Bank deregulation, credit markets, and the control of capital

Carnegie-Rochester

Conference

Series on Public

policy

26 (1987J

289-334

North-Holland

BANK DEREGULATION,CREDIT MARKETS,AND THE CONTROLOF CAPITAL GARY 6. GORTON and JOSEPH G. HAUBRICH The Wharton University

I, Public

policymakers

decisions

about

regulated

world since

help, existing if

they

there

endogenous

the

not

major

banks

players

in

related

intermediaries equalled

trillion markets

held $2.15

takes

a similarly

rich

securities

or

and money market

mutual

It in

between

banks

As

The Farmer

a preface,

consider

comments and Karl Brunner,

were

Examining

marketable

invest

greatly

0 167 - 2231/87/$03.50

assistance

Allan appreciated.

0

1987

why

of Meltrer,

Elsevier

task

of

the

Science

the

credit it

of

1983,

split to

consider

funds

or nonbank

theoretical

University Romer,

Publishers

of

B.V.

Smirlock.

(North-Holland)

over

Also,

both

$1.5

much

of

between

banks

banking and asset

allowing

banks

increased

to

competition

banks.

problem

Pennsylvania

Michael

and

commercial

consider the

banks

interactions

between without

as

corporate

held

119861).

around

exist

while

also

(Kaufman

model

both

$678 billion,

no sense to

policymakers

commercial

the

the

Dave

of

or

assisting

As of

revolves

makes

stock

First,

loans

example,

disappear

and technology,

Intermediaries

controversy

not

separately.

loans

and consumer

for

the

world.

and intermediaries.

markets.

to

markets

business

little

changes.

trillion.

regulatory

and underwriting,

Berlin,

adequate

of

a model

and

make highly

simultaneously

would

develops

banks

to

been

have

of preferences

and regulatory

financial

in mortgages current

of

level

having existing

have

banks

paper

occurrence at the

of the

which

which

This

and capital

the

models

and in

unregulated. is

task only

Economists

no

markets

a model

treat

reference.

currently

technological

equity the

of

model

Realistically, must

with

simultaneous

Since

can consider

unenviable

capital

completely and

markets.

are

and

were

the

deregulation

as a point

banks

Pennsylvania

INTRODUCTION

face

banking

School

of

is

Macro and,

not

Lunch

trivial.

Group,

especially.

Mitch Roger

Other

markets

hand

not

out

that

in

fund.

In

and

do not

need

a sufficient a frictionless

effect,

even

problem

of

the

invisible Relying

on

sense

theory [1984]),

an

banks

modern

and

and

essay

because

they

provide

indirect by

structures

behavior more

Allen the

the

way,

direct

bank bank

costly of

control results

of

regulations

are

and

takeover the

bids control

structures

includes 119821,

bonding

or

Leland

and

compatible

return

intermediaries

control

sit We

related

exist Markets

reward

Lenders

from

banks

capital.

covenants.

which

money, is

and

on both

on boards, show

and how the

a simultaneous

how, total

decision

control.

banks,

as inside

This

agents.

for

solutions

much of

incentive

of

economy

of

and Hart

Banks

set

corner

designing

firm.

119801). action

and indirect

regulation

requirements,

the

need focused

and

meetings

[Grossman

the

119821,

119851.

[19851), of

echoes

involves

markets

control

setting

forms

the

liabilities

circulate

Most

two of

of

form

from

enforce

and these

the

generally,

[1973],

of

Stiglitz

ratio

by limiting

inadequacy both

King

Hart

has

problems

and Stiglitz

and

the

literature

stockholder

(see

create

of

capital. banking

and

agency

which

theories

control

asymmetries,

the

aspects

takes

or

involving

When

adequacy"

holders

structure

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question

Haubrich

costs

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in

and

(Grossman

to

banks.

Because

debt-equity

technologically,

panics.

asymmetries-us to

developed

(19831,

agency But

management

projects,

financial

direct

the market

information-based

information

by Fama 119851

the

(Ross

modern

solution

complementary

acceptable

directly

problem

panics,

reducing

force

aggregate

theory

a model

control.

[1977]),

to

full

emphasized develops

via

approve

mutual

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also

Dybvig

where

like

equity

induce

signalling

and

due

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constrain

exercised

of

incentives.

provide

imperfectly

more

points

banking

holds,

has

both

structure

119761)

while

been

This

Pyle

arise

institutions

has recently

that

invisible

other

information

but

to

Diamond

managerial solutions,

markets

any

triviality.

costs,

message

capital

Meckling

appropriate corner

also

literature

serve

underlying [19841,

where of

Jensen

a

like banks,

theorem

the

which

(Diamond

message

eliminates

institutions

imperfections,

institutions

that

world

agency

financial

look

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Fama I19801

hand.

financial In

for

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to

is

market?

banks

firms

and

need

so why

credit

Modigliani-Miller

imperfections--transaction the

the

world,

The

structure

create

regulation,

for

an Arrow-Debreu

money.

capital

extensive

regulator

are

there

motivated such

as

prohibitions

is out

the

the of

capital

possibility fear

of

Glass-Steagal

against 290

controlling

interstate

of banking Act,

in banking panics. "capital

branching,

a

prohibitions

against

technological

change

of

banking

panics

disappear. Regulation, causing

the the

varying

show occurs, can

cause

the

need

for

further

Glass-Steagal premia,

II. In

are

would

problems

they

were

in

of

regulation

to

is

and

still

needed. is,

prevent,

in

turn

had

regulations,

required.

a

bank

insurance

optimal

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deposit

if

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meant

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that

possibility should

regulation.

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if

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then

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not

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are

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and control, of

know that

the

contracts

riskless

ownership control

investors i.e.,

complete

offer

of

to

How do the

efficient

shows

agent-managers

by a separation

entrust

projects.

making

make

exists

regulation

the

misguided.

investment

agents

regulation

when need

show

bank

case, that

We then

In this appears

on.

occurs,

AGENCYPROBLEMSAND THE ROLEOF MONITORING

will

oversee

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capital

the

presume

an economy

investors

it

Act.

may be completely

and

of

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cause

can

FOIC

this

we

itself,

regulations

banks,

control

can disappear.

