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Chapter 14 – Regulating the Financial System

Chapter 14

Regulating the Financial System

Chapter Overview

In this chapter the sources and consequences of financial fragility are examined, with the

emphasis on banking crises. Next, the chapter looks at the institutional safeguards, like deposit

insurance, that the government has built into the system in an attempt to avert financial crises.

Finally, the regulatory and supervisory environment of the banking system is examined.

Learning Objectives: Establish an understanding of:

1. Banking runs, panics, and crises

2. Government safety net

3. Regulation and supervision

Important Points of the Chapter

Banking crises are not a new phenomena; the history of commercial banking over the last two

centuries is replete with period of turmoil and failure. By their very nature, financial systems are

fragile and vulnerable to crisis. When financial crises occur, governments step in and put

financial intermediaries back on track. They often do so by assuming responsibility for the

banking system’s liabilities, so that depositors won’t lose their savings. But the clean up can also

require the injection of capital into failed institutions, which can be very expensive. Such crises

can also have a tremendous negative impact on a country’s growth.

Application of Core Principles

Principle #3: Information. Information asymmetries are the reason that a run on a single bank

can turn into a bank panic that threatens the entire financial system. People cannot assess the

quality of the bank’s balance sheet, and so can’t tell the difference between a good or a bad bank.

So when the rumors begin, depositors worry about their own bank’s condition.

Principle #5: Stability. The financial system is inherently unstable as a result of liquidity risk

and information asymmetries.

Principle #5: Stability. The goal of financial stability does not mean the stability of individual

financial institutions; this would defeat the purpose of competition. Rather, regulators should

strive to prevent large-scale catastrophes.

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Teaching Tips/Student Stumbling Blocks

Chapter 14 is your students’ first substantial exposure to Core Principle 5: stability

improves welfare. As you discuss regulation keep reminding students that the point is to

avert financial crises.

An effective way to present the material in this chapter is with an outline of bank balance

sheets displayed on the board or on a handout. Since many, though not all, of the

problems faced by regulators in assuring a stable financial system revolve around the

various items on the balance sheet, this will provide a useful structure for student

understanding.

Features in this Chapter

Your Financial World: The Securities Investor Protection Corporation

Brokerage firms will advertise that they are members of the Securities Investor Protection

Corporation or SIPC. The SIPC provides insurance in the event that a brokerage firm fails owing

its customers cash and securities that are missing. It is insurance against fraud, up to a limit of

$500,000. SIPC insurance does not compensate individuals for investments that lost value due to

changes in market prices, nor will it cover individuals who were sold worthless securities. The

SIPC is there to protect against theft by a broker.

Applying the Concept: The Day the Bank of New York Borrowed $23 Billion

On November 20, 1985 the Bank of New York’s computer system went haywire and the bank

could not keep track of its U.S. Treasury bond trades. Unable to keep track of the trades, the

bank had to make good on the transactions, and without the money ($23 billion) there might

have been a panic. The Federal Reserve, as lender of last resort, stepped in with a loan and

perhaps prevented a full-blown financial crisis.

Lessons from the Crisis: Should the Lender of Last Resort Also Supervise?

Who supervises the financial industry? In the U.S., there are a large number of regulatory

agencies that overlap in responsibility. The Fed is the lender of last resort and supervises bank

holding companies. Most intermediaries lie outside the Fed’s supervision. The U.K. has a

unified financial regulator: the Financial Services Authority. Other countries have systems that

fall in between. The financial crisis of 2007-2009 tested all of these regulatory arrangements.

None of the arrangements fared any better in the crisis than the others.

Applying the Concept: Does Deposit Insurance Really Work

Surprisingly to many, deposit insurance may do more harm than good. While it is supposed to

stabilize the financial system, it may in fact create moral hazard. Knowing that they are

protected by the government relieves depositors of the need to exercise market discipline on

banks. Some research indicates that when governments implement deposit insurance the

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Chapter 14 – Regulating the Financial System

probability of financial crises has increased rather than decreased. The real key to stabilizing the

financial system may be to give bank managers and owners incentives to protect depositors on

their own. One specific way to do this would be to require that banks sell subordinated debt; the

price of such publicly traded bonds would provide the market’s evaluation of the quality of the

bank and serve to discipline its management.

