Lecture 10

Regulation of FIs
 Specialness of FIs
Liquidity and Price Risk
Secondary claims issued by FIs have less
price risk
Demand deposits and other claims are more
liquid
More attractive to small investors
FIs have advantage in diversifying risks
 Other Special Services
Reduced transactions costs
Maturity intermediation
Transmission of monetary policy
Credit allocation (areas of special need such
as home mortgages)
Intergenerational transfers or time
intermediation
Payment services (BACS and CHAPS)
Denomination intermediation
 Specialness and Regulation
FIs receive special regulatory attention
Reasons:
Negative externalities of FI failure
Special services provided by FIs
Institution-specific functions such as money
supply transmission, credit allocation,
payment services, etc.
 Regulation of FIs
Important features of regulatory policy:
Protect ultimate sources and users of savings
Including prevention of unfair practices such as
redlining and other discriminatory actions
Primary role:
Ensure soundness of the overall system
 Regulation
Safety and soundness regulation:
Regulations to increase diversification
No more than 10 percent of equity to single
borrower
Minimum capital requirements
TARP and Capital Purchase Program
 Regulation
Guaranty funds:
Deposit insurance fund (DIF):
Securities Investors Protection Fund (SIPC)
Monitoring and surveillance:
FDIC monitors and regulates DIF participants
Increased regulatory scrutiny following crises
Regulation is not costless
Net regulatory burden
 Regulation
Monetary policy regulation
Federal Reserve directly controls outside
money
Bulk of money supply is inside money
(deposits)
Reserve requirements facilitate transmission
of monetary policy
 Regulation
Credit allocation regulation
Supports socially important sectors such as
housing and farming
Requirements for minimum amounts of assets in a
particular sector or maximum interest rates or fees.
 Regulation
Consumer protection regulation
Community Reinvestment Act (CRA)
Home Mortgage Disclosure Act (HMDA)
Effect on net regulatory burden
FFIEC processed info on as many as 17
million mortgage transactions in 2009
Analysts questioning the net benefit
 Consumer Protection Regulation
Potential extensions of regulations
CRA to other FIs such as insurance
companies in light of consolidation and trend
toward universal banking
New additions:
Consumer Financial Protection Agency (2009)
Credit card reform bill effective 2010
 Regulation
Investor protection regulation
Protections against abuses such as insider
trading, lack of disclosure, malfeasance,
breach of fiduciary responsibility
Key legislation
Securities Acts of 1933, 1934
Investment Company Act of 1940
 Regulation
Entry regulation
Level of entry impediments affects profitability
and value of charter
Regulations define scope of permitted
activities
Financial Services Modernization Act of 1999
Affects charter value and size of net
regulatory burden
 Changing Dynamics of Specialness

Trends in the United States

Decline in share of depository institutions and
insurance companies
Increases in investment companies
May be attributable to net regulatory burden
imposed on depository FIs
Financial Services Modernization Act
Financial services holding companies
 Risk and the Financial Crisis
Reactions to FSM Act and other factors:
Shift from originate and hold to originate
and distribute
Affects incentives to monitor and control risk
Shift to off balance sheet risks
Degraded quality and increased risk
Housing market bubble
Encouraged subprime market and more
exotic mortgages
 Global Trends
US FIs facing increased competition from
foreign FIs
Only 2 of the top ten banks are US banks
Foreign bank assets in the US typically
more than 10 percent
As high as 21.9 percent
 Financial Crisis
DJIA fell 53.8 percent in less than 1
years as of mid-March 2009
Record home foreclosures
1 in 45 in default in late 2008/2009
Goldman Sachs and Morgan Stanley
Only survivors of the major firms
 Financial Crisis
AIG bailout
Citigroup needed government support
Chrysler and GM declared bankruptcy in
2009
Unemployment in excess of 10 percent
 Beginning of the Collapse
Home prices plummeted in 2006-07
Mortgage delinquencies rose
Foreclosure filings increased 93 percent from
July 2006 to July 2007
Securitized mortgages led to large financial
losses
Subprime mortgages
Countrywide Financial bailed out and
eventually taken over by Bank of America
Ch 1-19
 Significant failures and events
Bear Stearns funds filed for bankruptcy
Acquired by J.P. Morgan Chase
Fed moved beyond lending only to Depository
Institutions
Government seizure of Fannie Mae and
Freddie Mac
Lehman Brothers failure
Crisis spread worldwide
Ch 1-20
 Rescue Plan
Federal Reserve and other central banks
infused $180 billion
$700 billion Troubled Asset Relief Program
(TARP)
Still struggling in 2009
$827 billion stimulus program
American Recovery and Reinvestment Act of
2009

Ch 1-21
 Monetary Policy Tools
Open Market Operations

The Discount Rate

Reserve Requirements (Reserve Ratios)

