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2 Why Do We Need Banking Regulation?

2 Why Do We Need Banking Regulation?

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Post-Crisis Banking Regulation in the European Union

relies on receiving compensation for accepting a maturity mismatch,

which is an additional source of fragility. The compensation stems from

the difference between the charges extracted from debtors and the premium paid to creditors. This gives banks incentives to increase lending

and to attract deposits in order to boost their profits. As a consequence of

creditor funding, banks are usually highly leveraged institutions, which

gives rise to their additional fragility (Mülbert, 2010). Additionally,

banks have notoriously opaque balance sheets compared to other companies. This opacity is due to the fact that the quality of bank loans and

various structured and securitised assets they hold in their portfolios, is

not readily observable. Banks are also confronted with high information

cost in their lending activity and the problem of adverse selection at borrower screening.

On the other hand, banks are viewed as special due their pronounced

risk taking incentives resulting from their protection by deposit insurance,

the subsequent moral hazard and debt pricing distortions, as well as their

involvement in risky non-banking activities. In the presence of deposit

insurance, banks face moral hazard and may take distorted decisions

regarding lending, funding or investment (Rosenbluth & Schaap, 2003).

Knowing that potential losses will be covered by the insurance fund, they

may have incentives to take on excessive risk to make extra profits and

maximise shareholder value. Deposit insurance also distorts debt pricing,

since it protects banks from market risk (Freixas, 2010). Deposit rates are

hence risk independent. Another factor strengthening this independence

is the fact that depositors do not only place their money in banks to strive

for returns, but also to obtain access to the payment system. Banks may

have incentives to hold too much debt due to underpricing. Hence, in

the presence of deposit insurance proper regulation of the banks’ funding

structure is necessary. Also, given the large share of non-interest income

in proportion to their revenues, banks’ profits and risk profiles are quite

volatile. This is due to sharp changes of the risk profiles of the complex

instruments in their portfolios, which are very sensitive to market conditions (Mülbert, 2010).

The special status of banks is also related to the inherent systemic risk

resulting from bank interconnectedness. Banks are interconnected due

to their common activity on the interbank market as well as on the over


Theoretical Aspects of Banking Regulation


the counter (OTC) derivatives and foreign exchange markets. Their common activity on these market segments creates an extraordinary situation

where the transaction parties are at the same time competitors, which

gives rise to pronounced counterparty risk (Mülbert, 2010). The interconnectedness of banks also renders them similarly exposed to market

conditions, which is conducive to the emergence of systemic risk. Even

if banks function well as individual entities, they may fail as a system if

they are all exposed to the same group of risky assets. Banks are also prone

to contagion; the deterioration of one bank’s financial condition spreads

very quickly to the rest of the sector.

Finally, banks are viewed as special due their systemic importance,

which stems from their role in maintaining economic activity and the

use of their securities in the payment system.

1.2.2 Market Failure Corrections

Further arguments for regulating banks are the need to correct market

failures and to mitigate the externalities of potential banks’ bankruptcy.

Market failure stems from the asymmetry of information and the fragility

of trust between transaction participants (Rosenbluth & Schaap, 2003).

From a theoretical point of view banks respond to correct such market

failures. Nevertheless, their response also creates new market imperfections, since banks exploit the information asymmetry for economic gain

(Freixas & Santomero, 2002). This is possible because depositors lack full

information about how banks use their money, which creates incentives

for banks to take on excessive risk in their lending and investment activities. As shown by Chiesa (2000), when specific banking outcomes are

not observable by the depositors, market discipline weakens and banks

are demotivated to monitor borrowers. This moral hazard situation is

even strengthened by the fact that the potential gains from risky loans or

investments outweigh the losses, due to the restricted liability of shares

and/or the existence of deposit insurance (Rosenbluth & Schaap, 2003).

On the other hand, in the absence of deposit insurance market participants may be reluctant to put their money in banks. The need of regulation becomes apparent to ensure the intermediation function of banks.


