Chapter 11. Economic Analysis of Chapter 11. Economic Analysis of Bank RegulationBank Regulation

Chapter 11. Economic Analysis of Chapter 11. Economic Analysis of Bank RegulationBank Regulation

• Asymmetric Information

• Banking Crisis of 1980s• Asymmetric Information

• Banking Crisis of 1980s

In economics,In economics,In economics,In economics,

• people respond to incentives• regulation needed to counteract

• sometimes, regulation creates the wrong incentives

• people respond to incentives• regulation needed to counteract

• sometimes, regulation creates the wrong incentives

I. Asymmetric InformationI. Asymmetric InformationI. Asymmetric InformationI. Asymmetric Information

• banks solve some asymmetric info problems• but creates others

• regulation deals with asymmetric info problems• but creates others

• banks solve some asymmetric info problems• but creates others

• regulation deals with asymmetric info problems• but creates others

A. Deposit InsuranceA. Deposit InsuranceA. Deposit InsuranceA. Deposit Insurance

• FDIC established 1934

• prevents depositors from panicking and withdrawing funds• “run on the bank”

• FDIC established 1934

• prevents depositors from panicking and withdrawing funds• “run on the bank”

2 types of action2 types of action2 types of action2 types of action

• payoff method• FDIC closes down insolvent bank• depositors paid up to $100,000• FDIC sells off assets• often depositors with more than

$100,000 often given full refund

• payoff method• FDIC closes down insolvent bank• depositors paid up to $100,000• FDIC sells off assets• often depositors with more than

$100,000 often given full refund

• purchase & assumption method• FDIC finds a healthy bank to buy

failing bank

-- FDIC offers incentives• no depositor losses• more common method

• purchase & assumption method• FDIC finds a healthy bank to buy

failing bank

-- FDIC offers incentives• no depositor losses• more common method

• before FDIC• bank panics

1819, 1837, 1857, 1873, 1884, 1893, 1907, 1930-33

• after FDIC• no national bank panics

• before FDIC• bank panics

1819, 1837, 1857, 1873, 1884, 1893, 1907, 1930-33

• after FDIC• no national bank panics

Problems w/ deposit insuranceProblems w/ deposit insuranceProblems w/ deposit insuranceProblems w/ deposit insurance

• moral hazard• insurance gives less incentive to

be careful• depositors less careful in selecting

bank• banks less careful with depositor

money

• moral hazard• insurance gives less incentive to

be careful• depositors less careful in selecting

bank• banks less careful with depositor

money

• adverse selection• if depositors not policing banks,

questionable people, knowing this, attracted to banking

• adverse selection• if depositors not policing banks,

questionable people, knowing this, attracted to banking

FDIC policies make problems FDIC policies make problems worseworseFDIC policies make problems FDIC policies make problems worseworse

• “too big to fail”• FDIC gives preferential treatment

to larger bank failures

-- covering deposits > $100,000

-- prevent large losses

• moral hazard/adverse selection worse for larger banks

• “too big to fail”• FDIC gives preferential treatment

to larger bank failures

-- covering deposits > $100,000

-- prevent large losses

• moral hazard/adverse selection worse for larger banks

B. Capital RequirementsB. Capital RequirementsB. Capital RequirementsB. Capital Requirements

• capital as % assets

• counteract moral hazard problems• capital is lost if failure• capital reduces risk-taking

• well-capitalized banks• less supervision• lower deposit insurance premiums

• capital as % assets

• counteract moral hazard problems• capital is lost if failure• capital reduces risk-taking

• well-capitalized banks• less supervision• lower deposit insurance premiums

C. Bank SupervisionC. Bank SupervisionC. Bank SupervisionC. Bank Supervision

• limiting ownership

• bank examinations• asset risk• bank loans• capital requirement• managing risk

• limiting ownership

• bank examinations• asset risk• bank loans• capital requirement• managing risk

• disclosure• financial statements

• consumer protection• terms of credit• fee disclosure• discrimination

“redlining”

• disclosure• financial statements

• consumer protection• terms of credit• fee disclosure• discrimination

“redlining”

• competition• restricted until 1990s

-- McFadden Act

-- Glass Steagall• increases health of banks

-- driving “bad” banks out

-- increasing efficiency

• competition• restricted until 1990s

-- McFadden Act

-- Glass Steagall• increases health of banks

-- driving “bad” banks out

-- increasing efficiency

II. Banking Crisis of the 1980sII. Banking Crisis of the 1980sII. Banking Crisis of the 1980sII. Banking Crisis of the 1980s

• 1934-80• less than 20 banks failure per year

• 1983-1993• 200 per year

• what happened?

• 1934-80• less than 20 banks failure per year

• 1983-1993• 200 per year

• what happened?

