Prudential Policy
Jean-Charles RochetThis paper studies the rationale behind prudential policies in the banking sector. The main components of these prudential policies are deposit
insurance, solvency regulations, and emergency liquidity assistance by
the central bank, acting as a lender of last resort. We discuss the institutional arrangements that are necessary to limit the frequency and extent
of individual bank failures as well as those of systemic banking crises.
Keywords: Banking supervision; Prudential regulation; Financial stability
JEL Classification: G18, G21

University of Toulouse, GREMAQ-IDEI, and Toulouse Business School (E-mail: rochet@cict.fr)
I thank my discussants for their comments.
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I. Introduction
In almost every country in the world, public authorities intervene a lot in thefunctioning of the banking sector. The two main components of this public intervention are on the one hand the financial safety nets (composed essentially of deposit
insurance systems and emergency liquidity assistance provided to commercial banks by
the central bank) and on the other hand prudential regulation systems, consisting
mainly of capital adequacy (and liquidity) requirements, and exit rules, which establish
when supervisory authorities should close commercial banks.
In spite of these sophisticated prudential regulation systems, many countries(especially but not exclusively emerging countries) have recently experienced majorbanking crises. A good account of these crises can be found, for example, in Lindgren,
Garcia, and Saal (1996). Some economists (e.g., Demirgüc-Kunt and Detragiache[1997]) have argued that financial safety net systems (particularly deposit insurance
funds) were actually responsible for these crises, because they generate moral hazard inbankers’ behavior.
Although the topic is still debated in the academic literature (for extended surveys,
see Bhattacharya and Thakor [1993], Freixas and Rochet [1995], and Santos [2000]),a large consensus seems to have emerged on the rationale behind this public intervention in the functioning of the banking sector. It is now widely accepted that bankregulation and supervision have essentially two purposes:• Protect small depositors, by limiting the frequency and cost of individual bankfailures. This is often referred to as micro-prudential policy.1• Protect the banking system as a whole, by limiting the frequency and cost of
systemic banking crises. This is often referred to as macro-prudential policy.
Notice that, from the point of view of economic analysis, these two types of policies
have very different justifications:• Micro-prudential policy is justified by the (presumed)2 inability of small depositors to control the use of their money by bankers. This is why most countries haveorganized deposit insurance funds (DIFs) that guarantee small deposits against therisk of bank failure. The role of bank supervisors is then to represent the interestsof depositors (or rather of the DIF) vis-à-vis banks’ managers and shareholders.3,4• Macro-prudential policy is justified by the (partial) failure of the market to deal
with aggregate risks, and by the public good component of financial stability. As
with other public goods, the total (declared) willingness of individual banks (ormore generally of investors) to pay for financial stability is less than the social
value of this financial stability. This is because each individual (bank or investor)“free rides” on the willingness of others to pay for financial stability.
These differences imply in particular that, while micro-prudential policy (andsupervision) can in principle be dealt with at a purely private level (i.e., that it amounts
to a collective representation problem for depositors), macro-prudential policy has
1. See, for example, Borio (2003) or Crockett (2001) for a justification of this terminology.
2. The supporters of the “free banking school” challenge this view.
3. Contrarily to what is often asserted, the need for a micro-prudential regulation is not a consequence of any “mispricing”
of deposit insurance (or other form of government subsidies) but simply of the existence of deposit insurance.
4. This is the “representation theory” of Dewatripont and Tirole (1994).

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Prudential Policy

intrinsically a public good component. This being said, governments have traditionallycontrolled both dimensions of prudential policy, which may be the source of serious
time-consistency problems5 (this is because democratic governments cannot commit on
long-run decisions that will be made by their successors) leading to political pressure
on supervisors, regulatory forbearance, and mismanagement of banking crises.
Once the principles for (the two types of ) bank regulation are established, it isimportant to determine how these principles can be put into practice and how banking regulation should be organized. I claim that there is a crucial need to reexamine
this question in depth. Indeed, the traditional vision of bank regulation, in many
countries, was extremely paternalistic. Roughly speaking, it was accepted that banksupervisors existed to tell banks what they had to do. Banks were protected from too
much competition in exchange for “helping” governments in different occasions:bailing out insolvent institutions, lending at subsidized rates to certain sectors of
the industry, and financing public deficits, not to mention (in certain countries)
more extreme forms of support such as financing political campaigns or providing
jobs for the friends and families of politicians.
This traditional view of banking regulation was abandoned in the 1990s under
the pressures of international competition and increased sophistication of financial
markets and instruments, as well as the growing realization in many countries of the
intrinsic inability of governments to prevent or resolve banking crises in a promptand efficient way. The two key phrases during this period were
• guaranteeing a “level playing field” for international competition (which essentially meant preventing governments from subsidizing domestic banks throughimplicit bailout commitments), and• forcing supervisors to adopt “prompt corrective action” (PCA) measures when abank started showing signs of financial distress.
The two main instruments developed for these purposes were the first Basel Accord,or Basel I (Basel Committee on Banking Supervision [1988]) in the G-10 countries
and, in the United States, the Federal Deposit Insurance Corporation Improvement Act(FDICIA),6 adopted in 1991. Even though these two reforms were basically successful(as illustrated by the substantial increase in banks’ capital ratios in most developed
countries since 1990),7 the Basel Accord was heavily criticized for having provoked a“credit crunch”8 and regulatory arbitrage,9 while PCA was never implemented, or evenseriously considered outside the United States. Besides, both reforms only concern
micro-prudential regulation. As argued by Borio (2003), there is, however, an urgent
need for a conceptualization and international harmonization of macro-prudential
regulation systems.
5. A similar time-consistency problem used to exist for monetary policy, until independence was granted to thecentral banks of many countries.
6. The FDICIA of 1991 requires that each U.S. bank be placed in one of five categories based on its regulatory
capital position and other criteria (CAMELS ratings). Undercapitalized banks are subject to increasing regulatoryintervention as their capital ratios deteriorate. This prompt corrective action (PCA) doctrine is designed to limit
supervisory forbearance. The consequences of FDICIA are assessed in Jones and King (1995) and Mishkin (1996).
7. See, for example, Furfine (2001) or Flannery and Rangan (2003).
8. On this, see, for example, Berger and Udell (1994), Bernanke and Lown (1991), Jackson et al. (1999), Peek andRosengren (1995), and Thakor (1996).
9. See Jones (2000).

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This paper builds a simple model of the banking industry where both micro andmacro aspects of prudential policies can be integrated. This model, already used in
Rochet (2004b), is an adaptation to the banking sector of the corporate financemodel of Holmström and Tirole (1997, 1998).
My results suggest that the main cause behind the poor management of banking
crises may not be the “safety net” per se as argued by many economists, but instead
the lack of commitment power of banking authorities, which are typically subject topolitical pressure. I show that the use of private monitors (market discipline) is a very
imperfect means of solving this commitment problem. Instead, I argue in favor of
establishing independent and accountable banking supervisors, as has been done formonetary authorities. I also suggest a differential regulatory treatment of banks
according to the costs and benefits of a potential bailout. In particular, I argue thatindependent banking authorities should make it clear from the start (in a credible
fashion) that certain banks with an excessive exposure to macro shocks should
be denied access to emergency liquidity assistance by the central bank. By contrast,banks that have access to the lender of last resort (LLR) facility either because they
have a reasonable exposure to macro shocks or because they are too big to fail should
face special regulatory treatment, with an increased capital ratio and deposit insurance
premium (or liquidity requirements).
The rest of this paper proceeds as follows.
• In Section II, we survey the academic literature on the impact of safety nets andmarket discipline on banks’ behavior.
• In Section III, we develop a simple model of moral hazard in banking (closely
following Holmström and Tirole [1997]) that justifies the need for prudential
regulation and/or market discipline.
• In Section IV, we extend this model by introducing macroeconomic shocks anddetermine the optimal closure rule for banks in a situation of crisis. We also
identify the source of regulatory forbearance: the lack of commitment power bypolitical authorities.
• Section V offers policy recommendations for reforming banking supervisorysystems.
• Finally, Section VI concludes.

II. Survey of the Academic Literature
The ongoing reform of the Basel Accord10 relies on three “pillars”: capital adequacy
requirements, supervisory review, and market discipline. Yet the articulation between
these three instruments is far from clear. On the one hand, the recourse to market
discipline is justified by common-sense arguments about the increasing complexity ofbanking activities, and the impossibility of banking supervisors’ monitoring of these
10. Basel I, elaborated in July 1988 by the Basel Committee on Banking Supervision (BCBS), required internationallyactive banks from the G-10 countries to hold minimum total capital equal to 8 percent of risk-adjusted assets.
It was later amended to cover market risks. It has been revised by the BCBS, which has released for comment
several proposals of amendment, commonly referred to as Basel II (Basel Committee [1999, 2001, 2003]).

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activities in detail. It is therefore legitimate to encourage monitoring of banks byprofessional investors and financial analysts as a complement to banking supervision.
Similarly, a notion of gradualism in regulatory intervention is introduced (in thespirit of the reform of U.S. banking regulation, following the FDICIA of 1991). It issuggested that commercial banks should, under “normal circumstances,” maintaineconomic capital significantly above the regulatory minimum and that supervisors
could intervene if that is not the case. Yet, and somewhat contradictorily, while theproposed reform states very precisely the complex refinements of the risk weights to
be used in the computation of this regulatory minimum, it remains silent on theother intervention thresholds. I briefly survey the academic literature on the impact
of solvency regulations, market discipline, regulatory intervention, and the LLR.
A. Solvency Regulations
I will not discuss in detail the enormous literature on Basel I and its relation to the“credit crunch” (good discussions can be found in Thakor [1996], Jackson et al.
[1999], and Santos [2000]). Briefly, it should be mentioned that most of the theoretical literature (e.g., Keeley and Furlong [1990], Kim and Santomero [1988], Koehn
and Santomero [1980], Rochet [1992], and Thakor [1996]) has focused on the
distortion of banks’ asset allocations that could be generated by the wedge between
market assessment of asset risks and its regulatory counterpart in Basel I.
1. Regulatory arbitrage
Following the implementation of Basel I, academic research has spent much effort
trying to assess the consequences of minimum capital standards on banks’ behavior.
For example, Furlong and Keeley (1989) show that value-maximizing banks tend to
reduce risk taking after a capital requirement is imposed. Using a mean varianceframework, Kim and Santomero (1988) and Rochet (1992) show that improperlychosen risk weights induce banks to select inefficient portfolios, and to undertake
regulatory arbitrage activities which might paradoxically result in increased risktaking. These activities are analyzed in detail in Jones (2000). Hellman, Murdock,
and Stiglitz (2000) argue in favor of reintroducing interest rate ceilings on deposits
as a complementary instrument to capital requirements in mitigating moral hazard.
By introducing these ceilings, the regulator increases the franchise value of the banks(even if the ceilings are not currently binding), which relaxes the moral hazard
constraint. Similar ideas are put forward in Caminal and Matutes (2002).
2. The credit crunch
The empirical literature (e.g., Bernanke and Lown [1991]; see also Thakor [1996],
Jackson et al. [1999], and the references therein) has sought to relate these theoreticalarguments to the large-scale (yet apparently transitory) substitution of commercial
and industrial loans by investment in government securities among U.S. banks in theearly 1990s, shortly after the implementation of Basel I and the FDICIA.11,12
Hancock, Laing, and Wilcox (1995) study the dynamic response to shocks in thecapital of U.S. banks using a vector autoregressive framework. They show that the
11. Peek and Rosengren (1995) find that the increase in supervisory monitoring also had a significant impact onbank lending decisions, even after controlling for bank capital ratios.
12. Blum and Hellwig (1995) analyze the macroeconomic implications of bank capital regulation.

