Economic
Analysis of
Banking
Regulation
Preview
the banks are among the most heavily
regulated of financial institutions. In
this chapter, we develop an economic
analysis of Banking regulations ;
why regulation of banking takes the
form it does; banking crisis; and how
the regulatory system can be
reformed to prevent future disasters.
Basic categories of
banking
There are eight basic categories of
banking regulation:
The government safety net,
restrictions on bank asset holdings,
capital requirements,
chartering and bank examination,
assessment of risk management,
disclosure requirements,
consumer protection, and
restrictions on competition
Questions
1. What are we studying in this
chapter?
2. Identify the basic categories
of regulations
Government Safety Net:
Deposit Insurance and
the FDIC
\
The asymmetric information problem leads
to two reasons why the banking system
might not function well.
First a bank failure meant that depositors
would have to wait to get a fraction of
their deposit funds until the bank was
liquidated.
Second the depositors’ lack of
information aboutthe quality of bank assets can lead to bank panics
Safety net
Typically, a government safety
net for depositors in the US
short-circuit runs on banks
and bank panics, and by
providing protection for the
depositor, it can overcome
reluctance to put funds in the
banking system.
Deposit insurance
One form of the safety net is
deposit insurance, FDIC),
in the United States in which
depositors are paid off in
full on the first $100,000
they have deposited in the
bank
The FDIC uses two primary
methods to handle a failed bank.
In the first, called the payoff
method, the FDIC allows the bank
to fail and pays off deposits up to
the $100,000 insurance limit .
deposits
n the second method, called
the purchase and
assumption method, the
FDIC reorganizes the bank, by
finding a willing merger partner
who assumes all of the failed
bank’
Lender of the last resort
In most countries, governments
provide support to domestic
banks when they face runs by
lending
from the central bank to troubled
institutions and is often referred to as
the “lender of last resort” role of the
central bank.
Inother cases, funds are
provided directly by the
government to troubled
institutions, or these
institutions are taken over by
the government which then
guarantees that depositors will
receive their money in full
Questions
1. Indicate two reasons that lead why
asymmetric information undermines
proper functions of the banks.
2. State the importance of FDIC for the
depositors and the use of banks .
3. Identify two primary methods that
FDIC USES to handle a failed bank.
4. State the ways other countries help
troubled banks
Moral hazard and the
gov’t safety net
Because the existence of
insurance provides increased
incentives for taking risks that
might result in an insurance
payoff, depositors do not
impose the discipline of the
marketplace on banks by
withdrawing deposits when they
suspect that the bank is taking on
too much risk.
Adverse Selection and
the Government Safety
Net
In addition, Risk-loving
entrepreneurs might find the
banking industry a particularly
attractive one to enter—they
know that they will be able to
engage in highly risky activities.
Even worse, because
protected depositors have so
little reason to monitor the bank’s
activities.
“Too Big to Fail.”
Because the failure of a very
large bank makes it more
likely that a major financial
disruption will occur, bank
regulators are naturally
reluctant to allow a big bank
to fail and cause losses to its
depositors
One problem with the too-big-to-fail
policy is that it increases the
moral hazard incentives for big
banks, because, large depositors
with more than $100,000 who
would suffer losses if the bank
failed, and thus should have
monitored the bank activities, have
little to worry because of the “too
big to fail” exception.
Questions
1.Indicate how the safety net
affected the adverse selection
and moral hazard problems.
Restrictions on Asset Holdings
and Bank Capital Requirements
Restrictions on asset
holdings
Bank regulations that restrict
banks from holding risky assets
such as common stock are a direct
means of making banks avoid too
much risk. Bank regulations also
promote diversification, which
reduces risk by limiting the amount
of loans in particular categories or to
individual borrowers. Requirements
that banks have sufficient
Bank capital requirement
Requirements that banks have
sufficient bank capital are
another way to influence the
bank’s incentives to take on less
risk. When a bank is forced to hold
a large amount of equity capital,
the bank has more to lose if it fails
and is thus more likely to pursue
less risky activities
Bank Supervision: Chartering
and Examination
Overseeing who operates banks and
how they are operated, referred to as
bank supervision is an important
method for reducing adverse selection
and moral hazard in the banking
business because banks can be used
by crooks or overambitious
entrepreneurs to engage in highly
speculative activities. Chartering
banks is one method for preventing
this adverse selection problem.
Regular on-site bank
examinations, which allow
regulators to monitor whether
the bank is complying with
capital requirements and
restrictions on asset holdings,
also function to limit moral
hazard. Bank examiners give
banks a so-called CAMELS
.Bank examiners give banks a so-
called CAMELS rating (the acronym
is based on the six areas assessed:
capital adequacy, asset quality,
A commercial bank obtains a
charter either from the Comptroller
of the Currency (in the case of a
national bank) or from a state
banking authority (in the case of a
state bank). To obtain a charter, the
people planning to organize the
bank must submit an application
that shows how they plan to
operate the bank
Assessment ofRiskRisk
Assessment of Management
Management
Bank examiners are now placing
far greater emphasis on
evaluating the soundness of a
bank’s management processes
with regard to controlling risk.
Now bank examiners give a
separate risk management rating
from 1 to 5 that feeds into the
overall management rating as
part of the CAMELS system
Four elements of sound risk
management are assessed in
management rating: (1) The
quality of oversight (2) the
adequacy of policies (3) the
quality of the risk
measurement and monitoring
systems, and (4) the adequacy
of internal controls.
regulators can enforce regulations
by taking such formal actions as
cease and desist orders to alter
the bank’s behavior or even
close a bank if its CAMELS rating
is sufficiently low. Actions taken to
reduce moral hazard by restricting
banks from taking on too much risk
help reduce the adverse selection
problem
Disclosure Requirements
Toensure that there is better
information for depositors and the
marketplace, regulators can require
that banks adhere to certain
standard accounting principles and
disclose a wide range of information
that helps the market assess the
quality of a bank’s portfolio and the
amount of the bank’s exposure to
risk.
Consumer Protection
Consumer protection requires that :
all lenders, not just banks, to
provide information to consumers
about the cost of borrowing andthe
total finance charges on the loan;
prohibition of discrimination by
lenders based on race, gender,
marital status, age, or national
origin
Restrictions on
Competition
Increased competition can
also increase moral hazard
incentives for banks to take
on more risk. Declining
profitability as a result of
increased competition could
tip the incentives of bankers
toward assuming greater risk
in an effort to maintain
aneffort to maintain former
profit levels. Thus
governments in many
countries have instituted
regulations to protect banks
from competition.
International Banking
Regulation
Banks are chartered and
supervised by government
regulators. Deposit insurance is
also a feature of the regulatory
systems in most developed
countries although its coverage
may vary. bank capital
requirements are standardized
across countries with agreements
like the Basel Accord.