A. OriginsA. OriginsA. OriginsA. Origins

• declining profitability of traditional activities• financial innovations

• rising short-term interest rates in 1970s• banks borrow short & lend long• especially hard on S&Ls

• declining profitability of traditional activities• financial innovations

• rising short-term interest rates in 1970s• banks borrow short & lend long• especially hard on S&Ls

DeregulationDeregulationDeregulationDeregulation

• banks lobby for change to reverse declining profits• 1980 DIDMCA• 1982 Garn-St. Germain

• banks lobby for change to reverse declining profits• 1980 DIDMCA• 1982 Garn-St. Germain

• repealed Regulation Q

• offer interest-bearing checking

• S&Ls allowed more asset choices• lending, junk bonds, common

stock

• increase deposit insurance ceilings

• repealed Regulation Q

• offer interest-bearing checking

• S&Ls allowed more asset choices• lending, junk bonds, common

stock

• increase deposit insurance ceilings

result?result?result?result?

• big increase in moral hazard• great incentive/ability to take risk• thrifts lacked skills to manage risk• regulators lacked resources to

police thrifts

• did not correct problem with short-term interest rates

• big increase in moral hazard• great incentive/ability to take risk• thrifts lacked skills to manage risk• regulators lacked resources to

police thrifts

• did not correct problem with short-term interest rates

economic eventseconomic eventseconomic eventseconomic events

• very high short-term interest rates in 1979-80

• recession 1981-82

• falling farm, energy prices in early 1980s• higher loan defaults

• very high short-term interest rates in 1979-80

• recession 1981-82

• falling farm, energy prices in early 1980s• higher loan defaults

by 1982by 1982by 1982by 1982

50% of all S&Ls are insolvent50% of all S&Ls are insolvent

B. Failure of regulatorsB. Failure of regulatorsB. Failure of regulatorsB. Failure of regulators

• by 1982, regulators SHOULD HAVE shut down failed S&Ls

• but, instead, regulatory forbearance• allowed insolvent S&Ls to keep

operating

• by 1982, regulators SHOULD HAVE shut down failed S&Ls

• but, instead, regulatory forbearance• allowed insolvent S&Ls to keep

operating

why?why?why?why?

• FSLIC lacked the funds for depositor payoff

• regulators too friendly w/ industry

• regulators would be admitting to failure

• FSLIC lacked the funds for depositor payoff

• regulators too friendly w/ industry

• regulators would be admitting to failure

zombie S&Lszombie S&Lszombie S&Lszombie S&Ls

• insolvent S&Ls, still operating

• nothing to lose• offer very high deposit rates• offer very low loan rates• taking business from healthy S&Ls

• insolvent S&Ls, still operating

• nothing to lose• offer very high deposit rates• offer very low loan rates• taking business from healthy S&Ls

C. Politics of the crisisC. Politics of the crisisC. Politics of the crisisC. Politics of the crisis

• economics caused the problems

• politics made the crisis

• principal-agent problem• agents act on behalf of principals• agents have different incentives

and do not act in best interest of principals

• economics caused the problems

• politics made the crisis

• principal-agent problem• agents act on behalf of principals• agents have different incentives

and do not act in best interest of principals

• principals: voters/taxpayers• elect politicians that appoint

regulators• pay cost of bailout

• agents: politicians/regulators

• principals: voters/taxpayers• elect politicians that appoint

regulators• pay cost of bailout

• agents: politicians/regulators

• principals benefit from dealing w/ crisis early to minimize costs

• agents benefit from re-election, career• politicians got huge campaign

contributions from S&L industry• regulators pressured to back off

• principals benefit from dealing w/ crisis early to minimize costs

• agents benefit from re-election, career• politicians got huge campaign

contributions from S&L industry• regulators pressured to back off

D. Bailout: FIRREA 1989D. Bailout: FIRREA 1989D. Bailout: FIRREA 1989D. Bailout: FIRREA 1989

• federal bonds to fund closure of S&Ls

• change in S&L regulation• FSLIC, FHLB gone• OTC created, FDIC for insurance

• RTC to liquidate assets• done in 1995

• federal bonds to fund closure of S&Ls

• change in S&L regulation• FSLIC, FHLB gone• OTC created, FDIC for insurance

• RTC to liquidate assets• done in 1995

• re-restricted S&L activities

• raised deposit insurance premiums

• more power to regulators in closing banks

• re-restricted S&L activities

• raised deposit insurance premiums

• more power to regulators in closing banks

E. Reform: FDICIA 1991E. Reform: FDICIA 1991E. Reform: FDICIA 1991E. Reform: FDICIA 1991

• deal with moral hazard problems with deposit insurance• limited “too big to fail”• risk-based premium• increased capital requirements• increased authority to FDIC

• additional funds to FDIC

• deal with moral hazard problems with deposit insurance• limited “too big to fail”• risk-based premium• increased capital requirements• increased authority to FDIC

• additional funds to FDIC

TodayTodayTodayToday

• fewer, stronger banks

• strong regulatory presence

• return to profitability• managing risk• nontraditional activities

• fewer, stronger banks

• strong regulatory presence

• return to profitability• managing risk• nontraditional activities