But shift

technological

follow

nonbank in the

literature

possible,

decisions

and

if

made by the

decisions

are

"second-

best." Second-best distortions claimant occurs

or

which (i.e., is

In the

investors

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manager

second constraint.

this

is

when

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it

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some residual

risk-neutral. and Winter

section

situation,

we will that

Our

analysis

it

is,

study where will

not

for

the

has

been

the there differ 291

agency is from

for

and Weiss

to

case,

of

the

studied

a binding

manager in

manager this

this insure

the

In

problem the

completely

situation

and Kahn and Scheinkman

of

residual

Holmstrom

in some states case

sole

in which

optimal

second

liability.

claim

because

the

cannot

[19791, is

feasible

This [19851,

and

The

limited

not

One situation

Holmstrom

claimant.

result

is

debt).

among others,

because

solutions

manager-agent risk-averse

studied

119791, is

hold is

Farmer In

manager

residual

occur claimant

[1983],

riskless

sole

residual the

issue

case,

to

distortions

not

this

and Shave11

be

the

the

[19851,

information

when

can

when

himself.

incomplete

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world by

sole

outside even

if

Sappington

119851. which

exists

limited existing

in liability

literature,

this

however,

in

that

considered. with

market

obtain such

are

in

problem

his

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agent-manager by

services

to

other

of

in our

of

marketable

setup

monitoring

this

decisions

market-principals

incentive-compatible

of the

securities

and

to

directly

of

precomnitment

the

Hart

which

[1982].

purchase

agent-manager

services.

securities it

can

control is

purpose

the

Grossman

incentive-compatibility.

Consequently, value

e.g.,

own behavior

managerial

those

design

his

to

We

monitoring

or

bonding,

in

securities.

purchase

directly

the

his

obtaining

market,

In order

constrain

through

agent-manager

serve

words,

achieve

through

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previously a contract

incentive-compatible.

same time,

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structuring

obtained,

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to selling In

how

allowing

the

has not

is

credibly

is

behavior

offers

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make.

or bonding

faces

is

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at

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firm

financing and,

he would

differ

a solution

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agent-manager

own interest,

anticipated

for

in a way which

a way that,

precomnitment the

allow

basic

principals

financing

in

we will

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sold

turn

the

out

firm,

conditional

but

on the

to

Some

bonding

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will

raise

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shareholders

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to

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existence

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purchased

by the

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project

at

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no

initial

wealth

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upon

8,

function

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financing

for

observable

output

the

manager.

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wealth;

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and

V(e)

security-market

‘As scale,

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in

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production and

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loss

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project, is

X.

assumed is

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entrepreneur-

to

invest

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in

return, state

h(e).

of

l19851,

X in

(or

The

initial

a X,

of

the

production

risk

=

F(e,

adopting

normalization

this.

292

wealth

by selling

The residual

claims,

be risk-neutral effort

(V'

neutral,

0)

yields

the

with

and

where > 0;

so the

stochastic

formulation relabelling

less

X - S(X)

by U = W - V(e),

also

function generality

to

given

disutility

participants

explained always

e, with

an

an opportunity project

effort,

51 c R,

has

the

the

realized

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X = 0e.l

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with

C.

manager's

e E [e.

follows.

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S(X),

on

accrues

to

respect

to

W is V"

realized

> 0).

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security

S(X)

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of

states

than

is

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= the

to

Be.

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valued

at

its

The

expected

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written

on

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expectations

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realization

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e or

The

choice

of

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fact,

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e(e),

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5.

manager's

offer the

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market

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e

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self-interest

-ex

post. In

designing

choose

to

an

be monitored.

services

which

effort

guarantee

independent

of

level

of

monitoring

where

Q(0)

= O.*

and

KL > 0.

section

of the

to:

(i)

I,

(ii)

(iv) The

optimal

monitoring,

L.

management practices of

mwal

state to is

discusses

choice K(L)

contract

is

the

may

for

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also

monitoring

some minimum variable

by

solves

manager

amount

L determines

technology

be performed monitoping

L I,be(e)

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a monitoring costly;

the

expends

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implicitly

cost,

a third

given

by

where

K(0)

= 0,

The

next

agent.

Q(L),

monitor. the

following

problem:

- S(e) - V(de))bWde

- K(L)

(1)

? C - S(m)

subject

e(m)

e(e)

2 Q(L)

S(e)

5 ee(e).

to:

{S(X),

of forbids as

monitoring certain

as

long

meet

scme

minimum

the

hazard:

for

example,

L},

Compatibility

Constraint)

Liability

Constraint)

is This of

both

tractability leaving

met. sort

a project

293

Similarly, of

and effort

by

can the

and a level

and a level

realism. at

accounting

monitoring chosen

S(X), S(X),

levels,

Constraint)

(Monitoring

a security, contract,

provides

restriction risks

is

the

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standard. the

(Incentive-

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(Limited

contract,

specification

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argmax[ee(m)

of the

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manager

8.

may

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(iii)

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limited

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all

Finally, problem

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1:

to

best effort

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is obtained

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must

3

in any state to

constraints.

market

costs.

monitor.

solution

the

four

the

monitoring

required

to

offered

The usual

contract

occurs

information Kuhn-

as follows:

when effort,

e(e),

is

satisfy:

v, = El. This

full

with

information

the

marginal

solution

benefit

To characterize recall

that

h(e)/Cl-H(e)), distribution. the

shadow

of more

the

the

equates effort,

incomplete

hazard

rate

of

h(e)

is

r'(e)

> 0. 4

2:

The

the

in each

a

where of

marginal

the

solution

distribution

density

is

and

Also,

financing

disutility to

effort

JI

q

With

problem

defined

H(e)

define

constraint.

of

state.

information

Assume price

the

is

as

the

(I), r(e)

i

cumulative

(A - l)/~

where

this

notation

which

solves

x is we can

now state: Proposition choice

of effort

incomplete

function,

e(e),

v, = [e - l~(& e

3 Note the

is

the

rate

4The

assumption

satisfied

Weibull the

that

required

with

for

of

financing return that

a

degrees

large of

information which

is

a

solves:

implicitly

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without

loss

of

generality,

that

zero.

the

hazard

class

of

freedom

(I)

- y)l

constraint is

contract

rate density

parameter

is

increasing

functions larger

uniform.

