Money and Banking Chapter 11 Economics of Financial Regulation

Chapter 11 The Economics of Financial Regulation CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Explain why the government ca simply legislate bad things out of existence . Describe the public interest and private interest models of government and explain why they are important . Explain how asymmetric information interferes with regulatory efforts . Describe how government regulators exacerbated the Great Depression . Describe how government regulators made the Savings and Loan Crisis worse . Assess recent regulatory reforms in the United States and both accords . URL books 242

Public Interest versus Private Interest LEARNING OBJECTIVE . Why ca the government legislate bad things out of existence and which model of government , public interest or private interest , is the most accurate depiction of reality ?

Whenever anything seemingly bad happens in the world , many people today immediately clamor for the government to do something about it . That is sometimes an appropriate response , but many times it is not . For starters , government can the world by decree . Simply making an activity illegal does not mean that it will stop . Because the government faces a budget constraint and opportunity costs , it can afford to monitor everyone all the time . What bad for some is often good for others , so many people willingly supply illegal goods or activities . As a result , many illegal activities are commonplace in no particular order , sodomy , drug use , reckless use of automobiles , and music piracy come to mind . The second problem with relying on government bad things is that government are not the angels many people assume they are . It not your fault . Especially if you went through the public school system , you likely learned an interpretation of government called the public interest model . As its name suggests , the public interest model posits that government work in the interests of the public , of the people , if you will . It the sort of thing Abraham Lincoln had in mind in his famous Gettysburg Address when he said that government of the people , by the people , for the people , shall not perish from the That outstanding political rhetoric , better than anything current spin artists concoct , but is it a fair representation of reality ?

Many economists think not . They believe that private interest prevails , even in the government . According to their model , called the public choice or , less , the private interest model , politicians and bureaucrats often behave in their own interests rather than those of the public . Of course , they don go around saying that we need law or regulation to help me to get rich via bribes , to bailout my , or to ensure that I soon receive a cushy job in the private sector . Rather , they say that we need law or regulation to protect widows and orphans , to stymie the efforts of bad guys , or to make the rich pay for their success . URL books 243

In many countries , the ones we will call predatory in the context ofthe Growth Diamond model discussed in Chapter 23 Aggregate Supply and Demand , the Growth Diamond , and Financial Shocks , the private interest model clearly holds sway . In rich countries , the public interest model becomes more plausible . Nevertheless , many economic regulations , though clothed in public interest rhetoric , appear on close inspection to conform to the private interest model . As University of Chicago economist and Nobel Laureate George pointed out decades ago , regulators are often captured by the industry they regulate . In other words , the industry establishes regulations for itself by the decisions of regulators . Financial regulators , as well see , are no exception . Regardless of regulators and politicians motivations , another very sticky question arises could regulators stop bad activities , events , even ifthey wanted to ?

The answer in many appears to be an unequivocal No ! The reason is our old nemesis , asymmetric information . That horrible hellhound , readers should recall , in nature and pervades all . It governments as much as markets and intermediaries . The implications of this insight are devastating for the effectiveness of regulators and their regulations , as Figure Asymmetric information and regulation makes clear . Figure ( URL books 244

