CHAPTER 15
ANSWERS TO "DO YOU UNDERSTAND?" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. Why are bank failures considered to be so undesirable that the government should try to prevent them?
Answer: Unlike other business failures, bank failures reduce the money supply and disrupt the financing of a variety of other business activities. Bank failures also tend to be contagious if liquidity is not promptly and decisively injected into troubled institutions to restore the confidence of the depositing public.
2. What has the U.S. trend in bank failures been since 1920?
Answer: In the 1920s small bank failures were relatively common in economically distressed regions. The national failure rate skyrocketed between 1929 and 1933 as the Great Depression unfolded. After the advent of deposit insurance in 1934, bank failures dropped sharply until the 1980s, when increased competition, moral hazard, and rising interest rates precipitated the most recent banking crisis in U.S. history. Failures declined sharply in the 1990s after adoption of risk-based capital standards. Failures then spiked in the late 2000s after the U.S. housing market bubble burst.
3. What is the difference between a “purchase and assumption” and a “payoff” method for liquidating a failed bank?
Answer: In purchase and assumption, another institution purchases the assets of the failed bank and assumes its liabilities. There is no direct deposit insurance payout. In a payoff, the FDIC pays insured depositors up to the limit, but any payment above the limit will be made in full only if the assets of the failed bank can be sold at a high enough price to repay all uninsured depositors and creditors in full.
4. Why might it be unfair to small banks if all large bank liquidations were accomplished via purchase and assumption rather than payoff transaction?
Answer: If only purchase and assumptions were used for large banks, large depositors would prefer to place their money in such banks to keep all their funds safe, even if their deposits exceeded $100,000. Large banks would thus have an unfair advantage in attracting large depositors. For that reason, the FDIC has experimented with modified purchase and assumption policies to give uninsured depositors an incentive to monitor the riskiness of large banks.
DO YOU UNDERSTAND?
1. What is moral hazard and how does deposit insurance contribute to it on the part of both depositors and bank management?
Answer: Moral hazard exists whenever a decision-maker is protected from the full consequences of a bad decision. This problem is inherent in all insurance contracts. The insured faces temptation to pursue riskier behavior, knowing that the insurance will cover losses. Deposit insurance makes depositors less careful about depositing their funds in insured banks. It allows banks to take more risk without having to compensate depositors by paying higher interest rates. Thus, unlike uninsured businesses, banks can often increase profits by taking extra risks without commensurate increases in cost of funds.
2. How can bank capital and subordinated debt help protect deposit insurance funds against losses?
Answer: If a bank is liquidated, depositors will be paid before owners or subordinated creditors. Thus, those items are analogous to a “deductible” on deposit insurance. Furthermore, nondeposit creditors stand to lose if a bank fails, so they monitor its risk-taking and price their securities accordingly, thereby alerting markets and regulators if anything is amiss.
3. What are the arguments for and against the regulators using a too big to fail policy?
Answer: The failure of a very large bank could destabilize the banking system, causing losses to firms and banks doing business with the failed bank and risking widespread financial disruption and loss of confidence. However, it is unfair to protect depositors in large banks fully while protecting depositors in small banks only partially. It also creates a serious moral hazard: Depositors in large banks will only care whether such banks are “TBTF”, not whether they are taking too much risk.
4. How do you think risk-based deposit insurance premiums help or hurt all of the situations discussed in this section?
Answer: The same way risk-based premiums help in other forms of insurance. Safer drivers pay less for car insurance; nonsmokers pay less for life insurance. Thus the cost of these kinds of insurance payouts is borne more proportionately by those more likely to cause them. If the cost of deposit insurance correlates with risk and affects profitability, then banks will weigh risks and rewards more rationally and allocate loanable funds more prudently. Banks who assume higher risks will bear more of the costs of deposit insurance. Banks who assume lower risks will provide less of a subsidy to riskier banks, and taxpayers will provide less of a subsidy to the banking system as a whole.
DO YOU UNDERSTAND?
1. Explain how bank capital protects a bank from failure.
Answer: Capital provides a “cushion” against losses. If these losses erode the bank’s capital below regulatory minimums, regulators will intervene and may close the bank.
2. Why has bank capital increased in recent years?
Answer: Bank capital has increased because banks enjoyed high profitability for the most of the 1990s, because growing earnings from off-balance-sheet banking have added equity relative to assets, and because risk-based regulatory minimums have been in effect since 1988.
3. Why do bank regulators prefer that banks have more equity capital than bankers would like?
Answer: Like any other firm, banks understand the role of leverage in increasing ROE. Bank managers believe that long-term profit maximization can best be achieved if their banks are highly leveraged. Regulators are more concerned about the risk of bank failures in general than the profits of an individual bank. Their overriding concern is protecting the economy from widespread bank distress.
DO YOU UNDERSTAND?
1. In what way did the Financial Services Modernization Act of 1999 merely formalize the regulatory interpretations of existing laws?
Answer: Over the years court and regulatory decisions had gradually but effectively eviscerated the traditional Glass-Steagall regime of segregation of commercial banking from investment banking. The FSMA formalized this practical reality. Congress is generally slow to repeal enabling legislation. Markets, regulators, and the courts are often far ahead.
2. What was the justification for separating commercial banking from investment banking?
Answer: The Banking Act of 1933 tried to reduce bank risk taking by separating commercial banking from investment banking. Commercial banks would not be exposed to price-risk fluctuations in the value of securities that they had underwritten but not yet sold. Glass-Steagall also prevented banks from acquiring equity securities for their own accounts and from acting as equity securities dealers. The prohibition against owning equity securities not only prevented banks from carrying certain risky assets on their balance sheets but also lessened potential conflicts that can arise when owner and creditor functions of banks are combined. Before passage of the Banking Act, the integrated banking houses of the era abused their commercial banking powers to grant cheap credit to buyers of the securities they were underwriting, capturing large underwriting profits while shifting most of the risk to uninsured depositors.
3. Why do bankers probably have more favorable attitudes toward the Truth-in-Lending Act than the Community Reinvestment Act?
Answer: The truth-in lending act may help bankers by showing that they charge relatively low rates on consumer credit compared to retailers, finance companies, and other lenders. Truth-in-lending regulations affect disclosures and recordkeeping, but not lending policy or resource allocation. The CRA, on the other hand, may prevent banks from merging, branching, or obtaining other regulatory approvals unless they can show they have allocated loanable funds to certain politically favored purposes or constituencies, which may or may not meet their credit criteria.
4. What does it mean to say that the Federal Reserve is an “umbrella” regulator? What is meant by “functional” regulation?
Answer: Under the Financial Services Modernization Act the Fed has overall responsibility for financial holding companies, but cedes “functional” regulatory authority to regulators of each of a holding company’s subsidiaries. For example, a holding company owning a national bank, a securities firm, and an insurance company would have those subsidiaries regulated by, respectively, the OCC, the SEC, and the state insurance regulators in each state where the insurance subsidiary was operating. This scheme will require increased coordination of regulatory actions and information in the future, as reflected to some extent in the existence and purpose of the Federal Financial Institutions Examination Council.