THE GOVERNMENT SAFETY NET:Supervision and Examination

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Money & Banking MGT411

Lesson 29

THE GOVERNMENT SAFETY NET

There are three reasons for the government to get involved in the financial system

To protect investors

To protect bank customers from monopolistic exploitation

To ensure the stability of the financial system

Investor Protection

Small investors are unable to judge the soundness of financial institutions

In practice only force of law ensure the bank's integrity, thus investors rely on government to

protect them from mismanagement and malfeasance

Protection from monopolistic exploitation

Monopolists exploit their customers by raising prices to earn unwarranted profits

Government intervenes to prevent firms in an industry from becoming too large. The same may

apply to banks as well

Stability of financial system

Liquidity risk and information asymmetry indicate the instability of financial system

Financial institution can create and destroy the value of its assets in a very short period, and a

single firm's failure can bring down the whole system

Government officials employ a combination of strategies to protect investors and ensure the

stability of the financial system

They provide the safety net to insure small depositors

They operate as the lender of last resort

The Unique Role of Depository Institutions

Depository institutions receive a disproportionate amount of attention from government

regulators because

They play a central role in the economy

They face a unique set of problems

We all rely heavily on banks for access to the payments system

Banks are also prone to runs, as they hold illiquid assets to back their liquid liabilities,

promising full and constant value to the depositors based on assets of uncertain value

They are linked to each other both on their balance sheets and in their customers' minds;

This interconnectedness of banks is almost unique to the financial industry

The Government as Lender of Last Resort

The best way to stop a bank failure from turning into a panic is to make sure solvent institutions

can meet their depositors' withdrawal demands

The existence of a lender of last resort significantly reduces, but does not eliminate, contagion

For the system to work, central bank officials who approve the loan applications must be able to

distinguish an illiquid from an insolvent institution

It is important for a lender of last resort to operate in a manner that minimizes the tendency for

bankers to take too much risk in their operations

Problems Created by the Government Safety Net

Protected depositors have no incentive to monitor their banks' behavior, and knowing this,

banks take on more risk than they would normally

In protecting depositors the government creates moral hazard

Some banks are too big to fail, meaning that their failure would cause havoc in the financial

system.

The managers of such institutions know that if they begin to founder the government will have

to bail them out

The too-big-to-fail policy limits the extent of the market discipline that depositors can impose

on banks and compounds the moral hazard problem

Money & Banking MGT411

Regulation and Supervision of the Financial System

Government officials employ three strategies to ensure that the risks created by the safety net

are contained:

Regulation establishes rules for bank managers to follow,

Supervision provides general oversight of financial institutions,

Examination provides detailed information on the firms' operations

Regulatory requirements are designed to minimize the cost of failures to the tax-paying public

One example of regulation is the requirement that banks obtain a charter in order to operate;

This provides screening to make sure that the people who own and run banks will not be

criminals.

Once a bank is operating other regulations control the assets, the amount of capital, and makes

information about the bank's balance sheet public

Government supervisors enforce the regulations;

They monitor, inspect, and examine banks to make sure that their business practices conform to

regulatory requirements

State Bank of Pakistan (SBP) is supreme regulatory authority for banking sector in Pakistan

www.sbp.org.pk

Asset Holding Restrictions and Minimum Capital

Requirements

The simplest way to prevent bankers from exploiting their safety net is to restrict banks' balance

sheets;

This can be through restrictions on the kinds of assets banks can hold and requirements that they

maintain minimum levels of capital

The size of the loans a bank can make to particular borrowers is also limited

Minimum capital requirements complement these limitations on bank assets

Capital serves as a cushion against declines in the value of the bank's assets, lowering the

likelihood of the bank's failure, and is a way to reduce the problem of moral hazard

Capital requirements take two basic forms:

The first requires banks to keep their ratio of capital to assets above some minimum level

regardless of the structure of their balance sheets;

The second requires banks to hold capital in proportion to the riskiness of their operations

Banks must provide information to the financial markets about their balance sheets;

Supervision and Examination

The government enforces banking rules and regulations through an elaborate oversight process

called supervision, which relies on a combination of monitoring and inspection

Supervision is done remotely, through an examination of the detailed reports banks must

submit, as well as through on-site examination

At the largest institutions, examiners are on site all the time; this is called continuous

examination

The most important part of a bank examination is the evaluation of past-due loans, to see if they

should be declared in default

Supervisors use the acronym CAMELS to describe the criteria used to evaluate the health of the

bank:

Capital adequacy,

Asset quality,

Management,

Earnings,

Liquidity,

Sensitivity to risk

Current practice is for examiners to act as consultants to banks, advising them on how to get the

highest return possible while keeping risk at an acceptable level that ensures the bank will stay

in business

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