What Works Best For Banking Regulation

What works best for banking regulation: market discipline or “hard-wired” rules? (3.000 Words)

INTRODUCTION It is a well-known fact that banks play a major role in any economy. In fact, if there were no banks then a great portion of a country’s capital base would remain idle. Currently in most jurisdictions banks are regulated by government entities and require a special bank license to operate. Banking in most countries tends to be regulated even though many economists agree that unregulated businesses generally serve consumers and the economy best if markets are competitive. Due to the importance of Banks it can be said that regulating them is not an option but a necessity. There is a variety of reasons that explain the importance of the regulation in the banking system. To be more specific, banking business is a business of receiving funds from the public through the acceptance of money deposits and use of such funds for investments therefore the depositors must be protected from great exposure to risk of banks failing. In other words banks should not be allowed to take great risks that might cause them to fail. Without regulation banks will be left to take more risk than is optimal and that sometimes leads to systemic dangers of bank failures. This means banks must be properly regulated by an authorized body so as to protect the depositors and guarantee the functioning and protection against systemic risks. Moreover, another possible reason is maintenance of public confidence in the banking system. Depositors rely on banks for withdrawals and so if depositors start to believe their banks are heading towards insolvency, the first most common reaction is to go and withdraw their deposits. These in turn create for serious problems for banks because bank runs are costly.1A major consequence of bank runs is the collapse of a bank due to the limited reserves it holds. Regulation provides a solution to this probability by setting the minimum reserves each bank must hold to cater for depositors. Moreover, it is the regulator’s responsibility to ensure that the banks are holding enough capital to bear the cost of losses. These capital requirement can only be imposed on banks through regulation.

1. http://www.res.org.uk/society/mediabriefings/pdfs/1996/July/benston.pdf

Regulation is proven to be a crucial factor for the well being of the economy. There must be some limits to the financial market and especially to the way Banks act to ensure that is accompliced. The current financial crisis is proof of what poor regulation can cause. The chairman of the Financial Services Authority has said its failure to spot the crisis in advance was partly due to the style of regulation. In the same way, Organization for Economic Co-operation and Development (OECD) claims that the regulatory framework was very poor because “not only did it fail to prevent the crisis but also contributed to it”. The crisis has shown that current regulations have not successfully controlled bank risktaking behavior.2 It is apparent that the influence of regulation upon an economy is substantial and in order to escape from the economic crisis that we are facing we have to give emphasis to a more efficient way of regulating the banking system. One of the most important weaknesses of the present regulation system is that it is unable to manage the information asymmetry which deals with the study of decisions during transactions where one party has more or better information than the other. As a result an imbalance of power during transactions is created which is totally unfair for the part that knows less and who does not know the risk it is exposed to. The situation is worsened by the principal-agent problems that exist in businesses and define the economy.

MARKET DISCIPLINE OR HARD-WIRED RULES Asymmetric information is a crucial problem that buyers and sellers face. Regulators try to find ways to regulate the information so as not to be false representation but accurate, sufficient, comparable and relevant so that the right amount of information is released. Two different ways of managing the risk caused information asymmetries can be supported by market discipline or hard-wired rules. Regulators have a choice to either promulgate countless new regulations governing every aspect of bank behavior

2. “Bank Regulation and Market Discipline around the World” http://www.rieti.go.jp/jp/events/05091301/pdf/3-2_tsuru_paper.pdf

