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Chapter 18 Bank Regulation Outline Background Regulatory Structure Regulators Regulation of Bank Ownership Regulation of Deposit Insurance Regulation of Deposits Regulation of Bank Loans Regulation of Bank Investment in Securities Regulation of Securities Services Regulation of Insurance Services Regulation of Off-Balance Sheet Transactions Regulation of the Accounting Process Regulation of Capital How Banks Satisfy Regulatory Requirements Basel I Accord Basel II Framework Basel III Framework Use of the Value-at-Risk Method to Determine Capital Levels Stress Tests Used to Determine Capital Levels Government Infusion of Capital During the Credit Crisis How Regulators Monitor Banks CAMELS Ratings Limitations of the CAMELS Rating System Corrective Action by Regulators Funding the Closure of Failing Banks Government Rescue of Failing Banks Argument for Government Rescue Argument Against Government Rescue Government Rescue of Bear Stearns Failure of Lehman Brothers and Rescue of AIG Protests of Bank Bailouts Financial Reform Act of 2010 Mortgage Originations Sales of Mortgage-backed Securities Financial Stability Oversight Council Orderly Liquidations Consumer Financial Protection Bureau Limits on Bank Proprietary Trading Trading of Derivative Securities Global Bank Regulations Key Concepts 1. Describe how the more important bank regulations have affected bank sources and uses of funds. 2. Describe why more stringent capital requirements can improve the banking system. Then, offer some disadvantages. 3. Describe why government rescues of banks can improve the banking system. Then, offer some disadvantages. 4. Explain the effects of the removal of regulatory barriers. POINT/COUNTER-POINT: Should Regulators Intervene to Take Over Weak Banks? POINT: Yes. Intervention could turn a bank around before weak management results in failures. Bank failures require funding from the FDIC to reimburse depositors up to the deposit insurance limit. This cost could be avoided if the bank’s problems are corrected before it fails. COUNTER-POINT: No. Regulators will not necessarily manage banks any better. Also, this would lead to excessive government intervention each time a bank experienced problems. Banks would use a very conservative management approach to avoid intervention, but this approach would not necessarily appeal to their shareholders who want high returns on their investment. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Regulators intervene to a limited degree by periodically assessing banks and imposing some conditions that a bank must meet if it experiences financial problems. The optimal solution is not obvious, but different opinions will likely emerge and allow for good class discussion. Questions 1. Regulation of Bank Sources and Uses of Funds. How are banks’ balance sheet decisions regulated? ANSWER: Banks are required to pay a premium on deposits, and to maintain a minimum level of capital, and are restricted to a maximum loan amount to any single borrower. They cannot use borrowed or deposited funds to purchase common stock. They can only invest in bonds that are considered “investment-grade” quality. 2. Off-Balance Sheet Activities. Provide examples of off-balance sheet activities. Why are regulators concerned about them? ANSWER: Off-balance sheet commitments occur when a bank guarantees a customer payment, through a standby letter of credit, or an interest rate swap, or foreign exchange commitments. Under some economic conditions, the bank could be exposed to too much risk. For example, if it guaranteed payments to back corporations that issued commercial paper, and those corporations fail, it will have to make the payments. Regulators are concerned about this risk. 3. Moral Hazard and the Credit Crisis. Explain why the moral hazard problem may have received so much attention during the credit crisis. ANSWER: Moral hazard was a serious problem during the credit crisis because the government was attempting to prevent failures of banks. Yet, some critics argued that the government should not bail out banks because it could send a signal that banks can take excessive risk without worry about failure. 4. FDIC Insurance. What led to the establishment of FDIC insurance? ANSWER: During the 1930–1932 Depression period, there was a run on bank deposits, causing many bank failures. The establishment of FDIC insurance in 1933 was intended to prevent such bank deposit runs. 5. Glass-Steagall Act. Briefly describe the Glass-Steagall Act. Then explain how the related regulations have changed. ANSWER: The Glass-Steagall Act (1933) separated banking and securities activities, in response to problems during the Great Depression when banks (1) sold poor-quality securities to their trust accounts, and (2) used inside information on loan activities to make decisions on securities to purchase or sell. The regulations have changed to allow banks to offer securities activities. Yet, there are still regulations that prevent the bank’s use of inside information from the banking business for making investment decisions in its securities business. 6. DIDMCA. Describe the main provisions of the DIDMCA that relate to deregulation. ANSWER: The provisions allowed deposit rates to be deregulated. In addition, all depository institutions were able to offer checking account services and provide some commercial loans. 7. CAMELS Ratings. Explain how the CAMELS ratings are used. ANSWER: Regulators monitor banks periodically so that if any deficiencies are detected, they may be corrected before the bank fails. CAMELS ratings are used to assess the capital, asset quality, management, earnings potential, liquidity, and sensitivity of banks. 