Domestic and International Financial Regulation

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Domestic and International Financial Regulation

• Xavier Vives
• INSEAD
• http//faculty.insead.edu/vives

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Background work

• Matutes and Vives (JFI 1996, EER 2000)
• Vives (EER 2001)
• Gale and Vives (QJE 2002)
• Rochet and Vives (JEEA 2004)

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Outline

• The rationale for regulation in banking
• Emerging markets
• The role of external discipline
• Assessing the trade-offs
• The role of an International LOLR
• Conclusion and issues for research

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Banking

• What do banks do?
• Crises and regulation
• Lender of Last Resort and moral hazard
• Prudential supervision
• Emergent economies

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What do banks do?

• Provide transaction services/payment system
• Provide insurance and risk sharing
• Finance illiquid entrepreneurial projects
• (because of asymmetric information problems, like
  adverse selection and moral hazard, firms
  projects need monitoring)

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Crises and fragility

• Liquidity provision leaves banks vulnerable to
  panics and crises (coordination failure of
  investors)
• Standard deposit contract and loan provision to
  opaque entrepreneurial projects are
  complementary
• Short-term debt provides incentives to bank
  managers subject to a moral hazard problem to
  monitor loans
• Competitive banking system may approximate second
  best efficiency but typically there is excessive
  project liquidation

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Regulation

• Rationale
• Systemic risk and economy-wide externalities
• Protection of investor
• Facilities and policies
• Lender of Last Resort, Deposit Insurance
• Too Big to Fail
• Capital requirements, prudential regulation
• Supervision

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Lender of Last Resort and Moral hazard

• Central bank helps banks in distress with a line
  of credit or open market operation
• Bailouts avoid costly liquidation of projects but
  induce a moral hazard problem
• banker will not monitor projects if he knows it
  will be bailed out when in trouble
• (e.g. bailouts in Argentina, Mexico, Thailand)
• Need threat of closure to discipline bank
  managers

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The commitment problem

• Central bank policy is time-inconsistent
• Ex ante the central bank would like to commit to
  close the bank (not to help) if returns are low
• Ex post (once the crisis is ongoing) it is always
  optimal to help (because to liquidate projects is
  costly and bank manager welcomes help)
• A time-inconsistent policy will lead to excessive
  bailouts
• Solution build a reputation for toughness to
  implement incentive-efficient solution
• Federal Reserve, Bundesbank

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Prudential supervision

• Limited liability and insurance/safety net yield
  excessive risk taking incentives
• Charter value/market power moderates risk taking
• Risk-based (deposit) insurance and disclosure
  requirements have been proposed to limit
  risk-taking behavior
• Three pillars of Basel II
• Risk-based capital requirements
• Supervision
• Market discipline (disclosure)

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Emergent economies

• High uncertainty and risk
• Higher economic volatility
• Higher direct and indirect exposure to exchange
  rate risk (leading to credit risk)
• Higher non-diversifiable risk in a typical loan
  portfolio
• Currency crises and banking crises

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Emergent economies

• More severe asymmetric information problems lead
  to
• Less developed financial markets (leading to
  worse hedging and maturity mismatches)
• Enhanced monitoring role of financial
  intermediaries
• High social cost of failure/cost of liquidation
  of projects
• High rate of discounting implying low charter
  values (even with relatively weak competition)

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Emergent economies

• Weak supervisory structure
• Information problems
• Enforcement problems
• Lack of protection of regulators
• Aggravated commitment problem of Central Bank
  because of weak regulatory structure and short
  horizons
• Tendency to bailouts and blanket insurance

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Regulatory implications

• Developed country strategy (disclosure, market
  discipline, risk-based insurance/capital
  requirements) difficult to follow
• E.g. Basel II, internal rating approach not
  calibrated to emergent economy while not enough
  rated institutions for standardized approach to
  make a difference
• Capital requirements need to be adapted to
  conditions of emerging economies and complemented
  by other asset restrictions
• Competitive pressures and market discipline
  should not be overdone
• Policy commitment problem becomes central Need
  to import external discipline

