MONEY AND BANKING (Eco 340)
Prof. Ranjit Dighe
Lecture notes to accompany Cecchetti's Chapter 14 ("Regulating the Financial System")
Last revised 1 April 2009.

In these notes:
I. Bank regulation in brief
II.   Sources and consequences of runs, panics, and crises
III. The government safety net
IV. Regulation and supervision of the financial system (in brief outline form, but it'll do)
V. Appendix:  Some key U.S. banking laws of the past 100 years


I.  INTRODUCTION:  BANK REGULATION IN BRIEF

In brief:  
Banks are very vital to our economy, and bank failures tend to be very harmful.
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Governments step in to provide a safety net to depositors and to the banks themselves (deposit insurance, emergency lending to banks, "too big to fail" policy). Governments also regulate banks to try to keep them safe.
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A safety net for the banks has the unintended consequence of creating more moral hazard for bank managers, since the safety net protects them somewhat from the consequences of risky behavior.
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Governments may need to impose additional regulations on banks to curb those risky activities.


II.  SOURCES AND CONSEQUENCES OF RUNS, PANICS, AND CRISES

Bank run -- a rush by a bank's depositors to withdraw as much money as possible.  Typically a bank run is due to reports, whether factual or false rumors, that the bank is insolvent.
-- Bank runs are very uncommon today, thanks to federal deposit insurance (FDIC).  There were big waves of bank runs in the early years of the Great Depression, which prompted the formation of the FDIC in 1933.

Bank panic -- basically the plural of "bank run," but affecting many banks.  A contagion is when panic spreads from one bank to others.  Such contagions are extremely dangerous, because with fractional reserve banking, no bank has enough reserves on hand to meet a bank run, so a bank panic could cause the failure of many healthy banks as well as sick ones.  In a bank panic, the entire banking system is thought to be at risk.
-- Systemic risk (the danger that many banks might become insolvent or fail, and that bank lending might break down) is a key concern of policymakers, notably in the crisis that began in 2007.

A financial crisis (a general breakdown of the financial and credit system) is broader than just the banks.  Recall that nonbank financial institutions and instruments like commercial paper and bonds play a very important role in our economy.  When people and businesses who normally have no trouble getting credit suddenly cannot because of problems in the banking and financial sector, then the economy is in a financial crisis.
-- In the fall of 2008, for example, many banks were unable to borrow money from other banks, and many firms suddenly saw huge spikes in the interest costs of borrowing money in the commercial paper and junk bond markets.  And many people and firms with excellent credit reported that they could not get a bank loan.  This phenomenon was often called a "credit crunch," and it is very similar to a financial crisis.
-- A financial crisis also typically involves rapid declines in asset prices, such as in the stock and real estate markets.  Again, we see that in the current (2007-) crisis.


III. THE GOVERNMENT SAFETY NET

Why it exists:
1. To protect depositors and investors
2. To protect bank customers from monopoly exploitation
3. To keep the financial system stable.

The unique role of depository institutions

The government as lender of last resort
-- This concept has been around for a long time.  (The term was originated by the British economist Walter Bagehot in 1873.)
-- In the US, the government established a lender of last resort in 1913, called the Federal Reserve System.  The Fed is supposed to loan money to banks when the banks are short of funds and unable to borrow from other sources.
---- Having a lender of last resort is supposed to prevent bank panics (if people know their banks can get money from the Fed, they'll be less worried about the bank running out of reserves).  It is also supposed to tide over insolvent banks until they can be healthy again.  By preventing bank panics and mass failures of banks, a lender of last resort should aid the stability of the banking and financial system.
------ Merely having a lender of last resort is not enough, however.  In times of need, the Fed has to lend and the banks have to borrow.  In 1920-21, for example, there was a major economic crisis, and the Fed made record numbers of loans to banks, and the crisis was soon over.  In 1930-33, however, in the early years of the Great Depression, the Fed made very few loans to banks, and the result was the failure of thousands of banks, about a third of all banks, resulting in a 25 percent drop in the money supply and the price level.  Clearly the Fed has not always been an effective lender of last resort.

Government deposit insurance
-- A law creating federal deposit insurance was passed in 1933, and the FDIC (Federal Deposit Insurance Corporation) began operations in 1934.  This institution is widely credited with having put an end to bank runs in this country.

