Outline Federal Banking Regulation Outline

Banking

1. In General

   1. Breakdown of Glass-Steagall

      1. The 1999 Gramm-Leach Bliley Act culminated the destruction of the Glass-Steagall firewall after a long period of erosion by regulatory actions.

         1. Repealed Glass-Steagall's anti-affiliation provisions and permitted banks to affiliate through specially qualified bank holding companies called "financial holding companies" with companies engaged in the full range of financial activities:

            • Activities included (1) underwriting, dealing in, and brokering securities; (2) acting as an investment advisor; (3) merchant banking (i.e., making long-term equity investments for which no public market exists); and (4) underwriting and selling insurance.

            • To qualify as a financial holding company, its subsidiary FDIC-insured depository institution must be (1) well-capitalized and adequately managed and (2) have satisfactory community-reinvestment records.

         2. Two key Glass-Steagall provisions remain in force:

            • (1) A bank can underwrite and deal in only a limited range of securities (e.g. government bonds). 12 U.S.C. §§ 24(Seventh), 335, 378(a)(1).

            • (2) The same firm cannot both accept deposits and underwrite securities. 12 U.S.C. § 378(a)(1).

   2. Breakdown of Distinction Among Different Types of Financial Institutions

      1. A Bank vs. A Thrift

         1. Three Key Differences

            • (1) Thrifts generally have more constrained investment powers than banks.

              • Thrifts generally cannot have more than 20% of their assets in commercial loans

              • Any commercial loan exceeding 10% of assets must be to small businesses

              • Loans secured by nonresidential real property generally cannot exceed four times a thrift's capital

            • (2) Thrifts must meet a "qualified thrift lender test" by keeping a certain percentage of their assets in investments like home mortgages

              • If not, risk being regulated as banks and their holding companies as bank holding companies

            • (3) The Bank Holding Company Act generally does not apply to a thrift holding company if the company owns no banks and the company's subsidiary thrifts all meet the qualified thrift lender test

         2. A thrift holding company that acquired a thrift after May 4, 1999 can engage only in the sort of activities permissible for financial holding companies

   3. What is a Bank?

      1. Definitions

         1. (1) Legal Form: A bank is a firm with a commercial bank charter

         2. (2) Services: A firm that accepts deposits withdrawable by check and makes loans

         3. (3) Economic Function: A financial intermediaries that provide transaction services to customers

            • Financial Intermediary

              • Financial intermediaries take money from investors, pool it, and invest the pooled money in other enterprises

                • Includes depository institutions, life insurance companies, mutual funds, pension funds, etc.

                • Benefits: (1) diversification, (2) Enable investors to enjoy economies of scale, (3) expertise, (4) ability to convert illiquid assets into liquid assets

            • Transaction Services

              • Provide an accounting system of exchange - a means of transferring wealth through bookkeeping entries

                • debiting (-) buyer's account and crediting (+) seller's account

                  • Includes depository institutions and mutual funds

                    • UNDER the functional definition of a bank, some mutual funds might be characterized as banks as they (1) take money from investors, pool it, and invest the pooled money in other enterprises, and (2) some allow customers to effect redemptions by writing checks on the fund payable to third parties.

                    • Functional difference between banks and mutual funds is that demand accounts at banks represent demand debt (the bank agrees to repay whatever sum the customer had on deposit) whereas demand accounts at mutual fund represent demand equity (the mutual fund agrees to repay not a sum certain but only the customers' proportional share of the fund's net assets)

      2. Demand Deposits

         1. Transaction Accounts: any account from which a customer may withdraw money by check, electronic transfer, or similar means for payment to others

            • Demand Deposit: you have the legal right to withdraw the money upon demand

              • Traditional checking account

            • NOW Account: "negotiable order of withdrawal"

              • Checks drawn on a NOW account look and work like a check payable upon demand BUT the bank technically has the right to demand seven days' notice of any withdrawal

                • This would make no sense to do as no bank would expect to stay in business by operating in this manner

                • The bank's right to require notice is merely a legal fiction to circumvent the rule against paying interest on demand deposits.

                  • NOW accounts are in practice payable upon demand

         2. Fractional Reserves

            • Banks need only keep a fraction of total deposits on reserve and can expect (based on the law of large numbers) no more than a small percentage of deposits to be withdrawn at any given time

   4. Leverage

      1. Leverage = Debt/Equity

         1. The more debt relative to equity, the more highly leveraged the firm is

      2. Return on Equity = Net Income/Equity

         1. Net Income = Operating Income less taxes and interest expense

      3. Three Key Points re Leverage

         1. (1) Leverage increases the potential profitability of equity

         2. (2) Leverage increases risk

         3. (3) Leverage benefits a firm's owners when the firm's return on assets disregarding interest expense (i.e., its operating income minus any income taxes, divided by total assets) exceeds the interest paid on the debt

      4. Reasons for High Leverage in banks

         1. (1) Banks have a more predictable return on assets than industrial firms

         2. (2) banks can readily obtain short-term loans from other banks or from the Federal Reserve

         3. (3) Federal Deposit Insurance helps banks to raise cash by attracting deposits

   5. Bank Runs, the Money Supply, and the Payment System

      1. Banks differ from other firms in three important respects: (1) susceptibility to bank runs, (2) role in the money supply, (3) role in the payment system

         1. Susceptibility to Bank Runs

            • Depository Institutions: susceptible to bank runs, but deposit insurance has made this rare

            • Money Market Funds:...

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