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

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.