Chapter Fourteen Chapter 10 Regulating the Financial System Financial Crisis Disruptions to financial systems are frequent and widespread around the world. Why? Financial systems are fragile and vulnerable to crisis coupled with failure of government oversight They are expensive to clean up and can have a dramatic impact on growth. Cost of Banking Crises in Other Countries (a) 1
Cost of Banking Crises in Other Countries (b) 2004 Pearson Addison-Wesley. All rights reserved 11-4 Introduction In this chapter we: Look at the sources and consequences of financial fragility focusing on the banking sector. Look at the safeguards the government has built into the system in an attempt to avert financial crises. Some of which may add to the problem Examine emerging approaches to regulation that focus on the safety of the financial system rather than on individual institutions. The Sources and Consequences of Runs, Panics, and Crises Fragility arises because banks (including shadow banks) provide liquidity to depositors. If a bank cannot meet the promise of withdrawal on demand, because of insufficient liquid assets, it will fail an otherwise solvent bank can fail due to lack of liquidity. 2
Example of a Bank Run Suppose depositors lose confidence in an otherwise healthy bank causing a run of the bank. Deposits are withdrawn first come-first served. To meet the withdrawals, the bank first uses liquid reserves and sells securities to meet depositor withdrawal The bank is next forced to sell loans at the fire-sale price say $0.50 per $1 to pay deposits The bank cannot pay off the remaining deposits and has negative net worth, so the remaining depositors and bank owners both lose. Run Example on a of Bank a Bank - Example Run Liquidate at 100% Liquidate at 50% Total value of liquidated assets = $40 + $40 = $80 Shadow Banking Run, Panic, and Crisis Quiet, invisible runs on shadow banks were even more dramatic during the peak of the financial crisis. In March 2008, repo lenders and other creditors stopped lending to Bear Sterns, the fifth largest U.S. investment bank. The Federal Reserve Bank of New York stepped in and helped JPMorgan Chase acquired Bear Sterns before it went bankrupt. 3
Shadow Banking Run, Panic, and Crisis Investment Bank Assets (Uses of Funds) Liabilities and Net Worth (Sources of Funds) - Stocks - MBS - US Gov t bonds - Corporate bonds - Bunch of other stuff - Repo Debt - Commercial Paper - Longer term Debt - Equity (3% to 4%) As repo lenders and other creditors stopped lending, the investment bank is forced to sell of assets to payoff creditors. 14-10 Shadow Banking Run, Panic, and Crisis Lehman Brothers issued a lot of commercial paper to source funds. MMMFs invested in Lehman commercial paper. Losses on Lehman CP compelled a money-market mutual fund to break the buck - to lower its value below $1. Investors in other funds rushed to withdraw their shares at the promised $1 per share. Solvency and Liquidity What matters during a bank run is not whether a bank is solvent, but whether it is liquid. Solvency means that the value of the bank s assets exceeds the value of its liabilities. It has positive net worth. Liquidity means that the bank has sufficient reserves and immediately marketable assets to meet depositors demand for withdrawals. 4
The Sources and Consequences of Runs, Panics, and Crises Contagion - A single bank s failure causes a run on other banks that could turn into a system-wide bank panic. Spreading panic on the part of depositors The Sources and Consequences of Runs, Panics, and Crises Information asymmetries are the reason that a run on a single bank can turn into a bank panic that threatens the entire financial system. Depositors are in the same position as uninformed buyers in the used car market. They cannot tell the difference between a good bank and a bad bank. Government Involvement The Government Safety Net A single firm s failure can bring down the entire system. 5
Recessions and Bank Panics a Little History on Regulation The Federal Reserve was established in 1913. Between 1871and 1913 the US had 11recessions Bank panics occurred during 7 recessions Congress passed the Federal Reserve Act to create a Lender of Last Resort The Government as Lender of Last Resort Intent: To stop bank failure from turning into a bank panic, make sure solvent institutions can meet their depositors withdrawal demands provide liquidity. In 1873 Walter Bagehot suggested the need for a lender of last resort. Such an institution could make loans to prevent the failure of solvent banks, and Provide liquidity in sufficient quantities to prevent or end a financial panic. The Government as Lender of Last Resort Fed blew it in the 1930 s. The Fed had the capacity to operate as the lender of last resort, banks did not take advantage of the opportunity. Their borrowing fell during panics. The Fed did not encourage borrowing. 6
