Lecture 10: Bank regulation

Introduction

Capital is the primary means of protection against insolvency

Major functions of capital

  1. Protect uninsured depositors, bondholders and creditors in case of insolvency and liquidation
  1. Protect FI insurance funds and the taxpayer(?)
  1. Protect FI owners against increases in insurance premium
  1. Absorb unanticipated losses => enable FI to continue as a going concern
  1. 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

  1. Retained earnings
  1. Loan loss reserve: special reserve set aside of retained earnings to meet expected and actual losses
  1. Surplus value of shares
  1. 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

  1. Difficult to implement: large amount of assets are non- traded
  1. Introduces unnecessary variability into an FI's earnings: unrealized paper capital gains/ losses passed to income statement
  1. FIs are less willing to take longer term asset exposures: because it is more sensitive to change in interest rate