Transcript Economic Analysis of Banking Regulation

Economic Analysis of Banking
Regulation
Terri Worth
Xu Wang
Learning Objectives
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Explain banking regulation
New challenges for bank regulation
How CDIC handles failed banks
Recent CDIC developments
Banking Crises
Asymmetric Information
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Different parties in a financial
contract do not have the same
information.
Leads to adverse selection and
moral hazard problems.
Important in why we have banking
regulations.
Banking prior to 1967
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In the event of a bank failure,
depositors would have to wait to get
their money back until the bank was
liquidated.
Only get a fraction of their money
back.
Depositors didn’t know how much
risk their bank was taking on.
Reluctant to put money in banks.
Banking prior to 1967
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Depositor’s lack of information
about the quality of bank’s assets
can lead to bank panics.
Bank panics have serious
consequences for the economy.
Banking prior to 1967
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No deposit insurance.
Adverse shock hits the economy and 5%
of banks have such large losses they
become insolvent.
Depositors don’t know if their bank is one
of the ones suffering losses.
Depositors run to banks to get their
money out.
Failure of one bank hastens the failure of
others, and a bank panic can ensue.
7 Categories of Banking Regulation
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Government Safety Net
Restrictions on Bank Asset Holdings
Capital Requirements
Chartering and Bank Examination
Disclosure Requirements
Consumer Protection
Restrictions on Competition
Government Safety Net
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Deposit insurance provided by the
Canada Deposit Insurance
Corporation (CDIC).
Depositors are paid off in full on the
first $100,000.
Funds to pay off depositors are
acquired through insurance
premiums paid by the banks.
CDIC and Bank Failures
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1.
2.
CDIC has two methods to handle a
failed bank.
Payoff method
Purchase and assumption method
Payoff Method
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The CDIC allows the bank to fail
and pays off the deposits.
After the bank has been liquidated,
the CDIC pays off other creditors of
the bank with the proceeds from
the liquidated assets.
Typically, depositors with more than
the $100,000 limit, get back 90
cents on the dollar.
Purchase and Assumption Method
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The CDIC reorganized the bank.
Find a willing merger partner who takes
over all the failed bank’s deposits.
CDIC may subsidize the merger partner
by providing subsidized loans or
purchasing some of the weaker loans.
In this case the CDIC has guaranteed all
deposits.
Other Government Safety Nets
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Provide support to domestic banks
when they face a run.
Lending from the central bank.
Funds are provided directly by the
government to the troubled
institutions.
Troubled institutions are taken over
by the government. Governments
guarantees the deposits.
Moral Hazard and the Safety Net
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Depositors know that they will not
suffer a loss if the bank fails.
Do not impose market discipline on
banks by withdrawing funds when
they think the bank is taking on too
much risk.
Banks with government safety nets
have incentive to take on greater
risk.
Too Big to Fail
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Failure of large banks makes it
more likely that a major financial
disruption will occur.
Bank regulators are not likely to let
a large bank fail and cause losses.
Increases moral hazard incentives
for big banks.
Financial Consolidation and the Safety
Net
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Larger, more complex financial
institutions.
Increases the Too Big to Fail
problem.
Safety net may have to be extended
to new activities such as
underwriting, insurance, etc.
Restrictions on Asset Holdings and
Bank Capital Requirements
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Directed at limiting moral hazard.
Bank regulations restrict banks from
holding risky assets such as
common stock.
Promote diversification by limiting
the amount of loans to individual
borrowers or categories.
Requirements for banks to have
sufficient bank capital.
Leverage ratio
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The amount of capital divided by
the bank’s total assets.
A well capitalized bank has a
leverage ratio of 5% or more.
A leverage ratio below 3% triggers
increased regulatory restrictions on
the bank.
Basel Accord
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Basel Committee on Banking
Supervisions comprised of central
banks and supervisory authorities of
10 countries met in 1987 in Basel,
Switzerland.
Created the Basel I Accord in 1988.
Created the Basel II Accord in 2008.
Purpose of Basel I Accord
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Strengthen the stability of
international banking system.
Set up a fair and consistent
international banking system in
order to decrease competitive
inequality among international
banks
Purpose of Basel I Accord
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Define bank capital and the capital
ratio.
Set up a minimum risk-based
capital adequacy applying to all
banks and governments.
Defining Capital
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Tier 1 – Core Capital
Includes stock issues or share
holders equity and declared
reserves set aside to cushion
against future losses.
Tier 2 – Supplementary Capital
Includes all other capital such as
gains on investments, long term
debt and hidden reserves.
