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Banking Law
University of North Carolina School of Law
Broome, Lissa Lamkin

Banking Outline
I.                    The Business of Banking
a.       Characteristics distinguishing banks from other financial institutions:
                                                               i.      Financial intermediation.
                                                              ii.      Transaction (i.e., checking) accounts.
b.       Financial Intermediation
                                                               i.      Financial intermediation: intermediaries pool financial resources from those with excess funds and make funds available for use by others who need additional funds.
1.       Return on deposit is interest rate paid by bank (probably less than 1%).
2.       Higher return likely on direct investment (no intermediary costs).
                                                              ii.      Intermediaries have information and expertise enabling them to make realistic evaluations of market and credit risks in selecting investment opportunities.
                                                            iii.      Two Categories of Financial Intermediaries:
1.       Depository: principal source of funds is deposits, and principal use of funds is making loans.
a.       Includes: banks, thrifts, credit unions.
2.       Non-depository: receive funds from sources other than customer deposits, such as insurance premiums.
a.       Includes: insurance companies, pension funds.
                                                            iv.      Opposite of intermediation is direct investment:
1.       Direct investment: person with excess funds finds way to profitably use excess, either by direct loan to or direct investment in person or entity.
2.       Not always feasible as alternative:
a.       Investor may lack time or expertise to find suitable direct investment (intermediaries have such information).
b.       Investment amount may not be enough (banks can pool many deposits together).
c.        No insurance for direct investments.
                                                             v.      Advantages of Intermediation:
1.       Intermediary is able to diversify risk by investing pooled funds in variety of direct investments (bad investment will not cripple bank).
2.       Bank deposits are very liquid (unlike direct investments).
a.       Direct investments are illiquid and less secure.
b.       Direct investments cannot be demanded back at any time.
c.        Transaction Accounts
                                                               i.      Checking (also called transaction accounts and demand deposits) and savings accounts are primary source of funds for depository institutions.
                                                              ii.      Checking accounts were originally a product unique to banks.
1.       Now, all depository institutions offer transaction accounts.
2.       Bank is drawee, check-writer is drawer, and third party is payee.
3.       If held by individuals, not-for-profit entities or governmental entities may earn interest.
a.       No payment of interest for business checking accounts.
                                                            iii.      Savings accounts do not offer transaction features like check-writing.
                                                            iv.      Banks normally only keep required reserve amount, not all of deposits.
                                                             v.      CUs and like were given transaction functions to fight disintermediation.
d.       Monetary Policy
                                                               i.      Structure of Federal Reserve System
1.       Federal Reserve Board of Governors (FRB) is empowered with authority and tools to establish and implement US monetary policy.
2.       FRB is composed of seven members appointed by President.
3.       Network of 12 Federal Reserve Banks and their twenty-five branches carries out a variety of system functions, including:
a.       Operating nationwide payments system.
b.       Distributing nation’s currency and coin.
c.        Supervising and regulating member banks and BHCs.
d.       Serving as banker for U.S. Treasury.
e.        Acting as depository for banks in its district.
4.       Only banks have accounts at Federal Reserve Banks.
5.       Income of FRS is derived primarily from interest on US gov’t securities it has acquired through OMO.
a.       Other major sources of income: interest on foreign currency investments; interest on loans to depository institutions; fees received for services provided to depository institutions.
6.       After pays expenses, FRS turns earnings over to Treasury.
7.       Tools employed by FRB to implement monetary policy through banks: reserve requirements, open market operations, and discount rate.
                                                              ii.      Reserve Requirements
1.       Requiring banks to hold certain fraction of their deposits in reserve, either as cash in their vaults or as non-interest-bearing balances at Federal Reserve.
a.       Cost on private sector is equal to amount of forgone interest on these funds.
b.       Normal reserve requirements:
                                                                                                                                       i.      0% on savings account.
                                                                                                                                      ii.      10% on transaction accounts.
2.       FRB requires banks to hold average amount of reserves over two-week maintenance period rather than specific amount for each day.
3.       Changes in reserve requirement ratios can be useful supplementary tool of monetary policy:
a.       Increasing ratios reduces volume of deposits supported by level of reserves, reduces money stock, raising cost of credit.
b.       Decreasing ratios leaves depositories with excess reserves, which may induce expansion of credit and deposit levels and decline in interest rates.
