Asymmetric Information and Banking Regulation

Conquering The Coming Collapse

Conquering The Coming Collapse

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In earlier chapters, we have seen how asymmetric information, 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 useful in understanding why government has chosen the form of banking regulation we see in the United States and in other countries. There are eight basic categories of banking regulation: the government safety net, restrictions on bank asset holdings, capital requirements, chartering and bank examination, assessment of risk management, disclosure requirements, consumer protection, and restrictions on competition.

As we saw in Chapter 8, 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 function well.

First, before the FDIC started operations in 1934, 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. Unable to learn

Government Safety Net: Deposit Insurance and the FDIC /regs.html

View bank regulation information.

if bank managers were taking on too much risk or were outright crooks, depositors would be reluctant to put money in the bank, thus making banking institutions less viable. Second is that depositors' lack of information about the quality of bank assets can lead to bank panics, which, as we saw in Chapter 8, 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 5% that are insolvent. Depositors at bad and good banks recognize that they may not get back 100 cents on the dollar for their deposits and will want to withdraw 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 if 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 (referred to as the contagion effect). If nothing is done 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 1920s, when the number of bank failures averaged around 600 per year.

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 funds 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 (FDIC) in the United States in which depositors are paid off in full on the first $100,000 they have deposited in the bank no matter what happens to the bank. With fully insured deposits, depositors don't need to run to the bank to make withdrawals—even if they are worried about the bank's health—because their deposits will be worth 100 cents on the dollar no matter what. From 1930 to 1933, the years immediately preceding the creation of the FDIC, the number of bank failures averaged over 2,000 per year. After the establishment of the FDIC in 1934, bank failures averaged fewer than 15 per year until 1981.

The FDIC uses two primary methods to handle a failed bank. In the first, called the payoff method, the FDIC allows the bank to fail and pays off deposits up to the $100,000 insurance limit (with funds acquired from the insurance premiums paid by the banks who have bought FDIC insurance). After the bank has been liquidated, the FDIC lines up with other creditors of the bank and is paid its share of the proceeds from the liquidated assets. Typically, when the payoff method is used, account holders with deposits in excess of the $100,000 limit get back more than 90 cents on the dollar, although the process can take several years to complete.

In the second method, called the purchase and assumption method, the FDIC reorganizes the bank, typically by finding a willing merger partner who assumes (takes over) all of the failed bank's deposits so that no depositor loses a penny. The FDIC may help the merger partner by providing it with subsidized loans or by buying some of the failed bank's weaker loans. The net effect of the purchase and assumption method is that the FDIC has guaranteed all deposits, not just those under the

$100,000 limit. The purchase and assumption method was the FDIC's most common procedure for dealing with a failed bank before new banking legislation in 1991.

Deposit insurance is not the only way in which governments provide a safety net for depositors. In other countries, governments have often stood ready to provide support to domestic banks when they face runs even in the absence of explicit deposit insurance. This support is sometimes provided by lending from the central bank to troubled institutions and is often referred to as the "lender of last resort" role of the central bank. In other cases, funds are provided directly by the government to troubled institutions, or these institutions are taken over by the government and the government then guarantees that depositors will receive their money in full. However, in recent years, government deposit insurance has been growing in popularity and has spread to many countries throughtout the world. Whether this trend is desirable is discussed in Box 1.

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 the other party. Moral hazard is an important concern in insurance arrangements in general because the existence of insurance provides increased incentives for taking

The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing?

For the first 30 years after federal deposit insurance was established in the United States, only 6 countries emulated the United States and adopted deposit insurance. However, this began to change in the late 1960s, with the trend accelerating in the 1990s, when the number of countries adopting deposit insurance doubled to over 70. Government deposit insurance has taken off throughout the world because of growing concern about the health of banking systems, particularly after the increasing number of banking crises in recent years (documented at the end of this chapter). Has this spread of deposit insurance been a good thing? Has it helped improve the performance of the financial system and prevent banking crises?

The answer seems to be no under many circumstances. Research at the World Bank has found that on average, the adoption of explicit government deposit insurance is associated with less banking sec tor stability and a higher incidence of banking crises.* Furthermore, on average it seems to retard financial development. However, the negative effects of deposit insurance appear only in countries with weak institutional environments: an absence of rule of law, ineffective regulation and supervision of the financial sector, and high corruption. This is exactly what might be expected because, as we will see later in this chapter, a strong institutional environment is needed to limit the incentives for banks to engage in the excessively risky behavior encouraged by deposit insurance. The problem is that developing a strong institutional environment may be very difficult to achieve in many emerging market countries. This leaves us with the following conclusion: Adoption of deposit insurance may be exactly the wrong medicine for promoting stability and efficiency of banking systems in emerging market countries.