Capital Ratio
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Credit risk defined as the risk
weighted asset of the bank , assets
weighted in relation to their relative
level of credit risk.
Banks should hold as capital at least
8% of their risk weighted assets.
Asset Classes
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Assets are allocated into 4 classes,
each with a different weight to
reflect their credit risk.
Examples
Incorporating Market Risk
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In 1996 the Basel I Accord was
revised to include market risk.
General market risk refers to
changes in market values due to
large market movements.
Specific risk refers to changes in
value of an individual asset due to
factors related to the issuer.
Incorporating Market Risk
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1)
2)
Market risk can be calculated in
two ways:
Standardized Basel model.
Value at Risk (VaR) – estimate the
probability of losses based on the
statistical analysis of historical
price trends and volatilities.
Criticizing the Basel I Accord
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Limited differentiation of credit risk
Static measure of default risk
Capital charges are set at the same level
regardless of the maturity of a credit
exposure.
Capital requirements ignore the different
levels of risks associated with different
currencies and macroeconomic risk.
Doesn’t recognize portfolio diversification
effects.
Basel II
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Pillar 1 – intends to link capital
requirements more closely to actual risk.
Specifies many more categories of risk
with different weights.
Pillar 2 – strengthening the supervisory
process.
Assessing quality of risk management and
evaluating whether institutions have
adequate procedures to determine
needed capital.
Basel II
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Pillar 3 – improving market discipline
through increased disclosure.
Credit exposures, amounts of reserves
and capital, the chief officers, and
effectiveness of internal rating system.
Not scheduled to be implemented until
2008 because of increased complexity.
Banking Supervision
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Overseeing who operates a bank
and how in order to reduce moral
hazard and adverse selection.
Chartering – proposals for new
banks are screened to prevent
undesirables from controlling them.
Obtaining a Charter
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Charters obtained through an Act of
Parliament or application to the
Minister of Finance.
Application shows how they plan to
operate the bank.
Look at management, likely
earnings, and initial capital.
A charter may not be granted if
existing banks will suffer.
Examination
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Allow regulators to monitor whether
the bank is complying with capital
requirements and restrictions on
asset holdings.
CAMELS – capital adequacy, asset
quality, management, earnings,
liquidity, sensitivity to market risk.
Formal actions are taken if CAMELS
rating is too low.
4 Elements of Sound Risk
Management
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2.
3.
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Quality of oversight provided by
the board and senior management.
The adequacy of policies and limits
on risky activities.
The quality of risk measurement
and monitoring systems.
Adequacy of internal controls to
prevent employee fraud or
unauthorized activities.
Disclosure Requirements
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Regulators require banks to adhere
to certain standard accounting
principles and disclose a wide range
of information that helps the market
assess quality of a bank’s portfolio
and exposure to risk.
Consumer Protection
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Truth in lending - requires all
lenders to provide information to
consumers about the cost of
borrowing, including APR and total
finance charges.
Provide information on the method
of assessing finance charges.
Handle billing complaints quickly.
Restrictions on Competition
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Increased competition can increase
moral hazard for banks to take
more risk.
Preventing nonbank institutions
from engaging in banking business.
Led to higher charges to consumers
and decreased efficiency.
Electronic Banking
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In 1994 a Russian computer
programmer accessed Citibank’s
computers and moved funds to his
own accounts.
Stole more than $10 million with
$400,000 not recovered.
6 people were arrested and
mastermind was sentenced to 3
years in jail.
Challenges of E-banking Security
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Confidentiality
Authentication of Sender’s Identity
Integrity of the data
Non-repudiation
Time-stamp
Addressing E-Banking Challenges
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Regulate to make sure encryption
procedures are accurate.
Regulators assess how a bank deals
with security issues.
Assess the technical skills of banks
in setting up E-banking services.
Limit distribution of personal data.
International Banking Regulation
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Most developed countries are
similar to Canada – deposit
insurance, government regulations,
Basel Accord.
Problems occur when banks are
engaging in international banking
and can shift business from one
country to another.
International Banking Regulation
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Local regulators don’t have the
time/ability to watch operations in
other countries.
Not always clear who has authority.
Bank of Credit and Commerce
International (BCCI)
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False accounting used to hide hefty
loans to a small group of favored
clients.
Money laundering operations in the
Tampa branch.
Drug allegations.
Caught by Price Waterhouse when
they prepared accounts in 1990.
Bank of Credit and Commerce
International (BCCI)
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Registered in Luxembourg.
Operations in 70 countries with $20 billion
dollars in assets.
Key operations in London.
