Regulation of Banks and Finance: Theory and Policy after the Credit Crisis

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In UK the banking industry like in any other economies across the whole world is the engine that drives whole economy. If there is lack of confidence and stability in the sector the whole economy is affected with devastating consequences, not only one economy is affected but this may spill over causing a contagion affecting the whole region and sometimes globally. The behaviour of bank executives is very important since risk and unsustainable investment decisions by the executives will have adverse effects on the industry and the economy at large.

The frequency of severe banking crisis increased in the last two decades 6 and this prompted the interest in studying how governments, banks and bank executives have responded to the crisis. At this point in time Greece and Cyprus are in turmoil while Portugal, Italy and Spain are in the brink of financial crisis. To understand the element of moral hazard it is important to find out how it comes into existence in the banking sector.

In a normal situation when markets are working properly politicians both home and abroad should allow the failing banks and other financial houses to fail and move out of the market. Executives running those organizations face the consequences of their unreasonable investment decisions, these are the dictates of a free market that all the free economies thrive for.

What We’ve Learned from the Financial Crisis

An example of moral hazard is when banks take excessive risks because they believe that the Central Bank or the government will bail them in case they run into financial trouble. The following are some of the unsustainable investment decisions taken by executives based on the aspect moral hazard; a the selling out of financial products consumers are not in need of or are not able to finance the subprime mortgage in the USA b huge risks taken by investment executives on behalf of the bankers, but not liable when a financial difficulty arises.

This only shows how inherent moral hazard has entrenched in the banking sector. Outside the banking sector an example of moral hazard is when the state provides free healthcare. This may encourage poor individual health care such as following poor diet and heavy alcohol consumption.

Other examples of how moral hazard can be illustrated include the deposit protection scheme and financial compensation. Some observers who argue for the protection schemes are of the view that they bring much needed confidence in the financial sector. There is current ongoing debate on the causes of moral hazard in the financial sector and how it can fuel banking crisis. What should be understood is that regulators are not omniscient and cannot totally anticipate every possible thing that could go wrong, whatever industry or activity they are regulating.

The banking crisis delivered a shock that rocked the whole world financial system and to respond to that crisis policy makers had to change the policy landscape. There was a call for more government involvement in the sector, commentators and other stake holders called for more regulation in the banking industry. They advocated for free market or less government intervention in the financial sector. Dowd dismissed the idea of free market saying that the markets have been operating with some form of state intervention going back a very long time ago.

Although the problems caused by bank bailouts and nationalization will be examined in great detail in the next chapter it is important to point out that such forms of regulation can cause the existence of moral hazard. In his argument for regulation Summers brings about three important points; firstly he says if there is a contagion the likelihood that it may spread across the border is inevitable, hence things should not be left to a free fall, this strengthens the argument that the state should come in and regulate the functions of the financial sector.

The second point he raises is the most talked about when bailing out banks, he argues that monetary intervention does not often impose financial burden on the tax payer. He further argues that it can actually make them better off. He cites LCTM case where taxpayers only footed the initial launch of the bail out. The third point raised by Summers is that moral hazard is a justifiable payment for various benefits that accrue from monetary policies.

One example cited is a monetary policy where financial firms are allowed to reduce their capital ratio, and as a result encourages the same firms to invest in productive illiquid projects. It is very difficult to completely prevent moral hazard in the financial sector and the economy in 16 Hulsman J G Beware the Moral hazard Trivializers,mises. It can be argued that it is difficult to have a financial sector that is free from regulation due to the fact that conditions for a free market do not exist, that is, free information no information asymmetry , free entry and exit from the market and many players.

The existence of moral hazard as a result of regulation will be discussed in the next section. Highlights of some regulation that have been used to mitigate banking crisis, leading to the possibility of creating moral hazard will be looked into. As said in the above section the financial crisis can be attributed to weak or failure in regulation, although this position can be contested this chapter is going to provide an explanation on how moral hazard can come about as a result of some aspects of regulation.

