Regulatory Forbearance Research Articles

How Much Competition is Enough Competition for Regulatory Forbearance?

Abstract Critical loss analysis is used to define product markets for merger analysis and determine if market forces are sufficient to discipline prices in transitionally competitive regulated markets. Unlike the approval of a merger, however, regulatory forbearance is a reversible act. The threat of future (re)-regulation, or regulatory contestability, in combination with high price-cost margins and complementary demands can lower the critical loss (elasticity) necessary to justify the competitive classification of regulated services. This suggests that the intensity of competition sufficient to forbear from regulation can be considerably less than what regulators may believe is required a priori.

When emergency medicine becomes a staple diet: Evidence from Indian banking crisis

We investigate the role of regulatory forbearance in causing a banking crisis. To mitigate the expected spillover effects of the global financial crisis, the Indian banking regulator allowed banks to restructure loans without creating provisions. The forbearance continued beyond the crisis due to political economy-related considerations. Using heterogeneity in the application of the policy, we find that healthy banks that benefited from forbearance became undercapitalized due to the non-recovery of unhealthy borrowers whose accounts were restructured. The undercapitalization led to distortionary lending practices; some distortions took the form of a quid pro quo between the government and the undercapitalized banks.

Differences in Covid‐Related Regulatory Forbearance Within and Outside the Banking Union – The Case of East‐Central European EU Member States

AbstractThis article analyses the practice of Covid‐related bank regulatory forbearance measures of eight East‐Central European Union member states from the perspective of differentiated integration. In line with the integration‐deepening nature of the Single Supervisory Mechanism, our expectation was that countries within the Banking Union (BU) would impose harmonized forbearance measures, while non‐BU members would use more discretional measures. Indeed, the practice of forbearance measures is significantly more harmonized within the BU than outside; however, there were also notable differences in the practice of BU members. For non‐BU member states, our expectation was that countries with the intention of favouring their domestic financial system would ease regulatory requirements more, while those that wanted to place the burden of the pandemic on foreign banks would ease these requirements less. However, the analysis only partially confirmed this expectation.

White-collar money laundering through opportunistic earnings management: fair value accounting practices of failed finance companies in Sri Lanka

PurposeThe purpose of this paper is to discuss how the failed finance companies in Sri Lanka used fair value accounting practices as an opportunistic earnings management practice to launder money under weak corporate governance structures.Design/methodology/approachThis paper uses a qualitative design under the philosophy of interpretivism. The case study research strategy is used inductively to investigate how fair value accounting had been used for money laundering.FindingsThe dishonest intention of major shareholders and board of directors had forced failed companies to misuse fair value accounting to manipulate performance and use them for personal benefits which were detrimental to the depositors and stability of the companies. The weak corporate governance structures which were developed because of regulatory forbearance were influential for manipulations. The concentrated ownership had reduced agency conflicts between shareholders and managers because major shareholders were the members of the board of directors. The appointed committees were not effective because of an inadequate number of independent directors with sufficient expertise. The reduced agency conflict between shareholders and managers has exaggerated the agency conflict with depositors. Therefore, it is recommended to dilute ownership concentration to establish good corporate governance structures and make stable institutions.Research limitations/implicationsThis study does not discuss the dishonest fair value accounting practices of all licensed finance companies because of the sensitivity of the matter for surviving companies.Originality/valueThis paper is an original work of the authors which discusses how fair value accounting practices had been used to launder money in failed finance companies in Sri Lanka as an emerging market context.

Effect of Prudential Regulation on the Financial Performance of Quoted Deposit Money Banks in Nigeria

