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1.1.1.1.1Chapter Thirteen
Regulation of Commercial Banks
1.1.1.2 I. Chapter Outline
1. Specialness and Regulation: Chapter Overview
2. Types of Regulations and the Regulators
a. Safety and Soundness Regulations
b. Monetary Policy Regulation
c. Credit Allocation Regulation
d. Consumer Protection Regulation
e. Investor Protection Regulation
f. Entry and Chartering Regulation
g. Regulators
3. Regulation of Product and Geographic Expansion
a. Product Segmentation in the U.S. Commercial Banking Industry
b. Geographic Expansion in the U.S. Commercial Banking Industry
4. Bank and Savings Institution Guarantee Funds
a. FDIC
b. The Demise of the Federal Savings and Loan Insurance Corporation (FSLIC)
c. Reform of Deposit Insurance
d. Non-U.S. Deposit Insurance Systems
5. Balance Sheet Regulations
a. Regulations on Commercial Bank Liquidity
b. Regulations on Capital Adequacy (Leverage)
c. Off-Balance-Sheet Regulations
6. Foreign Versus Domestic Regulation of Commercial Banks
a. Product Diversification Activities
b. Global or International Expansion Activities
Appendices A & B are in the text and Appendices C, D, and E are available through Connect
or your McGraw-Hill representative)
Appendix 13A: Calculating Deposit Insurance Premium Assessments
Appendix 13B: Calculating Minimum Required Reserves at U.S. Depository Institutions
Appendix 13C: Primary Regulators of Depository Institutions
Appendix 13D: Deposit Insurance Coverage for Commercial Banks in Various Countries
Appendix 13E: Calculating Risk-Based Capital Ratios
II. Learning Goals
1. Identify the types of regulations that commercial banks are subject to.
2. Review the major bank regulations that have been passed in the last 20 years.
3. Examine how commercial banks’ reentry into the investment banking business has evolved.
4. Describe how and why the scope of deposits insured by the FDIC has changed.
5. Compare regulations on U.S. commercial banks with those of other countries.
6. Understand why commercial banks are subject to reserve requirements.
7. Assess the capital regulations that commercial banks must meet.
1.1.1.3 III. Chapter in Perspective
In this chapter the major aspects of commercial bank regulations are covered. The purpose of
this chapter is to familiarize readers with the types of regulations banks must comply with, and
how these regulations affect profitability. Appendix C provides a list of various DIs and their
primary regulators and Appendix D lists deposit insurance coverage for select countries before
and after the crisis. After reviewing the primary areas of regulation, the effects of restrictions on
lines of business and geographic areas of operation are presented and the changes in these factors
being brought about by the Financial Services Modernization Act (FSMA) of 1999. The FSMA
was a landmark act that repealed many of the Glass-Steagall restrictions on banking. The history
and problems of the FDIC and the FSLIC are covered and the U.S. system is contrasted with
deposit insurance methods overseas. Appendix A demonstrates how to calculate deposit
insurance premium under the FDIC assessment method. The text provides information on
reserve requirements, risk based capital requirements and off-balance-sheet regulations.
Appendix E explains and provides numerical examples of calculating risk based capital
requirements and Appendix B contains details about calculating minimum required reserves at
U.S. depository institutions. Finally, the text compares foreign versus domestic regulations of
banks.
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Net regulatory burden Basle (Basel) Accord I, II and III
Outside money Risk adjusted assets
Inside money Total risk based capital ratio
Universal FI Tier I (core) capital ratios
Commercial banking NAFTA
Investment banking National treatment
Section 20 affiliate Cash reserves
Nonbank bank Transaction accounts
Denovo office Reserve computation period
Unit bank Weekend game
Multibank holding company (MBHC) Reserve maintenance period
Grandfathered subsidiary Lagged reserve accounting system
One-bank holding company Contemporaneous reserve accounting
system
Moral hazard Credit equivalent amount
Implicit premium Counterparty credit risk
Capital ratios Potential exposure
Prompt corrective action (PCA) Current exposure
Dodd-Frank Wall Street Consumer Protection Act Consumer Financial Protection
Agency
Regulatory Burden Financial Services Oversight Council
Federal Deposit Insurance Corporation Comptroller of the Currency
Deposit Insurance Fund (DIF) Systemic risk
Shadow Banking Credit risk adjusted assets
G-SIB
1.1.1.5
1.1.1.6 V. Teaching Notes
1. Specialness and Regulation: Chapter Overview
Banks are entrusted with a large portion of the liquid assets of households. In turn, banks
provide essential services to savers such as maturity and denomination intermediation, risk
assessment of investments and allocating funds to borrowers. Banks also play a major role in the
transmission of monetary policy and operating electronic payment mechanisms. Because of the
vital nature of the services provided by banks and the government’s deposit insurance liability,
the government is obligated to regulate this industry.
