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3 The Elements of Banking Regulation

3 The Elements of Banking Regulation

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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


Theoretical Aspects of Banking Regulation


for stakeholders in the case of the bank’s bankruptcy. The capital ratios

can be conditional on various types of bank risk (credit, market or operational risk). Besides capital adequacy, regulations state whether capital

sources are to be verified by the supervisor.

Capital regulations are supposed to trade off imperfect information

problems, risk shifting incentives, as well as the inefficiencies created by

deposit insurance, that is, moral hazard. Capital requirements impact

bank’s portfolio choices since they affect the returns of the respective assets

held by banks. They affect the competition and intermediation strategies

of banks and incentives to monitor borrowers (Mehran & Thakor, 2011).

They also constitute a guarantee of bank soundness and are viewed as a

buffer against potential losses.

Nevertheless, excessive capital accumulation is undesirable, since it

may decrease the value of the bank and elevate its financing costs, due

to replacement of deposit funding by equity (Berger, Herring, & Szegö,

1995; Diamond & Rajan, 2000, 2001; Gorton & Winton, 2014). Given

that equity financing is more expensive than deposit financing, capital

regulations may induce loan contraction and hence decrease the value of

a bank’s portfolio (Thakor, 1996). In the presence of deposit insurance,

capital regulation may stimulate banks to choose inefficient portfolios

due to biased returns of the respective assets (Rochet, 1992). High capital

requirements can also lead to excessive risk taking since they boost banks’

risk absorption capability; also banks’ higher financing costs push them

to take on more risk just to increase the future value of equity (Berger &

Bouwman, 2013; Blum, 1999). In this case capital regulations would not

trade off the mentioned agency problems.

Economic theory has developed a particular interest in determining

optimal capital regulation. Arguments in favour of optimal capital levels

are also found by Mehran and Thakor (2011) and Calem and Rob (1999).

They show that both very low and very high levels of capital are conducive to excessive risk taking by banks, although other studies postulate

that given the large volatility of banks’ credit and market risk profiles

optimal capital requirements are infeasible (Freixas & Santomero, 2002).

Various approaches to capital regulations have emerged. One of them

stipulates that banks, knowing their activity profile, should declare an

ex-ante capital threshold, which would be verified ex-post by the regula-


Post-Crisis Banking Regulation in the European Union

tor. Such a solution was, though, hard to introduce in practice (Freixas

& Santomero, 2002).

Another solution to strengthen monitoring over banks was the proposition that banks should hold a substantial part of capital as subordinated

debt. The pronounced incentives of subordinated creditors to monitor

the bank are expected to increase market discipline. Any price changes

of subordinated debt would trigger immediate market reactions. Another

rationale behind this approach is that higher leverage ratios motivate borrowers to exert pressure on bank managers and mitigate the problem

of risk shifting from managers and shareholders to debtholders, which

occurs in the case of high equity ratios (Diamond & Rajan, 2001). A

drawback of this solution is that the long-term maturity of subordinated

debt prevents the bank from incurring the immediate cost of increased

risk, therefore the disciplining effect of this type of capital is only limited.

Also, subordinated creditors are subjected to the imperfect information

problem, hence their ability to monitor the bank would be restricted.

A further proposition for setting capital requirements is based on

banks’ internal models. One of the rationales behind this approach

is that common capital regulations are inefficient and increase the

financing cost of banks, since the levels of capital are chosen for the

whole banking sector without accounting for individual bank characteristics (Allen, Carletti, & Marquez, 2011; Repullo & Suarez,

2008). Such an arbitrary approach to capital regulation does not

offer, though, a solution to the imperfect information problem, it

even exacerbates it. This internal model-based approach also requires

more intense ex-ante oversight on the part of the regulator (Freixas &

Santomero, 2002).

1.3.3 Activity Regulations

A widely discussed regulation type is restrictions on banks’ activities.

Restrictions usually refer to the scope and extent of non-typical banking

activities banks can engage in. As mentioned in Sect. 1.1.3 such activities

may encompass, primarily, securities trading, underwriting and brokerage, involvement in mutual funds activities, providing insurance con-


Theoretical Aspects of Banking Regulation


tracts and insurance underwriting, as well as investing in, developing and

managing real estate. Activity restrictions may also apply to the controversial mixing of the ownership of banks and non-financial firms (Barth

et al., 2013).

