Chapter Nine Government’s Role in Banking. Copyright © Houghton Mifflin Company. All rights...

Chapter Nine

Government’s Role in Banking

Copyright © Houghton Mifflin Company. All rights reserved. 9 | 2

• Banking is one of the most heavily regulated industries in the U.S

• An efficient payments system and circulation of money are essential to economic growth

• Like all regulation, bank regulation does not come without costs

Regulation of Banks


• To reduce the externalities caused by bank problems

• To keep banks small

• To prevent bank runs

• To ensure that payments flow through the banking system efficiently

• To stabilize the money supply

Why Does the Government Regulate Banks?


The government• Supervises banks to reduce externalities

• Restricts mergers and bank activities to keep banks small

• Provides a federal safety net to prevent bank runs

• Offers services to ensure efficient payments

• Requires banks to hold reserves to control the money supply

Achieving the Goals of Regulation


• Bank failures cause more problems than typical business failures as they harm a wider range of people

• Any activity banks engage in is subject to government regulation, costing both time and resources

• Approximately 13% of banks’ total cost of doing business is compliance with regulations

Bank Supervision


• Lawmakers attributed bank failures during the Great Depression to too much inter-bank competition

• The Glass-Steagall Act (1933) prohibits banks from participating in the securities industry and owning commercial firms

• Arguments of excessive monopoly power versus economies of scope

• The Gramm-Leach-Bliley Act (1999) allows banks to invest, sell insurance, and own commercial firms, but only those related to banking, securities, and insurance

Restricting Mergers


• Deposit insurance is provided through the Federal Deposit Insurance Corporation (FDIC)

• The Fed serves as a lender of last resort, guaranteeing funds to member banks in need

• Both policies result in asymmetric information problems, compensated for by supervision

• The government will not allow some banks to go bankrupt under the too-big-to-fail policy

Providing a Federal Safety Net


When a bank fails, the FDIC must decide what to do with the bank’s assets and how to pay off creditors & depositors. It may

1. Pay off (insured depositors, then creditors)

2. Purchase and assumption (sell the bank and its assets, and FDIC assumes debts)

3. Assistance (keep the bank open and loan funds to survive)

When Banks Close


Except for a brief period during the 80s (due to the S&L crisis), bank failures have become very rare

When Banks Close (cont’d)


• Payment clearing services provided by the Fed to commercial banks

• The Fed allows daylight overdrafts, allowing banks more flexibility

Ensuring Efficient Payments


• The government can effect flows of money though the banking system by requiring banks to hold a certain amount of reserves

• Banks prefer to use these funds to make additional loans or investments, thus imposing a large opportunity cost

Controlling the Money Supply


• The U.S. has a dual banking system, meaning banks can choose whether to be chartered at the federal or state level

• National banks must be members of the Federal Reserve system and be FDIC insured, and so are subject to federal supervision

• State banks are FDIC insured, but may choose not to be members of the Fed system. They are supervised only by the FDIC and their state banking department

Supervisors & Supervision


Supervision differs between national and state banks

Supervisors & Supervision (cont’d)


• Banking supervisors use the CAMELS rating system to assess a bank’s health

• Components of the CAMELS system– Capital adequacy– Asset quality– Management– Earnings– Liquidity– Sensitivity to risk

Rating Banks


• The only objective component of the CAMELS rating system

• Supervisors want banks to have a lot of equity capital so they have a stronger stake in good performance

• Total risk-adjusted assets (TRAA) are a measure of a bank’s exposure to risk, based on four categories of risk among the bank’s assets

Capital Adequacy


• To determine adequate capital, two levels of capital must be considered– Tier 1 capital- stockholder equity capital– Tier 2 capital- the bank’s loan loss reserves +

subordinated debt

Total Capital = Tier 1 capital + Tier 2 capital

• A bank is adequately capitalized when Tier 1 capital > 0.04 x TRAA and total capital > 0.08 x TRAA

• A bank is well capitalized when Tier 1 capital > 0.08 x TRAA and total capital > 0.10 TRAA

Capital Adequacy (cont’d)


• In evaluating bank mergers, lawmakers consider– The effect of the merger on competition– The adequacy of the financial and managerial resources

of the new bank– The ability of the bank to meet the convenience and

needs of the community– Whether the banks provided complete information about

the transaction to banking authorities

Evaluating Bank Mergers


Evaluating Bank Mergers (cont’d)

• Banking authorities use the Herfindahl-Hirschman index (HHI)

• The HHI measures the amount of competition in a banking market

• If HHI becomes >1,800 and/or the change in the HHI > 200

• Mergers are also denied if the new bank would hold more than 10% of the nation’s deposits

2 2 21 2 ... NHHI s s s

Chapter Nine Government’s Role in Banking. Copyright © Houghton Mifflin Company. All rights...

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