Unfortunately, the model is too simple to investigate lending at the aggregate level. However, it is possible that hidden loan losses may generate lending booms. In the model above, the supply of loans is generous, because banks must roll over the non-performing loans. Furthermore, the banks gamble for resurrection by growing rapidly and paying high interest on deposits. When the hidden loan losses finally surface, the bubble bursts: most of the financed projects proved to be worthless, banks are insolvent and the value of deposits slumps. The regulator then indemnifies deposits. This
kind of boom-bust cycle may arise even without irrational, over-optimistic investment manias (compare Kindleberger, 2000).
7. Conclusion
According to the standard banking theory, the problem of moral hazard arises between a bank and its depositors - or a deposit insurance agent - if the bank can seek a correlated risk for its loans (e.g.
Holmström & Tirole, 1997). This paper has pointed out that moral hazard may arise even when loan risks are quite diversified if the bank can hide its loan losses by rolling over the defaulted loans. The result expands the magnitude of moral hazard and may help to understand recent banking crises.
The paper has also studied how the time frame of the lending relationships affects on the magnitude of moral hazard. The model indicates that when the regulator’s auditing system is weak, moral hazard is more severe under long-term lending, since the bank can then hide its loan losses by extending the maturity of problem loans. The converse occurs, when the auditing system is strong. In that case, moral hazard is remote under long-term lending. First, banks cannot now hide their loan losses. Furthermore, when the regulator uncovers loan losses, she liquidates a bank. Since ongoing long-term loans have a minimal liquidation value, the bank liquidation yields nothing to the banker. This makes the moral hazard behaviour unprofitable.
As to the regulatory recommendations, the model has stressed the importance of the bank supervision/auditing. In a long run, the quality of the bank supervision ought to be strengthened so that banks cannot hide their true financial condition. Simultaneously, the monitoring costs of banks should be reduced so that banks are more motivated to monitor their borrowers. Unfortunately, these improvements take time. In the short run, the regulator optimally raises the equity requirement over the normal ratio, if the quality of the bank supervision is weak, bank transparency is poor or the costs of monitoring borrowers are high for banks. The composition of equity capital must be designed with extreme care so that the amount of equity provides a truthful signal of bank solvency. Interest receivables, for instance, should be omitted form equity capital. A bank’s attempt to shrink its lending and pay out equity capital should alert the regulator;
the bank may be insolvent and it may attempt to pay out as much dividends as possible prior to the surfacing of insolvency. Gambling for resurrection through rapid growth can be eliminated simply by forcing rapidly growing banks to maintain the normal equity ratio. If the regulator cannot be sure whether or not the equity ratio is sufficient, aggressive growth, together with high deposit rates,
provides a noteworthy warning that the equity requirement is too small, the bank is insolvent and gambling for resurrection.
Appendix A
Appendix A proves Proposition 1.Step 1shows that the bank neglects monitoring when E=0. Now, lShort meets (1−lShort)(1+Rm)= 1+r +c or lShort = m (1+Rm) >0 . When the realized share of loan losses is lower than lShort, with probability F(lShort)>0 (recall Assumption 2i), the banker’s earnings are positive. Thus, it is optimal to neglect monitoring.Step 2 shows that the earnings are negative when the amount of equity is big enough. Let E mark the smallest amount of equity that meets (1−L)(1+Rm)=(1+r)(1−E)+c . When E ≥E, the banker’s earnings
can be expressed as
)
which is negative (recall (2.4)).Step 3 points out how the earnings are decreasing in equity when E
Appendix B
Appendix B proves Proposition 3 using (5.5) and three steps.Step 1 indicates that the bank neglects monitoring when E=0. In that case, the banker’s expected earnings are
