Federal Reserve Paper

18 Bank Regulation

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the key regulations imposed on commercial banks,

· ▪ explain capital requirements of banks,

· ▪ explain how regulators monitor banks,

· ▪ explain the issues regarding government rescue of failed banks, and

· ▪ describe how the Financial Reform Act of 2010 affects the regulation of commercial bank operations.

Bank regulations are designed to maintain public confidence in the financial system by preventing commercial banks from becoming too risky.

18-1 BACKGROUND

Because banks rely on funds from depositors, they have been subject to regulations that are intended to ensure the safety of the financial system. Many of the regulations are intended to prevent banks from taking excessive risk that could cause them to fail. In particular, regulations are imposed on the types of assets in which banks can invest, and the minimum amount of capital that banks must maintain. However, there are trade-offs due to bank regulation. Some critics suggest that the regulation is excessive, and it restricts banks from serving their owners. Banks might be more efficient if they were not subject to regulations. Given these trade-offs, regulations are commonly revised over time in response to bank conditions, as regulators seek the optimal level of regulation that ensures the safety of the banking system, but also allows banks to be efficient.

   Many regulations of bank operations were removed or reduced over time, which allowed banks to become more competitive. Because of deregulation, banks have considerable flexibility in the services they offer, the locations where they operate, and the rates they pay depositors for deposits.

   Yet some banks and other financial institutions engaged in excessive risk taking in the 2005–2007 period, which is one the reasons for the credit crisis in the 2008–2009 period. Many banks failed as a result of the credit crisis, and government subsidies were extended to many other banks in order to prevent more failures and restore financial stability. This has led to much scrutiny over existing regulations and proposals for new regulations that can still allow for intense competition while preventing bank managers from taking excessive risks. This chapter provides a background on the prevailing regulatory structure, explains how bank regulators attempted to resolve the credit crisis, and describes recent changes in regulations that are intended to prevent another crisis.

18-2 REGULATORY STRUCTURE

The regulatory structure of the banking system in the United States is dramatically different from that of other countries. It is often referred to as a dual banking system because it includes both a federal and a state regulatory system. There are more than 6,000 separately owned commercial banks in the United States, which are supervised by three federal agencies and 50 state agencies. The regulatory structure in other countries is much simpler.

WEB

www.federalreserve.gov/bankinforeg/reglisting.htm

Detailed descriptions of bank regulations from the Federal Reserve Board.

   A charter from either a state or the federal government is required to open a commercial bank in the United States. A bank that obtains a state charter is referred to as a state bank; a bank that obtains a federal charter is known as a national bank. All national banks are required to be members of the Federal Reserve System (the Fed). The federal charter is issued by the Comptroller of the Currency. An application for a bank charter must be submitted to the proper supervisory agency, should provide evidence of the need for a new bank, and should disclose how the bank will be operated. Regulators determine if the bank satisfies general guidelines to qualify for the charter.

   State banks may decide whether they wish to be members of the Federal Reserve System. The Fed provides a variety of services for commercial banks and controls the amount of funds within the banking system. About 35 percent of all banks are members of the Federal Reserve. These banks are generally larger than the norm; their combined deposits make up about 70 percent of all bank deposits. Both member and nonmember banks can borrow from the Fed, and both are subject to the Fed's reserve requirements.

WEB

www.federalreserve.gov

Click on “Banking Information ft Regulation” to find key bank regulations at the website of the Board of Governors of the Federal Reserve System.

18-2a Regulators

National banks are regulated by the Comptroller of the Currency; state banks are regulated by their respective state agency. Banks that are insured by the  Federal Deposit Insurance Corporation (FDIC)  are also regulated by the FDIC. Because all national banks must be members of the Federal Reserve and all Fed member banks must hold FDIC insurance, national banks are regulated by the Comptroller of the Currency, the Fed, and the FDIC. State banks are regulated by their respective state agency, the Fed (if they are Fed members), and the FDIC. The Comptroller of the Currency is responsible for conducting periodic evaluations of national banks, the FDIC holds the same responsibility for state-chartered banks and savings institutions with less than $50 billion in assets, and the Federal Reserve is responsible for state-chartered banks and savings institutions with more than $50 billion in assets.

18-2b Regulation of Bank Ownership

Commercial banks can be either independently owned or owned by a  bank holding company (BHC) . Although some multibank holding companies (owning more than one bank) exist, one-bank holding companies are more common. More banks are owned by holding companies than are owned independently.

18-3 REGULATION OF BANK OPERATIONS

Banks are regulated according to how they obtain funds, how they use their funds, and the types of financial services they can offer. Some of the most important regulations are discussed here.

18-3a Regulation of Deposit Insurance

Federal deposit insurance has existed since the creation in 1933 of the FDIC in response to the bank runs that occurred in the late 1920s and early 1930s. During the 1930–1932 period of the Great Depression more than 5,000 banks failed, or more than 20 percent of the existing banks. The initial wave of failures caused depositors to withdraw their deposits from other banks, fearing that the failures would spread. These actions actually caused more banks to fail. If deposit insurance had been available, depositors might not have removed their deposits and some bank failures might have been avoided.

   The FDIC preserves public confidence in the U.S. financial system by providing deposit insurance to commercial banks and savings institutions. The FDIC is managed by a board of five directors, who are appointed by the President. Its headquarters is in Washington, D.C., but it has eight regional offices and other field offices within each region. Today, the FDIC's insurance funds are responsible for insuring deposits of more than $3 trillion.

Insurance Limits  The specified amount of deposits per person insured by the FDIC was increased from $100,000 to $250,000 as part of the Emergency Economic Stabilization Act of 2008, which was intended to resolve the liquidity problems of financial institutions and to restore confidence in the banking system. The $250,000 limit was made permanent by the Financial Reform Act of 2010. Large deposit accounts beyond the $250,000 limit are insured only up to this limit. Note that deposits in foreign branches of U.S. banks are not insured by the FDIC.

   In general, deposit insurance has allowed depositors to deposit funds under the insured limits in any insured depository institution without the need to assess the institution's financial condition. In addition, the insurance system minimizes bank runs on deposits because insured depositors believe that their deposits are backed by the U.S. government even if the insured depository institution fails. When a bank fails, insured depositors normally have access to their money within a few days.

Risk-Based Deposit Premiums  Banks insured by the FDIC must pay annual insurance premiums. Until 1991, all banks obtained insurance for their depositors at the same rate. Because the riskiest banks were more likely to fail, they were being indirectly subsidized by safer banks. This system encouraged some banks to assume more risk because they could still attract deposits from depositors who knew they would be covered regardless of the bank's risk. The act of insured banks taking on more risk because their depositors are protected is one example of what is called a  moral hazard problem . As a result of many banks taking excessive risks, bank failures increased during the 1980s and early 1990s. The balance in the FDIC's insurance fund declined because the FDIC had to reimburse depositors who had deposits at the banks that failed.

   This moral hazard problem prompted bank regulators and Congress to search for a way to discourage banks from taking excessive risk and to replenish the FDIC's insurance fund. As a result of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, risk-based deposit insurance premiums were phased in. Consequently, bank insurance premiums are now aligned with the risk of banks, thereby reducing the moral hazard problem.

