economics_of_money_banking__financial_markets

Scandinavia

Because misery loves company, it may make you feel better to know that the United States has by no means been alone in suffering a banking crisis. Indeed, as Table 2 and Figure 2 illustrate, banking crises have struck a large number of countries throughout the world, and many of them have been substantially worse than ours. We will examine what took place in several of these other countries and see that the same forces that produced a banking crisis in the United States have been at work elsewhere too.

As in the United States, an important factor in the banking crises in Norway, Sweden, and Finland was the financial liberalization that occurred in the 1980s. Before the 1980s, banks in these Scandinavian countries were highly regulated and subject to restrictions on the interest rates they could pay to depositors and on the interest rates they could earn on loans. In this noncompetitive environment, and with artificially low rates on both deposits and loans, these banks lent only to the best credit risks, and both banks and their regulators had little need to develop expertise in screening and monitoring borrowers. With the deregulated environment, a lending boom ensued, particularly in the real estate sector. Given the lack of expertise in both the banking industry and its regulatory authorities in keeping risk taking in check, banks

Latin America

engaged in risky lending. When real estate prices collapsed in the late 1980s, massive loan losses resulted. The outcome of this process was similar to what happened in the savings and loan industry in the United States. The government was forced to bail out almost the entire banking industry in these countries in the late 1980s and early 1990s on a scale that was even larger relative to GDP than in the United States (see Table 2).

The Latin American banking crises typically show a pattern similar to those in the United States and in Scandinavia. Before the 1980s, banks in many Latin American countries were owned by the government and were subject to interest-rate restrictions as in Scandinavia. Their lending was restricted to the government and other low-risk borrowers. With the deregulation trend that was occurring world-wide, many of these countries liberalized their credit markets and privatized their banks. We then see the same pattern we saw in the United States and Scandinavia, a lending boom in the face of inadequate expertise on the part of both bankers and regulators. The result was again massive loan losses and the inevitable government bailout. The Argentine banking crisis of 2001, which is ongoing, differed from those typically seen in Latin America. ArgentinaÕs banks were well supervised and in relatively good shape before

Russia and

Eastern Europe

Japan

the government coerced them into purchasing large amounts of Argentine government debt in order to help solve the governmentÕs fiscal problem. However, when market confidence in the government plummeted, spreads between Argentine government debt and U.S. Treasuries soared to more than 2,500 basis points (25 percentage points), leading to a sharp fall in the price of these securities. The losses on their holdings of government debt and rising bad loans because of the ongoing severe recession increased doubts about the solvency of the banking system.

A banking panic erupted in October and November 2001, with the Argentine public rushing to withdraw their deposits. On December 1, after losing more than $8 billion of deposits, the government imposed a $1,000 monthly limit on deposit withdrawals. Then with the collapse of the peso and the requirement that the banks must pay back their dollar deposits at a higher exchange value than they would be paid back on their dollar loans, banksÕ balance sheets went even further in the hole. The cost of the recent Argentine banking crisis is not yet clear, but it could very well be as large as the previous banking crisis in Argentina in the 1980Ð1982 period listed in Table 2 and could exceed 50% of GDP.

What is particularly striking about the Latin American experience is that the cost of the bailouts relative to GDP dwarfs that in the United States. The cost to the taxpayer of the government bailouts in Latin America has been anywhere from around 20% to more than 50% of GDP, in contrast to the 3% figure for the United States.

Before the end of the Cold War, in the communist countries of Eastern Europe and the Soviet Union, banks were owned by the state. When the downfall of communism occurred, banks in these countries had little expertise in screening and monitoring loans. Furthermore, bank regulatory and supervisory apparatus that could rein in the banks and keep them from taking on excessive risk barely existed. Given the lack of expertise on the part of regulators and banks, not surprisingly, substantial loan losses ensued, resulting in the failure or government bailout of many banks. For example, in the second half of 1993, eight banks in Hungary with 25% of the financial systemÕs assets were insolvent, and in Bulgaria, an estimated 75% of all loans in the banking system were estimated to be substandard in 1995.

On August 24, 1995, a bank panic requiring government intervention occurred in Russia when the interbank loan market seized up and stopped functioning because of concern about the solvency of many new banks. This was not the end of troubles in the Russian banking system. On August 17, 1998, the Russian government announced that Russia would impose a moratorium on the repayment of foreign debt because of insolvencies in the banking system. In November, the Russian central bank announced that nearly half of the countryÕs 1,500 commercial banks might go under and the cost of the bailout is expected to be on the order of $15 billion.