Your Financial World: Are Your Deposits Insured?

Deposit insurance covers individuals, not accounts; it insures depositors. So if your account is

joint, perhaps with a spouse, you are each covered up to the ceiling amount. If you have more

than one account the amounts will be combined in comparison to the deposit insurance limit. If

you have accounts at more than one bank they will be insured separately, up to the deposit

insurance limit. But remember, should the two banks merge, the accounts will be treated as if

they were at one bank. The FDIC also insures “self-directed retirement accounts” as well; on

these accounts, the limit is $250,000. While this may seem like a large number, many people

will reach that limit before they retire. So insuring your retirement savings is something you will

need to worry about.

Tools of the Trade: The Basel Accords: I, II, III and Counting

The Basel Accord of 1988 was an agreement that established a requirement that internationally

active banks must hold capital equal to or greater than 8 percent of their risk-adjusted assets. By

linking minimum capital requirements to the risk a bank takes on it forced regulators to change

the way they thought about bank capital. Also, it created a uniform international system and it

provided a framework that less-developed countries could use to improve the regulation of their

banks. The original Accord had its limits and was revised; the new Accord is based three pillars:

a revised set of minimum capital requirements, supervisory review of bank balance sheets, and

increased reliance of market discipline to encourage sound risk management practices. In 2010,

regulators refined and extended the Basel Accord. This new agreement sets restrictions on

leverage, introduces three buffers over and above the minimum capital requirement itself, and

adds a liquidity requirement.

In the News: How to Shrink the ‘Too-Big-to-Fail’ Banks

A dozen megabanks today control almost 70% of the assets in the U.S. banking industry.

Government policy has made these institutions exempt from the normal processes of bankruptcy

and creative destruction. The 2010 Dodd-Frnak Wall Street Reform and Consumer Protection

Act promised to end too big to fail. However, market discipline is still lacking for the largest

institutions.

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Lessons of the Article: Despite the Dodd‐Frank Act, megabanks enjoy an implicit

subsidy not available to smaller banks: They borrow at lower costs because many

creditors believe that they would be bailed out in a crisis. Ending that subsidy requires

that, if they fail, they can be quickly put under new ownership or liquidated without a

bailout and without damaging the financial system or the economy. To make this

feasible, the article proposes to shrink them. It also proposes to narrow the federal

safety net, but that may not reduce the government’s incentive to bail out the largest

intermediaries in a crisis.

Additional Teaching Tools

Janet Yellen was nominated by President Barack Obama in late 2013 for the Chairman of the

Federal Reserve. The following Wall Street Journal article follows the Senate confirmation

hearings.

http://blogs.wsj.com/economics/2013/11/14/live-blog-janet-yellens-confirmation-hearing-for-fed

-chair/?KEYWORDS=Yellen.

Virtual Tools

Visit the bank regulators on line:

For the FDIC go to: http://www.fdic.gov/

For the Comptroller of the Currency go to: http://www.occ.treas.gov/

For the Federal Reserve go to: http://www.federalreserve.gov/

To learn more about your state banking regulators you can go to this site which provides links to

all the state regulators: http://www.csbs.org/Pages/default.aspx

For More Discussion

For a different perspective on bank runs, have students read this short article by George G.

Kaufman, who is the John F. Smith Professor of Finance and Economics at Loyola University in

Chicago. He argues that the dangers of runs may be overstated.

http://www.econlib.org/library/Enc/BankRuns.html

Chapter Outline

I. The Sources and Consequences of Runs, Panics, and Crises

1. Banks’ fragility arises from the fact that they provide liquidity to depositors, allowing

them to withdraw their balances on demand, on a first-come, first-served basis.

2. Reports that a bank has become insolvent can spread fear that it will run out of cash

and close its doors; such a run on a bank can cause it to fail.

3. What matters during a bank run is not whether a bank is solvent but whether it is

liquid; false rumors that a bank is insolvent can lead to a run which renders it illiquid.

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4. When a bank fails, depositors may lose some or all of their deposits, and information

about borrowers’ creditworthiness may disappear; for this reason, governments take

steps to try to minimize the risk of failure.

