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Chapter Fourteen
Chapter 14
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)
Cost of Banking Crises in Other Countries (b)
© 2004 Pearson Addison-Wesley. All rights reserved
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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.
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– Deposits are withdrawn first come-first served.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.
Example
a Bank
Run
Run
on a of
Bank
- Example
Liquidate at
100%
Liquidate at Total value of liquidated
assets = $40 + $40 = $80
50%
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.
Shadow Banking Run, Panic, and Crisis
Investment Bank
Assets
(Uses of Funds)
-
Stocks
MBS
US Gov’t bonds
Corporate bonds
Bunch of other stuff
Liabilities and Net Worth
(Sources of Funds)
-
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.
• Recall “funding liquidity” and “asset liquidity” discussed in
chapter 2.
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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.
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.
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.
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.
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?
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.
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
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Too Big to Fail Safety Net
• Government officials are concerned about the
largest institutions because they can pose a
threat to the entire financial system.
• Collapse of an institution holding more than a
trillion dollars in assets is too much for most to
contemplate.
• Too big to fail or too interconnected to fail, too
complex to shut down.
Too Big to Fail Safety Net
• Too big to fail undermines the market discipline
that depositors and creditors impose on banks
and shadow banks.
• Normally, the fear of withdrawal of large
depositors from a bank or MMMF restrains them
from taking too much risk.
Solution to Too Big to Fail
• Some argue that too big to fail institutions are
just too big and need to be broken up.
• This, however, does not eliminate the bad
incentives from deposit insurance and
government guarantees to smaller institutions.
• Are there better solutions?
– Equity, equity and more equity.
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.
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
Basel Risk Based Capital Requirement –
Note, this is a 1000 page document
Asset
Cash and equivalents (reserves)
US Government securities
Interbank loans (Federal Funds)
Mortgage loans
Ordinary loans (Comm’l and Industrial)
Risk Weight
0
0
0.2
0.5
1.0
Capital Requirements for Melvin’s
Bank
First National Bank
Capital Requirements for Melvin’s
Bank
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.
Supervision and Examination
• SKIP
Evolving Challenges for Regulators and Supervisors
• Congress removed Glass-Steagall.
• Banks are now not just commercial banks, but
investment banks, insurance companies, and
securities firms all rolled into one.
– Each of these organizations is regulated and
supervised by different agencies, both
functionally and geographically.
Micro-prudential Versus Macro-prudential Regulation
• “micro-prudential” approach to regulation is one
in which regulation is aimed at preventing the
costly failure of an individual financial institution.
• regulation aims at limiting the risks within
intermediaries in order to reduce the possibility of an
individual institution's failure.
• By contrast, “macro-prudential” approach seeks
to safeguard the financial system as a whole.
• Regulators are broadening their focus beyond microprudential oversight to encompass macro-prudential
regulation.
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Micro-prudential Versus Macro-prudential
Regulation
• Macro-prudential regulation treats risk taking by
financial intermediaries as a kind of pollution that
spills over to other financial institutions and
markets – externality.
• Its one thing for a single firm to shrink its balance
sheet.
• Its quite another if a number of financial
intermediaries are forced to shrink balance sheets
at the same time.
Micro-prudential Versus Macro-prudential
Regulation
Common Exposure
• When many financial institutions have exposure to
the same specific risk factor, it can make the
system vulnerable to a shock to that factor.
– A lot of firms hold large amounts of mortgage backed
securities.
• Or a firm not holding mortgage back securities has
a lot of loans to one that does – counterparties
are themselves directly exposed to a frail
institution.
• All institutions may be vulnerable to the same
underlying risks.
Micro-prudential Versus Macro-prudential
Regulation
• Large intermediaries usually are more
interconnected, so they are typically a greater
source of systemic risk.
Micro-prudential Versus Macro-prudential
Regulation
• Pro-cyclicality.
– Financial activity is prone to virtuous and vicious
cycles.
– The interaction between financial and economic
activity can be mutually reinforcing leading to
unsustainable booms and busts.
– Euphoria feeds euphoria and vice versa.
Adrian and Shin: Investment Banks
Investment banks were not passive, pro-cyclical – leverage
increased.
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Micro-prudential Versus Macro-prudential Regulation
Macro-prudential Policy
• Aim is to make intermediaries bear, or internalize,
the costs that their behavior imposes on others.
• To limit systemic threats, a capital surcharge would
be disproportionately larger for firms that
contribute the most to systemic risk.
• Intermediaries would have an incentive to
limit the systemic risks they create.
Micro-prudential Versus Macro-prudential Regulation
Macro-prudential Policy
• Regulators could make capital requirements
vary with the business cycle.
– In good times, capital requirements would be high to
create a capital buffer against adverse shocks and to
discourage euphoria.
– Say need 8% capital ratio in recession to handle 4%
loss on assets. Have bank build ratio to 12% in good
times.
• Regulators could require banks to buy
catastrophe insurance.
Micro-prudential Versus Macro-prudential Regulation
Macro-prudential Policy
• Could also have banks issue so-called contingent
convertible (Coco) bonds that convert to equity
in the event of a capital shortfall.
• For example, in November 2009, Lloyds Bank
issued £7.5 billion in contingent convertible
debt, with conversion to equity to be triggered if
Lloyds’ equity ratio fell below 5 percent.
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