. Adverse selection , moral hazard , and the problem rear their beastly heads here too . Although voters ultimately select who gains elected . political parties select which candidates voters can choose from . Parties select candidates on the basis of their , not their ability to run large complex organizations ( adverse selection ) Once in office . politicians do not have to their campaign promises . only appear to try to ( moral hazard ) Finally . politicians ( agents ) often behave in ways detrimental to some or all oi the public ( the , at least in political theory ) 83 Politicians Public are the problems of asymmetric information we discussed in Chapter . Banks ( and other ) know more about their business and condition than regulators do so they can manipulate them into creating and enforcing regulations that aid the system rather than its customers or the general public . This is called regulatory capture . Regulators ( the agents ) know more about banks ( and other firms ) than politicians ( in this case the principals do . So they can manipulate politicians into enacting laws that aid themselves by giving them more authority , more opportunity for winning bribes , more employees . bigger budgets , and so . Source Adapted from James Barth . Gerard . and Ross Levine , Rethinking Bank Regulation Govern ( New York Cambridge University Press . 2006 ) Regulators Although Figure Asymmetric information and regulation is pleasing ( great job , guys ! it does not paint a pretty picture . Due to multiple levels of nearly intractable problems of asymmetric information , no guarantee that government will serve the public interest . Matters are even worse in societies still plagued by predatory government , where corruption further fouls up the works by giving politicians , regulators , and bankers ( and other financiers ) incentives to perpetuate the current system , no matter how suboptimal it may be from the public point of view . And if you really want to get your head spinning , consider this agency problems within the government , within regulatory bureaucracies , and within banks abound . Within banks , traders and loan want to keep their jobs , earn promotions , and bring home large bonuses . They can do the latter two by taking large risks , and sometimes they choose to do so . Sometimes shareholders want to take on much larger risks than managers or depositors or other debt holders do . Sometimes it the managers who have incentives to place big bets , to get their stock options in the Within bureaucracies , regulators have incentives to hide their mistakes and to take credit for good outcomes , even if they had little or nothing to do with them . The same is true for the URL books ( i 245

government , where the legislature may try to discredit the executive policies , or vice versa , and withhold information or even spread disinformation to prove its case . Stop and Think Box In the and early , a majority of states passed securities regulations called Blue Sky Laws that ostensibly sought to prevent slimy securities dealers from selling nothing but the blue sky to poor , defenseless widows and orphans . Can you out what was really going on ?

Hint Recall that this was a period of traditional banking , unit banks , the rule , and all that . Recall , too , that securities markets are an alternative method of linking investors to borrowers . We probably gave it away with that last hint . Blue Sky Laws , scholars now realize , were veiled attempts to protect the monopolies of unit bankers upset about losing business to the securities markets . Unable to garner public sympathy for their plight , the bankers instead spoke in terms of public interest , of defrauded widows and orphans . There were certainly some scams about , but not enough to warrant the more virulent Blue Sky Laws , which actually gave state officials the power to forbid issuance of securities they didn like , and in some states , that was most of them ! It okay if you feel a bit uneasy with these new ideas . We think that as adults you can handle straight talk . It be better for , me , our children and you learn to look at the government actions with a jaundiced eye . Regulators have failed in the past and will do so again unless we align the interests of all the major parties depicted in Figure Asymmetric information and regulation more closely , empowering to do most ofthe heavy lifting . KEY TAKEAWAYS The government ca legislate bad things away because it ca be every place at once . Like the rest of us , government faces budget constraints and opportunity costs . Therefore , it can not stop activities that some people enjoy or find profitable . According to the public interest model , government tries to enact laws , regulations , and policies that benefit the public . The private interest ( or public choice ) model , by contrast , suggests that government officials enact laws that are in their own private interest . URL books 246

It is important to know which model is a more accurate description of reality because the models have very different implications for our attitudes toward regulation . If one believes the public interest model is usually correct , then one will be more likely to call for government regulation , even if one admits that regulatory goals may in fact be difficult to achieve regardless of the intentions of politicians and bureaucrats . If one believes the private interest model is a more accurate depiction of the real world , one will be more skeptical of government regulation . Asymmetric information creates a problem between the public and elected officials , another problem between those officials and regulators , and yet another problem between regulators and banks ( and other financial firms ) because in each case , one party ( politicians , regulators , banks ) knows more than the other ( public , politicians , regulators ) So there are at least three places where the public interest can be stymied in political elections , in the interaction between Congress and the president and regulatory agencies , and in the interaction between regulators and the regulated . And that ignoring the often extensive agency problems governments , regulatory agencies , and financial institutions ! capture the URL books 247

The Great Depression as Regulatory Failure LEARNING OBJECTIVE . How did the government exacerbate the Great Depression ?