Deposit Insurance Fund  Before 2006, the Bank Insurance Fund was used to collect premiums and provide insurance for banks and the Savings Association Insurance Fund was used to collect premiums and provide insurance for savings institutions. In 2006 the two funds were merged into one insurance fund called the  Deposit Insurance Fund , which is regulated by the FDIC.

   The deposit insurance premiums were increased in 2009 because the FDIC had used substantial reserves during the credit crisis to reimburse depositors of failed banks. The range of premiums is now typically between 13 and 53 cents per $100, with most banks paying between 13 and 18 cents. The FDIC's reserves are currently about $45 billion, or about 1 percent of all insured deposits. The FDIC also has a large credit line against which it can borrow from the Treasury.

Bank Deposit Insurance Reserves  The Wall Street Reform and Consumer Protection Act (also called the Dodd-Frank Act) of 2010 requires that the Deposit Insurance Fund should maintain reserves of at least 1.35 percent 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 reserves exceed 1.50 percent of total insured bank deposits, the FDIC should distribute the excess as dividends to banks.

18-3b Regulation of Deposits

Three regulatory acts created more competition for bank deposits over time, as discussed next.

DIDMCA  In 1980, the  Depository Institutions Deregulation and Monetary Control Act (DIDMCA)  was enacted to (1) deregulate the banking (and other depository institutions) industry and (2) improve monetary policy. Because this chapter focuses on regulation and deregulation, only the first goal is discussed here.

   The DIDMCA was a major force in deregulating the banking industry and increasing competition among banks. It removed interest rate ceilings on deposits, allowing banks and other depository institutions to make their own decisions on what interest rates to offer for time and savings deposits. In addition, it allowed banks to offer NOW accounts.

   The DIDMCA has had a significant impact on the banking industry, most importantly by increasing competition among depository institutions.

Garn-St. Germain Act  Banks and other depository institutions were further deregulated in 1982 as a result of the  Garn-St. Germain Act . The act came at a time when some depository institutions (especially savings institutions) were experiencing severe financial problems. One of its more important provisions permitted depository institutions to offer money market deposit accounts (MMDAs), which have no minimum maturity and no interest ceiling. These accounts allow a maximum of six transactions per month (three by check). They are similar to the traditional accounts offered by  money market mutual funds  (whose main function is to sell shares and pool the funds to purchase short-term securities that offer market-determined rates). Because MMDAs offer savers similar benefits, they allow depository institutions to compete against money market funds in attracting savers' funds.

   A second key deregulatory provision of the Garn-St. Germain Act permitted depository institutions (including banks) to acquire failing institutions across geographic boundaries. The intent was to reduce the number of failures that require liquidation, as the chances of finding a potential acquirer for a failing institution improve when geographic barriers are removed. Also, competition was expected to increase because depository institutions previously barred from entering specific geographic areas could now do so by acquiring failing institutions.

Interstate Banking Act In September 1994, Congress passed the Reigle-Neal Interstate Banking and Branching Efficiency Act, which removed interstate branching restrictions and thereby further increased the competition among banks for deposits. Nationwide interstate banking enabled banks to grow and achieve  economies of scale . It also allowed banks in stagnant markets to penetrate other markets where economic conditions were more favorable. Banks in all markets were pressured to become more efficient as a result of the increased competition.

18-3c Regulation of Bank Loans

Since loans represent the key asset of commercial banks, they are regulated to limit a bank's exposure to default risk.

Regulation of Highly Leveraged Transactions  As a result of concern about the popularity of highly leveraged loans (for supporting leveraged buyouts and other activities), bank regulators monitor the amount of highly leveraged transactions (HLTs). HLTs are commonly defined as loan transactions in which the borrower's liabilities are valued at more than 75 percent of total assets.

Regulation of Foreign Loans  Regulators also monitor a bank's exposure to loans to foreign countries. Because regulators require banks to report significant exposure to foreign debt, investors and creditors have access to more detailed information about the composition of bank loan portfolios.

Regulation of Loans to a Single Borrower  Banks are restricted to a maximum loan amount of 15 percent of their capital to any single borrower (up to 25 percent if the loan is adequately collateralized). This forces them to diversify their loans to some degree.

Regulation of Loans to Community  Banks are also regulated to ensure that they attempt to accommodate the credit needs of the communities in which they operate. The Community Reinvestment Act (CRA) of 1977 (revised in 1995) requires banks to meet the credit needs of qualified borrowers in their community, even those with low or moderate incomes. The CRA is not intended to force banks to make high-risk loans but rather to ensure that qualified lower-income borrowers receive the loans that they request. Each bank's performance in this regard is evaluated periodically by its respective regulator.

18-3d Regulation of Bank Investment in Securities

Banks are not allowed to use borrowed or deposited funds to purchase common stock, although they can manage stock portfolios through trust accounts that are owned by individuals. Banks can invest only in bonds that are investment-grade quality. This was measured by a Baa rating or higher by Moody's or a BBB rating or higher by Standard & Poor's. The regulations on bonds are intended to prevent banks from taking excessive risks.

   However, during the credit crisis, the ratings agencies were criticized for being too liberal with their ratings. The Wall Street Reform and Consumer Protection Act (also called the Dodd-Frank Act) of 2010 changed the rules to require that banks use not only credit ratings assigned by credit rating agencies, but also other methods to assess the risk of debt securities, including their own assessment of risk. This is intended to ensure that banks do not rely exclusively on credit rating agencies when investing in debt securities. Thus, even if the credit rating agencies apply liberal ratings, the bank should be able to detect when debt securities are too risky when using its own analysis or other methods to assess risk.

18-3e Regulation of Securities Services

The Banking Act of 1933 (better known as the Glass-Steagall Act) separated banking and securities activities. The act was prompted by problems during 1929 when some banks sold some of their poor-quality securities to their trust accounts established for individuals. Some banks also engaged in insider trading: buying or selling corporate securities based on confidential information provided by firms that had requested loans. The  Glass-Steagall Act  prevented any firm that accepted deposits from underwriting stocks and bonds of corporations.

   The separation of securities activities from banking activities was intended to prevent potential conflicts of interest. For example, the concern was that if a bank were allowed to underwrite securities, it might advise its corporate customers to purchase these securities and could threaten to cut off future loans if the customers did not oblige.

WEB

www.federalreserve.gov/bankinforeg/default.htm

Links to regulations of securities services offered by banks.

Financial Services Modernization Act  In 1999, Congress passed the  Financial Services Modernization Act  (also called the Gramm-Leach-Bliley Act), which essentially repealed the Glass-Steagall Act. The 1999 act allows affiliations between banks, securities firms, and insurance companies. It also allows bank holding companies to engage in any financial activity through their ownership of subsidiaries. Consequently, a single holding company can engage in traditional banking activities, securities trading, underwriting, and insurance. The act also requires that the holding company be well managed and have sufficient capital in order to expand its financial services. The Securities and Exchange Commission regulates any securities products that are created, but the bank subsidiaries that offer the securities products are overseen by bank regulators.

   Although many commercial banks had previously pursued securities services, the 1999 act increased the extent to which banks could offer these services. Furthermore, it allowed securities firms and insurance companies to acquire banks. Under the act, commercial banks must have a strong rating in community lending (which indicates that they have actively provided loans in lower-income communities) in order to pursue additional expansion in securities and other nonbank activities.

