For those of us that maintain a strong interest in the theory of bank regulation (sad, I know) a speech by Ben Bernanke provides a very interesting read. (Thanks to Bank Law Professor for another great link).
In this speech, he runs through what amounts to a history of bank regulation in the USA to illustrate his various points, on what he terms “command and control” bank regulation, deposit insurance and the moral hazard inherent in it, minimum capital requirements and Basel II. A real tour de force.
I was disappointed, though, that he did not mention one major possibility for the regulation of major banking markets.
While he is clearly a fan of what he terms “market-based regulation” he has missed one possibility of doing this truly effectively – establishing competitive regulators.
In this scenario there would be several bank regulators (as there are currently in the US) but they would operate truly competitively – banks would be able to choose their regulators in a similar way to the way they can currently choose their auditors. The reason I believe this type of system would be able to work is the market forces that would be applied.
A regulator would not owe its position to statute, but to the way in which they are perceived. If they are seen as a light touch, banks using them would be discounted in the market. Banks using a stronger regulator would be advantaged. If a regulator cost too much, however, the bank would be able to move to a cheaper regulator. The discipline applied here, then, would work both ways – the regulator would have an incentive to be the best possible on a risk / reward basis and a bank would have a strong incentive to find a regulator that was well perceived in the market, without it costing too much.
Different regulators could also offer different products, with some offering deposit insurance and others not. Depositors would then have a true choice – higher costs but greater safety or lower cost but no insurance.
Others could specialise in more innovative forms of banking – for example Islamic finance – and offer appropriate products – provision of a Sharia board for example.
There would occasionally be regulatory failure, but I would argue that this sort of failure would be less than the sort of failure we are seeing now in the US, with the FDIC and the Fed stoushing it about the way that Basel II was implemented
All in all, a great speech for a read, but I would have liked to see this other option mentioned.
14 April, 2007 at 06:23
W. Britt Gwinner
On competing regulators, the U.S. has had that, and it used to be more important. Banks can charter as state institutions, and many that did so picked weak state regulators, like Texas. In that case, the rush to the bottom permitted substantial losses on mortgage lending during the oil-induced land boom in the early 1980s.
14 April, 2007 at 17:56
I would agree that this, in part at least, helped the S&L problems along. I would argue, however, that this became serious only because of the moral hazard from FDIC insurance. The S&Ls in problems had some sky-high deposit rates and depositors kept funding – indeed increased it if I remember correctly – as they knew it would be safe.
Bernanke was right to highlight this issue in his speech and I believe that the FDIC, far from being a solution to the problem of bank instability, in fact, through moral hazard, acts to promote it.
The chair of the FDIC is pushing hard to keep current capital levels, despite any improvements in risk management, precisely because it is her agency that is exposed to any losses. This is a pity as it is the risk management improvements, driven in part by Basel II initiatives, that will increase systemic stability.
17 April, 2007 at 03:12
Do you have any other articles or info on credit derivatives pricing or trading? I found some interesting information on the following sites:
– links removed by admin –
17 April, 2007 at 17:18
“Credit Derivative” your comment looks like spam. I have removed the links in it in case it is. If you believe this unjust or unfair, please let me know.
Also, in future, please place comments on a thread related to your comment.
28 May, 2007 at 13:49
I apologise for the belated comment, Andrew.
Your point on ‘regulator competition’ entirely misses the point of bank regulation. The reason for state intervention into a market is market failure. In the banking sector, this stems from the incentive for bank managers AND shareholders to take extra risk due to performance remuneration and limited liability, respectively. This is true for all limited liability companies, but what sets banks apart is their level of interconnectedness – raising the risk of systemic failure if any given bank topples over – and their central role to the economy. This, in turn, raises the likelihood of remedial state intervention – explicit via deposit insurance, or otherwise – in case failure does happen, providing liquidity and precluding systemic failure. The possibility of remedial intervention creates further risk-taking incentive not only to shareholders and bank management, but also to creditors and depositors, as the cost of intervention is bore by the tax-payer – current, past and future. Hence, bank regulation exists as preventative intervention.
Thus, creating incentives for banks ‘to find a regulator that was well perceived in the market’ does not really address the issue of effective and efficient regulation, as ‘the market’ is only partly served by regulation. Giving depositors ‘a true choice’ does not address the issue either, as depositors are already protected to some extent by remedial intervention, and are ultimately the sole cost bearers of regulation, as remuneration of all other stakeholders are competitively priced (salaries, debt, equity and supplies are priced in competition with other industries).
This is my personal opinion, at least.
Manager, Operational Risk
Australian Prudential Regulation Authority
28 May, 2007 at 23:02
Thanks for the comment(s). I must, however, disagree with this one (if not the other). To me the lack of true competition in the regulatory area is a problem. APRA is one of the better regarded regulators in the global market (although I disagree with you and your colleagues from time to time) but if you look elsewhere around the globe you see a very variable quality of regulation. To me if the better regulators were allowed to effectively take over the regulation (or the regulators) in other countries we would see notable improvements across the board. While the efforts of the FSI, for example, are laudable would it not be better if the strong, well perceived regulators were able to directly regulate more banks while the weaker regulators either improved or went out of “business”?
Apart from anything else, the scale benefits in the application of Basel II would be (IMHO) very large.
[Update] I should add that I do not mind delayed comments at all – This can be as leisurely a debate as you may want[/Update]
8 October, 2008 at 14:46
im really want to know all about bank regulation for my current assigment…
so i hope could get a book as a guideline to me….