Ch 1-22
 Effects of Monetary Policy
Effects of Monetary Policy Tools on
Various Economic Variables:
Expansionary Activities
Contractionary Activities

Ch 1-23
Financial Crisis
 Introduction
From 2007 to mid-2009, global financial markets and
systems have been in the grip of the worst financial crisis
since the Depression era of the late 1920s. Major banks
in the U.S., the U.K. and Europe have collapsed and
been bailed out by state aid

The crisis has had a massive adverse impact on global

banking systems. The International Monetary Funds
Global Financial Stability Report (IMF, 2009) reports an
estimate of $2.7 trillion for write-downs of U.S.-originated
assets by banks and other financial sector institutions
between 2007 to 2010
 What Went Wrong?
Macroeconomic factors
Global financial imbalances
Long period of low real interest rates

Microeconomic Factors
Consumers failed to watch out for themselves
Managers of financial firms increased returns by boosting
leverage
Manager compensation schemes further encouraged risk-
taking
Skewed incentives of the rating agencies
Limitations of risk measurement, management and
regulation
 Stages of The Crisis
Stage 1: Losses in the U.S. subprime market starting in
the summer of 2007 to June 2007 up to mid-March 2008
Stage 2: Events leading up to the Lehman Brothers
bankruptcy, mid-March to mid-September 2008
Stage 3: Global loss of confidence, 15 September to
late October 2008
Stage 4: Investors focus on the global economic
downturn, late October 2008 to mid-March 2009
Stage 5: Signs of stabilization, from mid-March 2009
 The Role Of Securitization
The rapid growth in securitization was a major cause of
the crisis. This activity has had a major impact on the
funding of residential property markets but also on the
flexibility with which banks can manage their loan books

The collapse of subprime mortgage lending in the U.S.

and related securitized products is seen by many as the
start of the credit crisis
 The Role of Securitization
Securitization involves the process where banks find
borrowers, originate loans but then sell the loans
(repackaged as securities) on to investors. This is
known as the originate-to-distribute model in contrast to
the traditional originate and hold approach

Securitization relates to the pooling of credit-risky assets,

traditionally residential mortgage loans (but nowadays
also includes other types of credits such as car loans,
credit card receivables or any credit generating some
form of predictable cash flow), and their subsequent sale
to a special purpose vehicle (SPV), which then issues
securities to finance the purchase of the assets
 The Role of Securitization
Subprime loans refer to loans to higher risk borrowers
those that are not prime borrowers.

The use of subprime loans in the underlying collateral

allowed mortgage-backed securities (MBS) and
collateralized debt obligation (CDO) packagers to
enhance their profit margins while offering competitive
returns on their securitizations
 The Role Of Securitization
Most securities issued by SPVs were rated by credit
rating agencies to make them more attractive to
investors

The risks of the portfolio could further be improved by

various credit enhancement techniques such as third-
party guarantees (insurance from monoline insurers to
protect the value of assets), overcollateralization (holding
a larger pool of assets than securities issued) and by
something known as excess spread (originators, namely
banks, inject cash into the SPV that will bear certain
early losses)
 Impact of the Crisis
The credit crisis spread rapidly, having a particularly
disastrous impact on the financial systems of the U.S.,
U.K., Ireland and Iceland

No major European system was immune from its effects

as banks failed or had to be supported via capital and
liquidity injections

Japanese banks appeared less affected by the crisis

than most, although they have had a poorly performing
domestic economy to worry about for over a decade
 Regulation
Governments and various international organizations
have proposed major reforms to the financial system
covering:
The cleansing of bank balance sheets
Increased capital and liquidity requirements
Increased oversight and regulation of securitization
business, hedge funds and credit rating agencies
See details of the Dodd Frank Act (2010) in the US
and the Vickers Commission Report (2011) for the UK
on reform to the system. (Details in Chapter 6) (Also
see Liikanen Report, June 2012) on EU reform)
Post-Crisis Changes in
regulation
 After the Crisis
Since the wave of government-backed bank bailouts,
recapitalization plans, liquidity injections, and credit guarantee
schemes promulgated by the financial crisis there have been
widespread policy concerns about the business models pursued by
banks and how they were regulated.

Large scale banking rescues have raised serious concerns about

the social and economic costs of Too-Big-To-Fail (TBTF) or Too
Systemically Important to Fail.

