Elements of Banking and

Finance (FINA 1001)

Monetary Policy & Bank Regulation

 Objectives

• Central Bank business- Monetary Policy

• Explain why banks need to be regulated
• Traditional regulation mechanisms
 Central Bank Business
• One of the central bank’s roles is to serve as the public
authority that regulates a nation’s depository institutions and
controls the quantity of money - Monetary policy and
regulation

• Goals of monetary policy

• High employment
• Price stability
• Interest rate stability
• Stability of financial markets
• Moderate the business cycle, and contribute to achieving long-
term economic growth
• Stability of the foreign exchange market
 Monetary Policy
• Monetary policy is one aspect of broader economic policy, the othe
is fiscal policy.

• Monetary and fiscal policies have repercussions on the whole

economy, affecting inflation, output, employment and BOP.

• Monetary policy influences economic trends through the cost and

availability of credit.

• Fiscal policy is an important determinant of aggregate demand -

directly affects the financial resources and public purchasing powe
 Monetary Policy
• The Central Bank can theoretically regulate the amount of money
creation by banks through control of their cash reserves, in
practice, the regulation of money supply is not wholly under the
Bank’s control

• Fiscal side effects (Expansionary fiscal policy) - Budgetary

deficits can be financed by borrowing from the Central Bank,
there will be an increase in money supply

• The expansion of bank reserves can provide the banking system

with the ability to expand credit

• Variations in money supply can occur through the BOP

 Monetary Policy
• The central bank relies on two types of instruments - direct and indirect

• The use of direct instruments refers to the use of reserve requirements,

administered interest rates and credit controls

• An indirect instrument of control is open market operations. Here the

aim is to adjust other variables through the money supply.

• Overall, there are a number of elements that tend to impact on money

supply:
• Net bank credit to government
• Bank commercial credit to the commercial sector
• Net foreign assets
 The Demand for Money

• Money multiplier
▫ Implies that when the Central Bank increases banking reserves by
another dollar, the overall increase in the money supply is a
multiple of that.
▫ Fractional banking system where banks are only required to hold a
percentage of every dollar deposited as reserves. The rest the bank
is free to loan out or use to purchase other assets.

• The quantity of money that people plan to hold depends

on four main factors:
 The price level/inflation
 The interest rate
 Real GDP
 Financial innovation
 Monetary Policy
• Potential conflicts among the goals of monetary policy.

• E.g. interest rate stability/financial market stability/high

employment with economic growth

• The goal of price stability often conflicts with the goals of interest
rate stability and high employment in the short run.
• When there is an expansion in the economy and
unemployment is falling, both inflation and real interest rates
may rise (tightening liquidity)
• If the central bank tries to prevent a rise in interest rates this
may cause the economy to overheat and stimulate inflation
• If the central bank chooses to raise nominal interest rates to
prevent inflation or an serious deterioration in the country’s
external position, in the short-run unemployment may rise
 Regulation

• Basle Committee on Capital:

• “The purpose of bank supervision is to ensure that banks operate in a
safe and sound manner and that they hold capital and reserves
sufficient to support the risks that arise in business.”

• Over the years there has been a greater focus from depositor
protection to financial stability
 Regulation?
• Why regulate the financial system?

• To what end? Objectives of regulation:

• Preserve safety and soundness of banks
• Protect depositors
• Encourage efficiency and competition in the financial system

• How? General types of regulation:

• Market conduct regulation (entry restrictions, licensing, and
information disclosure)
• Prudential regulation (risk assessment and oversight; product
restrictions)
 Categories of Regulation

• Prudential regulation: Focuses on the safety and

soundness of financial institutions

• Conduct of business regulation: Focuses on how

financial firms conduct business with their customers.
 Two main functions of banks
• Banks provide liquidity insurance to households
▫ Savers deposit funds against shocks that affect their
consumption needs. These funds represent liquidity
creation on the liability side by banks
▫ These same funds are utilized by banks to finance illiquid
investments.
• Banks can accurately value firms and select good credit
risks due to their expertise in information protection
▫ Banks are specialists in the screening and monitoring of
borrowers who are unable to acquire direct financing from
financial markets (delegated monitoring on the asset side).
• The nature of these two core services to depositors and
borrowers explains the financial structure of banks
▫ Liquid liabilities (deposits) an d illiquid assets (loans)
 What if a Bank fails?

