Banking ECO-20045

Lecture 10

Clip Art copyright belongs to Microsoft Corporation 1-1

 Lecture 10 - Outline (Ch. 11)

Economic Analysis of Financial Regulation

•Bank Failures
•Regulations Devised to Prevent Bank Failures (pros & cons)
– Government Safety Net
– Restrictions on Asset Holdings
– Capital Requirements
– Financial Supervision
– Assessment of Risk Management
– Disclosure Requirements
– Consumer Protection

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 Banks Play a Key Role

• We have seen that indirect finance, and banks in particular, play

a major role in the financial system:
– (1) Banks can reduce transaction costs.
– (2) Banks can mitigate adverse selection and moral hazard problems.
– (1) + (2) facilitate the flow of funds from savers to spenders  promote
economic growth.

• Since banks are key players, bank failures may cause

disruptions to the financial system
– Especially true if large banks fail…
– …or if a large number of banks fail at the same time.

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 Bank Failures

• What can cause a bank failure?

– We have seen that banks typically raise funds
by issuing short-term liabilities and invest funds in
illiquid, long-term, risky assets (i.e. loans)

– Example: if serious negative shocks hit the economy  many borrowers

may be unable to make the promised payments on those loans.

– The value of the bank loans and assets will fall.

– If value of assets < value of liabilities  the bank is technically insolvent

(i.e. unable to meet its obligations towards its creditors)  the bank will
be closed and its assets liquidated.
– Problem: some creditors (e.g. depositors) will not get paid off in full!

• Do bank failures occur in practice?

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Bank Failures in the United States, 1934–2016
600

500

400

300

200

100

0
1964
1936

1940

1944

1948

1952

1956

1960

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

2012

2016
Source: [Link]
(Commercial banks, savings institutions, savings banks, and savings associations)
 Banking Crises Throughout the World 1970-2011

A banking crisis is defined by the authors as systemic if two conditions are met:
1) Significant signs of financial distress in the banking system (as indicated by significant
bank runs, losses in the banking system, and/or bank liquidations).
2) Significant banking policy intervention measures in response to significant losses in the
banking system.

Source: Luc Laeven and Fabian Valencia, “Systemic Banking Crises Database: An Update” IMF Working Paper No.
WP/12/163 (June 2012).
Asymmetric Information in the Financial System

• We have seen that banks can mitigate adverse selection and

moral hazard problems by making private loans that avoid the
free-rider problem.

• Unfortunately, the existence of financial intermediaries (banks)

introduces a new type of asymmetric information:
– Bank depositors have less information than bank managers about the
quality of the bank’s loans (and assets in general).
Will I be able to
get my deposits
$ back?
$
$
$
$
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 Bank Runs
Some banks will suffer
If a major negative only minor losses on ?
shock hits the their loans
economy
Some banks will suffer Depositors
major losses on their
loans and may become
insolvent

Due to asymmetric
information, depositors cannot
tell whether their bank is likely
to fail or not

If bank fails, not enough funds

to pay off all depositors in full

Since banks only hold a fraction of To avoid losing their deposits,

deposits as reserves, if all depositors depositors have an incentive to
try to withdraw their funds at once, the be the first to rush to their bank
bank will not be able to meet its and withdraw their funds
obligations (insolvency!) 1-8
 Bank Panics

The failure of a If people notice that other To be safe, they may

bank can cause a people are running on bank A, decide it’s better to
contagion effect they too may start wondering withdraw their deposits
whether their bank is sound

Bank runs may spread Even banks whose assets

across the economy and are sound can become
cause a bank panic victims of bank runs

Bank B
Bank A

Bank C Bank D

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 Bank Runs in Practice

• Do bank runs occur in practice?

• Yes
• Examples:
– Major episodes very common in the US in the IXX and early XX century
(every 20 years or so)
– September 2007  Northern Rock bank in the UK

• Consequences:
– A bank panic and a chain of bank failures can cause a severe recession.
– As the banking system collapses, businesses and consumers cannot
acquire the funds they need  consumption and investment plummet 
aggregate spending falls  aggregate income falls.
– Rescuing troubled banks is also very costly.
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 2007, Northern Rock bank run

A branch in
Glasgow

Picture copyright belongs to David Mackay.

[Link] 1-11
The Cost of Rescuing
Banks in a Number of
Countries

Table 11.2,
page 247
 How to Avoid Bank Runs and Failures?

• (1) Government safety net

• The government can step in and provide some kind of safety net:
– (A) Deposit insurance
• Guarantee that, if a bank fails, all depositors will be paid off in full on the first £X they
have deposited in the bank.
• Such a guarantee removes the incentive at the heart of bank runs

– (B) The central bank may act as a “lender of last resort” and provide
liquidity to troubled banks that can’t raise funds elsewhere.

