Asset Structure and Loyalty Problems
The presence of a federal insurance fund also increases the risk of fraud and self-dealing in the banking industry by reducing incentives for monitoring. In the 1980s, it was estimated that fraud and self-dealing transactions were “apparent” in as many as one-third of today’s bank failures.A similar statistic shows that between 1990 and 1991.
Such behavior, of course, is a possibility in any large firm, since it is inefficient for owners to monitor all employees at all times. These sorts of problems are particularly acute in financial institutions, however, because of the large portion of their assets held in highly liquid form.
The same regulatory structure that creates a problem of excessive risk-taking by banks also leads to a reduction in the normal levels of monitoring within the firm, resulting in a higher incidence of bank failures due to fraud.
Not only does the protection afforded by the FDIC remove any incentive for insured depositors to control excessive risk-taking, it also removes their incentive to monitor in order to reduce the incidence of fraud and self-dealing.
Shareholders have an incentive to monitor to prevent fraud and self-dealing in banks, but such monitoring is notoriously ineffective in many cases because individual shareholders rarely have sufficient incentives to engage in monitoring because of collective-action problems.
Outside the banking setting, fraud and self-dealing are monitored by fixed claimants and preferred shareholders through contractual devices and by lenders through regular oversight of their borrowers’ affairs.
One might argue that FDIC insurance simply replaces one set of creditors: depositors, with another set of creditors: state and federal regulators.
These other creditors might appear more financially sophisticated than rank-and-file depositors and thus appear in a better position to conduct the monitoring necessary to prevent bank fraud.
The fact that both federal and state regulators require periodic reports from banks and conduct on-site inspections of bank premises supports this contention.
In addition to regulators’ power to monitor banks through reports and examinations, upon the discovery of a fraudulent banking practice—or indeed a practice that regulators deem to be “unsafe or unsound”—the appropriate federal banking agency may order the activity terminated. y.
Under the Federal Deposit Insurance Corporation Improvement Act, regulatory agencies were required to issue guidelines or regulations creating standards for safety and soundness in the following areas:
1) internal controls, information systems, and internal audit systems,
2) loan documentation,
3) credit underwriting,
4) interest rate exposure,
5) asset growth,
6) compensation, fees, and benefits, and
7) asset quality, earnings, and stock valuation.
Regulators have five main enforcement tools: cease and desist powers, removal powers, civil money penalty powers, withdrawal or suspension of federal deposit insurance powers, and prompt corrective-action powers. Cease and desist powers generally address both unsafe and unsound banking as well as violations of the law or regulations governing depository institutions. These powers allow regulators to issue injunctions as well as to take corrective actions against banks.
Bank regulators also may remove officers and directors from their posts, or ban them from ever working for a depository institution in the United States, if they can show that the individual acted unlawfully, received a personal benefit, or acted in a manner detrimental to the bank or its depositors. Federal banking agencies also have the power to impose civil monetary penalties against a banking institution and its affiliates.
Prompt corrective action powers are also triggered by capital requirements, and these allow regulators to reach every significant operational aspect of a bank.
Because the creditors’ own money is on the line, they will monitor until the losses avoided from such monitoring equal the marginal cost of such activity.
In addition, if a competitive market for bank services exists, those bankers that can develop mechanisms for providing depositors and creditors with credible assurances that they will refrain from fraudulent activities will thrive at the expense of their competitors.
The presence of a federal insurance fund also increases the risk of fraud and self-dealing in the banking industry by reducing incentives for monitoring. In the 1980s, it was estimated that fraud and self-dealing transactions were “apparent” in as many as one-third of today’s bank failures.A similar statistic shows that between 1990 and 1991.
Such behavior, of course, is a possibility in any large firm, since it is inefficient for owners to monitor all employees at all times. These sorts of problems are particularly acute in financial institutions, however, because of the large portion of their assets held in highly liquid form.
The same regulatory structure that creates a problem of excessive risk-taking by banks also leads to a reduction in the normal levels of monitoring within the firm, resulting in a higher incidence of bank failures due to fraud.
Not only does the protection afforded by the FDIC remove any incentive for insured depositors to control excessive risk-taking, it also removes their incentive to monitor in order to reduce the incidence of fraud and self-dealing.
Shareholders have an incentive to monitor to prevent fraud and self-dealing in banks, but such monitoring is notoriously ineffective in many cases because individual shareholders rarely have sufficient incentives to engage in monitoring because of collective-action problems.
Outside the banking setting, fraud and self-dealing are monitored by fixed claimants and preferred shareholders through contractual devices and by lenders through regular oversight of their borrowers’ affairs.
One might argue that FDIC insurance simply replaces one set of creditors: depositors, with another set of creditors: state and federal regulators.
These other creditors might appear more financially sophisticated than rank-and-file depositors and thus appear in a better position to conduct the monitoring necessary to prevent bank fraud.
The fact that both federal and state regulators require periodic reports from banks and conduct on-site inspections of bank premises supports this contention.
In addition to regulators’ power to monitor banks through reports and examinations, upon the discovery of a fraudulent banking practice—or indeed a practice that regulators deem to be “unsafe or unsound”—the appropriate federal banking agency may order the activity terminated. y.
Under the Federal Deposit Insurance Corporation Improvement Act, regulatory agencies were required to issue guidelines or regulations creating standards for safety and soundness in the following areas:
1) internal controls, information systems, and internal audit systems,
2) loan documentation,
3) credit underwriting,
4) interest rate exposure,
5) asset growth,
6) compensation, fees, and benefits, and
7) asset quality, earnings, and stock valuation.
Regulators have five main enforcement tools: cease and desist powers, removal powers, civil money penalty powers, withdrawal or suspension of federal deposit insurance powers, and prompt corrective-action powers. Cease and desist powers generally address both unsafe and unsound banking as well as violations of the law or regulations governing depository institutions. These powers allow regulators to issue injunctions as well as to take corrective actions against banks.
Bank regulators also may remove officers and directors from their posts, or ban them from ever working for a depository institution in the United States, if they can show that the individual acted unlawfully, received a personal benefit, or acted in a manner detrimental to the bank or its depositors. Federal banking agencies also have the power to impose civil monetary penalties against a banking institution and its affiliates.
Prompt corrective action powers are also triggered by capital requirements, and these allow regulators to reach every significant operational aspect of a bank.
Because the creditors’ own money is on the line, they will monitor until the losses avoided from such monitoring equal the marginal cost of such activity.
In addition, if a competitive market for bank services exists, those bankers that can develop mechanisms for providing depositors and creditors with credible assurances that they will refrain from fraudulent activities will thrive at the expense of their competitors.