Central banks, regulatory capture and banking supervision reform

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1 Central banks, regulatory capture and banking supervision reform Pierre C. Boyer and Jorge Ponce Toulouse School of Economics (Gremaq) and Banco Central del Uruguay XV Reunión de la Red de Investigadores del CEMLA La Paz, Bolivia November, 2010 Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

Uruguay XV Reunión de la Red de Investigadores del CEMLA La Paz, Bolivia November,

2 Disclaimer THE VIEWS IN THIS PRESENTATION ARE THOSE OF THE AUTHOR AND NOT OF THE BANCO CENTRAL DEL URUGUAY Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

3 Motivation Banking reforms tend to concentrate supervisory powers in central banks United Kingdom After Northern Rock the Bank of England receives a clear mandate on macro-prudential stability Now, the Conservative Party wants the Bank of England to conduct micro-prudential supervision as well United States The Restoring American Financial Stability Act of 2010 gives the Federal Reserve both micro- and macro-prudential responsibilities Should a single supervisor (a central bank) be in charge of micro-prudential as well as of macro-prudential supervision? Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

American Financial Stability Act of 2010 gives the Federal Reserve both micro- and macro-prudential responsibilities Should a single supervisor (a central bank) be

4 Related literature Efficiency: rationale for concentrating supervisory powers Central banks are the natural source of liquidity, Bagehot (1873) Interlinks between financial and price stability, Goodhart and Schoenmaker (1995), Masciandaro (1995, 2004) Synergies between financial supervision and monetary policy, Peek et al. (1999) Incentives and capture: the ignored possibilities Powerful supervisors may be easily captured, Barth et al. (2004), Djankov et al. (2002), Quintyn and Taylor (2002) Capture has been a concern in the past, Kane (1990,2001), Abrams and Settle (1993) Regulation under asymmetric information and collusion Laffont and Tirole (1993), Laffont and Martimort (1999) Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

(1999) Incentives and capture: the ignored possibilities Powerful supervisors may be easily captured, Barth et al. (2004), Djankov et al.

5 This paper Uses a formal model Analyzes the optimality of concentrating supervisory powers Focuses on the incentives of self-interested supervisors the allocation of bank supervisory powers Finds that micro- and macro-prudential supervision should be conducted by different supervisors Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

powers Finds that micro- and macro-prudential supervision should be conducted by different

6 The structure of the hierarchy Social planner Benevolent regulator Supervisory contract Bank regulation Supervisory arrangement One or two supervisors Bank supervision Bank Riskiness r, r, or r Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

supervisors Bank supervision Bank Riskiness r, r, or r Boyer - Ponce

7 The structure of the hierarchy Social planner Constitution, Legislature Supervisory-regulatory contract Supervisory arrangement One or two supervisors Bank regulation Bank supervision Bank Riskiness r, r, or r Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

supervisors Bank regulation Bank supervision Bank Riskiness r, r, or r Boyer

8 The model Banker Private information, riskiness: r = r + rm + r M, r m, r M {0, r} P(r) = α 2, P( r r + r) = 2α(1 α), P(r r + 2 r) = (1 α) 2 B = π rk 0 Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

9 The model Banker Private information, riskiness: r = r + rm + r M, r m, r M {0, r} P(r) = α 2, P( r r + r) = 2α(1 α), P(r r + 2 r) = (1 α) 2 B = π rk 0 Supervisor(s) Si = w i 0, i {1, 2} Supervisory technologies, Tj, j {m, M}, provide informative signals, σ j, with probability αɛ Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

Supervisory technologies, Tj, j {m, M}, provide informative signals, σ j, with probability αɛ

10 The model Banker Private information, riskiness: r = r + rm + r M, r m, r M {0, r} P(r) = α 2, P( r r + r) = 2α(1 α), P(r r + 2 r) = (1 α) 2 B = π rk 0 Supervisor(s) Si = w i 0, i {1, 2} Supervisory technologies, Tj, j {m, M}, provide informative signals, σ j, with probability αɛ Regulation, supervision and their costs Bank regulation affects k and π (then B) Bureaucratic costs λ(π + w) Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

informative signals, σ j, with probability αɛ Regulation, supervision and their costs Bank regulation affects k and π

11 The model Banker Private information, riskiness: r = r + rm + r M, r m, r M {0, r} P(r) = α 2, P( r r + r) = 2α(1 α), P(r r + 2 r) = (1 α) 2 B = π rk 0 Supervisor(s) Si = w i 0, i {1, 2} Supervisory technologies, Tj, j {m, M}, provide informative signals, σ j, with probability αɛ Regulation, supervision and their costs Bank regulation affects k and π (then B) Bureaucratic costs λ(π + w) Expected social welfare W = Ψ(k) + B + S (1 + λ)(π + w) = Ψ(k) (1 + λ)rk λb λs Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

Regulation, supervision and their costs Bank regulation affects k and π (then B) Bureaucratic costs λ(π + w) Expected social welfare W = Ψ(k)

12 The timing (i) The social planner defines the supervisory structure, i.e. one or two bank supervisors. (ii) The bank learns r m and r M and supervisor(s) σ m and σ M. (iii) The social planner announces its regulatory policy and the supervisor(s) wage(s). The bank and supervisor(s) decide whether or not to participate. (iv) Non-benevolent supervisor(s) may request bribes in exchange for hiding supervisory information to the social planner. (v) The supervisor(s) report(s) its (their) signal(s). The regulatory policy is executed and supervisory wages are paid. Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

(iv) Non-benevolent supervisor(s) may request bribes in exchange for hiding supervisory information to the social planner.