4.       Because even small changes can substantially affect required reserves, not suited for day-to-day implementation of monetary policy.
5.       Reserve requirements changed only infrequently and usually merely to reinforce or supplement effects of OMO on monetary condition.
6.       Money supply can be decreased or increased by raising or lowering reserve requirement.
a.       If reserve increases, first bank in chain keeps more and lends rest out (cannot “create” as much money).
7.       Monetary Control Act of 1980 extended reserve requirements to all banks in US regardless of membership in FRS.
a.       High percentage of reserves caused members to lose profit, leading to bank flight (which takes money supply out of control of FRS).
8.       NBs must join FRS but SBs can join FRS at their option.
9.       Because money in deposit at regional Reserve Bank does not earn interest, banks keep near minimum of required reserves.
a.       Starting in 2011, regional Reserve Banks can pay interest on reserve deposits by banks.
b.       FRB supports this because banks use certain accounts not subject to reserve requirement (business checking account).
                                                            iii.      Open Market Operations (OMO)
1.       OMO involves buying and selling of securities by FRB.
2.       FOMC oversees OMO, which is principal tool of monetary policy.
3.       FRB securities transaction changes volume of reserves in FRS.
a.       Purchase increases nonborrowed reserves.
                                                                                                                                       i.      When buying, FRB issues check, which is honored by increase in reserve amount of seller’s bank.
                                                                                                                                      ii.      Total volume of reserves increases.
                                                                                                                                    iii.      Increases amount of money available to be loaned.
                                                                                                                                    iv.      Interests rates decline.
b.       Sale decreases nonborrowed reserves.
                                                                                                                                       i.      When selling, FRB reduces reserve account of buyer’s bank.
                                                                                                                                      ii.      Total volume of reserves declines.
                                                                                                                                    iii.      Decreases amount of money available to be loaned.
                                                                                                                                    iv.      Interests rates increase.
4.       Dollar-for-dollar change in reserves of depository system with purchase or sale of securities makes OMO most powerful and flexible tool.
5.       In practice, OMO requires ability to buy and sell quickly, at its own convenience, in whatever volume may be needed to keep supply of reserves in line with policy objectives.
a.       Instrument must be traded in highly active market that can accommodate transactions without disruptions in market itself.
b.       Most of OMO involves US gov’t securities.
6.       Depending on reserve situation, FRB approaches OMO in two ways:
a.       When projections indicate supply of reserves will need continual adjustment, FRB may make outright purchase or sales of securities.
                                                                                                                                       i.      Only conducts outright transactions few times a year.
b.       When projections indicate temporary need to alter reserves, FRB may engage in transactions only temporarily affecting reserves.
                                                                                                                                       i.      Repos are used for temporary additions of reserves.
                                                                                                                                      ii.      Matched sale-purchase transactions are used to temporarily drain reserves.
                                                                                                                                    iii.      Used more frequently than outright transactions.
                                                            iv.      The Discount Rate and Federal Funds Rate
1.       FRB may increase supply of “borrowed reserves” by lending to banks at rate of interest called discount rate (currently 5.75%).
a.       Must be secured to satisfaction of Bank providing credit.
2.       Lending at discount window serves two functions:
a.       Complements OMO in managing reserves market day-to-day and in implementing longer-term monetary policy goals.
                                                                                                                                       i.      Serves as buffer against unexpected fluctuations.
b.       Facilitates balance sheet adjustments of individual banks that face temporary, unforeseen changes in asset-liability structure.
3.       Discount window lending has for many years accounted for a relatively small fraction of total reserves.
4.       MCA extended access to discount window to non-member institutions.
a.       Institutions eligible to borrow include domestic commercial banks, savings banks, S&Ls, and CUs.
5.       Two Manners in Which Discount Rate Credit is Extended:
a.       Discount of eligible paper (notes, drafts, and bills of exchange): borrower transfers eligible paper carrying endorsement to Federal Reserve Bank; in return, borrower is credited in amount equal to discounted value of eligible paper.
