University of Hargeisa Faculty of Business

and Public Adminstration

Course Title: Banking principles and practices

Chapter six; Economic Analysis of Banking

Regulation
 Introduction
• Asymmetric information analysis explains
what types of banking regulations are needed
to reduce moral hazard and adverse selection
problems in the banking system. However,
understanding the theory behind regulation
does not mean that regulation and
supervision of the banking system are easy in
practice
 Asymmetric Information
and Bank Regulation

There are eight basic categories of banking

regulation: the government safety net, restrictions
on bank asset holdings, capital requirements,
chartering and bank examination, assessment of
risk management, disclosure requirements,
consumer protection, and restrictions on
competition.

Money and Banking

Chapter eight
11-3
 Government safety net
1. Government safety net: Deposit insurance
– Short circuits bank failures and contagion effect
The FDIC uses two primary methods to handle a failed bank.
– Payoff method
– Purchase and assumption method
• Moral hazard is a prominent concern in government arrangements
to provide a safety net. Because with a safety net depositors know
that they will not suffer losses if a bank fails, they do not impose
the discipline of the marketplace on banks by withdrawing deposits
when they suspect that the bank is taking on too much risk.
Consequently, banks with a government safety net have an
incentive to take on greater risks.
 Payoff method

The payoff method used by the FDIC to address the bankruptcy of a

bank is when the FDIC:
A). Pays the owners of the bank for the losses they would otherwise
face.
B). Pays off all depositors the balances in their accounts so no
depositor suffers a loss, though the owners of the bank may suffer
losses.
C).Pays off the depositors up to the current $100,000 limit, so it is
possible that some depositors will suffer losses.
D). Takes all of the assets of the bank, sells them pays off the
liabilities of the bank in full and then replenishes their fund with any
remaining balance.
 Purchase and Assumption

• Purchase and assumption is a transaction in which a

healthy bank or thrift purchases assets and
assumes liabilities (including all insured deposits)
from an unhealthy bank or thrift. It is the most
common and preferred method used by the 
Federal Deposit Insurance Corporation (FDIC) to
deal with failing banks. Insured depositors of the
insolvent institution immediately become
depositors of the assuming bank and have access to
their insured funds.
• Understanding Purchase and Assumption
(P&A)
In a purchase and assumption transaction, the
FDIC arranges the sale of a troubled or insolvent
financial institution to a healthy one. Along with
becoming the depository for personal checking,
savings, and other insured accounts, the
acquiring bank may buy other assets (such as
loans or mortgages) of the failing bank as well.
 Adverse Selection

• A further problem with a government safety net like

deposit insurance arises because of adverse
selection, the fact that the people who are most
likely to produce the adverse outcome insured
against (bank failure) are those who most want to
take advantage of the insurance.
– Risk-lovers find banking attractive
– Depositors have little reason to monitor bank
 Conti………...
Financial consolidation poses two challenges to
banking regulation because of the existence of the
government safety net.
1. The increase size of banks as a result of financial
consolidation increases the too-big-to fail
problem.
2. Extends safety net to new activities, increasing incentives
for risk taking in these areas.
 Too Big to Fail
• Government provides guarantees of repayment
to large uninsured creditors of the largest banks
even when they are not entitled to this
guarantee
• Uses the purchase and assumption method
• Increases moral hazard incentives for big banks

Money and Banking 11-10

Chapter eight.
 2. Restrictions on Asset Holding and 3.Bank
Capital Requirements
• Attempts to restrict banks from too much risk taking.
– Promote diversification
– Prohibit holdings of common stock
– Set capital requirements
Bank capital requirements take two forms:-
• leverage ratio; the amount of capital divided by the bank’s total
assets, ratio must be 5%-3%
• Basel Accord: risk-based capital requirements
Regulatory arbitrage; situation where companies take advantage of
loopholes in order to avoid unprofitable regulations.
example, a company may relocate its headquarters to a country
with lower tax rules and favorable regulatory policies to save cost
and increase profit. Money and banking
Chapter eight 11-11
 4. Bank Supervision:Chartering and
Examination
• Chartering (screening of proposals to open new banks) to prevent adverse
selection
• Examinations (scheduled and unscheduled) to monitor capital requirements
and restrictions on asset holding to prevent moral hazard
• Bank examiners give banks a so-called CAMELS rating (the acronym is based
on the six areas assessed):-
– Capital adequacy
– Asset quality criteria
– Management
– Earnings
– Liquidity
– Sensitivity to market risk
With this information about a bank’s activities, regulators can enforce regulations
by taking such formal actions as cease and desist orders to the bank’s behavior or
even close a bank if its CAMELS rating is sufficiently low.
Money and Banking
11-12
Chapter eights
 5 Assessment of Risk Management
• Greater emphasis on evaluating soundness of management processes
for controlling risk.
• Trading Activities Manual of 1994 for risk management rating based
on.
– Quality of oversight provided by the board of directors and senior management.
– Adequacy of policies and limits for all activities that present significant risks.
– Quality of the risk measurement and monitoring systems
– Adequacy of internal controls to prevent fraud .
which provided bank examiners with tools to evaluate risk management
systems.
• Interest-rate risk limits
– Internal policies and procedures.
– Management and Implement internal control to monitor interest rate risk.

