C h a p t e r
11 Economic Analysis of Banking Regulation
As we have seen in the previous chapters, the financial system is among the most heavily regulated sectors of the economy, and banks are among the most heavily regulated of financial institutions. In this chapter, we develop an economic analysis of why regulation of banking takes the form it does.
Unfortunately, the regulatory process may not always work very well, as evidenced by recent crises in the banking systems, not only in the United States but in many countries throughout the world. Here we also use our economic analysis of banking regulation to explain the worldwide crises in banking and how the regulatory system can be reformed to prevent future disasters.
Asymmetric Information and Banking Regulation
Government
Safety Net:
Deposit Insurance
and the FDIC
www.ny.frb.org/Pihome /regs.html
View bank regulation information.
In earlier chapters, we have seen how asymmetric information, the fact that different parties in a financial contract do not have the same information, leads to adverse selection and moral hazard problems that have an important impact on our financial system. The concepts of asymmetric information, adverse selection, and moral hazard are especially useful in understanding why government has chosen the form of banking regulation we see in the United States and in other countries. There are eight basic categories of banking regulation: the government safety net, restrictions on bank asset holdings, capital requirements, chartering and bank examination, assessment of risk management, disclosure requirements, consumer protection, and restrictions on competition.
As we saw in Chapter 8, banks are particularly well suited to solving adverse selection and moral hazard problems because they make private loans that help avoid the free-rider problem. However, this solution to the free-rider problem creates another asymmetric information problem, because depositors lack information about the quality of these private loans. This asymmetric information problem leads to two reasons why the banking system might not function well.
First, before the FDIC started operations in 1934, a bank failure (in which a bank is unable to meet its obligations to pay its depositors and other creditors and so must go out of business) meant that depositors would have to wait to get their deposit funds until the bank was liquidated (until its assets had been turned into cash); at that time, they would be paid only a fraction of the value of their deposits. Unable to learn
C H A P T E R 1 1 Economic Analysis of Banking Regulation 261
if bank managers were taking on too much risk or were outright crooks, depositors would be reluctant to put money in the bank, thus making banking institutions less viable. Second is that depositorsÕ lack of information about the quality of bank assets can lead to bank panics, which, as we saw in Chapter 8, can have serious harmful consequences for the economy. To see this, consider the following situation. There is no deposit insurance, and an adverse shock hits the economy. As a result of the shock, 5% of the banks have such large losses on loans that they become insolvent (have a negative net worth and so are bankrupt). Because of asymmetric information, depositors are unable to tell whether their bank is a good bank or one of the 5% that are insolvent. Depositors at bad and good banks recognize that they may not get back 100 cents on the dollar for their deposits and will want to withdraw them. Indeed, because banks operate on a Òsequential service constraintÓ (a first-come, first-served basis), depositors have a very strong incentive to show up at the bank first, because if they are last in line, the bank may run out of funds and they will get nothing. Uncertainty about the health of the banking system in general can lead to runs on banks both good and bad, and the failure of one bank can hasten the failure of others (referred to as the contagion effect). If nothing is done to restore the publicÕs confidence, a bank panic can ensue.
Indeed, bank panics were a fact of American life in the nineteenth and early twentieth centuries, with major ones occurring every 20 years or so in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930Ð1933. Bank failures were a serious problem even during the boom years of the 1920s, when the number of bank failures averaged around 600 per year.
A government safety net for depositors can short-circuit runs on banks and bank panics, and by providing protection for the depositor, it can overcome reluctance to put funds in the banking system. One form of the safety net is deposit insurance, a guarantee such as that provided by the Federal Deposit Insurance Corporation (FDIC) in the United States in which depositors are paid off in full on the first $100,000 they have deposited in the bank no matter what happens to the bank. With fully insured deposits, depositors donÕt need to run to the bank to make withdrawalsÑeven if they are worried about the bankÕs healthÑbecause their deposits will be worth 100 cents on the dollar no matter what. From 1930 to 1933, the years immediately preceding the creation of the FDIC, the number of bank failures averaged over 2,000 per year. After the establishment of the FDIC in 1934, bank failures averaged fewer than 15 per year until 1981.
