Economics of Bank Regulation

1
Economics of Bank Regulation

• Sudipto Bhattacharya
• Arnoud W. A. Boot
• Anjan V. Thakor

2
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 gt enhanced welfare

3
Integrated Model

• Assumptions and Notation
• large number of depositors gt 1 to invest
• n....entrepreneurs gt need N
• K...monitoring per investor
• S...expected non-pecuniary penalty
• R...payoff
• Entrepreneur tries to minimize cost of financing
• Min NK,S

4

• With financial intermediation
• K(n)....monitoring cost per project for banks
• K(n) lt 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) lt Min NK,S

5
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

6
Introduction of risk averse investor

• Investment opportunities with maturity t1,2
• 1, R/N..unintermediated payoff at t1,2
• fraction of investors withdrawing at t1 is a
  random variable
• C1, C2... intermediated payoff at t1,2
• insurance feature....1lt C1ltC2ltR/N
• 2 Nash equilibria
• liquidity shock at t1 can induce bank run

7
Solution to panic bank runs

• Deposit insurance
• - liquidity provided by government is funded by
  taxes (deadweight costs)
• - not socially costless
• - creates moral hazard

• Suspension of convertibility
• - randomization of consumption across liquidity
  seekers and adversely informed depositors

8
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
9
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

10
Economic Implications

• Debt Deflation

2. Asset Value declines
1. Deflation
Regulation should prevent bank runs
6. Less liquidity
3. Increased defaults
5. No more loans provided by banks
4. Bank runs
11
Moral hazard

• Bank has insured debt contract with depositors
  with fixed conditions
• gt Bank chooses the entrepreneur with the highest
  risk premium
• gt wealth transfer from depositors to bank
  shareholders
• gt deposit insurance weakens market discipline
• gt banks hold lower liquidity than socially
  optimal

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Regulatory solutions to moral hazard

• 1. Cash asset reserve requirements
• gt minimum reserve requirements
• 2. Risk based capital requirements and deposit
  insurance premia
• gt if fairly priced it is not incentive
  compatible
• gt regulators have to provide rents or subsidies

13
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

14
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
15
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

16
Diminishing importance of deposit insurance

• 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

17
Diminishing importance of deposit insurance

• 3. Universal banking
• Ongoing trend for creation of universal banks
  versus functionally separated banks
• gt leads to large banks and induces the too big
  to fail (TBTF) doctrine
• gt financial institutions are not closed because
  of political pressures (compare LTCM)
• Universal banking increases cross-sectional and
  intertemporal reusabiltiy of information

18
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