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U.S. banks seem to adjust their capital ratios much faster than they adjust their loan
portfolios. Furfine (2001) extends this line of research by building a structural dynamic
model of banks’ behavior, which is calibrated using data from a panel of large U.S.
banks during the period 1990–97. He suggests that the credit crunch cannot be
explained by demand effects, but rather by the rise in capital requirements and/or theincrease in regulatory monitoring. He also uses his calibrated model to simulate theeffects of Basel II and suggests that its implementation would not provoke a second
credit crunch, given that average risk weights on quality commercial loans will decrease
if Basel II is implemented.
3. Dynamic aspects
Blum (1999) is one of the first theoretical papers to analyze the consequences of more
stringent capital requirements in a dynamic framework. He shows that more stringent
capital requirements may paradoxically induce an increase in risk taking by banks that
anticipate having difficulty meeting these capital requirements in the future.
Décamps, Rochet, and Roger (2004) and Rochet (2004a) analyze the articulation
between the three pillars of Basel II in a dynamic model. They suggest that regulators
should put more emphasis on implementation issues and institutional reforms, to reducea certain imbalance between Pillar 1 of the accord (capital adequacy requirements) andthe other two pillars (supervisory review and market discipline).
Merton (1977, 1978) is the first to use a diffusion model to study the behavior ofcommercial banks. He computes the fair pricing of deposit insurance in a context
where supervisors can perform costly audits. Fries, Mella-Barral, and Perraudin(1997) extend Merton’s framework by introducing a withdrawal risk on deposits.
They study the impact of the regulatory policy of bank closures on the fair pricing
of deposit insurance. The optimal closure rule must trade off between monitoring
costs and the costs of bankruptcy. Under certain circumstances, the regulator may
want to let the bank continue even when equity holders have decided to close it (theunderinvestment result).
Following Leland (1994), Bhattacharya et al. (2002) derive closure rules thatcan be contingent on the level of risk chosen by the bank. Then they examine thecomplementarity between two policy instruments of bank regulators: the level ofcapital requirements and the intensity of supervision. In the same spirit, Dangl andLehar (2001) mix random audits as in Bhattacharya et al. (2002) with risk shifting
possibilities as in Leland (1998) to compare the efficiency of the first Basel Accord(1988) and value-at-risk (VaR) regulation. They show that VaR regulation is better,
since it reduces the frequency of audits needed to prevent risk shifting by banks.
Calem and Rob (1996) design a dynamic (discrete-time) model of portfolio choice,and analyze the impact of capital-based premia when regulatory audits are perfect.
They show that regulation may be counterproductive: a tightening in the capitalrequirement may lead to an increase in the risk of the portfolios chosen by banks, andsimilarly, capital-based premia may sometimes induce excessive risk taking by banks.
However, this never happens when capital requirements are stringent enough.
Froot and Stein (1998) model the buffer role of bank capital in absorbing
liquidity risks. They determine the capital structure that maximizes the bank’s value
when there are no audits or deposit insurance. Milne and Whalley (2001) develop a

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model in which banks can issue subsidized deposits without limit to finance theirliquidity needs. The social cost of these subsidies is limited by the threat of regulatory
closure. Milne and Whalley (2001) study the relation between two regulatory instruments: the intensity of costly auditing and the level of capital requirements. They also
allow for the possibility of banks’ recapitalization. They show that banks’ optimal
strategy is to hold an additional amount of capital (above the regulatory minimum)used as a buffer against future solvency shocks. This buffer reduces the impact ofsolvency requirements.
Finally, Pagès and Santos (2001) analyze optimal banking regulations andsupervisory policies according to whether or not banking authorities are also in chargeof the deposit insurance fund. If this is the case, they show that supervisory authorities
should inflict higher penalties on the banks that do not comply with solvency
regulations, but should also reduce the frequency of regulatory audits.
B. Market Discipline versus Regulatory Intervention
Conceptually, market discipline can be used by banking authorities in two ways:• Direct market discipline, which aims at inducing market investors to influence 13
the behavior of bank managers, and works as a substitute for prudential supervision.
• Indirect market discipline, which aims at inducing market investors to monitor
the behavior of bank managers, and works as a complement to prudential supervision. The idea is that indirect market discipline provides new and objective
information that can be used by supervisors to improve their control of problem
banks, but also to implement PCA measures that limit forbearance.
The instruments for implementing market discipline are essentially of three types:• Imposing more transparency , in other words, forcing bank managers to disclose
publicly various types of information that can be used by market participants tobetter assess banks’ management.
• Changing the liability structure of banks, for example, forcing bank managers to
issue periodically subordinated debt.
• Using market information to improve the efficiency of supervision.
We now successively examine these three types of instruments.
1. Imposing more transparency
In a recent empirical study of disclosure in banking, Baumann and Nier (2003) findthat more disclosure tends to be beneficial to banks: it decreases stock volatility,
boosts market values, and increases the usefulness of accounting data. However, as
argued by D’Avolio, Gildor, and Shleifer (2001), “market mechanisms . . . are unlikely
themselves to solve the problems raised by misleading information . . . For the futureof financial markets in the United States, disclosure [of accurate information] is likely
to be critical for continued progress.” In other words, financial markets will notby themselves generate enough information for investors to allocate their funds
appropriately and efficiently, and in some cases will even tend to spread misleading
information. This means that disclosure of accurate information must be imposed byregulators. A good example of such regulations is the disclosure requirements imposed
13. This distinction between influencing and monitoring is due to Bliss and Flannery (2001).

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in the United States by the Securities and Exchange Commission (SEC) (and in othercountries by the agencies regulating securities exchanges) for publicly traded companies.
However, the banking sector is peculiar in two respects: banks’ assets are traditionallyviewed as “opaque,”14 and banks are subject to regulation and supervision, which
implies that bank supervisors are already in possession of detailed information on
the banks’ balance sheets. Thus, it may seem strange to require public disclosureof information already possessed by regulatory authorities: why cannot these authorities disclose the information themselves,15 or even publish their regulatory ratings(BOPEC, CAMELS, and the like)? There are basically two reasons:• First, as argued by Rochet and Vives (2004), too much disclosure may trigger bankruns and/or systemic banking crises. This happens in any situation wherecoordination failures may occur between many dispersed investors.
• Second, as explained below, the crucial benefit of market discipline is to limit thepossibilities of regulatory forbearance by generating “objective” information thatcan be used to force supervisors to intervene before it is too late when a bank isin trouble. This would not be possible if the information were disclosed by thesupervisors themselves.
In any case, there are intrinsic limits to transparency in banking: we must recall
that the main economic role of banks is precisely to allocate funds to projects of small
and medium-sized enterprises, which are “opaque” to outside investors. If theseprojects were transparent, commercial banks would not be needed in the first place.
2. Changing the liability structure of banks
The economic idea behind direct market discipline is that, by changing the liability
structure of banks (e.g., forcing banks to issue uninsured debt of a certain maturity),16
one can change the incentives of bank managers and shareholders. In particular, some
proponents of the mandatory subdebt proposal claim that informed investors have thepotential to “influence” bank managers. This idea has been discussed extensively in theacademic literature on corporate finance: short-term debt can in theory be used tomitigate the debt overhang problem (Myers [1984]) and the free cash flow problem(Jensen [1986]). In the banking literature, Calomiris and Kahn (1991) and Carletti(1999) have shown how demandable debt could be used in theory to discipline bankmanagers. The subdebt proposal has been only analyzed formally in a very few articles:
Levonian (2001) uses a Black-Scholes-Merton type of model (where the bank’s returnon assets and closure date are exogenous) to show that mandatory subdebt is typicallynot a good way to prevent bankers from taking too much risk.17 Décamps, Rochet,and Roger (2004) and Rochet (2004a) modify this model by endogeneizing the bank’s
14. Morgan (2002) provides indirect empirical evidence on this opacity by comparing the frequency of disagreements
among bond rating agencies about the values of firms across sectors of activity. He shows that these disagreements are much more frequent, all else being equal, for banks and insurance companies than for other sectors of
the economy.
15. One could also argue that the information of supervisors is “proprietary” information which could be used
inappropriately by the bank’s competitors if publicly disclosed. This is not an argument against regulatory
disclosure, since regulators can select which pieces of information they disclose.
16. The “subordinated debt proposal” is discussed, for example, in Calomiris (1998, 1999), Evanoff (1993), Evanoff
and Wall (2000), and Wall (1989).
17. The reason is that subdebt behaves like equity in the region close to liquidation (which is precisely the region
where influencing managers becomes crucial), so subdebt holders have some incentives as shareholders to take toomuch risk.

