REGULATION OF BANKS Free Banking Unregulated. No central bank or government intervention. Operates freely. A free banking system consists of banks whose deposits are largely repayable on demand and where those deposits are used as payment instruments. But no state insurance scheme for deposits. Give bank notes that can be cashed in on demand. Some banks can over-issue their currency, making the conversion impossible (so-called wildcat banking). Transaction costs increase. Free banking is inherently unstable because of market failures arising. Causes counterfeiting, fraudulency, over issue of notes, and over expansion. Prone to failure. So depositors require more assurance. So banks: i. ii. iii. Disclose lots of info Pursue prudent lending policies Hold adequate capital More capital a bank holds the more resilient to shocks. If want more insurance deposit to where there is more capital. When no external regulation, market would regulate. Why do banks need regulation? Fragility of banks Bank panics have been common. When banks started to finance illiquid loans, most recessions were accompanied by loss of public confidence. Moreover central banks started to offer ‘lender of last resort’ facilities in times of financial crises. Supply liquidity to banks threatened by liquidity crisis. One source of fragility is the role of banks in providing liquidity insurance to households. Some fraction of these deposits can be used by banks to finance profitable but illiquid investments. If a high number of depositors all at once decide to withdraw their funds for reasons other than those of normal liquidity needs. Mitigation of fragility is the role of banks in screening and monitoring borrowers who cannot obtain direct finance from financial markets. Systematic risk This is the risk that the failure of a particular bank spreads to other, solvent banks. This happens because depositors are unable to distinguish between good and bad banks. Due to asymmetric info. A solvent bank facing a run will quickly run out of liquidity to meet deposit withdrawals. A bank facing such a run may engage in a ‘fire-sale’ of assets reducing the total value of the asset as underpricing it to sell fast. Many banks became heavily dependent on wholesale market funding and funding through securitisation to finance their assets over the last decade. Run can also develop in wholesale markets. Banks are therefore highly interconnected and a problem in one part of the banking system can quickly spread to other parts. Protection of depositors Therefore prudential regulations are necessary because of the lack of expertise and knowledge of individual depositors to assess the quality of the bank. . Retail banking depositors are less knowledgeable than those of wholesale banks; therefore the need for regulation is greater in retail banking. The general public (depositors) lack the information and expertise to differentiate between safe and risky assets (banks). Self-regulation faces the problem of conflicts of interest inside the banks. Arguments against regulation Costs in the form of real resources on both the regulators and the regulated. Administrative costs with banks own compliance activities, admin costs of regulatory authorities to monitor bank, dedicated capital to comply with capital requirements and funds needed to compensate clients if bank fails. Danger of regulation being so much that it reduces competition. Regulation creates moral hazard. Banks may take more risk if they know they are likely to be bailed out if they get into difficulties. Depositors are less likely to monitor what banks are doing if they know there is a regulator monitoring on their behalf. Due to guaranteed compensation if failure occurs, depositors will look for bank with highest interest rates so banks will take more risks. Regulation may encourage risk taking. Finally, there is the danger that excessive regulation imposed in one centre will lead to the movement of the activity to centres where regulation is lighter. Ways to regulate: Central bank: Private issuance of means of payment could easily generate fraud, counterfeiting and adverse selection problems. Central banks stabilize price level. Minimises financial crises. Lender of last resort prevents collapse of bank. But could halt competition and cause more risky activities as there is a safety net. Bank supervision: restrictions and examinations Overseeing those who operate banks, and how the banks are operated. Reduce moral hazard and adverse selection in the banking industry through restrictions on entry and bank examinations. Chartering and licensing banks are two ways to prevent undesirable firms from entering. To enter msut obtain a charter. The regulatory authority then evaluates the soundness of the application. Only given if has an adequate system of liquidity, internal control and a good quality of management. Government safety net: Lender of last resort Deposit insurance Gov set up deposit insurance schemes to protect depositors. depositors have less incentive to join a run if they know their deposit is protected by an insurance scheme in the event of a bank failure. Bank pays a premium to a deposit insurance company, such as the Federal Deposit Insurance Corporation (FDIC). Uses two methods; payoff method and purchase and assumption method. Payoff method: the FDIC pays off deposit at a insurance limit. After the bank’s liquidation, the FDIC lines up with other creditors of the bank and receives its share of the proceeds from the liquidated assets. Purchase and assumption method: the FDIC finds a merger partner who takes over all the deposits of the failed bank so depositors don’t lose money. But if 100% insured causes moral hazard. So they use least cost approach; Riskier banks are required to pay higher insurance premiums to the FDIC. Also use co-insurance approach; amount of deposit insured under the scheme would be less than 100 per cent. Bank capital requirements Can reduce the bank’s incentive to take risks by introducing restrictions on asset holding and bank capital requirements. Restriction on holding risky assets, limitation on the amount of loans, diversification and have bank capital.
