J. K. Dietrich - FBE 524 - Fall, 2005 Financial Institution Regulation Week 4 – September 21,...

J. K. Dietrich - FBE 524 - Fall, 2005

Financial Institution Regulation

Week 4 – September 21, 2005


Rationales for Regulation of Financial Services

Economic activity– Monetary policy (money creation)– Credit allocation (‘disadvantaged’ sectors)– Government financing

Competition (equal opportunity and fairness) Asymmetry between providers and users Uninsurable (system-wide) risks

– Safety and promoting public confidence


Types of Financial Firm Regulation

Chartering, branching, and registration Ownership, mergers, acquisitions Pricing and product review Activity and asset restrictions Capital requirements Disclosure and examination


Key U.S. Banking Laws


Brief Historical Overview

Civil war and National Banking Act (1863, 1864) establish “dual banking” system

Nineteenth century crises yield Federal Reserve Act (1913) and FR System (Board and 12 FR banks)

Great Depression produced major legislative response affecting banks, thrifts, and securities firms

Inflation from 1960’s forces deregulation


Regulation in Response to 1930’s

Banking Act of 1933– Deposit insurance (FDIC)– Separation of underwriting activities

Securities Act of 1933 and Securities Exchange Act of 1934

Home Owners Loan Act and thrifts Banking Act of 1935

– Federal Open Market Committee (FOMC)– Interest-rate regulation


The Great American Inflation

Demand for deregulation as some rates reflected inflation and others did not– Disintermediation and thrifts– Market response: money market mutual funds,

Eurodollars, commercial paper, BHC, etc. Response: Deposit Institution Deregulation and

Monetary Control Act of 1980– Political compromises– Nature of changes


Inflation since 1950

-10

-5

0

5

10

15

20

25

50 55 60 65 70 75 80 85 90 95 00

CPIINFL MACPIINFL

CPI and Moving Average CPI Inflation 1950 to 2004


Inflation and Interest Rates

-4

0

4

8

12

16

20

50 55 60 65 70 75 80 85 90 95 00

FCM10 FTBS3 MACPIINFL

U.S. Inflation and Treasury Rates 1950 to 2004


The Last 25 Years


DIDAMCA (1980)

Monetary Control Act– All deposit-taking institutions subject to

reserves– Thrifts could offer checking accounts

Deregulation Act– Deregulation Committee and experience

Powers of Thrifts


1980’s: Savings and Loan Crisis

Garn-St Germain Act of 1982– Expanded powers: corporate (junk) bonds,

commercial real estate, commercial loans– Rules on acquisitions

Financial Institution Reform, Recovery and Enhancement Act of 1989 (FIRREA)– Restructure thrift regulators, re-regulation

Federal Deposit Insurance Corporation Improvement Act (1991) and closures


Bank Regulatory Establishment


Thrift Regulatory Establishment


Bank Capital Regulation Risk adjusted assets

– Basel Agreement I and negotiations over II– Banks, thrifts, and insurance companies– Risk weights, on- and off- balance sheet

Value-at-risk (VAR) capital requirements– Internal models, trading assets 10% or $1

billion, after January, 1998– 3 x 10-day 99th percentile risk and benchmarks


Basel I -- Background Basel I grew out of collaboration between

U.S. Federal Reserve and the Bank of England on standardizing regulation

The Bank for International Settlements (dating from German reparations in the 1920’s) became forum for the Group of 7

Most OECD countries accept the Basel I standards

Global acceptance wide by 1990’s


Basel I Standards Focus is on capital adequacy Capital viewed as a shock absorber to

prevent losses to liability holders (at first bank depositors but increasingly life insurance customers)

Bank capital regulation before Basel I differed greatly among OECD countries

1988 Standard simplified risk classification of assets into four classes, all commercial loans were in the same class


Capital Adequacy

Capital bufferBuffer = Assets - Liabilities =>Liabilities = Assets - Capital =>

Liabilities = Assets - Capital Assessing capital adequacy over time (U.S.)

