ECONOMIC ANALYSIS OF

BANKING REGULATION
GROUP MEMBERS ID NO
1. ABEL AMARE 1205362
2. ABEL EMISHAW 1205364
3. ABEL TEFERI 1205365
4. ABDURHAMAN AHMED 1306170
5. AMANUEL NIGUSSE 1205404
6. DAGEMAWIT ABEBE 1205510
7. ERMIYAS SISAY 1205560
8. FETHI ABDULHAMID 1205587
9. HAYAT HUSSEN 1205658
10. WESILA HASSEN 1205283
 OUT LINE
 Introduction
 Asymmetric Information and Financial Regulation
 Restrictions on Asset Holdings
 Assessment of Risk Management
 Political Economy of the Savings and Loan Crisis
 Introduction
• The economic analysis of banking regulation is a complex field
that examines how regulatory frameworks impact the behavior,
stability, and efficiency of the banking sector.
• It involves understanding the trade-offs between financial stability,
economic growth, and market efficiency.
Objectives of Banking Regulation
 Financial Stability: Regulations aim to prevent bank failures that can
lead to systemic crises, ensuring the overall stability of the financial
system.
 Consumer Protection: Regulations protect consumers from predatory
practices, ensuring fair access to financial services.
 Market Integrity: Regulations help maintain confidence in the financial
system by ensuring transparency, reducing fraud, and maintaining the
integrity of financial markets.
 Asymmetric Information and
Financial Regulation
What is asymmetric information in
banking?
• "Asymmetric information" is a term
that refers to when one party in a
transaction is in possession of more
information than the other.

• In certain transactions, sellers can

take advantage of buyers because
asymmetric information exists
whereby the seller has more
knowledge of the good being sold
than the buyer.
• The fact that different parties in a financial contract do not have the same
information (Asymmetric information) leads to adverse selection and moral
hazard problems that have an important impact on our financial system.
Difference between moral hazard and adverse selection:
• Both moral hazard and adverse selection are used in economics, risk
management, and insurance to describe situations where one party is at a
disadvantage as a result of another party's behaviour.
Moral hazard
• Occurs when there is asymmetric information between two parties and a
change in the behaviour of one party occurs after an agreement between
the two parties is reached.
• Moral hazard frequently occurs in the lending and insurance industries, but
it can also exist in employee-employer relationships.
• Any time two parties come into an agreement with each other, moral
hazards can be present.
Adverse selection
• refers to a situation where sellers have more information than buyers have,
or vice versa, about some aspect of product quality, although typically the
more knowledgeable party is the seller.
• Adverse selection occurs when asymmetric information is exploited.
• The concepts of asymmetric information, adverse selection, and
moral hazard are especially useful in understanding why
governments choose the form of financial regulation we see in
different countries.
• There are different categories of financial regulation:
 The government safety net,
 Restrictions on asset holdings,
 Capital requirements,
 Prompt corrective action,
 Chartering and examination,
 Assessment of risk management,
 Disclosure requirements,
 Consumer protection, and
 Restrictions on competition.
 Government safety net

