regulation: a theoretical framework. objectives: 4 justify the existence of banking regulation 4...
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REGULATION: A THEORETICAL FRAMEWORK
OBJECTIVES:
Justify the existence of banking regulation Consider banking regulation within the
theory of regulation Consider the effects adverse selection and
moral hazard have on regulation
Why regulation?
Regulation is the response to market failure The failure of financial institutions creates
important externalities because– Affect small uninformed depositors– Bank failures may trigger contagion through
• expectations
• Connectivity (Interbank market, Payment system, OTC derivatives)
Market failure in the banking industry
Financial intermediation and banking regulation
Financial marketimperfection
Banks emerge
New financialmarket failures
Market failures in the banking industry Monetary liquidity costs Social vs. Private costs of bankruptcy Financial stability as a public good The production of information The government distorting hand
Market Failures
Regulation
Public
Regulation
PrivateRegulation Self Regulation
Lack ofRegulation
REGULATOR INCENTIVES
ImperfectInformation
RegulatoryCapture
Degree ofIndependence
Regulatory
FrameworkStrategic
Behavior
Competition
Regulation Efectiveness
Incentives
Equilibriumm (Resource allocation)
Efficiency measure
Legal andInstitutionalConstraints
The three pillars of Basle II
Capital
Supervision
Market Discipline
The safety net
Deposit insurance Capital requirements
Lender of last resort
Bail-out policy and bank closure
Deposit insurance
Deposit insurance as a put option (Merton)– Option pricing and risk related premia– Are insurance premia fairly priced?– What effect of bank closure policy: callable put
option
Deposit insurance(II)
The adverse selection issue The moral hazard issue
– Flat deposit premia– Unobservable risk
Unobservable risk and mechanism design
Solvency regulation: CAPM
Consider the CAPM approach to banks optimal portfolio strategy.
Mean - Variance set up Risk averse bankers Banks are price takers and chose the
proportion of their wealth to be invested on assets (if positive) and on liabilities (if negative)
Solvency regulation: application
Application to regulation: Impact of Capital requirements
Kim and Santomero (1988) showed that if the coefficients on each asset are not proportional to its risk (beta), the bank will choose an inefficient portfolio. In an example they show the probability of failure could increase!
The Incomplete Contract Approach to bank closure Dewatripont - Tirole (1993) At date t=0 the contract is signed and the
manager chooses her level of effort. Her incentives depend upon how effort affect
her probability of continuing running the bank. At date t=1 a first repayment v(1) is obtained
and a signal u is observed about the banks value at time 2, v(2)
.
At date 2 the liquidation value v(2) is observed.
The regulator has to choose either to close down the bank or to allow continuation.
For a given level of effort, signals v(1) and u are independent. Still higher effort will increase the probability of reaching a higher value for both v(1) and v(2).
Optimal decision in a full information set up: close the bank down if : u < u
Second best decision:
the regulation has to provide incentives to exert a high level of effort.
Since a higher level of effort affects both v(1) and u the optimal decision will depend on both.
Notice: commitment is crucial
Bank monitoring and closure policy Who should be in charge of closing down
banks?– Deposit Insurance Company?(private or
public?)– Central Bank?
The credibility issue (Maliath and Mester)
The information revelation issue (Aghion et al.)
Market disciplineI:Free banking
The Scottish and US experience Could the Modigliani-Miller theorem justify
free banking? (Fama 1980) What’s different about banks?
– Their creditors are their customers (discipline)– Their securities are used in the payment system
(transaction costs)
Market discipline II
The subordinate debt proposal Defining market discipline
– Ex ante effects– Interim effects
• Chari and Jagganathan(1987)• Calomiris and Kahn(1991)
Empirical evidence– Does the market price of subordinated debt react to an increase
in risk?– Do debt spreads contain relevant information?– Does subordinated debt implement market discipline (interim
effects)
Some standard regulatory instruments Deposit rate regulation (obsolete) Entry, branching, network and merger
restrictions (network and merger restrictions can be justified)
Portfolio restrictions (Glass-Steagall)