CHAPTER FOUR

ECONOMIC ANALYSIS OF BANKING

REGULATION
Asymmetric information and bank regulation

• If the information is perfectly knowable in a

way where all parties know all that is available
information, this is called symmetric
information. (apply in free market)
• Buyers and sellers, Producers and
consumers ,borrowers and lenders, all have
exactly the same complete information.
• The fact that different parties in a financial
contract do not have the same information.
 Cont…
• Asymmetric information deals with the study of
decisions in transactions where one party has more or
better information than the other and uses that to their
advantage.
• E.g.1 For example, managers of a corporation know
whether they are honest or have better information
about how well their business is doing than the
stockholders.
• E.g.2 consider life insurance :a customer might have
information about their risk that the insurance company
can not easily obtain.
 Cont…
To compensate for a lack of information, the insurance
company might increase all the premiums to offset the
risk of uncertainty.
Asymmetric information leads to adverse selection and
moral hazard problems that have an important impact
on our financial system.
Adverse selection is an asymmetric information
problem that occurs before the transaction: Potential
bad credit risks are the ones who most actively seek out
loans.
 Cont…
Thus, the parties who are the most likely to produce an
undesirable outcome are the ones most likely to want to
engage in the transaction.
For example, big risk takers might be the most eager to
take out a loan because they know that they are
unlikely to pay it back.
Because adverse selection increases the chances that a
loan might be made to a bad credit risk, lenders might
decide not to make any loans, even though there are
good credit risks in the marketplace.
 Cont…
 Moral hazard arises after the transaction occurs: The lender runs
the risk that the borrower will engage in activities that are
undesirable from the lender’s point of view because they make
it less likely that the loan will be paid back.
 For example, once borrowers have obtained a loan, they may
take on big risks (which have possible high returns but also run
a greater risk of default) because they are playing with someone
else’s money.
 Because moral hazard lowers the probability that the loan will
be repaid, lenders may decide that they would rather not make a
loan.
 How adverse selection influence financial
structure
 A particular aspect of the way the adverse selection problem
interferes with the efficient functioning of a market was outlined
by George Akerlof.
 It is called the “lemons problem,” because it resembles the
problem Created by lemons in the used-car market.
 Potential buyers of used cars are frequently unable to assess the
quality of the car; that is, they can’t tell whether a particular used
car is a car that will run well or a lemon that will continually give
them grief.
 The price that a buyer pays must therefore reflect the average
quality of the cars in the market, somewhere between the low
value of a lemon and the high value of a good car.
 Cont…
 The owner of a used car, by contrast, is more likely to know
whether the car is a peach or a lemon.
 If the car is a lemon, the owner is more than happy to sell it at
the price the buyer is willing to pay, which being somewhere
between the value of a lemon and a good car, is greater than the
lemon’s value.
 However, if the car is a peach, the owner knows that the car is
undervalued at the price the buyer is willing to pay, and so the
owner may not want to sell it.
 As a result of this adverse selection, few good used cars will
come to the market.
 Lemons in the Stock and Bond Markets

 A similar lemons problem arises in securities markets.

 Suppose that the investor, a potential buyer of
securities such as common stock, can’t distinguish
between good firms with high expected profits and low
risk and bad firms with low expected profits and high
risk.
 In this situation, the investor will be willing to pay
only a price that reflects the average quality of firms
issuing securities—a price that lies between the value
of securities from bad firms and the value of those
from good firms.
 Cont…

 If the owners or managers of a good firm have better

information than investor and know that they are a
good firm, they know that their securities are
undervalued and will not want to sell them to the
investor at the price he is willing to pay.
 The only firms willing to sell investor securities will be
bad firms (because his price is higher than the
securities are worth).
 In an outcome similar to that in the used-car market,
this securities market will not work very well because
few firms will sell securities in it to raise capital.
 Cont…
 The analysis is similar if investor considers purchasing a corporate
debt instrument in the bond market rather than an equity share.
 The investor will buy a bond only if its interest rate is high enough
to compensate him for the average default risk of the good and bad
firms trying to sell the debt.
 The knowledgeable owners of a good firm realize that they will be
paying a higher interest rate than they should, so they are unlikely
to want to borrow in this market.
 Only the bad firms will be willing to borrow, and because
investors are not eager to buy bonds issued by bad firms, they will
probably not buy any bonds at all.
 Few bonds are likely to sell in this market, so it will not be a good
source of financing.
 Cont…

