I. The Asian Currency and Banking Crisis, 1997/8 -- A schematic representation A. Overvalued currencies 1. The nature of overvaluation (fig. 1) 2. The consequences of confidence in persistant overvaluation a. in domestic markets -- real consumption, investment, and current account b. unsterilized bank borrowing abroad (domestic lending rates vs.borrowing rates abroad -- unadjusted for devaluation risk) c.domestic bubbles (real estate, security markets) d.speculation -- domestic and foreign 3. Will there be a day of reckoning? a. the role of continued foreign exchange inflows (fig. 2) b. the government's foreign exchange reserves B. The bubble bursts 1. The trigger a. domestic b. international 2. Hot money leaves 3. Domestic macroeconomic policies a. use of foreign exchange reserves b. interest rate hikes C. Devaluation and its impact 1. On domestic economic activity 2. On domestic prices -- current production, asset prices 3. Domino effects D. The banking system 1. Domestic a. repricing foreign debts b. revaluation of domestic loans c. lending cutbacks and increased interest rates d. a vicious cycle -- caution in lending -->loan defaults -->reduced loan collateral value --> reduced bank capital -->further caution in lending 2. Foreign reactions a. foreign lenders b. foreign investors E. Preventing banking system collapse 1. Bubble prevention -- sound macroeconomic and banking policies 2. The dilemma -- consequences of bursting the bubble vs. its continued growth 3. Central bank as lender of last resort 4. Government support/takeover of banks F. IMF intervention 1. Prior to the crisis 2. During crisis a. short-term loans b. conditionalities G. Lessons -- The crucial role of 1. Foreign exchange valuation 2. The governments and central banks 3. Foreign government policies II. Theories of Regulation A. Public interest theories 1. perceived economic problems not remediable by nonpolitical means 2. socially-concerned government acts in the public interest N.B.: Implicit assumption: gov't can remediate effectively 3. agency may be established to implement regulation and subsequently monitor activity 4. If public interest objectives are not (fully) achieved, agency may adjust policy and/or propose legislative reforms 5. e.g., antitrust; ICC B. From public interest to capture 1. fallacies of the public interest theory a. is regulation limited to market failure cases? (occupational licensure, interstate trucking) b. is the public interest served by regulation? (Stigler on electricity rates; post-deregulation airfares) 2. the perversion of good intentions a. alternative #1: regulator venality b. alternative #2: regulator incompetence 1. patronage 2. inadequate incentives to attract the best and the brightest c. alternative #3: regulatory capture 1. the demand for regulation i. obtaining or preserving economic rent ii. information costs: the interested few vs. the amorphous mass 2. the supply of regulation i. legislator/regulator self-interest C. The economic theory of regulation 1. inadequacy of the capture theory a. insufficient capture b. inadequate preservation of rent 2. activating legislator/regulator utility functions a. the optimization process 1. the benefits (financial, power) 2. the costs (information, lobbying, etc.) b. rent-sharing implications 3. changes in the economic environment II. General Introduction to Banking and Banking Regulation A. Financial Intermediation 1. Direct vs. indirect finance 2. The advantages of financial intermediation B. The U.S. Banking Structure 1. Banks of various sorts a. Types b. Importance 2. The regulatory structure a. Federal b. State C. Areas of bank regulation 1. Entry 2. Balance sheet a. types of assets b. portfolio distribution 3. Income a. price controls on assets b. price controls on liabilities 4. Location 5. Activities a. financial b. non-financial 6. Exit D. The operation of an unregulated banking system 1. C1. - 6. in an unregulated system 2. Benefits a. efficiency 1. distribution of resources 2. reactions to change (e.g., new technology) 3. risk-return trade-offs b. consumer sovereignty c. in general, freedom to adjust 3. Costs: Market failure a. efficiency 1. economies of scale 2. public goods 3. externalities 4. information deficiencies b. imperfections in competition c. income distribution considerations d. macroeconomic instability E. A cynic's view of U.S. banking regulation 1. Motives a. Financing the government McCarthy, FRB Richmond Econ Review 70,2 (Mar/Apr 84) e.g. 1. 19th cent: bank notes secured by state bonds 2. NBAct: National bank notes collateralized by U.S. Treasury securities 3. FR non-payment of interest on bank reserves (Based on $25.5b in Je '93, and 3-mo. T-bill rate of 3.1%, annual cost to FR and thus T = $791m.) b. Intentional misunderstanding Elimination of interest on DD in 1933; presumed to be cause of bank failure. 