Banking is one of the most heavily regulated industries in the U.S

An efficient payments system and circulation of money are essential to economic growth

Like all regulation, bank regulation does not come without costs

To reduce the externalities caused by bank problems

To keep banks small

To prevent bank runs

To ensure that payments flow through the banking system efficiently

To stabilize the money supply

Supervises banks to reduce externalities

Restricts mergers and bank activities to keep banks small

Provides a federal safety net to prevent bank runs

Offers services to ensure efficient payments

Requires banks to hold reserves to control the money supply

Bank failures cause more problems than typical business failures as they harm a wider range of people

Any activity banks engage in is subject to government regulation, costing both time and resources

Approximately 13% of banks’ total cost of doing business is compliance with regulations

Lawmakers attributed bank failures during the Great Depression to too much inter-bank competition

The Glass-Steagall Act (1933) prohibits banks from participating in the securities industry and owning commercial firms

Arguments of excessive monopoly power versus economies of scope

The Gramm-Leach-Bliley Act (1999) allows banks to invest, sell insurance, and own commercial firms, but only those related to banking, securities, and insurance

Deposit insurance is provided through the Federal Deposit Insurance Corporation (FDIC)

The Fed serves as a lender of last resort, guaranteeing funds to member banks in need

Both policies result in asymmetric information problems, compensated for by supervision

The government will not allow some banks to go bankrupt under the too-big-to-fail policy

Pay off (insured depositors, then creditors)

Purchase and assumption (sell the bank and its assets, and FDIC assumes debts)

Assistance (keep the bank open and loan funds to survive)

Payment clearing services provided by the Fed to commercial banks

The Fed allows daylight overdrafts, allowing banks more flexibility

The government can effect flows of money though the banking system by requiring banks to hold a certain amount of reserves

Banks prefer to use these funds to make additional loans or investments, thus imposing a large opportunity cost

The U.S. has a dual banking system, meaning banks can choose whether to be chartered at the federal or state level

National banks must be members of the Federal Reserve system and be FDIC insured, and so are subject to federal supervision

State banks are FDIC insured, but may choose not to be members of the Fed system. They are supervised only by the FDIC and their state banking department

Banking supervisors use the CAMELS rating system to assess a bank’s health

Components of the CAMELS system - Capital adequacy - Asset quality - Management - Earnings - Liquidity - Sensitivity to risk

The only objective component of the CAMELS rating system

Supervisors want banks to have a lot of equity capital so they have a stronger stake in good performance

Total risk-adjusted assets (TRAA) are a measure of a bank’s exposure to risk, based on four categories of risk among the bank’s assets

To determine adequate capital, two levels of capital must be considered Tier 1 capital- stockholder equity capital Tier 2 capital- the bank’s loan loss reserves + subordinated debt Total Capital = Tier 1 capital + Tier 2 capital

A bank is adequately capitalized when Tier 1 capital > 0.04 x TRAA and total capital > 0.08 x TRAA

A bank is well capitalized when Tier 1 capital > 0.08 x TRAA and total capital > 0.10 TRAA

In evaluating bank mergers, lawmakers consider - The effect of the merger on competition -The adequacy of the financial and managerial resources of the new bank - The ability of the bank to meet the convenience and needs of the community - Whether the banks provided complete information about the transaction to banking authorities

Banking authorities use the Herfindahl-Hirschman index (HHI)

The HHI measures the amount of competition in a banking market

If HHI becomes >1,800 and/or the change in the HHI > 200

Mergers are also denied if the new bank would hold more than 10% of the nation’s deposits