5. A single bank failure can also turn into a system-wide panic; this is called contagion.

6. While banking panics and financial crises can result from false rumors, they can also

occur for more concrete reasons; anything that affects borrowers’ ability to repay their

loans or drives down the market price of securities has the potential to imperil the

bank’s finances.

7. The history of banking in the United States shows that downturns in the business

cycle put pressure on banks, substantially increasing the risk of panics.

8. Financial disruptions can also occur whenever borrowers’ net worth falls, as it does

during deflation.

II. The Government Safety Net

1. There are three reasons for the government to get involved in the financial system: to

protect investors, to protect bank customers from monopolistic exploitation, and to

safeguard the stability of the financial system.

2. Government officials employ a combination of strategies to protect investors and

ensure the stability of the financial system: they provide the safety net to insure small

depositors and they operate as the lender of last resort.

A. The Unique Role of Banks and Shadow Banks

1. Depository institutions receive a disproportionate amount of attention from

government regulators because they play a central role in the economy and because

they face a unique set of problems.

2. We all rely heavily on banks for access to the payments system. Shadow banks also

provide liquidity.

3. Banks are also prone to runs, and are linked to each other both on their balance sheets

and in their customers’ minds; this interconnectedness of banks makes bank failures

contagious. This is not true for nondepository institutions.

B. The Government as Lender of Last Resort

1. The best way to stop a bank failure from turning into a panic is to make sure solvent

institutions can meet their depositors’ withdrawal demands.

2. The existence of a lender of last resort significantly reduces, but does not eliminate,

contagion.

3. For the system to work, central bank officials who approve the loan applications must

be able to distinguish an illiquid from an insolvent institution.

4. It is important for a lender of last resort to operate in a manner that minimizes the

tendency for bankers to take too much risk in their operations.

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C. Government Deposit Insurance

1. To stem the bank panics of the 1930s Congress passed legislation creating the Federal

Deposit Insurance Corporation (FDIC), which guarantees that a depositor will receive

the full account balance up to some maximum amount, even if a bank fails.

2. When a bank fails, the FDIC resolves the insolvency either by closing the institution

(the payoff method) or by finding a buyer (the purchase and acquisition method).

3. Under the payoff method, the FDIC pays off all the depositors then sells the assets in

an attempt to recover the amount paid off.

4. Under the purchase and acquisition method, the FDIC pays another institution to take

over the one that failed.

5. Deposit insurance has been extraordinarily successful in eliminating bank runs and

financial crises, and because the U.S. Treasury backs the FDIC it can withstand

virtually any crisis.

D. Problems Created by the Government Safety Net

1. Protected depositors have no incentive to monitor their banks’ behavior, and knowing

this, banks take on more risk than they would normally.

2. Regulators must balance the often conflicting goals of crisis mitigation and crisis

prevention that sometimes creates moral hazard.

3. Some banks are too big to fail, meaning that their failure would cause havoc in the

financial system. The managers of such institutions know that if they begin to

founder the government will have to bail them out.

4. The too-big-to-fail policy limits the extent of the market discipline that depositors can

impose on banks and compounds the moral hazard problem.

III. Regulation and Supervision of the Financial System

1. Government officials employ three strategies to ensure that the risks created by the

safety net are contained: regulation establishes rules for bank managers to follow,

supervision provides general oversight of financial institutions, and examination

provides detailed information on the firms’ operations.

2. Regulatory requirements are designed to minimize the cost of failures to the

tax-paying public.

3. One example of regulation is the requirement that banks obtain a charter in order to

operate; this provides screening to make sure that the people who own and run banks

will not be criminals. Once a bank is operating other regulations control the assets,

the amount of capital, and makes information about the bank’s balance sheet public.

4. Government supervisors enforce the regulations; they monitor, inspect, and examine

banks to make sure that their business practices conform to regulatory requirements.

5. Banks are regulated and supervised by a combination of the U.S. Treasury, the

Federal Reserve, the FDIC, and state banking authorities. Shadow banks are regulated

by the SEC and the Commodity Futures Trading Commission (CFTC).

