Posts Tagged ‘Milton Harris’

Bank Regulation with Private-Party Risk Assessments

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday February 20, 2013 at 9:16 am
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Editor’s Note: The following post comes to us from Milton Harris, Professor of Finance at the University of Chicago; Christian Opp of the Department of Finance at the University of Pennsylvania; and Marcus Opp of the Finance Group at the University of California, Berkeley.

Triggered by the recent financial crisis, the regulation of banks has gained new traction among academics, regulators, and politicians. One of the key challenges in effective regulation is time inconsistency of regulation. While a regulator would like to commit not to bail out banks in order to set the right ex-ante incentives, this threat is generally not credible since the government does not follow through in the event of a crisis. Banks therefore have an incentive to expose themselves to risk that is partially insured by the government.

To mitigate this problem, regulators attempt to reduce the likelihood of banking crises by regulating both banks’ asset side and liability side. While there has been a recent push to focus on the liability side by mandating higher equity capital requirements, the very nature of a deposit-taking institution implies that leverage is an integral part of the business model of banks, unlike for other firms. In this paper, we therefore focus on the regulation of banks’ asset holdings. The starting point of our paper is the natural assumption that a regulator cannot directly observe the riskiness of assets, but needs to rely on an external (private) assessment of risk. Since the introduction of the Basel I framework, credit ratings have played an important role in bank regulation as “objective” measures of credit risk. This role has been confirmed in the Basel III (2011) guidelines, which still rely on credit ratings as measures of creditworthiness.

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Rating Agencies in the Face of Regulation

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday March 29, 2010 at 9:19 am
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Editor’s Note: This post comes to us from Milton Harris, Professor of Finance and Economics at the University of Chicago, Christian Opp, Ph.D. Candidate in Finance at the University of Chicago, and Marcus Opp, Assistant Professor of Finance at UC Berkeley.

In our paper, Rating Agencies in the Face of Regulation – Rating Inflation and Regulatory Arbitrage, which was recently made publicly available on SSRN, we develop a rational expectations framework to analyze how rating agencies’ incentives are altered when ratings are used for regulatory purposes such as bank capital requirements. Rating agencies have been criticized by politicians, regulators and academics as one of the major catalysts of the 2008/2009 financial crisis. One of the most prominent lines of attack, as voiced by Henry Waxman, is that rating agencies “broke the bond of trust” and fooled trustful investors with inflated ratings. However, should sophisticated financial institutions be realistically categorized as trustful and fooled investors in light of the fact that they interacted with rating agencies not only as investors but also as originators of subprime mortgage securities? Why would these institutional investors care about ratings when they knew about rating agencies’ practices?
 
…continue reading: Rating Agencies in the Face of Regulation

 
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