13
LECTURE 5
Economic Rationale for Market Regulation
Identifying the public interest
READ: Special Policy Report 12: Economic Rationale for Market Regulation
http://www.financialpolicy.org/dscreports.htm
The market, the magic of the market, the infamous “invisible hand,” is so highly regarded these days that its limits are often overlooked, forgotten or otherwise misunderstood. The market can do some things very well: generally setting prices that function as signals and disciplining incentives to allocate resources between competing uses in an efficient manner.
There are also things that the market does not do well, or perfectly or sometimes not at all. These things are called market failures, incomplete markets, or market imperfections. They are often analyzed in economics as externalities, economies of scale, non-competitive behavior, destructive competition, monopolistic or oligopolistic competition.
These analytical categories are often not as well studied as others in economics. In order to bring greater rigor to this discussion, let’s delve into these ideas more carefully.
First consider some illustrative examples of market imperfections in the area of corporate governance.
· Executive manipulate earning reports in order to boost stock prices so as to capture gains on stock options. Not only are investors ultimately cheated, but also investors in other firms that compete for resources with the cheating firm. It distorts prices in securities markets, thereby reducing their efficiency, and it threatens integrity of capital markets and thus the viability of overall economy. This imposes costs on people both inside and outside the firm, and market incentives do not adequately discourage but sometime encourage this activity.
· A firm, or rogue traders within a firm, manipulates market prices. They have incentives to manipulate because it maximizes their profits. (For a brief description of market manipulation strategies read, "Learning Our Lessons: A Short History of Market Manipulation And The Public Interest” at http://www.financialpolicy.org/dscbriefs.htm) This price distortion, however, causes losses for others in the market and economic inefficiencies in the overall economy as resources are misdirected and the integrity of the marketplace is undermined.
· A CEO of a financial institution pressures the firm’s research staff to produce overly optimistic assessment of another companies stock because the financial institution is acting a underwriter of its debt and securities. This generates profits for the financial institution and in turn for the CEO but it cheats investors and others in the market.
· Consider a more general point about investors’ need for all relevant market information. Firms have an incentive to hoard information and not disclose to the markets any thing but good information about their activities, and even then they may not disclose good information on a timely basis but instead when it is advantageous for them. Individual firm incentives are in this way inconsistent for overall market efficiency.
The Banking Sector
Today, there are 8,832 banks and thrifts (savings and loan associations and savings banks) at the end of 2005, down from 12,000 in 1995. There are 8,700 credit unions with 70 million members (and another 40 that qualify as members).
The term banks can be used to refer to a properly chartered bank, but today other depository institutions function roughly the same as chartered banks. These depository institutions include thrifts (savings and loans, savings bank, savings associations), credit unions, and industrial loan companies. In addition, there are ‘special’ credit card banks that have many bank functions but are largely limited to the purpose of handling credit card operations.
And while there are some non-banks that function like banks, there are some banks that engage in a range of financial activities that we do not think of as banking proper.
According to FDIC, end 2005,
· 1818 federal banks
· 5709 state chartered banks
· 772 federal thrifts
· 533 state thrifts
Commercial banks have $9.53 trillion in assets, while thrifts have $1.83 trillion and credit unions have $703 billion. Of a total of $41.7 trillion in credit market assets: $12.3 trillion in mortgages, $3.3 in loans, $10.5 trillion in private bonds and commercial paper, and $13.5 trillion in government and GSE bonds. Checkable deposits and cash amount to $1.5 trillion, savings and small time deposits are $4.7 trillion and money market funds are $2 trillion. Total corporate equity shares are valued at $19 trillion.
Commercial banks hold $5.5 trillion in loans amongst their $9.5 trillion in all assets. And $1.4 trillion in government and agency bonds.
