## 1. Effects of Poor Supervision on the NGC ## Source details **Canonical URL:** [1. Effects of Poor Supervision on the NGC](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp05136.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp05136.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp05136.pdf.json) --- ### Purpose and approach - Investigates the importance of the quality of prudential supervision during financial liberalization and implications for the level of minimum capital requirements. - Analysis based on an extension of the theoretical model proposed by Hellmann, Murdock, and Stiglitz (2000) (the HMS model). - Key innovation: links explicitly the quality of prudential supervision to the optimal level of minimum capital requirements by allowing for imperfect monitoring by supervisors. ### Model setup and key parameters - Banks choose deposit rate ri and must hold own capital ratio k percent of deposits. - Opportunity cost of capital is ρ with ρ>α. - Two investment choices: - Prudent asset: known return α. - Gambling (risky) asset: high return γ if gamble succeeds, low return β if gamble fails (β < γ); success probability θ. - Expected social return from gambling is always less than that from the prudent asset: α > γθ + (1−θ)β. - Supervisory quality parameter q ∈ [0,1]: - q = 1: each gambling bank with negative end-of-period net equity is closed (perfect ex post monitoring). - With probability (1−q) a failing gambling bank stays in business (supervisory forbearance). - Profit margins: - Prudent: mp(ri, k) = α(1+k) − ρk − ri. - Gambling: mg(ri, k) = θ[γ(1+k) − ri] − ρk. - Per period profits: πp(ri, r−i, k) = mp(ri, k) D(ri, r−i) and πg(ri, r−i, k) = mg(ri, k) D(ri, r−i). - Elasticity of deposit supply to interest rates: ε, with ε increasing as banking competition intensifies. ### No-Gambling Condition (NGC) - Bank chooses prudent investment if expected discounted profits satisfy: - Vp(ri, r−i, k) = (1−δ)−1 πp(ri, r−i, k) ≥ Vg(ri, r−i, k, q) = [1 − δ (1 − (1−θ) q)]−1 πg(ri, r−i, k,). - Rearranged intuition: - (1−θ) δ Vp(ri, r−i, k) ≥ πg(ri, r−i, k) − πp(ri, r−i, k) - The one-period rent from gambling must be less than lost franchise value δVp if the gamble fails. - Threshold deposit rate r* such that ri > r* implies gambling is optimal: - r* is an explicit function of parameters (see equation (3) in text). - Comparative statics: - ∂r*/∂q > 0: r* increases with supervisory quality q. - ∂r*/∂k > 0: r* increases with higher capital requirement k. - For admissible values of k (0 r*(q=0). ### Optimal prudent deposit rate - Optimal deposit rate offered by a prudently investing bank: - rp(k) = (1/(1+ε)) × (αρ + k) + (ε/(1+ε)) × (?) — presented in the text as equation (6): - rp = (1/(1+ε)) (αρ) + (ε/(1+ε)) (ρ + k)? (see equation (6) for precise algebraic expression). - rp increases (becomes steeper) as ε increases (greater competition). ### Findings: effect of poor supervision and liberalization - Proposition 1: The minimum capital requirement necessary to prevent gambling can always be lower in well-supervised than in poorly-supervised markets because r*(q=1) > r*(q=0) for 0 k*PL, and - in developed financial markets with high-quality supervision: k*L > k*D. - Policy implication: Basel Accord minimum requirements may be insufficient for economies with low-quality supervision; minimum capital requirements should be tailored to supervisory capacity and stage of liberalization. ### Policy recommendations and implications - Increase minimum capital requirements to compensate for poor prudential supervision. - Do not apply uniform minimum capital requirements across countries — adjust for supervisory quality. - During the first years following financial liberalization, increase capital requirements relative to pre-liberalization levels. - Give priority to strengthening supervisory capacity (skills, staffing, remuneration, enforcement) alongside liberalization; sequence reforms to avoid a prolonged period of poor supervision under liberalized markets. ### Limitations and suggested extensions - Paper does not explicitly model fiscal cost to government of recapitalization. - Caveat: without numerical simulations, cannot ascertain whether required higher capital ratios for very low q become prohibitively large and jeopardize banking services. - Suggested extensions: - Numerical analysis to assess magnitudes of implied capital requirements. - Distinguish prudential regulation (rules) from prudential supervision (implementation). - Link microeconomic model to macroeconomic effects, e.g., fiscal costs, welfare, and monetary policy implications. *Source: _wp05136 - 1. Effects of Poor Supervision on the NGC* ### 1. Effects of Poor Supervision on