   Since the passage of the Financial Services Modernization Act, there has been much more consolidation of financial institutions. Many of the larger financial institutions are able to offer all types of financial services through their various subsidiaries. Because individuals commonly use financial institutions to deposit funds, obtain mortgage loans and consumer loans (such as an automobile loan), purchase shares of mutual funds, order stock transactions (brokerage), and purchase insurance, they can obtain all their financial services from a single financial conglomerate. And because firms commonly use financial institutions to maintain a business checking account, obtain loans, issue stocks or bonds, have their pension fund managed, and purchase insurance services, they can obtain all of their financial services from a single financial conglomerate.

   The Financial Services Modernization Act also offers benefits to financial institutions. By offering more diversified services, financial institutions can reduce their reliance on the demand for any single service that they offer. This diversification may result in less risk for the institution's consolidated business provided the new services are not subject to a much higher degree of risk than its traditional services.

   The individual units of a financial conglomerate may generate some new business simply because they are part of the conglomerate and offer convenience to clients who already rely on its other services. Each financial unit's list of existing clients represents a potential source of new clients for the other financial units to pursue.

   The consolidation of banks and securities firms continued during the credit crisis in 2008, as some major securities firms (e.g., Bear Stearns and Merrill Lynch) were acquired by commercial banks while others (e.g., Goldman Sachs and Morgan Stanley) applied and were approved to become bank holding companies. 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.

18-3f Regulation of Insurance Services

As with securities services, banks have been eager to offer insurance services. The arguments for and against bank involvement in insurance are quite similar to those regarding bank involvement in securities. Banks could increase competition in the insurance industry by offering services at a lower cost. In addition, they could offer their customers the convenience of one-stop shopping (especially if the bank could also offer securities services).

   In 1998, regulators allowed the merger between Citicorp and Traveler's Insurance Group, which essentially paved the way for the consolidation of bank and insurance services. Passage of the Financial Services Modernization Act in the following year confirmed that banks and insurance companies could merge and consolidate their operations. These events encouraged banks and insurance companies to pursue mergers as a means of offering a full set of financial services.

18-3g Regulation of Off-Balance Sheet Transactions

Banks offer a variety of off–balance sheet commitments. For example, banks provide letters of credit to back commercial paper issued by corporations. They also act as the intermediary on interest rate swaps and usually guarantee payments over the specified period in the event that one of the parties defaults on its payments.

   Various off–balance sheet transactions have become popular because they provide fee income. That is, banks charge a fee for guaranteeing against the default of another party and for facilitating transactions between parties. Off–balance sheet transactions do expose a bank to risk, however. If a severe economic downturn causes many corporations to default on their commercial paper or on payments specified by interest rate swap agreements, the banks that provided guarantees would incur large losses.

   Bank exposure to off–balance sheet activities has become a major concern of regulators. Banks could be riskier than their balance sheets indicate because of these transactions. Therefore, the risk-based capital requirements are higher for banks that conduct more off–balance sheet activities. In this way, regulators discourage banks from excessive involvement in such activities.

Regulation of Credit Default Swaps  Credit default swaps are a type of off– balance sheet transaction that became popular during the 2004–2008 period as a means of protecting against the risk of default on bonds and mortgage–backed securities. A swap allows a commercial bank to make periodic payments to a counterparty in return for protection in the event that its holdings of mortgage-backed securities default. While some commercial banks purchased these swaps as a means of protecting their assets against default, other commercial banks sold them (to provide protection) as a means of generating fee income. By 2008, credit default swaps represented more than $30 trillion of mortgage-backed securities or other types of securities ($60 trillion when counting each contract for both parties).

   When commercial banks purchase credit default swaps to protect their assets against possible default, these assets are not subject to capital requirements. But if the sellers of the credit default swaps are overexposed, they may not be able to provide the protection they promised. Thus the banks that purchased credit default swaps might not be protected if the sellers default. As the credit crisis intensified in 2008 and 2009, regulators became concerned about 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 asked commercial banks to provide more information about their credit default swap positions.

18-3h Regulation of the Accounting Process

Publicly traded banks, like other publicly traded companies, are required to provide financial statements that indicate their recent financial position and performance. The Sarbanes-Oxley (SOX) Act was enacted in 2002 to ensure a more transparent process for reporting on a firm's productivity and financial condition. It was created following news about how some publicly traded firms (such as Enron) inflated their earnings, which caused many investors to pay a much higher stock price than was appropriate. The act requires all firms (including banks) to implement an internal reporting process that can be easily monitored by executives and makes it impossible for executives to pretend that they were unaware of accounting fraud.

   Some of the key provisions of the act require banks to improve their internal control processes and establish a centralized database of information. In addition, executives are now more accountable for a bank's financial statements because they must personally verify the accuracy of the statements. Investors may have more confidence in the financial statements now that there is greater accountability that could discourage accounting fraud.

   Nevertheless, questionable accounting practices may still occur at banks. Some types of assets do not have a market in which they are actively traded. Thus banks have some flexibility on valuing these assets. During the credit crisis, many banks assigned values to some types of securities they held that clearly exceeded their proper market values. Consequently, they were able to hide a portion of their losses.

   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 its provisions. Such a high expense may encourage smaller publicly traded banks to go private.

18-4 REGULATION OF CAPITAL

Banks are subject to capital requirements, which force them to maintain a minimum amount of capital (or equity) as a percentage of total assets. They rely on their capital as a cushion against possible losses. If a bank has insufficient capital to cover losses, it will not be able to cover its expenses and will fail. Therefore, regulators closely monitor bank capital levels.

   Some bank managers and shareholders would prefer that banks hold a lower level of capital, because a given dollar level of profits would represent a higher return on equity if the bank holds less capital. This might allow for larger bonuses to managers and higher stock prices for shareholders during strong economic conditions. However, regulators are more interested in the safety of the banking system than managerial bonuses, and have increased bank capital requirements in recent years as a means of stabilizing the banking system.

18-4a How Banks Satisfy Regulatory Requirements

When a bank's capital declines below the amount required by regulators, it can increase its capital ratio in the following ways.

Retaining Earnings  As a bank generates new earnings, and retains them rather than distributing them as dividends to shareholders, it boosts its capital. However, it cannot retain earnings if it does not generate earnings. If it incurs losses, it needs to use some of its existing capital to cover some of its expenses, because its revenue was not sufficient to cover its expenses. Thus losses (negative earnings) result in a lower level of capital. Poorly performing banks cannot rely on retained earnings to boost capital levels because they may not have any new earnings to retain.

Issuing Stock  Banks can boost their capital by issuing stock to the public. However, a bank's capital level becomes deficient when its performance is weak; under these conditions, the bank's stock price is probably depressed. If the bank has to sell stock when its stock price is very low it might not receive a sufficient amount of funds from its stock offering. Furthermore, investors may not have much interest in purchasing new shares in a bank that is weak and desperate to build capital because they might reasonably expect the bank to fail.

Reducing Dividends  Banks can increase their capital by reducing their dividends, which enables them to retain a larger amount of any earnings. However, shareholders might interpret a cut in dividends as a signal that the bank is desperate for capital, which could cause its stock price to decline further. This type of effect could make it more difficult for the bank to issue stock in the future.