Time again , government regulators have either failed to stop crises or have exacerbated them . Examples are too numerous to discuss in detail here , so we will address only two of the more egregious cases , the Great Depression of the and the Savings and Loan ( Crisis of the . Generally when economic matters go ( Fouled Up Beyond All Recognition in polite circles ) observers blame either market failures like asymmetric information and , or they blame the government . Reality is rarely that simple . Most major economic stem from a combination and , what we like to call . So while it would be an exaggeration to claim that government policies were the only causes of the Great Depression or the Savings and Loan Crisis , it is fair to say that they made matters worse , much worse . Everyone knows that the stock market crash of 1929 started the Great Depression . As we will learn in Chapter 23 Aggregate Supply and Demand , the Growth Diamond , and Financial Shocks , a precipitous decline in stock prices can cause uncertainty to increase and balance sheets to deteriorate , worsening asymmetric information problems and leading to a decline in economic activity That , in turn , can cause bank panics , further increases in asymmetric information , and yet further declines in economic activity followed by an unanticipated decline in the price Figure Major macro variables during the Great Depression shows , that is precisely what happened during the Great per capita gross domestic product ( shrank , the number soared , and ( measures ofthe money supply ) declined , and so did the price level . Figure ( luring ( Iron ! URL books ' 248

Weren evil completely responsible for this mess , as nine out of ten people thought at the time ?

Absolutely not . For starters , very few from the depression and they certainly did not have the ability to cause such a mess . Most would have stopped the downward spiral if it was in their power to do so , as Morgan did when panic seized the system in 1907 . In fact , only the government had the resources and institutions to stop the Great Depression and it failed to do so . Mistake number one occurred during the 19205 , when the government allowed stock prices to rise to dizzying heights . The Dow Jones Industrial Average started the decade at , dropped to the around 60 , then began a slow climb to 200 by the end of 1927 . It hit 300 by the end of 1928 and 350 by August 1929 . By slowly raising interest rates beginning in , say , URL books 249

1928 , the Federal Reserve could have the asset bubble before it grew to enormous proportions and burst in 1929 . Mistake number two occurred after the crash , in late 1929 and 1930 , when the Federal Reserve raised interest rates . As we see in Chapter 17 Monetary Policy Targets and Goals , the correct policy response at that point was to lower interest rates . The government third mistake was its banking policy . As described in Chapter 10 Innovation and Structure in Banking and Finance , the United States was home to tens unit banks that simply were not large or enough to ride out the depression . If a factory or other major employer succumbed , the local bank too was doomed . Depositors understood this , so at the first sign of trouble they ran on their banks , pulling out their deposits before they went under . Their actions guaranteed that their banks would indeed fail . Meanwhile , across the border in Canada , which was home to a few large and highly banks , few bank disturbances took place . California also weathered the Great Depression relatively well , in part because its banks , which freely branched throughout the large state , enjoyed relatively assets and hence avoided the worst of the bank crises . The government fourth failure was to raise in a misguided attempt to beggar thy Detailed analysis of this failure , which falls outside the bailiwick of , we leave to your international economics textbook and a case in Chapter 21 . Here , we just paraphrase Mackey from South Park Tariffs are bad , But what about Franklin Delano Roosevelt ( and his New Deal ?

the new administration stop the Great Depression , particularly via deposit insurance , securities market reforms , and reassuring speeches about having nothing to fear but fear itself ?