Banks by the nature of the activities are prone to what is called runs; this happens when consumers lose confidence in the banking system and withdraw their deposits en-mass. Theory and Evidence. This leads to a stampede that in turn triggers a bank run, which can result into a full blown contagion. A contagion can also spread across the borders, cases of the Bear Stearns and Lehman Brothers in in the USA and the Northern Rock in UK come into mind, where failure of one bank can threaten the existence of the whole financial system.

A contagion in the financial sector can easily spread because of the interconnectedness of the banks payment system. Once the crisis turns into full blown contagion it causes ripple effects across the whole economy, like stagnant growth, unemployment and low level productivity. This is where some commentators like Summers will come out advocating for more government intervention to try and correct market failure.

This leaves depositors without sufficient information to judge the soundness of their banks. Usually this is because the banks are unwilling or unable to provide all information required by the depositors to enable them to monitor their banks. Commentators on moral hazard have come to the conclusion that even the sophisticated customers are reluctant or find it difficult to cope with large volumes of information provided by banks, in order to make rational decisions. Other notable commentators who strongly advocated for an increased government role in preventing or reducing banking crisis happening are Greenspan and Goodhart.

In this regard Goodhart sees deposit protection schemes as a much needed safety net in the banking industry. The stability achieved in the UK banking crisis can be attributed to bailouts that helped stem out or minimise bank runs. Rationale against regulation: Economists, commentators, and other policy makers arguing against regulation of the banking industry cite moral hazard as a negative externality caused by regulation.

Others advocate for minimum or no regulation at all. In free market economies it has been noted that much state intervention distorts market fundamentals by taking away the rights of the consumers to discipline banks that take their deposits while performing below their expectations. Regulatory schemes such as the deposit protection and financial compensation encourage moral hazard, this happens when executives take uncalculated risks knowing full well that there is protection against their banks failing.

Roosevelt was vindicated when the USA experienced the waste banking crisis fifty years later. As was noted by the then Roosevelt administration and also true in modern economies today moral hazard caused by deposit insurance protection manifests itself in two ways: firstly they encourage banks to take risk investment and pocket profits, but shift losses to the government in case of a crisis. Secondly they discourage depositors from monitoring banks that take their deposits.

Government can create an enabling environment where there is minimal intervention and allow free market fundamentals play their role. Regulation is justified on the basis that it is put in place to try and correct market failure or negative externalities and also as a mechanism of redistributive justice.

This is done through bank bailouts, deposit protection, government grantees, prior and continued supervisions. The section that follows will try to answer why some aspects of regulations may cause moral hazard. Although these minimum requirements are not going to be explained further as they are out of the realm of this study it is vital to note that they may be linked to occurrence of moral hazard.

As banks play a pivotal in the economy it is important that only suitable players meeting licensing requirements should be allowed to enter the industry. In the UK the Financial and Markets Act and the Customer Credit Act gives the financial services and other related agencies the powers to authorize and supervise the banks. Although on the other hand they bring about stability and confidence in banking. It is important to note that the period of complete non government intervention in the financial sector is now hard to come by, as if left alone markets will not take care of themselves.

Prior and continued supervision of banks can be used as a way of reducing moral hazard as unorthodox market practices can be quickly detected and corrected.


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Lack of continued supervision can also lead to negative externalities such as regulatory capture. This can happen when regulatory agencies relax in supervising and monitoring banks, the banking crisis can be attributed to lack of supervision and surveillance in the banking industry. Regulatory capture is other negative externality that can occur in the banking sector, this happens when regulatory agencies turn a blind eye on unorthodox practices due to the fact that they can be later on be employed by the same firms. Some agencies can just get too familiar to the firms they are supposed to supervise.

If regulatory agencies are captured banks executives will have some incentives to use unorthodox means to get maximum gains like; insider trading, front running, market manipulation and spreading rumours. Some observers have noted that the issue of bank bailouts comes as a result of regulatory failure or market failure.

