Micro and macro prudential regulation

Micro prudential regulation concerns itself with the stability of each individual institution. Macro-prudential
regulation concerns itself with the stability of the financial system as a whole. Micro-prudential regulation examines
the responses of an individual bank to exogenous risks. By construction it does not incorporate endogenous risk. It
also ignores the systemic importance of individual institutions depending on such factors as size, degree of
leverage and interconnectedness with the rest of the system.
One of the key purposes of macro-regulation is to act as a countervailing force to the natural decline in
measured risks in a boom and the subsequent rise in measured risks in the subsequent collapse. This
has to be rule-based, or at least supervisory discretion needs to be more constrained. Supervisors currently have
plenty of discretion, but they find it hard to utilize it because of the politics of booms when all seems well, and
lenders, borrowers, politicians and the media are all basking in the rosy glow of apparent success.
Micro The term microprudential regulation or microprudential supervision refers to firm-level oversight
or financial regulation by regulators of financial institutions, "ensuring the balance sheets of individual institutions
are robust to shocks". The motivation for micro-prudential regulation is rooted in consumer protection:
ensuring solvency of financial institutions strengthens consumer confidence in the individual firms and the financial
system as a whole. In addition, if a large number of financial firms fail at the same time, this can disrupt the overall
financial system. Therefore, micro-prudential regulation also reduces systemic risk.
Micro-prudential regulation involves enforcing standards, e.g. the Basel III global regulatory standards for bank
capital adequacy, leverage ratios and liquidity.
Macro The term macroprudential regulation characterizes the approach to financial regulation aimed to
mitigate the risk of the financial system as a whole (or "systemic risk"). In the aftermath of the late-2000s financial
crisis, there is a growing consensus among policymakers and economic researchers about the need to re-orient the
regulatory framework towards a macroprudential perspective.
As documented by Clement (2010), the term "macroprudential" was first used in the late 1970s in unpublished
documents of the Cooke Committee (the precursor of the Basel Committee on Banking Supervision) and the Bank
of England.[1] But only in the early 2000safter two decades of recurrent financial crises in industrial and, most
often, emerging market countries[2]did the macroprudential approach to the regulatory and supervisory
framework become increasingly promoted, especially by authorities of the Bank for International Settlements. A
wider agreement on its relevance has been reached as a result of the late-2000s financial crisis.

Objectives and justification[edit]

The main goal of macroprudential regulation is to reduce the risk and the macroeconomic costs of financial
instability. It is recognized as a necessary ingredient to fill the gap between macroeconomic policy and
the traditional microprudential regulation of financial institutions (Bank of England, 2009).[3]
Macroprudential vs microprudential regulation[edit]
Following Borio (2003), the macro- and microprudential perspectives differ in terms of their objectives and
understanding on the nature of risk.[4] Traditional microprudential regulation seeks to enhance the safety and
soundness of individual financial institutions, as opposed to the macroprudential view which focuses on welfare of
the financial system as a whole. Further, risk is taken as exogenous under the microprudential perspective, in the
sense of assuming that any potential shock triggering a financial crisis has its origin beyond the behavior of the
financial system. The macroprudential approach, on the other hand, recognizes that risk factors may configure
endogenously, i.e., as a systemic phenomenon. In line with this reasoning, macroprudential policy addresses the
interconnectedness of individual financial institutions and markets, as well as their common exposure to economic
risk factors. It also focuses on the procyclical behavior of the financial system in the effort to foster its stability.

Theoretical rationale[edit]

On theoretical grounds, it has been argued that a reform of prudential regulation should integrate three different
paradigms:[5] the agency paradigm, the externalities paradigm, and the mood swings paradigm. The role
of macroprudential regulation is particularly stressed by the last two of them.
The agency paradigm highlights the importance of principalagent problems. Principal-agent risk arises from the
separation of ownership and control over an institution which may drive behaviors by the agents in control which
would not be in the best interest of the principals (owners). The main argument is that in its role of lender of last
resort and provider of deposit insurance, the government alters the incentives of banks to undertake risks. This is a
manifestation of the principal-agent problem known as moral hazard. More concretely, the coexistence of deposit
insurances and insufficiently regulated bank portfolios induces financial institutions to take excessive risks. [6] This
paradigm, however, assumes that risk arises from individual malfeasance, and hence it is at odds with the
emphasis on the system as a whole which characterizes the macroprudential approach.
In the externalities paradigm, the key concept is called pecuniary externality. This is defined as an externality that
arises when one economic agent's action affects the welfare of another agent through effects on prices. As argued
by Greenwald and Stiglitz (1986),[7] when there are distortions in the economy (such as incomplete markets or
imperfect information),[8] policy intervention can make everyone better off in a Pareto efficiency sense. Indeed, a
number of authors have shown that when agents face borrowing constraints or other sorts of financial frictions,
pecuniary externalities arise and different distortions appear, such as overborrowing, excessive risk-taking, and
excessive levels of short-term debt.[9] In these environments macroprudential intervention can improve social
efficiency. An International Monetary Fund policy study argues that risk externalities between financial institutions
and from them to the real economy are market failures that justify macroprudential regulation. [10]
In the mood swings paradigm, animal spirits (Keynes) critically influence the behavior of financial institutions'
managers, causing excess of optimism in good times and sudden risk retrenchment on the way down. As a result,
pricing signals in financial markets may be inefficient, increasing the likelihood of systemic trouble. A role for a
forward-looking macroprudential supervisor, moderating uncertainty and alert to the risks of financial innovation, is
therefore justified.
Indicators of systemic risk[edit]
In order to measure systemic risk, macroprudential regulation relies on several indicators. As mentioned in Borio
(2003),[11] an important distinction is between measuring contributions to risk of individual institutions (the crosssectional dimension) and measuring the evolution (i.e. procyclicality) of systemic risk through time (the time
dimension).
The cross-sectional dimension of risk can be monitored by tracking balance sheet informationtotal assets and
their composition, liability (financial accounting) and capital structureas well as the value of the institutions'
trading securities and securities available for sale. Additionally, other sophisticated financial tools and models have
been developed to assess the interconectedness across intermediaries (such as CoVaR), [12] and each institution's
contribution to systemic risk (identified as "Marginal Expected Shortfall" in Acharya et al., 2011). [13]
To address the time dimension of risk, a wide set of variables are typically used, for instance: ratio of credit to GDP,
real asset prices, ratio of non-core to core liabilities of the banking sector, and monetary aggregates. Some early
warning indicators have been developed encompassing these and other pieces of financial data (see, e.g., Borio
and Drehmann, 2009).[14] Furthermore, macro stress tests are employed to identify vulnerabilities in the wake of a
simulated adverse outcome.
Macroprudential tools[edit]
A large number of instruments have been proposed; [15] however, there is no agreement about which one should
play the primary role in the implementation of macroprudential policy.
Most of these instruments are aimed to prevent the procyclicality of the financial system on the asset and liability
sides, such as:

Cap on loan-to-value ratio and loan loss provisions

Cap on debt-to-income ratio

The following tools serve the same purpose, but additional specific functions have been attributed to them, as
noted below:

Countercyclical capital requirement - to avoid excessive balance-sheet shrinkage from banks in trouble.

