Justification For Banking Regulation
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Published: Thu, 15 Mar 2018
Over the last century the world experienced multitudes of financial crises with different scales of complexity and severity. The frequency of severe banking crisis has increased dramatically in last two decades, Bordo et al. (2001). This escalating severity can be observed in recent episodes of financial turbulences, particularly, the 1997 Asian crisis, in S&L crisis in US and the recent global financial crisis which started in 2007. Most economic downturns were related to financial panics. As a result, the governments in the world have become more concern about financial stability. The World Bank reveals that the government bailouts cost has reached 40% of GDP in many nations over the past two decades. Specifically, the saving and loan crisis in the US resulted in estimated losses of $180 billion or 3.2 percent of GDP, and the Asian crisis resulted in huge nonperforming loans (approximately 25 percent of GDP in Japan)  .
Financial crises are reputed for their devastating impact on macroeconomic stability and economic growth. The recent global financial crisis, probably the worst financial storm since 1929, engendered economic disruptions of extreme severity, resulting in significant decline of economic growth through the world.
Preventing financial crisis is of crucial importance for Central Banks, Governments, and Financial Regulators who have committed themselves to building up a strong framework for effective banking regulations. According to Llewellyn (1999, p.9) the rational for banking regulation is justified by the critical needs: The most renowned regulatory tools in government safety nets include prudential regulations (such as capital adequacy requirements, entry or competition restrictions, and so on), the deposit insurance scheme and the Lender of Last Resort function of central banks.
SOURCES OF MORAL HARZARD IN THE BANKING SECTOR
ROLE OF DEPOSIT INSURANCE AND LENDER OF LAST RESORT
Generally, banks are prone to runs due to their essential asset transformation role; that is borrowing “short” (by taking in demand deposits) and lending “long” (by making loans with longer maturities), (McCoy 2006). So, banks balance sheets are inherently unstable due to term mismatches. Banks provide financial liquidity insurance to meet the different and incompatible needs of economic agents. Having accepted liquid deposits from the public, as financial intermediaries, banks channel or reinvest these deposits in illiquid loan. In simple words, banks alter the long term illiquid assets with liquid assets collected from depositors in the form of certificates of deposits and checkable deposits.
In the asset transformation’s process, at least 80% of the bank’s funds are invested in illiquid assets, (McCoy, 2006). Hence, only a small amount of cash money is generally available to cover withdrawals at specific times (Horn, 2008). The banking system fragility is therefore extremely high. Banks operate on the principle of large numbers, as a result in the event of a run; the bank may not be able to liquidate immediately its assets to satisfy demands of depositors.
More importantly, bank runs can trigger immediate contagion and financial panic because; other depositors may start fearing the bankruptcy of their banks. If there is no deposit guarantees, the spread of rumors that a bank is on the edge of failure might causes depositors to panic on losing all their savings. The unpredicted sudden withdrawals ultimately lead to bank runs. In such situation, banks have to liquidate their assets; but liquidating the assets immediately might not be possible- even if it is, the price of assets will fall due to abrupt liquidation.
Bank runs and panics occur when depositor lose confidence. As a response to brutal banking panics which prevailed during the Great Depression, the US and many countries officially committed to guaranteeing deposits, generally through legislation by putting explicit or implicit deposit insurance in practice. This guarantee was an immediate response to resolve the problem of bank runs and the systemic economic consequences of financial contagion.
The main rational for this insurance was to strengthen depositors’ security and confidence in banking system. The deposit insurance scheme assures depositors that they are protected, hence strengthens confidence even in turbulent financial distress. Using analytical liquidity insurance models, Diamond (1983, p.416) and Horn (2008) argued that deposit insurance (DI) plays a crucial role in preventing the phenomenon of bank runs and banking panic, hence very essential for financial stability. According to Ketcha Jr. (1999, p.224), DI help maintain stable economic growth by protecting the economy from “interruptions in bank liquidity and credit availability” caused by bank runs.
