Economic Analysis Of Banking Regulation: © 2005 Pearson Education Canada Inc

Chapter 11 Economic Analysis of Banking Regulation

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How Asymmetric Information Explains Banking Regulation 1. Government Safety Net and Deposit Insurance A. Prevents bank runs due to asymmetric information: 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 increases moral hazard incentives for big banks 2. Restrictions on Asset Holdings A. Reduces moral hazard of too much risk taking

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How Asymmetric Information Explains Banking Regulation 3. Bank Capital Requirements A. Reduces moral hazard: banks have more to lose when have higher capital B. Higher capital means more collateral for FDIC 4. Bank Supervision: Chartering and Examination A. Reduces adverse selection problem of risk takers or crooks owning banks B. Reduces moral hazard by preventing risky activities 5. New Trend: Assessment of Risk Management 6. Disclosure Requirements A. Better information reduces asymmetric information problem © 2005 Pearson Education Canada Inc.

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How Asymmetric Information Explains Banking Regulation 3. Bank Capital Requirements A. 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 Examination A. 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 A. Better information reduces asymmetric information problem

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Major Banking Legislation in Canada

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Major Banking Legislation in Canada

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Why a Banking Crisis in 1980s? Early Stages 1. Managers did not have the required expertise to manage risk 2. The existence of CDIC, more opportunities for risk taking 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.   i , net worth of banks  A. Insolvencies  B. Incentives for risk taking  Result: Failures  and risky loans  Later Stages: Regulatory Forbearance 1. Regulators allow insolvent banks to operate because A. Insufficient funds B. Sweep problems under rug © 2005 Pearson Education Canada Inc.

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Political Economy of the Banking Crisis Explanation: Principal-Agent Problem 1. Politicians influenced by bank lobbyists rather than public A. Deny funds to close banks B. Legislation to relax restrictions 2. Regulators influenced by politicians and desire to avoid blame A. Loosened capital requirements B. Regulatory restrictions on risky asset holdings C. Regulatory forbearance © 2005 Pearson Education Canada Inc.

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CDIC Developments • CDIC insures each depositor at member institutions up to a loss of $60 000 per account • All federally incorporated financial institutions and all provincially incorporated TMLs are members of the CDIC • Insurance companies, credit unions, caisses populaires, and investment dealers are not eligible for CDIC membership • QDIB insures provincially incorporated institutions in Québec and the other provinces have deposit insurance corporations that insure the deposits of credit unions in their jurisdiction • CDIC insures only deposits in Canadian currency and payable in Canada; foreign currency deposits are not insured • Not all deposits and investments offered by CDIC member institutions are insurable © 2005 Pearson Education Canada Inc.

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Not All Deposits Are Insurable Insurable deposits include • Savings and chequing accounts • Term deposits with a maturity date < 5 years • Money orders and drafts, certified drafts and cheques, and traveller’s cheques The CDIC does not insure • Term deposits with an initial maturity date > 5 years • T-bills, bonds and debentures issued by governments and corporations (including the chartered banks) • Investments in stocks, mutual funds, and mortgages. © 2005 Pearson Education Canada Inc.

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Differential Premiums By-Law

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Opting-Out By-Law • 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 deposit insurance • It requires, however, an opted-out bank to inform all depositors, by posting notices in its branches, that their deposits will not be protected by the CDIC, and not to charge any early withdrawal penalties for depositors who choose to withdraw Implications: • Minimizes CDIC exposure to uninsured deposits • By compensating only the insured depositors rather than all depositors, this legislation increases the incentives of uninsured depositors to monitor the risk-taking activities of banks, thereby reducing moral hazard risk

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Evaluating CDIC 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 bank failure resolutions Risk-based Insurance Premiums 1. Hard to implement Other Proposed Changes 1. Regulatory consolidation 2. Market-value accounting © 2005 Pearson Education Canada Inc.

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Banking Crises Worldwide

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Cost of Banking Crises in Other Countries

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