This initiative both in the USA and Europe was led by the political leadership. This can also discourage both sophisticated and less sophisticated depositors to monitor institutions that take their deposits. Although this can be attributed to lack of sophisticated knowledge to understand financial information provided for by the banks. Bailouts encourage most depositors to monitor their banks as they know that if their banks run into trouble the government will bail them out. These are the explicit and implicit deposit protection schemes.

This level of certainty provided for by explicit schemes although help in maintaining confidence it can also bring about moral hazard. Depositors become less careful with their deposit and also the Bank executives expose the depositor deposits to great risk knowing full well that compensation will be provided in case there is systemic failure in the sector. What is important to note in the explicit scheme is that it has a set limit as resources are limited to make them open ended or give depositors hundred percent cover. As we shall see later coinsurance can provide for that.

Generally the increase will not stem from the deposit side, but from lending rate. When this happens the interpretation is that there is presence of moral hazard caused by the instrument. Deposit protection is arguably necessary because it is vital that small and other vulnerable depositors need to be protected against losses caused by bank failures because they have no capacity or knowledge to monitor firms taking their deposits.

Small-Business Financing after the Financial Crisis: Lessons from the Literature

The lack by the small and other vulnerable depositors to monitor banks can be attributed to a number of key factors such which are beyond their control such as reluctance by banks in providing all the information needed by the depositors to make informed decisions. This scenario leads to what is called information asymmetry.

The reasons for such information gaps are: first some of the products sold by the firms could be credence goods whose important aspects cannot be ascertained before the contract has been concluded Secondly most banks supply information to serious customers who value their products thereby increasing their sales and the third important aspect could be that firms are reluctant to provide information which they deem could be used by their competitors to their detriment.

Another key factor which has come to the attention of the UK government, World Bank and the UN is the lack of sufficient sophisticated knowledge by depositors to read and understand financial information provided by the institutions. Some of the consumers can understand information provided to them by their banks but cannot cope with volumes concerned.

Despite the distributive justice function implicit protection schemes also help reduce bank runs thereby bringing the much needed financial market stability. When depositors lack confidence in particular banks the result could be bank runs, whereby depositors withdraw their deposits even from safe and solid banks. Once this happens the result can be a financial contagion that can even spread across the borders to other countries affecting the world financial system.

Due to the fact that any lack of confidence in the financial system can cause devastating consequences which can send financial shock waves across borders. Deposit protection insurance scheme is a necessary safety net. Those who argue against the deposit protection put forward the argument that it causes a moral hazard. The scheme encourages bank executives to take more risk and discouraging depositors to monitor banks taking their deposits. The moral hazard usually increases with the ensured quota of the bank deposit.

This is the theoretical argument put forward by most opponents of the explicit deposit protection scheme.

Finance Gets Back to the Big Picture

But at sometimes can induce the undesirable moral hazard. The South African Government provides guarantees that in case of a bank running into trouble, customers deposits are protected. The government will step in to protect a substantial part of the deposit. Although there is cost avoidance in this scheme lack of established formal structures brings about problems when a crisis happens since funds have to be raised in short notice.

This causes panic and mayhem in the financial sector, leading to lack of confidence and bank runs. Deposit protection insurance schemes can be formulated to achieve many financial targets, but the main two objectives as discussed in previous chapters are deposit protection and systemic stability, hence the scheme can be classified as a function of public interest.

But it should be underlined that such a scheme can be financed by the private contributions as well government.

Regulation of Banks and Finance: Theory and Policy After the Credit Crisis

In the implicit schemes the government can decide on the case by case basis since there are no formal structures to deal with the crisis. This can lead to high levels of uncertainty caused by the lead depositors withdrawing their funds in fear that the government will not make a decision in favour of protecting their deposits When this happens a bank run can ensue undermining the fundamental objective of protection scheme that is promotion of systemic stability in the financial sector.

Thus, so the thinking might go, we can worry less about the non-banks because we will count on banks to continue extending credit and making markets. Meanwhile, bank regulation becomes more and more complex over time, leading to more restrictions, whether through regulation overt or examination covert. In their article, Kashyap and his co-authors find that when a standard economic model of banking is expanded to reflect a broader range of services that banks provide for example, providing deposits and making information-intensive loans , the results indicate that multiple regulatory requirements are needed to get the socially optimal outcome.

