381 CH 18

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Banking Act of 1933

(the Glass-Steagall Act) separated banking and securities activities -firms that accepted deposits could not underwrite stock and corporate bonds

financial services modernization act

(the Gramm-Leach-Bliley Act) -repealed the Glass-Steagall Act -since 1999, there has been more consolidation of financial institutions

character

*the most important the borrowers willingness to repay loans as measured by its payment history on the loan and credit report

Basel I Accord

-1988: The central banks of 12 major countries agreed to establish uniform capital requirements. -Banks with greater risk are required to maintain a higher level of capital, which discourages banks from excessive exposure to credit risk. -Assets are weighted according to risk.

orderly liquidation

-Assigned specific regulators to determine whether any particular financial institution should be liquidated. -Calls for the creation of an orderly liquidation fund that can be used to finance the liquidation of any financial institution that is not covered by the FDIC.

Basel III Framework

-Attempts to correct deficiencies of Basel II. -Calls for higher capital requirements to offset bank exposure due to derivative positions. -Recommends that banks maintain Tier I capital (retained earnings and common stock) of at least 6% of total risk-weighted asset. -Recommends the use of scenario analysis to determine how a bank's performance and capital level would be affected should economic conditions deteriorate. -Also calls for improved liquidity requirements.

regulation of off-balance sheet transactions

-Bank exposure to off-balance sheet activities has become a major concern of regulators. -Banks could be riskier than their balance sheets indicate because of these transactions.

capital adequacy

-Because adequate bank capital is thought to reduce a bank's risk, regulators determine the capital ratio (typically defined as capital divided by assets). -Banks with higher capital ratios are therefore assigned a higher capital adequacy rating. -Fair value accounting is used to measure the value of bank assets.

funding the closure of failing banks

-If a failing bank cannot be saved, it will be closed. -When liquidating a failed bank, the FDIC draws from its Deposit Insurance Fund to reimburse insured depositors. -The cost to the FDIC of closing a failed bank is the difference between the reimbursement to depositors and the proceeds received from selling the failed bank's assets.

argument FOR government rescue

-If all financial institutions that were weak during the credit crisis had been allowed to fail without any intervention, the FDIC might have had to use all of its reserves to reimburse depositors.

failure of Legman and Rescue of AIG

-In September 2008, Lehman Brothers was allowed to go bankrupt without any assistance from the Fed even though American International Group (AIG, a large insurance company) was rescued by the Fed. -One IMPORTANT difference between AIG and Lehman Brothers was that AIG had various subsidiaries that were financially sound at the time, and the assets in these subsidiaries served as collateral for the loans extended by the federal government to rescue AIG. -The risk of taxpayer loss due to the AIG rescue was low

corrective action by regulators

-Regulators may examine banks frequently and discuss with bank management possible remedies -Regulators may request that a bank boost its capital level or delay its plans to expand. -They can require that additional financial information be periodically updated to allow continued monitoring. -They have the authority to remove particular officers and directors of a problem bank if doing so would enhance the bank's performance. -They can take legal action against a problem bank if the bank does not comply with their suggested remedies.

regulatory structure

-a charter from either a state or the federal government is required to open a commercial bank in the US

Protests of government funding for banks

-bailouts led to the organization of various groups -the Tea Party organized in 2009 and staged protest mainly about excessive government spending -in 2011, Occupy Wall Street organized and also staged protests

global bank regulations

-each country has a system for monitoring and regulating commercial banks -most countries also maintain different guideline for deposit insurance -differences in regulatory restrictions give some banks a competitive advantage in a global banking environment

Depository Institutions Deregulation and Monetary Control Act (DIDMCA)

-enacted to deregulate the banking (and other depository institutions) industry -also enacted to improve monetary policy

regulatory stress tests during the credit crisis

-forecasting the likely effect on the banks capital levels if the recession existing at that time lasted longer than expected -potential impact of an adverse scenario such as a deeper recession varies among banks

regulation of insurance services

-in 1998, regulators allowed the merger between Citicorp and Traveler's insurance group -this paved the way for the consolidation of bank and insurance services

limitations of the VaR model

-ineffective at detecting the risk of banks during the credit crisis -The use of historical data from before 2007 did not capture the risk of mortgages because investments in mortgages during that period normally resulted in low defaults.