8. Uniform Capital Requirements. Explain how the uniform capital requirements can discourage banks from taking excessive risk. ANSWER: The capital requirements were imposed among numerous countries so that banks from any of these countries would be subject to the same rules and would not have an unfair advantage. In addition, the capital requirements varied according to risk levels so banks that took more risk were required to maintain more capital. The capital requirements are set as a percentage of a bank’s assets. However, assets are weighted differently according to perceived risk. The riskier assets are weighted heavier so that more capital will be needed to support those assets. Banks with less risky assets will not have to hold as much capital. 9. Value at Risk. Explain how the value at risk (VaR) method can be used to determine whether a bank has adequate capital. ANSWER: In general, a bank defines the VaR as the estimated potential loss from its trading businesses that could result from adverse movements in market prices. Banks estimate the VaR by assessing the probability of specific adverse market events (such as an abrupt change in interest rates) and the sensitivity of responses to those events. Banks with a higher maximum loss (based on a 99 percent confidence interval) are subject to higher capital requirements. 10. HLTs. Describe highly leveraged transactions (HLTs), and explain why a bank’s exposure to HLTs is closely monitored by regulators. ANSWER: HLTs are loan transactions in which the borrower’s liabilities are valued at more than 75 percent of total assets. Regulators monitor bank exposure to HLTs, because HLTs are frequently thought to be riskier than other loans (given the high proportion of debt relative to the borrower’s equity). 11. Bank Underwriting. Given the higher capital requirements imposed on them, why might banks be even more interested in underwriting corporate debt issues? ANSWER: Underwriting can generate cash flow without requiring more capital, given that the bank can use its existing assets to support the underwriting business. 12. Moral Hazard. Explain the “moral hazard” problem as it relates to deposit insurance. ANSWER: While deposit insurance helps to prevent bank deposit runs, it encourages banks to take more risk. Thus, the risky banks are subsidized by the more conservative banks. This situation reflects the moral hazard problem. Risk-based insurance premiums have alleviated this problem. 13. Economies of Scale. How do economies of scale in banking relate to the issue of interstate banking? ANSWER: If banks need to maximize growth to fully achieve economies of scale, they would need to grow nationwide. Interstate banking restrictions could prevent them from fully achieving economies of scale. 14. Contagion Effects. How can the financial problems of one large bank affect the market’s risk evaluation of other large banks? ANSWER: The financial problems of one large bank can cause the public to change its risk perception about the banking industry in general. Consequently, the risk of other banks is perceived to be higher than before. 15. Regulating Bank Failures. Why are bank regulators more concerned about a large bank failure than a small bank failure? ANSWER: Large bank failures can carry indirect costs, such as a change in the public’s risk perception of the banking industry, which in turn could affect bank deposit runs and the risk of other banks. 16. Financial Services Modernization Act. Describe the Financial Services Modernization Act of 1999. Explain how it affected commercial bank operations, and how it changed the competitive landscape among financial institutions. ANSWER: The Financial Services Modernization Act of 1999 allowed banks to merge with other financial service firms such as insurance companies and securities firms. Banks can now offer a more diversified product line as a result of merging with securities firms and insurance companies. They can serve as a one-stop shop. Financial institutions can now expand into other services that were previously off limits. Consequently, there is more competition among financial institutions for each type of financial service. 17. Impact of SOX on Banks. Explain how the Sarbanes-Oxley (SOX) Act improved the transparency of banks. Why might the act have a negative impact on some banks? ANSWER: Some of the key provisions of the SOX Act require that banks improve their internal control process to establish a centralized database of information. They must implement a system that automatically checks data for unusual discrepancies relative to norms. They must speed the process by which all departments and all subsidiaries have access to the data that they need. Their executives are now more accountable for financial statements by personally verifying their accuracy. One negative effect of the SOX Act is that publicly-traded banks have incurred expenses of more than $1 million per year to comply with the costs of satisfying the SOX provisions. 18. Conversion of Securities Firms to BHCs. Explain how the conversion of securities firms to a bank holding company (BHC) structure might reduce their risk. ANSWER: While securities firms were allowed to borrow short-term funds from the Federal Reserve during the credit crisis, their conversion to a bank holding company would give them permanent access to Federal Reserve funding. The bank holding company structure allows the securities firms to also offer commercial banking services, including federally-insured deposits. It also results in a greater degree of regulatory oversight by the Federal Reserve, including stringent capital requirements. 19. Capital Requirements During the Credit Crisis. Explain why banks struggled to satisfy capital requirements because of the accounting method applied to mortgage-backed securities. ANSWER: Banks are required to periodically mark their assets to market in order to determine the revised needed capital based on the reduced market value of the assets. The fair value accounting method forced them to “write down” the value of their assets. Given a decline in the bank’s book value of assets, and no associated change in its book value of liabilities, a bank’s balance sheet is balanced by reducing its capital. Thus, many banks were required to replenish their capital in order to meet the capital requirements, and some of them were subject to extra scrutiny by regulators. 