Improving Banking Supervisory Mechanisms
In the OIC Member Countries
6
concerns of regulators because of this inherited instability of banks. However, instabilities of
individual banks and their failures cannot be separated from the banking system; they cannot
be dealt with in isolation, because of their interconnections and contagious effects. Therefore,
deposit insurance should be combined with capital requirements, since the collapse of a bank
actually hurts other banks; this is the fact that separates banks from other firms, as they
mostly benefit from the exit of competitors by expanding their market share. Prudential
regulation, in a broad sense, should target the protection of the banking industry as a whole
and ensure the smooth functioning of the economy.
The banking sector exhibits a large degree of asymmetric information, as depositors usually
are not able to fully monitor banks’ activities. The main rationale behind deposit insurance is
the inability to monitor or lack of monitoring on the side of customers. Deposit insurance can
be seen as one of the commitment devices by authorities to enhance the confidence of
customers in the banking system. However, this commitment by authorities to support banks
in the case of their failures, as the well-known terminology “too big to fail” or “too
interconnected to fail” suggests,2 leads to potential excessive risk-taking by banks, which is
known as a moral hazard problem,3 as the market price of risk will be driven to zero. This
phenomenon imposes a challenge for policy makers as they design optimal regulatory policies
to achieve a socially desirable outcome. One important observation is that financial crises
usually originate from the problems accumulated in periods of economic expansions,4 as banks
and other financial institutions increase their risk profile to exploit enhanced profit
opportunities. They usually do so by increasing their leverage, which leads to a fragile
environment and raises concerns about systemic build-up of risks.5
Therefore, new regulation schemes are leaning towards a more integrated approach, a
combination of micro- and macro-prudential regulation. The combined approach to
supervision and regulation targets financial stability and aims at aligning private and social
incentives to improve the welfare of citizens. As discussed above, the accumulation of risks in
good times may lead to a point where bailouts are unavoidable and will impose significant cost
on taxpayers and erode benefits of the financial system. Therefore, prudential approaches
designed with the correct incentive structures lead to improvement of public welfare, an
ultimate target for any public policy.
Macro-prudential regulation emerged as a necessity as micro-prudential regulation by itself is
not sufficient to prevent the accumulation of systemic risk for it does not take into account the
interdependency among institutions. Consequently, they complement micro-prudential
regulations, as they explicitly take into account externalities arising from the actions of
individual institutions. The main purposes of macro-prudential policies are firstly to mitigate
ex-ante externalities, i.e. prevention of systemic build-up of risks, and secondly to mitigate ex-
post externalities, i.e. failure of an institution with a sound financial position.
Ex-ante externalities are often related to strategic complementarities, a term that refers to the
incentives of institutions to perform actions in line with aggregate movements in the market.
Institutions in the pursuit of higher profits tend to invest in similar assets or raise credits to
similar industries, which leads to correlated risk-taking in financial markets. Therefore, they
2See Brunnermeier et.al (2009).
3 See Chari and Phelan (2013) for a discussion of social value of banks integrated to the moral hazard problem created by
commitment for bailouts. For the literature on strategic complementarities, see Morris and Shin (1998)-(2001) , Schneider
and Tornell (2004) Chari and Kehoe (2013)
4Known as pro-cyclicality. See Pro-cyclicality Working Group (2014).
5For the implications of systemic risk on banking regulation, see Acharya (2009).