The FDIC uses two primary methods to handle a failed bank. In the first, called the payoff method, the FDIC allows the bank to fail and pays off deposits up to the $100,000 insurance limit (with funds acquired from the insurance premiums paid by the banks who have bought FDIC insurance). After the bank has been liquidated, the FDIC lines up with other creditors of the bank and is paid its share of the proceeds from the liquidated assets. Typically, when the payoff method is used, account holders with deposits in excess of the $100,000 limit get back more than 90 cents on the dollar, although the process can take several years to complete.
In the second method, called the purchase and assumption method, the FDIC reorganizes the bank, typically by finding a willing merger partner who assumes (takes over) all of the failed bankÕs deposits so that no depositor loses a penny. The FDIC may help the merger partner by providing it with subsidized loans or by buying some of the failed bankÕs weaker loans. The net effect of the purchase and assumption method is that the FDIC has guaranteed all deposits, not just those under the
262 P A R T I I I |
Financial Institutions |
$100,000 limit. The purchase and assumption method was the FDICÕs most common procedure for dealing with a failed bank before new banking legislation in 1991.
Deposit insurance is not the only way in which governments provide a safety net for depositors. In other countries, governments have often stood ready to provide support to domestic banks when they face runs even in the absence of explicit deposit insurance. This support is sometimes provided by lending from the central bank to troubled institutions and is often referred to as the Òlender of last resortÓ role of the central bank. In other cases, funds are provided directly by the government to troubled institutions, or these institutions are taken over by the government and the government then guarantees that depositors will receive their money in full. However, in recent years, government deposit insurance has been growing in popularity and has spread to many countries throughtout the world. Whether this trend is desirable is discussed in Box 1.
Moral Hazard and the Government Safety Net. Although a government safety net has been successful at protecting depositors and preventing bank panics, it is a mixed blessing. The most serious drawback of the government safety net stems from moral hazard, the incentives of one party to a transaction to engage in activities detrimental to the other party. Moral hazard is an important concern in insurance arrangements in general because the existence of insurance provides increased incentives for taking
Box 1: Global
The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing?
For the first 30 years after federal deposit insurance |
tor stability and a higher incidence of banking |
was established in the United States, only 6 countries |
crises.* Furthermore, on average it seems to retard |
emulated the United States and adopted deposit |
financial development. However, the negative effects |
insurance. However, this began to change in the late |
of deposit insurance appear only in countries with |
1960s, with the trend accelerating in the 1990s, when |
weak institutional environments: an absence of rule |
the number of countries adopting deposit insurance |
of law, ineffective regulation and supervision of the |
doubled to over 70. Government deposit insurance |
financial sector, and high corruption. This is exactly |
has taken off throughout the world because of grow- |
what might be expected because, as we will see later |
ing concern about the health of banking systems, par- |
in this chapter, a strong institutional environment is |
ticularly after the increasing number of banking crises |
needed to limit the incentives for banks to engage in |
in recent years (documented at the end of this chap- |
the excessively risky behavior encouraged by deposit |
ter). Has this spread of deposit insurance been a good |
insurance. The problem is that developing a strong |
thing? Has it helped improve the performance of the |
institutional environment may be very difficult to |
financial system and prevent banking crises? |
achieve in many emerging market countries. This |
The answer seems to be no under many circum- |
leaves us with the following conclusion: Adoption of |
stances. Research at the World Bank has found that |
deposit insurance may be exactly the wrong medicine |
on average, the adoption of explicit government |
for promoting stability and efficiency of banking sys- |
deposit insurance is associated with less banking sec- |
tems in emerging market countries. |
*See World Bank, Finance for Growth: Policy Choices in a Volatile World (Oxford: World Bank and Oxford University Press, 2001).