*See World Bank, Finance for Growth: Policy Choices in a Volatile World (Oxford: World Bank and Oxford University Press, 2001).

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.

Moral hazard is a prominent concern in government arrangements to provide a safety net. Because with a safety net depositors know that they will not suffer losses if a bank fails, they do not impose the discipline of the marketplace on banks by withdrawing deposits when they suspect that the bank is taking on too much risk. Consequently, banks with a government safety net have an incentive to take on greater risks than they otherwise would.

Adverse Selection and the Government Safety Net. A further problem with a government safety net like deposit insurance arises because 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. Even worse, because protected depositors have so little reason to monitor the bank's activities, without government intervention outright crooks might also find banking an attractive industry for their activities because it is easy for them to get away with fraud and embezzlement.

"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 ten largest banks in the United States when it became insolvent in May 1984. Not only did the FDIC guarantee depositors up to the $100,000 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 the FDIC's policy was to regard the 11 largest banks as "too big to fail"—in other words, the FDIC would bail them out so that no depositor or creditor would suffer a loss. The FDIC would do this by using the purchase and assumption method, giving the insolvent bank a large infusion of capital and then finding a willing merger partner to take over the bank and its deposits. The too-big-to-fail policy was extended to big banks that were not even among the 11 largest. (Note that "too big to fail" is somewhat misleading because when a bank is closed or merged into another bank, the managers are usually fired and the stockholders in the bank lose their investment.)

One problem with the too-big-to-fail policy is that it increases the moral hazard incentives for big banks. If the FDIC were willing to close a bank using the alternative payoff method, paying depositors only up to the $100,000 limit, large depositors with more than $100,000 would suffer losses if the bank failed. Thus they would have an incentive to monitor the bank by examining the bank's activities closely and pulling their money out if the bank was taking on too much risk. To prevent such a loss of deposits, the bank would be more likely to engage in less risky activities. However, once large depositors know that a bank is too big to fail, they have no incentive to monitor the bank and pull out their deposits when it takes on too much risk: No matter what the bank does, large depositors will not suffer any losses. The result of the too-big-to-fail policy is that big banks might take on even greater risks, thereby making bank failures more likely.1

Financial Consolidation and the Government Safety Net. With financial innovation and the passage of the Riegle-Neal Interstate Banking and Branching and Efficiency Act of 1994 and the Gramm-Leach-Bliley 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 regulation because of the existence of the government safety net. First, the increased size of banks as a result of financial consolidation increases the too-big-to-fail problem, because there will now be more large institutions whose failure exposes the financial system to systemic (system-wide) risk. 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 services 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 are resulting from recent changes in legislation will be one of the key issues facing banking regulators in the future.

Restrictions on Asset Holdings and Bank Capital Requirements

As we have seen, 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 risk-taking activities, they would immediately withdraw their deposits if the bank was taking on too much risk. To prevent such a loss of deposits, the bank would be more likely to reduce its risk-taking activities. Unfortunately, acquiring information on a bank's 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 risky activities. A strong rationale for government regulation to reduce risk taking on the part of banks therefore existed even before the establishment of federal deposit insurance.

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

Evidence reveals, as our analysis predicts, that large banks took on riskier loans than smaller banks and that this led to higher loan losses for big banks; see John Boyd and Mark Gertler, "U.S. Commercial Banking: Trends, Cycles and Policy," NBER Macroeconomics Annual, 1993, pp. 319-368.

bank capital are another way to change the bank's incentives to take on less 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 less risky activities.

Bank capital requirements take two forms. The first type is based on the so-called leverage ratio, the amount of capital divided by the bank's total assets. To be classified as well capitalized, a bank's leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank. Through most of the 1980s, minimum bank capital in the United States was set solely by specifying a minimum leverage ratio.

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 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 the Basel Committee on Banking Supervision (because it meets under the auspices of the Bank for International Settlements in Basel, Switzerland), which has implemented the so-called Basel Accord on a second type of capital requirements, risk-based 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 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 in the OECD, Organization for Economic Cooperation and Development, (industrialized) countries. The second category has a 20% weight and includes claims on banks in OECD 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 1996 Market Risk Amendment to the Accord set minimum capital requirements for risks in banks' trading accounts.

Over time, limitations of the 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 what is known as regulatory arbitrage, 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. The Basel Accord could thus lead to increased risk taking, the opposite of its intent. To address these limitations, the Basel Committee on Bank Supervision has released proposals for a new capital accord, often referred to as Basel 2, but it is not clear if it is workable or if it will be implemented (see Box 2).

