3/22/2010. Chapter 11. Eight Categories of Bank Regulation. Economic Analysis of. Regulation Lecture 1. Asymmetric Information and Bank Regulation

Transcription

1 Chapter 11 Economic Analysis of Banking Regulation Lecture 1 Asymmetric Information and Bank Regulation Adverse Selection and Moral Hazard are the two concepts that underlie government regulation of the banking system Copyright 2007 Pearson Addison-Wesley. All rights reserved Eight Categories of Bank Regulation 1)Government safety net 2)Restrictions on bank assets 3)Capital requirements 4)Chartering and bank examination 5)Assesment of risk management 6)Disclosure requirements 7)Consumer protection 8)Restrictions on competition Copyright 2007 Pearson Addison-Wesley. All rights reserved

2 Government safety net The fact that depositors do not have information about the private loans leads to two reasons why the banking system may not function well: Because depositors don't know whether the managers are taking too much risk or not, they may be unwilling to put their money in a bank Depositors lack of info. about the quality of bank assets can lead to bank panics Following a negative shock, all depositors may rush to get their deposits back irrespective of knowing whether their bank is affected from the shock or not Copyright 2007 Pearson Addison-Wesley. All rights reserved Government safety net (cont d) Government safety net provides protection for depositors: FDIC: deposit insurance Payoff method: pay deposits up to $100,000 The goal of deposit insurance is to short circuit bank failures and contagion effect Copyright 2007 Pearson Addison-Wesley. All rights reserved Government safety net: Drawbacks What is the drawback? Commercial banks may be willing to take more risk if the government is there to save them from bankruptcy This is particularly a problem with developing countries with weak institutional environments Copyright 2007 Pearson Addison-Wesley. All rights reserved

3 Government safety net: Drawbacks Moral Hazard Depositors do not impose the discipline of marketplace (i.e. they don t withdraw funds if there is government insurance) Banks have an incentive to take on greater risk Adverse Selection Risk-lovers find banking attractive Gov. insurance may make it more appealing for risky entrepreneurs to enter the banking sector Those who are more likely to engage in risky activities are those who are more willing to take the insurance Copyright 2007 Pearson Addison-Wesley. All rights reserved Too Big to Fail Because the failure of a very large bank may trigger a financial crisis, the government may provide extra support for these banks (e.g. guarantees of repayment to large uninsured creditors) This may increase the M.H problem for big banks because depositors have little reason to monitor the bank Recent example: AIG (not a bank) Copyright 2007 Pearson Addison-Wesley. All rights reserved Restrictions on Asset Holding and Bank Capital Requirements These restrictions aim to decrease M.H risk that is increased due to government safety net regulations that restrict banks from holding risky assets (e.g. stocks) regulations to promote diversification regulations to ensure sufficient bank capital Copyright 2007 Pearson Addison-Wesley. All rights reserved

4 Regulations to ensure sufficient bank capital 1) Leverage ratio : Assets/Capital : set a minimum leverage ratio 3% 2) Basel Accord (risk based capital requirements): Banks hold as capital at least 8% of their risk-weighted assets Weights: -little default risk (e.g. government securities of OECD) 0% -claims on banks 20% -municipal bonds and residential mortgages 50% -Customer loans 100% Copyright 2007 Pearson Addison-Wesley. All rights reserved Drawbacks of Basel Accord The weighting scheme can not account for actual risk accurately. In order to get the most out of their capital requirements banks tended d to give more loans to more risky customers rather than less risky ones (which is not differentiated in the weighting scheme above): regulatory arbitrage Basel 2 Accord (too complex) Copyright 2007 Pearson Addison-Wesley. All rights reserved Bank (Prudential) Supervision: Chartering and Examination Chartering refers to screening out proposals for new banks to prevent undesirable people from controlling them. This is a measure against Adverse Selection If the chartering agency decides that the bank is likely to be sound, it gives the bank a charter and the bank can be formed. Once the charter is received, the bank is required to file periodic call reports that reveal the banks assets and liabilities, income dividends, etc. Copyright 2007 Pearson Addison-Wesley. All rights reserved

5 The bank is also subject to examination by regulatory agencies annually to prevent moral hazard. Asset quality Management Earnings Liquidity Sensitivity to market risk Copyright 2007 Pearson Addison-Wesley. All rights reserved Assessment of Risk Management The traditional way of evaluating a bank s position at a point in time proved to be inefficient Today s world of financial innovations and new markets make it very easy for a bank to become insolvent. This led to the rise of Risk Management which involves an evaluation of the bank s management process with respect to controlling risk. Copyright 2007 Pearson Addison-Wesley. All rights reserved Assessment of Risk Management Four elements of risk management: Quality of oversight provided (internally) Adequacy of policies (to limit risky activities) Quality of the risk measurement and monitoring systems Adequacy of internal controls Interest-rate risk limits Internal policies and procedures Internal management and monitoring Implementation of stress testing and Value-at risk (VAR) Copyright 2007 Pearson Addison-Wesley. All rights reserved

6 Disclosure Requirements Requirements to adhere to standard accounting principles and to disclose wide range of information This helps the markets assess the bank s portfolio and exposure to risk. Copyright 2007 Pearson Addison-Wesley. All rights reserved Consumer Protection Lenders are required to provide info. to consumers about the cost of borrowing and total finance changes associated with a loan. Same rules for credit card users. Copyright 2007 Pearson Addison-Wesley. All rights reserved Restrictions on Competition Competition decreases profitability Banks may try to maintain the same profit level by engaging in riskier activities Moral hazard Gov. imposes regulation to limit competition in the banking industry. Copyright 2007 Pearson Addison-Wesley. All rights reserved

7 What is the drawback? Limited competition leads to: higher charges on consumers decrease the efficiency of the banking sector Trend towards removal of restrictions Question: Which way is this trend going to change after the recent crisis? Copyright 2007 Pearson Addison-Wesley. All rights reserved Summary Understanding the theory behind regulation does not mean that regulation and supervision is easy in practice. Several Reasons: i) financial institutions have strong motives to avoid existing regulations ii) difficulty in supervising : small differences in details may have unintended consequences iii) regulators may face political pressures to not to do their jobs Copyright 2007 Pearson Addison-Wesley. All rights reserved Copyright 2007 Pearson Addison-Wesley. All rights reserved

8 Copyright 2007 Pearson Addison-Wesley. All rights reserved Copyright 2007 Pearson Addison-Wesley. All rights reserved