Chapter 11

Economic Analysis of
Banking Regulation
 How Asymmetric Information
Explains Banking Regulation
1. Government Safety Net and Deposit Insurance
A. Prevents bank runs due to asymmetric information:
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 increases moral hazard incentives for big
banks
2. Restrictions on Asset Holdings
A. 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 FDIC
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
5. New Trend: Assessment of Risk Management
6. Disclosure Requirements
A. Better information reduces asymmetric information problem

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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
5. Disclosure Requirements
A. Better information reduces asymmetric information problem

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Major Banking
Legislation in
Canada

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Major
Banking
Legislation
in Canada

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 Why a Banking Crisis in 1980s?
Early Stages
1. Managers did not have the required expertise to manage risk
2. The existence of CDIC, more opportunities for risk taking
3. Because of the lending boom, bank activities were becoming
more complicated. Regulators had neither the expertise nor
the resources to monitor these activities appropriately
  i , net worth of banks 
A. Insolvencies 
B. Incentives for risk taking 
Result: Failures  and risky loans 
Later Stages: Regulatory Forbearance
1. Regulators allow insolvent banks to operate because
A. Insufficient funds
B. Sweep problems under rug

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 Political Economy of
the Banking Crisis
Explanation: Principal-Agent Problem
1. Politicians influenced by bank lobbyists rather than public
A. Deny funds to close banks
B. Legislation to relax restrictions

2. Regulators influenced by politicians and desire to avoid

blame
A. Loosened capital requirements
B. Regulatory restrictions on risky asset holdings
C. Regulatory forbearance

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 CDIC Developments
• CDIC insures each depositor at member institutions up to a loss
of $60 000 per account
• All federally incorporated financial institutions and all
provincially incorporated TMLs are members of the CDIC
• Insurance companies, credit unions, caisses populaires, and
investment dealers are not eligible for CDIC membership
• QDIB insures provincially incorporated institutions in Québec
and the other provinces have deposit insurance corporations that
insure the deposits of credit unions in their jurisdiction
• CDIC insures only deposits in Canadian currency and payable in
Canada; foreign currency deposits are not insured
• Not all deposits and investments offered by CDIC member
institutions are insurable

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 Not All Deposits Are Insurable

Insurable deposits include

• Savings and chequing accounts
• Term deposits with a maturity date < 5 years
• Money orders and drafts, certified drafts and
cheques, and traveller’s cheques
The CDIC does not insure
• Term deposits with an initial maturity date > 5 years
• T-bills, bonds and debentures issued by governments
and corporations (including the chartered banks)
• Investments in stocks, mutual funds, and mortgages.
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 Differential Premiums By-Law

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 Opting-Out By-Law
• Permits Schedule III banks, that accept primarily wholesale
deposits (defined as $150 000 or more), to opt out of CDIC
membership and therefore to operate without deposit insurance
• It requires, however, an opted-out bank to inform all depositors, by
posting notices in its branches, that their deposits will not be
protected by the CDIC, and not to charge any early withdrawal
penalties for depositors who choose to withdraw
Implications:
• Minimizes CDIC exposure to uninsured deposits
• By compensating only the insured depositors rather than all
depositors, this legislation increases the incentives of uninsured
depositors to monitor the risk-taking activities of banks, thereby
reducing moral hazard risk

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Evaluating CDIC
Limits on Scope of Deposit Insurance
1. Eliminate deposit insurance entirely
2. Lower limits on deposit insurance
3. Eliminate too-big-to-fail
4. Coinsurance
Prompt Corrective Action
1. Critics believe too many loopholes
2. However: accountability increased by mandatory review of
bank failure resolutions
Risk-based Insurance Premiums
1. Hard to implement
Other Proposed Changes
1. Regulatory consolidation
2. Market-value accounting
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 Banking Crises Worldwide

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Cost of
Banking
Crises in
Other
Countries

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