https://www.nber.org/system/files/working_papers/w14113/w14113.pdf

Bank governance, regulation and risk taking

Bank Regulation and Supervision: What Works Best?

1. Introduction: 1.A Motivation 1.B Objectives and contributions 1.C Key findings: a brief synopsis 1.D Guide to the book 2. Contrasting approaches to bank regulation: 2.A Two approaches to bank regulation: 2.A.1 Public interest approach 2.A.2 Private interest view of regulation 2.B Bank regulation: how 2.C The Basel Committee and regulatory convergence 2.D Conclusion 3. How are banks regulated and supervised around the world?: 3.A Overview 3.B Structure, scope and independence of regulation and supervision 3.C What is a 'bank'? 3.D Entry into banking, capital requirements and supervisory powers 3.E Explicit deposit insurance schemes 3.F Private monitoring and external governance 3.G Does bank ownership type affect the choice of regulations and supervisory practices? 3.H Forces for greater harmonization of regulation and supervision among countries 4. What works best: 4.A Goals and boundaries 4.B Bank regulation and supervision and bank development 4.C Bank supervision, regulation, and stability 4.D Bank supervision, regulation, and bank efficiency 4.E Bank supervision, regulation, and bank lending 4.F Supervision, regulation, and bank governance 4.G Summary of results 5. Choosing bank regulations 5.A Recap and motivation 5.B Motivating example: Mexico and the United States 5.C Conceptual framework 5.D Empirical framework and data 5.E Summary remarks 6. Rethinking bank regulation: 6.A Approach and context 6.B Lessons and implications.

Rethinking Bank Regulation: Till Angels Govern

The authors draw on their new database on bank regulation and supervision in 107 countries to assess different governmental approaches to bank regulation and supervision and evaluate the efficacy of different regulatory and supervisory policies. First, the authors assess two broad and competing theories of government regulation: the helping-hand approach, according to which governments regulate to correct market failures, and the grabbing-hand approach, according to which governments regulate to support political constituencies. Second, they assess the effect of an extensive array of regulatory and supervisory policies on the development and fragility of the banking sector. These policies include the following: Regulations on bank activities and the mixing of banking and commerce. Regulations on entry by domestic and foreign banks. Regulations on capital adequacy. Design features of deposit insurance systems. Supervisory power, independence, and resources; stringency of loan classification; provisioning standards; diversification guidelines; and powers to take prompt corrective action. Regulations governing information disclosure and fostering private sector monitoring of banks. Government ownership of banks. The results raise a cautionary flag with regard to reform strategies that place excessive reliance on a country's adherence to an extensive checklist of regulatory and supervisory practices that involve direct government oversight of and restrictions on banks. The findings, which are much more consistent with the grabbing-hand view of regulation than with the helping-hand view, suggest that the regulatory and supervisory practices most effective in promoting good performance and stability in the banking sector are those that force accurate information disclosure, empower private sector monitoring of banks, and foster incentives for private agents to exert corporate control.

This paper examines the role of capital in financial institutions. As the introductory article to a conference on the role of capital management in banking and insurance, it describes the authors' views of why capital is important, how market-generated capital requirements' differ from regulatory requirements and the form that regulatory requirements should take. It also examines the historical trends in bank capital, problems in measuring capital and some possible unintended consequences of capital requirements. According to the authors, the point of departure for all modern research on capital structure is the Modigliani-Miller (MM it is difficult to measure, and its measured value may be subject to manipulation by gains trading . The risk exposure in the denominator is also difficult to measure, corresponds only weakly to actual risk and may be subject to significant manipulation. These imprecisions worsen the social tradeoff between the externalities from bank failures and the quantity of bank intermediation. To keep bank risk to a tolerable level, capital standards must be higher on average than they otherwise would be if the capital ratios could be set more precisely, raising bank costs and reducing the amount of intermediation in the economy in the long run. Since actual capital standards are, at best, an approximation to the ideal, the authors argue that it should not be surprising that they may have had some unintended effects. They examine two unintended effects on bank portfolio risk or credit allocative inefficiencies. These two are the explosive growth of securitization and the so-called credit crunch by U.S. banks in the early 1990s. The authors show that capital requirements may give incentives for some banks to increase their risks of failure. Inaccuracies in setting capital requirements distort relative prices and may create allocative inefficiencies that divert financial resources from their most productive uses. During the 1980s, capital requirements may have created artificial incentives for banks to take off-balance sheet risk, and changes in capital requirements in the 1990s may have contributed to a credit crunch.

The Role of Capital in Financial Institutions

This paper investigates the role of bank capital regulation in risk control. It is known that banks choose portfolios of higher risk because of inefficiently priced deposit insurance. Bank capital regulation is a way to redress this bias toward risk. Utilizing the mean-variance model, the following results are shown: (a) the use of simple capital ratios in regulation is an ineffective means to bound the insolvency risk of banks; (b) as a solution to problems of the capital ratio regulation, the "theoretically correct" risk weights under the risk-based capital plan are explicitly derived; and (c) the "theoretically correct" risk weights are restrictions on asset composition, which alters the optimal portfolio choice of banking firms. THE RECENT INCREASE in bank failures, especially after the 1980 and 1982 Deregulatory Acts, has again ignited a controversy over the risk portfolio of the banking industry. Given the importance of this sector, there has been increased scrutiny of the industry's motives for risk taking and possible regulatory changes to improve its stability. These investigations have centered around two rather complementary areas. The first of these is the role of deposit insurance and how its current pricing procedure encourages risk taking and justifies current bank regulations. The works of Buser, Chen, and Kane [4], Kane [9], and Benston et al. [2] have made substantive contributions. The authors demonstrates the way in which our current fixed-rate insurance system rewards risk taking by the firm and insulates it through deposit insurance from the market discipline that needs to exist to ensure proper risk evaluation. This realization has led these authors to propose a series of regulatory changes to encourage proper portfolio choice within the industry. These include a shift to, market value accounting, risk-based deposit insurance premiums, and additional capital regulation. The last of these serves as a method of coinsurance whereby higher capital levels require the bank to absorb greater losses in the event of failure and encourage additional prudence in management. In essense it is one method of risk reduction that may offset the risk preference imposed on the industry due to the inappropriate insurance pricing. Because the amount of capital influences the probability of bank insolvency and thus the soundness of the entire banking system, the regulators, ceteris paribus, prefer more capital to

http://www.ww.uni-magdeburg.de/bizecon/teaching/ST_08/banks/Kim,%20D_Santomero,A.M(1988)_Risk%20in%20Banking%20and%20Capital%20regulation_J%20of%20F_43(5)_1219-1233.pdf

Anthony M. Santomero

Papers

Risk in Banking and Capital Regulation