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return on assets and closure date. They find that under certain conditions (sufficiently
long maturity of the debt, sufficient liquidity of the subdebt market, limited scopefor asset substitution by the bank managers) mandating a periodic issuance ofsubordinated debt could allow regulators to reduce equity requirements (Tier 1).
However, it would always increase total capital requirements (Tier 1 + Tier 2).
In any case, empirical evidence for direct market discipline is weak: Bliss and
Flannery (2001) find very little support for equity or bond holders influencing U.S.
bank holding companies.18 It is true that studies of crisis periods, either in the recent
crises in emerging countries (see Martinez Peria and Schmukler [2001] or Calomirisand Powell [2000]), during the Great Depression (see Calomiris and Mason [1997]),or the U.S. savings and loan (S&L) crisis (see Park and Peristiani [1998]) have foundthat in extreme circumstances depositors and other investors were able to distinguishbetween “good” banks and “bad” banks and “vote with their feet.” There is no doubt
indeed that depositors and private investors have the potential to provoke bankclosures, and thus ultimately discipline bankers. But it is hard to see this as “influencing” banks’ managers, and is not necessarily the best way to manage banking failures
or systemic crises. This leads me to an important dichotomy within the tasks ofregulatory-supervisory systems: one is to limit the frequency of bank failures, theother is to manage them in the most efficient way once they become unavoidable.
I am not aware of any empirical evidence showing that depositors and private
investors can directly influence bank managers before their bank becomes distressed(i.e., help supervisors in their first task). As for the second task (i.e., managing
closures in the most efficient way) it seems reasonable to argue that supervisors
should in fact aim at an orderly resolution of failures, in other words, exactly prevent
depositors and private investors from interfering with the closure mechanism.
3. Using market information
The most convincing mechanism through which market discipline can help banksupervision is indirect: by monitoring banks, private investors can generate new,“objective” information on the financial situation of these banks. This information canthen be used to complement the information already possessed by supervisors. Thereis a large academic literature on this question.19 Most empirical studies of market
discipline focus indeed on market monitoring, in other words, indirect market
discipline. The main questions examined by this literature are: What is the informational content of prices and returns of the securities issued by banks? More precisely,is this information new with respect to what supervisors already know? Someauthors also examine if bond yields and spreads are good predictors of bank risk.
Flannery (1998) reviews most of the empirical literature on these questions. Morerecent contributions are Jagtiani, Kaufman, and Lemieux (1999) and De Young et al.
(2001). The main stylized facts are as follows:
18. A recent article by Covitz, Hancock, and Kwast (2003) partially challenges this view. However, they focus exclusively on funding decisions. More specifically, they find that in the United States, riskier banks are less likely toissue subdebt. This does not necessarily imply that mandating subdebt issuance would prevent banks from taking
too such risk.
19. See, for example, De Young et al. (2001), Evanoff and Wall (2001a, 2001b, 2003), Flannery (1998), Flannery
and Sorescu (1996), Gropp, Vesala, and Vulpes (2002), Hancock and Kwast (2001), Jagtiani, Kaufman, andLemieux (1999), and Pettway and Sinkey (1980).

101• Bond yields and spreads contain information not contained in regulatory ratings,
and vice versa. More precisely, bank closures can be predicted more accurately
by using both market data and regulatory information than by using each ofthem separately.20,21• Subdebt yields typically contain bank risk premiums. However, in the UnitedStates, this is only true since explicit too-big-to fail policies were abandoned (i.e.,
after 1985–86). This shows that market discipline can work only if regulatory
forbearance is not anticipated by private investors.
• However, as shown by Covitz, Hancock, and Kwast (2003), bond and subdebt
yields can also reflect other things than bank risk. In particular, liquidity premia
are likely to play an important role.
In any case, even if there seems to be a consensus that complementing the information set of banking supervisors with market information is useful, it seems difficult
to justify, on the basis of existing evidence, mandating that all banks issue subordinateddebt for the sole purpose of generating additional information. Large banks and U.S.
bank holding companies already issue publicly traded securities, and therefore thisinformation is already available, while small banks would probably find it difficult
to issue such securities on a regular basis and the market for them would probably not
be very liquid.22
Also, there is a basic weakness in most empirical studies of indirect market discipline: for data availability reasons, they have essentially used cross-sectional datasets
containing a vast majority of well-capitalized banks. Remember that the problem atstake is the dynamic behavior of undercapitalized banks. Thus, what we should beinterested in is instead the informational content of subdebt yields for predicting
banks’ problems. That is, empirical studies should essentially focus on panel data andrestrict their analysis to problem banks.
Finally, most of the academic literature (both theoretical and empirical) has
focused on the asset substitution effect, exemplified by some spectacular cases, suchas those of “zombie” S&Ls in the U.S. crisis of the 1980s. However, as convincingly
argued by Bliss (2001), “poor investments are as problematic as excessively risky
projects . . . Evidence suggests that poor investments are likely to be the major explanation for banks getting into trouble.” Thus, there is a need for a more thoroughinvestigation of the performance of weakly capitalized banks: is asset substitution the
only problem, or is poor investment choice also a factor?
In fact, the crucial aspect in using market regulation to improve banking supervision is probably the possibility of limiting regulatory forbearance by triggering
PCA, based on “objective” information. As soon as stakeholders of any sort (private
20. A similar point was made earlier by Pettway and Sinkey (1980). They showed that both accounting informationand equity returns were useful to predict bank failures.
21. Berger, Davies, and Flannery (2000) obtain similar conclusions by testing causality relations between changes insupervisory ratings and in stock prices.
22. The argument that subordinated debt has the same profile as (uninsured) deposits and can thus be used toreplace forgone market discipline (due to deposit insurance) is not convincing. Indeed, as pointed out by
Levonian (2001), the profile of subdebt changes according to the region of scrutiny: it indeed behaves likedeposits (or debt) in the region where the bank starts to have problems, but like equity when the bank comescloser to the failure region.

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investors, depositors, managers, shareholders, or employees of a bank in trouble) cancheck that supervisors have done their job, that is, that they have reacted soon
enough to “objective” information (provided by the market) on the bank’s financial
situation, the scope for regulatory forbearance will be extremely limited. Of course,
the challenge is to design (ex ante ) sufficiently clear rules (i.e., set up a clear agenda
for the regulatory agency) specifying how regulatory action will be triggered bywell-specified market events.
4. How to integrate market discipline and banking supervision
A few conclusions emerge from our short review:• First, it seems that supervision and market discipline are more complements thansubstitutes: one cannot work efficiently without the other. Without credible
closure policies implemented by supervisors, market discipline is ineffective.
Conversely, without the objective data generated by prices and yields ofbanks bonds and equity, closure policy is likely to be plagued by ambiguity
and forbearance.
• Second, indirect market discipline (private investors monitoring bank managers)
seems to be more empirically relevant than direct market discipline (private
investors influencing bank managers). Also, mandating that all banks regularly
issue a certain type of subordinated debt would not generate much new information on large bank holding companies (because most of them already issue
publicly traded securities), but would be very costly for smaller banks.23• Third, more attention should be directed to the precise ways in which supervisory
action can be gradually triggered by market signals. Instead of spending so muchtime and energy refining Pillar 1 of Basel II, the Basel Committee should
concentrate on this difficult issue, crucial to creating a level playing field for international banking.
There is also clearly much more to be done, both by academics and regulators,
if we really seek to understand the interactions between banking supervision andmarket discipline. In particular, very little attention has been paid24 so far to macroprudential regulation: how to prevent and manage systemic banking crises. It seems
clear that market discipline is probably not a good instrument for improving macroprudential regulation. Indeed, market signals often become erratic during crises, andthe very justification of macro-prudential regulation is that markets do not deal
efficiently with aggregate shocks of sufficient magnitude. Macro-prudential control
lies, therefore, almost exclusively on the shoulders of bank supervisors, in coordination with the central bank and the Treasury. A difficult question then is how toorganize the two dimensions (macro and micro) of prudential regulation in such a
way that systemic crises are efficiently managed by governments and central banks,
while individual bank closure decisions remain protected from political interference.

23. The only convincing argument for mandating regular issuance of a standardized form of subdebt is that it may
improve liquidity of such a market, and therefore increase informational content of prices and yields.
24. Borio (2003) is one exception.

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C. The Lender of Last Resort (LLR)
1. The doctrine and the facts
The concept of LLR was elaborated in the 19th century by Thornton (1802) andBagehot (1873). The essential point of the classical doctrine associated with Bagehot
asserts that the LLR role is to lend to “solvent but illiquid” banks under certain
conditions. More precisely, the LLR should lend freely against good collateral,valued at pre-crisis levels, and at a penalty rate. These conditions can be found in
Bagehot (1873) and are also presented, for instance, in Humphrey (1975) and Freixas
et al. (1999).
This policy has clearly been effective: traditional banking panics were eliminatedwith the LLR facility and deposit insurance by the end of the 19th century inEurope, after the crisis of the 1930s in the United States and, more recently, in many
emerging market economies, which had previously suffered numerous such crises.25
Modern liquidity crises associated with securitized money or capital markets have also
required the intervention of the LLR. Indeed, the Federal Reserve System intervenedin the crises provoked by the failure of Penn Central in the U.S. commercial paper
market in 1970, by the stock market crash of October 1987, and by Russia’s default
in 1997 and subsequent collapse of Long-Term Capital Management (in the last case,a “lifeboat” was arranged by the Federal Reserve Bank of New York). For example, in
October 1987 the Fed supplied liquidity to banks through the discount window.26
2. The main criticisms
The LLR’s function of providing emergency liquidity assistance has been criticizedfor provoking moral hazard on the banks’ side.27 Perhaps more importantly,
Goodfriend and King (1988) (see also Bordo [1990], Kaufman [1991], and Schwartz[1992]) remark that Bagehot’s (1873) doctrine was elaborated at a time whenfinancial markets were underdeveloped. They argue that, whereas central bankintervention on aggregate liquidity (monetary policy) is still warranted, individualinterventions (banking policy) are not anymore: with sophisticated interbank
markets, banking policy has become redundant. Goodfriend and Lacker (1999)
suggest that commercial banks could instead provide each other with multilateralcredit lines, remunerated ex ante by commitment fees.
3. The modern view
Rochet and Vives (2004) provide a theoretical foundation for Bagehot’s (1873)
doctrine in a model that fits the modern context of sophisticated and presumably
efficient financial markets. Their approach bridges a gap between the “panic” and“fundamental” views of crises by linking the probability of occurrence of a crisis to thefundamentals. They show that in the absence of intervention by the central bank, somesolvent banks may be forced to liquidate if too large a proportion of wholesale deposits
is not renewed. Freixas, Parigi, and Rochet (2004) formalize two common criticisms
25. See Gorton (1988) for U.S. evidence and Lindgren, Garcia, and Saal (1996) for evidence on other International
Monetary Fund (IMF) member countries.
26. See Folkerts-Landau and Garber (1992). See also Freixas, Parigi, and Rochet (2004) for a modeling of theinteractions between the discount window and the interbank market.
27. However, Cordella and Levy-Yeyati (2003) show that, in some cases, moral hazard can be reduced by thepresence of LLR.