Jurisdiction for banking supervisions rests
with the country where branches are
based.
US authorities uncovered the fraud, but
had trouble convincing the UK.
Had to be closed down.
The 1980s Canadian Banking Crisis
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1923-1985 one in which the failure of
Canadian chartered banks was thought to
be impossible
Mid-1980s situation in Canada changed
dramatically with the failure of two
character banks and financial difficulties
for large number of other financial
institutions
Why did this happen?
Early Stages of the Crisis
The managers did not have the expertise
to manage risk.
 Rapid credit growth > available
information recourse of the banking
situation =>
Excessive Risk Taking
 The activities of Canadian Commercial
and Northland were expanding in scope
and were becoming more complicated,
requiring an expansion of regulatory
resources to monitor these activities
appropriately.
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Early Stages of the Crisis con’t
Late 1979-1981 Sharp increase in interest
rate =>
rapidly rising costs of funds for banks
 1981-1982 recession and collapse in the
price of energy and farm products hit the
economy so bad =>
defaults on many loans and negative net
worth for Canadian Commercial and
Northland
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Later Stages of the Crisis:
Regulatory Forbearance
Two main reasons why the Bank of
Canada and the Inspector General
of Banks opted for regulatory
forbearance are:
﹡ CDIC did not have sufficient funds
﹡ Regulators referred to sweep their
problems under the rug
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Political Economy of the Banking Crisis
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Principal-Agent Problem for Regulators and
Politicians
- Problem occurs because the agent (a politician
and regulator) does not have the same incentives
to minimize costs to the economy as the principal
(the taxpayer)
- Canadian Commercial and Northland debacle
indicate
﹡ loosened capital requirements
﹡ restriction on risky assets holding
﹡ purchasing regulatory forbearance
CDIC Developments
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The Canada Deposit Insurance Corporation (CDIC)
insures each depositor at member institutions up
to a loss of $100,000 per account.
All federally incorporated financial institutions and
all provincially incorporate trust and mortgage
loan companies are members of the CDIC
Insurance companies, credit unions, caisses
popularies are investment dealers are not eligible
for CDIC memberships
The Québec Deposit Insurance Board (QDIB)
insures provincially incorporated financial
institutions in Québec and the other provinces
have deposit insurance corporations that insure
the deposits of credit unions in their jurisdiction,
on term similar to the CDIC’s
CDIC Developments con’t
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Not all deposits and investments offered by CDIC
member institutions are insurable
- insurable deposit
﹡savings and chequing accounts
﹡term deposits with a maturity date of less than
five years
﹡money orders and drafts, certified drafts and
cheques, and traveler's cheques.
- CDIC does not insure
﹡term deposits with an initial maturity date of
more than five year
﹡treasury bills, bonds and debentures issued by
governments and corporations (including the
chartered banks)
﹡investments in stocks, mutual funds and
mortgages
Differential Premiums
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Differential Premiums means investments
with differencing risk profiles are subject
to different insurance premiums
The new system the premium rates for
CDIC member institutions
Premium Category
Premium Rate
(as a % of Insured Deposit)
1
1/24 of 1% or 0.0417%
2
1/12 of 1%, or 0.0833%
3
1/6 of 1%, or 0.1667%
4
1/3 of 1%, or 0.3333%
Copyright © 2008 Pearson Education Canada
Opting-out
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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 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
The most important feature is its minimization
of 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
Limits on the Scope of Deposit
Insurance
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CDIC’s reductions of the scope of
deposit insurance by limiting
insurance to insured deposit
Deposit insurance should be
eliminated entirely
Coinsurance
A lower limit on deposit insurance
Too-big-to fail
Prompt Corrective Action
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Requires regulators to intervene
early when bank capital begins to
fall
Regulation no longer have the
option of regulator forbearance
Risk-Based Insurance Premiums
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Consequently reduce the moral
hazard incentives for banks to take
on higher risk
One problem is scheme for
determining the amount of risk the
bank is taking may not be very
accurate
Other CDIC Provisions
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Regulators perform frequent bank
examinations
Allows CDIC discretion in
examining the performance of
problem member institutions
Other Proposed Changes in Banking
Regulations
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Regulations
- three federal agencies
﹡Bank of Canada
﹡Office of the Superintendent of
Financial Institution
﹡CDIC
Market Value Accounting For Capital
Requirement
Banking Crisis Throughout the World
Copyright © 2008 Pearson Education Canada
United States
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1980s saving and loans (S&L)
- Financial innovation and new financial
instruments increasing risk taking
