U.S. Financial Regulatory Policy: The Banking Sector

Overview

The banking sector plays a crucial role in the U.S. financial system, providing essential services such as accepting deposits and making loans. However, this sector also poses significant regulatory challenges due to its complex nature.

Types of Contracts and Bank Structures

Types of Contracts

• Hybrids: Combine elements of bank-like loans with securities contracts
• Insurance: Provides protection against potential losses or damages
• Swaps: Exchanges one cash flow for another based on a notional amount
• Forwards: Agreements to buy or sell an underlying asset at a predetermined price

Commercial vs. Investment Banks

• Commercial Banks:
  • Accept customer deposits
  • Offer commercial loans
• Investment Banks:
  • Underwrite and register new securities
  • Market them to individual or institutional investors

Banking Model and Regulatory Issues

The Business Model of Commercial Banks

• Accept deposits from savers to make loans to borrowers, creating an agency relationship between the bank and its depositors.

Economic Policy Problems

• Conflicts of Interest: Bank managers may act in their own interests rather than the best interests of the bank
• Maturity Mismatch: Banks borrow short-term to offer longer-term loans, making them vulnerable to interest rate volatility and “runs”
• Credit Shortages: Insufficient credit available for borrowers
• Lending Discrimination: Unequal access to credit based on factors such as race or income
• Systemic Risk: A single bank’s risk-taking can pose a threat to the entire financial system

Recurring Economic Issues in the Banking Sector

Agency Relationships

• Banks act on behalf of depositors to identify credit-worthy borrowers, write and administer loan contracts, and enforce the loan terms if the borrower defaults.

Maturity Transformation

• Banks can earn profits by borrowing short-term in order to offer longer-term loans, creating a maturity mismatch that makes them vulnerable to interest rate volatility and “runs” if depositors withdraw their funds simultaneously.

Addressing Policy Problems through Regulations

Restricting Conflicts of Interest

• Regulations can restrict conflicts of interest of bank managers and prevent them from acting in their own interests rather than the best interests of the bank.

Limiting Deposits and Withdrawals

• Regulations can limit the proportion of bank resources that can be devoted to or drawn from particular markets or counterparties, and rules on the loan application process can help prevent lending discrimination.

Preventing Systemic Risk

• Regulations can help prevent systemic risk by limiting a single bank’s ability to take excessive risk and ensure that there are enough healthy banks to borrow from in case of unexpected losses or withdrawals.