1 1
1) ( )
1 (
1
dl l f c r R l
h m
l
L
−
−
∫
− , (B.1)where (1−l1)Rm −r −c =0. Since l1 >L (Assumption 2), there exists a positive probability F(l1) that the bank makes a profit. Hence, (B.1) is positive. Since the bank incurs no costs, the banker’s earnings are positive without monitoring.Step 2 points out that the earnings are negative without monitoring when E=1. The banker earns Π(1) that satisfies
<
+
−
−
∫
1(1−l1)R c f(l1)dl1 (1 r) hl
L
m h (1 l1)(1 R ) f(l1)dl1 (1 r c) (1 h)(1 r c)
L
L
m − + + <− − + +
+
∫
− .(B.2)Step 3 indicates that the banker’s earnings are decreasing in equity
0 ) 1 ( )
) (
( 1
1
1 − + <
Π =
∫
r f l dl rE h d
E
d l
L
. (B.3)
In sum, the earnings are positive when E=0, negative when E=1 and decreasing inE, when 1
0<E< . There exists an incentive compatible amount of equity, 0<ELong* <1, that eliminates the non-monitoring strategy. QED
Appendix C
Appendix C proves Proposition 4: the weaker the auditing system, the bigger the incentive compatible amount of equity. Appendix B showed that d Π dE*Long <0 (recall (B.3)). Now (5.5) implies dΠ(ELong* ) dh = π1(ELong* ) >0. Putting d Π(ELong* ) dh >0 and d Π dELong* <0 together provides and a total differential
* 0
Appendix D proves proposition 5: the heavier the costs of monitoring, the larger the incentive compatible amount of equity. Recalling Rm =r+c+m and using (5.5), it is easy to get
The bank returns during period-2 (recall (6.3)) can be rewritten as
2
The term in the brackets is positive,
{ }
0.The contents of both parenthesis are positive. Since the second term of (E.1) is negative and since the returns from growth are non-negative in total, the first term of (E.1) must be positive even on the upper limit, l2,
First, recall (F.1). Then note that in (F.2) both sides are positive and diminishing in l2. The term on the R.H.S is the relative burden of period-1 loan losses. If S2 could grow without bound, the
relative burden (the R.H.S, where the numerator is finite) would decline to zero with every lˆ1. Thus, ˆ1 assumed to be finite, the relative burden of inherited loan losses does not fully vanish and
<
This appendix proves Lemma 3: when E=EShort* growth is not optimal, but when E<EShort* growth is optimal if it is rapid enough. The banker’s earnings during period-2, (G.3), can be rewritten as
brackets is positive. Next, the term is shown to be positive when E<EShort* and S2 is large enough.
To begin with, it is useful to denote bank returns as
c
From Appendix A it is known that without the burden of hidden loan losses, equity requirement
*
Given Appendix A, when E<EShort* there is ε >0 so that the banker’s earnings exceed ε
ε
Π in (G.2); the banker’s earnings from growth are positive when E<EShort* and growth is rapid enough. Furthermore, the earnings approach to infinity when S2 grows without bound.
Regarding E=EShort* ,see (G.1). The lower line is non-positive (recall (5.4)). When
Since the term in brackets is positive (Appendix E), the earnings from growth are decreasing in the volume of hidden loan losses from period-1. QED.
Appendix H
Step 1:The banker’s earnings from growth are assumed to be positive
[
ˆ (1 ) ( )]
. ( .1)On the upper limit, l2, bank returns are zero
[
(1 2)(1 ) (1 )(1 )]
(1 )2ˆ1(1 2) ˆ1 (1 ) ( 2) . ( .2)2 l R E r c R l l l R r X S c H
S − + m − − + − − + m − = − m + + + h
Inserting (H.2) into (H.1) indicates
[ ]
. ( .3)The term in parenthesis is positive.Step 2: From (H.1), it is easy to solve the optimal bank size
. second-order constraint of (H.4) (a more detailed proof is possible, but omitted for brevity). The objective is to show that the case ˆ 0
1
* 2 dl >
S
d is possible. Thus, the denominator must be negative.
Since ˆ ˆ 0
( . To study this, (H.4) is first rewritten as
,
and this is then inserted into (H.3),
Hence, Φ is negative, when the L.H.S is positive. This is true with certainty when the R.H.S is positive. On the R.H.S the first term is positive and the second term is negative. The R.H.S is positive if the second term is almost zero. This is true when E is small enough. In sum, when E is small enough, Φ is negative and thus ˆ 0.
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