Selling Assets  When banks sell assets, they can improve on their capital position. Assuming the assets were perceived to be risky, banks would have been required to maintain some capital to back those assets. By selling the assets, they are no longer required to back those assets with capital.

18-4b Basel I Accord

When bank regulators of various countries develop their set of guidelines for capital requirements, they are commonly guided by the recommendations in the Basel guidelines. These guidelines are intended to guide the banks in setting their own capital requirements.

   In the first Basel Accord (1988, often called Basel I), the central banks of 12 major countries agreed to establish a framework for determining uniform capital requirements. A key provision in the Basel Accord bases the capital requirements on a bank's risk level. Banks with greater risk are required to maintain a higher level of capital, which discourages banks from excessive exposure to credit risk.

   Assets are weighted according to risk. Very safe assets such as cash are assigned a zero weight, while very risky assets are assigned a 100 percent weight. Because the required capital is set as a percentage of risk-weighted assets, riskier banks are subject to more stringent capital requirements.

18-4c Basel II Framework

WEB

www.federalreserve.gov/bankinforeg/basel/USimplementation.htm

Information about the Basel framework.

A committee of central bank and regulatory authorities of numerous countries (called the Basel Committee on Banking Supervision) created a framework in 2004 called Basel II, which was added to the Basel Accord. It has two major parts: revising the measurement of credit risk and explicitly accounting for operational risk.

Revising the Measurement of Credit Risk  When banks categorize their assets and assign risk weights to the categories, they account for possible differences in risk levels of loans within a category. Risk levels could differ if some banks required better collateral to back their loans. In addition, some banks may take positions in derivative securities that can reduce their credit risk, while other banks may have positions in derivative securities that increase their credit risk.

   A bank's loans that are past due are assigned a higher weight. This adjustment inflates the size of these assets for the purpose of determining minimum capital requirements. Thus, banks with more loans that are past due are forced to maintain a higher level of capital (other things being equal).

   An alternative method of calculating credit risk, called the internal ratings-based (IRB) approach, allows banks to use their own processes for estimating the probability of default on their loans.

Explicitly Accounting for Operational Risk  The Basel Committee defines operational risk as the risk of losses resulting from inadequate or failed internal processes or systems. Banks are encouraged to improve their techniques for controlling operational risk because doing so could reduce failures in the banking system. By imposing higher capital requirements on banks with higher levels of operational risk, Basel II provided an incentive for banks to reduce their operational risk.

   The United States, Canada, and countries in the European Union created regulations for their banks that conform to some parts of Basel II. When applying the Basel II guidelines, many banks underestimated the probability of loan default during the credit crisis. This motivated the creation of the Basel III framework, described next.

18-4d Basel III Framework

In response to the credit crisis, the Basel Committee on Banking Supervision began to develop a Basel III framework in 2011, which attempts to correct deficiencies of Basel II. This framework recommends that banks maintain Tier 1 capital (retained earnings and common stock) of at least 6 percent of total risk-weighted asset. It also recommended a more rigorous process for determining risk-weighted assets. Prior to Basel III, some assets were assigned low risk based on liberal ratings by ratings agencies. Basel III proposed that banks apply scenario analysis to determine how the values of their assets would be affected based on possible adverse economic scenarios.

   Basel III also recommended that banks maintain an extra layer of Tier 1 capital (called a capital conservation buffer) of at least 2.5 percent 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 can easily cover their cash needs under adverse conditions.

18-4e Use of the VaR Method to Determine Capital Levels

To comply with the Basel Accord, banks commonly apply a value-at-risk (VaR) model to assess the risk of their assets, and determine how much capital they should hold. The VaR model can be applied in various ways to determine capital requirements. 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 typically use a 99 percent confidence level, meaning that there is a 99 percent chance that the loss on a given day will be more favorable than the VaR estimate. When applied to a daily time horizon, the actual loss from a bank's trading businesses should not exceed the estimated loss by VaR on more than 1 out of every 100 days. 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.

   This focus on daily price movements forces banks to monitor their trading positions continuously so that they are immediately aware of any losses. Many banks now have access to the market values of their trading businesses at the end of every day. If banks used a longer-term horizon (such as a month), larger losses might build up before being recognized.

Limitations of the VaR Model  The VaR model was generally ineffective at detecting the risk of banks during the credit crisis. The VaR model failed to recognize the degree to which the value of bank assets (such as mortgages or mortgage-backed securities) could decline under adverse conditions. The use of historical data from before 2007 did not capture the risk of mortgages because investments in mortgages during that period normally resulted in low defaults. Thus, the VaR model was not adequate for predicting the possible estimated losses.

Limitations of the VaR Model  The VaR model was generally ineffective at detecting the risk of banks during the credit crisis. The VaR model failed to recognize the degree to which the value of bank assets (such as mortgages or mortgage-backed securities) could decline under adverse conditions. The use of historical data from before 2007 did not capture the risk of mortgages because investments in mortgages during that period normally resulted in low defaults. Thus, the VaR model was not adequate for predicting the possible estimated losses.

18-4f Stress Tests Imposed to Determine Capital Levels

Some banks supplement the VaR estimate with their own stress tests.

EXAMPLE

Kenosha Bank wants to estimate the loss that would occur in response to an extreme adverse market event. First, it identifies an extreme scenario that could occur, such as an increase in interest rates on one day that is at least three standard deviations from the mean daily change in interest rates. (The mean and standard deviation of daily interest rate movements may be based on a recent historical period, such as the last 300 days.) Kenosha Bank then uses this scenario, along with the typical sensitivity of its trading businesses to such a scenario, to estimate the resulting loss on its trading businesses. It may then repeat this exercise based on a scenario of a decline in the market value of stocks that is at least three standard deviations from the mean daily change in stock prices. It may even estimate the possible losses in its trading businesses from an adverse scenario in which interest rates increase and stock prices decline substantially on a given day.

Regulatory Stress Tests during the Credit Crisis  In 2009, regulators applied stress tests to the largest bank holding companies to determine if the banks had enough capital. These banks account for about half of all loans provided by U.S. banks.

   One of the stress tests applied to banks in April 2009 involved forecasting the likely effect on the banks' capital levels if the recession existing at that time lasted longer than expected. This adverse scenario would cause banks to incur larger losses farther into the future. As a result, the banks would periodically be forced to use a portion of their capital to cover their losses, resulting in a reduction of their capital over time.

   The potential impact of an adverse scenario such as a deeper recession varies among banks. During the credit crisis, banks that had a larger proportion of real estate assets were expected to suffer larger losses if economic conditions worsened because real estate values were extremely sensitive to economic conditions. Thus banks with considerable exposure to real estate values were more likely to experience capital deficiencies if the recession lasted longer than expected. Regulators focused on banks that were graded poorly on the stress tests in order to ensure that these banks would have sufficient capital even if the recession lasted for a longer period of time. Regulators now impose stress tests on an annual basis for banks with asset levels of $50 billion or larger, but will apply the tests in the future to smaller banks with at least $10 billion in assets.