104 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

Prudential Policyof the Bagehot doctrine of the LLR: that it may be difficult to distinguish between
illiquid and insolvent banks (Goodhart [1995]) and that LLR policies may generate
moral hazard. They find that when interbank markets are efficient, there is still a
potential role for an LLR but only during crisis periods, when market spreads are
too high. In “normal” times, liquidity provision by interbank markets is sufficient.

III. A Simple Model of Prudential Policy
In this section, we introduce the benchmark model of banking regulation, used alsoin Rochet (2004b) in the absence of macroeconomic shocks. We consider a static
model with two dates (t = 0, 1) following Holmström and Tirole (1997),28 wherebanks are modeled as delegated monitors in the manner of Diamond (1984). Theycollect a volume D of deposits from the public and invest them, together with theirown funds E, in loans to private borrowers. The volume of loans granted by the bankis denoted by L. Since we focus on the role of banks as monitors of private borrowers,
we take small depositors out of the picture by assuming that they are perfectly
insured by a DIF. We also neglect conflicts of interest inside the bank, that is,
between managers and shareholders. Thus, in the first version of the model there are
only two protagonists:29 the “banker” (who represents the collective interests of thebank’s managers and shareholders) and the DIF (which subrogates the collective
interests of retail depositors). The budget constraint of the bank at date 0 is thus
D + E = L + P,
where P is the deposit insurance premium charged by the DIF. The lending technology has a constant return to scale.30 This return is binomial: R (per unit) in case of
success and zero in case of failure. All agents are risk neutral and do not discountfuture payments (alternatively, the interest rate is normalized to zero). Banking
supervision is modeled as a contract between the banker and the DIF.31 This contract
stipulates the volume of loans L and the volume D of deposits that the bank cancollect, the level of equity E being taken as given. The specificities of banking arethus captured by three assumptions:• First, we assume that L > E, which implies that some fraction of bank loans isfinanced by deposits.
• Second, we assume that the quality of loans is affected by an unobservabledecision of the banker. He can either monitor the loans, in which case they havea “high” probability of repayment p , or “shirk,” in which case the loans have a
28. Holmström and Tirole (1997) study the financing needs of nonfinancial firms. We adapt their model to study
the financing needs of banks.
29. We later introduce the central bank and the Treasury.
30. Empirical evidence on the nature of returns to scale in the banking sector is mixed. Moreover, capital requirements are (for a given asset structure) roughly proportional to the size (asset volume) of the bank. Thus, assuming
constant returns seems to be a reasonable approximation of reality.
31. In fact, the contract is signed between the banker and the regulator, who is supposed to represent the interests of
the DIF.

105

probability of repayment of only p − p. Shirking provides the banker with a
private benefit with monetary equivalent B (per unit of investment).
• The social value of the bank exceeds the present value of its investments: weassume that, from the point of view of the economy32 as a whole, the bank has
an additional continuation value of v ≥ 0 per unit of assets, which corresponds,
for example, to public good aspects of the bank’s activity such as the bank’srole in the payments system33 (Solow [1982]).
The time line of the model is summarized in Figure 1.
At this stage, we need two assumptions on the parameters of our model:
Assumption 1: (p − p)R + B + v < 1 < pR + v.
Assumption 1 means that loans have a positive social value only when they aremonitored. This assumption implies in particular that R > B/p.
Assumption 2: p(R − B/p) < 1.
As explained below, Assumption 2 implies that banks need capital. If it were notsatisfied, banks could be 100 percent externally financed.
The optimal contract (L *, D * ) maximizes expected social surplus under two
constraints: the DIF must break even and the banker must be given incentives tomonitor the loans. Denoting by P the premium paid by the bank to the DIF, andusing the budget constraint of the bank at date 0, we see that the DIF breaks even if
and only if
P = D + E − L ≥ (1 − p )D,or
Figure 1 Time Line of the Model

RLBank succeeds,banker gets RL − D.

0Bank fails, banker
gets nothing, and DIF
repays depositors.

pMoral hazard

t=0
Contract signed,bank collects D,
lends L, andpays P to the DIF.

Banker either
monitorsloans or shirks.

t=1
Returns
are realized.

32. There may also be a private continuation value, associated with the banker’s nontransferable knowledge ofborrowers (relationship banking as in Sharpe [1990], or Degryse and Van Cayseele [2000]). We do not discuss
this aspect.
33. This feature is not crucial: our results also hold when v = 0. However, in the next section it allows us to discuss thebasic trade-off confronted by banking authorities during crises: rescuing insolvent banks and losing credibility,
or closing them and creating social disruption.

106 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

Prudential Policy

L ≤ pD + E.

(1)

Similarly, the incentive compatibility constraint is
p (RL − D) ≥ (p − p)(RL − D) +BL,
which can be rewritten as

(

)

B L.
D ≤ R − –––p(2)

The optimal contract (L, D) is thus a solution ofmax L [pR + v − 1],L ≤ pD + E,D ≤ R − –––
B L.

p

(

)

(1)
(2)

It is characterized as follows:
Proposition 1: In the absence of macroeconomic shocks, the optimal organization of thebanking sector can be implemented by a combination of two instruments:• A deposit insurance system financed by (fair) risk-based premiums:
P = (1 − p)D.

• A capital adequacy requirement limiting banks’ lending to a certain multiple oftheir equity:B −(pR − 1) > 0.
L ≤ –E–, where k = p –––kpProof: The optimal organization of the banking sector is obtained by solving the above
program. The solution is obtained by saturating the two constraints. In particular,()

B L *.
D * = R − –––pPlugging this into the other constraint, we obtain
B  = E.
 − p R − –––L * 1

p 

(

)

These two conditions characterize the optimal contract (D *, L * ).

107

We now show that this contract can be implemented by actuarial deposit insurance
premiums and a capital requirement, E /L ≥ k. Indeed shareholders’ value equals
S = p [RL − D ],where L = D + E − P = pD + E (since deposit insurance is actuarially priced).
Therefore, shareholders’ value can also be written as
S = (pR − 1)L + E,
which is increasing in L. Thus, if the bank is subject to a capital requirement, L ≤ E/k,shareholders will select the maximum possible volume of loans, L = E /k. By choosing
in turn the appropriate level for the capital ratio, that is,
B −(pR − 1),
k = p –––
p■
the bank regulator will implement the optimal allocation (D *, L * ).
Notice that this optimal allocation can also be implemented by a private arrangement between the DIF and the banker: the DIF offers a deposit insurance contract
with a fair premium P and stipulates that the bank’s assets L should not exceed E/k.
The difference between private and public arrangements only appears if macro shocks
are introduced. This is what we do in Section IV.

IV. How to Deal with Macroeconomic Shocks?
Protection of depositors is not the only preoccupation of bank supervisors: theyalso care about what may lead to the instability of the financial system as a whole(systemic risk). The theoretical literature has insisted a great deal on a first cause
of instability, namely, bank runs, provoked by a sudden loss of confidence of depositors in the banks’ safety. These bank runs were, for example, very common in the
United States prior to the creation of the Fed. However, since the implementation ofdeposit insurance systems in most countries, such bank runs have become muchless frequent, and banking authorities are now more concerned about systemic risk.
One strand of the literature (e.g., Rochet and Tirole [1996] or Freixas, Parigi, andRochet [2000]) has examined the possible mechanisms of contagion, that is, propagation of one bank failure to other banks. We focus here on another source ofsystemic risk, namely systematic risk, generated by a common exposure of banks tomacroeconomic shocks, such as recessions, asset market crashes, and the like. We
introduce these macro shocks by assuming, as in Holmström and Tirole (1998),34
that at an interim date (t = 1/2), each bank35 suffers with some probability q from a
34. In Holmström and Tirole (1998), the cause of the liquidity shock can be microeconomic (i.e., diversifiable) or
macroeconomic. We focus here on the second case.
35. Holmström and Tirole (1998) do not consider banks but instead nonfinancial firms. Moreover, they take  tobe a random variable, but assume that it is identically distributed across firms. We assume instead that  isdeterministic, but varies across banks.

108 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

Prudential Policy

liquidity shock: continuation can only occur if an additional amount of cash L is
injected into the bank. We interpret this shock as resulting from a nondiversifiable
event, such as a recession: the projects financed by the bank need a further injectionof cash, otherwise they lose all value. We assume that the probability q is sufficiently
small for bank lending to remain profitable even if the risk of recession is taken into
account. Specifically:
Assumption 3: (1 – q)pR > 1.
Notice that all banks are hit simultaneously but  differs across banks. This parameter  is known ex ante by the supervisor: it measures the bank’s exposure to macro
shocks. The new time line is indicated in Figure 2.
Confronted with the possibility of such macro shocks, the regulators must now
consider the situation of the banking system as a whole. We assume that there is acontinuum of banks, which for simplicity only differ through their exposure36  tomacro shocks.  is distributed according to a continuous distribution with continuous distribution function F. F ( ˆ ) can thus be interpreted as the proportion ofbanks such that  ≤ ˆ .
Since  , the macro exposure of each bank, is known ex ante by the supervisors,
the optimal regulation contract can be conditioned on it. Moreover, the supervisors
may decide to close a bank at t = 1/2 in case of a recession, again conditionally on  .
We denote by x (  )∈[0, 1] the probability that the bank is allowed to continue incase of recession. If a bank is closed, its assets are liquidated37 and its depositors arecompensated by the DIF. A regulation contract is described by a continuation probability x (  ), a volume of loans L(  ), and a volume of deposits D (  ). For the moment,
we adopt a normative perspective and solve for the (ex ante ) optimal contract without
specifying the way in which it is implemented (this is done in the next section).
Since moral hazard takes place after the liquidity shock, it is easy to see that the
optimal volume of deposits still corresponds to the maximal payment that can beobtained from bankers while preserving incentive compatibility, namely:
Figure 2 Time Line in the Presence of Macro Shocks
t = 1/2
liquidity shock(0 or  )
t=0

Stop

Contract signed,
Bank closed,bank collects D ( ),DIF repays
lends L ( ), anddepositors.
pays P ( ) to the DIF.