• A government safety net in the context of banking refers to

a range of protections and interventions provided by the
government to ensure the stability of the financial system,
safeguard depositors, and prevent the collapse of banks.
• These safety nets are crucial in maintaining confidence in
the financial system, especially during times of economic
distress.
• Financial intermediaries, such as banks, are effective at
addressing adverse selection and moral hazard issues by making
private loans, which help avoid the free-rider problem.
• However, this approach introduces a new issue: depositors lack
information about the quality of these private loans, creating an
asymmetric information problem. This lack of transparency can
lead to inefficiencies and instability in the financial system.
• The free-rider problem occurs when individuals or entities benefit
from resources, goods, or services without paying for them or
contributing to their provision.
Bank Panics and the Need for Deposit Insurance
• A banking panic or bank panic is a financial crisis that occurs
when many banks suffer runs at the same time, as a cascading
failure.
• The Great Depression in the 1930s
saw numerous bank panics in the
United States, where many banks
failed due to widespread withdrawals.
Other Forms of the Government Safety Net
• Deposit insurance is a protection scheme provided by
governments or specialized agencies to guarantee the safety of
deposits made by individuals and businesses in banks and other
financial institutions.
• If a bank fails or becomes insolvent, deposit insurance ensures
that depositors are reimbursed up to a certain amount, preventing
them from losing their savings.
The Moral Hazard and Government Safety Net
• When banks are deemed "too big to fail," the government provides
assistance to protect all stakeholders, including customers and employees.
However, this creates moral hazard (a situation where the safety net
encourages risk-taking because stakeholders expect a bailout if things go
wrong).
• While the government safety net can prevent financial crises, it also reduces
market discipline, leading institutions to take on greater risks, knowing that
taxpayers will cover potential losses. This problem is especially pronounced
for large financial institutions, which may engage in riskier activities because
they expect to be bailed out due to their systemic importance.
• “Too big to fail” refers to an entity so important to a financial system that a
government would not allow it to go bankrupt due to the seriousness of the
economic repercussions.
Adverse Selection and the Government Safety Net
• A government safety net, like deposit insurance, can lead to adverse
selection. This happens because those most likely to benefit from the
insurance (such as risk-seeking individuals or institutions) are also those
who might engage in riskier behavior.
• For instance, just as high-risk drivers are more likely to choose low-
deductible insurance, financial institutions protected by deposit insurance
might take on more risk, knowing that they won’t face the full consequences
of their actions.
Financial Consolidation and the Government Safety Net
• Financial consolidation refers to the process of combining the
financial statements of different entities within a group into a
single set of financial statements.
• Financial consolidation increases the size of financial institutions,
which intensifies the too-big-to-fail problem.
• Larger institutions pose a greater systemic risk if they fail,
making it more likely that the government will step in to prevent
collapse. This safety net encourages these institutions to take on
more risk, knowing they might be bailed out, which in turn
increases the overall fragility of the financial system.
Restrictions on asset holdings
• Restrictions on asset holdings refer to regulations that limit the types
or amounts of assets that financial institutions, particularly banks,
can own.
• These restrictions are designed to reduce risk and promote financial
stability by preventing excessive exposure to volatile or risky assets.

Capital Requirements
• When a financial institution is forced to hold a large amount of equity
capital, the institution has more to lose if it fails and is thus more
likely to pursue less risky activities.
Capital requirements take two basic forms:
 Most banks are required to keep their ratio of capital to total assets
above some minimum level, regardless of the structure of their
balance sheets leverage ratio ( well capitalized a bank’s leverage ratio
must exceed 5% and below 3% triggers increased regulatory
restrictions on the bank).
 Banks are required to hold capital in proportion to the riskiness of
their assets (risk weighted capital requirement).
Financial supervision: chartering and examination
• Chartering (screening of proposals to open new financial institutions)
to prevent adverse selection.
• Examinations (scheduled and unscheduled) to monitor capital
requirements and restrictions on asset holding to prevent moral
hazard.
Bank examiners give banks a CAMELS rating. The acronym is based on
the six areas assessed:
 Capital Adequacy: Evaluates compliance with capital reserve
requirements.
 Asset Quality: Assesses the risk and quality of the bank's assets,
including loans and investments.
 Management Capability: Measures the management team’s ability to
respond to financial stress.
 Earnings: Evaluates the bank’s profitability and long-term viability.
 Liquidity: Assesses the bank’s ability to meet its short-term
obligations.
 Sensitivity to Market Risk: Measures the impact of market changes on
Prompt Corrective Action
• PCA is used to maintain financial stability and protect
depositors by taking early action when an institution's
financial health deteriorates.
If a financial institution’s capital drops too low, it faces two
major issues:
 Increased Failure Risk: With less capital, the bank has a
smaller buffer to absorb loan losses or asset write-downs,
making it more likely to fail.
 Greater Risk-Taking: Less capital means the bank has less
at stake, so it may take on excessive risks. This
exacerbates the moral hazard problem, increasing the
chance of failure and leaving taxpayers potentially
covering the losses.
 Assessment of risk management
• Greater emphasis on evaluating soundness of management processes
for controlling risk.
• Traditional bank exams focused on balance sheet quality and
compliance, but this is inadequate in today's fast-paced financial
environment (rapid innovation), where institutions can quickly take on
excessive risks.
To address this, bank examiners now use a separate risk management
rating, scored from 1 to 5, as part of the CAMELS system. This rating
evaluates four key elements of sound risk management:
1. Quality of Oversight: The effectiveness of the board of directors and
senior management in overseeing risk.
2. Adequacy of Policies and Limits: The robustness of policies and
limits for activities with significant risks.
3. Risk Measurement and Monitoring: The effectiveness of systems in
measuring and monitoring risk.
4. Internal Controls: The adequacy of controls to prevent fraud or
unauthorized activities.
 Disclosure Requirements
• The free-rider problem limits depositors' and creditors' motivation
to gather private information about a financial institution's assets.
• To address this, regulators require institutions to follow standard
accounting principles and disclose key information.
• Disclosure requirements are vital for financial regulation, as they
enhance market discipline by ensuring banks reveal their credit
exposure, reserves, and capital.
• This reduces excessive risk-taking and improves market
transparency, enabling investors to make informed decisions.
• By mandating disclosure and regulating financial entities, the
government helps ensure efficient capital allocation and protects
investors.
 Restrictions on Competition
• Increased competition can push financial institutions to take on
more risk to maintain profitability, leading some governments to
restrict competition to protect banks.
• While these restrictions helped bank stability, they also led to
higher consumer charges and reduced efficiency. Asymmetric
information justified these regulations, but they had drawbacks.
• Recently, the trend in many industrialized countries is moving
away from restricting competition, especially with new challenges
from electronic banking.
Political Economy of the Savings and Loan Crisis