The purpose of imposing restrictions on banks’ activities is to trade off

the agency conflicts and to mitigate the information asymmetry with particular consideration of the pronounced risk shifting incentives brought

about by the involvement in non-typical banking activities. Strict regulations prevent banks from subordinating less profitable activities to more

profitable ones, a practice which may increase their propensity to take on

excessive risk (Boyd, Chang, & Smith, 1998; Barth et al., 2004). Ring

fencing of non-banking and banking activity can prevent conflicts of

interest between the respective activities. Non-typical activities are usually more profitable, hence bank owners will strive to increase their share

in a bank’s profile. Given, that the income derived from non-interest

activities is much more volatile than interest income, banks involved in

non-typical activities are exposed to much higher losses, in the case of

downturns, than ring-fenced institutions. Restrictions are, hence, aimed

at limiting this risk and preventing its shift to creditors.

A further argument for imposing activity regulations is that broadened

banking activity may motivate banks to consolidate. As a consequence,

bank size may increase, rendering regulatory oversight more difficult.

Also, a multiplicator effect may be at work here, since larger banks tend

to take on excessive risk, mainly due to their moral hazard incentives

(Too-Big-To-Fail), and the possibility of engaging in diversified highrisk activities. Increased bank size might hence be conducive to more

excessive risk taking. This tendency is especially pronounced during crises (Altunbas etal., 2011; Demirgỹỗ-Kunt & Huizinga, 2012; Vallascas

& Keasey, 2012). Bank consolidation would also lead to oligopolistic

structures, impeding competition and exacerbating the above mentioned

asymmetry and agency problems.

A counterargument for activity restrictions is that liberalisation allows

banks to achieve economies of scale and scope, and diversification benefits; hence it may be conducive to greater bank stability (Altunbas et al.,

2011; Barth et al., 2004). Empirical evidence, in general, supports the

view that non-interest income increases bank risk (De Jonghe, 2010;


Post-Crisis Banking Regulation in the European Union

Lepetit, Nys, Rous, & Tarazi, 2008), although benefits of banking activity diversification are also found (Altunbas et al., 2011).

1.3.4 Auditing Requirements and Private Monitoring

Auditing requirements and private monitoring are established to reduce

the information asymmetry and agency conflicts through a strengthened

framework enabling private investors to monitor banks. The main elements of such regulations are the requirement to supervise banks by certified auditors, the requirement to rate banks by rating agencies, the extent

of information subjected to disclosure requirements (unconsolidated

and consolidated reports), and the explicit standards for the audit and

the legal liability of directors for the accuracy of information provided.

Auditing requirements and private monitoring thus allow bank stakeholders to be informed appropriately about the bank’s financial situation

and enable them to take better, non-distorted decisions.

Private monitoring can be also used for the benefit of the supervisory

authority since banks may be required to disclose the auditor’s report. The

regulator can also reserve the right to communicate with the auditor with

or without the banks’ approval, depending on the regulation stringency.

Regulators can also require auditors to communicate to them directly any

fraudulent activity of the bank discovered during the audit and potentially

take legal action against it in the case of negligence (Barth et al., 2013).

1.3.5 Liquidity and Asset Quality Requirements

Liquidity requirements are a substantial element of regulation, since they

maintain one of the basic functions of banks: asset transformation for

liquidity provision. As mentioned, banks not only produce liquidity, but

also need access to it. This need becomes very apparent during times of

financial turmoil. One of the important tasks of the regulators is thus to

formulate strict prudential regulatory norms for banks’ liquidity risk and

its management.

Liquidity regulations mainly concern explicit liquidity or funding

ratios, or maturity mismatch restrictions. More preventive, forward looking regulatory measures comprise limits on concentrated exposures: that


Theoretical Aspects of Banking Regulation


is, standards that dictate to what extent banks are limited in their lending

to single or interrelated borrowers or requirements concerning asset and

funding diversification. Such measures counteract the excessive impact

of a potential illiquidity of a counterparty on the bank’s liquidity position. Substantial measures are also contingency funding provisions, for

example stress tests, which help to maintain the credit institution’s liquidity during times of financial turmoil or economic downturn (Barth et al.,


While liquidity regulations primarily impose quantitative limits on

banks’ portfolios, asset quality requirements help to determine the quality of these portfolios. They may impact directly the liquidity provision

function by determining the ability of the bank to perform the transformation function with the assets held. This regulation type entails such

elements as the existence and coverage of a regulatory asset classification

system, standard of loan classification, criteria for the determination of

non-performing loans and the consequences in terms of financial reporting, and standards for loan provisioning.

