Liquidity, Risk Taking, and the Lender of Last Resort

This paper studies the strategic interaction between a bank whose deposits are randomly withdrawn and a lender of last resort (LLR) that bases its decision on supervisory information on the quality of the bank’s assets. The bank is subject to a capital requirement and chooses the liquidity buffer that it wants to hold and the risk of its loan portfolio. The equilibrium choice of risk is shown to be decreasing in the capital requirement and increasing in the interest rate charged by the LLR. Moreover, when the LLR does not charge penalty rates, the bank chooses the same level of risk and a smaller liquidity buffer than in the absence of an LLR. Thus, in contrast with the general view, the existence of an LLR does not increase the incentives to take risk, while penalty rates do.

Labour's record on financial regulation

In 1997 the new Labour government launched major initiatives in the area of financial regulation, setting up the Financial Services Authority as a comprehensive regulatory body, supported by the legislative framework of the Financial Services and Markets Act 2000. We evaluate the Labour government’s record on financial regulation in terms of its achievements and failures, especially in dealing with the global financial crisis that started in 2007. While we identify some clear flaws in regulatory design and enforcement, our evaluation highlights some inherent difficulties of financial regulation

Regulating financial conglomerates

We investigate the optimal regulation of financial conglomerates which combine a bank and a non-bank financial institution. The conglomerate’s risk-taking incentives depend upon the level of market discipline it faces, which in turn is determined by the conglomerate’s liability structure. We examine optimal capital requirements for stand-alone institutions, for integrated financial conglomerates, and for financial conglomerates that are structured as holding companies. For a given risk profile, integrated conglomerates have a lower probability of failure than either their stand-alone or decentralized equivalent. However, when risk profiles are endogenously selected, conglomeration may extend the reach of the deposit insurance safety net and hence provide incentives for increased risk-taking. As a result, integrated conglomerates may optimally attract higher capital requirements. In contrast, decentralised conglomerates are able to hold assets in the socially most efficient place. Their optimal capital requirements encourage this. Hence, the practice of “regulatory arbitrage”, or of transferring assets from one balance sheet to another, is welfare-increasing. We discuss the policy implications of our finding in the context not only of the present debate on the regulation of financial conglomerates but also in the light of existing US bank holding company regulation

Liquidity Provision, Ambiguous Asset Returns and the Financial Crisis

For an economy with dysfunctional intertemporal financial markets the financial sector is modelled as a competitive banking sector oering deposit contracts. In a setting similar to Allen and Gale (1998) properties of the optimal liquidity provision are analyzed for illiquid assets with ambiguous returns. In the context of the model, ambiguity | i.e. incalculable risk | leads to dynamically inconsistent investor behaviour. If the financial sector fails to recognize the presence of ambiguity, unanticipated fundamental crises may occur, which are incorrectly blamed on investors 'loosing their nerves' and 'panicing'. The basic mechanism of the current financial crisis resembles a banking panic in the presence of ambiguous asset returns. The combination of providing additional liquidity and supporting distressed financial institutions implements the regulatory policy suggested by the model. A credible commitment to such 'bail-out policy' does not create a moral hazard problem. Rather, it implements the second best efficient outcome by discouraging excessive caution. Reducing ambiguity by increasing stability, transparency and predictability | as suggested by ordo-liberalism and the 'Freiburger Schule’ | enhances ex-ante welfare.Financial Intermediation, Liquidity, Ambiguity, Choquet Expected Utility, Financial Crisis

