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As we saw in Chapter 8, financial intermediaries, like banks, are particularly well suited to solving adverse selection and moral hazard problems because they make private loans that help avoid the free-rider problem. However, this solution to the free-rider problem creates another asymmetric information problem, because depositors lack information about the quality of these private loans. This asymmet- ric information problem leads to several reasons why the financial system might not function well.
BANK PANICS AND THE NEED FOR DEPOSIT INSURANCE Before the CDIC started operations in 1967, a bank failure (in which a bank is unable to meet its obligations to pay its depositors and other creditors and so must go out of business) meant that depositors would have to wait to get their deposit funds until the bank was liquidated (until its assets had been turned into cash); at that time, they would be paid only a fraction of the value of their deposits. Unable to learn if bank man- agers were taking on too much risk or were outright crooks, depositors would be reluctant to put money in the bank, thus making financial institutions less viable.
Depositors lack of information about the quality of bank assets can lead to bank panics, which, as we saw in Chapter 9, can have serious harmful consequences for the economy. To see this, consider the following situation. There is no deposit insur- ance, and an adverse shock hits the economy. As a result of the shock, 5% of the banks have such large losses on loans that they become insolvent (have a negative net worth and so are bankrupt). Because of asymmetric information, depositors are unable to tell whether their bank is a good bank or one of the 5% that are insolvent.
Depositors at bad and good banks recognize that they may not get back 100 cents on the dollar for their deposits and will want to withdraw them. Indeed, because banks operate on a sequential service constraint (a first-come, first-served basis), depositors have a very strong incentive to show up at the bank first because if they are last in line, the bank may have run out of funds and they will get nothing.
Uncertainty about the health of the banking system in general can lead to runs on banks both good and bad, and the failure of one bank can hasten the failure of oth- ers (referred to as the contagion effect). If nothing is done to restore the public s con- fidence, a bank panic can ensue.
A government safety net for depositors can short-circuit runs on banks and bank panics, and by providing protection for the depositor, it can overcome reluc- tance to put funds in the banking system. One form of the safety net is deposit insurance, a guarantee such as that provided by the Canada Deposit Insurance Corporation (CDIC) in which depositors are paid off in full on the first $100 000 they have deposited in the bank no matter what happens to the bank. With fully insured deposits, depositors don t need to run to the bank to make withdrawals even if they are worried about the bank s health because their deposits will be worth 100 cents on the dollar no matter what.
The CDIC uses two primary methods to handle a failed bank. In the first, called the payoff method, the CDIC allows the bank to fail and pays off deposits up to the
$100 000 insurance limit (with funds acquired from the insurance premiums paid by the banks that have bought CDIC insurance). After the bank has been liquidated, the CDIC lines up with other creditors of the bank and is paid its share of the pro- ceeds from the liquidated assets. Typically, when the payoff method is used, account holders with deposits in excess of the $100 000 limit get back more than 90 cents on the dollar, although the process can take several years to complete.
In the second method, called the purchase and assumption method, the CDIC reorganizes the bank, typically by finding a willing merger partner who assumes (takes over) all of the failed bank s liabilities so that no depositor or other credi-
Government Safety Net
tor loses a penny. The CDIC often sweetens the pot for the merger partner by pro- viding it with subsidized loans or by buying some of the failed bank s weaker loans. The net effect of the purchase and assumption method is that the CDIC has guaranteed all of a bank s deposits, not just those under the $100 000 limit.
In recent years, government deposit insurance has been growing in popularity and has spread to many countries throughout the world. Whether this trend is desirable is discussed in the Global box, The Spread of Government Deposit Insurance Throughout the World: Is It a Good Thing?
OTHER FORMS OF THE GOVERNMENT SAFETY NET Deposit insurance is not the only form of government safety net. In other countries, governments have often stood ready to provide support to domestic banks facing runs even in the absence of explicit deposit insurance. Furthermore, banks are not the only finan- cial intermediaries that can pose a systemic threat to the financial system, as our discussion of financial crises in Chapter 9 has illustrated. When financial institu- tions are very large or highly interconnected with other financial institutions or markets, their failure has the potential to bring down the entire financial system.
Indeed, as we saw in Chapter 9, this is exactly what happened in the United States when Bear Stearns and Lehman Brothers, two investment banks, and AIG, an insurance company, got into trouble during the subprime financial crisis in 2008.
One way governments provide support is through lending from the central bank to troubled institutions, as the Bank of Canada did during the recent finan- cial crisis (more on this in Chapter 17). This form of support is often referred to as C H A P T E R 1 0 Economic Analysis of Financial Regulation 227
The Spread of Government Deposit Insurance Throughout the World: Is It a Good Thing?
GLOBAL
Government deposit insurance has taken off throughout the world because of growing concern about the health of banking sys- tems, particularly after the increasing number of banking crises in recent years (docu- mented at the end of the chapter). Has this spread of deposit insurance been a good thing? Has it helped improve the perfor- mance of the financial system and prevent banking crises?
