《货币银行学》课程教学资源（文献资料）Understanding Financial Crisis

NBERWORKINGPAPERSERIESUNDERSTANDINGFINANCIALCRISES:ADEVELOPINGCOUNTRYPERSPECTIVEFrederic S.MishkinWorkingPaper5600NATIONALBUREAUOFECONOMICRESEARCH1050 Massachusetts AvenueCambridge, MA 02138May 1996Prepared for the World Bank Annual Conference on Development Economics,April 25-26, 1996,Washington,DC.I thankAgustin Carstens and the staff at theBank of Mexico,TerryChecki,Marilyn Skiles, and participants at seminars at the Federal Reserve Bank of New York, theInternational Monetary Fund, the Interamerican Development Bank and the World BankDevelopmentConferencefortheirhelpfulcommentsandMartinaHeydforresearchassistance.The findings, interpretations and conclusions expressed in this paper are entirely those of theauthor.They donot necessarilyrepresent theviewsof theWorld Bank, its ExecutiveDirectors,or the companies it represents, nor of Columbia University,the National Bureau of EconomicResearch,theFederal ReserveBank of NewYorkortheFederalReserveSystem.Thispaperis part of NBER's research programs in Economic Fluctuations and Growth, and MonetaryEconomics. 1996 by Frederic S. Mishkin. All rights reserved. Short sections of text, not to exceed twoparagraphs, may be quoted without explicit permission provided that full credit, including notice,isgiventothe source

NBER WORKING PAPER SERES UNDERSTAND~G FINANCIAL CRISES: A DEVELOPING COUNTRY PERSPECTIVE Frederic S. Mishkin Working Paper 5600 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 May 1996 Prepared for the World Bank Annual Conference on Development Economics, April 25-26, 1996, Washington, DC, I thank Agustin Carstens and the staff at the Bank of Mexico, Terry Checki, Marilyn Skiles, and participants at seminars at the Federal Reserve Bank of New York, the International Monetary Fund, the Interamerican Development Bank and the World Bank Development Conference for their helpful comments and Martina Heyd for research assistance. The findings, interpretations and conclusions expressed in this paper are entirely those of the author. They do not necessarily represent the views of the World Bank, its Executive Directors, or the companies it represents, nor of Columbia University, the National Bureau of Economic Research, the Federal Reserve Bank of New York or the Federal Reserve System. This paper is part of NBER’s research programs in Economic Fluctuations and Growth, and Monetary Economics. O 1996 by Frederic S. Mishkin, All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including O notice, is given to the source

NBERWorkingPaper5600May1996UNDERSTANDINGFINANCIALCRISESADEVELOPINGCOUNTRYPERSPECTIVEABSTRACTThis paper explains the puzzle of how a developing economy can shift dramatically froma path of reasonable growth before a financial crisis, as was the case in Mexico in 1994, to asharp decline in economic activity after a crisis occurs.It does so by outlining an asymmetricinformation framework for analyzing banking and financial crises in developing countries. Theasymmetric information framework shows why the banking sector is so important to theeconomy,particularly in developing countries and provides a rationale for bank regulation andsupervision. This asymmetric information framework is then used to understand why bankingand financial crises occur and why they can have such a devastating effect on the economy,particularly in developing countries.The paper concludes by discussing policy implications fordeveloping countries. An important theme is that an appropriate institutional structure is criticalto preventing banking and financial crises in developing countries and to reducing theirundesirableeffectsiftheyshould occur.Frederic S. MishkinFederalReserveBankof NewYork33LibertyStreetNew York,NY 10045and NBER