18-4g Government Infusion of Capital during the Credit Crisis

During the 2008–2010 period, the Troubled Asset Relief Program (TARP) was implemented to boost the capital levels of 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 allowed banks to cushion their loan losses. It was also intended to encourage additional lending by banks and other financial institutions so that qualified firms or individuals could borrow funds. The Treasury also purchased some “toxic” assets that had declined in value, and it even guaranteed against losses of other assets at banks and financial institutions. The financial institutions that received these capital injections were required to make dividend payments to the Treasury, but they could repurchase the preferred stock that they had issued to the Treasury (in essence, repaying the funds injected by the Treasury) once their financial position improved.

   As a result of this program, the government became a large investor in banks and other financial institutions. For example, by February 2009, the Treasury had a 36 percent ownership stake in Citicorp. By June 2010, more than half of the TARP funds that were extended by the federal government were repaid, and the program generated more than $20 billion in revenue that was due primarily to dividends received on preferred stock that was purchased.

   In October 2010, the TARP program stopped extending new funds to banks and other financial institutions. Although the government was subject to some criticism for its intervention in the banking system, it was also complimented for restoring the confidence of depositors and investors in the system.

18-5 HOW REGULATORS MONITOR BANKS

Bank regulators typically conduct an on-site examination of each commercial bank at least once a year. During the examination, regulators assess the bank's compliance with existing regulations and its financial condition. In addition to on-site examinations, regulators periodically monitor commercial banks with computerized monitoring systems that analyze data provided by the banks on a quarterly basis.

WEB

www.fdic.gov

Information about specific bank regulations.

18-5a CAMELS Ratings

Regulators monitor banks to detect any serious deficiencies that might develop so that they can correct the deficiencies before the bank fails. The more failures they can prevent, the more confidence the public will have in the banking industry. The evaluation approach described here is used by the FDIC, the Federal Reserve, and the Comptroller of the Currency.

   The single most common cause of bank failure is poor management. Unfortunately, no reliable measure of poor management exists. Therefore, the regulators rate banks on the basis of six characteristics that constitute the  CAMELS ratings , so named for the acronym that identifies the six characteristics:

· ▪ Capital adequacy

· ▪ Asset quality

· ▪ Management

· ▪ Earnings

· ▪ Liquidity

· ▪ Sensitivity

   Each of the CAMELS characteristics is rated on a 1-to-5 scale, with 1 indicating outstanding and 5 very poor. 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. They are closely monitored because their risk level is perceived to be very high.

Capital Adequacy  Because adequate bank capital is thought to reduce a bank's risk, regulators determine the  capital ratio  (typically defined as capital divided by assets). Regulators have become increasingly concerned that some banks do not hold enough capital, so they have increased capital requirements. If banks hold more capital, they can more easily absorb potential losses and are more likely to survive. Banks with higher capital ratios are therefore assigned a higher capital adequacy rating. Even a bank with a relatively high level of capital could fail, however, if the other components of its balance sheet have not been properly managed. Thus, regulators must evaluate other characteristics of banks in addition to capital adequacy.

   Because a bank's capital requirements depend on the value of its assets, they are subject to the accounting method that is used in the valuation process. Fair value accounting is used to measure the value of bank assets. That is, a bank is required to periodically mark its assets to market so that it can revise the amount of needed capital based on the reduced market value of the assets. During the credit crisis, the secondary market for mortgage-backed securities and mortgage loans was so illiquid that banks would have had to sell these assets at very low prices (large discounts). Consequently, the fair value accounting method forced the banks to “write down” the value of their assets.

   Given a decline in a 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 banks came under extra scrutiny by regulators. Some banks satisfied the capital requirements by selling some of their assets, but they would have preferred not to sell assets during this period because there were not many buyers and the market price of these assets was low. An alternative method of meeting capital requirements is to issue new stock, but since bank stock values were so low during the credit crisis, this was not a viable option at that time.

   Banks complained that their capital was reduced because of the fair value accounting rules. They argued that their assets should have been valued higher if the banks intended to hold them until the credit crisis ended and the secondary market for these assets became more liquid. If the banks' assets had been valued in this manner, their write-downs of assets would have been much smaller, and the banks could have more easily met the capital requirements. As a result of the banks' complaints, the fair value accounting rules were modified somewhat in 2009.

Asset Quality  Each bank makes its own decisions as to how deposited funds should be allocated, and these decisions determine its level of credit (default) risk. Regulators therefore evaluate the quality of the bank's assets, including its loans and its securities.

EXAMPLE

The Fed considers “the 5 Cs” to assess the quality of the loans extended by Skyler Bank, which it is examining:

· ▪ Capacity-the borrower's ability to pay

· ▪ Collateral-the quality of the assets that back the loan

· ▪ Condition-the circumstances that led to the need for funds

· ▪ Capital-the difference between the value of the borrower's assets and its liabilities

· ▪ Character-the borrower's willingness to repay loans as measured by its payment history on the loan and credit report

   From an assessment of a sample of Skyler Bank's loans, the Fed determines that the borrowers have excessive debt, minimal collateral, and low capital levels. Thus, the Fed concludes that Skyler Bank's asset quality is weak.

Rating an asset portfolio can be difficult, as the following example illustrates.

EXAMPLE

A bank currently has 1 ,000 loans outstanding to firms in a variety of industries. Each loan has specific provisions as to how it is secured (if at all) by the borrower's assets; some of the loans have short-term maturities, while others are for longer terms. Imagine the task of assigning a rating to this bank's asset quality. Even if all the bank's loan recipients are current on their loan repayment schedules, this does not guarantee that the bank's asset quality deserves a high rating. The economic conditions existing during the period of prompt loan repayment may not persist in the future. Thus, an appropriate examination of the bank's asset portfolio should incorporate the portfolio's exposure to potential events (such as a recession). The reason for the regulatory examination is not to grade past performance but rather to detect any problem that could cause the bank to fail in the future.

   Because of the difficulty in assigning a rating to a bank's asset portfolio, it is possible that some banks will be rated lower or higher than they deserve.

Management  Each of the characteristics examined relates to the bank's management. In addition, regulators specifically rate the bank's management according to administrative skills, ability to comply with existing regulations, and ability to cope with a changing environment. They also assess the bank's internal control systems, which may indicate how easily the bank's management could detect its own financial problems. This evaluation is clearly subjective.

Earnings  Although the CAMELS ratings are mostly concerned with risk, earnings are very important. Banks fail when their earnings become consistently negative. A profitability ratio commonly used to evaluate banks is  return on assets (ROA) , defined as after-tax earnings divided by assets. In addition to assessing a bank's earnings over time, it is also useful to compare the bank's earnings with industry earnings. This allows for an evaluation of the bank relative to its competitors. In addition, regulators are concerned about how a bank's earnings would change if economic conditions change.

Liquidity  Some banks commonly obtain funds from outside sources (such as the Federal Reserve or the federal funds market), but regulators would prefer that banks not consistently rely on these sources. Such banks are more likely to experience a liquidity crisis whereby they are forced to borrow excessive amounts of funds from outside sources. If existing depositors sense that the bank is experiencing a liquidity problem, they may withdraw their funds, compounding the problem.