Problems created by the government safety net
-- Moral hazard, moral hazard, moral hazard.
---- If the government or the Fed is guaranteeing your depositors' money and will extend loans (or bailouts) to you if you run the bank into insolvency, then you have a lot more room to take wild risks.  If those risks pay off, you are rich; if they don't, the government bails out your depositors and/or your bank.
---- The problem is even more acute with very large banks that are deemed "too big to fail."

IV. REGULATION AND SUPERVISION OF THE FINANCIAL SYSTEM

multiple regulators (Table 14.1)

Restrictions on competition

Asset holding restrictions and minimum capital requirements

Disclosure requirements

Supervision and examination

The challenge to regulators and supervisors

V. APPENDIX: SOME KEY U.S. BANKING LAWS OF THE PAST 100 YEARS 

(This is mostly review of laws covered earlier, especially in chapter 13.)  In chronological order:

* (1) Federal Reserve Act (1913): created the Federal Reserve System. In part, the impetus for the Federal Reserve Act was a severe financial panic a few years earlier, the Panic of 1907. The Act established a network of 12 regional Fed banks in various cities, plus a Fed Board of Governors in Washington, DC. The Fed was to be a "lender of last resort" to banks in need of liquidity.  The Fed's importance has grown considerably over time.

* (2) McFadden Act (1927): effectively prohibited interstate banking, thereby promoting a nation of small, localized banks.  Repealed in 1994.

* (3) Glass-Steagall Act (1933): separated commercial banking from the securities and insurance industries. Investment banks could underwrite corporate securities and hold stock, but they could not hold individuals' deposits; likewise, commercial banks were barred from holding stock, underwriting securities, or engaging in brokerage activities.   Most of that was repealed by the Gramm-Leach-Bliley Act of 1999, although banks are still not allowed to hold stock.
-- The Glass-Steagall Act and the Banking Act of 1935 also prohibited banks from paying interest on checking deposits and put interest-rate ceilings on other deposits (Regulation Q).
-- Perhaps most importantly, the Glass-Steagall Act created the FDIC (Federal Deposit Insurance Corporation), which guaranteed people's bank deposits (up to a certain maximum), thereby doing much to prevent future banking panics. The impetus for the Glass-Steagall Act was the Great Depression, which had hit rock bottom by the time of the Glass-Steagall Act and in which much-publicized Congressional hearings portrayed widespread abuses by commercial banks in their investment activities.

* (4) Depository Institutions Deregulation and Monetary Control Act (DIDMCA, 1980): phased out interest-rate ceilings on deposits, and in the meantime allowed NOW accounts (interest-bearing checking accounts) and ATS (automatic transfer from savings) accounts nationwide. It eliminated "usury ceilings" on loans. It also raised the individual-account limit on deposit insurance from $40,000 to $100,000. The Act's most unfortunate provision was its granting of wider latitude to S&L's and other thrift institutions -- that ill-timed act of deregulation helped precipitate the S&L crisis of the 1980s and early 1990s. It also made all banks subject to the Fed's reserve requirements, so as to give the Fed greater control over the money supply. The background for the DIDMCA was the high and rising inflation of the 1970s, which (through the Fisher effect) raised market interest rates to levels well above the interest-rate ceilings established by Regulation Q back in the 1930s. The inflation also fostered the perception that the Fed had lost control of the money supply, perhaps because bank membership rates in the Federal Reserve System had fallen off in recent years; imposing reserve requirements on all banks was seen as a way to give the Fed more control over bank reserves and the money supply.

* (5) Garn-St. Germain Act (Depository Institutions Act of 1982): This Act, reflecting a general trend toward deregulation that had accelerated after the Reagan Administration came to power in 1981, continued the DIDMCA's deregulation.  It allowed the thrifts still more latitude, as it let them make many different, and often risky, types of loans, in addition to their traditional mortgage loans.  S&L regulators interpreted the Act broadly, and allowed the S&L's to hold up to 10% of their assets in junk bonds, stocks, real estate, and other risky investments. The Garn-St. Germain Act helped erode interstate banking regulations by giving the FDIC and its S&L counterpart, the FSLIC, emergency powers to merge banks and thrifts across state lines. The Act was also notable for allowing banks to offer money market deposit accounts (MMDA's), high-yielding deposit accounts that were much like money-market funds.