Garn-St. Germain Act

-permitted depository institutions to offer money market deposit account and to acquire failing institutions across geographic boundaries

explicitly accounting for operational risk

-provided an incentive for banks to reduce their operational risk by imposing higher capital requirements on banks with higher level of operational risk -many banks underestimated the risk of loan default during the credit crisis which led to development of Basell III

deposit insurance fund

-regulated by the FDIC -range of premiums typically between 13 and 53 cents per $100 with most banks between 13 and 18 cents

interstate banking act

-removed interstate branching restrictions and thereby further increased the competition among banks for deposits -nationwide interstate banking enabled banks to grow and achieve economies of scale

how a rescue might reduce systemic risk

-the financial problems of a large bank failure can be contagious to other banks -the rescue of large banks might be necessary to reduce systemic risk in the financial system

bank deposit insurance reserves

-the wall street reform and consumer protection act of 2010 requires that the deposit insurance fund should maintain reserves of at least 1.35% of total insured bank deposits -must develop a restoration plan if drops below 1.35% -must pay back as dividends if grows above 1.5%

deregulation

1. interest rate 2. geographic 3. asset powers

regulation of highly leveraged transactions

As a result of concern about the popularity of highly leveraged loans, bank regulators monitor the amount of highly leveraged transactions (HLTs), loans in which liabilities are greater than 75% of assets

regulation of capital

Banks are subject to capital requirements, which force them to maintain a minimum amount of capital (or equity) as a percentage of total assets.

CAMELS ratings

Capital adequacy Asset quality Management Earnings Liquidity Sensitivity -each characteristic is rated on a 1-5 scale, with 1 indicating outstanding and 5 very poor -banks with a composite rating of 4.0 or higher are considered to be problem banks

regulation of bank ownership

Commercial banks can be either independently owned or owned by a bank holding company (BHC)

the 5 C's

Fed considers these to assess the quality of the loans extended by a bank, which it is examining: -capacity -collateral -condition -capital -character

mortgage origination

Requires that banks and other financial institutions granting mortgages verify the income, job status, and credit history of mortgage applicants before approving mortgage applications.

sales of mortgage backed securities

Requires that savings institutions and other financial institutions that sell mortgage-backed securities to retain 5% of the portfolio unless the portfolio meets specific standards that reflect low risk.

financial stability oversight council

Responsible for identifying risks to financial stability in the United States and makes recommendations that regulators can follow to reduce risks to the financial system.

consumer financial protection bureau

Responsible for regulating finance products and services offered by commercial banks and other financial institutions, such as online banking, checking accounts, and credit cards

limitations of regulatory reform

The complex set of regulators for financial institutions can lead to overlapping and excessive regulation for some types of financial institutions but very little oversight of other types of financial institutions. Inconsistent levels of regulation among regulators motivate some financial institutions to pursue a particular charter that can avoid regulations or allow for easier compliance.

insurance limits

The specified amount of deposits per person insured by the FDIC was increased from $100,000 to $250,000 as part of the Emergency Economic Stabilization Act of 2008 and made permanent with the Financial Reform Act of 2010.

national bank

a bank that obtains a federal charter -required to be members of the fed

state bank

a bank that obtains a state charter -may decide whether they wish to be members of the federal reserve system

earnings

a profitability ratio used to evaluate banks return on assets (ROA) -defined as after tax earnings divided by assets

troubled asset relief program (TARP)

addressed the financial problems experienced by financial institutions with excessive exposure to mortgages or mortgage-backed securities

testing the validity of a Bank's VaR

assessed by comparing the actual daily trading gains or losses to the estimated VaR over a particular period

regulation of bank investments in securities

banks are not allowed to use borrowed or deposited funds to purchase common stock -banks can invest in bonds that are investment grade quality (as measured by a Baa rating or higher by Moddy's or a BBB rating or higher by standard & poor's)