 Generally the presence of asymmetric information in

financial markets leads to adverse selection and moral
hazard problems that interfere with the efficient
functioning of those markets.
 Tools to help solve these problems involve the private
production and sale of information, government
regulation to increase information in financial markets,
the importance of collateral and net worth to debt
contracts, and the use of monitoring and restrictive
covenants.
 Bank regulation

 Bank regulation is the process of setting and enforcing

rules for banks.
 The main purpose of a bank regulation is to protect
consumers, ensure the stability of financial system and
prevent financial crime.
 Bank regulation is a form of government regulation
which subjects banks to certain requirements, restrictions
and guidelines, designed to create market transparency
between banking institutions and the individuals.
 Objectives of bank regulation

 The most common objectives are:

 To reduce the level of risk to which bank creditors are
exposed (i.e. to protect depositors).
 To reduce the risk of disruption resulting from adverse
trading conditions for banks causing multiple or major
bank failures.
 Cont…

 To reduce the risk of banks being used for criminal

purposes,
 To protect banking confidentiality
 To direct credit to favored sectors
 It may also include rules about treating customers fairly
and having corporate social responsibility
 A. Minimum requirements

 A national bank regulator imposes requirements on banks

in order to promote the objectives of the regulator.

 Often, these requirements are closely tied to the level of

risk exposure for a certain sector of the bank.

 The most important minimum requirement in banking

regulation is maintaining minimum capital ratios.
 B. Market discipline

 The regulator requires banks to publicly disclose

financial and other information and depositors and other
creditors are able to use this information to assess the
level of risk and to make investment decisions.

 As a result of this, the bank is subject to market

discipline and the regulator can also use market pricing
information as an indicator of the bank's financial health.
 C. Capital requirement

 The capital requirement sets a framework on how banks

must handle their capital in relation to their assets.

 Internationally, the Bank for International Settlements'

Basel Committee on Banking Supervision influences
each country's capital requirements.

 In 1988, the Committee decided to introduce a capital

measurement system commonly referred to as the Basel
Capital Accords.
 D. Reserve requirement
 The reserve requirement sets the minimum reserves each bank
must hold to demand deposits and banknotes.

 The purpose of minimum reserve ratios is liquidity rather than

safety.

 An example of a country with a contemporary minimum reserve

ratio is Hong Kong, where banks are required to maintain 25% of
their liabilities that are due on demand or within 1 month as
qualifying liquefiable assets.

 Reserve requirements have also been used in the past to control the
stock of banknotes and/or bank deposits.
 E. Corporate governance
 Corporate governance requirements are intended to encourage the
bank to be well managed, and is an indirect way of achieving other
objectives.

 As many banks are relatively large, and with many divisions, it is

important for management to maintain a close watch on all
operations.

 Investors and clients will often hold higher management

accountable for missteps, as these individuals are expected to be
aware of all activities of the institution.
 F. financial reporting and disclosure requirements

 Among the most important regulations that are placed on banking

institutions is the requirement for disclosure of the bank's finances.
 Particularly for banks that trade on the public market, in the US for
example the Securities and Exchange Commission (SEC) requires
management to prepare annual financial statements according to a
financial reporting standard, have them audited, and to register or
publish them.
 Often, these banks are even required to prepare more frequent
financial disclosures, such as Quarterly Disclosure Statements.
 In addition to preparing these statements, the SEC also stipulates
that directors of the bank must confirm to the accuracy of such
financial disclosures.
 Cont…
 Thus, included in their annual reports must be a report of
management on the company's internal control over financial
reporting.

 The internal control report must include:

 a statement of management's responsibility for establishing and

maintaining adequate internal control over financial reporting for
the company;

 management's assessment of the effectiveness of the company's

internal control over financial reporting as of the end of the
company's most recent fiscal year;
 Cont…

 a statement identifying the framework used by

management to evaluate the effectiveness of the
company's internal control over financial reporting;

 and a statement that the registered public accounting firm

that audited the company's financial statements included
in the annual report has issued an verification report on
management's assessment of the company's internal
control over financial reporting.
 G. Credit rating requirement

 A credit rating is a quantified assessment of the creditworthiness of

a borrower in general terms or with respect to a financial
obligation.