2. Types of Regulations and the Regulators
a. Safety and Soundness Regulations
Safety and soundness regulations are designed to limit the probability of failure of a DI.
Examples include:
Lending limits on the amount that can be lent to one or related borrowers. Banks cannot
lend an amount greater than 10% of their own equity capital to one company or borrower
(more if the loan is collateralized by liquid assets).
Minimum amounts of DI equity capital are required. Greater amounts of equity capital are
required if a bank invests in riskier assets.
The existence of guaranty funds such as the Deposit Insurance Fund (DIF) operated by the
FDIC. Deposit insurance premiums increase with the riskiness of the bank. Risk based
insurance premiums and capital requirements help limit moral hazard problems (see below).
Deposit insurance prevented runs on banks during the financial crisis.
Examinations and reporting requirements. DIs must file quarterly call reports and large
institutions must be examined annually. Examiners analyze the bank’s loan policy (credit
evaluation procedures) and internal control processes (among other things) to help ensure the
safety and soundness of the institution. Fraud and embezzlement have also always plagued
the banking industry, and regular examinations are required to prevent illegal activities.
These and other regulations impose a cost called the net regulatory burden upon DIs. The net
regulatory burden is the difference between the private benefit from being regulated, such as the
reduction in liability cost brought about by deposit insurance, less the private cost of adhering to
regulations, producing reports, etc.
The Dodd-Frank Act of July 2010 (or the Wall Street Reform and Consumer Protection Act)
was designed to improve the safety and soundness of the financial system and prevent another
financial crisis. The bill’s five key objectives were:
1. Promote better supervision of financial firms by creating a new Financial Services Oversight
Council chaired by the Treasury and including the heads of the primary federal regulators.
The main purpose is to give the Treasury more oversight. The Treasury now has a new office,
the Office of National Insurance, to oversee systemic risks caused by insurance companies.
The other major change is to give the Federal Reserve more authority over nonbanks that pose
systemic risks. This is giving the Fed the authority they used during the crisis.
In 2011 the Fed decided to limit net credit exposures of the nation’s six largest banks to
10% of regulatory capital. Net exposure is generally limited to 25% of regulatory capital
at other institutions. It is possible that these strict limits will have unintended
consequences such as limiting hedging at these large institutions and perhaps reducing
liquidity by limiting interbank trading.
The Fed is now seeking additional regulatory oversight of nonbank financial service
firms (so called shadow banks). Finance companies, life insurers and others are
examples. In addition, structured investment vehicles (SIVs), special purpose vehicles
(SPVs) and issuers of asset backed commercial paper (ABCP) would be included in this
list. According to the text shadow bank assets comprised $9.2 trillion in 2013. The
Dodd-Frank bill grants potential supervisory power to the Federal Reserve of these
entities and it is likely that capital requirements and risk management standards will be
imposed.
Teaching Tip: It is not apparent to me whether additional Federal Reserve oversight of these
firms is necessary or good for the economy. The motivation for regulating depository
institutions is primarily the taxpayer’s liability associated with deposit insurance. These
‘shadow’ entities do not accept insured deposits. Imposing a higher regulatory burden on
these institutions will raise the cost of credit and impose greater inefficiencies in the credit
system. Raising the cost or limiting the availability of bank credit by regulating shadow bank
financing is likely to result in slower job growth over time since small firms are primary job
creators and rely on bank credit. Presumably the argument is that these institutions may be
too interconnected to be allowed to lend in an unregulated fashion. As always, our capitalist
system will respond, perhaps by increasing the amount of unregulated private lending from
pooled investor funds.
Hedge fund and private equity advisors are required to register with the SEC. Hedge fund
practices such as selling credit default swaps without sufficient capital, alleged short selling of
leveraged instruments they helped created and other such problems indicate a need for more
oversight.