The United States did suffer its most acute banking crisis in March 1933 , just as took on March . The Twentieth Amendment , ratified in 1938 , changed the presidential inauguration date to January 20 , which it is to this day . But many suspect that himself brought the crisis on by increasing uncertainty about the new administration policy path . Whatever the cause ofthe crisis , it shattered in the banking system . creation ofa deposit insurance scheme under the aegis ofa agency , the Federal Deposit Insurance Corporation ( did restore , inducing people to stop running on the banks and thereby stopping the economy URL books ' 250

death spiral . Since then , bank runs have been rare occurrences directed at specific shaky banks and not disturbances as during the Great Depression and earlier banking crises . But as with everything in life , deposit insurance . Infact , the latest research suggests it is a Deposit insurance does prevent bank runs because depositors know the insurance fund will repay them if their bank goes belly up . Today , it insures per depositor per insured bank . For details , browse deposit deposits insured . However , insurance also reduces depositor monitoring , which allows bankers to take on added risk . In the nineteenth century , depositors disciplined banks that took on too much risk by withdrawing their deposits . As we ve seen , that decreases the size of the bank and reduces reserves , forcing bankers to decrease their risk . With deposit insurance , depositors ( quite rationally ) blithely ignore the adverse selection problem and shift their funds to wherever they will fetch the most interest . They don ask how Shaky Bank is able to pay 15 percent for of deposit ( when other banks pay only percent . Who cares , they reason , my deposits are insured ! Indeed , but as we learn below , taxpayers insure the insurer . Another New reform , in no way helped the economy system and may have hurt both . As we learned in Chapter 10 Innovation and Structure in Banking and Finance , for over half a century , prevented banks from simultaneously engaging in commercial and investment banking activities . Only two groups clearly gained from the legislation , politicians who could thump their chests on the campaign stump and claim to have saved the country from greedy financiers and , ironically enough , big investment banks . The latter , it turns out , wrote the act and did so in such a way that it protected their oligopoly from the competition of commercial banks and smaller , more investment banks . The act was clearly unnecessary from an economic standpoint because most countries had no such legislation and suffered no ill effects because of its absence . The Security and Exchange Commission ( SEC ) genesis is almost as tawdry and its record almost as bad . The SEC stated goal , to increase the transparency of Americas markets , was a laudable one . Unfortunately , the SEC simply does not do its job very well . As the late , great , market proponent Milton put it URL books ' 251

You are not free to raise funds on the capital markets unless you out the numerous pages of forms the SEC requires and unless you satisfy the SEC that the prospectus you propose to issue presents such a bleak picture of your prospects that no investor in his right mind would invest in your project if he took the prospectus literally . 10 And getting SEC approval may cost upwards of certainly discourages the small our government professes to Stop and Think Box As noted above , the insures bank deposits up to per depositor per insured bank . What if an investor wants to deposit million or billion ?

Must the investor put most of her money at risk ?

Depositors can loophole mine as well as anyone . And they did , or , to be more precise , intermediaries known as deposit brokers did . Deposit brokers chopped up big deposits into chunks , then spread them all over creation . The telecommunications revolution made this relatively easy and cheap to do , and the crisis created many a zombie bank willing to pay high interest for deposits . KEY TAKEAWAYS In addition to imposing high tariffs , the government exacerbated the Great Depression by ( allowing the asset bubble of the late to continue ( responding to the crash inappropriately by raising the interest rate and restricting and and ( passing reforms of dubious efficacy , including deposit insurance , and the SEC . of staff at South Park . 5057 124 URL books 252

This part is inaccurate . Just as we would expect from the discussion in Chapter 10 Innovation and Structure in Banking and Finance , financiers went loophole mining and found a real doozy called a private placement . As opposed to a public offering , in a private placement , securities can avoid SEC disclosure requirements by selling directly to institutional investors like life insurance companies and other accredited investors ( legalese for rich people ) 10 This part is all too true . Check out the prospectus of Internet giant Google . If you do dig Google , check out any company you like via Edgar , the SEC filing database , at . URL books 253

The Savings and Loan Regulatory Debacle LEARNING OBJECTIVE . How did regulators exacerbate the Savings and Loan Crisis of the 19805 ?