1. Benston data on spread: 1928 1931 country city country city int on DD(%) .745 1.134 .804 1.31 int on loans (%) 6.37 5.623 6.745 5.73 2. Other countries: i on DD paid, yet no failures 3. Benston: US -- no correlation between interest paid and bank failures c. Defective understanding 1. Real bills theory and eligible paper 2. Glass-Steagall on failures and security affiliates d. Anticompetitive 1. protection from outsiders a. entry restraints b. G-S separation of commercial from investment banking 2. protection from insiders a. unit banking states b. branching, BHCs, and unit banking: the proof of the pudding c. FDIC as a substitute for nationwide banks [On interbank politics, see Eugene N. White, The Regulation and Reform of the American Banking System, 1900 - 1929] e. The Panda's Thumb Stephen J. Gould, Nat Hist 1/87 relates history of QWERTY keyboard (based on study by David; see reference in Holland and Huertas, Financial Services Revolution (1988); Meigs there uses idea of historical accident and inertia to explain development of US banking system; e.g.: if not for FRS, then no Great Depression f. Regulatory dynamics e.g., FDIC led to removal of incentive for market supervision, led to closer govt supervision (e.g., capital ratios) led to avoidance (off-balance sheet) led to attempts to revise capital ratio determination. 2. Assessment Specific Issues A. Banking Efficiency 1. Reasons for studying banking efficiency 2. Defining a bank for efficiency purposes a. Deposits: input or output? 3. Empirical issues a. Isolating economies of scale 1. scale vs. scope 2. organizational structure b. Measuring operating costs c. Accounting for joint costs d. "Free" services e. X-efficiency f. Functional Cost Analysis (FCA) and the giant banks g. modelling: Cobb-Douglas vs. Translog h. The "absence of systematic bias" assumption 4. Empirical studies: an arbitrary sample a. Alhadeff (1954): the pioneer study b. Horvitz (1963): an expanded tabular report c. Schweiger-McGee (1961): multiple regression d. Greenbaum (1967): disaggregated costs e. Benston (1965): further disaggregation f. Benston, Hanweck, Humphrey (1982): translog 5. Conclusions B. Entry 1. Private vs. corporate banking: the issue 2. Private banking a. in Scotland 1. How it worked "The Scottish free banking system in its heyday thus had evolved the following features....[:] There were many competing banks; most of them were well capitalized by alarge number of shareholders; none was disproportionally large; all but a few were extensively branched. Each bank issued notes for l pound and above; most banks' notes passed easily throughout the greater part of the country. All the banks of issue participated in an effective note-exchange system. All offered a narrow spread between deposit and discount (loan) rates of interest." Lawrence H. White, p. 34. 2. The failure of the Ayr Bank (1772) b. in the U.S. Did you know that by the beginning of the 20th century, over 5,000 private banks existed in the U.S.? c. Europe d. Evaluation 3. The rise of the corporate bank a. State and national chartering around the turn of the 18th century in the U.S. b. Free banking, 1837 - 1865: Inviting fraud? 1. The theory 2. The presumed outcome: wildcat banking 3. Recent views: Rockoff vs. Rolnick and Weber 4. Conclusions from the evidence c. Post-Depression controls on entry 1. Banking Act of 1935 criteria a. Adequacy of capital structure b. Future earning prospects c. Character of management d. "Convenience and needs" of the community 2. Comptroller's interpretation (e.g.) "Whether it would appear that his [i.e., the promoter's] desire to organize a new bank is primarily for personal reasons (borrowing opportunities, unjustified animosity toward existing banks, prestige, or immoderate personal gain), rather than as a sound investment opportunity which will result in fulfilling a community need." d. The new breath of air: post-1979 policy 1. "It is not the policy of the [Comptroller's] Office to ensure that a [bank charter] proposal is without risk nor to protect existing competitors from the competition a new bank will provide." Federal Code, 1984. 2. Data on federally chartered banks: 1960 1965 1970 1975 1980 1985 1990 4,530 4,815 4,620 4,741 4,425 4,968 (The reduction after '85 stems from new bank formation being overwhelmed by consolidations and to a lesser extent closings.) C. Bank Failures 1. Why banks fail -- banking risks a. interest risk 1. portfolio balance 2. contingent liabilities b. credit risk 1. normal risktaking 2. linkage of risks and diversification c. liquidity risk d. operations risk e. regulatory-induced risk 2. Bank failures and fraud 3. Failures and the regulators a. GAAP vs. RAP b. The regulatory costs 4. The consequences of bank failure a. Systemic vs. individual failure b. The microbenefits D. Bank Safety: Capital and Deposit Insurance 1. The function of capital a. In non-financial firms b. Reasons for low capital ratios in depository institutions 1. Liquidity of bank