Chapter 18
Bank Regulation
Outline
Regulatory Structure
Regulators
Regulation of Bank Ownership
Regulation of Bank Operations
Regulation of Deposit Insurance
Regulation of Deposits
Regulation of Capital
How Banks Satisfy Regulatory Requirements
Basel I Accord
How Regulators Monitor Banks
CAMELS Ratings
Government Funding During the Crisis
Troubled Asset Relief Program (TARP)
Chapter 18: Bank Regulation ❖ 2
Financial Reform Act of 2010
Mortgage Origination
Sales of Mortgage-backed Securities
Financial Stability Oversight Council
Global Bank Regulations
Compliance with Basel III
Chapter 18: Bank Regulation ❖ 3
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.
POINT/COUNTER-POINT:
Should Regulators Intervene to Take Over Weak Banks?
POINT: Yes. Intervention could turn a bank around before weak management results in failures. Bank
failures require funding from the FDIC to reimburse depositors up to the deposit insurance limit. This cost
could be avoided if the bank’s problems are corrected before it fails.
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?
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,
Chapter 18: Bank Regulation ❖ 4
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?
5. Glass-Steagall Act. Briefly describe the Glass-Steagall Act, and then explain how the related
regulations have changed since it was enacted.
ANSWER: The Glass-Steagall Act (1933) separated banking and securities activities, in response to
problems during the Great Depression when banks (1) sold poor-quality securities to their trust
6. DIDMCA. Describe the main provisions of the DIDMCA that relate to deregulation.
7. CAMELS Ratings. Explain how the CAMELS ratings are used.
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
any of these countries would be subject to the same rules and would not have an unfair advantage. In
Chapter 18: Bank Regulation ❖ 5
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 VaR by
10. HLTs. Describe highly leveraged transactions (HLTs) and explain why regulators closely monitor a
bank’s exposure to HLTs.
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?
ANSWER: Underwriting can generate cash flow without requiring more capital, given that the bank
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?
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?
ANSWER: Large bank failures can carry indirect costs, such as a change in the public’s risk
Chapter 18: Bank Regulation ❖ 6
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 how the accounting method applied to
mortgage-backed securities made it more difficult for banks to satisfy capital requirements
during the credit crisis of 2008–2009.
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 during the credit crisis was necessary.
ANSWER: Bear Stearns facilitated many transactions in financial markets, and its failure would have
Chapter 18: Bank Regulation ❖ 7
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
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 TARP was
expected to help resolve problems during the credit crisis.
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
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?
ANSWER: The Financial Reform 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
the excess as dividends to banks.
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
capital conservation buffer) of at least 2.5% of risk-weighted assets by 2016. Banks that do not
29. Regulation of Financial Disclosure Lehman Brothers continued to report positive earnings
throughout 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 managers’ compensation
incentives discourage banks from fully disclosing their financial condition? Why or why not?
ANSWER: As the mortgage markets began to experience weakness near the end of 2007, Lehman
Chapter 18: Bank Regulation ❖ 9
30. Regulatory Dilemma Involving AIG Explain the government’s dilemma regarding whether it
should rescue American International Group (AIG) during the credit crisis.
ANSWER: AIG had a very large amount of credit default swap contracts with banks and other
financial institutions, whereby each contract assigned it to be the insurer against the possibility of
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.
ANSWER: Large banks sold preferred stock to the Treasury. They were required to make dividend
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
An argument for proprietary trading is that it may allow banks to capitalize on a special skill and generate
more profits for their shareholders. It enables them to diversity their operations and may also allow them
Interpreting Financial News
Chapter 18: Bank Regulation ❖ 10
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 from these deals.”
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.”
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. IT has historically been rated favorably by
regulators, but the bank 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?
The capital level will increase, asset quality will improve, and liquidity will improve. However,
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.
Open-ended. Conservative strategies are desirable in that they may reduce the risk of failure and
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 services, 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.
The nonbank services include underwriting of securities, insurance, and full-service brokerage.
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