Although the economy improved after 1933 , regulatory regimes did not . Ever fearful of a repeat of the Great Depression , regulators sought to make banks highly safe and highly so none would ever dare to fail . We can move quickly here because most of this you read about in Chapter 10 Innovation and Structure in Banking and Finance . Basically , the government regulated the interest rate , assuring banks a nice what the rule was all about . Regulators also made it to start a new bank to keep competition levels down , all in the name of stability . The game worked well until the late , then went to hell in a as technological breakthroughs and the Great conspired to destroy traditional banking . Here where things get interesting . Savings and loan associations were particularly hard hit by the changed environment because their gaps were huge . The sources of their funds were savings accounts and their uses were mortgages , most of them for thirty years at rates . Like this ' and Loan Bank ( Assets Liabilities Reserves 10 Deposits 130 Securities 10 15 Mortgages 130 Capital 15 Other assets 10 Totals 160 160 Along comes the Great and there go the deposits . We know Bank Management what happened next ' and Loan Bank ( Assets Liabilities Reserves Deposits 100 Securities 30 URL books 254

' Batik ( Millions ) Mortgages 130 Capital 10 Other assets Totals 140 140 This bank is clearly in deep . Were it alone , it would have failed . But there were some 750 of them in like situation . So they went to the regulators and asked for help . The regulators were happy to oblige . They did not want to have a bunch of failed banks on their hands after all , especially given that the deposits of those banks were insured . So they eliminated the interest rate caps and allowed to engage in a variety ofnew activities , like making commercial real estate loans , hitherto forbidden . Given the demise banking , that was a reasonable response . The problem was that most bankers didn have a clue about how to do anything other than traditional banking . Most of them got chewed . Their balance sheets then began to resemble a train wreck ' Batik ( Millions ) Assets Liabilities Reserves Deposits 120 Securities 22 Mortgages 130 Capital Other assets 10 Totals 142 142 Now comes the most egregious part . Fearful of losing their jobs , regulators kept these economically dead ( capital ) banks alive . Instead them down , they engaged in what is called regulatory forbearance . they allowed to add goodwill to the asset side of their balance sheets , restoring them to paper . Technically , they allowed the banks to switch from generally accepted accounting principles to regulatory accounting principles RAP . Seems like a cool thing for the regulators to do , right ?

Wrong ! A teacher can pass a kid who can read , but the kid still can read . Similarly , a regulator can pass a bank with no capital , but still can make the bank viable . In fact , the bank situation is worse because the kid has other chances to learn to read . By contrast zombie banks , as these were called , have little hope of recovery . Regulators URL books 255

should have shot them in the head instead , which as any fan knows is the only way to stop the undead dead in their tracks . Recall that if somebody has no capital , no skin in the game , to borrow Warren phrase again , moral hazard will be extremely high because the person is playing with other peoples money . In this case , the money wasn even that of depositors but rather of the deposit insurer , a government agency . The managers ofthe did what anyone in the same situation would do they rolled the dice , engaging in highly risky with deposits and which they paid a hefty premium . In other words , they borrowed from depositors and other lenders at high rates and invested in highly risky loans . A few got lucky and pulled their banks out of the red . Most of the risky loans , however , quickly turned sour . When the whole thing was over , their balance sheets looked like this ' Assets Liabilities Reserves 10 Deposits 200 Securities 10 100 Mortgages 100 Capital 60 Goodwill 30 Crazy , risky loans 70 Other assets 20 Totals 240 240 The regulators could no longer forbear . The insurance could not meet the deposit liabilities of the thousands , so the bill ended up in the lap of taxpayers . Stop and Think Box In the 19805 , in response to the Great and the technological revolution , regulators in ( Sweden , Norway , and Finland ) deregulated their heavily regulated banking systems . Bankers who usually lent only to the best borrowers at government mandated rates suddenly found themselves competing for both depositors and borrowers . What happened ?

