Prospects for Prudential Policy: Toward Achieving an Efficient and Stable Banking System

This paper examines how public intervention (prudential policy) in the banking area should be pursued and aims at providing points for discussion in considering what kind of system should be established to promote both the efficiency and stability of banking functions. The basic thrust of the paper is that it is effective to utilize market mechanisms to improve the efficiency of banking functions and that public intervention is justified in coping with various market failures if optimality is satisfied. Here, market failure is taken to mean (1) information asymmetry between banks and creditors (especially small-lot depositors) and (2) any negative externality that illiquidity and insolvency transmit in a networked way to other banks, leading to the likely emergence of various risks such as (a) small-lot depositors bearing losses, (b) the collapse of solvent banks due to a liquidity shortage, (c) the spreading by contagion of illiquidity of banks, and (d) the spreading by contagion of insolvency of banks. In examining public intervention to cope with these risks, we conclude that a deposit insurance system with a variable premium and prompt closure action are effective in dealing with risk (a), that the invocation of the central bank's lender of last resort function is effective for risks (b) and (c), and that the introduction of a charge system to internalize externality is effective for risk (d). Arguments in this paper are conceptual in that they are derived based on certain assumptions with respect to entities related to the banking system, and thus do not exhaustively cover all the factors necessary for deciding actual policies. We hope that our conceptual summary provides grounds for future discussions on more specific system design.