294

is including

than

I,

the

not

particularly the

Exponential,

Normal

Distribution,

restrictive. the

It Gamma

Laplace,

and and

where

r

is

the

incentive of

shadow

price

compatibility

of

the

monitoring

condition,

constraint

imposed

(ii).

constraint

(r

is

on the

a function

e.)

Proof:

See Appendix

A.

The benefits at

the

is

clear

of

corner

solution

that

the

solution

because:

Corollary

2A:

supplied

is

highest. In

the

solution

If

less

no

than

being

if

unable has

principal.

make a fixed limited

solution

in the

to

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output so

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is

true

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benefit

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costs under

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agent

from

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of

except

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to

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guarantee

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promises

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a higher-

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the

agent

share

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marginal

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agent

to

to

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is

market-

the

extra

highest. possibility.

the

agent

monitoring. be forced

to

a costly

conditional

and

information

the

accrues

the

of

295

full

if

he must

effort

full

financing

cannot

states. In

the

payment

even

following

required

to

outside

therefore,

for

first-best, states,

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less

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payment,

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claimant, with

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debt.

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effort

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to

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low

longer

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ion

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y = 0,

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to

than-first-best not

case

of

Because too

over

in that

full

in every

with

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A),

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first-best

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of

It

a proof.)

solution

Appendix

solution

contract

[19851 for

the

i.e.,

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considered.

to

chosen,

complete

by first

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relative

is

state

understood

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inferiority

solution the

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best

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information as

when e = G because information

is

are

monitoring

0 > 0 (see

The

the

and Winter

incomplete behaves

Since

monitoring

which

(See Farmer

manager 8.

direct

Suppose

regardless

of

First,

K(L)

must

work

harder

in

inefficiency.

on the

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be paid some

low

But,

the

the

agent

need

not

promise,

the

agent

will

Comparing

ex ante, have

these

marginal

monitoring

level.

compared.

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Proposition

3:

as much of

the

incentive

to

more In

the

costs

and

Appendix

notation

the

level

to

work

the

harder

benefits

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A positive

residual

market. in

determines

marginal

appendix

Hence,

those

states.

the

costs

and

choice

of

benefits

are

we have:

of monitoring

is chosen

if:

I, P2(e)@,YLh(e)de > xKL+ I, q(e)h(e)de when evaluated

at

L = 0.

Proof:

The

condition

equality

for

L >

Theorem.

See Appendix

Informally, marginal solution shadow otherwise. it

positive

Figure points monitoring the

the the

schedule full

world

results

because

outsider-market

of

monitoring (for

to

the

is

(I)

using

with Hestenes'

act

the

the

forces

to

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solution the

on

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when as if

Y is

he

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the

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y > 0.

would

state

the not

were

3 determines

e

whether

with

the

the loss

the

to work

Essentially,

harder

Proposition

296

reduced

previously

3

of

Without remaining, to

incomplete area

C + 6

when

the

Area

discussed. A results

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297

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FIGURE

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298

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299

investors high.

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Direct

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300

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Costly.

302

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behavior.

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THE GLASS-STEAGAL ACT The

National

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119861. the

credit.

303

banking,

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7:

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308

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claims

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constraint.)

new monitoring

be

may require

monitor

equity

to

shortfall

S is

traded

non-Diamond. Q.E.D.

According

to

Proposition

securities

as

assets,

securities

in

the

sheet

be:

would

9,

banks,

if

corresponding

economy.

The

allowed, to

the

unregulated,

311

would new

hold

equilibrium

representative

some marketable division bank-balance

of

Assets Nonmarketable

Loans

Marketable

For

the

Liabilities Demand

Assets

same market

Deposits

Equity

value

of

liabilities,

the

bank

now holds

some

traded

assets. The stocks

marketable

and

Marketing

securities

bonds

or

loans,

banking

competitive

ground claims

deposits, information

the

in bank

since

loans,

consequently,

the

about

the

is

eliminated

asymmetry

would

the

form

of

could

also

be loans

be a natural

it

investment

their

information

take assets

on loans,

industry to

on

and

specific

could

marketable

or claims

comnercial market

the

claims

price

of

entire

thereby,

would

such

bank

be

a claim

would The

creation

of

the

concede if

junior

portfolio.

by the

for

Notably,

industry.

these

traded themselves.

development

not,

would

banking

existing,

banks

to

demand

reveal

bank-

panic-causing

a secondary

market

loans.

However, Corollary

a corollary

9A:

QI(L),

UL,

binding,

If-Q*(L) D t

then

Proof:

If

L > i,

to Proposition is

El is

the

the

new monitoring

binding,

Proposition

Act

were

9 would

technology,

E 2 E is

Glass-Steagal

Glass-Steagal

9 is:

not

causes

binding, the

binding,

such and

of

since

Q*(L)

>

Glass-Steagal

possibility

then,

that

is

panics.

we would

not

require

hold. Q.E.D.

other

words,

possibility

In

of

creates

the

regulation panics

need

becomes which

for

self-justifying

it

deposit

is

because

supposed

to

insurance).

But

it

prevent this

creates

(and, is

not

the

thereby, the

only

implication. Proposition

10:

If

and Glass-Steagal world

than

Proof: The

if

Q*(L) is

> QI(L),

binding,

Glass-Steagal

See Appendix intuition

behind

banks

are

forced

level

of

monitoring

to

UL,

then were

D 2 0 is

banks

not

will

binding,

fail

E t E is

over

more

binding,

states

of

the

binding.

B. Proposition hold to

loans the

10 is

as follows.

as assets, new

equilibrium 312

the

banking level.

At

the

system The

same time

that

can reduce banking

the

system

monitors

the

range

of

other

than

economy for

same amount loans,

has

taken "loan

is

called

sells

are

and

put

the

'participant'

loses.

a shorter

than

secondary

past

few

years.