An important question for policy makers is whether limits should be

placed on bank size, growth or concentration, to minimize the moral
hazard concerns raised by banks having achieved TBTF or related
status.
 After the Crisis
In addition to the actions of national governments, the
European Commission has issued several
communications concerning aspects of the crisis
covering:
the application of state aid rules to the
banking sector;
the treatment of banks' impaired assets;
the recapitalisation of financial institutions;
and
the provision of restructuring aid to banks.
Many of the regulatory or supervisory frameworks for
dealing with problems in the financial system at an EU level
were found to be lacking.
 Frequency of Crises
There were 124 systemic banking crises in 101 countries
and they often occur regularly in the same countries,
with 19 countries experiencing more than one banking
crisis (e.g., Argentina, 4; Mexico, 2; USA, 2).
Banking crises can have very large fiscal costs (e.g.,
Argentina, 75% of GDP; Chile, 36% of GDP; China, 18%
of GDP; Korea, 31% of GDP; Indonesia, 57% of GDP;
Mexico, 20% of GDP).
Banking crises are often associated with very large
output losses. For example, relative to trend output,
losses reached 73% in Argentina, 92% in Chile, 37% in
China, 59% in Finland, and 31% in Sweden.
 Rationale for Regulation
Monopoly power. Regulation may be needed to prevent
banks from distorting competition if they have monopoly
power.

Welfare considerations. Regulating for welfare reasons

mainly reflects the desire to protect people in cases
where information is limited or is costly to obtain.

Externalities. The riskiness of an individual bank is the

responsibility of the banks managers, owners and debt
holders except in so far as the banks failure impacts on
the wider system via spillover externalities
 Information Asymmetries
This occurs when the party to one side of an economic
transaction has more information than the other party.
There are two types of asymmetric information in
financial institutions and markets:
adverse selection - the riskiest
individuals/institutions will be the most eager to
borrow, but lenders are aware of this and may not
lend to low and high risk borrowers because they
cannot distinguish between them
moral hazard borrowers take actions that harm
lenders, which means that lenders may not lend
because they cannot monitor borrowers effectively
 Too-Big-To-Fail
Too-big-to-fail is a problem if governments care more
about the largest institutions, then banks have an
incentive to become large and then take on too much
risk
Systemic risk refers to all events capable of imperiling
the stability of the banking and financial system
Most Systemically Important Financial Institutions (SIFIs)
are European
 Regulatory Response to the
Crisis
Main regulatory response to the crisis has been the US
Dodd Frank Act 2010, recommendations made by the
UK Vickers Commission in September 2011, Basel 3 (to
be implemented by 2019) and in Europe the
establishment of the ESFS and EBA stress testing.
All seek to re-capitalize the banks, boost liquidity and
constrain activity.
Recent stress tests still reveal capital shortages in the
banking sector, and more pessimistic scenarios
regarding sovereign debt haircuts suggest that many
European banks in particular will have to continue to
keep on capital raising into the foreseeable future.
EU Bank Performance & Stress
Tests
The ECB estimates of the performance of large
and complex banking groups in the Euro Area
between 2005 and 2010 highlighting the
disastrous losses made in 2008 and small pick-
up in ROE thereafter.
See the colossal increase in cost-income ratios
in 2008 due to a collapse in income in following
Table
Also witness the substantial increase in Tier 1
capital and solvency ratios in 2009 and 2010.
 Performance of Large and Complex
Banking Groups in the Euro Area
Cost-Income
Tier 1 Ratio Solvency Ratio
Return on Equity Impaired Loans/ Ratio
Year
(%) Total Assets (%)
(%) (%) (%)

Median Average Median Average Median Average Median Average Median Average

2005 10.04 11.93 0.08 0.11 60.69 58.87 7.89 8.2 11.05 11.23

2006 14.81 14.61 0.07 0.11 5595 56.4 7.75 8.07 11.01 11.16

2007 11.97 11.65 0.05 0.1 63 62.95 7.4 7.72 10.6 10.72

2008 2.26 -14.65 0.27 0.31 73.36 160.96 8.59 8.58 11.7 11.37

2009 2.97 0.34 0.45 0.55 60.35 62.47 10.15 10.33 13.6 13.37

2010 7.68 6.76 0.24 0.32 60.4 62.01 11.2 11.38 14.1 14.38

Source: Adapted from ECB, Financial Stability Review, June 2011, Table S5, page S30-S31.
 European Banking Authority
(EBA) Stress Tests
European Banking Authority (EBA) did bank stress tests
on 15th July 2011 that covered 90 banks operating in 21
European countries.
The main findings can be summarised as follows:
By December 2010 twenty banks would not have achieved the
benchmark 5% Tier 1 capital ratio over the two-year horizon
2010-2012 of the exercise. This amounts to a capital shortfall of
some EUR 26.8 billion.
The 90 banks in question raised an additional EUR 50 billion
between January and April 2011.
Eight banks did not achieve the 5% the capital threshold
amounting to a shortfall of EUR2.5 bn.
16 banks achieved a Tier 1 ratio of between 5% and 6%.
 Overhaul of Regulatory
Architecture
An overhaul of current regulatory structures will
inevitably continue to take place.
New rules place a greater emphasis on: simple
leverage and liquidity ratios; the curtailment of
opaque business models; and minimising the
distortions caused by TBTF or/and strategically
important banks.
A new supervisory architecture will gradually be
put in place.
 Reading and Task
Basle I
Basle II
Basle III
Exam Questions