FNAN 320: Chapter 14 - Regulating the financial system

Lending by the Federal Reserve to Commercial Banks in 1914-1940

- As banks became illiquid in the early 1930s, lending declined - the existence of a lender of last resort is no guarantee it will be used

Should the lender of last resort also supervise?

- The crisis exposed faults in every system and strengthened the case for making the central bank the leading financial supervisor. - Multiple regulators complicated the U.S. response. - The United Kingdom's streamlined system facilitated rapid analysis and response, but had problems as their central bank is not the financial supervisor. 1. The lack of immediate, direct access to supervisory information also was a handicap for the European Central Bank (ECB). 2. During the crisis, the ECB acted early to flood the euro-area system with liquidity

Supervision and Examination

- all charted banks must file quarterly reports known as call reports - Every depository institution that is insured by the FDIC is examined at least once a year - at the largest institutions, examines are on site all the time - they follow a process known as continuous examination - the most important part of bank examination is the evaluation of past-due loans - the examiner's job is to make sure that when written off and the bank's balance sheet properly reflects the losses - supervisors use what is called the CAMELS

The unique role of banks and shadow banks

- as they key providers of liquidity, banks ensure a sufficient supply of the means of payment for the economy to operate smoothly and efficiently - we all rely heavily on these intermediaries for access to the payments system - if they were to disappear, we would no loner be able to transfer funds - other financial institutions do not have these essential day-to-day functions of facilitating payments - because of their role in liquidity provision, banks and shadow banks are prone to runs - they hold illiquid assets to back their liquid liabilities - a bank promise of full and constant value to depositors is based on assets of uncertain value - banks and shadow banks are linked to one another both on their balance sheets and in their customers minds - if a bank begins to fail, it will default on its loan payments to other banks and thereby transmit its financial distress to them - MMMFs hold large volumes of commercial paper, most of which was issued by banks - and (shadow) banks are the key repo lenders to securities brokers and hedge funds - banks and shadow bank are so interdependent they are capable of initiating contagion throughout the financial system - the ramifications of a financial crisis outside the system of banks and shadow banks may be more limited, but they are still damaging - as a result, the government also protects individuals who do business with finance companies, pension funds, and insurance companies

The sources and consequences of runs, panics and crises

- banks fragility arises from the fact that they provide liquidity to depositors 1. they allow depositors to withdraw their balances - if a bank cannot meet this promise of withdrawal on demand because of insufficient liquid assets, it will fail - banks also promise to satisfy depositors withdrawal requests on a first-come, first-served basis - reports that a bank has become insolvent can spread fear that it will run out of cash and close its doors - mindful of the first-come, first-served policy, people rush to the bank to et their money first - such a bank run can cause a bank to fail - no bank is immune to the loss of depositor's confidence just because it is profitable and sound - the largest savings banks in the U.S., Washington mutual, failed in September 2008 - withdrawals from Wachovia Bank, at the time the fourth largest U.S. commercial bank, led to its emergency sale - quiet, invisible runs on shadow banks were even more dramatic - in march 2008, repo lenders and other creditors stopped lending to Bear Sterns, the fifth largest U.S. investment bank - the run halted only when the federal reserve bank of new york stepped in and JPMorgan Chase acquired Bear Sterns

Disclosure requirements

- disclosure of accounting information to the financial markets protects depositors in a different way - it allows both regulators and the financial markets to assess the quality of a bank's balance sheet - three measures of the capital ration of U.S. Banks: risk-weighted assets, assets measured according to U.S. GAAP that use net derivatives positions, and assets measured according to U.S. IFRS that use gross derivatives position

Pro-cyclicality

- financial activity is prone to virtuous and vicious cycles - the interaction between between financial and economic activity can be mutually reinforcing leading to unsustainable booms and busts - euphoria feeds euphoria and vice versa

Evolving Challenges for regulators and supervisors

- globalization and technological innovation along with changes in the law, have challenged the traditional structure of regulation and supervision - congress removed the functional and geographic barriers that once separated commercial banking from other forms of intermediation and outlawed interstate banking - banks are now not just commercial banks, but investment banks, insurance companies, and securities firms all rolled into one - each of these organizations ire regulated and supervised by different agencies, both functionally and geographically - State and federal agencies must either cooperate or merge, as must regulators of banks, insurance companies and securities firms - finally, integration of the international financial system will increase the need for cooperation across national borders

