© 2008 pearson education canada11.1 chapter 11 economic analysis of banking regulation

© 2008 Pearson Education Canada11.1

Chapter 11Chapter 11Economic Analysis of Banking Regulation


Asymmetric Information Asymmetric Information and Bank Regulationand Bank Regulation

• Government safety net: Deposit insurance and

the CDIC– Short circuits bank failures and contagion effect– Payoff method– Purchase and assumption method

• Moral Hazard– Depositors do not impose discipline of marketplace– Banks have an incentive to take on greater risk

• Adverse Selection– Risk-lovers find banking attractive– Depositors have little reason to monitor bank


Too Big to FailToo Big to Fail

• Government provides guarantees of repayment to large uninsured creditors of the largest banks even when they are not entitled to this guarantee

• Increases moral hazard incentives for big banks


Financial ConsolidationFinancial Consolidation

• Larger and more complex banking organizations challenge regulation– Increased “too big to fail” problem– Extends safety net to new activities, increasing

incentives for risk taking in these areas


Restrictions on Asset Restrictions on Asset Holding Holding and Bank Capital Requirementsand Bank Capital Requirements

• Attempts to restrict banks from too much risk taking

– Promote diversification– Prohibit holdings of common stock– Set capital requirements

• Minimum leverage ratio• Basel Accord: risk-based capital requirements• Regulatory arbitrage


Bank (Prudential) Supervision: Bank (Prudential) Supervision: Chartering and ExaminationChartering and Examination

• Chartering (screening of proposals to open new banks) to prevent adverse selection

• Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard– Capital adequacy– Asset quality– Management– Earnings– Liquidity– Sensitivity to market risk

• Filing periodic ‘call reports’


Assessment of Risk Assessment of Risk ManagementManagement

• Greater emphasis on evaluating soundness of management processes for controlling risk

• Focus is four elements of risk management– Quality of oversight provided– Adequacy of policies and limits – 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)


Disclosure RequirementsDisclosure Requirements

• Requirements to adhere to standard accounting principles and to disclose wide range of information

• Eurocurrency Standing Committee of the G-10 Central Banks also recommends estimates of financial risk generated by the firm’s internal monitoring system be adapted for public disclosure


Consumer ProtectionConsumer Protection

• Requires lenders to provide information to consumers on the costs of borrowing (including a standardized interest rate)

• Requires provision of information on the method of assessing finance charges

• Requires that billing complaints be handled quickly


Restrictions on Restrictions on CompetitionCompetition

• Justified by moral hazard incentives to take on more risk as competition decreases profitability

• Disadvantages– Higher consumer charges– Decreased efficiency


International Banking International Banking Regulation Regulation (Cont’d)(Cont’d)

• Similar to Canada– Chartered and supervised– Deposit insurance– Capital requirement

• Particular problems– Easy to shift operations from one country

to another– Unclear jurisdiction lines


RegulationRegulation

• Applies to a moving target– Calls for resources and expertise

• Details are important

• Political pressures


Why a Banking Crisis in 1980s?Why a Banking Crisis in 1980s?Early Stages

1. Managers did not have the required expertise to manage risk

2. The existence of CDIC, more opportunities for risk taking

3. Because of the lending boom, bank activities were becoming more complicated. Regulators had neither the expertise nor the resources to monitor these activities appropriately


Why a Banking Crisis in 1980s? Why a Banking Crisis in 1980s? (Cont’d)(Cont’d)

Early Stages (continued)

inflation interest rates , net worth of banks - Insolvencies - Incentives for risk taking

Result: Failures and risky loans


Why a Banking Crisis in 1980s? Why a Banking Crisis in 1980s? (Cont’d)(Cont’d)

Later Stages: Regulatory Forbearance

Regulators allow insolvent banks to operate becauseA. Insufficient funds B. Sweep problems under rug


Political Economy ofPolitical Economy ofthe Banking Crisisthe Banking Crisis

Explanation: Principal-Agent Problem1.Politicians influenced by bank lobbyists rather

than publicA. Deny funds to close banksB. Legislation to relax restrictions

2.Regulators influenced by politicians and desire to avoid blameA. Loosened capital requirementsB. Regulatory restrictions on risky asset

holdingsC.Regulatory forbearance


CDIC DevelopmentsCDIC Developments• CDIC insures each depositor at member institutions up to a

loss of $100 000 per account • All federally incorporated financial institutions and all

provincially incorporated TMLs are members of the CDIC• Insurance companies, credit unions, caisses populaires, and

investment dealers are not eligible for CDIC • QDIB insures provincially incorporated institutions in Québec

and the other provinces have deposit insurance corporations that insure the deposits of credit unions

• Not all deposits and investments offered by CDIC member institutions are insurable


Not All Deposits Are InsurableNot All Deposits Are Insurable

Insurable deposits include• Savings and chequing accounts• Term deposits with a maturity date < 5 years• Money orders and drafts, certified drafts and cheques,

and traveller’s chequesThe CDIC does not insure• Foreign currency deposits or term deposits with maturity

date > 5 years• T-bills, bonds and debentures issued by governments and

corporations (including the chartered banks)• Investments in stocks, mutual funds, and mortgages.


Differential PremiumsDifferential Premiums

• Differential premiums means investments with differing risk profiles are subject to different insurance premiums

• Premium categories range from 1 (best) for a well capitalized bank, to 4 (worst) for a significantly under capitalized bank


Opting-OutOpting-Out

• Permits Schedule III banks, that accept primarily wholesale deposits (defined as $150 000 or more), to opt out of CDIC membership and therefore to operate without deposit insurance

• It requires, however, an opted-out bank to inform all depositors, by posting notices in its branches, that their deposits will not be protected by the CDIC, and not to charge any early withdrawal penalties for depositors who choose to withdraw


Opting-Out Opting-Out (Cont’d)(Cont’d)

Implications:• Minimizes CDIC exposure to uninsured deposits• By compensating only the insured depositors

rather than all depositors, this legislation increases the incentives of uninsured depositors to monitor the risk-taking activities of banks, thereby reducing moral hazard risk


Evaluating CDIC Evaluating CDIC

Limits on Scope of Deposit Insurance1.Eliminate deposit insurance entirely2.Lower limits on deposit insurance3.Eliminate too-big-to-fail4.Coinsurance

Prompt Corrective Action1.Critics believe too many loopholes2.However: accountability increased by

mandatory review of bank failure resolutions


Evaluating CDIC Evaluating CDIC (Cont’d)(Cont’d)

Risk-based Insurance Premiums - Scheme for determining risk, it is accurate?

Other CDIC Provisions - Regulators perform frequent examinations - Gives CDIC discretion in examining performance

of problem institution

Other Proposed Changes - Regulatory consolidation - Market-value accounting


Banking Crisis Throughout The World Banking Crisis Throughout The World (Cont’d)(Cont’d)


Deja VuDeja Vu

• It is the existence of a government safety net that increases moral hazard incentives for excessive risk taking on the part of banks

© 2008 pearson education canada11.1 chapter 11 economic analysis of banking regulation

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