Economics of Bank Regulation Sudipto Bhattacharya Arnoud W. A. Boot Anjan V. Thakor

Eugen Puschkarski Franz Jakob Why do banks exist Two dominant paradigms –Asset side (loans): e.g. Diamond (1984) monitoring/verifying cash-flows diversification through many projects with imperfectly correlated rates of return –Liability side (deposits): e.g. Diamond and Dybvig (1983) improved risk sharing => enhanced welfare

Eugen Puschkarski Franz Jakob Integrated Model Assumptions and Notation: ¤ large number of depositors => $ 1 to invest ¤ n....entrepreneurs => need $ N ¤ K...monitoring per investor ¤ S...expected non-pecuniary penalty ¤ R...payoff Entrepreneur tries to minimize cost of financing Min [NK,S]

Eugen Puschkarski Franz Jakob With financial intermediation –K(n)....monitoring cost per project for banks –K(n) < K because banks can use cross-sectional information –S(n)....signaling cost between bank and depositors –as n  , S(n)  0, if project cash-flows are i.i.d. –Intermediation is welfare enhancing if [K(n) + S(n)] < Min [NK,S]

Eugen Puschkarski Franz Jakob Implications and Conclusions 1. There should be no regulatory restrictions on bank size Portfolios will have almost zero unsystematic risk Liabilities will be debt contracts

Eugen Puschkarski Franz Jakob Introduction of risk averse investor Investment opportunities with maturity t=1,2 1, R/N..unintermediated payoff at t=1,2 fraction of investors withdrawing at t=1 is a random variable C 1, C 2... intermediated payoff at t=1,2 “insurance feature”....1< C 1 <C 2 <R/N 2 Nash equilibria liquidity shock at t=1 can induce bank run

Eugen Puschkarski Franz Jakob Solution to panic bank runs Deposit insuranceDeposit insurance - liquidity provided by government is funded by taxes (deadweight costs) - not socially costless - creates moral hazard Suspension of convertibilitySuspension of convertibility - randomization of consumption across liquidity seekers and adversely informed depositors

Eugen Puschkarski Franz Jakob Implications and Conclusions 1. There should be no regulatory restrictions on bank size Portfolios will have almost zero unsystematic risk Liabilities will be debt contracts 2. Sequentially service-constrained debt contracts, without interest rate restrictions, may provide superior intertemporal risk sharing 3. Deposit insurance should be preferred to suspension of convertibility

Eugen Puschkarski Franz Jakob Empirical evidence Bank runs are not historically important in that sense that they are not an important factor in bank illiquidity bank runs are predictable by “dual threshold” criterion –declining stock prices –increasing business failure rates market discipline is diminished by deposit insurance

Eugen Puschkarski Franz Jakob Economic Implications Debt Deflation 1. Deflation 2. Asset Value declines 3. Increased defaults 4. Bank runs 5. No more loans provided by banks 6. Less liquidity Regulation should prevent bank runs

Eugen Puschkarski Franz Jakob Moral hazard Bank has insured debt contract with depositors with fixed conditions => Bank chooses the entrepreneur with the highest risk premium => wealth transfer from depositors to bank shareholders => deposit insurance weakens market discipline => banks hold lower liquidity than socially optimal

Eugen Puschkarski Franz Jakob Regulatory solutions to moral hazard 1. Cash asset reserve requirements => minimum reserve requirements 2. Risk based capital requirements and deposit insurance premia => if fairly priced it is not incentive compatible => regulators have to provide rents or subsidies

Eugen Puschkarski Franz Jakob Regulatory solutions to moral hazard 3. Partial deposit insurance increases market discipline 4. Bank Closure Policy Regulators will be to lax on bank closures because their payoff will depend on first period monitoring reputation 5. Bank charter value is the expected value of future rents. The higher the charter value the higher the cost associated with losing it

Eugen Puschkarski Franz Jakob Implications and Conclusions 1. There should be no regulatory restrictions on bank size Portfolios will have almost zero unsystematic risk Liabilities will be debt contracts 2. Sequentially service-constrained debt contracts, without interest rate restrictions, may provide superior intertemporal risk sharing 3. Deposit insurance should be preferred to suspension of convertibility 4. Deposit insurance induces moral hazard 5. Risk sensitive capital requirements and risk-calibrated deposit insurance are useful tools in coping with moral hazard 6. Bank closure policy and market discipline can also reduce the appetite for risk taking 7. Increasing bank charter value can also help

Eugen Puschkarski Franz Jakob Diminishing importance of deposit insurance 1. Interbank borrowing and Lender of Last Resort (LLR) Interbank borrowing: bank specific liquidity shocks are imperfectly correlated, banks balance their liquidity needs among each other Central bank as LLR Difference to deposit insurance: payment is conditional on future returns

Eugen Puschkarski Franz Jakob 2. Capital market developments Liquidity can also be obtained on the capital market via - money market mutual funds - off balance sheet items: loan commitments, standby letters of credit - corporate bonds Diminishing importance of deposit insurance

Eugen Puschkarski Franz Jakob 3. Universal banking Ongoing trend for creation of universal banks versus functionally separated banks => leads to large banks and induces the “too big to fail” (TBTF) doctrine => financial institutions are not closed because of political pressures (compare LTCM) Universal banking increases cross-sectional and intertemporal reusabiltiy of information Diminishing importance of deposit insurance

Eugen Puschkarski Franz Jakob Implications and Conclusions 1. There should be no regulatory restrictions on bank size Portfolios will have almost zero unsystematic risk Liabilities will be debt contracts 2. Sequentially service-constrained debt contracts, without interest rate restrictions, may provide superior intertemporal risk sharing 3. Deposit insurance should be preferred to suspension of convertibility 4. Deposit insurance induces moral hazard 5. Risk sensitive capital requirements and risk-calibrated deposit insurance are useful tools in coping with moral hazard 6. Bank closure policy and market discipline can also reduce the appetite for risk taking 7. Increasing bank charter value can also help 8. Interbank borrowing, LLR, Asset liquidity and new financial market developments reduce the need for deposit insurance 9. Regulator imposed limits on investment opportunities should limit the liability of the deposit insurance, but can destroy charter value 10. Universal banking can exploit cross sectional information, but TBTF