History of banks, thrifts, and credit unions
Economic Function of Banking System
· Payments and settlements: provide liquidity and safe and sound payments system
· Savings vehicle: collect together savings from diverse customers
· Mobilize savings: mobilize additional savings from float and delays in payments
· Capital and Credit supplier:
· raise capital
· finance commerce and trade
· consumer finance
· finance governments
· Underwriters of some securities
· Market makers of FX, derivatives and some securiti
How banks make profit
· maturity conversion: borrow short, lend long along yield curve
· hold credit risk:
· charge credit risk spread to borrowers, require collateral, and diversify to manage risk
· underwrite loans and securities
· act as dealer or market maker in securities
· funds management
· transactions fees
The market for banking services: various institutions and transactions
· commercial
· merchant banks
· wholesale financial institutions
· major, money center banks
· super regional
· independent banks
· federal versus state
· bank holding company
· foreign bank
· Edge Act bank
· agent bank
Public Interest Concerns
· safety and soundness:
- timely and safe and dependable payments
- dependable savings institution
· non-discrimination in lending and financial services
· stable credit supply
· liquidity supply (elastic money supply to provide transactions services across business cycle)
· Bank run – consumer panic, whether warranted or not, removes liquidity from banks and in turn the economy
· Operations risk – clearing and checking services fail. This happened with technical failures or with external disasters such as North East blackout and terrorist attack.
· Insolvency – losses to creditors and shareholders. This leads to failures in derivatives markets (trading freezes up and price discovery ceases).
· Transmission of price shocks
· change in interest rates balance sheet and derivatives
· change in foreign exchange rates ditto
· change in equity prices derivatives
· change in commodity prices derivatives
Miskin, AEI and Other Free-Market Approach
Asymmetric information
Adverse selection
Those whose are most apt to abuse insurance are those most likely to take out such insurance.
Moral Hazard
Deposit insurance creates moral hazard for banks who can take large risks without fear that depositors will desert them. This leads to more than efficient levels of risk taking.
Too Big To Fail
Banks know that government views them as too big to fail, and thus they take greater risks knowing they will be not be allowed to fail.
[However even Miskin admits that government “purchase and assumption” followed by its sale, the shareholders lose everything and the management is fired. The fate of non-depositor creditors is not well defined. In some instances they were protected. This is not necessarily so. One reason to keep them whole is that they are other banks who would in turn suffer – create contagion – if they were allowed to fail.]
Create signaling device through required issuance of subordinated debt
Regulatory Response
Regulatory Agencies
· Fed (1913)
· OCC (1863)
· FDIC (1933)
· OTS (1933 as FSLIC)
· NCUA
· FFIEC
· State governments – beginning of republic
Three pillars of prudential regulation:
1. Registration and Reporting
2. Capital and collateral requirements
3. Orderly market rules
REGISTRATION: Acquiring a Bank Charter – state or federal
This is a registration process to prevent fraud, recklessness and inadequate capitalization
· anti-fraud
· stabilize market – no fools rushing in
· can also reduce competition or excess competition
REPORTING: Disclosure or Reporting Requirements
This provides information to the markets so that they can make more informed investment decisions
This also provides info to government regulators and supervisions. Some of this information is collected through Call Reports. Other is gathered from onsite examinations of the institution.
Examinations and Supervision
– some information must be treated as proprietary or of such heterogeneous nature that it does not lend itself to useful disclosure. Examiners evaluate loans and other assets to evaluate than ‘quality.’
Examination guidelines and objectives
CAMEL standards
- Capital
- Assets
- Management
- Earnings
- Liquidity
Risk Management
- Oversight by Board of Directors
- Controls of risk taking (position limits)
- Risk measurement and monitoring
- Internal Controls – prevent fraud and unauthorized trading
Capital Requirements
8%, risk based on assets – both on balance sheet and off
Applies to credit exposure and sometimes “potential credit exposure”
- may be not an effective forecasting measure.
- Buffer
- Risk governor
Collateral requirements
Loans – no regulations but operating standards
Derivatives – no regulations and little in the way of standards
Other measures to govern risk-taking
Asset restrictions
Orderly Market Rules
Consumer protection
· Truth in lending: use of APR, credit card box
· Deposit Insurance – avoids bank runs
· CRA
· Anti-predatory lending
· Anti-usury laws
REGULATORY INSTITUTIONS
Federal Reserve Board of Governors (Fed)
Created in 1913 to conduct monetary policy, supervise banking institutions, maintain the stability of the financial system, and provide financial services to the government.
Oversees 5,863 Bank Holding Companies
Oversees 919 State chartered banks that are members of Federal Reserve system
Federal Reserve Banks (12)
The Federal Reserve System (FRS), established in 1913, supervises bank
holding companies, state-chartered banks that are members of FRS, and the
U.S. operations of foreign banking organizations; it also regulates foreign
activities and investments of FRS member banks (both national and state
chartered), and Edge Act corporations.