The government safety net

- government officials employ a combination of strategies to protect investors and ensure stability of the financial system - they operate as the lender of last resort - they provide deposit insurance - the safety net causes bank managers to take on too much risk

Regulation and supervision of the financial system

- government officials employ three strategies to ensure that the risk created by the safety net are contained - the goal of government regulation is not to remove all the risk that investors face - financial intermediaries facilitate the transfer and allocation of risk, improving economic efficiency - tightening regulations on banks might push risk taking outside the view of the authorities - banks are regulated and supervised by a combination of the U.S. Treasury, the federal reserve, the FDIC and state banking authorities - the overlapping nature of this regulatory structure means the more than one agency works to safeguard the soundness of each bank - a bank can effectively choose its regulators by choosing whether to be a state or national bank and whether or not to be belong to the federal reserve system - in 2010, the Dodd-Franck Act closed OTC and merged it with the SEC and fulfilling report requirements

The government as lender of last resort

- in 1873 Walter Bagehot suggested the need for a lender of last resort to make sure solvent institutions can meet their depositors withdrawal demands - significantly reduces, but does not eliminate, contagion - while the Fed had the capacity to operate as the lender of last resort in the 190s, banks did not take advantage of the opportunity - the mere existence of a lender of last resort will not keep the financial system from collapsing - Another flaw in the system is that those who approve the loans must be able to distinguish an illiquid from an insolvent institution 1. During a crisis, computing the market value of a bank's assets is almost impossible - a bank will go to the central bank only after exhausting all other options 1. this need to seek a loan from the government raises the question of its solvency 2. officials are likely to be generous in their evaluation - knowing that the government will be there, also gives bank managers that incentive to take on too much risk 1. the central bank's difficulty in distinguishing a bank's insolvency from its illiquidity creates a moral hazard for bank managers - 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 the crisis of 2007-2009, we learned that the U.S. lender of last resort mechanism has not kept pace with the evolution of the financial system 1. Some intermediaries facing sudden flight were shadow banks, which do not normally have access to Fed loans - by using its emergency lending authority, the Fed was able to lend to such nonbank intermediaries to stem the crisis - during the crisis, the Fed utilized this emergency authority repeatedly when it needed to lend to securities brokers, MMMFs insurers, other nonbank intermediaries and even to nonfinancial firms - Because of this the Fed developed a number of new policy tools to deliver liquidity when and where it was needed

Time consistency

- in good times governments and central banks say they will not bail out financial intermediaries - they intermediaries know that in a time of crisis, policymakers will have incentive to bail them out - promises in the good times lack creditability - there is no costless way to overcome the problem of time consistency

Problems created by the government safety net

- in protecting depositors, the government creates moral hazard - comparing bank balance sheets before and after the implementation of deposit insurance: 1. in the 1920s , banks ratio of assets to capital was about 4 to 1 2. today it is about 9 to 1 - most economic historians believe government insurance led to this rise in risk - government officials are worried about the largest institutions because they can pose a threat to the entire financial system if they fail - some intermediaries are treated as too big to fail or too interconnected to fail - in most cases, the deposit insurer quickly finds a buyer for a failed bank or the government may act as the lender of last resort - following the Lehman failure, governments in Europe and the U.S. guaranteed all of the liabilities of their largest banks - during the crisis, governments also recapitalized some intermediaries to prevent a run by their creditors 1. the government gave them public money in return for partial ownership rights - the FDIC shut down 297 banks in 2009 and 2012 - whenever the government provides a safety net without charging an appropriate fee in advance of the protection, they create an incentive for financial institutions to take risks that can threaten the system as a whole - however, in the midst of a crisis, they must balance the often-conflicting goals of crisis management and crisis prevention - in the aftermath of the crisis, limited the unintended consequences of the government safety net is the lending problem facing regulators 1. some argue that too big to fail institutions are just too big and need to be broken up 2. this does not eliminate the ban incentives from deposit insurance and government guarantees to smaller institutions - the conflict between crisis prevention and crisis mitigation exemplifies the problem of time consistency