Using time-series statistics from over 58 countries across the globe, Cull et al. (2005) empirically proved that a well designed and implemented DI scheme helps promote the development of the financial sector and economic growth through banking stability. In the 1930s, the US recorded over 9000 bank failures, most of which were causes by contagion runs. A careful examination of the frequency of bank runs before and after the adoption deposit insurance in 1933 is a clear proof that the insurance scheme was indeed effective in consolidating confidence, mitigating bank run problems, and fostering stability in the banking sector, Temzelides (1997).
The cost of banking crisis has deeper economic ramifications which surpass the massive cost of government bailouts to mitigate systemic risk and central banks’ quantitative easing to boost economic activity. The systemic nature of banking sector problems is the primary justification of extremely costly government intervention in the financial system. One of the most important regulatory tools to mitigate the problem of bank runs is the central bank’s lender of last resort facility to solvent banks in times of financial distress. Sinclair (2001, p.8), “the obvious symptom of a financial crisis is a bank failure”. By providing short term liquidity to solvent banks, the central bank therefore has the capability to promptly prevent the collapse of a large bank; hence reduce the probability of a banking crisis and mitigate its systemic disruption on the entire economy.
In the United States, the too big to fail policy was adopted simply because the failure of one large financial institution can brutalize the whole financial system and lead to serious negative financial shocks with devastating macroeconomic spillovers. LLR and the deposit insurance scheme are therefore very critical in reducing the mounting cost of government bailouts, ensuring the stability of banking system, and all owing the financial system to operate smoothly and promote economic growth, Demirguc-Kunt and Huizinga (2000). However, it has become a common knowledge that DI is an incontestable source of moral hazard. In the next section we will discuss the moral hazard implications of government safety nets and other multidimensional aspects of moral hazard problems in the banking sector.
THE MORAL HAZARD IMPLICATIONS OF GOVERNMENT SAFETY NETS
President Franklin Roosevelt was the first person who opposed the adoption of explicit deposit insurance in the United States in 1933; and he argued that the deposit insurance program would create unsound banking in the future, (McCoy, 2006). After five decades, his predictions became real with the eruption of series of financial crises in the 1980s in the US and across the globe. The IMF (1996) statistics revealed that over 130 nations suffered financial crisis in the 1980s. Roosevelt in 1933 had warned that the deposit insurance policy could create moral hazard incentives (McCoy 2006).
Moral hazard is the name given due to the increased risk taking temptation emerging from insurance policy (Grubel, 1971). In this context, moral hazard is manifested in two ways; the explicit deposit insurance decreases incentives of shareholders and depositors to monitor banks’ risk-taking. Secondly, this program stimulated banks’ incentives to take more risks, because they will capture abnormal profits while they shift losses to the governments when they are in trouble. Prof. Lovett (1989) strongly argued that if modern nations and governments permit most banks to fail, management of banks will be better disciplined in their risk management approaches, and they will also avoid poor asset- liability management.
In the presence of deposit insurance, a bank would consider increasing interest rate in an extremely competitive environment to attract more depositors. In turn, in order to meet depositors’ interest rate obligations, the bank will have an increased incentive to make risky loans to increase its profit and compensate depositors for taking on extra risk. (Demirguc-Kunt and Kane). Depositors know that their deposits are insured up to some limit by the governments; and they do not request a risk premium. Therefore, banks have higher incentives to take more risks, when deposits are insured, either by investing in riskier projects or elevating their leverage. This is to say that the government’s loss exposure or taxpayers cost becomes higher in the presence of DI, ( Hovakimian, Kane and Laeven, 2003). As long as a bank’s total expected returns from its asset portfolio exceed its explicit costs for deposit insurance premiums, moral hazard will continue to prevail, (Fischel, Rosenfield and Stillman, 1987).
Far from being a theoretical concern, moral hazard in explicit deposit insurance is significant and has real effect on banking stability, (McCoy, 2006). Throughout the world, it is empirically tested that explicit deposit insurance increased the likelihood of banking crises dramatically in the 1980s.
Moreover, when deposit insurance combined with interest rate liberalization, moral hazard becomes even worse, because it allows banks to aggressively compete against each by raising interest rate on deposits, and constraining themselves to invest in extremely risk projects, hence putting at risk depositors money at the expense of taxpayers,( Demirguc-Kunt and Detragiache, 2000). In addition, since all the deposits are secured, depositors find no incentive in monitoring their bank’s risk taking, therefore tolerating risk-loving managements to engage in excessive risky investments to uplift returns.
