An increase in financial liberalization in the banking sector leads to a growth in competition that destroys the future profits of the banks and therefore their franchise value, – a present value of the future gains. The probability of good loans decreases and involves a moral hazard problem. It leads to bigger incentives for the banks to invest in the gamble assets.
Competition has always been regarded to be an environment of extreme risk-taking and as a result, it takes a lot of measures to control the amount invested in the risky assets, and motivation of the prudent behavior of the banks.
The most important instruments of regulation that will be taken into account in the paper are capital regulations and deposit rate ceilings in the context of dynam-ic model of imperfect competition according to Repullo (2004). In this model, banks can invest either into the prudent asset (riskless) or gambling asset (risky). Without any regulations there are two potential types of equilibrium, which are, prudent equilibrium, where the banks invest into the riskless assets and gambling equilibrium, in which the banks invest into the risky assets. The expected payoff of the prudent asset is higher than the expected payoff of the gambling asset, but the latter gives a higher return if the gamble turns out well. The intermediation margin of the banks in prudent and gambling equilibrium is equal to the relationship between the transportation costs and the number of banks. This represents the so called market power of the banks.
Table of Contents
1. Introduction
2. The Model According to Repullo (2004)
2.1. Short Description of the Model
2.2. Prudent Asset Equilibrium
2.3. Gambling Asset Equilibrium
2.4. The General Description of Prudent and Gambling Equilibrium with Capital Requirements
3. Instruments of Regulation
3.1. Risk-based Capital Requirements as Instrument of Regulation
3.2. Deposit Rate Ceilings as Instrument of Regulation
4. Extensions
4.1. Discussing the Optimal Capital Requirements
4.2. Capital Requirement under the Basel III
5. Conclusion
Research Objectives and Themes
This paper investigates the effectiveness of regulatory instruments—specifically capital requirements and deposit rate ceilings—in mitigating risk-seeking behavior among banks operating in an environment of imperfect competition, based on a dynamic model by Repullo (2004).
- Impact of financial liberalization on banking competition and risk incentives.
- The duality of prudent versus gambling asset equilibrium in banking operations.
- Regulatory mechanisms including capital requirements and deposit rate ceilings.
- Analysis of Basel III implementation and optimal capital structures.
- Welfare implications for depositors and bank shareholders under different regulatory constraints.
Excerpt from the Book
1. Introduction
An increase in financial liberalization in the banking sector leads to a growth in competition that destroys the future profits of the banks and therefore their franchise value, – a present value of the future gains. The probability of good loans decreases and involves a moral hazard problem. It leads to bigger incentives for the banks to invest in the gamble assets.
Competition has always been regarded to be an environment of extreme risk-taking and as a result, it takes a lot of measures to control the amount invested in the risky assets, and motivation of the prudent behavior of the banks. The regulation of deposit rate, the restrictions and barriers for entry of a new bank into the market, and the limitations of the bank activities and capital requirements are considered to be the most important measures to limit the incentive for risk-taking by the banks.
It is also not clear whether competition leads to a higher stability in banking sector. On one hand, it is obvious that an increase in competition among banks drives them to lower the loan rates that diminishes the risk of borrowers and hence increases stability in banking. But on the other hand, one of the key instruments of risk-taking regulation, mainly, capital requirements can push banks to increase loan rates and therefore, creates a burden of a risky portfolio for the borrowers: the risk of insolvency of banks increases.
Summary of Chapters
1. Introduction: Outlines the problem of increased competition leading to risk-seeking behavior in banks and defines the research scope regarding regulatory instruments.
2. The Model According to Repullo (2004): Provides the theoretical framework for bank behavior, defining conditions for prudent and gambling asset equilibria.
3. Instruments of Regulation: Examines risk-based capital requirements and deposit rate ceilings as mechanisms to steer banks toward prudent equilibrium.
4. Extensions: Discusses optimal capital requirements in the light of the financial crisis and the transition toward Basel III standards.
5. Conclusion: Summarizes the effectiveness of regulatory tools and notes the ongoing challenges in maintaining banking stability through future reforms.
Keywords
Banking Regulation, Capital Requirements, Deposit Rate Ceilings, Imperfect Competition, Prudent Equilibrium, Gambling Equilibrium, Risk-taking, Financial Liberalization, Basel III, Franchise Value, Moral Hazard, Intermediation Margin, Banking Stability, Risk-based Regulation, Financial Crisis.
Frequently Asked Questions
What is the primary focus of this research?
The paper examines how regulatory instruments such as capital requirements and deposit rate ceilings can be used to prevent banks from engaging in excessive risk-taking within a competitive market.
What are the central themes of the work?
The central themes include the dynamics of banking competition, the trade-off between prudent and risky asset investment, and the impact of regulatory interventions on banking stability and stakeholder welfare.
What is the core research question?
The study explores which regulatory mechanisms effectively incentivize banks to maintain a prudent investment strategy rather than pursuing high-risk "gambling" strategies in the face of financial liberalization.
Which scientific methodology is employed?
The author utilizes a formal dynamic model of imperfect competition in banking, originally proposed by Repullo (2004), to derive critical values for equilibrium stability under various regulatory scenarios.
What does the main body cover?
The main body covers the formal modeling of prudent vs. gambling equilibria, the comparative analysis of specific regulatory tools, and a discussion of practical policy transitions like Basel III.
How are the keywords defined?
The work is characterized by terms reflecting modern bank supervision and regulatory theory, such as risk-based capital adequacy, moral hazard, and systemic financial stability.
How does the model treat the concept of "franchise value"?
The model defines franchise value as the present value of future gains, showing how it is influenced by competition, the costs of capital, and the specific regulatory environment applied to the bank.
What conclusion does the author draw regarding deposit rate ceilings?
The author concludes that while binding deposit rate ceilings can make shareholders wealthier, they often leave depositors worse off, making them a complex tool that requires careful implementation compared to other regulatory instruments.
- Arbeit zitieren
- Olga Korniienko (Autor:in), 2011, Capital requirements and deposit rate ceilings as regulatory instruments in a dynamic model of imperfect competition in banking, München, GRIN Verlag, https://www.hausarbeiten.de/document/208849