Japan was a latecomer to the banking crisis game. Before 1990, the vaunted Japanese economy looked unstoppable. Unfortunately, it has recently experienced many of the same pathologies that we have seen in other countries. Before the 1980s, JapanÕs financial markets were among the most heavily regulated in the world, with very strict restrictions on the issuing of securities and interest rates. Financial deregulation and innovation produced a more competitive environment that set off a lending boom, with banks lending aggressively in the real estate sector. As in the other countries we have examined here, financial disclosure and monitoring by regulators did not keep

East Asia

“Déjà Vu All

Over Again”

down by the government. Since then, the clean-up process has stalled and the economy has remained weak, with a growth rate from 1991Ð2002 averaging an anemic 1%. A new, reform-oriented prime minister, Junichiro Koizumi, who pledged to clean up the banking system, came into office in 2001; yet he has been unable to come to grips with the Japanese banking problem. This situation does not bode well for the Japanese economy.

We discussed the banking and financial crisis in the East Asian countries (Thailand, Malaysia, Indonesia, the Philippines, and South Korea) in Chapter 8. Due to inadequate supervision of the banking system, the lending booms that arose in the aftermath of financial liberalization led to substantial loan losses, which became huge after the currency collapses that occurred in the summer of 1997. An estimated 15% to 35% of all bank loans have turned sour in Thailand, Indonesia, Malaysia, and South Korea, and the cost of the bailout for the banking system is estimated at more than 20% of GDP in these countries and over 50% of GDP in Indonesia. The Philippines is expected to fare somewhat better, with the cost below 10% of GDP.

What we see in banking crises in these different countries is that history has kept on repeating itself. The parallels between the banking crisis episodes in all these countries are remarkably similar, leaving us with a feeling of dŽjˆ vu. Although financial liberalization is generally a good thing because it promotes competition and can make a financial system more efficient, as we have seen in the countries examined here, it can lead to an increase in moral hazard, with more risk taking on the part of banks if there is lax regulation and supervision; the result can then be banking crises. However, these episodes do differ in that deposit insurance has not played an important role in many of the countries experiencing banking crises. For example, the size of the Japanese equivalent of the FDIC, the Deposit Insurance Corporation, was so tiny relative to the FDIC that it did not play a prominent role in the banking system and exhausted its resources almost immediately with the first bank failures. This means that deposit insurance is not to blame for some of these banking crises. However, what is common to all the countries discussed here is the existence of a government safety net, in which the government stands ready to bail out banks whether deposit insurance is an important feature of the regulatory environment or not. It is the existence of a government safety net, and not deposit insurance per se, that increases moral hazard incentives for excessive risk taking on the part of banks.

Summary

1.The concepts of asymmetric information, adverse selection, and moral hazard help explain the eight types of banking regulation that we see in the United States and other countries: the government safety net, restrictions on bank asset holdings, capital requirements, bank supervision, assessment of risk mangement, disclosure requirements, consumer protection, and restrictions on competition.

2.Because asymmetric information problems in the banking industry are a fact of life throughout the world, bank regulation in other countries is similar to that in the United States. It is particularly problematic to regulate banks engaged in international banking, because they can readily shift their business from one country to another.

3.Because of financial innovation, deregulation, and a set of historical accidents, adverse selection and moral hazard problems increased in the 1980s and resulted in huge losses for the U.S. savings and loan industry and for taxpayers.

4.Regulators and politicians are subject to the principalÐagent problem, meaning that they may not have sufficient incentives to minimize the costs of deposit insurance to taxpayers. As a result, regulators and politicians relaxed capital standards, removed restrictions on holdings of risky assets, and relied on regulatory forbearance, thereby increasing the costs of the S&L bailout.

5.The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 provided funds for the S&L bailout; created the Resolution Trust Corporation to manage the resolution of insolvent thrifts; eliminated the Federal Home Loan Bank Board and gave its regulatory role to the Office of Thrift Supervision; eliminated the FSLIC, whose insurance role and

regulatory responsibilities were taken over by the FDIC; imposed restrictions on thrift activities similar to those in effect before 1982; increased the capital requirements to those adhered to by commercial banks; and increased the enforcement powers of thrift regulators.

6.The Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 recapitalized the Bank Insurance Fund of the FDIC and included reforms for the deposit insurance and regulatory system so that taxpayer losses would be minimized. This legislation limited brokered deposits and the use of the too-big- to-fail policy, mandated prompt corrective action to deal with troubled banks, and instituted risk-based deposit insurance premiums. These provisions have helped reduce the incentives of banks to take on excessive risk and so should help reduce taxpayer exposure in the future.

7.The parallels between the banking crisis episodes that have occurred in countries throughout the world are striking, indicating that similar forces are at work.

Questions and Problems

Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó

1.Give one example each of moral hazard and adverse selection in private insurance arrangements.

*2. If casualty insurance companies provided fire insurance without any restrictions, what kind of adverse selection and moral hazard problems might result?

3.What bank regulation is designed to reduce adverse selection problems for deposit insurance? Will it always work?

