Competition vs Cooperation: What Are the Downsides of Banking Regulation?

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In this article, we discuss moral hazard and regulatory measures, such as capital requirements, to stave off a banking crisis. We then introduce a model we have developed where we analyze the trade-off between competition to attract depositors and cooperation to enhance liquidity. We evaluate different policy tools with the objective of promoting financial stability.

Banking Regulation – the Unintended Risks

The Great Financial Crisis of 2008 reignited a fierce debate about banking risk and, in particular, the stability of the global financial system. The regulator, in its desire to prevent crises, can actually make them more severe and their consequences more unpredictable. In this sense, the problem of moral hazard has been a research topic on which countless academic papers have been written and published, yet the specter of the next financial crisis continues to loom across the economic landscape.

The traditional role of banks as financial intermediaries that facilitate the transformation of liquid funds provided by depositors into long-term loans makes the banking system inherently fragile. In a world where depositors are too atomistic to know with precision the quality and characteristics of the loans made by the banks where they hold their deposits, these depositors may be tempted to respond to unclear signals about the evolution of those loans to ensure the recovery of their deposits. Stated differently, if customers feel their bank is ‘playing’ with their money, they might pull their deposits out and stuff their cash ‘under the mattress’ or deposit it with a more cautious bank.

Without a guarantee that their funds will be available at all times, depositors can generate (or accelerate) crises due to liquidity problems— and not only due to bad business decisions from the banks with which they work. To avoid such a run on the banks, most countries in the world have some type of deposit insurance system that guarantees depositors up to a certain amount, in the event the banks where they keep their deposits go bankrupt.

The Definition of Moral Hazard

Among other tools, these regulatory measures (e.g., bailouts for banks that are systemically important or highly connected to other banks and companies) make it highly unlikely that a big bank would not be rescued in the event of bankruptcy. Indeed, the costs of not doing so may exceed the cost of a bailout … Read More