Cap on leverage (finance) - to limit asset growth by tying banks' assets to their equity (finance).

Levy on non-core liabilities - to mitigate pricing distorsions that cause excessive asset growth.

Time-varying reserve requirement - as a means to control capital flows with prudential purposes, especially
for emerging economies.

To prevent the accumulation of excessive short-term debt:

Liquidity coverage ratio

Liquidity risk charges that penalize short-term funding

Capital requirement surcharges proportional to size of maturity mismatch

Minimum haircut requirements on asset-backed securities

In addition, different types of contingent capital instruments (e.g., "contingent convertibles" and "capital
insurance") have been proposed to facilitate bank's recapitalization in a crisis event.). [16] [17]
Implementation in Basel III[edit]
Several aspects of Basel III reflect a macroprudential approach to financial regulation. [18] Indeed, the Basel
Committee on Banking Supervision acknowledges the systemic significance of financial institutions in the rules
text. More concretely, under Basel III banks' capital requirements have been strengthened and
new liquidity requirements, a leverage cap and a countercyclical capital buffer have been introduced. Also, the
largest and most globally active banks are required to hold more and higher-quality capital, which is consistent
with the cross-section approach to systemic risk.

Effectiveness of macroprudential tools[edit]

For the case of Spain, Saurina (2009) argues that dynamic loan loss provisions (introduced in July 2000) are helpful
to deal with procyclicality in banking, as banks are able to build up buffers for bad times. [19]
Using data from the UK, Aiyar et al. (2012) find that unregulated banks in the UK have been able to partially offset
changes in credit supply induced by time-varying minimum capital requirements over regulated banks. Hence, they
infer a potentially substantial "leakage" of macroprudential regulation of bank capital. [20]
For emerging markets, several central banks have applied macroprudential policies (e.g., use of reserve
requirements) at least since the aftermath of the1997 Asian financial crisis and the 1998 Russian financial crisis.
Most of these central banks' authorities consider that such tools effectively contributed to the resilience of their
domestic financial systems in the wake of the late-2000s financial crisis.[21]
Costs of macroprudential regulation[edit]
There is available theoretical and empirical evidence on the positive effect of finance on long-term economic
growth. Accordingly, concerns have been raised about the impact of macroprudential policies on the dynamism of
financial markets and, in turn, on investment and economic growth. Popov and Smets (2012)[22] thus recommend
that macroprudential tools be employed more forcefully during costly booms driven by overborrowing, targeting
the sources of externalities but preserving the positive contribution of financial markets to growth.
In analyzing the costs of higher capital requirements implied by a macroprudential approach, Hanson et al. (2011)
[23]
report that the long-run effects on loan rates for borrowers should be quantitatively small. [24]
Some theoretical studies indicate that macroprudential policies may have a positive contribution to long-run
average growth. Jeanne and Korinek (2011),[25]for instance, show that in a model with externalities of crises that
occur under financial liberalization, well-designed macroprudential regulation both reduces crisis risk and increases
long-run growth as it mitigates the cycles of boom and bust.
Institutional aspects[edit]
The macroprudential supervisory authority may be given to a single entity, existing (such as central banks) or new,
or be a shared responsibility among different institutions (e.g., monetary and fiscal authorities). Illustratively, the
management of systemic risk in the United States is centralized in the Financial Stability Oversight Council (FSOC),
established in 2010. It is chaired by the U.S. Secretary of the Treasury and its members include the Chairman of
theFederal Reserve System and all the principal U.S. regulatory bodies. In Europe, the task has also been assigned
since 2010 to a new body, the European Systemic Risk Board (ESRB), whose operations are supported by
the European Central Bank. Unlike its U.S. counterpart, the ESRB lacks direct enforcement power.

Role of central banks[edit]

In pursuing their goal of preserving price stability, central banks remain attentive to the evolution of real and
financial markets. Thus, a complementary relationship between macroprudential and monetary policy has been
advocated, even if the macroprudential supervisory authority is not given to the central bank itself. This is well
reflected by the organizational structure of institutions such as the Financial Stability Oversight
Council and European Systemic Risk Board, where central bankers have a decisive participation. The question of
whether monetary policy should directly counter financial imbalances remains more controversial, although it has
indeed been proposed as a tentative supplementary tool for addressing asset price bubbles.[26]
International dimension[edit]
On the international level, there are several potential sources of leakage and arbitrage from macroprudential
regulation, such as banks' lending via foreign branches and direct cross-border lending. [27] Also, as emerging
economies impose controls on capital flows with prudential purposes, other countries may suffer negative spillover
effects.[28] Therefore, global coordination of macroprudential policies is considered as necessary to foster their
effectiveness.

BASEL COMMITTEE ON BANKING SUPERVISION

The Basel Committee on Banking Supervision (BCBS)[1] is a committee of banking supervisory authorities that
was established by the central bankgovernors of the Group of Ten countries in 1975.[2] It provides a forum for
regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory
issues and improve the quality of banking supervision worldwide. The Committee frames guidelines and standards
in different areas - some of the better known among them are the international standards on capital adequacy, the
Core Principles for Effective Banking Supervision and the Concordat on cross-border banking supervision.
The purpose of BCBS is to encourage convergence toward common approaches and standards. The Committee is
not a classical multilateral organization, in part because it has no founding treaty. BCBS does not issue binding
regulation; rather, it functions as an informal forum in which policy solutions and standards are developed. [4]
The Basel Committee formulates broad supervisory standards and guidelines and recommends statements of best
practice in banking supervision (seebank regulation or "Basel III Accord", for example) in the expectation that
member authorities and other nations' authorities will take steps to implement them through their own national
systems.
Committee members come from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong
SAR, India, Indonesia, Italy, Japan,Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi
Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.
The Committee's Secretariat is located at the Bank for International Settlements (BIS) in Basel, Switzerland.
However, the BIS and the Basel Committee remain two distinct entities.
BASEL I
Basel I, that is, the 1988 Basel Accord, is primarily focused on credit risk and appropriate risk-weighting of assets.
Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of 0%
(for example cash, bullion, home country debt like Treasuries), 20% (securitisations such as mortgage-backed
securities (MBS) with the highest AAA rating), 50% (municipal revenue bonds, residential mortgages), 100% (for
example, most corporate debt), and some assets given No rating. Banks with an international presence are
required to hold capital equal to 8% of their risk-weighted assets (RWA).
The tier 1 capital ratio = tier 1 capital / all RWA
The total capital ratio = (tier 1 + tier 2 + tier 3 capital) / all RWA
Leverage ratio = total capital/average total assets
Banks are also required to report off-balance-sheet items such as letters of credit, unused commitments, and
derivatives. These all factor into the risk weighted assets. The report is typically submitted to the Federal Reserve
Bank as HC-R for the bank-holding company and submitted to the Office of the Comptroller of the Currency (OCC)
as RC-R for just the bank.
From 1988 this framework was progressively introduced in member countries of G-10, comprising 13 countries as
of
2013: Belgium, Canada, France,Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, Unit
ed Kingdom and the United States of America.
Over 100 other countries also adopted, at least in name, the principles prescribed under Basel I. The efficacy with
which the principles are enforced varies, even within nations of the Group.

