Regulating the Banking Industry ECO 473 – Money & Banking – Dr. D. Foster.

ECO 473 – Money & Banking – Dr. D. ECO 473 – Money & Banking – Dr. D. FosterFoster

Maintaining depository institution liquidity.

Assuring bank solvency bylimiting failures.

Promoting an efficient financial system.

Protecting consumers.

The Banking Act of 1933 (Glass-Steagall Act):◦ Created the Federal Deposit Insurance

Corporation (FDIC).

◦ Placed interest rate ceilings on checking deposits of commercial banks.

◦ Separated commercial and investment banking.

◦ Branching restrictions.

Disintermediation in the 1970s.

1980 - Depository Institutions 1980 - Depository Institutions Deregulation and Monetary Control Act Deregulation and Monetary Control Act (DIDMCA):(DIDMCA):

◦ Six-year phaseout of interest rate ceilings. ◦ Permitted NOW accounts.◦ Increased FDIC coverage to $100,000.

The Garn–St. Germain Act of 1982:The Garn–St. Germain Act of 1982:◦ Authorized money market deposit accounts.

◦ Increase the DIDMCA limit on consumer loans and commercial paper.

◦ Authorized savings institutions to make commercial real estate loans.

◦ Gave these institutions the power to purchase “unsecured loans,” including low-rated, “junk” bonds.

◦ Gave the FDIC power to permit troubled financial institutions to merge with healthier partners.

1989 - Financial Institutions Reform, 1989 - Financial Institutions Reform, Recovery & Enforcement Act (FIRREA)Recovery & Enforcement Act (FIRREA):

◦ Authorized taxpayer funds to cover cost of liquidating failed thrifts.--Insurance wasn’t enough!

◦ Abolished current thrift regulatory structure.--Created Office of Thrift Supervision.--Created the Resolution Trust Corp. to liquidate thrifts.

◦ Moved thrift insurance (FSLIC) into FDIC.

◦ Required insurance fund = 1.25% of insured deposits.

The moral-hazard problem of deposit The moral-hazard problem of deposit insuranceinsurance:◦ S&L crisis.

Too-big-to-fail policyToo-big-to-fail policy:◦ Continental Illinois.

The FDIC Improvement Act Of 1991The FDIC Improvement Act Of 1991-- Allowed for earlier intervention by the FDIC.-- Let FDIC set/change premiums to boost fund.-- Mandated risk-based premium structure.

Origins to the Civil War …-- The Commercial National Bank.-- Mergers in 1910 and in 1929.-- Name change in 1932.

$50 million loan to survive the Great Depression-- Reconstruction Finance Corp. (gov’t.)

One of two largest Chicago banks in 1900s.

Generally, a conservative bank …-- Until the 1970s and its focus on commercial lending.

By 1981, CINB was 7th largest bank in the U.S.-- Total assets = $45 billion.

Largest provider of commercial loans.-- $14 billion.-- Citibank was next, at $12.5 billion.

Great average ROE from 1977-1981. -- 14.35% (2nd highest among top 10 banks).

Stock price high and rising.-- 1974 - $13; 1979 - $27; 1981 - $42.

1/25/1982

Morgan Stanley - CINB stock is an

“attractive” buy.

Current price = $38.

-- Penn Square Bank fails in July, 1982- Large portfolio of speculative oil & gas loans.- CINB owns $1 billion in Penn participations. (About half Penn’s total; Penn had $500 mill. in assets).

• Problems:-- Loan/Assets = 69% in 1981 (58% in 1977)-- ROA falling to .51% in 1981.

- Rolling over loans at lower interest rates.

-- Large corporate customers going bankrupt.- Nucorp, Int’l Harvester had $250 mill. in loans.

-- Core deposits constant from 1977-1981.- Falling from 30% to 20% of total deposits.

-- Expensive, long-term CDs double; up to 30% of dep.-- Stock price down to $16.

The Continental Illinois StoryThe Continental Illinois Story

-- Major shareholders dump CINB- U.S. Steel & Carnegie pensions completely divest

themselves.- Stock had been recovering was back down to $14.

• It gets worse:

-- By early 1984, non-performing loans …$2.3 billion

Over half from troubled Latin America

-- In early May 1984, the bank run begins.

“The only difference between Continental and the Titanicis that the Titanic had a band.”

--A.F. Ehrbar, Fortune magazine, 2/7/1983

The Continental Illinois StoryThe Continental Illinois Story

-- FDIC promises to protect all deposits, even if over the $100,000 maximum!

• The bank run:-- By May 11, CINB borrows $3.6 bill. from Fed’l Reserve

-- Correspondent banks withdraw deposits.

-- CINB creates $5.4 billion loan package w/16 banks.

-- FDIC provides $2 billion in assistance.

-- A group of 24 banks puts together a $5.3 billion deal.

-- In July, as $ continue to flow out, FDIC “buys” $4.5 billion in bad loans from CINB.-- By September, all of top management & board of directors are replaced and a permanent plan is in place.

-- In 1994, merged into Bank of America.

The Continental Illinois StoryThe Continental Illinois Story

The moral-hazard problem of deposit The moral-hazard problem of deposit insurance.insurance.

Too-big-to-fail policy.Too-big-to-fail policy.

Was their strategy bad, or was it Was their strategy bad, or was it something else?something else?

ResolutionDepository Assets Failure Cost Institution ($ Billions) Date ($ Billions)

First Republic Bank (Dallas) $33.5 July 1988 $3.9

MCorp (Dallas) 15.7 February 1989 2.8

Continental Illinois (Chicago) 33.6 May 1984 1.1

Texas American (Fort Worth) 4.8 July 1989 1.1

First City Bancorp (Houston) 4.8 April 1988 1.1

Bank of New England (Boston) 21.8 January 1991 0.9

Goldome FSB (Buffalo) 8.7 May 1988 0.8

New York Bank for Savings (NYC) 3.4 March 1982 0.8

1st National Bank of Keystone (WV) 1.1 September 1999 0.8

Crossland Savings Bank (Brooklyn) 7.3 January 1992 0.7

Superior Bank (Illinois) 2.3 July 2001 0.6

Capital requirementsCapital requirements:◦ Minimum equity capital standards.

Risk-based capital requirementsRisk-based capital requirements:

◦ Risk factors that distinguish different depository institutions. [Degree of capitalization.]

Risk-adjusted assetsRisk-adjusted assets:◦ A weighted average of bank assets to account

for risk differences across types of assets. [Type of capitalization.]

Act removes Glass-Steagall restrictionsand permits:

◦ Securities firms and insurance companies to own commercial banks.

◦ Banks to underwrite insurance andsecurities, including shares of stock.

Off-balance-sheet banking:◦ Loan commitment; credit default swaps.

Asset valuation:◦ Historical cost vs. market value

Derivatives:◦ Replacement cost exposure.◦ Credit/market/operating risks.

New wave of regulation:◦ SOX; Dodd-Frank

ECO 473 – Money & Banking – Dr. D. ECO 473 – Money & Banking – Dr. D. FosterFoster