2. Chapter Eighteen Banking Regulation

3. Copyright © 2004 Pearson Education Canada Inc. Slide 18–3 How Asymmetric Information Explains Banking Regulation 1.Government Safety Net and Deposit Insurance a.Prevents bank runs due to asymmetric info: depositors can't tell good from bad banks b.Creates moral hazard incentives for banks to take on too much risk c.Creates adverse selection problem of crooks and risk-takers wanting to control banks d.Too-Big-to-Fail increase moral hazard incentives for big banks and is unfair 2.Restrictions on Asset Holdings –Reduces moral hazard of too much risk taking

4. Copyright © 2004 Pearson Education Canada Inc. Slide 18–4 How Asymmetric Information Explains Banking Regulation 3.Bank Capital Requirements a.Reduces moral hazard: banks have more to lose when have higher capital b.Higher capital means more collateral for CDIC 4.Bank Supervision: Chartering and Examination a.Reduces adverse selection problem of risk takers or crooks owning banks b.Reduces moral hazard by preventing risky activities c.New trend: assessment of risk management

5. Copyright © 2004 Pearson Education Canada Inc. Slide 18–5 How Asymmetric Information Explains Banking Regulation 5.Disclosure Requirements –Better info reduces asymmetric info problem 6.Consumer Protection a.Standardized interest rates (APR) b.Prevent discrimination 7.Restrictions on Competition to Reduce Risk-Taking a.Branching restrictions b.Separation of banking and securities industries

6. Copyright © 2004 Pearson Education Canada Inc. Slide 18–6 How Asymmetric Information Explains Banking Regulation International Banking Regulation 1.Bank regulation abroad similar to ours 2.Particular problem of regulating international banking (e.g., BCCI scandal)

7. Copyright © 2004 Pearson Education Canada Inc. Slide 18–7 Major Banking Legislation in Canada

8. Copyright © 2004 Pearson Education Canada Inc. Slide 18–8 Canada Deposit Insurance Corporation Developments 1.Differential Premiums 2.Opting-Out

9. Copyright © 2004 Pearson Education Canada Inc. Slide 18–9 Evaluating CDIC and Other Reforms Limits on Scope of Deposit Insurance 1.Eliminate deposit insurance entirely 2.Lower limits on deposit insurance 3.Eliminate too-big-to-fail 4.Coinsurance Prompt Corrective Action 1.Critics believe too many loopholes 2.However: accountability increased by mandatory review of bank failure resolutions

10. Copyright © 2004 Pearson Education Canada Inc. Slide 18–10 Financial Services Reform for the 21 st Century Bank Holding Companies The Permitted Investment Regime New Ownership Rules Access to the Payments and Clearance System Merger Review Policy Implications for the Canadian Banking Industry

11. Copyright © 2004 Pearson Education Canada Inc. Slide 18–11 Figure 1: Banking Crises Throughout the World Since 1970

12. Copyright © 2004 Pearson Education Canada Inc. Slide 18–12 Cost of Banking Crises in Other Countries

13. Copyright © 2004 Pearson Education Canada Inc. Slide 18–13 Calculating Capital Requirements

14. Copyright © 2004 Pearson Education Canada Inc. Slide 18–14 Calculating Capital Requirements Leverage Ratio= Capital/Assets = $7m/$100m = 7% Bank is well capitalized

15. Copyright © 2004 Pearson Education Canada Inc. Slide 18–15 Calculating Risk-Adjusted Requirements

16. Copyright © 2004 Pearson Education Canada Inc. Slide 18–16 Calculating Risk-Adjusted Requirements Core Capital Requirement = 4%  risk-adjusted assets = 4%  $91.4m = $3.66m < $7m of core capital Total Capital Requirement = 8%  risk-adjusted assets = 8%  $91.4m = $7.31m < $9m of total capital = $7m of core + $2m of loan loss reserves