This seems intuitively correct. The issue, though, is the cost of a multiplicity of rules aimed at only 15 to 20 financial institutions and their activities. There are two main costs. First is a reduction in the level of economic activity, which is inarguable, yet rarely acknowledged in regulatory proposals or academic work. Second, and the focus here, is a possible shift as opposed to reduction of risk to those who may be less able to manage it — either non-bank financial companies or consumers or non-financial businesses — or to government-guaranteed securities for which taxpayers directly bear the risk.

We already see evidence of this in numerous markets. Moreover, non-banks are vulnerable to liquidity pressures both at origination and during the servicing of such loans; thus, non-bank failures could be quite costly for taxpayers. Banks are shifting out of holding the term part of leveraged loans, which are largely funded instead in collateralized loan obligations and non-banks now dominate home lending to low- and moderate-income LMI borrowers.

Moreover, small-dollar lending to LMI communities is increasingly being done by non-bank lenders. Market depth in corporate securities markets has diminished and as bank-affiliated broker-dealers hold less inventory the capital cost of holding and hedging inventory has risen. In sum, post-crisis regulation has forced banks and their affiliates to manage fewer risks for the economy, leaving those risks either to be managed by non-bank financial companies; not to be managed at all, and thus retained by non-financial firms; or held by the government.

What is of even greater concern, though, is how markets will behave in the next financial crisis.


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One is a capital conservation buffer of 2. A fifth, de facto, buffer may be forthcoming in the form of the current expected credit loss CECL accounting methodology, which will require banks at the origination of a loan to establish a reserve against all future expected losses with no offset for future expected income.

Thoughts on the Financial Crisis, Macroeconomic Policy and the G20

As Stephen G. Thus, if one reads the red bar as the amount of capital necessary for the largest banks to survive a financial crisis even worse than the global financial crisis of —, which is how the Federal Reserve calibrates its stress scenario, then you can see that the affected banks hold a mountain of buffer.

If those buffers will never be used, they represent a significant drain on banking activity and economic growth. The rationale for these buffers is that when stress occurs, banks will treat these them as buffers, not legal or practical minimum requirements, and therefore allow their capital levels to drift down toward regulatory minimums in order to remain engaged in lending, market making, and other activities that support the economy. They will also use their buffers to acquire troubled firms, or their assets, lessening fire-sale risk.

This belief is an important foundation of post-crisis capital and liquidity regulation. Indeed, one could say that is the most important foundation of post-crisis capital and liquidity regulation. Rather, market participants universally believe that banks will never allow their liquidity and capital levels to drop, even if that means shrinking their balance sheets and turning away deposits.

In his article, Douglas J. Elliott describes those reasons ably. If so, the recession-related risks have likely become higher, not lower, as a result of the increased requirements. In sum, when internal constraints or credit rating agency standards operate as the binding constraint on bank capital and liquidity levels, a bank might choose to operate at somewhat lower capital or liquidity levels under stress — continuing to lend and make markets.

We already have some hints of how markets might behave, based on rather low-stress events like reporting dates. As an early adherent of behavioral economics and the work of Kahneman and Tversky in particular, 7 I believe that work can have valuable contributions to financial regulation.

We publish here an article that examines how our innate biases make it difficult for us to foresee crises — something readily observed in recent financial crises. I think a far more significant application could be toward how buffers would work in practice, which reflects how banks and regulators would behave. Why would a bank in the midst of market uncertainty and regulatory scrutiny choose to report that it was no longer in compliance — or, put another way, no longer able to comply — with its regulatory capital and liquidity buffers? For that matter, would a regulator in the midst of market uncertainty publicly allow a bank to do so — for example, by lowering a previously imposed countercyclical capital buffer?

Anecdotal evidence and some back-of-the-envelope game theory seems to suggest that they would not.