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External discipline

• Dollarization represents a commitment to a
  limited use of the LOLR facilities
• Help must be arranged in advance (stabilization
  funds and/or tax schemes, or pre-contracted in
  the international market) like in Argentina when
  currency board was in place
• It is costly to reverse (although a currency
  board is less credible...)
• Short-term debt denominated in foreign currency
  (cannot be inflated away by Central Bank like
  domestic debt)

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Trade-offs of external discipline

• Benefit
• Solves the time-inconsistency problem of CB
  policy/opportunistic behavior of government
• Imposes discipline to banker/private sector by
  avoiding excessive help
• Cost
• Excessive liquidation of entrepreneurial projects
• (e.g., help is not available even when it is ex
  ante good)

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Foreign-denominated short-term debt

• Two-edged sword
• disciplining device but
• leaves door open to systemic risk, speculative
  attack, and sudden reversal of capital flows
• Optimal amount of foreign short-term debt is not
  zero but danger of overexposure
• Empirical results on impact on probability of
  crisis are mixed
• Partial dollarization can be a risky strategy
• (exchange rate risk transformed into credit risk,
  CB help counterproductive)

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Where to import external discipline?

• Countries with a credibility problem for the
  Central Bank in which
• there is a significant but not extreme (hopeless)
  moral hazard problem
• monitoring effort by bankers and entrepreneurs is
  important in improving returns and
• cost of liquidating projects is not too large

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What countries are those?

• Factors point at intermediate range of countries
  with a weak institutional structure but without
  an extreme agency problem
• How to (crudely) measure the factors?
• Moral hazard
• Battery of legal indicators reflecting rule of
  law and property rights (''law and order
  tradition'' of the country, corruption, risk of
  expropriation and risk of contract repudiation by
  the government)
• Importance of monitoring to obtain returns
• relevance of banks in financial system
• Cost of liquidation of projects
• creditors rights, level of development of
  financial system, accounting standards

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Universe of countries of reference

• Latin America
• Argentina, Brazil, Chile, Colombia, Ecuador,
  Mexico, Peru, Uruguay and Venezuela
• East Asia
• Hong Kong, Indonesia, Malaysia, Philippines,
  Singapore, South Korea, Taiwan and Thailand
• Periphery of Europe Turkey

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Level of external discipline

• High Chile, Ecuador, South Korea, Taiwan and
  Thailand (with high benefit and medium or low
  cost).
• Medium Hong Kong, Malaysia, Singapore (with
  medium benefit and low cost) and Argentina,
  Brazil, Colombia, Mexico, Turkey (with high
  benefit and medium or high cost).
• Low Venezuela, Uruguay (with high cost and
  severe MH problem).
• Very low Peru, Indonesia, Phillipines (very
  severe MH problem).

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Magic proposals

• Narrow banking
• Monetary Union
• Foreign banks and foreign regulation
• Public banks
• Offshore banking

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An International LOLR?

• Market failures
• Coordination problem of international investors
• Commitment problem of domestic institutions
• Context Country with foreign-denominated
  short-term debt to access international capital
  market
• With no ILLR typically the coordination failure
  of investors imposes liquidation too often

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Role of ILOLR (I)

• ILOLR can
• inject liquidity in international markets or
• help countries in trouble
• In (2) tension between crisis prevention and
  moral hazard
• ILOLR à la Bagehot modified with a policy of
  prompt corrective action and with facilities for
  orderly failure resolution can implement
  incentive-efficient solution

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Role of ILOLR (II)

• An ILLOR facility of help for solvent countries
  needs to be complemented with
• a policy of prompt corrective action whenever the
  country is close to insolvency if the moral
  hazard problem in the country is severe
• an orderly resolution of failure process for an
  insolvent country when not too far away from the
  solvency threshold if the moral hazard problem in
  the country is moderate.

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Summary

• Regulatory problems in emergent country
  aggravated by more acute asymmetric information
  and weak institutions
• Regulation needs to be adapted (e.g., limited
  reliance on transparency and risk-based
  instruments)
• Commitment problem of domestic institutions is
  central and external discipline has an important
  role
• A modified international LOLR may implement
  incentive-efficient solution

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Issues for research

• Determinants of the optimal level of short-term
  foreign debt for a small open economy with a
  policy commitment problem
• Optimal regulatory policy mix for each stage of
  development and maturity of institutional
  structure of emergent economy
• Role of international agencies