Friday Talk: Financial crisis Course in spring on financial crisis

Chapter 11 &12 Regulation & Industry Structure

Links: Marginal Revolution▪ http://www.marginalrevolution.com/

Safety and soundness regulation Entry, branching, network, and mergers▪ Chapter 12

Deposit insurance Deposit interest ceilings Portfolio restrictions, including reserve

requirements Capital requirements Regulatory monitoring and supervision

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-3

Source: www.fdic.gov/bank/historical/bank/index.html.

11-5

A story of Changing financial conditions

▪ See marginal revolution link

Deregulation

Reregulation

Declining profitability of traditional business High interest rate environment ▪ Cost of funds increase, but long term loans on books

Regulatory relief Depository Institutions Deregulation and

Monetary Control Act▪ Rate ceilings abolished (both lending and deposit)▪ Increased deposit insurance▪ Entry to new businesses allowed

Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-6

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Managers did not have expertise in managing risk

Rapid growth in new lending, real estate in particular

Activities expanded in scope; regulators at FSLIC did not have expertise or resources

High interest rates and recession increased incentives for moral hazard

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Regulatory forbearance by FSLIC Insufficient funds to close insolvent S&Ls Established to encourage growth Did not want to admit agency was in trouble

Zombie S&Ls taking on high risk projects

Attract business from healthy S&Ls

Losses amount to $150 billion

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Regulatory apparatus restructured Federal Home Loan Bank Board relegated

to the OTS FSLIC given to the FDIC RTC established to manage and resolve

insolvent thrifts Re-restricted asset choices

FDIC went broke Federal Deposit Insurance Corporation Improvement

Act of 1991 Recapitalize the Bank Insurance Fund

▪ Increase ability to borrow from the Treasury▪ Higher deposit insurance premiums

Reform the deposit insurance and regulatory system to minimize taxpayer losses Prompt corrective action provisions

▪ Classification scheme 1-5 , category 3 must have corrective action plan▪ Category 5 - weakest banks must be closed by FDIC▪ equity< 2% of assets receivership within 90 days

Risk-based insurance premiums▪ Later led to CDS market

Preserve independence of regulator by eliminating discretion Discretion creates opportunities for

corruption or capture Eliminate ‘zombies’ with prolonged capital

inadequacy Zombies likely to create additional harms

(by taking on more risky deals) Either bank or regulator must add capital

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