Financial Markets and Institutions (2-downloads)

call reports that reveal the bank’s assets and liabilities, income and dividends, own-

ership, foreign exchange operations, and other details. The bank is also subject to

examination by the bank regulatory agencies to ascertain its financial condition at

least once a year. To avoid duplication of effort, the three federal agencies work

together and usually accept each other’s examinations. This means that, typically,

national banks are examined by the Office of the Comptroller of the Currency, the

state banks that are members of the Federal Reserve System are examined by the

Fed, and insured nonmember state banks are examined by the FDIC.

Bank examinations are conducted by bank examiners, who sometimes make unan-

nounced visits to the bank (so that nothing can be “swept under the rug” in anticipa-

tion of their examination). The examiners study a bank’s books to see whether it is

complying with the rules and regulations that apply to its holdings of assets. If a bank

is holding securities or loans that are too risky, the bank examiner can force the bank

to get rid of them. If a bank examiner decides that a loan is unlikely to be repaid, the

examiner can force the bank to declare the loan worthless (to write off the loan, which

reduces the bank’s capital). If, after examining the bank, the examiner feels that it does

not have sufficient capital or has engaged in dishonest practices, the bank can be

declared a “problem bank” and will be subject to more frequent examinations.

Assessment of Risk Management

Traditionally, on-site examinations have focused primarily on assessment of the qual-

ity of a financial institution’s balance sheet at a point in time and whether it com-

plies with capital requirements and restrictions on asset holdings. Although the

traditional focus is important for reducing excessive risk taking by financial institu-

tions, it is no longer felt to be adequate in today’s world, in which financial innova-

tion has produced new markets and instruments that make it easy for financial

institutions and their employees to make huge bets easily and quickly. In this new

financial environment, a financial institution that is healthy at a particular point in time

can be driven into insolvency extremely rapidly from trading losses, as forcefully

demonstrated by the failure of Barings in 1995 (discussed in Chapter 17). Thus an

examination that focuses only on a financial institution’s position at a point in time may

not be effective in indicating whether it will, in fact, be taking on excessive risk in

the near future.

This change in the environment for financial institutions has resulted in a major

shift in thinking about the prudential supervisory process throughout the world.

Bank examiners, for example, are now placing far greater emphasis on evaluating

the soundness of a bank’s management processes with regard to controlling risk.

This shift in thinking was reflected in a new focus on risk management in the Federal

Reserve System’s 1993 guidelines to examiners on trading and derivatives activities.

The focus was expanded and formalized in the Trading Activities Manual issued early

in 1994, which provided bank examiners with tools to evaluate risk management sys-

tems. In late 1995, the Federal Reserve and the Comptroller of the Currency

announced that they would be assessing risk management processes at the banks

they supervise. Now bank examiners give a separate risk management rating 

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from 1 to 5 that feeds into the overall management rating as part of the CAMELS

system. Four elements of sound risk management are assessed to come up with

the risk management rating: (1) the quality of oversight provided by the board of

directors and senior management, (2) the adequacy of policies and limits for all

activities that present significant risks, (3) the quality of the risk measurement

and monitoring systems, and (4) the adequacy of internal controls to prevent fraud

or unauthorized activities on the part of employees.

This shift toward focusing on management processes is also reflected in guide-

lines adopted by the U.S. bank regulatory authorities to deal with interest-rate risk.

These guidelines require the bank’s board of directors to establish interest-rate

risk limits, appoint officials of the bank to manage this risk, and monitor the bank’s

risk exposure. The guidelines also require that senior management of a bank develop

formal risk management policies and procedures to ensure that the board of 

directors’ risk limits are not violated and to implement internal controls to moni-

tor interest-rate risk and compliance with the board’s directives. Particularly impor-

tant is the implementation of stress testing, which calculates losses under dire

scenarios, or value-at-risk (VaR) calculations, which measure the size of the loss

on a trading portfolio that might happen 1% of the time—say, over a two-week

period. In addition to these guidelines, bank examiners will continue to consider

interest-rate risk in deciding the bank’s capital requirements.