Post-Crisis Banking Regulation in the European Union

Market failure also stems from an asymmetry of risk management

skills, between small, uninformed depositors and large, sophisticated

banks. Banks take the risk of their lending and investment activity, while

depositors free-ride and renounce monitoring banks. The market thus

fails to supply the public good, which is bank monitoring. There is the

need to supply this public good by a third party, the regulator, who

would act on behalf of the depositors (Tirole, 2001). This argument is

referred to in the literature as the representation hypothesis. It entails that

a public regulator represents the interest of the depositors better than a

private regulator would. Considering the alternative, self-regulation in

banking, one has to point out its substantial disadvantages. Given that

bank regulate themselves, incumbent credit institutions will be reluctant

to allow new entities to enter the market, ensuing negative externalities

of monopolistic structures. A serious issue would also be the absence of

the lender of last resort (LOLR), especially in the case of a systemic crisis. Even in the presence of private deposit insurance, if a systemic crisis

occurs, the capital shortfall cannot be covered by the other banks, since

all of them are exposed to the common shock (Tirole, 2001). A further

complication is that a private deposit insurer will be reluctant to insure

worse performing banks. As consequence weaker banks would take on

excessive risk to make potentially larger gains enabling their recovery.

Finally, given the information imperfection and the absence of a central monitoring institution, the depositors would not have the necessary

knowledge about the financial soundness of the insurer. The drawbacks

of self-regulation give support to the representation hypothesis and justify the need for a public regulator.

Further market failures, for which regulation has to account, are related

to the monetary liquidity costs due to the transformation of illiquid into

liquid assets by banks. Intermediaries aim to maximise their fee from

this activity. Since liquidity provision is the delegated role of the central

banks, their responsibility is also to monitor the activity of the banks

(Freixas & Santomero, 2002). The central banks’ oversight should ensure

a prudent allocation of banks’ assets enabling proper liquidity transformation and provision.

Market inefficiency may also arise in connection with the information production function of banks. Credit institutions, having incurred


Theoretical Aspects of Banking Regulation


costs of information gathering, are reluctant to reveal it to the public.

Regulation in the form of disclosure requirements enhances transparency

and market efficiency due to better pricing signals. It enables market participants to take better, non-distorted, investment decisions.

The literature also stresses inefficiencies relating to excessive market

power (Freixas & Santomero, 2002). Banks may exploit their unique

skills in intermediation, misuse their dominant market position and pursue their private interest, instead of carrying out their delegated monitoring function. Proper regulation should correct this market inefficiency.

Finally, one has to consider the inefficiency generated by the conflict

between the social and private costs of unregulated banking. If there are

no common regulations, banks can arbitrarily choose whether to follow

prudent conduct rules, or not. Given, that the private returns for firms

strictly following the conduct are lower than the social returns, banks

have no incentive for careful monitoring. Additionally, if only some of

the banks adhere to the conduct, the less prudent banks can just freeride on the other banks’ good reputation (Freixas & Santomero, 2002).

This creates a situation of mistrust and instability in the banking market.

Again, a response to this market failure would be to supply the missing

public good, which is banking regulation.

1.2.3 Externalities of a Bank’s Failure

In an unregulated environment one has to account for the possibility

of a bank’s failure. Such a scenario entails the destruction of capital and

the reduction of economic welfare, due to loss of the relationship with

the bank’s clients and specific management knowledge about customers’ risk preferences (Freixas & Santomero, 2002). The externalities of a

bank’s failure involve dramatic third-party effects. Affected parties would

be above all dispersed, uninformed depositors that cannot take any action

to hedge the risk of credit institutions’ default. Moreover such a failure

would impact negatively on other stakeholders of a bank, such as shareholders, creditors, borrowers and employees. Also, due to spillovers, the

effects of a bank’s bankruptcy would affect parties that are not direct

stakeholders. Such spillovers may stem from banks’ interconnectedness


Post-Crisis Banking Regulation in the European Union

due to mutual claims on the interbank market, in OTC derivatives, or

from payment system servicing. Depending on the extent of the failure and the spillover effects, bank bankruptcy may constitute a threat

to financial stability. Finally, given the systemic importance of banks, a

failure might negatively affect the real economy due to constrained credit

availability to enterprises.

An important aspect of the bank failure’s externalities is the prevalent

contagion in the banking sector. Besides the above mentioned interconnectedness of banks via mutual claims, one has to stress the role of behavioural factors that trigger spillovers. A bank failure affects not only the

actual stability of the system but also the perceived one. Information

asymmetry causes markets to be ineffective, that is, security prices do

not reflect the full available information. Moreover, investors do not act

fully rationally; their decisions are based on superficial information and

heuristic methods. They are prone to disaster myopia which occurs if the

objective and subjective probabilities of crisis events differ. Banks tend

to base their assessment on past events which may not be accurate in

the current situation. As a consequence, market participants are prone

to herding effects and panic runs. Given this behavioural aspects, even

sound credit institutions can be the subject of bank runs. Domino effects

exacerbate the situation and lead to fire sales and deleveraging.

