The Regulation and Reform of the American Banking System Essay Example

The Regulation and Reform of the American Banking System Essay Example The Regulation and Reform of the American Banking System Essay The Regulation and Reform of the American Banking System Essay Difference in Bank Regulation Between The United States And Dominican Republic Banking regulations viewed for a positive impact on the protection of depositors and to the institution as such, this important action that banking institutions are more supervision, and individual staff members are more likely to do their work carefully and honesty. Banking regulations existed since 1 869 in the Dominican Republic, since for DRY is very important that the find these methods by high uncertainty by the banking authorities in DRY. Asymmetric Information and Banking Regulation The fact that different parties in a financial contract do not have the same information leads to adverse selection and moral hazard problems that have an important impact on our financial system. The concepts of asymmetric information, adverse selection, and moral hazard are especially usefully useful in understanding why government has chosen the form of baking regulation the people see in the United States and in other countries. There are eight basic categories of baking regulation: the government safety net, restrictions on bank asset holding capital requirements, chartering and bank examination, assessment of risk management, disclosure requirements, consumer protection, and restrictions on competition (Manikins Snakeskin, 2009). Government Safety Net: Deposit Insurance and the FED Banks are particularly well suited to solving adverse selection and moral hazard problems because they make private loans that help avoid the free- rider problem. However, this solution to the free-rider problem creates another asymmetric information problem, because depositors lack information about the quality of these private loans. This asymmetric information problem leads to two reasons why the banking system might not unction well (Manikins Snakeskin, 2009). First, before the FIDE started operations in 1 934, a bank failure (in which a bank is unable to meet its obligations to pay its depositors and other creditors and so must go out of business) meant that depositors would have to wait to get their deposit funds until the bank was liquidated (until its assets had been turned into cash); at that time, they would be paid only a fraction of the value of their deposits (Manikins Snakeskin, 2009). Unable to learn if bank managers were taking on too much risk or were outright crooks, depositors would be reluctant to put none in the bank, thus making banking institutions less viable. Second, depositors lack of information about the quality of bank assets can lead to bank panics, which, can have serious harmful consequences for the economy. To see this, consider the following situation. There is no deposit insurance, and an adverse shock hits the economy. As a result of the shock, 5% of the banks have such large losses on loans that they become insolvent (have a negative net worth and so are bankrupt). Because of asymmetric information, depositors are unable to tell whether their bank is a good bank or one of the % that are insolvent. Depositors at bad and good banks recognize that they may not get back 1 00 cents on the dollar for their deposits and will want to with draw them. Indeed, because banks operate on a sequential service constraint (a first come, first served basis), depositors have a very strong incentive to show up at the bank first, because it they are last in line, the bank may run out of funds and they will get nothing. Uncertainty about the health of the banking system in general can lead to runs on banks both good and bad, and the failure of one bank can hasten the failure of others. If nothing is one to restore the publics confidence, a bank panic can ensue. Indeed, bank panics were a fact of American life in the nineteenth and early twentieth centuries, with major ones occurring every 20 years or so in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930, 1933. Bank failures were a serious problem even during the boom years of the 1 sass, when the number of bank failures averaged around 600 per year (Manikins Snakeskin, 2009). A government safety net for depositors can short circuit runs on banks and bank panics, and by providing protection for the depositor, it can overcome reluctance to put ends in the banking system. One form of the safety net is deposit insurance, a guarantee such as that provided by the federal deposit insurance corporation (FIDE) in the United States in which depositors are paid off in full on the first $ 100,000 they have deposited in a bank no matter what happens to the bank. With fully insured deposits, depositors dont need to run to the bank to make with drawls even fifthly are worried about the banks health because their deposits will be worth 100 cents on the dollar no matter what. From 1930 to 1933, the years immediately proceeding the creation of the FIDE, he number of bank failures averaged more than 2,000 per year. After the establishment of the FIDE in 1 934, bank failures averaged fewer than 15 per year until 1981 (Manikins Snakeskin, 2009). The FIDE uses two primary methods to handle a failed bank. In the first, called the payoff method, the FIDE allows the bank to fail and pays off deposits up to the $1 00,000 insurance limit (with funds acquired from the insurance premiums paid by the banks who have bought FIDE insurance). After the bank has been liquidated the FIDE lines up with other creditors of the bank and is paid its hare of the proceeds from the liquidated assets. Typically, when the payoff method is used, account holders with deposits in excess of the $ 1 00,000 limit get back more than 90 cents on the dollar, although the process can take several years to complete (Manikins Snakeskin, 2009). Moral Hazard And The Government Safety Net Although a government safety net has been successful at protecting depositors and preventing bank panics, it is a mixed