chapter 15 the regulation of markets and institutions
TRANSCRIPT
Chapter 15
The Regulation of Markets and Institutions
Key Ideas
Different methods of regulating financial markets
Dual banking system and the regulators who oversee it
Universal banking and its possible benefits and risks
Introduction Financial system is one of most intensely regulated sectors in US economy
Objectives of the regulations are: To promote competition To protect individual consumers To maintain stability of financial system
To facilitate monetary policy
Primary Market
Philosophy Best protection is provide adequate information about securities and investments
Full disclosure broadens participation in financial markets
Primary Market
Securities Act of 1933 Requires disclosure of information for newly issued publicly traded securities
Privately held firms are not required to reveal financial information to the public at large, only to the lenders
Primary Market
Securities Exchange Act of 1934 Created the Securities and Exchange Commission (SEC) to administer provisions of 1933 Act
Publicly traded security must file registration statement and preliminary prospectus disclosing information about issue
Primary Market
Securities Exchange Act of 1934 The prospectus does not state
the interest rate on a bond issue or price for equity issues determined in the market when sold
If information is adequate, SEC approves the statement and sale
Approval by the SEC does not imply that it views the new issue as an attractive investment
Approval simply means disclosure of information is adequate
Regulation of Secondary Market
Securities Exchange Act of 1934 Extended 1933 Act
Periodic disclosure of relevant financial information
For firms trading in secondary market 10K Report
Annual financial statement and Information about a firm’s performance and activity
Secondary Market
Securities Exchange Act of 1934 Prohibits Insider Trading
Prohibit insiders from trading on private information not previously disclosed to public
Corporate officers and major stockholders must report all their transactions of their own firm’s stock
Regulation of Commercial Banks
Philosophy Protect individual depositor Foster a competitive banking system
Ensure safety and soundness of banking system
Commercial Banks
Dual banking system Federal and State banks existing side-by-side
Legislation in 1860 established federally chartered banks
Created Comptroller of the Currency (US Treasury Department) to supervise chartered banks
Imposed a prohibitive tax on issuance of state banknotes
Intent was to drive existing state chartered banks out of business
Commercial Banks
Dual banking system However, state banks survived
Stopped issuing banknotes Started to accept of demand deposits
State chartered banks are supervised by regulators in their respective state
Federally chartered banks tend to be larger in size, but state banks are more in number
Commercial Banks
Federal Reserve Act of 1913 Required national banks to become members of the Fed
State chartered banks had option of being a nonmember
All state banks (including nonmember) currently fall under regulation of the Fed Reserve System
Commercial Banks
Federal Deposit Insurance Corporation (FDIC) All member banks of Fed are required to carry FDIC insurance
Members include, All national and Some state banks
A majority of state banks (including non members) have opted to participate in FDIC program
Commercial Banks
Multiple Regulators at Federal level with Overlapping and Conflicting authority.
Federal Reserve System Comptroller of Currency FDIC
Some experts suggest that all regulation should be combined in a single agency
However, no legislation exists to unify the structure
Commercial Banks
Philosophy Protect Individual Depositors Maintain Stability of Financial System
Strategy of Regulation: Disclosure is not enough Physical examination of member banks Bank examinations are often not public by design
Commercial Banks
Primary Liabilities: Demand Deposit
Banks must maintain sufficient liquidity to meet demand deposits
It is costly to keep excess reserve or liquid assets
Fear of insolvency may cause a run on the bank causing a system-wide bank panic
Paid on a first-come/first-serve basis
Periodic examination of a bank by regulatory agencies to insure banks are solvent
Commercial Banks
Deposit Insurance FDIC established by Banking Act of 1933 to insure deposits at commercial and mutual savings banks.
Created after a large number of bank failures in the early 1930’s
Objective is to protect small savers
Reduce the incentive for depositors to join a bank run
Commercial Banks Deposit Insurance
Currently insure deposits up to $100,000 for single account
Coverage depends on procedure used by FDIC: Payoff Method
Bank goes into receivership by FDCI FDIC pays out funds up to $100,000
Purchase and Assumption Method FDIC merges failed bank with a healthy one Deposits of failed bank are assumed by solvent bank
Commercial Banks Moral Hazard and Deposit Insurance Existence of FDIC eliminates large-scale bank failure and bank run.
However, it creates a classic moral hazard problem
With FDIC insurance, depositors have little or no incentive to monitor riskiness of their banks.