The answer seems to be no under many circumstances. Research at the World Bank has found that on average, the adoption of explicit government deposit insurance is associated with less banking sector stability and a higher incidence of banking crises.*
Furthermore, on average it seems to retard financial development. However, the negative
*See World Bank,Finance for Growth: Policy Choices in a Volatile World(Oxford: World Bank and Oxford University Press, 2001).
effects of deposit insurance appear only in countries with weak institutional environ- ments: an absence of rule of law, ineffective regulation and supervision of the financial sec- tor, and high corruption. This is exactly what might be expected because, as we will see later in this chapter, a strong institutional envi- ronment is needed to limit the moral hazard incentives for banks to engage in the exces- sively risky behaviour encouraged by deposit insurance. The problem is that developing a strong institutional environment may be very difficult to achieve in many emerging-market countries. This leaves us with the following conclusion: adoption of deposit insurance may be exactly the wrong medicine for pro- moting stability and efficiency of banking sys- tems in emerging-market countries.
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the lender of last resort role of the central bank. In other cases, funds are pro- vided directly to troubled institutions as was done by the government of Canada through the Canada Mortgage and Housing Corporation (CMHC), the U.S.
Treasury, and by other governments in 2008 during the most virulent phase of the subprime financial crisis. Governments also take over (nationalize) troubled insti- tutions and guarantee that all creditors will be repaid their loans in full.
MORAL HAZARD AND THE GOVERNMENT SAFETY NET Although a government safety net can help protect depositors and other creditors and prevent or amelio- rate financial crises, it is a mixed blessing. The most serious drawback of the gov- ernment safety net stems from moral hazard, the incentives of one party to a transaction to engage in activities detrimental to the other party. Moral hazard is an important concern in insurance arrangements in general because the existence of insurance provides increased incentives for taking risks that might result in an insurance payoff. For example, some drivers who have automobile collision insur- ance with a low deductible might be more likely to drive recklessly, because if they get into an accident, the insurance company pays most of the costs for dam- age and repairs.
Moral hazard is a prominent concern in government arrangements to provide a safety net. With a safety net depositors or creditors know that they will not suf- fer losses if a financial institution fails, so they do not impose the discipline of the marketplace on financial institutions by withdrawing funds when they suspect that the financial institution is taking on too much risk. Consequently, financial institu- tions with a government safety net have an incentive to take on greater risks than they otherwise would, with taxpayers paying the bill if the bank subsequently goes belly up. Financial institutions have been given the following bet: Heads I win, tails the taxpayer loses.
ADVERSE SELECTION AND THE GOVERNMENT SAFETY NET A further problem with a government safety net like deposit insurance arises because of adverse selection, the fact that the people who are most likely to produce the adverse out- come insured against (bank failure) are those who most want to take advantage of the insurance. For example, bad drivers are more likely than good drivers to take out automobile collision insurance with a low deductible. Because depositors and creditors protected by a government safety net have little reason to impose discipline on financial institutions, risk-loving entrepreneurs might find the finan- cial industry a particularly attractive one to enter they know that they will be able to engage in highly risky activities. Even worse, because protected depositors and creditors have so little reason to monitor the financial institution s activities, with- out government intervention outright crooks might also find finance an attractive industry for their activities because it is easy for them to get away with fraud and embezzlement.
TOO BIG TO FAIL The moral hazard created by a government safety net and the desire to prevent financial failures has presented financial regulators with a partic- ular quandary. Because the failure of a very large financial institution makes it more likely that a major financial disruption will occur, financial regulators are nat- urally reluctant to allow a big institution to fail and cause losses to its depositors and creditors.
One problem with the too-big-to-fail policy is that it increases the moral haz- ard incentives for big banks. If the CDIC were willing to close a bank using the payoff method, paying depositors only up to the $100 000 limit, large depositors
with more than $100 000 would suffer losses if the bank failed. Thus they would have an incentive to monitor the bank by examining the bank s activities closely and pulling their money out if the bank was taking on too much risk. To prevent such a loss of deposits, the bank would be more likely to engage in less-risky activ- ities. However, once large depositors know that a bank is too big to fail, they have no incentive to monitor the bank and pull out their deposits when it takes on too much risk: no matter what the bank does, large depositors will not suffer any losses. The result of the too-big-to-fail policy is that big banks might take on even greater risks, thereby making bank failures more likely.
Similarly, the too-big-to-fail policy increases the moral hazard incentives for nonbank financial institutions that are extended a government safety net. Knowing that the financial institution will get bailed out, creditors have little incentive to monitor the institution and pull their money out when the institution is taking on excessive risk. As a result, large or interconnected financial institutions will be more likely to engage in high-risk activities, making it more likely that a financial crisis will occur.
