Regulating the Banking

System
Banks provide important economic functions
Access to the payments system
Reduction of asymmetric information problems
Liquidity transformation

BUT, the structure of banks assets and

liabilities that provides liquidity
transformation makes banks prone to runs
Furthermore, interconnectedness and common
exposure of banks can cause a bank run to
spread into a full-blown financial crisis

Regulating the Banking

System
Government safety net reduces likelihood
of bank runs
Deposit insurance
Lender of last resort

BUT, government safety net creates

moral hazard for banks
Incentives for excessive risk-taking (banks
reap gains, government/taxpayers bear
losses)
Too-big-to-fail

Regulating the Banking

System
What is the objective of financial regulation?
Mitigate the asymmetric information problems and excessive risktaking in the financial system
Incentives for excessive risk-taking result from limited liability, and
are amplified by the government safety net

Forms of regulation:

Restrictions on asset holdings

Capital requirements
Prompt corrective action
Supervision: Chartering, examination, risk assessment
Disclosure requirements
Consumer protection
Restrictions on competition

Restrictions on Asset
Holdings
Cannot hold common stock
Bonds must be investment-grade
Bonds from a single issuer cannot exceed
25% of capital
Loans to another bank cannot exceed
25% of capital

Capital Requirements
Leverage ratio
Capital/total assets must be >5% to be considered well-capitalized
Banks with lower leverage ratios are subject to increased regulatory
restrictions

Why set capital requirements?

Basel Accords: Risk-weighted capital requirements
International agreement on capital requirements
Capital should exceed to 8% of risk-weighted assets

Reserves and OECD sovereign debt: 0%

Bank debt from OECD countries banks: 20%
Muni bonds and residential mortgages: 50%
Consumer and corporate loans: 100%

Off-balance sheet activities are converted using a credit-equivalent

percentage and included in the computation of risk-weighted assets

Capital Requirements
Basel III
Updated risk weights
Absolute (not risk-weighted) minimum leverage ratio
Why?

Restrictions on dividends and bonuses when bank gets too

close to the minimum leverage ratio
Why?

Countercyclical capital buffer: higher minimum leverage

ratio in good times, lower in bad times
Why?

Systemic capital surcharge: higher minimum leverage ratio

for systemically important financial institutions (SIFIs)
Why?

Financial Supervision
Chartering
With Comptroller of the Currency (national banks)
With state banking authority (state banks)
Review initial capital, management quality, likely earnings,
etc to determine whether bank will be sound

Examination
Regular onsite inspections by regulators
Capital adequacy, Asset quality, Management, Earnings,
Liquidity, Sensitivity to market risk (CAMELS)

Assessment of Risk Management

Assess internal oversight and policies for risk management
Stress tests
Value at risk

Regulatory Capture
Refers to potential for regulators become
co-opted by the entities or industries
they are supposed to regulate
Work to advance the commercial/political
interests of the industry, rather than the
public interest
Difficult to avoid, because former bank
executives are often the only ones with
expertise to be effective regulators

Regulatory Capture
In October of 2010, Judge George Painter (83)
retired as 1 of two acting judges at the CFTC
(Commodity Futures Trading Commission). As part
of his retirement, he asked that his pending cases
not be turned over to the only other CFTC judge,
the honorable Bruce Levine.
Painter said, in a written statement,
"On Judge Levine's first week on the job, nearly twenty
years ago, he came into my office and stated that he
had promised Wendy Gramm, then Chairwoman of
the Commission, that we would never rule in a
complainant's favorA review of his rulings [over
nearly 20 years]will confirm that he fulfilled his vow."

Regulatory Capture
Wendy Gramm (was chair of the CFTC under
George Bush)
Shortly after President Bill Clinton took office in
1993, and Gramm was set to lose her
chairmanship, she pushed through a rule
deregulating the trading of energy contracts.
Enron had been lobbying for exemption from
regulation for months.
Six days later she resigned. Five weeks later
she was on the board at Enron and served on
its Audit Committee
After the Enron Scandal (executives agreed to
a $168 million settlement, of which $155
million was paid by insurance)
She currently sits on several boards (of large,
well-known firms) and is a distinguished senior
scholar at the Mercatus Center a think tank
at George Mason University.
She has discussed running for president.