Without monitoring, bank managers finds it easy to engage in risk shifting
Commercial Banks
Moral Hazard and Deposit Insurance Shareholders and directors of banks have incentive to make their banks riskier at the expense of the FDIC
“Too big to fail” Doctrine FDIC may extend loans to very large banks in trouble to allow continued operations
This doctrine may unintentionally exacerbate the moral hazard problem
Recently bank failures have increased due to banking deregulation and commercial banking activities have become riskier
Regulation of Commercial Banks
Risk-Based Capital Requirements Bank capital acts as a cushion against failure
Banks are required to maintain a capital to asset ratio
This ratio measures of bank’s risk exposure
Risk-based capital requirements Higher capital requirement for banks with risky assets.
With higher risk amount of risk-based asset will go up.
This will cause Capital to Asset ratio to go down.
These requirements are agreed upon by the United States and members of the Bank for International Settlements (BIS)
Regulation of Commercial Banks
Prompt Corrective Action (PCA) Passed as a part of FDIC Improvement Act of 1991
Established procedures to handle troubled banks
Designed to close banks before FDIC is exposed to excessive losses
Prevent regulatory forbearance when regulators keep an insolvent institution operating in hopes of “turning it around”
Banks are ranked according to their perceived risk and more restrictions placed on riskier banks
Established a risk-based deposit insurance premium in FDIC charge insurance premium based on the perceived risk of the bank
Regulation of Nondepository
Regulations are designed based on the type of liabilities they issue
Pension funds and life insurance companies
Heavily regulated because their liabilities are purchased by small investors and need to protect small investors
Employee Retirement Income Security Act (ERISA)
Regulation of Nondepository
Employee Retirement Income Security Act (ERISA)
Established the Pension Benefit Guaranty Corporation
Guarantees defined benefits pension plans, subject to a maximum amount
Establishes minimum reporting, disclosure and investment standards
Regulation of Nondepository
Life Insurance Companies Regulated at the state level Impose risk-based capital requirements
Perform periodic audits Implicit and explicit restrictions on pricing of particular products
Regulation of Nondepository
Finance companies Raise funds by issuing debt and equity
Have virtually no regulation beyond the securities laws governing publicly traded securities
Regulation of Nondepository
Mutual Funds Regulated by the SEC Also subject to state regulations
Objective is to protection of individual investors through full disclosure
The Glass-Steagall Act
Segregated the banking industry from the rest of the financial services industry
Banks are barred from owning corporate stock and other activities deemed too risky
The Genesis of Glass-Steagall Prior to 1933, investment banking and commercial banking were conducted under same roof
Following the financial collapse of the 1930s, it was felt that investment banking activities were too risky for banks
The Glass-Steagall Act
The Genesis of Glass-Steagall This combination represented a substantial threat to financial system stability
Although there was little empirical evidence to support this contention, the legislation mandated separation of the two activities
The Glass-Steagall Act
The Erosion of Glass-Steagall Commercial banks exerted pressure on the Federal Reserve and courts to reduce the barriers caused by Glass-Steagall
Bank-holding Companies Permitted banks to conduct nonbanking activities through subsidiaries
In 1970 Federal Reserve was given power to determine what activities were permissible
Activities had to be closely related to traditional banking
During the 1970s and 80s banks acquired more freedom to engage in nontraditional banking activities
The Glass-Steagall Act
The Erosion of Glass-Steagall In 1989 the Federal Reserve granted five banks the power to underwrite corporate debt through a Section 20 affiliate
Gradually the Federal Reserve granted more and more banks the right to underwrite corporate debt
The Glass-Steagall Act
The Gramm-Leach-Bliley Act (1999) Allowed affiliates of financial holding companies to engage in various banking activities and insurance underwriting
Overall responsibility for regulation lies with the Federal Reserve through its role as the “umbrella” regulator
Federal Reserve has power to ensure capital adequacy of holding companies, safety and soundness of their activities
The Glass-Steagall Act
The Gramm-Leach-Bliley Act (1999) Individual affiliates of holding companies are subject to regulation by functional supervisors such as the SEC
This regulation framework blends the disclosure-based and inspection-based approaches to regulation
The Glass-Steagall Act
The Risk of Universal Banking Risk inherent in securities activities, especially the underwriting business, may affect the stability of the banking system
Losses in securities activities lead to more bank failures and significant losses to FDIC
The Glass-Steagall Act
The Risk of Universal Banking Other view: Just because investment banking is riskier than commercial banking, this does not mean that the combination of the two will be riskier
Universal Banking
The Risk of Universal Banking The portfolio theory suggests that diversification may reduce risk when commercial banking is combined with investment banking and life insurance activities
Perhaps it is time to let the banks decide for themselves whether universal banking reduces risk