Module 5.2

Question 1

Background

Answer 1

Bank regulation is needed to protect customers who supply
funds to the banking system.
Many regulations were removed or reduced over time, which
allowed banks to become more competitive.
Because of deregulation, banks have considerable flexibility
in the services they offer, the locations where they operate,
and the rates they pay depositors for deposits.
Some banks and other financial institutions engaged in
excessive risk taking in recent years, which is one the
reasons for the credit crisis in the 2008 2009 period.

Question 2

Regulatory Structure (1 of 2)

Answer 2

Often referred to as a
dual banking system because it
includes both a federal and a state regulatory system.
A charter from either a state or the federal government is
required to open a commercial bank in the United States.
A bank that obtains a state charter is referred to as a state
bank; a bank that obtains a federal charter is known as a
national bank.
National banks are required to be members of the Fed.
State banks may decide whether they wish to be members
of the Federal Reserve System.

Question 3

Regulators

Answer 3


National banks are regulated by the Comptroller of the
Currency, while state banks are regulated by their
respective state agency.

Banks that are insured by the Federal Deposit
Insurance Corporation (FDIC) are also regulated by the
FDIC.
Regulation of Bank Ownership

Commercial banks can be either independently owned or
owned by a bank holding company (BHC).

Question 4

Regulation of Deposit Insurance

Answer 4


Federal deposit insurance has existed since the creation in 1933 of the
FDIC in response to the bank runs that occurred in the late 1920s and
early 1930s.

The FDIC preserves public confidence in the U.S. financial system by
providing deposit insurance to commercial banks and savings
institutions.

Question 5

Insurance Limits

Answer 5

The specified amount of deposits
per person insured by the FDIC was increased from
$100,000 to $250,000 as part of the Emergency
Economic Stabilization Act of 2008 and made permanent
with the Financial Reform Act of 2010.

Question 6

Risk Based Deposit Premiums

Answer 6

Banks insured by

the FDIC must pay annual insurance premiums.

Question 7

Deposit Insurance Fund

Answer 7

Regulated by the FDIC

Range of premiums typically between 13 and 53 cents per $100
with most banks between 13 and 18 cents

Question 8

Bank Deposit Insurance Reserves

Answer 8


The Wall Street Reform and Consumer Protection Act of 2010 requires
that the Deposit Insurance Fund should maintain reserves of at least
1.35% of total insured bank deposits.

Must develop a restoration plan if drops below 1.35%

Must pay back as dividends if grows above 1.5%

Question 9

Regulation of Deposits

Answer 9

DIDMCA Depository Institutions Deregulation and
Monetary Control Act

Enacted to deregulate the banking (and other depository
institutions) industry.

Also enacted to improve monetary policy.

Garn St. Germain Act

Permitted depository institutions to offer money market deposit
accounts (MMDAs).

Permitted depository institutions (including banks) to acquire
failing institutions across geographic boundaries.

Question 10

Interstate Banking Act

Answer 10

Removed interstate branching restrictions and thereby further
increased the competition among banks for deposits.

Nationwide interstate banking enabled banks to grow and
achieve economies of scale.

Question 11

Regulation of Bank Loans

Answer 11

Regulation of Highly Leveraged Transactions

As a result of concern about the popularity of highly
leveraged loans, bank regulators monitor the amount of
highly leveraged transactions (HLTs), loans in which
liabilities are greater than 75% of assets.

Regulation of Foreign Loans

Monitor a bank’s exposure to loans to foreign countries.

Regulation of Loans to a Single Borrower
Banks are restricted to a maximum loan amount of 15% of
their capital to any single borrower (up to 25% if the loan is
adequately collateralized).

Question 12

Regulation of Loans to Community

Answer 12

Banks are regulated to ensure that they attempt to
accommodate the credit needs of the communities in which
they operate.

The Community Reinvestment Act (CRA) of 1977
(revised in 1995) requires banks to meet the credit needs of
qualified borrowers in their community, even those with
low or moderate incomes.

Question 13

Regulation of Bank Investment in Securities

Answer 13

Banks are not allowed to use borrowed or deposited
funds to purchase common stock.

Banks can invest only in bonds that are investment
grade quality (as measured by a Baa rating or higher by
Moody’s or a BBB rating or higher by Standard & Poor’s).