POLICY OF CREDIT CEILING AND MORAL HAZARD
Standard thinking about the need of the financial liberalization and interest rate describe policies that alter and distort domestic capital markets through high reserve requirements and interest rates ceilings. In a financially repressed economy, real lending and deposit rates are mostly negative, with adverse results for the financial system’s development and for investment and saving generally. Therefore, the purpose of the standard approach by this liberalization is to eliminate credit control as well as to achieve positive real interest rates on bank loans and deposits.
Financial and initial economic conditions throughout the countries significantly varied and influenced subsequent performance. However, the policies of interest rate, the banking system’s prudential supervision and banking regulations were common certain characteristic to the relatively successful cases of financial liberalization. Countries, specifically, avoided the adverse outcome of large financial liberalization- financial institutions’ bankruptcies, sharp rises in interest rates. Doing so, they characterized stable macroeconomic conditions (Villanueva and Mirakhor, 1990).
In the earlier period, low interest rates was the one of the two consequences of government intervention with credit rationing, and controlling to remove interest rate would guide to a more efficient, dynamic, and healthy financial system (Villanueva and Mirakhor, 1990). Because, in most countries, banks were not allowed to pay explicit interest on demand deposits by the interest rate ceiling, the ceiling on deposit interest rates has been abolished since 1980s (Villanueva and Mirakhor, 1990).
However, the current literature has substantially made it clear to understand how bank credit markets operate, particularly how asymmetric information between borrowers and lenders might lead to efficient optimal interest rates, when the interest rate ceilings is absent. It is also understood that how inadequate bank supervision generally ends with an immediate rise in real interest rate with risky levels (Villanueva and Mirakhor, 1990).
Additionally, one of the main reasons for the ceiling is (entitled as “public interest”), the need for reducing or cutting the competition among banks (Eichberger and Harper, 1989, p:19). Banks are forced to pay more for the deposits and this resulted in that temptation of banks in investing in riskier project increased to offset the interest cost. As a consequence; banks became riskier and banking crisis is increased.
McKinnon (1986) suggested that it ought to be imposed that some ceiling on standard deposits and loan interest rates by government to overcome moral hazard in banking sector. Because banks have intensive to provide risky loans at high interest rates and expect that deposit insurance or government will cover the large losses.
FINANCIAL INNOVATION AND MORAL HAZARD (FINANCIAL CRISIS 08) In the United States, securitization is one of the most important innovations that promoted the growth of mortgage credit supply at aggregate level, Shin (2009). During the housing boom that preceded the subprime crash in 2007, banks unwisely exploited innovations in securitization to increase returns by excessive leveraging their capital to unsustainable level, without considering systemic risk. In the securitization mechanism, banks massively originated mortgages that they assembled together in CDOs, marketed to investors to finance their loans. The originate-to-distribute process of shifting risk off balance sheets and transferring them to external investors, reduced banks’ incentives to properly screen borrowers because they knew they would not bear full cost of bad loans in the worst scenarios.
In addition, credit rating agencies accentuated this moral risk by mispricing CDOs (Junk bonds rated AAA). “Multi-layered agency problems” and distorted incentives in securitization chain eroded the quality of lending standards, and huge amount of credit were cheaply granted to unworthy households (Shin 2009, p.312). Central bank’s monetary excesses resulted in abundant liquidity that in turn fuel the housing bubble, Blundell-Wignall et al (2008). Banking supervision failed to assess and control all these risks. Banks took advantage of profit opportunities that arose during the housing boom to expand their mortgage holdings regardless of concentrations risk and potential risk of defaults in the event of a bursting of the bubble. This tendency of banks to abuse innovations in structured finance and take reckless risks while expecting the government to bear the cost of their wrong actions is a critical aspect of moral hazard in the banking sector. Traders massive invested in CDSs bets, “Subsidized Risk-Taking: Heads I Win, Tails You Lose”; leading to strong interconnections and counterparty risk between banks and other financial markets participants Dowd (2009, p.142). Over $500 billion of CDOs and 60 trillion Webs of CDSs derivatives were outstanding in 07/08, Dowd (2009).