URL books 256 suffered from worse banking crises than the United States . In particular , Scandinavian bankers were not very good at screening good from bad borrowers because they had long been accustomed to lending to just the best . They inevitably made many mistakes , which led to defaults and ultimately asset and capital . The most depressing aspect of this story is that the United States has unusually good regulators . As Figure Banking crises around the globe through 2002 shows , other countries have suffered through far worse banking crises and losses . Note that at percent of , the crisis was no picnic , but it pales in comparison to the losses in Argentina , Indonesia , China , Jamaica and elsewhere . Figure ( I ( around the globe ( URL books 257

sun I lit ! I ! in new ow ! 11 Nu . no . oi . gummy . hair I mi mama spawn In mam ! my man my . In mum um . un ! I nu Ann I 91 . roan mu . ma tun ta ! emu ) am ( mum ol aw Ia My Nu , a . I ( mun . new ma ( I ( at ' I ( no ) lo nun ( mug mu WI ( new pa am In man so nun summon ( nu Episodes af Systematic and Borderline Financial Crises , Gerald and Daniela . KEY TAKEAWAYS First , regulators were too slow to realize that traditional rule and easy profitable dying due to the Great Inflation and technological improvements . URL books Tel ) 258

Second , they allowed the institutions most vulnerable to the rapidly changing financial environment , savings and loan associations , too much latitude to engage in new , more sophisticated banking techniques , like liability management , without sufficient experience or training . Third , regulators engaged in forbearance , allowing essentially bankrupt companies to continue operations without realizing that the end result , due to very high levels of moral hazard , would be further losses . URL books 259

Better but Still Not Good Regulatory Reforms LEARNING OBJECTIVE . Have regulatory reforms and changes in market structure made the banking industry safer ?

The crisis and the failure of a few big commercial banks induced a series of regulatory reforms in the United States . The first such act , the Financial Institutions Reform , Recovery , and Enforcement Act ( became law in August 1989 . That act canned the old regulators , created new regulatory agencies , and bailed out the bankrupt insurance fund . In the end , taxpayers reimbursed depositors at the failed . also , increasing their capital requirements and imposing the same capital standards that commercial banks are subject to . Since passage of the act , many have converted to commercial banks and few new have been formed . In 1991 , the government enacted further reforms in the Federal Deposit Insurance Corporation ( which continued the bailout of the and the deposit insurance fund , raised deposit insurance premiums , and forced the to close failed banks using the least costly method . Failed banks can be dismembered and their pieces sold off one by one . That often entails selling assets at a discount . Or an entire bank can be sold to a healthy bank , which , of course , wants a little sugar read , cash to induce it to embrace a zombie ! The act also forced the to charge insurance premiums instead of a fee . The system it developed , however , resulted in 90 percent of banks , accounting for 95 percent of all deposits , paying the same premium . The original idea of taxing risky banks and rewarding safe ones was therefore subverted . crowning glory is that it requires regulators to intervene earlier and more stridently when banks first get into trouble , well before losses eat away their capital . The idea is to close banks before they go broke , and certainly before they arise from the dead . See Figure Regulation of bank capitalization for details . Of course , banks can go under , have gone under , in a matter of hours , well before regulators can act or even know what is happening . Regulators do not and , of course , can not monitor banks . And despite the law , regulators might still forbear , just like your neighbor might still smoke pot , even though it illegal . URL books

Figure Regulation capitalization The other problem with is that it weakened but ultimately maintained the fail ( policy . Regulators cooked up during the to justify bailing out a big shaky bank called Continental Illinois . Like deposit insurance , was ostensibly a noble notion . If a really big bank failed and owed large sums to lots of other banks and institutions , it could cause a domino effect that could topple numerous companies very quickly . That , in turn , would cause uncertainty to rise , stock prices to fall . you get the picture . The problem is that if a bank thinks it is too big to fail , it has an incentive to take on a lot of risk , that the government will have its back URL books ?