Counteracting and mitigating such costly scenarios are further arguments for introducing banking regulation. These rationales become even

more pronounced if one underscores the large social cost of bank bankruptcy versus the relatively mitigated private costs. Banks receive state

aid and may be bailed out at taxpayers’ cost. Importantly, the mentioned

welfare reduction constitutes a substantial social cost.

1.2.4 Agency Theory Arguments

The need for regulation is also well demonstrated within the framework

of agency theory. Basic agency theory states that in corporations there is a

conflict of interest between owners and managers stemming from information asymmetry. The theory assumes normal or competitive markets

and refers generally to industrial corporations, that is, “ordinary firms”


Theoretical Aspects of Banking Regulation


(Jensen & Meckling, 1976). Due to the special status of banks, their

activity involves multiple stakeholders embedded in a conflict of interests. The bank’s stakeholders include:







Large shareholders (blockowners)

Small, dispersed shareholders

Managers or executive directors

Supervisory board members

Creditors (e.g., depositors, bondholders, deposit insurers)


The agency conflicts that may arise between stakeholders can take at

least five forms. For one, there can be a conflict between shareholders and

managers which results from the separation of ownership and control.

Managers are more risk averse than shareholders since the company’s financial condition is majorly their responsibility. Also, shareholders, unlike

managers, are dispersed, hence they can take a higher risk as a group. The

risk limitations are usually only put on managers, not on owners, which

strengthens the agency conflict between these two parties. A second type of

conflict arises between blockowners and small shareholders. Blockowners

are more risk averse, since they have invested a large share of their funds

in the bank. Also, they prefer payouts in the form of exclusive benefits

rather than dividends (Mülbert, 2010). The third type of conflict arises

between owners (shareholders) and creditors. Creditors are adherents of

less risky investment strategies since their major interest is to regain their

claims, whereas shareholders put pressure on higher returns and more risk

taking. Fourth, a conflict also arises between depositors and bank managers. Due to delegated monitoring, bank managers strive for different risk

profiles than depositors. Fifth, delegated monitoring also produces a conflict between borrowers and managers due to differences in preferred risk

profiles, conducive to different preferred rates charged to loans.

Agency conflicts encourage risk shifting from owners to managers, creditors and borrowers. Also, owners and managers may follow

short-term objectives to increase profits at the creditors’ expense. The

consequences of such behaviour are even more pronounced given that

banks’ risk profiles can change very rapidly, in contrast to regular firms.


Post-Crisis Banking Regulation in the European Union

This situation is exacerbated even further due the mentioned opacity of

banks’ balance sheets, which makes it harder to control banks and to

align the interests of the stakeholders (Mülbert, 2010).

To control these agency problems, outside monitoring mechanisms are

essential. As discussed in Sect. 1.1.1 banking theory puts forward demandable deposits as a control device; nevertheless if deposits are insured

they cannot fulfil the monitoring function (Olszak, Pipień, Kowalska,

& Roszkowska, 2015). Another solution is proper equity levels (Tirole,

2006), which could be subject to capital regulations. Also, other forms

of oversight, for instance disclosure requirements, asset quality review

or liquidity requirements, could help to trade off the mentioned agency

conflicts. Assuming that the banking sector is regulated, there is an additional party involved in the agency conflict: the regulator. Regulators are

one of the main stakeholders of banks, nevertheless their objectives are

not in line with the ones of shareholders or managers. Hence, regulations

trade off the market power of bank stakeholder behaviour (Ciancanelli &

Reyes Gonzales, 2001).

The presence of the regulator creates additional information asymmetries and subsequent agency problems. The regulator is expected to act

as an agent of public interest. The regulating institution is not in possession of the information a bank has, and it also follows a different objective then the owners and managers. It aims at ensuring financial stability

and also shares the risk of the bank. The risk sharing with the regulator

gives rise to pronounced moral hazard on the bank’s part. Regulation

thus affects the balance of the intermediaries’ costs and benefits and may

boost the creation of banks that would not exist in the absence of regulation (Ciancanelli & Reyes Gonzales, 2001).

