Banking Regulation Copy Notes

BANKING REGULATION

Lecture 1 – RECENT TREND IN BANKING ACTIVITY

HOW DID FIs CHANGE?

The products sold and the risks faced by modern FIs are becoming more complex and increasingly similar because of:

1. DEREGULATION: increased competition; consolidation within the country (M&A); diversification across products and geography (foreign bank entry)

   1. Glass-Steagall Act, 1933:

      1. Separation between Investment Banks (IBs) & Commercial Banks (CBs)

      2. CBs are with deposits but restricted asset choice

IBs are without deposits but greater freedom on the asset side

3. IBs have protection from CBs competition in the equity market

4. CBs are subject to many regulations related to capital, risk, etc, while IBs are subject to only Securities and Exchange Commission

2. Financial Service Modernization Act, 1999:

   1. Removes barriers between CBs, Insurance companies and IBs

   2. Creation of “financial services holding companies” that could engage in banking, insurance and securities activities (it basically does everything, and so they hold the highest share of total assets)

   3. Large banks could place certain activities in its subsidiaries

2. FINANCIAL INNOVATION: new derivative market

Understanding these changes are important because the risks of FIs change together with these structure and activities of banks.

Although product and geographical diversification and derivative instruments were supposed to reduce the risk faced by FIs, they have actually resulted in higher systemic risk.

DEREGULATION and FINANCIAL INNOVATION facilitates a change of the business model from “originate and hold” to “originate and distribute”.

• ORIGINATE and HOLD: creation of FUNDING liquidity through ASSETS TRANSFORMATION

1. Banks hold loan to maturity

2. Banks hold credit risk

3. Banks have an incentive to screen and monitor borrowers

4. Banks have an incentive to price risk correctly

• ORIGINATE and DISTRIBUTE: creation of MARKET liquidity through LOAN SALE and SECURITIZATION

1. Better risk sharing between banks and markets

2. Banks get rid of the associated credit risk

3. Banks get new funds to originate new loans from this sale

4. Less incentive to screen and monitor borrowers, and price risk correctly

This change in the business model resulted in a dramatic increase in systemic risk of the financial system due to:

1. Lower screening standards – higher average credit risk

2. The originator of the ABS gets rid of the underlying credit risk

3. If banks lose their ability to sell/securitize at a fair price then it will create Market liquidity risk (cannot trade loans and thus no liquidity provision)

4. Market liquidity risk feeds back into funding liquidity risk

5. 
   

Lecture 2 – LIQUIDITY, INTEREST & CREDIT RISKS

LIQUIDITY RISK

LIQUIDITY RISK arises for 2 reasons:

1. LIABILITY SIDE liquidity problems:

   1. Risk that many depositors demand immediate cash for their financial claims

   2. ST lenders do not renew their credit lines

2. ASSET SIDE liquidity problems:

   1. The risk of being unable to satisfy claims like loans commitments

   2. Drop in investment portfolio value (caused by increase in interest rate)

LIABILITY SIDE OF THE COMMERCIAL BANK:

1. DEPOSITS:

   1. Demand deposits – have a high degree of withdrawal risk. Withdrawals can be instantaneous and largely expected by the DI manager, such as pre-weekend cash withdrawals. Despite the 0 explicit interest paid on demand deposit accounts, competition among DIs and other FIs has resulted in the payment of implicit interest, or payments of interest-in-kind on these accounts. Finally, demand deposits have an additional cost in the form of non-interest bearing reserve requirements the DI must hold.

   2. NOW accounts – are interest-bearing. The major difference between NOW accounts and demand deposits is that NOW accounts require the depositor to maintain a minimum account balance to earn interest. The payments of explicit interest and the existence of minimum balance requirements make NOW accounts potentially less prone to withdrawal risk than demand deposits.

   3. Passbook savings – are generally less liquid than demand deposits and NOW account for 2 reasons. First, they are non-checkable and usually involve physical presence at the FI for withdrawal. Second, the DI has the legal power to delay payment or withdrawal requests, which provides important withdrawal risk control to DI managers.

   4. Money market deposit accounts (MMDA) – are liquid but not as liquid as demand deposits and NOW accounts. In the US, MMDAs are checkable but subject to restrictions on the number of checks written on each account per month, the number of transfers per month, and the minimum denomination of the amount of each check.

   5. Retail time deposits and CDs – are fixed-maturity instruments and carry early withdrawal penalties (before maturity) such as the loss of a certain number of month’s interest. These instruments have relatively low withdrawal risk compared with demand deposits and NOW accounts.

2. WHOLESALE CDs – allow depositors to liquidate their positions in these CDs by selling them in the secondary market rather than settling up with the DI, as a result, a depositor can sell a relatively liquid instrument without causing adverse liquidity risk exposure for the DI. The only withdrawal risk is that these wholesale CDs are not rolled over and reinvested by the holder of the deposit claim.

3. FEDERAL FUNDS – since the funds generated from these purchases are borrowed funds, not deposits, they are not subject to reserve requirements nor deposit insurance premium payments to the FDIC. While DIs with excess cash reserves can invest some of this excess in interest-earning liquid assets such as T-bills, an alternative is to lend excess reserves for short intervals to other DIs seeking to increase short-term funding. The interbank market for excess cash reserves is called the FEDERAL FUNDS market. Fed funds are short-term uncollateralized loans made by one DI to another; more than 90% of such transactions have maturities of 1 day. For the borrowing DIs, there is no...

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