Chapter 10:

Bank Regulation
 ❖ Bank run
▪ A bank run is defined as sudden, large withdrawals by depositors who lose
confidence in a bank
▪ The risk of a bank run is an extreme form of liquidity risk, the risk that a bank
will have trouble meeting demands for withdrawals.
▪ It runs out of liquid assets and cannot borrow enough to cover all the
withdrawals. The bank is forced to sell its loans at fire-sale prices, reducing its
capital. If the bank loses enough, capital falls below zero: the run causes
insolvency.

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How Bank Runs Happen
• Suppose someone starts a rumor that a bank has lost money and become insolvent.
This rumor is totally false.
• However, depositors hear the rumor and worry that it might be true. Some decide to
play it safe and withdraw their funds Suddenly, there are lots of withdrawals: a run
does occur. Ultimately, the bank is forced into a fire sale of assets, and its capital is
driven below zero.
• If people expect stock prices to fall, then they sell stocks, causing prices to fall. Bank
runs are the same kind of event: if people expect a run, then a run occurs. This can
happen even if nothing is wrong at the bank before the run.

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..cont’d
• In case of a plausible bank run, the bank cannot borrow from other banks
because of the threat to the bank’s solvency.

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Suspension of Payments
▪ A bank run often leads to a suspension of payments. Overwhelmed by the demand
for withdrawals, a bank announces that it will not allow them. A depositor who
shows up at the bank finds the doors closed.
▪ Suspension of payments can end a run in two ways. First, it can help change the
self-fulfilling psychology of the run. While the bank is closed, depositors have a
chance to calm down. They can check that the bank is solvent and realize there’s
no good reason to withdraw their money.
▪ Second, the suspension gives the bank a chance to increase its liquid assets. It
may be able to borrow from other banks. With a little time, it may find buyers for
its loans that pay what the loans are worth, not fire-sale prices. With a high level
of liquid assets, the bank can meet demands for withdrawals when it reopens.

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Bank Panics
• Sometimes runs occur simultaneously at many individual banks. People lose
confidence in the whole banking system, and depositors everywhere try to
withdraw their money. This event is called a bank panic.
• Nationwide bank panics were once common in the United States. Between 1873
and 1933, the country experienced an average of three panics per decade. Bank
panics occur because a loss of confidence is contagious. A run at one bank triggers
runs at others, which trigger runs at others, and so on.

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 ❖ DEPOSIT INSURANCE
▪ Deposit insurance is the government’s guarantee to compensate depositors for
their losses when a bank fails.
▪ In our previous example of “How bank runs happen”, insurance would pay off
the last $20 in deposits after the bank runs out of assets.
▪ In addition to protecting depositors when bank failures occur, insurance makes
failures less likely. This effect arises because insurance eliminates bank runs, a
major cause of failures.

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 ❖ MORAL HAZARD AGAIN

▪ Banking creates a problem of moral hazard: bankers have incentives to misuse

deposits. Bankers may take excessive risks, or they may simply steal money, as
happened at the First National Bank of Keystone.
▪ Deposit insurance exacerbates moral hazard because it reduces depositors’
incentives to monitor banks. Because of this effect, governments limit the
coverage of deposit insurance.
▪ Some research suggests that deposit insurance makes banking crises more likely,
at least in countries with weak bank supervision.

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 ❖ RESTRICTIONS ON BALANCE SHEETS
After a bank receives a charter, regulators restrict its activities in many ways. One
set of regulations concerns the assets that banks are allowed to hold on their balance
sheets. Other regulations mandate minimum levels of capital that banks must hold.
All these rules are meant to reduce moral hazard and the risk of insolvency.