– ABC– Leverage– Risk-based capital


Basel I Capital Standard


Types of Risk

Market or interest-rate and exchange-rate risk– How values of assets change with changes in

interest and exchange rates Operating risks

– Losses due to failure of systems, personnel, or fraud

Credit risks – Losses due to departures from loan or debt

contracts regarding payments of cash


Basel I Risk-Adjusted Capital

Assets classified into four risk weight classes– Short-term domestic governments and cash (0%)– Guaranteed loans and foreign governments (20%)– Revenue bonds and residential loans (50%)– All other loans and investments (100%)

Weighted assets must be backed by capital– 4% equity capital (Tier 1 capital)– 8% by equity and long-term subordinated debt

(Tier 1 and Tier 2 capital)


Basel II

BIS has become the global forum for discussion of bank risk assessment

Basel I standards too simple– All private lending classified as equally risky

(100% risk weight, 8% capital backing)– Sophisticated market and credit-risk models– Value at Risk (VAR) analysis and acceptance

in assessing capital requirements for trading portfolios


Basel II Focus

Credit risk and operating risk Three ‘pillars’

– Minimum capital requirements– Supervisory review– Effective market discipline

Goal is not to raise average capital requirements

Same Tier 1 and Tier 2 capital concept


Application of Capital Standards Basel II standards apply to bank holding

companies on a consolidated basis Banks implement in one of three ways

– Standardized approach– Foundation internal ratings based (IRB)

approach– Advanced IRB approach

Strong emphasis on asset securitizations and other off-balance sheet activities


Bank Responses to Basel II

Large banks want to reduce capital requirements– Income of $10 and capital of $100 implies

return on equity of 10%– Income of $10 and capital of $50 implies return

on equity of 20% Use of advanced internal risk-based

standards promises reduced capital


Internal Risk-Based Capital

Require data and models– Data must include details on loans (terms,

collateral and subordination, participations or sales, etc.)

– Must include payment history and details of defaults and workouts

– Models must be acceptable to regulators Major effort must be undertaken and is

already well under way in some banks (U.S., Europe, Australia)


Risk “Culture” Return and earnings objectives set in terms

of risk-adjusted returns with a focus on economic value added (earning a higher than risk-adjusted return)

Determine a firm risk-adjusted return on capital (RAROC)

– Deals must have appropriate capital charge– Prices must yield RAROC

Risk management must have political authority within the organization


Holding Company Regulation

Bank holding companies– Bank Holding Company Act of 1956– 1970 amendments– FIRREA changes

Non-bank holding companies– Thrifts– Insurance companies– Securities firms


Holding Companies andGlass-Steagall Act (to 1999)

Securities FirmInsurance Company

Non-Bank HoldingCompany

Bank HoldingCompany

Commercial Bank

Securities Subsidiary(Section 20)

SEC, ExchangesSROs

State InsuranceAgencies

Federal ReserveBoard

OCC, FDIC, orFRB


Securities Markets Regulation

Issuers and investors– Registration and disclosure

Investor behavior– Insider trading– Market manipulation– Speculation and margin requirements

Investors and brokers– NASD and exchanges


Securities Regulators

Securities Exchange Commission (SEC) Commodity Futures Trading Commission

(CFTC), outgrowth of trading in agricultural contracts

Treasury Department for government trading Federal Reserve for margin requirements Bank regulators for some aspects of banks’

trading activities


Legal Liabilities

Securities Regulation

MutualFunds

Exchanges and SROs

Brokers,Dealers, IBs

Investor Issuer

Investor

Investor

Issuer

Issuer

Disclosure and Reporting

Man

ipu

lati

on, I

nsi

der

Tra

din

g

SEC ReviewLegal Liabilities


Securities Firm Regulation

Registration Reporting (FOCUS) Capital requirements

– Haircuts Self-regulatory organizations

– NYSE– NASD– Futures Merchants Association

Government


Insurance Regulation

United States vs. Rest of the World– States and McCarran-Ferguson Act– National Association of Insurance Commissioners

(NAIC)– Ministries of Finance, etc., elsewhere

Domestic, foreign, alien insurance companies in United States

EEC and 1992 China


Finale: Gramm-Leach-Bliley Act

Established Financial holding companies– Insurance

– Securities activities

– Maintained separate of banking and commerce in general

Federal Reserve in umbrella regulator, but legislation compromise relied mainly on functional regulation, state insurance commissioners, SEC, CFTC, to protect turf


Banks with Glass-Steagall

Finance CompanyCommercial Bank

Bank HoldingCompany

Discount Broker

Securities Subsidiary(Section 20)


Financial Holding Company

Investment BankCommercial Bank

Financial HoldingCompany

Insurance Company

Thrift InstitutionAsset Management

Company


Next week: September 28

Read Chapter 5 through 6 of Money and Capital Markets

Read articles posted on website suggested by students and download any handouts before class

Bring a Wall Street Journal to class every Tuesday

J. K. Dietrich - FBE 524 - Fall, 2005 Financial Institution Regulation Week 4 – September 21,...

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