Money and banking

Chapter eight 11-13
 6. Disclosure Requirements

• Requirements to adhere to standard accounting

principles and to disclose wide range of
information that helps the market assess the
quality of a bank’s portfolio and the amount of
the bank’s exposure to risk.
• To ensure that there is better information for
depositors and the marketplace.

Money and Banking

Chapter eight 11-14
 7. Consumer Protection
Consumer protection regulation has taken several
forms;-
• Truth-in-lending mandated under the Consumer
Protection Act of 1969, which requires all
lenders, not just banks, to provide information
to consumers about the cost of borrowing
including a standardized interest rate (called the
annual percentage rate, or APR) and the total
finance charges on the loan.
Money and Banking
Chapter eight 11-15
 Conti………
• Equal Credit Opportunity Act of 1974, extended in
1976 for bid discrimination by lenders based on
race, gender, marital status, age, or national origin.
• The Community Reinvestment Act requires that
banks show that they lend in all areas in which they
take deposits, and if banks are found to be in
noncompliance with the act, regulators scan reject
their applications for mergers, branching, or other
new activities.
 8.Restrictions on Competition
• Increased competition can also increase moral hazard incentives
for banks to take on more risk.
• Declining profitability as a result of increased competition could
tip the incentives of bankers toward assuming greater risk in an
effort to maintain former profit levels. Thus governments in
many countries have instituted regulations to protect banks
from competition.
These regulations have taken two forms;-
– Branching restrictions (eliminated in 1994)
– Glass-Steagall Act (repeated in 1999, involved preventing nonbank
institutions from competing with banks by engaging in banking
business)
Disadvantages
– Higher consumer charges
– Decreased efficiency
 Problems in Regulating International Banking
• Particular problems in bank regulation occur when
banks are engaged in international banking and
thus can readily shift their business from one
country to another.
• Bank regulators closely examine the domestic
operations of banks in their country, but they
often do not have the knowledge or ability to keep
a close watch on bank operations in other
countries, either by domestic banks’ foreign
affiliates or by foreign banks with domestic
branches
 Financial Crisis
The financial crisis happened because banks
were able to create too much money, too
quickly, and used it to push up house prices and
speculate on financial markets.
1.Banks created too much money…
Every time a bank makes a loan, new money is
created. In the run up to the financial crisis,
banks created huge sums of new money by
making loans.
 Conti………
2. Money to push up house prices and speculate on financial
markets.

• Very little of the trillion pounds that banks created between 2000-2007
went to businesses outside of the financial sector:
• Around 31% went to residential property, which
pushed up house prices faster than wages.
• A further 20% went into commercial real estate (office buildings and
other business property).
• Around 32% went to the financial sector, and the same financial
markets that eventually collapsed during the financial crisis.
• But just 8% of all the money that banks created in this time went to
businesses outside the financial sector.
• A further 8% went into credit cards and personal loans.
 Conti…….
3. Eventually the debts became un payable
Lending large sums of money into the property
market pushes up the price of houses along with
the level of personal debt.
Interest has to be paid on all the loans that
banks make, and with the debt rising quicker
than incomes, eventually some people become
unable to keep up with repayments. 
 conti……..

• This process caused the financial crisis. Straight after

the crisis, banks limited their new lending to
businesses and households.
•  The slowdown in lending caused prices in these
markets to drop, and this means those that have
borrowed too much to speculate on rising prices had
to sell their assets in order to repay their loans.
• House prices dropped.
As a result, banks panicked and cut lending even further.
 After the crisis, banks refuse to lend, and the
economy shrinks

• Banks lend when they’re confident that they

will be repaid. So when the economy is doing
badly, banks prefer to limit their lending.
• However, although they reduce the amount of
new loans they make, the public still have to
keep up repayments on the debts they already
have.
 End

Thank you