Chapter Eighteen Banking Regulation Copyright © 2004 Pearson Education Canada Inc. Slide 18–3 How Asymmetric Information Explains Banking Regulation

Chapter Eighteen

Banking Regulation

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



3. Bank Capital Requirementsa. 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 Examinationa. 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. Disclosure Requirements– Better info reduces asymmetric info problem

6. Consumer Protectiona. Standardized interest rates (APR)

b. Prevent discrimination

7. Restrictions on Competition to Reduce Risk-Takinga. Branching restrictions

b. Separation of banking and securities industries



• International Banking Regulation1. Bank regulation abroad similar to ours

2. Particular problem of regulating international banking (e.g., BCCI scandal)


Major Banking Legislation in Canada


Canada Deposit Insurance Corporation Developments

1. Differential Premiums

2. Opting-Out


Evaluating CDIC and Other Reforms

• Limits on Scope of Deposit Insurance1. Eliminate deposit insurance entirely

2. Lower limits on deposit insurance

3. Eliminate too-big-to-fail

4. Coinsurance

• Prompt Corrective Action1. Critics believe too many loopholes

2. However: accountability increased by mandatory review of bank failure resolutions


Financial Services Reform for the 21st 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


Figure 1: Banking Crises Throughout the World Since 1970


Cost of Banking Crises in Other Countries


Calculating Capital Requirements

First Bank Assets Liabilities

Reserves $3 m Chequable deposits $20 m Canada securities $10 m Nontransactions

deposits $60 m

Government agency securities

$7 m Borrowings $11 m

Municipal bonds $10 m Loan loss reserves $2 m Residential mortgages $10 m Bank capital $7 m Real estate loans $20 m C&I loans $35 m Fixed assets $5 m


Calculating Capital Requirements

• Leverage Ratio = Capital/Assets = $7m/$100m = 7%

• Bank is well capitalized


0 $3 million (Reserves) +0 $10 million (Treasury securities)

+ .20 $7 million (Agency securities) + .50 $10 million (Municipal bonds) + .50 $10 million (Residential mortgages) +1.00 $20 million (Real estate loans) +1.00 $35 million (Commercial loans) +1.00 $5 million (Fixed assets)

+1.00 $20 million (Letters of credit) $91.4 million (Total risk-adjusted assets)

Calculating Risk-Adjusted Requirements


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

Documents

Chapter Eighteen Banking Regulation Copyright © 2004 Pearson Education Canada Inc. Slide 18–3 How Asymmetric Information Explains Banking Regulation