economics_of_money_banking__financial_markets

PREVIEW

As we have seen in the previous chapters, the financial system is among the most heavily regulated sectors of the economy, and banks are among the most heavily regulated of financial institutions. In this chapter, we develop an economic analysis of why regulation of banking takes the form it does.

Unfortunately, the regulatory process may not always work very well, as evidenced by recent crises in the banking systems, not only in the United States but in many countries throughout the world. Here we also use our economic analysis of banking regulation to explain the worldwide crises in banking and how the regulatory system can be reformed to prevent future disasters.

Government

Safety Net:

Deposit Insurance

and the FDIC

www.ny.frb.org/Pihome /regs.html

View bank regulation information.

In earlier chapters, we have seen how asymmetric information, the fact that different parties in a financial contract do not have the same information, leads to adverse selection and moral hazard problems that have an important impact on our financial system. The concepts of asymmetric information, adverse selection, and moral hazard are especially useful in understanding why government has chosen the form of banking regulation we see in the United States and in other countries. There are eight basic categories of banking regulation: the government safety net, restrictions on bank asset holdings, capital requirements, chartering and bank examination, assessment of risk management, disclosure requirements, consumer protection, and restrictions on competition.

As we saw in Chapter 8, banks are particularly well suited to solving adverse selection and moral hazard problems because they make private loans that help avoid the free-rider problem. However, this solution to the free-rider problem creates another asymmetric information problem, because depositors lack information about the quality of these private loans. This asymmetric information problem leads to two reasons why the banking system might not function well.

First, before the FDIC started operations in 1934, a bank failure (in which a bank is unable to meet its obligations to pay its depositors and other creditors and so must go out of business) meant that depositors would have to wait to get their deposit funds until the bank was liquidated (until its assets had been turned into cash); at that time, they would be paid only a fraction of the value of their deposits. Unable to learn

Restrictions on Asset Holdings and Bank Capital Requirements

monitor the bank and pull out their deposits when it takes on too much risk: No matter what the bank does, large depositors will not suffer any losses. The result of the too-big-to-fail policy is that big banks might take on even greater risks, thereby making bank failures more likely.1

Financial Consolidation and the Government Safety Net. With financial innovation and the passage of the Riegle-Neal Interstate Banking and Branching and Efficiency Act of 1994 and the Gramm-Leach-Bliley Financial Services Modernization Act in 1999, financial consolidation has been proceeding at a rapid pace, leading to both larger and more complex banking organizations. Financial consolidation poses two challenges to banking regulation because of the existence of the government safety net. First, the increased size of banks as a result of financial consolidation increases the too-big-to- fail problem, because there will now be more large institutions whose failure exposes the financial system to systemic (system-wide) risk. Thus more banking institutions are likely to be treated as too big to fail, and the increased moral hazard incentives for these large institutions to take on greater risk can then increase the fragility of the financial system. Second, financial consolidation of banks with other financial services firms means that the government safety net may be extended to new activities such as securities underwriting, insurance, or real estate activities, thereby increasing incentives for greater risk taking in these activities that can also weaken the fabric of the financial system. Limiting the moral hazard incentives for the larger, more complex financial organizations that are resulting from recent changes in legislation will be one of the key issues facing banking regulators in the future.

As we have seen, the moral hazard associated with a government safety net encourages too much risk taking on the part of banks. Bank regulations that restrict asset holdings and bank capital requirements are directed at minimizing this moral hazard, which can cost the taxpayers dearly.

Even in the absence of a government safety net, banks still have the incentive to take on too much risk. Risky assets may provide the bank with higher earnings when they pay off; but if they do not pay off and the bank fails, depositors are left holding the bag. If depositors were able to monitor the bank easily by acquiring information on its risk-taking activities, they would immediately withdraw their deposits if the bank was taking on too much risk. To prevent such a loss of deposits, the bank would be more likely to reduce its risk-taking activities. Unfortunately, acquiring information on a bankÕs activities to learn how much risk the bank is taking can be a difficult task. Hence most depositors are incapable of imposing discipline that might prevent banks from engaging in risky activities. A strong rationale for government regulation to reduce risk taking on the part of banks therefore existed even before the establishment of federal deposit insurance.