blessing. The most serious drawback Of the government safety net stems from moral hazard, the incentives of one party to a transaction to engage in activities detrimental to he other party. Moral hazard is an important concern in insurance arrangements in general because the existence of insurance provides increased incentives for taking risks that might result in an insurance payoff. For example, some drivers with automobile collision insurance that has a low deductible might be more likely to drive recklessly, because if they get into an accident, the insurance company pays most of the costs for damage and repairs (Manikins Snakeskin, 2009). Adverse Selection and The Government Safety Net A further problem with a government safety net like deposit insurance arises cause of adverse selection, the fact that the people who are most likely to produce the adverse outcome insured against (bank failure) are those who most want to take advantage of the insurance. For example, bad drivers are more likely than good drivers to take out automobile collision insurance with a low deductible. Because depositors protected by a government safety net have little reason to impose discipline on the bank, risk loving entrepreneurs might find the banking industry a particularly attractive one to enter they know that they will be able to engage in highly risky activities (Manikins Snakeskin, 2009). Too Big To Fail The moral hazard created by a government safety net and the desire to prevent bank failures have presented bank regulators with a particular quandary. Because the failure of a very large bank makes it more likely that a major financial disruption will occur, bank regulators are naturally reluctant to allow a big bank to fail and cause losses to its depositors. Indeed, consider continental Illinois, one of the 10 largest banks in the United Stated when it became insolvent in May 1984 (Manikins Snakeskin, 2009). Not only did the FIDE errant depositors up to the $1 00,000 insurance limit but it also guaranteed accounts exceeding $ 100,000 and even prevented losses for continental Illinois bondholders. Shortly thereafter, the comptroller of the currency (the regulator of national banks) testified to congress that 11 of the largest banks would receive a similar treatment to that of continental Illinois. Although the comptroller did not use the term too big to fail (it was actually used by congressman Mckinney in those hearing), this term is now applied to a policy in which the government provides guarantees of repayment of large insured creditors of the largest banks, so that no depositor or creditor suffers a loss, even when they are not automatically entitled to this guarantee (Manikins Snakeskin, 2009). Financial consolidation and the government safety net with financial innovation and the passage of the rigger Neal interests banking infant branching and efficiency act of 1994 and the Grammar Leach Bailey financial services modernization act in 1999, financial consolidation has been proceeding at a rapid pace, leading to both larger and more complex banking organizations. Financial consolidation poses two challenges to banking exultation because of the existence of the government safety net. First, the increased size of banks as a result o financial consolidation increases the too big to fail problem, because there will now be more large institutions whose failure would expose the financial system to systemic (systemic) risk (Manikins Snakeskin, 2009). Thus, more banking institutions are likely to be treated as too big to fail, and the increased moral hazard incentives for these large institutions to take on greater risk can then increase the fragility of the financial system. Second, financial consolidation of banks with other financial arrives firms means that the government safety net may be extended to new activities, such as securities underwriting insurance or real estate activities, thereby increasing incentives for greater risk taking in these activities that can also weaken the fabric of the financial system. Limiting the moral hazard incentives for the larger more complex financial organizations that have arisen as a result of recent changes in legislation will be one of the key issues facing banking regulators in the future (Manikins Snakeskin, 2009). Restrictions On Asset Holdings And Bank Capital Requirements. The moral hazard associated with a government safety net encourages too much risk taking on the part of banks. Bank regulations that restrict asset holdings and bank capital requirements are directed at minimizing this moral hazard, which can cost the taxpayers dearly. Even in the absence of a government safety net, banks still have the incentive to take on too much risk. Risky assets may provide the bank with higher earnings when they pay off but if they do not pay off and the bank fails, depositors are left holding the bag. If depositors were able to monitor the bank easily by acquiring information on its taking activities, they would immediately withdraw their deposits if the bank was taking on too much risk (Manikins Snakeskin, 2009). To prevent such a loss of deposits, the bank would be more likely to reduce its risk taking activities. Unfortunately, acquiring information on a banks activities to learn how much risk the bank is taking can be a difficult task. Hence. Most depositors are incapable of imposing discipline that might prevent banks from engaging in risk activities. A strong rationale for government regulation to reduce risk taking on the part of banks therefore existed even before the establishment f federal deposit insurance. (Mish kin Snakeskin, 2009). Bank regulations that restrict banks from holding risky assets such as common stock are a direct means of making banks avoid too much risk. Bank regulations also promote diversification, which reduces risk by limiting the amount of loans in particular categories or to individual borrowers. Requirements that banks have sufficient bank capital are another way to reduce the banks incentives to take on risk. When a bank is forced to hold a large amount of equity capital, the