Chapter Eighteen
Banking Regulation
How Asymmetric Information
Explains Banking Regulation
1. Government Safety Net and Deposit Insurance
a. Prevents bank runs due to asymmetric info: 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 increase moral hazard incentives for big banks
and is unfair
2. Restrictions on Asset Holdings
– 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 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
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How Asymmetric Information Explains
Banking Regulation
5. Disclosure Requirements
– Better info reduces asymmetric info problem
6. Consumer Protection
a. Standardized interest rates (APR)
b. Prevent discrimination
7. Restrictions on Competition to Reduce Risk-Taking
a. Branching restrictions
b. Separation of banking and securities industries
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How Asymmetric Information Explains
Banking Regulation
• International Banking Regulation
1. Bank regulation abroad similar to ours
2. Particular problem of regulating international banking
(e.g., BCCI scandal)
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Major Banking
Legislation
in Canada
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Canada Deposit Insurance Corporation
Developments
1. Differential Premiums
2. Opting-Out
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Evaluating CDIC and Other Reforms
• Limits on Scope of Deposit Insurance
1.
2.
3.
4.
Eliminate deposit insurance entirely
Lower limits on deposit insurance
Eliminate too-big-to-fail
Coinsurance
• Prompt Corrective Action
1. Critics believe too many loopholes
2. However: accountability increased by mandatory review
of bank failure resolutions
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Financial Services Reform for the 21st Century
• Bank Holding Companies
• The Permitted Investment Regime
• New Ownership Rules
• Access to the Payments and Clearance System
• Merger Review Policy
• Implications for the Canadian Banking Industry
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Figure 1: Banking Crises Throughout the World
Since 1970
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Cost of Banking Crises in Other Countries
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Calculating Capital Requirements
First Bank
Assets
Reserves
Canada securities
Government agency
securities
Municipal bonds
Residential mortgages
Real estate loans
C&I loans
Fixed assets
Liabilities
$3 m
$10 m
$7 m
$10 m
$10 m
$20 m
$35 m
$5 m
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Chequable deposits
Nontransactions
deposits
Borrowings
Loan loss reserves
Bank capital
$20 m
$60 m
$11 m
$2 m
$7 m
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Calculating Capital Requirements
• Leverage Ratio = Capital/Assets
= $7m/$100m = 7%
• Bank is well capitalized
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Calculating Risk-Adjusted Requirements
0  $3 million
+0  $10 million
+ .20  $7 million
+ .50  $10 million
+ .50  $10 million
+1.00  $20 million
+1.00  $35 million
+1.00  $5 million
+1.00  $20 million
$91.4 million
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(Reserves)
(Treasury securities)
(Agency securities)
(Municipal bonds)
(Residential mortgages)
(Real estate loans)
(Commercial loans)
(Fixed assets)
(Letters of credit)
(Total risk-adjusted assets)
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Calculating Risk-Adjusted Requirements
• Core Capital Requirement
= 4%  risk-adjusted assets
= 4%  $91.4m = $3.66m
< $7m of core capital
• Total Capital Requirement
= 8%  risk-adjusted assets
= 8%  $91.4m = $7.31m
< $9m of total capital
= $7m of core + $2m of loan loss reserves
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