Bank capital regulation and asset risk

Bank capital ; Deposit insurance ; Risk ; Bank assets

Design, Structure and Implementation of a Modern Deposit Insurance Scheme

One of the important consequences to be drawn from the course of the financial crisis up to now is the insight that more attention must be paid in the future to the factors of liquidity, liquidity management and liquidity protection. That holds true for the protection of the stability of an individual bank as it does for that of a whole national or even international financial system. The liquidity problems of a bank can certainly have a variety of causes. However, as an examination of the history of bank insolvencies and financial crises shows, an accelerated withdrawal of bank deposits by unsecured customers nearly always leads in the end to the collapse of an institution and, as an ultimate consequence, to a national or even international banking crisis. This insight has also brought the deposit insurance institutions in many countries around the world to the attention of political, regulatory and banking management discussions. The rapid, politically necessary, factually often not well founded, guarantee promises made by many governments have shown those responsible that in Europe the need for a fundamental revision of the present deposit insurance schemes must be urgently addressed. In most industrialized countries of the OECD, as well as in a range of other states, working groups are studying the necessary revisions and adjustments of the relevant institutions to meet the new economic and political conditions. Even if solutions of this sort continue to be arranged differently from one country to another on the basis of differing regulatory, historical and structural circumstances, a consensus is emerging over the important basic questions of deposit insurance system design and architecture. As a result of the worldwide financial crisis most European countries massively increased their coverage limits for their national deposit insurance schemes in the fall of 2008. Where no deposit insurance existed, it was introduced. Existing systems were critically scrutinized. In most countries the maximum insurance coverage was raised and the eligible deposit base was extended. Some individual states have even promised an unlimited deposit protection (in some cases with a time restriction). Under the pressure of an increasing number of bank failures these promises were made without revising the existing deposit insurance schemes themselves. In the course of 2009, both the individual European states and the EU itself then set about scrutinizing their existing protection schemes and mechanisms and revising the existing national deposit insurance schemes. It is accepted throughout the world that well designed deposit insurance is an important element in a national safety net for maintaining and extending the stability of the financial system. The design and structure, but also the implementation, of a deposit insurance scheme (DIS) of this sort throws up numerous institutional, procedural and instrumental questions. Such operative and strategic issues must be answered against the background of the overall national circumstances and in line with the country specific realities of the respective financial intermediate system. However, there is a series of topics that can be assessed and solved independently of such individual circumstances. This is even more the case since the worldwide revision of the deposit insurance schemes offers the opportunity to create the conditions for a future harmonization of national deposit insurance schemes at least within Europe. An assimilation of this sort is, in turn, the basis for future EU-wide or perhaps even European depositor protection, which, like any broadly based guarantee, would certainly be more efficient than a multitude of national solutions. This publication intends to make a contribution to the ongoing discussion of the complex questions connected with the further development of European deposit insurance schemes. Both complementing and extending the broad range of theoretical literature available, it focuses on some key design questions of modern deposit insurance schemes, on the discussion of their basic structural elements and on the appropriate consequences for the stakeholders in deposit insurance. We focus on: - the derivation of the most important requirements of a modern European deposit insurance, and the - discussion of specific organizational aspects and fundamental institutional requirements as well as of solutions for selected system building blocks. The first chapter analyzes the institutional framework of deposit insurance schemes and its various aspects of cost/benefit considerations. The second chapter discusses the fundamentals of modern deposit insurance. The third chapter examines selected strategic and instrumental questions concerning the organization and implementation of deposit insurance schemes. The fourth chapter focuses on some questions related to the international harmonization and coordination of the design of deposit insurance schemes. In all sections we address some lessons learned from the recent financial turmoil. The fifth chapter finally addresses some conclusions and sketches some policy implications for designing and implementing a modern deposit insurance scheme.Deposit insurance, risk-based premium, risk-adjusted pricing, premium calculator, system risk, fund size, funding, guarantee promises, depositor categories, eligible deposits, covered deposits, membership, expected loss, pan-european deposit insurance system, moral hazard, resolution regime, payout

The Polish deposit insurance scheme compared to arrangements adopted in other EU countries

