hapter 14: Regulating the Financial System
The financial system is highly organized and complex, yet it is vulnerable to failures and crises as demonstrated in over 200 years of history. Unlike a restaurant or department store, the failure of financial institutions creates waves of panic that spread through the system and spill over to the economy as a whole. Due to the importance of the financial system and the consequences of crises, the government steps in with a substantial amount of rules and regulations along with agencies to enforce these regulations. In this chapter we look at the motivation and structure of this regulation.
Runs, Panics and Crises
Banks are particularly vulnerable due to their liquidity services: Depositors are allowed to withdraw their balances on demand. In the absence of any guarantee or insurance, the belief about a bank's insolvency will causes depositors to panic and run to the bank in an attempt to retrieve their funds before the bank fails. It is important to note that the bank may or may not be insolvent, but the belief that it is will trigger the bank run. The concerns about one institution may then spread to other banks, causing a system-wide bank panic.
The U.S. banking sytstem in the 19th and first half of the 20th centuries suffering several system-wide bank panics as shown in figure 14.2 (353).
The Government Safety Net
Your text gives 3 reasons for government intervention in the financial system:
1. To protect investors, especially small investors unable to judge the soundness of financial institutions,
2. To protect consumers from monopolies in the provision of financial services,
3. To promote the stability of the financial system.
Stability is of particular importance for the banking system. They play a central role in facilitating a payments system, one not duplicated by any other financial institution. Banks are particularly prone to panics and runs given their on-demand liabilities and their illiquid asset portfolio (mostly loans). Finally, banks are linked to one another through interbank lending in ways that other financial institutions are not.
Lender of Last Resort
One way the government can promote stability in the banking system to to act as a lender of last resort. A central bank (in the U.S., the Federal Reserve System) stands ready to make loans and provide liquidity to banks facing unexpected despositor withdrawals. This may prevent a panic, but is not foolproof, as seen in the bank panics of the Great Depression.
Deposit Insurance
As further help to promoting stability, Congress created deposit insurance through the FDIC in 1933. Today bank deposits are insurance up to $100,000. FDIC insurance has been quite successful. Prior to its creation, bank panics occurred in the U.S. about every 10- 20 years: 1819, 1837, 1857, 1873, 1884, 1893, 1907, 1930-33. Since its creation we have not seen a single national bank panic.
When a bank becomes insolvent, the FDIC can take two types of action. First, using the payoff method, the FDIC closes down the bank, pays off depositors up to the $100,000 (current) limit, and sells off the assets. Depositors over the limit often get back most of their money as well. The second alternative is the purchase and assumption method. Here the FDIC finds a healthy bank to merge or buy the failing bank, so no depositor loses anything. The FDIC will often pay off bad loans or offer subsidies to induce a merger to take place. The second alternative is more common.
Moral Hazard and the Safety Net
Despite the success of the FDIC in preventing bank panics, it's operations create some undesirable incentives:
- Moral hazard. Any insurance creates a moral hazard problem: when people are insured against losses, they lose some incentive to be careful. In this case, depositors will not watch bank activities because they know they are covered if the bank fails. Banks, knowing this, may be encouraged to take greater risks, since depositors will not get worried and withdraw their money.
- Adverse selection. Given deposit insurance and the resulting lack of oversight by depositors, the banking industry will be more likely to attract owners wanting to engage in risky or even fraudulent activities in the first place.
Regulation of the Financial System
Because of the dual banking system there are multiple regulatory agencies: The Office of the Comptroller of the Currency (1863), the Federal Reserve (1913), the FDIC (1933) and state agencies. Which agency has primary control depends on whether a bank has a federal or state charter, is part of bank holding company that owns multiple banks, or is FDIC insured. However, all regulators have some general guidelines in what they regulate.
Restrictions on Competition
The repeals of Regulation Q, the McFadden Act and Glass-Steagall have dramatically changed the competitive environment, but some restrictions still remain. Bank mergers still require approval from the appropriate regulator, and are scrutinized based on the impact a merger will have on competition and servicing smaller customers. With competition comes the incentive to take on greater risk as the profit margins in traditional banking activities are squeezed. Regulators deal with this incentive through restricting and supervising bank activities.
Asset Restrictions and Capital Requirements
One type of restriction designed to control risk-taking is restrictions on holding certain types of assets. Banks face restrictions on the quality of bonds held as well as minimum diversification requirements in lending and securities holdings.
Banks are also required to keep the ratio of capital-to-assets above some minimum level. Capital provides a safety net in case some of the banks assets fall in value, so the bank can still meet it obligations to the depositors and creditors. Given the moral hazard problems created with deposit insurance, capital requirements are one way to discourage banks from taking on too much risk. Requiring banks to hold a certain amount of capital (as a % of assets and for off-balance-sheet activities). If the bank fails, that equity capital is lost, so requiring a large amount of capital reduces the risk-taking incentives created by deposit insurance. Because of this, well-capitalized banks face less government supervision and lower deposit insurance premiums than poorly capitalized banks.
Disclosure Requirements
Stockholders, bondholders, and depositors need reliable, timely information to assess the health of a bank. Banks must file detailed financial statements with regulators, available to the public. Consumers likely have inferior information about the terms of credit and thus are at risk for fraud or deception. Several laws require full disclosure to consumers about the terms of credit. The landmark "truth in lending" legislation in 1969 requires the use of the same interest rate measure (annual percentage rate, or APR) for all lenders so terms of credit may be compared. Later legislation in the 1970s assert consumer rights in the disclosure of all finance charges and handling of complaints, and prohibit discrimination in lending.
Supervision
The government enforces all of its regulation through extensive oversight of individual banks and bank holding companies. The FDIC examiniers visit banks a least once each year to check the books, verify cash in the vault, and even check on collateral. Examiners make sure that bad loans are written off in a timely fashion so that balance sheet statements are an accurate reflection of a bank's financial health.
The proliferation of off-balance-sheet activities create other areas for bank regulators to scrutinize. While some of these activities are designed to manage the risk inherent in traditional banking activities, they also introduce new risks that can potentially destabilize the banking system.
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