C H A P T E R 1 1 Economic Analysis of Banking Regulation 263
risks that might result in an insurance payoff. For example, some drivers with automobile collision insurance that has a low deductible might be more likely to drive recklessly, because if they get into an accident, the insurance company pays most of the costs for damage and repairs.
Moral hazard is a prominent concern in government arrangements to provide a safety net. Because with a safety net depositors know that they will not suffer losses if a bank fails, they do not impose the discipline of the marketplace on banks by withdrawing deposits when they suspect that the bank is taking on too much risk. Consequently, banks with a government safety net have an incentive to take on greater risks than they otherwise would.
Adverse Selection and the Government Safety Net. A further problem with a government safety net like deposit insurance arises because of adverse selection, the fact that the people who are most likely to produce the adverse outcome insured against (bank failure) are those who most want to take advantage of the insurance. For example, bad drivers are more likely than good drivers to take out automobile collision insurance with a low deductible. Because depositors protected by a government safety net have little reason to impose discipline on the bank, risk-loving entrepreneurs might find the banking industry a particularly attractive one to enterÑthey know that they will be able to engage in highly risky activities. Even worse, because protected depositors have so little reason to monitor the bankÕs activities, without government intervention outright crooks might also find banking an attractive industry for their activities because it is easy for them to get away with fraud and embezzlement.
“Too Big to Fail.” The moral hazard created by a government safety net and the desire to prevent bank failures have presented bank regulators with a particular quandary. Because the failure of a very large bank makes it more likely that a major financial disruption will occur, bank regulators are naturally reluctant to allow a big bank to fail and cause losses to its depositors. Indeed, consider Continental Illinois, one of the ten largest banks in the United States when it became insolvent in May 1984. Not only did the FDIC guarantee depositors up to the $100,000 insurance limit, but it also guaranteed accounts exceeding $100,000 and even prevented losses for Continental Illinois bondholders. Shortly thereafter, the Comptroller of the Currency (the regulator of national banks) testified to Congress that the FDICÕs policy was to regard the 11 largest banks as Òtoo big to failÓÑin other words, the FDIC would bail them out so that no depositor or creditor would suffer a loss. The FDIC would do this by using the purchase and assumption method, giving the insolvent bank a large infusion of capital and then finding a willing merger partner to take over the bank and its deposits. The too-big-to-fail policy was extended to big banks that were not even among the 11 largest. (Note that Òtoo big to failÓ is somewhat misleading because when a bank is closed or merged into another bank, the managers are usually fired and the stockholders in the bank lose their investment.)
One problem with the too-big-to-fail policy is that it increases the moral hazard incentives for big banks. If the FDIC were willing to close a bank using the alternative payoff method, paying depositors only up to the $100,000 limit, large depositors with more than $100,000 would suffer losses if the bank failed. Thus they would have an incentive to monitor the bank by examining the bankÕs activities closely and pulling their money out if the bank was taking on too much risk. To prevent such a loss of deposits, the bank would be more likely to engage in less risky activities. However, once large depositors know that a bank is too big to fail, they have no incentive to
264 P A R T I I I |
Financial Institutions |
Restrictions on Asset Holdings and Bank Capital Requirements
monitor the bank and pull out their deposits when it takes on too much risk: No matter what the bank does, large depositors will not suffer any losses. The result of the too-big-to-fail policy is that big banks might take on even greater risks, thereby making bank failures more likely.1
Financial Consolidation and the Government Safety Net. With financial innovation and the passage of the Riegle-Neal Interstate Banking and Branching and Efficiency Act of 1994 and the Gramm-Leach-Bliley Financial Services Modernization Act in 1999, financial consolidation has been proceeding at a rapid pace, leading to both larger and more complex banking organizations. Financial consolidation poses two challenges to banking regulation because of the existence of the government safety net. First, the increased size of banks as a result of financial consolidation increases the too-big-to- fail problem, because there will now be more large institutions whose failure exposes the financial system to systemic (system-wide) risk. Thus more banking institutions are likely to be treated as too big to fail, and the increased moral hazard incentives for these large institutions to take on greater risk can then increase the fragility of the financial system. Second, financial consolidation of banks with other financial services firms means that the government safety net may be extended to new activities such as securities underwriting, insurance, or real estate activities, thereby increasing incentives for greater risk taking in these activities that can also weaken the fabric of the financial system. Limiting the moral hazard incentives for the larger, more complex financial organizations that are resulting from recent changes in legislation will be one of the key issues facing banking regulators in the future.
