Banking Supervision in Integrated Financial Markets: Implications for the EU

3.4 Regulator/Supervisor

The regulator aims at limiting the banks’s moral hazard due to limited lia-
bility. He is assumed to know the functional form of C(e), the relationship
between quality and the bank’s efforts (q = q₀ + e), and the impact of q on
G(r). I abstract from information asymmetries. The regulator can, thus,
observe the realization of q0 and the level of effort e.

The regulator uses the capital-asset ratio k and the total realized quality
q as regulatory instruments to deal with the bank’s moral hazard. He will
set both instruments depending on the observed innate quality.

The sequence of actions are described in the following:

Before t0 :

• Bank and regulator observe the innate quality of the bank’s assets q0 .

At t0 :

• Regulator imposes {q(q0), k(q0)} on bank.

• Bank raises equity E and issues deposits D in line with the regulation.

• Bank invests in loans L with the innate quality q0 and exerts effort e.

• Regulator prevents bank from operating if bank violates regulatory
terms.

• If bank abides by regulation, it remains in operation until t1.

At t1 :

• Cash flows are realized and distributed in the manner described above.

The supervisor is assumed to have a prudential as well as a systemic
mandate. Prudential supervision consists of a microeconomic approach that
focuses on screening the activity of individual banks with the aim of protect-
ing the assets of banking clients. This last view is the concept predominant in
theory and practice (see, for instance, Dewatripont and Tirole’s (1994) “rep-
resentation hypothesis” according to which the regulator-supervisor’s task is
to protect small and uninformed depositors). Therefore, the supervisor gives
negative weight to the loss of depositors in case of bankruptcy.

Systemic supervision is responsible for safeguarding the stability of the
entire banking system. Under a systemic supervisory mandate, banking su-
pervisors are concerned about two key issues: first, limiting the risk of finan-
cial contagion in the banking system that results from the interconnections

<<   7   8   9   10   11   12   13   >>

More intriguing information