International and national financial authorities are constantly issuing new prudential policies, rules, and guidelines to ensure a safe and sound financial system. How well the deposit money banks (DMBs) have kept to these prudential thresholds is expected to reflect on their financial performance. However, there has been no consensus by previous studies on the effect of prudential regulation on financial performance of deposit money banks. As such, this study seeks to assess the effect of prudential regulation on the financial performance of deposit money banks in Nigeria from 2011 to 2020. The prudential regulation is proxied by - capital adequacy, liquidity, leverage, and asset quality as the independent variables while the financial performance is proxied by earnings per share (EPS) as dependent variable. The data was sourced from the annual reports of the thirteen (13) quoted deposit money banks and analysed using descriptive statistics and Panel Data Regression to determine the relationships between the variables. As a form of diagnostics test, Jarque-Bera test was engaged for checking for normality, Pearson Correlation was employed to evaluate the degree of relationship among variables and extent of linearity, Unit root test was used to test for stationarity and the Hausman test to determine whether to use fixed or random effect panel least square regression of which fixed effect model was favoured. Data were estimated with STATA 15. The significance level was set at 0.05. Findings from the study reflect that capital adequacy has a positive coefficient of 0.7166 and a non-significance level of 0.5250 on financial performance using the EPS. Liquidity has a positive coefficient of 0.1804 and non-significance level of 0.8720 on the EPS. Asset quality has a co-efficient of -0.2843 and non-significance level 0.8850 on the EPS. Leverage has a coefficient of -1.5006 and a non-statistical significance level of 0.3800 on the EPS. The study concludes that an increase in capital does not necessarily translate to higher EPS, higher liquidity lessens banks’ liquidity risk, asset quality in form of non-performing loans reduces the bank’s capacity to create further loans, hence less earnings for the bank and leverage negatively influences financial performance. It is also discovered that control variables - age and size of banks - are positive determining factors for financial performance of banks. The study recommends that the CBN as the Regulator needs to strengthen capital adequacy by moving it to thresholds that will be impactful enough on the financial performance, get the banks to improve on asset quality by bringing non-performing loans to the regulatory limit, be discretional in the use of regulatory forbearance and interventions to bail out the banks to prevent reckless lending conduct. Lastly, banks are required to pay attention to the capital mix (leverage) to reap its benefits and manage the associated risk.

Asset Reclassifications and Bank Recapitalization During the Financial Crisis

Regulators frequently relax accounting rules during a financial crisis as a means of regulatory forbearance. The new accounting options provide banks with an opportunity for an accrual-based increase in their regulatory capital. The use of such an accounting option helps reduce the costs of government interventions such as bailouts and avoid the dilution of existing shareholders’ ownership rights. We examine the introduction of the reclassification option for financial assets during the 2008 financial crisis and study the position of accrual-based options in the pecking order of banks’ recapitalization measures. The findings suggest that the accrual-based increase in regulatory capital is temporary and does not provide permanent relief. Consistent with the long-term costs of accrual-based measures, investors perceive the accounting choice as a negative signal. If banks do not complement their use of the accounting option by other corrective actions that result in a real capital increase and a liquidity injection, they continue to suffer from low capitalization and financial difficulties in the following years. Ultimately, government interventions in accounting regulation are unlikely to offer a sustainable solution to capital shortfalls in the banking sector if they are not supported by the concurrent enforcement of real corrective actions. This paper was accepted by Brian Bushee, accounting. Funding: The authors acknowledge financial support from Deutsche Forschungsgemeinschaft (Project-ID 403041268-TRR 266) as well as from IAAER and KPMG under the “Research Informing the IASB Standard Setting” grant. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2022.4364 .

The Banking Union and evidence on bail‐ins and bailouts

AbstractThis article analyzes the euro area's banking sector regulatory framework, known as the Banking Union. It shows how distressed banks' noncompliance with supervisory, state aid, or central bank lending policies can trigger the application of resolution or liquidation measures. Further, it provides new evidence on large banks distress episodes in the European Union and the United States, suggesting that recapitalization is a more cost‐effective policy instrument than resolution or liquidation. Finally, it argues that the Banking Union lacks an appropriate recapitalization instrument for borderline distressed banks and that a more nuanced and structured stance on regulatory forbearance is probably warranted.

Regulatory Forbearance and its Application in the Banking System during the COVID-19 Pandemic: Jurisdictional Experiences

Regulatory Forbearance and its Application in the Banking System during the COVID-19 Pandemic: Jurisdictional Experiences

Revisiting the valuation of deposit insurance

AbstractThis study proposes a framework for pricing deposit insurance that evaluates the effect of depositor preference laws and the issuance of contingent capital bonds. Four main findings emerge from this study. First, traditional option pricing models of deposit insurance overestimate insurance premiums. Second, only large issuances of contingent capital bonds decrease deposit insurance premiums under depositor preference. Third, the issuance of contingent capital bonds can partially offset banks' excessive risk‐taking caused by regulatory forbearance. Finally, although large banks have implied too‐big‐to‐fail risks, the deposit insurer's costs from large banks are not nearly as high as reported in previous studies.

The politics of bank opacity

The distribution of power in the political system shapes the financial reporting opacity of banks. Specifically, banks located in states with senators on the Senate Banking Committee (BC senators) have greater abnormal loan loss provisions than banks in other states. The result is stronger for larger banks and banks with higher risk. In addition, BC senators have a negative effect on the likelihood of banks in their home states receiving enforcement actions, and, more importantly, this effect is stronger for more opaque banks. These findings suggest that politicians, regulators, and banks use opaque financial reporting to facilitate regulatory forbearance. Moreover, we show that opacity is a significant channel through which BC senators increase bank risk. During economic downturns, however, BC senators appear to promote bank opacity to encourage bank lending and create liquidity. Finally, the capital market does not penalize the reporting opacity of banks in states with BC senators.