ContinueMoralhazardp
t=1

RL () Bank succeeds,banker gets
RL ( ) − D ( ).
0Bank fails,
DIF repays
depositors.

36. This exposure results in fact from policy decisions by banks, and therefore should be endogenized. We leave thisfor further research. In this paper, the distribution of  is taken as exogenous.
37. For simplicity, we assume that the liquidation value of the bank’s asset at t = 1/2 is zero.

109

(

)

B L (  ).
D (  ) = R − –––p(3)

We rule out cross-subsidies between banks or between the banking sector and thegovernment. Thus, taking into account the expected cost of liquidity injections, thebudget constraint of the bank at date 0 can then be written
B + q  x (  ) = E.
 − {1 − q + qx (  )}p R − –––L (  ) 1

p


(

)

(4)

This budget constraint takes into account the unconditional probability of continuation of the bank at t = 1/2 (that is, 1 − q + qx (  )) and the liquidity injectionneeded in case of a recession (that is,  x (  )).
Social surplus W is the sum of two terms:• the expected net surplus generated by bank lending, and• the social value–of the banking system as a whole, captured by a function38 V of
the total assets L of the banks at the interim date t = 1/2.
Therefore–+
W = ∫0 {(1 − q )pR + q x (  )(pR −  ) − 1}L (  )dF +V (L ),

(5)

– +
L = ∫0 L(  ){1 − q + qx (  )}dF.

(6)

where

The optimal regulatory contract is obtained by choosing x ( • ) and L ( • ) thatmaximize W under the budget constraint (4) of each bank.
Proposition 2: In the presence of macroeconomic shocks, the optimal regulatory contract
is characterized by a separation of banks into two categories:• The banks such that  ≤ * = 1/(1 – q ) (small exposure to macro shocks) are
rescued in case of a crisis, but are subject to a higher capital ratio (than in theabsence of macro shocks). This capital ratio increases with their exposure  tomacro shocks:()

E = 1 − p R − –––B + q .
k 1(  ) = ––––p
L ( )(7)• The banks such that  >  (large exposure to macro shocks) are closed in case of a*crisis and are subject to a flat capital ratio:()

E = 1 − (1 − q)p R − –––B .
k 0 = ––––p
L ( )(8)

38. This generalizes– the constant v introduced in Section III in the case of a single bank. In what follows, v is
replaced by V ′(L ), the marginal value of letting any given bank continue at t = 1/2.

110 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

Prudential Policy

The interpretation of our notion of exposure to macro shocks should be wide.
Indeed, our model assumes for simplicity that banks are identical in all other respects.
If, more realistically, we also introduce differences in sizes of loans or positions in theinterbank markets, the important distinction arising from Proposition 2 concerns
which banks have access to the LLR facility and which do not. Proposition 2 thenmakes two points:• This distinction39 should be made explicitly ex ante by banking authorities, basedon assessments for the (ex ante) social costs and benefits of a potential bailout incase of a crisis.
• Banks that are eligible for the LLR facility should face special regulatory
treatment, with an increased capital ratio and deposit insurance premium (orliquidity requirement).
Proof: Given that there is a separate budget constraint for each  (condition [4]), we
can solve for L (  ) and maximize with respect to x the following quantity:–(1 − q + qx)(pR +V ′(L )) − qx  − 1
U (x, ) = ––––––––––––––––––––––––––––
B + qx 
1 – (1 − q + qx)p R − –––
p

(

)

(E has been omitted, because it only appears multiplicatively and therefore does not
influence the optimal value of x (  )). The expression of U can be simplified as follows:–pB(1 − q + qx) V ′(L ) + –––p
U (x, p ) = −1 + –––––––––––––––––––––––––––
B
1 + qx  − (1 − q + qx )p R − –––
p

(

)

(

)

–
pB
V ′(L ) + –––p= −1 + –––––––––––––––––––– .
1 + qx B––––––––– − p R − –––1 − q +qx
p()

For a given  , this expression is monotonic in x : increasing if  < 1/(1 − q ), anddecreasing if  > 1/(1 − q). Thus, the optimal regulatory contract involves
x (  ) = 1 if  ≤ ––––
1 – *,

≡
1 −q


= 0 if  > *.


39. However, eligibility for the LLR facility should not be taken for granted and could evolve over time as a functionof regulatory assessments.

111

The corresponding capital ratios are deduced from constraint (4):()

E = 1 − {1 − q + qx (  )}p R − –––B + q  x (  ),k (  ) ≡ ––––p
L ( )
by replacing x (  ) with its optimal value found above.
■
Proposition 2 adopts a normative perspective, in other words, it characterizes the
optimal closure rule for banks in the presence of macroeconomic shocks. We now adopt
a positive perspective and compare the optimal closure rule with the effective closurerules implied by two institutional arrangements: pure private contracting between thebanks and the DIF on the one hand, and pure public supervision on the other.
Proposition 3: A purely private organization of the banking sector leads to too
many closures in the event of a recession; indeed, a bank is closed whenever  ≤  0 =p (R − B/p) < *.
Proof: In the absence of a public intervention, the only way in which a bank can obtainliquidity at the interim date t = 1/2 is by borrowing from other banks (or issuing newcertificates of deposit). The maximum amount of cash that can be raised in that way isequal to the collateral value of the bank’s assets, in other words, the maximal expected
payment that can be obtained from bankers while preserving incentive compatibility,that is,

(

)

B L.
 0 L ≡ p R − –––pAssumption 2 states that  0 < 1, which implies that  0 < * = 1/(1 − q ). Therefore,
all the banks with an intermediate exposure to macro shocks (  ∈]  0, *[) should beallowed to continue, but would be closed in the absence of a public intervention. ■Proposition 3 shows the need for the central bank acting as an LLR: by providing
liquidity assistance to the banks characterized by  ∈]  0, *[, the central bank
improves upon the purely private organization discussed in Proposition 3. However,there is also a problem with public intervention. Indeed, once a bank has granted
a certain volume of loans, its social continuation value is positive as long as  < pR +–V ′(L ) ≡  1, which is larger than * = 1/(1 − q ) by Assumption 3. If the bank authorities are subject to political pressure, it will be impossible for them to limit liquidity
assistance to the banks such that  ≤ *, since it is ex post optimal to also let all thebanks characterized by  ∈] *,  1[ continue. Not only does this imply too few
closures (regulatory forbearance), but also overinvestment at t = 0, since bankers
anticipate this forbearance. This is explained in the next proposition.
Proposition 4: Prudential regulation by a public authority leads to forbearance: allbanks such that  ≤  1 receive liquidity support in case of a recession. In this case, theonly thing regulatory authorities can do is impose on these banks a flat capital ratio:40
40. Banks such that  <  0 are subject to the same capital ratio as in Proposition 2.

112 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

Prudential Policy

(

)

B .
k 0 = 1 − (1 − q )p R − –––pCompared with the optimal contract characterized in Proposition 2, we see that thisleads to overinvestment by these banks, which thus exploit this anticipated regulatory
forbearance.
Proof: We have already seen that it is ex post optimal for the government to provide–
liquidity assistance to all banks such that  ≤  1 = pR + V ′(L ) (positive social
continuation value). When  <  0 (solvent banks), this liquidity support is fully
collateralized and the central bank does not lose any money. However, when ∈]  0,  1], the central bank loses (  −  0)L in expectation, but seizes maximum
income (R − B/p)L = D in case of success. From the DIF point of view, the cost of
deposit insurance becomes
P = [(1 − q )(1 − p ) + q ]D.
The associated capital ratio is
E = 1 + –––––
P − D = 1 − (1 − q )p R − –––B .
k 0 = ––
L
L
p

(

)

It is smaller than the efficient capital ratio characterized in Proposition 2:()

B + q .
k 0 < k 1(  ) = 1 − p R − –––pThis is because  >  0 = p (R − B/p). Thus, there is overinvestment. Finally, noticethat from an ex ante perspective, the marginal social value of loans made by a banksuch that  ∈]  0,  1] is equal to (  1 −  ), which is non-negative. This means that it
would be inefficient ex ante to restrict further the volume of credit granted by suchbanks. Thus, the government cannot compensate for its lack of commitment power■with an increase in capital ratios.
We see this as the fundamental problem faced by prudential supervision: public
intervention is needed41 to avoid too many bank closures, but since governments are
subject to commitment problems, public supervision alone leads to too few bankclosures and overinvestment. By analogy with Dewatripont and Maskin (1995), wecall this a soft budget constraint phenomenon.42
This problem is summarized in Figure 3.
We discuss in Section V a possible organization of banking supervision that could
solve this problem.
41. Holmström and Tirole (1998) show that, when  corresponds to a diversifiable shock, private arrangements
between firms and banks (namely, private lines of credit) can be enough to implement the (second-best) optimum.
However, when there are macro shocks, public provision of liquidity is needed.
42. Notice, however, that the mechanism which underlies the soft budget constraint in Dewatripont and Maskin(1995) is different.

113

Figure 3 The Fundamental Problem Faced by Prudential Supervision

Need for alender oflast resort

Solventbanks

0Regulatory
forbearanceBanks that are closed
if a macro shock occurs


*

1

Exposure tomacro shocks

V. Policy Recommendations for Prudential Policy
This section offers some reflections on the ways in which the optimal contract characterized in Section IV can be implemented by an adequate design of the supervisoryregulatory system. As we saw in Section IV, two crucial elements are needed:• Intervention of the central bank as an LLR to provide liquidity assistance, incase of a recession, to a subset of banks that satisfy certain criteria (in our model,
this reduces to  ≤ * ).
• Preventing extension of this liquidity assistance to the banks characterizedby * <  ≤  1, for which ex post continuation value is positive (from a social
perspective) but for which a bailout would be welfare decreasing from an
ex ante perspective.
We claim that these two elements can only be reconciled if the central bank ismade independent from political authorities, as has been done for monetary policy.
To ensure accountability of the central bank in its functions as an LLR, a precise
agenda must be defined ex ante, namely, providing liquidity assistance to a subset ofbanks that would be backed by the supervisors (or the DIF). To ensure that the DIF
selects properly the banks that can be assisted, we require that the liquidity loans
granted by the central bank (acting as an LLR) be backed by the DIF. In other words,
such loans would be insured by the DIF: the central bank would be completely
protected against credit risk, and no taxpayer money would be involved. The next
proposition summarizes the proposed organization of the regulatory system.
Proposition 5: The optimal contract (characterized in Proposition 2) can be implemented
by the following organization of the regulatory system:• For each commercial bank, the supervisory authorities evaluate the ex ante social
costs and benefits of bailout in case of a systemic shock. This assessment determines
the treatment of the bank by regulators.
• Banks for which ex ante social benefits of bailout exceed costs are backed by the
DIF and, in case of a macro shock, receive liquidity assistance by the central
bank. They face a higher capital adequacy requirement and an adjusted deposit
insurance premium.
• Banks for which bailout costs exceeds social benefits are not backed by the DIF:
they do not receive liquidity assistance by the central bank.