 Credit ratings determine whether a borrower is approved for credit

as well as the interest rate at which it will be repaid.

 A credit rating or score is assigned to any entity that wants to

borrow money—an individual, a corporation, a state or provincial
authority, or a sovereign government.
 Cont…

 A credit rating determines the likelihood that the

borrower will be willing and able to pay back a loan
within the confines of the agreement without defaulting.

 A high credit rating indicates that a borrower is likely to

repay the loan in its entirety without any issues, while a
poor credit rating suggests that the borrower might
struggle to make their payments.
 H. Large exposures restrictions

 Banks may be restricted from having irresponsibly large exposures

to individual counterparties or groups of connected counterparties.

 Such limitation may be expressed as a proportion of the bank's

assets or equity, and different limits may apply based on the
security held and/or the credit rating of the counterparty.

 Restricting disproportionate exposure to high-risk investment

prevents financial institutions from placing equity holders' (as well
as the firm's) capital at an unnecessary risk.
 Assessment of Risk Management
 Managing financial institutions has become even more difficult
because of greater uncertainty in the economic environment.

 Interest rates have become much more volatile, resulting in

substantial fluctuations in profits and in the value of assets and
liabilities held by financial institutions.

 Defaults on loans and other debt instruments have also climbed

dramatically, leading to large losses at financial institutions.

 Financial institution managers have become more concerned about

managing the risk their institutions face as a result of greater
interest-rate fluctuations and defaults by borrowers.
 Managing Credit Risk
 A major part of the business of financial institutions is making
loans, and the major risk with loans is that the borrow will not
repay.

 Credit risk is the risk that a borrower will not repay a loan
according to the terms of the loan, either defaulting entirely or
making late payments of interest or principal.

 Once again, the concepts of adverse selection and moral hazard

will provide our framework to understand the principles financial
managers must follow to minimize credit risk, yet make successful
loans.
 Cont…
 Adverse selection is a problem in the market for loans because
those with the highest credit risk have the biggest incentives to
borrow from others.

 Moral hazard plays as role as well.

 Once a borrow has a loan, she has an incentive to engage in risky

projects to produce the highest payoffs, especially if the project is
financed mostly with debt

 Solving Asymmetric Information Problems

Financial managers have a number of tools available to assist in

reducing or eliminating the asymmetric information problem
 Cont…
 Screening
Collecting reliable information about prospective borrowers.
This has also lead some institutions to specialize in regions or
industries, gaining expertise in evaluating particular firms or
individuals.
 Monitoring
Requiring certain actions, or prohibiting others, and then periodically
verifying that the borrower is complying with the terms of the loan
contact.
 Long-term Customer Relationships
Past information contained in checking accounts, savings accounts,
and previous loans provides valuable information to more easily
determine credit worthiness.
 Cont…
 Loan Commitments

Arrangements where the bank agrees to provide a loan up to a fixed

amount, whenever the firm requests the loan.

 Collateral

A pledge of property or other assets that must be surrendered if the

terms of the loan are not met (the loans are called secured loans).

 Compensating Balances

Reserves that a borrower must maintain in an account that act as

collateral should the borrower default.
 Managing Liquidity Risk
 Assured the ability to meet its liabilities as they become due
reduces the probability of an adverse situation developing.

 Liquidity shortfall in one institution can have effects on the entire

system.

 Liquidity has to be tracked through maturity or cash flow

mismatches (Maturing liability is a cash outflow and maturing
asset is a cash inflow)

 To measure and manage liquidity risk exposure, a standard tool

can be applied.
 Cont…
Financial institutions, banks in particular, specialize in earning a
higher rate of return on their assets relative to the interest paid on
their liabilities.

As interest rate volatility increased, interest-rate risk exposure has

become a concern for financial institutions.

To measure and manage interest-rate risk exposure, two tools can be

applied to assist the financial manager in this effort

 Income Gap Analysis and

 Duration Gap Analysis

 Cont…
 Income Gap Analysis

Measures the sensitivity of a bank’s current year net income to

changes in interest rate.

Requires determining which assets and liabilities will have their

interest rate change as market interest rates change.

 Duration Gap Analysis

Owners and managers do care about the impact of interest rate

exposure on current net income.

They are also interested in the impact of interest rate changes on the
market value of balance sheet items and the impact on net worth.
CHAPTER FOUR HAS COMPLETED
THANK YOU !!