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Government safety net: Deposit insurance and the CDIC Short circuits bank failures and contagion effect Payoff method Purchase and assumption method Government can support banks through lending from the central bank “Lender of Last Resort” role for central bank Government can provide funds directly to institutions in need
Copyright 2011 Pearson Canada Inc. 10- 1 Chapter 10 Economic Analysis of Banking Regulation Copyright 2011 Pearson Canada Inc. 10- 2 Asymmetric Information and Bank Regulation I • Government safety net: Deposit insurance and the CDIC – Short circuits bank failures and contagion effect – Payoff method – Purchase and assumption method • Government can support banks through lending from the central bank – “Lender of Last Resort” role for central bank – Government can provide funds directly to institutions in need Copyright 2011 Pearson Canada Inc. 10- 3 Asymmetric Information and Bank Regulation II • Moral Hazard – Depositors do not impose discipline of marketplace – Banks have an incentive to take on greater risk – “Heads I win, tails the taxpayer loses” • Adverse Selection – Risk-lovers find banking attractive – Depositors have little reason to monitor bank Copyright 2011 Pearson Canada Inc. 10- 4 Too Big to Fail • Failure of very large financial institution makes it more likely that major financial disruption will occur • Regulators unwilling to let large institutions fail • Government provides guarantees of repayment to large uninsured creditors of the largest banks which reduces investors incentive to monitor banks activities • Increases moral hazard incentives for big banks making a financial crisis more likely Copyright 2011 Pearson Canada Inc. 10- 5 Financial Consolidation • Larger and more complex banking organizations challenge regulation – Increased “too big to fail” problem – Extends safety net to new activities, increasing incentives for risk taking in these areas Copyright 2011 Pearson Canada Inc. 10- 6 Restrictions on Asset Holding • Even without government intervention banks have incentive to take more risk as risky assets provide higher returns. • Full information to creditors/depositors on banks risk-taking activities might mitigate problem. • Government regulation directly attempts to restrict banks from too much risk taking – Restrict holdings of common stock – Promote diversification Copyright 2011 Pearson Canada Inc. 10- 7 Capital Requirements • Government can impose set capital requirements – Minimum leverage ratio (amount of capital divided by the bank’s total assets) • Increase in off balance sheet activities a concern – Basel Accord: risk-based capital requirements – Regulatory arbitrage Copyright 2011 Pearson Canada Inc. 10- 8 Financial Supervision: Chartering and Examination • Chartering (screening of proposals to open new banks) to prevent adverse selection • Examinations (scheduled and unscheduled) to monitor capital requirements and restrictions on asset holding to prevent moral hazard – Capital adequacy – Asset quality – Management – Earnings – Liquidity – Sensitivity to market risk • Filing periodic ‘call reports’ Copyright 2011 Pearson Canada Inc. 10- 9 Assessment of Risk Management • Greater emphasis on evaluating soundness of management processes for controlling risk • Focus is four elements of risk management – Quality of oversight provided – Adequacy of policies and limits – Quality of the risk measurement and monitoring systems – Adequacy of internal controls • Interest-rate risk limits – Internal policies and procedures – Internal management and monitoring – Implementation of stress testing and Value-at risk (VAR) Copyright 2011 Pearson Canada Inc. 10- 10 Disclosure Requirements • Requirements to adhere to standard accounting principles and to disclose wide range of information • Eurocurrency Standing Committee of the G-10 Central Banks also recommends estimates of financial risk generated by the firm’s internal monitoring system be adapted for public disclosure [...]... performance of problem institution Other Proposed Changes - Regulatory consolidation - Market-value accounting Banking Crisis Throughout The World Deja Vu All Over Again • Deposit insurance not important role for many countries experiencing banking crises • It is the existence of a government safety net that increases moral hazard incentives for excessive risk taking on the part of banks The Costs of Rescuing... excessive risk taking on the part of banks The Costs of Rescuing Banks in Several Countries Financial Regulation after Subprime Financial Crisis • • • • • Increased Regulation of Mortgage Brokers Fewer Subprime Mortgage Products Regulation Compensation Higher Capital Requirements Additional Regulation of Privately Owned Government-Sponsored Enterprises ... costs of borrowing (including a standardized interest rate) • Requires provision of information on the method of assessing finance charges • Requires that billing complaints be handled quickly Restrictions on Competition • Justified by moral hazard incentives to take on more risk as competition decreases profitability • Disadvantages – Higher consumer charges – Decreased efficiency International Banking. .. incentives of uninsured depositors to monitor the risk-taking activities of banks, thereby reducing moral hazard risk Evaluating CDIC I Limits on Scope of Deposit Insurance 1 Eliminate deposit insurance entirely 2 Lower limits on deposit insurance 3 Eliminate too-big-to-fail 4 Coinsurance Prompt Corrective Action 1 Critics believe too many loopholes 2 However: accountability increased by mandatory review of. .. the required expertise to manage risk 2 The existence of CDIC, more opportunities for risk taking The 1980s Canadian Banking Crisis II 3 Because of the lending boom, bank activities were becoming more complicated Regulators had neither the expertise nor the resources to monitor these activities appropriately 4 inflation ↑ interest rates ↑, net worth of banks ↓ - Insolvencies ↑ - Incentives for risk taking... risky loans ↑ The 1980s Canadian Banking Crisis III Later Stages: Regulatory Forbearance Regulators allow insolvent banks to operate because A Insufficient funds to close insolvent banks and pay off their deposits B Sweep problems under rug Insolvencies caused further banking difficulties CDIC Developments I • CDIC insures each depositor at member institutions up to a loss of $100 000 per account • All... provincially incorporated TMLs are members of the CDIC • Insurance companies, credit unions, caisses populaires, and investment dealers are not eligible for CDIC CDIC Developments I • CDIC insures each depositor at member institutions up to a loss of $100 000 per account • All federally incorporated financial institutions and all provincially incorporated TMLs are members of the CDIC • Insurance companies,... Decreased efficiency International Banking Regulation • Similar to Canada – Chartered and supervised – Deposit insurance – Capital requirement • Particular problems – Easy to shift operations from one country to another – Unclear jurisdiction lines The 1980s Canadian Banking Crisis I • Mid 1980s Canadian Commercial and Northland banks in Alberta failed and a large number of other institutions were having financial... premiums means investments with differing risk profiles are subject to different insurance premiums • Premium categories range from 1 (best) for a well capitalized bank, to 4 (worst) for a significantly under capitalized bank Opting-Out I • Permits Schedule III banks, that accept primarily wholesale deposits (defined as $150 000 or more), to opt out of CDIC membership and therefore to operate without... CDIC CDIC Developments II • QDIB insures provincially incorporated institutions in Québec and the other provinces have deposit insurance corporations that insure the deposits of credit unions • Not all deposits and investments offered by CDIC member institutions are insurable Not All Deposits Are Insurable Insurable deposits include • • • Savings and chequing accounts Term deposits with a maturity date