Transcript Chapter 15 The Regulation of Markets and Institutions Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Chapter 15
The Regulation
of Markets and
Institutions
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Learning Objectives
• Describe the different methods of regulating
primary, secondary, and intermediated financial
markets
• Understand the United Stated dual banking
system and the array of regulators who oversee
it
• Explain universal banking and its possible
benefits and risks
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Introduction
• Financial system is one of most intensely
regulated sectors in US economy
–
–
–
–
Promote competition
Protect individual consumers
Assure stability of financial system
Facilitate monetary policy
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Regulation of Financial Markets in
the United States
• Desire to protect individual investor
• Best protection is adequate information about
securities
• Full disclosure broadens investor’s participation
in financial markets
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Regulation of Financial Markets in
the United States (Cont.)
• Regulation of the 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
– 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
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Regulation of Financial Markets in
the United States (Cont.)
• Regulation of the Primary Market (Cont.)
– Securities Exchange Act of 1934 (Cont.)
• 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—merely means
disclosure of information is adequate
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Regulation of Financial Markets in
the United States (Cont.)
• Regulation of Secondary Market
– Securities Exchange Act of 1934
• Extended 1933 Act to include periodic disclosure of relevant financial
information for firms trading in secondary market
• 10K Report—Annual financial statement and relevant information
about a firm’s performance and activity
• Insider Trading Laws
– 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
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Regulation of Financial Markets in
the United States (Cont.)
• Regulation of Secondary Market (Cont.)
– Securities Exchange Act of 1934 (Cont.)
• SEC and other regulatory agencies
– Have authority to regulate securities exchanges, OTC trading,
dealers, and brokers
– Basically rely on self-regulation by markets and firms under their
control
• Fed sets margin requirements on stocks—how much of
purchase price an investor can borrow
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Regulation of Commercial Banks in
the United States
• Protect individual depositor
• Foster a competitive banking system
• Ensure bank safety and soundness
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Regulation of Commercial Banks in
the United States (Cont.)
• U.S. Banking Regulatory Structure
– Dual banking system
• Federal and State banks existing side-by-side
• Legislation in 1860’s established federally chartered banks
under supervision of Comptroller of the Currency (US
Treasury Department)
• Intent was to drive existing state chartered banks out of
business by imposing a prohibitive tax on issuance of state
banknotes
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Regulation of Commercial Banks in
the United States (Cont.)
• U.S. Banking Regulatory Structure (Cont.)
– Dual banking system (Cont.)
• However, state banks survived due to acceptance of
demand deposits in lieu of currency
• State chartered banks are supervised by regulators in their
respective state
• Federally chartered banks tend to be larger, but state banks
are more numerous
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Regulation of Commercial Banks in
the United States (Cont.)
• U.S. Banking Regulatory Structure (Cont.)
– Federal Reserve Act of 1913
• Required national banks to become members of the Fed, while state
banks had option.
• All state banks currently fall under regulation of the Fed (member
or not)
– Federal Deposit Insurance Corporation (FDIC)
• All member banks of Fed (national and some state banks) are required
to carry FDIC insurance
• A majority of state banks not members of the Fed have opted to
participate in FDIC program
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Regulation of Commercial Banks in
the United States (Cont.)
• U.S. Banking Regulatory Structure (Cont.)
– Multiple and sometimes conflicting supervisory
authority at Federal level
– Fed, Comptroller of Currency (Department of the
Treasury), and FDIC frequently clash over
interpretation of certain laws
– Suggestion that all regulation should be combined in
a single agency, but no legislation exists to unify the
structure
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Regulation of Commercial Banks in
the United States (Cont.)
• Protecting Individual Depositors and Financial
System Stability
– Rather than relying on disclosure, thrust of bank regulation is
on bank examinations and prompt corrective action when
necessary
– The primary liabilities of a commercial bank are their
demand deposits
• Paid on a first-come/first-serve basis
• Banks must maintain sufficient liquidity to meet demand deposits
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Regulation of Commercial Banks in
the United States (Cont.)
• Protecting Individual Depositors and
Financial System Stability (Cont.)
– The primary liabilities of a commercial bank are
their demand deposits (Cont.)
• Difficult and costly for banks to sell illiquid assets
• Fear that a bank is insolvent will cause a run on the bank
or a system-wide bank panic (Figure 15.a1)
• Periodic examination of a bank by regulatory agencies
to insure banks are solvent
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Regulation of Commercial Banks in
the United States (Cont.)
• Deposit Insurance
– FDIC established by Banking Act of 1933 to insure
deposits at commercial and mutual savings banks.
– Federal Savings and Loan Insurance Corporation
(FSLIC) insured deposits in S&Ls
– Resulted from large number of bank failures in the
early 1930’s
– Intent is to protect small savers and reduce the
incentive for insured depositors to join a bank run
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Regulation of Commercial Banks in
the United States (Cont.)