Question 14

Regulation of Securities Services

Answer 14

The Banking Act of 1933 ( The Glass Steagall Act )
separated banking and securities activities. Firms that
accepted deposits could not underwrite stocks and
corporate bonds.

Financial Services Modernization Act (The Gramm
Leach Bliley Act)

Repealed the Glass Steagall Act.

Since 1999, there has been more consolidation of financial
institutions.

Question 15

Regulation of Insurance Services

Answer 15

In 1998, regulators allowed the merger between Citicorp
and Traveler’s Insurance Group

This paved the way for the consolidation of bank and
insurance services

Question 16

Regulation of Off

Balance Sheet Transactions

Answer 16

Bank exposure to off balance sheet activities has
become a major concern of regulators.

Banks could be riskier than their balance sheets indicate
because of these transactions.

Regulation of Credit Default Swaps

Regulators increased their oversight of this market and
asked commercial banks to provide more information about
their credit default swap positions.

Question 17

Regulation of the Accounting Process

Answer 17

The Sarbanes Oxley (SOX) Act was enacted in 2002 to

ensure a transparent process for financial reporting.

Question 18

Regulation of Capital (1 of 7)

Answer 18

Banks are subject to capital requirements, which force them
to maintain a minimum amount of capital (or equity) as a
percentage of total assets.
How Banks Satisfy Regulatory Requirements

Retaining Earnings Banks commonly boost their capital levels by
retaining earnings or by issuing stock to the public.

Reducing Dividends Banks can increase their capital by reducing
their dividends.

Selling Assets When bank regulators of various countries develop
their set of guidelines for capital requirements, they are commonly
guided by the recommendations in the Basel accords.

Question 19

Basel I Accord

Answer 19


1988: The central banks of 12 major countries agreed to
establish uniform capital requirements.

Banks with greater risk are required to maintain a higher
level of capital, which discourages banks from excessive
exposure to credit risk.

Assets are weighted according to risk.

Question 20

Basel II Framework

Answer 20

Refines risk measures and increases transparency.

Revising the Measurement of Credit Risk

Categories are refined to account for differences in risk
levels.

Explicitly Accounting for Operational Risk

Provided an incentive for banks to reduce their operational
risk by imposing higher capital requirements on banks with
higher levels of operational risk.

Many banks underestimated the risk of loan default during
the credit crisis which led to development of Basel III.

Question 21

Basel III Framework

Answer 21

Attempts to correct deficiencies of Basel II.

Calls for higher capital requirements to offset bank
exposure due to derivative positions

Recommends that banks maintain Tier I capital (retained
earnings and common stock) of at least 6% of total risk
weighted asset .

Recommends the use of scenario analysis to determine
how a bank’s performance and capital level would be
affected should economic conditions deteriorate.

Also calls for improved liquidity requirements.

Question 22

Use of the VaR Method to Determine Capital

Levels

Answer 22

The capital requirements to cover general market risk are
based on the bank’s own assessment of risk when
applying a value at risk (VaR) model.

A bank defines the VaR as the estimated potential loss
from its trading businesses that could result from adverse
movements in market prices.

Testing the Validity of a Bank’s VaR Assessed by
comparing the actual daily trading gains or losses to the
estimated VaR over a particular period

Question 23

Limitations of the VaR Model

Answer 23

Generally ineffective at detecting the risk of banks during
the credit crisis.

The use of historical data from before 2007 did not capture
the risk of mortgages because investments in mortgages
during that period normally resulted in low defaults.

Question 24

Stress tests Imposed to Determine Capital Levels

Answer 24

Some banks supplement the VaR estimate with their own
stress tests.

Regulatory Stress Tests during the Credit Crisis

Forecasting the likely effect on the banks’ capital levels if the
recession existing at that time lasted longer than expected.

Potential impact of an adverse scenario such as a deeper recession
varies among banks.

Question 25

Government Infusion of Capital during the Credit Crisis

Answer 25

The Troubled Asset Relief Program (TARP) addressed the
financial problems experienced by financial institutions with
excessive exposure to mortgages or mortgage backed
securities.

Question 26

How Regulators Monitor Banks (1 of 7)

Answer 26

CAMELS Ratings

Capital adequacy

Asset quality

Management

Earnings

Liquidity

Sensitivity

Each characteristic is rated on a 1 to 5 scale, with 1
indicating outstanding and 5 very poor.

