Economics 330

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Economics 330

• Bank Regulation
• Why and How?
• Deposit Insurance
• Lectures 21-22
• Ref Chapters 8, 9, 11

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• Why Regulate Banks?
• Four principal reasons
• Deposit Safety/Customer Protection to guard
  against loss of peoples life-time savings
  against the risk-taking behaviour of third
  parties.
• Stability of the Financial System to ensure
  efficient flow of loanable funds from lenders to
  borrowers.
• Encourage competition and efficiency monopoly
  set higher prices, restricts output, creates
  deadweight losses.
• Facilitate the conduct of monetary policy
  control of the medium of exchanges and all that
  go with it matter in the pace and level of
  economic activities.

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• 2. Regulation of the financial system in general
  is based on the premise that
• (a) The unregulated financial market is
  inherently unstable. It can generate undesirable
  shocks for the economy. (See Chp 8. pp. 177-183
  for the factors that can trigger financial
  crises.)
• Increase in interest rates (problem of
  sub-prime),
• Increase in market uncertainty,
• Problems in Banking such as bank panic,
• Stock market crashes, or asset market effect on
  banks balance sheet,
• Government fiscal imbalances.

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• (b) The undesirable financial shocks may lead to
  socially undesirable or less optimal economic
  outcomes Potential loss of wealth of many people
  
• (c) Financial instability imposes both private
  and social costs.
• (d) That the Social cost may be greater than
  Private Cost

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• 3. Asymmetric Information in the Financial
  System.
• (i) Asymmetric information Adverse Selection
  (before transaction) and Moral Hazard (after
  transaction) problems
• Asymmetric information affects the financial
  system through the
• Behaviour of depositors. How?
• Behaviour of borrowers. How?
• Behaviour of financial intermediaries. How?
• Consequences Imperfect information and
  uncertainty in financial markets can all lead to
• Unwillingness of surplus spending units to put
  money in a bank
• Unwillingness of lenders to lend.
• Excessive risk-taking by financial
  intermediaries.
• Excessively high average cost of borrowing.

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• 4. Example
• Imperfect Information and Financial
  Intermediation in less developed economies.
• In many less developed financial economies, part
  of the reasons people find it difficult to invest
  is not for the lack of investment opportunities.
• Limited supply of deposits means limited supply
  of loanable funds and high cost of borrowing.
• Low bank credit means (credit rationing, p. 208)
  less investment, less investment means less
  capital to support private sector growth.
• Slow or no growth means low per capita incomes
  and low standard of living.
• Imperfect or Asymmetric information impedes the
  flow of funds in the economy with overall adverse
  effect on the level of economic activities.
  Solution?

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• 5. Banking Regulation is a public good
• What is a public good?
• Safety of the financial system depends on the
  public perception of the safety of deposits.
• Safety of deposits in turn depends on the public
  perception of the honesty and soundness of all
  deposits and therefore of all banks.
• There is an interdependence of banking
  relationships.
• Bank failures are contagious (Domino effects)
• Bank Runs Failure of one bank can erode
  publics confidence and cause panic runs. (p. 253)

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• (a) Public versus Private Regulation of banks
• The alternative to government regulation is the
  myriad of private surveillance and private
  contracts by economic agents. (See Chp. 9 pp. 205
  209 of banks instruments to manage credit or
  default risk).
• These measures, however, entail High Information
  And Monitoring Costs on the part of the bank.
• (b) Public regulation
• Is a better substitute for the myriad of private
  contracts.
• Is cost saving and efficient with common
  standards.
• It establishes confidence in every single bank
  because of the common rules and assurances of
  safety.
• It establishes confidence in the entire banking
  system

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• 6. Other Reasons for Public regulation of Banks
• (a) Encourage Competition and Efficiency
• Financial intermediaries exist to provide
  intermediation services efficiently.
• Efficiency means the ability to provide
  services at least cost with greatest convenience.
• Regulated competition in financial markets is a
  tool to encourage efficiency.
• Competition forces firms to be innovative in
  responding to both technological and market
  demand changes.
• Regulation ensures that few large institutions
  do not capture certain aspects of the financial
  market. Regulated entry is important to curtail
  monopoly tendencies.