114 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

Prudential Policy• The LLR activities of the central bank are made independent from political powers:
the central bank exclusively provides liquidity assistance to the banks that are backed
by supervisory authorities. Central bank loans are fully insured by the DIF.
This organization is summarized in Figure 4.
Figure 4 Optimal Management of Systemic Crises

Commercial
banks
Low exposure
to macro shocks( ≤ * )( > * )High exposure
to macro shocks• Have access to emergency liquidity
assistance by the central bank.

• Have no access to emergency liquidity
assistance by the central bank.

• Pay a deposit insurance premium that
increases with  :P ( ) = D 1 − p + pq — .

• Pay a flat deposit insurance premium:

(

0

)

• Are subject to a capital requirement that
increases with  :P0 = D (1 − p + pq ).
• Are subject to a flat capital requirement:
k 0 = 1 − (1 − q ) 0.

k 1( ) = 1 −  0 + q .

VI. Conclusion
The main reason behind the frequency and magnitude of recent banking crises might
not be deposit insurance, bad regulation, or incompetence of supervisors. It might beessentially the commitment problem of political authorities, which are likely to exertpressure to bail out insolvent banks and delay crisis resolution.
The remedy to political pressure exerted on banks’ supervisors is probably not to
substitute supervision by market discipline. This is because market discipline can only
be effective if the absence of government intervention is anticipated. Market disciplineand central supervision are more complements than substitutes. In fact, the way torestore credibility of banks’ closure policy is to ensure independence and accountability of bank supervisors, as has been done for monetary policy. However, thisindependence is probably more difficult to implement, given the difficulty to define
explicit, quantitative objectives for LLR interventions. Another difficulty is the need tocoordinate LLR interventions between the central bank, supervisory authorities, andthe Treasury without reintroducing disguised forbearance.
The other key reform is to find a way to restrict liquidity assistance by the central
bank to a subset of banks that are backed by the independent supervisors. Supervisors
should be in charge of selecting these banks, which then would face special regulatory
treatment. Finally, central bank loans should be senior to wholesale deposits, toprotect taxpayers’ money and provide adequate incentives to banks’ supervisors.

115

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119Comment
ALEX BOWEN43
Bank of England

I. Introduction
Over the past 30 years, banking crises have become more common.44 And theevidence of how costly they can be has been mounting. In one study by some of mycolleagues,45 it was estimated that output losses during banking crises are on averagearound 15 to 20 percent of annual GDP. Crises have occurred in both developedand emerging market economies. It is not surprising, then, that central banks andother public authorities have been focusing more attention on how to maintainfinancial stability and the question, “how should macro-prudential policy be
designed?” My interest lies in this macro -prudential element of prudential policy,
given my own institution’s remit to safeguard “the overall stability of the U.K. financial
system as a whole.”46
The problem is that financial stability authorities have not had at their disposal ananalytical framework as developed as that available to their colleagues in the monetary policy arena. There is no consensus definition of financial stability. And it has
been difficult to establish precisely why banking crises have taken place and precisely
why they have imposed heavy output costs. So I very much welcome Jean-Charles
Rochet’s paper, both for demonstrating that there has been considerable progress inanalyzing prudential policy questions and for carrying the analysis further.
In my brief remarks, I would like first to comment on some of the conclusions
that Rochet draws from his review of the literature on prudential policy. Then I
would like to say something about the model that he develops. Finally, I want tomention some of the challenges to financial stability authorities suggested to me byhis stimulating paper.

II. Rochet’s Survey of the Academic Literature
In his survey of the literature, the author outlines the twofold rationale for prudential
policy: first, the micro-prudential challenge (how to address the principal-agent problem facing depositors in their relations with banks); second, the macro-prudential
challenge (how to promote the public good of financial stability, which banks andinvestors will tend to under-supply).
This is a dichotomy that makes sense and has proved useful in assigning responsibilities to public authorities. But it is important to note that some of the economic
characteristics which give rise to a case for public policy intervention have both
43. These remarks are made in a personal capacity and do not reflect the official view of the Bank of England.
44. See Bordo et al. (2001) and Crockett (2003).
45. See Hoggarth, Reis, and Saporta (2001).
46. HM Treasury, Bank of England, and Financial Services Authority (1998).

120 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

Comment

micro- and macro-prudential consequences. Three examples are asymmetric andincomplete information, problems with contracts and pre-commitment, and network
externalities. All can give rise to spillover effects sufficient to merit interest from amacro-prudential angle.
Some of the problems often discussed in a micro-prudential context can havewide-ranging consequences. Examples include contagion following a bank run, afailure of a large complex financial institution, or interruption of vital financial
infrastructure services. In many of these cases, it is desirable to model the general equilibrium aspects and spillovers to the economy at large.47 But at the root of the analysis
should be the identification and modeling of the key market imperfections—this isnecessary whether one is developing micro- or macro-prudential policy instruments.
Rochet reviews the extensive literature on solvency regulation. He notes how inprinciple it could induce inefficiency and distort risk management as well as discipline
bank managers. But my reading of his paper leads to the conclusion that the empiricalimpact of capital adequacy requirements is still uncertain, suggesting a need forcaution in implementing changes.
The paper does not address the regulation of bank liquidity at any great length,
but research both by the author48 and by Plantin, Sapra, and Shin (2005), presented
by Hyun Song Shin in the next session of this conference, suggests that there are
difficult issues for financial stability authorities here. Given the increasing interest inrevisiting the regulation of banks’ liquidity management, it is important for theauthorities to engage with these issues. But Rochet reminds us that solvency andliquidity regulation do not exhaust the list of prudential policy instruments. One also
needs to consider the intensity of supervisory monitoring—supervisory review—andthe promotion of information disclosure and market discipline.
The studies cited show that there is interesting work going on concerning supervisory strategies—where to focus monitoring, how much to undertake—but also
plenty of scope for further modeling of supervisory agencies’ behavior, objectives, andconstraints, to relate them to the range of market imperfections they have implicitly
been set up to address.
Turning next to market discipline, Rochet expresses some skepticism about how
much it can achieve. He is doubtful that it can, in theory or practice, solve theprincipal-agent problem confronting depositors or indeed shareholders; he reminds
us that, in some circumstances, information disclosure can lead to market movementsthat trigger a rush for the exit by depositors; and he argues that market discipline isirrelevant as far as the macro-prudential objective of policymakers is concerned.
I am a little less skeptical about the possible benefits of information disclosure andmarket discipline. As Rochet notes, it can exercise discipline on regulators—just as apublic commitment to an inflation target, defined in terms of a specific statisticalmeasure, can impose discipline on monetary policymakers. Market prices can disseminate information disclosed by banks, increasing the information set available to all. And
47. As Rochet observes, there has not been a great deal of work in this area. But see, for example, Haldane et al.
(2004) and Goodhart, Sunirand, and Tsomocos (2004, 2006).
48. See Rochet (2005).

121empirical work by my colleague Erlend Nier suggests that banks are less likely to suffer
distress, the more they disclose.49 The advantages appear to outweigh the disadvantages.
I would argue that this is relevant for the macro-prudential objective. Promoting
disclosure to the market helps to address problems of imperfect information, improving ex ante incentives, and reducing contagion risk in the event of financial distress.
But I would agree with Rochet that disclosure and market discipline do not provide apanacea. If externalities or other market imperfections remain, more information
may simply make them more problematic in some circumstances. As editor of the
Bank of England’s Financial Stability Review, I am very conscious of the possible
danger of triggering, by disseminating information and analysis, the very problems
we are seeking to avoid. Unless financial stability authorities have means with whichto address the underlying externalities, public information disclosure is not necessarily optimal; transparency is not as straightforward for them as it is for monetary
policy authorities. Hyun Song Shin and my colleague Prasanna Gai have written
about this conundrum.50
Finally, in Rochet’s literature review, he considers the doctrine of lender of lastresort (LLR). Is Bagehot out of date? Rochet’s own work suggests not—there is still arole in periods of systemic stress for central bank emergency liquidity assistance. He
notes the scope for private liquidity insurance arrangements in “normal” times, but
we have seen some episodes in the past few years when banks became reluctant to rollover lines of credit in the face of uncertainty about the creditworthiness of individual
lenders or about general liquidity conditions. So it seems to me that the empiricalevidence backs up Rochet’s defense of Bagehot.
The model that Rochet has presented at this conference suggests that, in somecircumstances, the authorities will be inclined to support too many banks and that
there will be overinvestment by banks in projects. It is interesting that banking crises
associated with more LLR activity have actually tended to be more serious andlengthy.51 This offers some support for Rochet’s thesis. But it is very difficult empirically to sort out cause and effect here. It is not at all easy to assess the size of theshock leading to each banking crisis. So in practice, the degree of LLR activity may
reflect the seriousness of the initial shocks.
The other point I wish to mention here is that there is some empirical evidence52
that explicit and implicit government guarantees may reduce the beneficial impact
of disclosure and market discipline—another form of the moral hazard which
Rochet mentions.

III. Rochet’s Model for Prudential Policy
Rochet then goes on to lay out a simple model for prudential policy, introducing,
first, the principal-agent problem facing a deposit insurance fund (DIF); then, a
49. See Nier (2004).
50. See Gai and Shin (2003).
51. See Hoggarth, Reidhill, and Sinclair (2004).
52. See Baumann and Nier (2003).

