The core economic role of bank regulation is to ensure the stability and efficiency of the banking system. The banking system is a fundamental part of the financial system as a whole and is critical to other financial instruments, such as the payment system. Due to their systemic importance the proper functioning of banks is a matter of public interest and regulating bank activities is necessary to protect the economy as a whole. The implicit assumption underlying the belief that bank creditors are better placed than public authorities to monitor and regulate bank activities is that the majority of banking problems are institutional in nature and can be resolved by taking coercive action agianst specific institutions which are undertaking too much risk. Bank creditors coercive power has proven largely ineffectual in environments where systemic risks are greater than idiosyncratic ones. Public authorities have greater reach and coercive power than bank creditors who in turn have more flexibility and greater incentive to appropriately monitor bank activities. Due to the limited ability of both regulators and creditors to control bank activities and assume the associated risk, they are both necessary for the appropriate regulation of banks.
Public authorities have been the primary regulators of the banking sector throughout much of the 20th century. The public has a strong interest in the overall stability of the financial system, which public authorities seek to protect. The first major initiatives in bank regulation by public authorities were introduced after the Great Depression. Initially, these regulations consisted of various safety nets which aimed to limit the probability of banks defaulting. Primarily, lenders of last resort and deposit insurance schemes were adopted across the world. These safety nets limited the risks that banks, their creditors, and associated institutions faced which led to a spike in banks neglecting precautionary measures and making riskier investments. The moral hazard problems created by safety nets were one of the primary causes of the US Savings and Loan Crisis in the 1980s. In response, regulators attempted to constrain the risk taking behaviour of banks by introducing regulations which protect banks from competition while constraining their activities, such as con- straining interest rates and imposing capital adequacy requirements. Supervisory review processes were also strengthened under the Basel II Accords in 1988 and the idea of using market actors to monitor and regulate bank activities was introduced. None of these regulatory or supervisory innovations, however, prevented banks from defaulting during the 2008 Global Financial Crisis. Due to the rapidly evolving nature of financial innovations, banks and other financial institutions were quickly able to find ways to work around the newly introduced regulations. The 2008 Crisis prompted a new wave of regulations to be enacted, strengthening some existing ideas like raising capital requirements, and introducing new ideas such as liquidity regulation, establishing macro-prudential regulators, and introducing stress-testing for large banks.
The major problem which public authority regulators have when attempting to regulate banks is the rigid, static nature of financial regulations. Regulation is usually enacted during or immediately after a financial crisis when there is insufficient information regarding what exactly happened. In practice, this means that financial regulations enacted by public authorities lead to unsatisfactory outcomes but are very difficult to revise or repeal. The environment in which banks and other financial firms operate is rapidly evolving, meaning that even the most informed regulatory responses are likely to produce backward-looking regulations which are full of errors. Banks adapt to regulations in ways which reduce their effectiveness much faster than regulators can change them. Public authority regulators have a large amount of power to control and constrain the activities of banks due to their state backed authority and ability to create system wide regulations. This power is constrained by the practical realities of enacting regulation with limited information and in a format that does not lend itself to change.
Public authority’s supervision of banks is similarly relied upon by the financial system for stability. In order to ensure that banks are following the regulations laid down by regulators, prudential supervision by public authorities is utilised. Prudential supervision only became a core part of public authorities regulation strategy in the mid-1990s, prior to which supervision consisted largely of periodic reviews to see if banks had complied with a specific regulatory requirement. The proliferation of multi-functional transnational banks rendered such supervision woefully inadequate, requiring supervisors to increase the frequency and intensity of reviews. Supervisors obtain information from both publicly available sources and reports filed by banks with regulators. Supervisors then analyse the information they are given and, if necessary, work with banks to address any deficiencies in their risk management strategies. In order to be able to effectively exercise the discretionary powers they are given, supervisors must have analytical expertise in the banking field and maintain constant, close relationships with the firms they are supervising.
Public authorities are able to access information which is not available to the general public and can ensure that supervisors have the appropriate expertise and authority. Unfortunately however, Supervisory endeavours are hugely expensive for public authorities to undertake, and face challenges of staffing, information gather- ing, and bias. Oversight from public authorities is necessarily limited by the funds they have available. The increasing complexity of banks, particularly large multinational banks makes them very difficult to monitor and control using traditional supervisory methods. Between 1980 and 1997 40 out of 61 countries studied by the world bank suffered financial crises, much of the blame for which was laid at the feet of inadequate government supervision. The heavy reliance placed on supervisory discretion to resolve the issues of banks before the issues become serious under current supervisory regimes raises concerns that supervisors decisions may be biased, inconsistent, or wrong. Public authority supervisors may also not have incentives to do an adequate job, as they typically do not bear the cost if they fail to identify excessive risk or force the bank to take coercive action. In addition, bankers may attempt to hide or downplay their exposures and may even reward regulators who turn a blind eye to such practices.