Sensitivity  Regulators also assess the degree to which a bank might be exposed to adverse financial market conditions. Two banks could be rated similarly in terms of recent earnings, liquidity, and other characteristics, yet one of them may be much more sensitive than the other to financial market conditions. Regulators began to explicitly consider banks' sensitivity to financial market conditions in 1996 and added this characteristic to what was previously referred to as the CAMEL ratings. In particular, regulators place much emphasis on a bank's sensitivity to interest rate movements. Many banks have liabilities that are repriced more frequently than their assets and are therefore adversely affected by rising interest rates. Banks that are more sensitive to rising interest rates are more likely to experience financial problems.

Limitations of the CAMELS Rating System  The CAMELS rating system is essentially a screening device. Because there are so many banks, regulators do not have the resources to closely monitor each bank on a frequent basis. The rating system identifies what are believed to be problem banks. Over time, other banks are added to the “problem list,” some problem banks improve and are removed from the list, and others may deteriorate further and ultimately fail.

   Although examinations by regulators may help detect problems experienced by some banks in time to save them, many problems still go unnoticed; by the time they are detected, it may be too late to find a remedy. Because financial ratios measure current or past performance rather than future performance, they do not always detect problems in time to correct them. Thus, although an analysis of financial ratios can be useful, the task of assessing a bank is as much an art as it is a science. Subjective opinion must complement objective measurements to provide the best possible evaluation of a bank.

   Any system used to detect financial problems may err in one of two ways. It may classify a bank as safe when in fact it is failing or it may classify a bank as risky when in fact it is safe. The first type of mistake is more costly, because some failing banks are not identified in time to help them. To avoid this mistake, bank regulators could lower their benchmark composite rating. If they did, however, many more banks would be on the problem list and require close supervision, so regulators' limited resources would be spread too thin.

18-5b Corrective Action by Regulators

WEB

www.occ.treas.gov/interp/monthly.htm

Information on the Latest bank regulations and their interpretation from the Office of the Comptroller.

When a bank is classified as a problem bank, regulators thoroughly investigate the cause of its deterioration. Corrective action is often necessary. Regulators may examine such banks frequently and thoroughly and will discuss with bank management possible remedies to cure the key problems. For example, regulators may request that a bank boost its capital level or delay its plans to expand. They can require that additional financial information be periodically updated to allow continued monitoring. They have the authority to remove particular officers and directors of a problem bank if doing so would enhance the bank's performance. They even have the authority to take legal action against a problem bank if the bank does not comply with their suggested remedies. Such a drastic measure is rare, however, and would not solve the existing problems of the bank.

18-5c Funding the Closure of Failing Banks

If a failing bank cannot be saved, it will be closed. The FDIC is responsible for the closure of failing banks. It must decide whether to liquidate the failed bank's assets or to facilitate the acquisition of that bank by another bank. When liquidating a failed bank, the FDIC draws from its Deposit Insurance Fund to reimburse insured depositors. After reimbursing depositors, the FDIC attempts to sell any marketable assets (such as securities and some loans) of the failed bank. The cost to the FDIC of closing a failed bank is the difference between the reimbursement to depositors and the proceeds received from selling the failed bank's assets.

18-6 GOVERNMENT RESCUE OF FAILING BANKS

The U.S. government periodically rescues failed banks in various ways. The FDIC provides some financial support to facilitate another bank's acquisition of the failed bank. The financial support is necessary because the acquiring bank recognizes that the market value of the failed bank's assets is less than its liabilities. The FDIC may be willing to provide funding if doing so would be less costly than liquidating the failed bank. Whether a failing bank is liquidated or acquired by another bank, it loses its identity.

   In some cases, the government has given preferential treatment to certain large troubled banks. For example, the government has occasionally provided short-term loans to a distressed bank or insured all its deposits, even those above the insurance limit, in an effort to encourage depositors to leave their funds in the troubled bank. Or the government might orchestrate a takeover of the troubled bank in a manner that enables the shareholders to receive at least some payment for their shares (when a failed bank is acquired, shareholders ordinarily lose their investment). However, such intervention by the government is controversial.

18-6a Argument for Government Rescue

If all financial institutions that were weak during the credit crisis had been allowed to fail without any intervention, the FDIC might have had to use all of its reserves to reimburse depositors. To the extent that FDIC intervention can reduce the extent of losses at depository institutions, it may reduce the cost to the government (and therefore the taxpayers).

How a Rescue Might Reduce Systemic Risk  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. The rescue of large banks might be necessary to reduce systemic risk in the financial system, as illustrated next.

EXAMPLE

Consider a financial system with only four large banks, all of which make many mortgage loans and invest in mortgage-backed securities. Assume that Bank A sold credit default swaps to Banks B, C, and D and so receives periodic payments from those banks. It will have to make a large payment to these banks if a particular set of mortgages default.

   Now assume that the economy weakens and many mortgages default, including the mortgages referenced by the credit default swap agreements. This means that Bank A now owes a large payment to Banks B, C, and D. But since Bank A incurred losses from its own mortgage portfolio, it cannot follow through on its payment obligation to the other banks. Meanwhile, Banks B, C, and D may have used the credit default swap position to hedge their existing mortgage holdings; however, if they do not receive the large payment from Bank A, they incur losses without any offsetting gains.

   If bank regulators do not rescue Bank A, then all four banks may fail because of Bank A's connections with the other three banks. However, if bank regulators rescue Bank A then Bank A can make its payments to Banks B, C, and D, and all banks should survive. Thus, a rescue may be necessary to stabilize the financial system.

   In reality, the financial system is supported not only by a few large banks, but by many different types of financial institutions. The previous example is not restricted to banks, but extends to all types of financial institutions that can engage in those types of transactions. Furthermore, a government rescue of a bank benefits not only bank executives, but bank employees at all levels. To the extent that a government rescue can stabilize the banking system, it can indirectly stimulate all the sectors that rely on funding from the banking system. This potential benefit was especially relevant during the credit crisis.

18-6b Argument against Government Rescue

Those who oppose government rescues say that, when the federal government rescues a large bank, it sends a message to the banking industry that large banks will not be allowed to fail. Consequently, large banks may take excessive risks without concern about failure. If a large bank's risky ventures (such as loans to risky borrowers) pay off, the return will be high. If they do not pay off, the federal government will bail the bank out. If large banks can be sure that they will be rescued, their shareholders will benefit because they face limited downside risk.

   Some critics recommend a policy of letting the market work, meaning that no financial institution would ever be bailed out. In this case, managers of a troubled bank would be held accountable for their bad management because their jobs would be terminated in response to the bank's failure. In addition, shareholders would more closely monitor the bank managers to make sure that they do not take excessive risk.

18-6c Government Rescue of Bear Stearns

The credit crisis led to new arguments about government rescues of failing financial institutions. In March 2008, Bear Stearns (a large securities firm) was about to go bankrupt. Bear Stearns had facilitated many transactions in financial markets, and its failure would have delayed them and so caused liquidity problems for many individuals and firms that were to receive cash as a result of those transactions. The Federal Reserve provided short-term loans to Bear Stearns to ensure that it had adequate liquidity. The Fed then backed the acquisition of Bear Stearns by JPMorgan Chase by providing a loan so that JPMorgan Chase could afford the acquisition.

