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)