$413

billion

of

loans

$453

billion

of

total

sold

out

[1986]).

In

Every

leaps

loans of

recent

explanation

$474

technological

a binding

as

parties.

of this

than for

to

which

the

the the

since

life

were in

sold

1985,

total

of

loan the

participation in

the

this

way,

out

of

were

sold,

out

of

worth

of

$18 billion

loans

outstanding

market

will

is

consistent

the

then

enormously

billion

loan

underlying the

grown

bank

underlying

participation,

$10.5

and

The These

risk

has

assets

follows.

at

market

A

participations

nonmarketed

works

loans

change

constraint.

loan

third

loses 19

1984,

that

this

the

also

billion is

some loans

loan. of

in

development

of

representative

reducing

the

level

of

The new balance

sheet

18Notice

that

Proposition

are

prohibited

not

continue

(Zweig to

grow

by

19See

but Norton

cannot [19861,

banking

shift bank

monitoring

in

the

sells to

forms

of

secondary

correspond

with control

loan

to

the

the of

above

capital.

participations,

new social

optimum.

is:

9

from

government securities Act, however, as

result,

in

a technological

our

the

bank

outstanding;

expectation

Suppose

since Steagal

of

$3 billion

the

and bounds. This

they

firm

underlying

outstanding;

to trade

maturities

the

participation

1983

to

life the

the

loan

if

prefer

previously

shorter

the

though

is

participation

However,

life

The

were

made

words,

a larger securities

riskier,

secondary

selling

stripping

the

during

Act of

has for

of

other

defaults

of

over

holding

system

that

creation

Loan it

typically

In

made

loans

the

now fail from

it.l*

Glass-Steagal

is

buyer

participation.

is of

the

loan

would

suggest

The practice a

banking

Banks

banking

banking

in

can banks

prevents

"securitization."

participations

was

in

stripping."

which

the

riskier.

regulation

and that in

shares

loan

makes

developments place

loans

by prohibiting

not

but

new development or

is

stocks,

Recent

holds

regulation

as a whole

traded

but

Ironically,

states.

in

assumes

holding have active Proposition

eliminate Berg

it

that by

banks For

law.

will

secondary markets. IO, the existence

completely.

119861,

and

Zweig

313

not

hold

Proposition

119861.

In of

government 9

this

considering

government

securities, makes

no a

securities

which difference,

binding may

Glassaffect

Assets

Liabilities Demand Deposits

Loans

Held

Loans

Participations Loans Sold New Securities

The

bank

temporarily used

from

to

Steagal

some

the

purchase Act

market

sells

it

are

these

is

reflect

the

information

loan Since

if

demand

risk

has created

the

can

quite

is

are the

solvent

Glasscapital

a loan

the

information senior

(and

bank

and

price

only of

defaulting.

then

directly

*'

the

participants

if

the

underlying

This

would

is

exactly

because

banks.

limit

bank-

a participation

panics

among

revealing

claimant,

then,

banking eliminates

to

are

The

marketable

making

them

operation

loans.

being of

market

which

this

new

from

distinguish

likely

of

be

process

eliminate

new market

are

the

particular

would

proceeds must

removing

be repeated.

Consequently,

of

this

is

participations,

securities

deposits

bank

depositors

regulators

new must

solvent). which

information

The

participation

the

as

which

Consequently,

paid

borrower

loans

sheet.

as a participation risk.

only

its

securities,

prohibits

The secondary specific

of

balance

new

securities.

selling

Equity

the

with

this

Technological

information or

change

asymmetry,

prohibit

this

but

market's

development.

(B)

INTERSTATE The

change

technological.

In

representative

bank

production against

interstate bank

representative

to

this

banking

*‘In fact, there likely to be debatable claimants to deposits,

the

considered

were

eliminated,

tend

regulatory

a change technology,

We suppose

increase. would

is

we consider monitoring

constant.

would bank

be

section

holding

technology,

American

AND THE SIZE OF THE BANKING FIRM

BANKING

second

then

that the

An increase mitigate against

has

the

and the

in

to

in

rather

if

the

average

than

size

of

inside

the money

prohibition size

of

the

size

of

the

occurrence

the the of

not been a legal case to actually test this proposition, and it is whether participations are really secured loans, and hence, junior or purchase-sale agreements. This same issue has confused the status In either case, however, the participation must price bank-specific of repurchase agreements. risk. If the participation is junior-to-demand deposits, then bank default risk must be priced. If the participation is a purchase-sale agreement, the bank’s monitoring capabilities of underlying loans must be priced.

314

banking

panics

currently

because

larger

feasible,

banks

making

could

the

insure

themselves

information

in

asymmetry

a way

not

irrelevant

to

depositors. Proposition

5 shows

diversifying able

to

risk, efficiently

the

risk, 5.

oft-made

the

commonly 1837,

cited

particular, In

the

United occur

a typical

loan

originator

of

syndicate the

i.e.,

enforcing

Definition bank

observable

loan,

8.

is

by

an

the

Participants

contract I.e.,

States. happened

in

1960s.

In

to diversify

A

which

loan

syndicates.

is most is

In

likely

elected

the by

the

negotiate

producing

the

the

monitoring,

is

an arrangement

between

of

the

participants lead

is

(the

bank's

nor

the

state

of

only

realized

output

of

contracts

cannot

implement

a

principals)

efforts,

participants, observe

not

borrower.

and a group above.

is

1930s.

bank

for

the

to with

United

participants

responsible

participation (I)

agent

away

size

in the

banks

bank,

be

panic

in loan

syndicate

against

agent-manager)

by problem

project,

bank

in the

small

a lead

the

bank

was enacted

for

diversify corresponds

banking in the

for to

according

banks

participating

is

can

where

panic

important economy

monitored of

last

insurance

there all

be

than

the

is the

banks

size

larger

Otherwise,

covenants

A loan

is where

banks'

firm for

countries

opportunities

While agent

the

other

size

small

loan.

loan

(the

described

With

the

can

about

deposit

participation

4:

Larger

was no banking

States

or

monitor.