                                                                                                                                       i.      When paper matures, returned to borrower, whose reserve account is debited by full amount of paper.
b.       Advance secured by collateral: simply loan by Bank to borrowing institution secured by collateral.
6.       Federal funds market: bank with excess reserves deposited at its regional reserve bank may lend excess to institutions (5.25%).
a.       FRB uses OMO to achieve targeted federal funds rate.
b.       Discount window rates are normally 100 basis points above the targeted federal funds rate (recently changed).
7.       Prime rate of interest: several percentage points higher than federal funds rate or discount window rate.
a.       Rate bank would charge to consumer customer who is not too much risk.
8.       LIBOR: usually less than prime rate but still more than federal funds rate or discount window rate.
a.       Rate bank would charge to business customer who is not too much risk.
                                                             v.      Fed Intervention to Prevent Systemic Risk
1.       FRB fills role of central bank by intervening to provide liquidity in times of crisis (such as when events create systemic risk).
a.       Systemic risk: threat to entire financial system.
2.       Lender of las

ven several responsibilities, including developing of efficient check clearing system.
                                                                                                                                      ii.      Federal Reserve Banks are authorized to collect checks for other reserve banks, for members, and for affiliated non-members.
d.       FRB also has regulatory function and issues paper currency.
                                                                                                                                       i.      FRB is regulator of SMBs (not subject to NBA).
e.        Federal Reserve Notes
                                                                                                                                       i.      Federal Reserve notes became part of circulation of currency and form basis for our paper currency.
                                                                                                                                      ii.      FRA rescinded power of NBs to issue their own notes to serve as currency.
4.       Monetary Policy
a.       FRS struggled with issue of what constituted correct monetary policy: provide liquidity or dampen speculation.
b.       See list of Federal Reserve Bank functions on page 42.
5.       Advantages of Dual Banking System:
a.       Provides healthy competition between two regulators because banks could easily change charters.
b.       Can use state economic system as laboratory for experiments.
c.        Provides important escape valve from oppressive regulator.
                                                            iii.      The New Deal Legislation
1.       Rationale for bank runs:
a.       Panic arises from rumors of bank failure.
b.       Under our fractional reserve system, banks do not have enough money to satisfy these demands.
2.       Creation of Federal Deposit Insurance
a.       Banking Act of 1933 (BA) was enacted to strengthen US banking system and allow resumption of banking.
b.       BA established FDIC (made permanent by BA of 1935).
c.        FDIC has stockholders (US and Federal Reserve Banks) and it has insureds.
                                                                                                                                       i.      Insurance company supported by assessments levied upon insured banks.
                                                                                                                                      ii.      Function of FDIC: stop destructive bank runs and prevent bank insolvency.
                                                                                                                                    iii.      Created federal deposit insurance.
                                                                                                                                    iv.      All NBs must have FDIC insurance.
1.       Most SBs required to have it by charters.
                                                                                                                                     v.      FDIC is primary regulator of SNBs.
3.       Strengthening the Federal Reserve System:
a.       Congress strengthened independence of FRB in BA of 1935.
                                                                                                                                       i.      FRB was given responsibility for FRS administration.
                                                                                                                                      ii.      Gave FRB more power to alter reserve requirements, ability to broaden lending powers of Reserve Banks, and power to regulate credit granted by banks and brokers to customers for purchasing securities.
                                                                                                                                    iii.      FRB’s grasp on control over monetary policy was still weak, even after BA of 1935.
4.       Glass-Steagall Act Restrictions on Securities Activities
a.       In 1902, OCC ruled that NB could not act as investment bank in underwriting securities.
                                                                                                                                       i.      To avoid that restriction, some larger NBs formed affiliates to act as securities dealers.
b.       Glass-Steagall Act of 1933 (GSA) was part of BA of 1933.
                                                                                                                                       i.      GSA separated commercial and investment banking.
1.       Not clear why Congress took this approach.
2.       This prohibition has since been lifted.
                                                                                                                                      ii.      GSA limited power of commercial bank to engaged in business of dealing in stock and securities, and it prohibited NB from buying securities, other than investment securities, for its own account.
                                                                                                                                    iii.      Established ability of NBs to establish branch banks away from headquarters.
1.       NBA said nothing about ability of NB to establish branch office.