#10918 - Outline Federal Banking Regulation - Federal Banking Regulation

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 Repealed Glass-Steagall's anti-affiliation provisions and permitted banks to affiliate through specially qualified bank holding companies called "financial holding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: panic may occur where they "break the buck" (i.e., < $1 net asset value = (total assets - total liabilities)/# of shares)

              • Rare as they generally invest in safe, liquid, short-term securities

              • However, during the financial crisis, they did indeed "break the buck" and had to be covered by deposit insurance to prevent run

            • Mutual Funds: redemptions do not appreciably increase the risk that other shareholders will suffer loss as each redemptions are at net asset value (redemptions do not create a liquidity crisis in contrast to fractional reserve banking) - demand equity rather than demand debt

         1. Role of Banks in the Money Supply

            • Any breakdown in the banking system will affect the money supply

              • Banks have a special role as they create money when they make loans and destroy money when they accept repayment of loans

            • The process of creating money is greatly slowed where borrowers hold money as cash rather than in a checking account

              • High-powered money

                • Cash and Federal Reserve accounts (the Federal Reserve adds reserves) constitute high-powered money because adding them to the banking system creates money in a multiple of their face amount, and decreasing them destroys money in that same multiple

         2. Role of Banks in the Payment System

            • Banks play a key role (along with the Federal Reserve) in operating the U.S. payment system - the system for transferring wealth through bookkeeping entries, notably by clearing checks and transmitting electronic payments

2. Getting Started

   1. Entry into banking

      1. Forming a Bank

         1. Six Steps

            • (1) Having settled on the charter type, you form an organizing group of at least five individuals

              • "Each organizer must have a history of responsibility, personal honesty, and integrity."

              • The organizers must have "experience, competence, willingness, and ability" to direct the bank's affairs safely and soundly.

              • The group should "include diverse business and financial interests and [evince] community involvement." 12 C.F.R. § 5.20(g)(1).

            • (2) Have a prefiling meeting with the OCC's regional office

            • (3) File an application

              • The most important part of application package is the business plan

                • Must (1) identify the proposed bank's sources of capital, (2) set forth its business strategy, (3) analyze earning prospects, (4) include projected balance sheets and income statements, and (5) show how the bank will satisfy and soundly meet its community's banking needs. 12 C.F.R. § 5.20(h)(2), (5).

              • In addition to reviewing the business plan, the OCC considers whether the proposed bank has "organizers . . . familiar with national banking laws"; will have "competent management, including the board of directors, with ability and expertise relevant to the types of services" the bank plans to provide; will have capital "sufficient to support the projected volume and type of business"; is likely to remain profitable; and will operate safely and soundly. 12 C.F.R. § 5.20(f)(2).

              • The OCC also considers how the bank will meet "the credit needs of its entire community, including low- and moderate-income neighborhoods" as required by the Community Reinvestment Act.

            • (4) Receive preliminary conditional approval

            • (5) Follow up by filing with the OCC an organization certificate and articles of association, electing the initial board of directors and fulfilling any other conditions imposed by the OCC

            • (6) Receive final approval

      2. Judicial Review of Chartering Decisions

         1. An applicant may seek judicial review of chartering decision

         2. Camp v. Pitts

            • The appropriate standard of review is whether the Comptroller's determination...