Bank runs, bank panics and financial crises

- losses on Lehman Brothers debt compelled a money-market mutual fund (MMMF) to "break the buck" to lower its value below $1 - investors in other funds rushed to withdraw their shares at the promised $1 per share - the resulting runs undermined a key components of the U.S. intermediation mechanism

Lender of last resort

- make loans to prevent the failure of solvent banks - provide liquidity in sufficient quantity to prevent or end a financial panic

The day the bank of new york borrowed $23 billion

- on November 20th, 2985, there was a software error at Bank of New York - they made payments without receiving funds - it was committed to paying out $23 billion that it did not have, at least until it could correct the computer error - the Fed, as lender of last resort, stepped in and made a collateralized loan of $23 billion - this prevented a computer problem from becoming a full-blown financial crisis

Restrictions on Competition

- one long standing goal of financial regulators has been to prevent banks from growing too big and too powerful - while recent legislation has changed the banking industry, restrictions on bank size remain - bank mergers still require government approval - competition reduces the prices customers must pay and forces companies to innovate in order to survive - lower interest margins and reduced fee income cause bankers to look for other ways to turn a profit 1. some may be temped to assume more risk than advisable, to increase leverage, or to rely excessively on short term funding - the financial crisis of 2007-2009 accelerated the ongoing concentration in the U.S. financial system - when banks and shadow banks weakened or failed during the crisis, regulators encouraged other institutions to buy them - as of 2015, 36 percent of deposits at U.S. commercial banks were held by only four banks - in the process of trying to keep the crisis from deepening by merging failing banks with the largest ones, authorities made the too-big-to-fail problems even bigger

Asset holding restrictions and minimum capital requirements

- one way to prevent bankers from exploiting their safety net is to restrict banks balance sheets - these regulations take two forms: 1. Restrictions on the types of assets banks can hold 2. Requirements that they maintain minimum levels of capital - U.S. banks cannot hold common stock - regulations also restrict both the grade and quantity of bonds a bank can hold 1. Banks are generally prohibited from purchasing bonds that are below investment grade 2. Holding from any single private issuer cannot exceed 25% of their capital - the size of the loans they can make to particular borrowers is also limited - minimum capital requirements complement those limitations on bank assets - banks face a multitude of other risks, including trading risk, operational risk, etc. - regulators require banks to hold capital based on assessments of those risks as well - unfortunately banks can learn to evade or "game" any fixed set of rules - leading up to the financial crisis of 2007-2009 banks in the U.S. and Europe purchased large volumes of mortgage backed securities - these assets carried high ratings - this meant the amount of capital they needed to hold was reduced - lower capital meant more leverage, which increase both risk and expected return - regulators of many countries have agreed to impose a cap on leverage and to reform the risk-weighted capital requirements

Micro-prudential versus Macro-prudential regulation

- regulators must recognize that the goal of financial stability does not mean the stability of individual financial institutions - the government official's job is not to stabilize the profits of an individual bank or insurance company - the regulators goal should be to prevent large scale catastrophes - regulators are broadening their focus beyond micro-prudential oversight to encompass macro-prudential regulation

Stress Test

- stress tests evaluated the prospective capital needs of the 19 largest U.S. banks in light of the deep recession that was under way - the results were sufficient to reassure the government, market participants, and banks that most of the intuitions were solvent - The Dodd-Frank Act requires the Fed to conduct annual tests for SIFIs - the European banking authority has developed a similar testing regime for banks in the EU

The securities investor protection corporation

- the securities investor protection corporation, SIPC, insures investors from fraud - if a brokerage firm fails and you don't receive the securities you purchased, you are insured - SPIC insurance replaces missing securities or cash that were supposed to be there - up to $500,000 - the SIPC does not insure you against making poor investments

Too big to fail or too interconnected to fail

- they are too big or too complex to shut down or sell in an orderly fashion without painful spillovers - regulators call such an institution too big to resolve and the Dodd-Frank law gave special legal definition to such a firm: systemically important financial institutions (SIFI)

Maco-preudential policy

- this aims to make intermediaries bear, or internalize, the costs that their behavior imposes on others - to be effective in limiting systemic threats, a systemic capital surcharge probably would be disproportionately larger for firms that contribute the most to systemic risk - intermediaries would have an incentive to limit the systemic risks they create - regulators could also make capital requirements vary with the business cycle - in good times, capital requirements would rise above the long-run average to create a capital buffer against adverse shocks and to discourage euphoria - regulators could require banks to buy catastrophe insurance - could also have baks issue so-called contingent convertible bonds that convert to equity in the event of a capital shortfall

