AC942 Modern Banking

1
AC942 Modern Banking

• Dr. Paul Hamalainen
• pkhamal_at_essex.ac.uk
• Office Hours
• Monday 2-4
• Tuesday 9-10

2
Lecture 2 Regulation in banking the need for
regulation

• Aims of the lecture
• Introduce the key features and concepts
  underlying banking theory
• Explain why banks are perceived as special
• Explain the economic rationale for regulation in
  banking and financial services
• Critically appraise the arguments for and against
  regulation

3
Key features and concepts in banking

• Transaction, information and search costs
• Economies of scale and scope
• Asymmetric information
• Adverse selection
• Moral Hazard
• Principal-agent problems

4
Asymmetric information

• Not everyone has the same information
• Everyone has less than perfect information
• Some parties to a transaction have inside
  information which is not made available to both
  sides of the transaction.
• Acquiring information is costly
• Delegated monitoring role of banks (Diamond,
  1984)

5
Adverse selection (1)

• The better informed economic agent has a natural
  incentive to exploit their informational
  advantage.
• The uninformed economic agent should anticipate
  their informational handicap and behave
  accordingly.
• Leads to distortion away from the first best
  outcome ( where both agents are equally well
  informed)

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Adverse selection (2)

• Information problem at search/verification stage
  of transaction (ex ante)
• Market for lemons (Akerlof, 1970)
• Second-hand car market
• Solutions
• Signalling by informed party
• Screening by uninformed party

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Adverse selection in banking

• Attracting the wrong type of customers
• Bad customers more likely to be selected
• Screen out/monitor such customers
• Assess risk profile
• Adjust insurance premiums and loan rates to
  reflect risk
• Restrict size of credit

8
Moral Hazard

• Contract or financial arrangement creates
  incentives for parties to behave against the
  interest of others
• Information problem once loan has been granted
  (ex post)
• Monitor such customers
• Submit periodic report/inspect firms
• Rating agencies/credit ratings
• Harder with individuals loans

9
Principal-agent problems

• Concerns the relationship between a principal and
  an agent of the principal and the costs of
  resolving conflicts of interest between them
  (agency costs)
• Examples?
• Agent has superior information
• Moral hazard issues
• Solution - monitoring

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Why are banks special?

• Pivotal position of banks in the financial system
  
• unique form of asset transformation
• Payment systems (liquidity provision)
• Nature of bank contracts
• Potential systemic dangers
• Role in the macro-economy

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Reasons for regulation in markets

• Protect smaller retail clients caveat emptor
  (buyer beware) is insufficient.
• Protect consumers against monopolistic
  exploitation
• To deal with the effects of market imperfections
  and failures
• To deal with the effects of externalities

12
Objectives of financial regulation/supervision

• Protect the consumer
• Monopolistic exploitation
• Information asymmetries
• Illegal activities
• Maintain the safety and soundness of financial
  institutions
• Ensure systemic stability

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Types of financial regulation/supervision

• Prudential regulation and supervision
• Systemic regulation and supervision
• Kelly (1997) It is probably fair to say that
  there is considerable agreement among central
  bankers and other economic policy makers that
  banks unique balance sheet structure creates an
  inherent potential instability in the banking
  system. Rumours concerning an individual banks
  financial condition can spread if the distressed
  institution is large or prominent the panic can
  spread to other banks, with potentially
  debilitating consequences for the economy as a
  whole.
• Conduct of business regulation

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Types of financial regulation/supervision (2)

• Prudential regulation and supervision
• Capital / liquidity regulations
• Risk management standards
• Systemic regulation and supervision
• Deposit insurance
• LOLR
• Conduct of business regulation
• Business practices
• Product information disclosure

15
Economic rationale for regulation in banking and
financial Services

• Externalities Systemic Issues
• Market imperfections and failures
• Need for continual monitoring of financial firms
• Need for consumer confidence
• Grid lock problem
• Moral hazard associated with governments
  preference to create safety net arrangements
• Consumer demand for regulation

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Financial regulation - critique

• Free Banking no government regulations
• Spillover effects of bank runs overstated
• Costs of bank failure overstated
• Govt safety nets create MH behaviour
• Cost of compliance exceed benefits?
• Are financial products special?
• Disclosure voluntary versus mandatory?
• Regulatory forbearance