1.3.6 Lender of Last Resort and Deposit Insurance


Deposit insurance schemes are established to prevent bank runs, potential

contagion effects and as a consequence systemic crises. In their absence,

banks would have to pay their depositors a rate corresponding to the

riskiness of their portfolios. Given the asymmetry of information, this

might be a costly solution for the depositors. Deposit insurance schemes

create a substantial “safety net” for the banking system to protect bank

customers; that is, from the theoretical point of view, dispersed, uninformed agents. Nevertheless, other stakeholders can also benefit from the

existence of deposit insurance (Freixas & Santomero, 2002). The extent

of this safety net is thus the subject of an intense debate.

The downside of deposit insurance for the regulator is the arising moral

hazard for the bank to take on excessive risk and to shift it to the insurer.

Banks, knowing the level of insurance premiums, can take on excessive

risk to achieve a predetermined return (Dewatripont & Tirole, 1994). If


Post-Crisis Banking Regulation in the European Union

the insurance premium is fixed, risk taking allows us to increase the value

of insurance. Banks do not really have to worry about the downside of

their risky activities, since potential losses will be covered by the insurer.

Moreover, depositors are prone to free-riding, since they have less incentive to monitor the bank. Hence, the presence of deposit insurance can

exacerbate the above mentioned agency conflicts between bank owners,

managers, and creditors.

To mitigate moral hazard and free-riding, a proper structuring of the

deposit insurance scheme is necessary. The regulator has to set the limit,

scope and conditions of the insurance cover to be able to control the

behaviour of owners and depositors. Important incentive devices are

coinsurance, that is, the involvement of banks in financing the scheme,

the overall structure of funding for the scheme, as well as the structure

of the insurance premium. A substantial control instrument is also the

extent of the rights of the insurer to intervene in banks, for instance, to

revoke insurance or take legal action against banks that violate the statute

and regulations of the scheme (Barth et  al., 2013). Deposit insurance

does not usually depend on a bank’s risk. It has been argued in the literature, that uniform insurance entails subsidising riskier banks at the cost

of more prudent ones, although, fair pricing of deposit insurance would

be a hard task, due to the above mentioned information asymmetries.

This difficulty causes that regulators to strive for risk-based capital regulation rather than for risk-based deposit insurance (Freixas & Santomero,


Another element of the safety net, the LOLR, is a liquidity facility

granted to banks. As opposed to deposit insurance, LOLR is implicit

and unregulated. Theoretically it is a facility open to illiquid, but solvent,

credit institutions against good collateral. In practice it is used as rescue

package for failing banks. Bank bail-outs entail large costs for taxpayers, who have to bear the burden of banks’ distorted, excessively risky

decisions. It exacerbates the risk shifting incentives relating to agency

problems, although, the presence of systemically important institutions

renders bail-out programmes unavoidable. The large costs of the LOLR

function can be mitigated by non-conventional liquidity provision methods by central banks via multiple channels. Another helpful measure is

proper bank resolution mechanisms and bank closure requirements.


Theoretical Aspects of Banking Regulation


1.3.7 Supervision Over Sound and Problematic


Supervision over sound institutions is aimed at trading off information

asymmetry, while problematic institutions’ discipline strives at preventing bank failures and their negative externalities. A substantial aspect of

this regulation type is the supervisory power granted to the regulator.

Supervisory power determines the rights of the regulator to obtain the

necessary information from the banks in order to assess their financial

situation, as well as the entitlement to undertake corrective or discretionary action.

Besides the supervisor’s rights to obtain information from the banks’

auditors, substantial instruments of supervisory power are intervention

rights in banks. Depending on the regulatory stringency, regulators may

enforce changes to the bank’s organisational structure and give mandatory directions for managers regarding provisioning. They may also be

entitled to suspend the directors’ decisions concerning dividends or extra

compensation, or even replace management or directors. An important

supervisory instrument in terms of bank resolution is the right of the

regulator to declare the insolvency of a bank. The most far-reaching intervention tool is the entitlement to ownership rights suspension.