20. Fed Rescue of Bear Stearns. Explain why regulators might argue that the assistance they provided to Bear Stearns was necessary. ANSWER: Bear Stearns facilitated many transactions in financial markets, and its failure would have delayed these financial transactions, and would have caused liquidity problems for many individuals and firms that were to receive cash as a result of the transactions. 21. Fed Rescue of Nonbanks. Should the Fed have the power to rescue firms such as Bear Stearns that are not commercial banks? ANSWER: Some critics (including Paul Volcker, a previous chair of the Fed) suggested that the rescue of a firm other than a commercial bank should be the responsibility of Congress and not the Fed. The Fed’s counter was that it recognized the potential financial transactions that would be frozen if it did not rescue Bear Stearns. Thus, its argument is based on its role of attempting to stabilize the financial system rather than its role of regulating commercial banks. 22. Bank Regulation of Credit Default Swaps. Why were bank regulators concerned with credit default swaps? ANSWER: Regulators became concerned with credit default swaps because of the lack of transparency regarding the exposure of each commercial bank, and the credibility of the counterparties on the swaps. They increased their oversight of this market, and requested that commercial banks provide more information. 23. Impact of Bank Consolidation on Regulation. Explain how bank regulation can be more effective when there is consolidation of banks and securities firms. ANSWER: Some major securities firms such as Bear Stearns and Merrill Lynch were acquired by commercial banks, while others such as Goldman Sachs and Morgan Stanley applied to become bank holding companies (BHCs). This consolidation improved the stability of the financial system because regulations on bank holding companies are generally more stringent than the regulations on independent securities firms. 24. Concerns about Systemic Risk During the Credit Crisis. Explain why the credit crisis caused concerns about systemic risk. ANSWER: During the crisis, many banks were failing. The financial problems of a large bank failure can be contagious to other banks. This so-called systemic risk occurs because of the interconnected transactions between banks. 25. Troubled Asset Relief Program (TARP). Explain how the Troubled Asset Relief Program was expected to help resolve problems during the credit crisis. ANSWER: During the 2008-2010 period, the Troubled Asset Relief Program (TARP) was implemented to alleviate the financial problems experienced by banks and other financial institutions with excessive exposure to mortgages or mortgage-backed securities. The Treasury injected more than $300 billion into banks and financial institutions, primarily by purchasing preferred stock. The injection of funds qualified as Tier 1 capital, and therefore boosted the capital levels of banks, so that banks could more easily offset some of their existing loan losses. The injection of funds was also intended to encourage addition lending by the banks and other financial institutions. In addition, the Treasury purchased some "toxic" assets that had declined in value, and even guaranteed against losses of other assets at banks and financial institutions. 26. Financial Reform Act. Explain how the Financial Reform Act resolved some problems during the credit crisis. ANSWER: In July, 2010, the Financial Reform Act (also referred to as Wall Street Reform Act or Consumer Protection Act) was implemented. It requires that banks and other financial institutions granting mortgages verify the income, job status, and credit history of mortgage applicants before approving mortgage applications. This provision is intended to prevent applicants from receiving mortgages unless they are creditworthy, so that it can prevent another credit crisis in the future. The Financial Reform Act created the Financial Stability Oversight Council, which is responsible for identifying risks to financial stability in the U.S., and makes regulatory recommendations to regulators that could reduce any risks to the financial system. The council can recommend methods to ensure that banks do not rely on regulatory bailouts, which may prevent situations where a large financial institution is viewed as too big to fail. The act also assigned specific regulators with the authority to determine that any particular financial institution should be liquidated. This expedites the liquidation process, and can limit the losses incurred by a failing financial institution. The act calls for the creation of an orderly liquidation fund that can be used to finance the liquidation of a financial institution that is not covered by the Federal Deposit Insurance Corporation. The act mandates that commercial banks must limit their proprietary trading, whereby they pool money received from customers and use it to make investments for their clients. It also requires that derivative securities be traded through a clearinghouse or exchange, rather than over the counter. 27. Bank Deposit Insurance Reserves. What changes to reserve requirements were added by The Wall Street Reform and Consumer Protection Act (also called the Dodd-Frank Act) of 2010? ANSWER: The Doo-Frank Act requires that the Deposit Insurance Fund should maintain reserves of at least 1.35% of total insured bank deposits, to ensure that it always has sufficient reserves to cover losses. If the reserves fall below that level, the FDIC is required to develop a restoration plan to boost reserves to that minimum level. The act also requires that if the Deposit Insurance Fund’s reserves exceed 1.50 % of total insured bank deposits, the FDIC should distribute the excess as dividends to banks. 