The case for more regulation of banks' liquidity

The case for more regulation of banks' liquidity

EVEN the fiercest free-market advocates would concede that governments can justly intervene to curtail businesses that become too powerful. Most would allow that dominant firms with the clout to gouge their customers should be broken up or subjected to strict price regulations. Similarly a judicious regulator should penalise polluters for imposing costs on othe 626t1920g rs by taxing their activities. When markets provide the wrong incentives, because there are too few competing firms (ie, a monopoly), or no market price (ie, pollution) or for some other reason, there is a case for the state to act.

Do you approve government intervention in a free - market economy? In what sector?

Provide examples of dominat firms, worldwide and in Romania, subjected to strict price regulation?

State whose the last to pay in a monopoly case. Explain the situation.

But not all regulated firms are monopolists or polluters. Commercial banks are an unusual mix of hazardous might and fragility. Long before he became the Federal Reserve's chairman, Ben Bernanke wrote an influential research paper showing how bank failures in America were largely responsible for the depth and longevity of the Great Depression. Today, even with larger capital markets, banks are still central to the economy's fortunes, as providers of credit and processors of payments.

What was the Great Depression? Where it was located? What were the main causes? Did it cover Europe also? Were the American banks responsible for prolonging the situation? If yes, in what way?

What was the situation back then in Romania? Can we say that in Romania commercial banks were responsible for fueling the recession? Were there commercial banks in Romania?

Generally speaking, how would the policy of commercial banks influence the economy of a country? In what way? Provide Romanian examples.

State how the commercial banks would influence/regulate the flow of capital traded on the capital markets.

Yet for all their might banks are fragile entities. What a bank owes in deposits can be quickly called in, but what it is owed in loans to businesses and households cannot easily be converted to cash. This mismatch between liquid debt and illiquid assets makes banks susceptible to sudden losses of funding.

Explain why the mismatch between liquid debt and illiquid assets makes banks susceptible to sudden losses of funding?

Do you know examples of Romanian banks when this mismatch created a disequilibrium on the entire market? What sectors were affected?

It is partly this vulnerability that makes them candidates for supervision. In a panic, individual depositors have an incentive to withdraw their cash, even if collectively they (and the bank) might be better off if they held fast. This weakness begs for a regulatory hand to co-ordinate actions in the common interest.

Would it be possible for depositors to withdraw all their money in the same time?

What should be the first reaction/measure of the National Bank to control the panic?

Banks hold liquid assets. In this situation, do they give up making profitable investments?

The two shortcomings-the co-ordination difficulties that cause bank runs and the problem of sporadic cash shortages-are market failures that have spawned familiar regulatory remedies: deposit insurance and liquidity support. Deposit insurance is a standard antidote to bank runs and is typically financed by a levy on deposit-takers. Coverage has to be large and repayment swift, to deter panic withdrawals. If depositors believe that it will be hard to get their cash tomorrow, they will queue at the counter today-as the throngs outside branches of Northern Rock, a British mortgage lender, recently demonstrated.

Is deposit insurance available in Romania?

What would a levy on deposit takers signify?

The deposit-insurance remedy begets problems of its own. Once depositors are sure of getting their money back, whatever the circumstances, they have little incentive to monitor a bank's business. This weakens the market discipline of caveat emptor. But a bank's prospects are so difficult to assess for small depositors that some form of supervision might be necessary anyway.

What do you understand by "the market discipline of caveat emptor"?

A more fundamental problem is how deposit insurance distorts banks' incentives. A secure deposit base encourages banks to take excessive lending risks, since the profits go to shareholders and the risks are borne by insurers. One way of mitigating this problem is to charge insurance premiums that vary according to the riskiness of each bank's lending.

1. Why would the profits go to shareholders and risks to the insurers?

Provide examples of risky loans.

Are there limits put on banks'assets? What is the purpose of such a measure?

The other main plank of state intervention is the liquidity backstop provided by central banks. The regular operations in money markets by the Federal Reserve and its brethren are designed to meet the vagaries of demand for ready cash.

Banks and government have a regulatory pact. In exchange for the stability provided by deposit insurance and the central bank, banks submit to regulatory oversight. The main thrust of regulation is to keep banks solvent by ensuring that their capital is sufficient to cover expected losses.

How is the amount of capital lent by commercial banks controlled by the Central bank?

Is any government implication, type of policy ruled, controlling the Central Bank's policy?

Solvency or liquidity?

This is fine, up to a point. But recent events suggest that it may not be enough to base a regime solely on capital adequacy. The private cost to banks of being light on liquid assets was clearly too low compared with the public cost that the liquidity squeeze produced in terms of instability and high interest rates.

Do commercial banks put aside enough liquid assets?

Whose to help commercial banks in case of liquidy problems and how? Refer yourself also to the Romanian situation?

For that reason, central banks had little choice but to intervene. Trying to discipline banks after the fact by withholding liquidity risked damaging the economy. But it is galling that the profitability of the banks was partly founded on an excessive reliance on central banks as liquidity providers.

Why and in what way does trying to discipline banks by withholding liquidity risk damaging the economy?

Why is the profitability of banks partly founded on an excessive reliance on central banks as liquidity providers? Expalin the situation.

What is particularly worrying is that huge convulsions in money markets were caused by potential losses in subprime lending that are small relative to banks' capital. Unless banks are forced to protect themselves, much bigger shocks in the future might require even larger interventions by central banks. Banking regulation may need to put as much emphasis on banks' liquidity as their solvency. The Basel 2 agreement fine-tunes the risk-capital framework but, as regulators freely admit, it has little to say about provisioning for funding shortages.

What does the Basel 2 agreement stipulate in this respect?

What would be the connection between convulsions in money market and subprime lending?

Raghuram Rajan, of the University of Chicago's business school (and a former chief economist of the IMF), believes that what is needed is consistent monitoring of banks' liquidity position over the economic cycle. One benefit of the recent crisis, he says, is that it will provide a benchmark for assessing whether banks have enough liquidity in the future. More scrutiny may be the only way to ensure less reliance on the state.