Canada

there

through

lead

the

most

that

banking

necessary

bank is

members.

loan,

not

average

in Canada

portfolios

in

fact

of the

condition

consequently,

that

the

size

the

observation

example

despite

lead

and

This point

constrained,

the

is

monitor

nonsystematic Proposition

that

which

e(e),

the

the

are

underlying

participation

x = ee(e). this

definition,

Proposition

11:

equilibrium

of

we have: Loan

Proposition

We need

Proof: diversify

by

to

participating Suppose

representative

bank

must

be

the

Diamond

5. show

originated.

contract,

participation

that in

there

has originated

a party to a the lead bank

a

representative

every are

a loans

loan

bank other

projects to.

I.e.,

participation contracts. faces a binding financing 315

than

other

cannot the than

the

completely ones

the

it

has

ones

the

representative

In each constraint.

bank

participation Since

all

banks,

of

each

which

there

participation

lead

bank.

From

Proposition

are,

contract here

say,

n + 1, want

will

require

the

proof

to

participate

in

m participants,

proceeds

each

loan,

in addition

exactly

like

to

the

the

proof

to

4. Q.E.D.

According above

cannot

is

required.

of

agency

each

The

be

which

bank

cannot

system

directly

either

banking

of

monitors of

by other

banking

bank

government

(II)

monitors

an extra know

is not--and,

regulators

layer

panics

Depositors

their

problem

introduces

diversify.

by

planning

because that

while

hence,

or

the

must

depositors

panic. banks

until

suggests because

recently,

limits

of banks

possibility

comparison small

which,

prohibition

to the

small

the

completely

international

number

many

is well-diversified,

in a banking

An

solution

monitoring

of

creates

monitored

themselves large

because

existence

costs

banking

11, the

Proposition

be achieved

small

the

to

banks

of

were

to

that

United

prohibitions

clearly

accepting

the

against

binding

deposits

States

has

interstate

constraints.

only

in

a

their

This own

states.

Thus, Definition that

5:

A binding

D 5 0, where

Then,

the

banking

maximum amount

prohibition

of

deposits

is

a constraint

in a state.

we have:

Proposition banking

12: system In

project

requires

project, must

But,

by

Diamond

to

given

achieve

Q(-). which

attempt

Proposition

interstate

a minimum

by D/L,

bank

the

banking

prohibition

is

binding,

then

the

2,

each

non-Diamond.

order

for

given

If is

Proof:

is

D is

interstate

the

interior

amount

of

But, is

the

less

number

than

diversification

11, loan

optimum

of

monitoring -.

of

Proposition

corresponding

projects

the

Consequently,

through participation

loan

to

bank the

monitor

representative

participation

contracts

can

L per

contracts.

cannot

implement

the

equilibrium. Q.E.D.

Once again,

then,

Recent of

states

nonbank

regulation

developments mutually

banks

agree (discussed

can be self-justifying. in to

legalizing

regional

compacts

(in

which

allow

interstate

banking)

and developments

next)

strongly

suggest

that

316

the

groups with

regulatory

constraints

on bank

(Cl

NONBANK

size

BANKS

OF INSIDE The amount

final of

size

of

such

production

of the

which to

through

system.

Unlike

deposits

have

form

is

deposits

asymmetry

could

a

secondary

Proposition inside

to

13: money

monitoring

If

firms

Proof:

Since

*‘There

the

is

an

two

information do

not

asymmetry. have

traded

all

In is

not

may

information obtaining

require is

the is

for that

the thin

of

trading

a minimum-size costly.

information.

(Grossman then

such

assets

their

which

also

efficiently banking demand debt,

in

a feature

of

the

be considered cannot

cannot

a firm

to order

the

are

have

a

be traded

the

informative

to

make L19801

market

317

If

banks

point

efficiency.)

banks

in

bank

hold

firm

must

prices,

no

that

an the

achieve

13,500

assets

companies

or

have that

trading

profitable if

there

are

any

traded

a minimum

also

possibilities out

larger,

eliminate roughly

traded

but

firms

were and

existence,

to

arbitrage

and

delegated

monitoring

open

addition

large

traded,

monitoring neither

non-Diamond.

size.

14,000 in

to

Stiglitr reduce

then

potentially

and

be

lead

delegated

delegated

bank

(this,

banks

and

with the

to

which

firms

of

Larger

costs

as

debt,

allows

could

traded

in

panic-

bank

change

separated,

States,

firm

is

the

notes,

between

one

separated,

stock

not

it

is:

concerning

does

bank

at

change

bank

United

to

debt,

rate

bank

are

actively

stock

fixed

from

point in

liabilities).

order only

In which

nonequity

stock. It

stock

is

activities

market

function

most

internal

bank

money-producing

additional

information-revealing

the

If

then

are

The technological

be feasibly

inside

is

The exchange

a technological

nor

a the

allows

associated

Checks

circulating

to

is

that

monitoring

loans,

the

a stronger

associated.

nontraded

which

Our conclusion

production

the

are

of circulating

be separated

markets.

such

be one which

characteristic

currency

this

would

exchange.

money.

allows

market,

in secondary

and

money

in

there

Moreover,

from

from

market.

inside

Suppose

inside

deposits

system form

0.

a shift

be eliminated.

of

clearing

is

binding.

separated

an important

older

a check,

which

be

demand

medium

product,

one

to

of

not change

demand

the

is

consider

money,

production debt

backing

no secondary

of

monetary

the

bank

have

to

up inside

a technological

a circulating

cleared

the

in

money

separate

exercise

back

of

assets

information

as

to

inside

Demand deposits use

static

improvement

with

IN THE PRODUCTION

CHANGE

MONEY

on the

interpretation

causing

AND TECHNOLOGICAL

needed

technological

21

binding.

comparative

debt

constraint

feasible

are

size. at when

costs

to

will

have

secondary

firms

will

have

markets

traded

for

their

debt,

and

inside

money-producing

assets. Q.E.D.

Casual in

the

form

Company "(1)

evidence of

Act

demand,

1956

(2) is

undertaken.

this

banks.