bank has more to lose if it fails and is thus more likely to pursue sees risky activities (Manikins Snakeskin, 2009). Bank capital requirements take two forms. The first type is based on the leverage ratio, the amount of capital divided by the banks total assets. To be classified as well capitalized, a banks leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3% triggers increased regulatory restrictions on the bank. Through most of the 1 sass. Minimum bank capital in the united States was set solely by specifying a minimum leverage ratio (Manikins Snakeskin, 2009). In the wake of the continental Illinois and savings and loans bailouts, regulators in the United States and the rest of the world have become increasingly worried about worried about banks holdings of risky assets and about the increase in banks off balance sheet activities, activities that involve trading financial instruments and generating income from fees. Which do not appear on bank balance sheets but nevertheless expose banks to risk. An agreement among banking officials from industrialized nations set up to risk. (Manikins Snakeskin, 2009). The Basel committee on banking supervision, which has implemented the Basel Accord that deals with a second type of capital requirements risk eased capital requirements. The Basel Accord, which required that banks hold as capital at least 8% of their risk weighted assets, has been adopted by more than 100 countries, including the United States. Assets and off balance sheet activities were allocated into in to four categories, each with a different weight to reflect the degree of credit risk. The first category carries a zero weight and includes items that have little default risk, such as reserves and government securities issued by the organization for Economic Cooperation and Development countries (Manikins Snakeskin, 2009). The second category has a 20% weight and includes claims on banks in COED countries. The third category has a weight of 50% and includes municipal bonds and residential mortgages. The fourth category has the maximum weight of 100% and includes loans to consumers and corporations. Off balance sheet activities are treated in a similar manner by assigning a credit equivalent percentage that converts them to on balance sheet items to which the appropriate risk weight applies. The 1 996 market risk amendment to the Basel Accord set minimum capital requirements for risk in banks trading accounts (Manikins Snakeskin, 2009). Over time, limitations of the Basel Accord have become apparent, because the regulatory measure of bank risk as stipulated by the risk weights can differ substantially from the actual risk the bank faces. This has resulted in regulatory arbitrage, a practice in which banks keep on their books assets that have the same risk based capital requirement but are relatively risky, such as a loan to a company with a very low credit rating, while taking off their books low risk assets, such as a loan to a company with a very high credit rating(Manikins Snakeskin, 2009). Bank Supervision: Chartering And Examination Overseeing who operates banks and how they are operated, referred to as bank supervision or more generally as prudential supervision, is an important method for reducing adverse selection and moral hazard in the banking business. Because banks can be used by crooks or overambitious entrepreneurs to engage in highly speculative activities, such undesirable people would be eager to run a bank. Chartering proposals for new banks are screened to prevent undesirable people from controlling them (Manikins Snakeskin, 2009). Regular onsite bank examinations, which allow regulators to monitors whether the bank is complying with capital requirements and restrictions on asset holdings, also function to limit moral hazard. Bank examiners give banks a CAMELS rating. The acronym is based on the six area: assessed: capital adequacy, asset quality, management, earning, liquidity, NC sensitivity to market risk. With this information about a banks activities, regulators can enforce regulations by taking such formal actions as cease NC desist orders to alter the banks behavior or even close a bank it its CAMELS rating is sufficiently low (Manikins Snakeskin, 2009). Actions taken to red cue oral hazard by restricting banks from taking on too much risk help reduce the adverse selection problem further, because with less opportunity for risk taking, risk loving entrepreneurs will be less likely to be attracted to the banking industry. Note that the methods regulators use to cope with adverse selection and moral hazard have their counterparts in private financial markets (Manikins Snakeskin, 2009). Chartering is similar to the screening of potential borrowers, regulations restricting risky asset holdings are similar to restrictive covenants that prevent borrowing firms from engaging in risk risky investment activities, bank capital requirements act like restrictive covenants that require minimum amounts Of net worth for borrowing firms, and regular bank examinations are similar to the monitoring of borrowers by lending institutions (Manikins Snakeskin, 2009). Assessment Of Risk Management Traditionally, on site bank examinations have focused primarily on assessment of the quality of the banks balance sheet at a point in time and whether it complies with capital requirements and restrictions on asset holdings. Although the traditional focus is important for reducing excessive sis taking by banks, it is no longer felt to be adequate in todays world, in which financial innovation has produced new markets and instruments that make it easy for banks and their employees to make huge bets easily and quickly. In this new financial environment, a bank 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 Baring in 1 995 (Manikins Snakeskin, 2009). Thus, an examination that focuses only on banks position at a point in time may not be effective in indicating whether a bank ill, in fact, be taking on excessive risk in the near future (Manikins Snakeskin, 2009). This change in the financial environment for baking institutions