Regulatory Forbearance in the U.S. Insurance Industry: The Effects of Removing Capital Requirements for an Asset Class

Abstract We analyze the effects of a reform of capital regulation for U.S. insurance companies in 2009. The reform eliminates capital buffers against unexpected losses associated with portfolio holdings of MBS, but not for other fixed-income assets. After the reform, insurance companies are much more likely to retain downgraded MBS compared to other downgraded assets. This pattern is more pronounced for financially constrained insurers. Exploiting discontinuities in the reform’s implementation, we can identify the relevance of the capital requirements channel. We also document that the insurance industry crowds outs other investors in the new issuance of (high-yield) MBS. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Financial Regulation and Bank Supervision during a Pandemic

Pandemics lead to a sudden decline in the level of economic activities. Lending institutions reduce credit supply to businesses due to fears of rising bad debts during a pandemic. This paper highlights some approach to financial regulation and bank supervision during a pandemic such as the SARS and COVID-19 pandemic. I show that financial regulation during a pandemic can be enhanced by diversifying the financial system, maintaining adequate liquidity in the financial system, stimulating financial institutions to provide more credit, delaying the recognition of significant increase in credit risk, lowering the reference interest rate to encourage more lending, and providing stimulus packages to affected financial institutions in the economy. I also suggest measures to improve bank supervision during a pandemic which include adopting a flexible supervisory framework, modifying bank supervisory examinations, using ad-hoc stress tests, releasing the countercyclical capital buffer to banks, and increase the use of regulatory forbearance. The implication of these approaches to coping with a pandemic is that these measures can help to ensure the survival of small and large businesses and financial institutions who rely on credit from financial institutions. It can also help to preserve jobs and help to reduce the long term damage to the economy caused by the pandemic.

Governing through non‐enforcement: Regulatory forbearance as industrial policy in advanced economies

AbstractPolitical economy scholarship generally assumes that governments are interested in enforcing economic regulations. Cases of non‐enforcement are predominantly studied in the context of developing countries and are chiefly associated with states' deficient institutional capacity. This article casts doubts on these assumptions by showing how governments in advanced democracies manipulate the regulatory regime and generate selective non‐enforcement of economic regulations to shape markets at their discretion. We argue that regulatory forbearance becomes an attractive form of industrial policy when governments are prevented from intervening discretionally in markets due to legal obstacles, which they cannot overcome; or when the productive structure of the country makes alternative forms of intervention unviable. Drawing on the study of tax non‐enforcement in two most‐different cases of strong and weak state capacity such as Germany and Italy, the article theorizes three techniques through which governments manipulate regulatory regimes: legal and organizational sabotage and shirking. By shedding light on the economic logic of forbearance, the article points at non‐enforcement as an overlooked mode of regulatory governance and suggests the need to inquire further into governments' strategic agency behind regulatory regimes.

Politically Robust Financial Regulation

The deferred recognition of COVID-induced losses at banks in many countries has reignited the debate on regulatory forbearance. This paper presents a model where the public's own political pressure drives regulatory policy astray, because the public is poorly informed. Using probabilistic game stages, the model parameterizes how time consistent policy is. The interaction between political motivations and time consistency is novel and complex: increased policy credibility can entice the politically-motivated regulator to act in the public's best interest, or instead repel it from doing so. Considering several regulatory instruments, the paper probes the nexus of political pressure, perverse bank incentives and time inconsistent policy.

Misdiagnosing Bank Capital Problems

Banks' reluctance to repair their balance sheets, combined with deposit insurance and regulatory forbearance in recognizing greater risks and losses, can lead to solvency problems that look like liquidity (bank-run) crises. Regulatory forbearance incentivizes banks to both retain risky loans and reject new good opportunities. With sufficient regulatory forbearance, partially-insured banks act exactly as if they are fully insured. Stress tests certify that uninsured creditors will be paid, not that banks are solvent, and have ambiguous effects on the efficiency of investment.