* (7) Basel accord of 1988 and regulatory procedures of 1992 (actually an international regulation, but is still very important to U.S. banks):
-- The 1988 Based accord imposed minimum capital requirements on international banks
-- With the increasing internationalization of banking, the world has lately been moving in the direction of making the domestic regulation of such banks more standardized and thorough. In 1992, the Basel Committee did the same, by drawing up new, more standardized regulatory procedures for international banks.
---- An accord like this was necessary because international banks have proved more difficult to regulate than domestic banks. Domestic regulators typically do not have the resources to oversee a bank's entire international operations.
------ Perhaps the most notorious example of this problem was the BCCI scandal, involving the London-based, Luxembourg-chartered Bank of Credit and Commerce International, whose operations grew to include more than 70 different countries. Monitoring the bank's operations was way beyond the capacity of tiny Luxembourg (which appears to have been the main reason the bank's owner, a Pakistani businessman, had it chartered in that country in the first place). The bank routinely siphoned off funds to secret accounts in the Cayman Islands, and nearly half of the bank's assets appear to have "disappeared" altogether. The bank also helped various dictators and terrorist groups around the world plunder their people -- observers joked that BCCI stood for "the Bank of Crooks and Criminals, Inc." Since oversight of the BCCI was beyond Luxembourg's capacity and out of the jurisdiction of England and the USA and other countries affected, the bank effectively had free reign over its first 15 years, from 1972 to 1987. Only in 1990 did a seven-country group of regulators uncover evidence of fraud; the Bank of England finally closed down the BCCI in 1991. The BCCI scandal was a big impetus for the Basel Committee's new regulatory procedures in 1992.

* (9) FDIC Improvement Act (1991): This Act was passed in the wake of the savings-and-loan-association scandal of 1989-91.  It limited the FDIC's "too big to fail" policy of protecting large banks at all costs, established risk-based deposit insurance premiums, increased bank capital and reporting requirements, and increased examinations. A key amendment, the Foreign Bank Supervision Enhancement Act, gave the Fed additional powers to supervise foreign banks. 
-- Clearly the limitations on "too big to fail" were either temporary or inadequate, as "too big to fail" is widely seen as one of the leading causes of the banking and economic crisis of 2007-present.

* (10) Riegel-Neal Interstate Banking and Branching Efficiency Act (1994): With the banking industry seemingly on an upturn, as the number of bank failures fell below 25 for the first time in a decade, the Riegel-Neal Act eliminated one of the most inefficient and long-standing bank regulations, as it repealed the McFadden Act of 1927 and allowed interstate banking.  This act contributed to the bank merger movement and the rise of many large banks.

* (11) Gramm-Leach-Bliley Financial Services Modernization Act (1999):  Allowed banks to own securities or insurance firms, thereby the Glass-Steagall Act's separation of the banking and securities industries.  Notably, Citibank had merged with the Travelers insurance company even before the Act, in anticipation of a change in the law.  This act also contributed mightily to the merger movement within the financial sector.
-- In the wake of the 1994 and 1999 laws that facilitated financial mergers, the scale of the largest U.S. financial institutions is much larger than ever before.  Some observers believe the increased "bigness" of U.S. financial institutions, combined with deregulation and the "too big to fail" policy, encouraged these institutions to take on excessive risks and contributed to the financial crisis of 2007-present.

* (12) Commodity Futures Modernization Act (2000):  Also sponsored by former Senator Phil Gramm of Texas, this lengthy bill deregulated many derivative instruments.  The bill became notorious in the early 2000s after the scandal involving the Enron Corporation's unsavory trading in energy commodity markets; critics said an "Enron loophole" in the Act made that kind of trading possible.  More recently, the Act has come under fire for its provisions preventing federal agencies from regulating credit default swaps (CDS's; derivative instruments that pay the buyer in case a particular security defaults.  In the  financial crisis that began in 2007, one of the key problems has been the billions of dollars in CDS obligations on the part of AIG and other large financial institutions.)