Most academics, politicians (representing the taxpayer), depositors and investors accept the idea that the banking sector is different. Banks play such a critical role in the economy that they need to be singled out for more intense regulation than other sectors. The presence of asymmetric information is at the heart of the problem. Bankers, their customers, regulators and investors have different information sets on the health of a bank. Small depositors are the least likely to have information and, for this reason, they are usually covered by a deposit insurance scheme, creating a moral hazard problem (see below for more detail). Regulators have another information set, based on their examinations, and investors will rely on the results of external audits.
Managers of a bank have more information about its financial health than depositors, regulators, shareholders or auditors. The well-known principal-agent problem arises because of the information wedge between managers and shareholders. Once shareholders delegate the running of a firm to managers, they need to monitor them to ensure managers take decisions to maximize shareholder value added rather than, say, maximizing short-term sales revenue to boost their personal power and remuneration. However, agency problems are not unique to the banking sector.
The difference in the banking sector, it is argued, is that asymmetric information, agency problems and moral hazard, taken together, can be responsible for the collapse of the financial system, a negative externality. To see how a bank run might commence, recall a core banking function, intermediation. Put simply, banks pay interest on deposits and loan out the money to borrowers, charging a higher rate of interest to include administration costs, a risk premium and a profit margin for the bank. All banks have a liquidity ratio, the ratio of liquid assets to total assets, meaning that only a fraction of deposits are available to be paid out to customers at any point in time. However, there is a gap between the optimal liquidity for safety and the ratio a profit-maximizing bank will choose.4
Governments may also impose a reserve ratio, requiring banks to place a fraction of non-interest-earning deposits at the central bank. It is treated as a tax on banking activity. The effective tax the bank pays is obtained by multiplying the interest forgone by the volume of funds held as reserves. Since the nominal rate of interest incorporates inflation expectations, the reserve ratio is often loosely thought of as a source of inflation tax revenue. Over the past 20 years, many Western governments have reduced or eliminated this reserve ratio. For example, in the United Kingdom, the reserve ratio has been reduced from 8 per cent in the 1971 to just 0.4 per cent in 2002. In developing and emerging markets, the reserve ratio imposed on banks can be as high as 20 per cent, because it is a means of earning revenue in poorer countries.
The reserve ratio can also be used as a tool in monetary policy: raising a reserve ratio will take money out of the economy, so reducing the money supply. It was a common tool of monetary policy in most countries until the late 1970s, and then largely abandoned. However, in certain key countries, such as Japan, the central bank authorities continue to use it as an integral part of their monetary policy.
Returning to the liquidity ratio, given that banks, even healthy ones, only have a fraction of their deposits available at any one time, an unexpected sudden surge in the withdrawal of deposits will mean that they soon run out of money in the branches. Asymmetric information means rumours (ill-founded or not) of financial difficulties at a bank will result in uninsured depositors withdrawing their deposits, and investors selling their stock. Contagion arises when healthy banks become the target of runs, because depositors and investors, in the absence of information to distinguish between healthy and weak banks, rush to liquidity.
In the absence of intervention by the central bank to provide the liquid ity necessary to meet the depositors' demands, a bank's liquidity problem (unable to meet its liabilities as they fall due) can turn into one of insolvency, or negative net worth. Normally if the central bank and/or other regulators believe that but for the liquidity problem, the bank is sound, it will intervene, providing the necessary liquidity (at a penalty rate) to keep the bank afloat. Once depositors are satisfied they can get their money, the panic subsides and the bank run is stopped. However, if the regulators decide that the bank is insolvent and should not be rescued, the run on deposits continues, and it is forced to close it doors.
If the authorities do intervene but fail to convince depositors that the problem is confined to the one bank, contagion results in systemic problems, affecting most or all banks, and the sector is in danger of collapsing. In the extreme, the corresponding loss of intermediation and the payments system could reduce the country to a barter economy. A 'bank holiday' may be declared in an effort to stop the run on banks, using the time to meet with the stricken banks and decide how to stem the withdrawals, usually by an agreement to supply unlimited liquidity to solvent banks when their doors open after the holiday.
If the bank holiday agreement fails to assure depositors, or no agreement is reached, the outcome is a classic negative externality because what began as a run on one bank (or a few small banks) has resulted in the collapse of the country's financial system. The economic well-being of all the agents in an economy has been adversely affected by the actions of less than perfectly informed depositors and investors, who, with or without good reason, decided that their bank was in trouble and sought to get their money out. The negative externality is a type of market failure, as is the presence of asymmetric information. Market failure is a classic argument for a sector to be singled out for government intervention and regulation.
Another argument for intervention arises because of the utility-maximizing behaviour of individuals. Senior management are normally the first to recognize that their bank is, or will be, in serious trouble. They have the option of taking no action, letting it fail, and losing their jobs. However, if they are the only ones with information on the true state of the bank, downside risk is truncated. Returns are therefore convexified, encouraging gambling to increase their survival probability and resurrect the bank. Thus, they will undertake highly risky investments, even with negative expected returns. Likewise, 'looting' (see below for more detail) may be seen as a way of saving the bank, and if not, to provide a comfortable payoff for the unemployed managers. Given the presence of contagion in the sector, such behaviour should be guarded against through effective monitoring.
