Financial Intermediation - Bank

Regulations

2013-2014

Learning Outcomes
2

FINANCIAL INTERMEDIATION

BANK REGULATION

Clearly recognise the problems created by

liquidity transformation
Thoroughly analyse well-established
principles of the theory of bank runs
Fully describe and critically analyse the
system of international regulation of bank
capital adequacy with minimum guidance
List and carefully analyse the arguments in
favour of, and against, banking regulation

2013 Lillibeth Ortiz

Contents
3

Questions
4

A.
B.
C.
D.
E.
F.
G.

Arguments for bank regulations

Arguments against bank regulations
Problem with Deposit Insurance
Market Developments
Possible Solutions
Conclusion
Past Year Exam Questions, Essential
Reading

Should banks be regulated?

Are

you for or against bank regulations?

(Recall PBF arguments)

A. Reasons For Bank Regulation

5

How do we keep the banking system safe

and sound?

Exercise
6

FIs receive special regulatory attention.

Reasons:
Special services provided by FIs in general.
functions such as money
supply transmission (banks), credit allocation
(thrifts, farm banks), payment services (banks,
thrifts), etc.

How does a bank failure affect:

Households

Institution-specific

______

______ ______ arise if these services are

not provided

Lillibeth Ortiz

Firms

The

economy

Financial Intermediation - Bank

Regulations

2013-2014

Questions
7

Glitch cripples largest ATM network

8

social marginal costs are greater

than private marginal costs mean?
What does

(Tue, Jul 06, 2010, my paper By Rachel Chan)

http://www.asiaone.com/Business/News/Story
/A1Story20100706-225404.html

How important is the banks provision of

liquidity and payment services?

A. Reasons For Bank Regulation

9

Traditional Regulation Mechanisms

10

Important features of regulatory policy:

Protect

Recall in PBF:

ultimate sources and users of savings.

Creation

of a central bank
supervision: restrictions on entry and
bank examination
Government safety net: deposit insurance,
lender of last resort, bailouts of ______ ______
______
Bank capital requirements (Basel I & II)
Assessment of risk management
Monitoring of liquidity
Disclosure requirements

Consumers

lack market power & are prone to

banks exploitation
Including prevention of unfair practices
Depositors are uninformed and unable to
monitor banks & therefore require protection
Uninsured depositors are likely to run than
monitor banks
Ensure

system

Bank

the safety & stability of the banking

Review Questions
11

Review Questions
12

FIs are special because

1.

2.

3.

4.

5.

a.
their failure can impose negative
externalities on the economy.
b.
they receive special regulatory
oversight.
c.
their business is the management of
money.
d.
they provide a source of backup
liquidity to nonfinancial firms.
e.
we are studying them.

Lillibeth Ortiz

Why is the failure of a large bank more detrimental to the

economy than the failure of a large steel manufacturer?
1.
a. The bank failure usually leads to a government bailout.
2.
B. There are fewer steel manufacturers than there are
banks.
3.
c. The large bank failure reduces credit availability
throughout the economy.
4.
d. Since the steel company's assets are tangible, they
are more easily reallocated than the intangible bank
assets.
5.
e. Everyone needs money, but not everyone needs steel.

Financial Intermediation - Bank

Regulations

2013-2014

Review Questions
13

B. Arguments against Regulations

14

The following are protective mechanisms that have

been developed by regulators to promote the
safety & soundness of the banking system EXCEPT
1.
a. encouraging banks to rely more on deposits
rather than debt or capital as a cushion against
failure.
2.
b. the provision of deposit insurance.
3.
c. the periodic monitoring of banks.
4.
d. encouraging banks to produce timely
accounting statements and reports.
5.
e. none of the above

Net

regulatory burden

Direct resource

costs and compliance costs

Free banking
Since
Poor

free trade is welfare superior

record of central banks

IMF (1998)

shows widespread banking crises

under central bank supervision
Unable to maintain value of the currency
(inflation)

Problems with deposit insurance

C. Deposit Insurance & Moral

Hazard

Question
15

Regulation is not costless

16

What is the problem with deposit insurance

(and other types of implicit government
guarantees)?

Bank runs can serve a useful purpose: a way

of disciplining risky banks
With deposit insurance, Heads I win,

Tails I dont lose (much)

C. Deposit Insurance & Moral

Hazard

C. Illustration
17

18

Rolnick (1993): deposit insurance distorts

bank behavior and creates moral hazard
Deposit

insurance encouraged under-pricing

of risk and reduced depositor discipline.
Riskier banks do not have to pay higher rates
to their depositors to compensate them for
riskier deposits
Inadequate monitoring.
Once

depositors are insured, they will no longer

have the incentive to monitor the bank they
keep deposits in

Lillibeth Ortiz

Financial Intermediation - Bank

Regulations

2013-2014

Needmarketshelptocurbbankrisk
19

True or False?
20

By James Mackintosh, Financial Times, 21 July 2010

In two years the biggest problem in banking has gone

from too big to fail to too big to lift.

Review Questions
21

Deposit insurance is often blamed for the

deterioration in depositor discipline that
allowed FIs to accept more risk in the asset
selection process.
If regulators provide more protection
against bank runs, the incidence of moral
hazard is likely to increase.

D. Market Developments
22

Moral hazard at FIs may

Deregulation
Mortgage

1.

2.

3.

4.

5.

