Chapter 18

Financial Regulation

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Chapter Preview

─ One topic in the chapter:─ Asymmetric Information and Financial Regulation

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Asymmetric Information and Financial Regulation

• Asymmetric information, resulting in moral hazard and adverse selection, explain the regulatory environment in banking.

• The 10 basic categories of bank regulation (see the numbers in slide headers), which we will examine from an asymmetric information perspective: 1. Government Safety Net2. Restrictions on Asset Holdings 3. Capital Requirements4. Prompt Corrective Action5. Financial Supervision: Chartering and Examination6. Risk Management Assessment 7. Disclosure Requirements8. Consumer Protection9. Restrictions on Competition10.Macroprudential Supervision

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1. Asymmetric Information:Bank Panics and the Need for Deposit Insurance

• Prior to FDIC insurance, bank failures meant depositors lost money. “Good” banks need to separate themselves from “bad”banks, but investors cannot tell the difference.

• The inability of depositors to assess the quality of a bank’s assets can lead to panics.─ Bank panics did occur prior to the FDIC, with major panics in

1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930–1933.• A form of safety net is deposit insurance provided by FDIC,

CDIC.─ With a safety net, depositors will not flee the banking system

at the first sign of trouble. Indeed, between 1934 and 1981, fewer than 15 banks failed each year.

─ Canada had just one bank failure during the 1920-30, while the US had 10,000. Deposit insurance in Canada was barely used (since 1967). Canada had just two bank failures (in 1985) and several trust failures (1990s).

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Insurance PremiumsFDIC (since 1992) and CDIC (since 1999) charge banks risk-adjusted premiums, rather than flat premiums (such as 16.7bp per $ of deposits).

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Deposit Insurance• The FDIC handles failed banks in one of two ways:

the payoff method and the purchase and assumption method.

• The payoff method: the bank is allowed to fail, and depositors are paid up to the insurance limit (US$250K) from the Deposit Insurance Fund made of the insurance premiums. Then the bank is liquidated, its assets are sold, and the proceeds are distributed among creditors. Depositors whose accounts had more than $250K are paid a “haircut” less than the value of deposits above $250K (typically, 10% less).

• The purchase and assumption method: the FDIC reorganizes the bank and finds an acquirer to buy it, sometimes offering subsidized loans or other preferences to it. The acquirer takes the assets and assumes the liabilities of the failing bank. That is, depositors’ accounts do not suffer any losses and are simply transferred to the new bank.

• In both methods, amounts above the insurance limit are effectively guaranteed by the FDIC.

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Asymmetric Information and Financial Regulation

• The FDIC insurance creates moral hazard incentives for banks to take on greater risk and investors’ disincentives to monitor the banks.

• The FDIC insurance creates adverse selection. ─ Those who can take advantage of (abuse) the insurance are

mostly likely to find banks attractive.• Regulators are reluctant to let the largest banks fail because

of the potential impact on the entire system. This is known as the “Too Big to Fail” doctrine. It increases the moral hazard problem.─ This Too Big to Fail term first appeared in 1984 when the 7th

largest bank Continental Illinois failed but was bailed out by FIDC. All deposits were protected, but so were the bondholders! - Even creditors may not be interested in a bank’s health!

─ The too-big-to-fail problem increases because of US bank mergers, and commercial banks now engage in more than just banking, effectively making FDIC cover such activities as underwriting.

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Global: The Spread of DepositInsurance throughout the World

• Up to the 1960s, only six countries had deposit insurance. The International Association of Deposit Insurers formed in 2002 has 67 countries in 2013.

• Has this spread of insurance been a good thing? Did it improve the performance of the financial system and prevent crises?

• The answer appears to be “no”.• Explicit government insurance is associated with less bank

sector stability and higher bank crises because of ineffective laws, regulation, high corruption, and poor financial disclosure in those countries. Indeed, for emerging markets, deposit insurance may be the wrong medicine!

─ Implicit insurance—government bailout of troubled FIs—is available in some countries where no explicit deposit insurance organization exists.─ The costs of rescuing banks has reached 40%-50% of GDP (Table

18.2).

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2. Restrictions on Asset Holdings

─ To reduce the moral hazard of banks making too risky investments, banking regulations limit the type of assets banks may hold. ─ For instance, banks may not hold common equity, are

limited in their derivative dealing (since 2010), cannot make too big loans to a single individual.

