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The Foundations of Banks' Risk Regulation: a Review of the Literature

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  • Georges Dionne

Abstract

The stability of the banking industry around the world has been observed as periodical since the Great Depression. Financial markets have changed dramatically over the last twenty-five years, introducing more competition for and from banks. Banks are the financial institutions responsible for providing liquidity to the economy. This responsibility is, however, the main cause of their fragility. Deposit insurance is the most efficient instrument for protecting depositors and for preventing bank runs. Pricing deposit insurance according to the individual bank's risk seems to be the most appropriate strategy but it does not seem to be sufficient in the sense that it seems to remain residual information problems in the market, although there is no appropriate statistical analysis on this issue. In 1988, the G10 modified banking regulation significantly by setting capital standards for international banks. These standards have now been adopted by more than one hundred countries as part of their national regulation of banks' risk. Current regulation of bank capital adequacy has its critics because it imposes the same rules on all banks. This seems particularly unsuitable when applied to credit risk which is the major source of a bank's risk (about 70%). Moreover, diversification of a bank's credit-risk portfolio is not taken into account in the computation of capital ratios. These shortcomings seem to have distorted the behaviour of banks and this makes it much more complicated to monitor them. In fact, it is not even clear that the higher capital ratios observed since the introduction of this new form of capital regulation necessarily lower risks. Additional reform is expected in 2004, but there is as yet no consensus on othe form it will take nor on whether it will suitably regulate banks in individual countries. Consequently, it might be appropriate to continue developing national regualtion based on optimal deposit insurance (with individual insurance pricing and continuous auditing on individual risk) and to keep searching for other optimal complementary instruments for use against systemic risk, instruments suitably designed to fit the banking industry's peculiar structure. Other market discipline (such as subordinated debt) and governance instruments may be more efficient than the current capital requirement scheme for the banks' commitment problem associated to deposit insurance. The central bank should be responsible for aggregate liquidity. Confidence inthe financial sector is a public good that must be ensured by the government. Who should be in charge: the central bank or a regulatory agency? The revised literature seems to say that this role should be taken by a regulatory agency independent fromthe central bank and independent from the political power.

Suggested Citation

  • Georges Dionne, 2003. "The Foundations of Banks' Risk Regulation: a Review of the Literature," Cahiers de recherche 0346, CIRPEE.
  • Handle: RePEc:lvl:lacicr:0346
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    References listed on IDEAS

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    1. MacDonald, James M. & Nelson, Paul Jr., 1991. "Do the poor still pay more? Food price variations in large metropolitan areas," Journal of Urban Economics, Elsevier, vol. 30(3), pages 344-359, November.
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    3. Glazer, Amihai, 1981. "Advertising, Information, and Prices-A Case Study," Economic Inquiry, Western Economic Association International, vol. 19(4), pages 661-671, October.
    4. Alcaly, Roger E & Klevorick, Alvin K, 1971. "Food Prices in Relation to Income Levels in New York City," The Journal of Business, University of Chicago Press, vol. 44(4), pages 380-397, October.
    5. Parke E. Wilde & Christine K. Ranney, 2000. "The Monthly Food Stamp Cycle: Shooping Frequency and Food Intake Decisions in an Endogenous Switching Regression Framework," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 82(1), pages 200-213.
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    Cited by:

    1. Benjamin Lorent, 2006. "Raisons fondamentales d'une régulation prudentielle du secteur des assurances," Brussels Economic Review, ULB -- Universite Libre de Bruxelles, vol. 49(3), pages 203-244.
    2. Ralf Bebenroth & Diemo Dietrich & Uwe Vollmer, 2009. "Bank regulation and supervision in bank-dominated financial systems: a comparison between Japan and Germany," European Journal of Law and Economics, Springer, vol. 27(2), pages 177-209, April.
    3. Dionne, Georges & Harchaoui, Tarek, 2007. "Bank Capital, Securitization and Credit Risk: an Empirical Evidence," MPRA Paper 56693, University Library of Munich, Germany, revised 2007.
    4. Etienne Wasmer, 2009. "Links between labor supply and unemployment: theory and empirics," Journal of Population Economics, Springer;European Society for Population Economics, pages 773-802.
    5. Georges Dionne, 2013. "Risk Management: History, Definition, and Critique," Risk Management and Insurance Review, American Risk and Insurance Association, vol. 16(2), pages 147-166, September.
    6. J. Cummins & Georges Dionne & Robert Gagné & A. Nouira, 2009. "Efficiency of insurance firms with endogenous risk management and financial intermediation activities," Journal of Productivity Analysis, Springer, pages 145-159.

    More about this item

    Keywords

    Bank; liquidity; deposit insurance; capital standard; national regulation; credit risk; capital regulation; subordinated debt; governance; capital requirement; central bank; regulatory agency;

    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation

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