Lack of competition will arise in a highly concentrated banking sector and can also be a source of market failure. However, anti-competitive behaviour can arise in other sectors, and is referred to a government body with the power to act, should the behaviour of firms or firms be deemed uncompetitive.
To summarize, the banking system needs to be more closely regulated than other markets in the economy because of the presence of market failures, as evidenced by asymmetric information, and the negative externality caused by the systemic collapse of the financial system. The special regulation can take a number of forms, including deposit insurance (funded by bank premiums being set aside in an insurance fund), the licensing and regular examination of banks, intervention by the authorities at an early stage of a problem bank, and lifeboat rescues.
In fact, the complete collapse of a country's banking or financial system is rare. The best example is that of the United States, where the collapse of the banking sector in 1930-33 threatened the entire financial system, and was a contributory factor to the deep depression. Going further back in history, we can identify a British financial crisis in 1866. Proponents of special regulation of banks, and timely intervention if a bank or banks encounter difficulties, would argue that it is the presence of strict regulation of the banking sector which has headed off any serious threats to financial systems of the developed economies. Additionally, there have been many bank failures and crises in emerging markets, most recently in some Asian countries. Contagion spread from problems in Thailand and Indonesia to the economies of a number of countries in the region.
Unfortunately, there is a downside to the regulation of banks. The key problem is one of moral hazard. A term borrowed from the insurance literature, it means that incentives of the insured party may be altered once the insurance contract is entered into. The classic example is that of a comprehensive house contents insurance policy. The insured individual may be less concerned about security than in the absence of a contract. The insurer will attempt to counter the problem by introducing conditions attached to the insurance. For example, an unsecured house (doors unlocked, windows open) may cancel the contract if the house is burgled. No-claims bonuses also help to reduce moral hazard.
In banking, moral hazard arises in the presence of deposit insurance and/or because a central bank is willing to intervene should a bank encounter difficulties. If a deposit is backed by insurance, then the depositor is unlikely to withdraw the deposit if there is some question raised about the health of the bank. Hence, bank runs are less likely, effectively putting an end to the possibility of systemic failure of the banking system. The deposit insurance has to cover 100 per cent of deposits to guarantee the absence of any systemic risk. However, deposit insurance is costly, and normally, governments limit its coverage to the retail depositor, on the grounds that this group lacks the resources to be fully informed about the health of a bank. For example, in the United States, the amount of deposit insurance is considered generous, at $100,000, and through the practice of deposit brokerage5 it is effectively much higher.
The problem with restricted deposit insurance is it that it does not eliminate the possibility of bank runs because wholesale depositors and others (for example, non-residents, or those holding funds in foreign currencies) can initiate a run. For example, in 1998, the Japanese authorities had to extend the insurance to cover all deposits after the collapse of insurance firms led to a run on products such as pension funds. In 1984, Continental Illinois Bank suffered a withdrawal of funding by uninsured wholesale depositors.
On the other hand, the more extensive the deposit insurance coverage, the more pronounced the problem because depositors have little incentive to monitor the banks, making it easier for senior management to undertake risks greater than they might have in the absence of closer scrutiny by their customers. This argument applies in particular to bank managers who know their bank is in trouble, and undertake highly risky investments in an attempt to rescue themselves from the problem.
A counter-argument made by proponents of deposit insurance is that even in its presence, the incentives of senior management are not altered to such a degree that they undertake riskier investments. Management is still answerable to shareholders, who do have an incentive to monitor their investments, which are unprotected in the event of failure. Also, if the bank does fail, it is the managers and employees who lose their livelihoods.
A final argument relates to the fund itself. Normally it is the banks that pay the insurance premia to fund the deposit insurance. In most countries, all banks pay the same premium but in the United States, regulators rank banks according to their risk profile, which is kept confidential. The riskier the bank, the higher the premium paid. Being answerable to shareholders, linking the deposit insurance premium to banks' risk profiles, and loss of employment will help to reduce the consequences of moral hazard on the part of bank management.
While most economists accept the need for some special regulation of the banking sector, a minority advocate a return to free banking. The interpretation of this term varies widely, but essentially, it means banks are left to regulate themselves to some degree. A model of nineteenth-century free banking was the Scottish system. Between 1716 and 1844, banks were allowed to operate with virtually no government regulation. Cameron (1972) argues that in the absence of regulation, the banking sector promoted economic growth because intense competition forced banks to innovate; they were the first to introduce overdrafts, interest-earning deposit accounts and overdraft facilities.
Modern-day free bankers argue that government regulation or the presence of a central bank is undesirable because of the possibility of collusion among the regulators and regulated. While recognizing the desirability of protecting the small depositor, avoidance of collusive behaviour by banks has been one of the principal objectives of much of the banking legislation passed in the United States, beginning with the National Bank Act (1863; amended in 1864) and the 1913 Federal Reserve Act. Even so, as will be seen in the next section, 'regulatory forbearance'6 has been a costly problem associated with the large number of thrift and bank failures in the 1980s in the United States, the ongoing Japanese banking problems, and in the United Kingdom.