Bank regulations that restrict banks from holding risky assets such as common stock are a direct means of making banks avoid too much risk. Bank regulations also promote diversification, which reduces risk by limiting the amount of loans in particular categories or to individual borrowers. Requirements that banks have sufficient

Bank Supervision:

Chartering and

Examination

C H A P T E R 1 1 Economic Analysis of Banking Regulation 265

bank capital are another way to change the bankÕs incentives to take on less risk. When a bank is forced to hold a large amount of equity capital, the bank has more to lose if it fails and is thus more likely to pursue less risky activities.

Bank capital requirements take two forms. The first type is based on the so-called leverage ratio, the amount of capital divided by the bankÕs total assets. To be classified as well capitalized, a bankÕs leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank. Through most of the 1980s, minimum bank capital in the United States was set solely by specifying a minimum leverage ratio.

In the wake of the Continental Illinois and savings and loans bailouts, regulators in the United States and the rest of the world have become increasingly worried about banksÕ holdings of risky assets and about the increase in banksÕ off-balance-sheet activities, activities that involve trading financial instruments and generating income from fees, which do not appear on bank balance sheets but nevertheless expose banks to risk. An agreement among banking officials from industrialized nations set up the

Basel Committee on Banking Supervision (because it meets under the auspices of the Bank for International Settlements in Basel, Switzerland), which has implemented the so-called Basel Accord on a second type of capital requirements, risk-based capital requirements. The Basel Accord, which required that banks hold as capital at least 8% of their risk-weighted assets, has been adopted by more than 100 countries, including the United States. Assets and off-balance-sheet activities were allocated into four categories, each with a different weight to reflect the degree of credit risk. The first category carries a zero weight and includes items that have little default risk, such as reserves and government securities in the OECD, Organization for Economic Cooperation and Development, (industrialized) countries. The second category has a 20% weight and includes claims on banks in OECD countries. The third category has a weight of 50% and includes municipal bonds and residential mortgages. The fourth category has the maximum weight of 100% and includes loans to consumers and corporations. Off-balance-sheet activities are treated in a similar manner by assigning a credit-equivalent percentage that converts them to on-balance-sheet items to which the appropriate risk weight applies. The 1996 Market Risk Amendment to the Accord set minimum capital requirements for risks in banksÕ trading accounts.

Over time, limitations of the Accord have become apparent, because the regulatory measure of bank risk as stipulated by the risk weights can differ substantially from the actual risk the bank faces. This has resulted in what is known as regulatory arbitrage, in which banks keep on their books assets that have the same risk-based capital requirement but are relatively risky, such as a loan to a company with a very low credit rating, while taking off their books low-risk assets, such as a loan to a company with a very high credit rating. The Basel Accord could thus lead to increased risk taking, the opposite of its intent. To address these limitations, the Basel Committee on Bank Supervision has released proposals for a new capital accord, often referred to as Basel 2, but it is not clear if it is workable or if it will be implemented (see Box 2).

The Basel CommitteeÕs work on bank capital requirements is never-ending. As the banking industry changes, the regulation of bank capital must change with it to ensure the safety and soundness of the banking institutions.

Overseeing who operates banks and how they are operated, referred to as bank supervision or more generally as prudential supervision, is an important method for reducing adverse selection and moral hazard in the banking business. Because

www.federalreserve.gov /Regulations/default.htm

Access regulatory publications of the Federal Reserve Board.

banks can be used by crooks or overambitious entrepreneurs to engage in highly speculative activities, such undesirable people would be eager to run a bank. Chartering banks is one method for preventing this adverse selection problem; through chartering, proposals for new banks are screened to prevent undesirable people from controlling them.

Regular on-site bank examinations, which allow regulators to monitor whether the bank is complying with capital requirements and restrictions on asset holdings, also function to limit moral hazard. Bank examiners give banks a so-called CAMELS rating (the acronym is based on the six areas assessed: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk). With this information about a bankÕs activities, regulators can enforce regulations by taking such formal actions as cease and desist orders to alter the bankÕs behavior or even close a bank if its CAMELS rating is sufficiently low. Actions taken to reduce moral hazard by restricting banks from taking on too much risk help reduce the adverse selection problem further, because with less opportunity for risk taking, risk-loving entrepreneurs will be less likely to be attracted to the banking industry. Note that the methods regulators use to cope with adverse selection and moral hazard have their counterparts in private financial markets (see Chapters 8 and 9). Chartering is similar to the screening of potential borrowers, regulations restricting risky asset holdings are similar to restrictive covenants that prevent borrowing firms from engaging in risky investment activities, bank capital requirements act like restrictive covenants that require

Assessment of

Risk Management

C H A P T E R 1 1 Economic Analysis of Banking Regulation 267

minimum amounts of net worth for borrowing firms, and regular bank examinations are similar to the monitoring of borrowers by lending institutions.

