Lecture 12_Chapter 11

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					          Chapter 11
Economic Analysis of Banking Regulation
                    Bank Failure
• Any indication of insolvency can cause a run on
  banks causing a healthy bank into insolvency.
   – creating losses for its owners and depositors

• Depositors cannot tell the good from the bad.
   – problem of asymmetric information.

• “Contagion effect”
An Example of a Bank Run
• Assume depositors lose confidence in an otherwise healthy
  bank causing a run of the bank

• The bank first uses liquid reserves and sells securities to
  meet depositor demands to withdraw funds

• The bank is next forced to sell loans at the fire-sale price of
  $0.50 per $1, the bank pays off half of remaining deposits

• The bank cannot pay off the remaining deposits and has
  negative net worth, so the remaining depositors and bank
  owners both lose.
Run on a Bank - Example
Cyclical downturns are associated with
bank panics (bank runs)

• The period prior to the Federal Reserve, 1871-
  – Eleven recessions
  – Bank panics during 7 recessions
  – No panics without recessions.
    The Government Safety Net

• Lender of Last Resort (Federal Reserve)

• Deposit Insurance (FDIC)
Government Safety Net: Lender of Last Resort

• Lend to solvent but illiquid banks

• Does this create a moral hazard?
   – Does the “lender of last” resort encourage banks to take
     on too much risk?
Government Safety Net: Deposit Insurance

 • Does this create a moral hazard?
 • Depositors lose incentive to monitor risk taken by
   the bank’s managers
 • Do banks have incentive to take on more risk?
    – Before deposit insurance, ratio of assets to bank capital
      was 4 to 1.
    – After deposit insurance, ratio of assets to bank capital
      was 13 to 1.

• Created in 1934
• Eliminate run on banks and prevent bank
• Deposits insured up to $100,000 – now
  $250,000 through 12/31/2013.
• 1930 – 1933, 2000 failures per year.
• 1934 - 1981 fewer than 15 failures per year.
What does the FDIC do if bank fails?

• Payoff method.

• Purchase and assumption method.
     How to reduce Moral hazard
1. Restrictions on Asset Holdings
   A. Reduces moral hazard of too much risk taking.
      For example, Glass - Steagall Act, bank’s can’t
      hold common stock.
   B. Limits on loans to particular borrower or industry.
2. Minimum Bank Capital Requirements
      Reduces moral hazard: banks have more to lose
      when have higher capital.
      Must be >5% to avoid regulatory restrictions.
      Basel Accord: 8% of risk-weighted assets. Also,
      higher capital means more collateral for FDIC to
 Minimum Capital Requirement:
 Basel – I Capital Requirements

     Asset                           Risk Weight

Cash and equivalents (reserves)                    0
Government securities                              0
Interbank loans (Federal Funds)                    0.2
Mortgage loans                                     0.5
Ordinary loans (Comm’l and Industrial)             1.0
Capital Requirements for Melvin’s
Bank        First National Bank
Capital Requirements for Melvin’s
         How to reduce Moral hazard

3. Bank Supervision: Chartering and Examination
   A. Chartering reduces adverse selection problem of
      risk takers or crooks owning banks
   B. Examination reduces moral hazard by preventing
      risky activities
   -   Capital adequacy
   –   Asset quality
   –   Management
   –   Earnings
   –   Liquidity
   –   Sensitivity to market risk
Bank Failures in the United States,

Source: www.fdic.gov/bank/historical/bank/index.html.
Why a Banking Crisis in 1980s? - Early Stage
 1.   Loss of “sources of funds” to competition due to financial
      innovation - Money Market Mutual Funds
 2.   Loss of “uses of funds” to competition - Commercial Paper
      and junk bonds (financial innovation in direct finance)
 3. Loss of revenues, loss of cost advantages => reduced profits
 4.   Lack of diversification - no branch banking (geographic)
         Texas banks concentrated in energy loans (industry)

 5.   π =>i  => cost of funds 
 6. Incentives for greater risk taking
            - Real estate, corporate takeover
            Result: Risky loans and bank Failures
    Why a Banking Crisis in 1980s?
Later Stages: Regulatory Forbearance (Regulatory Failure)

•   Insolvent banks should have been closed, but regulators
    allowed insolvent S&Ls to operate with lowered capital
    requirements because:
    –    Insufficient funds to pay depositors.
    –    Sweep problems under rug.
    –    Regulator ( FHLBB) cozy with S&Ls

•    Huge increase in moral hazard for zombie “living dead” S&Ls.
     They have nothing to lose, their incentive is to “gamble for

•    Zombies became vampires. Hurt healthy S&Ls by attracting
     funds away by offering above market rates.

•    Outcome: Huge losses
Political Economy of S&L Crisis
Explanation: Principal-Agent Problem
• Politicians influenced by S&L lobbyists rather
  than public
       • Deny funds to close S&Ls
       • Passed legislation to relax restrictions on S&Ls.
         S&Ls allowed to expand into commercial real
         estate, credit cards and even junk bonds and
         common stock. S&Ls had no experience in these
         areas – DIDMCA
• Regulators influenced by politicians and desire to
  avoid blame
   A. Loosened capital requirements
   B. Regulatory forbearance. Insolvent S&Ls and
      banks allowed to remain in operation.

• Depository Institutions Deregulation and
  Monetary Control Act
    – S&L- up to 40% commercial real estate
    – S&L- up to 30% consumer loans and 10% junk bonds
      and common stock.

• FDIC deposit insurance increased from $ 40,000
  to $100,000

• Phased out Regulation Q restrictions on interest
  rates. This allowed banks to issue large
  denomination insured CDs

Turning Point: Financial Institutions Reform,
Recovery and Enforcement Act (FIRREA) of 1989

 Resolution Trust Corporation (RTC) created and
 given funds to close insolvent S&Ls
 –   cost of $150 billion, 3% of GDP
 –   25% (750) of S&Ls closed.
 Capital requirement  from 3% to 8%
 Re-regulation: Re-impose pre-1980 asset
Federal Deposit Insurance Corporation
Improvement Act (FDICIA) of 1991
Prompt Corrective Action
  An undercapitalized bank is more likely to fail
  and more likely to engage in risky activities.
  The FDIC Improvement Act of 1991 requires the
  FDIC to act quickly to avoid losses to the FDIC.
  “Undercapitalized banks” must submit a capital
  restoration plan, restrict asset growth, and seek
  regulatory approval to open new branches or
  develop new lines of business.
Cost of Banking Crises in Other Countries (a)
Cost of Banking Crises in Other Countries (b)

  © 2004 Pearson Addison-Wesley. All rights reserved   11-24
Déjà Vu All Over Again!
Banking crises are just history repeating itself.
Financial liberalization leads to moral hazard (and
bad loans!).
Government stands ready to bailout the system. That
implicit guarantee is enough to exacerbate the moral
hazard problem.

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