Failure of the Lenders of Last Resort: Federal Reserve Lending, 1914-1940 As banks became illiquid in the early 1930s, lending declined. The existence of a lender of last resort is no guarantee it will be used. Lender of Last Resort Safety Net In the financial crisis of 2007-2009, shadow banks faced funding and asset liquidity. They do not normally have access to Fed loans. The Fed, using its emergency lending authority, was able to lend to such nonbank intermediaries to stem the crisis recall the Primary Dealer Lending Facility. Lender of Last Resort Safety Net The Fed utilized this emergency authority repeatedly when it needed to lend to securities brokers, MMMFs, insurers, other nonbank intermediaries, and even to nonfinancial firms. Fed took a lot of heat for this Does a Lender of Last Resort create a moral hazard? 7
Government Deposit Insurance Safety Net Congress response to the Fed s inability to stem the bank panics of the 1930s was to create nationwide deposit insurance. The Federal Deposit Insurance Corporation (FDIC) created in 1933 to guarantee Deposits. Currently, a depositor will receive the full account balance up to $250,000 even if a bank fails. Bank failures, in effect, become the problem of the government; bank customers need not worry. Government Deposit Insurance When a banks fails, the FDIC resolves the insolvency either by closing the bank or finding a buyer. Closing the bank is called the payoff method. The FDIC pays off all the bank s depositors, then sells all the bank s assets. The second approach is called the purchase-andassumption method. The Fed finds a firm willing to take over the failed bank. Government Deposit Insurance Depositors prefer the purchase-and-assumption method. The transition is typically seamless. No depositors suffer a loss, even above the max of $250,000 Deposit insurance clearly helps to prevent runs on commercial banks. 8
Government Deposit Insurance Shadow banks faced runs by their short-term creditors. There is no deposit insurance So, we can now define a shadow bank. A shadow bank is an institution that provides liquidity and banking type services without the government backstop of lender of last resort or deposit insurance. Deposit Insurance Safety Net Moral Hazzard In protecting depositors, the government creates moral hazard. Comparing bank balance sheets before and after the implementation of deposit insurance: In the 1920s, banks ratio of assets to bank capital was about 4 to 1. After deposit insurance increased to 13 to 1. Today it is about 9 to 1. Most economic historians believe government insurance led to this rise in risk. What does Each depositor insured to $250,000 really mean? 1. Deposit insurance covers individuals, not accounts. 2. If you have more than one account at the same bank, all in your name, they will be insured together up to the $250,000 insurance limit. 3. If you have accounts at more than one bank, they will be insured separately, up to the insurance limit at each bank. https://www.fdic.gov/deposit/cov ered/categories.html 14-27 9
Regulation of the Financial System Banks are regulated and supervised by a combination of: U.S. Treasury, Federal Reserve, FDIC, and state banking authorities. A bank can choose its regulators by choosing whether to be a state or national bank and whether or not to belong to the Federal Reserve System banks can shop around. Regulation and Supervision of the Financial System Restrictions on Asset Holding and Minimum Capital Requirements Regulation place restrictions on bank s balance sheet to prevent banks from exploiting their safety net and take on too much risk. These regulations take two forms: Restrictions on the types of assets banks can hold. Requirements that they maintain minimum levels of capital. 10
Restrictions on Asset Holding U.S. banks cannot hold common stock. Restrict both the grade and quantity of bonds a bank can hold. Banks are generally prohibited from purchasing bonds that are below investment grade. Holdings from any single private issuer cannot exceed 25% of their capital. The size of the loans they can make to particular borrowers is also limited: 15% to 25% of their capital. Minimum Capital Requirements Capital requirements take two basic forms: Most banks are required to keep their ratio of capital to total assets above some minimum level, regardless of the structure of their balance sheets leverage ratio. Banks are required to hold capital in proportion to the riskiness of their assets risk weighted capital requirements. Minimum Capital Requirements The leverage ratio is the amount of capital divided by the bank s total assets. To be classified as well capitalized a bank s leverage ratio must exceed 5%; adequate is 4%; under capitalized is <4%; <3% triggers increased regulatory restrictions on the bank The second type is risk-based capital requirements 11
Basel Risk Based Capital Requirement Note, this is a 1000 page document Asset Risk Weight Cash and equivalents (reserves) 0 US Government securities 0 Interbank loans (Federal Funds) 0.2 Mortgage loans 0.5 Ordinary loans (Comm l and Industrial) 1.0 Capital Requirements for Melvin s Bank First National Bank Capital Requirements for Melvin s Bank 12
Unfortunately, banks can learn to evade or game any fixed set of rules. In the years leading up to the financial crisis of 2007-2009, banks in the U.S. and Europe purchased large volumes of mortgage backed securities. These assets carried (misleadingly) high ratings. This meant the amount of capital they needed to hold under the risk-weighted capital rules was reduced. Lower capital meant more leverage, which increase risk. 13