REGULATION: A THEORETICAL FRAMEWORK

OBJECTIVES: 4 Justify the existence of banking regulation 4 Consider banking regulation within the theory of regulation 4 Consider the effects adverse selection and moral hazard have on regulation

Why regulation? 4 Regulation is the response to market failure 4 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 4 Financial intermediation and banking regulation

Market failures in the banking industry 4 Monetary liquidity costs 4 Social vs. Private costs of bankruptcy 4 Financial stability as a public good 4 The production of information 4 The government distorting hand

The three pillars of Basle II 4 Capital 4 Supervision 4 Market Discipline

The safety net 4 Deposit insurance 4 Capital requirements 4 Lender of last resort 4 Bail-out policy and bank closure

Deposit insurance 4 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) 4 The adverse selection issue 4 The moral hazard issue –Flat deposit premia –Unobservable risk 4 Unobservable risk and mechanism design

Solvency regulation: CAPM 4 Consider the CAPM approach to banks optimal portfolio strategy. 4 Mean - Variance set up 4 Risk averse bankers 4 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 4 Application to regulation: Impact of Capital requirements 4 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 4 Dewatripont - Tirole (1993) 4 At date t=0 the contract is signed and the manager chooses her level of effort. 4 Her incentives depend upon how effort affect her probability of continuing running the bank. 4 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)

. 4 At date 2 the liquidation value v(2) is observed. 4 The regulator has to choose either to close down the bank or to allow continuation. 4 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: 4 close the bank down if : 4 u < u

Second best decision: 4 the regulation has to provide incentives to exert a high level of effort. 4 Since a higher level of effort affects both v(1) and u the optimal decision will depend on both. 4 Notice: commitment is crucial

Bank monitoring and closure policy 4 Who should be in charge of closing down banks? –Deposit Insurance Company?(private or public?) –Central Bank? 4 The credibility issue (Maliath and Mester)

The information revelation issue (Aghion et al.)

Market disciplineI:Free banking 4 The Scottish and US experience 4 Could the Modigliani-Miller theorem justify free banking? (Fama 1980) 4 Whats different about banks? –Their creditors are their customers (discipline) –Their securities are used in the payment system (transaction costs)

Market discipline II 4 The subordinate debt proposal 4 Defining market discipline –Ex ante effects –Interim effects Chari and Jagganathan(1987) Calomiris and Kahn(1991) 4 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 4 Deposit rate regulation (obsolete) 4 Entry, branching, network and merger restrictions (network and merger restrictions can be justified) 4 Portfolio restrictions (Glass-Steagall)