Stability of the Banking System

1
Stability of the Banking System

• Background
• If the banking system is to fulfill its role, it
• needs to be stable.
• Banking crises have been detrimental to
• many economies e.g. the USA in the 1930s,
• Chile 1980s.
• There are 3 factors that can contribute to
• the stability of a banking system. These are
• The Central Bank (Reserve Bank)
• Deposit Insurance
• Prudential Regulation

2
Stability of the Banking System

• Central Bank
• Serves 4 main roles
• Regulating the issue of currency and
• controlling the quantity of money and credit
• for monetary policy purposes.
• Acting as banker to the government.
• Acting as banker to commercial banks,
• including lender of last resort.
• Managing the countrys international
• reserves.

3
Stability of the Banking System

• Issuing Currency and Controlling Credit
• These roles are undertaken for monetary
• policy purposes.
• The goal of monetary policy in many
• economies is price stability.
• We know that increases in money supply
• can be inflationary.
• In South Africa we have an inflation
• targeting policy 3 - 6. The Reserve
• Bank uses the interest rate as a tool to
• achieve this policy.

4
Stability of the Banking System

• Banker to Government
• The relationship between the Central
• Bank and Government is important
• not only for the stability of the financial
• sector, but for the economy as a whole.
• This relationship implies that Central
• Banks play not only a monetary role,
• but a fiscal one as well.
• For example, providing (a) interest-free
• or subsidized loans to government and (b)
• directed credit to specific sectors identified
• by the government.
• The greater the fiscal involvement of the
• Central Bank, the less independent it is to
• pursue monetary policy. Fiscal activities

5
Stability of the Banking System

• Banker to Commercial Banks
• Commercial banks are required to hold a
• certain proportion of their deposits with the
• central bank the required reserve ratio.
• This can affect 2 things
• The ability of commercial banks to lend. The
• higher the reserve ratio the less lending
• banks can do.
• The amount of funds available for lending to
• the government. Helps central banks to
• pursue their fiscal activities.

6
Stability of the Banking System

• Banker to Commercial Banks
• The central bank plays the role of lender of
• last resort. That is, the central bank acts to
• bail out commercial banks in periods of
• crises.
• Crises are characterized by a sudden rise in
• demand for cash that banks are unable to
• meet.
• This raises the problem of moral hazard.
• Banks can decide to undertake riskier
• lending because they know they will be
• bailed out.
• To address the moral hazard problem the
• bailing out should only be for a period and

7
Stability of the Banking System

• Managing International Reserves
• The exchange rate is very important for
• small open economies, which is what many
• developing countries are.
• Proper management of reserves and an
• understanding of the implications of the
• exchange rate are essential.
• In many developing countries the domestic
• currency is so overvalued that the provision
• of foreign exchange is tantamount to a gift
• (Fry, 1995).
• This implies that exporters have to bear the
• cost. For example, they will receive a lower
• price for their export earnings.

8
Stability of the Banking System

• Deposit Insurance
• Deposit insurance was first introduced in the
• US in 1934 following the banking panic that
• took place between 1930-33.
• Its main objective was to prevent bank
• panics. According to Friedman and
• Schwartz (1963) deposit insurance
• contributed more to monetary stability that
• the Federal Reserve System.
• Deposit insurance has been a major policy
• prescription for developing countries given
• by the IMF and World Bank.
• According to Fry (1995) deposit insurance
• appears to have prevented bank runs in
• Argentina and Chile.

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Stability of the Banking System

• Deposit Insurance
• Recall that favourable outcomes produce
• large bank profits. Unfavourable outcomes
• result in losses that are borne by the deposit
• insurance agency.
• Therefore, like any insurance scheme moral
• hazard problems can arise (e.g. managers
• giving riskier loans).
• Likewise, banks will be more prone to
• adverse selection. If they know depositors
• are protected by insurance, the screening
• process will be less rigorous.

10
Stability of the Banking System

• Prudential Regulation
• The primary objective of bank regulation is
• to achieve a safe and stable banking system.
• Such a system will ideally have no bank
• panics and failures. It will tend to minimize the
  
• problems of adverse selection and moral
• hazard.
• There are 2 main types of regulation
• (1)To make sure that banks are not taking undue
  risks and other practices that endanger their
  depositors money.
• This involves establishing minimum net worth
• requirements, guidelines on diversification of
• loans, limits on risky loans, minimum liquidity
• standards, and safeguards against fraudulent
• practices.

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Stability of the Banking System

• Prudential Regulation
• (2)To shield banks from competition.
• Why?
• When banks are restricted from competing
• actively for deposits and loans they are
• more profitable. As a result, they are
• less likely to fail.
• This is done by policies that restrict the
• entry of new banks, that place limits on
• mergers, and that set interest rate ceilings.

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Stability of the Banking System

• Government Owned Financial Institutions
• Private Owned To make profits for
• shareholders.
• Government Owned To promote economic
• development.
• Notably, private banks tend to promote
• economic development more successfully
• that government ones as a by-product of
• profit maximization.
• Why?
• Private banks are better managed.
• Government banks obliged to participate in
• directed credit programmes. These
• programmes have proved to be a
• misallocation of resources in developing

13
Stability of the Banking System

• Government Owned Financial Institutions
• Government owned institutions are
• characterized by
• Low resource mobilization.
• Low profitability and high staffing costs.
• Risky priority sector lending.
• Reduced autonomy of bank management.
• Increased administrative requirements.
• Poor quality of field staff.
• Weak management and supervision.
• As a result the share of nonperforming loans
• in these banks is higher than in private
• banks.
• The implication is that the banking system is