and hire examiners to enforce them or seek ways to impose a greater degree of market discipline on the system. The third pillar of Basel II encourages market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information. It focuses on market discipline mechanisms to improve the flow of information between banks and investors. These mechanisms help market participants monitor and punish excessive risk-taking behavior.3Banks will have incentives to improve their internal controls, systems operations and overall risk management practices if they improve the quality of information regarding the bank’s exposure and management practices. It can be said that that private sector agents including depositors, creditors and stockholders face costs that are increasing in the risks undertaken by banks and take action on the basis of these costs. For example, uninsured depositors, who are exposed to bank risk-taking, may penalize riskier banks by requiring higher interest rates otherwise banks face depositors’ funds.4A high risk sensitivity of depositors implies that banks will be punished by paying higher deposit interest rate. It is widely supported that market discipline is beneficial for incorporating market information into the supervisory process. Some commentators have even argued that market discipline should progressively replace, rather than complement official supervision. In reality it has less to do with the market per se than with the institutional and legal framework used to address moral hazard and asymmetric information problems that are endemic in the financial system. A very important role of market discipline is that it gives regulators the information on how much risk a bank is taking. Not only do market signals provide a good sense of whether one bank is taking more risk than another, the use of these signals could lead regulators to act more quickly than they might otherwise. This also provides regulators with a sense of how much risk taking is efficient. A number of studies underline that markets can be effective in assessing the risk. Moreover, monitoring risk in banks should not only be conducted

3. “Time to rethink market discipline” October 24, 2008 http://crisistalk.worldbank.org/2008/10/time-to-rethink.html 4. Martinez Peria and Schmukler 2001 p.1030

by official agencies whose specialist task it is. The market has incentives to monitor the behavior of other financial firms. The disciplines imposed by the market can be as powerful as any sanctions imposed by official agencies. Several parties are potentially able to monitor the management of banks: owners, bank depositors and customers and so on. The merit of increasing the role of market discipline is that large, well-informed creditors have the resources, expertise, market knowledge and incentives to conduct monitoring and to impose discipline. Having agents instead of official supervisory bodies to monitor banks removes the inherent danger of having it conducted by a monopolist with less than perfect and complete information and has the inevitable result that mistakes will be made. Market discipline seems to be a solution to monitor the risk that banks take. But while it is potentially powerful, it has its limitations. To be more specific, there is a variety of reasons why it is unlikely to be an effective complete alternative to the role of official regulatory and supervisory agencies. First of all, it can be claimed that the private cost of market monitoring and information collection may exceed the private benefits to those undertaking it. Another reason is that market discipline is not effective in monitoring and disciplining public sector banks while sometimes “free-rider” problems may emerge. This is a situation where some individuals in a population either consume more than their fair share of a common resource, or pay less than their fair share of the cost of a common resource. It is a fact that the market is able to price bank securities and interbank loans efficiently only to the extent that relevant information is available, and in many cases the necessary information is not available. Furthermore, the market participants that are responsible for monitoring the risk don’t always have the necessary expertise to carry out risk assessment of complex banks. In addition, there are some areas within a bank where disclosure is not feasible. Market discipline doesn’t work in every country because in some countries debt markets (including securities and debt issued by banks) are limited, insufficient and cartelized. As it can be seen, market monitoring and discipline cannot effectively replace official supervision although it has a powerful role. While we examine market discipline and whether it works best for banking regulation, it is useful to mention an interesting case study by Birchler and Maechler(2001)

concerning the discipline imposed by bank depositors in Switzerland. The main hypothesis underlying the empirical tests is that “depositors exert market discipline by monitoring their banks and by withdrawing uninsured deposits whenever performance of their bank is no longer satisfactory. Bank fundamentals therefore help to explain the amount of uninsured deposits a bank is able to attract” The authors use quantity indicators rather than price indicators. Their key conclusions which they came up with are underlined below: •

Contrary to conventional wisdom, depositors do seem to monitor their banks

•

Uninsured savings deposits react to business conditions and deposits are

withdrawn when the fundamentals of the bank deteriorate. •

Depositors responded to changes in the Swiss deposit protection system

•

Depositors were found to be sensitive to institutional differences across banking

groups •

State guarantees have tended to weaken market discipline.

