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This article, was originally published in the January/February 1993 issue of Economic Review The author, currently a financial economist and policy adviser in the Atlanta Fed's research department, was at the time the research officer Dr, charge of the department's financial section. He thanks Robert Eisenbeis, Frank King, Ellis Tallman, Sheila Tschinkel, and Carolyn Takeda for helpful comments., The special treatment historically accorded large failing banks--judging them 'too big to fail'--is an important issue in reforming deposit, insurance. All unaffiliated depositors, and in some cases all creditors, at [...]

In the first part (in the previous issue of Economic Review) of this two-part study, the authors identified a number of possible benefits from combining banking and commerce, including portfolio diversification, the creation of internal capital markets, and economies of scale and scope. This second part of the study analyzes the one source of possible gains--portfolio diversification--that can be estimated with existing data. Using methodologies from previous studies, the authors combine ten financial and nonfinancial industries into hypothetical portfolios using industry-level profitability data calculated from corporate tax returns filed with the Internal Revenue Service between 1994 and 2004. The analysis demonstrates that pairwise combinations of banks with construction firms or with retail firms would have produced substantially higher returns on equity with less risk during the sample period. Efficient portfolios combining banks with several other industries showed even higher levels of returns relative to risk, although banks were not necessarily a dominant part of some combinations. These findings suggest that portfolio diversification could be an important benefit from combining banks with some types of nonbank firms. The authors stress that bank management contemplating diversification into the commercial sector must be selective about which specific industries they choose, while corporate management interested in moving into banking might need to settle for somewhat lower returns to achieve a substantial reduction in risk. JEL classification: G21, G34, G28 Key words: banking and commerce, portfolio diversification, The limits on the affiliation of commercial banks with domestic nonbank firms have varied through time (see Haubrich and Santos 2003). Most of the barriers separating commercial banks from nonbank [...]

The policy debate on whether to strengthen or to remove the legal barriers between banking and commerce has paid little attention to what the practical effects of removing the barriers would be. To help answer this question, this article, the first part of a two-part study, provides an overview of the potential gains of integrating banking and commerce. Economic theory, the authors note, suggests that joint corporate ownership of banks and commercial firms has several potential benefits, including economies of scale and scope, increased internal capital markets, and diversification. Commercial firms could also enjoy a significant reduction in funding costs if affiliation with a bank extended the federal safety net for banks to cover the commercial firms' liabilities. But some benefits are already available without common ownership. Moreover, common ownership may also result in some disadvantages, such as significant diseconomies of scale and scope. Actual experience provides better insight than theory can about the relative magnitudes of the benefits and costs of cross-industry combinations. U.S. experience with limited openings between banking and nonbank activities suggests that the most common combinations were banks with nonbank financial firms, relationships that were authorized by a 1999 reform act. Foreign experience and U.S. conglomerates of nonbank firms in different industries fail to provide compelling evidence for large-scale combinations of banking and commercial firms. JEL classification: G21, G34, G28 Keywords: banking and commerce, The application by Wal-Mart in 2005 to acquire a type of bank called an industrial loan company (ILC) sparked a renewed interest in the issue of mixing banking and commerce. [...]

The use of subordinated debt in the measurement of risk-taking and bank capital is discussed. Mandatory supervisory action by bank regulators may be triggered by some of the findings.

The federal government has an interest in the financial stability of Fannie Mae and Freddie Mac because of their importance to financial markets and the government's implicit guarantee of their liabilities. In October 2000 these two housing government-sponsored enterprises (GSEs) announced six voluntary initiatives. One initiative would enhance market discipline by having the GSEs issue subordinated debt. A second would boost liquidity by having the GSEs maintain a liquid securities portfolio. The other four initiatives would increase transparency by having the GSEs disclose their credit and interest rate losses under certain scenarios, obtain a credit rating for the government's exposure to loss, and disclose whether the GSEs comply with certain capital adequacy standards. This article evaluates the initiatives from the perspective of current banking standards. The analysis suggests that the initiatives are beneficial but could be made more effective. The authors point out that the contribution of the subordinated debt initiative depends largely on whether investors believe the implicit guarantee extends to subordinated debtholders. The need for the liquidity initiative has not been established, the authors conclude, and can be criticized as allowing the GSEs to earn a credit spread. The most important of the disclosure initiatives, the one for interest rate risk, will provide some new information but could be more informative if it summarized a wider set of interest rate scenarios., The federal government created the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) to enhance the availability of mortgage credit by providing stability [...]