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• (b) Government Regulation Control the Quantity
  of the Money Stock
• Key M1 Cp Demand Deposits (Type A Type B)
• (Ref. Chp 9 how banks create different deposits.
  
• Should there be an optimum amount of the money
  stock in the economy?
• Do you agree that there should there be limits on
  loan expansion in a market economy?
• Who should determine the price of loans?
• What prevents individual banks from expanding
  their loan portfolio as earning assets to any
  limits they see fit?
• The ability to control the money stock in the
  economy depends in part on the ability of
  deposit-taking institutions to create bank money
  through the expansion of credit.

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• HOW DO WE REGULATE BANKS?
• Market Approach (Self-regulation versus
  Government regulation)
• What is self-regulation?
• Advantages and Disadvantages of self-regulation
  (ENRON)

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Basic Categories of Bank Regulation (Chp. 11, pp.
266-274)

• Government Safety Net Use of Deposit Insurance
  Explicit or Implicit
• Restrictions on Asset holdings and Capital
  requirements portfolio restrictions
• Bank Licensing and Examinations prudential
  supervision
• Assessment of Risk Management
• Disclosure requirements Free-rider problem,
  Information production for the benefit of all
  depositors.
• Consumer protection
• Restrictions on open competition.

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Principal-Agent Problem the Distribution gains
from banking and the cost of bank failures
Taxpayers
Depositors
Borrowers
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Asymmetric Information in Financial Markets, and
Banking Regulation (See Chp 8, 11)

• Adverse Selection
• What is adverse selection problem in financial
  markets?
• Describe the nature of the adverse selection and
  the consequences in each of the following
  relationships
• Depositors and bankers
• Bankers and borrowers
• Government regulators and bankers

• Moral Hazard
• What is moral hazard problem in financial
  markets?
• Describe the nature of the moral hazard problem
  and the consequences in each of the following
  relationships
• Depositors and bankers
• Bankers and borrowers
• Government regulators and bankers

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DEPOSIT INSURANCE

• Canadian Deposit Insurance Corporation
• Established in 1967 Crown Corporation
• Objectives
• Provide insurance on deposits to protect
  depositors from bank insolvency
• To enhance public confidence in the soundness of
  these institutions.
• Ensure financial stability

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What CDIC Covers

• What is covered and what is not covered (See p.
  281)
• only C deposits in Canada up to C100,000.
• - US accounts not covered.
• - Covers savings and chequing accounts, term
  deposits (lt 5years)
• All federally chartered institutions
• Provincially chartered TML companies
• Not Covered
• Credit Unions (covered under provincial insurance
  arrangements)
• Caisses populaires (covered under Quebec
  arrangements)
• Investment bankers

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How CDIC Performs its Functions

• How its performs its Functions
• Provides cash settlement or equivalent deposits
  of C100,000 (foreign currency deposits not
  covered)
• Requires all insured institutions to follow
  standards of sound business and financial
  practices
• Extends loans to or acquire assets of distress
  institutions
• Provides assistance for the re-organization/takeov
  er of distressed institutions

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Financing Deposit Insurancea) Flat Premium
option- Case For case Against?b)
Differential-risk-based premium case for case
againstc) Use of Coinsurance a fraction say
x of deposits will be insured and the balance
will not be insured.

• Premium Category
  Premium rate
• 
  ( of Insured Deposits)
• 1 1/24 of 1 (0.417) 0.0417 cents per
  100
• 2 1/12 of 1 (0.0833) 0.083 cents per
  100
• 3 1/6 of 1 (0.1667) 0.16.67 cents per
  100
• 4 1/3 of 1 (0.333) 0.333 cents per
  100
• Opting Out clause (banks that accept primarily
  wholesale deposits)

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Questions

• Who benefits from deposit insurance? Explain.
• Who should pay for deposit insurance premiums?
  The banks, the depositors, the lenders, the
  general public, or the government? Justify your
  response.
• Some recent proposals for reforming banking
  regulatory system include the elimination of
  deposit insurance. Would you support this
  proposal
• (a) if you are a banker? Why?
• (b) if you are a depositor? why?
• c) Finally would you support this proposal if
  your job is to protect the public interest?