The Basel Committee's work on bank capital requirements is never-ending. As the banking industry changes, the regulation of bank capital must change with it to ensure the safety and soundness of the banking institutions.

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

Basel 2: Is It Spinning Out of Control?

Starting in June 1999, the Basel Committee on Banking Supervision released several proposals to reform the original 1988 Basel Accord. These efforts have culminated in what bank supervisors refer to as Basel 2, which is based on three pillars. Pillar 1 intends to link capital requirements more closely to actual risk. It does so by specifying many more categories of risk with different weights in its so-called standardized approach. Alternatively, it allows sophisticated banks to pursue instead an internal ratings-based approach that permits banks to use their own models of credit risk. Pillar 2 focuses on strengthening the supervisory process, particularly in assessing the quality of risk management in banking institutions and in evaluating whether these institutions have adequate procedures to determine how much capital they need. Pillar 3 focuses on improving market discipline through increased disclosure of details about the bank's credit exposures, its amount of reserves and capital, the offi cials who control the bank, and the effectiveness of its internal ratings system.

Although Basel 2 makes great strides toward limiting excessive risk taking by banking institutions, it has come at a cost of greatly increasing the complexity of the Accord. The document describing the original Basel Accord was twenty-six pages, while the second draft of Basel 2 issued in January 2001 exceeds 500 pages. The original timetable called for the completion of the final round of consultation by the end of May 2001, with the new rules taking effect by 2004. However, criticism from banks, trade associations, and national regulators has led to several postponements, with the final draft now scheduled to be published in the last quarter of 2003 and the Accord to be implemented in 2006. Will the increasing complexity of the Basel Accord lead to further postponements? Will Basel 2 eventually be put into operation? As of this writing, these questions remain unanswered. /Regulations/default.htm

Access regulatory publications of the Federal Reserve Board.

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 banks is one method for preventing this adverse selection problem; through chartering, proposals for new banks are screened to prevent undesirable people from controlling them.

Regular on-site bank examinations, which allow regulators to monitor whether the bank is complying with capital requirements and restrictions on asset holdings, also function to limit moral hazard. Bank examiners give banks a so-called CAMELS rating (the acronym is based on the six areas assessed: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk). With this information about a bank's activities, regulators can enforce regulations by taking such formal actions as cease and desist orders to alter the bank's behavior or even close a bank if its CAMELS rating is sufficiently low. Actions taken to reduce moral 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 (see Chapters 8 and 9). 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 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.

A commercial bank obtains a charter either from the Comptroller of the Currency (in the case of a national bank) or from a state banking authority (in the case of a state bank). To obtain a charter, the people planning to organize the bank must submit an application that shows how they plan to operate the bank. In evaluating the application, the regulatory authority looks at whether the bank is likely to be sound by examining the quality of the bank's intended management, the likely earnings of the bank, and the amount of the bank's initial capital. Before 1980, the chartering agency typically explored the issue of whether the community needed a new bank. Often a new bank charter would not be granted if existing banks in a community would be hurt by its presence. Today this anticompetitive stance (justified by the desire to prevent bank failures of existing banks) is no longer as strong in the chartering agencies.

Once a bank has been chartered, it is required to file periodic (usually quarterly) call reports that reveal the bank's assets and liabilities, income and dividends, ownership, 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 unannounced visits to the bank (so that nothing can be "swept under the rug" in anticipation 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). 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 Traditionally, on-site bank examinations have focused primarily on assessment of the

Risk Management quality of the bank's 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 risk taking by banks, it is no longer felt to be adequate in today's 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 quite 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 9). Thus an examination that focuses only on a bank's position at a point in time may not be effective in indicating whether a bank will in fact be taking on excessive risk in the near future.

This change in the financial environment for banking 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 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 Systems 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 systems. 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 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 recent guidelines adopted by the U.S. bank regulatory authorities to deal with interest-rate risk. At one point, U.S. regulators were contemplating requiring banks to use a standard model to calculate the amount of capital a bank would need to have to allow for the interest-rate risk it bears. Because coming up with a one-size-fits-all model that would work for all banks has proved difficult, the regulatory agencies have instead decided to adopt guidelines for the management of interest-rate risk, although bank examiners will continue to consider interest-rate risk in deciding on the bank's capital requirements. 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 director's risk limits are not violated and to implement internal controls to monitor interest-rate risk and compliance with the board's directives.