Office of Comptroller of the Currency (OCC)
Handles nationally chartered banks (it issues their charters). Created by National Bank Act of 1864 to charter, supervise, and regulate banks as well as be responsible for national currency. Conflict with Fed after its creation in 1913 because of overlapping authority. Today, the OCC: 1) charters national banks; 2) supervises member (national + state member) banks and enforces McFadden Act (interstate banking); 3) approves mergers and branches. Has permanent offices in London to oversee foreign banks.
The Office of the Comptroller of the Currency (OCC), established in 1864, charters and supervises national banks and federal branches and agencies of foreign banks.
Office of Thrift Supervision (OTS, formerly FSLIC)
Created by FIRREA. A bureau of Treasury. Regulation and supervision successor to Fed. Home Loan Bank Board (FHLBB) over state and federal thrifts, and their holding companies. The Regulatory and supervisory component of former FSLIC.
The Office of Thrift Supervision (OTS) charters and supervises national
thrifts and also supervises state-chartered thrifts and thrift holding
companies. OTS assumed these functions in 1989 from the Federal Home
Loan Bank Board, which was established in 1932.
National Credit Union Administration (NCUA)
An independent federal agency that charters and supervises federal credit unions, and it operates the federal credit union share insurance fund.
Regulates and supervises 9,128 credit unions.
Federal Deposit Insurance Corporation (FDIC)
Created as an independent agency in 1933 by Glass-Steagall Act.
It insures deposits, monitors risk to bank insurance fund, and limits the effects on overall economy when a depository institution fails.
It also handles state chartered banks that are not members of the Federal Reserve system.
The FDIC has taken over FSLIC’s role as provider of deposit insurance to thrifts. In doing so it administers two deposit insurance funds: the Band Insurance Fund (BIF) and Savings Association Insurance Fund (SAIF).
Presently, the FDIC oversees 5,272 institutions – about half of all banking institutions, and provides deposit insurance to 8,854 banks.
The Federal Deposit Insurance Corporation (FDIC), established in 1933, is
the federal supervisor of federally insured, state-chartered banks that are
not FRS members.
FFIEC – Congress created the Federal Financial Institutions Examination Council
(FFIEC) in 1979—comprising OCC, FDIC, FRS, OTS, and the National Credit
Union Administration representatives—to promote consistency among
these regulatory agencies, primarily in the area of financial examinations.
REGULATORY STATUTES IN THE USA
[See GAO Report on US Bank Regulatory Structures, 1997.]
1908.
Aldrich Vreeland Act of 1908.
Response to currency shortage by allowing other securities to back up currency. Expired in 1915.
1913.
The Federal Reserve Act of 1913 enacted on December 23, 1913.
Response to great panic in 1907. Created the Federal Reserve System. Designed to be able to create an elastic currency or monetary or credit supply, and to improve the supervision of banking. Also empowered to enforce against fraud against consumers and discrimination in lending practices.
The System is comprised principally of the Board of Governors, 12 Federal Reserve Banks (privately owned), and the Federal Open Market Committee (key policy committee). The 12 Federal Reserve Banks are each owned by its members and supervised by the Board of Governors. The Board is an independent government agency whose 7 Governors serve staggered 14 year terms. The President, with advice and consent of the Senate, appoints the 7, one as a Chair and one as Vice-Chair for 4-year terms. The Banks are governed by a board of 9 directors serving 3-year terms. Member banks elect 6 of the directors and the other 3 are appointed by the BOG. The FOMC consists of the 7 Governors plus 5 of the Bank Presidents – one of which is always from the New York FRB. The Advisory Council is appointed by the Board of Governors to represent consumers and creditors.
The BOG supervises activities of Banks in open market and discount window operations, it regulates check clearing and collections, and the issuance of Federal Reserve notes. It is the primary federal regulator of state chartered banks, and a secondary role behind the OCC in federal chartered banks, and a primary role in bank holding companies. The BOG also set margin requirements on securities transactions and derivatives on equities. It implements consumer credit protection legislation. It regulates Edge Act banks, and the non-banking activities of foreign banks operating in the U.S. The BOG sets reserve requirements for banks.