The

the in

1970

bank"

has

is

being

to

the

realized

Bank

Holding

be an institution right

making

only

a firm

to

a legal

of

if

already

Amendment

business

legally,

is

bank

depositor

the

a bank,

A "nonbank

scenario

a commercial

that

engages not

that

defined

deposits

and

corporation

nonbank

of

accepts

suggests

to

withdraw

commercial

one of

these

that on

loans."

two

A

activities

which

undertakes

only

forego

commercial

lending,

is

one of

the

two activities. Most this

is

opened

nonbank not

such

International.

case.

Firms

Hutton,

banks

as a device

current

regulatory

is

the

banks

Household

the

delegated

chosen

nonbank

E.F.

if

have

always

Western,

that

banks

include

which

J.C.

have

Penny,

Prudential-Bathe, Bank

for

of

constraint and

inside

to

Pen,

have

interstate

such

banks

the

separation

money

is

is

binding,

though

open

Sears,

or

have

Gulf

and

Express,

also

banking

nonbank

preventing

monitoring

Parker

Companies

circumventing

status

attempted

Shearson/American

Holding

opened

and nonbank

prohibitions.

unclear.

The

It

of

the

then

the

is

clear

activities

of

banking

system

non-Diamond.

VI. Regulatory

reform

policymakers. its based

been

work neglects also

the ignores

our

basic

to

meet

regulate

this

model

criterion should

analyses often

which between

as a focus set

forth

take

into

(for

by

failed

to

within

example

and

119671).

because determine these Meltzer

account

unhelpful

analysis

unique

often

structure

and help that

and We hope

intermediaries. 119671

the

[1967])

or

standard

issues,

fulfill

Much conventional

financial

and

and between

Meltzer

seem unrealistic

markets for

economists

has both

(Tobin

skepticism,

imperfections serve

partnership

economists

interaction can

banking

this

between

communication,

principles

other

practical

market the

the

even

cooperation

Careful

economic

or

deserves

because

difficult.

on standard

regulators

for

however,

frequently

has

CONCLUSION

calls

Too often,

promise,

groups, to

to

both

sides

"Attempts

features

to

of

the

has many

uses

industry." From

the

economic

standpoint,

the 318

model

presented

here

beyond

those

agent

problem

employed

contracting.

Likewise,

may answer

other

basic

model

adding

extensions tastes

are and

critique In both

possible.

speaking

the

to

interaction

diversify

risk.

information supports

the

in

the

place.

invoked

the

credit current The

for

existing that leads

to

presents

has

existing very

changed

if

the

regulation failures,

at

the

problems

of

are years,

also

resolve

is

already

realize

the

nature not

fully

accept

weakens

the

financial

319

to

justifications

should current

it

to

important

regulation

will

inefficiencies

of

intermediaries

and the of

of

banks

difficult

Policymakers

stress

stability

convey of

influences

prevent.

Lucas

to

allow

securities

picture:

fifty

and

markets

existence

in

and

of

nature

form

policymakers panics,

the

the

self-justifying

a biased

artificially

we

level

we wish

the

and the

may be outdated. strongly

even the

Policy

world

regulation the

markets.

We extended

problems

secondary

stocks

Conversely,

regulations

inefficiencies,

bank

the

affect and

which

regulation--other

modeled the

labor

markets

policymaker,

and

directly

public.

world

is

principal-

institutions.

or

markets

asset

discussing

avoid

planner

the

example,

questions.

and to

futures for

to for

and

economy

claim

markets

Markets

to

the

social

Stock-bond

banks

when analyzing

between

Financial

intermediaries.

because

the

of

money

can

[1985])

monitoring

and normative

Since it

Adding

applications,

system

inside

Haubrich

regulation.

other

positive

technology,

(see

paper.

the

derive

by

this have

in

should

is

that

crises our in

and

argument

system

and

place

to

APPENDIX A In

this

appendix

Scheinkman

[1985],

(I)

we assume

strategy

of

problem basic problem, for

we solve

solution.

and

is

below,

to

to

lines

are 2 0.

transform

Kahn and In solving

continuous.

problem

(I)

We then

verify

problem

to

[1985].

absolutely

transform e,

similar

and Winter

e(e)

assuming

In order

along

and Farmer

S(e)

solution

(AII)

problem

the

that

(I)

problem

[1985j,

Farmer

The

into

another

that

e,

2 0

(I),

we need the

following

(If

the

liability

lemmas:

1:

Lemna

If

constraint

ee(t)

is

higher

states.)

Proof:

Using

satisfied

the

ee(e) From

the

2 S(f),

then

at

the

fundamental

- S(e)

agent's

ee(e) lowest

- Tee

= 0.

of

- S(e)

maximization

Bee - Se - V,e,

state,

theorem

= ee(e) - -

2 S(e). then

the

Thus,

is

[ee,

at

all

+ e - Se]dx.

constraint

eP,

satisfied

calculus,

+ ,:=,

problem,

it

limited

(ii)

- Se = V,P,

of

+ rPe.

(I),

Problem Substituting,

get:

ee@)- S(e) + Size[V,e, When monitoring 0,

the

S(e)

does

not

is

always

integral t

0.

For

bind,

- yee + e]dx

Y = 0.

positive,

e where

the

forces

a constant

level

of

positive

integral

of ledx.

Then so

constraint

= ee(e)

since

te(e)

namely,

V, > 0, e(e) - S(e)

binds,

effort,

- S(e).

i.e., Q(L),

2 0 and ee >

> 0

implies

r f 0,

the

so

ee = 0,

ee(e) constraint yielding

a

Q-E-0. Lenmia 2: Proof:

If

e(e)

Imnediate, Using

the

since lemmas,

MAX: S(e)Ae) subject

2 Q(L),

then

e(e)

2 Q(L).

ee 2 0. problem

Je[ee(e)

(I) - S(e)

can

be written

- v(e(e))lh(e)de

to:

320

-

as:

WI)

j-,

(i) (ii)

S(e)h(e)de

e(e)

(iii)

? C

2 Q(L)

w(r) - -

z S(e)

ee = C,

(iv)

se = ee, - v,is, + Ye, .

(VI

In this and

- K(L)

(v)

problem,

are

equations

the

are

control

L,

and e(e)

associated

related,

variable,

chosen.

