Contemporary Issues in Regulatory Risk Management of Commercial Banks

Banks are unique economic entities primarily due to their ability to create money, and the impact that bank information production and liquidity services have on the real economy. The origin of bank regulation in the U.S. is often viewed as a manifestation of the ‘‘free banking’’ period prior to the middle of the 19 century. In the absence of regulation banks could create violent swings in the amount of money created and therefore have real effects on business activity and prices. In addition, banks of that time were often inadequately capitalized due to excessive dividends and/or the prevalent practice of contributing capital in the form of promissory notes. Banking of the era was further characterized by speculative loans and inadequate liquidity. Government regulation was seen as the answer to bank panics and subsequent recessions. The traditional theory of financial intermediation identified a critical function of commercial banks as the transformation of the financial contracts that borrowers (i.e., people and firms that need money but don’t have it) prefer to issue into the contracts that savers (i.e., people and firms who have money but don’t immediately need it) prefer to hold. More recent theories have stressed the role of delegated monitoring in shaping the assets in which banks invest and the role of liquidity services in shaping the liabilities that banks issue. A detailed review of the theory of financial intermediation is beyond the scope of this study. It is important to note, however, the theoretical foundation for the systemic high leverage in the banking industry. Diamond and Rajan (1998) do so. In their model savers need liquidity because they are uncertain about when they will need to sell a financial asset and borrowers need liquidity to meet unanticipated funds needs and also because they may not be able to retain current funding in the future. The authors argue that the real problem is neither borrowers nor lenders can commit future human capital to the savers and therefore both real assets and financial assets are illiquid. The real assets cannot be sold for the full value of the potential cash flows because the entrepreneur may be absent. In the same vein, incumbent lenders can obtain more for real assets that come under their control than any third-party simply selling the