2. Improving market regulations by increasing regulation of securitization processes by requiring
more transparency, stronger regulations of credit ratings agencies and increasing the
percentage of sold loans that must be retained by originators. This section also increases
regulation of OTC derivatives and gives the Federal Reserve additional authority to oversee
the nation’s payment mechanisms. These are all welcome changes that are necessary.
Teaching Tip:
Proposed changes to credit ratings agencies probably do not go far enough. The funding
model for rating agencies is flawed since the security seller pays the rating agency. This
payment model creates a conflict of interest and may result in overly optimistic ratings. There
is a plethora of evidence that ratings change too slowly over time when negative events occur.
The proposed changes include allowing a greater number of ratings agencies to foster
competition and a reduced reliance on the ratings.
3. Establish a Consumer Financial Protection Agency (CFPA) to protect consumers from
unfair, deceptive and abusive practices and improve transparency in dealing with consumers.
A similar credit card bill effective in 2010 limits card issuer’s ability to increase interest rates
in the first year a card is obtained, limits fees and penalties for missed payments, which had
become exorbitant, and abolishes universal default penalties (prior to this, when missing a
payment on any bill, the credit card issuer could apply default rates and fees on the credit card
holder). These changes were long overdue, but they will result in less credit availability for
marginally creditworthy individuals and may result in higher credit card charges for the
general populace. This may reduce consumer spending and perhaps result in slower economic
growth. Credit card charge-off rates are traditionally high and were very high during and after
the crisis. Nevertheless there are only a few credit card issuers and this creates the possibility
of a less than fully competitive market so an argument for regulation can be made.
Teaching Tip: The CFPA is hated by the industry, but while undoubtedly the majority of
transactions with individual consumers are above board, some of the larger banks have
acquired a reputation of not treating individual customers very well. Particularly the
treatment of less financially astute customers has not always been very good. The individual’s
recourse to correct billing errors and make reasonable accommodations for workouts has been
very poor. For instance bank fees for bounced checks are extremely high. Such practices
have encouraged some lower income individuals to pay very high interest rates at payday
lenders to avoid these type fees. The danger is that the CFPA may institute lending
requirements that will require offering credit to people who may not be able to repay, thus
potentially creating a situation similar to the subprime mortgage market bubble that helped
fuel the financial crisis.
4. Establish new methods to resolve problems in non-banks that may present systemic risks and
improve the Fed’s accountability in its emergency lending facilities.
5. Increase international regulatory standards and cooperation, primarily by increasing capital
requirements at U.S. and non-U.S. banks. In June 2011, regulators eliminated a 2007 rule that
allowed large banks to use internal models to calculate how much capital they must hold.1
Under Basel II, banks with $250 billion or more in assets might have been able to have lower
capital ratios than smaller banks. The Collins Amendment now requires large banks to
calculate their capital requirements using the rules for small banks and the Basel II
calculations where their capital requirement is the larger of the two measures. Banks argued
against the rule claiming that higher capital requirements will hurt U.S. growth. A BIS study
indicates that since funding with capital is more expensive, loan spreads may increase with
greater capital requirements.2 However, their models reveal only a modest reduction in
resulting growth. The study finds that the most likely impact is a 1% increase in the required
ratio of tangible common equity to risk weighted assets results in a maximum reduction in
annual growth of 0.04% over a four and one half year period. The researchers note that there
is uncertainty in their estimates.
Three years after its passage in 2010, the massive 2,319 page Dodd-Frank bill is about 1/3
implemented. About 60% of the law’s implementation deadlines have been missed.
b. Monetary Policy Regulation
The central bank directly controls only outside money (money outside the banks such as
currency and coins in circulation) but the majority of the money supply is inside money (bank
deposits). Many governments require banks to back deposits with reserves held at the central
bank or other government authority. In the U.S. the Fed requires banks to hold reserves at the
Fed, and can manipulate both the level of required reserves and the price of holding excess
reserves by manipulating interest rates (see Chapter 4).
c. Credit Allocation Regulation
Credit allocation regulations are designed to channel funds to what are deemed socially
deserving areas such as housing, farming or lending in economically disadvantaged areas. These
laws and regulations may require DIs to lend minimum amounts in one area or to provide loans
at subsidized rates. Examples include the Qualified Thrift Lender Test (for more on the QTL
Test see Chapter 14) and the Community Reinvestment Act (CRA) of 1977. In 1995 CRA
regulations were revised to make the objectives more measurable and to reduce the regulatory
burden imposed by the law. Revised rules focus on three measures:
1. Lending:
a. Geographic and demographic distribution of lending. The object is to prevent
redlining and similar discriminatory practices as well as to encourage lending to
disadvantaged groups.