Making finance safe

- to absorb large unforeseen losses, banks need to finance themselves with equity not just debt - large capital buffers are the principal mechanism to limit systemic risk and are the most effect response to the too-big-to-fail problem - risk taking being shifted from banks to shadow banks which could offset the gain in safety - ratchet up bank equity capital requirements until the tradeoff between banking efficiency and financial safety shift in favor of the later

Many intermediaries are required to provide information:

- to their customers about the cost of their products - to the financial markets about their balance sheets

Sources and Consequences of runs, panics and cirses

- what matters during a bank run is not whether a bank is solvent, but whether it is liquid - solvency means that the value of the bank's assets exceeds the value of its liabilities 1. it has positive net worth - Liquidity means that the bank has sufficient reserves and immediately marketable assets to meet depositors demand for withdrawals - the primary concern is that a single bank's failure might cause a small-scale bank run that could turn into a system-wide bank panic - this phenomenon of spreading panic on the part of depositors in banks is called contagion - this was powerful at the peak of the 2007-2009 financial crisis - information asymmetries are the reason that a run on a single bank can turn into a bank panic - depositors are in the same position as uninformed buyers in the used car market - cannot tell the difference between a good bank and a bad bank - anything that affects borrowers ability to make their loan payments or drives down the market value of securities has the potential to imperil the bank's finances - downturns in the business cycle put pressure on banks, increasing the risk of panics - financial disruptions can also occur whenever borrowers net worth falls, like during deflation

Common Exposure

- when many institutions have an exposure to the same specific risk factor, it can make the system vulnerable to a shook to that factor - intermediaries may be directly exposed to a frail institution through financial contracts - they may be exposed indirectly and unknowingly through their counter-parities, who are themselves directly exposed to a frail institution - all institutions may be vulnerable to the same underlying risks

Regulators of Depository Institutions

1. Commercial banks - regulators: 1. federal deposit insurance corporation 2. office of the comptroller of the currency 3. federal reserve system 4. state authorities 2. Savings banks/saving loans - regulators: 1. office of the comptroller of the currency 2. federal deposit insurance corporation 3. state authorities 3. Credit Unions - regulators: 1. national credit union administration 2. state authorities

Where Dodd-Frank Falls Short

1. Fails to streamline the U.S. regulatory apparatus 2. Government guarantees are free 3. Fannie Mae and Freddie Mac remain under direct federal control and dominate U.S. housing finance 4. Ignores key shadow banks like MMFs 5. Regulates according to institutional form rather than function 6. Doubt that this will end big bailouts -Perception that designation as a SIFI implies a government guarantee for some creditors

There are two ways to avoid this moral hazard:

1. Government officials can explicitly restrict competition 2. Government can prohibit them from making certain types of loans and from purchasing particular securities

Consequences of regulatory competition

1. Regulators force each other to innovate, improving the quality of the regulations they write 2. It allows bank managers to shop for the most lenient regulator - the one whose rules and enforcement are the least stringent

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

1. To protect investors 2. to protect bank customers from monopolistic exploration 3. to safeguard the stability of the financial system

Capital requirements take two basic forms:

1. most banks are required to keep their ration of capital to assets above some minimum level, regardless of the structure of their balance sheets 2. Banks are required to hold capital in proportion to the riskiness of their operations

Regulatory requirements designed to minimize the cost of failures to the public:

1. new banks must obtain a charter 2. once open, regulations: - restricts competition - specifies what assets the bank can and cannot hold - requires the bank to hold a minimum level of capital - makes public information about the banks balance sheet

Addressing systemic risk will require a broad framework of macro-prudential supervision that includes:

1. rules and mechanisms that promote better risk management on the part of intermediaries 2. Reforms that reduce the vulnerability of the financial system to the liquidation of any single financial firm

Dodd-Frank Wall Street Reform and Consumer Protection Act has four primary goals:

1. strengthening the financial system 2. preventing crisis through systemic risk management 3. ending too big to fail 4. reducing moral hazard