NBER Working Paper 5600 May 1996 UNDERSTANDING FINANCIAL CRISES : A DEVELOPING COUNTRY PERSPECTIVE ABSTRACT This paper explains the puzzle of how a developing economy can shift dramatically from a path of reasonable growth before a financial crisis, as was the case in Mexico in 1994, to a sharp decline in economic activity after a crisis occurs. It does so by outlining an asymmetric information framework for analyzing banking and financial crises in developing countries. The asymmetric information framework shows why the banking sector is so important to the economy, particularly in developing countries and provides a rationale for bank regulation and supervision. This asymmetric information framework is then used to understand why banking and financial crises occur and why they can have such a devastating effect on the economy, particularly in developing countries. The paper concludes by discussing policy implications for developing countries. An important theme is that an appropriate institutional structure is critical to preventing banking and financial crises in developing countries and to reducing their undesirable effects if they should occur. Frederic S. Mishkin Federal Reserve Bank of New York 33 Liberty Street New York, NY 10045 and NBER

I.IntroductionFinancial crises and their subset, banking crises, have become a worldwide phenomenain recent years.Not only have banking crises occurred in developed countries such as theUnited States, Japan, and in the Nordic countries, but they have been a feature of the recenteconomic scene in developing countries as well. In the case of developed countries, banking andfinancial crises have been costly to the economy, yet the damage that these crises seem toimpose on developing countries seems to be far greater than for developed countries.Indeedan important puzzle for the study of development economics is how a developing economy canshift dramatically from a path of reasonable growth before a financial crisis, as was the case inMexico in 1994, to a sharp decline in economic activity after a crisis occurs that is verydamaging to both the economy and social fabric of the country.This paper attempts to explain this puzzle by outlining an asymmetric informationframework for analyzing banking and financial crises in developing countries.It starts byoutlining the role that asymmetric information plays in a financial system and shows why thebanking sector is so important to the economy, particularly in developing countries. Theasymmetric information framework can then be used to derive a rationale for bank regulationand supervision, and raise some of the problems that may hinder the effective performance ofbank regulatory systems.(Because my expertise lies more with the financial system in the UnitedStates, I will take examples of how the bank regulatory/supervisory system may not work asintended from the U.S. experience.However, the parallels with the problems occurring indeveloping countries are actually quite close.) We then can apply this asymmetric informationframework to understand why banking and financial crises occur and why they can have sucha devastating effect on the economy,particularly in developing countries.Thepaper concludesby applying the analysis earlier in the paper to discuss policy implications for developingcountries.An important theme is that an appropriate institutional structure is critical topreventing banking and financial crises in developing countries and to reducing their undesirableeffectsif theyshouldoccur

I. Introduction Financial crises and their subset, banking crises, have become a worldwide phenomena in recent years. Not only have banking crises occurred in developed countries such as the United States, Japan, and in the Nordic countries, but they have been a feature of the recent economic scene in developing countries as well. In the case of developed countries, banking and financial crises have been costly to the economy, yet the damage that these crises seem to impose on developing countries seems to be far greater than for developed countries. Indeed an important puzzle for the study of development economics is how a developing economy can shift dramatically from a path of reasonable growth before a financial crisis, as was the case in Mexico in 1994, to a sharp decline in economic activity after a crisis occurs that is very damaging to both the economy and social fabric of the country. This paper attempts to explain this puzzle by outlining an asymmetric information framework for analyzing banking and financial crises in developing countries. It starts by outlining the role that asymmetric information plays in a financial system and shows why the banking sector is so important to the economy, particularly in developing countries. The asymmetric information framework can then be used to derive a rationale for bank regulation and supervision, and raise some of the problems that may hinder the effective performance of bank regulatory systems. (Because my expertise lies more with the financial system in the United States, I will take examples of how the bank regulatory/supervisory system may not work as intended from the U.S. experience. However, the parallels with the problems occurring in developing countries are actually quite close.) We then can apply this asymmetric information framework to understand why banking and financial crises occur and why they can have such a devastating effect on the economy, particularly in developing countries. The paper concludes by applying the analysis earlier in the paper to discuss policy implications for developing countries. An important theme is that an appropriate institutional structure is critical to preventing banking and financial crises in developing countries and to reducing their undesirable effects if they should occur