28. Basel III Changes to Capital and Liquidity Requirements. How did Basel III change capital and liquidity requirements for banks? ANSWER: Basel III recommended that banks maintain an extra layer of Tier 1 capital (called a capital conservation buffer) of at least 2.5% of risk-weighted assets by 2016. Banks that do not maintain this extra layer could be restricted from making dividend payments, repurchasing stock, or granting bonuses to executives. In addition to the increased capital requirements, Basel III also called for liquidity requirements. Some banks that specialize in low risk loans and have adequate capital might not have adequate liquidity to survive an economic crisis. Basel III proposes that banks maintain sufficient liquidity so that they could easily cover their cash needs under adverse conditions. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The FDIC recently subsidized a buyer for a failing bank, which had different effects on FDIC costs than if the FDIC closed the bank.” Closing a bank would have resulted in the liquidation of assets. In this case, the FDIC would use the proceeds of liquidation to pay off depositors, and it would make up the difference. By assuming temporary control, the FDIC can search for a buyer and does not have to liquidate the assets. However, it has to provide some financial support to potential buyers to encourage the acquisition of the failed bank. b. “Bank of America has pursued the acquisitions of many failed banks, because it sees potential benefits.” The FDIC would have to support the acquisition, so that a bank may be able to acquire the operations of failed banks at a low price. The acquiring bank could shed the bad loans, and restructure the operations to make the bank more efficient. c. “By allowing a failing bank time to resolve its financial problems, it imposes an additional tax on taxpayers.” An advantage is that if a failed bank resolves its problems on its own, the FDIC would not need to provide financial support. However, a disadvantage is that a failed bank’s losses may increase, which would ultimately increase the amount of financial support to be provided by the FDIC. Managing in Financial Markets A bank has asked you to assess various strategies it is considering, and explain how they could affect its regulatory review. Regulatory reviews include an assessment of capital, asset quality, management, earnings, liquidity, and sensitivity to financial market conditions. Many types of strategies can result in more favorable regulatory reviews based on some criteria but less favorable regulatory reviews based on other criteria. The bank is planning to issue more stock, retain more of its earnings, increase its holdings of Treasury securities, and reduce its business loans. The bank has historically been rated favorably by regulators, yet believes that these strategies will result in an even more favorable regulatory assessment. a. Which regulatory criteria will be affected by the bank’s strategies? How? The capital level will increase, asset quality will improve, and liquidity will improve. However, the bank’s expected earnings will probably decline. b. Do you believe that the strategies planned by the bank will satisfy shareholders? Is it possible for the bank to use strategies that would satisfy both regulators and shareholders? Explain. No. The bank’s strategies reflect less risk, which may satisfy regulators but may be viewed as too conservative by shareholders. Given that the bank did not need to become more conservative to satisfy bank regulators, there is no need to reduce risk further. It is possible to satisfy regulators and shareholders. The shareholders recognize that the bank must abide by regulatory guidelines; however, they do not want the bank to focus so much on exceeding regulatory guidelines that it ignores the goal of maximizing shareholder wealth. c. Do you believe that the strategies planned by the bank will satisfy the bank’s managers? Explain. Open-ended. Conservative strategies are desirable in that they may reduce the risk of failure and increase job security. However, the strategies will likely reduce earnings, which could result in less compensation for some bank managers. Also, the bank could become a takeover target if it does not achieve its earnings potential (some other bank may believe that it is undervalued and acquire it). In this case, the managers may not have job security. Flow of Funds Exercise Impact of Regulation and Deregulation on Financial Services Carson Company relies heavily on commercial banks for funding and for some other services. a. Explain how the services provided by a commercial bank (just the banking, not the nonbank services) to Carson may be limited because of bank regulation. Banks are discouraged from providing loans to firms whose borrowed funds represent more than 75 percent of their total assets. If Carson Company issued bonds, commercial banks could not buy them unless they received an investment grade rating (Baa by Moodys or BBB by Standard & Poor’s) from rating agencies. b. Explain the types of nonbank services that Carson Company can receive from the subsidiaries of a commercial bank as a result of recent deregulation. The nonbank services include underwriting of securities, insurance, and full-service brokerage. c. How might Carson Company be affected by the deregulation that allows subsidiaries of a commercial bank to offer nonbank services? Carson Company can have virtually all of its financial services provided by one financial conglomerate. In addition, the pricing of services should be more competitive now that banks can (through their subsidiaries) offer nonbank services. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
