AN ANALYSIS OF CLOSURE POLICY UNDER ALTERNATIVE REGULATORY STRUCTURES GREG CALDWELL BANK OF CANADA September 2005 Purpose of this paper To identify (using a theoretical model) the welfare tradeoffs of closure and resolution policy under
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BANK OF CANADA
(1) a dual regulatory regime (separate supervisor and deposit insurer); and
(2) a “meta-regulatory” regime (single entity) .
For (1) measure the ex ante expected welfare and characterize the equilibrium then compare (2) and (3).
Note: A0 ≡ Φ+ (1- Φ)R(v)
R∙(1-P(L)) + P(L)∙E(recovery|L) = 1
L : liquidation
R = f(μ,v,ω,λ,Φ,θ)
(1) Risk-Shifting (deposit insurance combined with limited liability; inefficient lending opportunities).
(2) Disintermediation (caused by capital requirements).
CL(A)= Φ - λA∙ (Φ / (Φ +(1- Φ) ∙R))
Cm(A)=-NW(A)+ωA=Φ +(1- Φ)∙R-(1-ω)A
Same methodology as under 2 regulators. Now the resolution decision is based on what is ex post optimal. (EPOR)
Liquidation: surplus is the amount that insured depositors receive, the fraction of liquidated funds allocated to uninsured depositors and the social cost of liquidation process government:
WL(A)= φ +λA [(1- φ)R / (φ+(1- φ) ∙R)] + (1+θ)(-CL(A))
Merger: both uninsured and insured depositors get their funds in full, there is a social cost of merger and the banking sector gets new recapitalization funds:
Wm(A) = φ +(1- φ )R+ (1+θ)(-Cm(A))+ωA
Result: For STRUCTURESλ<1 and Φ <1, A*<Am however as θ increases A* approaches Am.
EPOR is more prone to merger relative to LCR but this effect dissipates as the shadow cost of government bailout increases.Relationship between merger and liquidation regions for two regimes
(a) When market discipline is present:
LCR (dual) generally dominates EPOR (meta) and LCR as an ex post policy imposes lower ex ante optimal capital requirements than EPOR.
(b) When market discipline is not present neither regime dominates