122 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

Comment

systematic shock to banks that gives rise to a potential time-inconsistency problem
for the policymaker.
Rochet derives a solution in which the capital adequacy ratio agreed by contract
is a positive function of the benefit to managers of shirking and a negative functionof the return to a successful project and of the probability of a loan repayment.
Rochet shows that the optimal allocation of loans and deposits, taking the levelof equity as given, can be implemented by a private arrangement between the DIF
and banks.
Two aspects of this setup concern me. First, the assumption of risk neutrality. In
practice, public authorities are likely to be concerned about the consequences of bad
outcomes in cases where the law of large numbers does not apply; the social costs ofextreme outcomes may be very high. Second, is there not a possible role for a subsidy
if the externality from increasing the size of the banking system is positive? In otherwords, should not the DIF’s budget constraint be loosened? The model focuses moreon the principal-agent problem than on this externality, which may be just as relevantfrom the macro-prudential point of view.
Rochet then goes on to consider the implications of a common exposure of banks
to macro shocks in this model. There is some probability of a systematic liquidity
shock; if it crystallizes, some banks need a bigger cash injection than others if they areto survive and find whether the projects in which they invested pay off. If I understand the model correctly, this shock entails a real deadweight cost that does notreflect an information or coordination problem that could be addressed directly by apolicymaker, thus eliminating the costs. Deadweight costs would still have to be paidin the first-best solution to the problem; the structure of incentives determines bywhom. Another important aspect of the so-called macro shock is that it is not related
to project returns or the continuation value of the bank—which seems odd to me if
we are to think of this shock as reflecting macroeconomic developments.
Rochet then derives ranges for the exposure of a bank to this macro shock; these
determine what ought to happen to banks in the optimal solution. The key results
are, first, there is a need for an LLR; and second, there is a zone for the exposure
parameter where, ex post, the regulator will be tempted to exercise forbearance but, inthe optimal solution, should not. A private arrangement would not work, becausesome banks would not have enough collateral to be able to borrow enough fromother banks; potential lenders realize that these banks would shirk if they knew they
had to pay back the loans. But a public arrangement where the regulator could not
stick to ex ante rules would result in too many banks being rescued. Knowing that,banks would overinvest in projects, and the costs to the authorities of a macro shock
would increase.
The solution, Rochet suggests, is that banks with a large exposure to macro shocks
should not get support from the DIF or liquidity assistance from the central bank;the fund should fully insure the central bank; and capital requirements and deposit
insurance premiums should be set according to a sliding scale (with more exposedbanks paying more) to rule out moral hazard. So insured banks would bear the
expected cost of the macro shocks. High-risk banks pay a deposit insurance premium
but do not get insurance against the “macro liquidity” shock.

123

I have some questions about this setup. First, again, is the budget constraint specified correctly to reach the social optimum, given that there is a positive externality
associated with loans? Why does the public good element of loans not play a larger
role? Second, is the characterization of a macro liquidity shock that is unrelated to abank’s continuation value and has nothing to do with the information structure of
the model sufficiently representative of the real-world nature of systematic shocks?
Third, how easy would it be for the DIF to identify ex ante the parameter of interest,
the degree of exposure of a bank to the systematic liquidity shock? Is it not likely tochange, depending on the specific source of the shock to the macroeconomy? Just toillustrate how tricky this can be, I looked at beta coefficients—as one crude measureof sensitivity to macro developments—for daily total equity returns for some Britishbanks year by year to see how stable their rank ordering was. Not surprisingly, thebetas changed over time, as illustrated in Figure 1.
So did the rank ordering, as illustrated in Figure 2. The change in HSBC’s position
from “most sensitive” in 2001 to “less sensitive” in 2002 is striking.
So I have some doubts about the practicality of the Rochet proposal. And I am notsure that the refusal to bail out big banks which failed would necessarily hold simply
because the DIF could not afford it and had said in advance that it would not bailthem out. Nevertheless, the proposal does suggest that further thought about variable
capital adequacy ratios and deposit insurance premiums would be worthwhile.
Figure 1 Stability of Estimated Market Betas: HSBC

1.8

Estimated beta coefficients

1.6
1.4
1.2
1.0
0.8
0.6
0.4

Annual subsamples (with 95 percent confidence intervals)
Whole sample

0.2
0.0
1993

94

95

96

97

98

99

2000

01

124 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

02

03

04

Comment

Figure 2 Ranking of Estimated Betas of Six British Banks1

Rank of estimated betas

2

3

4
Abbey National
Barclays
HBOS
HSBC
Lloyds TSB
RBS

5

6
1987 88

89

90

91

92

93

94

95

96

97

98

99 2000 01

02

03

04

Note: Shadow indicates the years shared by all six banks in the sample.

IV. Conclusion
To sum up, Rochet is in favor of establishing independent and accountable banking
supervisors. I think it would be well worth exploring further the parallels with theliterature on the independent central bank and monetary policy.53 In particular, what
incentives do financial stability authorities actually face, and can they be improved?
To answer that needs greater clarity about what market failures or externalities arebeing addressed.
Rochet’s paper is a step in the right direction. I would also like to see more
explicit modeling of multiple instruments and objectives in the macro-prudential
arena. That could perhaps advance the debates on issues such as asset price bubbles
and procyclical credit conditions. But let us not rush to experiment in the real world:
we have the natural experiment of Basel II to analyze first !

53. Under U.K. arrangements, for example, the central bank’s LLR function is likely to be exercised only with theagreement of the finance ministry. If there is any uncertainty about whether banks are insolvent or illiquid, thequestion about the terms under which finance ministry support is available is likely to arise. So the question ofcentral bank independence, as with the question of transparency, is rather more difficult in the macro-prudential
policy area than in the monetary policy area. See the discussion in Buiter (2005).

125References

Baumann, U., and E. Nier, “Market Discipline and Financial Stability: Some Empirical Evidence,”
Financial Stability Review, 14, Bank of England, 2003.
Bordo, M., B. Eichengreen, D. Klingebiel, and M. Martinez-Peria, “Is the Crisis Problem Growing
More Severe?” Economic Policy, 32, 2001, pp. 51–82.
Buiter, W., “New Developments in Monetary Economics: Two Ghosts, Two Eccentricities, a Fallacy, aMirage and a Mythos,” Economic Journal, 115 (502), 2005, pp. 1–31.
Crockett, A., “Central Banking under Test?” in “Monetary Stability, Financial Stability and the Business
Cycle,” BIS Paper No. 18, Bank for International Settlements, 2003.
Gai, P., and H. S. Shin, “Transparency and Financial Stability,” Financial Stability Review, 15, Bank ofEngland, 2003.
Goodhart, C., P. Sunirand, and D. Tsomocos, “A Model to Analyse Financial Fragility: Applications,”
Journal of Financial Stability, 1 (1), 2004, pp. 1–30.
———, ———, and ———, “A Model to Analyse Financial Fragility,” Economic Theory, 27 (1),2006, pp. 107–142.
Haldane, A., V. Saporta, H. Hall, and M. Tanaka, “Financial Stability and Macroeconomic Models,”
Financial Stability Review, 16, Bank of England, 2004.
HM Treasury, Bank of England, and Financial Services Authority, “Memorandum of Understanding,”
Quarterly Bulletin, 38 (2), Bank of England, 1998, pp. 97–99.
Hoggarth, G., J. Reidhill, and P. Sinclair, “On the Resolution of Banking Crises: Theory andEvidence,” Bank of England Working Paper No. 229, Bank of England, 2004.
———, R. Reis, and V. Saporta, “Costs of Banking System Instability: Some Empirical Evidence,”
Bank of England Working Paper No. 144, Bank of England, 2001.
Nier, E., “Bank Stability and Transparency,” Financial Stability Review, 17, Bank of England, 2004.
Plantin, G., H. Sapra, and H. S. Shin, “Marking to Market, Liquidity, and Financial Stability,”
Monetary and Economic Studies, 23 (S-1), Institute for Monetary and Economic Studies, Bankof Japan, 2005, pp. 133–155 (this issue).
Rochet, J.-C., “How Should We Regulate Banks’ Liquidity?” unpublished presentation at the Bank ofEngland Conference on “The Future of Payments,” May, 2005.

Comment
WENSHENG PENG
Hong Kong Monetary Authority
First of all, I would like to thank the Bank of Japan and the conference organizers
for inviting me to this very interesting conference. It is an honor to be here and tocomment on Jean-Charles Rochet’s paper.
I find this paper to be a valuable and very interesting one. The paper has twoparts. The first part offers a quite comprehensive review of the literature on capital
adequacy and market discipline and the lender of last resort (LLR) policy. The
second part presents a model of banking regulation. The basic model justifies a
deposit insurance system and a capital adequacy requirement for the optimal organization of the banking sector. By including macroeconomic shocks, the model isextended to show that prudential regulation by a public authority leads to regulatory
forbearance. But its absence results in too many closures in a recession, for example.
The paper ends by suggesting a regulatory system.

