Lecture 10: Bank regulation
Introduction
Capital is the primary means of protection against insolvency
Major functions of capital
- Protect uninsured depositors, bondholders and creditors in case of insolvency and liquidation
- Protect FI insurance funds and the taxpayer(?)
- Protect FI owners against increases in insurance premium
- Absorb unanticipated losses => enable FI to continue as a going concern
- Partially fund the FI's real investment activities
explicit vs implicit insurance
higher capital
lower cost of funds
source of financing
regulation is costly => decreases economic efficiency
banking crises are systemic and contagious
Capital and insolvency risk
Net worth: Market value of assets - Market value of liabilities
Book value: asset and liability values based on historical cost
Economists prefer market value while regulators prefer book value
Market value of capital
losses in assets value are first borne by equity holders
if losses exceed the value of equity => liability holders will be affect
sufficient capital => protect liability holders from losses
capital acts as insurance fund
protect liability holders against insolvency risk (increases in net worth => insolvency protection increases)
useful ratio to assess insolvency: net worth to assets
Book (historical) value of capital
Components
- Retained earnings
- Loan loss reserve: special reserve set aside of retained earnings to meet expected and actual losses
- Surplus value of shares
- Par value of shares
Book value of equity: price paid on shares when originally offered
Mark to market => immediate revaluation of net worth
Managerial discretion: tendency to defer write- downs of bad loans => window dressing => misleading
losses in asset values do to adverse interest rate changes might not recognized in book value
Discrepancy of market to book value of equity
Measure of discrepancy: Market to Book ratio = MV/ BV
MV/ BV decreases => book value overstates the market net worth
Arguments
- Difficult to implement: large amount of assets are non- traded
- Introduces unnecessary variability into an FI's earnings: unrealized paper capital gains/ losses passed to income statement
- FIs are less willing to take longer term asset exposures: because it is more sensitive to change in interest rate