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3. Bank Capital Requirements

• Since the Basel I accord (1988), banks are subject to capital requirements. They are required to hold a certain minimum level of capital.

• There are several Capital/Assets ratios the bank has to exceed (several – because there are different definitions of Capital, see the next slide). – The Assets amount in the denominator depends on the

type of assets that the bank holds and is calculated as the risk-weighted assets and off-balance sheet activities (details follow).

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Capital adequacy regulation (continued)

• Capital here is related to but different from the accounting concept of shareholders' equity. Basel III (2010, implementation extended to 2019 and further) distinguishes between:

– Common Equity Tier I (CET1) capital = the book value of common equity + retained earnings - goodwill

– Additional Tier I capital includes noncumulative perpetual preferred stock and perpetual items

• Tier I capital = Common Equity Tier I + Additional Tier I

– Tier II capital includes subordinated debt longer than five years, cumulative perpetual and finite lived preferred stock, allowance for loan and lease losses (max 1.25% of risk weighted assets), and some other exceptions that may be allowed by the regulators

• Total capital = Tier I capital +Tier II capital

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Capital Adequacy Ratios

• Five capital ratios and requirements are employed to determine capital adequacy.

• CET1 ratio = CET1 / Credit risk-adjusted assets• Tier I ratio = Tier I / Credit risk-adjusted assets• Total Capital ratio = Total capital / Credit risk-

adjusted assets• Capital Ratio = Total capital / (Total Assets + Off

Balance Sheet Exposure)o Note: the textbook sometimes calls this the Leverage

Ratio. This is confusing because, normally, what we know as leverage is Debt/Assets.

• Additional directives on the level of capital required by regulators

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Example. Calculating Capital Requirements

First National Bank Assets Liabilities

Reserves $5 m Checkable deposits $20 m Treasury securities $10 m Nontransaction deposits $60 m Government agency securities

$7 m Borrowings $13 m

Municipal bonds $10 m Residential mortgages $10 m Bank capital $7 m Real estate loans $20 m C&I loans $35 m Allowance for loan losses -$2 m

Fixed assets $5 m

• Capital Ratio = Capital/Assets = $7m/$100m = 7%• For a bank to be considered “well capitalized”, its Capital ratio

should be > 5%, and the other ratios also have to be greater than their minimum requirements.

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Credit Risk-Adjusted Assets• Credit risk-adjusted assets is the sum of on- and off-

balance-sheet assets, whose values are adjusted for approximate credit risk.• Each risk category is given a different weight in the sum.• Cash or government securities/bonds have the lowest weight.

• Standardized weights (based on our balance sheet example):

0 × $3 million (Reserves) +0 × $10 million (Treasury securities)

+ .20 × $7 million (Agency securities and claims on banks) + .50 × $10 million (Municipal bonds) + .50 × $10 million (Residential mortgages) +1.00 × $20 million (Real estate loans) +1.00 × $35 million (Commercial loans)

+1.00 × $5 million (Fixed assets) +1.00 × $0 million (Letters of credit)

$71.4 million (Total risk-adjusted assets) Weights reference tool: http://www.usbasel3.com/tool/

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Example (cont’d). Calculating Risk-Adjusted Requirements

• Tier I Capital Ratio Requirement– Assuming all Capital on the balance sheet is just Tier I

capital,Tier I capital / risk-adjusted assets = $7m / $71.4m = 9.8%

• Total Capital Ratio Requirement– Total capital = Tier I + Tier II – Tier II capital here includes only the allowance for loan

losses, which is $2m on the balance sheet. However, it cannot exceed 1.25% of risk-adjusted assets, which is $71.4m * 0.0125 = $0.8925m.

– Thus, Total capital = Tier I + Tier II = $7m + $.8925m =$7.8925m

– Total Capital Ratio = $7.8925m / $71.4m = 11.05%

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Basel III Bank Classifications based on Capital Ratios (to be fully implemented by 2019)

Our sample bank would be classified as a well-capitalized bank.

Capital

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4. Prompt Corrective Action

• An undercapitalized bank is more likely to fail and more likely to engage in risky activities. The FDIC Improvement Act of 1991 requires the FDIC to act quickly to avoid losses to the FDIC.

• A critically undercapitalized bank will be placed into receivership even before its capital ratio is 0%.

