Regulation as the provider of incentives/disincentives

Arguments Presented - While Butterworth is of the opinion that the regulatory system not only allowed
but actually provided banks incentives for risk-taking and capital accumulation (which was then to be
diverted towards risky assets). One of the instruments which facilitated this was risk-insensitive Deposit
Insurance Scheme. The policies led to moral hazard problems as banks found these lucrative options to
indulge in high-risk investments in turn raising the cost of capital. While Butterworth finds it imperative
to continue with the Glass-Stegall Act which separates the commercial banks from the investment banks,
Appleton is of the opinion that to do away with the act would be a blessing, as all the banks would be on
the same level playing field. Butterworth pointed out the fact that the regulators did not do their jobs they
were supposed to do, by ignoring the S&L which had negative economic worth (and not asking them to
liquidate them), which resulted in failure of many of them. Appleton blamed the uncertainty in the
regulations for the rising non-diversifiable risk and hence the cost of capital which in turn forced banks to
go for much riskier instruments like Swaps and Securitization.
Theory learnt in the class in context of the above argument - The regulations are formed to prevent
failure of banks. The regulating institutions are there to help banks with liquidity problems but not
solvency issues. Hence they are not supposed to provide incentives to banks for taking disproportionate
risks that may create mistrust among depositors and aggravate those problems. Improper rate settlements,
pricing are to be watched over by regulators (for e.g. by means of disincentives of penal interests) which
they clearly failed during S&L crisis as banks indulged in attracting depositors by giving them higher
interest rates.
Deposit Insurance and Capital Maintenance requirements
Arguments Presented - Deposit Insurance according to Butterworth was actually an incentive for banks
to indulge in excessive risk-taking as the nature of insurance was risk-insensitive. At the same time he
believed that a risk-sensitive Deposit Insurance Scheme may be practically impossible to implement in
the first place. Butterworth reasserted that contingent liabilities were not accounted by Deposit Insurance
which further increased the unforeseen exposure. When moderator asked why not no Deposit Insurance at
all, Butterworth pointed out that it is one of the best ways to help during bank runs.
For Capital Maintenance requirements, Moderator pointed out to the hierarchy of capital requirements
which would ensure only the well capitalized banks to participate, however Appleton found some of the
requirements of the BIS stringent as they required Capital Maintenance against Off-Balance Sheet items.
Then they went on to discuss about funding of various assets, whether they should be done via capital or
securitization.
Theory learnt in the class in context of the above argument - Deposit Insurance should not lead to
moral hazard behavior, however risk-sensitive insurance may lead to demarcation of struggling banks
which may aggravate their problems resulting in their failures as their depositors would start money after
identifying them. But it definitely needs to keep a watch on off-balance sheet items while the insurance is
provided. Capital Maintenance is required so that they can honor withdrawals even if they sustain
operating losses (and their financial leverage is under control). The Capital requirements are usually as a
percentage of their risk-weighted assets, and hence it is important that it accounts for different risks banks
undergo and the unforeseen risk of contingent liabilities. The hierarchy of capital is also important for
segregating and matching of capital with different types of risks.