Finish Chapter 10 Capital adequacy (solvency) and returns

to equityFDIC this weekend

Resolves 9 banks http://www.fdic.gov/index.html (bair)

Chapter 11 Regulation

High Bank Capital Low Bank Capital

Assets Liabilities Assets Liabilities

Reserves $10M Deposits $90M Reserves $10M Deposits $96M

Loans $90M Bank Capital $10M Loans $90M Bank Capital $4M

High Bank Capital Low Bank Capital

Assets Liabilities Assets Liabilities

Reserves $10M Deposits $90M Reserves $10M Deposits $96M

Loans $85M Bank Capital $5M Loans $85M Bank Capital -$1M

Return on Assets: net profit after taxes per dollar of assets

ROA = net profit after taxes

assetsReturn on Equity: net profit after taxes per dollar of equity capital

ROE = net profit after taxes

equity capital

Relationship between ROA and ROE is expressed by the

Equity Multiplier: the amount of assets per dollar of equity capital

EM =Assets

Equity Capital

net profit after taxes

equity capitalnet profit after taxes

assets assets

equity capital

ROE = ROA EM

Basic microeconomic principles on efficiency If market is competitive regulation can only

harm society

Conditions for competitive market Homogeneous good Free entry and exit Participants have full information Many buyers and sellers

Exceptions: where regulations can help Market failures▪ Market power (monopoly)▪ Pollution & environmental harms▪ Lack of property rights (e.g. fishing)▪ Asymmetric information (e.g. credit)

Caution▪ Government failure is possible when trying to

solve a market failure. However there are have been successes▪ e.g. clean air act estimate 22 trillion in benefits

These boats arethe same length Regulation intended

to cut fishing effort Instead regulation

limits boat length Result: ▪ Short & tall boats▪ Fishing effort up▪ Resources wasted…

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A huge part of the company’s credit-default swap business was devised.. to allow banks to make their balance sheets look safer than they really were.

Under a misguided set of international rules that took hold toward the end of the 1990s, banks were allowed use their own internal risk measurements to set their capital requirements.

How did banks get their risk measures low? … they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G….which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more “risk-free” assets.

http://dealbook.blogs.nytimes.com/2009/03/02/propping-up-a-house-of-cards/

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Safety and soundness regulation Entry, branching, network, and mergers Deposit insurance Deposit interest ceilings Portfolio restrictions, including reserve

requirements Capital requirements Regulatory monitoring and supervision

1-8

Canada: 60 banks, US: 8000 banks 1927 US Laws allows state to restrict

interstate and intrastate competition Too many inefficient banks Bank holding companies are a way

around the law▪ Independent company purchases many banks

in many states. States relax laws (1972-1991)

What’s the impact?

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Impacts of increased competition Operating costs decline (about 8%)▪ Includes wage decline ▪ Down 12% for men & 3% for women▪ Difference across gender: Evidence of

discrimination in noncompetitive setting

Loan losses decline

Interest rates decline for borrowers

What about economic growth? In States deregulating▪ economic growth increases by .51% to

1.19%▪ Convinced? What is the counterfactual?▪ States that don’t deregulate saw a decline

in growth rate (.6%) What is the mechanism?▪ The quality of lending improved not just the

quantity.

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Restrictions on interest paid on deposits

5.5% maximum (1934-1980)▪ Difficult to generate deposits when interest

rate are high e.g. late 1970’s▪ Regulation interacts with new economic

conditions, harming banks Response▪ Money market mutual funds▪ Push for deregulation

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Decline in cost advantages in acquiring funds (liabilities) Rising inflation led to rise in interest rates and

disintermediation Low-cost source of funds, checkable deposits,

declined in importance

Decline in income advantages on uses of funds (assets) Information technology has decreased need for

banks to finance short-term credit needs or to issue loans

Information technology has lowered transaction costs for other financial institutions, increasing competition

Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-14