• What does a bank failure mean exactly?

• How does a bank fail?

• How might a problem of illiquidity cause insolvency?

• So what if a bank fails? Who cares? (Who is adversely

affected and how?)
 Bank fragility

• If a large number depositors without warning decide to withdraw

their funds for reasons other than those of normal liquidity wants, a
bank run would ensue:
• Depositors lose confidence in their bank’s ability to remain solvent
• Savers at one banking institution observe problems at other banks
• Banks are highly interconnected and a problem at one particular
institution could easily spread to other solvent banks (systemic
risk)
• This occurs because depositors are unable to distinguish between
good and bad banks (a just run on an imprudent bank leads to a run
on solvent banks as a result of asymmetric information).
 Solvent to Insolvent
• In the case of a bank run or systemic failure of the banking
system:
•A bank will quickly run out of liquidity to meet deposit
withdrawals as most of its assets cannot be easily
liquidated as they are long-term in nature
• A bank may engage in a ‘fire sale’ of its assets (assets are
sold off at a lesser price). This would reduce the total value
of the banks’ assets.
• In order to generate liquidity, a solvent bank may become
insolvent. As a consequence of the pivotal position of banks in
the financial system, there is great emphasis on bank
regulation.
 Protection of Depositors

• The unique feature of banks is that their creditors (depositors)

are also their customers.
• Bank debt is held largely by uninformed, dispersed, small agents
(households)

• Prudential regulations are necessary because of the lack of

expertise and knowledge of depositors (the general public) to
assess the quality of the bank.
 Consequences of bank failures

• Bank failures are very costly to depositors and to the bank’s

stockholders. They are also costly to other banks on account
of their interbank lending relationship.

• This situation disrupts the payment system which is a critical

function of banks.

• Tax payers bear the brunt of these failures

 Traditional regulation mechanisms

• The Central Bank

• Bank supervision
• Government safety net
• Bank capital requirements
• Assessment of risk management
• Monitoring of liquidity
• Disclosure requirements
 The Central Bank

• Implement monetary policy (already discussed)

• Prudential control in relation to the minimization of financial
crises
• Central Bank acts as the ‘lender of last resort’
 Bank supervision
• This involves the overseeing of bank operations
• Assessing the safety and soundness of banks

• Reduces moral hazard and adverse selection in the

banking industry through bank examinations and entry
restrictions
• Bank examination is necessary to ensure that banks continue to operate
in a prudent manner. Regular on-site bank examinations allows regulators
to monitor whether the bank is complying with capital requirements and
restrictions on asset holdings.
• Bank examiners utilize the CAMELS system to evaluate banks. This
international framework considers six areas (capital adequacy, asset
quality, management quality, earnings’ performance, liquidity and
sensitivity to market risk) from which a score is computed. If CAMELS
rating is sufficiently low, regulators can take formal actions to alter a ban
k’s behaviour.
• Entry restrictions serve to prevent undesirable firms from entering the
banking sector
 Government safety net
• Government provides a safety net for depositors through:
• Central Bank as a ‘lender of last resort’
• A provision of liquidity supplied to a bank facing financial distress
• Deposit insurance
• Deposits are insured up to a fixed limit. In Barbados, the
Barbados Deposit Insurance Corporation (BDIC) provide
insurance coverage of up to BDS$25,000
• Direct funding by the government to troubled institutions
• Government provide capital injections to large distressed banks
(banks considered to-big-to-fail)
• These safety nets cause moral hazard problems.
• With these safety nets, depositors do not impose the discipline of the
market place (bank run) if they suspect too much risk-taking by bank.
Banks thus have an incentive to take on greater risks. (“Heads I win,
tails the taxpayer loses”)
 Bank capital requirements

