Chapter 13

Regulation of Commercial Banks

Commercial banks provide many unique services information, liquidity,
price-risk reduction, low transaction costs, maturity intermediation,
payment services, money supply transmission, credit allocation,
intergenerational wealth transfers, and denomination intermediation.
Failure to provide these services can be costly to both users and
suppliers of funds
Government deposit insurance liability creates moral hazard
Accordingly, commercial banks are regulated at the federal (and
sometimes state) level
1. Types of Regulations and the Regulators
a. Safety and Soundness Regulations
Safety and soundness regulations are designed to limit the probability of failure of a DI.
Examples include:
 Lending limits on the amount that can be lent to one or related borrowers. Banks cannot
lend an amount greater than 10% of their own equity capital to one company or borrower
(more if the loan is collateralized by liquid assets).
 Minimum amounts of DI equity capital are required. Greater amounts of equity capital are
required if a bank invests in riskier assets.
 The existence of guaranty funds such as the Deposit Insurance Fund (DIF) operated by the
FDIC. Deposit insurance premiums increase with the riskiness of the bank. Risk based
insurance premiums and capital requirements help limit moral hazard problems (see below).
Deposit insurance prevented runs on banks during the financial crisis.
 Examinations and reporting requirements. DIs must file quarterly call reports and large
institutions must be examined annually. Examiners analyze the bank’s loan policy (credit
evaluation procedures) and internal control processes (among other things) to help ensure the
safety and soundness of the institution. Fraud and embezzlement have also always plagued
the banking industry, and regular examinations are required to prevent illegal activities.

These and other regulations impose a cost called the net regulatory burden upon DIs. The net
regulatory burden is the difference between the private benefit from being regulated, such as the
reduction in liability cost brought about by deposit insurance, less the private cost of adhering to
regulations, producing reports, etc.

The Dodd-Frank Act of July 2010 (or the Wall Street Reform and Consumer Protection Act)
was designed to improve the safety and soundness of the financial system and prevent another
financial crisis. The bill’s five key objectives were:
1. Promote better supervision of financial firms by creating a new Financial Services Oversight
Council chaired by the Treasury and including the heads of the primary federal regulators.
The main purpose is to give the Treasury more oversight. The Treasury now has a new office,
the Office of National Insurance, to oversee systemic risks caused by insurance companies.
The other major change is to give the Federal Reserve more authority over nonbanks that pose
systemic risks. This is giving the Fed the authority they used during the crisis.
 In 2011 the Fed decided to limit net credit exposures of the nation’s six largest banks to
10% of regulatory capital. Net exposure is generally limited to 25% of regulatory capital
at other institutions. It is possible that these strict limits will have unintended
consequences such as limiting hedging at these large institutions and perhaps reducing
liquidity by limiting interbank trading.
 The Fed is now seeking additional regulatory oversight of nonbank financial service
firms (so called shadow banks). Finance companies, life insurers and others are
examples. In addition, structured investment vehicles (SIVs), special purpose vehicles
(SPVs) and issuers of asset backed commercial paper (ABCP) would be included in this
list. According to the text shadow bank assets comprised $9.2 trillion in 2013. The
Dodd-Frank bill grants potential supervisory power to the Federal Reserve of these
entities and it is likely that capital requirements and risk management standards will be
imposed. .

Hedge fund and private equity advisors are required to register with the SEC. Hedge fund
practices such as selling credit default swaps without sufficient capital, alleged short selling of
leveraged instruments they helped created and other such problems indicate a need for more
oversight.

2. Improving market regulations by increasing regulation of securitization processes by requiring

more transparency, stronger regulations of credit ratings agencies and increasing the
percentage of sold loans that must be retained by originators. This section also increases
regulation of OTC derivatives and gives the Federal Reserve additional authority to oversee
the nation’s payment mechanisms. These are all welcome changes that are necessary.