QUIZ

*4. What bank regulations are designed to reduce moral hazard problems created by deposit insurance? Will they completely eliminate the moral hazard problem?

5.What are the costs and benefits of a too-big-to-fail policy?

*6. Why did the S&L crisis not occur until the 1980s?

7.Why is regulatory forbearance a dangerous strategy for a deposit insurance agency?

*8. The FIRREA legislation of 1989 is the most comprehensive banking legislation since the 1930s. Describe its major features.

9.What steps were taken in the FDICIA legislation of 1991 to improve the functioning of federal deposit insurance?

*10. Some advocates of campaign reform believe that government funding of political campaigns and restrictions on campaign spending might reduce the principalÐagent problem in our political system. Do you agree? Explain your answer.

11.How can the S&L crisis be blamed on the principalÐagent problem?

*12. Do you think that eliminating or limiting the amount of deposit insurance would be a good idea? Explain your answer.

13.Do you think that removing the impediments to a nationwide banking system will be beneficial to the economy? Explain your answer.

*14. How could higher deposit insurance premiums for banks with riskier assets benefit the economy?

15.How has too-big-too-fail been limited in the FDICIA legislation? How might limiting too-big-too-fail help reduce the risk of a future banking crisis?

Web Exercises

1.Go to www.fdic.gov/regulations/laws/important /index.html. This site reports on the most significant pieces of legislation affecting banks since the 1800s. Summarize the most recently enacted bank regulation listed on this site.

2.The Office of the Comptroller of the Currency is responsible for many of the regulations affecting bank operations. Go to www.occ.treas.gov/. Click on ÒRegulatory Information.Ó Now click on the 12 CFR Parts 1 to 199. What does Part 1 cover? How many parts are there in 12 CRF? Open Part 18. What topic does it cover? Summarize its purpose.

Study Guide

Limits on the Scope of Deposit Insurance

FDICIA is a major step in reforming the banking regulatory system. How well will it work to solve the adverse selection and moral hazard problems of the bank regulatory system? LetÕs use the analysis in the chapter to evaluate the most important provisions of this legislation to answer this question.

Before looking at the evaluation for each set of provisions and proposals in this application, try to reason out how well they will solve the current problems with banking regulation. This exercise will help you develop a deeper understanding of the material in this chapter.

FDICIAÕs reduction of the scope of deposit insurance by limiting insurance on brokered deposits and restricting the use of the too-big-to-fail policy might have increased the incentives for uninsured depositors to monitor banks and to withdraw funds if the bank is taking on too much risk. Because banks might now fear the loss of deposits when they engage in risky activities, they might have less incentive to take on too much risk. Limitations on the use of the too-big-to-fail policy starting in 1992 have resulted in increased losses to uninsured depositors at failed banks as planned.

Although the cited elements of FDICIA strengthen the incentive of depositors to monitor banks, some critics of FDICIA would take these limitations on the scope of deposit insurance even further. Some suggest that deposit insurance should be eliminated entirely or should be reduced in amount from the current $100,000 limit to, say, $50,000 or $20,000. Another proposed reform would institute a system of coinsurance in which only a percentage of a depositÑsay, 90%Ñwould be covered by insurance. In this system, the insured depositor would suffer a percentage of the losses along with the deposit insurance agency. Because depositors facing a lower limit on deposit insurance or coinsurance would suffer losses if the bank goes broke, they will have an incentive to monitor the bankÕs activities. Other critics believe that FDICIA provides too much support for the too-big-to-fail policy. Because under FDICIA the Fed, the Treasury, and the FDIC can still agree to implement too-big-to-fail and thus bail out uninsured as well as insured depositors, big banks will not be subjected to enough discipline by uninsured depositors. These critics advocate eliminating the too-big-to-fail policy entirely, thereby decreasing the incentives of big banks to take on too much risk.

Prompt

Corrective

Action

However, other experts do not believe that depositors are capable of monitoring banks and imposing discipline on them. The basic problem with reducing the scope of deposit insurance even further as proposed is that banks would be subject to runs, sudden withdrawals by nervous depositors. Such runs could by themselves lead to bank failures. In addition to protecting individual depositors, the purpose of deposit insurance is to prevent a large number of bank failures, which would lead to an unstable banking system and an unstable economy as occurred periodically before the establishment of federal deposit insurance in 1934. From this perspective, federal deposit insurance has been a resounding success. Bank panics, in which there are simultaneous failures of many banks and consequent disruption of the financial system, have not occurred since federal deposit insurance was established.