II.TheRoleof AsymmetricInformationintheFinancial SystemThe financial system has an extremely important function in the economy because itenables funds to move from economic agents who lack productive investment opportunities tothose who have such opportunities. Unless the financial system can do this job effectively, theeconomy will not function efficiently and economic growth will be severely hampered.A crucial impediment to the efficient functioning of the financial system is asymmetricinformation, a situation in which one party to a financial contract has much less accurateinformation than the other party. For example, a borrower who takes out a loan usually hasmuch better information about the potential returms and risk associated with the investmentprojects he plans to undertake than the lender does.Asymmetric information leads to two basicproblems in the financial system: adverse selection and moral hazard.AdverseSelectionAdverse selection is an asymmetric information problem that occurs before the transactionoccurs when potential bad credit risks are the ones who most actively seek out a loan. Thus theparties who are the most likely to produce an undesirable (adverse) outcome are most likely tobe selected.For example, those who want to take on big risks are likely to be the most eagerto take out a loan because they know that they are unlikely to pay it back. Since adverseselection makes it more likely that loans might be made to bad credit risks, lenders may decidenot to make any loans even though there are good credit risks in the marketplace. This outcomeis a feature of the classic "lemons problem" analysis first described by Akerlof (1970).Aspointed out by Myers and Majluf (1984) and Greenwald, Stiglitz and Weiss (1984), a lemonsproblem occurs in the debt and equity markets when lenders have trouble determining whethera lender is a good risk (he has good investment opportunities with low risk) or, alternatively,2

II. The Role of Asymmetric Information in the Financial System The financial system has an extremely important function in the economy because it enables funds to move from economic agents who lack productive investment opportunities to those who have such opportunities. Unless the financial system carI do this job effectively, the economy will not function efficiently and economic growth will be severely hampered. A crucial impediment to the efficient functioning of the financial system is asymmetric information, a situation in which one party to a financial contract has much less accurate information than the other party. For example, a borrower who takes out a loan usually has much better information about the potential returns and risk associated with the investment projects he plans to undertake than the lender does. Asymmetric information leads to two basic problems in the financial system: adverse selection and moral hazard. Adverse Selection Adverse selmtion is an asymmetric information problem that occurs before the transaction occurs when potential bad credit risks are the ones who most actively seek out a loan. Thus the parties who are the most likely to produce an undesirable (tiverse) outcome are most likely to be selected. For example, those who want to take on big risks are likely to be the most eager to take out a loan because they know that they are unlikely to pay it back. Since adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though there are good credit risks in the marketplace. This outcome is a feature of the classic “lemons problem” analysis first described by Akerlof (1970). As pointed out by Myers and Majluf (1984) and Greenwald, Stiglitz and Weiss (1984), a lemons problem occurs in the debt and a lender is a good risk (he has equity markets when lenders have trouble determining whether good investment oppotiunities with low risk) or, alternatively, .2

is a bad risk (he has poorer investment projects with high risk). In this situation, a lender willonly be willing to pay a price for a security that reflects the average quality of firms issuing thesecurities --a price below fair market value (the net present value of the expected incomestreams)for high-quality firms, but abovefair market value for low-quality firms.The ownersor managers of a high-quality firm that know their quality then also know that their securitiesare undervalued and will not want to sell them in the market. On the other hand, the firmswilling to sell their securities will be low-qualityfirms because theyknow that the price of theirsecurities is greater than their value.Since asymmetric information prevents investors fromdetermining whether some firms are high quality, these high quality firms will issue fewsecurities and credit markets will not work as well since many projects with a positive netpresent value will not be undertaken.MoralHazardMoral hazard occurs after the transaction occurs because the lender is subjected to thehazard that the borrower has incentives to engage in activities that are undesirable (immoral)from the lender's point of view: i.e., activities that make it less likely that the loan will be paidback. Moral hazard occurs because the borrower has incentives to invest in projects with highrisk in which the borrower does well if the project succeeds but the lender bears most of the lossif the project fails.Also the borrower has incentives to misallocate funds for his own personaluse, to shirk and just not work very hard, or to undertake investment in unprofitable projectsthat increase his power or stature.The conflict of interest between the borrower and lenderstemming from moral hazard (the agency problem) implies that many lenders will decide thatthey would rather not make loans, so that lending and investment will be at suboptimal levels.!'Note that asymmetric information is not the only source of the moral hazard problem.Moral hazardcan also occur because high enforcement costs might make it too costly for the lender to prevent moralhazard even when the lender is fully informed about the borrower's activities.3