These conclusions suggest that market discipline does work when the conditions are propitious. The authors state “The fact that investors use their information does not imply that they use it correctly. Market discipline therefore does not shield banks and depositors from irrational swings in general market discipline”. They concluded that the total reliance cannot be placed on market discipline. Moreover, depositors are in a position to monitor banks and to respond to bank-specific risks that quantity indicators rather than price signals have a role in potentially disciplining banks and when conditions are conductive, market discipline can be a viable disciplining mechanism on banks. When conditions are conductive, market discipline can be a viable disciplining mechanism on banks. According to another case (Boyle et al 2002) banks in Denmark were realistic in disclosing their potential losses during the banking crisis and did not try to hide losses in the hope that the problem might ease in the future. It emerges that market discipline backed up by more disclosure might operate in practice. There are some proposals for enhancing the effectiveness of market discipline so as to monitor the risk in a more

efficient way. To be more specific, there are various approaches to enhancing the effectiveness of market discipline of bank risk and choosing one approach over another depends in part on which basic objective of deposit insurance is considered to be most important The proposals 5 are the following: ➢

Phase out federal deposit insurance to facilitate the development and use of

private deposit insurance. Short and O’ Driscoll (1983). Ely(1985). England (1985) and Smith (1988). ➢

Lower the ceiling on federal insurance coverage per account. Council

of

Economic Advisers (1989). p p.203-4 ➢

Co-insurance, limit federal deposit insurance to some fraction of each account

Boyd and Rolnick (1988) ➢

Place a ceiling on federal deposit insurance per individual at all depository

institutions. England (1988) ➢

All institutions must maintain subordinated debt liabilities that are some fraction

of their total assets. Cooper and Fraser (1988). Keehn (1989) and Wall (1989).

5. R. Alton Gilbert “Market Discipline of Bank Risk: Theory and Evidence” http://research.stlouisfed.org/publications/review/90/01/Discipline_Jan_Feb1990.pdf”

➢

Early closure: close or reorganize depository institutions when their capital ratios,

reflecting the market value of assets and liabilities, are low but still positive. This proposal is designed to enhance the effectiveness of market discipline by closing or reorganizing banks whose shareholders have weak incentive to limit risks. Benston and Kaufman (1988). These proposals are designed so as to reduce the incentives for banks to expose themselves to high risks. Market discipline has the advantage of understanding the way

depositors and creditors react to any impulse of the market and tries to take advantage of it. Bankers will not adhere to the rules because they have to but on the other hand they will do what is best for them so as not to loose their money and gain more. This means that they will abide by the rules. Rules based regulation on its one causes problems. The probability of loosing the control of the “game” appears and the market fail to monitor the risk-taking by banks. The model of market discipline therefore does not provide the ultimate solution to the way banks should be regulated. More drastic measures have to be taken on some occasions.

Some regulators claim that markets should be subject to hard-wired rules. This is because they will provide important support to consumers. Global bank regulators have agreed tough new rules for banks that could see defined limits placed on lending, dividend payouts and the amount and quality of capital banks should have. It is a wellknown fact that rules help banks to gain the stability and the safety that the bankers and customers need. If the customer feels that there are rules that protect him from loosing his money and guarantee the function of the bank then it is easier for him to invest in a bank .It is claimed that Banks would not work without rules. It is supported also that hard-wired rules must be implemented in order to avoid any kind of future crisis. Law according to these supporters must interfere and provide guidance to every single function of the bank. It is the only way bankers are deterred from taking unlimited risk because there would be restrictions and very strict supervision from the government. Definitely the rules are beneficial for a variety of reasons. To be more specific, law capitalization exists in the banks which lead to many problems, either there is not enough capital or the level is just low. Here comes the law to solve this problem. Rules of how much capital banks are obliged to hold come to the surface. In fact, it is agreed that many in Europe will be forced to raise tens of billions of euro in capital. Moreover, banks are battling a liquidity crunch and an asset liability mismatch in their books. An asset-liability mismatch situation occurs if for example banks mobilize short-term deposits and lend loans on longer terms. This, borrow short and lend long means that they have to roll over their liabilities (deposits) faster than their assets (loans). When the spread between the long-term and short-term rates narrows down, a serious asset-

