Chapter11EconomicAnalysisofBankingRegulation*©2005PearsonEducationCanadaInc.HowAsymmetricInformationExplainsBankingRegulation1.GovernmentSafetyNetandDepositInsuranceA.Preventsbankrunsduetoasymmetricinformation:depositorscan’ttellgoodfrombadbanksB.CreatesmoralhazardincentivesforbankstotakeontoomuchriskC.Createsadverseselectionproblemofcrooksandrisk-takerswantingtocontrolbanksD.Too-Big-to-Failincreasesmoralhazardincentivesforbigbanks2.RestrictionsonAssetHoldingsA.Reducesmoralhazardoftoomuchrisktaking3.BankCapitalRequirementsA.Reducesmoralhazard:bankshavemoretolosewhenhavehighercapitalB.HighercapitalmeansmorecollateralforFDIC4.BankSupervision:CharteringandExaminationA.ReducesadverseselectionproblemofrisktakersorcrooksowningbanksB.Reducesmoralhazardbypreventingriskyactivities5.NewTrend:AssessmentofRiskManagement6.DisclosureRequirementsA.BetterinformationreducesasymmetricinformationproblemHowAsymmetricInformationExplainsBankingRegulation3.BankCapitalRequirementsA.Reducesmoralhazard:bankshavemoretolosewhenhavehighercapitalB.HighercapitalmeansmorecollateralforCDIC4.BankSupervision:CharteringandExaminationA.ReducesadverseselectionproblemofrisktakersorcrooksowningbanksB.ReducesmoralhazardbypreventingriskyactivitiesC.Newtrend:Assessmentofriskmanagement5.DisclosureRequirementsA.BetterinformationreducesasymmetricinformationproblemHowAsymmetricInformationExplainsBankingRegulationMajorBankingLegislationinCanadaMajorBankingLegislationinCanada©2005PearsonEducationCanadaInc.WhyaBankingCrisisin1980s?EarlyStages1.Managersdidnothavetherequiredexpertisetomanagerisk2.TheexistenceofCDIC,moreopportunitiesforrisktaking3.Becauseofthelendingboom,bankactivitieswerebecomingmorecomplicated.Regulatorshadneithertheexpertisenortheresourcestomonitortheseactivitiesappropriately4.i,networthofbanksA.InsolvenciesB.IncentivesforrisktakingResult:FailuresandriskyloansLaterStages:RegulatoryForbearance1.RegulatorsallowinsolventbankstooperatebecauseA.InsufficientfundsB.SweepproblemsunderrugPoliticalEconomyoftheBankingCrisisExplanation:Principal-AgentProblem1.PoliticiansinfluencedbybanklobbyistsratherthanpublicA.DenyfundstoclosebanksB.Legislationtorelaxrestrictions2.RegulatorsinfluencedbypoliticiansanddesiretoavoidblameA.LoosenedcapitalrequirementsB.RegulatoryrestrictionsonriskyassetholdingsC.RegulatoryforbearanceCDICDevelopmentsCDICinsureseachdepositoratmemberinstitutionsuptoalossof$60000peraccountAllfederallyincorporatedfinancialinstitutionsandallprovinciallyincorporatedTMLsaremembersoftheCDICInsurancecompanies,creditunions,caissespopulaires,andinvestmentdealersarenoteligibleforCDICmembershipQDIBinsuresprovinciallyincorporatedinstitutionsinQuébecandtheotherprovinceshavedepositinsurancecorporationsthatinsurethedepositsofcreditunionsintheirjurisdictionCDICinsuresonlydepositsinCanadiancurrencyandpayableinCanada;foreigncurrencydepositsarenotinsuredNotalldepositsandinvestmentsofferedbyCDICmemberinstitutionsareinsurableNotAllDepositsAreInsurableInsurabledepositsincludeSavingsandchequingaccountsTermdepositswithamaturitydate<5yearsMoneyordersanddrafts,certifieddraftsandcheques,andtraveller’schequesTheCDICdoesnotinsureTermdepositswithaninitialmaturitydate>5yearsT-bills,bondsanddebenturesissuedbygovernmentsandcorporations(includingthecharteredbanks)Investmentsinstocks,mutualfunds,andmortgages.DifferentialPremiumsBy-LawOpting-OutBy-LawPermitsScheduleIIIbanks,thatacceptprimarilywholesaledeposits(definedas$150000ormore),tooptoutofCDICmembershipandthereforetooperatewithoutdepositinsuranceItrequires,however,anopted-outbanktoinformalldepositors,bypostingnoticesinitsbranches,thattheirdepositswillnotbeprotectedbytheCDIC,andnottochargeanyearlywithdrawalpenaltiesfordepositorswhochoosetowithdrawImplications:MinimizesCDICexposuretouninsureddepositsBycompensatingonlytheinsureddepositorsratherthanalldepositors,thislegislationincreasestheincentivesofuninsureddepositorstomonitortherisk-takingactivitiesofbanks,therebyreducingmoralhazardriskEvaluatingCDICLimitsonScopeofDepositInsurance1.Eliminatedepositinsuranceentirely2.Lowerlimitsondepositinsurance3.Eliminatetoo-big-to-fail4.CoinsurancePromptCorrectiveAction1.Criticsbelievetoomanyloopholes2.However:accountabilityincreasedbymandatoryreviewofbankfailureresolutionsRisk-basedInsurancePremiums1.HardtoimplementOtherProposedChanges1.Regulatoryconsolidation2.Market-valueaccountingBankingCrisesWorldwideCostofBankingCrisesinOtherCountries