Transcript Document

Chapter 11
Economic Analysis of
Banking Regulation
11.1
© 2008 Pearson Education Canada
Asymmetric Information
and 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
11.2
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Too 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
11.3
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Financial 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
11.4
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Restrictions on Asset Holding
and 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
11.5
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Bank (Prudential) Supervision:
Chartering 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
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Capital adequacy
Asset quality
Management
Earnings
Liquidity
Sensitivity to market risk
• Filing periodic ‘call reports’
11.6
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Assessment of Risk
Management
• Greater emphasis on evaluating soundness of
management processes for controlling risk
• Focus is four elements of risk management
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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)
11.7
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Disclosure Requirements
• Requirements to adhere to standard
accounting principles and to disclose wide
range of information
• Eurocurrency Standing Committee of the G10 Central Banks also recommends
estimates of financial risk generated by the
firm’s internal monitoring system be adapted
for public disclosure
11.8
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Consumer 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
11.9
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Restrictions on
Competition
• Justified by moral hazard incentives to take
on more risk as competition decreases
profitability
• Disadvantages
– Higher consumer charges
– Decreased efficiency
11.10
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International Banking
Regulation (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
11.11
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Regulation
• Applies to a moving target
– Calls for resources and expertise
• Details are important
• Political pressures
11.12
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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
11.13
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Why a Banking Crisis in
1980s? (Cont’d)
Early Stages (continued)
4. inflation  interest rates , net worth of banks 
- Insolvencies 
- Incentives for risk taking 
Result: Failures  and risky loans 
11.14
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Why a Banking Crisis in
1980s? (Cont’d)
Later Stages: Regulatory Forbearance
Regulators allow insolvent banks to operate because
A. Insufficient funds
B. Sweep problems under rug
11.15
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Political Economy of
the Banking Crisis
Explanation: Principal-Agent Problem
1. Politicians influenced by bank lobbyists rather
than public
A. Deny funds to close banks
B. Legislation to relax restrictions
2. Regulators influenced by politicians and
desire to avoid blame
A. Loosened capital requirements
B. Regulatory restrictions on risky asset
holdings
C. Regulatory forbearance
11.16
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CDIC 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
11.17
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Not All Deposits Are
Insurable
Insurable deposits include
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Savings and chequing accounts
Term deposits with a maturity date < 5 years
Money orders and drafts, certified drafts and cheques,
and traveller’s cheques
The 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.
11.18
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Differential 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
11.19
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Opting-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
11.20
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Opting-Out
(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
11.21
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Evaluating CDIC
Limits on Scope of Deposit Insurance
1. Eliminate deposit insurance entirely
2. Lower limits on deposit insurance
3. Eliminate too-big-to-fail
4. Coinsurance
Prompt Corrective Action
1. Critics believe too many loopholes
2. However: accountability increased by
mandatory review of bank failure resolutions
11.22
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Evaluating CDIC
(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
11.23
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Banking Crisis Throughout The World
(Cont’d)
11.24
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Deja Vu
• It is the existence of a government safety net
that increases moral hazard incentives for
excessive risk taking on the part of banks
11.25
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