Before granting a merger, officials must be convinced on two points

1. the new bank must not constitute a monopoly in any geographic region 2. If a small community bank is to be taken over by a large regional bank, the small bank's customers must be well served by the merger

Government Deposit Insurance

Congress response to the Fed's inability to stem the bank panics of the 1930s was to create nationwide deposit insurance

The combustible mix of liquidity risk and information symmetries means that the financial system in inherently unstable

a financial institution can create and destroy the value of its assets in a short period of time - a single firm's failure can bring down the entire system

Micro-pudential regulation

aims to limited the risks within intermediaries in order to reduce the possibility of an individual institution's failure - oversight is insufficient to prevent systemic risks

CAMELS

criteria to evaluate the health of the banks they monitor - Capital adequacy - Asset quality - Management - Earnings - Liquidity - Sensitivity to risk - these are not made public - they are used to make decisions about whether to take formal action against the bank or even to close it - current practice is for supervisors to act as consultants, advising banks how to get the highest return possible while keeping risk at an acceptable level

Government regulation

established a set of specific rules for intermediaries to follow

Deposit insurance

guaranteeing that depositors receive the full value of their accounts if the institution fails

The Federal deposit insurance corporation (FDIC)

guarantees that a depositor will receive the full account balance up to some maximum amount even if a bank fails - bank failures, in effect, become the problem of the insurer; bank customers need not worry - when a bank fails, the FDIC resolves the insolvency either by closing the institution or finding a buyer - closing the bank is called payoff method - the second approach, and more commonly applied is called the purchase and assumption method - because the U.S. treasury backs the FDIC, it can withstand virtually any crisis that does not undermine the nations sovereign credit standing - deposit insurance clearly helped to prevent runs on commercial banks - however, it did not prevent the crisis of 2007-2009 and the runs associated with it. 1. deposit insurance only covers depository institutions - however, as the system developed, shadow banks gained importance 1. they too face the risk of runs by their short-term creditors 2. these nonbanks lack the benefits of deposit insurance

Too-big-to fail policy

is ripe from reform - normally, the fear of withdraw of large depositors from a bank or MMF restrains them from taking too much risk - but the too-big-to-fail policy renders to deposit insurance ceiling meaningless - compounds the problems or moral hazard

Lender of last resort

making loans to banks that face sudden deposits outflows

The government is obligated to protect small investors

many are unable to judge the soundness of their financial institution - competition is supposed to discipline all the institutions in the industry, but only the force of law can ensure a bank's integrity

Risk-weighted assets

measurement problems arise both with a simple unweighted measure of assets and with the regulatory quantity - calculating the level of risk-weighted assets is difficult

The growing tendency for small firms to merge into large ones reduced competition

monopolies are inefficient, so they government intervenes to prevent the firms in an industry from becoming too large - in the financial system, that means making sure even large banks face competition

Government examination

of an institution's books by specialists provides detailed information on the firm's operation

continuous examination

once they get to the end, they start over and do it all again

Government supervision

provides general oversight of financial institutions

Regulator Shopping

results in ineffective oversight from the financial crisis of 2007-2009 highlighted in these cases - AIG was supervised by the U.S. Office of Thrift Supervision (OTS) that also had supervised failed savings banks like countrywide, IndyMac and Washington Mutual - they has less expensive than other supervisors with the insurance business, especially the complexity of AIG

Purchase-and-assumption method

the FDIC finds a firm willing to take over the failed bank - depositors prefer this method - the transaction is typically seamless - no depositors suffer a loss

Payoff method

the FDIC pays off all the bank's depositors, then sells all the bank's assets

Supervision

the government enforces banking rules and regulations through an elaborate oversight process - this relies on a combination of monitoring and inspection - it is done both remotely and through on-site examination

Macro-pudential regulation

treats systemic risk taking by an intermediary as a king of pollution that spills over to other financial institutions and markets

Are your deposit insured?

what does "each depositor insured to $250,000 really mean? 1. Deposit insurance covers individuals, not accounts 2. If you have more than one account at the same bank, all in your name, they will be insured together up to the insurance limit 3. If you have accounts at more than one bank, they will be insured separately, up to the insurance limit at each bank 4. The rules for government deposit insurance can change