   At this point, the question was whether the Federal Reserve (a regulator of commercial banks) should be assisting a securities firm such as Bear Stearns that it did not regulate. 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 that many financial transactions would potentially be frozen if it did not intervene. Thus, it was acting in an attempt to stabilize the financial system rather than in its role as a regulator of commercial banks.

18-6d Failure of Lehman and Rescue of AIG

In September 2008, Lehman Brothers (another large securities firm) was allowed to go bankrupt without any assistance from the Fed even though American International Group (AIG, a large insurance company) was rescued by the Fed. Some critics asked why some large financial institutions were bailed out but others were not. At what point does a financial institution become sufficiently large or important that it deserves to be rescued? This question will continue to trigger heated arguments.

   Lehman Brothers was a large financial institution with more than $600 billion in assets. However, it might have been difficult to find another financial institution willing to acquire Lehman Brothers without an enormous subsidy from the federal government. Many of the assets held by Lehman Brothers (such as the mortgage-backed securities) were worth substantially less in the market than the book value assigned to them by Lehman.

   American International Group had more than $1 trillion in assets when it was rescued and, like Lehman, had many obligations to other financial institutions because of its credit default swap arrangements. However, one important difference between AIG and Lehman Brothers was that AIG had various subsidiaries that were financially sound at the time, and the assets in these subsidiaries served as collateral for the loans extended by the federal government to rescue AIG. From the federal government's perspective, the risk of taxpayer loss due to the AIG rescue was low. In contrast, Lehman Brothers did not have adequate collateral available and so a large loan from the government could have been costly to U.S. taxpayers.

18-6e Protests of Bank Bailouts

The bailouts during the credit crisis led to the organization of various groups. In 2009, the Tea Party organized and staged protests throughout the United States. Its main theme was that the government was spending excessively, which led to larger budget deficits that arguably could weaken economic conditions. Their proposed solution is to eliminate the bailouts as one form of reducing the excessive government spending.

   In 2011, Occupy Wall Street organized and also staged protests. While this movement also protested government funding decisions, its underlying theme is not as clear. Some protestors within this movement believe that bank bailouts are appropriate, whereas others do not. In addition, many protestors wanted the government to direct more funding to their own specials interests, such as health care, education, or programs to reduce unemployment. This led to the common sign or phrase associated with Occupy Wall Street protests: “Where's my bailout?” Although the Occupy Wall Street movement gained much support for protesting against the government, there does not appear to be a clear consensus solution among protestors regarding bailouts or the proper use of government funding.

18-7 FINANCIAL REFORM ACT OF 2010

In July, 2010, the Financial Reform Act (also referred to as the Dodd-Frank Act, or the Wall Street Reform and Consumer Protection Act) was implemented. This act contained numerous provisions regarding financial services. The provisions that concern bank regulation are summarized here.

18-7a Mortgage Origination

The Financial Reform Act 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, which should minimize the possibility of a future credit crisis. It may seem that this provision would naturally be followed even if there was no law. Yet there were many blatant violations shortly before and during the credit crisis in which mortgages were approved for applicants who were clearly not creditworthy.

18-7b Sales of Mortgage-Backed Securities

The act requires that banks and other financial institutions that sell mortgage-backed securities retain 5 percent of the portfolio unless it meets specific standards that reflect low risk. This provision forces financial institutions to maintain a stake in the mortgage portfolios that they sell. The act also requires more disclosure regarding the quality of the underlying assets when mortgage-backed securities are sold.

18-7c Financial Stability Oversight Council

The Financial Reform Act created the Financial Stability Oversight Council, which is responsible for identifying risks to financial stability in the United States and makes recommendations that regulators can follow to reduce 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. Furthermore, it can recommend rules such as higher capital requirements for banks that are perceived to be too big and complex, which may prevent these banks from becoming too risky.

   The council consists of 10 members, including the Treasury Secretary (who chairs the council) and the heads of three regulatory agencies that monitor banks: the Federal Reserve, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation. Because systemic risk in the financial system may be caused by financial security transactions that connect banks with other types of financial institutions, the council also includes the head of the Securities and Exchange Commission and of the U.S. Commodities Futures Trading Commission. The remaining members are the heads of the National Credit Union Association, the Federal Housing Finance Agency, and the Consumer Financial Protection Bureau (described shortly) as well as an independent member with insurance experience who is appointed by the President.

18-7d Orderly Liquidation

The act assigned specific regulators with the authority to determine whether 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 any financial institution that is not covered by the Federal Deposit Insurance Corporation. Shareholders and unsecured creditors are expected to bear most of the losses of failing financial institutions, so they are not covered by this fund. If losses are beyond what can be absorbed by shareholders and unsecured creditors, other financial institutions in the corresponding industry are expected to bear the cost of the liquidation. The liquidations are not to be financed by taxpayers.

18-7e Consumer Financial Protection Bureau

The act established the Consumer Financial Protection Bureau, which is responsible for regulating consumer finance products and services offered by commercial banks and other financial institutions, such as online banking, checking accounts, and credit cards. The bureau can set rules to ensure that bank disclosure about financial products is accurate and to prevent deceptive financial practices.

18-7f Limits on Bank Proprietary Trading

The act mandates that commercial banks must limit their proprietary trading, in which they pool money received from customers and use it to make investments for the bank's clients. A commercial bank can use no more than 3 percent of its capital to invest in hedge fund institutions, private equity funds, or real estate funds (combined). This requirement has also been referred to as the Volcker rule, and it has led to much controversy.

   The implementation of the limits on proprietary trading has been deferred to July 2014. This gives banks time to sell divisions if they exceed the limit. This provision had a larger impact on securities firms (such as Goldman Sachs and Morgan Stanley) that had converted to bank holding companies shortly before the act, because those firms had previously engaged in heavy proprietary trading.

   The general argument for this rule is that commercial banks should not be making investments in extremely risky projects. If they want to pursue very high returns (and therefore be exposed to very high risk), they should not be part of the banking system, and should not have access to depositor funds, or be able to obtain deposit insurance. That is, if they want to invest like hedge funds, they should apply to be hedge funds and not commercial banks.

   However, some critics believe that the Volcker rule could prevent U.S. banks from competing against other banks on a global basis. In addition, there is much disagreement regarding the degree to which banks should be allowed to take risks. Some critics argue that the Volcker rule would not have prevented some banks from making the risky investments that caused them to go bankrupt during the credit crisis. Furthermore, although JPMorgan Chase posted a trading loss of $2 billion in May 2012 while the Volcker rules were still being developed, it has been argued that the trades that caused that loss would not have been prohibited by the Volcker rule. There are also concerns that the provisions of the Volcker rule are not sufficiently clear, which will allow some banks to circumvent the rule when making investments by using their own interpretations of the rule.

18-7g Trading of Derivative Securities

The act requires that derivative securities be traded through a clearinghouse or exchange, rather than over the counter. This provision should enable a more standardized structure regarding margins and collateral as well as more transparency of prices in the market. Consequently, banks that trade these derivatives should be less susceptible to risk that the counterparty posted insufficient collateral.

18-8 GLOBAL BANK REGULATIONS

Although the division of regulatory power between the central bank and other regulators varies among countries, each country has a system for monitoring and regulating commercial banks. Most countries also maintain different guidelines for deposit insurance. Differences in regulatory restrictions give some banks a competitive advantage in a global banking environment.

