Questions
1. Regulation of Bank Sources and Uses of Funds. How are banks’ balance sheet decisions regulated?
ANSWER: Banks are required to pay a premium on deposits, and to maintain a minimum level of
2. Off-Balance Sheet Activities. Provide examples of off-balance sheet activities. Why are regulators
concerned about them?
ANSWER: Off-balance sheet commitments occur when a bank guarantees a customer payment,
3. Moral Hazard and the Credit Crisis. Explain why the moral hazard problem may have received so
much attention during the credit crisis.
ANSWER: Moral hazard was a serious problem during the credit crisis because the government was
4. FDIC Insurance. What led to the establishment of FDIC insurance?
ANSWER: During the 1930–1932 Depression period, there was a run on bank deposits, causing
5. Glass-Steagall Act. Briefly describe the Glass-Steagall Act. Then explain how the related regulations
have changed.
ANSWER: The Glass-Steagall Act (1933) separated banking and securities activities, in response to
The regulations have changed to allow banks to offer securities activities. Yet, there are still
6. DIDMCA. Describe the main provisions of the DIDMCA that relate to deregulation.
7. CAMELS Ratings. Explain how the CAMELS ratings are used.
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Chapter 18: Bank Regulation 2
ANSWER: Regulators monitor banks periodically so that if any deficiencies are detected, they may
8. Uniform Capital Requirements. Explain how the uniform capital requirements can discourage
banks from taking excessive risk.
ANSWER: The capital requirements were imposed among numerous countries so that banks from
The capital requirements are set as a percentage of a bank’s assets. However, assets are weighted
9. Value at Risk. Explain how the value at risk (VaR) method can be used to determine
whether a bank has adequate capital.
ANSWER: In general, a bank defines the VaR as the estimated potential loss from its trading
businesses that could result from adverse movements in market prices. Banks estimate the
10. HLTs. Describe highly leveraged transactions (HLTs), and explain why a bank’s exposure to HLTs is
closely monitored by regulators.
ANSWER: HLTs are loan transactions in which the borrower’s liabilities are valued at more than 75
11. Bank Underwriting. Given the higher capital requirements imposed on them, why might banks be
even more interested in underwriting corporate debt issues?
12. Moral Hazard. Explain the “moral hazard” problem as it relates to deposit insurance.
ANSWER: While deposit insurance helps to prevent bank deposit runs, it encourages banks to take
13. Economies of Scale. How do economies of scale in banking relate to the issue of interstate banking?
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Chapter 18: Bank Regulation 3
ANSWER: If banks need to maximize growth to fully achieve economies of scale, they would need to
14. Contagion Effects. How can the financial problems of one large bank affect the market’s risk
evaluation of other large banks?
ANSWER: The financial problems of one large bank can cause the public to change its risk
15. Regulating Bank Failures. Why are bank regulators more concerned about a large bank failure than
a small bank failure?
ANSWER: Large bank failures can carry indirect costs, such as a change in the public’s risk
16. Financial Services Modernization Act. Describe the Financial Services Modernization Act of 1999.
Explain how it affected commercial bank operations, and how it changed the competitive landscape
among financial institutions.
ANSWER: The Financial Services Modernization Act of 1999 allowed banks to merge with other
financial service firms such as insurance companies and securities firms. Banks can now offer a more
17. Impact of SOX on Banks. Explain how the Sarbanes-Oxley (SOX) Act improved the transparency of
banks. Why might the act have a negative impact on some banks?
ANSWER: Some of the key provisions of the SOX Act require that banks improve their internal
control process to establish a centralized database of information. They must implement a system that
18. Conversion of Securities Firms to BHCs. Explain how the conversion of securities firms
to a bank holding company (BHC) structure might reduce their risk.
ANSWER: While securities firms were allowed to borrow short-term funds from the Federal Reserve
during the credit crisis, their conversion to a bank holding company would give them permanent
19. Capital Requirements During the Credit Crisis. Explain why banks struggled to satisfy capital
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Chapter 18: Bank Regulation 4
requirements because of the accounting method applied to mortgage-backed securities.
ANSWER: Banks are required to periodically mark their assets to market in order to determine the
revised needed capital based on the reduced market value of the assets. The fair value accounting
20. Fed Rescue of Bear Stearns. Explain why regulators might argue that the assistance they provided
to Bear Stearns was necessary.
ANSWER: Bear Stearns facilitated many transactions in financial markets, and its failure would have
21. Fed Rescue of Nonbanks. Should the Fed have the power to rescue firms such as Bear Stearns that
are not commercial banks?
ANSWER: Some critics (including Paul Volcker, a previous chair of the Fed) suggested that the
22. Bank Regulation of Credit Default Swaps. Why were bank regulators concerned with credit
default swaps?
