DISTORTED INCENTIVES FOR THE PARTICIPANTS OF THE BANKING SYSTEM

1
DISTORTED INCENTIVES FOR THE PARTICIPANTS OF THE
BANKING SYSTEM

• Besides the above listed factors that lie behind
  the origin of banking crises in many countries, a
  major part of the problem is the existing
  structure of incentives in the banking industry.
  Appropriate incentives must discourage
  risk-taking and encourage corrective action at an
  early stage. We will examine the existing
  incentives for bank owners, managers, bank
  depositors and bank supervisors, as well as the
  ways in which these incentives can improve.
• The incentives of bank owners to prevent the bank
  from becoming insolvent are the following bank
  capital, their contribution to the costs of any
  bank restructuring and the franchise value of the
  bank.
• The banks own capital acts primarily as a
  cushion against unforeseen losses. In the case
  of losses from nonperforming loans, the bank will
  have to reduce its own capital by using those
  funds to pay back its depositors.

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• Bank capital provides an additional, and perhaps
  more significant, role by offering the incentive
  for better corporate governance. If the bank
  owners have a lot of their own funds at risk,
  then they have a strong incentive to monitor the
  activities of the managers in order to prevent
  any bank insolvency.
• Furthermore, the bank owners have strong
  incentives to monitor the activities of the bank
  if they believe that they will have to incur a
  significant portion of the costs of
  restructuring. In that way, the public ensures
  that those who benefited from risk-taking also
  absorb the costs when their expectations are not
  realized.
• To ensure that banks face part of the costs that
  could occur as a result of excessive risk-taking,
  bank supervisors require that they maintain
  certain minimum capital standards.

3

• The Basle Committee on Banking Supervision,
  established by the G-10 group of countries,
  set as a minimum capital adequacy ratio for
  international banks that the banks capital
  should be 8 of total assets. This standard has
  been adopted by many countries.
• However, this standard does not account for the
  riskiness of the assets. For example, the assets
  (loans) of one bank may be more risky than that
  of another because the first bank has lent money
  to risky projects. Thus, it is better to use
  what is called the risk-based capital ratio
  which shows the capital that the bank must hold
  based on how risky its loans are.
• Banks in emerging markets do not have risk-based
  capital ratios significantly higher than those in
  industrial countries, despite the fact that they
  are faced with a more risky environment.

4

• There is no comprehensive information available
  on what share of the bank restructuring costs was
  incurred by the banks shareholders in various
  countries. It has been found that a major
  failure of the restructuring programs in Latin
  America during the early 1980s was the absence of
  penalties for shareholders.
• Finally, measuring the franchise value of the
  bank is not an easy task and economists have not
  agreed on the proper method to do that. A
  popular measure is the average return on assets.
  Given the short-term horizon of financial systems
  in many developing countries (meaning that
  participants do not pursue long-term investment
  projects), economists have suggested that a
  better measure for franchise value in these
  countries is the ability of banks to cover their
  deposit liabilities with liquid funds.

5

• The implication of the above-suggested measure is
  that banks that can attract deposits and closely
  monitor the liquidity of their borrowers (their
  ability to make payments on their loans) have a
  higher franchise value. However, obtaining a
  measure of that ability is not as straightforward
  as it seems.
• Overall, banks in developing countries are less
  efficient than banks in industrial countries.
  The banking industries in these countries are
  also more concentrated, given the share of the
  five largest banks in total assets.
• Thus we can conclude that, in terms of bank
  capital, contribution of bank shareholders into
  the costs of restructuring, and franchise value,
  there exist no strong incentives that would
  discourage excessive risk-taking by bank owners
  in developing countries.

6

• Several studies point to the role of poor
  management in creating the conditions for bank
  failures to follow. Given the many factors that
  contribute to the occurrence of banking crises,
  it becomes difficult to single that one out. A
  failure to penalize the senior management for
  contributing to a banks failure offers the wrong
  incentives for future managers.
• Furthermore, bank depositors are not contributing
  to the creditworthiness of banks through their
  actions. On the one hand, depositors do not have
  all the available information to take the
  necessary action (bank run) because it is often
  not disclosed to them. On the other, government
  bailouts send the wrong signals to depositors,
  who then feel that their deposits are guaranteed
  no matter what the financial condition of the
  bank is.

7

• One more argument regarding the existence of
  appropriate incentives is related to the bank
  supervisors. Bank regulators and supervisors in
  developing countries often operate within a legal
  and political environment that discourages them
  from closing an insolvent bank or from imposing
  the required penalties.
• If the supervisory authority decides to take
  steps to close a bank or restrict its activities,
  then it will face reaction from powerful interest
  groups. If the necessary action is delayed, then
  the supervisory authority will face the criticism
  of the public.
• In most of the cases, delaying the appropriate
  response of the regulatory authority will result
  in higher bailout costs. The reason for this is
  what is called gamble for resurrection.

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• In other words, managers will try to engage in
  riskier activities with the hope that they will
  obtain high returns if the outcome is favorable.
  In most of the times, this results in more losses
  accumulated and increases the costs that the
  government has to incur to bailout the banking
  system.
• One way to avoid these problems is to ensure that
  the supervisory authority is independent of the
  government. That authority can be the Central
  Bank, if it is a truly independent bank.
  Alternatively, we can reduce the discretion of
  supervisors and require that they follow a
  rule-based supervisory system. This is the way
  bank supervision takes place in the United
  States. Supervisors are required to take
  corrective action once a banks capital reaches
  certain minimum levels.

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• However, a rule-based system may not allow
  supervisors to take action when they believe it
  is necessary, simply because the banks capital
  has not fallen below certain predetermined levels.