BASEL II
Basel II is the second of the Basel Accords, (now extended and partially superseded[clarification needed] by Basel III),
which are recommendations on banking laws and regulations issued by the Basel Committee on Banking
Supervision.
Basel II, initially published in June 2004, was intended to amend international standards that controlled how much
capital banks need to hold to guard against the financial and operational risks banks face. These rules sought to
ensure that the greater the risk to which a bank is exposed, the greater the amount of capital the bank needs to
hold to safeguard its solvency and economic stability. Basel II attempted to accomplish this by establishing risk and
capital management requirements to ensure that a bank has adequate capital for the risk the bank exposes itself
to through its lending, investment and trading activities. One focus was to maintain sufficient consistency of
regulations so to limit competitive inequality amongst internationally active banks.
Basel II was implemented in the years prior to 2008, and was only to be implemented in early 2008 in most major
economies;[1][2][3] that year's Financial crisis intervened before Basel II could become fully effective. AsBasel III was
negotiated, the crisis was top of mind and accordingly more stringent standards were contemplated and quickly
adopted in some key countries including in Europe and the USA.
The final version aims at:
1. Ensuring that capital allocation is more risk sensitive;
2. Enhance disclosure requirements which would allow market participants to assess the capital adequacy of
an institution;
3. Ensuring that credit risk, operational risk and market risk are quantified based on data and formal
techniques;
4. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory
arbitrage.
While the final accord has at large addressed the regulatory arbitrage issue, there are still areas where
regulatory capital requirements will diverge from theeconomic capital.
The accord in operation: Three pillars
Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory
review and (3) market discipline.
The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar,
only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk
was not dealt with at all.
The first pillar: Minimum capital requirements
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a
bank faces: credit risk, operational risk, andmarket risk. Other risks are not considered fully quantifiable at this
stage.
1. The credit risk component can be calculated in three different ways of varying degree of sophistication,
namely standardized approach, Foundation IRB, Advanced IRB and General IB2 Restriction. IRB stands for
"Internal Rating-Based Approach".
2. For operational risk, there are three different approaches basic indicator approach or BIA, standardized
approach or TSA, and the internal measurement approach (an advanced form of which is the advanced
measurement approach or AMA).
3. For market risk the preferred approach is VaR (value at risk).
As the Basel II recommendations are phased in by the banking industry it will move from standardised
requirements to more refined and specific requirements that have been developed for each risk category by each
individual bank. The upside for banks that do develop their own bespoke risk measurement systems is that they
will be rewarded with potentially lower risk capital requirements. In the future there will be closer links between the
concepts of economic and regulatory capital.
The second pillar: Supervisory review
This is a regulatory response to the first pillar, giving regulators better 'tools' over those previously available. It
also provides a framework for dealing withsystemic risk, pension risk, concentration risk, strategic risk, reputational
risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. Banks can review their
risk management system.
The Internal Capital Adequacy Assessment Process (ICAAP) is a result of Pillar 2 of Basel II accords.
The third pillar: The Market Discipline

This pillar aims to complement the minimum capital requirements and supervisory review process by developing a
set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an
institution.
Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others,
including investors, analysts, customers, other banks, and rating agencies, which leads to good corporate
governance. The aim of Pillar 3 is to allow market discipline to operate by requiring institutions to disclose details
on the scope of application, capital, risk exposures, risk assessment processes, and the capital adequacy of the
institution. It must be consistent with how the senior management, including the board, assess and manage the
risks of the institution.
When market participants have a sufficient understanding of a bank's activities and the controls it has in place to
manage its exposures, they are better able to distinguish between banking organizations so that they can reward
those that manage their risks prudently and penalize those that do not.
These disclosures are required to be made at least twice a year, except qualitative disclosures providing a
summary of the general risk management objectives and policies which can be made annually. Institutions are also
required to create a formal policy on what will be disclosed and controls around them along with the validation and
frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the
banking group to which the Basel II framework applies.

Basel II and the global financial crisis

The role of Basel II, both before and after the global financial crisis, has been discussed widely. While some argue
that the crisis demonstrated weaknesses in the framework, [3] others have criticized it for actually increasing the
effect of the crisis.[16] In response to the financial crisis, the Basel Committee on Banking Supervision published
revised global standards, popularly known as Basel III.[17] The Committee claimed that the new standards would
lead to a better quality of capital, increased coverage of risk for capital market activities and better liquidity
standards among other benefits.
Nout Wellink, former Chairman of the BCBS, wrote an article in September 2009 outlining some of the strategic
responses which the Committee should take as response to the crisis. [18] He proposed a stronger regulatory
framework which comprises five key components: (a) better quality of regulatory capital, (b) better liquidity
management and supervision, (c) better risk management and supervision including enhanced Pillar 2 guidelines,
(d) enhanced Pillar 3 disclosures related to securitization, off-balance sheet exposures and trading activities which
would promote transparency, and (e) cross-border supervisory cooperation. Given one of the major factors which
drove the crisis was the evaporation of liquidity in the financial markets, [19] the BCBS also published principles for
better liquidity management and supervision in September 2008. [20]
A recent OECD study[21] suggest that bank regulation based on the Basel accords encourage unconventional
business practices and contributed to or even reinforced adverse systemic shocks that materialised during the
financial crisis. According to the study, capital regulation based on risk-weighted assets encourages innovation
designed to circumvent regulatory requirements and shifts banks' focus away from their core economic functions.
Tighter capital requirements based on risk-weighted assets, introduced in the Basel III, may further contribute to
these skewed incentives. New liquidity regulation, notwithstanding its good intentions, is another likely candidate
to increase bank incentives to exploit regulation.
Think-tanks such as the World Pensions Council (WPC) have also argued that European legislators have pushed
dogmatically and naively for the adoption of the Basel II recommendations, adopted in 2005, transposed in
European Union law through the Capital Requirements Directive (CRD), effective since 2008. In essence, they
forced private banks, central banks, and bank regulators to rely more on assessments of credit risk by private
rating agencies. Thus, part of the regulatory authority was abdicated in favor of private rating agencies. [22]

BASEL III
Basel III (or the Third Basel Accord) is a global, voluntary regulatory framework on bank capital adequacy,stress
testing, and market liquidity risk. It was agreed upon by the members of the Basel Committee on Banking
Supervision in 201011, and was scheduled to be introduced from 2013 until 2015; however, changes from 1 April
2013 extended implementation until 31 March 2018 and again extended to 31 March 2019. [1][2]The third installment
of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial
regulation revealed by the financial crisis of 200708. Basel III is intended to strengthen bankcapital
requirements by increasing bank liquidity and decreasing bank leverage.
Unlike Basel I and Basel II, which focus primarily on the level of bank loss reserves that banks are required to hold,
Basel III focuses primarily on the risk of a run on the bank, requiring differing levels of reserves for different
forms of bank deposits and other borrowings. Therefore, Basel III does not, for the most part, supersede the
guidelines known as Basel I and Basel II; rather, it will work alongside them.