ANSWER: Regulators became concerned with credit default swaps because of the lack of
23. Impact of Bank Consolidation on Regulation. Explain how bank regulation can be more effective
when there is consolidation of banks and securities firms.
ANSWER: Some major securities firms such as Bear Stearns and Merrill Lynch were acquired by
commercial banks, while others such as Goldman Sachs and Morgan Stanley applied to become bank
24. Concerns about Systemic Risk During the Credit Crisis. Explain why the credit crisis caused
concerns about systemic risk.
ANSWER: During the crisis, many banks were failing. The financial problems of a large bank failure
25. Troubled Asset Relief Program (TARP). Explain how the Troubled Asset Relief Program was
expected to help resolve problems during the credit crisis.
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Chapter 18: Bank Regulation 5
ANSWER: During the 2008-2010 period, the Troubled Asset Relief Program (TARP) was
implemented to alleviate the financial problems experienced by banks and other financial institutions
with excessive exposure to mortgages or mortgage-backed securities. The Treasury injected more
26. Financial Reform Act. Explain how the Financial Reform Act resolved some problems during
the credit crisis.
ANSWER: In July, 2010, the Financial Reform Act (also referred to as Wall Street Reform Act or
Consumer Protection Act) was implemented. It requires that banks and other financial institutions
The Financial Reform Act created the Financial Stability Oversight Council, which is responsible for
identifying risks to financial stability in the U.S., and makes regulatory recommendations to
regulators that could reduce any risks to the financial system. The council can recommend methods to
The act mandates that commercial banks must limit their proprietary trading, whereby they pool
27. Bank Deposit Insurance Reserves. What changes to reserve requirements were added by The
Wall Street Reform and Consumer Protection Act (also called the Dodd-Frank Act) of 2010?
ANSWER: The Doo-Frank Act requires that the Deposit Insurance Fund should maintain reserves of
at least 1.35% of total insured bank deposits, to ensure that it always has sufficient reserves to cover
28. Basel III Changes to Capital and Liquidity Requirements. How did Basel III change capital
and liquidity requirements for banks?
ANSWER: Basel III recommended that banks maintain an extra layer of Tier 1 capital (called a
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Chapter 18: Bank Regulation 6
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “The FDIC recently subsidized a buyer for a failing bank, which had different effects on FDIC
costs than if the FDIC closed the bank.”
Closing a bank would have resulted in the liquidation of assets. In this case, the FDIC would use
the proceeds of liquidation to pay off depositors, and it would make up the difference. By
b. “Bank of America has pursued the acquisitions of many failed banks, because it sees potential
benefits.”
The FDIC would have to support the acquisition, so that a bank may be able to acquire the
c. “By allowing a failing bank time to resolve its financial problems, it imposes an additional tax on
taxpayers.”
An advantage is that if a failed bank resolves its problems on its own, the FDIC would not need
Managing in Financial Markets
A bank has asked you to assess various strategies it is considering, and explain how they could affect its
regulatory review. Regulatory reviews include an assessment of capital, asset quality, management,
earnings, liquidity, and sensitivity to financial market conditions. Many types of strategies can result in
more favorable regulatory reviews based on some criteria but less favorable regulatory reviews based on
other criteria. The bank is planning to issue more stock, retain more of its earnings, increase its holdings
of Treasury securities, and reduce its business loans. The bank has historically been rated favorably by
regulators, yet believes that these strategies will result in an even more favorable regulatory assessment.
a. Which regulatory criteria will be affected by the bank’s strategies? How?
b. Do you believe that the strategies planned by the bank will satisfy shareholders? Is it possible for
the bank to use strategies that would satisfy both regulators and shareholders? Explain.
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Chapter 18: Bank Regulation 7
No. The bank’s strategies reflect less risk, which may satisfy regulators but may be viewed as too
It is possible to satisfy regulators and shareholders. The shareholders recognize that the bank
c. Do you believe that the strategies planned by the bank will satisfy the bank’s managers? Explain.
Open-ended. Conservative strategies are desirable in that they may reduce the risk of failure and
increase job security. However, the strategies will likely reduce earnings, which could result in
Flow of Funds Exercise
Impact of Regulation and Deregulation on Financial Services
Carson Company relies heavily on commercial banks for funding and for some other services.
a. Explain how the services provided by a commercial bank (just the banking, not the nonbank
services) to Carson may be limited because of bank regulation.
If Carson Company issued bonds, commercial banks could not buy them unless they received an
b. Explain the types of nonbank services that Carson Company can receive from the subsidiaries of
a commercial bank as a result of recent deregulation.
c. How might Carson Company be affected by the deregulation that allows subsidiaries of a
commercial bank to offer nonbank services?
Carson Company can have virtually all of its financial services provided by one financial
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