Banking Supervision in Integrated Financial Markets: Implications for the EU



3OutlineoftheModel

While banking regulation and banking supervision are generally regarded as
having the same objective, it should be remarked that they are different in
that ”regulation deals with the formation of rules (... whereas) supervision
deals with the enforcement of rules both ex ante (control) and ex post (sanc-
tions)”.7 According to Basel II, supervisors will have discretion to use tools
such as requiring the bank to hold more capital. However, when a supervisor
has such wide competencies, he actually acts as a regulator. In this sense,
regulation and supervision are often indistinguishable. Hence, regulator and
supervisor are modelled as one institution and both expressions are used as
synonyms.

The regulator’s aim is to maximize social welfare. Banks provide two
socially valuable services. First, they take in retail and interbank deposits
which are liquid and, thus, valuable to depositors who are assumed to have a
preference for liquidity. Second, banks invest these proceeds in risky retail or
interbank loans. Limited liability is assumed so that banks are only interested
in cash flows which accrue in states other than bankruptcy. This convex
pay-off structure encourages banks to increase asset risk, which increases
the expected pay-off. Due to this classical moral hazard problem, banks
are not interested in employing costly resources in order to lower the risk
associated with its loan portfolio. However, such a reduction in portfolio risk
would lower the probability of failure and, hence, the probability of losses to
depositors and of negative systemic impacts.

The regulator’s problem guides my model construction. Many details are
borrowed from Giammarino, Lewis, and Sappington (1993) (from now on,
referred to as GLS). However, my focus is different: In GLS, the regulator
tries to balance the interests of the bank against the interest of the deposit
insurance which is funded via distortionary taxes. In contrast, I assume
the absence of deposit insurance. Hence, bankruptcy can trigger losses to
depositors and systemic costs along the chain of banks which the regulator
is concerned to balance against bank profits.

In my model, there are four classes of risk-neutral actors: (1) retail depos-
itors with wealth which can be invested or loaned, (2) companies which seek
loans to finance projects, (3) banks that provide intermediation services and
are active in the interbank market, and (4) a benevolent regulator-supervisor
who maximizes social welfare. More details are provided in the following.

7See Di Giorgio and Di Noia (2001).



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