Key principles
Capital requirements[edit]
The original Basel III rule from 2010 required banks to fund themselves with 4.5% of common equity (up from 2%
in Basel II) of risk-weighted assets(RWAs). Since 2015, a minimum Common Equity Tier 1 (CET1) ratio of 4.5% must
be maintained at all times by the bank.[3] This ratio is calculated as follows:
The minimum Tier 1 capital increases from 4% in Basel II to 6%,[3] applicable in 2015, over RWAs.[4] This 6%
is composed of 4.5% of CET1, plus an extra 1.5% of Additional Tier 1 (AT1).
Furthermore, Basel III introduced two additional capital buffers:

A mandatory "capital conservation buffer", equivalent to 2.5% of risk-weighted assets. Considering the
4.5% CET1 capital ratio required, banks have to hold a total of 7% CET1 capital, from 2019 onwards.

A "discretionary counter-cyclical buffer", allowing national regulators to require up to an additional 2.5% of

capital during periods of high credit growth. The level of this buffer ranges between 0% and 2.5% of RWA
and must be met by CET1 capital.

Leverage ratio
Basel III introduced a minimum "leverage ratio". This is a non-risk-based leverage ratio and is calculated by
dividing Tier 1 capital by the bank's average total consolidated assets (sum of the exposures of all assets and
non-balance sheet items).[5][6] The banks are expected to maintain a leverage ratio in excess of 3% under Basel
III.
In July 2013, the U.S. Federal Reserve announced that the minimum Basel III leverage ratio would be 6%
for 8 Systemically important financial institution(SIFI) banks and 5% for their insured bank holding
companies.[7]
Liquidity requirements
Basel III introduced two required liquidity ratios. [8]

The "Liquidity Coverage Ratio" was supposed to require a bank to hold sufficient high-quality liquid
assets to cover its total net cash outflows over 30 days. Mathematically it is expressed as follows:

The Net Stable Funding Ratio was to require the available amount of stable funding to exceed the
required amount of stable funding over a one-year period of extended stress. [9]

Analysis of Basel III impact

In the United States higher capital requirements resulted in contractions in trading operations and the number of
personnel employed on trading floors.[28]
Macroeconomic impact
An OECD study released on 17 February 2011, estimated that the medium-term impact of Basel III implementation
on GDP growth would be in the range of 0.05% to 0.15% per year. [29] Economic output would be mainly affected
by an increase in bank lending spreads, as banks pass a rise in bank funding costs, due to higher capital
requirements, to their customers. To meet the capital requirements originally effective in 2015 banks were
estimated to increase their lending spreads on average by about 15 basis points. Capital requirements effective as
of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by
about 50 basis points.[30] The estimated effects on GDP growth assume no active response from monetary policy. To
the extent that monetary policy would no longer be constrained by the zero lower bound, the Basel III impact on
economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to
80 basis points.[29]
Criticism
Think tanks such as the World Pensions Council have argued that Basel III merely builds on and further expands the
existing Basel II regulatory base without fundamentally questioning its core tenets, notably the ever-growing
reliance on standardized assessments of "credit risk" marketed by two private sector agencies- Moody's and S&P,
thus using public policy to strengthen anti-competitive duopolistic practices.[31][32] The conflicted and unreliable
credit ratings of these agencies is generally seen as a major contributor to the US housing bubble.
Opaque treatment of all derivatives contracts is also criticized. While institutions have many legitimate ("hedging",
"insurance") risk reduction reasons to deal in derivatives, the Basel III accords:

treat insurance buyers and sellers equally even though sellers take on more concentrated risks (literally
purchasing them) which they are then expected to offset correctly without regulation
do not require organizations to investigate correlations of all internal risks they own

do not tax or charge institutions for the systematic or aggressive externalization or conflicted marketing of
risk - other than requiring an orderly unravelling of derivatives in a crisis and stricter record keeping

Since derivatives present major unknowns in a crisis these are seen as major failings by some critics [33] causing
several to claim that the "too big to fail" status remains with respect to major derivatives dealers who aggressively
took on risk of an event they did not believe would happen - but did. As Basel III does not absolutely require
extreme scenarios that management flatly rejects to be included in stress testing this remains a
vulnerability. Standardized external auditing and modelling is an issue proposed to be addressed in Basel
4 however.
A few critics argue that capitalization regulation is inherently fruitless due to these and similar problems and despite an opposite ideological view of regulation - agree that "too big to fail" persists. [34]
Basel III has been criticized similarly for its paper burden and risk inhibition by banks, organized in the Institute of
International Finance, an international association of global banks based in Washington, D.C., who argue that it
would "hurt" both their business and overall economic growth. Basel III was also criticized as negatively affecting
the stability of the financial system by increasing incentives of banks to game the regulatory framework.
[35]
The American Bankers Association,[36] community banks organized in the Independent Community Bankers of
America, and some of the most liberal Democrats in the U.S. Congress, including the entire Maryland congressional
delegation with Democratic Senators Ben Cardin and Barbara Mikulski and RepresentativesChris Van
Hollen and Elijah Cummings, voiced opposition to Basel III in their comments to the Federal Deposit Insurance
Corporation,[37] saying that the Basel III proposals, if implemented, would hurt small banks by increasing "their
capital holdings dramatically on mortgage and small business loans". [38]
Others[who?] have argued that Basel III did not go far enough to regulate banks as inadequate regulation was a cause
of the financial crisis.[39] However, these arguments should be examined closely, as Basel III was not in effect until
after the financial crisis occurred. On 6 January 2013 the global banking sector won a significant easing of Basel III
Rules, when the Basel Committee on Banking Supervision extended not only the implementation schedule to 2019,
but broadened the definition of liquid assets.[40]
The Background of the Basel norms: (Why it come into picture)
On 26 June 1974, a number of banks had released payment of Deutsche Marks (DEM - German Currency at that
time) to Herstatt ( Based out of Cologne, Germany) in Frankfurt in exchange for US Dollars (USD) that was to be
delivered in New York. Because of time-zone differences, Herstatt ceased operations between the times of the
respective payments. German regulators forced the troubled Bank Herstatt into liquidation.The counter party banks
did not receive their USD payments. Responding to the cross-jurisdictional implications of the Herstatt debacle, the
G-10 countries, Spain and Luxembourg formed a standing committee in 1974 under the auspices of the Bank for
International Settlements (BIS), called the Basel Committee on Banking Supervision. Since BIS is headquartered in
Basel, this committee got its name from there. The committee comprises representatives from central banks and
regulatory authorities.
Basel I:
In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum
capital requirements for banks.These were known as Basel I. It focused almost entirely on credit risk (default risk) the risk of counter party failure. It defined capital requirement and structure of risk weights for banks.
Under these norms:Assets of banks were classified and grouped in five categories according to credit risk, carrying
risk weights of 0%(Cash, Bullion, Home Country Debt Like Treasuries), 10, 20, 50 and100% and no rating. Banks
with an international presence are required to hold capital equal to 8% of their risk-weighted assets (RWA) - At
least, 4% in Tier I Capital (Equity Capital + retained earnings) and more than 8% in Tier I and Tier II Capital. Target By 1992.
One of the major role of Basel norms is to standardize the banking practice across all countries. However, there are
major problems with definition of Capital and Differential Risk Weights to Assets across countries, like Basel
standards are computed on the basis of book-value accounting measures of capital, not market values.
Accounting practices vary significantly across the G-10 countries and often produce results that differ markedly
from market assessments.
Other problem was that the risk weights do not attempt to take account of risks other than credit risk, viz., market
risks, liquidity risk and operational risks that may be important sources of insolvency exposure for banks.
Basel II:
So, Basel II was introduced in 2004, laid down guidelines for capital adequacy (with more refined definitions), risk
management (Market Risk and Operational Risk) and disclosure requirements.
- use of external ratings agencies to set the risk weights for corporate, bank and sovereign claims.
- Operational risk has been defined as the risk of loss resulting from inadequate or failed internal processes,