• The S&L crisis highlights how political and regulatory

structures can lead to moral hazard through the principal (agent
problem).
The Principal–Agent Problem for Regulators and Politicians
• Regulators and politicians (agents) are supposed to act in the
taxpayers' (principals') best interest by minimizing costs and
enforcing strict regulations.
• However, their incentives often conflict with this goal. To avoid
blame and delay addressing issues, regulators sometimes
loosen capital requirements and allow risky practices, a
behavior known as “bureaucratic gambling” as described by
Edward Kane.
• This misalignment of incentives contributed to the S&L crisis.
PRACTICAL PART
 INTERVIEW REPORT ON CBE KEZIRA B.

Introduction
• Today, we will be presenting key takeaways from our interview
with Getachw Wolda, the Manager – Customer service of CBE .
Our conversation focused on the Banking regulations are
designed to promote financial stability and customer protection.
Interviewee Background
• The Commercial Bank of Ethiopia (CBE), founded in 1942, is
Ethiopia's largest and oldest bank. Initially formed by merging
the Bank of Ethiopia and the State Bank of Ethiopia, CBE
became the dominant financial institution in the country,
especially after nationalization in 1974.
• CBE has a vast branch network and has modernized its
services with digital banking, ATMs, and international
branches. It plays a critical role in Ethiopia's economic
development, financing major projects and promoting financial
inclusion.
• Despite challenges like competition and regulatory
complexities, CBE continues to lead the Ethiopian banking
sector, focusing on innovation and supporting national growth.
Key Questions and Responses
Question 1: “Can you explain how banking regulations aim to promote
financial stability?”
Mr Getachw Wolda Response :
 "Banking regulations are crucial in ensuring financial stability
through several mechanisms. First, capital requirements are
enforced, meaning banks must maintain a certain level of capital
reserves. This acts as a buffer against potential losses, reducing the
risk of insolvency. Additionally, liquidity requirements ensure that
banks hold enough liquid assets to meet short-term obligations.
This prevents scenarios like bank runs, where customers withdraw
their money en masse, by ensuring the bank has the necessary
funds available."
 "Furthermore, regulatory bodies provide continuous supervision
and oversight. They monitor banks' activities closely to ensure they
are operating within safe and sound practices. This proactive
approach helps identify and mitigate risks before they escalate into
something that could impact the broader financial system. Lastly,
banks are required to implement comprehensive risk management
frameworks. These frameworks help in identifying, assessing, and
managing various financial risks, such as credit and market risks."
Question 2: "How do these regulations protect customers?"
Mr Getachw Wolda Response :
 "Regulations protect customers primarily through transparency
and safeguards. They ensure that banks clearly disclose terms,
fees, and risks, allowing customers to make informed decisions
and avoid hidden charges. Additionally, deposit insurance
protects customers' savings up to a certain limit if a bank fails,
which helps maintain trust in the banking system."
 "Regulations also enforce fair lending practices, ensuring equal
access to credit without discrimination. Lastly, strict data
protection rules require banks to safeguard customers' personal
and financial information, reducing the risk of fraud and identity
theft."
Question 3: "How do regulations ensure accountability within
banks?"
Mr Getachw Wolda Response :
 "Regulations enforce strong corporate governance standards
within banks. This involves setting clear guidelines on how
banks should be governed, ensuring there is accountability at all
levels. Good governance reduces the likelihood of
mismanagement and ensures that the actions of bank
executives are aligned with the interests of customers and
stakeholders."
 "Ethical conduct is another area regulated by the authorities.
Banks are often required to adhere to codes of conduct and
ethical guidelines. This promotes responsible banking practices,
ensuring that the bank operates in a manner that prioritizes
customer interests and maintains public trust."