• Deposit Insurance (Cont.)
– Currently insure deposits up to $100,000, but actual coverage
may be more.
– Coverage depends on procedure used by FDIC:
• Payoff method—Bank goes into receivership and FDIC pays out
funds up to $100,000
• Assumption method—FDIC merges failed bank with a healthy one
and deposits of failed bank are assumed by solvent bank
• “Too big to fail” Doctrine—FDIC may extend loans to very large
banks in trouble to allow continued operations
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Regulation of Commercial Banks in
the United States (Cont.)
• Moral Hazard and Deposit Insurance
– Existence of FDIC eliminates possibility of largescale bank failure and “run on the banks”
– Moral Hazard
• Depositors have little incentive to monitor riskiness of
their banks
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Regulation of Commercial Banks in
the United States (Cont.)
• Moral Hazard and Deposit Insurance (Cont.)
– Moral Hazard (Cont.)
• Shareholders and directors of banks have incentive to make their
banks riskier at the expense of the FDIC
• However, several factors may reduce risk taking
– Risk averse—banks are privately owned and directors are paid based on
performance
– Bank examination and other regulatory efforts
• “Too big to fail” doctrine man unintentionally exacerbate the moral
hazard problem
• Recently bank failures have increased due to banking deregulation
and commercial banking activities becoming riskier
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Regulation of Commercial Banks in
the United States (Cont.)
• Risk-Based Capital Requirements
– Bank capital provides a cushion against failure
– Banks are required to maintain a capital-asset ratio based on
a measure of the riskiness of their total assets
– Risk-based capital requirements—as a bank’s assets
become riskier regulators will force banks to increase their
capital
– These requirements are agreed upon by the United States and
members of the Bank for International Settlements (BIS)
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Regulation of Commercial Banks in
the United States (Cont.)
• Prompt Corrective Action (PCA)—FDIC
Improvement Act of 1991
– Established procedures to handle troubled banks
– Designed to close banks/thrifts 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
– FDIC established risk-based deposit insurance premium—
charge insurance premium based on the perceived risk of the
bank
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Regulation of Nondepository
Financial Intermediaries
• Depends very much 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)
• Established the Pension Benefit Guaranty Corporation
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Regulation of Nondepository
Financial Intermediaries (Cont.)
– Employee Retirement Income Security Act (ERISA)
• Guarantees defined benefits pension plans, subject to a maximum
amount
• Establishes minimum reporting, disclosure and investment standards
– Life Insurance Companies
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Regulated at the state level
Impose risk-based capital requirements
Perform periodic audits
Implicit and explicit restrictions on pricing of particular products
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Regulation of Nondepository
Financial Intermediaries (Cont.)
• Finance companies raise funds by issuing debt and
equity and have virtually no regulation beyond the
securities laws governing publicly traded securities
• Mutual Funds
– Regulated by the SEC
– Also subject to state regulations
– Motivation is protection of individual investors through full
disclosure
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The Glass-Steagall Act, A Collapsing
Barrier
• 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
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The Glass-Steagall Act, A Collapsing
Barrier (Cont.)
• The Genesis of Glass-Steagall (Cont.)
– 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
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The Glass-Steagall Act, A Collapsing
Barrier (Cont.)
• 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
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15-27
The Glass-Steagall Act, A Collapsing
Barrier (Cont.)
• The Erosion of Glass-Steagall (Cont.)
– 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
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The Glass-Steagall Act, A Collapsing
Barrier (Cont.)
• The Erosion of Glass-Steagall (Cont.)
– 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
• 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
• Federal Reserve has power to ensure capital adequacy of holding
companies and insure depository institutions are not threatened by
other activities
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The Glass-Steagall Act, A Collapsing
Barrier (Cont.)
• The Risk of Universal Banking
– The issue of risk has become a key issue in the debate over
Gramm-Leach-Bliley
– Some concern that the risk of securities activities, especially
the underwriting business, may jeopardize the stability of the
banking system
– Would bank losses in securities activities lead to more bank
failures and significant losses to FDIC
– Just because investment banking is riskier than commercial
banking, this does not mean that the combination of the two
will be riskier
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15-30
The Glass-Steagall Act, A Collapsing
Barrier (Cont.)
• The Risk of Universal Banking (Cont.)
– The portfolio theory of risk suggests that
diversification may reduce risk when commercial
banking combine with investment banking and life
insurance activities
– Perhaps it is time to let the banks decide for
themselves whether universal banking reduces risk
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TABLE 15.1 Principal Financial
Regulators in the United States
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TABLE 15.2 Status of Insured Commercial
Banks, 2007 (dollars in billions)
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TABLE 15.3 Capital Ratios—An
Example
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TABLE 15.4 Summary of Prompt Corrective Action*
(any restrictions in one category apply to all lower
categories as well)
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