As we have seen, the moral hazard associated with a government safety net encourages too much risk taking on the part of banks. Bank regulations that restrict asset holdings and bank capital requirements are directed at minimizing this moral hazard, which can cost the taxpayers dearly.
Even in the absence of a government safety net, banks still have the incentive to take on too much risk. Risky assets may provide the bank with higher earnings when they pay off; but if they do not pay off and the bank fails, depositors are left holding the bag. If depositors were able to monitor the bank easily by acquiring information on its risk-taking activities, they would immediately withdraw their deposits if the bank was taking on too much risk. To prevent such a loss of deposits, the bank would be more likely to reduce its risk-taking activities. Unfortunately, acquiring information on a bankÕs activities to learn how much risk the bank is taking can be a difficult task. Hence most depositors are incapable of imposing discipline that might prevent banks from engaging in risky activities. A strong rationale for government regulation to reduce risk taking on the part of banks therefore existed even before the establishment of federal deposit insurance.
Bank regulations that restrict banks from holding risky assets such as common stock are a direct means of making banks avoid too much risk. Bank regulations also promote diversification, which reduces risk by limiting the amount of loans in particular categories or to individual borrowers. Requirements that banks have sufficient
1Evidence reveals, as our analysis predicts, that large banks took on riskier loans than smaller banks and that this led to higher loan losses for big banks; see John Boyd and Mark Gertler, ÒU.S. Commercial Banking: Trends, Cycles and Policy,Ó NBER Macroeconomics Annual, 1993, pp. 319Ð368.
266 P A R T I I I Financial Institutions
Box 2: Global
Basel 2: Is It Spinning Out of Control?
Starting in June 1999, the Basel Committee on |
cials who control the bank, and the effectiveness of its |
Banking Supervision released several proposals to |
internal ratings system. |
reform the original 1988 Basel Accord. These efforts |
Although Basel 2 makes great strides toward limit- |
have culminated in what bank supervisors refer to as |
ing excessive risk taking by banking institutions, it has |
Basel 2, which is based on three pillars. Pillar 1 intends |
come at a cost of greatly increasing the complexity of |
to link capital requirements more closely to actual risk. |
the Accord. The document describing the original |
It does so by specifying many more categories of risk |
Basel Accord was twenty-six pages, while the second |
with different weights in its so-called standardized |
draft of Basel 2 issued in January 2001 exceeds 500 |
approach. Alternatively, it allows sophisticated banks |
pages. The original timetable called for the comple- |
to pursue instead an internal ratingsÐbased approach |
tion of the final round of consultation by the end of |
that permits banks to use their own models of credit |
May 2001, with the new rules taking effect by 2004. |
risk. Pillar 2 focuses on strengthening the supervisory |
However, criticism from banks, trade associations, |
process, particularly in assessing the quality of risk |
and national regulators has led to several postpone- |
management in banking institutions and in evaluating |
ments, with the final draft now scheduled to be pub- |
whether these institutions have adequate procedures |
lished in the last quarter of 2003 and the Accord to be |
to determine how much capital they need. Pillar 3 |
implemented in 2006. Will the increasing complexity |
focuses on improving market discipline through |
of the Basel Accord lead to further postponements? |
increased disclosure of details about the bankÕs credit |
Will Basel 2 eventually be put into operation? As of |
exposures, its amount of reserves and capital, the offi- |
this writing, these questions remain unanswered. |
www.federalreserve.gov /Regulations/default.htm
Access regulatory publications of the Federal Reserve Board.
banks can be used by crooks or overambitious entrepreneurs to engage in highly speculative activities, such undesirable people would be eager to run a bank. Chartering banks is one method for preventing this adverse selection problem; through chartering, proposals for new banks are screened to prevent undesirable people from controlling them.
