Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)
Kjell G. Nyborg
Bank Supervision after the Financial Crisis: Signals from the Market for Liquidity
Abstract: The financial turmoil that we have been living with since
August 2007 has left central banks, regulators, politicians, and economists
with two big, overriding questions: How do we best get out of the crisis
and how should banks be regulated and markets organized to avoid such
crises in the future. This paper deals with the second question.
Specifically, the paper deals with the third pillar of Bank supervision
under Basel II, namely market discipline. The idea of this pillar, as
summarized by Emmons, Gilbert, and Vaughan (2001), is for supervisors and
regulators to make use of information about the financial health of banks
that is contained in securities prices. In particular, as explained by
Emmons et al: “The recent market discipline discussion centers on proposals
to require some banks to issue a standardized form of subordinated debt.”
Flannery (1998) discusses this more broadly and reviews the evidence on the
effectiveness of using market information in prudential supervision. My
proposal here is that the market discipline approach could usefully look
for information about banks’ financial health outside of the securities
markets. The market that I would suggest is especially valuable is the
market for liquidity. This is motivated by the simple observation that the
financial crisis of 07/08 has manifested itself in -- and rippled outwards
from -- this market. Below, I briefly outline some features of the market
for liquidity during the crisis and draw some comparisons to times of
normalcy, before turning to my proposal. Some of what we see during the
crisis period arguably can be explained by imperfections such as adverse
selection, leading to credit rationing and relatively high unsecured rates.
There are also imperfections present in the market for liquidity during
times of normalcy (see, e.g., Bindseil, Nyborg, and Strebulaev~(2008)).
Thus, as new regulation gets shaped in the wake of the crisis, it would
appear that it is valuable to put measures in place to control these
imperfections so that they do not flare up again. The suggestions I make in
this paper are motivated by this concern.
Keywords: Bank Supervision; Financial Crisis; Market for Liquidity; (follow links to similar papers)
JEL-Codes: E58; G00; G21; (follow links to similar papers)
12 pages, April 10, 2015
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