Banks with a composite rating of 4.0 or higher are
considered to be problem banks.

Question 27

Capital Adequacy

Answer 27

Because adequate bank capital is thought to reduce a bank’s
risk, regulators determine the capital ratio (typically defined as
capital divided by assets).

Banks with higher capital ratios are therefore assigned a higher
capital adequacy rating.

Fair value accounting is used to measure the value of bank
assets.

Question 28

Asset Quality

Answer 28

Each bank makes its own decisions as to how deposited funds
should be allocated, and these decisions determine its level of
credit (default) risk.

The Fed considers “the 5 Cs” to assess the quality of the loans
extended by a bank, which it is examining:

Capacity The borrower’s ability to pay.

Collateral The quality of the assets that back the loan.

Condition The circumstances that led to the need for funds.

Capital The difference between the value of the borrower’s
assets and its liabilities.

Character The borrower’s willingness to repay loans as
measured by its payment history on the loan and credit report.

Question 29

Management

Answer 29

Regulators specifically rate the bank’s management according to
administrative skills, ability to comply with existing regulations,
and ability to cope with a changing environment.

Question 30

Earnings

Answer 30

A profitability ratio used to evaluate banks is return on assets
(ROA), defined as after tax earnings divided by assets.

Question 31

Liquidity

Answer 31

If existing depositors sense that the bank is experiencing a
liquidity problem, they may withdraw their funds, compounding
the problem.

Question 32

Sensitivity

Answer 32

Regulators assess the degree to which a bank might be exposed to
adverse financial market conditions.

Question 33

Limitations of the CAMELS Rating System

Answer 33

Because there are so many banks, regulators do not have the
resources to closely monitor each bank on a frequent basis.

Many problems go unnoticed.

Question 34

Corrective Action by Regulators

Answer 34

Regulators may examine banks frequently and discuss with
bank management possible remedies

Regulators may request that a bank boost its capital level or
delay its plans to expand.

They can require that additional financial information be
periodically updated to allow continued monitoring.

They have the authority to remove particular officers and
directors of a problem bank if doing so would enhance the
bank’s performance.

They can take legal action against a problem bank if the bank
does not comply with their suggested remedies.

Question 35

Funding the Closure of Failing Banks

Answer 35

If a failing bank cannot be saved, it will be closed.

When liquidating a failed bank, the FDIC draws from its
Deposit Insurance Fund to reimburse insured depositors.

The cost to the FDIC of closing a failed bank is the
difference between the reimbursement to depositors and the
proceeds received from selling the failed bank’s assets.

Question 36

Argument for Government Rescue

Answer 36

If all financial institutions that were weak during the credit
crisis had been allowed to fail without any intervention,
the FDIC might have had to use all of its reserves to
reimburse depositors.

Question 37

How a Rescue Might Reduce Systemic Risk

Answer 37

The financial problems of a large bank failure can be contagious
to other banks.

The rescue of large banks might be necessary to reduce systemic
risk in the financial system, as illustrated next.

Question 38

Argument against Government Rescue

Answer 38

When the federal government rescues a large bank, it sends a
message to the banking industry that large banks will not be
allowed to fail.

Some critics recommend a policy of letting the market work,
meaning that no financial institution would ever be bailed
out.

Question 39

Government Rescue of Bear Stearns

Answer 39

Bear Stearns had facilitated many transactions in financial
markets, and its failure would have caused liquidity problems

The Fed provided short term loans to Bear Stearns to ensure
that it had adequate liquidity.

Question 40

Failure of Lehman and Rescue of AIG

Answer 40

In September 2008, Lehman Brothers was allowed to go
bankrupt without any assistance from the Fed even
though American International Group (AIG, a large
insurance company) was rescued by the Fed.

One important difference between AIG and Lehman
Brothers was that AIG had various subsidiaries that were
financially sound at the time, and the assets in these
subsidiaries served as collateral for the loans extended
by the federal government to rescue AIG.

The risk of taxpayer loss due to the AIG rescue was low.

Question 41

Protests of Government Funding for Banks

Answer 41

Bailouts led to the organization of various groups.

The Tea Party organized in 2009 and staged protest
mainly about excessive government spending.

In 2011, Occupy Wall Street organized and also staged
protests.