Three government-sponsored enterprises (GSEs)--Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System--were created to improve the availability of home mortgage financing by supplementing local funding. But today's more evolved financial markets enable retail lenders to tap national markets. Thus, the main contribution of the three housing GSEs has become providing homebuyers an interest rate subsidy that is made possible by the GSEs' special relationship with the federal government. This article examines the economic issues arising from the provision of such subsidies via the housing GSEs. The authors first review the benefits and costs of subsidizing housing finance and then provide background information about the housing GSEs and their relationship to the federal government. The GSEs' importance to the financial markets, coupled with their special relationship with the government, raises concerns about the potential for moral hazard and the problems that would arise if a housing GSE became financially distressed or insolvent. The discussion then focuses on two public policy debates that have been sparked by this special relationship. The first is whether the housing GSEs are efficient mechanisms for subsidizing housing. The second relates to the housing GSEs' safety and soundness and questions whether implicit guarantees of their liabilities are the best way to subsidize them., Three government-sponsored enterprises (GSEs) play a central role in U.S. housing finance markets. Together, the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and [...]

Current discussions about deposit insurance reform center on issues such as the size of insurance premiums, the size of the fund, and the size of the coverage limits--all issues that reflect a concern with how to allocate the losses arising from bank failures. The authors of this article argue that such issues, while important, do not affect the performance of the deposit insurance system nor should they be the focus of deposit insurance reform. They suggest that reform efforts should be directed toward strengthening the incentives to enforce the least cost resolution provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The authors make the case that the large losses the FDIC has borne with some bank failures were due to supervisory forbearance. They suggest that a useful step forward would be to carry out FDICIA's mandate to develop and implement market value-type disclosures of the value of banks' assets and liabilities. Increasing the transparency of bank risk taking, as academics have long argued, would improve regulators' ability to monitor bank risk exposure. These reforms, combined with a different approach to risk-based premiums and measures to strengthen market discipline, such as expanded use of subordinated debt, merit further consideration as potential partial solutions to the problem of implementing FDICIA., The current debate on deposit insurance reform addresses a host of issues, but most of them boil down to three concerns: the size of the net premiums (premiums minus rebates) [...]

A system of bank supervision and regulation should protect taxpayers and the financial system without imposing unnecessary costs on banks. This article focuses on whether existing capital regulations, one of the primary tools of bank supervision and regulation, are imposing unnecessary costs on banks. In particular, the capital requirements may be requiring banks to issue equity when it would be less costly for them to issue subordinated debt. The authors obtain evidence on the costs generated by equity issues by examining the type of capital banks issued in response to the capital guidelines of the 1980s, which included a type of debt in capital. The findings suggest that banks prefer to avoid issuing common equity, especially when the ratio of the market price of their stock to its book value is less than one. The results suggest that the option to substitute debt for equity in meeting the capital standards is especially valuable for banks with low market values. The results also suggest that the ability to issue debt as a substitute for equity is more valuable to larger banks., A number of very large banking organizations have recently proposed or consumated mergers, including Chemical and Chase Manhattan, Citicorp and Travelers, and NationsBank and BankAmerica. These combinations have increased the [...]

Are existing regulatory policies adequately limiting taxpayer's exposure to deposit insurance losses? Looking to the past, if there had been a credible, independent answer to this question, there might have [...]

A model that examines the incentives rewarded to bank managers in exchange for risky assets is introduced. Risk choices of bank managers depend on the timing of regulations and the framework of compensation agreements. However, these choices may be eliminated by providing for limitations in compensation agreements. The Federal Deposit Insurance Corp. Improvement Act of 1991 authorizes the regulation of bonuses for managers of troubled banks.

An economic model that simulates and tests the effect of both regulations and the workings of the financial market on the capital ratios of bank holding companies is discussed. The application of the model demonstrates that majority of these firms were content with their capital ratios in 1989 but accelerated pressure from regulatory authorities for the period 1990-1992 contributed to some sort of a credit crisis.

The new Federal Deposit Insurance Corporation Improvement Act was written to stem losses from deposit insurance. The new plan gets somewhat away from the traditional 'too-big-to-fail' concept that regulators had held. FDICIA requires that bank failures be handled, in general, in whatever way generates the lowest costs to the FDIC. Times when the FDIC does not follow this rule would be when a bank failure is a risk to other banks or the nonbanking sector or when the failure interferes too greatly with the bank's consumer services.

Changes to the laws on discount windows, deposit insurance and closure policies under the Federal Deposit Insurance Corp are an improvement to the regulation of banking and financial stability. Discount window lending to unstable banks and aid to uninsured banks has been curtailed while aid to nonbank financial services has been increased. The result will be a separation of systemic risk from individual cases of insolvency.