A. result when actions and consequences are

separated.
B. occur when interest rates are very high and
volatile.
C. occur when commodity prices are very high
and volatile.
D. be a consequence of strict regulatory
supervision.
E. be a consequence of an erosion of family
values.

Financial Crisis bail outs

New Regulations
More

capital, more liquidity

risky trading activities

Separate

News: No choice, govt has to bail

out banks: PM

News Quote: Oct 2008

23

lending

Leverage

24

That is the risk deregulation brings: It

encourages behavior that leads to systemic
risk. In the present case, the global credit

Business Times, October 08, 2012, By Chuang Peck Ming in

Auckland

http://www.businesstimes.com.sg/premium/singap
ore/no-choice-govt-has-bail-out-banks-pm20121008

markets have frozen, threatening a

worldwide recession.
(Barry Ritholtz, The Big Picture, Oct 2008)

Lillibeth Ortiz

Financial Intermediation - Bank

Regulations

2013-2014

THE IMF: Here's How Much Financial

Regulation Is Going To Cost The US

News Quote: Oct 2008

25

26

THERE is a danger that politicians and policymakers will learn the wrong lessons from the
current financial crisis ... In the developed
world, this could lead to over-regulation
and could stifle the healthy development of
the financial sector

Joshua Berlinger, Business Insider, 12 Sep 2012

http://www.businessinsider.com/imf-financialregulation-costs-outweigh-benefits-20129#ixzz28o2GAdOi

(Dr Tony Tan, deputy chairman and executive

director of the Government of Singapore
Investment Corp, Oct 2008)

Questions
27

Discuss
28

So, how do we keep the banking system

safe and sound?!?

How

do we solve the problem of deposit

insurance and moral hazard?
Is there a middle ground between
regulation and free banking?
Should regulations with all their complexity be
imposed on a banking system or should a
simple system arise out of a market system?

E. Possible Solutions
29

Do we need more or less bank

regulation?

E. Possible Solutions
30

Bhattacharya et al (1998): because of the

existence of deposit insurance,

This supports regulation on reserve ratios

and capital adequacy

Banks hold few reserves

Banks are tempted to take on excessive asset risk

Link banks shareholder capital to the risk of the

bank to deal with excess asset risk

Benston & Kaufmann (1996) suggest the

types of regulation:
Prohibiting
Monitoring

banks

of excessively risky activities

& controlling the risky activity of

Requiring

banks to hold sufficient capital to

absorb potential losses

Therefore, the existence of deposit

insurance provides the motivation for
regulation

Lillibeth Ortiz

Financial Intermediation - Bank

Regulations

2013-2014

E. Possible Solutions

Illustration: Subordinated Debt

Impact
Consultancy
& Training Pte
Ltd

31

Subordinated

Assets

Redesign current regulated system to allow

market discipline to counteract moral
hazard

Liabilities

debt (Wall, 1998)

Disclosure based systems

Deposit insurance only for payment banks

E. Subordinated Debt
33

E. Subordinated Debt
34

Proposal:

Banks

issue puttable sub-debts of (minimum)

4-5% of risk weighted assets at all times

Banks would have to stand ready to

redeem at par value within 90 days any
debt put to them by investors.
If

investor exercises the put and this reduces a

banks outstanding subordinated debt below
the prescribed minimum, the bank would
have to

Sub-debt investors will charge a riskpremium on the debt to reflect bank risk
Investors have strong incentives to monitor
banks.

issue

additional subordinated debt,

assets to reduce its minimum debt
requirements or
face closure by regulators

Each

bank must continuously satisfy the

market of its soundness.

sell risky

E. Subordinated Debt

Wall Street Is Too Big to Regulate

36

Role of subordinate debt

market discipline
monitoring
Increase transparency and improve
disclosure
Increase capital cushion

By GAR ALPEROVITZ, July

22, 2012, New York Times

Improve
Ease

http://www.nytimes.com/2012/07/23/opinion/bank
s-that-are-too-big-to-regulate-should-benationalized.html?smid=pl-share

Source: Saunders & Cornett, Financial Institutions Management, 2008

Lillibeth Ortiz

Financial Intermediation - Bank

Regulations

2013-2014

F. Summary

F. Summary: Cost-Benefit Analysis

37

38

Matthews & Thompson (2008): cost-benefit

analysis between current regulated banking
system and free banking
Under

Reasons FOR regulation

Arguments AGAINST
regulation

free banking,

Individual bank

reserves and capital ratios

would be higher (than under regulated
banking)
Interest rates would be higher
Under

regulated banking,

Higher risk
Interest

liquidity

and potential for bank crisis

rates would be lower and would create

Review Question
39

Exercise:
think-pairshare

Under a regulated bank system, indicate if

the following would be higher or lower:
1.
2.
3.
4.
5.
6.
7.

Regulatory costs
Moral hazard
Counterfeiting, fraud
Financial innovation
Interest rates for loans
Liquidity in the economy
Bank failures/crises

G. Past Year Exam Questions

40

Analyse the roles of the gearing ratio and

the risk-assets ratio in banking regulation.
(2011 and 2010, Zone A)
Critically analyse the general arguments for
and against banking regulation, and with
particular reference to the role of the
deposit contract. (2009, Zone A)

G. Essential Reading
41

References (Essential reading)

Matthews
Saunders

& Thompson - Chapter 12.

& Cornett (2008)

Chapter

1, pp.10 15

Chapter

19, pp.551-71

Lillibeth Ortiz