Regular on-site bank examinations, which allow regulators to monitor whether the bank is complying with capital requirements and restrictions on asset holdings, also function to limit moral hazard. Bank examiners give banks a so-called CAMELS rating (the acronym is based on the six areas assessed: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk). With this information about a bankÕs activities, regulators can enforce regulations by taking such formal actions as cease and desist orders to alter the bankÕs behavior or even close a bank if its CAMELS rating is sufficiently low. Actions taken to reduce moral hazard by restricting banks from taking on too much risk help reduce the adverse selection problem further, because with less opportunity for risk taking, risk-loving entrepreneurs will be less likely to be attracted to the banking industry. Note that the methods regulators use to cope with adverse selection and moral hazard have their counterparts in private financial markets (see Chapters 8 and 9). Chartering is similar to the screening of potential borrowers, regulations restricting risky asset holdings are similar to restrictive covenants that prevent borrowing firms from engaging in risky investment activities, bank capital requirements act like restrictive covenants that require
C H A P T E R 1 1 Economic Analysis of Banking Regulation 269
ditional accounting conventions by providing information about risk exposure and risk management that is not normally included in conventional balance sheet and income statement reports.
The existence of asymmetric information also suggests that consumers may not have enough information to protect themselves fully. Consumer protection regulation has taken several forms. First is Òtruth in lending,Ó mandated under the Consumer Protection Act of 1969, which requires all lenders, not just banks, to provide information to consumers about the cost of borrowing including a standardized interest rate (called the annual percentage rate, or APR) and the total finance charges on the loan. The Fair Credit Billing Act of 1974 requires creditors, especially credit card issuers, to provide information on the method of assessing finance charges and requires that billing complaints be handled quickly. Both of these acts are administered by the Federal Reserve System under Regulation Z.
Congress has also passed legislation to reduce discrimination in credit markets. The Equal Credit Opportunity Act of 1974 and its extension in 1976 forbid discrimination by lenders based on race, gender, marital status, age, or national origin. It is administered by the Federal Reserve under Regulation B. The Community Reinvestment Act (CRA) of 1977 was enacted to prevent Òredlining,Ó a lenderÕs refusal to lend in a particular area (marked off by a hypothetical red line on a map). The Community Reinvestment Act requires that banks show that they lend in all areas in which they take deposits, and if banks are found to be in noncompliance with the act, regulators can reject their applications for mergers, branching, or other new activities.
Restrictions on
Competition
www.fdic.gov/regulations/laws /important/index.html
Describes the most important laws that have affected banking industry in the U.S.
Study Guide
Increased competition can also increase moral hazard incentives for banks to take on more risk. Declining profitability as a result of increased competition could tip the incentives of bankers toward assuming greater risk in an effort to maintain former profit levels. Thus governments in many countries have instituted regulations to protect banks from competition. These regulations have taken two forms in the United States in the past. First were restrictions on branching, such as those described in Chapter 10, which reduced competition between banks. The second form involved preventing nonbank institutions from competing with banks by engaging in banking business, as embodied in the Glass-Steagall Act, which was repealed in 1999.
Although restricting competition propped up the health of banks, restrictions on competition also had serious disadvantages: They led to higher charges to consumers and decreased the efficiency of banking institutions, which did not have to compete as hard. Thus, although the existence of asymmetric information provided a rationale for anticompetitive regulations, it did not mean that they would be beneficial. Indeed, in recent years, the impulse of governments in industrialized countries to restrict competition has been waning. Electronic banking has raised a new set of concerns for regulators to deal with. See Box 3 for a discussion of this challenge.
Because so many laws regulating banking have been passed in the United States, it is hard to keep track of them all. As a study aid, Table 1 lists the major banking legislation in the twentieth century and its key provisions.