– (C) The government may nationalize troubled banks and guarantee all
creditors will be repaid in full.
• i.e. taxpayers pay the bill.
• E.g. in February 2008, Northern Rock was nationalized.
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 Deposit
Insurance

Table 11.1, page 234

UK £75,000 100% Since January 1, 2016

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 Is a Government Safety Net the Right Medicine?

• Drawbacks:
– If depositors know they won’t lose anything in case of bank failure  they
have little reason to monitor banks  no need to rush to withdraw deposits

– Moral hazard problem:

• Since bank managers now know they’re not being monitored by
depositors, they have an incentive to take on excessive risk
• They’re essentially gambling with the taxpayers’ money
• Banks more likely to fail in the future!

– Too big to fail problem:

• Large banks often receive a “special” treatment from regulators, as the failure of a
major bank could cause serious disruptions to the system
– Not only depositors but all creditors may get implicit guarantee they will be repaid
in full
• If a bank is perceived as “too big to fail”, then its depositors and creditors will have no
reason to monitor it
• Large banks then will have a bigger incentive to take on excessive risk
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 How to Avoid Bank Failures?

• (2) Restrictions on asset holdings

– Regulators may mitigate moral hazard problem by imposing limits on
amount of risky assets banks can hold
– Regulations can limit holding of risky assets (e.g. stocks) or promote
diversification
• In terms of sectors and individual borrowers

• (3) Equity capital requirements

– Regulators can force banks to hold large amounts of equity capital:
• If bank shareholders have more skin in the game, they will have an
incentive to prevent managers from taking on excessive risk.
• Bank capital also works as a cushion when negative shocks occur, reducing
the chance that bank will fail.
– Basel Accord of 1988 (Basel 1) required that banks hold as equity capital
at least 8% of their risk-weighted assets.
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 How to Avoid Bank Failures?

• (4) Financial supervision

– Opening a new bank typically requires a license  the goal is to
mitigate adverse selection by preventing undesirable people (i.e. crooks
and risk-loving entrepreneurs) from controlling banks.
– Licensed banks are required to file periodic reports to reveal
information about their activities.

– Authorities conduct on-site examinations to make

sure banks are complying with capital requirements
and restrictions on asset holdings.

– Bank examiners give banks CAMELS ratings (Capital adequacy, Asset

quality, Management, Earnings, Liquidity, Sensitivity to market risk).

– If CAMELS rating too low  regulators can force bank to modify its
behaviour or even close it. 1-17
 How to Avoid Bank Failures?

• (5) Assessment of risk management

– Regulators have been putting more and more emphasis on examining
how banks evaluate, monitor, and manage the risks they’re exposed to.

– Now bank examiners give a separate risk management rating from 1

to 5 as part of the CAMELS system.
– Rating is based on four criteria:
• Quality of oversight provided by the Board of Directors
• Adequacy of policies and limits for all risky activities
• Quality of the risk measurement and monitoring systems
• Adequacy of internal controls to prevent fraud or unauthorized activities on the part of
employees

– Banks may be required to implement periodic “stress testing”

• A type of scenario analysis to calculate potential losses under extreme negative
scenarios  would the bank experience liquidity or insolvency problems?

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 How to Avoid Bank Failures?

• (6) Disclosure requirements

– Regulators can force banks to
• (A) adhere to certain standard accounting principles.
• (B) disclose information about their assets, liabilities, and activities.

– The goal is to increase the amount of information available in the

market place (i.e. reduce degree of asymmetric information).

– With more information available, shareholders, depositors, and creditors

will be able to monitor banks more effectively and evaluate their risk
exposure.

–  this will reduce banks’ incentives to take on excessive risk.

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 How to Avoid Bank Failures?

• (7) Consumer protection

– Most consumers do not have a finance/econ background  they may
not have enough information to protect themselves fully.

– EU has introduced a directive that requires all lenders

to provide info to consumers about:
• the cost of borrowing
• the total finance charges on loans.

– In the EU consumers also have the right of withdrawal within 14 days

of the credit contract at no financial penalty.

– Consumer protection mitigates adverse selection  if bank customers

are well protected, criminals and unethical entrepreneurs will be less
likely to enter the banking business.

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 Pros and Cons of Bank Regulation

In conclusion, authorities need to find the optimal amount of bank

regulation by taking into account:
• Pros:
– Bank failures, runs, and panics impose severe costs on the rest of the
economy.
– Systemic problems for the banking system may cause the financial
system to freeze and hamper economic growth.
– Regulation may reduce the risk of bank failures (?)

• Cons:
– Regulations imposes direct costs on banks (between
5% and 10% of their operational costs).
– Once regulations are in place, banks will find new ways
to avoid them (costly cat-and-mouse game).
– Banks have an incentive to lobby politicians so that regulators and
supervisors will go easy on them. 1-21
Note:
•The section “Wither financial regulation after the subprime
financial crisis?” (pp. 246-250) will not be covered in the
module.
•It is not required for the exams.

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