S(e)

ea.

But, is

state

differential

however,

however,

are

not

(v).

Consequently,

level

of

a function

of

monitoring, 8,

Constraints The

equations.

by the

variables.

and

is,

two there L,

(iv)

differential is

only

must

therefore,

one

also

be

a control

parameter. Formulated Hestenes. problem

this

Using

way,

the

(II)

Hestenes

is

the

Theorem

optimal (see

control

Takayama

problem [19741),

of

Bolza-

we solve

the

as follows.

The Hamiltonian

is:

H = [ee(e) PI and P2 are

- S(e)

costate

+ P2Sa + A[S(eh(e)

- Cl-

is:

f = H + sl[e(e) parameters b = [e,

+ PIeo

variables.

The Lagrangian

The control

- VIe[e))lh(e)

Q(L)1

+ q2[ee(e)

- s(e)].

are:

15, S, S, Ll,

where: e(e) Optimal

= e; choice

PI + P2(e The Euler-Lagrange

e(8)

= e;

and,

S(e) -

= S; S(G) -

= S.

of C, implies:

(AlI

- V, + Y) = 0. equations

are: 321

dP1 de=

-h(e

- Ve) + P V e 2 ee 9

dP2 de = h(l-a) Totally

(A3)

(Al)

and

substitute

(A2)

and

(A3)

into

the

total

to get:

-0 =

hy(x-1)

- P2 - v,

ha

The transversality

conditions

-Pi(e)

.

are

(A4)

(see

q(l-QL)WeW

= I,

Takayama

+ I,

119741.

p.

660):

qph(e)de

(A5)

PI(B)

= 0

W)

f’2(9)

= I, q$Wde

(A7)

P2(9

= 0

w

lKL Integrate

lP2eeuL

= 1,

Euler-Lagrange P2(e)

which,

.

differentiate

differential

WI

= P2(e)

evaluated 0 = I,

Therefore,

- qlh[e)de . equation

to get:

+ (1-x)H(e)

at 5, using q2h(e)de

(A3)

WI

the

+ (l-A)

WO) transversality

conditions,

yields:

.

we have: (x - 1) = le

Define

1, z

written

as:

(x

-

1)/x.

q2h(e)de (All)

z Q > 0 . implies

322

(All) I, E IO,

11.

Now

(All)

can

be

P*(e) $ xh(e)=-’ r(e)

Substitute

(A12)

(Al21

into

(A4)

16 - J, (q&

-

to get:

Yll

implicitly defines (AI3) condition of Proposition given

as Proposition

fact,

was

ea > 0.

subject

the

optimal-effort

2 in

the

solved

We now

has ea L 0. M?

(AI3)

e’ function

text.

e(a)

Transversality

and

condition

is

the

(A9)

is

3.

(AII)

Problem assuming

= v

Incentive

ee(m)

- S(m)

using

the

lemmas.

to

verify

that

need

compatibility

The the

lemmas

were

solution

requires

derived

(AII),

to

in

that:

- V[e(m)l

to: e(m)

Q(L)

::

occurs

at m = e for

to

market.

the

(AI4) all

8, where

The first-order

m is

the

message

condition

for

which

(A14)

the

manager

conveys

requires:

eee - Se - Veee + yeg = 0 . By totally order

differentiating

conditions

(A15)

for

(A14),

incentive-compatible. Kuhn-Tucker e(e)

> Q(L),

e(e)

= Q(L)

Proof

of

then

and

it

To see

condition

on the

(Al51 comparing

follows

that

this

monitoring

that

ee

2 0

holds

for

our

constraint,

y = 0 and ee > 0 follows

Proposition

subject

to

constraint.

H,

if

r'(e)

with

the

the

contract

is

recall

the

solution,

y(e(e)

from

the

6:

To

additional So,

prove

- Q(L)]

> 0.

If

constraint the

the

Hamiltonian,

as above.

The only

that

Lagrangian

is

the

6 we solve

Proposition

L > L,

row

second-

If

= 0.

y f 0,

then

same

difference

as is

323

i.e.,

(AII),

above,

a binding

Glass-

is:

f = H + ql[e@)-Q(L)] + q2[~e($-Wj)] where

result

and e, = 0.

Steagal

Theorem

the

+ q31L-il above.

in the

Now apply transversality

Hestenes' condition

(A9)

which

is now:

aKL = j-, [P2SerL - q1 - q31h(e)de. In order = 0.

And,

for

the by the

assumption

the

Therefore,

q3(e)

above

solution,

Hestenes

Theorem,

Glass-Steagal > 0,

Ue,

(A13),

to

be achieved,

q3(R)IL-i]

= 0, at

constraint and

the

solution

is

we must an optimum.

binding, to

have

Proposition

i.e.,

q3(e) But,

L

>

2 cannot

achieved. Q-E-0.

324

by i. be

APPENDIX B In

this

above

where

same

status.

appendix bank

The

recognizable But,

this

bankruptcy,

particular,

we

than

L

is

of

the

bank

debt,

of

Section

claimants

can

be

the

claimants

III of

the

supported

equity,

consider

a hierarchy on

1

=

the

the

firms,

L

if

e* 5 e 5 e

Me)

if

_9 5 e < e*

amount

that

suffers Let

pays

honor

bank

least

off

its

cannot

repay

a capital

loss.