is a bad risk (he has poorer investment projects with high risk). In this situation, a lender will only be willing to pay a price for a security that reflects the average quality of firms issuing the securities - a price below fair market value (the net present value of the expected income streams) for high-quality firms, but above fair market value for low-quality firms. The owners or managers of a high-quality firm that know their quality then also know that their securities are undervalued and will not want to sell them in the market. On the other hand, the firms willing to sell their securities will be low-quality firms because they know that the price of their securities is greater than their value. Since asymmetric information prevents investors from determining whether some firms are high quality, these high quality firms will issue few securities and credit markets will not work as well since many projects with a positive net present value will not be undertaken. Moral Hazard Moral hazard occurs after the transaction occurs because the lender is subjected to the hazard that the borrower has incentives to engage in activities that are undesirable (immoral) from the lender’s point of view: i.e., activities that make it less likely that the loan will be paid back. Moral h=ard occurs because the borrower has incentives to invest in proj=ts with high risk in which the borrower does well if the projwt SUCCASbut the lender bears most of the loss if the project fails. Also the borrower has incentives to misallocate funds for his own personal use, to shirk and just not work very hard, or to undertake investment in unprofitable projwts that increase his power or stature. The conflict of interest between the borrower and lender stemming from moral hzard (the agency problem) implies that many lenders will decide that they would rather not make loans, so that lending and investment will be at suboptimal levels. 1 ‘Note that asymmetric information is not the only source of the moral hazard problem. Moral hazard can also occur because high enforcement costs might make it too costly for the lender to prevent moral hazard even when the lender is fully informed about the borrower’s activities. 3

WhyareBanks So Important?Asymmetric information theory explains why banks are such importantplayers in thefinancial system in all countries throughout the world, and particularly so in developedcountries.2 Becausean adverse selection (lemons)problem exists in securitiesmarkets in whichlow quality firms will be more eager to issue securities, securities markets are unlikely to playa key role in the financial system in most countries. One solution to this problem is the privateproduction and sale of information which can reduce the degreeof asymmetric information thatcreates the lemons problem for securities.However, the so-called free rider problem,in whichpeople who do not pay for information can still take advantage (free ride off)of the informationthat other peoplehave paid for, will result in too littleprivate production and sale ofinformation.To understand the free rider problem recognize that if some investors acquire informationthat tells them which securities are undervalued and therefore buy their securities, other investorswho have not paid for this information may be able to buy right along with the well-informedinvestors.If enough free-riding investors can do this, the increased demand for the undervaluedsecurities will cause their low price to be bid up to reflect the securities'full net present valuegiven this information. As a result of all these free riders, investors who have acquiredinformation will no longer be able to earn the entire increase in the value of the security arisingfrom this additional information.The weakened ability of private firms to profit fromproducing information will mean that less information is produced in securities markets, so thatthe adverse selection problem continues to be an impediment to a well-functioning securities2Gertler (1988a)provides an excellent survey of the literature on asymmetric information and financialstructure whichis moregeneral than that herebecause itlooks at additional elements of financial structurethat are explained by asymmetric information considerations.Note also that transactions cost also playa role in explaining why banks are such important players in the financial system. Banks are very wellsuitedtoreducetransactions costsbecausetheirsizeenablesthemtotakeadvantageof economiesofscaleto keep transactions costs low.In addition,they develop expertise,say with computer and legaltechnology, to reduce transactions costs.Although transactions costs do play a role in making banksimportant in the financial system, asymmetric information issues are emphasized in this paper becausethey help explain why banks are so unique in the financial system and also help us understand phenomenasuchasfinancial crises..4