b. Extent of community development lending. Encourages banks to lend to startups
1 U.S. Approves Minimum Capital Standards for Big Banks, Alan Zibel, Wall Street Journal
Online, June 14, 2011
2 Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity
Requirements, Macroeconomic Assessment Group, Financial Stability board and the Basel
Committee on Banking Supervision, Bank for International Settlements, August 2010
and engage in loans to micro businesses.
c. Use of innovative or flexible lending practices to assist low or moderate income
individuals.
2. Investment: The institution’s involvement with qualified programs that assist certain
people or areas. An example may include funding for public service organizations that
invest in disadvantaged areas.
3. Service: The extent to which the institution provides banking services to the community
and their willingness to accommodate to area needs.
CRA ratings range from outstanding to substantial noncompliance. Poor ratings can affect
regulatory approval of proposed mergers and other related activities. A bank’s CRA rating must
be made publicly available; most banks of any size put together a brochure outlining their
community involvement.
Teaching Tip:
It is an open question how much the unintended consequences of the CRA (and the regulatory
mindset that goes with it) contributed to the financial crisis. The CRA has been around for a long
time so ipso facto it could not have been the cause by itself. However, the mindset that banks
should grant credit to those who may not be a good credit risk can have negative consequences
for the economy if practiced extensively. The housing crisis occurred for other reasons as well,
including speculative increases in home prices fueled by easy credit.
d. Consumer Protection Regulation
The CRA and the Home Mortgage Disclosure Act (1975) are both designed to prevent
discrimination in the granting of credit. Lenders must fill out a standard form for each loan
stating why a loan application was accepted or denied. Bankers have complained that
government requirements result in excessive, costly documentation.
e. Investor Protection Regulation
The Securities Acts of 1933 and 1934 are the two primary pieces of legislation that form the
basis of investor protection. The 1933 act created strict disclosure requirements for primary
public offerings. The 1934 act established the SEC and its right to regulate secondary markets.
Teaching Tip: Other major acts include the Investment Company Act of 1940, the Investment
Advisor’s Act of 1940, and ERISA in 1974. The Investment Company Act of 1940 (as amended
in 1970) requires that mutual funds and closed-end funds meet disclosure requirements
similar to new issues. This law also requires funds to publish and adhere to a clear statement of
goals (which may not be changed without shareholders' consent) and other anti-fraud procedures.
The Investment Advisors Act of 1940 requires that anyone who sells advice about securities or
investments register with the SEC. Information such as criminal record, age, experience,
education must be disclosed. The SEC does not deny anyone the right to sell unless they have a
criminal record.
f. Entry and Chartering Regulation
Market entry is regulated. For instance, national bank charters are granted by the Office of the
Comptroller of the Currency (OCC). A given charter also limits the activity of the entity.
Controlled entry into an industry creates a potential competitive barrier that may allow banks to
enjoy higher profitability.
g. Regulators
The U.S. tends to have more regulatory overlap than other countries. A state chartered insured
bank that is a member of the Federal Reserve System may technically be regulated by the Fed,
the FDIC, and a state banking commission.
Teaching Tip: In reality due to resource constraints a more rational system is used. The
Comptroller of the Currency has the primary examination responsibility for national banks. The
FDIC may defer to the Fed on state chartered Fed member banks and the FDIC will concentrate
more on state banks that are not members of the Fed.
Appendix 13C: Primary Regulators of Commercial Banks (available on Connect or from
your McGraw-Hill representative)
Text Appendix 13C lists types of institutions and their regulators. Some institutions can have up
to four regulators, although most have three. Note that only Edge Act corporations have only
one regulator.
Teaching Tip: What does the existence of multiple regulators imply about the quality of
supervision? Have banks ever pushed hard for consolidation of the regulatory agencies? What
does this imply? A good argument can be made that we don’t really need all the additional
regulations of the new act; we simply need better enforcement of the existing regulations.
Without proper enforcement no new regulations will be successful at preventing another crisis.
In any case it seems very unlikely that any set of regulations will prevent another crisis from
occurring.