S(e)

denote

Hence,

debt

the

can

above

payoff

and

by

options.

implications

and argue

that

debt

the

of the

bank

has

following

S(e),

since

if

repay

these

e*

less

securities

realized higher

is

lowest

the

e*,

the

value

consequently, and

earn

and

states

than

and,

holders only

as the

for

where

par,

securities

T(e)

be

a positive are

the total

return

junior

if

claimants.

is:

e* < e 5 ?i

ife
.

can now be financed structure

in

the

bank

model

of

the

the

main

realized

bankruptcy at

par,

by some combination

and marketable

introduces

debt

explicitly

securities

between However,

the

is,

par,

at

principal

as long

states

security

(i.e.,

That

at

debt

to

- L

L.

realized

bank

repay

=

difference

claimants.

debt

of these

nonmarketable

present

to

securities,

structure

The project i.e.,

commitment

For

0

debt,

debt

bank

payment

T(e) S(e)

to

equal

the

be repaid,

payoff

promises

this

at

The credit-market bank

firm

L = e*e(e*).

output

output.

is

firm

such

the

can

output

the

the

bank

to

text

explicitly

claimant

The firm

e*

state

not

main

of

not

claimant.

senior

interest). value

the

the

problem are

structure:

where

the

in

in

appendix

L(e)

of

securities

equilibrium

senior

the

payoff

social-planning

so we impose

be the As

up the

and credit-market

securities,

in

will

we set

debt

new element text.

output for

the

i.e.,

or

of bonds.

bankruptcy.

of

bank The

which

was

management

receives

to

outside

payments

is defined

realizations 325

of

The firm and

firm

stocks

the

to

be the

the

state

inability less

than

e*.

The

default

agent-manager

on the

bank

only

The introduction manager main

faces text

because

the

marginal

in

what

bankruptcy,

on

the

bankruptcy

sense.

definition

of

technique.

more (e(e)).

of

the

when

link to

markets,

main

he does

not

In all

share

if is

of

output

is

much greater, The definition

be chosen. of

the

states

limited-liability

everything

value

agent-

text. large

then,

would

the

in

binding

takes

face

So the

the

bank

agent-manager

This

reports,

calls

debt

can

(L)

affect

and when

so

that

=

1

eQ(L,) L

is

endogeneity

now directly is

and choice

the

a monitoring have

when in

this

better

bankruptcy

order

then

to

use

requires

us

bankruptcy as

on the

follows.

be a constant,

of

i,

states,

For the

Let

across

all

monitoring

the

bank

and so on.

monitoring

level

and

disutility

bank

example,

carpet,

agent-manager the

of

bankruptcy directly

requires

Assume

determines

more

that effort

i

is in

Then:

L

L(e)

of

on the

choice

states.

managers,

and bankruptcy.

way.

management

make

to

claimant But

not

as

likely

determine

senior

in bankruptcy

this

the

viewed

is

technique.

be achieved

if,

in

does

on

be

should

be the

imposition

can

costs

monitor, debt

must

technology

bankruptcy

should

the

bank

agent-manager

the

enough

occurs as

debt

the

of

imposes

as a monitoring

can occur

bankruptcy

definition

the

bank

the

disutility

both

the distorted

the

bank

on the

bank,

process

creates

are

to

monitoring

bankruptcy

between

states.

principal

in is

The distortion,

bankruptcy

the

monitoring

monitoring

Bankruptcy

which

a disproportionately the

the

Since

optimally

bankruptcy

all

incentives

the

agent

(due

owed.

function

Therefore,

large

is

depends

than

bankruptcy The

states

that

Since

information

the

if

discussed the

received

however,

endogeneity

economic

link

(consumption)

occurs.

This

to

of

bankruptcy,

bank

expect

effort

occurs.

low

the

and one might of

problem

claimants

Now, with

than

the

changes

decision

outside

effort

payment

bankruptcy to

effort

constraint). less

of

compared

the

receives

debt.

if

e* 5 13 5 G

if

e < e < e*

defined

circumvented. interest

on the

by the Lm is

bank

debt.

variables.

326

the

bank

since

level In

e* = of

the

monitoring

above

formulation

and the and

L is these

The social

MAX: S(e) Ae)

subject

planner

now solves:

J$[ee(a)-S(e)-L-V(e(a))lh(a)de-V

@I)

to: &[S(e)+L]h(o)de

(i) (ii)

(Ve)

+ [&][E'e'

e E argmax[ee(m) subjkt

(iii)

e(e)

se(e)

this

form,

problem

problem

of

Appendix

A.

problem

satisfies

important is

of To

difference

compare Appendix multiplier Theorem, consider

here

A,

order

except on the

(BI) the

can

is

can

solved

in

the

same

transformed

using

of

Hestenes

theorem.

end point

e*

that

control

be the

the

lower

parameters

analogous is

way

as

the

lemmas,

the

The

only

variable

since

L and l,,,.

10:

solution In

(BI)

.

Proposition

that

binding.

? Q(L,)

conditions

of the

Proposition prove

2 C

- V(e(m))l

e(m)

Once

the

a function

Proof

- K(Lm)

> Qb,,,) + L(e)

In

- If,eh(o)de]

- S(m)

to:

S(e)

(iv)

it

II-J$h(a)dal

10 to

we

the

solution

to

solve

(BI)

that

here

e*

Glass-Steagal be solved

need

is

to

solve

we get we need the

lowest

constraint, as

transversality

in

Appendix

conditions

problem

when

the

lemmas

(BI)

above

Glass-Steagal

analogous

to

and

Act

is

those

in

state. Then, let q3 be the . Applying the Hestenes' L > L. To prove Proposition (10) A. for

choice

of

L

and

Lm,

respectively:

‘(QE( -ifi

)

=

jf$(l/Q(Lm)

- 1) - q2 - c131WW

LQL )+ i(e*)(--- Q(L”1,2) = .@-qlQh+ m 327

xLQL q2 + --&b(e)de m

01)

@3

Notation

is

optimized,

analogous

q3 = 0,

and

respectively. which

(Bl)

too

then,

monitoring

the

binding

banking

system

Glass-Steagal

choices

if

is (Bl)

A.

i(e*)

is

Glass-Steagal the

determine

bankruptcy

being binding, into

The constrained is costly.

* euc=&J
So,

characterize

substituting choice.

Appendix

Now,

Glass-Steagal

unconstrained

low because

of

e*.

without If

But

(82) these

be realized

"unconstrained." be the

that at

and

Then,

can

Theorem).

to

and evaluated

optimal

is

declared. (B2),

Lagrangian, binding,

choices

e* which then

the

is not

of

the

the of

choice

L and

lowest

Call

this

q3 > 0 (by

level

then

the of

monitoring,

Lm,

state sic

for

Hestenes Lm cannot Lmc,

is

Consequently,

* i =c Qk,,)

fails

over

more

states

of

the

world

because

of

the

Act. Q.E.D.

328

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