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Chapter 9: Government’s Role in Banking 96

CHAPTER 9

Government’s Role in Banking

TEACHING OBJECTIVES

Goals of Chapter 9

A. Discuss how and why government authorities supervise and regulate

bank activities.

B. Describe the rules and regulations that govern bank activities.

C. Show how the government supervises banks by asking them for

information about their activities and telling them when they are not

acting properly.

D. Discuss how the government decides whether or not banks can merge.

TEACHING NOTES

A. Regulation of Banks

1. Why Does the Government Regulate Banks?

a) Reducing externalities

b) Keeping banks small; use Policy Insider: How Today’s Banking

System Reffect Yesterday’s Regulations

c) Preventing bank runs

(1)A bank run occurs when many depositors go to a bank at the

same time to withdraw their funds

(2)Contagion occurs when a run at one bank leads to runs at

other banks

d) Making the payments system work efficiently

2. How Does Government Regulation Achieve Its Goals? (Use Policy

Insider: A History of Major Banking Regulations)

a) Supervising banks to reduce externalities

b) Restricting mergers and bank activities to keep banks small

(1)The Glass-Steagall Act, passed in 1933, prohibited banks from

underwriting securities, selling mutual funds, or owning

commercial 8rms, to prevent abuses such as those that

occurred in the 1920s

Chapter 9: Government’s Role in Banking 97

(2)Banks tried various innovations to get around the Glass-Steagall

prohibitions, but they were unable to do so successfully

(3)In 1999, the Gramm-Leach-Bliley Act reversed most of

Glass-Steagall; allowed banks to underwrite insurance or to own

commercial 8rms on a temporary basis if they formed a

&nancial holding company; and allowed banks to own

insurance agencies, securities agencies, and securities

underwriting firm

c) Providing a federal safety net to prevent bank runs

(1)Deposit insurance is the main method of preventing bank runs,

as customers will not rush to the bank to withdraw their funds if

they are insured; the FDIC limit is now $250,000 per person per

bank

(2)The Fed acts as a lender of last resort to keep solvent but

illiquid banks from failing by making loans available at the

discount window

(4)The too-big-to-fail policy prevents large banks from failing,

which might otherwise lead to a financial crisis

(5)The FDIC can close an insolvent bank in one of three ways:

(a) The payo@ method is used by selling o@ the assets of the

banks and distributing the proceeds to creditors of the bank

(b) The purchase-and-assumption method is used by selling

the bank to another bank, giving the buyer the bank’s good

assets and disposing of the bank’s bad loans

bank open and lends it funds to survive; the method is used

under the too-big-to-fail policy, but restrictions on that policy

put in place in 1991 restrict the use of the method; point

students to Figure 9.1

d) offering services to ensure e2cient payments

e) Requiring banks to hold reserves to control the money supply

3. Do Banks Receive a Net Subsidy from the Government?

a) Former Chairman, Greenspan, argued that the benefit to banks

from government supervision and regulation exceeded the costs to

the banks, so they received a net subsidy

b) The U.S. Treasury Department disagreed with Greenspan and

argued that the benefit and costs were about even

Chapter 9: Government’s Role in Banking 98

B. Policy Insider: How Today’s Banking System Reffect Yesterday’s

Regulations

1. The setup of banks today reffect the regulations that they were

subject to in the past

C. Policy Insider: A History of Major Banking Regulations

1. This section lists all major bank regulations from the National Bank

Act of 1864 to the Dodd-Frank Act of 2010

2. Generally, regulations in the 1930s restricted what banks could do;

regulations in the 1980s and 1990s reversed those restrictions

D. Supervision of Banks

1. Bank Supervisors

a) The dual banking system gives a bank the choice of federal or

state regulators; see Figure 9.2

b) A bank can choose whether to become a commercial bank, a thrift

institution, or a credit union

c) Commercial banks

(1)Commercial banks may get a charter from the federal

government through the O2ce of the Comptroller of the

Currency (becoming a national bank) or a state agency

(becoming a state bank)

d) Thrift institutions

(1)Thrift institutions may get a federal charter from the O2ce of

Thrift Supervision or a state charter from the state government

(2)They must obtain FDIC insurance

(3)Thrifts can engage in certain activities that commercial banks

cannot engage in, such as owning or being owned by a

commercial 8rm

(4)Thrifts that have 65 percent or more of their assets in mortgage

or consumer loans and 20 percent or less of their assets in

commercial loans can borrow at low rates from a Federal Home

Loan Bank, which is designed to encourage home mortgage

lending

e) Credit unions

Chapter 9: Government’s Role in Banking 99

(1)Credit unions may get a federal charter from the National Credit

Union Association (NCUA) or a state charter

(2)They are insured by the National Credit Union Share Insurance

Fund or by a state or private insurance fund

2. Deposit Insurance

a) Riskier banks pay higher deposit insurance premiums than safer

banks

b) By 1997, the FDIC fund was so large that banks in good condition

were no longer required to pay deposit insurance premiums

c) The 2008 financial crisis changed the health of the deposit

insurance system dramatically

3. Rating Banks

a) Regulators use the CAMELS rating system to rate banks on

Capital adequacy, Asset quality, Management, Earnings, Liquidity,

and Sensitivity to risk.

d) Banks must comply with laws a@ecting their interactions with

consumers and their community

(1)Banks must comply with the Community Reinvestment Act

(CRA), which requires them to serve their local communities

(2)Banks at one time engaged in redlining, refusing to make loans

in parts of inner cities

(3)The CRA requires banks to show that they do not discriminate in

credit markets

E. Policy Perspectives: Should Mergers of Big Banks Be Allowed?

1. Evaluating Bank Mergers

a) The government can prevent bank mergers that “substantially

lessen competition”

b) In evaluating mergers, the regulators examine the e@ect of the

merger on competition, the financial and managerial resources of

Chapter 9: Government’s Role in Banking 100

the new bank, the ability of the new bank to meet the convenience

and needs of the community, and whether the banks provided

complete information to the regulators regarding the merger

c) To evaluate the e@ect of a merger on competition, regulators follow

several steps

(1)The relevant area of local competition is defined

time

(5)Regulators can consider mitigating circumstances in evaluating

mergers

2. The Merger of Wachovia and Wells Fargo

a) An example of the merger approval process is the merger between

the largest banks in the country, Wells Fargo and Wachovia, in

2008

b) In analyzing the competitiveness of banks affected by the merger,

the Fed analyzed the 49 banking markets in which both Wells Fargo

and Wachovia had operations

c) In 37 of the 49 markets, the merger would not violate any of the

guidelines. However, in 12 markets, the new HHI would exceed the

guidelines

3. The Impact of Mergers on Bank Pro8ts

a) Mergers usually lead to an increase in bank pro8ts

b) Researchers studying the impact of mergers on profit 8nd that

banks generally increase their risk after a merger, and higher risk

means a higher expected return

c) The research also shows that mergers help banks reduce their

costs, increasing efficiency

Chapter 9: Government’s Role in Banking 101

d) It seems likely that both reduced costs and reduced competition

have boosted banks’ pro8ts. Neither factor is dominant alone