regulation of loans to community

banks are regulated to ensure that they attempt to accommodate the credit needs of the communities in which they operate

regulation of loans to a single borrower

banks are restricted to a maximum loan amount of 15% of their capital to any single borrower (up to 25% if the loan is adequately collateralized)

reducing dividends

banks can increase their capital by ____ their ____

retaining earnings

banks commonly boost their capital levels by ____ _____ or by issuing stock to the public

deregulation

banks have considerable flexibility in the services they offer, the locations where they operate, and the rates the pay depositors for deposits

risk based deposit premiums

banks insured by the FDIC must pay annual insurance premiums

government rescue of bear stearns

bear stearns had facilitated many transactions in financial markets, and its failure would have caused liquidity problems -the Fed provided short term loans to Bear Stearns to ensure that it had adequate liquidity

limitations of the CAMELS rating system

because there are so many banks, regulators do not have the resources to closely monitor each bank on a frequent basis -many problems go unnoticed

revising the measurement of credit risk

categories are refined to account for differences in risk levels

community reinvestment act (CRA)

created in 1977 revised in 1995 requires banks to meet the credit needs of qualified borrowers in their community, even those with low or moderate incomes

asset quality

each bank makes its own decisions as to how deposited funds should be allocated, and these decisions determine its level of credit (default) risk

sarbanes-oxley act

enacted in 2002 to ensure a transparent process for financial reporting

regulation of deposit insurance

federal deposit insurance has existed since the creation in 1933 of the FDIC in response to the bank runs that occurred in the late 1920's and early 1930's -the FDIC preserves public confidence in the US financial system by providing deposit insurance to commercial banks and savings institutions

nationalized bank

government owns this bank

liquidity

if existing depositors sense that the bank is experiencing a liquidity problem, they may withdraw their funds, compounding the problem

dual banking system

includes both a federal and a state regulatory system

regulation of foreign loans

monitor a banks exposure to loans to foreign countries

regulators

national banks are regulated by the comptroller of the currency, while state banks are regulated by their respective state agency -banks that are insured by the Federal Deposit Insurance are also regulated by the FDIC

bank regulation

needed to protect customers who supply funds to the banking system -many regulations were removed or reduced over time which allowed banks to become more competitive

Basel II Framework

refines risk measures and increases transparency

sensitivity

regulators assess the degree to which a bank might be exposed to adverse financial market conditions

regulation of credit default swaps

regulators increased their oversight of this market and asked commercial banks to provide more information about their credit default swap positions

management (of the bank)

regulators specifically rate the bank's management according to: -administrative skills -ability to comply with existing regulations -and ability to cope with a changing environment

trading of derivative securities

requires that derivative securities be traded through a clearinghouse or exchange, rather than over the counter

regulation of the accounting process

sarbanes-oxley act

credit crisis of 2008-2009

some banks and other financial institutions engaged in excessive risk taking in recent years

money market fund

take money and buy treasury bills

capacity

the borrowers ability to pay

value at risk (VaR) model

the capital requirements to cover general market risk are based on the bank's own assessment of risk when applying this -the estimated potential loss from its trading businesses that could result from adverse movements in market prices

condition

the circumstance that led to the need for funds

capital

the difference between the value of the borrowers assets and its liabilities

collateral

the quality of the assets that back the loan

selling assets

when bank regulators of various countries develop their set of guidelines for capital requirements, they are commonly guided by the recommendations in the Basel accords

argument AGAINST government rescue

when the federal government rescues a large bank, it sends a message to the banking industry that large banks will NOT be allowed to fail -some critics recommend a policy of letting the market work, meaning that no financial institution would ever be bailed out

limits on bank proprietary trading

■Mandates that commercial banks must limit their proprietary trading, in which they pool money received from customers and use it to make investments for the bank's clients. -Also known as the Volcker Rule after Paul Volcker, a previous chair of the Federal Reserve, who initially proposed the rule


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