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• W776507965 abstract "INTRODUCTION In July 1988 the Basle Committee on Banking Regulations and Supervisory Practices (Basle Committee) published a document proposing new rules for the regulation of bank capital. In 1991 the EC Own Funds and Solvency Ratio Directives came into law. These came into force in Ireland in January 1993. As well as providing an internationally agreed definition of capital the Basle guide-lines provided an agreed measure of the adequacy of Bank capital. This has been continued in the EC directives. Bank assets are assigned differential weights according to the level of riskiness of the assets. The risk adjusted value of the banks asset portfolio is calculated and a minimum value of 8% is recommended for the ratio of bank capital to the risk adjusted value of the bank's asset portfolio. The purpose of this paper is to examine the validity of risk adjusted capital adequacy rules and their application to Ireland in the light of evidence from the economics of regulation and from finance theory. THE ECONOMIC REASONS FOR REGULATION The financial sector is highly regulated in most market economies. The requirement that banks, and other financial institutions, hold a minimum level of capital in relation to their assets is just one of the many instruments that the regulatory authorities use to constrain the behaviour of financial institutions. REASONS FOR REGULATION The primary economic rationale for intervention in any market, and thus in the financial markets, is the existence of what is termed 'market failure'. In the financial context, this failure results from the existence of externalities, due mainly to informational asymmetries between one bank and another and between banks and their customers. Banks have an informational advantage over their customers in relation to the level of risk in their asset portfolios. As a consequence, customers may have difficulty in determining quality, even after purchase. Goods, such as financial services, which are have this characteristic are termed 'Credence Goods'. The cost of obtaining comparable information to the vendor is prohibitive. Most professional services are such goods--consider the medical and legal professions. Depositors (especially smaller non-corporate customers) are usually unable to distinguish fully between prudent, financially sound banks and banks adopting a high risk (or possibly fraudulent) investment strategy. In an unregulated environment these informational asymmetries would have a number of negative consequences. As can be seen above, deposit rates would incorporate an unnecessary risk premium for 'safe' banks, while rates for 'risky' banks would be too low. This distortion in the cost of funds would lead to a misallocation of risk taking in the economy with prudent banks adopting an excessively conservative lending strategy while risky institutions would be able to free ride on the good habits of safe banks. These are classic examples of adverse selection and moral hazard problems, common in insurance markets. Insurance companies try to counteract these problems by splitting the market with pricing strategies designed to attract different customers, and by screening customers to ascertain their risk characteristics. To some extent, customers can screen banks by reputation and past performance but the customers' information set can never be complete. Mistakes can be hidden by a bank until it is too late. In addition banks with a good track record can change strategies. Another negative externality resulting from information asymmetries is the danger of contagion. Banks produce positive externalities in their role as intermediaries, matching short term funds from call deposits with the longer term funding needs of borrowers. Banks derive their profits from this activity because of their comparative advantage in the collection of information on risk and uncertainty. However, this informational advantage over their depositors, together with the highly liquid nature of their liabilities compared to their assets makes banks vulnerable to a loss of confidence on the part of their depositors. …" @default.
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• W776507965 title "The EC and BIS risk weighted capital adequacy measures: A critical analysis" @default.
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