the NGC ....................................................................8 ### 1. Effects of Poor Supervision on the NGC ### Purpose and approach - Investigates the importance of the quality of prudential supervision during financial liberalization and implications for the level of minimum capital requirements. - Analysis based on an extension of the theoretical model proposed by Hellmann, Murdock, and Stiglitz (2000) (the HMS model). - Key innovation: links explicitly the quality of prudential supervision to the optimal level of minimum capital requirements by allowing for imperfect monitoring by supervisors. ### Model setup and key parameters - Banks choose deposit rate ri and must hold own capital ratio k percent of deposits. - Opportunity cost of capital is ρ with ρ>α. - Two investment choices: - Prudent asset: known return α. - Gambling (risky) asset: high return γ if gamble succeeds, low return β if gamble fails (β < γ); success probability θ. - Expected social return from gambling is always less than that from the prudent asset: α > γθ + (1−θ)β. - Supervisory quality parameter q ∈ [0,1]: - q = 1: each gambling bank with negative end-of-period net equity is closed (perfect ex post monitoring). - With probability (1−q) a failing gambling bank stays in business (supervisory forbearance). - Profit margins: - Prudent: mp(ri, k) = α(1+k) − ρk − ri. - Gambling: mg(ri, k) = θ[γ(1+k) − ri] − ρk. - Per period profits: πp(ri, r−i, k) = mp(ri, k) D(ri, r−i) and πg(ri, r−i, k) = mg(ri, k) D(ri, r−i). - Elasticity of deposit supply to interest rates: ε, with ε increasing as banking competition intensifies. ### No-Gambling Condition (NGC) - Bank chooses prudent investment if expected discounted profits satisfy: Vp(ri, r−i, k) = (1−δ)−1 πp(ri, r−i, k) ≥ Vg(ri, r−i, k, q) = [1 − δ (1 − (1−θ) q)]−1 πg(ri, r−i, k,). - Rearranged intuition: (1−θ) δ Vp(ri, r−i, k) ≥ πg(ri, r−i, k) − πp(ri, r−i, k) - The one-period rent from gambling must be less than lost franchise value δVp if the gamble fails. - Threshold deposit rate r* such that ri > r* implies gambling is optimal: - r* is an explicit function of parameters (see equation (3) in text). - Comparative statics: - ∂r*/∂q > 0: r* increases with supervisory quality q. - ∂r*/∂k > 0: r* increases with higher capital requirement k. - For admissible values of k (0 r*(q=0). ### Optimal prudent deposit rate - Optimal deposit rate offered by a prudently investing bank: rp(k) = (1/(1+ε)) × (αρ + k) + (ε/(1+ε)) × (?) — presented in the text as equation (6): rp = (1/(1+ε)) (αρ) + (ε/(1+ε)) (ρ + k)? (see equation (6) for precise algebraic expression). - rp increases (becomes steeper) as ε increases (greater competition). ### Findings: effect of poor supervision and liberalization - Proposition 1: The minimum capital requirement necessary to prevent gambling can always be lower in well-supervised than in poorly-supervised markets because r*(q=1) > r*(q=0) for 0 k*PL, and - in developed financial markets with high-quality supervision: k*L > k*D. - Policy implication: Basel Accord minimum requirements may be insufficient for economies with low-quality supervision; minimum capital requirements should be tailored to supervisory capacity and stage of liberalization. ### Policy recommendations and implications - Increase minimum capital requirements to compensate for poor prudential supervision. - Do not apply uniform minimum capital requirements across countries — adjust for supervisory quality. - During the first years following financial liberalization, increase capital requirements relative to pre-liberalization levels. - Give priority to strengthening supervisory capacity (skills, staffing, remuneration, enforcement) alongside liberalization; sequence reforms to avoid a prolonged period of poor supervision under liberalized markets. ### Limitations and suggested extensions - Paper does not explicitly model fiscal cost to government of recapitalization. - Caveat: without numerical simulations, cannot ascertain whether required higher capital ratios for very low q become prohibitively large and jeopardize banking services. - Suggested extensions: - Numerical analysis to assess magnitudes of implied capital requirements. - Distinguish prudential regulation (rules) from prudential supervision (implementation). - Link microeconomic model to macroeconomic effects, e.g., fiscal costs, welfare, and monetary policy implications. *Source: _wp05136 - 1. Effects of Poor Supervision on the NGC* ### References ### References ### Financial regulation, supervision, and banking stability - Barth J. R., G. Caprio, and R. Levine, 1999, “Financial Regulation and Performance: Cross-Country Evidence,” World Bank Policy Research Working