Why are Banks So Important? Asymmetric information theory explains why banks are such important players in the financial system in all countries throughout the world, and particularly so in developed countries. 2 Because an adverse selection (lemons) problem exists in securities markets in which low quality firms will be more eager to issue securities, securities markets are unlikely to play a key role in the financial system in most countries. One solution to this problem is the private production and sale of information which can reduce the degree of asymmetric information that creates the lemons problem for securities. However, the so-called free rider problem, in which paple who do not pay for information can still take advantage (free ride off) of the information that other people have paid for, will result in too little private production and sale of information. To understand the free rider problem rmognize that if some investors acquire information that tells them which securities are undervalued and thereforebu y their securities, other investors who have not paid for this information may be able to buy right along with the well-informed investors. If enough free-riding investors can do this, the increased demand for the undervalued securities will cause their low price to be bid up to reflect the securities’ full net present value given this information. As a result of all these free riders, investors who have acquired information will no longer be able to earn the entire increase in the value of the security arising from this additional information. The weakened ability of private firms to profit from producing information will mean that less information is produced in swunties markets, so that the adverse selection problem continues to be an impediment to a well-functioning securities 2Gertler (1988a) provides an excellent survey of the literature on asymmetric information and financial structure which is more general than that here because it looks at additional elements of financial structure that are explained by asymmetric information considerations. Note also that transactions cost also play a role in explaining why banks are such important players in the financial system. Banks are very well suited to reduce transactions costs because their size enables them to take advantage of economies of scale to keep transactions costs low. In addition, they develop expertise, say with computer and legal technology, to reduce transactions costs. Although transactions costs do play a role in making banks important in the financial system, asymmetric information issues are emphasized in this paper because they help explain why banks are so unique in the financial system and also help us understand phenomena such as financial crises. .4

market.More importantly,thefree-rider problem makes it less likely that securities markets willact to reduce incentives to commit moral hazard.Monitoring and enforcement of restrictivecovenants (provisions in debt contracts that restrict and specify certain activities of the borrower)are necessary to reduce moral hazard. By monitoring a borrower's activities to see whether heis complying with the restrictive covenants and enforcing the covenants if he is not, lenders canprevent borrowers from taking on risk at their expense.However, because monitoring andenforcementof restrictivecovenants are costly,thefree-rider problemdiscourages this kind ofactivity in securities markets.If some investors know that other securities holders aremonitoring and enforcing the restrictive covenants, then they can free ride on the other securitiesholders' monitoring and enforcement. Once these other securities holders realize that they cando the same thing, they also may stop their monitoring and enforcement activities, with theresult that not enough resources are devoted to monitoring and enforcement.The outcome isthat moral hazard continues to be a severe problem for marketable securities.The analysis above thus explains why,as Mayer (1990) points out, securities markets arefrequently a relatively unimportant source of external finance to nonfinancial businesses indeveloped countries. Furthermore it suggests why securities markets are even less important indeveloping countries.Clearly,the better the quality of information about firms, the more likelyit is that they can issue securities to raise funds.This implication of the theory indicates whyonly the largest and best known firms in developed countries issue securities.In developingcountries, information about private firms is even harder to collect than in developed countriesand not surprisingly, securities markets therefore play a much smaller role.Banks play the most important role in financial systems throughout the world becausethey are so well suited to reducing adverse selection and moral hazard problems in financialmarkets.They are not as subject to the free rider problem and profit from the information theyproduce by making private loans that are not traded. As a result, other investors have moredifficulty free riding off the financial intermediary and bidding up the loan's price which wouldprevent the intermediary from profiting from their information production activities. Similarly,it is hard to free rideoff banks'monitoring activities when they make private loans.Banks thusreceive the benefits of monitoring and so are better equipped to prevent moral hazard on the part5