liability mismatch could expose the banks to interest rate risk and could affect their profitability. As a consequence, liquidity problems arise and drastic measures must be taken. To face this crucial problem banks need Central Banks to provide them with liquidity so as to illuminate the systemic risk. This provides a case for setting rules to define the role of Central Banks in providing assistance to banks and the circumstances under which this help has to be laid on. Research has proven that excessive regulation endangers growth in the real economy and as a consequence it does not seem to be a good solution to economic problems.6 The implementation of tougher rules will reduce borrowing and economic activity in general, which is the opposite of what the objective should be in a recession. Furthermore, the rules that are applied must be really enforceable and sometimes this is very difficult. The markets are always changing therefore regulation has to be flexible to accommodate these changes. The needs of bankers and the investors also change rapidly and so any rules that are proposed must be aligned with changing events. As a result of the fact that hard wired rules do not provide flexibility and cannot change as rapidly as market does, enforcing specific rules in every single function of a bank is not a solution because they prove to be inefficient and provide very little foundation for

6. Financial Times http://www.ft.com/cms/s/0/f694ed24-d3b8-11de-8caf-00144feabdc0.html

financial stability. There is also the disadvantage that hard-wired rules prove to be highly costly to implement.7This is because firms have to hire experts to interpret the rules in order to design efficient regulation policies and supervisory tools to ensure rules are being followed. It can be said that the implementation and the enforcement of rules will be even more expensive especially for developing countries. CONCLUSION As discussed above, neither market discipline nor “hard-wired” rules can be employed as a regulatory mechanism by itself. Market discipline cannot be a substitute for banking because whilst it has is benefits it also has limitations. The solution is somewhere in the

middle. To be more specific, there must be some minimum set of rules set by a regulatory body that give some form of

guidance concerning how banks should

function. The rules must be employed as minimum standards in giving guidance to crucial aspects of the banking system. An example of this might be the rules concerning the amount of capital banks are obliged to hold. The banking system does not need hard-wired rules on their own to function but just the right combination of rules that allow banks to maintain a certain level of discipline. As far as regulation is concerned, macroprudential regulation must be adopted for banks. The essence of macroprudential regulation is that financial firms acting in an individually prudent manner will be guarded against systemic failure. Macro-prudential regulation is the response to a failure of composition – we cannot make the financial system safe merely by making every financial institution and product safe. The future of regulation therefore requires the collaboration of market discipline and hard-wired rules in order for financial institutions to be more prudent. On their own, neither market discipline nor hard-wired rules can sustain the ever changing financial system but together they can provide the stability, safety and innovation financial institutions need to survive.

7. Global Governance of Financial Systems: The International Regulation of Systemic Risk by John Eatwell, Kern Alexander, Rahul Dhumale

BIBLIOGRAPHY 1. Global Governance of Financial Systems: The International Regulation of Systemic Risk by John Eatwell, Kern Alexander, Rahul Dhumale 2. Martinez Peria and Schmukler 2001 p.1030 3. R. Alton Gilbert “Market Discipline of Bank Risk: Theory and Evidence” http://research.stlouisfed.org/publications/review/90/01/Discipline_Jan_Feb1990.pdf” 4. “Time to rethink market discipline” October 24, 2008 http://crisistalk.worldbank.org/2008/10/time-to-rethink.html

5. “Bank Regulation and Market Discipline around the World” http://www.rieti.go.jp/jp/events/05091301/pdf/3-2_tsuru_paper.pdf 6.

http://www.res.org.uk/society/mediabriefings/pdfs/1996/July/benston.pdf

7. Financial Times http://www.ft.com/cms/s/0/f694ed24-d3b8-11de-8caf-00144feabdc0.html