Bank run. Economics

Critically discuss why banking sector needs to be regulated. Regulation of banks is particularly strict, as bank failures have been associated with crises of the whole financial system as the negative externalities, that is to say, problems in the financial sector are likely to spill over to real economy. Since the American financial crisis in 2008 has swept across the world, every country and region cannot avoid the plague.

Bank system, as the main debiting and financing source of emerging market real economy , its health condition can directly affects the real economy through the credit channel. Therefore highly-debt enterprises are more easily affected with a sharp decline in their performance. Although the overall effect of this subprime crisis on the real economy cannot be seen, it has shown that the financial crisis is the most serious one which has affect the real economy in decades. Weak Banks spread external financial risk to the real economy.

It is obviously that financial risks in America has firstly infected European Banks, deteriorating their balance sheets rapidly , and spreads bank crisis through the credit channel to the real economy, thus causes the economy recession. Domac and Ferri took Malaysia and South Korea as examples, which had bank crisis from 1997 to 1998, they found that the small or medium-sized enterprises had much more loss relatively compared with the big companys. (D. Klingebiel, L. Laeven 2005) as the small and medium-sized companies rely on bank credit higher than large enterprises.

As a matter of fact, on the one hand, when the financial crisis comes, if banks cannot effectively provide credits, it will give to highly-debt enterprises serious credit constraints, which will lead to enterprises’ profit decline. On the other hand, enterprises with high debt will increase their vulnerability, thus makes the enterprises more easy to meet performance decline. If one bank fails bank runs, it could occur even on solvent banks, which may become illiquid, and spur further bank runs.

This problem occurs because of asymmetric information, thus it is high time we need for rules regarding corporate governance to ensure investors are not ripped off or misled . The Asymmetric Information Theory derived from George A. Akerlof in the 1970s thinks that social information channels are varied, nowadys the information flows fast and convenient, so the information distribution imbalance and information asymmetry phenomenon exist generally. This may cause reduced economic efficiency and thus result in adverse selection and moral hazard.

(G. Akerlof 1970) The problem of asymmetric information is mainly embodied with the following aspects. In the credit market, due to the information asymmetry, faced with many enterprises with different degree of risk, banks cannot observe the project investment risk or the investment risk cost is too high, they could only decide the loan interest rate according to the enterprises’ average risk situations. Usually banks will raise interest rates to compensate for the potential risks, otherwise banks will choose to quit the credit market.

After the loaning process, banks are lack of powerful monitoring means to supervise the trading actions of the enterprises and whether they obey the contrasts, so it would appear accounting frauds, transferring profits etc to branch loans and its earnings, or human management would cause losses, so the banks could not have the investment returned. Even some enterprises use bankruptcy, joint venturing to transfer assets and avoid bank debts. These above are the so-called moral hazard.

Therefore we need to set up an all-round information transferring mechanism, in order to reduce the cost of information and improve the enterprise information disclosure system. Secondly, banks should improve their ability of information recognition and establish long-lasting relationship with enterprises . Last but not least, we need to build a perfect social credit environment and mechanism. Deposit insurance schemes aim at deterring bank runs, but may incentivise excessive risk-taking,which may result in moral hazard.

Due to the principal-agent relationship between banks and customers, in the deposit insurance system, it has inevitably produced the moral risk of the banks. The moral risk mainly refers to that under the protection of the deposit insurance system, banks could predict their own failure probability very small, so in order to seek profit maximization, weaken its own supervision, they may get engaged in financial activities with higher risks and more profits . (A. Kunt, E. Detragiacheb 2002)

Take an example of China’s current implicit deposit insurance system, as depositors regard the bank credit equivalent to national credit, they will not have give too much attention on financial status and business risk condition of the deposit banks, which will give convenience to the banks to do those loan business with high risks and profits. At the same time, bank regulators cannot curb the the moral risk motivation through the implementation of differentiating insurance rate and regulatory measures . In the single zero tariff system, banks have no need to pay costs for their excessive risk-taking behavior.

The existence of principal-agent relationship will definitely cause the conflict of interest between managers and shareholders may be detrimental to shareholders’interests. Principal-agent relationship illustrates such a management behavior, a client can design a reward system used to inspire agent according to the interests of the client . (J. Stiglitz , A. Weiss 1981). Kenneth Lee,the former CEO of Enron Corporation, sold shares and got $11 billion profit, CEO of Xerox Corporation got 70 million dollars reward through bubble economy in 2002.

From the case above we can see the agents have the internal information and stay in dominant position, while the clients are at an informational disadvantaged position. The managers want to increase shareholders’ wealth, at the same time, they also expect to earn more bonus. However,the shareholders want to maximize the income with minimum costs . Under the circumstances of their different interests, without effective arrangement system , the managers’ behaviour are likely to eventually damage the interests of the shareholders. In order to solve this problem,we can use a set of incentive and constraint and punishment mechanism.

It needs active measures to safeguard shareholders’ rights to know and participate in business through good corporate governance mechanism and effective investor relations, stockholders’ equity will be secured. References: [1]John K. ,Paul. M,Recent Developments in U. S Subprime Mortgage Markets , LMF Working Paper, 2007 [2]Diamond,D. W. ,Dybvig,P. H Bank runs, Deposit insurance and Liquidity , Journal of Political Economy, 1983 [3]Grossman,R. , Deposit Insurance, Regulation,and Moral Hazard ,Thrift Industry:Evidence from the 1930s , American Economic Reviews,1992

[4]Daniela K,Luc L, Managing the Real and Fiscal Effects of Banking Crises, World Bank World Bank Publications,2002p. 49 [5]George A. Akerlof,The Market for Lemons: Quality Uncertainty and the Market Mechanism , The Quarterly Journal of Economics ,Vol. 84, No. 3, Aug. ,1970, p. 488-500 [6]Asli K, Enrica. D, Does deposit insurance increase banking system stability? An empirical investigation, Journal of Monetary Economics,Vol. 49, Issue 7, Oct. ,2002, p. 1373–1406 [7]Joseph. S, Andrew . W, Credit Rationing in Markets with Imperfect Information, American Economic Review ,Vol. 71, No. 3, Jun. , 1981, p. 393-410 ?