Chapter 11 Flashcards
Primary supervisory responsibility of banking regulatory agencies
- Federal Reserve and state banking authorities: state banks that are members of the Federal Reserve System.
- Fed also regulates bank holding companies.
- FDIC: insured state banks that are not Fed members.
- State banking authorities: state banks without FDIC insurance.
Financial engineering
A change in the financial environment will stimulate a search by financial institutions for innovations that are likely to be profitable
Adjustable Rate Mortgages
- Flexible interest rates keep profits high when rates rise
- Lower initial interest rates make them attractive to home buyers
Financial derivatives
- Ability to hedge interest rate risk
- Payoffs are linked to previously issued (i.e. derived from) securities
Securitization
- To transform otherwise illiquid financial assets into marketable capital market securities.
- Securitization played an especially prominent role in the development of the subprime mortgage market in the mid 2000s
Loophole mining
- Reserve requirements act as a tax on deposits
- Restrictions on interest paid on deposits led to disintermediation (loss of deposits)
- Money market mutual funds (paid higher interest rates than banks did)
- Sweep accounts (A way to avoid tax)
Banks’ responses
1) Expand into new and riskier areas of lending
-Commercial real estate loans, Corporate takeovers and leveraged buyouts
2) Pursue off-balance-sheet activities
Non-interest income, Concerns about risk
Benefits of bank consolidation and nationwide banking
- Increased competition, driving inefficient banks out of business
- Also, increased efficiency from economies of scale and scope
- Lower probability of bank failure from more diversified portfolios
Costs of bank consolidation and nationwide banking
- Elimination of community banks may lead to less lending to small business
- Banks expanding into new areas may take increased risks and fail
Erosion of Glass-Steagall
- Prohibited commercial banks from underwriting corporate securities or engaging in brokerage activities
- Section 20 loophole was allowed by the Federal Reserve enabling affiliates of approved commercial banks to underwrite securities as long as the revenue did not exceed a specified amount
- U.S. Supreme Court validated the Fed’s action in 1988
Gramm-Leach-Bliley Financial Services Modernization Act of 1999
- Abolishes Glass-Steagall
- States regulate insurance activities
- SEC keeps oversight of securities activities
- Office of the Comptroller of the Currency regulates bank subsidiaries engaged in securities underwriting
- Federal Reserve oversees bank holding companies
Universal banking
No separation between banking and securities industries
British-style universal banking
May engage in security underwriting
- Separate legal subsidiaries are common
- Bank equity holdings of commercial firms are less common
- Few combinations of banking and insurance firms
Savings and loan institutions
- Chartered by the federal government or by states
- Most are members of Federal Home Loan Bank System (FHLBS)
- Deposit insurance provided by Savings Association Insurance Fund (SAIF), part of FDIC
- Regulated by the Office of Thrift Supervision
Mutual savings banks
- Approximately half are chartered by states
- Regulated by state in which they are located
- Deposit insurance provided by FDIC or state insurance
