This paper analyzes the value maximization of regulated banks within a moral-hazard framework. In the model, regulators monitor both the capital ratio and the asset portfolio, and banks simultaneously select the optimum capital ratio and asset portfolio. A key assumption is that a bank cannot expect a positive put option value once it is classified as risky by regulators. The optimum values of the two variables depend on investment opportunities and charter values, as well as regulatory parameters. The model that explicitly incorporates regulation can explain various phenomena that are seemingly inconsistent with the predictions of moral hazard models — for example, a positive relationship between the capital ratio and the riskiness of the asset portfolio. A particularly interesting result is that a larger charter value results in a higher-risk interior solution

When should regulators close a financially ailing bank? FDIC practice in the US has moved in the direction of early closure. In contrast, banking regulators in Japan continue to follow a more patient approach. This paper analyses a series of models in which closure rules and bailout policies arise endogenously through the interaction of (i) regulators' attempts to minimize discounted, expected bankruptcy costs, and (ii) equity-holders' incentives to recapitalise banks. We characterize subsidy policies for distressed banks that implement socially optimal closure rules at minimum financial cost to regulators and which reduce moral hazard

This paper examines whether golden parachute adoptions in the banking industry during the eighties aligned the interests of CEOs with those of regulators and or shareholders. Our results provide evidence supporting concerns expressed by regulators: that boards of directors behaved opportunistically by adopting golden parachutes prior to large bank failures in order to exploit the FDIC guarantee. Parachute adoption was correlated with poor performance ex ante and ex post. Moreover, adoption of parachutes virtually ceased when the FDIC guarantee was withdrawn by FDICIA

This paper explores the determinants of optimal bank interest margins based on a simple firm-theoretical model under multiple sources of uncertainty and risk aversion. The model demonstrates how cost, regulation, credit risk and interest rate risk conditions jointly determine the optimal bank interest margin decision. We find that the bank interest margin is positively related to the bank's market power, to the operating costs, to the degree of credit risk, and to the degree of interest rate risk. An increase in the bank's equity capital has a negative effect on the spread when the bank faces little interest rate risk. The effect of rising interbank market rate on the spread is ambiguous and depends on the net position of the bank in the interbank market. Our findings provide alternative explanations for the empirical evidence concerning bank spread behavior

This article applies finite mixture distributions to the estimation of cost functions for financial firms through time. The mixture approach allows the estimation of multiple technologies when firms' technology choices are unobservable. Technology switching (‘diffusion’) and underlying technical change are simultaneously evaluated. An application to large samples of U.S. banks for the years 1982–1986 illustrates the approach. Results suggest banks switch to lower cost production technologies when unburdened by strict branching regulations

This paper attempts to estimate both the direct and indirect costs of regulation for major sectors of the UK financial services industry. We also compare UK direct costs with those for the US and France and this provides a benchmark for assessing the effect of regulation on the competitive position of the UK financial services industry. We believe that this is the first attempt to compare regulatory costs in the UK with those of its major competitors. For indirect costs, in the absence of an international benchmark we compare our results with the predictions made at the time of the introduction of the Financial Services Act, by Lomax (Lomax, D., 1987. London Markets After the Financial Services Act, Butterworths, London) and Goodhart (Goodhart, C., 1988. The costs of regulation. In: Seldon, A. (Ed.), Financial Regulation or Over-regulation. Institute of Economic Affairs, London, p. 31). They estimated that indirect costs would be £4 for every £1 of direct costs and that annual aggregate costs would be £100 million. Our results suggest that, so far as direct costs are concerned, the costs of regulation for the securities and derivatives trading and broking sector are substantially lower for the UK than for the US and France. In contrast, for the investment management and unit trust industry UK costs are significantly higher than those for the other two countries. For the life insurance industry, UK costs are similar to those in France but markedly lower than those for the US. We also find for the securities industry around £4.1 of indirect costs per £1 of direct costs. For the investment management industry the corresponding figure is £3.2. However there is substantial variation across firms and, although our sample is too small to be definitive, the ratio appears to be related to firm size. Although these results are broadly in line with the predictions of Lomax and Goodhart it should be borne in mind that both numerator and denominator are substantially higher in real terms than those used by Lomax and Goodhart

Recent occurrences of financial distress to some insurers have raised questions about whether the current guaranty system is adequate to protect policyholders. Four new systems have been proposed. Using the state preference model, it was found the Stewart's national system faring the best, if it adopts uniform regulation. Based on agency theory, the pre-assessment approach and the policyholder surcharge (or premium increase) recoupment method were found to be better than the current post-assessment approach and premium tax offset method. Furthermore, uniform policy limits and regulations are recommended

Many regulations use private sector credit ratings to determine investment prohibitions and capital requirements for institutional portfolio investments. These regulations implicitly assume that different agencies have equivalent rating scales, despite the fact that some agencies assign systematically higher ratings than others. We assess the appropriateness of these regulatory practices by testing whether observed rating differences reflect different rating scales or simply result from sample selection bias. Our analysis reveals only limited evidence of selection bias. We also ask what types of firms of firms are most likely to seek ratings from the agencies with higher rating scales. Our analysis uncovers no evidence that firms seek ratings from these agencies to clear specific regulatory hurdles or to reduce ex ante uncertainty about default risk

This paper examines the performance of the leading methods for setting capital requirements for securities firms' trading books. Tests are conducted on a large sample of UK equity market makers' books over a substantial number of periods of equity market stress from 1985 to 1995. The comprehensive and building-block approaches, favoured by US and European regulators, fail to provide effective cover. Only portfolio-based, value-at-risk (VaR) type models are efficient in providing appropriate levels of capital to cover the position risk of equity trading books