126 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

Comment

As my comments are mainly concerned with the policy implications of the model,
I will repeat the main points of the recommended regulatory system as follows. First,
the supervisory authorities evaluate each bank’s exposure to macroeconomic shocks.
Second, banks with a small exposure are backed by a deposit insurance fund (DIF)
and have access to the LLR facilities in the event of a macroeconomic shock. Thesebanks face a capital adequacy requirement and a deposit insurance premium that
increases with the size of exposure. And banks with large exposure to macroeconomic
shocks do not have access to the deposit insurance and the LLR facilities and are
subject to a higher capital ratio. Finally, the LLR activities of the central bank are
independent from political interference.
In my view, the model makes a useful contribution to the theoretical literature
on banking regulation. It provides a simple and yet insightful formalization of key
elements of banking regulation, including deposit insurance, emergency liquidity
support by the central bank, and capital requirements. The model is a static one. In
my view, it would be more interesting and the results or policy recommendations
would be more realistic if a multiperiod dynamic model were employed. In particular,
as mentioned by the author, the ratio of a bank’s macroeconomic exposure, a key
parameter in the model, could be endogenized in a dynamic framework. Moreover,
the assumption of full insurance of deposits by the DIF may not be realistic. I would
like to hear the author’s comments on whether and how the result would be affectedby a relaxation of some of these restrictions.
However, my comments are mainly related to the policy implications of theframework based, in part, on Hong Kong’s experience. Hong Kong has experienced
some major macroeconomic shocks in the past decade, including the Asian financial
crisis and the bursting of the property bubble in 1997–98. In addition, Hong Kong
has a fixed exchange rate, with a link to the U.S. dollar. Therefore, we do not have an
independent monetary policy that could be used to guard against fluctuations inmacroeconomic conditions. So prudential regulation is an important part of ourregulatory framework for ensuring financial and monetary stability.
I would like to make the following points about the policy recommendations.
First, I am sympathetic to the point made by Alex Bowen about the practicality ofassessing macroeconomic shocks. There are many types of macroeconomic shocks
with different probabilities, and they change over time. Thus, there is an issue of how
to define macroeconomic shocks and assess their developments over time. In particular, there is a risk of underestimating or overestimating the probability of certain
macroeconomic scenarios. The assessed overall exposure of a bank to macro shocks
ex ante may turn out to be substantially different ex post.
Take Hong Kong’s case as an example. Defining banks’ exposure to changes, say,in interest rates and asset prices, is not an easy job. About half of Hong Kong banks’lending is related to the property market, including both mortgage lending andlending to property developers. From the peak of 1997 to the trough of 2003,
property prices in Hong Kong declined by more than 70 percent. Considering thatHong Kong has a fixed exchange rate and therefore we do not have an independent
monetary policy, one would expect that such a sharp decline in property prices would
have a large impact on the banking system. Indeed, banks’ profitability was affected,

127

but there was no crisis and in fact most banks continued to record profits throughout
this period despite the sharp decline in property prices and recession in 1998. Indeed,
our analysis suggests that banks with relatively large exposure to the property market
suffered less from the recession and bursting of the property bubble because, despite
the decline in property prices, mortgage lending remained relatively safe for banks
compared to other lending.
Thus, considering the difficulties in assessing exposure to macroeconomic shocks,
controversies would arise if this assessed exposure were used to determine capitalrequirements and access to the emergency liquidity support by the central bank or
the monetary authority. A particular problem would be how to determine the threshold at which to divide banks into two groups. Traditionally, it is argued that the LLR
should lend to solvent but illiquid banks. But because it is difficult to distinguishbetween illiquid and insolvent banks, the LLR policies may generate problems of
moral hazard. In this framework, the same concern arises, because it is difficult todefine the exposure and determine the threshold above which no emergency liquidity
support would be provided.
My second comment on policy implications relates to the coordination between
the supervisory authority and the central bank. In the case of a bank that had beenassessed to have shifted from a “low” exposure to “high” exposure, the cutoff of accessto the LLR and deposit insurance would be a major shock and would risk triggering
a depositor run on the bank. Because of this, there might be a tendency on the partof the supervisory authority to underestimate macroeconomic exposure or to set avery high threshold. This would raise a question about the effectiveness of the system
in practice.
Related to this, I would like to offer some comments on the effective way toregulate or limit banks’ exposure to macroeconomic shocks. Again, take Hong Kongas an example. I mentioned earlier the seemingly surprising resilience of Hong Kongbanks to the sharp decline in property prices. There are a number of explanations
for this. In my view, given the absence of independent monetary policy, prudential
regulation has played an important role in guarding against asset price bubbles
and their impact on the banking system. In the early 1990s, because of concern
about the banks’ exposure to the property market, the Hong Kong Monetary
Authority (HKMA) introduced a prudential regulation that required banks toobserve a 70 percent loan to value ratio. For the luxury end of the market, themaximum loan to value ratio was set at 60 percent. In 1994, the HKMA issued aguideline that required banks’ aggregate exposure to the property market not toexceed 40 percent of the total loan portfolio. These regulations—particularly the capon the loan to value ratio—limited the banks’ vulnerability to the property pricedecline in the subsequent period.
My third comment is related to capital injection to banks by the central bank or agovernment, which is another form of support from the public sector to the banking
system in addition to the liquidity assistance. Some banks, even though they have alarge exposure to macroeconomic shocks and thus should be denied access to the
LLR in this framework, may be too big to fail. Their collapse would pose risks to thestability of the banking system as a whole. In such a case, capital injection by the

128 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/OCTOBER 2005

General Discussion

government may be required if a shock threatens the stability of the system. Thus, it
is not clear that denying access to the LLR would resolve the problem of moral
hazard. Indeed, moral hazard is of more concern in relation to capital injection
than to liquidity support. In principle, if the two can be separated, moral hazard
created by liquidity assistance would be limited to possible mismanagement of liquidity
risk. Capital support may raise the expectation that the bank is insured against
mismanagement of virtually all types of risks.
My last comment relates to the form of liquidity support by the central bankto banks to deal with macroeconomic shocks. For some major macro shocks, theeffective way for the central bank to provide liquidity support may be to do so to
the markets rather than to individual banks. Again, take Hong Kong’s case as an
example. In the wake of the Asian financial crisis, outflows of capital from Hong
Kong reflecting speculation about a devaluation of the Hong Kong dollar led to
sharp rises in Hong Kong dollar interest rates and a fall in asset prices, particularly
stock prices. And there were indeed so-called double plays in the market to takeadvantage of the currency board system. Therefore, the government took the decisive
action in 1998 of intervening in the stock market. That is, the HKMA intervened
by buying Hong Kong stocks to counter short selling by speculators. This kind ofintervention, in my view, can be regarded as liquidity support to the market, and it
turned out to be quite a successful operation.
In summary, the author’s paper makes a useful contribution to the theoretical
literature. However, to turn this into policy recommendations, as Section V of thepaper attempts to do, would require a richer structure and a consideration of otheraspects of banking regulation.

General Discussion
As a rejoinder to the discussants, Jean-Charles Rochet stressed that his model was afirst attempt to deal with the macro-prudential issue and admitted that many additional aspects had to be introduced before it could be useful for policy purposes. In
particular, he deliberately chose to rule out any public subsidies and risk premiums asa cost of liquidity during crises. Regarding the realism of his policy implications,Rochet stated that what he had in view was the situation where the authority
constantly negotiated with a large and complex banking organization and imposed
different capital requirements or different policy insurance premiums according todifferent exposures, which would vary over time. He claimed that the authority could
implement the intervention gradually rather than brutally. Rochet insisted that hewas not a skeptic about the benefits of market discipline, but he had the feeling thatit might work in the wrong direction and that it should be complemented by public
supervision when there was a crisis. Finally, Rochet noted that the “too-big-to-fail”
issues were better managed ex ante than ex post.
In the general discussion, Jean-Philippe Cotis (Organisation for Economic
Co-operation and Development) questioned the meaning of “exposure to macro
shocks.” Erdem Başçi (Central Bank of the Republic of Turkey) proposed that a ratio129

of short-term assets to short-term liabilities be used as a measure of exposure tomacro liquidity shocks. Reuven Glick (Federal Reserve Bank of San Francisco)
insisted that solvency shocks should be distinguished from the liquidity shocks onwhich Rochet’s model focused. Rochet responded that the distinction in his model
was between diversifiable risk and nondiversifiable risk, or between idiosyncratic
shocks and common shocks. Rochet remarked that he had assumed that liquidity
shocks were common shocks simply to illustrate the specific role of the central
bank in providing emergency liquidity assistance and not to distinguish them fromsolvency shocks.
George Pickering (Bank of Canada) expressed doubts about the necessity andfeasibility of defining all the outcomes of a wide range of shocks that might hit thebanking sector before any crisis. Shigenori Shiratsuka (Bank of Japan) also expressed
doubts about the feasibility of ex ante separation of banks based on their exposure tomacro shocks and suggested the possibility of an incentive-compatible self-selection
mechanism, which induces individual banks to announce their exposure in advance.
Rochet agreed with suggestions on using possible incentive mechanisms and statedthat their introduction would depend on discussions between the banks and thefinancial supervisory authority, as had occurred for the Basel II framework.
Regarding the role of the central bank, Ulrich Kohli (Swiss National Bank)
claimed that it was a political decision to bail out an insolvent bank and therefore
central banks should stay out of that. Alex Bowen (Bank of England) pointed outthat many central banks would not save securities firms that encountered troubles
because they had very liquid assets and liabilities, which could support Rochet’s
model. Hiroshi Fujiki (Bank of Japan) remarked on a similarity between Rochet’s
model and Scott Freeman’s models on payment systems, which highlighted the roleof the central bank in a context with aggregate shocks.54 Fujiki suggested an extensionof Rochet’s model to the case where there were two regulators in two economies andtheir shocks might be correlated with each other.
Based on Wensheng Peng’s discussion, Francesco Giavazzi (Università Bocconi)
pointed out that all banks hit by a macro liquidity shock in an open economy could
have credit lines with foreign banks so that the liquidity problem could be solved
without resorting to a lender of last resort function. Eli M. Remolona (Bank forInternational Settlements) pointed out the problem of procyclicality in the bailout
policy suggested by Rochet—that is, if banks exposed to macro shocks tend to failduring a recession, refusing to bail them out might make things worse.
Eiji Hirano (Bank of Japan) pointed out that there should be a huge politicaldisincentive for politicians to get involved in financial matters and a strong incentive
for supervisors to delay actual and decisive solutions of financial difficulties even if
they were independent of political pressure. Pickering pointed out that bankers
seemed to be incompetent in some areas owing to financial-sector liberalization andthere seemed to be accounting sleight-of-hand at an earlier stage of recent financial
crises. Rochet responded that there would be a time-consistency problem even in a
54. See, for example, Bruce Champ and Scott Freeman, Modeling Monetary Economies, Cambridge: Cambridge
University Press, 2001, Chapter 11.

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General Discussion

democratic country with full transparency and even if the incompetence of bankers
or supervisors were removed.
Kohli explained that Switzerland has no deposit insurance scheme for its banking
sector, consisting of hundreds of small banks and two very large banks. Kohli insisted
on “constructive clarity” in prudential policy: the bank must be solvent be systemically relevant, and be lent against good collateral. Wolfgang W. Fritsch (Deutsche
Bundesbank) remarked that the policy of “constructive ambiguity” pursued byGerman supervisors did not appear to differ materially from the strategy adopted in
Switzerland. Rochet responded that he was in favor of “constructive clarity” rather
than “constructive ambiguity” but understood the need for flexibility in the sense
that, in practice, the optimal threshold level of exposure to macro shocks in his
model could not be set once and for all.

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