3. Establish a Consumer Financial Protection Agency (CFPA) to protect consumers from

unfair, deceptive and abusive practices and improve transparency in dealing with consumers.
A similar credit card bill effective in 2010 limits card issuer’s ability to increase interest rates
in the first year a card is obtained, limits fees and penalties for missed payments, which had
become exorbitant, and abolishes universal default penalties (prior to this, when missing a
payment on any bill, the credit card issuer could apply default rates and fees on the credit card
holder). These changes were long overdue, but they will result in less credit availability for
marginally creditworthy individuals and may result in higher credit card charges for the
general populace. This may reduce consumer spending and perhaps result in slower economic
growth. Credit card charge-off rates are traditionally high and were very high during and after
the crisis. Nevertheless there are only a few credit card issuers and this creates the possibility
of a less than fully competitive market so an argument for regulation can be made.
4. Establish new methods to resolve problems in non-banks that may present systemic risks and
improve the Fed’s accountability in its emergency lending facilities.
5. Increase international regulatory standards and cooperation, primarily by increasing capital
requirements at U.S. and non-U.S. banks. In June 2011, regulators eliminated a 2007 rule that
allowed large banks to use internal models to calculate how much capital they must hold.
Under Basel II, banks with $250 billion or more in assets might have been able to have lower
capital ratios than smaller banks. The Collins Amendment now requires large banks to
calculate their capital requirements using the rules for small banks and the Basel II
calculations where their capital requirement is the larger of the two measures. Banks argued
against the rule claiming that higher capital requirements will hurt U.S. growth. A BIS study
indicates that since funding with capital is more expensive, loan spreads may increase with
greater capital requirements. However, their models reveal only a modest reduction in
resulting growth. The study finds that the most likely impact is a 1% increase in the required
ratio of tangible common equity to risk weighted assets results in a maximum reduction in
annual growth of 0.04% over a four and one half year period. The researchers note that there
is uncertainty in their estimates.

Three years after its passage in 2010, the massive 2,319 page Dodd-Frank bill is about 1/3
implemented. About 60% of the law’s implementation deadlines have been missed.

b. Monetary Policy Regulation

The central bank directly controls only outside money (money outside the banks such as
currency and coins in circulation) but the majority of the money supply is inside money (bank
deposits). Many governments require banks to back deposits with reserves held at the central
bank or other government authority. In the U.S. the Fed requires banks to hold reserves at the
Fed, and can manipulate both the level of required reserves and the price of holding excess
reserves by manipulating interest rates (see Chapter 4).

c. Credit Allocation Regulation

Credit allocation regulations are designed to channel funds to what are deemed socially
deserving areas such as housing, farming or lending in economically disadvantaged areas. These
laws and regulations may require DIs to lend minimum amounts in one area or to provide loans
at subsidized rates. Examples include the Qualified Thrift Lender Test (for more on the QTL
Test see Chapter 14) and the Community Reinvestment Act (CRA) of 1977. In 1995 CRA
regulations were revised to make the objectives more measurable and to reduce the regulatory
burden imposed by the law. Revised rules focus on three measures:
1. Lending:
a. Geographic and demographic distribution of lending. The object is to prevent
redlining and similar discriminatory practices as well as to encourage lending to
disadvantaged groups.
b. Extent of community development lending. Encourages banks to lend to startups
and engage in loans to micro businesses.
c. Use of innovative or flexible lending practices to assist low or moderate income
individuals.
2. Investment: The institution’s involvement with qualified programs that assist certain
people or areas. An example may include funding for public service organizations that
invest in disadvantaged areas.
3. Service: The extent to which the institution provides banking services to the community
 and their willingness to accommodate to area needs.
CRA ratings range from outstanding to substantial noncompliance. Poor ratings can affect
regulatory approval of proposed mergers and other related activities. A bank’s CRA rating must
be made publicly available; most banks of any size put together a brochure outlining their
community involvement.

d. Consumer Protection Regulation

The CRA and the Home Mortgage Disclosure Act (1975) are both designed to prevent
discrimination in the granting of credit. Lenders must fill out a standard form for each loan
stating why a loan application was accepted or denied. Bankers have complained that
government requirements result in excessive, costly documentation.

e. Investor Protection Regulation

The Securities Acts of 1933 and 1934 are the two primary pieces of legislation that form the
basis of investor protection. The 1933 act created strict disclosure requirements for primary
public offerings. The 1934 act established the SEC and its right to regulate secondary markets.

Teaching Tip: Other major acts include the Investment Company Act of 1940, the Investment
Advisor’s Act of 1940, and ERISA in 1974. The Investment Company Act of 1940 (as amended
in 1970) requires that mutual funds and closed-end funds meet disclosure requirements
similar to new issues. This law also requires funds to publish and adhere to a clear statement of
goals (which may not be changed without shareholders' consent) and other anti-fraud procedures.
The Investment Advisors Act of 1940 requires that anyone who sells advice about securities or
investments register with the SEC. Information such as criminal record, age, experience,
education must be disclosed. The SEC does not deny anyone the right to sell unless they have a
criminal record.

f. Entry and Chartering Regulation

Market entry is regulated. For instance, national bank charters are granted by the Office of the
Comptroller of the Currency (OCC). A given charter also limits the activity of the entity.
Controlled entry into an industry creates a potential competitive barrier that may allow banks to
enjoy higher profitability.

g. Regulators
The U.S. tends to have more regulatory overlap than other countries. A state chartered insured
bank that is a member of the Federal Reserve System may technically be regulated by the Fed,
the FDIC, and a state banking commission.