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MGT411 - Money & Banking - Lecture Handout 29

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THE GOVERNMENT SAFETY NET

  • There are three reasons for the government to get involved in the financial system
  • To protect investors
  • To protect bank customers from monopolistic exploitation
  • To ensure the stability of the financial system
  • Investor Protection
  • Small investors are unable to judge the soundness of financial institutions
  • In practice only force of law ensure the bank’s integrity, thus investors rely on government to protect them from mismanagement and malfeasance
  • Protection from monopolistic exploitation
  • Monopolists exploit their customers by raising prices to earn unwarranted profits
  • Government intervenes to prevent firms in an industry from becoming too large. The same may apply to banks as well
  • Stability of financial system
  • Liquidity risk and information asymmetry indicate the instability of financial system
  • Financial institution can create and destroy the value of its assets in a very short period, and a single firm’s failure can bring down the whole system
  • Government officials employ a combination of strategies to protect investors and ensure the stability of the financial system
  • They provide the safety net to insure small depositors
  • They operate as the lender of last resort

The Unique Role of Depository Institutions

  • Depository institutions receive a disproportionate amount of attention from government regulators because
  • They play a central role in the economy
  • They face a unique set of problems
  • We all rely heavily on banks for access to the payments system
  • Banks are also prone to runs, as they hold illiquid assets to back their liquid liabilities, promising full and constant value to the depositors based on assets of uncertain value
  • They are linked to each other both on their balance sheets and in their customers’ minds;
  • This interconnectedness of banks is almost unique to the financial industry

The Government as Lender of Last Resort

  • The best way to stop a bank failure from turning into a panic is to make sure solvent institutions can meet their depositors’ withdrawal demands
  • The existence of a lender of last resort significantly reduces, but does not eliminate, contagion
  • For the system to work, central bank officials who approve the loan applications must be able to distinguish an illiquid from an insolvent institution
  • It is important for a lender of last resort to operate in a manner that minimizes the tendency for bankers to take too much risk in their operations

Problems Created by the Government Safety Net

  • Protected depositors have no incentive to monitor their banks’ behavior, and knowing this, banks take on more risk than they would normally
  • In protecting depositors the government creates moral hazard
  • Some banks are too big to fail, meaning that their failure would cause havoc in the financial system.
  • The managers of such institutions know that if they begin to founder the government will have to bail them out
  • The too-big-to-fail policy limits the extent of the market discipline that depositors can impose on banks and compounds the moral hazard problem

Regulation and Supervision of the Financial System

  • Government officials employ three strategies to ensure that the risks created by the safety net are contained:
  • Regulation establishes rules for bank managers to follow,
  • Supervision provides general oversight of financial institutions,
  • Examination provides detailed information on the firms’ operations
  • Regulatory requirements are designed to minimize the cost of failures to the tax-paying public
  • One example of regulation is the requirement that banks obtain a charter in order to operate;
  • This provides screening to make sure that the people who own and run banks will not be criminals.
  • Once a bank is operating other regulations control the assets, the amount of capital, and makes information about the bank’s balance sheet public
  • Government supervisors enforce the regulations;
  • They monitor, inspect, and examine banks to make sure that their business practices conform to regulatory requirements
  • State Bank of Pakistan (SBP) is supreme regulatory authority for banking sector in Pakistan
  • www.sbp.org.pk

Asset Holding Restrictions and Minimum Capital

  • Requirements
  • The simplest way to prevent bankers from exploiting their safety net is to restrict banks’ balance sheets;
  • This can be through restrictions on the kinds of assets banks can hold and requirements that they maintain minimum levels of capital
  • The size of the loans a bank can make to particular borrowers is also limited
  • Minimum capital requirements complement these limitations on bank assets
  • Capital serves as a cushion against declines in the value of the bank’s assets, lowering the likelihood of the bank’s failure, and is a way to reduce the problem of moral hazard
  • Capital requirements take two basic forms:
  • The first requires banks to keep their ratio of capital to assets above some minimum level regardless of the structure of their balance sheets;
  • The second requires banks to hold capital in proportion to the riskiness of their operations
  • Banks must provide information to the financial markets about their balance sheets;

Supervision and Examination

  • The government enforces banking rules and regulations through an elaborate oversight process called supervision, which relies on a combination of monitoring and inspection
  • Supervision is done remotely, through an examination of the detailed reports banks must submit, as well as through on-site examination
  • At the largest institutions, examiners are on site all the time; this is called continuous examination
  • The most important part of a bank examination is the evaluation of past-due loans, to see if they should be declared in default
  • Supervisors use the acronym CAMELS to describe the criteria used to evaluate the health of the bank:
  • Capital adequacy,
  • Asset quality,
  • Management,
  • Earnings,
  • Liquidity,
  • Sensitivity to risk
  • Current practice is for examiners to act as consultants to banks, advising them on how to get the highest return possible while keeping risk at an acceptable level that ensures the bank will stay in business

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