market. More importantly, the free-rider problem makes it less likely that securities markets will act to reduce incentives to commit moral hazard. Monitoring and enforcement of restrictive covenants (provisions in debt contracts that restrict and specify certain activities of the borrower) are necessary to reduce moral h=ard. By monitoring a borrower’s activities to see whether he is complying with the restrictive covenants and enforcing the covenants if he is not, lenders can prevent borrowers from taking on risk at their expense. However, because monitoring and enforcement of restrictive covenants are costly, the free-rider problem discourages this kind of activity in securities markets. If some investors know that other securities holders are monitoring and enforcing the restrictive covenants, then they can free ride on the other securities holders’ monitoring and enforcement. Once these other securities holders realize that they can do the same thing, they also may stop their monitoring and enforcement activities, with the result that not enough resources are devoted to monitoring and enforcement. The outcome is that moral hazard continues to be a severe problem for marketable s~urities. The analysis above thus explains why, as Mayer (1990) points out, securities markets are frequently a relatively unimportant source of external finance to nonfinancial businesses in developed countries. Furthermore it suggests why securities markets are even less important in developing countries. Clearly, the better the quality of information about firms, the more likely it is that they can issue securities to raise funds. This implication of the theory indicates why only the largest and best known firms in developed countries issue securities. In developing countries, information about private firms is even harder to collwt than in developed countries and not surprisingly, securities markets therefore play a much smaller role. Banks play the most important role in financial systems throughout the world because they are so well suited to reducing adverse selection and moral hazard problems in financial markets. They are not as subject to the free rider problem and profit from the information they produce by making private loans that are not traded. As a result, other investors have more difficulty free riding off the financial intermediary and bidding up the loan’s price which would prevent the intermediary from profiting from their information production activities. Similarly, it is hard to free ride off banks’ monitoring activities when they make private loans. Banks thus receive the benefits of monitoring and so are better equipped to prevent moral hazard on the part .5

ofborrowers.3Banks have particular advantages over other financial intermediaries in solvingasymmetric information problems.For example,banks'advantages in information collectionactivities are enhanced by their ability to engage in long-term customer relationships and issueloans using lines of credit arrangements. In addition their ability to scrutinize the checkingaccount balances of their borrowers provides them with an additional advantage in monitoringthe borrowers behavior.Banks also have advantages in reducing moral hazard because, asdemonstrated by Diamond (1984), they can engage in lower cost monitoring than individuals,and because, as pointed out by Stiglitz and Weiss (1983), they have advantages in preventingrisk taking by borrowers since they can use the threat of cutting off lending in the future toimprove borrower's behavior.Banks'natural advantages in collecting information and reducingmoral hazard explain why banks have such an important role in financial markets in thedeveloped countries. Furthermore, the greater difficulty of acquiring information on privatefirms indeveloping countries makesbanks even moreimportant in thefinancial systems ofthesecountries.4,s3Note that by making private loans, banks can not entirely eliminate the free rider problem.Knowingthat a bank has made a loan to a particular company reveals information to other parties that the companyis more likely to be creditworthy and will be undergoing monitoring by the bank.Thus some of thebenefits of information collection producedbythebankwill accruetoothers.Thebasicpointhereis thatby making private loans, banks have the advantage of reducing the free rider problem, but they can noteliminate it entirely.4Rojas-Suarez and Weisbrod (1994)document that banks playamore important role in thefinancialsystems in developing countries than they do in developed countries.'As pointed out in Edwards and Mishkin (1995),the traditional financial intermediation role ofbanking has been in decline in boththe United States and otherdeveloped countries because of improvedinformation technology which makes it easier to issue securities.Although this suggests that the decliningrole of traditional banking which is occuIrring inthedeveloped countries may eventually occurin thedeveloping countriesas well,thebarriers tomationcollectionindeveloping countriesaresogreatntorithat the dominance ofbanks in these countrieswill continuefortheforeseeablefuture..6