Disclosure The free-rider problem described in Chapter 8 indicates that individual depositors

Requirements and other bank creditors will not have enough incentive to produce private informa tion about the quality of a bank's assets. To ensure that there is better information for depositors and the marketplace, regulators can require that banks adhere to certain standard accounting principles and disclose a wide range of information that helps the market assess the quality of a bank's portfolio and the amount of the bank's exposure to risk. More public information about the risks incurred by banks and the quality of their portfolio can better enable stockholders, creditors, and depositors to evaluate and monitor banks and so act as a deterrent to excessive risk taking. This view is consistent with a position paper issued by the Eurocurrency Standing Committee of the G-10 Central Banks, which recommends that estimates of financial risk generated by firms' own internal risk management systems be adapted for public disclosure purposes.2 Such information would supplement disclosures based on tra-

2See Eurocurrency Standing Committee of Central Banks of Group of Ten Countries (Fisher Group), "Discussion Paper on Public Disclosure of Markets and Credit Risks by Financial Intermediaries," September 1994, and a companion piece to this report, Federal Reserve Bank of New York, "A Discussion Paper on Public Disclosure of Risks Related to Market Activity," September 1994.

ditional accounting conventions by providing information about risk exposure and risk management that is not normally included in conventional balance sheet and income statement reports.

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. 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 (called the annual percentage rate, or APR) and the total finance charges on the loan. The Fair Credit Billing Act of 1974 requires creditors, especially 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 administered by the Federal Reserve under Regulation B. The Community Reinvestment Act (CRA) of 1977 was enacted to prevent "redlining," a lenders refusal to lend in a particular 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.

Restrictions on Competition /important/index.html

Describes the most important laws that have affected banking industry in the U.S.

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 to maintain former profit levels. Thus governments in many countries have instituted regulations to protect banks from competition. These regulations have taken two forms in the United States in the past. First were restrictions on branching, such as those described in Chapter 10, which reduced competition between banks. The second form involved preventing nonbank institutions from competing with banks by engaging in banking business, as embodied in the Glass-Steagall Act, which was repealed in 1999.

Although restricting competition propped up the health of banks, restrictions on competition also had serious disadvantages: They led to higher charges to consumers and decreased the efficiency of banking institutions, which did not have to compete as hard. Thus, although the existence of asymmetric information provided a rationale for anticompetitive regulations, it did not mean that they would be beneficial. Indeed, in recent years, the impulse of governments in industrialized countries to restrict competition has been waning. Electronic banking has raised a new set of concerns for regulators to deal with. See Box 3 for a discussion of this challenge.

Study Guide Because so many laws regulating banking have been passed in the United States, it is hard to keep track of them all. As a study aid, Table 1 lists the major banking legislation in the twentieth century and its key provisions.

Box 3: E-Finance

Electronic Banking: New Challenges for Bank Regulation

The advent of electronic banking has raised new concerns for banking regulation, specifically about security and privacy.

Worries about the security of electronic banking and e-money are an important barrier to their increased use. With electronic banking, you might worry that criminals might access your bank account and steal your money by moving your balances to someone else's account. Indeed, a notorious case of this happened in 1995, when a Russian computer programmer got access to Citibank's computers and moved funds electronically into his and his conspirators' accounts. Private solutions to deal with this problem have arisen with the development of more secure encryption technologies to prevent this kind of fraud. However, because bank customers are not knowledgeable about computer security issues, there is a role for the government to regulate electronic banking to make sure that encryption procedures are adequate. Similar encryption issues apply to e-money, so requirements that banks make it difficult for criminals to engage in digital counterfeiting make sense. To meet these challenges, bank examiners in the United States assess how a bank deals with the special security issues raised by electronic banking and also oversee third-party providers of electronic banking platforms. Also, because consumers want to know that electronic banking transactions are executed correctly, bank examiners also assess the technical skills of banks in setting up electronic banking services and the bank's capabilities for dealing with problems. Another security issue of concern to bank customers is the validity of digital signatures. The Electronic Signatures in Global and National Commerce Act of 2000 makes electronic signatures as legally binding as written signatures in most circumstances.

Electronic banking also raises serious privacy concerns. Because electronic transactions can be stored on databases, banks are able to collect a huge amount of information about their customers—their assets, creditworthiness, what they purchase, and so on—that can be sold to other financial institutions and businesses. This potential invasion of our privacy rightfully makes us very nervous. To protect customers' privacy, the Gramm-Leach-Bliley Act of 1999 has limited the distribution of these data, but it does not go as far as the European Data Protection Directive, which prohibits the transfer of information about online transactions. How to protect consumers' privacy in our electronic age is one of the great challenges our society faces, so privacy regulations for electronic banking are likely to evolve over time.

Table 1 Major Banking Legislation in the United States in the Twentieth Century

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