The mentioned distortions created by banking regulation can be alleviated by a proper design of the regulatory framework. The risk shifting

incentives are only pronounced in the case of minimalist regulation, for

example, unconditional deposit insurance or LOLR function. If these

bank support measures were accompanied by sophisticated regulations,

for example, liquidity requirements or disclosure standards, the mentioned asymmetric information and agency problems could be mitigated.

The next section focuses on the various elements of banking regulations,

which can be incorporated individually or jointly in the frameworks.



Theoretical Aspects of Banking Regulation


The Elements of Banking Regulation

Given the importance of the banking sector for the economy and the

mentioned conflicts of interest between the involved stakeholders, banking regulation has to fulfil a prominent role. The literature enumerates

the following main functions of banking regulation:

(1) Depositors’ protection

(2) Monitoring of banks’ individual and systemic risk

(3) Monitoring of legal aspects of banks’ activity.

Given the “special status” of banks, the instruments of banking regulation have to be adjusted to the sector’s specific features (Freixas &

Rochet, 1997). As mentioned in the previous section, banking regulation

can potentially create market distortions. As a consequence, it is essential

to design instruments that would allow us to supervise the banks and

counteract their excessive risk taking (Dionne, 2003). As a matter of fact,

contemporary banking regulation subjects banks to a broad, diverse set

of restrictions and rules.

Regulators are confronted with the problem of how to choose the optimal combination of regulatory tools. The approaches vary from minimalist, to far-reaching interventionist patterns. The two extreme ends

are “prudential regulation”, which pushes the cost of the maintenance

of banking system stability on the banks themselves, and “profit padding” regulation, which imposes these costs on taxpayers and bank customers by constraining competition in the banking sector (Rosenbluth

& Schaap, 2003). In the latter case, the monopolistic structure helps to

keep loan rates at a high level, and deposit rates at a low level. Potential

bank bail-outs are financed by taxpayers. In practice, regulators choose

between numerous instruments that can be classified into broad areas of

banking regulation. The main ones are discussed below.

1.3.1 Entry and Ownership Regulations

One of the main types of banking regulations is entry requirements.

Usually the establishment of a bank is subject to numerous restrictions.


Post-Crisis Banking Regulation in the European Union

The regulatory barriers to entry determine substantially the degree of

competition in the banking market (Barth, Caprio, & Levine, 2013).

On one hand, such regulation can help to increase the quality of credit

institutions and contribute to financial stability. The market power of

the incumbent banks may lead to increased franchise value and prevent

credit institutions from excessive risk taking (Keeley, 1990). On the other

hand, entry restrictions can serve as a pretext for protectionism in banking, ensuing competition constraints. Strict entry regulation may lead to

excessive power of incumbent banks, entailing negative externalities for

depositors and borrowers (Barth, Caprio, & Levine, 2004).

Entry regulations usually refer to the complexity of the application

procedure for a banking licence and the scope of information that has to

be provided by the candidate. This may comprise the draft of the statute,

the planned organisational form, financial information about the owners

and the sources of funds, as well as information about the qualifications

of the directors and managers (Barth et al., 2013).

Also, regulators put restrictions on bank ownership (the ratio of shares

that can be held by a single entity or related parties), barriers to foreign

ownership, non-bank financial firm ownership or non-financial firm ownership in banks. The rationale behind this type of regulation is to avoid the

emergence of large financial conglomerates that would be hard to supervise

and to counteract excessive market power concentration in single entities.

1.3.2 Capital Requirements

Capital requirements refer to the amount, type and quality of capital that

banks should hold. The requirements are usually expressed as a ratio of

capital to assets. Of crucial importance is the definition of capital and

the valuation of banks’ assets (Barth et al., 2013). Capital, in the strictest

sense (Tier I), refers to equity and disclosed reserves, or retained earnings,

although in a broader sense it may also comprise undisclosed and revaluation reserves, hybrid debt-equity instruments, as well as general provisions and subordinated debt (Tier II). Tier I capital is often referred to as

“going concern capital”, that is, used by a solvent, operating bank, while

Tier II capital is called “gone concern capital” and constitutes a guarantee

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2 Why Do We Need Banking Regulation?

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