of borrowers. 3 Banks have particular advantages over other financial intermediaries in solving asymmetric information problems. For example, banks’ advantages in information collection activities are enhanced by their ability to engage in long-term customer relationships and issue loans using lines of credit arrangements. In addition their ability to scrutinize the checking account balances of their borrowers provides them with an additional advantage in monitoring the borrowers behavior. Banks also have advantages in reducing moral hazard because, as demonstrated by Diamond (1984), they can engage in lower cost monitoring than individuals, and because, as pointed out by Stiglitz and Weiss (1983), they have advantages in preventing risk taking by borrowers since they can use the threat of cutting off lending in the future to improve borrower’s behavior. Banks’ natural advantages in collecting information and reducing moral hazard explain why banks have such an important role in financial markets in the developed countries. Furthermore, the greater difficulty of acquiring information on private firms in developing countries makes banks even more important in the financial systems of these countries.4’5 3Note that by making private loans, banks can not entirely eliminate the free rider problem. Knowing that a bank has made a loan to a particular companyreveals informationto other parties that the company is more likely to be creditworthy and will be undergoing monitoring by the bank. Thus some of the benefits of information collection producti by the bank will accrue to others. The basic point here is that by making private loans, banks have the advantage of reducing the free rider problem, but they can not eliminate it entirely. 4Rojas-Suarez and Weisbrod (1994) document that banks play a more important role in the financial systems in developing countries than they do in developed countries. 5As pointed out in Edwards and Mishkin (1995), the traditional financial intermediation role of banking has been in decline in both the United States and other developed countries because of improved information technology which makes it easier to issue securities. Although this suggests that the declining role of traditional banking which is occurring in the developed countries may eventually occur in the developing countries as well, the barriers to information collection in developing countries are so great that the dominance of banks in these countries will continue for the foreseeable future. .6

III.AsymmetricInformation and Bank RegulationWe have seen how asymmetric information leads to adverse selection and moral hazardproblems that have an important impact on the structure of the financial system. This sameanalysis is also very useful in understanding the common forms that bank regulation andsupervision take in most countries in the world, which include: a safety net for depositors,restrictions on bank asset holdings, capital requirements, disclosure requirements, chartering,bank examinations, and prompt corrective action.Government Safety NetAs we have seen, banks are particularly well suited to solving adverse selection andmoral hazard problems because they make private loans which avoids the free riderproblem.However, this solution to thefreeriderproblem createsanotherasymmetric information problembecause depositors lack information about the quality of these private loans, which can lead tobank panics.6 To understand the problem consider a situation in which there is no safety netfor depositors.Suppose an adverse shock hits the economy, with the result that 5% of acountry's banks have such large loan losses that they are insolvent.Because of asymmetricinformation, depositors are unable to tell whether their bank is a good bank or one of the 5%of insolvent banks. Depositors at bad and good banks recognize that they may not get back 100cents on the dollar for their deposits and will want to withdraw them.Indeed, because banksoperate on a first-come-first-served basis (the so-called sequential service constraint), depositorshave a very strong incentive to show up at the bank first because if they are last on line, thebank may run out of funds and they will get nothing.Therefore uncertainty about the health ofthe banking system in general can lead to "runs" on banks, both good and bad, and the failureof one bank can hasten the failure of others, leading to a contagion effect.If nothing is done‘For example, see Gorton and Calomiris (1991).7

III. Asymmetric Information and Bank Regulation We have seen how asymmetric information leads to adverse selection and moral hazard problems that have an important impact on the structure of the financial system. This same analysis is also very useful in understanding the common forms that bank regulation and supervision take in most countries in the world, which include: a safety net for depositors, restrictions on bank asset holdings, capital requirements, disclosure requirements, chartering, bank examinations, and prompt corrective action. Government Safety Net As we have seen, banks are particularly well suited to solving adverse selection and moral hazard problems because they make private loans which avoids the free rider problem. However, this solution to the free rider problem creates another asymmetric information problem because depositors lack information about the quality of these private loans, which can lead to bank panics. 6 To understand the problem consider a situation in which there is no safety net for depositors. Suppose an adverse shock hits the economy, with the result that 5% of a country’s banks have such large loan losses that they are insolvent. Because of asymmetric information, depositors are unable to tell whether their bank is a good bank or one of the 5 % of insolvent banks. Depositors at bad and good banks recognize that they may not get back 100 cents on the dollar for their deposits and will want to withdraw them. Indeed, because banks operate on a first-come-first-served basis (the so-called sequential service constraint), depositors have a very strong incentive to show up at the bank first because if they are last on line, the bank may run out of funds and they will get nothing. Therefore uncertainty about the health of the banking system in general can lead to “runs” on banks, both good and bad, and the failure of one bank can hasten the failure of others, leading to a contagion effect. If nothing is done 6For example, see Gorton and Calomiris (1991). 7

