Regulation in Financial Markets

These workshops were the first two of a series of meetings to be held on Regulation in Financial Markets organised by Paul Grout (Bristol University and CEPR). They form part of a wider series of workshops on financial markets organised by Colin Mayer Director of the Centre's Applied Economic Theory and Econometrics Programme. In the first workshop held on March 12 there were preliminary discussions of three aspects of regulation where new research is most needed and most likely to prove fruitful.

Takeovers
Ailsa Roell (London School of Economics) introduced the first session with a talk on the regulation of takeovers. She noted the difficulties faced by the Takeover Panel because of the limited sanctions available to it: this problem appeared to be most severe in cases where the bid had already been successful. Roell also discussed the treatment of minorities and the extent to which such shareholders needed protection within the code: would such protection limit the number of beneficial takeovers? This depends on the nature of the takeover process itself, Roell argued. Existing evidence suggested that takeovers were better described within the competitive-bidder rather than the free- rider framework. The workshop discussed at length the importance of insider information, both in terms of takeovers and in financial markets more generally. Participants agreed on the need to better understand the process by which information enters a particular market before making detailed judgements on the impact of insider information. We also need a better understanding of the degree of overlap between those who make decisions and those in a position to gain financially from information: this affects the distortions created by insider information.

Risk, reputation and regulation
Ian Jewitt (University of Bristol) discussed the relevance of theoretical models of risk and reputation to the regulation of financial markets. Jewitt began by discussing how the issues of risk and reputation affect the analysis of financial intermediaries (both those which may need regulating and those which do not). It is often argued that financial intermediaries arise because of the existence of asymmetric information and adverse incentive effects, both of which make bilateral financial trades costly. Intermediaries are able to reduce these costs by gathering information. How are the intermediaries themselves kept honest? A variety of mechanisms are possible: diversification may reduce risks and thereby reduce the costs of moral hazard and reputations are likely to be important. Participants discussed whether this framework provided a good description of the banking system. There was also a discussion of the effect of information gathering by regulators on reputations of those who are regulated. For example, the widespread knowledge that regulators are closely observing a particular intermediary may actually precipitate the event the regulators are attempting to avoid. This must impose restrictions on the forms of regulation which are feasible.
Regulating portfolios
Banking supervision, particularly the methods and approach used by regulators, has attracted relatively little public attention. Stephen Schaefer (London Business School and CEPR) discussed the issues underlying regulating the riskiness of banks' asset portfolios and the assessing capital adequacy of banks. Schaefer outlined the system of supervision used in the UK. The techniques of financial economics, although relevant to the supervision problem, do not appear to be much used. Schaefer argued that existing systems, such as the Bank of England's Risk Asset Ratio, concentrate too much on definition and too little on the process of measurement. He discussed the construction of alternative measures which took account of more information such as the covariances between asset classes in a bank's portfolio. It was generally agreed that such measures would contain more useful information and deserved further investigation.

The justification for minimum capital requirements was also discussed. Schaefer pointed out that that bankers apparently view capital as more expensive than non-capital liabilities. He argued that a financial economist would see no theoretical reason why this should be so and that, if regulators are to perform their task adequately, it is necessary to develop a theoretical frmaework within which capital inadequacy could occur.

The second meeting took place on April 24th. The first session of the meeting was introduced by Tad Rybczynski (Lazard Brothers and City University Business School) with "Some Comments on Mergers and Takeovers". He considered the causes of the postwar growth in merger activity, emphasising the separation between ownership and control, the role of financial innovation, the importance of institutional investors, and the emphasis on growth and short-term returns. The discussion which followed concentrated on the issue of controlling a firm's managers. Recent moves toward incentive-based remuneration such as options should alleviate some of these difficulties to the extent that they arise not because managers are of low quality but because they pursue their own objectives. Nicholas Ilett (HM Treasury) suggested that difficulties may arise partly because institutional shareholders are not in general equipped to decide on the quality of management and that they may have a more useful role in policing the behaviour of boards.

In the second session, Luca Anderlini (St Johns College, Cambridge, and CEPR) presented a paper on "Central Banks and Moral Hazard". He analysed the role of central banks in a banking system which transforms illiquid into more liquid assets. Such a system is vulnerable to runs: Anderlini's model yielded not only the conventional equilibrium but also one in which there was a panic run on the banks. He outlined two mechanisms for preventing bank runs. Convertibility of deposits could be suspended, but this created difficulties. Because of aggregate uncertainty suspension may be triggered even when there is no likelihod of a bank run. Consequently the system is inefficient. Anderlini noted that suspensions of convertibility which occurred in the US during the 1930s seemed to have helped create pressure for the banking reforms which followed. Suspension of convertibility also requires central monitoring of the private banks to make sure that they are not misusing the system to their own advantage.

Automatic bail-out rules, if correctly anticipated by depositors, will also prevent bank runs. Anderlini pointed out that the major difficulty is that such insurance creates problems of moral hazard. Bankers may intentionally rely on the insurance in order to compete for depositors more aggressively. Therefore there needs to be additional regulation of the banks to prevent misuse of the insurance. Anderlini showed that in his model, an interest-rate ceiling is sufficient to solve the problem. The discussion which followed concentrated on whether private insurance could prevent bank runs. At the time of a run on a single bank this bank is short of funds while other banks have an excess of deposits. Redepositing of these funds may be sufficient therefore to prevent a run. Participants agreed that we must know more about how bank runs arise before one can be sure that such a "club" solution could prevent runs. Lionel Price (Bank of England) emphasized that it is important to know the cost to the individual of claiming on deposit insurance. If this cost is high then individuals may still prefer to move funds between banks even though the funds are fully insured while they remain in the bank in difficulty.

John Flemming (Bank of England) introduced the final session with a talk on "Aspects of Financial Regulation". He initially discussed the arguments for regulating financial markets, pointing out that many other markets are regulated in a similar way. He emphasized the role of asymmetric information, the fact that liqudity itself may be a public good and the problem of panic runs on intermediaries. In the latter case he drew the analogy of innoculation against contagious diseases, emphasizing that the competitive solution may lead to too little regulation. Private insurance may be good at providing the exact opposite of what is required: the optimal solution may require insurance against large scale catastrophic events whereas private insurance would be better at providing insurance on a smaller scale. Furthermore a bank in difficulties would face an increase in insurance premium charges and this is very likely to generate the run which the system is trying to prevent. Nicholas Ilett emphasized the distinction between regulation to reduce systemic risk and regulation for investor protection: these frequently conflicted. Flemming pointed out that the informal system of banking regulation depended on the interrelationship between existing banks: a significant proportion of the interbank business was done to keep the particular bank's name in the public and that this improves interbank information flows. The difficulty with this, Flemming argued, is that it increases the systemic risk. Lionel Price noted that exposure rules would limit the systemic risks. Flemming also pointed out that little was known about the costs of the regulatory system and that a detailed cost-benefit analysis would prove fruitful though difficult. Participants generally agreed that the benefits would be far harder assess than the costs but that such an exercise would indeed be worthwhile.