• Bank regulation can impose restrictions on asset holdings and

bank capital requirements. This may include:
• Limitation on holding risky assets

• Restriction on the amount of loans (also the categories of borrowers)

• Lessening of the risk of the loan portfolio through diversification

• Maintaining adequate bank capital

• Minimizes the risk of insolvency

 Risk-Based Capital Regulation
• The Basel Accord targets risk-based capital requirements
• Under BASEL I & II, banks hold as capital at least 8% of their risk-
weighted assets (assets are categorized, each class is assigned a
different weight to reflect the degree of credit risk)
• BASELL III recognizes the inadequate capital requirements against
market risks and credit risks under BASEL I & II
▫ This framework introduces the capital conservation buffer and the
discretionary capital buffers
 Regulators can impose this when credit growth in the banking system is growing
excessively

• Limitations of Basel Accord have become apparent since the

regulatory measure of bank risk stipulated by risk weights can differ
substantially from the actual risk the bank faces (regulatory capital
arbitrage)
 Assessment of risk management
• Due to financial innovation, no longer can the focus be on the
quality of the bank’s assets at a specific point in time.

• The use of new financial instruments has rendered this

process unsatisfactory because a bank may be healthy at
a particular point and become insolvent quickly on
account of trading losses

• Bank examiners further evaluate the soundness of risk

management systems.

• A risk management rating is included into the

management components of the CAMELS system
 Corporate Governance
• Financial regulators should ensure that banking institutions
have strong governance structures
• Adequate corporate governance structures require internal
control systems within banks (enables the resolution of
agency problems)
▫ Management may have different risk preferences than their
stakeholders (government, owners, creditors)

• Standards established include:

▫ BOD provides checks and balances to senior managers and senior
managers in turn oversee line managers in specific business areas
▫ The organizational structure of the BOD with respect to clear,
identifiable lines of communication and responsibility for business
areas should be transparent
 Monitoring of Liquidity

• Regulators are focusing their attention on strengthening

liquidity monitoring of banks.
• The last financial crisis required significant levels of liquidity support
from central banks

• Banks are required to hold more high quality liquid assets

 Disclosure requirements

• Bank regulators can require the disclosure of a wide range of

information.
• This enables the market to assess the quality of a bank’s portfolio and
the amount of bank’s exposure to risk
• More public information about risks incurred by banks enables the
monitoring by depositors, creditors and stockholders (acts as a deterrent
to excessive risk-taking)
 Recent Issues
• U.S. bank failures stand at 16 in 2014, down from 24 in 2013

• Large banks requiring bailouts by the US Treasury Department in 2008: JP Morgan Chase & Co.
($25 bn), Bank of America Corp. ($15 bn), Citigroup ($25 bn)

• HBOS plc. fails in the UK in 2008 but through a takeover has become part of the Lloyds
Banking Group

• Bank failure of three of Iceland’s largest banks , Kaupthing, Glitnir and Landsbanki (systemic
failure ensued)

• http://www.the guardian.com/business/2012/jun/26/iceland-banking-collapse-diary-death-
spiral

• Stanford International Bank based in the Caribbean foiled in 2009 due to its activities involving
the issuance of certificates of deposits that offered “improbable and unsubstantiated high
interest rates”. Basically, a Ponzi scheme operation in which there was a misappropriation of
billions of investors’ funds accompanied by falsified financial statements to hide FRAUD.
 References

• Financial markets and Institutions by Mishkin & Eakins (6 th

Edition)- Chapter 20

• Alexander (2004), “Corporate Governance and bank

regulation”. Working Paper 17 as part of CERF Research
Programme.

• Goldfarb (2009), “SEC charges Stanford Financial in $8 B

Fraud”. Washington Post, February 18, 2009.