Paper No. 2037 (Washington: World Bank). - Barth J. R., G. Caprio, and R. Levine, 2004, “Bank Regulation and Supervision: What Works Best?,” Journal of Financial Intermediation, Vol. 13, No. 2, pp. 205-48. - Brownbridge, M., and C. Kirkpatrick, 2000, “Financial Regulation in Developing Countries,” Journal of Development Studies, Vol. 37, (October), pp. 1-24. - Caprio, G., and P. Honohan, 1999, “Beyond Capital Ideals: Restoring Banking Stability,” World Bank Policy Research Working Paper No. 2235 (Washington: World Bank). - Dekle, R., and K. M. Kletzer, 2001, “Domestic Bank Regulation and Financial Crises: Theory and Empirical Evidence from East Asia,” NBER Working Paper No. 8322 (Cambridge, Massachusetts: National Bureau of Economic Research). - Demirgüç-Kunt, A., and E. Detragiache, 1998, “The Determinants of Banking Crisis: Evidence from Developing and Developed Countries,” IMF Staff Papers, Vol. 45, pp. 81-109. - Demirgüç-Kunt, A., and E. Detragiache, 1998, “Financial Liberalization and Financial Fragility,” IMF Working Paper 98/83 (Washington: International Monetary Fund). - Dewatripont, M., and J. Tirole, 1994, The Prudential Regulation of Banks (Cambridge, Massachusetts: MIT Press). - Lindgren, C., G. Garcia, and M. Saal, 1996, Bank Soundness and Macroeconomic Policy, (Washington: International Monetary Fund). - Rossi, M., 1999, “Financial Fragility and Economic Performance in Developing Economies: Do Capital Controls, Prudential Regulation and Supervision Matter?” IMF Working Paper 99/66 (Washington: International Monetary Fund). - Santos, J.A.C., 2000, “Bank Capital Regulation in Contemporary Banking Theory: A Review of the Literature,” BIS Working Papers, No. 90, (Basel: Bank for International Settlements). - Villanueva, D., and A. Mirakhor, 1990, “Strategies for Financial Reforms: Interest Rate Policies, Stabilization, and Bank Supervision in Developing Countries,” Staff Papers, International Monetary Fund, Vol. 37 (September), pp. 509-36. ### Financial liberalization, crises, and moral hazard - Diaz-Alejandro, Carlos, 1985, “Good-Bye Financial Repression, Hello Financial Crash,” Journal of Development Economics, No. 19. - Fischer K. and M. Chenards, 1997, “Financial Liberalization Causes Banking Systems Fragility” Working Paper 97-12, Centre de Recherche en Economie et Finance Appliquées (Canada: Université Laval). - Furman J., and J. E. Stiglitz, 1998, “Economic Crisis: Evidence and Insights from East Asia,” Brookings Papers on Economic Activity, No. 2 (Washington: Brookings Institution), pp.1–135. - Hellmann, T., K. Murdock, and J. Stiglitz, 2000, “Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?” American Economic Review, Vol. 90, No.1 (March), pp. 147–65. - Goldstein, M., and P. Turner, 1996, “Banking Crises in Emerging Economies: Origins and Policy Options,” BIS Working, Papers No. 46 (Basel: Bank for International Settlements). - Krugman, P., 1998, “What Happened to Asia?” Chulalongkorn Journal of Economics, Vol. 10, No. 1 (January), pp.69–87. - Johnston, Barry R., and others, 1997, “Sequencing Capital Account Liberalization— Lessons from the Experiences in Chile, Indonesia, Korea and Thailand,” IMF Working Paper 97/157 (Washington: International Monetary Fund). - Goldstein, M., 1997, “The Case for an International Banking Standard,” Policy Analyses in International Economics, No. 47 (Washington: Institute for International Economics). ### Finance, growth, and development - Beck, T., R. Levine, and N. Loayza, 2000, “Finance and the Sources of Growth,” Journal of Financial Economics, Vol. 58, (October-November), pp. 261-300. - Freixas, X., and J.C. Rochet, 1997, Microeconomics of Banking (Cambridge, Massachusetts: MIT Press). - Fry, Maxwell J., 1997, “In Favour of Financial Liberalisation,” Economic Journal, Vol. 107 (May) pp. 754-70. - King, R.G., and R. Levine, 1993, “Finance and Growth: Schumpeter Might be Right,” Quarterly Journal of Economics, Vol. 108, (August), pp. 717-37. - Levine, R., 1997, “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature, Vol. 35 (June), pp. 688-726. - McKinnon, R.L., 1973, Money and Capital in Economic Development (Washington: Brookings Institution). - Rochet, J.C., 1992, “Capital Requirements and Behavior of the Commercial Banks,” European Economic Review, Vol. 36, No. 5, pp. 1137–70. - Shaw, E. S., 1973, Financial Deepening in Economic Development, New York: Oxford University Press. - Williamson, J., and M. Mahar, 1998, “A Survey of Financial Liberalization,” Essays in International Finance, No. 211. (Princeton: Princeton University, Department of Economics, International Finance Section) *Source: _wp05136 - References* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp05136.pdf_