Bank regulation, reputation and rents: theory and policy implications

The Economics of Bank Regulation

“…Since these would be independent insured institutions, the TBTF issue for them would be no different from the TBTF issue for General Electric or IBM. These arguments are developed more fulIy in Boot and Greenbaum [1993].…”

“…In Boot and Greenbaum [1993], banks differ in their monitoring ability; cost functions for monitoring at intensity m are V(m) or zero for the two types of banks. Entrepreneurs with loans from banks choose among projects with a two-state retum distribution where the bank's monitoring intensity affects the probability distribution ofits payoffs.…”

“…In addition to improving these expected future rents, bank monitoring improves its reputation for monitoring with uninsured depositors, which serves to 10wer the bank's cost of funding in the subsequent periodo An increase in either the expected rent (expected payoff on banks' loans 1ess the cost of deposits) or the funding-re1ated reputational benefit increases banks' monitoring efforts. However, unless regu1ators malee an analogous calcu1ation in deciding on deposit insurance premia, the reputational benefit is 10st with insured deposits, which is undesirab1e especial1y when enhanced competition decreases future 23 Boot and Greenbaum [1993] argue that their set up, rather than one of choice of asset riskiness by the bank itself, is the appropriate mode1, since the choice of riskiness of bank 10ans cou1d be inferred by regu1ators from the promised interest rate that banks charge on such 10ans.…”

“…Suares briefly considers the issue of recapitalization 26 by the bank when current cash flows 24 Bensaid, Pages and Rochet [1993] examine sorne issues similar to those in Boot and Greenbaum [1993]. The bank's payoff is affected both by its monitoring effort (unobservable to the regulator) and its privately-known investment quality.…”

Bank Competition and Financial (In)Stability in Europe: A Sensitivity Analysis

“…Bank failures are likely to occur when adverse selection and moral hazard problems indicate that banks are getting more reluctant to monitor borrowers and thereby falling short of exploiting the benefits of relationship banking (Boot and Greenbaum, 1993). Thus, loan portfolios tend to comprise marginal applicants and potentially exacerbate the risk exposure (Allen and Gale, 2000).…”