has resulted in a major shift in thinking about the bank supervisory process throughout the world. Bank examiners are now placing far greater emphasis On evaluating the soundness of a banks management processes with regard to controlling risk. This shift in thinking was reflected In a new focus on risk management in the Federal Reserve Systems 1 993 guidelines to examiners on trading and derivatives activities. The focus was expanded and formalized n the Trading Activities Manual issued early in 1 994, which provided bank examiners with tools to evaluate risk management systems (Manikins Snakeskin, 2009). In late 1 995, 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 from 1 to 5 that fees 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 revived by the board of directors and senior management, (2) the adequacy of policies and limits for all activities that present significant risk, (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 recent guidelines adopted by the US bank regulatory authorities to deal with interest rate risk. These guidelines require the banks board of directors to establish interest rate risk limits, appoint officials of the ann. to manage this risk, and monitor the banks risk exposure (Manikins Snakeskin, 2009). 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 is not violated and to implement internal controls to monitor interest rate risk and compliance with the boards directives. Particularly important is the implementation of stress testing, which calculates losses under dire scenarios, or value at risk (VARY) calculations, who ICC measure the size of the loss on a trading portfolio that eight happen 1 % of the time say, over a two week period (Manikins Snakeskin, 2009). Disclosure Requirements To ensure that there is better information for depositors and the marketplace, regulators can require that banks adhere to certain standard accounting prince plea and disclose a wide range of information that helps the market assess the quality of a banks portfolios and the amount of the banks exposure to risk (Manikins Snakeskin, 2009). Consumer Protection The existence of asymmetric information also suggests that consumers may not have enough information to protect themselves fully. Consumer redirecting regulation has taken several forms. First is truth in lending mandated under the consumer protection act of 1969, which requires all lenders, not just banks, to provide information to consumers about the cost of borrowing, including a standardized interest rate and the total finance charges on the loan (Manikins Snakeskin, 2009). Restrictions On Competition Increased competition can also increase moral hazard incentives for banks to take on more risk. Declining profitability as a result of increased competition could tip the incentives of bankers toward assuming greater risk in an effort o maintain former profit levels. Thus, governments in many countries have instituted regulations to protect banks from competition. These regulations have taken too forms in the United Stated in the past. First were restrictions on branching, such as those described in charter 18, which reduced competition between banks, but were eliminated in 1994. The second form involved preventing embank institutions from competing with banks by engaging in banking business, as embodied in the Glass Steal Act, which was repealed in 1999 (Manikins Snakeskin, 2009). International Banking Regulation Because asymmetric information problems in the banking industry are a fact of life throughout the world, bank regulation in other countries is similar to that in the United Stated. Banks are chartered and supervised by government regulators, just as they are in the United Stated. Deposit insurance is also a feature of the regulatory system in most other developed countries, although its coverage is often smaller than in the United Stated NC is intentionally not advertised (Manikins Snakeskin, 2009). Problems Is Regulating International Banking Particular problems in bank regulation occur when banks are engaged in international banking and thus can readily shift their business from one country to another. Bank regulators closely examine the domestic operations of banks in their country, but they often do not have the knowledge or ability to keep a close watch on bank operations in other countries, either by domestic banks foreign affiliates or by foreign banks with domestic branches (Manikins Snakeskin, 2009). Banking Regulation In Dominican Republic The first signs of banking regulation in Dominican Republic appear with the emergence of the National Bank of Santos Domingo, AS in 1869. In 1909, the Dominican Government promulgated the first General Banking Law, where specific regulations for mortgage banks, issuers and sharecropping are established and emerging credit institutions with the characteristics of commercial banks under the supervision and control of the Ministry of Finance and Commerce, known today Ministry of Finance, which was equipped with auditors appointed by the executive branch in each bank to exercise control (Tortes N;fizz 2014). The year 1947 marked the transformation of the Dominican financial system; Dominican Monetary Unit, the Central Bank and the Superintendence of Banks, the latter under Law No. 530 of October 9, 1 947, a law that creates the foundation for the supervision and regulation Of financial Dominican Sis-theme is created (Tortes N;hex 2014). The economist Virgil ?Avarice Sniche will be the first to hold the position of Superintendent of Banks, a position he occupied for two years. In principle, the task of supervision which performed this entity was simple considering the limited business operations of that era and its main function was the authorization of new offices (Tortes N;ex 2014). The No. 1530 law that gave rise to the Superintendence of Banks will be amended and replaced y Law 708, General Banking Law of 14 April 1965, where it is put in charge of this entity implementation and administration of the scheme legal for banks, under the aegis of the Ministry of Finance, Ministry of Finance today.