Disclosure Requirements

The free-rider problem described in Chapter 7 indicates that individual depositors

and creditors will not have enough incentive to produce private information about

the quality of a financial institution’s assets. To ensure that there is better informa-

tion in the marketplace, regulators can require that financial institutions adhere to

certain standard accounting principles and disclose a wide range of information that

helps the market assess the quality of an institution’s portfolio and the amount of

its exposure to risk. More public information about the risks incurred by financial

institutions and the quality of their portfolios can better enable stockholders, cred-

itors, and depositors to evaluate and monitor financial institutions and so act as a

deterrent to excessive risk taking.

Disclosure requirements are a key element of financial regulation. Basel 2 puts

a particular emphasis on disclosure requirements with one of its three pillars focus-

ing on increasing market discipline by mandating increased disclosure by banking

institutions of their credit exposure, amount of reserves, and capital. The Securities

Act of 1933 and the Securities and Exchange Commission (SEC), which was estab-

lished in 1934, also impose disclosure requirements on any corporation, including

financial institutions, that issues publicly traded securities. In addition, it has required

financial institutions to provide additional disclosure regarding their off-balance-sheet

positions and more information about how they value their portfolios.

Regulation to increase disclosure is needed to limit incentives to take on exces-

sive risk and to improve the quality of information in the marketplace so that investors

can make informed decisions, thereby improving the ability of financial markets to

allocate capital to its most productive uses. The efficiency of markets is assisted by

the SEC’s disclosure requirements mentioned above, as well as its regulation of bro-

kerage firms, mutual funds, exchanges, and credit-rating agencies to ensure that they

produce reliable information and protect investors. The Sarbanes-Oxley Act of 2002,

discussed in Chapter 7, took disclosure of information even further by increasing

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Part 6 The Financial Institutions Industry

the incentives to produce accurate audits of corporate income statements and bal-

ance sheets, established the Public Company Accounting Oversight Board (PCAOB)

to oversee the audit industry, and put in place regulations to limit conflicts of inter-

est in the financial services industry.

Particularly controversial in the wake of the 2007–2009 financial crisis is the move

to so-called mark-to-market accounting, also called fair-value accounting, in which

assets are valued in the balance sheet at what they could sell for in the market (see

the Mini-Case box, “Mark-to-Market Accounting and the 2007–2009 Financial Crisis”).

Consumer Protection

The existence of asymmetric information also suggests that consumers may not have

enough information to protect themselves fully. Consumer protection regulation

has taken several forms. The Consumer Protection Act of 1969 (more commonly

referred to as the Truth in Lending Act) requires all lenders, not just banks, to pro-

vide information to consumers about the cost of borrowing, including a standard-

ized interest rate (called the annual percentage rate, or APR) and the total finance

charges on the loan. The Fair Credit Billing Act of 1974 requires creditors, espe-

cially credit card issuers, to provide information on the method of assessing finance

charges and requires that billing complaints be handled quickly. Both of these acts

are administered by the Federal Reserve System under Regulation Z.

Congress has also passed legislation to reduce discrimination in credit markets. The

Equal Credit Opportunity Act of 1974 and its extension in 1976 forbid discrimination

by lenders based on race, gender, marital status, age, or national origin. It is adminis-

tered by the Federal Reserve under Regulation B. The Community Reinvestment Act

(CRA) of 1977 was enacted to prevent “redlining,” a lender’s refusal to lend in a par-

ticular area (marked off by a hypothetical red line on a map). The Community

Reinvestment Act requires that banks show that they lend in all areas in which they take

deposits, and if banks are found to be in noncompliance with the act, regulators can

reject their applications for mergers, branching, or other new activities.

The 2007–2009 financial crisis has illustrated the need for greater consumer pro-

tection because so many borrowers took out loans with terms that they did not under-

stand and which were well beyond their means to repay. The result was millions of

foreclosures, with many households losing their homes. Because weak consumer pro-

tection regulation played a prominent role in this crisis, there have been increasing

demands to strengthen this regulation, as is discussed in the Mini-Case box, “The

2007–2009 Financial Crisis and Consumer Protection Regulation.”

Restrictions on Competition

Increased competition can also increase moral hazard incentives for financial institu-

tions to take on more risk. Declining profitability as a result of increased competi-

tion could tip the incentives of financial institutions toward assuming greater risk

in an effort to maintain former profit levels. Thus governments in many countries

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Chapter 18 Financial Regulation