people and systems or from external events. This definition includes legal risk, but excludes strategic and
reputation risk, whereby legal risk includes exposures to fines, penalties, or punitive damages resulting from
supervisory actions, as well as private settlements. There are complex methods to calculate this risk.
- disclosure requirements allow market participants assess the capital adequacy of the institution based on
information on the scope of application, capital, risk exposures, risk assessment processes, etc.
Basel III:
It is widely felt that the shortcoming in Basel II norms is what led to the global financial crisis of 2008. That is
because Basel II did not have any explicit regulation on the debt that banks could take on their books, and
focused more on individual financial institutions, while ignoring systemic risk. To ensure that banks dont take on
excessive debt, and that they dont rely too much on short term funds, Basel III norms were proposed in 2010.
- The guidelines aim to promote a more resilient banking system by focusing on four vital banking parameters viz.
capital, leverage, funding and liquidity.
- Requirements for common equity and Tier 1 capital will be 4.5% and 6%, respectively.
- The liquidity coverage ratio(LCR) will require banks to hold a buffer of high quality liquid assets sufficient to deal
with the cash outflows encountered in an acute short term stress scenario as specified by supervisors. The
minimum
LCR requirement will be to reach 100% on 1 January 2019. This is to prevent situations like "Bank Run".
- Leverage Ratio > 3%:The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total
consolidated assets;.
BANK REGULATION

Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions
and guidelines, designed to create market transparency between banking institutions and the individuals
andcorporations with whom they conduct business, among other things.
Given the interconnectedness of the banking industry and the reliance that the national (and global) economyhold
on banks, it is important for regulatory agencies to maintain control over the standardized practices of these
institutions. Supporters of such regulation often base their arguments on the "too big to fail" notion. This holds that
many financial institutions (particularly investment banks with a commercial arm) hold too much control over the
economy to fail without enormous consequences. This is the premise for government bailouts, in which
government financial assistance is provided to banks or other financial institutions who appear to be on the brink
of collapse. The belief is that without this aid, the crippled banks would not only become bankrupt, but would
create rippling effects throughout the economy leading to systemic failure.

The objectives of bank regulation, and the emphasis, vary between jurisdictions. The most common objectives are:

prudential to reduce the level of risk to which bank creditors are exposed (i.e. to protect depositors) [1]

systemic risk reduction to reduce the risk of disruption resulting from adverse trading conditions for
banks causing multiple or major bank failures[2]

to avoid misuse of banks to reduce the risk of banks being used for criminal purposes, e.g. laundering
the proceeds of crime

to protect banking confidentiality

credit allocation to direct credit to favored sectors

it may also include rules about treating customers fairly and having corporate social responsibility.

General principles of bank regulation[edit]

Banking regulations vary widely between jurisdictions.
Licensing and supervision[edit]

Banks usually require a banking license from a national bank regulator before they are permitted to carry on
a banking business, whether within the jurisdiction or as an offshore bank. The regulator supervises licensed banks
for compliance with the requirements and responds to breaches of the requirements by obtaining undertakings,
giving directions, imposing penalties or (ultimately) revoking the bank's license.
Minimum requirements[edit]
A national bank regulator imposes requirements on banks in order to promote the objectives of the regulator.
Often, these requirements are closely tied to the level of risk exposure for a certain sector of the bank. The most
important minimum requirement in banking regulation is maintaining minimum capital ratios.[3] To some extent,
U.S. banks have some leeway in determining who will supervise and regulate them. [4]
Market discipline[edit]
The regulator requires banks to publicly disclose financial and other information, and depositors and other creditors
are able to use this information to assess the level of risk and to make investment decisions. As a result of this, the
bank is subject to market discipline and the regulator can also use market pricing information as an indicator of the
bank's financial health.

Instruments and requirements of bank regulation[edit]

Capital requirement[edit]
Main article: Capital requirement
The capital requirement sets a framework on how banks must handle their capital in relation to their assets.
Internationally, the Bank for International Settlements' Basel Committee on Banking Supervision influences each
country's capital requirements. In 1988, the Committee decided to introduce a capital measurement system
commonly referred to as the Basel Capital Accords. The latest capital adequacy framework is commonly known
as Basel III.[5] This updated framework is intended to be more risk sensitive than the original one, but is also a lot
more complex.
Reserve requirement[edit]
Main article: Reserve requirement
The reserve requirement sets the minimum reserves each bank must hold to demand deposits and banknotes. This
type of regulation has lost the role it once had, as the emphasis has moved toward capital adequacy, and in many
countries there is no minimum reserve ratio. The purpose of minimum reserve ratios is liquidity rather than safety.
An example of a country with a contemporary minimum reserve ratio is Hong Kong, where banks are required to
maintain 25% of their liabilities that are due on demand or within 1 month as qualifying liquefiable assets.
Reserve requirements have also been used in the past to control the stock of banknotes and/or bank deposits.
Required reserves have at times been gold, central bank banknotes or deposits, and foreign currency.
Corporate governance[edit]
Corporate governance requirements are intended to encourage the bank to be well managed, and is an indirect
way of achieving other objectives. As many banks are relatively large, with many divisions, it is important for
management to maintain a close watch on all operations. Investors and clients will often hold higher management
accountable for missteps, as these individuals are expected to be aware of all activities of the institution. Some of
these requirements may include:

to be a body corporate (i.e. not an individual, a partnership, trust or other unincorporated entity)
to be incorporated locally, and/or to be incorporated under as a particular type of body corporate, rather
than being incorporated in a foreign jurisdiction
to have a minimum number of directors

to have an organisational structure that includes various offices and officers, e.g. corporate secretary,
treasurer/CFO, auditor, Asset Liability Management Committee, Privacy Officer, Compliance Officer etc. Also
the officers for those offices may need to be approved persons, or from an approved class of persons

to have a constitution or articles of association that is approved, or contains or does not contain particular
clauses, e.g. clauses that enable directors to act other than in the best interests of the company (e.g. in the
interests of a parent company) may not be allowed.