The problematic institutions’ oversight entails similar tools as the

monitoring of sound banks with the addition of discipline devices in

the case of imprudent bank practices. Such instruments may take the

form of cease and desist type orders, setting extra regulatory limits for

capital levels, or imposing additional restrictions on activity. The supervisor may also be entitled to order a bank to make specific provisions or to

enforce measures of internal bank governance. The problematic institutions’ oversight also triggers the rights to banking licence withdrawal.

Important tools, in terms of crisis prevention, are early intervention measures, for instance, automatic prompt corrective action rights in the case

where banks do not fulfil specific regulatory requirements.

Many studies, though, stress the importance of carefully balanced

supervisory power for proper banking system functioning. If the authorities are granted too much supervisory power thist may lead to politically


Post-Crisis Banking Regulation in the European Union

induced decisions and disable the banks’ intermediary function (Djankov,

La Porta, Lopez-de-Silanes, & Shleifer, 2002; Quintyn & Taylor, 2002).


The Post-Crisis Paradigm of Regulation

Substantial changes to the theory of banking regulation were introduced

after the emergence of the recent financial crisis. Two contradictory

strands of treatment of banking crises in regulations evolved. The first

view regards them as unavoidable and puts forward the necessity of providing mitigating regulatory tools. According to the other view, crises can

be avoided if appropriate regulatory instruments are available. Regulators

have to strike a balance between these two extreme approaches, since

settling for one may not fully address the potential inefficiencies of the

banking sector (Freixas, 2010).

The crisis exacerbated the problem of information asymmetry and

consequently deteriorated market discipline. The pre-crisis view that disclosure is sufficient to counteract information asymmetry proved inadequate, since the existing rules did not provide the desired transparency.

In the economic literature a discussion emerged as to how to improve

the transparency of information. To solve the problem of information

asymmetry one has to account for the different information dissemination patterns during times of stabilisation and during crises. While disclosure requirements mainly concern the standards of the provided data,

transparency is only achieved if the disclosed information reaches the

market and is processed in an appropriate way. This is conditional on

the ability of market participants to access and manage the abundant,

available information. One should also stress the endogenous mechanism

between information provision and processing. While investors base their

reactions on the disclosed information, the banks’ incentives to disclose

information are conditional on the expected outcome of the investors’

reactions. Given behavioural biases, for instance, decisions based on heuristic methods and herding, investors might be prone to overreaction.

Banks, knowing that, filter the disclosed information in an appropriate

way to avoid price crashes or liquidity shortages. Another complication is

caused by expectations resulting from regulation; that is, if investors con-


Theoretical Aspects of Banking Regulation


sider regulatory standards, or the existence of the lender of last resort as

legitimate, they may be demotivated to collect the disclosed information

(Dewatripont & Freixas, 2012).

The lack of transparency led to a similar treatment of solvent and insolvent banks in the wake of and during the financial crisis, which indicated

the failure of market discipline. The immediate reaction of regulators was

the introduction of stress tests, which alleviated a part of the information asymmetry. To enhance their credibility and counteract behavioural

biases the tests were based on clear, identical scenarios for all banks and

were certified by regulatory agencies. Stress tests allowed market participants to discriminate between well, and badly, performing banks and

hence to reinforce market discipline.

A further solution put forward to counter the problem of pronounced

information asymmetry during crises is to require disclosure standards

based on information that cannot be manipulated, instead of arbitrary

bank risk models. This would help to avoid practices like asset reclassification and window-dressing of financial statements. Given that investors

base their decisions on multiple information sources, clear-cut reports

should be also required from rating agencies. Information provision and

market discipline could also be improved by explicit bank resolution


The pre-crisis information asymmetry and the lack of market discipline were due to important fallacies of regulations. These include, above

all, regulatory arbitrage resulting from an unregulated shadow banking

system, insufficient regulation of systemically important institutions,

the materialisation of endogenous systemic risk, as well deficient international coordination of regulation despite the increased international

interconnectedness of banks. These four issues are analysed in the subsections below.

1.4.1 Shadow Banking and Regulatory Arbitrage

Major challenges for regulators arose due to pronounced regulatory arbitrage, resulting from the activity of shadow banking institutions. Shadow

banks, for instance money markets funds or special purpose vehicles, play

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3 The Elements of Banking Regulation

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