Chapter 10 - Problem Set.pdf

Iii capital requirements also minimize moral hazard

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(iii) capital requirements also minimize moral hazard when institutions are forced to hold a large amount of equity capital, they have more to lose if they fail and is thus more likely to pursue lower-risk activities. Capital also functions as cushion when bad shocks occur. Forms of capital requirements: leverage ratio (capital/assets of over 5% as well capitalized banks) and risk-based capital requirements (Basel Accord requires banks to hold capital of at least 8% of risk-weighed assets). Basel committee on Banking Supervision has implemented risk-based capital requirements (Basel Accord), which required that the bank holds as capital at least 8% of their risk-weighted assets. Assets and off-balance-sheet activities were allocated into four categories (each with a different weight to reflect the degree of credit risk): (a) items with little default risk carried a zero weight (reserves and government securities). (b) 20% weight applied to claims on banks in OECD countries. (c) 50% weight applied to municipal bonds and residential mortgages. (d) 100% weight applied to debts to consumers and corporations. Off-balance-sheet activities are treated in a similar manner by assigning a credit- equivalent percentage that converts them to on-balance-sheet items to which the appropriate risk weight applies. Regulatory arbitrage banks keep on their books assets that have the same risk- based capital requirements, but are relatively risky (loans to companies with very low credit ratings). (iv) CDIC adopted prompt corrective action provisions that require the CDIC to intervene earlier and more vigorously when a bank gets into trouble (the amount of a financial institution’s capital falls to low levels) . (v) financial (prudential) supervision: overseeing who operates financial institutions and how they are operated. Since banks can be used by crooks or overambitious entrepreneurs to engage in highly speculative activities, proposals for new banks are screened to prevent undesirable people from controlling them through chartering (one method for preventing the adverse selection problem). To limit the moral hazard problem, regular on-site bank examinations to monitor whether the bank is complying with capital requirements and restrictions on asset holdings ( CAMELS capital adequacy, asset quality, management, earnings,
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ECO349 2011 Winter Chapter 10 Problem Set Michael Ho 4/12 liquidity, and sensitivity to market risk). Regulators can enforce regulations by taking actions such as cease and desist orders to alter the bank’s behaviour or even close a bank if its CAMEL rating is sufficiently low. Actions taken to reduce moral hazard by restricting banks from taking on too much risk help reduce the adverse selection problem further because with less opportunity for risk taking, risk-loving entrepreneurs will be less likely to be attracted to the banking industry.
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  • Fall '09
  • H
  • Fractional-reserve banking, Bank run

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