Financial reporting and disclosure requirements[edit]

Among the most important regulations that are placed on banking institutions is the requirement for disclosure of
the bank's finances. Particularly for banks that trade on the public market, in the US for example the Securities and
Exchange Commission (SEC) requires management to prepare annual financial statements according to a financial

reporting standard, have them audited, and to register or publish them. Often, these banks are even required to
prepare more frequent financial disclosures, such as Quarterly Disclosure Statements. The SarbanesOxley Act of
2002 outlines in detail the exact structure of the reports that the SEC requires.
In addition to preparing these statements, the SEC also stipulates that directors of the bank must attest to the
accuracy of such financial disclosures. Thus, included in their annual reports must be a report of management on
the company's internal control over financial reporting. The internal control report must include: a statement of
management's responsibility for establishing and maintaining adequate internal control over financial reporting for
the company; management's assessment of the effectiveness of the company's internal control over financial
reporting as of the end of the company's most recent fiscal year; a statement identifying the framework used by
management to evaluate the effectiveness of the company's internal control over financial reporting; and a
statement that the registered public accounting firm that audited the company's financial statements included in
the annual report has issued an attestation report on management's assessment of the company's internal control
over financial reporting. Under the new rules, a company is required to file the registered public accounting
firm's attestation report as part of the annual report. Furthermore, the SEC added a requirement that management
evaluate any change in the company's internal control over financial reporting that occurred during a fiscal
quarter that has materially affected, or is reasonably likely to materially affect, the company's internal control over
financial reporting.[6]
Credit rating requirement[edit]
Banks may be required to obtain and maintain a current credit rating from an approved credit rating agency, and
to disclose it to investors and prospective investors. Also, banks may be required to maintain a minimum credit
rating. These ratings are designed to provide color for prospective clients or investors regarding the relative risk
that one assumes when engaging in business with the bank. The ratings reflect the tendencies of the bank to take
on high risk endeavors, in addition to the likelihood of succeeding in such deals or initiatives. The rating agencies
that banks are most strictly governed by, referred to as the "Big Three" are the Fitch Group, Standard and
Poor's and Moody's. These agencies hold the most influence over how banks (and all public companies) are viewed
by those engaged in the public market. In recent years, following the Great Recession, many economists have
argued that these agencies face a serious conflict of interest in their core business model. [7] Clients pay these
agencies to rate their company based on their relative riskiness in the market. The question then is, to whom is the
agency providing its service: the company or the market?
European financial economics experts notably the World Pensions Council (WPC) have argued that European
powers such as France and Germany pushed dogmatically and naively for the adoption of the "Basel
II recommendations", adopted in 2005, transposed in European Union law through theCapital Requirements
Directive (CRD). In essence, they forced European banks, and, more importantly, the European Central Bank itself,
to rely more than ever on the standardized assessments of "credit risk" marketed aggressively by two US credit
rating agencies Moody's and S&P, thus using public policyand ultimately taxpayers' money to strengthen anticompetitive duopolistic practices akin to exclusive dealing. Ironically, European governments have abdicated most
of their regulatory authority in favor of a non-European, highly deregulated, private cartel.[8]
Large exposures restrictions[edit]
Banks may be restricted from having imprudently large exposures to individual counterparties or groups of
connected counterparties. Such limitation may be expressed as a proportion of the bank's assets or equity, and
different limits may apply based on the security held and/or the credit rating of the counterparty. Restricting
disproportionate exposure to high-risk investment prevents financial institutions from placing equity holders' (as
well as the firm's) capital at an unnecessary risk.
Activity and affiliation restrictions[edit]
In the US in response to the Great depression of the 1930s, President Franklin D. Roosevelts under the New
Deal enacted the Securities Act of 1933 and the GlassSteagall Act (GSA), setting up a pervasive regulatory
scheme for the public offering of securities and generally prohibiting commercial banks from underwriting and
dealing in those securities. GSA prohibited affiliations between banks (which means bank-chartered depository
institutions, that is, financial institutions that hold federally insured consumer deposits) and securities firms (which
are commonly referred to as investment banks even though they are not technically banks and do not hold
federally insured consumer deposits); further restrictions on bank affiliations with non-banking firms were enacted
inBank Holding Company Act of 1956 (BHCA) and its subsequent amendments, eliminating the possibility that
companies owning banks would be permitted to take ownership or controlling interest in insurance companies,
manufacturing companies, real estate companies, securities firms, or any other non-banking company. As a result,
distinct regulatory systems developed in the United States for regulating banks, on the one hand, and securities
firms on the other.
SYSTEMIC RISK
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk
associated with any one individual entity, group or component of a system, that can be contained therein without
harming the entire system.[1][2] It can be defined as "financial system instability, potentially catastrophic, caused or
exacerbated by idiosyncratic events or conditions in financial intermediaries". [3] It refers to the risks imposed
by interlinkages and interdependencies in a system or market, where the failure of a single entity or cluster of
entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market.
One of the main reasons for regulation in the marketplace is to reduce systemic risk. [5] However, regulation
arbitrage the transfer of commerce from a regulated sector to a less regulated or unregulated sector brings

markets a full circle and restores systemic risk. For example, the banking sector was brought under regulations in
order to reduce systemic risks. Since the banks themselves could not give credit where the risk (and therefore
returns) were high, it was primarily the insurance sector which took over such deals. Thus the systemic risk
migrated from one sector to another and proves that regulation of only one industry cannot be the sole protection
against systemic risks.
Too big to fail and moral hazard
Among the reasons for maintaining close regulation of banking institutions is the aforementioned concern over the
global repercussions that could result from a bank's failure; the idea that these bulge bracket banks are "too big to
fail". The objective of federal agencies is to avoid situations in which the government must decide whether to
support a struggling bank or to let it fail. The issue, as many argue, is that providing aid to crippled banks creates a
situation of moral hazard. The general premise is that while the government may have prevented a financial
catastrophe for the time being, they have reinforced confidence for high risk taking and provided an invisible
safety net. This can lead to a vicious cycle, wherein banks take risks, fail, receive a bailout, and then continue to
take risks once again.

DEPOSIT INSURANCE
Explicit deposit insurance is a measure implemented in many countries to protect bank depositors, in full or in
part, from losses caused by a bank's inability to pay its debts when due. Deposit insurance systems are one
component of a financial system safety net that promotes financial stability.