On the one hand, evidence that the largest banks benefiting from the de facto too- big-to-fail policy before 1991 were also the ones that took on the most risk suggests that limiting its application, as FDICIA does, may substantially reduce risk taking. On the other hand, eliminating the too-big-to-fail policy altogether would also cause some of the same problems that would occur if deposit insurance were eliminated or reduced: The probability of bank panics would increase. If a big bank were allowed to fail, the repercussions in the financial system might be immense. Other banks with a correspondent relationship with the failed bank (those that have deposits at the bank in exchange for a variety of services) would suffer large losses and might fail in turn, leading to a full-scale panic. In addition, the problem of liquidating the big bankÕs loan portfolio might create a major disruption in the financial market.

The prompt corrective action provisions of FDICIA should also substantially reduce incentives for bank risk taking and reduce taxpayer losses. FDICIA uses a carrot-and- stick approach to get banks to hold more capital. If they are well capitalized, they receive valuable privileges; if their capital ratio falls, they are subject to more and more onerous regulation. Increased bank capital reduces moral hazard incentives for the bank, because the bank now has more to lose if it fails and so is less likely to take on too much risk.

In addition, encouraging banks to hold more capital reduces potential losses for the FDIC, because increased bank capital is a cushion that makes bank failure less likely. Furthermore, forcing the FDIC to close banks once their net worth is less than 2% (group 5) rather than waiting until net worth has fallen to zero makes it more likely that when a bank is closed, it will still have a positive net worth, thus limiting FDIC losses.

Prompt corrective action, which requires regulators to intervene early when bank capital begins to fall, is a serious attempt to reduce the principalÐagent problem for politicians and regulators. With prompt corrective action provisions, regulators no longer have the option of regulatory forbearance, which, as we have seen, can greatly increase moral hazard incentives for banks.

Some critics of FDICIA feel that there are too many loopholes in the bill that still allow regulators too much discretion, thus leaving open the possibility of regulatory forbearance. However, an often overlooked part of the bill increases the accountability of regulators. FDICIA requires a mandatory review of any bank failure that imposes costs on the FDIC. The resulting report must be made available to any member of Congress and to the general public upon request, and the General Accounting Office must do an annual review of these reports. Opening up the actions of the regulators to public scrutiny will make regulatory forbearance less attractive to

Risk-Based

Insurance

Premiums

Other FDICIA

Provisions

Other Proposed

Changes in

Banking

Regulations

them, thereby reducing the principalÐagent problem. It will also reduce the incentives of politicians to lean on regulators to relax their regulatory supervision of banks.

Under FDICIA, banks deemed to be taking on greater risk, in the form of lower capital or riskier assets, will be subjected to higher insurance premiums. Risk-based insurance premiums will consequently reduce the moral hazard incentives for banks to take on higher risk. In addition, the fact that risk-based premiums drop as the bankÕs capital increases encourages the bank to hold more capital, which has the benefits already mentioned.

One problem with risk-based premiums is that the scheme for determining the amount of risk the bank is taking may not be very accurate. For example, it might be hard for regulators to determine when a bankÕs loans are risky. Some critics have also pointed out that the classification of banks by such measures as the Basel riskbased capital standard solely reflects credit risk and does not take sufficient account of interest-rate risk. The regulatory authorities, however, are encouraged by FDICIA to modify existing risk-based standards to include interest-rate risk and, as we have seen earlier in the chapter, have proposed guidelines to encourage banks to manage interest-rate risk.

FDICIAÕs requirements that regulators perform bank examinations at least once a year are necessary for monitoring banksÕ compliance with bank capital requirements and asset restrictions. As the S&L debacle illustrates, frequent supervisory examinations of banks are necessary to keep them from taking on too much risk or committing fraud. Similarly, beefing up the ability of the Federal Reserve to monitor foreign banks might help dissuade international banks from engaging in these undesirable activities.

The stricter and more burdensome reporting requirements for banks have the advantage of providing more information to regulators to help them monitor bank activities. However, these reporting requirements have been criticized by banks, which claim that the requirements make it harder to lend to small businesses.

Regulatory Consolidation. The current bank regulatory system in the United States has banking institutions supervised by four federal agencies: the FDIC, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve. Critics of this system of multiple regulatory agencies with overlapping jurisdictions believe it creates a system that is too complex and too costly because it is rife with duplication. The Clinton administration proposed a consolidation in which the duties of the four regulatory agencies would be given to a new Federal Banking Commission governed by a five-member board with one member from the Treasury, one from the Federal Reserve, and three independent members appointed by the president and confirmed by the Senate. The Federal Reserve strongly opposed this proposal because it believed that it needed to have hands-on supervision of the largest banks through their bank holding companies (as is the case currently) in order to have the information that would enable the Fed to respond sufficiently quickly in a crisis. The Fed also pointed out that a monolithic regulator might be less effective than two or more regulators in providing checks and balances for regulatory supervision. The Clinton administrationÕs proposal was not passed by Congress, but the issue of regulatory consolidation is sure to come up again.