FINANCIAL CONSOLIDATION AND THE GOVERNMENT SAFETY NET Financial consolidation has been proceeding at a rapid pace, leading to both larger and more complex financial organizations. Financial consolidation poses two chal- lenges to financial regulation because of the existence of the government safety net. First, the increased size of financial institutions as a result of financial consol- idation increases the too-big-to-fail problem, because there will now be more large institutions whose failure exposes the financial system to systemic (system-wide) risk. Thus more financial institutions are likely to be treated as too big to fail, and the increased moral hazard incentives for these large institutions to take on greater risk can then increase the fragility of the financial system. Second, financial con- solidation of banks with other financial services firms means that the government safety net may be extended to new activities such as securities underwriting, insur- ance, or real estate activities, as occurred in the United States during the subprime financial crisis in 2008. This increases incentives for greater risk taking in these activities that can also weaken the fabric of the financial system. Limiting the moral hazard incentives for the larger, more complex financial organizations that have arisen as a result of recent changes in legislation will be one of the key issues fac- ing financial regulators in the aftermath of the subprime financial crisis in the United States.
As we have seen, the moral hazard associated with a government safety net encour- ages too much risk taking on the part of financial institutions. Financial regulations that restrict asset holdings are directed at minimizing this moral hazard, which can cost the taxpayers dearly.
Even in the absence of a government safety net, financial institutions still have the incentive to take on too much risk. Risky assets may provide a financial insti- tution with higher earnings when they pay off; but if they do not pay off and the institution fails, depositors are left holding the bag. If depositors and creditors were able to monitor the institution easily by acquiring information on its risk-taking activities, they would immediately withdraw their funds if the institution was tak- ing on too much risk. To prevent such a loss of funds, the institution would be more likely to reduce its risk-taking activities. Unfortunately, acquiring information on an institution s activities to learn how much risk the institution is taking can be a difficult task. Hence, most depositors and creditors are incapable of imposing C H A P T E R 1 0 Economic Analysis of Financial Regulation 229
Restrictions on Asset Holdings
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discipline that might prevent financial institutions from engaging in risky activities.
A strong rationale for government regulation to reduce risk taking on the part of financial institutions therefore existed even before the establishment of deposit insurance.
Because banks are most prone to panics, they are subjected to strict regulations to restrict their holding of risky assets such as common stocks. Bank regulations also promote diversification, which reduces risk by limiting the amount of loans given in particular categories or to individual borrowers. With the extension of the government safety net during the 2007 2008 financial crisis, it is likely that non- bank financial institutions (to be discussed in detail in Chapter 12) may face greater restrictions on their holdings of risky assets. There is a danger, however, that these restrictions may become so onerous that the efficiency of the financial system will be impaired.
Government-imposed capital requirements are another way of minimizing moral hazard at financial institutions. When a financial institution is forced to hold a large amount of equity capital, the institution has more to lose if it fails and is thus more likely to pursue lower-risk activities. In addition, as will be illustrated in Chapter 13, capital functions as a cushion when bad shocks occur, making it less likely that a financial institution will fail, thereby directly adding to the safety and soundness of financial institutions.
Capital requirements for banks take two forms. The first type is based on the leverage ratio, the amount of capital divided by the bank s total assets. To be clas- sified as well capitalized, a bank s leverage ratio must exceed 5%; a lower lever- age ratio, especially one below 3%, triggers increased regulatory restrictions on the bank.
In the past decade, regulators in Canada and the rest of the world have become increasingly worried about banks holdings of risky assets and about the increase in banks off-balance-sheet activities, activities that involve trading financial instruments and generating income from fees, which do not appear on bank bal- ance sheets but nevertheless expose banks to risk. An agreement among banking officials from industrialized nations has set up the Basel Committee on Bank Supervision (because it meets under the auspices of the Bank for International Settlements in Basel, Switzerland), which has implemented the Basel Accord that deals with a second type of capital requirement, risk-based capital requirements.
The Basel Accord, which required that banks hold as capital at least 8% of their risk-weighted assets, has been adopted by more than 100 countries, including Canada and the United States. Assets and off-balance-sheet activities were allo- cated into four categories, each with a different weight to reflect the degree of credit risk. The first category carried a zero weight and included items that have little default risk, such as reserves and government securities issued by the Organisation for Economic Co-operation and Development (OECD industri- alized) countries. The second category has a 20% weight and includes claims on banks in OECD countries. The third category has a weight of 50% and includes municipal bonds and residential mortgages. The fourth category has the maxi- mum weight of 100% and includes debts to consumers and corporations. Off- balance-sheet activities are treated in a similar manner by assigning a credit- equivalent percentage that converts them to on-balance-sheet items to which the appropriate risk weight applies. The 1996 Market Risk Amendment to the Basel Accord set minimum capital requirements for risks in banks trading accounts.
Over time, limitations of the Basel Accord have become apparent, because the regulatory measure of bank risk as stipulated by the risk weights can differ sub-
Capital
Requirements