There has been a push in the last few decades to allow bank creditors to take a larger role in monitor- ing and regulating bank activities to minimise the problems encountered by public authority regulations and supervision. Bank creditors are much more flexible than public authorities and have a personal stake in the performance of the bank. The Basel II Accords first introduced this concept as the third pillar of its regulatory approach in the hopes that bank creditors and the market generally could impose strong incentives on banks to conduct business safely and efficiently. The Basel III Accords maintained the need for bank creditors involvement in regulating banks. Three main categories of bank creditors have the incentive and position to control bank activities, equity holders, subordinated debt holders, and uninsured depositors.
Equity holders can influence the actions of the banks which they are stakeholders in both through buying and selling of shares or options and by exercising various corporate governance mechanisms. Equity holders can influence the behaviour of bank managers by controlling the hiring and firing of managers, incentivising them to act in the interests of the equity holders. They can also introduce performance-based compensation for bank managers to provide further incentive. It is argued that because equity holders have an economic stake in the performance of the bank, they have a strong incentive to monitor the banks activities as if the bank fails they will lose money. At an individual institutional level, however, shareholder limited liability weakens equity holder’s inclination and ability to affect banks risk taking. Banks operate and turn a profit by assuming debt that is many times higher than shareholders equity, meaning that banks do not fully internalise the cost of their risky behaviour. It is therefore untenable to expect equity holders alone to control the risk taking activities of banks, particularly as any increase in a bank’s leverage translates into an increase in the bank’s assets and therefore profitability. Equity holders, particularly powerful ones, tend to have short-term goals and will prefer managers who assume risk over and beyond what is safe for the financial system as a whole.
The large increase in institutional investors in the stock market in the latter half of the 20th century is often assumed to mean that the monitoring and regulatory function of bank equity holders is strengthened due to the increased resources and expertise of institutional investors when compared to individual investors. In practice, institutional investors tend towards passivity both due to government over-regulation and a lack of incentives to motivate the managers of institutional investors to properly monitor and regulate the banks they invest in. Institutions that have well diversified portfolios cannot take the amount of interest that traditional shareholders do in improving the behaviour of every individual company they are invested in because they hold too many companies, monitoring all of which to a satisfactory degree would be too costly. The managers of institutional investment funds, like bank managers, do not invest their own money and as a result they do not have a personal stake in the performance of banks or other companies the fund invests in and do not benefit from the oversight that they are expected to perform as a traditional equity holder would. Managers of institutional investors need monitoring and appropriate incentives to perform their jobs adequately as bank managers do. The nature of institutional investors means that those who invest their money into them often either do not easily have access to the trading data of the fund, as with pension funds, or do not have the requisite knowledge to properly monitor their activities, as with the majority of hedge fund investors. As a result the usual corporate accountability mechanisms are compromised or unavailable in the case of institutional investors.
Despite the issues with equity holders controlling bank behaviour, the equity market itself is an important signal of the health of the bank. Equity holders are far more likely to sell their stake in banks and reorganise their portfolios in ways that protect them from losses than they are to effectively intervene in the governance of the bank. Such portfolio reorganisation tents to begin far enough in advance of a bank crisis to signal to both the bank itself and external supervisors that corrective action is needed.
Subordinated debt holders may also act as monitors, and to a lesser extent regulators, for bank activities. Subordinated debt holders have much stronger incentives than equity holders to monitor banks and limit their risk taking activities as they will lose their stake in the event of a bank default, but do not see any of the profits gained if the bank takes excessive risk. In order for subordinated debt holders to be effective, however, substantial proportions of both equity and subordinated debt need to exist on a bank’s balance sheet. If the bank holds a majority of subordinated debt and little to no equity then the subordinated debt holders will be incentives to act as equity holders and prefer the bank undertake risky behaviour because they will almost certainly loose money if the bank does not do so. On the other hand, if the bank holds a very small amount of subordinated debt on its balance sheet then it is not dependent on such debt for funding and there are no market incentives to listen to the concerns of subordinated debt holders. The role that subordinated debt holders play has been recognised in public authority regulations following the 2008 Global Financial Crisis as mandatory minimum amounts of subordinated debt were implemented in the Basel III Accords’ capital adequacy requirements. Without such public authority regulations it is doubtful that banks would hold an appropriate balance of equity and subordinated debt on their balance sheets to optimise the monitoring and regulatory functions of such creditors.