Historical example of government interventions that created moral hazard in the US include the Federal Reserve bailout plan to contain systemic risk when Long Term Capital Management was in trouble in 1998; Bear Stern was also bailed out in 2008 at the expense of moral hazard, Alm, et al. (2008). The catastrophic collapse of Lehman in Sep 2008 amplified the cost government bailouts during the global financial crisis, over $700Bn troubled asset relief bailout plan. Central banks around the globe enormously injected liquidity in the financial system to restore stability and revive economic activity, see Figure 3:
FINANCIAL INTERMEDIATION AND CREDIT POLICY IN BUSINESS CYCLE ANALYSIS (FINANCIAL CRISIS 08)
Not long ago, the world has experienced one of the worst financial crises. The financial sector was injured; the real economy slowed down and went into a severe recession leading to a significant fall real output. The crisis disrupted the financial intermediation mechanism and caused credit supply to the private sector to drop significantly. In many countries fiscal and monetary authorities put unconventional credit policies into practice involving direct lending in credit markets to combat the crisis and reduce its macroeconomic spillovers.
Before the 2nd world war, the Federal Reserve abstained itself from intervening in the prive sector lonable fund credit markets. These traditional credit policies have changed overtime. During the recent financial turmoil, central banks “acted to offset the disruption of intermediation” by supplying “imperfectly secured loans” to banks and by lending them directly to non- financial borrowers, Gertler and Kiyotaki (2010, p.3). Additionally, the central bank injected equity into large banks with the purpose of facilitation credit flows to various sectors of the economy. Numerous observers and policy makers believed that these interventions facilitated financial markets stabilization and as a result, helped limit the slowdown in real aggregate economic activity, Gertler et al (2010).
Gertler and Bernanke (1989) endogenized financial markets friction by presenting an agency problem between lenders and borrowers (due asymmetric information with regard to counterparty credit worthiness). This problem of agency brings about the trade-off between the opportunity cost of internal finance (which increases the overall credit cost borrowers face) and of external finance. The external finance premium depends on the borrowers balance sheets’ conditions which vary across the business cycle. If an investment project’s outcome for borrowers increases, the borrower incentive to deviate from the lenders’ interest will decline. As a result, the external finance premium will decline. In times of recession asset prices will decrease sharply, and the deterioration of borrowers’ balance sheets becomes inevitable; causing the premium of external finance to jump up (Gertler and Kiyotaki, 2010). The impact of financial distress on the credit cost ultimately slows down real activity.
Gertler et al. (2010) argues that the disturbance of financial intermediation was the main characteristic of the recent financial crisis. Banks face significant difficulties in obtaining funds not only on wholesale financial markets, but also in interbank markets, (Gertler and Kiyotaki, 2010). In fact, the sharp declines interbank market liquidity is usually one of the first signal that crisis is underway. When interbank markets operate efficiently, funds flow effectively in the banking system. In such a case, loan rates are effectively balanced between different banks and aggregate behavior is similar to the homogeneous intermediaries. The systemic impact of Lehman collapse is an illustration on the how the dysfunction of the interbank markets can accentuate the depression of aggregate activity.
When liquidity becomes rare on financial markets, the problem of agency may also restrict the availability of equity financing for the bank. Taking into account the effects of their own liability structure on the aggregate, banks generally prefer the decision in favor debt financing and turn away from the outside equity. As a result, the features of aggregate balance sheets tend to be excessively leveraged, Korinek (2009). Even though, credit policy is illustrated to stabilize the volatility, it decreases the banks intensive to resort to outside equity financing. In turn, the aggregate leverage in the intermediary sector is lifted and another financial crisis is made likely to be occurred. Therefore, further government intervention might be required, hence worsening moral hazard problems.
FUTURE CASH FLOWS AND MANAGERIAL INPUTS
One of the key objectives of financial economics is to advice companies on how to make a decision of investment. The theory of finance sets the rule of net present value (NPV) to a firm and warns that investment decisions ought to be taken when the present value of the projects expected cash flows exceeds the investment cost. Nevertheless, if NPV role “naively applied”, it does not responsible for the information as well as incentive problems that might occur in a “decentralized ¬rm” (Bernardo, Cai and Luo, 2001).