- Increased deposit insurance led to increased
moral hazard
- Deregulation
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﹡Depository Institutions Deregulation and
Monetary Control Act of 1980
﹡Depository Institutions Act of 1982
Brokered deposits means enable depositors to
circumvent the US$100,000 limit on deposit insurance
United States Banking Crisis con’t
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Financial innovation and deregulation led to
expanded powers for S&L industry several
problems
- S&L managers did not have the required
expertise to manage risk
- New expanded powers
- FSLIC had neither the expertise nor the
resources that would have enabled them to
monitor these new activities sufficiently
Zombie S&Ls taking on high risk projects and
attracting business from healthy S&Ls
In the late 1980s, collapse of real estate market
led to additional huge loan losses
Scandinavia
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Before 1980s, banks were highly
regulated and subject to restrictions on
the interest rate
Late 1980s, real estate prices collapsed,
massive loan losses resulted
- Reason: the lack expertise in the
banking industry and its regulatory
authorities in keeping risk taking in check,
banks engaged in risky lending
Latin America
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Similar to Canada, the United States, and Scandinavia
Before 1980s, banks were owned by Government and
were subject to interest rate restrictions
Lending boom in the fact of inadequate expertise on the
part of both bankers and regulators => massive loan
losses and inevitable government bailout
Banking panic erupted in October and November 2001,
with the Argentine public rushing to withdraw their
deposits
On December 1, after losing US $8 billion of deposits, the
government imposed a US $1000 monthly limit on deposit
withdrawals. Then, the collapse of the peso and the banks
must pay back their dollar deposits at a higher exchange
value, the deficit getting worse.
Russia and Eastern Europe
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On August 24, 1995, a bank panic occurred in
Russia when the interbank loan market seized up
and stopped functioning because of concern about
the solvency of many new banks
On August 17,1998, government announced that
Russia would impose a moratorium on the
repayment of foreign debt because of insolvencies
in the banking system.
In November, the Russian central bank
announced that nearly half of the country’s 1500
commercial banks might go under and the cost of
the bailout is expected to be on the order of US
$15 billion
Japan
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Before the 1980s, Japan’s financial markets were among the
most heavily regulated in the world, with very strict restrictions
on the issuing of securities and interest rate
In the early 1990s, property values collapsed, the banks were
left holding massive amounts of bad loans
- lending market by setting up the so-called jusen
- home mortgage lending companies that raised funds by
borrowing from banks and then lending these funds out to
household
- Seven of these jusen became insolvent, leaving banks with the
bad loans
In July 1995, Tokyo-based Cosmo Credit Corporation, Japan’s
fifth-largest credit union failed
On August 30, Kizu Credit Cooperative, Japan’s second-largest
credit union closed. Hyogo Bank, the first commercial bank was
liquidating
In later 1996, the Hanwa Banks, a large regional bank was failed.
In November 1997, Hokkaido Takushoku Bank was closed during
the crisis
Going through a cycle of forbearance similar to the one that
occurred in the United States in the 1980s
Japan Banking Crisis con’t
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In the middle of 1998, Japanese government
began to take some steps to attack problems
- In June, reports directly to the prime minister
- In October, the parliament passed a bailout
package of US $500 billion (60 trillion yen)
- the banking sector in Japan thus remains in
very poor shape
After 1998, Long-term Credit Bank of Japan
declared insolvent
In December 1998, Nippon Credit Bank was
finally put out of its misery and closed down
In 2003, the fifth-largest bank, Resona, was
declared insolvent and nationalized.
With the pickup of the Japanese economy in 2003,
bad loans in Japanese banks finally began falling
China
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Banking problem nearly as sever as that in Japan
In 1998, the Chinese government injected US $30 billion
into four largest banks, all state-owned-industrial and
Commercial Bank of China, Agricultural Bank of China,
Bank of China, and China Reconstruction Bank
Another US $170 billion injection in 2000-2001
In 2004, entered into third bailout, over US $100,000
billion
Trouble for state-owned banks
- lent massively to unprofitable state-own enterprise
- notoriously inefficient
How to solve the crisis?
- speed up their disposal of nonperforming loans
- close unprofitable branches
- lay off unproductive employees
East Asia
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In the summer 1997, the lending
booms that arose in the aftermath
of financial liberalization led to
substantial loans losses, which
became huge after the currency
collapse
Already discussed in the Chapter 8
“Déjà vu All Over Again”
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The parallels between the banking
crisis episodes that have occurred in
countries throughout the world are
striking, indicating that similar
forces are at work
It is the existence of a government
safety net that increases moral
hazard incentives for excessive risk
taking on the part of banks
Questions