assets 2. Federal Reserve/FHLBB borrowing facilities 3. Deposit insurance 4. The record of FDIC/FSLIC 2. Regulators and bank capital adequacy a. Rules of thumb and history b. The erosion of standards Capital/Total Domestic Assets (%), Insured Commercial Banks, 1935-1980 (from Sinkey, p.415) 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 12.2 9.5 5.5 6.8 7.2 8.1 8.0 7.4 7.2 7.0 c. Capital adequacy guidelines, the 1980s d. Risk-related capital and off-balance sheet items 1. domestic aspects 2. international issues 3. Deposit insurance reform a. risk-related deposit insurance and CAMEL b. the problems c. privatization as a solution 3. Structural banking reform vs. insurance reform E. Security Activities 1. The Glass-Steagall Act again a. commercial bank security activities (sec. 16) b. commercial bank/investment bank affiliations (secs. 20, 21, and 32) c. justification in theory and fact 2. Official vs. market deregulation: the blurring of lines during the 1970s and 1980s a. BHC rulings 1. the BHC Act 1970 amendments 2. "closely related to banking and a proper incident thereto" 3. Federal Reserve Board decisions a. discount brokerage b. security affiliates b. Securitization 3. The economic issues a. the theory of portfolio diversification [Levi & Sarnat, Capital Investment and Financial Decisions (1986), pp. 307-313] b. competition c. economies of scope d. bank safety e. conflicts of interest 4. Historical experience a. other countries b. U.S. in the post-war world 1. trust activities 2. general obligation bonds 3. eurobond markets 5. The consequences of incorrect decisions a. the depositing public b. the stockholding public c. the regulatory authorities 6. Non-security activities a. insurance b. commercial and industrial activities F. Geographical Expansion 1. Theoretical concerns a. size and competition 1. definition of industry 2. definition of market b. size and political power 2. Branching constraints as anticompetitive device a. reaction to 1909 California legislation b. the Depression and liberalization c. 1927: McFadden Act d. 1933: Glass-Steagall again e. The BHC loophole f. 1956: The BHC Act and multistate holding companies g. The new loopholes i. consumer banks (closed by 1987 CEBA) ii. failing banks (from Garn-St. Germain to FIRREA) iii. regional compacts (with and without triggers) iv. New York/California reciprocity 3. The present status 4. Remaining fears of bank power a. The role of the antitrust laws b. competition from nonbanks i. Supreme Court rulings on industry ii. Federal Reserve decisions on market G. Programs for Reform 1. Objectives a. The Bush Commission i. safety and soundess ii. consumer protection iii.competition and efficiency b. Corrigan i. stability and soundness ii. "voluntarism" (freedom of choice) iii. competition and competitive equality iv. minimize conflicts of interest 2. Principles a. The Bush Commission i. government as the primary means of attaining objectives ii. deposit insurance supplemented by risk-related insurance fees and improved capital ratios iii. competitive equality b. Corrigan i. separation of banking and commerce ii. functional supervision iii. market discipline supplemented by regulation 3. The Bush Commission and the Regulatory Structure a. simplification (see chart) i. functional regulation in practice ii. can you find the exception? iii. the ostensible vs. the actual motives b. other i. approval of branches 4. Corrigan a. The regulators and the special role of banks i. banks as a source of national liquidity ii. banks and the payments system iii. banks as providers of credit iv. banks as the transmission channel of monetary policy b. Implications i. protecting bank functions ii. are banks special? systemic vs. individual problems 5. Litan 6. The failure of reform H. Deregulation: Progress to date 1. Market deregulation and official deregulation a. deposit rate deregulation b. activity deregulation c. dissipation of geographical constraints 2. The barriers to further progress a. inertia b. interest groups c. the divided banking industry 3. Implications for the banking industry a. domestically b. internationally III. Banking Regulation in the LDCs A. Demand-following vs. supply-leading finance 1. Savings mobilization 2. Investment financing B. Some characteristics of LDC financial systems 1. degree of monetization 2. limited money/capital markets 3. limited sources of information (e.g., credit) C. Overcoming the limits 1. Government as banker: The socialist model 2. Nationalization of existing banks: the colonial model a. colonial banking practices b. post-independence banking 3. New institutions a. development banks b. central banks 4. Consequences D. Some questions 1. Effectiveness 2. Evasion as a principle a. quantitative controls b. qualitative controls 3. Encouragement of corruption 4. Financial repression: the debate a. the MacKinnon thesis b. the vanWijnbergen response
E. Some final thoughts