According to proponents of free banking, it is in the collective interest of the banks to prevent bank runs, so they will establish a private deposit insurance scheme. The sector could also form a private clearing house which would intervene in much the same way as a state central bank does, to prevent a run on one bank turning into a systemic problem. However, a fund and/or a clearing house is not going to eliminate the market failures arising from the presence of asymmetric information and the negative externality associated with systemic collapse. Individual bank managers will still have an incentive to free ride on the system, hiding problems from the rest of the banking community, and if the bank is in serious trouble, going for broke by investing in highly risky assets.
There is no reason to expect a private clearing house to be able to prevent bank runs on healthy banks any better than a central bank. In fact, the clearing house's fund would have a finite amount for rescuing illiquid banks, whereas the government which controls the money supply has, in theory, an infinite amount.
Prudential regulation in New Zealand was similar to systems found in most industrialized economies until January 1996, when the government radically altered its regulation of the banking sector, moving to a limited form of free banking in January 1996. The key idea is a 'partnership between supervision and market disciplines' (Don Brash, Governor, Reserve Bank of New Zealand). The main regulatory reforms are:
1. Each bank is required to produce a quarterly 'Key Information Summary', with a summary of the bank's credit rating, capital ratios (using the Basle definitions), and information on exposure, concentration, asset quality, profitability, and, if applicable, shareholder guarantees. All branches must display the summary prominently. Thus, the public has easy access to this information, and can make informed decisions on where to keep their deposits.
2. A more extensive disclosure document is produced for professional analysts and the media, including comprehensive financial statements, detailed information on capital adequacy, exposure concentration, loans to controlling shareholders, asset quality and exposure to market risk.
3. Disclosure statements are subject to external audit twice a year.
4. Bank directors (or appointed agents) are required to confirm that the bank is meeting the licence conditions set by the Reserve Bank and has adequate risk management systems which are being used properly. They must disclose a bank's exposure to controlling shareholders if it is contrary to the interests of the bank.
5. Should a disclosure statement prove to be false or misleading, bank directors face personal liability for creditors' losses, and up to three years in jail.
At the same time, the Reserve Bank removed regulations on lending exposures to individual customers or groups of closely related borrowers, open foreign exchange positions, and its audit requirements in relation to a bank's risk control systems. However, supervision of the banking system remains the responsibility of the Reserve Bank. It licenses any firm wishing to call itself a bank, imposing a capital requirement of NZ$15 million for bank registration. Banks incorporated in New Zealand are subject to limits on lending to major shareholders and must conform to the Basle risk assets ratio requirements. Although the Reserve Bank continues to monitor banks on a quarterly basis, the information comes from the disclosure statements, not private information passed from bank to supervisor. The Bank also consults with senior management, typically on an annual basis. There is no deposit insurance scheme.
The disclosure system was introduced to provide the public with information about the health of a bank. Placing a burden of responsibility on directors of banks to produce accurate information is a strong incentive for banks to employ adequate risk-management systems. The absence of private information flows between banks and the regulator reduces the likelihood of a problem with regulatory forbearance. Although the Reserve Bank acts as lender of last resort, it has made it clear that problem banks, no matter what their size, will not be bailed out.
The banking system in New Zealand consists of subsidiaries of foreign banks. At the time of writing in 2000, one small retail bank, the Taranaki Savings Bank, is domestically owned, and it is a (largely) mortgage bank operating in one region, though it does offer a banking service to small-business clients. With a recent takeover (see below), there are six (foreign-owned) bank subsidiaries offering universal banking services.
The extensive foreign ownership of banks has given rise to accusations that New Zealand is 'free riding' on the costly prudential regulatory systems of the home countries of its key banks - it effectively imports its regulation at a considerable saving to the government of New Zealand. The supervision of insolvent foreign subsidiaries is the joint responsibility of the host and home countries under the revised Basle Concordat (1983). Were it not for their unique situation, assigning sole responsibility for disclosure to the banks might have encouraged increased risk taking and looting by managers. In refusing to bail out any bank, the government knows that the parent bank is likely to inject capital if it wants to maintain a presence in New Zealand. On the other hand, the changes are consistent with other radical reforms of New Zealand's economy which began in the early 1980s.
This section reviewed the controversies related to bank failures. Proponents of government intervention are by far the majority, though bankers and regulators alike are watching the New Zealand reforms with interest. Those who support special regulation of the banking sector expect governments/regulators to use the determinants of bank failure to achieve an optimum where the marginal benefit of regulation/rescue is equal to its marginal cost. More recently, some researchers have gone further and argued that the benefits should exceed any costs. Free bankers also have an interest in what causes a bank to fail, if only because investors and depositors lose out when a bank goes under. Either way, it is an important question, and the next section attempts to answer it.
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