FHCE 3100 1st Edition Lecture 23Current LectureCredit, Loans and Debt Warning Signs - Debt collectors and Creditor Rightso Debts are what is owed Examples of debts are bonds, notes, mortgages and other forms of paper evidencing amounts owed and payable on specified dates or on demand o A debtor is a person who owes money Reasons for Bank Regulation- Banks are less stable than other businesses because…o Bank debts tend to be short term—many depositors could withdraw their funds with little notice  Remember consumer deposits are “loans” to banks; thus, they pay us interest on these loans (Usually cash paycheck Friday, withdrawal Monday) o The behavior of depositors depends on their confidence that the bank is sound, and this confidence can be easily shaken Bank regulation: An overview - Primary bank regulators in the US:o Office of the Comptroller of the Currency (OCC)  Part of the US Department of Treasury o Federal Reserve System—the US central bank o Federal Deposit Insurance Corporation (FDIC)o State bank regulators - **Exam: What year did OCC start? What about Federal Reserve System and FDIC? What President was in during the implementation of each of these?Federal Deposit Insurance (*Exam: 3 or more questions about role of FDIC in banking collapse) - The US Congress in the Federal Deposit Insurance Corporation (FDIC) in 1933, after the bank failures in the Great Depression - Today the FDIC guarantees each bank depositor up to a maximum of $250,000 These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- FDIC Insurance is funded by a small fee paid by banks based on their deposits - (Banks cannot opt out of FDIC, have to pay fee) - *Exam: Know how FDIC allows banks to be bad Incentive Effects of Deposit Insurance: A Closer Look - Deposit insurance increases the supply of deposits from consumers (within the insurance coverage limits) o Incentive to put money in the bank - Banks attract deposits pay lower interest rates on their deposits even as they pursue risky strategies that increase the risk of bank failure - As a result, deposit insurance reduces banks’ incentives to avoid risk - (If covered by FDIC, no risk) Capital Requirements- Also known as: Regulatory Control - When there’s deposit insurance, banks have an incentive to hold too little capital - Therefore the government imposes capital requirements to ensure that banks hold sufficient capital - Also considered the ratio of the bank’s equity to its debt Bank Examinations- Banks are visited on a regular schedule by bank examiners from the OCC, the Federal Reserve System, the FDIC, or other agencies - Bank examiners review the bank’s financial statements and its confidential accounts - The results are summarized in a “CAMELS” rating given to the bankBank Examinations- *Know for exam- CAMEL….o Capital adequacy o Asset qualityo Management o Earningso Liquidity o Sensitivity to market risk Camel Ratings- ***EXAM- 1. Sound in every aspect- 2. Fundamentally sound, but with modest weaknesses that can’t be corrected- 3. Moderately severe to unsatisfactory weaknesses: vulnerable if there’s a business - 4. Many serious weaknesses that have not been addressed; failure is possible but not imminent- 5. High probability of failure in the short term Bank Examinations - CAMELS ratings are disclosed to bank management, but not to the public - If the CAMELS rating for a bank is unfavorable, regulators can take actions like these: o Require banks to disclose unfavorable information in their public financial statements o Issue a “cease and desist” order requiring the bank to stop doing things that cause financial troubles and to correct problems o Impose fines (up to 1 million a day) Regulating Banking- Truth in Lending Acto Requires financial institution to reveal annual percentage yield/rate, fees charged, information about the loan balance, payment due, total amount charged - Federal Deposit Insurance Corporationo Government insurance of banks or savings and loans accounts currently up to $250,000 per depositor per bank What can go wrong?- “Bank failure”—the bank goes out of business o Bank depositors might lose some of their funds o Bank creditors might lose some of their investmento Bank owners lose their capital - The bank suffers significant losses—the government might have to help Banking Crisis 1930s- Two reasons for bank failure: o The value of bank assets/investments/holdings falls, so assets<liability o Deposit outflow; a large number of depositors withdraw their funds from the bank, exhausting the bank’s cash (reserves) and other liquid assets Baking Crisis 1930s- The bank collapse of the 1930s and the ensuing Great Depression had introduced some institutional changes aimed at making banking system less fragile- These wereo Central bank as lender of last resort o Deposit insurance o Separation of commercial banking and investment banking (Glass-Steagall Act 1933) - Most economics thought that this would be sufficient to produce safety and to prevent large scale banking crisis- It was not- Why?- In order to answer question we first have to discuss “moral hazard” Moral Hazard (*Exam) - General insight: agents who are insured will tend to take fewer precautions to avoid the risk they are insured against - The insurance provided by central bank and governments gave bankers strong incentivesto take more risks - To counter this, authorities have to supervise and regulate - They did this for most of the post-war period The Banking Crisis of the 1980s- Starting in the late 1970s, banks grew fast, with lots of loans to businesseso Poor quality loans o Too many loans to risky firms- High cost of fundso Large share of funds borrowed from other banks Magnitude of the Crisis- From 1980 through 1994, over 2,900 banks and S&L’s failed- On average, a bank or S&L failed every 15 days from 1980 to 1994 - During this period, about one out of every 6 banks or S&Ls (holding a total of over 20% of the assets of the system) was closed or received government assistance Causes of the 1980s Crisis: changes in regulation- The banking industry was partially deregulated in the early 1980s:o S&L’s had mostly been restricted to home mortgage lending before, but now theywere allowed to invest in commercial real estate and stocksCauses of the 1980s Crisis- As a result, S&L’s held more risky