261 if it gets into trouble . Banks in this respect are little different from drunken frat boys , or so I ve heard . Financier Henry has termed this problem the Bigness Dilemma and long feared that it could lead to a catastrophic economic meltdown , a political crisis , or a major economic slump . His fears came to fruition during the financial crisis of , of which we will learn more in Chapter 12 The Financial Crisis of . Similarly some analysts believe that policy was a leading cause of its recent economic funk . In 1994 , the Interstate Banking and Branching Act overturned most prohibitions on interstate banking . As discussed in Chapter 10 Innovation and Structure in Banking and Finance , that law led to considerable consolidation , the effects of which are still unclear . Nevertheless , the act was long overdue , as was the Financial Services Modernization Act of 1999 , which repealed , allowing the same institutions to engage in both commercial and investment banking activities . The act has led to some conglomeration , but not as much as many observers expected . Again , it may be some time before the overall effects of the reform become clear . So far , both acts appear to have strengthened the system by making banks more and diversified . So far , some large complex banking organizations and large complex financial institutions ( and Is , respectively ) have held up well in the face of the subprime mortgage crisis , but others have failed . The crisis appears rooted in more fundamental issues , like and a dearth of internal incentive alignment within institutions , big and small . KEY TAKEAWAYS To some extent , it is too early to tell what the effects of financial consolidation , concentration , and conglomeration will be . Overall , it appears that recent financial reforms range from salutary ( repeal of branching restrictions and ) to destabilizing ( retention of the policy ) The dilemma is that big banks in other regards are stabilizing rather than destabilizing because they have clearly achieved efficient scale and maintain a diversified portfolio of assets . URL books 262

Third Pillar LEARNING OBJECTIVE . Will II render the banking industry safe ?

If not , what might ?

Due to the prevalence of banking crises worldwide and the system increasingly global and integrated nature , international regulators , especially the Bank for International Settlements in , Switzerland , have also been busy . Their recommendations are not binding on sovereign nations , but to date they have obtained significant worldwide . Americas financial reforms in the , for example , were by the I recommendations of 1988 . Almost all countries have complied , on paper anyway , with I rules on minimum and capitalization . weighting was indeed an improvement over the older capitalization requirements , which were simply a minimum leverage ratio So the leverage ratio of the following bank would be percent ( 100 , or ) which in the past was generally considered adequate . Sonic Shoot ( Assets Liabilities Reserves 10 Deposits 80 Securities 10 14 Loans 70 Capital Other assets 10 Totals 100 100 Of course , leverage ratios are much too simplistic because a bank with capital of only percent but with a diversified portfolio of very safe loans would be much safer than one with capital of 10 percent but whose assets were invested entirely in lottery tickets ! The concept of weighting risks is therefore a solid one . A bank holding nothing but reserves would need very little capital compared to one holding mostly loans to biotech and nanotech startups . Bankers , however , consider the I weights too arbitrary and too broad . For example , URL books ' 253

I suggested weighting sovereign bonds at zero . Thats great for developed countries , but plenty of poorer nations regularly default on their bonds . Some types of assets received a weighting of , others , others , and so , as the asset grew riskier . So , for example , the following assets would be weighted according to their risk before being put into a leverage ratio Reserves Governments Commercial loans Mortgages And . But the weights were arbitrary . Are mortgages exactly as risky as commercial loans ?

I basically encouraged banks to decrease their holdings that the regulations and to stock up on assets that it underweighted . Not a pretty sight . In response to such criticism , the Committee on Banking Supervision announced in June a new set , called II , for implementation in 2008 and in the countries . 11 contains three pillars capital , supervisory review process , and market discipline . According to the latest and greatest research , Rethinking Bank Regulation by James Barth , Gerard , and Ross Levine , the two pillars are not very useful ways of regulating banks . The new risk weighting is an improvement , but it still grossly risk management and is not holistic enough . Moreover , supervisors can not monitor every aspect of every bank all the time . Banks have to make periodic call reports on their balance sheets , income , and dividends but , like homeowners selling their homes , they pretty up the place before the prospective buyers arrive . In more developed countries , regulators also conduct surprise site examinations during which the examiners rate banks according to the CAMELS formulation capital adequacy A asset quality management earnings URL books 0792 . 254

