The Economics of Bank Regulation

By Bhattacharya, Sudipto; Boot, Arnoud W. A. et al. | Journal of Money, Credit & Banking, November 1998 | Go to article overview

The Economics of Bank Regulation

Bhattacharya, Sudipto, Boot, Arnoud W. A., Thakor, Anjan V., Journal of Money, Credit & Banking

We review the economics of bank regulation as developed in the contemporary literature. We begin with an examination of the central aspects of modern banking theories in explaining the asset transformation function of intermediaries, optimal bank liability contracts, coordination problems leading to bank failures and their empirical significance, and the regulatory interventions suggested by these considerations. In particular, we focus on regulations aimed primarily at ameliorating deposit-insurance-related moral hazards, such as cash-asset reserve requirements, risk-sensitive capital requirements and deposit insurance premia, and bank closure policy. Moreover, we examine the impact of the competitive environment (bank charter value) and industry structure (scope of banks) on these moral hazards. We also examine the implications of banking theory for alternatives to deposit insurance.

The principal objective of this paper is to survey the modern literature on bank regulation, with a focus on exploring the implications of banking theory for optimal regulation. The 1980s and the ongoing 1990s have been witness to exciting developments in banking. On the academic front, the contributions of Leland and Pyle (1977), Diamond (1984), and Ramakrishnan and Thakor (1984) on financial intermediary existence, and those of Bryant (1980) and Diamond and Dybvig (1983) on bank runs and deposit insurance, generated new interest in the microeconomics of financial intermediaries. The new economics of asymmetric information and contract design have helped generate insights about how banks function and are regulated. These insights have been augmented by those in the literatures on credit market functioning under asymmetric information (Bernanke and Gertler 1990; Greenwald and Stiglitz 1990; Stiglitz and Weiss 1981, for example), corporate financing and governance (Myers and Majluf 1984 and Stiglitz 1985), and incomplete contracting (Hart 1991).

During this time governmental regulation of banking has also evolved. In the United States, for example, major banking legislations enacted in the 1930s (for example, the Glass-Steagall Act and the Bank Holding Company Act) have seen important changes. The market-induced "disintermediation" of the 1970s caused regulators to be concerned about the erosion in the competitiveness of banks, and led to the easing of regulatory constraints on banks in the early 1980s. However, the experience with bank deregulation in the 1980s was not entirely pleasant. Many S&L's failed in the late 1980s and early 1990s with total losses exceeding $200 billion, over $2,000 per U.S. household. This has led to a rethinking of the framework of banking regulation, and contemporaneous new regulatory legislation such as the Federal Deposit Insurance Corporation Improvement Act (1991) and the 19818 BIS agreement on capital requirements. In addition, there has been rapid financial innovation, accompanied by an expanding role of financial markets, and this has led to fundamental reconfiguration of the financial services sector; see Berger, Kashyap and Scalise (1995).

Partly due to these developments, many issues in bank regulation remain unresolved, such as these:

   (a) Is deposit contracting (the right to demand withdrawal of contractual
   claims at any point in time from the issuer) important for investor welfare
   on the scale at which it is present in banking today?

   (b) Should deposit insurance continue to be provided for such claims? If
   so, how universal (across intermediaries) and up to what scale should the
   coverage be?

   (c) How should financial intermediaries with insured liabilities be
   regulated? What should be the role of bank capital controls and closure
   rules for troubled institutions?

   (d) What role should the government play in managing idiosyncratic and
   systematic liquidity shocks experienced by banks?

   (e) What should be regulatory policy toward banking scope and interbank
   competition in loan markets? … 

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