Particularly, headquarter of a firm might have to trust the given information about the future cash flows. Additionally, future cash flow of a project might depend on unobservable “managerial input”.
Because, it is expected that headquarter of a firm ought to trust the given information about the future cash flows and future cash flows of a project might depend on unobservable “managerial input” (Bernardo, Cai and Luo, 2001), the incentive and information problem might occur in a way that; the managers in the firm may report unverifiable projects quality to central office (headquarters), and then according to the report, capital is allocated. Having allocated capital for the project, input such as effort is able to be provided by the managers. This will occur that the cash flows of the project are enhanced but it is not verifiable by the headquarters and costly to the manager. Additionally, Managers usually report the maximum quality of the project to to gain a greater capital allocation and they also put a minimum effort into the project to minimise the private cost (Bernardo, Cai and Luo, 2001).
For instance, incentive of the managers to exaggerate the quality of the project might be declined by allocating capital and supplying the manager better incentive-based pay, at the time when a higher quality of project is reported by the manager. Furthermore, a problem of moral hazard might be mitigated, if headquarter rises the contract’s incentive-based components. It is to say that moral hazard and asymmetric information is the reason of managerial compensation and the capital budget (Zhang, 1997).
The capital budget serves as the funding source for investment, also serves as a “strategic device to control managerial shirking” (Zhang, 1997). Although, a large amount of budget permits the company to invest in all profitable projects, funding guarantee generates the tendency for managers to under-report the quality of project for the purpose of lowering the level of production. Therefore, management behaviours due to higher benefit desire is one of the reason of the moral hazard.
LINKAGE BETWEEN FINANCE AND ECONOMIC GROWTH
Banks have always been regarded as extremely crucial organs of the financial system that specializes in reconciling the financial needs of savers and borrowers in the economy. In the traditional approach to banking, banks pool deposits from savers or depositors and channel these resources to borrowers or investors through the financial intermediation mechanism. According to Beck, Levine and Loayza (2000), the banking sector act as an intermediary bridge that connects borrowers and lenders to ensure optimal allocation of resources within the economy. Financial institutions are therefore vital economic agents that enhance efficient allocation of funds within the economy.
There is a substantial body of empirical research which provides supportive evidences on the positive relationship between financial systems developments and economic growth. Bagehot (1873) suggested that if financial system works efficiently, a nation’s economy will grow rapidly. King and Levine (1993) carried out cross-country empirical investigations which confirmed that the banking system is one of the most prominent accelerators of economic growth. Compiling firm-level and industry-level data across many nations, development policy makers and researchers at the World Bank sought to have a deeper understanding on the relationship between economic development and finance.
Levine at el. (1998) empirically tested the existence of a positive correlation between efficient financial development and economic growth. Maksimovic and Demirguc-Kunt (1998) used a financial planning model and firm level data to empirically conclude that the banking system provides firms with the financial reservoir they need to grow rapidly.
Small manufacturing, entrepreneurial firms and industries are heavily dependent on the loanable funds of the banking sector to expand their production scale through the implementation of efficient and costly technology. This in turn helps promote market efficiency through economies of scales, and creates substantial employment opportunities and boosts economic growth, Levine (2005).
Levine (2005) contends that financial institutions affect the allocation of resources and ease market conflicts over different sectors and industries within the economy. Levine (2005) further mentioned five main financial institution’s functions which are necessary for the economic growth. Those include: the production of information which drive investments and allocation of capital decisions, the monitoring of investments, diversification and management of risks, the traditional mobilization of savings and the financing of international trades. Additionally, the empirical side of his studies demonstrated the strong link between the financial deepening and economic growth; see: Chart I.
Pagano, (1993) and Thiel, (2001) have classified three key contributions of financial intermediaries to economic growth. Firstly, the leakage of resources from depositors to investors is reduced by an efficient banking system. Secondly, intermediaries enhance fund allocation since banks distinguish between bad projects and good ones, and accordingly naturally prefer to invest in those with higher marginal capital productivity and also finally, the financial intermediaries consolidate savings level. The banking system facilitates the financing of productive investments by decreasing the quantity liquid funds held the householder and invest them into illiquid projects with high productivity performance that promote economic growth. Levine and King (1993) argued that the variability of intermediation margins automatically influence the growth rate of aggregate output. Galetovic (1996) argued that financial innovation fosters efficiency and reduces default risk through efficient monitoring and screening of investment projects. According to Greenwood and Javanovic (1990)’s long run growth model, there is a “dual direction of causality over a time horizon” between economic growth and financial systems development.