   Historically, Canadian banks were not as restricted in offering securities services as U.S. banks and therefore control much of the Canadian securities industry. Recently, Canadian banks have begun to enter the insurance industry. European banks have had much more freedom than U.S. banks in offering securities services such as underwriting corporate securities. Many European banks are allowed to invest in stocks.

   Japanese commercial banks have some flexibility to provide investment banking services, but not as much as European banks. Perhaps the most obvious difference between Japanese and U.S. bank regulations is that Japanese banks are allowed to use depositor funds to invest in stocks of corporations. Thus, Japanese banks are not only the creditors of firms but also their shareholders.

SUMMARY

· ▪ Banks must observe regulations on the deposit insurance they must maintain, their loan composition, the bonds they are allowed to purchase, and the financial services they can offer. In general, regulations on deposits and financial services have been loosened in recent decades in order to allow for more competition among banks. When a bank is failing, the FDIC or other government agencies consider whether it can be saved. During the credit crisis, many banks failed and also Lehman Brothers failed, but the government rescued American International Group (AIG). Unlike Lehman brothers, AIG had various subsidiaries that were financially sound at the time, and the assets in these subsidiaries served as collateral for the loans extended by the government to rescue AIG.

· ▪ Capital requirements are intended to ensure that banks have a cushion against any losses. The requirements have become more stringent and are risk adjusted so that banks with more risk are required to maintain a higher level of capital.

· ▪ Bank regulators monitor banks by focusing on six criteria: capital, asset quality, management, earnings, liquidity, and sensitivity to financial market conditions. Regulators assign ratings to these criteria in order to determine whether corrective action is necessary.

· ▪ In July 2010, the Financial Reform Act was implemented. It set more stringent standards for mortgage applicants, required banks to maintain a stake in the mortgage portfolios that they sell, and established a Consumer Financial Protection Bureau to regulate consumer finance products and services offered by commercial banks and other financial institutions.

POINT COUNTER-POINT

Should Regulators Intervene to Take Over Weak Bank?

Point  Yes. Intervention could turn a bank around before weak management results in failure. 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.

QUESTIONS AND APPLICATIONS

· 1. Regulation of Bank Sources and Uses of Funds How are a bank's balance sheet decisions regulated?

· 2. Off-Balance Sheet Activities Provide examples of off–balance sheet activities. Why are regulators concerned about them?

· 3. Moral Hazard and the Credit Crisis Explain why the moral hazard problem received so much attention during the credit crisis.

· 4. FDIC Insurance What led to the establishment of FDIC insurance?

· 5. Glass-Stagall Act Briefly describe the Glass-Steagall Act. Then explain how the related regulations have changed.

· 6. DIDMCA Describe the main provisions of the DIDMCA that relate to deregulation.

· 7. CAMELS Ratings Explain how the CAMELS ratings are used.

· 8. Uniform Capital Requirements Explain how the uniform capital requirements established by the Basel Accord can discourage banks from taking excessive risk.

· 9. Value at Risk Explain how the value at risk (VaR) method can be used to determine whether a bank has adequate capital.

· 10. HLTs Describe highly leveraged transactions (HLTs), and explain why a bank's exposure to HLTs is closely monitored by regulators.

· 11. Bank Underwriting Given the higher capital requirements now imposed on them, why might banks be even more interested in underwriting corporate debt issues?

· 12. Moral Hazard Explain the moral hazard problem as it relates to deposit insurance.

· 13. Economies of Scale How do economies of scale in banking relate to the issue of interstate banking?

· 14. Contagion Effects How can the financial problems of one large bank affect the market's risk evaluation of other large banks?

· 15. Regulating Bank Failures Why are bank regulators more concerned about a large bank failure than a small bank failure?

· 16. Financial Services Modernization Acr Describe the Financial Services Modernization Act of 1999. Explain how it affected commercial bank operations and changed the competitive landscape among financial institutions.

· 17. Impact of SOX on Banks Explain how the Sarbanes-Oxley Act improved the transparency of banks. Why might the act have a negative impact on some banks?

· 18. Conversion of Securities Firms to BHCs Explain how the conversion of a securities firm to a bank holding company (BHC) structure might reduce its risk.

· 19. Capital Requirements during the Credit Crisis Explain how the accounting method applied to mortgage-backed securities made it more difficult for banks to satisfy capital requirements during the credit crisis.

· 20. Fed Assistance to Bear Stearns Explain why regulators might argue that the assistance they provided to Bear Stearns was necessary.

· 21. Fed Aid to Nonbanks Should the Fed have the power to provide assistance to firms, such as Bear Stearns, that are not commercial banks?

· 22. Regulation of Credit Default Swaps Why were bank regulators concerned about credit default swaps during the credit crisis?

· 23. Impact of Bank consolidation on Regulation Explain how bank regulation can be more effective when there is consolidation of banks and securities firms.

· 24. Concerns about Systematic Risk during the Credit Crisis Explain why the credit crisis caused concerns about systemic risk.

· 25. Troubled Asset Relief Program (TARP) Explain how the Troubled Asset Relief Program was expected to help resolve problems during the credit crisis.

· 26. Financial Reform Act Explain how the Financial Reform Act resolved some problems during the credit crisis.

· 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?

· 28. Basel III Changes to Capital and Liquidity Requirements How did Basel III change capital and liquidity requirements for banks?

Interpreting Financial News

Interpret the following comments 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 had closed the bank.”

· b. “Bank of America has pursued the acquisition of many failed banks because it sees potential benefits.”

· c. “By allowing a failing bank time to resolve its financial problems, the FDIC imposes an additional tax on taxpayers.”

Managing in Financial Markets

Effect of Bank Strategies on Bank Ratings 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 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?

· b. Do you believe that the strategies planned by the bank will satisfy its shareholders? Is it possible for the bank to use strategies that would satisfy both regulators and shareholders? Explain.

· c. Do you believe that the strategies planned by the bank will satisfy the bank's managers? Explain.

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.

· b. Explain the types of nonbank services that Carson Company can receive from the subsidiaries of a commercial bank as a result of deregulation. How might Carson Company be affected by the deregulation that allows subsidiaries of a commercial bank to offer nonbank services?

INTERNET/EXCEL EXERCISE

Browse the most recent Quarterly Banking Profile at  www.fdic.gov/bank/analytical/index.html . Review the information provided about failed banks, and describe how regulators responded to one recent bank failure listed here.

WSJ EXERCISE

Impact of Bank Regulations

Using a recent issue of the Wall Street Journal, summarize an article that discusses a particular commercial bank regulation that has recently been passed or is currently being considered by regulators. (You may wish to use the Wall Street Journal Index to identify a specific article on a commercial banking regulation or bill.) Would this regulation have a favorable or unfavorable impact on commercial banks? Explain.

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. bank AND deposit insurance

· 2. bank AND moral hazard

· 3. bank loans AND regulation

· 4. bank investments AND regulation

· 5. bank capital AND regulation

· 6. bank regulator AND rating banks

· 7. bank regulator AND stress test

· 8. too big to fail AND conflict

· 9. bank regulation AND conflict

· 10. government rescue AND bank