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6. The existence of regulatory competition has two consequences: regulators force each

other to innovate, improving the quality of the regulations, but it also allows banks to

look for the more lenient regulator.

A. Restrictions on Competition

1. One long-standing goal of financial regulators has been to prevent banks from

growing too big and powerful, both because their failure might threaten the financial

system and because without competition banks might exploit their customers.

2. Even though recent legislation has changed the banking industry, restrictions on bank

size remain, and bank mergers require government approval.

3. To approve a merger, officials must be convinced that the new bank will not

constitute a monopoly in any geographic region and that (in the case of a big bank

taking over a small bank) the acquired bank’s customers will be well served by the

merger.

4. Government officials also worry that the greater the competition among banks, the

harder it is for banks to make a profit, and that this could drive banks to take on too

much risk.

5. This type of moral hazard can be avoided if government officials restrict competition

or if they prohibit banks from making certain kinds of loans and from purchasing

certain types of securities that are considered to be too risky.

B. Asset Holding Restrictions and Minimum Capital Requirements

1. The simplest way to prevent bankers from exploiting their safety net is to restrict

banks’ balance sheets; this can be through restrictions on the kinds of assets banks can

hold and requirements that they maintain minimum levels of capital.

2. U.S. banks cannot hold common stock, and regulations also limit the grade and

quantity of bonds a bank can hold.

3. The size of the loans a bank can make to particular borrowers is also limited.

4. In effect, regulators are telling banks to do what they should be doing: holding a

well-diversified portfolio of liquid, high-grade bonds, and loans.

5. Minimum capital requirements complement these limitations on bank assets.

6. Capital serves as a cushion against declines in the value of the bank’s assets, lowering

the likelihood of the bank’s failure, and is a way to reduce the problem of moral

hazard.

7. Capital requirements take two basic forms: the first requires banks to keep their ratio

of capital to assets above some minimum level regardless of the structure of their

balance sheets; the second requires banks to hold capital in proportion to the riskiness

of their operations.

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C. Disclosure Requirements

1. Many intermediaries must provide information to customers about the cost of their

products; this is to protect customers.

2. Banks must also provide information to the financial markets about their balance

sheets; this also protects depositors, but in a different way.

D. Supervision and Examination

1. The government enforces banking rules and regulations through an elaborate

oversight process called supervision, which relies on a combination of monitoring and

inspection.

2. Supervision is done remotely, through an examination of the detailed reports banks

must submit, as well as through on-site examination.

3. At the largest institutions, examiners are on site all the time; this is called continuous

examination.

4. The most important part of a bank examination is the evaluation of past-due loans, to

see if they should be declared in default.

5. Supervisors use the acronym CAMELS to describe the criteria used to evaluate the

health of the bank: Capital adequacy, Asset quality, Management, Earnings,

Liquidity, and Sensitivity to risk.

6. Current practice is for examiners to act as consultants to banks, advising them on how

to get the highest return possible while keeping risk at an acceptable level that ensures

the bank will stay in business.

E. Evolving Challenges for Regulators and Supervisors

1. Recent changes in the law, together with technological innovation, have challenged

the traditional structure of regulation and supervision.

2. Among these changes are globalization and the explosion in the number and variety

of instruments traded.

3. Adding to these is the fact that Congress removed the functional and geographic

barriers that once separated commercial banking from other forms of intermediation.

4. A compelling case can be made for a super-regulator that would make the entire

process more uniform and coherent.

5. The need for international cooperation will also increase as globalization continues.

6. Regulators must also realize that the goal of financial stability does not mean the

stability of individual financial institutions; that would defeat the purpose of

competition.

7. The regulator’s goal should be to prevent large-scale catastrophes.

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F. Micro-Prudential Versus Macro-Prudential Regulation

1. Regulators are broadening their focus beyond micro-prudential oversight to

macro-prudential regulation

2. Traditional regulation is micro-prudential and aims to limit risk within intermediaries

in order to reduce the risk that a particular institution will fail.

3. Macro-prudential regulation attempts to prevent systemic risks, including limiting

costly spillovers (externalities), common exposure in which many institutions are

exposed to the same risk factor, pro-cyclicality where interaction between financial or

economic activity can be mutually reinforcing leading to unsustainable booms and

busts.