Despite their relatively short history, deposit insurance schemes (DISs) are currently a common element of the banking system. In 2004, 83 explicite DISs operated around the world. The Bank Guarantee Fund (Bankowy Fundusz Gwarancyjny – BFG) – the Polish institution guaranteeing household deposits – is celebrating its 10th anniversary this year. Over its 10 years of active operation the BFG has proved that, along with the National Bank of Poland and the Commission for Banking Supervision, it is among the most important institutions protecting the Polish financial system from destabilisation. The introductory part of this paper presents the position of the Bank Guarantee Fund within the Polish financial safety net. Other guarantee schemes operating in the Polish financial services sector have also been presented. Moreover, the paper explains the reasons for the launching of a DIS and points out the purposes for the establishment of the BFG. Further, it describes the evolution of Polish deposit guarantee arrangements since 1982. Special emphasis has also been put on the analysis of Bank Guarantee Fund administration. The main aim of this paper is to describe Polish deposit insurance scheme. Particular features of the Polish scheme are discussed with reference to the Community regulations in this field and also arrangements adopted in the remaining 24 countries of the European Union. The third chapter of this paper describes the fundamental area of the Fund’s activity, i.e. guarantee activities consisting in making compensation payouts to depositors in the event of a bank’s bankruptcy. The scope of coverage (eligible types of deposits and depositors) offered by the Polish scheme has been analysed. The scope of the BFG’s guarantee activities from 1995 to 2004 has also been presented. In the fourth chapter, the BFG’s activities aimed at minimising risk in the banking sector have been presented. The principles and experience of the Fund regarding financial support for the rehabilitation of banks threatened with insolvency have been discussed in greatest detail here. The fifth chapter describes the principles and procedures regarding the financing of guarantee and assistance activities of the Bank Guarantee Fund. In the summary, the paper indicates possible directions for changes in the BFG legislation. It has been pointed out that despite the fact that Polish regulations comply with EU requirements,they must be adjusted to suit the changing domestic conditions.deposit insurance scheme, bank failure, assistance activities, Polish banking sector, financial stability, financial safety net, central bank, banking supervision, Community regulations

The Belgian deposit guarantee scheme in a European perspective

During the recent financial crisis, the deposit guarantee scheme in Belgium – as in other European countries – played a role in preventing bank runs and restoring confidence : to that end, the intervention ceilings were raised substantially and the scope of the scheme was extended to include certain life insurance policies. Finally, the expansion of the system’s coverage had to be financed by a sharp increase in the contributions from financial institutions. First of all, that measure had a positive impact on the budget ; secondly, increased contributions may also boost the credibility of the deposit guarantee system. A recent European initiative proposes further ambitious reforms. Besides a better consumer protection, the European deposit guarantee schemes would be largely harmonised, thus also promoting European financial integration. Risk-weighted financing of the schemes should counteract moral hazard, benefiting financial stability. However, this proposal has yet to be approved by the European Parliament and the Council. Its impact ought to be assessed in the light of the broader package of measures aimed at making the financial system more resilient, such as the new prudential supervision structure, the Basel III proposal for stricter capital and liquidity requirements, and the possible new levies on the financial sector.deposit assurance, financial institutions, financial crisis, moral hazard

An Incentive Problem in the Dynamic Theory of Banking

This paper develops a continuous-time model of liquidity provision by banks, in which customers can deposit and withdraw their funds strategically. The strategic withdrawal option introduces an incentive-compatibility problem that turns the problem of designing deposit contracts into a non-standard, non-convex optimal control problem. The paper develops a solution method for this problem and shows that, in this more general frame-work, the insights obtained from the traditional banking models change considerably, up to the point of liquidity provision becoming impossible. The continuous-time framework allows to discuss the problem elegantly and may help to make this part of the banking literature more operational in the sense of modern asset pricing theory.Liquidity; deposit contracts; banking; incentive compatibility; continuous time; dynamic programming

Liquidity and Ambiguity: Banks or Asset Markets?

We study the impact of ambiguity on two alternative institutions of financial intermediation in an economy where consumers face uncertain liquidity needs. The ambiguity the consumers experience is modeled by the degree of confidence in their additive beliefs. We analyze the optimal liquidity allocation and two institutional settings for implementing this allocation: a secondary asset market and a bank deposit contract. For full confidence we obtain the well-known result that consumers prefer the bank deposit contract over the asset market, since the former can provide the optimal cross subsidy for consumers with high liquidity needs. With increasing ambiguity this preference will be reversed: the asset market is preferred, since it avoids inefficient liquidation if the bank reserve holdings turn out to be suboptimal.Financial institutions, Liquidity, Ambiguity, Choquet Expected Utility.