In early stages of economic development, economic growth supports the expansion of financial institutions whereas, afterwards, a consolidated and mature financial system promotes more efficient investment allocations and, therefore, triggers faster economic growth. According to Robinson (1952) economic growth naturally generates demand for financial instruments. This body research explored above provides compelling evidences and solid grounds for a relative consensus that financial deepening promotes real economic growth.
Figure 4: Finance and Growth, source Levine, R., (2005)
THE FINANCIAL SYSTEM AND MACROECONOMIC STABILITY
The recent economic troubles in the world economies are often connected with the financial sector disturbances. The relationship between economic slowdowns and troubled banking systems therefore needs to be emphasized. More recently the macroeconomic slowdown has been the consequence of the financial crisis 08. Therefore the key question to answer is whether there is a relationship between the macroeconomic performance and financial stability.
The banking sector is (usually) one of the most heavily regulated industries in an economy. There are two main reasons of why high attention is being paid to the banking sector. Firstly, the banking system is the heart of a market economy and is extremely interconnected with all the other parts of the economic system. Its purpose is to allocate funds efficiently from people who do not need it temporarily to people who are with profitable investment projects.
In addition, banks play a vital role in the monetary policy mechanism and the smooth operation of payments and settlement systems. It is therefore rational that disturbances in this industry are likely to impact other industries of the economy. During the past financial crises, the explosion of contagion risks significantly aggravated problems in banking sector and resulted catastrophic and extremely damaging consequences which deteriorated the global economy; this is known as systemic banking risks.
Over the years the financial system has undergone significant metamorphoses. Financial innovations significantly developed and globalization in the global financial system. For example, over the past decades, complex financial innovations such as securitization and credit transfer structured derivative products such as credit default swaps resulted in stronger financial linkages and networks in the global financial system architecture. These linkages have increased systemic risk in the sense that the failure of large bank could trigger severe turbulent ramifications not only in the domestic financial system, but also massive systemic shocks on all internationally interconnected market participants, hence threatening financial stability on a global scale. For example, the liquidity crunch post Leman’s bankruptcy dried credit supply on interbank markets and corporate credit markets, hence triggering macroeconomic shocks and contractions of severe magnitude. (see: Fig 1&2).
Secondly, due to the fact that the whole banking business model is based on confidences of depositors, the financial system stability is very fragile. Under the normal conditions, it is assumed that depositors withdraw only when necessary. Any unexpected withdrawals by the depositors due to asymmetric information or rumors may handicap the asset transformation ability of banks and result in bank runs which may have severe contagion and financial implications. During the Great Depression (1930s), the US economy suffered the sequel of the most devastating financial crisis in human history. Indeed the 1929’s crisis was debatably the result of a brutal banking panic which caused more than 9,000 bank failures and over $140Bn deposit losses; leading to systemic and confidence break downs in the financial system, Temzelides (1997). According to Saunders and Wilson (1996), Calomiris et al. (1997) and Temzelides (1997, p.8), “contagion effects played an important role in the panic’s development” in the 1930’s, Tosun and Aloko (2010).
DRIVERS OF ECONOMIC GROWTH
“Drivers of economic growth” is a very controversial theme that has been extensively debated in the realm of economic development policy. First of all economic growth is defined as a rise in the total output of an economy, generally, a rise in the real Gross Domestic Product (GDP) per capital (Wyplozs and Burda, 2005). Studying economic growth brings about essential questions such as why some countries develop faster than other countries, or why are there disappearances in the income level of countries, or why some countries are rich whereas some are poor?
Over the past decades, many economists have been seeking to understand the key drivers of economic growth and the factors which affect growth. The dynamics and complex interactions between various organs in the economic system make it difficult for economists to attest with certainty all the factors influencing economic growth. However, many researchers have pointed out three key factors which are vital f
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