➢Restrictions on Assets:
• Banks can choose among a variety of assets, including safe assets with relatively
low returns and riskier assets with high returns. Banks have incentives to take on
too much risk because the costs that might result are paid partly by depositors or
the deposit insurance fund. To address this problem, regulators restrict the assets
that banks can hold.
• The goal is to reduce the risk of large losses. To this end, lending must be
diversified: no single loan can be too large.
• In our country, loans to one borrower cannot exceed 25%(Funded+Non funded) of
the bank’s capital
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 ….(Cont’d)
➢Capital Requirements:
When a bank chooses its level of capital, it faces a trade-off. Lower capital raises
the return on equity but it also raises the bank’s insolvency risk. This trade-off
creates moral hazard. Regulators address this problem by imposing capital
requirements. These rules mandate minimum levels of capital that banks must
hold. Required capital is set high enough to keep insolvency risk low.

▪ The Basel Accord:

According to Basel 3, Bank must maintain capital (Tier 1 and Tier 2) equal to at
least 10.5% of their risk-weighted assets including capital conservation buffer.
This ensures banks hold a certain amount of capital to meet obligations.

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Brief History of Basel Accords

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BASEL Accords in Bangladesh

To ensure smooth transition to Basel III, appropriate transitional arrangements

have been provided for meeting the minimum Basel III capital ratios, full
regulatory adjustments to the components of capital etc. Consequently, Basel III
capital regulations have been fully implemented as on January 1, 2019.

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 ❖SUPERVISION
• Another element of government regulation is bank supervision, or monitoring of banks’
activities. The agency that regulates a bank checks that the bank is meeting capital
requirements and obeying restrictions on asset holdings. Regulators also make more
subjective assessments of the bank’s insolvency risk. If they perceive too much risk,
they demand changes in the bank’s operations.
• Information gathering: Regulators gather information by call reports and bank
examinations.
✓ Call report: Quarterly financial statement, including a balance sheet and income
statement, that banks must submit to regulators as part of bank supervision.
Regulators examine call reports for signs of trouble, such as declining capital,
increases in risky assets
✓ Bank examination: Visit by regulators to a bank’s headquarters to gather information
on the bank’s activities; part of bank supervision. Every bank is visited at least once a
year, more often if regulators suspect problems based on call reports or past exams.
Examiners sometimes arrive without warning, making it harder for banks to hide
questionable activities.
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….(Cont’d)
CAMELS Ratings: Evaluations by regulators of a bank’s insolvency risk based on its
capital, asset quality, management, earnings, liquidity, and sensitivity.

Capital: A bank’s examiners check that it is meeting the capital requirements. They also
make a more subjective assessment of whether the bank has enough capital given the
risks it faces. They look for signs that the bank will lose capital in the future. A bank’s
rating can fall, for example, if it is paying large dividends to shareholders, as these
deplete capital

Asset quality: Examiners gauge the riskiness of a bank’s assets, especially default risk on
loans. They select a sample of loans and gather information on the borrowers, such as
their credit histories and current financial situation, to judge the likelihood of default. In
addition to reviewing specific loans, examiners consider a bank’s general policies for loan
approval. They evaluate whether these policies are effective at screening out risky
borrowers. They also check whether the bank follows its stated policies or makes
exceptions

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….(Cont’d)
• Management: Examiners try to evaluate the competence and honesty of bank
managers. This is important because many bank failures result from flawed
management.
• Earnings: Examiners look at a bank’s current earnings and try to project future
earnings. High earnings raise the bank’s capital over time, reducing insolvency risk.
• Liquidity: Examiners evaluate a bank’s liquidity risk—the risk that it will have
difficulty meeting demands for withdrawals.
• Sensitivity: This means sensitivity to interest rates and asset prices—in other words,
interest-rate risk and market risk. Examiners look for activities that could produce
large losses if asset prices move in an unexpected direction. One example is excessive
speculation with derivatives.

If a bank’s overall CAMELS rating is 1 or 2, regulators leave it alone until its next
examination. If the rating is 3 or worse, regulators require the bank to take action to
reduce risk and improve its score. Regulators can either negotiate an agreement with
the bank or issue a unilateral order.
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Thank you!

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