Bank regulation, reputation and rents: theory and policy implications

Abstract

Introduction US bank regulation, and more particularly the government deposit insurance system, is widely believed to be obsolete and substantially to blame for hundreds of billions of dollars of taxpayers' losses stemming from the recently deteriorating performance of the US banking system. With the Federal Deposit Insurance Corporation's Bank Insurance Fund nearing exhaustion, a sense of urgency has gripped Washington and the banking community, prompting a variety of proposals for banking reform. In this paper, we derive implications for bank regulation from a reputational model of financial intermediation. En route, we examine the various reform proposals that are part of the debate on US banking reform. Our ideas, however, transcend the specifics of US banking and therefore allow us to discuss contemporary developments in European banking. Most analyses of banking regulation focus on deposit insurance that permits banks to finance risky assets with governmentally insured liabilities. The moral hazards created by a fixed-rate, risk-insensitive deposit insurance system are widely acknowledged; any increase in the underlying asset risk benefits the banks' shareholders to the detriment of the deposit insurer (see Merton, 1977). Recently, John, John and Senbet (1991) have argued that these moral hazards are induced simply by the presence of risky debt, and represent just another example of the conflict of interest between debt and equity holders. This suggests that the benefits to shareholders of increasing asset risk may have little to do with deposit insurance per se. However, as we will see, this conclusion is unwarranted.