to restore the public's confidence, a bank panic can ensue in which both solvent and insolventbanks go out of business, leaving depositors with large losses.A government safety netfor depositors can short circuit runs on banks and bank panics.Deposit insurance is one form of the safety net in which depositors, sometimes with a limit toamount and sometimes not, are insured against losses due to a bank failure.With fully insureddeposits, depositors don't need to run to the bank to make withdrawals -- even if they areworried about the bank's health -- because their deposits will be worth 100 cents on the dollarno matter what.Even with less than full insurance,the incentive for depositors to run towithdraw deposits when they are unsure about the bank's health is decreased.Deposit insurance is not the only way in which governments provide a safety net todepositors.Governments often stand ready to provide support to domestic banks when they faceruns even in the absence of explicit deposit insurance.This support is sometimes provided bylending from the central bank to troubled institutions, and is often referred to as the lender-of-last-resort role of the central bank.In other cases, funds are provided directly by thegovernment to troubled institutions, or these institutions are taken over by the government andthe government then guarantees that depositors will receive their money in full.Moral Hazard, Adverse Selection and the Government Safety NetAlthough a govermment safety net can be quite successful at protecting depositors andpreventing bank panics, it is a mixed blessing.The most serious drawback of a safety net stemsfrom moral hazard, an important feature of insurance arrangements in general because theexistence of insurance provides increased incentives for taking risks that might result in aninsurancepayoff.Moral hazard isaprominent attributeingovernment arrangements toprovidea safety net because depositors expect that they will not suffer losses if a bank fails. Thus theymay not impose the discipline of the marketplace on banks by withdrawing deposits when theysuspect that the bank is taking on too much risk. Consequently, banks that are provided witha safety net can (and do) take on greater risks than they otherwise would.A further problem when there is a safety net arises because of adverse selection,where.8

to restore the public’s confidence, a bank panic can ensue in which both solvent and insolvent banks go out of business, leaving depositors with large losses. A government safety net for depositors carI short circuit runs on banks and bank panics. Deposit insurance is one form of the safety net in which depositors, sometimes with a limit to amount and sometimes not, are insured against losses due to a bank failure. With fully insured deposits, depositors don’t n~ to run to the bank to make withdrawals - even if they are worried about the bank’s hdth - because their deposits will be worth 100 cents on the dollar no matter what. Even with less than full insurance, the incentive for depositors to run to withdraw deposits when they are unsure about the bank’s hdth is decreased. Deposit insurance is not the only way in which governments provide a safety net to depositors. Governments often stand ready to provide support to domestic banks when they face runs even in the absence of explicit deposit insurance. This support is sometimes provided by lending from the central bank to troubled institutions, and is often referred to as the lender-of￾last-resort role of the central bank. In other cases, funds are provided directly by the government to troubld institutions, or these institutions are taken over by the government and the government then guarant=s that depositors will receive their money in full. Moral Hazard, Adverse Selection and the Government Safety Net Although a government safety net can be quite successful at protecting depositors and preventing bank panics, it is a mixed blessing. The most serious drawback of a safety net stems from moral hazard, an important feature of insurance arrangements in general because the existence of insurance provides increased incentives for taking risks that might result in an insurance payoff. Moral huard is a prominent attribute in government arrangements to provide a safety net because depositors expect that they will not suffer losses if a bank fails. Thus they may not impose the discipline of the marketplace on banks by withdrawing deposits when they suspat that the bank is taking on too much risk. Consequently, banks that are provided with a safety net can (and do) take on greater risks than they otherwise would. A further problem when there is a safety net arises because of adverse selection, where 8