liquidity ( reserves ) sensitivity to market risk . A , and are even more to ascertain than , and and , as noted above , any or all of the variables can change very rapidly . Moreover , as discussed in Chapter 10 Innovation and Structure in Banking and Finance , much banking activity these days takes place the balance sheet , where it is even more for regulators to and accurately assess . Finally , in many jurisdictions , examiners are not paid well and hence do not do a very thorough job . Barth , and Levine argue that the third pillar of II , financial market monitoring , is different . In aggregate , market participants can and in fact do monitor banks and bankers much more often and much more astutely than regulators can because they have much more at stake than a relatively paying job . Barth , and Levine argue persuasively that instead of conceiving of themselves as police , judges , bank regulators should see themselves as aides , as helping bank depositors ( and other creditors ofthe bank ) and stockholders to keep the bankers in line . After all , nobody gains from a bank failure . The key , they believe , is to ensure that debt and equity holders have incentives and opportunities to monitor bank management to ensure that they are not taking on too much risk . That means reducing asymmetric information by ensuring reliable information disclosure and urging that corporate governance best practices be followed . Regulators can also provide banks with incentives to keep their asset bases and to prevent engaging in inappropriate activities , like building rocket ships or running water treatment plants . Screening new banks and bankers , if regulators do it to reduce adverse selection ( omit shysters or inexperienced people ) rather than to aid existing banks ( by blocking all or most new entrants and hence limiting competition ) or to line their own pockets ( via bribes ) is another area where regulators can be effective . By focusing on a few key reachable goals , regulators can concentrate their limited resources and get the job done , the job of letting people look after their own property themselves . The approach , scholars note , is most important in countries where regulators are more likely to be on the take ( to enact and enforce regulations simply to augment their incomes via bribes ) URL books 255

KEY TAKEAWAYS I and II have provided regulators with more sophisticated ways of analyzing the adequacy of bank capital . Nevertheless , it appears that regulators lag behind banks and their bankers , in part because of agency problems within regulatory bureaucracies and in part because of the gulf of asymmetric information separating banks and regulators , particularly when it comes to the quality of assets and the extent and risk of activities . If scholars like Barth , and Levine are correct , regulators ought to think of ways of helping financial markets , particularly bank debt and equity holders , to monitor banks . They should also improve their screening of new bank applicants without unduly restricting entry , and set and enforce broad guidelines for portfolio diversification and admissible activities . Frederick , Corporate Governance Best Practices Strategies for Public , Private , and Organizations ( Wiley , 2006 ) URL books 266

Suggested Reading , Douglas . Financial Stability , Economic Growth , and the Role of Law . New York Cambridge University Press , 2007 . Barth , James , Gerard , and Ross Levine . Rethinking Bank Regulation . New York Cambridge University Press , 2006 . Barth , James , and Glenn Yago . The Savings and Loan Crisis Lessons from a Regulatory Failure . New York Springer , 2004 . George . Regulating Financial Markets A Critique and Some Proposals . Washington , Press , 1999 . Ben Essays on the . Princeton , Princeton University Press , 2000 . Gup , Benton . Too Big to Fail Policies and Practices in Government Bailouts . 2004 . Stern , Gary , and Ron . Too Big to Fail The Hazards of Bank Bailouts . Washington , Institution Press , 2004 . Gordon , Arthur , and Gordon Brady . Government Failure A Primer in Public Choice . Washington , Institute , 2002 . Winston , Clifford . Government Failure Versus Market Failure Policy Research and Government Performance . Washington , Joint Center for Regulatory Studies , 2006 . URL books 257