Dodd-Frank Act (2010)

Dodd-Frank Wall Street Reform and
Consumer Protection Act
Single biggest overhaul of financial system
since 1930s
800-page monster
Proposed by Barney Frank (D) and Chris Dodd
(D) using a series of proposals crafted by the
Obama administration

Dodd-Frank Act (2010)

The stated aim of the legislation:
To promote the financial stability of the
United States by improving accountability
and transparency in the financial system,
to end "too big to fail", to protect the
American taxpayer by ending bailouts, to
protect consumers from abusive financial
services practices, and for other
purposes.
The Dodd-Frank Act has 16 different
provisional headings.

Dodd-Frank Act (2010)

Major components of the original proposals:
1. The consolidation of regulatory agencies, elimination of the national thrift
charter, and new oversight council to evaluate systemic risk;
2. Comprehensive regulation of financial markets, including increased
transparency of derivatives (bringing them ontoexchanges);
3. Consumer protection reforms including a new consumer protection agency
and uniform standards for "plain vanilla" products as well as strengthened
investor protection;
4. Tools for financial crises, including a "resolution regime" complementing
the existingFederal Deposit Insurance Corporation(FDIC) authority to
allow for orderly winding down of bankrupt firms, and including a proposal
that the Federal Reserve (the "Fed") receive authorization from the
Treasury for extensions of credit in "unusual or exigent circumstances";
5. Various measures aimed at increasing international standards and
cooperation including proposals related to improved accounting and
tightened regulation ofcredit rating agencies.

Dodd-Frank Act (2010)

Volcker Rule
Essentially a reestablishment and
clarification of the original
separation between commercial and
investment banks (Glass-Steagal)
Effectively bans proprietary-trading
(prop-trading)
by commercial banks using
deposited funds.

Why is this a good idea?

Why is this a bad idea?

Dodd-Frank Act:
Successes?
These are widely contested and debated. Why might each of
these help? Why might it hurt or be ineffective?
1.Improved systemic risk management. DF creates a new
committee, the Financial Stability Oversight Council
Chaired by the Secretary of Treasury
Voting members consist of heads of the Treasury, Federal
Reserve, OCC, SEC, CFTC, FDIC, FHFA, NCUA, and the Bureau
of Consumer Financial Protection (another new committee) as
well as an independent member with insurance expertise
appointed by the President and confirmed by the Senate
There are several non-voting members as well.
The council has the ability to directly intervene in institutions
that are termed Systemically Important Financial Institutions
(SIFIs)

Dodd-Frank Act:
Successes?
2.Volcker Rule and skin-in-the-game provisions
requiring issuers to maintain partial ownership of
financial instruments.
3.Reducing TBTF through tighter FDIC restrictions and
restrictions on federal loans to nonbank institutions.
4.Creating the Consumer Financial Protection Bureau to
protect consumers from unscrupulous business
practices
5.The Whistleblower provision reporting security
violations entitles the whistleblower to a financial
reward.
6.The construction of clearinghouses (of sorts) and public
exchanges for derivatives to increase transparency.

Dodd-Frank Act: Failures?

These are also widely contested and debated.
1.Fails to address the overlapping and confusing mess of
regulator responsibilities.
2.The implicit insurance of FDIC and SIFI-status continues
to encourage moral hazard and does not end TBTF.
3.GSEs are still a question mark. Governing these quasigovernment, quasi-private entities is still a mystery.
4.DF says very little about MMMFs (remember Lehman
and Reserve Primary Fund)
5.Legislative and regulatory uncertainty continue to
curtail progress.

Final Thoughts
Will DF ultimately be successful? What
is success in this context?
Should banking regulation focus on
limiting behavior, or modifying
incentives? Why?
Economic roles of banks:
What makes banks prone to runs?
Is this financial structure for banks, and all of
the problems it creates, really necessary?
Which of the economic roles of banks requires this
structure?
Do we still need banks to preform this role?