A commercial bank obtains a charter either from the Comptroller of the Currency (in the case of a national bank) or from a state banking authority (in the case of a state bank). To obtain a charter, the people planning to organize the bank must submit an application that shows how they plan to operate the bank. In evaluating the application, the regulatory authority looks at whether the bank is likely to be sound by examining the quality of the bankÕs intended management, the likely earnings of the bank, and the amount of the bankÕs initial capital. Before 1980, the chartering agency typically explored the issue of whether the community needed a new bank. Often a new bank charter would not be granted if existing banks in a community would be hurt by its presence. Today this anticompetitive stance (justified by the desire to prevent bank failures of existing banks) is no longer as strong in the chartering agencies.

Once a bank has been chartered, it is required to file periodic (usually quarterly) call reports that reveal the bankÕs assets and liabilities, income and dividends, ownership, foreign exchange operations, and other details. The bank is also subject to examination by the bank regulatory agencies to ascertain its financial condition at least once a year. To avoid duplication of effort, the three federal agencies work together and usually accept each otherÕs examinations. This means that, typically, national banks are examined by the Office of the Comptroller of the Currency, the state banks that are members of the Federal Reserve System are examined by the Fed, and insured nonmember state banks are examined by the FDIC.

Bank examinations are conducted by bank examiners, who sometimes make unannounced visits to the bank (so that nothing can be Òswept under the rugÓ in anticipation of their examination). The examiners study a bankÕs books to see whether it is complying with the rules and regulations that apply to its holdings of assets. If a bank is holding securities or loans that are too risky, the bank examiner can force the bank to get rid of them. If a bank examiner decides that a loan is unlikely to be repaid, the examiner can force the bank to declare the loan worthless (to write off the loan). If, after examining the bank, the examiner feels that it does not have sufficient capital or has engaged in dishonest practices, the bank can be declared a Òproblem bankÓ and will be subject to more frequent examinations.

Traditionally, on-site bank examinations have focused primarily on assessment of the quality of the bankÕs balance sheet at a point in time and whether it complies with capital requirements and restrictions on asset holdings. Although the traditional focus is important for reducing excessive risk taking by banks, it is no longer felt to be adequate in todayÕs world, in which financial innovation has produced new markets and instruments that make it easy for banks and their employees to make huge bets easily and quickly. In this new financial environment, a bank that is quite healthy at a particular point in time can be driven into insolvency extremely rapidly from trading losses, as forcefully demonstrated by the failure of Barings in 1995 (discussed in Chapter 9). Thus an examination that focuses only on a bankÕs position at a point in time may not be effective in indicating whether a bank will in fact be taking on excessive risk in the near future.

This change in the financial environment for banking institutions has resulted in a major shift in thinking about the bank supervisory process throughout the world. Bank examiners are now placing far greater emphasis on evaluating the soundness of a bankÕs management processes with regard to controlling risk. This shift in thinking

Disclosure

Requirements

was reflected in a new focus on risk management in the Federal Reserve SystemÕs 1993 guidelines to examiners on trading and derivatives activities. The focus was expanded and formalized in the Trading Activities Manual issued early in 1994, which provided bank examiners with tools to evaluate risk management systems. In late 1995, the Federal Reserve and the Comptroller of the Currency announced that they would be assessing risk management processes at the banks they supervise. Now bank examiners give a separate risk management rating from 1 to 5 that feeds into the overall management rating as part of the CAMELS system. Four elements of sound risk management are assessed to come up with the risk management rating: (1) The quality of oversight provided by the board of directors and senior management, (2) the adequacy of policies and limits for all activities that present significant risks, (3) the quality of the risk measurement and monitoring systems, and (4) the adequacy of internal controls to prevent fraud or unauthorized activities on the part of employees.