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Summary of Prompt Corrective Actions

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5. Financial Supervision: Chartering and Examination

• The entry of commercial banks (whether a bank is granted a charter) is regulated. The permissible activities of commercial banks are defined by regulators.─ Reduces the adverse selection problem related to risk-

takers or crooks owning banks.─ In Canada, the Bank Act (updated every 5 years) defines entry

requirements and the scope of activities permitted for banks.

• Periodic examinations assign a CAMELS rating (next slide) to US banks.─ If the CAMELS rating is low, the bank can be declared a

“problem bank” and subject to more frequent examinations or even closed.

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CAMELS Ratings• CAMELS ratings rely heavily on financial statement data• Capital adequacy

Risk-based capital ratio requirements are now used. • Asset quality

Banks are required to classify assets according to soundness and to allocate loss reserves based on their evaluation of the quality of their assets.

• Management qualityThe technical competence of management, their history of compliance, adequacy of internal controls, and compensation

• Earnings qualityStability and growth rate of earnings, peer group comparisons of profitability and interest rate risk exposure

• LiquidityTurnover rates of the bank’s sources of funds, the volume of liquid assets held by the bank, access to sources of funds

• Sensitivity to market riskExposure of earnings and capital to changes in interest rates, foreign exchange rates, and commodity or equity prices

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6. Assessment of Risk Management

• Past examinations focused primarily on the quality of assets. A new trend has been to focus on risk management and control, including– Quality of board and senior management oversight– Adequacy of policies limiting risk activity– Quality of risk measurement and monitoring– Adequacy of internal controls to prevent fraud

─ Regulators have also adopted similar-minded guidelines for dealing with interest-rate risk. Particularly important is the implementation of stress testing, or VAR (value at risk) calculations, to measure the amount of potential losses for a given probability of losses.

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7. Disclosure Requirements

─ Better information reduces both moral hazard and adverse selection problems

─ Sarbanes-Oxley increased requirements for accurate accounting statements

─ Mark-to-market accounting may help, if asset values can be determined correctly ─ Problems: 1) a bank may appear undercapitalized when

asset prices are not accurate, as during the financial crisis (mortgage assets were overvalued before the crisis, then undervalued during the crisis). 2) too much variability in earnings and asset values

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8. Consumer Protection

• Protects investors against unfair treatment such as insider trading, lack of disclosure, and breach of fiduciary responsibility

─ For example,─ Requires banks to report standardized interest rates (APR)

on loans and deposits─ Prevents discrimination (e.g., to help avoid redlining

particular areas/neighborhoods)─ Protect consumers against themselves: the “NINJA”

mortgage loan was issued to borrowers with No Income, No Job, and No Assets, who then defaulted.

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9. Restrictions on Competition• Geographical branching restrictions, which reduced competition

between banks.• Separation of banking and securities industries (particularly,

investment banks): Glass-Steagall Act (1933). It prevented nonbanks from competing with banks. (It also created the FDIC).

• Reduced competition can lead to higher fees and less innovation.

• By 1987 commercial banks were allowed to engage in limited investment banking activity through Section 20 affiliates. Example: Citigroup (holding company) includes Citibank and Smith Barney.

• The Glass-Steagall Act was repealed in 1999, allowing investment banking and commercial banking within the same FI. Further, bank holding companies can open insurance underwriting affiliates, and insurance companies can open banks.– Banks then engaged in high-risk securities trading,

exacerbating the losses during the financial crisis.– Volcker Rule (part of the Dodd-Frank act of 2010): Limits

proprietary trading by commercial banks, prohibit them from investing in hedge funds or PE funds.

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Separation of Banking and Other Financial Service Industries

• Separation in various countries1. Universal banking: Germany

• No separation of banking and underwriting, insurance, real estate, etc.

2. British-style universal banking• Underwriting is OK, but there is more legal separation

of subsidiaries, no equity stakes in firms, insurance is uncommon

3. Japan• Banks are allowed to hold equity in firms, but BHCs are

illegal. Leaning toward the British system

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10.Macroprudential regulation

Macroprudential vs. microprudential regulation─ Micro regulation focuses on individual banks─ Macro regulation looks at the banking system as a whole

─ E.g., to avoid booms and busts in lending ─ The financial crisis showed the micro regulation is

insufficient.