Regulation of banks Flashcards
What are the three main differences between banks and non-financial firms ?
- Banks engaged in maturity transformation
- Banks finance loans typically characterized by asymmetric information
- Cusomers of bank = creditors
What are the consequences about banks as maturity transformators ?
- Inherently unstable and prone to liquidity crises
* Risk of financial contagion
What is the consequence about banks as delegated monitors ?
- Banks’ assets = opaque + hard to value for outsiders
* Huge liquidation costs due to loss of information capital
What is the consequence of customers being the banks’ creditors
Banks are financed by large numbers of uninformed depositors.
What are the justifications behind bank regulation ?
- Market failure
- Customer protection
- Favoritism of interest groups and other pollical reasons
Why do banks emerge ?
Because they reduce market imperfections mainly caused by asymmetric information
What happens when a bank suddenly fails ?
It confronts its customers and the public with the market imperfections
What are the strong negative externalities of bank failures ?
- Contagion may affect other institutions without any direct links to failing bank
- Failing bank’s borrowers face sudden refinancing + liquidity problems as loans = opaque and cannot be easily transferred to other institutions
- Costs of default inflicted upon small uninformed depositors may be politically unacceptable
Why do negative externalities cause market failure ?
Banks ignore costs of negative externalities when making economic decisions
What happens as government and/or central bank rescues large banks to prevent contagion and liquidity crises in real sector ?
- Large banks enjoy implicit subsidies as creditors anticipate government aid
- Anticipation of eventual government aid induces moral hazard + gives banks incentive to take excessive risks
What are the reasons behind customer protection ?
- Non-financial firms usually financed by professional, well-informed creditors
- In contrast, banks finance themselves in large parts with deposits from small uniformed and dispersed agents
- Deposits and payment services offered by banks play crucial role in economic transactions
What are the main problems affecting public regulation in practice ?
- Regulatory capture
- Forbearance
- Biased objectives
What is the problem with the regulatory capture and public regulation ?
Authorities advance concerns of sector they regulate instead of pursuing optimal regulation
What is the problem with the forbearance and public regulation ?
Authorities try to avoid conflicts or to cover up own mistakes
What is the problem with the biased objectives and public regulation ?
Authorities follow policial goals such as promoting national champions instead of implementing optimal regulation.
What are the two tools of public regulation for maintaining financial stability ?
- Preventive (ex-ante) measures
* Curative(ex-post) measures
What are the objectives of the preventive measures ?
- Aim at increasing banks’ safety and soundness
* Reduce potential for contagion
What are the curative measures’ objectives ?
- Support banks to avoid failure
* Reduce fallout of eventual failures
What is meant by asset restrictions ?
Banks either required to hold certain assets or restricted from certain investments as for example :
- Requrirement to hold bonds
- Restrictions on holding shares
- Encadrement du crédit
What are the drawbacks from asset restrictions ?
- Regulator has to determine assets too risky to hold
* Likely to be misused for political goals
What is meant by restrictions on activities ?
Banks prohibited from undertaking certain activities or offering certain products
What are the advantages and disadvantages of restrictions on activities ?
• Advantages
o Separation of retail/commercial banking from investment banking reduces risk of cross-contamination
o Better allocation of resources form societal perspective
• Disadvantages
o Less diversification
o Loss of synergies
What are the consequences of the advantages of restrictions on activities ?
- High private return investment banking may crowd-out resources from high societal return commercial banking
- Avoid cross-subsidization of investment banking activities via cheap funding obtained from deposit taking
What is meant by limits on interbank-competition ?
Limit competition in banking sector and create rents for banks
What are the various regulatory tools ?
- Asset restrictions
- Restrictions on activities
- Limits on interbank-Competition
- Limits to large exposures
- Liquidity requirements
- Capital requirements
- Deposit insurance
- Lending of last resort
- State guarantees and bail outs
What is the potential trade-off between financial stability and full competition ?
- Banks’enjoy limited liability + have private knowledge about risk of their opaque assets
- Value of banking licenses increases if competition limited and banks can earn rents
What is the consequence to the bank’s enjoy limited liability and private knowledge about their opaque assets ?
Incentive for banks to take excessive risks at public’s and uninformed depositors’ expense
What are the consequences of banking licenses ?
