economic analysis of banking regulation

Government safety net: Deposit insurance and the CDIC Short circuits bank failures and contagion effect Payoff method Purchase and assumption method Government can support banks through lending from the central bank “Lender of Last Resort” role for central bank Government can provide funds directly to institutions in need

Chapter 10

Economic Analysis of

Banking Regulation

Asymmetric Information and Bank Regulation I

• Government safety net: Deposit insurance and the CDIC

– Short circuits bank failures and contagion effect

– Payoff method

– Purchase and assumption method

• Government can support banks through lending from the central bank

– “Lender of Last Resort” role for central bank

– Government can provide funds directly to

Asymmetric Information and Bank Regulation II

– Risk-lovers find banking attractive

– Depositors have little reason to monitor bank

Too Big to Fail

• Failure of very large financial institution makes it

more likely that major financial disruption will occur

• Regulators unwilling to let large institutions fail

• Government provides guarantees of repayment to

large uninsured creditors of the largest banks which reduces investors incentive to monitor banks

activities

• Increases moral hazard incentives for big banks

making a financial crisis more likely

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

Restrictions on Asset Holding

• Even without government intervention banks have

incentive to take more risk as risky assets provide

higher returns

• Full information to creditors/depositors on banks

risk-taking activities might mitigate problem

• Government regulation directly attempts to restrict banks from too much risk taking

– Restrict holdings of common stock

– Promote diversification

Capital Requirements

• Government can impose set capital

requirements

– Minimum leverage ratio (amount of capital

divided by the bank’s total assets)

• Increase in off balance sheet activities a

concern

– Basel Accord: risk-based capital requirements

– Regulatory arbitrage

Financial 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

– Sensitivity to market risk

• Filing periodic ‘call reports’

Assessment of Risk Management

• 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 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 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

International Banking Regulation

The 1980s Canadian Banking Crisis I

banks in Alberta failed and a large number of other institutions were having financial difficulties

The 1980s Canadian Banking Crisis II

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

- Insolvencies 

- Incentives for risk taking 

Result: Failures  and risky loans 

The 1980s Canadian Banking Crisis III

Later Stages: Regulatory Forbearance

Regulators allow insolvent banks to operate because

A Insufficient funds to close insolvent banks and pay

off their deposits

B Sweep problems under rug

Insolvencies caused further banking difficulties

CDIC Developments I

• 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

CDIC Developments I

• 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

• Not all deposits and investments offered by CDIC

member institutions are insurable

Not 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 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.

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

Opting-Out I

• 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 II

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 taking activities of banks, thereby reducing moral

risk-hazard risk

Evaluating CDIC I

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

Evaluating CDIC II

Risk-based Insurance Premiums

- Scheme for determining risk, it is accurate?

Other CDIC Provisions

- Gives CDIC discretion in examining performance of

problem institution

Other Proposed Changes

- Regulatory consolidation

- Market-value accounting

Banking Crisis Throughout The World

Deja Vu All Over Again

• Deposit insurance not important role for many countries experiencing banking crises

• It is the existence of a government safety net that increases moral hazard incentives for

excessive risk taking on the part of banks

The Costs of Rescuing Banks in Several

Countries

Financial Regulation after Subprime

Financial Crisis

• Increased Regulation of Mortgage Brokers

• Fewer Subprime Mortgage Products

• Regulation Compensation

• Higher Capital Requirements

• Additional Regulation of Privately Owned

Government-Sponsored Enterprises