Question 42

Financial Reform Act of 2010 (1 of 4)

Answer 42

Mortgage Origination
Requires that banks and other financial institutions granting
mortgages verify the income, job status, and credit history of
mortgage applicants before approving mortgage applications.
Sales of Mortgage
Backed Securities
Requires that financial institutions that sell mortgage
backed
securities retain 5% of the portfolio unless it meets specific
standards that reflect low risk.
Financial Stability Oversight Council
Responsible for identifying risks to financial stability in the
United States and makes recommendations that regulators
can follow to reduce risks to the financial system.

Question 43

Orderly Liquidation

Answer 43

Assigned specific regulators to determine whether any
particular financial institution should be liquidated.

Calls for the creation of an orderly liquidation fund that can
be used to finance the liquidation of any financial institution
that is not covered by the FDIC.

Question 44

Consumer Financial Protection Bureau

Answer 44

Responsible for regulating consumer finance products and
services offered by commercial banks and other financial
institutions, such as online banking, checking accounts, and
credit cards.

Question 45

Limits on Bank Proprietary Trading

Answer 45

Mandates that commercial banks must limit their proprietary
trading, in which they pool money received from customers
and use it to make investments for the bank’s clients.
■
Also known as the Volcker Rule after Paul Volcker, a previous
chair of the Federal Reserve, who initially proposed the rule.

Question 46

Trading of Derivative Securities

Answer 46

Requires that derivative securities be traded through a

clearinghouse or exchange, rather than over the counter.

Question 47

Limitations of Regulatory Reform

Answer 47

The complex set of regulators for financial institutions
can lead to overlapping and excessive regulation for
some types of financial institutions but very little
oversight of other types of financial institutions.

Inconsistent levels of regulation among regulators
motivate some financial institutions to pursue a particular
charter that can avoid regulations or allow for easier
compliance.

Question 48

Global Bank Regulations

Answer 48

Each country has a system for monitoring and regulating
commercial banks.

Most countries also maintain different guidelines for
deposit insurance.

Differences in regulatory restrictions give some banks a
competitive advantage in a global banking environment.

Question 49

SUMMARY (1 of 4)

Answer 49

The regulatory structure of the U.S. banking system
includes both a federal and a state regulatory system.
Federal regulators include the Federal Reserve, the
Office of the Comptroller of the Currency, and the
Federal Deposit Insurance Corporation.
■
Banks must observe regulations on the deposit
insurance they must maintain, their loan composition, the
bonds they are allowed to purchase, and the financial
services they can offer. In general, regulations on
deposits and financial services have been loosened in
recent decades in order to allow for more competition
among banks.

Question 50

SUMMARY (2 of 4)

Answer 50

Capital requirements are intended to ensure that banks
have a cushion against any losses. The requirements
have become more stringent and are risk adjusted so
that banks with more risk are required to maintain a
higher level of capital.

Bank regulators monitor banks by focusing on six criteria:
capital, asset quality, management, earnings, liquidity,
and sensitivity to financial market conditions. Regulators
assign ratings to these criteria in order to determine
whether corrective action is necessary. When a bank is
failing, the FDIC or other government agencies consider
whether it can be saved.

Question 51

SUMMARY (3 of 4)

Answer 51

During the credit crisis, many banks failed and also
Lehman Brothers failed, but the government rescued
American International Group (AIG). Unlike Lehman
brothers, AIG had various subsidiaries that were
financially sound at the time, and the assets in these
subsidiaries served as collateral for the loans extended
by the government to rescue AIG.
■
The U.S. government injected capital into many banks
during the credit crisis to cushion them against massive
losses. Although the government argued that the
intervention was necessary to protect the financial
system, it was controversial and led to protests by
different groups.

Question 52

SUMMARY (4 of 4)

Answer 52

In July 2010, the Financial Reform Act was implemented.
It set more stringent standards for mortgage applicants,
required banks to maintain a stake in the mortgage
portfolios that they sell, and established a Consumer
Financial Protection Bureau to regulate consumer
finance products and services offered by commercial
banks and other financial institutions. The Volcker Rule
limits proprietary trading by banks.
■
All countries have systems for monitoring and regulating
banks, but the services that banks are allowed to offer
differ considerably among countries. Many countries
have taken steps to increase their capital requirements
for banks in line with the Basel III recommendations.