1. © 2008 Pearson Education Canada11.1 Chapter 11 Economic Analysis of Banking Regulation

2. © 2008 Pearson Education Canada11.2 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

3. © 2008 Pearson Education Canada11.3 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

4. © 2008 Pearson Education Canada11.4 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

5. © 2008 Pearson Education Canada11.5 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

6. © 2008 Pearson Education Canada11.6 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 –Capital adequacy –Asset quality –Management –Earnings –Liquidity –Sensitivity to market risk Filing periodic ‘call reports’

7. © 2008 Pearson Education Canada11.7 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)

8. © 2008 Pearson Education Canada11.8 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

9. © 2008 Pearson Education Canada11.9 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

10. © 2008 Pearson Education Canada11.10 Restrictions on Competition Justified by moral hazard incentives to take on more risk as competition decreases profitability Disadvantages –Higher consumer charges –Decreased efficiency

11. © 2008 Pearson Education Canada11.11 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

12. © 2008 Pearson Education Canada11.12Regulation Applies to a moving target –Calls for resources and expertise Details are important Political pressures

13. © 2008 Pearson Education Canada11.13 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

14. © 2008 Pearson Education Canada11.14 Why a Banking Crisis in 1980s? (Cont’d) Early Stages (continued)  inflation  interest rates , net worth of banks  -Insolvencies  -Incentives for risk taking  Result: Failures  and risky loans 

15. © 2008 Pearson Education Canada11.15 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

16. © 2008 Pearson Education Canada11.16 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

17. © 2008 Pearson Education Canada11.17 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

18. © 2008 Pearson Education Canada11.18 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.

19. © 2008 Pearson Education Canada11.19 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

20. © 2008 Pearson Education Canada11.20 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

21. © 2008 Pearson Education Canada11.21 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

22. © 2008 Pearson Education Canada11.22 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

23. © 2008 Pearson Education Canada11.23 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

24. © 2008 Pearson Education Canada11.24 Banking Crisis Throughout The World (Cont’d)

25. © 2008 Pearson Education Canada11.25 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