Banks are allowed (and usually encouraged) to lend or invest most of the money deposited with them instead of
safe-keeping the full amounts (seefractional-reserve banking). If many of a bank's borrowers fail to repay their
loans when due, the bank's creditors, including its depositors, risk loss. Because they rely on customer deposits
that can be withdrawn on little or no notice, banks in financial trouble are prone to bank runs, where depositors
seek to withdraw funds quickly ahead of a possible bank insolvency. Because banking institution failures have the
potential to trigger a broad spectrum of harmful events, including economic recessions, policy makers maintain
deposit insurance schemes to protect depositors and to give them comfort that their funds are not at risk.
Deposit insurance was formed to protect small unit banks in the United States when branching
regulations existed. Banks were restricted by location thus did not reap the benefits coming from economies of
scale, namely pooling and netting. To protect local banks in poorer states, the federal government created deposit
insurance.[1][2]
Many national deposit insurers are members of the International Association of Deposit Insurers (IADI), an
international organization established to contribute to the stability of financial systems by promoting international
cooperation and to encourage wide international contact among deposit insurers and other interested parties.
This is a scheme run by either a government agency or a private company which aims to insure the deposits of
private investors in case a bank goes bankrupt.
The advantage of deposit insurance schemes is that they can prevent individuals and firms losing their
savings. Also, the security of having deposits insured prevents bank runs where a panic about solvency of banks
can lead to queues of people wanting to get their money out.
The problem with deposit insurance is that can encourage moral hazard. This involves banks taking greater risks
because of the security of government bail outs. It can also encourage firms / individuals to deposit with risky (high
interest bearing banks). Thus banks may have to take a riskier strategy to attract customers
LENDER OF LAST RESORT
The term lender of last resort originates from the French expression dernier ressort. While the concept itself had
been used previously, the term, "lender of last resort", was supposedly first used in its current context bySir Francis
Baring in his Observations on the Establishment of the Bank of England which was published in 1797.[1] In 1763 the
king was the lender of last resort in Prussia.[2] Different definitions of the lender of last resort exist in the literature.
A comprehensive one is the following: "the discretionary provision of liquidity to afinancial institution (or the
market as a whole) by the central bank in reaction to an adverse shock which causes an abnormal increase in
demand for liquidity which cannot be met from an alternative source".[3] This means that the central bank is the
lender (provider of liquidity) of last resort (if there is no other way to increase the supply of liquidity when there is a
lack thereof). The function has been performed by many central banks since the beginning of the 20th century. The
goal is to prevent financial panics and bank runs spreading from one bank to the next due to a lack of liquidity.
Classical theory[edit]
The classical theory of the lender of last resort was mostly developed by two Englishmen in the 19th
century: Henry Thornton and Walter Bagehot.[4] Although some of the details remain controversial their general

theory is still widely acknowledged in modern research and provides a suitable benchmark. Thornton and Bagehot
were mostly concerned with the reduction of the money stock. This is because they feared that the deflationary
tendency caused by a reduction of the money stock could reduce the level of economic activity. If prices did not
adjust quickly this would lead to unemployment and a reduction in output. By keeping the money stock constant,
the purchasing power remains stable during shocks. When there is a shock induced panic, two things happen:
1. The depositors fear that they will not be able to convert their deposits into high powered moneyin the
19th century Britain this meant gold or Bank of England notes. They therefore increase the amount of cash
they hold relative to deposits.
2. Banks on the other hand, afraid of becoming illiquid, increase their reserves. Taken together this reduces
themoney multiplier which, multiplied by the amount of base money, gives the money stock.[4] The
equation showing this relation is:
where M is the money stock, B is the money base, C/D is the ratio of cash to deposits held by the public,
and R/D is the ratio of reserves to deposits held by the banks. [5] If the multiplier is reduced due to a shock
and the amount of base money is constant, the money stock will decrease as a consequence. Thornton and
Bagehot therefore suggested that the lender of last resort should increase the money base to offset the
reduction of the multiplier. This was meant to keep the money stock constant and prevent an economic
contraction.
Thornton's foundations[edit]
Henry Thornton first published An Enquiry into the Nature and Effects of the Paper Credit of Great Britain in
1802. His starting point was that only a central bank could perform the task of lender of last resort because it
holds a monopoly in issuing bank notes. Unlike any other bank the central bank has a responsibility towards
the public to keep the money stock constant, thereby preventing negative externalities of monetary
instability .[6]
Bagehot's contribution[edit]
Walter Bagehot was the second important contributor to the classical theory. In his book Lombard
Street (1873), he mostly agreed with Thornton (without ever mentioning him) but he also develops some new
points and emphases. Bagehot advocates: "Very large loans at very high rates are the best remedy for the
worst malady of the money market when a foreign drain is added to a domestic drain". [7] His main points can
be summarized by his famous rule: lend "it most freely to merchants, to minor bankers, to 'this and that
man', whenever the security is good".[8]
Summary of the classical theory[edit]
Humphrey,[6] who has done extensive research on both Thornton's and Bagehot's works, summarizes their
main proposals as follows: (1) protect the money stock instead of saving individual institutions; (2) rescue
solvent institutions only; (3) let insolvent institutions default; (4) charge penalty rates; (5) require good
collateral; and (6) pre-announce these conditions before a crisis so that the market knows exactly what to
expect. Many of these points remain controversial today but it seems to be accepted that the Bank of England
strictly followed these rules during the last third of the 19th century. [6]
Bank runs and contagion[edit]
Most industrialized countries have had a lender of last resort for many years. Why this is reasonable can be
explained by a couple of famous models. These models propose that a bank run or bank panic can arise in any
fractional reserve banking system and that the lender of last resort function is a way of preventing panics from
happening. Diamond and Dybvig's model of bank runs has two Nash equilibria: one in which welfare is optimal,
and one where there is a bank run. The bank run equilibrium is an infamously self-fulfilling prophecy: if
individuals expect a run to happen, it is rational for them to withdraw their deposits early, i.e. before they
actually need it. This makes them lose some interest, but it is better than losing everything due to a bank run.
In the model, introducing a lender of last resort can prevent bank runs from happening, so that only the
optimal equilibrium remains. This is because individuals are no longer afraid of a liquidity shortage and
therefore have no incentive to withdraw early. The lender of last resort will never come into action because the
mere promise is enough to provide the confidence necessary to prevent a panic. [9]
Subsequently, this model has been extended to allow for contagion, i.e. the spreading of a panic from one
bank to another, by Allen and Gale,[10] and Freixas et al.[11] respectively.
Allen and Gale[10] introduced an interbank market into the Diamond-Dybvig model to study contagion of bank
panics from one region to another. An interbank market is created by banks because it insures them against a
lack of liquidity at certain banks as long as the overall amount of liquidity is sufficient. Liquidity is allocated by
the interbank market so that banks that have excess liquidity can provide this to banks that lack liquidity. As
long as the total demand for liquidity does not exceed the supply, the interbank market will allocate liquidity
efficiently and banks will be better off. But if demand exceeds supply, this can have disastrous consequences.
The interregional cross holdings of deposits cannot increase the total amount of liquidity. This means that longterm assets have to be liquidated (fire sale) which causes loss.
The degree of contagion depends on the interconnectedness of the banks in different regions. In an incomplete
market (banks do not exchange deposits with all other banks) a high degree of interconnectedness causes
contagion. Contagion is not caused if the market is either complete (banks have exchanged deposits with all

