Chapter 18
Bank Regulation
Outline
Background
Regulatory Structure
Regulators
Regulation of Bank Ownership
Regulation of Bank Operations
Regulation of Deposit Insurance
Regulation of Deposits
Regulation of Bank Loans
Regulation of Bank Investment in Securities
Regulation of Securities Services
Regulation of Insurance Services
Regulation of Off-Balance Sheet Transactions
Regulation of the Accounting Process
Regulation of Capital
How Banks Satisfy Regulatory Requirements
Basel I Accord
Basel II Framework
Basel III Framework
Use of the Value-at-Risk Method to Determine Capital Levels
Stress Tests Used to Determine Capital Levels
How Regulators Monitor Banks
CAMELS Ratings
Limitations of the CAMELS Rating System
Corrective Action by Regulators
Funding the Closure of Failing Banks
Government Rescue of Failing Banks
Argument for Government Rescue
Argument Against Government Rescue
Government Rescue of Bear Stearns
Failure of Lehman Brothers
Government Rescue of AIG
Protests of Bank Bailouts
Chapter 18: Bank Regulation ❖ 2
Financial Reform Act of 2010
Mortgage Originations
Sales of Mortgage-backed Securities
Financial Stability Oversight Council
Orderly Liquidations
Consumer Financial Protection Bureau
Limits on Bank Proprietary Trading
Trading of Derivative Securities
Global Bank Regulations
Compliance with Basel III
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Key Concepts
1. Describe how the more important bank regulations have affected bank sources and uses of funds.
2. Describe why more stringent capital requirements can improve the banking system. Then, offer some
disadvantages.
3. Describe why government rescues of banks can improve the banking system. Then, offer some
disadvantages.
4. Explain the effects of the removal of regulatory barriers.
POINT/COUNTER-POINT:
Should Regulators Intervene to Take Over Weak Banks?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
Questions
1. Regulation of Bank Sources and Uses of Funds. How are banks’ balance sheet decisions regulated?
2. Off-Balance Sheet Activities. Provide examples of off-balance sheet activities. Why are regulators
concerned about them?
3. Moral Hazard and the Credit Crisis. Explain why the moral hazard problem may have received so
much attention during the credit crisis.
4. FDIC Insurance. What led to the establishment of FDIC insurance?
5. Glass-Steagall Act. Briefly describe the Glass-Steagall Act. Then explain how the related regulations
have changed.
6. DIDMCA. Describe the main provisions of the DIDMCA that relate to deregulation.
7. CAMELS Ratings. Explain how the CAMELS ratings are used.
8. Uniform Capital Requirements. Explain how the uniform capital requirements can discourage
banks from taking excessive risk.
9. Value at Risk. Explain how the value at risk (VaR) method can be used to determine
whether a bank has adequate capital.
10. HLTs. Describe highly leveraged transactions (HLTs), and explain why a bank’s exposure to HLTs is
closely monitored by regulators.
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.
13. Economies of Scale. How do economies of scale in banking relate to the issue of interstate banking?
14. Contagion Effects. How can the financial problems of one large bank affect the market’s risk
evaluation of other large banks?
15. Regulating Bank Failures. Why are bank regulators more concerned about a large bank failure than
a small bank failure?
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.
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?
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.
19. Capital Requirements During the Credit Crisis. Explain why banks struggled to satisfy capital
requirements because of the accounting method applied to mortgage-backed securities.
20. Fed Rescue of Bear Stearns. Explain why regulators might argue that the assistance they provided
to Bear Stearns was necessary.
21. Fed Rescue of Nonbanks. Should the Fed have the power to rescue firms such as Bear Stearns that
are not commercial banks?
Chapter 18: Bank Regulation ❖ 7
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ANSWER: Some critics (including Paul Volcker, a previous chair of the Fed) suggested that the
rescue of a firm other than a commercial bank should be the responsibility of Congress and not the
Fed. The Fed’s counter was that it recognized the potential financial transactions that would be frozen
if it did not rescue Bear Stearns. Thus, its argument is based on its role of attempting to stabilize the
financial system rather than its role of regulating commercial banks.
22. Bank Regulation of Credit Default Swaps. Why were bank regulators concerned with credit
default swaps?
23. Impact of Bank Consolidation on Regulation. Explain how bank regulation can be more effective
when there is consolidation of banks and securities firms.
24. Concerns about Systemic Risk During the Credit Crisis. Explain why the credit crisis caused
concerns about systemic risk.
25. Troubled Asset Relief Program (TARP). Explain how the Troubled Asset Relief Program was
expected to help resolve problems during the credit crisis.
ANSWER: During the 2008-2010 period, the Troubled Asset Relief Program (TARP) was
26. Financial Reform Act. Explain how the Financial Reform Act is intended to prevent some problems
that contributed to the credit crisis.
ANSWER: In July, 2010, the Financial Reform Act (also referred to as Wall Street Reform Act or
Chapter 18: Bank Regulation ❖ 8
27. Bank Deposit Insurance Reserves. How did the Financial Reform Act of 2010 change the reserve
requirements of the FDIC’s Deposit Insurance Fund?
28. Basel III Changes to Capital and Liquidity Requirements. How did Basel III change capital
and liquidity requirements for banks?
29. Regulation of Financial Disclosure Lehman Brothers continued to report positive earnings through
the spring of 2008, even though mortgage valuations were clearly declining. Nevertheless, some
institutional investors were concerned that Lehman Brothers might have been overstating its earnings
in 2007 and early 2008. Explain why more complete and accurate disclosure by banks and other
financial institutions may help to resolve financial problems. Could compensation incentives
discourage banks from fully disclosing their financial condition? Why or why not?
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
30. Regulatory Dilemma Involving AIG Explain the government’s dilemma regarding whether it
should rescue American International Group (AIG) during the credit crisis.
30. Government’s Injection of Capital into Large Banks Describe the U.S. government’s efforts to
infuse capital in all of the very large banks during the credit crisis.
CRITICAL THINKING QUESTION
Proprietary Trading by Banks The Volcker Rule is intended to prevent banks from engaging in
proprietary trading. Write a short essay offering your opinion on whether banks should be allowed to
engage in proprietary trading.
ANSWER
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
Chapter 18: Bank Regulation ❖ 10
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.”
b. “Bank of America has pursued the acquisitions of many failed banks, because it sees potential
benefits.”
c. “By allowing a failing bank time to resolve its financial problems, it imposes an additional tax on
taxpayers.”
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, but it 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.
Chapter 18: Bank Regulation ❖ 11
c. Do you believe that the strategies planned by the bank will satisfy the bank’s managers? Explain.
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.
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?