13 Benchmark Benevolent supervision máx W B = (1 αɛ) 2 W 0 + 2αɛ(1 αɛ)w 1 + (αɛ) 2 W 2 subject to incentive compatibility constraints participation constraints Proposition 1 Optimal regulation under benevolent supervision entails more severe regulations for the most risky banks such that (i) the most risky banks face more stringent capital (size) regulations than the less risky banks; (ii) the less risky banks make more profits. Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

most risky banks such that (i) the most risky banks face more stringent capital (size) regulations than the less risky banks; (ii)

14 One non-benevolent supervisor máx W O = (1 αɛ) 2 W 0 + 2αɛ(1 αɛ)w 1 + (αɛ) 2 W 2 C O subject to incentive compatibility constraints participation constraints capture-proof constraints w 2 w 1 τb 1 w 2 w 0 τb 0 w 1 w 0 τ mín{b 0 B 1, B 0 } Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

capture-proof constraints w 2 w 1 τb 1 w 2 w 0 τb 0 w 1 w 0 τ mín{b 0 B 1, B 0 }

15 One non-benevolent supervisor (cont.) máx W O = (1 αɛ) 2 W 0 + 2αɛ(1 αɛ)w 1 + (αɛ) 2 W 2 C O subject to incentive compatibility constraints participation constraints capture-proof constraints Proposition 2 Optimal regulation with one non-benevolent bank supervisor entails more capital restrictions for the most risky banks and lower profits for the less risky banks with respect to the case of benevolent supervision. Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

capture-proof constraints Proposition 2 Optimal regulation with one non-benevolent bank supervisor entails more capital

16 Two non-benevolent supervisor máx W O = (1 αɛ) 2 W 0 + 2αɛ(1 αɛ)w 1 + (αɛ) 2 W 2 C T subject to incentive compatibility constraints participation constraints capture-proof constraints w 1 w 0 τ mín{ B 0, B 0 B 1, B 1 } Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

capture-proof constraints w 1 w 0 τ mín{ B 0, B 0 B 1, B 1 } Boyer - Ponce (TSE

17 Two non-benevolent supervisor (cont.) Proposition 3 Optimal regulation with two non-benevolent bank supervisors entails more capital restrictions for the most risky banks and lower profits for the less risky banks with respect to the case of benevolent supervision. However, for banks of riskiness r (respectively r), optimal regulation is less (respectively more) distorted when two non-benevolent bank supervisors are used instead of using only one non-benevolent bank supervisor. Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

profits for the less risky banks with respect to the case of benevolent supervision.

18 Comparison Partial information reduces the stake from being captured Formally, we get ride of one capture-proof constraint The social cost of being informed is lower when using two instead of one supervisor C O C T = αɛλτ r[2(k O 0 k T 0 ) + αɛ( k 0 O ko 0 )] > 0 Proposition 4 From an ex ante point of view, the gain in expected social welfare from using two non-benevolent bank supervisors instead of only one non-benevolent bank supervisor is at least equal to zero. Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

an ex ante point of view, the gain in expected social welfare from using two non-benevolent bank supervisors instead of only one

19 Comments and policy implications Concentration of supervisory powers makes capture more likely Separation Appears as an optimal response to the threat of capture Introduces more rules to banking supervision Improves social welfare by reducing the discretion of supervisors There are good reasons for central banks to conduct macro-prudential supervision Hence, policy makers would like to appoint a different from the central bank agency as micro-prudential supervisor Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

are good reasons for central banks to conduct macro-prudential supervision Hence, policy makers would like to appoint a different from the

20 Extensions and discussion Positive correlation between risks No changes qualitative results but complicates the algebra Possibility of using yardstick competition between supervisors A different structure of hierarchy Different accuracy of supervisory technologies Better information by using a single supervisor But, more stake from capture Excessive costs of duplicating supervisory structures Central banks would like to conduct micro- and macro-prudential supervision into different units Boyer - Ponce (TSE - BCU) Central banks and banking supervision reform CEMLA, November / 16

using a single supervisor But, more stake from capture Excessive costs of duplicating supervisory structures Central banks would like to conduct

Central banks, regulatory capture and banking supervision reform

Central banks, regulatory capture and banking supervision reform Pierre C. Boyer Jorge Ponce 003-2010 1688-7565 Central banks, regulatory capture and banking supervision reform Resumen Los bancos centrales,