other banks) or if the banks are only little connected. In Allen and Gale's model, the role of the central bank is
to complete the markets in order to prevent contagion.[10]
Freixas et al.'s[11] model is similar to the one by Allen and Gale, except that, in Freixas et al.'s model, individuals
face uncertainty about the location where they need their money. There is a fraction of individuals (travelers)
who need their money in a region other than home. Without a payment system, an individual has to withdraw
his deposit early, when he finds out that he will need the money in a different place in the next period, and
simply take the money along. This is inefficient because of the foregone interest payment. Banks therefore
establish credit lines to allow individuals to withdraw their deposits in different regions. In the good
equilibrium, welfare is increased just as in the Diamond-Dybvig model, but again there is a bank run
equilibrium, too. This equilibrium can arise if some individuals expect too many others to want to withdraw
money in the same region in the next period. It is then rational to withdraw money early instead of not
receiving any in the next period. This bank run equilibrium can happen even if all banks are solvent. [11]
Disputed areas[edit]
The most relevant controversies will be discussed in this section. Depending on the view one favours for either
of them, the design of the optimal lender of last resort will be rather different.
Moral hazard[edit]
Moral hazard has been an explicit concern in the context of the lender of last resort since the days of Thornton.
Saving illiquid banks from liquidation by allowing them to borrow from a central bank can cause excessive risk
taking by both bankers and investors. In this way the lender of last resort can alleviate current panics in
exchange for increasing the likelihood of future panics through risk taking induced by moral hazard. [12] This is
exactly what the Report of the International Financial Institution Advisory Commission accuses the IMF of doing
when it lends to emerging economies: "By preventing or reducing losses by international lenders, the IMF had
implicitly signalled that, if local banks and other institutions incurred large foreign liabilities and government
guaranteed private debts, the IMF would provide the foreign exchange needed to honour the guarantees".
[13]
Investors are protected against the downside of their investment and at the same time receive higher
interest rates to compensate them for their risk. This encourages risk-taking and reduces the necessary
diversification. This led the Commission to conclude that "[t]he importance of the moral hazard problem
cannot be overstated".[13]
However, not having a lender of last resort because of the fear that it may cause moral hazard, may have
worse consequences than moral hazard itself.[14]Consequently, many countries have a central bank that acts as
lender of last resort. These countries then try to prevent moral hazard by other means, e.g. as suggested by
Stern:[15] "official regulation; encouragement for private sector monitoring and self-regulation; and the
imposition of costs on those who make mistakes, including enforcement of bankruptcy procedures when
appropriate."[16] Some authors also suggest that moral hazard should not be a concern of the lender of last
resort. The task of preventing it should be given to a supervisor or regulator which limits the amount of risk
that can be taken.[17]
Macro or micro responsibility[edit]
Whether or not the lender of last resort has a responsibility for saving individual banks has been a very
controversial topic. Does the lender of last resort provide liquidity to the market as a whole (through open
market operations) or should it (also) make loans to individual banks (through discount window lending)?
There are two main views on this question, the money and the banking view: the money viewas argued for
example by Goodfriend and King,[12] and Capie[5]suggests, that the lender of last resort should provide
liquidity to the market by open market operations only because this suffices to limit panics. What they call
"banking policy" (i.e. discount window lending) may even be harmful because of moral hazard. The banking
view finds that in reality the market does not allocate liquidity efficiently in times of crisis. Liquidity provided
through open market operations is not efficiently distributed among banks in the interbank market and there is
a case for discount window lending. In a well-functioning interbank market only solvent banks can borrow. But
if the market is not functioning, even solvent banks may be unable to borrow, most likely because of
asymmetric information.[3]
A model developed by Flannery[18] suggests that the private market for interbank loans can fail if banks face
uncertainty about the risk involved in lending to other banks. In times of crisis with less certainty, however,
discount window loans are the least costly way of solving the problem of uncertainty.
Rochet and Vives extend the traditional banking view to provide more evidence that interbank markets indeed
do not function properly as Goodfriend and King had suggested. "The main contribution of our paper so far has
been to show the theoretical possibility of a solvent bank being illiquid, due to a coordination failure on the
interbank market."[19]
Goodhart[14] proposes that only discount window lending should be considered lending of last resort. The
reason is that central banks' open market operations cannot be separated from regular open market
operations.
Distinction between illiquid and insolvent[edit]
According to Bagehot, and following him, many later writers the lender of last resort should not lend to
insolvent banks. This is reasonable in particular because it would encourage moral hazard. The distinction
seems logical and is helpful in theoretical models but some authors find that in reality, it is difficult to apply.
Especially in times of crisis, the distinction is difficult to make. [3]

When an illiquid bank approaches the lender of last resort, there should always be a suspicion of insolvency.
But according to Goodhart it is a myth that the central bank can evaluate that these suspicions are untrue
under the usual constraints of time for arriving at a decision. [14] Like Obstfeld[20] he considers insolvency a
possibility that arises with a certain amount of probability, not something that is certain.
Penalty rate and collateral requirement[edit]
Bagehot's reasoning behind charging penalty rates (i.e. higher rates than are available in the market) was that
(1) this would really make the lender of last resort the very last resort and (2) it would encourage the prompt
repayment of this debt.[4]
Some authors suggest that charging a higher rate does not serve the purpose of the lender of last resort. This
is because a higher rate could make it too expensive for banks to borrow. Flannery [21] and others mention that
the Fed has neither asked for good collateral nor charged rates above the market in recent years.[12]
Announcement in advance and too big to fail[edit]
If the central bank announces in advance that it will act as lender of last resort in future crises, this can be
understood as a credible promise and prevent bank panics. At the same time it may increase moral hazard.
While Bagehot emphasized that the benefit of the promise outweighs the costs, many central banks have
intentionally not promised anything.[6]
Private alternatives[edit]
Before the founding of the US Federal Reserve System as lender of last resort, its role had been assumed by
private banks. Both the clearing-house system of New York [22] and the Suffolk Bank of Boston [23] had provided
member banks with liquidity during crises. In the absence of a public solution a private alternative had
developed. Advocates of the free banking view suggest that these examples show that there is no necessity
for government intervention.[24]
The Suffolk Bank acted as lender of last resort during the Panic of 1837-9. Rolnick, Smith and Weber "argue
that the Suffolk Bank's provision of note-clearing and lender of last resort services (via the Suffolk Banking
System) lessened the effects of the Panic of 1837 in New England relative to the rest of the country, where no
bank provided such services".[25]
During the panic of 1857 a policy committee of the New York Clearing House Association (NYCHA) allowed the
issuance of the so-called clearing-house loan certificates. While their legality was controversial at the time, the
idea of providing additional liquidity eventually led to a public provision of this service that was to be
performed by the central bank founded in 1913.[26]
Some authors view the establishment of clearing-houses as proof that the lender of last resort does not have
to be provided by the central bank.[24] Bordo agrees that it does not have to be a central bank. But from
historical experience (mainly Canada and US) he suggests that it has to be a public authority and not a private
clearing-house association that provides this service. [27]