Politically Robust Financial Regulation

The deferred recognition of COVID-induced losses at banks in many countries hasreignited the debate on regulatory forbearance. This paper presents a model where thepublic's own political pressure drives regulatory policy astray, because the public is poorlyinformed. Using probabilistic game stages, the model parameterizes how time consistentpolicy is. The interaction between political motivations and time consistency is novel andcomplex: increased policy credibility can entice the politically-motivated regulator to actin the public's best interest, or instead repel it from doing so. Considering severalregulatory instruments, the paper probes the nexus of political pressure, perverse bankincentives and time inconsistent policy.

Zombie Lending and Policy Traps

We build a model with heterogeneous firms and banks to analyze how policy can affect the efficiency of credit allocation and long-term economic outcomes. When transitory demand or productivity shocks are small, conventional monetary policy can restore efficient bank lending and production by lowering interest rates. For moderately large shocks, however, conventional policy may hit the effective lower bound, necessitating unconventional policy such as regulatory forbearance towards banks to stabilize the economy. Aggressive unconventional policy runs the risk of introducing zombie lending and a “diabolical sorting”, whereby low-capitalization banks extend new credit or evergreen existing loans to low-productivity firms. In a dynamic setting, policy aimed at avoiding short-term recessions can be trapped into protracted excessive forbearance due to congestion externalities imposed by zombie lending on healthier firms. The resulting economic sclerosis transforms transitory shocks into phases of delayed recovery and potentially permanent output losses. Our model highlights the importance of maintaining a well-capitalized banking system to avoid such policy traps as not raising capital requirements upfront but raising them significantly upon the arrival of shocks can also backfire by encouraging zombie lending.

The Unholy Trinity: Regulatory Forbearance, Stressed Banks and Zombie Firms

During the global financial crisis, the Reserve Bank of India enacted forbearance measures that lowered capital provisioning rates for loans under temporary liquidity stress. Matched bank-firm data reveal that troubled banks took advantage of the policy to also shield firms facing serious solvency issues. Perversely, in industries and bank portfolios with high proportions of failing firms, credit to healthy firms declined and was reallocated to the weakest firms. By incentivizing banks to hide true asset quality, the forbearance policy provided a license for regulatory arbitrage. The build-up of stressed assets in India’s predominantly state-owned banking system is consistent with accounting subterfuge.

Public Finance in Pandemic Times

Never before in living memory has economic destruction been so severe as it has been caused by the COVID-19 pandemic. The pandemic has struck at a time when the economy has already been slowing due to structural problems. Therefore, hastening the recovery process and accelerating the pace of economic growth requires the government not only to provide substantial stimulus but also to implement structural reforms. The stimulus provided so far has been mainly by the RBI on the supply side in terms of reducing interest rate, augmenting augment liquidity, restructuring loans to stressed sectors, moratorium on repayment of loans to severely impacted businesses and regulatory forbearance. The fiscal stimulus on the demand side has not been significant and amounted to just about 1.5 percent to 2 percent of GDP. The sharp contraction of the economy by 15.7 percent in the first half has substantially eroded revenue collections requiring both central and state governments to sharply reduce both government consumption and investment expenditures. Faster recovery in the second half of the year will crucially depend upon heavy lifting by the governments which requires them to increase consumption expenditures, transfers as well as capital expenditure by scaling up borrowing as well as monetizing the assets. The aggregate fiscal deficit as well as outstanding debt are likely to show a sharp increase which will raise questions of sustainability. The government has initiated a number of reforms, particularly to infuse flexibility to land and labour markets, reform regulatory systems in education and healthcare, and has made additional borrowing to the states conditional on undertaking power sector reforms, property tax reforms and improving the ease of doing business. However, implementation of these reforms holds the key. There is a need to urgently address problems of the financial sector. Reforms in sectors such as police and judiciary too are overdue to protect the life and property of people and enforce contracts.

Currency Uncertainty, Interest Guarantee, and Risk-Based Premiums in Life Insurance Guaranty Schemes

Abstract This paper investigates risk-based premiums in ex-ante insurance guaranty schemes. Exchange rate risk is incorporated into the asset portfolio to reflect the growing practice of life insurers taking offshore risks for yield enhancement. The closed-form solutions of the risk-based premium charged by the insurance guaranty fund are derived. Our premium rating includes currency mismatches between assets and liabilities, and the effects of early closure, capital forbearance, and grace periods are fully explored. First, we discover that the insurance guaranty fund premium is underestimated if currency fluctuation uncertainty is overlooked. Second, the premium is higher under regulatory forbearance than it is under the Merton stock put option, which implies that the cost is substantial. Finally, we note that the premium increases with higher financial leverage and greater foreign exposure in the asset portfolio. The results of our analysis provide further insight for regulators to implement regulatory policies and insurance guaranty schemes.