4. Macro-prudential policy aims to make intermediaries bear the costs that their behavior

imposes on others.

G. Regulatory Reform: The Dodd-Frank Act of 2010

1. The Dodd-Frank Wall Street Reform and Consumer Protection Act has four explicit

or implicit goals: (1) to make the financial system robust; (2) to anticipate and prevent

financial crises by limiting systemic risk; (3) to end “too big to fail”; and (4) to reduce

the moral hazard resulting from policy actions such as those taken in the 2007–09

crisis. The act addresses each of them in multiple ways.

2. Some of the biggest shortcomings are:

a. The act fails to streamline the US regulatory apparatus

b. Government guarantees largely come for free

c. The Act regulates according to form rather than function, among others

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Terms Introduced in Chapter 14

adverse feedback

bank panic

bank run

Basel Accord

CAMELS

common exposure

contagion

deposit insurance

examination

externality

illiquid

insolvent

lender of last resort

macro-prudential

micro-prudential

pro-cyclicality

regulation

regulatory competition

shadow bank

supervision

systemically important financial institution (SIFI)

too-big-to-fail policy

Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

Failures of depositories BKFTTLA641N

FDIC failure and assistance transactions BKIFDCA641N

Purchase and assumption transactions BKTTPIA641N

Payout transactions BKTTPOA641N

Commercial bank equity/Assets ratio EQTA

Retail MMMFS RMFSL

Institutional MMMFS IMFSL

Discount window borrowings of depositories DISCBORR

Asset‐backed commercial paper outstanding ABCOMP

Lessons of Chapter 14

1. The collapse of banks and the banking system disrupts both the payments system and the

screening and monitoring of borrowers.

a. Intermediaries are insolvent when their liabilities exceed their assets.

b. Because banks guarantee their depositors cash on demand on a first-come,

first-served basis, they are subject to runs. Shadow banks like MMMFs and

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securities brokers also face runs because some of their liabilities can be

withdrawn at face value without notice.

c. A bank run can occur simply because depositors have become worried about a

bank’s soundness. Shadow banks also may face runs due to a loss of confidence.

d. The inability of unsophisticated depositors to tell a sound from an unsound bank

can turn a single bank’s failure into a bank panic, causing even sound banks to fail

through a process called contagion. Shadow banks face similar risks.

e. A financial crisis in which the entire banking system ceases to function can be

caused by:

i. False rumors.

ii. The actual deterioration of bank balance sheets for economic reasons.

2. The government is involved in every part of the financial system.

a. Government officials may intervene in the financial system in order to

i. Protect small depositors.

ii. Protect bank customers from exploitation.

iii. Safeguard the stability of the financial system.

b. Most financial regulations apply to depository institutions, while shadow banks

usually face less regulation.

c. Intermediaries that are less prone to runs, such as pension funds and most

insurers, face less intrusive government oversight than the banking industry.

d. The U.S. government has established a two-part safety net to protect the nation’s

financial system.

i. The Federal Reserve acts as the lender of last resort, providing liquidity to

solvent institutions in order to prevent the failure of a single intermediary

from becoming a systemwide panic.

ii. The Federal Deposit Insurance Corporation (FDIC) insures individual

depositors helping to prevent bank runs by reducing depositors’ incentive

to flee at the first whiff of trouble.

e. The government’s safety net encourages bank managers to take more risk than

they would otherwise, increasing the problem of moral hazard.

3. Through regulation and supervision, government officials reduce the amount of risk banks

can take, lowering their chances of failure. Regulators and supervisors

a. Restrict competition.

b. Restrict the types of assets banks can hold.

c. Require banks to hold minimum levels of capital.

d. Require banks to disclose their fees to customers and their financial indicators to

investors.

e. Monitor banks’ compliance with government regulations.

4. Regulators use macro-prudential tools to limit systematic threats to the financial system.

Such risks usually arise from externalities—costly spillovers from the behavior of

intermediaries. These externalities have two sources: (1) common exposure of intermediaries

to frail institutions or to underlying risks and (2) pro-cyclicality of the links between financial

and economic activity, which amplifies boom and bust cycles.

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