Depositors whose deposits are not protected by federal deposit insurance have perhaps the strongest incent- ive to closely monitor the activities of banks, as they do not experience any profit when the bank undertakes risky behaviour and are liable to loose the majority of their savings if the bank fails. In theory, depositors will take note of the banks risky behaviour and withdraw their funds from weaker institutions to redeposit in stronger ones. There is some empirical evidence to suggest that the amount of deposits is affected by a perceived change in bank risks, however many economists do not believe that depositors have the ability to properly assess the strength of individual banks. Many depositors are small and uniformed and will not play a strong role in monitoring or disciplining banks. Additionally, banks can turn to the insured deposit market to make up any potential loses from the uninsured deposit market, meaning that banks in difficulty may only face a small funding limitation. Data has found that, in practice, there is no significant difference in super- visory behaviour between insured and uninsured depositors, suggesting that the security of a depositors funds does not affect the effectiveness of a given depositors monitoring.
Bank creditors do provide an important function in terms of monitoring and controlling the activities of banks, however under the current regulatory system this role is insufficient. Bank creditors supervision was not sufficient to identify or punish banks which took excessive risks prior to the 2008 Global Financial Crisis and in fact encouraged banks to take on greater risks to maximise profit. In order for creditor monitoring to be successful it is necessary to have public availability of adequate reliable information on the bank’s financial performance and risk exposures, and independent creditors with appropriate incentives to monitor the bank and accurately assess information they are given. The intrinsic information asymmetries in the banking sector are so large that it is impossible for bank creditors, who only have access to public information, to make truly informed decisions. Confidentiality agreements, competition concerns, and the susceptibility of banks to runs ensure that crucial information on the business practices and risks of banks will never be released to the wider market. Banks may also try to conceal information which would negatively affect investment from the market, although some authors have suggested that dedicated investors could force more disclosure than is currently provided. If creditors cannot readily verify the condition of banks, then public trust in the bank may lead to a bank run or other crisis event. Regulators have access to otherwise confidential information from banks which the market may never see, and can take action over and above what creditors are able to do.
In addition to adequate information, bank creditors need appropriate monitoring incentives in order to optimally regulate banks. The safety net policies of many government regulators and resulting moral hazards counteract this requirement as they provide a false sense of stability for creditors and bank managers alike. The existence of too-big-to-fail institutions, which are so interconnected that allowing them to fail would be catastrophic to the entire financial system, undermines bank creditors incentives and power to regulate bank activities. The special status provided to such banks increases the possibility of a public bail out, which in turn creates artificial discounts in the market for too-big-to-fail banks, distorting perceptions of the activities of such institutions. Evidence suggests that where governments implement credible no-bail-out-policies the coercive actions of bank creditors are more effective. Likewise, deposit insurance attempts to prevent bank runs by ensuring public confidence in the security of their deposits. If the public does not fear the loss of their money in the event of bank defaults, they have less incentives to monitor the bank. Lenders of last resort also act as a backstop in the event a bank defaults, further deincentivising close creditor supervision over bank activities. These safety net regulations are intended to limit the opportunities for public panic, however the unintended consequence is weakening both creditor incentives to closely monitor bank activities and lessening the pressure on bank managers to listen to creditor pressures with regard to their activities.
Banks are a cornerstone of the financial system as it currently exists. The public has a vested interest in the stability and continued functioning of banks. Public authorities have the power to regulate the banking system as a whole, negating competition concerns by levelling the playing field. They have access to confidential information which would never be released to the market, the power to ensure that those supervising and regu- lating banks have the appropriate authority and expertise to be effective. However, public authority regulators do not have the requisite flexibility to optimally regulate banks. They are limited by their resources, which are not always adequate, and the regulations that have been put into place which are not easily changed. Bank creditors, on the other hand, do have the requisite flexibility and are personally invested in the functioning of the bank giving them greater incentive than pubic authorities have to effectively monitor and limit banks risk-taking behaviours. Due to inherent information asymmetries and the nature of many creditors, however, bank creditors will never be more knowledgeable about the market than public authority regulators. Bank creditors also have limited coercive power over bank activities, along with a number of perverse incentives to see that the bank takes on risky investments in order to turn a higher profit. Both public authorities and bank creditors are necessary to optimally monitor and regulate banks, however, bank creditors are not better placed than public authorities to perform such functions.
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ABOUT THE AUTHOR
Nicole Terry grew up in Vancouver, Canada and obtained an LLB in law from Queen Mary University of London where she was a member of the Queen Mary Law Journal Editorial Board for two years. She went on to obtain an LLM in International Law and Governance from Durham University in 2020. Nicole is passionate about human rights, legal advocacy, and public policy. During her undergraduate degree she participated in several street law projects through the Queen Mary Legal Advice Centre. She was also a student advisor on the LAC’s pink law project, providing pro-bono legal advice to members of the LGBTQ+ community.