- Failing and loosing banking license more costly in case of limited competition → less excessive risk taking
- Limited competition may lead to higher financial stability
What is Keeley’s empirical stragegy ?
• Analyze risk taking behavior of 150 largest US bank holding companies between 1970 and 1986
• Measure market power using Tobin’s q :
q = Mkt value / book value
→ Banks with mkt power earn rents and exhibit a high q
What is the simultaneity problem faced by Keeley ?
Mkt value is itself influenced by bank’s risk taking decision
→ Banks take more risk because increases mkt value
Use regulatory changes as instruments : influence mkt power q but are independent of banks risk taking decision
What were Keeley’s main results ?
- Mkt power negatively related to degree of liberalization in banking sector
- Mkt power has large and significantly effect on banks’ risk-taking behavior
Why do newer empirical studies question Keeley’s results ?
- Interest rate shocks = main cause for increase in bank failures in 1980s & 1990s
- Financial risks = mainly interest rate & exchange rate risk → generally increased after Bretton-Woods-System’s demise
→ Translate into higher risk in banks’ BS
What are the policy implications of the limits Interbank-Competition
- Limits on competition in banking sector may not be worth efficiency costs
- However, banks in liberalized mkts should be monitored closely as banking crises often occur after deregulations
→ Special emphasis on large exposure limits, liquidity regulation and especially capital requirements
What is meant by limits on large exposures ?
Limit maximum exposure vis-a-vis an individual counterparty in order to :
• Ensure diversificaiton
• Mitigate risk of contagion
What is the aim of liquidity requirements ?
Aim at ensuring banks have enough liquid funds to cover eventual outflows
What does liquidity requirements prevent ? And why is it especially important ?
- Mitigate risk of contagion
* May be especially important if competition amon bank is intense as holding liquidity has opportunity costs
What is the objectif of capital requirements ?
Strengthen banks’ safety and soundness by requiring adequate loss.absorption capacity
What are the aims of deposit insurance ?
Ex-ante as well ex-post tool that aims at two goals :
- Ex-ante : preventing bank runs by reassuring depositors
- Ex-post : reducing depositors’ losses in case of failure
Why is the government the natural and most credible provider of deposit insurance ?
Due to its ability to tax
When does deposit insurance represent an implicit subsidy ?
When it is priced below actuarially fair premium
When does deposit insurance induce moral hazard ?
When the premium is not correctly adjusted for risk
Who is the lender of last resort and why ?
Central banks because of its ability to create money
What is meant by state guarantees & bailouts ?
In case of insolvency, government injects capital into bank or provides guarantee for all or some of banks’ liabilities
What is meant by the bank’s problems are resolved in an orderly fashion ?
Without undue costs for real economy and stress for financial system
What are the tools available to solve the banks’ problemes in an orderly fashion ?
- Debt restructuring
- Merger
- Bridge bank
- Wind down/liquidation
What are the advantages and drawbacks of self-regulation ?
Advantages
• Lower costs and higher efficiency
• Higher flexibility and speed
• Better acceptance within industry
Drawbacks
• Potential for conflicts of interest
• Risk of creating mkt power
• Lack of transparency
What is the main intuition of the self-regulation’s theoretical model (DeMarzo) ?
Large number of agents compete and offer contracts in which repayment to customers depends on risky cash flow
• Realization of CF = privat information to agents
→ Moral hazard : agents misreport realized CF
→ Agents need to be disciplined, otherwise no trade
What are the two possibilities to discipline the agents and avoid misreporting in DeMarzo’s model ?
- Carrot: offer agents bonus directly depending on realized CF and allows to earn rents
- Sich: Perform investigations and sanction misreporting agents
→ Agents prefer carrot which allows to earn rents
What is meant by the fact that SRO and government can perform costly investigations ?
- SRO = cost efficient but acts in agent’s interest
- Government = inefficient but acts in customers’ interest
→ SRO confers mkt power to agents by favoring rents over investigations
→ Government relies more on investigations but is inefficient
What is the solution to increase investigations performance ?
SRO with government insight:
- SRO in charge of performing cost efficient investigations
- Government oversees SRO and threatens to step in if SRO implements too lax investigation policy
→ Governement’s threat forces SRO to choose stricter investigation policy that gives agents less mkt power