This shift toward focusing on management processes is also reflected in recent guidelines adopted by the U.S. bank regulatory authorities to deal with interest-rate risk. At one point, U.S. regulators were contemplating requiring banks to use a standard model to calculate the amount of capital a bank would need to have to allow for the interest-rate risk it bears. Because coming up with a one-size-fits-all model that would work for all banks has proved difficult, the regulatory agencies have instead decided to adopt guidelines for the management of interest-rate risk, although bank examiners will continue to consider interest-rate risk in deciding on the bankÕs capital requirements. These guidelines require the bankÕs board of directors to establish interest-rate risk limits, appoint officials of the bank to manage this risk, and monitor the bankÕs risk exposure. The guidelines also require that senior management of a bank develop formal risk management policies and procedures to ensure that the board of directorÕs risk limits are not violated and to implement internal controls to monitor interest-rate risk and compliance with the boardÕs directives.

The free-rider problem described in Chapter 8 indicates that individual depositors and other bank creditors will not have enough incentive to produce private information about the quality of a bankÕs assets. To ensure that there is better information for depositors and the marketplace, regulators can require that banks adhere to certain standard accounting principles and disclose a wide range of information that helps the market assess the quality of a bankÕs portfolio and the amount of the bankÕs exposure to risk. More public information about the risks incurred by banks and the quality of their portfolio can better enable stockholders, creditors, and depositors to evaluate and monitor banks and so act as a deterrent to excessive risk taking. This view is consistent with a position paper issued by the Eurocurrency Standing Committee of the G-10 Central Banks, which recommends that estimates of financial risk generated by firmsÕ own internal risk management systems be adapted for public disclosure purposes.2 Such information would supplement disclosures based on tra-

2See Eurocurrency Standing Committee of Central Banks of Group of Ten Countries (Fisher Group), ÒDiscussion Paper on Public Disclosure of Markets and Credit Risks by Financial Intermediaries,Ó September 1994, and a companion piece to this report, Federal Reserve Bank of New York, ÒA Discussion Paper on Public Disclosure of Risks Related to Market Activity,Ó September 1994.

Consumer

Protection

ditional accounting conventions by providing information about risk exposure and risk management that is not normally included in conventional balance sheet and income statement reports.

The existence of asymmetric information also suggests that consumers may not have enough information to protect themselves fully. Consumer protection regulation has taken several forms. First is Òtruth in lending,Ó mandated under the Consumer Protection Act of 1969, which requires all lenders, not just banks, to provide information to consumers about the cost of borrowing including a standardized interest rate (called the annual percentage rate, or APR) and the total finance charges on the loan. The Fair Credit Billing Act of 1974 requires creditors, especially credit card issuers, to provide information on the method of assessing finance charges and requires that billing complaints be handled quickly. Both of these acts are administered by the Federal Reserve System under Regulation Z.

Congress has also passed legislation to reduce discrimination in credit markets. The Equal Credit Opportunity Act of 1974 and its extension in 1976 forbid discrimination by lenders based on race, gender, marital status, age, or national origin. It is administered by the Federal Reserve under Regulation B. The Community Reinvestment Act (CRA) of 1977 was enacted to prevent Òredlining,Ó a lenderÕs refusal to lend in a particular area (marked off by a hypothetical red line on a map). The Community Reinvestment Act requires that banks show that they lend in all areas in which they take deposits, and if banks are found to be in noncompliance with the act, regulators can reject their applications for mergers, branching, or other new activities.

Restrictions on

Competition

www.fdic.gov/regulations/laws /important/index.html

Describes the most important laws that have affected banking industry in the U.S.

Study Guide

Increased competition can also increase moral hazard incentives for banks to take on more risk. Declining profitability as a result of increased competition could tip the incentives of bankers toward assuming greater risk in an effort to maintain former profit levels. Thus governments in many countries have instituted regulations to protect banks from competition. These regulations have taken two forms in the United States in the past. First were restrictions on branching, such as those described in Chapter 10, which reduced competition between banks. The second form involved preventing nonbank institutions from competing with banks by engaging in banking business, as embodied in the Glass-Steagall Act, which was repealed in 1999.

Although restricting competition propped up the health of banks, restrictions on competition also had serious disadvantages: They led to higher charges to consumers and decreased the efficiency of banking institutions, which did not have to compete as hard. Thus, although the existence of asymmetric information provided a rationale for anticompetitive regulations, it did not mean that they would be beneficial. Indeed, in recent years, the impulse of governments in industrialized countries to restrict competition has been waning. Electronic banking has raised a new set of concerns for regulators to deal with. See Box 3 for a discussion of this challenge.

Because so many laws regulating banking have been passed in the United States, it is hard to keep track of them all. As a study aid, Table 1 lists the major banking legislation in the twentieth century and its key provisions.