Government regulation of banks is pervasive, and its rationale stems from two factors: the inherent fragility of banks; and the negative externalities from bank failures. Banks provide liquidity by issuing demand deposits and also act as delegated monitors by making loans to opaque borrowers. This combination of loan-making and deposit-taking makes banks vulnerable to runs, as they finance relatively illiquid loans with liquid demand deposits. Individual bank fragility can, in turn, trigger contagious runs, even on healthy banks, culminating in system-wide failures with a consequent disruption of credit flows to the rest of the economy.
Government insurance of deposits can be effective in preventing bank runs, thereby avoiding systemic bank failures and their negative spillovers to the rest of the economy. However, deposit insurance and other government assistance, such as central bank lending facilities, can create incentives for banks to take excessive risks. If unchecked, this moral hazard may lead to large losses by governments when bailing out insolvent banks. Bank regulation aims to mitigate moral hazard through the setting of capital standards and, in some cases, deposit insurance premia. However, for regulation to be effective, it must be risk-based in a manner that neutralizes moral hazard incentives.
The current regulatory framework of risk-based capital and deposit insurance might actually create a particular form of moral hazard. Specifically, regulation that sets capital and/or insurance premia to cover expected default losses may encourage banks to take excessive systematic risk; that is, to make loans and invest in bonds that are highly likely to suffer losses simultaneously during an economic downturn. As shown by Kupiec (2004) and Pennacchi (2006), such moral hazard occurs if regulators measure the risk of a bank’s assets based on their physical (actual) expected default losses, rather than their risk-neutral expected default losses which reflect the assets’ systematic risks.
For example, under Basel II capital regulations, as well as in the new Basel III framework, a bank’s required capital is set according to either external or internal credit ratings. If credit ratings are based on physical - rather than risk-neutral expected default losses, credit rating based regulation effectively will undercharge banks for their cost of funding systematically risky investments. As a result, banks will have an incentive to make loans and invest in bonds that have the highest systematic risk within each rating class. This occurs because theory predicts that such systematically risky loans and bonds have the highest yields (credit spreads) within each rating class.
Download
Bank Regulation, Credit Ratings, and Systematic Risk
