the common measurement standard

for capital adequacy; Basel III imposed high capital
requirements on all banks.
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Community Reinvestment Act
 Requires banks to serve their local communities
 Prevents banks from engaging in redlining
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Evaluating Bank Mergers
 In evaluating bank mergers, lawmakers consider:
– the effect of the merger on competition
– the adequacy of the financial and managerial
resources of the new bank
– the ability of the bank to meet the
convenience and needs of the community
– whether the banks provided complete
information about the transaction to banking
authorities
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Evaluating Bank Mergers (cont’d)
 Banking authorities use the Herfindahl-Hirschman index (HHI).
 The HHI measures the amount of competition in a banking market.
HHI  s  s  ...  s 2
1
2
2
2
N
■ If HHI becomes >1,800 and/or the change in the HHI > 200, merger
could be challenged.
■ Mergers are also denied if the new bank would hold more than 10%
of the nation’s deposits or 30% of a state’s deposits.
22
The Merger of Wachovia and Wells
Fargo
 The merger did not violate the guidelines of the
HHI index.
 The other requirements for approval of the merger

—adequacy of financial and managerial resources,
furnishing the required information about the
merger, ability of the bank to meet the needs of the
community—were all passed.
23
Mergers and Bank Profits
 After a merger, most banks increase their risk,
expected returns, and efficiency, and reduce costs.
 Bank profits rise after a merger.
24

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GOVERNMENT’S

 An efficient payments system and circulation of

 Like all regulation, bank regulation does not come

 Restricts mergers and bank activities to keep banks

 Any activity banks engage in is subject to government

 Approximately 13% of banks’ total cost of doing

■ The Gramm-Leach-Bliley Act (1999) allows banks to

■ The Fed serves as a lender of last resort, guaranteeing

■ Both policies result in asymmetric-information problems,

■ The government will not allow some banks to go bankrupt

1. Pay off (insured depositors, then creditors)

3. Assistance (keep the bank open and loan funds to survive)

■ Payment clearing services provided by the Fed

■ Provides lower costs, efficiency, and

■ Banks prefer to use these funds to make additional

 National banks must be members of the Federal

 State banks are FDIC insured, but may choose not to

Supervision differs between national and state banks

■ Components of the CAMELS system

 Supervisors want banks to have a lot of equity capital

 Basel Accord is the common measurement standard

 Prevents banks from engaging in redlining

 The other requirements for approval of the merger

 Bank profits rise after a merger.

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Chapter 9 Government's Role in Banking

Chapter 9 Government's Role in Banking